Business Horizons (2008) 51, 535540

www.elsevier.com/locate/bushor

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Corporate social responsibility, corporate

governance, and financial performance:
Lessons from finance
Robert Neal, Philip L. Cochran *
Kelley School of Business, Indiana University, 801 West Michigan Street, Indianapolis, IN 46202-5151, U.S.A.

1. Just how influential is corporate

social responsibility?
What can management and, in particular, business
ethics learn from recent research in finance? One of
the problems with much of modern scholarship is
that there is often little communication between
various academic silos. The authors of this article
have reviewed a range of recent studies published in
the finance field. These studies suggest that firms
practicing good ethics and good corporate governance are rewarded by the financial markets, while
firms practicing poor ethics and poor corporate
governance are punished.
Corporate social responsibility (CSR) looks at how
firms treat their stakeholders. One key stakeholder
group that is frequently overlooked is the firms
shareholders. All too often, the corporate social
responsibility literature focuses on customers, employees, and the natural environment, but rarely on
shareholders. The focus of this article is the impact
of the firm on its shareholders as expressed through
its corporate governance practices. If a firm cant
treat its shareholders well, what hope is there for
the other stakeholders? Herein, we argue that there
are market forces at work which reinforce good CSR
* Corresponding author.
E-mail addresses: skyking@iupui.edu (R. Neal),
plcochra@iupui.edu (P.L. Cochran).

behavior. A natural starting point is to examine the

lessons from one of the most prominent bankruptcies in U.S. history.

1.1. Lessons from Enron

In addition to being the largest bankruptcy in American corporate history, Enron is also a prime example
of corporate social irresponsibility. In particular,
Enron provides one of Americas most striking examples of stakeholder neglect. From 1998 to the end
of 1999, Enron had been one of the stars of the
financial markets. It was innovative and aggressive.
It had an apparently well-structured business model
and seemed to be very profitable. Then, in the space
of a year, it all collapsed. The firm went from having
a market capitalization of over $60 billion in January
2001, to bankruptcy less than 12 months later (see
Appendix).
How could this happen? Enron was founded in
1985 from the merger of two natural gas pipeline
companies. At that time, the U.S. energy market
was changing from regulated prices and low natural
gas production to deregulated prices and dramatically expanded production. The market shifted from
long-term fixed price contracts, to transactions
based on the current spot market price. Both developments made Enrons pipelines more valuable.
The prices in the new spot markets, however,
were more volatile and many natural gas customers

0007-6813/$ see front matter # 2008 Kelley School of Business, Indiana University. All rights reserved.
doi:10.1016/j.bushor.2008.07.002

536
were conservative utilities. Enron realized that it
could position itself as an intermediary in the natural gas business. By absorbing much of the price risk,
Enron could offer its customers long-term fixed
price contracts that could help them manage the
price risk of natural gas. This business model proved
to be highly profitable; by the mid-1990s, Enron was
accruing greater profits from its operations as a risk
manager than from its pipeline operation.
At about this same time, several other changes
occurred. First, to maintain the companys growth
rate, Enron expanded into areas that were not
closely related to its area of expertise as energy
intermediaries. Enron designed and built power
plants overseas, acquired paper and pulp factories,
and purchased water utilities. While the existence
of a diversification discount has been the subject of
much research, recent findings (Mackey & Barney,
2005) have tended to support the original conclusion
that unrelated acquisitions can reduce firm value.
Second, Enrons off-balance-sheet entries
grew rapidly. Most of these entries were derivative
contracts that were structured to offset the exposures that Enron faced from offering long-term
natural gas contracts. Thus, Enron could reduce its
exposure to future price volatility by locking in both
costs and income.
At this point, it would be useful to describe the
difference between on-balance-sheet and off-balance-sheet items in U.S. financial statements. For
many years, U.S. accounting required that only tangible items be represented on the balance sheet
things such as physical plants and accounts due to be
paid soon. Since the ultimate payoff of derivative
contracts is difficult to predict, these contracts were
relegated to the off-balance-sheet entries. As the
number of off-balance-sheet entries grew, financial
transparency suffered. It became increasingly more
difficult to understand a firms economic exposure to
such entries. Fortunately, recent accounting rule
changes have improved the situation and made the
financial statements more informative.
Returning to Enron, the third development was
adoption of accounting practices that ranged from
very aggressive to clearly illegal. In one case, Enron
created an off-balance-sheet company, whose profits were double-counted for both the company and
Enron itself. When subsequent changes should have
required Enron to consolidate the balance sheets, it
violated the accounting rules and chose to keep the
company off its balance sheet. When this problem
was finally rectified, Enron was required to take a
$1.4 billion write down.
These developmentsespecially the accounting
fraudmade it possible for Enron to disguise its true
condition from investors. Arthur Andersen, the

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firms auditor, was heavily involved in consulting
activities with Enron. Many have argued that these
lucrative consulting contracts created a conflict of
interest, and led Andersen to ignore the warning
signs in Enrons financial statements. Andersen
clearly failed in its auditing role. In addition, Enrons
expansion into areas outside its expertise eventually
produced losses for the company, and fraudulent
accounting pumped up the profits of the energy
trading business. It was a bubble waiting to burst.
The lessons of Enron, however, go far beyond
fraud and bankruptcy. It has forced us to ask: How
could this happen? What were the auditors doing?
How could they have missed Enrons true activities?
What about the bankers who lent money to Enron?
Didnt they examine the financial statements carefully? What about professional investors like mutual
funds and pension funds? What about the agencies
that rated Enrons bonds? Not only do all these
parties have a vested interest in correct financial
analysis, they also have fiduciary and legal obligations to get the analysis right. The parties are
regulated by a variety of sources, including the
U.S. Securities and Exchange Commission (SEC),
the U.S. Federal Reserve Bank, the U.S. Department
of Labor, the Financial Accounting Standards Board,
and the New York Stock Exchange. In the words of
Healy and Palepu (2003, p. 4):
Despite this elaborate corporate governance and
intermediation network, Enron was able to attract large sums of capital to fund a questionable
business model, conceal its true performance
through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels. We believe that the problems of governance
and incentives that emerged at Enron can also
surface at many other firms, and may potentially
affect the entire capital market.

2. An answer? The Sarbanes-Oxley Act

of 2002
One reaction to the problems of Enron was the
Sarbanes-Oxley Act. This law was adopted in 2002
as a response to growing frustration with corporate
governance and the lack of transparency of financial
statements among U.S. firms. The concerns were
highlighted by the massive run-up and collapse of
technology company stock prices and by the largest
bankruptcies in U.S. corporate history. For example,
the NASDAQ Composite Stock Index rose 180% from
March 1998 to its peak in March 2000. Only 2 years
later, all those gains had evaporated. In 2001 and
2002, 446 publicly traded firms with assets of $628
billion went bankrupt.

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The changes from the Sarbanes-Oxley Act fall
primarily into three areas: auditing, financial reporting, and corporate governance (see Appendix).
In the auditing area, the primary change was the
creation of the Public Company Accounting Oversight Board, a regulatory organization designed to
develop and enforce auditing standards. Other
changes included strengthening the independence
and authority of firms audit committees, disclosure
of auditing fees and relationships, and limiting the
ability of auditing firms to provide both auditing and
consulting services to the same company.
Under Sarbanes-Oxley, Chief Executive Officers
and Chief Financial Officers are now required to
personally certify the accuracy of the firms financial
reports, and the SEC must review the statements
every 3 years. The Act requires increased disclosure
of off-balance-sheet items and contractual obligations, transactions between management and principle stockholders, and real-time disclosure of material
changes in operating or financial condition.
In the corporate governance area, firms must
develop and disclose corporate codes of ethics,
and assess the effectiveness of internal audit and
risk management controls. CEOs and CFOs may be
required to forfeit compensation if the firm has to
restate its financial statements, and senior management faces additional criminal and civil penalties
for defrauding shareholders.

3. Necessary changes? In the light of

finance
Were the changes introduced by Sarbanes-Oxley
really necessary? Or were they an over-reaction
to current events? Methodology used in Finance
can address these questions from the perspective
of at least one stakeholder group, namely stockholders, by looking at the stock price reaction to
adoption of the new law. If a companys stock price
declines, then either the additional disclosure is
not valued by investors or they consider it not
worth the incremental costs. In either case, the
costs of compliance reduce firm profits. If the stock
price rises, however, then the additional disclosure
is valued by investors and the increased transparency makes them more willing to purchase additional shares.
With this in mind, the authors examined recent
studies published in Finance journals to determine
what light they might be able to shine on this
question. A recent analysis by Jain and Rezaee
(2006) examined these two alternatives. In the
U.S., changes in law require a legislative process
that usually takes years. The Sarbanes-Oxley Act,

537
however, was enacted very quickly, and so represents a significant unanticipated event to the financial markets. Jain and Rezaee examined the
performance of stock indices on days when political
developments increased the likelihood that the Act
would be approved, and on days when the likelihood
fell. They found that stock prices tended to rise
when the likelihood increased, and fell when the
likelihood decreased. Thus, the stock market reacted favorably to news of the additional disclosure
and transparency requirements.
Consistent with this finding, Jain and Rezaee conducted a second test whereby they used transparency
and disclosure indices to measure the quality of a
firms corporate governance. They found that firms
with good governance had a positive price reaction to
the new disclosure and transparency requirements,
while those with poor governance had a negative
reaction. Overall, the results suggest that good corporate governance is valued in the stock market and
that investors are willing to pay more for a company
with good governance principles.
Another recent study indicated that good corporate governance is valued in the financial markets.
Gompers, Ishii, and Metrick (2003) constructed a
measure of the quality of corporate governance and
relate the firms governance to its profitability,
operating performance, and stock returns. Their
governance measures are based on the ability of
shareholders to monitor and control a firms management. Corporate policies that limit these abilities, such as poison pills to prevent hostile
takeovers, and staggered boards that make it difficult to change a firms board of directors will give a
firm a lower score in their quality index.
Gompers and colleagues study examines 1,500
U.S. companies from 1990 to 1998. For each firm,
they construct an aggregate measure of corporate
governance based on 24 variables. Their results are
quite striking. The firms that were classified as
having very poor governance underperformed the
market by 3.5% per year, while firms that were
classified as very good outperformed the market
by 5% per year. Thus, the difference between good
and bad corporate governance in the U.S. is about
8.5% per year.
These same authors find similar, but statistically
less robust, results for other performance measures.
Over the 1991 to 1999 period, firms that practiced
good governance reported higher average profit
margins, higher average sales growth, and higher
average return on equity (ROE). Overall, the inference drawn from these results is that poor governance tends to produce poor firm performance.
Likewise, good governance tends to produce good
performance.

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Yermack (2006) provides yet another perspective
on how corporate governance is valued in the equity
markets. He argues that agency problemsconflicts
of interest between the firms shareholders and the
firms managementare one of the most important
governance challenges and reflect the quality of
corporate governance. Yermack proposes a novel
way of measuring the degree of agency problems
by looking at the perks enjoyed by top management.
While perks can be used as incentives to motivate
managers, they can also reduce firm value if they
are used too intensively.
Yermacks study focuses on the personal use of
company aircraft by CEOs. In one extreme example, a
firm provided senior management with 10 aircraft
and 36 full-time pilots. The planes were frequently
used by celebrities, golf instructors, family friends,
and even pets. From 1993 to 2002, he finds that
reported aircraft use tripled, a fact he attributes
to both increased use and stronger SEC disclosure
requirements.
Yermack finds that the disclosure of personal
aircraft use is associated with about a 1% initial
decline in firm value and, over the next year, the
firm underperforms the market by about 4%. Consistent with the idea that personal aircraft use is an
indicator of agency problems and a measure of
corporate governance quality, he finds that firms
with aircraft are more likely to report large accounting write-offs. These firms are also more likely to
report earnings that are significantly below the
forecasts made by analysts.
This pattern of the market reaction to corporate
governance also shows up in other countries, as well.
For example, Giannetti and Simonov (2006) examine
how corporate governance influences investor ownership in Sweden. Using data from 2001, they construct several measures of corporate governance
based on the likelihood that management will expropriate wealth from shareholders. In their approach,
total profits from a firm can either be distributed to
shareholders on a pro-rata basis or they can be used to
disproportionately benefit corporate insiders.
Giannetti and Simonovs results show that the
governance structure influences the pattern of equity ownership. After controlling for factors like size
or dividends that are likely to affect ownership, they
find that investors who are more likely to be expropriatedsmall retail investors and foreign investorshold smaller stakes in weak governance
companies. Likewise, investors that are more likely
to receive the benefits of expropriationlarge domestic investorsare more likely to hold larger
stakes.
When the takeover process starts, the bidding
firm is willing to pay a price that is higher than the

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current market price of the target company. The
ratio of the offer price to the market price just prior
to the takeover announcement is called the takeover premium. In cases where a large percentage of
the firm was acquired, firms with poor governance
structures received a takeover premium of about 7%
more than the good governance firms. Thus, even in
Swedena country with high governance standards
and strict enforcement of securities lawsexpropriation risk significantly reduces the value of a firm.
Another illustration of governance problems
arises with the form of executive compensation.
In the U.S., it is common for high-level executives
to receive stock options as part of their overall
compensation. The idea behind issuing these options
is to align the interests of management and shareholders. According to this theory, if a significant
portion of managements wealth is the company
stock, then the agency conflicts between shareholders and management are reduced.
There is an important difference, however, between granting stock options to executives and
granting them shares of the company. While both
function to reduce agency problems, the payoff of
the stock is symmetric; the gain from a $10 increase
in the stock price is the same as the loss from a $10
decrease in price. In contrast, the payoff from a
stock option is asymmetric. Because the option
price is a convex function of the stock price, the
gain to the option from a $10 increase in the stock
price will exceed the loss from a $10 decrease.
Burns and Kedia (2006) show that firms in which
the CEOs compensation is more heavily tilted toward stock options are likely to employ aggressive
accounting standards. These authors compare a
control group of firms to firms which were required
to restate their earnings because of GAAP violations.
Burns and Kedia find a strong positive association
between the option delta and the likelihood of
earnings restatement. (Option delta is a term that
reflects the sensitivity of changes in the value of an
option to changes in the underlying stock price. All
else constant, the higher the delta, the greater the
value of an employee stock option.) In other words,
the greater the sensitivity of a CEOs stock options
to the underlying stock price, the greater the likelihood of earnings manipulation.
The discussion of governance issues might create
the impression that the U.S. governance and accounting systems are fundamentally flawed. At least
relative to the other industrialized countries, this is
clearly not the case. A global survey of comparative
accounting systems and standards by Lang (2003)
argues that the U.S. standardsdespite all their
problemsoffer investors the most protection.
Comparisons between common law-based countries

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(U.S., UK, Australia, and Canada) and code-based
countries (most of Western Europe) suggest that
common law systems provide outside investors a
more transparent picture of corporate operations.
For example, Ball, Kothari, and Robin (2000) find
that countries whose legal systems are based on
English common law tend to exhibit a stronger correlation between reported earnings and stock price
reactions. This is interpreted as a measure of the
informativeness of accounting disclosure. The logic is
that if reported earnings are subject to manipulation
by management, then investors will tend to discount
the reported earnings, and thus the correlation between earnings and stock returns will be diminished.
Among the common law countries, Ball and colleagues find that U.S. firms exhibit the strongest
correlation, suggesting U.S. standards are the most
informative.
A similar conclusion is reached by Leuz, Nanda,
and Wysocki (2003). These authors provide a comparison of earnings management across 31 countries. Their logic is that when companies smooth
earnings over time, they provide a distorted picture
of the companys financial condition. In particular,
bad times are hidden from investors by borrowing
from future or past earnings. Leuz et al. examine
several measures of earnings management and find
that U.S. firms tend to have the lowest levels of
earnings management, and thus the most informative earnings statements. This, of course, does not
mean that U.S. firms dont manage their earnings; it
only means that U.S. firms have a lower degree of
managed earnings than firms in other countries.
Another type of comparison is provided in studies
that examine firms which choose to cross list their
stock. Firms that list on a stock exchange are required to meet the disclosure requirement of the
exchange and the country; cross listing typically
occurs when emerging market firms seek listing on
more developed markets.
In a comparison of firms that choose to cross list in
the U.S., Miller (1999) finds that companies benefit
from cross listing. On average, the value of the firm
rises several percent from the dual listing. The
inference is that the greater disclosure required
by the U.S. markets offers investors more transparency and confidence in the reported financial statements. Cross listing thus offers firms the ability to
certify that their reports meet the high standards of
good corporate governance, and thereby increase
their attractiveness to investors.
Additional evidence comes from cross-sectional
tests. There are several different ways firms can cross
list in the U.S., and these different ways have different disclosure requirements. Miller finds a positive
relation between the stock price reaction and the

539
degree of disclosure: firms that meet the stricter
standards tend to exhibit the largest price increase.
There are similar lessons in emerging markets. The
scope of the empirical studies is, however, much
more limited. One interesting study examines the
impact of corporate governance among emerging
market firms during the Asian Crisis of 1997-98.
Mitton (2002) examines 398 firms across six different
countries. He focuses on the potential expropriation
of minority shareholders and argues that the crisis
period increased the stress on companies, and made
expropriation somewhat more likely. Accordingly,
investors would avoid firms with poor governance
and greater expropriation likelihood. The performance of these firms should be worse than the average firm.
Mitton measures the quality of governance in two
simple ways. First, he examines whether the firm has
cross listed its stock in the U.S. in the form of an
American Depository Receipt (ADR). As we discussed
earlier, this imposes stricter disclosure standards and
makes the firm more transparent to outside investors. The second measure is the auditor used by the
firm. Mitton separates the companies into two categories: those which use major accounting firms,
such as Ernst and Young, and companies which use
other accounting firms.
His results provide strong evidence that governance and the transparency of financial statements
are valued in emerging markets. After controlling for
country- and industry-specific factors, firms that
have ADRs produced returns that were 10.8% higher
than other emerging market firms from July 1997 to
August 1998. In addition, if the companys auditor
was one of the major accounting firms, then the
returns to the company were higher by an additional
8.1%. Mitton also reports that highly diversified exhibit returns are lower by 7.6%. This is attributed to
the likelihood that the strong subsidiaries will have
their resources inefficiently diverted to support the
weak subsidiaries.
For a long time, it was difficult for non-domestic
investors to participate in many emerging markets.
This was frustrating for non-domestic investors because they were denied portfolio diversification and
the ability to pursue favorable investment opportunities. The process of making equity markets
accessible to non-domestic investors created an
additional incentive for good corporate governance.
To attract external capital, they needed to satisfy
the requirements of international investors.
Evidence proffered by Bekaert, Harvey, and
Lundblad (2005) suggests that corporate governance
policies may also have macro-economic effects. Via
examination of 95 countries, these authors find that
opening up the equity markets is associated with an

540
annual increase in GDP of about 1% over a 5 year
period. In addition, for countries with a strong legal
and institutional framework, the annual increase
was about 2.2%. Overall, this suggests that progress
toward meeting the disclosure requirements for the
global financial markets can have a strong positive
impact on a countrys economic growth.
A study by Klapper and Love (2004) considers
whether high quality domestic institutions and enforcement of securities laws can substitute for corporate governance. These authors use a measure of
corporate disclosure from Credit Lyonnais that covers 25 different countries during 1999. Since their
data only covers 1 year, the comparisons are across
firms and across countries.
Klapper and Love find several interesting results.
Firms in countries with a higher degree of investor
protection exhibit a higher return on assets. This
suggests that the legal environment is an important
contributor to corporate governance and the profitability of corporate operations. In addition, within
countries, they find that firms with higher quality
corporate governance have higher rates of profitability. This is consistent with the findings of
Gompers, Ishii, and Metrick (2003) for the U.S.
The most interesting result occurs for firms with
good governance which are located in countries with
poor shareholder protection institutions. For these
firms, the positive impact of corporate governance
on profitability is much stronger. These firms realize
that it is in their self-interest to meet the governance requirements of the global financial markets,
even if these actions are not required in their home
country. Taking these additional steps will likely
increase the value of the company, and increase
the interest from outside investors.

4. Final thoughts
In summary, there is compelling empirical evidence
that corporate governance matters. Not only do the
markets pay attention to corporate governance, but
they reward good governance and punish poor governance, which in turn is integral to Corporate
Social Responsibility.

EXECUTIVE DIGEST

Appendix
Our discussion of Enron is adapted from Healy and
Palepu (2003). Please see their article for a complete analysis. Our discussion of Sarbanes-Oxley
changes is based on Appendix A in Jain and Rezaee
(2006). Please see their article for additional detail.

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