Corporate Philanthropy as Signaling and Co-optation

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Sunday May 27, 2012 at 9:53 am
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Editor’s Note: The following post comes to us from Roy Shapira, fellow of the Program on Corporate Governance.

In a paper recently published in Fordham Law Review, Corporate Philanthropy as Signaling and Co-optation, I examine a previously unnoticed mechanism through which corporate philanthropy (CP) can enhance company value: signaling.

Current value-enhancing accounts rest on the premise that CP “buys goodwill” for the company: companies, by acting nicely, can increase consumers’ or employees’ willingness to pay. But the necessary conditions underlying this theory are simply too unrealistic. For one, consumers have to be aware of companies’ CP policies and be willing to pay to delegate their philanthropy (that is, pay for someone else’s charitable preferences). We should focus less on charitable preferences and warm-glow concepts, and more on the potential of pro-social sacrifices to convey messages about a firm’s fundamentals. Explicit sacrifices of profits can serve as costly signals. They reliably convey messages about attributes that are important to shareholders, consumers, and employees – who are evaluating whether to invest in, buy products from, or work for those companies (that is, important even to those stakeholders who are strictly profit-minded).

To illustrate, the paper elaborates on the option of CP as a costly signal to investors. An increase in the level of donations could convey messages about financial strength to potential investors, who could infer that future free cash flows are perceived by insiders to be relatively high, that the company is now less financially constrained, or that the riskiness of future cash flows has decreased. Pro-sociality could also bridge asymmetric information between insiders and non-financial stakeholders, such as employees and consumers, by conveying messages about the styles and characteristics of top management and the extent to which they are subject to short-termism.

But corporate philanthropy is not unequivocally good for the company. This is where the paper’s second, more modest contribution comes in: examining the conditions under which corporate philanthropy decreases firm value. Traditionally, the “negative” accounts treat CP as a managerial perk, an agency cost. But even if we accept the premise that CP decisions are driven by managerial utility, it is unclear whether they are detrimental to shareholder value or merely a value-neutral diversion (i.e., a substitute for other managerial perks within a fixed level of appropriation). The interesting question, then, is whether giving managers wide discretion over pro-social expenditures affects the level of overall appropriation. The paper endeavors to show that insiders have both the will and the means to strategically select the levels and targets of corporate charity in order to covertly bypass mechanisms that are supposed to cap managerial agency costs. Donations to directors’ pet charities can co-opt board independence. Donations to certain educational charities can influence politicians and policies, resulting in a sub-optimal level of shareholder protection. Spending on certain environmental or social agendas can help managers create coalitions with activist groups, thereby entrenching themselves and sub-optimally reducing CEO turnover.

The paper next sketches the legal implications. The theoretical arguments presented on how philanthropy can be good (signaling) or bad (co-optation) for the company strengthen the case for introducing some form of mandatory disclosure. Stressing the importance of potential informational benefits focuses our attention on how the current regulatory vacuum leads to an uninformative “cheap talk” environment. Regulating some standardized, comparable, subject-to-liability form of disclosure could be good for the market by increasing awareness and mitigating asymmetric information. This form of disclosure could also be good for the non-profit sector by allowing companies to focus on real impact, rather than marketing. At the same time, exploiting the potential to use undisclosed CP to co-opt governance mechanisms stresses the importance of not leaving CP in the dark. Leaving agency problems totally unregulated in the CP context could create negative spillovers in other contexts. In this respect, legal intervention should focus not only on the levels of pro-sociality, but also on its targets. I then tie the discussion to the related, timely topic of corporate political donations laws.

The full paper is available for download here.

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    Pingback by Corporate Philanthropy as Signaling and Co-optation — The Harvard Law School Forum on Corporate Governance | Accounting and Small Business /Beverly Shares — May 29, 2012 @ 6:46 pm

 

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