Agency Problems of Corporate Philanthropy

The following post comes to us from Ronald Masulis, Professor of Finance at the Australian School of Business, and Syed Reza of the Finance Area at Queensland University of Technology.

While corporate charitable contributions are frequent and often substantial, there is no clear evidence in the literature on whether these expenditures have positive effects on firm revenues or performance or on shareholder wealth. In our paper, Agency Problems of Corporate Philanthropy, which was recently accepted at the Review of Financial Studies, we use contributions of American Fortune 500 firms during 1997-2006 and find in a variety of tests that corporate donations advance CEO interests and suggest that misuses of corporate resources that reduce firm value.

First, we find little support for the conventional idea that corporate giving is profit-enhancing. Instead, in a natural experiment using the 2003 Tax Reform Act, we uncover substantial evidence supporting agency theory. More specifically, we find that CEO charity connections—a measure of the CEO’s personal preference for charity—increase the likelihood and the amount of corporate giving, whereas an increase in CEO ownership reduces the likelihood and the amount of giving.

Second, our results show that corporate giving has a substantial negative impact on firm value through its impact on cash: the estimated marginal value of cash is 8.1 cents lower if a firm raises its corporate giving from the sample median to the 75th percentile level. For firms with non-independent boards where board oversight is expected to be weaker, the negative impact of corporate giving on firm value more than doubles. We also find that a US$1 million reduction in corporate giving after the 2003 tax-cut year is associated with an increase of at least US$6.4 million in dividends.

Third, we find that approximately two out of three firms contribute to CEO-affiliated charities. Moreover, the average cost to a company from such contributions is larger than the combined costs of CEO corporate jet use and other perks and is comparable to a CEO’s promised cash severance payment. Furthermore, CEO-affiliated charitable contribution levels decline if the CEO’s financial interests are more aligned with the interests of shareholders. We also examine the share price reaction of the first disclosure by a corporation of “charity awards” and find a three-day CAR of -0.87%, suggesting that shareholders perceive corporate donations that are related to company officers and directors negatively.

Fourth, we examine whether charitable causes supported by corporate giving overlap with independent directors’ charitable interests and then evaluate the effect of this alignment on CEO compensation. We find a 69% overlap with the interests of independent directors, indicating that a strategic use of corporate giving is to support independent directors’ charity interests and thereby strengthen their ties to a CEO. We also find that this particular alignment of charitable interest is positively associated with excess CEO compensation.

The overall evidence in our study raises serious concerns about the decision process surrounding corporate charitable contributions. One implication of this study is that securities regulators should consider requirements to promptly disclose insider-affiliated corporate giving, given that it can adversely affect minority shareholders.

The full paper is available for download here.

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