Standing out from the Crowd via Corporate Goodness: Evidence from a Natural Experiment

Juan (Julie) Wu is Assistant Professor of Finance at the University of Nebraska at Lincoln College of Business Administration. This post is based on a recent paper by Professor Wu; Lei Gao, Assistant Professor of Finance at Iowa State University College of Business; and Jie (Jack) He, Associate Professor at the University of Georgia Terry College of Business.

The past few decades have witnessed increasing awareness of corporate social responsibility (CSR) activities. These corporate goodness activities, where firms commit to giving simultaneous attention to the legitimate interests of all stakeholders, include (but are not exclusive to) employee relations, corporate philanthropy, and environment initiatives. Increases in corporate CSR engagement have generated ever-growing attention from academics of various disciplines, regulators, professional investors, and various other stakeholders. However, despite the continuous academic effort to better understand why firms engage in CSR, we still lack strong evidence on the motives of corporate goodness due to the endogeneity problem, a well-known methodological issue faced by most empirical studies. Our paper overcomes this challenge by using a natural experiment setting and sheds new light on why firms undertake CSR activities.

Although previous literature has proposed a few potential reasons for a firm’s engagement in CSR, such as incentives to streamline business activities and attract quality workforce (e.g., Bénabou and Tirole [2010]), managerial private benefits (e.g., Jensen and Meckling [1976]), and signaling incentives (e.g., Fombrun and Shanley [1990], McWilliams et al. [2006]), it is difficult to empirically establish and distinguish among these motives. This is mainly due to the lack of randomized experiments that can offer a clean identification strategy to test these theories. Our study employs a unique empirical setting (i.e., a regulatory shock that affects a firm’s signaling motive) to test a firm’s incentive to stand out from the crowd via corporate goodness.

Specifically, we examine a firm’s changes in CSR in response to Regulation SHO, which exogenously loosens short sales constraints on a randomly selected group of firms (pilot firms) by suspending the uptick rule. Since the uptick rule significantly constrains short sales (e.g. Alexander and Peterson [1999]), the lifting of it has the potential to increase regulatory uncertainty and affect firm behaviors because firm managers are quite concerned about how short sales in their stocks are executed (Lamont [2012]).

Given that the relaxation of short sale constraints by Regulation SHO exposes pilot firms to greater short selling pressure ( e.g., Diether et al. [2009]) and larger downside risk (e.g., De Angelis et al. [2015]), managers of pilot firms have stronger incentives to signal their true firm quality in an attempt to convince the market (and other important stakeholders) that the increases in short selling and the associated negative price pressure induced by SHO are not driven by worsening fundamentals. In addition, pilot managers’ fear for uninformed bear raiders who can worsen the adverse feedback effect on real decisions (Goldstein and Guembel [2008], Goldstein et al. [2013]) gives managers extra incentives to signal. Since corporate goodness can potentially serve as a signaling device to help a firm stand out from the crowd, we expect pilot firms to engage in CSR to a greater degree than control firms with similar characteristics around Regulation SHO.

We apply a difference-in-differences (DiD) approach to the natural experiment of Regulation SHO. This regulatory program, which changes the costs of short selling only for pilot firms but not for non-pilot firms, offers a nice experimental setting to test CSR as a signaling device. The change in the trading environment provides an exogenous shock to the signaling motive of corporate goodness, as the pilot program was not initiated to affect a firm’s CSR in any way. Consistent with the signaling motive for corporate goodness, our analysis reveals that pilot firms exhibit a greater increase in CSR than control firms surrounding Regulation SHO.

To further support the signaling explanation for our findings, we conduct cross-sectional analyses on firms’ signaling abilities and signaling incentives (Spence [1973]). We find that the positive effect of short selling pressure on CSR is stronger for firms with better signaling abilities (proxied by fewer financial constraints, higher profitability, larger cash flows, higher Tobin’s Q, and larger stock price run-ups over the past 12 months). The positive effect of Regulation SHO on CSR is also stronger for firms facing more non-fundamental-driven (i.e. hedging-related) short selling, a more opaque or uncertain information environment (e.g., with lower analyst coverage or greater analyst disagreement), and greater product-market competition because the marginal benefit of signaling is higher under such circumstances.

We also rule out an alternative explanation for our findings, namely, the disciplinary effect of short sellers on pilot firm management who may have potentially under-invested in CSR due to managerial shirking, i.e., their preference for a “quiet life” (Bertrand and Mullainathan [2003]). If this alternative explanation is true and short selling is a substitute for other corporate governance mechanisms as previous studies show (e.g., Fang et al. [2015]), the positive effect of Regulation SHO on CSR would be stronger in firms with more severe agency problems (i.e., weaker corporate governance) because the marginal disciplining effect of short selling should be stronger for such firms. However, contrary to the alternative explanation based on disciplining, our DiD results are stronger for firms with better corporate governance and fewer agency conflicts.

Overall, our paper provides fresh and causal evidence that CSR is a device actively used by firms to signal their quality.

The full paper is available for download here.

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