And Come Out on Top...

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On March 18, 2006, The Wall Street Journal unleashed a tsunami, reporting that several U.S. firms had falsified the dates they had awarded stock options to employees. This “stock options backdating scandal” ultimately cost Apple and the other firms involved an average of 3.6 per cent of their share price.

But some firms suffered steeper losses than others. One reason why certain companies fared better might be their overall healthy reputations. But how does a reputation for social responsibility reduce the negative impact of a scandal? How should firms communicate their involvement in a scandal? It is better to disclose early or wait until the firm and shareholders have a better handle on the situation?

Jay Janney of the University of Dayton, and Steve Gove of Virginia Tech answered these questions by studying market reactions to firm disclosures of involvement in the backdating scandal. Using a sample of 108 firms, they compared predicted stock returns before the firm’s announcement to the actual returns after the announcement. The study specifically looked at firm's trading on one of the three major North American stock exchanges (NYSE, American, and NASDAQ).

Damage Control: CSR Buffers Stock Price

The study found that although firms involved in the scandal, on average, suffered significant stock price declines, CSR created a layer of protection. Firms with strong reputations for social responsibility experienced average price drops of 1.3 per cent less than other firms.

However, this buffering effect is contingent on the basis of the firm's reputation. While CSR initiatives in areas like philanthropy and community involvement afforded protection, a reputation for good governance actually worsened the negative impact (to the tune of an additional 1.3 per cent decline). This is likely because investors see this type of behaviour as hypocrisy.

Full Disclosure

“Firms with strong reputations for social responsibility experienced average price drops of 1.3 per cent less than firms without such reputations.”

The research conducted on the backdating scandal also uncovered two crucial lessons on how to best manage corporate mishaps:

Disclose voluntarily.

Waiting for a regulatory body or the media to break the news makes it look like your firm is attempting to hide. Voluntary disclosure allows you to apply your own framing, giving your company more control over investor perception of the scandal. For instance, investors can perceive disclosure as a signal of the company’s willingness to cooperate with authorities, further alleviating concerns about the depth of the problems at hand. Firms that voluntarily announced experienced declines of -2.67 per cent compared to -3.46 per cent for firms exposed by others.

But don’t disclose too early.

Delay disclosure until a few other firms reveal information about the same scandal. Over time, as more information is revealed, the firm and shareholders better understand the scope of the situation. Delaying disclosure also allows the firm to frame the announcement as a resolution announcement, suggesting management has already scoped the problem and has begun working to address it. Firms that waited to disclose saw stock price declines of less than half of those firms that disclosed early (-1.81 versus -4.41 per cent).

The CSR Safety Net

Your firm can buffer the effects of bad press by implementing a healthy CSR strategy and responding appropriately to damaging behaviour. Aptly-timed and voluntarily-disclosed scandals can have less of an impact on your stock price than being outed by the media.

To better understand investor reactions to scandal announcements and the ability of CSR to protect firms against declines in stock value, future research can investigate other scandals, different stock exchanges, and longer timeframes.

Source

Janney, J., and Gove, S. 2011. "Reputation and Corporate Social Responsibility Aberrations, Trends, and Hypocrisy: Reactions to Firm Choices in the Stock Option Backdating Scandal." Journal of Management Studies. 48.7: 1562-1585.