How corporate social responsibility reduces the risk of stock crashes

Ariadna Dumitrescu

The practice of corporate social responsibility (CSR) by firms can play a significant role in mitigating the risk of stock price crashes, particularly in undervalued firms. Social CSR practices that benefit stakeholders play a greater mitigating role than governance and environmental initiatives, which have negligible impact. 

These are the findings of Esade’s Ariadna Dumitrescu and Mohammed Zakriya from IESEG School of Management, whose research provides evidence for the differential impacts on stock price crash risk of CSR targeted at different stakeholder groups. 

In their article in the Journal of Corporate Finance, Dumitrescu and Zakriya explain how they used a single framework to study the relationship between CSR, stock price crash risk, and firm valuation. Using data from over 35,000 US firms between 1991 and 2015, the pair analysed stock performance with MSCI Environmental, Social, and Governance (ESG) CSR data

CSR’s risk-mitigating role is crucially determined by firm valuation

‘The association between CSR and financial performance has been widely debated in recent years’, they explain. ‘While the importance of CSR for firm valuation has been firmly established in the literature, the present study is the first to show that CSR’s risk-mitigating role is crucially determined by firm valuation. By studying stakeholder, crash risk, and firm valuation together, we investigate whether and how CSR can mitigate or contribute to future stock price crash risk, conditional on firms being undervalued’. 

Stakeholder vs shareholder  

In the long-standing ‘stakeholder vs shareholder’ debate, the economic, legal, ethical, and philanthropic responsibilities of corporations have tended to favour the interests of shareholders. However, in a 2019 statement, a consortium of over 200 major American CEOs including Jeff Bezos and Tim Cook committed to leading companies ‘for the benefit of all stakeholders – customers, employees, suppliers, communities, and shareholders’. 

Two years on, this statement continues to attract scepticism. But, say Dumitrescu and Zakriya, stakeholder engagement through CSR activities need not undermine shareholder interests if they can create long-term value for firms.  

‘We want to understand whether CSR’s risk-mitigating role is a possible important channel that offers value benefits to both firms and their investors’, they say.  

We examine whether and how stakeholders can influence managerial bad news hoarding and the resultant price crashes

‘Specifically, we study how undervalued firms benefit from CSR activities through crash risk mitigation. By focusing on stock price crash risk, we investigate managerial bad news hoarding behaviour and its ability to increase information asymmetry.  

‘In other words, we examine whether and how stakeholders can influence managerial bad news hoarding and the resultant price crashes, and how this relationship is affected by the undervaluation of firms’. 

Bad news hoarding 

The main objective, say Dumitrescu and Zakriya, is to understand the impact of individual categories of CSR performance on bad news hoarding, or selectively withholding bad news from investors.  

When a satisfactory CSR performance results in responsible financial and accounting reports (the stakeholder effect), transparent practices reduce the likelihood of bad news hoarding and the potential for stock price crashes.  

Some of the CSR categories or dimensions may incentivise managerial bad news hoarding, while others may mitigate them

However, satisfactory CSR may merely be a whitewashing mechanism to conceal managerial misdemeanour’, explain Dumitrescu and Zakriya. ‘This may be the case when managers indulge in earnings management and financial misreporting – the agency cost effect – which increases the likelihood of managers concealing bad news. Consequently, this increases the likelihood of future stock price crashes’. 

‘We expect these contrasting influences on crash risk to vary when individual categories of CSR performance are considered instead of the overall CSR performance. Some of the CSR categories or dimensions may incentivise managerial bad news hoarding, while others may mitigate them’. 

The impact of different stakeholder groups 

The ESG data has seven categories of CSR strengths and concerns: community; governance; diversity; employee relations; environment; human rights; and product. After analysing the influence of each category separately, Dumitrescu and Zakriya discovered that only the social CSR dimension influences future stock crashes

‘This is important from the investor perspective because we show that the mitigating influence of overall CSR performance on crash risk is mainly driven by social CSR activities and CSR’s locally oriented sub-categories’, they explain. 

However, analysis of the social dimension revealed that results were not homogenous: social activities aimed primarily at stakeholders (such as customers and employees) reduced the likelihood of a crash, whereas those that target the society at large (such as human rights and diversity initiatives) either increase the likelihood of a crash or have no impact. 

When managers care for the community, employees, and customers, they are more likely to perceive investor needs as well

Firms that target specific stakeholder groups and exhibit stronger employee relations, more community initiatives, and superior product performance have a significantly lower likelihood of a future stock price crash’, say Dumitrescu and Zakriya.  

‘When managers care for the community, employees, and customers, they are more likely to perceive investor needs as well; this helps them to abstain from bad news hoarding. Investors, in turn, associate positive value with the CSR activities that target these stakeholder groups’. 

‘Managers cannot hide the broad-based governance information covered by MSCI from investors, hence the governance dimension does not have an impact on crashes’, they continue. ‘Similarly, environmental initiatives are often long-term and little understood, and so have little influence in possible declines in stock returns’. 

Risk and valuation 

To identify the role that valuation plays in CSR performance and crash risk, Dumitrescu and Zakriya split their sample according to the Rhodes-Kropf misvaluation measure.  

‘Our results show that CSR’s mitigating effect on crash risk is stronger for undervalued firms’, they confirm. ‘As regards the various stakeholder categories, we find that only the community and employee relations subgroups are moderated by undervaluation of firms. 

‘Taken together, these findings support the good governance view of CSR and suggest that CSR, its social ESG dimension, and some of the stakeholder groups, are related to shareholder wealth maximisation through their mitigating effects on future price crashes’

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