The following comes to us from Jillian Popadak, an applied economics doctoral student in the Business Economics and Public Policy Department at Wharton, University of Pennsylvania.

Corporate governance affects firm value, capital productivity and economic growth. Given its economic importance, there has been an ongoing, nationwide movement to strengthen corporate governance over the past two decades. Yet details about the transmission mechanisms from governance to economic outcomes are not fully understood.  In “A Corporate Culture Channel: How Increased Shareholder Governance Reduces Firm Value,”  I examine whether increased governance affects firm value via its impact on intangible assets, and corporate culture in particular. I find that corporate culture is a significant transmission mechanism for the governance-value link, but in contrast to the paradigm that stronger governance is good, firm value declines 1.4% through this corporate culture channel.

The intuition for an interaction between governance and culture follows from a simple multitasking model which predicts that governance reform creates a tension within the firm around behaviors that are rewarded and unrewarded in the new system.  In particular, stronger governance affects corporate culture by encouraging managers to increase aspects of culture that are heavily rewarded by shareholders, such as results-orientation, but reduce their focus on other aspects, such as collaboration or integrity.

Using novel text-based measures of corporate culture, I study increases in governance through shareholders’ legal power to act and through activist investors engaging management.  This process produced two major findings.  First, I show that stronger governance leads to significant increases in results-orientation but at the expense of customer-orientation, integrity, and collaboration. This suggests that following an increase in governance, managers implement processes that lead employees to believe that performance and achievement are the appropriate response to unforeseen contingencies even if this involves sacrificing honesty, quality, and teamwork.

Second, I link the governance-induced changes in corporate culture to firm value. As a motivating example of the governance-value link via corporate culture, consider Sears Holdings. In 2005, hedge fund billionaire Eddie Lampert acquired a large position in the company. In the first year after the acquisition, Sears Holdings thrived and equity prices outperformed the market by 18%. Two years later, profits had declined 45% and sales retreated to pre-Lampert levels. Press commentary (see here and here) suggests the cause of Sears’ descent is Mr. Lampert’s re-orientation of Sears’ corporate culture toward results.  Many insiders claim that by focusing on tasks that can be easily quantified, Sears was skimping on tasks that cannot easily be quantified but are important to long-term value. For example, an insider notes “the model creates a warring-tribes culture… cooperation and collaboration are not there.” Another Sears employee remarked, “the result was confusing to the customer; it became disjointed.”

I show that the story of Sears is not an outlier; rather, I find the same pattern of governance, culture, and value changes occurring for the firms in my study.  In the short term, firms realize financial gains from the results-oriented corporate culture, but in the long term, the gains are reversed.  Consistent with the positive link between governance and value, stronger governance increases tangible results such as sales and profitability in the short term. But by focusing on tangible benchmarks, managers hurt the intangibles, which is not in the firm’s best long-term interests.  Governance reduces intangibles such as goodwill and customer satisfaction, which ends up reducing firm value by 1.4%.  These findings reveal that shareholders face a tradeoff between the unobservable quality of corporate culture and observable, tangible results.