Is There a Local Culture of Corruption in the U.S.?

Culture often helps explain the behavior of individuals and firms. The general finding in the law and economics literature is that certain societal norms, such as attitudes toward corruption, persist even when individuals relocate to a very different legal and social milieu (e.g., Fernandez, 2011). Studies show that individuals with cultural ties to more corrupt countries exhibit a greater propensity to engage in unethical behavior in the U.S., such as illegal parking by U.N. diplomats (Fisman and Miguel, 2007), corporate tax evasion (DeBacker, Heim, and Tran, 2015), and accounting fraud (Liu, 2016).

In our study of public corporations (Dass, Nanda, and Xiao, 2017), we build on the prior literature and examine whether there is a local, cultural component behind the predisposition of some U.S. public corporations to engage in corrupt behavior. We argue that corrupt behavior of corporations could be reflective of the culture in which they are located and may be part of the local social mores and norms. These environments could prompt managers to  maximize firm profits by, for instance, offering bribes to win government contracts. In this case, corrupt behavior could be generating value for shareholders. In other instances, self-serving corporate managers could act to the detriment of their shareholders, thus reflecting greater agency problems.

To test whether firms’ policies are influenced by a culture of corruption, the challenge is to separate the effects attributable to the local culture rather than various other local economic and institutional factors. For instance, firm policies could be affected by unobserved factors that also affect the level of public corruption and the policies of firms located in a state. Further, even if firms are not inherently corrupt, they may choose policies, such as limited information disclosure, in response to the threat of expropriation from corrupt officials. Hence, in line with the existing literature on the effects of corruption, we fashion a test in which corrupt activities occur strictly outside the local area and outside the direct influence of states and local authorities.

We document the effects of local corruption using the passage of the Foreign Corrupt Practices Act (FCPA) in 1977. The FCPA was enacted to curb the corrupt practices of U.S. firms in foreign countries. We test whether the FCPA’s effect varied with the level of corruption in a particular firm’s home state. If corruption is part of the local  culture from which a firm arises, we expect it to also influence managers’ actions in a foreign country, even when these actions are outside the purview of local public officials. Thus, to the extent that the FCPA curtailed U.S. firms’ ability to bribe abroad (which would then adversely affect firms’ cash flows), the enactment passage of the FCPA should have a more adverse impact on firms from more corrupt states.

For our measure of local corruption, we use state-level figures from the Department of Justice’s (DoJ’s) data on corruption-related convictions of public officials. This measure of corruption has been used in the recent literature to study income equality (Glaeser and Saks, 2006) and the cost of borrowing for local governments (Butler, Fauver, and Mortal, 2009), among other things. Using data on publicly-listed firms, we estimate a difference-in-differences (“diff-in-diff”) model to test for the effects of the FCPA on firm value (measured by Tobin’s Q) over a seven-year window around the law’s enactment in 1977. We find that the FCPA lowers the value of a firm headquartered in a relatively corrupt state. For example, our estimates indicate that, in three years following enactment of the FCPA, firms in more corrupt states saw an 8.5 percent greater drop in their value relative to other firms. Results are similar when we use alternative survey-based measures of state-level corruption.

We conduct additional tests to ensure that the decline in firm value is driven by the FCPA and not other events. First, we perform a (placebo) test to ensure that our results are not driven by trends in firm value or performance prior to FCPA enactment. Second, we show that these value effects are also evident in the short term after enactment of the FCPA. The cumulative abnormal return (CAR) over a seven-day window around the enactment of the FCPA is significantly more negative for firms located in corrupt states. Third, since the FCPA curbs firms’ ability to bribe foreign officials, we contend that firms that are in more export-oriented industries should experience a greater decline in firm value. Supportive of our prediction, we find that the negative effects of FCPA enactment on firm value are greater among firms that are headquartered in more corrupt states and operate in more export-oriented industries, and the effects are even greater if the export-destination countries are more corrupt.

The loss in firm value following enactment of the FCPA suggests that foreign corrupt practices of firms appear to have benefited their shareholders. In other contexts, however, a culture of corruption may correspond to greater agency problems and self-dealing among firm managers, which may hurt shareholder value. Our findings support this agency-based argument as well: We show that exogenous variation in corporate governance due to the passage of anti-takeover laws more strongly affects firms located in corrupt states. Specifically, we follow the literature (e.g., Bertrand and Mullainathan, 2003; Giroud and Mueller, 2011) to examine the effect of business combination laws (BC) on the operating performance of firms in corrupt states using the diff-in-diff approach. The results reveal that firms in corrupt states are more adversely affected by the enactment of BC laws. For example, firms located in states with an above-median level of corruption experienced an 8 percent greater drop in return on assets after the adoption of BC laws in their state of incorporation, compared with other firms incorporated in the same state but physically located in states with lower corruption.

Further, we show that other indicators of agency problems may also be more severe in states with higher public corruption. First, we find that firms located in corrupt states are more likely to engage in earnings management through discretionary accruals. Second, among larger and older firms, the ones located in more corrupt states are more likely to be subject to a securities class action. These results suggest that the local culture of corruption is manifested in managers’ opportunistic behavior in financial reporting, which results in misleading statements and increased litigation risk. Overall, our evidence shows that the local culture of corruption is also associated with greater agency problems and self-dealing among firm managers, which is detrimental to shareholder value.

This post comes to us from Professor Nishant Dass at the Georgia Institute of Technology’s Scheller College of Business, Professor Vikram Nanda at the University of Texas at Dallas’ Naveen Jindal School of Management, and Professor Steven Chong Xiao at the University of Texas at Dallas’ Naveen Jindal School of Management. It is based on their recent paper, “Is There a Local Culture of Corruption in The U.S.?” available here.