Why do for-profit corporations have charitable foundations? Charitable foundations are burdensome to create, costly to administer, may be constrained by payout requirements and excise taxes, and are not necessary for corporations to make charitable donations. Yet as of 2013, 203 of the S&P 500 publicly traded companies had such foundations. That corporate foundations are so common despite their costs suggests that foundations create substantial benefits for corporations or corporate managers. Our new research demonstrates that corporate foundations are a sign of, and vehicle for, self-dealing by entrenched corporate executives.
We demonstrate that foundations play a role in self-dealing in two steps. First, we demonstrate that corporate foundations are much more prevalent in firms where the chief executive is shielded from shareholder accountability, using an index of such protections (specifically: poison pills, golden parachutes, and staggered boards, and super-majority requirements to amend the charter, amend corporate bylaws, or approve mergers). Firms that the index rates as having highly entrenched executives are 41 percent likelier to have a foundation than firms with very low entrenchment.
Of course, this correlation does not prove that foundations (or entrenched managers) lead to adverse outcomes for shareholders. We subsequently examine the role of corporate charitable foundations in shareholder payout policy by exploring how firms with and without foundations responded to the 2003 cut in taxes on dividends and long-run capital gains.
This approach gives us insight into managers’ priorities and how those priorities differ by foundation status. When taxes on corporate distributions are cut, the cost of making a shareholder distribution goes down, in the sense that each dollar the firm spends on dividends or share buybacks results in a greater fraction of a dollar the shareholder gets to keep after tax. If, after the tax cut, firms with foundations increase their distributions less than otherwise similar firms, this suggests that managers place more value on keeping money within the firm for other uses.
Sure enough, foundation firms increased payouts by about one-half as much following the tax cut as did comparable firms without foundations. While foundation firms were not more likely to end or reduce payouts than non-foundation firms, they were less likely to initiate or rapidly increase payouts after the tax cut. This large effect on payout behavior is not explained by other potential determinants of corporate distributions, such as executive shareholding, internal finance conditions, firm age, or past payout behavior.
Why might foundation firms be less eager to pay out dividends and buybacks than similar, non-foundation firms? To be clear: The magnitude of the difference in payouts by foundation status is consistent with an amount of money orders of magnitude greater than all corporate charitable giving. So where is the money going?
We look at other uses of corporate funds to see if foundation firms are more likely than non-foundation firms to pursue other uses of corporate cash that our empirical methodology might not be controlling for. We find that, while foundation firms do not have higher return on investment than non-foundation firms, they invested more in business expansion after the tax cut than non-foundation firms. They were also more likely to increase executive compensation.
Corporate foundations are a signal of executive entrenchment and a vehicle that enables executive self-dealing. The money firms don’t give to shareholders is overwhelmingly not going to soup kitchens and community hospitals. Much of it, instead, goes to empire-building and executive enrichment. The tolerance of boards and shareholders for highly entrenched, powerful executives leads to indulgence of pet projects of the C-suite that include playing philanthropist with firm funds as well as empire-building and self-enrichment. These findings both explain one of the reasons firms have charitable foundations — they lower the cost of the philanthropic activities of entrenched executives — and suggest a further value of foundations: They indicate that the executive is likely firmly entrenched.
This post comes to us from professors Nicolas Duquette at the University of Southern California and Eric Ohrn at Grinnell College. It is based on their recent article, “Corporate Charitable Foundations, Executive Entrenchment, and Shareholder Distributions,” available here.