Companies involved in scandals often suffer damage to their reputations from media, consumer, or investor criticism For instance, notable oil spills, from Exxon’s 1989 Exxon Valdez disaster to BP’s 2010 Deepwater Horizon debacle, resulted in both hundreds of millions of dollars in direct regulatory penalties and short-term stock market losses (Länsilahti 2012), substantial longer-term losses of reputational capital, (McGuire, Holtmaat, and Prakash 2020) and punitive legislation. The reputational consequences of socially irresponsible corporate actions may also escalate in light of a recent increase in investors’ interest in environmental, social, and governance (ESG) issues.

However, little is known about whether, and how, firms systematically respond to major environmental or social violations. We address that deficiency in our recent paper. We (i) characterize the nature of firms’ efforts to repair their reputations and how those efforts relate to the type of violation; (ii) assess whether the stock market reacts to these actions; and (iii) evaluate whether these actions correlate with improvements in firms’ treatment by environmental and social regulators.

Would firms engage in significant remedial actions after a negative ESG event? Prior literature documents the actions that firms may take to regain shareholder trust after a major accounting restatement (Chakravarthy, deHaan, and Rajgopal 2014). However, environmental and social violations may arise from different factors at firms and affect different sets of stakeholders, so the findings in that study likely do not generalize to our setting. Karpoff, Lott, and Wehrly (2005) document that the stock market reaction to environmental violations appears to be driven almost entirely by direct monetary penalties rather than by any reputational losses, suggesting that firms may not have a (shareholder-driven) need to repair their reputations after an environmental violation. However, during that study’s sample period firms received significantly less investor pressure in response to their nonfinancial performance. Even less is known about how firms respond to violations of social (labor and consumer) laws associated with discrimination, wage theft, and worker or consumer safety.

To test these questions, we construct a novel, hand-collected dataset on 10,270 reputation-repair actions taken by individual firms after 468 serious violations of environmental or social laws between 2000 and 2020]. We compare treated firms after the revelation of a major violation with (i) the same firm prior to the violation coming to light and with (ii) a set of matched control firms, during the same window, that were not caught engaging in major environmental or social violations. We follow a procedure similar to that in Chakravarthy et al. (2014) to identify companies’ reputation-building actions. Specifically, from each press release we identify reputation-building strategies related to both environmental and social initiatives (e.g., empowering women or minorities; supporting the disabled; making charitable contributions; protecting the environment) as well as those focused on corporate governance and investors (e.g., replacing board members or managers or restructuring the company).

Using this approach, we first test whether the number of reputation-building actions taken by firms increases following the revelation of environmental or social violations. Our key takeaway is that after getting caught in a serious such violation, firms significantly increase their reputation-building efforts. A firm, on average, takes 13.5 percent more remedial actions after a violation than it did before the violation compared with their matched control firms during the same period, from one year before the violation to one year after the violation.

Next, we distinguish direct from indirect reputation-building actions. We define a direct action as one that matches the type of violation, (e.g., environment-oriented actions in response to an environmental violation such as an oil spill; or actions that empower women after gender discrimination). We find that direct and indirect actions increase after a firm is accused of a serious environmental or social violation. Interestingly, we also find that the post-violation increase in indirect actions is greater than the increase in direct actions. This may be driven by different stakeholders having different reputational concerns from the firm’s perspective. Consistent with this argument we find that, irrespective of violation type, firms are most likely to try to pacify investors, customers, and female employees to rebuild their reputations.

Given our finding that firms are more likely to engage in social remedial actions after major violations, our next set of tests examines potential firm-level determinants of such actions. We focus on diversity at the board and rank-and-file employee levels. Prior work (e.g., Matsa and Miller 2011) highlights the importance of diverse leadership in ensuring the fair treatment of minorities. Building on this literature, we first examine whether firms with more diverse board members – measured as the fraction of ethnic minorities – are more likely to engage in social-reputation rebuilding after a serious environmental or social issue. We find evidence that minority board members may be more concerned about restoring either the firm’s behavior, or at least the perception of its behavior, in the wake of serious misconduct. In a second set of tests, we exploit novel data on rank-and-file employee diversity within a subset of our sample to examine whether firms with more diverse workforces engage in more reputation-repair actions. We posit two reasons for such a relation: (i) firms found to be engaging in serious misconduct must genuinely improve so as to not scare off employees, or (ii) firms must at least give the perception of doing so. We find, consistent with (i) and (ii), more social reputation-repair actions in firms with a more diverse workforce. In our next set of tests, we examine whether our findings are more likely to reflect (i) or (ii).

Our approach to identifying reputation-building actions is based on corporate press releases and, as such, reflects forward-looking promises. In light of recent work on “empty ESG pledges” (Kim and Yoon 2021; Raghunandan and Rajgopal 2022a, 2022b), we examine whether remedial reputation-building actions result in sustained environmental or social performance for affected firms. We find that remedial actions by firms are associated with a reduction in the likelihood of future environmental or social violations in the two years, subsequent to the violations], relative to the effects of actions taken by control firms during the same period. Interestingly, this effect differs for social and environmental violations: The effect is concentrated in indirect actions for social violations but direct actions for environmental violations. This is consistent with the notion that firms can only improve environmental performance through direct environmental investment, but that broader pro-social and corporate culture changes – which would be coded as social actions, but not direct with respect to the underlying violation – may be a more effective way to induce pro=social corporate behavior.

Conversely, and in contrast with Chakravarthy et al. (2014), we find that the stock market does not react differently to ESG-related remedial actions in the post-violation period relative to the control firms, suggesting that any potential financial benefits to nonfinancial reputation-rebuilding efforts may be realized indirectly (or that the market does not directly reward firms for taking pro=social actions). Alternatively, the stock market anticipates remedial actions and prices these before such actions are actually announced.

We find that firms do view the reputational damage from environmental and social violations as material enough to take pro-social actions to restore stakeholders’ trust. Such actions are more likely to be socially-focused and targeted at either consumers or employees, especially in firms with higher board or employee diversity. We then show that remedial actions are associated with a better record with environmental and social regulators, although this effect is not uniform across types of reputation-rebuilding actions and violations. Finally, we find no evidence that the stock market reacts to reputation-building actions taken in the wake of an environmental or social scandal, relative to actions taken before the violation or with respect to actions taken by a control sample. Taken together, our findings shed light on the significant heterogeneity in whether and how firms react to environmental or social reputational damage.

REFERENCES

Chakravarthy, J., DeHaan, E., and Rajgopal, S. 2014. Reputation repair after a serious restatement. The Accounting Review 89(4), 1329-1363.

Karpoff, J., Lott Jr, J., and Wehrly, E. 2005. The reputational penalties for environmental violations: Empirical evidence. The Journal of Law and Economics, 48(2): 653-675.

Kim, S. and Yoon, A. 2021. Analyzing active managers’ commitment to ESG: Evidence from United Nations Principles for Responsible Investment. Management Science, forthcoming.

Länsilahti, S. 2012. Market reactions to environmental, social, and governance (ESG)-news: Evidence from European markets. Thesis, available at https://aaltodoc.aalto.fi/handle/123456789/3021.

Matsa, D. A., & Miller, A. R. 2011. Chipping away at the glass ceiling: Gender spillovers in corporate leadership. American Economic Review, 101(3), 635-39.

McGuire, W., Holtmaat, E., and Prakash, A. 2020. Risks of Offshore Drilling: Did the Deepwater Horizon Accident Impact BP’s Corporate Reputation and Stock Price? Working paper, available at http://www.wpsanet.org/papers/docs/Risks%20of%20Offshore%20Oil%20Drilling.pdf.

Raghunandan, A. and Rajgopal, S. 2022a. Do ESG funds make stakeholder-friendly investments? Review of Accounting Studies 27, 822-863.

Raghunandan, A. and Rajgopal, S. 2022b. Do socially responsible firms walk the talk? Working paper, available at https://dx.doi.org/10.2139/ssrn.3609056

McGuire, W., Holtmaat, E., and Prakash, A. 2020. Risks of Offshore Drilling: Did the Deepwater Horizon Accident Impact BP’s Corporate Reputation and Stock Price? Working paper, available at http://www.wpsanet.org/papers/docs/Risks%20of%20Offshore%20Oil%20Drilling.pdf.

This post comes to us from Wei Cai at Columbia Business School, Aneesh Raghunandan at the London School of Economics, Shivaram Rajgopal at Columbia Business School, and Wenxin Wang at Harvard Business School. It is based on their recent article, “Remedial Actions After Corporate Social Irresponsibility,” available here.