CLS Blue Sky Blog

Does Being Ethical Pay for Firms?

Most businesses follow an explicit or implicit code of conduct that guides their operations, their relations with the public, and their treatment of customers, employees, and other stakeholders. These rules often go beyond what is legally required, and businesses often refer to them as their code of business ethics, treating them as an important part of their social and corporate governance.

However, as the debate over ESG requirements (i.e., environment, social, and governance goals of a firm) highlights, the costs and benefits of requiring businesses to have clear social goals, or of following a code of business ethics, are not always obvious. This raises important questions of whether a firm’s code of business ethics or its ethics related decisions affect its financial performance and, if so, how to measure that effect.

In a new paper, we seek to address these questions by examining the impact of Section 406 of the Sarbanes-Oxley Act (SOX), which mandates that all publicly listed companies in the U.S. adopt a code of ethics for their senior financial officers. Section 406 is an important component of the broader Sarbanes-Oxley Act (SOX), which was enacted in 2002 following major corporate accounting scandals involving, for example, Enron and WorldCom to bolster investor trust in publicly listed companies by enhancing financial reporting and accountability standards.

Through a comprehensive, multi-year analysis, our findings reveal compelling evidence that firms that embraced this ethical mandate experienced clear financial benefits. Our study indicates that companies adopting a code of ethics for senior financial officers (which we label as CEFO firms) enjoyed higher valuations, lower risk-adjusted returns (i.e., a lower cost of raising equity capital), increased profitability, lower audit fees, and fewer shareholder disputes compared with non-CEFO firms (i.e., those that did not adopt a code of ethics for their senior financial officers). These results are especially compelling because we compare CEFO twith non-CEFO firms that are of similar size and operate in the same industry.

At the core of our research lies the notion that ethical conduct, when ingrained into corporate culture and decision-making processes, can translate into important benefits, such as improved performance and stakeholder trust. The adoption of a CEFO signals a firm’s commitment to transparency, accountability, and responsible financial reporting.

Our study is based on the collection of data about firms’ adoption of a code of ethics for senior financial officers in 2005 and 2011. Our sample consisted of firms from the Fortune 500, representing a broad range of industries. We examined each firm’s website, SEC filings, and other public sources to identify those that had developed a customized code of ethics for their senior financial officers post-SOX (CEFO firms) and those that either used a pre-existing generic code or had not adopted such a code (non-CEFO firms). This process yielded a final sample of 176 firms, allowing us to conduct a longitudinal study spanning multiple years.

A key finding of our research is that CEFO firms enjoy higher valuations. Over a three-year period following our data collection in 2005, CEFO firms exhibited a Tobin’s Q that was nearly 10 percent higher than the Tobin’s Q for non-CEFO firms. This trend persisted in subsequent years, with CEFO firms maintaining a valuation premium ranging anywhere from 3 percent to 7 percent over non-CEFO firms.

Why might CEFO firms enjoy higher valuations as compared to non-CEFO firms.? Our results indicate that the reason is that CEFO firms benefit from lower risk-adjusted returns. A basic tenant in finance is that risk and return go hand-in-hand, thus lower returns for CEFO firms suggest investors perceive them as less risky investments, thus requiring a rate of return lower than that of their non-CEFO counterparts of similar size and in the same industry. Over certain periods, this difference in risk-adjusted returns can be as large 4 percent to 5 percent. In addition, all else being equal, a CEFO firm with the same revenues or cash flows as a non-CEFO firm would have a higher valuation because these cash flows are discounted at a lower rate resulting in a higher present value.

Our study also uncovered higher profitability for CEFO firms. In the three-years after 2005, CEFO firms’ profitability was 25 percemt higher than that of their non-CEFO counterparts. While this advantage diminished slightly in later years, CEFO firms consistently maintained a profitability edge, potentially driven by lower compliance costs and greater operational efficiencies.

Our research also revealed that CEFO firms paid significantly lower audit fees than did non-CEFO firms. Over hree-year and five-year windows starting in 2005 and 2011], CEFO firms paid audit fees that were up to 16.3 cents lower per dollar of total book value of assets than such fees for non-CEFO firms. These lower audit costs again indicate how CEFO firms benefit from their clear commitment to transparency, accountability, and responsible financial reporting practices and could be yet another reason CEFO firms are perceived as low-risk, more profitabile, with higher valuations).

Furthermore, we found evidence suggesting that CEFO firms experienced fewer shareholder disputes and shareholder concerns about corporate strategy.. While the initial years showed a higher incidence of such disputes for CEFO firms, potentially due to data limitations, the trend reversed in later years. In the five-year period following 2011, CEFO firms witnessed a 57 percent reduction in shareholder disputes and a staggering 75 percent decrease in [shareholder concerns compared with non-CEFO firms.

Our findings have significant practical implications for businesses and corporate leaders. First, they challenge the notion that implementing ethical standards and codes of conduct is a financial burden. The study demonstrates that embracing ethical practices, particularly in the realm of financial reporting and decision-making, can yield clear financial rewards in the form of higher valuations, lower risk perceptions, and improved profitability.

Moreover, the research underscores the importance of fostering an ethical corporate culture, starting from the top echelons of leadership. By adopting a CEFO, companies signal their commitment to ethical conduct, which resonates with investors, stakeholders, and the broader market. This commitment can contribute to building trust, enhancing transparency, and mitigating risks associated with financial misconduct or inadequate reporting practices.

For corporate boards and executives, our study’s findings provide a compelling case for prioritizing ethical governance and integrating ethical principles into strategic decision-making. Implementing a comprehensive CEFO tailored to the risks and challenges of an organization can help shape an ethical corporate culture and align employee behavior with the company’s values.

Furthermore, our research highlights the potential benefits of effective communication and disclosure regarding ethical initiatives. By communicating their commitment to ethical practices, companies can signal their commitment to stakeholders, fostering trust and enhancing their reputation and brand value.

This post comes to us from Saurabh Ahluwalia at the University of New Mexico, Linda Ferrell and O.C. Ferrell at Auburn University’s Harbert College of Business, and Priyank Gandhi at Rutgers University. It is based on their recent article, “Does being Ethical Pay? Evidence from the Implementation of SOX Section 406,” available here.

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