ESG

I got interested in the Environmental, Social and Governance movement (ESG) because of India's unique experiment in this area. In 2013, a new law required Indian ﬁrms to spend at least 2% of their net income on corporate social responsibility (CSR). A close reading of the law suggests that spending that improves employee welfare such as creches or daycare do not qualify. Hence, the rule basically imposes a quasi tax. In one of our papers, we show that stock prices of Indian firms affected by the law fell by around 4%.

When we probe deeper, we realized that firms that were voluntarily spending more than 2% before the new rule came in, cut their spending to only 2%! On top of that, the erstwhile, non-spenders have not all ramped up spending to 2%. A large portion of the funds are given to family run foundations and it is not obvious how the funds were actually spent. Most of the CSR reports are glossies full of pictures of the "good" done by the firm. The reports are not comparable across companies. It is hard to assess what, if any, is the social ROI of this spending? And, the problem is multi-dimensional and unbounded in that firms find more and more novel metrics to disclose (number of batteries recycled, computers re-purposed, children vaccinated, girls educated and so on).

Such skepticism led me to consider the data in the U.S. I have written a series of op-eds on this topic including pointing out the limitations of commercial scores provided by ESG rating agencies, whether the signatories to the Business Round Table were indeed upstanding corporate citizens and ideas on how to simplify the disclosure overload problem by making firms identify one or two evils they need to get rid of and propose a simple model that lays out the cash outflows associated with such an endeavor. The debate also led to an academic paper questioning whether the BRT and ESG oriented mutual funds and ETFs walk the talk in terms of environmental, social and governance dimensions. As a follow up, I ask whether the U.S. is rushing to adopt European corporatism without a full appreciation of the economic and social trade-offs that system entails. A detailed look at European corporatism suggests that continental European firms suffer large valuation discounts and roughly similar E&S records relative to their American counterparts.

Measuring E, S and G are important but challenging tasks. The following page summarizes my work on G. "E" is somewhat easier because we have data on scope 1 emissions, although there are questions about the reliability of those numbers. "S" is more complicated. What is the right mix of "S" for every company? A firm may have gender balance but does not invest in training. And that might the right combination for that firm. Along these lines, we have tried to measure the corporate culture of a firm. The big point we make is that if the aspirational values of a firm don't gel with how these values are lived out in day to day practice, the firm experiences poor outcomes in terms of innovation, productivity and compliance.

G in particular - Managerial myopia

In a lead article published in Journal of Accounting and Economics (JAE) (2005) my co-authors and I find that a majority of 400 odd CFOs we surveyed would avoid initiating a positive NPV project if it meant falling short of the current quarter’s consensus earnings. Similarly, more than 3/4th of the surveyed executives would give up economic value in exchange for smooth earnings. Managers believe that missing an earnings target or reporting volatile earnings reduces the predictability of earnings, which in turn reduces stock price because investors and analysts dislike uncertainty. The paper has been extensively covered in the popular press and has garnered several awards and notable mentions.

Projects related to short-termism inspired by the ideas in the paper include:

(i) Should professional firms such as law firms/audit firms be publicly listed on a stock exchange? In the first of the two papers, we find that Moody’s credit ratings, when bench-marked to S&P’s, for the same underlying set of corporate bonds and mortgage backed securities, were systematically laxer after it went public in 2000. In the second paper, we show that Moody’s ratings on bonds issued by important investee firms of its two stable large shareholders, Berkshire Hathaway and Davis Selected, are more favorable relative to S&P's ratings.

(ii) Only shorts seem to have responded to signals about the build-up of risk reflected in banks’ financial statements before the financial crisis. Analysts, auditors and rating agencies were relatively unresponsive.

(iii) What is good governance? An analysis of the reporting, compensation, governance and valuation principles espoused by Warren Buffett, the patron saint of patient capital, suggests that his stated principles are often not reflected in the practices of his investee firms.

(iv) Why do firms give up earnings guidance? When we asked CFOs why some firms were giving up earnings guidance, they mentioned that such firms were merely poor performers who were “cloaking themselves in virtue.” We document that this is indeed the case with archival data.

(v) How does the stock market interpret small EPS beats? In this paper, we show that the stock market appears to view firms meeting and beating the analyst consensus EPS estimate by a cent with more suspicion after the Enron scandal than before.

G in particular - Exec Compensation & Boards

I am the faculty director of the Corporate Governance Program at Columbia Business School. The program is informed by years of academic work on executive compensation and boards of directors.

There are two prevailing views on the growth of executive compensation to senior executives. The efficient contracting view suggests that, on average, compensation is well structured to encourage managers to pursue value maximizing policies whereas the rent extraction view argues that pay arrangements encourage excessive risk taking and value destroying behavior. After decades of research, I have found support for both these views. My current position is that "it depends." Specific firms do have dysfunctional plans. Others have better ones. Which is which depends on the question and the context.

Efficient contracting view:

In one of my earlier papers, we show that the convexity of an executives' option packages is systematically correlated with greater operational risk suggested that pay plans work as intended.
In another paper, we show that a dollar of options given to the top five executives of a firm is associated with $3.82 in future operating income over the next five years.
A number of governance activists question why CEO pay rises with an increase in the broad market. In a Journal of Finance (JF) paper, we show that variation in the CEO’s human capital accounts for the link between CEO compensation and the broad market index.
CEOs hire talent agents to negotiate compensation and other terms on their behalf from company’s boards. We find that the observed “abnormal” compensation to these CEOs represents a premium for CEO talent.
The firm's location explains a significant portion of its option grants to rank and file employees.

Rent extraction view:

Firms that misreport financials seem to grant more options to rank and file employees when they fudge their books presumably to co-opt workers into the misrepresentation.
Cost of capital adjusted equity or option compensation suggests that a non-trivial segment of CEOs are overpaid.
Certain firms accelerate the vesting of employee stock options to avoid mandatory expensing of options before SFAS 123-R comes into effect.
We observe a spike in CEO bonuses when a firm is prosecuted confirming concerns expressed by judges, prosecutors, lawmakers, and academics that corporate prosecutions do not sufficiently impact high-level decision-makers like CEOs.