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Reputational Penalties in Financial Markets: An Ethical Mechanism?

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Part of the book series: Issues in Business Ethics ((IBET,volume 31))

Abstract

Responsible investment (RI) and responsible corporate behaviour received a lot of attention during the last decade in the corporate social responsibility (CSR) literature (McWilliams and Siegel 2001, 2006). After the U.S. and European financial markets were being troubled in the early 2000s by several major scandals like Enron, Worldcom, Tyco and Parmalat, financial ethics received a lot of attention by the public as well. Irresponsible corporate behaviour can occur in different ways such as corruption, market abuse, fraud, insider trading, ecological harm, racial or sexual discrimination. Examples include foreign briberies to get supply contracts (Volkswagen), insider trading ahead of a profit warning (EADS), lower salaries for female employees (Wal-Mart), and worker’s conditions in Indonesia (Nike).

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Notes

  1. 1.

    The chapter by Sandberg in this volume suggests that the investment decisions taken by RI investors have no impact on stock prices. We show here that the presence of RI investors is unnecessary to induce corporations to behave responsible on a number of issues, provided that there are primary stakeholders of the corporations who sanction the corporate misbehavior by altering their interactions with that corporation, for example withholding discretionary effort (employees), renegotiating payment periods (suppliers), or changing brand (customers). Hence, resonating with the critique of Eccles in his chapter in this book, if issues are material they will be sanctionned by the market. If they are not material, they can be of concern to RI.

  2. 2.

    Before the negative news about the irresponsible behavior reaches the market, the stock price is at its equilibrium level Pbefore in Figure 5.2. After the news release the stock price drops to a new equilibrium level Pafter. In an efficient market this stock price adjustment is permanent, since prices will only adjust if new information reaches the market. Measured as abnormal returns, this implies a significant negative return on the announcement date and zero abnormal returns on all other trading days. If the stock market penalization on the announcement date would only be temporarily, one would have to observe a post-announcement abnormal return drift in the opposite direction (while no new information arrives to the market). In the conventional post-event windows of about 10–20 trading days after the announcement date, most studies do not show such trend. More background information on the efficient market hypothesis and the dissemination of information on financial markets can be found in Engelen (2005) and Engelen and Kabir (2006).

  3. 3.

    The downward revision of the stock price is the result of supply and demand on the stock market. Translated in financial economics terminology, the revision reflects either lower expected future cash flows or a higher required cost of equity (discount rate). Although it would be interesting to see what type of investors set the new market price at the margin (e.g. SRI investors or regular investors), no empirical study shows the identity of the marginal investors around the announcement of corporate misconduct.

  4. 4.

    Legal penalties can include fines, damage payments, compliance costs or cleanup costs (depending on the type of misconduct).

  5. 5.

    We discuss these results in more detail in section 5.4.

  6. 6.

    A market value of 10 billion dollars can be considered as a mid-cap company, and would be too small to be included in the Top 500 of world wide companies.

  7. 7.

    Figures at the end of 2008.

  8. 8.

    The difference in price reaction between U.S. and Japanese car producers is not statistically significant.

  9. 9.

    The market structure of the software market and the dominance of Microsoft obviously distort the results as well. Microsoft was involved in 54 of the 92 cases in their sample.

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Engelen, PJ., van Essen, M. (2012). Reputational Penalties in Financial Markets: An Ethical Mechanism?. In: Vandekerckhove, W., Leys, J., Alm, K., Scholtens, B., Signori, S., Schäfer, H. (eds) Responsible Investment in Times of Turmoil. Issues in Business Ethics, vol 31. Springer, Dordrecht. https://doi.org/10.1007/978-90-481-9319-6_4

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