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Excess insider control and corporate social responsibility: Evidence from dual-class firms

https://doi.org/10.1016/j.jaccpubpol.2021.106877Get rights and content

Highlights

  • Excess insider control in dual-class firms and CSR ratings are negatively associated.

  • CSR ratings of dual-class firms are lower except when financial resources are ample.

  • Insiders at dual-class firms may reduce CSR for self-serving reasons.

Abstract

We investigate the corporate social responsibility (CSR) performance of firms with a dual-class share structure. Dual-class firms, which represent a fast-growing segment of the U.S. capital market, violate the "one share, one vote" principle by giving corporate insiders control in excess of their economic interest in the firm. We observe a negative association of excess insider control and firms’ CSR performance, primarily with respect to the community- and employee-related dimensions of CSR. Extended analyses reveal that this negative association is mitigated by high financial resource availability. Consistent with a trade-off between corporate spending on CSR or on benefits for insiders, we also observe a negative association between CSR performance and executive pay in dual-class firms. Taken together, these extended analyses are consistent with self-interested behavior of entrenched insiders who, unless resources are abundant, appear to reduce CSR activities to maintain resources available for their personal benefit. While the exposure to risks engendered by a dual-class equity structure may be reflected in the share price, our findings draw attention to an externality: diminished CSR performance affects not just shareholders, but all stakeholders.

Introduction

We examine whether and how excess control of corporate insiders is associated with firms’ corporate social responsibility (CSR) performance. These questions are timely as CSR increasingly receives attention from investors, customers, supply-chain partners, regulators, and other stakeholders. For instance, the number of S&P 500 index companies providing corporate responsibility or sustainability reports has increased from 20 percent in 2011 to over 90 percent in 2019 (G&A Institute, 2020). At the same time, dual-class equity structures, which enable excess insider control through classes of shares with differential voting rights, are also increasingly prominent in the U.S. capital market.1 How dual-class firms perform with respect to their CSR is therefore an important question located at the intersection of two significant trends.

Dual class share structures typically encompass one class of shares with superior voting rights that is held by corporate insiders and a second class of shares with inferior voting rights that is publicly traded. In the most common arrangement, superior shares carry ten times the voting power of regular shares and hence provide insiders with control rights considerably in excess of their economic interest in the firm. Dual-class structures therefore present a hybrid structure that combines the characteristics of a public firm, i.e., access to the equity market, with those of a private firm, i.e., close control by specific individuals. Compared to single-class firms, which are governed by the "oneshare, one vote" principle, the effectiveness of shareholder democracy in dual-class firms is diminished. For example, in 2018, 94 percent of Snap, Inc.’s voting power resided with Evan Spiegel and Robert Murphy even though the two co-founders only owned about 19 percent of the firm’s equity. As a result, the company’s 2018 annual shareholder meeting lasted less than three minutes and there were no proposals or questions from shareholders (Wolverton, 2018). Similarly, at Facebook’s May 2019 shareholder meeting, 68 percent of outside shareholders voted to separate the roles of chairman of the board and CEO, and to remove Mark Zuckerberg from the role of chairman. However, the voting rights of insiders, including Mr. Zuckerberg, who only own about 18 percent of Facebook’s shares, but command a combined 70 percent of the vote, allowed an effortless defeat of this shareholder proposal (Kozlowska, 2019).

Excess insider control and the extent of firms’ CSR activities are connected through the type and magnitude of the agency problem prevalent in the firm. While insider ownership serves to mitigate the classic (Type I) agency conflict between owners and managers, high levels of insider ownership can give rise to a Type II agency conflict between inside and outside owners (Villalonga and Amit, 2006). Due, in part, to Type II agency conflicts, in which the interests of controlling inside and minority outside shareholders diverge, the two groups’ preferences with respect to a firm’s CSR may differ distinctly.

Outside owners generally focus on maximizing shareholder returns and therefore should desire CSR activities to the extent that they contribute to shareholder value. Relative to this threshold, however, firms characterized by excess insider control may engage in higher levels of CSR activities because entrenched insiders, who are protected from outside influences, can more easily resist capital market demands to prioritize short-term shareholder returns over long-term CSR activities that would benefit other stakeholders. For instance, myopic external pressure may dictate that firms pay market wages as opposed to higher living wages to employees. In essence, sheltered from contravening outside pressures, insiders with excess control may find it easier to “do the right thing.”

Research indicates that entrenched insiders may also prefer higher levels of CSR engagement because insiders with excess control are prone to self-interested behavior (Masulis et al., 2009). These insiders may therefore increase CSR activities to manage their reputation and image (e.g., Bebbington et al., 2008, Petrenko et al., 2016), to benefit from halo effects (Barnea and Rubin, 2010, Chernev and Blair, 2015), and/or to legitimize their entrenchment through collaboration with outside stakeholders (Surroca and Tribó, 2008). The concern of self-interested behavior is particularly salient because excess control enables insiders to significantly influence the extent of their firm’s CSR engagement yet avoid the proportionate personal cost of such activities (Jensen and Meckling, 1976).

On the other hand, self-interest may also prompt insiders to alternatively engage in lower levels of CSR activities. Specifically, insiders, entrenched by virtue of their excess control, may decrease CSR behavior because they are positioned to withstand pressure from shareholders as well as other stakeholders, such as non-profit organizations, advocacy groups, suppliers, customers, and employees who, ceteris paribus, would prefer higher levels of CSR activity (Kock et al., 2012). Prior work finds evidence consistent with entrenched insiders indeed reducing CSR spending to increase resources of the firm available for their personal benefit (Oh et al., 2017, Seaborn et al., 2020).

Using a hand-collected sample of U.S. dual-class firms and data from CSRHub, our primary analyses investigate whether and how excess insider control is associated with CSR performance. To this end, we analyze the relationship between excess insider control and overall CSR as well as the distinct CSR dimensions of communities, employees, and the environment (Brammer and Pavelin, 2006, Fabrizi et al., 2014). In both univariate and multivariate analyses, we find that excess insider control is associated with decreased overall CSR ratings. The community and employee dimensions of CSR display the strongest negative association with excess insider control. Contrary to Seaborn et al. (2020), we however fail to find a robust negative relationship between excess insider control and environmental CSR performance.2

To investigate the role of self-interested behavior as a driving force behind the negative association that we find, we next explore the impact of financial resource availability, as well as the association between CSR performance and executive compensation, in dual-class firms. Prior work establishes that resource availability plays an important role in firms’ CSR behavior (e.g., Chin et al., 2013, Sun and Gunia, 2018). We find that high levels of financial resource availability, alternatively defined as the top decile or quartile of firms with respect to their cash and cash equivalents, operating cash flow, and free cash flow, mitigate the negative association between excess insider control and CSR performance. In fact, the CSR performance of dual-class firms with the highest level of financial resources is no worse than that of firms without excess insider control. With respect to the association between CSR performance and executive compensation, we find that CSR performance and executive pay are negatively associated. In dual class firms, lowered CSR performance is associated with enhanced executive compensation.

Taken together, the findings of these two additional analyses are consistent with, and lend credence to, the possible self-interested behavior explanation suggested by Oh et al., 2017, Seaborn et al., 2020. Specifically, unless resources are plentiful, firms characterized by excess insider control reduce their CSR activities more than firms without excess insider control, enabling the diversion of CSR spending, at least in part, toward more self-serving objectives as evidenced by enhanced levels of executive pay.3

Finally, because “caution is…needed when interpreting findings based on the data supplied by one CSR rating provider” (Bouton et al., 2017, p. 33), in extended analysis we also use the MSCI ESG STATS (formerly KLD) database as an alternate data source of CSR activity. We obtain consistent results. Moreover, we observe that excess insider control negatively affects CSR strengths (which are reflective of proactive, generous, and future-oriented CSR activities), but not CSR concerns (which are reflective of current CSR deficiencies related to output and performance).

Our findings contribute to the literature in multiple ways. We put forward the first study to comprehensively investigate the CSR performance of U.S. dual-class firms. While the number of dual-class firms has significantly increased in the U.S. capital market in recent years, studies on dual-class firms continue to be limited or predate the recent wave of such firms. Our results reveal yet another consequence of the consolidation of voting control in the hands of insiders: decreased CSR performance. The negative association we find is consistent with other evidence that isolation from the demands of capital markets and other stakeholders enables firms to engage in less socially responsible behavior (Oh et al., 2017, Seaborn et al., 2020).

Dual-class share structures are controversial, yet whether dual-class voting structures should be limited is debatable. Arguably, as long as the voting structure of a firm is properly disclosed, any increase in agency problems stemming from the dual-class share structure should be reflected in the share price. If the holders of the inferior voting shares know what they are buying, and the price reflects all firm-specific risk, it is not obvious that regulatory action is needed to protect shareholder rights. The decreased CSR performance of dual-class firms we observe, however, represents an externality. The cost of lagging CSR performance is not borne by shareholders alone. Our findings hence represent an important additional consideration in the ongoing debate regarding the need to curtail dual-class equity structures: for instance, by requiring sunset provisions to limit their duration (Bebchuk and Kastiel, 2018, Jackson, 2018).

The remainder of our paper is structured as follows: Section 2 develops theory and hypotheses; Section 3 details our sample and models; Section 4 presents primary results while Section 5 provides additional analyses; Section 6 discusses implications and concludes.

Section snippets

Insider ownership and agency theory

The effect of insider ownership on the extent of agency problems in the firm is unclear. Insider ownership certainly alleviates the classic Type I agency conflict between shareholders and managers through incentive-alignment. However, inside shareholders with a controlling interest can also use their dominant position to run the firm for their private benefit at the cost of minority shareholders, a Type II agency conflict (Villalonga and Amit, 2006). Consistent with these countervailing forces,

Sample selection

Following Baran and Forst (2015), we construct a sample of non-financial U.S. dual-class firms in the 2009 to 2016 period from several sources. First, we include all firms reported as dual-class firms in the Gompers et al. (2010) sample, which spans from 1995 to 2002 and identify potential additional dual-class firms based on differences in the number of shares outstanding as reported in the Center for Research in Security Prices (CRSP) and Compustat databases. Further dual-class candidate

Descriptive statistics and univariate analysis

Table 1 provides descriptive statistics for the matched sample. Mean CSR ratings for the dual-class sample range from 52.143 for communities, to 52.954 for employees; the mean overall score is 52.549 for dual-class observations. The mean value of WEDGE for dual-class firms is 2.745, indicating that insiders’ voting rights are on average 2.745 times their cash flow rights. Dual-class firms’ mean ROA is 2.9 percent. Dual-class firms have a mean log of total assets of 7.572, equating to a

Moderating role of financial resource abundance

Companies, including those characterized by excess insider control, may reduce CSR activities for numerous reasons. While we find consistent evidence that firms characterized by excess insider control have lower CSR performance compared to firms without excess insider control, empirically pinpointing the exact reason for this observation is difficult. To examine the plausibility of a self-serving behavior explanation suggested by agency theory, the dominant theory relied upon in previous

Conclusion

Equity structures that enable insiders to exert voting control in excess of their economic interest are growing in prominence. As a consequence, the fundamental tenet of shareholder democracy, the "one share, one vote" rule, which ensures that control of the firm is proportionate to the economic interest in it, appears to be losing ground. We comprehensively examine a further consequence of diminished shareholder democracy that has not garnered much attention to date: whether and how excess

Declaration of Competing Interest

The authors declare that they have no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.

Acknowledgements

We express gratitude to the associate editor and two anonymous reviewers for their astute comments. We also thank participants at the 2018 American Accounting Association (AAA) Southwest Region meeting, where the paper was awarded the McGraw-Hill Education Distinguished Paper Award, as well as participants at the 2017 AAA Annual and Ohio region meetings. We are especially grateful to Andrea Romi for her feedback on earlier drafts as well as Lois Mahoney, Jing Zheng, workshop participants at

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