Stanford Research Shows How Corporations Can Regain Financial Value After a Scandal

Released: 1/15/2014 2:00 PM EST
Source Newsroom: Stanford Graduate School of Business
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Newswise — Few companies took a bigger hit to their reputation in recent years than JPMorgan Chase. Among many other blows, it agreed to pay $20 billion this past fall to settle federal investigations and investor lawsuits about misrepresenting the quality of mortgages it sold during the housing bubble.

Small wonder that JPMorgan seemed bent on building goodwill not just with shareholders but also with the public at large.

In October and November alone, the bank pledged $1 million to help typhoon victims in the Philippines; $1.4 million to nonprofits that offer savings tools to underserved communities; $6.3 million for nonprofits that help “struggling Americans access safe, affordable housing”; and $250 million in donated “corporate-owned” homes to community organizations around the country. The bank also led a campaign to hire more veterans and offered help to U.S. federal workers caught in the government shutdown.

Do shareholders care if a tarnished company tries to rebuild its reputation by helping disaster victims, veterans, or underserved communities?

Surprisingly, the answer may be yes. A new study, coauthored by Ed deHaan of Stanford Graduate School of Business, suggests that rebuilding “reputation capital” goes well beyond relations with investors and creditors — and shareholders know it.

DeHaan, who collaborated with Shivaram Rajgopal and Jivas Chakravarthy of Emory University, cautions that the study did not include JPMorgan Chase or make any comment about its philanthropic activities.

But the study, which examined fence-mending efforts of public corporations, breaks new ground on the financial importance of shoring up a company’s reputation with “softer” constituencies such as customers, employees, and local communities. That’s true even when the reputation damage stems specifically from financial misreporting to investors and creditors.

In the study, deHaan and his colleagues examined more than 10,000 press releases at companies that restated their accounting reports after having intentionally misrepresented their numbers.

Previous research already showed that an accounting scandal typically takes a reputation-related toll equal to about 27 percent of a company’s pre-scandal share price.

DeHaan and his colleagues decided to study how companies tried to bounce back, and how shareholders responded. What they found was that companies reached out not just to shareholders but also to other constituencies, and that those nonfinancial efforts helped share prices.

Why? Because shareholders aren’t the only people who may head for the exits at a company caught in financial dishonesty. At a company that makes durable equipment, such as cars or construction gear, customers may worry about the company’s willingness to make good on warranties or commitments to provide service and spare parts. At companies with specialized workforces, such as biotech firms, employees may be the ones to run away. At companies with a high-profile presence in many locations, local community leaders may pull their support due to concerns about integrity.

The researchers describe “reputation capital” as a genuine, if intangible, financial asset that is embedded in a company’s market value. It essentially reflects the improvement in cash flow and lowered cost of capital that a company enjoys when its various stakeholders trust it to uphold its commitments.

DeHaan and his colleagues focused on some 94 companies that announced serious accounting restatements as a result of intentional misreporting from 1997 through July 2006. As you might expect, the companies sharply increased the number of their reputation-bolstering actions aimed at investors and lenders. These included announcements to replace senior executives, revamp corporate governance, improve internal controls, and change incentive programs.

Moreover, 51 percent of the reputation-repair efforts were aimed at softer constituencies. Of 898 announcements in the year after restatements, 216 were aimed at local communities, 189 were aimed at customers, and 54 were aimed at the firms’ employees.

On average, shareholders responded favorably to all of it. After separating out the effect of other market movements, the researchers estimate that announcements of reputation-repair actions lifted share prices, on average, 2 percent. Also, investors tended to react more strongly to earnings announcements of firms that took the most reputation-enhancing actions, an indication that shareholders were ready to believe what the companies were saying. These effects were observed for both actions aimed at investors and actions aimed at nonfinancial stakeholders.

DeHaan thinks this makes sense. Shareholders and lenders are likely the first people to be shaken by evidence of financial dishonesty, but other stakeholders also take note. “When customers, employees, and community leaders see a company misleading its financing partners, they become worried that the firm might rip them off too,” he says. A company that only repairs ties to investors runs the risk of ignoring that broader fallout, and shareholders know that can be just as dangerous to its outlook.

View the complete research paper: “Reputation Repair After a Serious Restatement.”

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