A Resource Guide from Ethical Systems
Is good ethics really good for business? Crime and sleazy behavior sometimes pay off handsomely. People wouldn’t do such things if they didn’t think they were more profitable than the alternatives.
But lets make two distinctions right up front. First, let’s contrast individual employees with companies. Of course it can benefit individual employees to lie, cheat, and steal when they can get away with it. But these benefits usually come at the expense of the firm and its shareholders, so leaders and managers should work very hard to design ethical systems that will discourage such self-serving behavior (known as the “principal-agent problem”).
The harder question is whether ethical violations committed by the firm or for the firm’s benefit are profitable. Cheating customers, avoiding taxes, circumventing costly regulations, and undermining competitors can all directly increase shareholder value. And here we must make the second distinction: short-term vs. long-term. Of course bad ethics can be extremely profitable in the short run. Business is a complex web of relationships, and it’s easy to increase revenues or decrease costs by exploiting some of those relationships. But what happens in the long run?
As Thomas Teal wrote in Fortune Magazine,
Any idiot with a strong enough stomach can make quick money, sometimes a lot of it, by slashing costs and milking customers, employees, or a company’s reputation. But clearly that’s not the way to make a lot of money for a long time. The way to do that is to create so much value that your customers wouldn’t dream of looking for another supplier. Indeed, the idea is to build a value creation system of superior products, service, teamwork, productivity, and cooperation with the buyer.
Teal’s words are inspiring, but are they true? On this page we review the existing evidence which suggests it pays to be ethical in the long-run.
The value of ethics differs by nation and industry. If you are working in a highly corrupt country that lacks good laws and institutions, and that lacks a free press that can disseminate information about unethical companies, then the research described below may not apply. We focus our review only on companies based in the United States, doing business primarily in the United States and other OECD nations that have reasonably good rule of law and a free press. We list here research studies that have investigated whether, when, and why good ethics pays off for such companies, relative to their less scrupulous competitors.
We also note a distinction between doing business ethically (which is the focus of Ethical Systems) and Corporate Social Responsibility, which is a set of policies and practices firms adopt to advance community involvement and interaction.
Areas of Research
Ideas to Apply
To Learn More
AREAS OF RESEARCH
A good and accessible review of the research literature is found in Linda Treviño and Katherine Nelson’s book “Managing Business Ethics,” summarized on our Books page. Treviño & Nelson examine the evidence on three major pathways by which good ethics may be good business. We quote their review extensively, adding hyperlinks so that you can read their sources. We also add additional studies after each section.
1) A Good Reputation is Valuable
Treviño & Nelson‘s review:
“Does reputation really matter? According to Business Week, “business has a huge stake in the way the rest of society perceives its ethical standards” (2/15/88, not available online). On the negative side, scandals give business “a black eye” and cost money. For example, Exxon faced years of negative media scrutiny after the Exxon Valdez oil spill. [On the positive side] a favorable corporate reputation “may enable firms to charge premium prices, attract better applicants, enhance their access to capital markets, and attract investors.”
In general, research has supported the idea that having a good reputation pays off in lower costs, higher sales, and the ability to charge higher prices than firms with poor reputations can. Studies have also found that workers are more attracted to firms with a reputation for social responsibility. In a Stanford University study of 800 MBA graduates from 11 leading European and North American business schools, 94 percent of the students said they would be willing to forgo financial benefits to work for an organization with a better reputation for ethics and corporate social responsibility. Once employed, people are also more committed to organizations that have a “benevolent climate”—one that focuses on the welfare of employees and the community, while organizational commitment is lower in “egoistic” climates (based on self-interest and people being out for themselves).”
2) Illegal Conduct can be Extremely Costly
Treviño & Nelson‘s review:
“The conventional wisdom says that firms don’t suffer enough for illegal behavior. Butone academic study examined the penalties imposed on nearly 600 firms for financial misrepresentation over more than two decades. Beyond the monetary penalties, which averaged $23.5 million, the researchers found a much larger reputational penalty imposed by the market that was felt only after the legal penalty was revealed. Firms lost 41 percent of market value on news of the misconduct, and most of that decrease can be attributed to lost reputation.
“Interestingly, punishment comes from business partners as well. When illegal or unethical conduct is revealed via the media, firms lose legitimacy with business partners such that, after the illegal conduct is revealed, their executives are more likely to serve on the boards of firms with lower reputations and profitability than before, and the company’s own board members are more likely to come from firms with lower reputations and profitability.
More serious illegal or unethical conduct is associated with even stronger effects. Sofirms that engage in illegal or unethical conduct find that high-quality network connections are severed as those associated with more profitable and reputable firms distance themselves. …Research has also found that failure to be socially responsible is costly. One study synthesized the results of 27 studies that covered over 2,000 incidents of socially irresponsible or illegal behavior. Across these studies, stock prices decreased significantly in response to socially irresponsible or illegal acts, thereby decreasing shareholder wealth. These results suggest that there are definitely costs to being socially irresponsible.”
Additional studies (or essays) showing that law abiding behavior is, in the long run, profitable:
- Banks that adapt to new global rules will be best able to reduce risk and prosper, says a study from Boston Consulting Group. “Winning banks will be those that adopt a strategic approach allowing them to categorize, prioritize, and execute against old, new, and evolving regulations and an uncertain future.”
Additional studies that have FAILED to find that illegal behavior is, on net, costly. (Of course, there are many specific instances of companies that behaved unethically and escaped prosecution–as often happened in the 2008 global financial crisis. We are looking for published studies that looked in a systematic way across companies).
- [None found yet. Email email@example.com if you know of any]
3) Good governance pays off financially
Treviño & Nelson’s review:
“Finally, research has demonstrated that companies with good corporate governance structures and policies …have higher profitability, sales growth, and market values as well as higher stock prices than do companies without such structures and policies. Gavin Anderson at Governance Metrics International (a firm that evaluates corporate governance practices) suggests that, before investing in a company, wary investors should search for a pattern of previous litigation and regulatory problems (available through the Securities and Exchange Commission and other public data sources). Such a pattern suggests that the firm has a culture that tolerates unethical and illegal behavior and should be avoided.”
Additional resources that have found that good and ethical governance pays:
- Business Standard (2015) Both research as well as corporate practice from around the world has demonstrated quite the opposite-that being ethical and socially responsible actually enhances share prices and profitability in the longer term.
- The Telegraph (2015) Good corporate governance can improve a company’s bottom line: B Corp certification and its results on one British company. To receive approval, a company has to pass a very strict and exhaustive assessment which measures its impact on the communities where it operates; its relationship with employees; its impact on the environment, and the governance by which the company is run. And then you have to go much further changing the legal constitution (The Memorandum And Articles Of Association) of the business to state that the legal obligation of the directors is to run the business for all the stakeholders mentioned above, rather than just for maximising financial return for the shareholders.
- Popadak (2013) examined what happens when firms make governance reforms that shift them toward prioritizing shareholders more strongly. She found that these changes caused an immediate shift toward a “results orientation,” in which managers try to maximize the few variables that are being measured (such as sales). This led to a boost in financial performance in the first year. But this new emphasis on “getting results” damaged many of the firms more intangible resources, such as good will from customers and employees. Popadak found declines in customer focus, integrity, and collaboration among employees. These declines got more severe, year after year, and by year 3, on average, these costs outweighed the benefits of being more results-focused. The governance reforms had backfired, and were now making financial performance worse overall.
- Guiso, Sapienza and Zingales (2013) studied, in a paper entitled The Value of Corporate Culture, a dataset from the Great Places to Work Institute (GPTWI), as well as public data from S&P 500 listed firms, to address which dimensions of corporate culture are related to a firm’s financial performance. They found that simply stating or advertising one’s corporate values had no detectable impact on financial performance. To study this effect, they collected statements of core values from the websites of S&P 500 firms, a majority of which included statements relating to a company’s integrity. After aggregating and classifying this information, they found that (with one exception, which related to customer satisfaction) advertised values had no detectable correlation with firm financial performance, and no correlation with the frequency of class action suits.
The researchers did, however, find that data relating to employee perceptions of the integrity of management does highly correlate with financial performance. They reviewed the GPTWI institute employee survey data relating to two questions: 1) management’s actions match its words; and 2) management is honest and ethical in its business practices. The researchers found that employee perceptions of integrity are positively and significantly correlated with performance, as well as with attractiveness to job seekers. Furthermore, where there were high perceptions of integrity, fewer employees joined unions. The Ethical Systems Culture Measurement projects aims to further this research.
Additional studies that have FAILED to find that good and ethical governance pays:
- [None found yet. Email firstname.lastname@example.org if you know of any]
- Rachel Ensign, writing in WSJ, expresses skepticism that a positive ROI can be proven for compliance programs. Not that it’s not there, it’s just that she thinks it’s not possible to quantify the costs of scandals avoided.
Treviño & Nelson also reviews the evidence on whether a commitment to CSR (corporate social responsibility) is associated with financial returns or other material benefits:
“Over the last 30 years or so, a growing number of academic studies have attempted to document the relationship between social responsibility and financial performance more rigorously. A statistical review (a meta-analysis) of 52 such studies found a positive relationship between CSR and financial performance, especially when reputation-based measures of corporate social performance and accounting-based measures of financial performance were used… Research also suggests a reciprocal relationship, meaning that social responsibility leads to increased financial performance and financial performance provides firms with more slack resources that they can then devote to future social responsibility efforts.
The study used an index of eight attributes of CSR as rated by KLD. Firms with strong financial performance were rated higher on corporate social performance, suggesting that companies that do well financially also allocate more resources to social concerns—they “do good by doing well.” Those that are not in good financial health may not have the funds to engage in philanthropy or other discretionary social performance activities. The study also found that financial performance depends on good social performance, suggesting that firms also “do well by doing good.” The authors termed this the “good management theory,” arguing that good social performance is related to other good managerial practices.
Clearly, being socially responsible doesn’t harm the firm’s bottom line as some economists have suggested in the past. In fact, the study’s findings suggest that a firm’s relationships with key stakeholders (e.g., employees, community, natural environment) are important to its financial performance.”
Additional relevant studies which HAVE found benefits from good CSR programs
- Corporate Social Responsibility and the Cost of Corporate Bonds: “Using credit ratings as an ex ante cost of debt, we find that better CSR performance is associated with better credit ratings [for corporate bonds].”
- Investments in CSR mitigate the risk of a stock price crash: “The results are consistent with the notion that firms that actively engage in CSR also refrain from bad news hoarding behavior, thus reducing crash risk.”
- Commitment to Social Good and Insider Trading: “We find that executives of CSR-conscious firms profit significantly less from insider trades and are less likely to trade prior to future news than executives of non-CSR-conscious firms.”
- The 2012 Great Place to Work® Institute report claims the stock price growth of the 100 firms with the most ethical cultures outperformed stock market and peer measures by almost 300 percent.
- Corporate social responsibility and access to finance: “firms with better CSR performance face significantly lower capital constraints.
- Corporate social responsibility and stakeholder value maximization: Evidence from mergers…”compared with low CSR acquirers, high CSR acquirers realize higher merger announcement returns, higher announcement returns on the value-weighted portfolio of the acquirer and the target, and larger increases in post-merger long-term operating performance… These results suggest that acquirers’ social performance is an important determinant of merger performance and the probability of its completion, and they support the stakeholder value maximization view of stakeholder theory.”
- The Impact of Corporate Social Responsibility on Firm Value: The Role of Customer Awareness. “Corporate social responsibility (CSR) and firm value are positively related for firms with high customer awareness, as proxied by advertising expenditures.” [But not for firms that operate mostly outside of the awareness of the general public].
- Do Investors Value a Firm’s Commitment to Social Activities? “From a sample of top corporate citizens, we find that: (1) a firm’s social responsibility commitment (CSR) contributes to its financial performance; (2) [even] after controlling for investment in innovation activities, CSR continues to have a positive impact on a firm’s financial performance.”
- Alex Edmans talks about the long-term impacts of social responsibility and challenges the idea that caring for society is at the expense of profit (article link). Video:
Additional relevant studies which have NOT found benefits from CSR policies:
- Are red or blue companies more likely to go green? Found that firms score higher on CSR when they have Democratic rather than Republican founders, and when they are headquartered in blue rather than red states. But this study found “no evidence that firms recover these expenditures through increased sales. Indeed, increases in firm CSR ratings are associated with negative future stock returns and declines in firm ROA.’
- B-corps: A growing form of social enterprise. Found that B-corps did NOT outperform competitors in similar industries, on revenue growth or employee productivity growth. (But neither did they underperform, so the social benefits B-corps provide did not cost shareholders).
IDEAS TO APPLY
- There is a very strong business case to be made for ethical systems design. In the long run,ethical companies generally outperform their less scrupulous peers — although this may not be true in every industry.
- Aside from the business case, running an ethical business is simply the right thing to do.
- Running an ethical business is no guarantee of success — a company that lacks a great product and great strategy will fail, no matter how ethical it is. Levi-Strauss in the 1990s is an example of such a company.
- In what industries does ethics fail to pay?
- When operating in highly corrupt countries, does it generally pay to be ethical?
TO LEARN MORE
- Treviño & Nelson, Managing Business Ethics
- Follow any of the links in the “areas of research.”
Jonathan Haidt delivers a talk at the 2015 Aspen Ideas Festival on “Why Ethics (Usually) Pays and How to Make It Pay More”:
Linda Treviño, in a series of videos, discusses current researchers and precursors to ethics paying:
Dan Ariely gives a perspective on markets and social relationships:
Watch more discussions of the general concept of CSR, valuing it, leveraging it in a profitable way, as well as specific examples from BP and IBM, and more on our Ethics Pays playlist, at the Ethical Systems YouTube channel.
Miscellaneous Links & References
- Kevin Lewis list of studies on corporate ethics
- Jeff Kaplan, “Culture, Integrity and Profitability: The Results of an Important New Study,” Conflict of Interest Blog, 1/26/14. “The authors write, “we find that high levels of perceived integrity are positively correlated with good outcomes, in terms of higher productivity, profitability, better industrial relations, and higher level of attractiveness to prospective job applicants.”” Read the full study here.
- Companies With Weak Ethical Cultures Experience 10x More Misconduct Than Those With Strong Ones, Corporate Executive Board (via PRNewswire), September 2010.