Corporate irresponsibility and stock price crash risk

• Published date: 01 September 2021
• Author: Rashid Zaman,Stephen Bahadar,Haroon Mahmood
• Date: 01 September 2021
• DOI: http://doi.org/10.1111/irfi.12296

ORIGINAL ARTICLE

Corporate irresponsibility and stock price

crash risk

Rashid Zaman

1

| Stephen Bahadar

2

| Haroon Mahmood

2†

1

School of Business and Law, Edith Cowan

University, Australia

2

Department of Financial and Business

Systems, Lincoln University, Canterbury,

New Zealand

Correspondence

Rashid Zaman, School of Business and Law,

Edith Cowan University, 270 Joondalup Drive,

Joondalup 6027, Western Australia.

Email: r.zaman@ecu.edu.au; rashid.zaman@

lincolnuni.ac.nz

Abstract

We investigate the impact of corporate irresponsibility on

future stock price crash by employing a unique dataset of

1,529 penalties imposed on 411 United States (U.S.) firms,

from 2003 to 2015. We provide robust evidence that the

total amount of penalties (in U.S. dollars) imposed on firms

are negatively associated with firm-specific future stock price

crash risk. Our findings are consistent with the following view

that imposition of penalties remove uncertainty about a par-

ticular firm's future, investors please that the case is closed,

the firm successfully manages the aftermath of misconduct

and the firm's financial gains are often larger compare d to the

total cost of the penalty imposed. Moreover, we find corpo-

rate social responsibility (CSR) to be a channel through which

penalties impact stock price crash risk. Our findings demon-

strate that the negative association between monetary penal-

ties and stock price crash risk is more pronounced in the

postfinancial crisis andin environmentally sensitive firms.

KEYWORDS

corporate irresponsibility, corporate social responsibility,

monetary penalties, stock price crash risk, system GMM

JEL CLASSIFICATION

G32; M14; M41

This article is dedicated in loving memory of our friend and coauthor Dr. Haroon Mahmood (Late), who died tragically in the horrific terror attack on theAl

Noor and Linwood mosques in Christchurch, New Zealand, on March 15, 2019, while he was offering his Friday prayers. We mourn the sudden loss of our

friend and colleague who still had a great deal to offer the field of finance.

†

Deceased

Received: 8 May 2018 Revised: 1 September 2019 Accepted: 19 December 2019

DOI: 10.1111/irfi.12296

© 2020 International Review of Finance Ltd. 2020

786 International Review of Finance. 2021;21:786–820.wileyonlinelibrary.com/journal/irfi

1|INTRODUCTION

Stock price crash risk (hereafter “crash risk”)—that captures asymmetry in risk, especially downside risk, is imperative

for investment and risk management and has attracted increasing attention in recent years from a variety of stake-

holders, including academicians, practitioners, investors, management, and legislators (Habib, Hasan, & Jiang, 2018).

One of the main reasons behind this rising interest in the field is the recent and increasing “corporate irresponsible”

incidents as evident by the renowned corporate scandals around the world, including the Volkswagen emissions

scandal (2015), the 2007–2009 global financial crisis (GFC), the Deepwater BP oil spill (2010), and the U.S. Mortgage

crisis (2007) (Guenster, Bauer, Derwall, & Koedijk, 2011; Molina-Azorin, Claver-Cortes, Lopez-Gamero, & Tari,

2009). In this regard, academic literature, though, substantially improved the conception of crash risk antecedents

such as corporate disclosure, managerial incentives, capital market transaction, corporate governance, and institu-

tional voids (Habib et al., 2018). However, this literature falls short to account “corporate irresponsibility”as an ante-

cedent of crash risk.

Corporate irresponsibility—defined as any public disclosed firm actions that under some set of conditions, a stake-

holder would deem illegal, unethical, or socially irresponsible and take actions to punish (Barnett, 2014, p. 682), has

attracted increasing attention in recent years from a variety of stakeholders, including academicians, practitioners,

investors, management, and legislators (Jain & Zaman, 2019). Firms have long been criticized for their irresponsible

behaviors and have attracted severe legislative penalties and fines as a result (Barnett & Salomon, 2012; Koster &

Pelster, 2017). Notably, the penalties on Volkswagen (VW) for its emissions scandal have risen to USD 30 billion

(Schwartz & Bryan, 2017); legal penalties on British Petroleum (BP) for its oil spill amounted to approximately USD

18.7 billion (Robertson, Schwartz, & Pérez-Peña, 2015); and Wells Fargo's federal fines for mortgage and insurance

abuses have reached USD 1 billion (Borak, 2018).

There are two schools of thoughts in the extant empirical literature that largely associate corporate irresponsible

behavior with the shareholders' wealth. First are the proponents of the efficient market hypothesis (EMH),

1

who

under the influence of EMH believe that the disclosure of corporate misconduct causes the instantaneous decline in

the market value, on disclosure of misconduct (Kang, Germann, & Grewal, 2016). However, the impact of corporate

irresponsibility is contemporaneous and the announced allegations of corporate misconduct resolved over time that

is, time taking investigative and trials (Karpoff, Lott, John, & Wehrly, 2005). Therefore, the scholars who advocate

the conflict-resolution hypothesis

2

(CRH) believe that conflict is an inevitable phenomenon that hinders firm perfor-

mance (Mannix, 2003) until resolved. According to CRH proponents, if the size of monetary penalties offset the ben-

efits

3

obtained by shareholders from irresponsible behavior, then management could use monetary penalties as a

tool to resolve the conflict, thereby increasing the firm performance (Kim, Li, & Li, 2014). Similarly, the imposition of

penalties often seen as conflict resolution between the firm and its stakeholder (i.e., regulator) by the investors and

therefore the corporate irresponsible behavior (measured as monetary penalties) is irrelevant for investors which

results in the negative relationship between corporate irresponsibility and stock return. The divergent view on the

impact of corporate irresponsibility, whether beneficial or detrimental for shareholders, calls for an in-depth exami-

nation of the corporate irresponsibility and crash risk nexus.

However, despite some excursions in literature that establish the corporate irresponsibility and stock return rela-

tionship (Koster & Pelster, 2017), the association of corporate irresponsibility and crash risk is yet to investigate.

Therefore, this study is an endeavor to examine the impact of corporate irresponsibility on crash risk. To do, we

followed Chen, Hong, and Stein (2001) and measured crash risk as the conditional skewness of the third moment of

return distribution, rather than the likelihood of extreme negative return distribution. To capture corporate irrespon-

sibility, we developed and employed a unique measure (i.e., monetary penalties) based on Thomson Reuters ASSET4

controversies cost dataset. Specifically, we used two measures of corporate irresponsibility, (1) the dollar value of

monetary penalties and (2) the number of monetary penalties imposed on firms iin year t. We base our investiga-

tions on publicly listed firms in the United States from 2003 to 2015 and employ a sophisticated system generalized

method of moments (GMM) with dynamic panel model that simultaneously accounts for unobserved heterogeneity,

ZAMAN ET AL.787

serial correlation, endogeneity problems, and reverse causality (Nadeem, Zaman, & Saleem, 2017; Wintoki, Linck, &

Netter, 2012).

We found that monetary penalties, both in dollar value and numbers, have negative and significant association

with future crash risk, supporting the CRH. The negative association between monetary penalties and crash risk is

justified in the U.S. context, where legal proceedings and litigations are expensive and inefficient (Koku, Qureshi, &

Akhigbe, 2001). Consistent with CRH view, our findings show that investors expect better prospects, assuming man-

agers will become more responsible and good governance practices for the company will increase the company's

market value, in the aftermath of misconduct. These results are in line with one recent studies that find a positive

association between financial penalties on banks and their stock performance (Koster & Pelster, 2017).

We further explore our results, to ascertain whether this negative association varies with increased regulatory

conditions; that is, financial crisis, industrial characteristics, and the nature of the corporate irresponsibility. We find

that excessive regulations, especially after post-GFC, significantly strengthened the negative association between

corporate irresponsibility and crash risk, reinforcing our main results. Moreover, this negative relationship between

corporate irresponsibility and crash risk tends to be more pronounced in environmentally sensitive industries,

reflecting the excessive monitoring of these industries due to the nature of their business operations. In respect to

the type of corporate irresponsibility, we bifurcated corporate irresponsibility into two categories; (1) corporate irre-

sponsibility due to environmental violations and (2) nonenvironmental violations. Our results are consistent for non-

environmental corporate irresponsibility, suggesting that environmental violations are less pronounced in explaining

crash risk. These results are robust after controlling for other variables such as accounting (i.e., Firm size, i.e., Return

on assets (ROA), leverage, liquidity, earning management) and market (i.e., RET,SIGMA,MTB) performance indicators.

To mitigate concerns about endogeneity, we employed the fixed effect-two stage least square (FE-2SLS) and added

additional control variables that may affect both corporate irresponsibility and crash risk such as gross domestic

product (GDP) per capita, the standard deviation of GDP growth and economic policy uncertainty.

Finally, we explore channel through which corporate irresponsibility may affect crash risk. Prior studies have

identified that firms with better CSR can be a potential mechanism through which corporate irresponsibility might

affect crash risk (Kim et al., 2014; Lee, 2016). Firms with CSR culture, maintaining high ethical standards are less

prone to bad news hoarding and thus would expect lower corporate irresponsibility leading to lower crash risk (Kim

et al., 2014; Lee, 2016). On contrary, some firms might undertake CSR to cover up misbehavior (Kang et al., 2016).

For instance, Enron—a firm with several national awards for its environmental and community contribution, was also

indulged in fraudulent activities.

4

Firms using CSR as a form of symbolic or greenwashing practice, may divert stake-

holders' attention and scrutiny of their poor practices, thereby increasing the likelihood of corporate irresponsibility

and subsequent higher crash risk (Lee, 2016). Consistent with this, we found that the in high CSR firm, penalties (cost

and number) significantly decreases the crash risk for both proxies of crash risk (i.e., NCSKEW and DUVOL).

Our study offers several contributions to the extant literature on crash risk and corporate irresponsibility. It adds

to the limited literature that examines corporate irresponsibility from a financial perspective. Previous studies have

mainly focused on CSR benefits (i.e., doing good) (Jamali & Carroll, 2017). In our research, we provide an excursion

extending that literature by focusing on corporate irresponsibility through a novel measure, that comprises an essen-

tial, yet overlooked determinants of firm financial performance (Lin-Hi & Müller, 2013; Murphy & Schlegelmilch,

2013). To our best knowledge, this is the first study that investigates the link between corporate irresponsibility and

crash risk, whereas previous studies have mainly analyzed the impact of financial penalties on firm's stock

performance.

Second, our study also contributes by introducing monetary penaltiesas a unique and new measure of corporate

irresponsibility. We used the dollar value of monetary penalties and the number of monetary penalties imposed on

firms for engaging in irresponsible activities. In this manner, we offer an alternative and objective view of corporate

irresponsibility over prior studies that often operationalize it as perceptual (Aouadi & Marsat, 2018; Bird, Hall,

Momentè, & Reggiani, 2007; Groening & Kanuri, 2013; Lange & Washburn, 2012; Mattingly, 2017; Scholtens &

Zhou, 2008). The measure used, as a proxy for corporate irresponsibility, in most of the prior studies is estimated

788 ZAMAN ET AL.