The Value of Integrity Luigi Guiso (Eief) Paola

The Value of Integrity Luigi Guiso (Eief) Paola

The Value of Integrity Luigi Guiso (Eief) Paola Sapienza (Northwestern) Luigi Zingales (Chicago) Firms and values 85% of S&P 500 companies have a section in their web page (sometimes even two) dedicated to corporate values. The values companies proclaim range from integrity to teamwork, from innovation to respect., from creativity to dedication Cheap Talk? Firms and values or an essential component of a broader strategy? What role do values play in a theory of the firm? With few exceptions (e.g., Kreps (1990)), economics and finance have ignored the role culture plays in firms Not so the organizational literature (e.g., OReilly,

1989), but a lot of ambiguity on what corporate culture means Even more so which values (if any) matter for performance. This paper 1. Why are corporate values good (i.e., they create value in addition of the normal incentive schemes) 2. If they are good, why doesnt every firm adopt them? 3. How do the ownership and governance structures affect the sustainability of these values inside the firm?. Which values? Most commonly advertised values in S&P firms web pages is innovation (mentioned by 80% of them), followed by integrity and (70%). Role innovation plays in firms is wellknown and amply studied Role played by a culture of integrity is not. We focus on this understudied dimension. Work plan 1. Define integrity 2. Integrity as a social norm to reduce moral hazard At the top of an organization Inside an organization

3. Because it helps reduce moral hazard, an integrity value increases firm performance 4. Use model to explore how integrity interacts with different governance structures. Integrity more difficult to sustain in publicly traded firms, where control is more in play and managers more subject to Wall Streets pressure in private firms that plan to go public soon (as venture-backed private firms) 5. Use survey data to check these predictions Defining integrity Erhard and Jensen (2007): integrity is the quality or state of being complete; in an unbroken condition; sound. For an individual, group, or organization integrity as: honoring ones word In their view, adherence to integrity facilitates coordination among employees. Example: coordinating on the time for a meeting. If all co-workers arrive on time there is no cost of being punctual; otherwise it is costly to be on time Integrity - keeping your word and if you cannot, make sure you warn that you cannot - makes it more credible that co-workers are on time

Why does it work? Social Norms Why legal norms affect behavior? They create an incentive scheme: who violates a legal norm faces a certain probability of a legal punishment (Becker, 1968). Outcome should be verifiable What about social norm? They do the same, but punishment is social rather than legal. Outcome only needs to be observable Ex: a sexual joke acceptable in Italy, not in the States. Announcing a corporate value is an attempt to foster a norm within the company by increasing the social sanction and increasing the social enforcement

Problems with Social Norms Why social norms do not solve all the problems? 1. Limited punishment available 2. Detection must be relatively easy 3. Observability Simplicity of the norm (very coarse) Need for consistency Lead by example An Integrity Value A social norm to keep your own word helps alleviate moral hazard problems. Two types of moral hazard:

1. At the top: Top managers cannot credibly commit to reward employees who make firm specific investments 2. Inside the organization: Employees less organization likely to cheat inside the A model of limited commitment In each period, our firm is composed of a manager/CEO and two workers. CEO owns 100% of the firms equity and is long-lived Workers last two periods. Young workers are unproductive, but they learn how to work within the firm Old workers produce. Their productivity is a function of how much they specialize to the firm. This knowledge is firm-specific To become specialized a worker has to incur a (private) cost C With probability p: specific investment => worthless With probability (1-p): => value of Y.

Limited commitment model: 2 W: extra wage a worker receives for being more productive=> Invest if (1-p)W > C Manager willing to pay W<= (1-p)Y Assume that (1-p)Y > C=> socially optimal the worker makes the investment. If contractible => promise a wage contingent on investing which ranges between C and (1-p)Y. If investment and output are observable but not verifiable, as in Grossman and Hart (1986), a simple contract cannot resolve this problem. Limited commitment model: 3 Since the effort is observable the CEO can promise a wage contingent on effort In each period he chooses whether to maintain the promise or not Maintaining the promise: pay W in each period and receive Y with probability (1-p) next period from the current young worker who will specialize Since world is stationary, if the CEO maintains the promise this period, she will maintain in the future. Value of maintaining the promise is: W (1 p )Y p

If CEO reneges he makes (1-p)Y Limited commitment model: 4 Hence CEO will not breach the contract if Y W (1 p) 2 And since a worker will invest if (1-p)W > C, CEO will not breach if Y C (1 p )3 C C Y (1 p) (1 p)3 optimal Thus if to promise the higher wage but not feasible due to lack of commitment A role for integrity CEO values integrity (keeping his own word)=> incurs a personal cost K(I) if breaches his word

Under integrity commitment strategy feasible if Y C pK ( I ) (1 p)3 (1 p ) 2 Thus we have : Result 1: Ceteris paribus, firms where integrity is upheld as a value will be more profitable. The role of turnover Let be the probability that founder is replaced by a new CEO If Y if Anticipating this workers make specific investment (1 p )(1 )W C and commitment feasible if Y if

C (1 p )3 new CEO will have an incentive to renege C pK (1 p)3 (1 ) (1 p) 2 Hence if 0 feasible C pK C pK Y (1 p )3 (1 p ) 2 (1 p)3 (1 ) (1 p) 2 good equilibrium but not otherwise. Thus: Result 2: Ceteris paribus, integrity is more likely to be upheld as a value when the probability of turnover of the current CEO is lower. Summing up Three implications from model of limited commitment and integrity. 1. Firms with shared integrity values should achieve higher performance

2. Integrity less likely to be sustained as a value when CEO turnover higher publicly traded firms venture-backed firms less likely to be able to sustain an equilibrium where integrity is upheld. The ideal data Measures of integrity not easy to obtain: Proclamations of integrity in companies web site not necessarily truthful What matters is integrity as it appears in the eyes of the employees Ideally we would like to measure how workers perceive that top managers uphold integrity as a value A dataset assembled by the Great Place to Work Institute fulfils this requirement The GPTW data Collects data on employees perceptions about prevailing values through ad-hoc surveys of a sample of employees. Purpose of survey: identify the top 100 best companies to work for To be in GPTW companies must

submit an application, have been in business for at least 7 years, have at least 1,000 employees For each company, a random sample of 400 employees across all job levels are invited to participate Respond anonymously, response rate 60% GPTW integrates this with factual information gathered from company representatives The GPTW data Use surveys over 2007-2011 Include all firms that applied to GPTWI (not only the top 100) Final sample: 679 companies, 294 privately held, 385 public companies, 191 part of S&P 500 244 interviewed employees per company Overall 410,000 full time employees interviewed Supplement with data on corporate ownership, presence of founder, venture capital financing from various sources Performance (ROS and Tobins q) from Compustat Measuring integrity Main proxy: employees assessment of how true is the statements in the employee survey: => Managements actions match its words Use also

=> Management is honest and ethical in its business practices Answers on a scale 1 (almost always untrue) to 5 (almost always true) Try to capture three key dimensions of integrity Wholeness characteristic emphasized by Erhard et al (2007), Ethical dimension Sample statistics of shared values Mean Media n Managerial Integrity 3.90 Managerial Ethics 4.29 Variable Sd 10th p. 90th p. Obs

3.90 0.25 3.57 4.20 639 4.30 0.23 3.97 4.57 639 Estimation model Two type of regressions: Effect of integrity on firm outcomes: yi xi Fi i Effect of governance structure on integrity: xi gi Fi i Various problems to achieve identification, deal with some Halo effect

Values highly correlated May reflect a halo effect pervading all the answers: arises in data collection when there is carry-over from one judgment to another (Thorndike, 1920) Model halo effect as an error-in-variable that affects potentially all the answers xi xi* hi wi wi* hi cov(wi* , hi ) cov(wi* , hi ) 0 Two potential problems: a) errors in variable; b) unobserved heterogeneity if halo present in variables of interest Halo effect: consequences and solution Type of bias depends on whether integrity is RHS or LHS yi x *i Fi i hi yi xi Fi i (1 )hi Integrity RHS: z z *i hi such that cov( xi* , z *i ) 0 A variable the problem used as control can address

x *i gi Fi i xi gi Fi i hi Integrity LHS: cov( gi , hi ) 0 z z *i hi such that cov( gi , z *i ) 0 If a variable as control can address the problem (otherwise an instrument) used The right z control Need a variable that is affected by the halo effect and is uncorrelated with: true measure of integrity; governance variables GPTW has 58 statements in five groups Exclude a priori variables in the groups called credibility and fairness (too close to integrity) Focus on two statements: 1.

This is a physically safe place to work 2. I can be myself around here Impact of values on outcomes: Tobins q VARIABLES Managerial Integrity (1) (2) (3) (4) Tobin's Q Tobin's Q Tobin's Q Tobin's Q 1.417*** 2.880*** (0.422) (0.503) 1.479*** 3.070***

(0.464) (0.536) Managerial Ethics Safe Place 0.761 0.674 (0.557) (0.587) Being Myself Company Age Log Employees -2.232*** -2.358*** (0.769) (0.786) 0.001 -0.000 0.000 -0.001 (0.002)

(0.002) (0.002) (0.002) -0.087 -0.123* -0.094 -0.131** (0.066) (0.066) (0.066) (0.066) 1 sd increase in integrity =>25% of 1sd in Tobins q Impact of values on outcomes: ROS (5) (6) (7) (8) VARIABLES ROS

ROS ROS ROS Managerial Integrity 0.041 0.174*** (0.030) (0.036) 0.023 0.164*** (0.033) (0.039) Managerial Ethics Safe Place 0.096** 0.111*** (0.040) (0.042) Being Myself Company Age Log Employees

-0.176*** -0.159*** (0.055) (0.056) 0.000 -0.000 0.000 -0.000 (0.000) (0.000) (0.000) (0.000) -0.006 -0.009* -0.007 -0.009* (0.005) (0.005) (0.005)

(0.005) 1 sd increase in integrity =>40% of 1sd in ROS Impact on other outcomes (1) VARIABLES Managerial Integrity (2) -0.038 (0.024) -0.125*** (0.033) Log Employees -0.046* (0.028) -0.195*** (0.033) -0.204*** (0.031) Being Myself Company Age (4) Unionized Unionized Unionized Unionized Workers/E Workers/E Workers/E Workers/E mployees mployees mployees mployees

Managerial Ethics Safe Place (3) 0.000*** (0.000) 0.013*** -0.011 (0.050) 0.000*** (0.000) 0.012*** 0.000*** (0.000) 0.013*** -0.171*** (0.034) 0.030 (0.049) 0.000*** (0.000) 0.012*** Impact on other outcomes -2 VARIABLES Managerial Integrity (9) (10) (11) (12) Top100

Top100 Top100 Top100 Universum Universum Universum Universum Student Student Student Student Survey Survey Survey Survey 0.058 (0.057) 0.216*** (0.076) Managerial Ethics Safe Place 0.186** (0.073) Being Myself Company Age Log Employees 0.057 (0.067) 0.183** (0.080) 0.000 (0.000) 0.108*** (0.009)

-0.141 (0.114) 0.000 (0.000) 0.108*** (0.009) 0.000 (0.000) 0.107*** (0.009) 0.248*** (0.080) -0.161 (0.114) 0.000 (0.000) 0.107*** (0.009) Corporate ownership and values (1) (2) (3) (4) (5) (6) Managerial Integrity

Managerial Integrity Managerial Integrity Managerial Ethics Managerial Ethics Managerial Ethics -0.105*** (0.019) -0.106*** (0.019) 0.020 (0.030) -0.067*** (0.017) -0.069*** (0.017) 0.024 (0.026) 0.750*** (0.049) -0.010 (0.008) 0.000 (0.000) -0.025

(0.022) -0.048** (0.019) 0.747*** (0.049) -0.010 (0.008) 0.000 (0.000) -0.025 (0.022) -0.047** (0.019) -0.117*** (0.021) -0.085 (0.070) 0.132* (0.075) 0.751*** (0.051) -0.009 (0.008) 0.000 (0.000) -0.023 (0.022) -0.046** (0.020) 0.794*** (0.043) -0.010 (0.007) 0.000* (0.000)

-0.030 (0.019) -0.058*** (0.017) 0.791*** (0.044) -0.010 (0.007) 0.000* (0.000) -0.031 (0.019) -0.058*** (0.017) -0.078*** (0.019) -0.049 (0.061) 0.094 (0.066) 0.790*** (0.045) -0.010 (0.007) 0.000 (0.000) -0.031 (0.020) -0.058*** (0.017) Number of coverages of the health insurance -0.001 (0.012)

-0.001 (0.012) -0.005 (0.012) -0.003 (0.011) -0.003 (0.011) -0.006 (0.011) Number of onsite percks and benefits 0.008** (0.003) -0.011** (0.005) 0.060 (0.071) 0.008** (0.003) -0.011** (0.005) 0.062 (0.071) 0.008** (0.003) -0.010** (0.005) 0.082 (0.074)

0.006* (0.003) -0.001 (0.004) 0.087 (0.062) 0.005* (0.003) -0.001 (0.004) 0.090 (0.063) 0.006** (0.003) 0.000 (0.004) 0.108* (0.065) VARIABLES Public =1 Company is venture backed Public*Venture Backed Safe Place Log Employees Company Age Business-to-Consumer Layoff Average Tenure Manager (Survey Average) Controls: usual, plus share or male, blacks, Hispanics, average age and tenure. Effect of public=> 40% of 1SD in integrity IV Strategy

VARIABLES Public First Stage Public IV IV Managerial Integrity Managerial Ethics -0.245* (0.135) 0.016** (0.008) Fraction Public (NAICS3) 0.333** (0.161) Safe Place 0.068 0.757*** (0.119) (0.055) Log Employees 357828.04.576363.1 0.155*** 0.013 (0.017) (0.024) Business-to-Consumer -0.010 -0.022 (0.051) (0.022) Layoff 0.156*** -0.025 (0.044)

(0.030) Number of coverages of the health insurance 0.013 0.003 (0.028) (0.013) Number of onsite percks and benefits -0.004 0.008** (0.008) (0.003) Average Tenure -0.023** -0.014** (0.010) (0.006) Manager (Survey Average) 0.232 0.104 (0.168) (0.080) -0.134 (0.114) Highest Industry M/B 0.785*** (0.046) 0.001 (0.020) -0.025 (0.019) -0.049* (0.025) -0.001 (0.011)

0.006** (0.003) -0.001 (0.005) 0.114* (0.068) Other Corp. Governance Variables VARIABLES Venture Backed Perc. Inside Directors Managerial Integrity Managerial Integrity Managerial Integrity Managerial Integrity Managerial Integrity Managerial Integrity 0.067* 0.042 0.069**

0.062* 0.062* 0.062* (0.034) (0.036) (0.031) (0.033) (0.037) (0.036) 0.157 (0.121) G-Index (last available observation in risk metrics) 0.003 357828.04.576363.1 (0.005) Perc Inst. Investors 0.009 (0.038) Perc. Owners more 5 perc. -0.122** (0.061)

CEO Log(Total compensation (K USD)) -0.002 (0.011) CEO Variable to Total Compensation -0.027 (0.070) Safe Place 0.759*** 0.691*** 0.763*** 0.746*** 0.700*** 0.702*** (0.069) (0.074) (0.061) (0.069) (0.072) (0.072)

A case-study : the insider view at Goldman Greg Smith accused of having a toxic and destructive culture. 357828.04.576363.1 Conclusions 85% of firms post some corporate values, with integrity at the top The values shared by the employees are positively correlated with a companys financial performance and quality of labor relations Being private seems to sustain stronger values A simple model of commitment can account for these correlations

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