Is good ethics good for business? Crime and sleazy behavior sometimes pay off handsomely. People would not do such things if they didn’t think they were more profitable than the alternatives.
But let us make two distinctions right up front. First, let us 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 is easy to increase revenues or decrease costs by exploiting some of those relationships. But what happens in the long run?
“Building an ethical culture is a challenging task that offers enormous long-term rewards. The benefits go beyond the management of fraud, corruption, conflicts of interest, and other forms of unethical conduct. It goes beyond the need to reduce the cost of regulatory action, investigations, and financial penalties. Companies with ethical cultures will have more sustainable growth, retain and attract the best employees, earn public trust and consumer loyalty, and be far better placed to survive disruptive political, social, and environmental forces.”– Alison Taylor
Customers are happy and confident in knowing they’re dealing with an honest company. Ethical companies retain the bulk of their employees for the long-term, which reduces costs associated with turnover. Investors have peace of mind when they invest in companies that display good ethics because they feel assured that their funds are protected. Good ethics keep share prices high and protect businesses from takeovers.
Culture has a tremendous influence on ethics and its application in a business setting. A corporation’s ability to deliver ethical value is dependent on the state of its culture. The culture of a company influences the moral judgment of employees and stakeholders. Companies that work to create a strong ethical culture motivate everyone to speak and act with honesty and integrity. Companies that portray strong ethics attract customers to their products and services, and are far more likely to manage their negative environmental and social externalities well.
ETHICAL CORPORATE CULTURE
From an ethical systems perspective, creating and sustaining a strong ethical culture is fundamental to creating an organization that supports people making good ethical decisions and behaving ethically every day. Establishing a formal strategy to understand ethics in your organization can serve as a starting point to create a common vocabulary on the topic, enable discussions for next steps, highlight the various ways in which ethical behavior will add value to your organization, and reveal potential risks that could ultimately affect your bottom line. Assessments that examine corporate culture, particularly those with ethical components, are a great place to begin.
KEY FINDINGS (based on research covered below)
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. However, context also matters; running an ethical business is no guarantee of success. Consider the following key findings for their value to you and your organization.
Create a strong ethical corporate culture. A strong ethical culture can provide significant benefits to an organization, such as Increased employee job satisfaction, reduced employee burnout and increased intention to stay, decreased illegal activity, and improved organizational performance, value, and innovativeness. Encouraging ethical behavior, making ethical leadership a top priority, embedding ethical values throughout the organization, establishing ethical hiring standards, and formalizing ethical programs are all effective ways to help develop and maintain an ethical corporate culture. Visit our Corporate Ethical Culture page to learn about other ideas to apply.
A good reputation is valuable. A positive ethical reputation results in lower costs, higher sales, increased ability to charge higher prices, and stronger financial health (e.g., cash-flow, credit constraints). Poor reputations impose substantial additional penalties from both regulators and customers when unethical conduct occurs. Firms that make an explicit commitment to follow an ethics code provide twice the value to shareholders than companies that do not.
Ethical companies are more competitive. Companies with a more ethical culture have higher economic profit brought by market innovation, and their executives are also more likely to serve on other firm boards with strong ethical reputations and profitability. Firms with strong corporate ethical value are more likely to have better employee work-performance. Conversely, firms that engage in unethical conduct have a diminished quality of network partners, with the deterioration in partner quality tending to be greater for acts of greater misconduct and result in being less equipped to respond to market demands. Organizations should formally recognize and reward employee’s ethical conduct and treat the development of an ethical culture as a strategic priority.
Illegal conduct can be extremely costly. Firms with lower levels of ethical “culture and values” are more likely to be subjected to regulatory penalties and class-action lawsuits. One study found the average cost for financial misconduct averaged $23.5 million per incident. Managers should consider how to impose sanctions on employees who engage in unethical behavior, and stay cognizant of the rules, norms, and both formal (e.g., ethical training) and informal system structures (e.g., ethical norms) that encourage ethical behavior.
Ethical culture makes strong corporate governance worth it. Companies with good corporate governance structures and policies obtain higher profitability, sales growth, and higher stock-market value. An ethical corporate culture appears to be an important channel through which governance affects firm value. Strong governance alone may incentivize people to focus on easy-to-observe benchmarks over the harder-to-measure intangibles, and emphasize a results-orientation among the workforce that inadvertently decreases customer-focus, integrity, and collaboration. Organizations should focus more effort on building the right culture than on building a compliance infrastructure.
Integrity matters. The benefits of an ethical corporate culture are dependent on the organization’s integrity (i.e., quality of honesty, fidelity, authenticity, and adherence to moral principles). Financial performance increases when managers have higher integrity toward ethical behavior.
An ethical culture enables Corporate Social Responsibility. There is a distinction between doing business ethically (which is a product of an ethical corporate culture and the focus of Ethical Systems) and Corporate Social Responsibility, which is a set of voluntary policies and practices firms adopt to manage their environmental and social impacts. Firms with strong reputations for Corporate Social Responsibility have significantly higher financial performance, reduced financial risks, and are better equipped to sustain CSR initiatives. However, efficacy of CSR programs on firm performance is dependent on the firm’s internal corporate culture. Thus, CSR may best be viewed as a product or outcome of an ethical corporate culture rather than a separate mechanism for maximizing profit.
Become a company that uses Environmental, Social & Governance (ESG) standards. More recently, a movement to make business’ CSR efforts measurable have led to distinct Environmental, Social & Governance (ESG) standards. When firms are assessed against ESG, the result is a tangible set of ratings that are used by investors and consumers alike in understanding a company’s environmental, social, and internal governance practices. ESG factors have been found to be a priority interest among investors, and top-performing firms have been found to have a strong focus on ESG. However, there remain pressing concerns about the quality, level of disclosure, and overall intentions of ESG metrics. These approaches are most successful when they are assessed and implemented strategically, rather than in an effort to achieve a higher external “score”. In practice this means focusing on material, relevant issues, rather than philanthropic initiatives divorced from the core business. How to measure and define materiality is itself contested, but regulators are gradually aligning on the idea that corporations need to consider their impact as well as just the level of financial risk presented by an issue.
AREAS OF RESEARCH
Reputation Value. Research findings suggest a strong relationship between business reputation and market performance (Fombrun & Shanley, 1990; Trevino & Nelson, 2011; Saeidi et al., 2015; Liu et al., 2019; Brammer et al., 2015). Perception of a business’ ethical standards appears to be a significant factor in determining an organization’s reputation (Trevino & Nelson, 2011). Poor reputation appears to moderate a firm’s ability to overcome controversial events (e.g., product recalls, environmental accidents) while positive reputation results in lower costs, higher sales, and increased ability to charge higher prices compared to firms with poor reputations (Rhee & Haunschild, 2006).
A study on the effects of financial misconduct by Karpoff, Lee & Martin (2008) estimated the impact of a reputational penalty. The researchers defined this as the expected loss in the present value of future cash flows due to lower sales and higher contracting and financing costs. A reputational penalty’s impact was found to be significantly larger (over 7.5 times) than the sum of all penalties imposed through the legal and regulatory system; a 41% reduction in market shareholder value. A more recent study estimated a loss of 31.7% in market capitalization for companies caught in financial misrepresentation, though only approximately 3.5% will be caught (Alawadhi et al., 2020).
Conversely, firms with a positive ethical reputation appear to have lower investment–cash flow sensitivity and are able to overcome credit constraints more easily (Jiang, Kim, Ma, Nofsinger & Shi, 2019). Moreover, firms that were perceived to make an explicit commitment to follow an ethics code provided twice the value to shareholders than companies that did not (Sims, 2009).
For environmental misconduct, and many other settings, reputational penalties seem to depend on perceptions of other parties. “If revelations of wrongdoing in these settings do not affect the future value of interacting with the firm, then the reputational costs of misconduct will be negligible” (Brady et al., 2019).
Independent assurance is also important. Investors respond positively to firms that plan to achieve financial returns from being more socially and environmentally responsible (Stuart et al., 2020). However, independent assurance improves perceptions of ethical culture, resulting in even more positive investment judgments while also protecting against the fallout from negative events.
Firm Effectiveness and Survivability. Firms perceived as having positive reputations for ethics were found to attract more competitive and diverse workforce talent (Osburg et al., 2020; Pfister, 2020) and achieve higher commitment from those already employed (Chatzopoulou et al., 2021; Esenyel, 2019; LaPlante, 2004; Nguyen et al., 2020), in part due to greater trust, job satisfaction, and value congruence.
Ethical culture was a significant factor in predicting the overall return of managed fund performance for financial institutions, where those with higher ethical values appear to be more effective in providing viable investment products to the market and sustained career-growth to employees (Smimou, 2020). Firms with a more ethical culture also have higher economic profit through market innovation as their workforce is more capable to drive change and develop innovation that detect and seize on new market opportunities (Vranceanu, 2014).
Research also found the perception of a firm’s corporate ethics significantly mediated the relationship between diversity management practices and firm performance, where an increase in firm ethics resulted in an increase in overall performance (Porcena, Parboteeah & Mero, 2020). Firm performance increases when employees perceive top managers as trustworthy and ethical (Guiso, Sapienza & Zingales, 2015; Kim & Thapa, 2018; Saha et al., 2020). Furthermore, perception of corporate ethical values has a significant effect on employee work performance, accounting for 20% of the variance (Koronios, Kriemadis, Dimitropoulos & Papadopoulos, 2019).
Firms that engaged in unethical conduct were also found to have diminished quality of network partners, with the deterioration in partner quality tending to be greater for acts of greater misconduct (Sullivan, Haunschild & Page, 2007). Firms with illegal or unethical conduct were also more likely to have their executives 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 (Trevino & Nelson, 2011). One key factor in maintaining strong relationships with network partners may be the companies’ congruence on CSR values (Liu et al., 2021).
Penalties for Illegal Conduct. Ethics are commonly cited as a primary component for determining employee perceptions of corporate culture, values, and their workplace behavior (Trevino & Nelson, 2011; Schepers, 2003; Smimou, 2020). Culture is frequently credited as having a heavy influence in shaping an employees’ ability to make determinations about what is and what is not appropriate behavior. The likelihood of an employee to engage in unethical activity is reported to be much higher for organizations with ambiguous ethical cultural norms (Umphress & Bingham, 2011). As a result, firms with lower levels of ethical “culture and values” are more likely to be subjected to SEC fraud enforcement actions and securities class-action lawsuits (Ji, Rozenbaum & Welch, 2017). An academic study examining more than two decades of fines imposed on firms for financial misconduct determined the average regulatory penalty to be $23.5 million (Karpoff, Lee & Martin, 2008).
Financial penalties alone suggest that corporate financial crimes are not punished adequately to deter behavior, because the fines are a fraction of what is gained from the crimes (Klimczak et al., 2021). However Karpoff et al. found in their 2008 research that reputational penalties cost more than fines: “for each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $3.08. Of this additional loss, $0.36 is due to expected legal penalties and $2.71 is due to lost reputation. In firms that survive the enforcement process, lost reputation is even greater at $3.83”. Looking to the future, Karpoff predicts that when considering all forces that penalize financial fraud, including reputational ones, fraud is likely to decrease over long spans of time (Karpoff, 2021).
Employees with a strong (perhaps excessive) affective attachment or commitment to their organization or its members sometimes engage in pro-organizational unethical behaviors to benefit the company (Trevino & Nelson, 2011; Veetikazhi et al., 2020). Employees may also engage in unethical pro-organizational behavior when they feel the company or their job are in jeopardy, when the business environment activates traits within the employee, or when pressures place greater emphasis on goal pursuits than on moral requirements. When employees conduct unethical acts to benefit their organizations, organizations likely experience the repercussions of such behaviors in the form of societal sanctions and other punitive measures (Umphress & Bingham, 2011). Internal efforts to be ethical can limit these repercussions by transmitting moral and ethical expectations, increasing job security, and maintaining, and ensuring that organizational leadership does not create pressures to be unethical.
Governance and firm performance. Contrary to the common belief that corporate governance is a hindrance or a drag on profit maximization, evidence from research has demonstrated that companies with good corporate-governance structures and policies obtain higher profitability, sales growth, and market values as well as higher stock prices than do companies without such structures and policies (Ghosh & Zaher, 2011). Those with minimal corporate governance are more likely to be tolerant of unethical and illegal employee behavior and are less appealing to investors (Trevino & Nelson, 2011). Obtaining the benefits from ethical culture and governance is not simple, and more research is needed to fully understand the mechanisms that drive increases in performance.
Ethical corporate culture appears to be an important channel through which governance affects firm value. Strong governance alone may incentivize focus on easy-to-observe benchmarks over harder-to-measure intangibles and emphasize a results-orientation among the workforce that inadvertently decreases customer-focus, integrity, and collaboration (Popadak, 2013). Financial gains from increased sales, profitability, and payout can be fleeting. Long-term effects on intangible assets associated with deteriorating culture eventually offset short-term gains and result in overall firm value declining by 1.4% (Grennan, 2019).
Integrity of Corporate Ethical Values. Research findings suggest the financial benefits of an ethical corporate culture are moderated by the perceived integrity (i.e., the quality of honesty, fidelity, authenticity, and adherences to moral principles) to which the organization abides. Perceptions of management integrity were found to positively correlate with the firm’s financial performance. In contrast, companies perceived to have low integrity (i.e., those that only stated or advertised their corporate ethical values) had no improvement in financial performance or reduction in frequency of lawsuits (Guiso, Sapienza & Zingales, 2015).
Subordinate performance is also higher, via a “trickle down” effect, when management and supervision are perceived as trustworthy, and even more so when this trust is demonstrated by including subordinates in decision-making processes (De Cremer et al., 2018). From the top-down, supervisors are typically rated as more trustworthy when they rate their managers as trustworthy as well, meaning that higher-level management trustworthiness may impact performance at lower levels.
A strong corporate culture may aid in weathering difficult times more successfully. After the COVID-19 pandemic, organizations with a strong culture outperform those with weaker cultures in terms of revenue, while also adapting more effectively to digital transformation, innovating more, and making greater contributions to their communities (Li et al., 2021).
Corporate Social Responsibility (CSR). CSR is a form of self-regulation ensuring a company’s actions have a positive impact on the environment, consumers, employees, and communities (Fontaine, M, 2013). The idea is related to the management of environmental, social, and governance (ESG) issues described below, but not identical to it. ESG aims to quantify performance on non-financial measures. CSR includes charitable or philanthropic initiatives, or employee volunteering—where a direct business benefit is not needed. Therefore, any business benefit would accrue from improved reputation, employee motivation, or similar intangible factors.
Little to no evidence exists to suggest CSR has a negative effect on firm performance but evidence on the financial benefits of CSR continues to grow. Early academic studies, limited by the ability to adequately measure CSR, failed to discover any relationship between social responsibility and profitability (Aupperle, Carroll & Hatfield, 1985). However, more recent studies employing reputation-based measures of corporate social performance found a positive relationship between CSR and financial performance (Salvi et al., 2019; Wang, Dou & Jia, 2016). Financial risk also appears to decline as CSR reputation increases (Orlitzky & Benjamin, 2001). A large meta-analysis from 42 studies also estimated the overall effect of CSR on Corporate Financial Performance is positive and significant, thus supporting the argument that CSR does enhance financial performance. The effect may be moderated by other environmental factors as effects appeared much stronger for firms from advanced economies than those from developing economies (Wang, Dou & Jia, 2016).
Employees may view CSR as a reflection on their own reputation by working for the organization. External CSR is positively related to job satisfaction, and in turn, commitment (Chatzopoulou et al., 2021). Internal CSR may not be directly related to these same benefits, but the benefits of external CSR seem to be amplified when internal CSR is also high. This is perhaps because other-focused motives are valued as indicators of doing good.
Research suggests a reciprocal relationship exists between CSR and firm performance. Social responsibility leads to increased financial performance and financial performance provides firms with more resources to apply towards social-performance activities (Orlitzky, Schmidt & Rynes, 2003). Conversely, organizations with poor financial health are less likely to have a good CSR reputation due to having fewer resources available to engage in social-performance activities (Waddock & Graves, 1997; Trevino & Nelson, 2011).
CSR as a mechanism to increase firm performance also appears to be somewhat controversial. Some authors suggest the distinction between ethical corporate culture and CSR is important, as the former is perceived by internal stakeholders while the latter is perceived by external stakeholders. Successful CSR programs may be neutral in a firm’s profit-maximizing strategy and more appropriately viewed as the outcome of an ethical corporate culture rather than a driving force (McWilliams & Siegel, 2001).
There is plentiful literature on how CSR can be abused and manipulated. For example, firms who exploit CSR may be incentivized to capture regulators, continue acting unethically internally, or engage in lobbying efforts that contradict societal interests (Biscaccianti, 2003). Public companies may benefit more from additional CSR activities as shareholder sentiment is more important (Donaldson, 2000).
Some researchers suggest a risk that leadership with strong stakeholder values can reverse the positive CSR-performance relationship by practicing “excessive” CSR (Javed et al., 2020). Balanced and prudent CSR may have more financial benefits.
Environmental Social Governance (ESG). ESG provides quantifiable indicators to measure accountability in how companies treat their workforce, manage supply chains, respond to climate change, increase diversity and inclusion, and affect communities. Studies seeking to examine the relationship of corporate ESG factors on overall firm performance are increasingly prevalent, and generally act as key indicators of management competence, risk management, and non-financial performance of an organization (Richardson, 2009). ESG as a topic is broad and includes a variety of issues related to the environment (e.g., climate change, energy and water use, carbon emissions), social responsibility (e.g., fair trade principles, human rights, product safety, gender equality, health, and safety), and corporate governance (e.g., board independence, corruption, and bribery, reporting and disclosure, shareholder protection) (Galbreath, 2013). Firms are supposed to focus on, address and report on issues to the degree they are “material” to the industry and business in question.
Research on the effects of ESG rating for increasing company stock premiums remains inconclusive (Landi & Sciarelli, 2019). However, there is strong evidence to suggest a relationship between a company’s focus on ESG and overall firm value. A longitudinal study of the most profitable companies in Australia found firm performance was much stronger at companies where ESG increased the most. Strong ESG was also found to increase firm value while weak ESG appeared to decrease it (Fatemi, Glaum & Kaiser, 2018; Galbreath, 2013). Aggregated evidence from more than 2,000 empirical studies were found to show that the business case for ESG investing is empirically very well founded. Roughly 90% of studies reported ESG as having no negative effects on company financial performance. In addition, most of those studies also found some degree of a positive relationship between ESG and company financial performance (Friede, Busch & Bassen, 2015)
Top firms are also more likely to associate ESG targets for the organization to executive compensation and pay incentives (Gosling, Guymer, O’Connor, Harris & Savage, 2021). An organization’s performance on ESG has also been found to be a priority interest for investors, with one study ranking it the fourth highest factor when considering investing (following investment performance, client demand, and product strategy) (Amel-Zadeh & Serafeim, 2018). However, results from another study suggest performance on ESG may be valued by investors only if they do not disrupt an organization’s pursuit of economic performance of the organization (Gosling, Guymer, O’Connor, Harris & Savage, 2021).
When assessing subcomponents of ESG and financial performance, some negative relationships may exist, despite an overall positive and significant relationship (e.g. environmental and CSR disclosure were negatively related to ROA and ROE; Alareeni & Hamdan, 2020). We recommend ongoing research into relationships between ESG’s individual components and various practices, culture and performance. The focus on “ESG” as a single category may not survive extended scrutiny, not least because performance varies so widely.
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