The Relation between Stakeholder Management, Firm Value,

and Corporate Governance

Bradley W. Benson*
Department of Economics and Finance
Louisiana Tech University
Ruston, LA 71270
318-257-2389
bbenson@latech.edu

Wallace N. Davidson III

Finance Department – Mailcode 4626
Southern Illinois University
Carbondale, IL 62901
618-453-1429
davidson@cba.siu.edu

Hongxia Wang
Department of Economics and Finance
Ashland University
Ashland, OH 44805
419-289-5222
hwang2@ashland.edu

December 2, 2009

* Corresponding Author

The authors would like to thank seminar participants at the University of Mississippi for many
helpful and insightful comments. All errors remain the responsibility of the authors.

Electronic copy available at: http://ssrn.com/abstract=1497205

 The Relation between Stakeholder Management, Firm Value, and
Corporate Governance

Abstract

In this paper, we examine the relation between stakeholder management, firm value, and
corporate governance. Building good relations with various stakeholders may help create firm
value, but excess investment in stakeholder management may be an agency cost. High quality
corporate governance may mitigate value-destroying over-investment in stakeholder
management. Using an unbalanced panel of 3,632 firm-year observations for 974 firms and three
proxies for the deviation from expected investment in stakeholder management, we find that
CEOs with a high portfolio vega, more independent boards, dual CEO/Chairs, and firms with a
high level of institutional ownership effectively control deviations from expected investment in
stakeholder management. These results are consistent with both the managerial ownership
incentive and the board monitoring hypotheses; excess stakeholder management is negatively
related to CEO portfolio vega, controlling for portfolio delta; excess stakeholder management is
negatively related to proxies for effective board monitoring. Consistent with Jensen’s
“Enlightened Value Maximization” theory, the results show that corporations with good
governance pursue shareholder value maximization without overinvesting in stakeholders.

JEL classification: G34; J33; L21; M14; M52

Keywords: Corporate Governance; Corporate Social Responsibility; Enlightened Value

Maximization; Institutional Ownership; Firm Value; Managerial Ownership Incentives;
Stakeholder Theory

Electronic copy available at: http://ssrn.com/abstract=1497205

 The Relation between Stakeholder Management, Firm Value, and Corporate
Governance

1. Introduction

Proponents of stakeholder management argue that a firm should manage the relations

with all of its stakeholders rather than focus on shareholder wealth. Researchers in a wide range

of fields have examined the implications of stakeholder management (e.g. strategic management,

organizational behavior, business ethics, and sustainable development) (Laplume, Sonpar, and

Litz, 2008). The corporate scandals of the early 2000s have brought corporate social

performance and stakeholder management to the forefront (Neubaum & Zahra, 2006)1.

Furthermore, constituency statutes have been enacted in over half of US states in recent years

that either require or permit directors to consider stakeholder interests, other than shareholders,

when conducting their duties (Keay, 2009).2

The principal argument of stakeholder management (SM) is that organizations should be

operated and managed in the legitimate interests of all their constituents who can affect or be

affected by the achievement of the organization’s objectives (Freeman, 1984; Donaldson and

Preston, 1995). Stakeholder management captures various firm-stakeholder relationships.

Proponents maintain that stakeholder management is strategically important, and firms can

benefit from properly managing the relationship with these important groups (Fong, 2009;

Bhattacharya, Korschun, & Sen, 2009). Empirical studies, however, have documented that only

1
Stakeholder management and social performance are similar in their construct such that firms which manage
stakeholder relations may be seen as socially responsible.
2
The legal duty of directors to consider the interest of additional stakeholders has also taken hold in the UK. For
example, section 172 of the Companies Act 2006 states that directors have a duty to promote the success of the
company by considering such factors as: (a) the likely consequences of any decision long term, (b) the interests of
the company’s employees, (c) the need to foster the business relationships of the company with suppliers, customers
and other organizations, (d) the impact of the company’s operations on the community and the environment, (e) the
desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act
fairly as between members of the company.

2
some stakeholders are critical to firm value creation (such as Galbreath, 2006; Hillman and

Keim, 2001).

One of the downsides to investing in stakeholder management is that it consumes a firm’s

limited resources. Directing excess resources from shareholders to stakeholders may hurt firm

value. Some shareholders view stakeholder management as being at odds with profits. For

example, two shareholders at Goldman Sachs protested the company’s donation of land for a

nature preserve. The shareholders based their protest on the idea that while the donation would

have benefitted one of the firm’s stakeholders (the world environment), it would be costly to

shareholders because the land could have been put to profitable use (Kelly and Davis, 2007).

Stakeholder theory seems to be at odds with value maximization. Jensen (2001; 2002)

addresses this problem and proposes enlightened value maximization. He argues that a firm’s

goal is to increase firm value, but a firm cannot maximize its value unless it takes good care of

its stakeholders. Jensen’s theory implies that there is an optimal level of stakeholder

management that maximizes shareholder wealth. Similarly, Brickley, Smith, and Zimmerman

(2002) argue that “creating shareholder wealth involves allocating resources to all constituencies

that affect the process of shareholder value creation, but only to the point at which the benefits

from such expenditures do not exceed their additional costs” (p.113). That is, when the marginal

cost of stakeholder management exceeds the marginal benefit to shareholders, it would not be

optimal to pursue stakeholder management any further. Benson and Davidson (2009) find that

while stakeholder management is positively related to firm value, firms do not compensate

managers for stakeholder management; instead, firms compensate their CEOs for achieving the

firm’s ultimate goal—value maximization. Their results indicate that effective managers

optimize relations with stakeholders to accomplish value maximization.

3
 If, however, firms spend excess resources on stakeholder management, shareholder

wealth would suffer. We propose that excess resource allocation to stakeholder management is,

therefore, an agency cost. As with other agency conflicts, there are various governance

mechanisms that should protect shareholders. The allocation of excessive resources toward

stakeholder management should be no exception. The quality of corporate governance may,

therefore, affect a firm’s stakeholder management policy.

In this paper, we examine how various corporate governance mechanisms affect the

amount of resources diverted toward stakeholders. We argue that good corporate governance,

proxied by managerial ownership incentives, board monitoring, and monitoring from

institutional investors, effectively controls agency costs caused by excessive investment in

stakeholder management.

Using an unbalanced panel of 3,632 firm-year observations for 974 firms, we find CEOs

with a high portfolio vega (the sensitivity of CEO wealth to stock return volatility), more

independent boards, and CEO duality effectively control deviations from expected investment in

stakeholder management, and that these mechanisms are most effective at constraining

overinvestment in stakeholder management. We find that excess stakeholder management is

negatively related to CEO portfolio vega, controlling for delta (sensitivity of CEO wealth to

stock price), and excess stakeholder management is negatively related to proxies for effective

board monitoring. These results are consistent with both the managerial incentive and the board

monitoring hypotheses. We also document that firms with high levels of excess stakeholder

management have lower levels of institutional ownership which indicates that institutional

investors may either avoid investing in such firms or provide governance that lessens this

behavior.

4
 This study is unique. To the best of our knowledge, we are the first to introduce the

concept of deviation from expected investment in stakeholder management and empirically test

how various governance mechanisms are related to excess stakeholder management. The

remainder of this paper is organized as follows. In Section 2, we motivate our research, review

the literature, and develop our hypotheses. We provide an overview of our data and the sample in

Section 3. In Section 4, we test our hypotheses regarding the effect of internal governance

mechanisms on excess stakeholder management. We provide concluding remarks in Section 5.

2. Background, motivation, and development of hypotheses

2.1. Stakeholder theory

Under stakeholder theory, the firm is a collection of groups and individuals with a stake

in the firm. The purpose of the firm is to manage the interests of these various stakeholders.

Stakeholder theory has diverged into at least two approaches. The first is the strategic approach

in which firms manage stakeholder relations in the pursuit of value maximization. Here, profit

maximization is the fundamental purpose of the firm with stakeholder management as a means to

an end (Freeman et al., 2004). The second approach is the moral approach where firms manage

stakeholder relations for ethical or moral reasons (Freeman, 1984; Evan and Freeman, 1988).3

Another issue in stakeholder theory is the identification of stakeholders and the allocation

of resources between them. Freeman (1984, p. 46) is credited with the classic definition in which

a stakeholder is defined as "any group or individual who can affect or is affected by the

achievement of the organization's objectives". Reviewing 75 sources in the literature, Friedman

3
Donaldson and Preston (1995) define these approaches as instrumental and normative stakeholder theory.
Instrumental stakeholder theory is concerned with how managers act if they are to further goals of the organization,
such as long-run profit maximization or shareholder value. On the other hand, normative stakeholder theory is used
to explain how managers should behave and arrive at the purpose of the organization based on ethical principles.
Freeman (1994; 1999) maintains that business and ethical decisions cannot be separated.

5
and Miles (2006) find 55 definitions of what constitutes a stakeholder group. Stakeholder

definitions range from only those who have a vested interest in the firm (Carroll, 1993) to those

including any entity that affects or is affected by the firm (Starik, 1993).

Still another issue in stakeholder theory/management is the allocation of resources

between stakeholders. Clarkson (1995) argues that all legitimate (primary) stakeholders have

intrinsic value and no one is more important than the other. If all stakeholders are treated with

the same priority, it would be difficult to manage a firm because various stakeholders have

different interests. For example, suppliers would want to receive high prices, and customers

would want low prices; accomplishing these goals would be unlikely to produce value for

another stakeholder group, shareholders (Sundaram & Inkpen, 2004).

2.2. Value Maximization

Milton Friedman stated that “the social responsibility of business is to increase its

profits” (Friedman, 1970)4. Brickley et al. (2002) argue that a company must focus its attention

on shareholder wealth to survive in a competitive and technology-oriented business world.

Shareholder wealth maximization has been taught in colleges as a basic concept in finance

courses for decades and is a dominating view of many if not most financial scholars. One of the

major differences between shareholder wealth maximization and stakeholder theories is the role

of managers in the resolution of a firm’s internal conflicts (Laurent, 2007). Shareholder value

theory emphasizes that the role of managers is to make decisions that enhance shareholder value

while normative stakeholder theory maintains that managers should focus on the welfare of all

stakeholders (Laurent, 2007). Proponents of value maximization believe that other

4
Hillman and Keim (2001) argue that social responsibility and stakeholder management are closely related and that
social responsibility is a measure of how well a firm manages the relations with its stakeholders. Graves and
Waddock (2000) state that social performance can be defined as stakeholder relations. The groups identified in
social responsibility discussions are often the same groups identified as stakeholders. As such, corporate social
responsibility and stakeholder theory may be directly linked and are at a minimum based on a similar foundation.

6
constituencies can become better off if shareholders interests are met. Jensen (2001; 2002)

proposes that a business cannot maximize wealth simply by stating this as its goal; it requires

working with stakeholders to achieve this objective. So, simply focusing on shareholder value

maximization may be like putting blinders on a horse, and it may not be applicable in today’s

business world.5

3. Enlightened value maximization

Jensen (2001; 2002) argues that while the goal of the corporation is to maximize

shareholder wealth, this goal cannot be met by treating stakeholders poorly. Companies should

not try to maximize the welfare of all stakeholders, but work with stakeholders to produce

shareholder wealth. More specifically, companies should improve stakeholder welfare until the

marginal cost of doing so exceeds the marginal benefit to shareholders. Thus, Jensen’s approach

is somewhat consistent with the management of stakeholders as a means to an end where the end

is shareholder value maximization6.

There are at least two questions raised by this logic. The first question is: how would

actions aimed at improving the welfare of stakeholders contribute to shareholder wealth; and the

second is: does stakeholder management actually improve company financial performance and

increase shareholder wealth.

To address this first question, we must realize that the effect of stakeholder management

on shareholder wealth could be bi-directional. There may be rewards for positive actions, as well

5
In the recent business downturn and stock market drop, the press has increasingly focused on business social
responsibility and the relations between business and stakeholders. Value maximization, as the sole firm goal, is
viewed very negatively in the popular press and even in the financial press.
6
Instrumental stakeholder theory posits that stakeholder management will lead to better financial performance.
Jensen’s (2001; 2002) enlightened value maximization does differ from instrumental stakeholder theory. Jensen
argues that stakeholder theory fails to provide a mechanism for making the tradeoffs between competing stakeholder
claims. Enlightened value maximization implies that managers will make tradeoffs between stakeholders using the
effect on firm value as the decision criteria.

7
 as penalties for irresponsible ones. Companies that build better relations with primary

stakeholders such as employees, customers, suppliers, and communities may be able to increase

their financial gains (Freeman, 1984). Prior research has documented these rewards (Turban &

Greening, 1996; Greening & Turban, 2000; De Luque, Washburn, Waldman, and House, 2008).

Godfrey (2005) argues that corporate social responsibility and philanthropic activities can

generate positive “moral capital” among stakeholders which may provide an insurance-like

effect for firm reputation if social problems occur.

Companies that mistreat stakeholders may face penalties. Researchers have documented

these penalties (Davidson & Worrell, 1988; Karpoff & Lott, 1993; Cohen, Fenn, & Naiman,

1995; Davidson, Worrell, & El-Jelly, 1995; Hart & Ahuja, 1996; Karpoff, Lott, & Rankine,

1998; Karpoff, Lee & Vendrzyk, 1999; Klassen & Whybark, 1999; Konar & Cohen, 2001;

Davidson, Worrell, & El Jelly, 2000). On the other hand, Brammer, Brooks and Pavelin (2006)

find that portfolios of UK stocks of firms viewed as socially irresponsible outperform portfolios

of firms viewed as socially responsible; so it is not clear whether these penalties are sufficient.

While stakeholder theory posits that stakeholder management may generate increases in

income or shareholder wealth, companies that spend resources directed at stakeholder welfare, in

excess of the marginal benefits, may find that income and/or shareholder wealth decreases

(Hillman & Keim, 2001). Therefore, whether companies actually increase or decrease

shareholder wealth by managing stakeholder relations is an empirical question.7

7
Numerous researchers have addressed this question with equivocal findings. Many have found a positive relation
between stakeholder management and financial performance (Berrone, Surroca, & Tribó, 2007; Barbara, Myron, &
Bruce, 2006; Hillman & Keim, 2001; Moore, 2001; Ogden & Watson, 1999; Ruf, Muralidhar, Brown, Janney, &
Paul, 2001; Waddock & Graves, 1997; Moneva, Rivera-Lirio, & Munoz-Torres, 2007) while others have found a
negative or a mixed relation (Meznar, Nigh & Kwok, 1994; Berman et al., 1999; Omran, Atrill, & Pointon, 2002;
Bird, D. Hall, Momentè, & Reggiani, 2007).

8
 Jensen’s theory of enlightened value maximization (enlightened stakeholder theory)

suggests that value maximization cannot be achieved if companies ignore or mistreat their

stakeholders. Others have made similar propositions (Graves & Waddock, 2000; Davis, 2005).

Jensen’s model differs from traditional instrumental stakeholder theory because his model

provides a basis for making tradeoffs between stakeholder groups. The company’s relations with

its stakeholders must be rooted in the company’s strategies and must be a means to an end—

value maximization. Accordingly, managers optimize relations with stakeholders to maximize

firm value. Managing stakeholder welfare may be a partial determinant of firm value. However,

excess investment in stakeholder management may be detrimental to a firm’s value.

3.1. Excess stakeholder management as an agency cost

Once an owner-manager owns less than 100 percent of the corporation, the costs of

providing the manager with pecuniary and non-pecuniary benefits are borne, in part, by

shareholders (Jensen & Meckling, 1976). These costs are called agency costs. If management

spends resources on managing stakeholder relations and the expenditures do not lead to

increased firm value, then these expenditures would be an agency cost. What incentive would

management have to spend resources on stakeholders?

Cespa and Cestone (2007) argue that stakeholder management can become a powerful

entrenchment strategy for incumbent CEOs because inefficient managers may commit

themselves to a socially responsible behavior to gain stakeholders’ support against shareholders.

A firm’s resources are limited, and there are interest conflicts between shareholders and other

constituents. Managers must solve these conflicts. Diverting resources from shareholders may

either hurt shareholders or benefit shareholders in the long run. Proponents of the strict

shareholder value maximization philosophy argue that philanthropic activities and maintaining

9
stakeholder welfare would waste company resources that would be better spent to produce value

for shareholders. However, diverting some resources in the management of stakeholder welfare

may produce long-run value maximization (Jensen, 2001, 2002; Brickley et al., 2002). The

question may not be whether a firm should invest in stakeholder management, but how much

should be dedicated to stakeholder management in the pursuit of shareholder wealth

maximization.

If stakeholder management is the mean to an end, then investment in stakeholder

management is a necessity of doing business. However, when these costs exceed the benefits,

stakeholder management leads to agency costs. Determining an optimal level of stakeholder

management investment may be a challenging issue to any firm. High quality corporate

governance could control excess stakeholder management.

3.2. Internal governance mechanisms and agency costs

3.2.1. Managerial ownership incentives and agency costs

Managerial equity-based compensation and equity-based ownership are important

mechanisms for alleviating agency conflicts between managers and shareholders (Jensen &

Meckling, 1976). Increasing managerial equity-based compensation in the form of stock and

options leads to an increased sensitivity of CEO wealth to stock price, delta, which may help

alleviate agency conflicts between managers and shareholders. However, high levels of delta

may potentially make mangers risk averse, causing them to forgo some high risk positive NPV

projects (Amihud & Lev, 1981; Smith & Stulz, 1985). Risk averse managers may prefer lower

firm risk given that they are exposed to greater risk than diversified investors (Amihud & Lev,

1981; Schrand & Unal, 1998; Smith & Stulz, 1985). As a result, managers may decrease firm

10
risk by selecting projects with lower cash flow volatility or by investing assets that will stabilize

a firm’s revenue stream through diversification strategies.

The convex payoff function of option-based compensation increases the sensitivity of

CEO wealth to stock return volatility, vega, which is seen as one potential mechanism to offset

managerial risk aversion. Its effectiveness, however, depends on the managerial utility function.

For example, Guay (1999) and Ross (2004) demonstrate that the convexity payoff of stock

options can be offset by the concavity of the utility function of a risk-averse manager. Similarly,

Ju, Leland, and Senbet (2002) and Carpenter (2000) show that a risk averse manager may choose

lower risk investments when given more call options. Furthermore, Parrino et al. (2005) show

that while stock options increase risk taking to a greater degree than restricted stock, in-the-

money options make managers more risk averse relative to at-the-money or out-of-the-money

options. Finally, Lewellen (2006) demonstrates that in the money options make managers more

risk averse to stock price volatility. Thus, whether the convexity of higher vega overcomes the

concavity of higher delta remains a theoretical and empirical question.

A large branch of literature examines the relation between managerial incentive structure

and firm performance under the assumption that firm performance is the direct result of risk-

related investment decisions. These studies find a positive relation between managerial

ownership and firm performance (Mehran, 1995; Core and Larker, 2002), or a positive but

decreasing relation between managerial ownership and firm performance (Morck, Schleifer, and

Vishney, 1988; McConnell and Servaes 1990, 1995; Hermalin and Weisbach, 1991; Hubbard

and Palia, 1995; Holderness, Krosner, and Sheehan, 1999; Anderson and Reeb, 2003; Tian,

11
2004; Davies, Hillier, and McColgan, 2005; Adams and Santos, 2006; Pukthuanthong, and Roll,

Walker, 2007; McConnell, Servaes, and Lins, 2008; Tong, 2008; Benson and Davidson, 2009).8

Studies also analyze the effect of managerial incentive compensation on other risk-related

investment decisions. DeFusco et al. (1990) find that stock return variance increases after the

approval of stock option plans. Guay (1999), likewise, finds a positive relation between vega and

the standard deviation of returns. Rajgopal and Shevlin (2002) find a positive association

between vega and oil exploration risk, while Knopf et al. (2002) document that the use of

derivatives, a hedging mechanism, is negatively related to vega but positively related to delta.

Cohen et al. (2002) document a positive relation between CEO wealth elasticity and stock return

volatility. Coles, Naveen, and Naveen (2006) document that higher vega, controlling for delta, is

positively related to higher R&D expenditures, less investment in property, plant, and equipment,

increased focus, and greater firm risk. In a study of publicly-traded banks, Mehran and

Rosenberg (2007) find a positive relation between CEO stock option holdings and equity and

asset volatility. Low (2009), additionally, finds that firms with higher CEO portfolio vega,

controlling for delta, reduce firm risk less following an exogenous increase in takeover

protection in Delaware during the mid-1990s. Conversely, while the majority of studies have

documented a positive relation between vega and risk related measures, Brick et al. (2008)

document that both systematic and idiosyncratic firm risks decrease after increases in CEO pay

sensitivity, measured using delta and vega.

8
However, the interpretation of a positive relation between managerial ownership and firm performance has been
criticized for ignoring potential endogeneity (Demsetz, 1983).Studies by Demsetz and Lehn (1985), Agrawal and
Knoeber (1996), Lorderer and Martin (1997), Cho (1998), Demsetz and Villalonga (2001), Himmelberg, Hubbard,
& Palia, (1999), Palia (2001), Coles, Lemmon, & Meschke (2003), Brick, Palia, & Wang (2005), and Cheung &
Wei (2006) find no relation between managerial ownership and firm performance, supporting the Demsetz argument
that firms optimally contract with management after controlling for other firm and manager specific variables using
firm fixed effects.

12
 We assume that firms choose a combination of delta and vega to implement value

maximizing decisions. High levels of delta expose managers to more risk relative to diversified

shareholders, which may induce a preference for less risky projects. However, option-based

compensation increases the sensitivity of managerial wealth to stock return volatility. Therefore,

higher vega may persuade managers to take on greater risk. The empirical question, then, is

whether or not the concavity of the manger’s utility function dominates the convexity of the

payoff. We expect CEOs with high levels of vega, controlling for delta, to make more value

maximizing investment decisions. When managerial ownership incentives are in alignment with

the goals of shareholders, managers will have lower levels of investment in stakeholder

management that is unrelated to firm value. As a result, the managerial ownership incentive

hypothesis is:

H1: Excess stakeholder management is negatively related to CEO portfolio vega,

controlling for delta.

3.2.2. Board monitoring and agency costs

Cespa and Cestone (2007) show that inefficient CEOs are always opposed to any

institutionalization of stakeholder protection which would deprive them of their discretion over

stakeholders. This behavior suggests that there is an agency problem in stakeholder

management. A board’s attitude towards various stakeholders is likely to become an important

determinant of its stakeholder policy. In addition, many state statutes have challenged the

traditional dominant view of the shareholder-only fiduciary duty of the board of directors and

specified that boards have the right to take the interests of all stakeholders into account

(McDonnell, 2004). Under such pressure, boards may be more likely to apply “enlightened

stakeholder management” in dealing with stakeholders while maximizing shareholder wealth.

13
So, effective monitoring by boards may serve to mitigate agency problems in terms of the

amount of resources diverted to other stakeholders.

Board composition may affect the board’s management policy. Regulators and academics

believe that outside directors are generally more effective monitors than inside directors. The

Sarbanes-Oxley Act and the exchange rules in 2002 require that the majority of the board be

independent. Numerous studies link the proportion of outside directors to financial performance

and shareholder wealth (e.g. Rosenstein & Wyatt, 1990; Byrd & Hickman, 1992; Brickley,

Coles, & Terry, 1994; Cotter, Shivdasani, & Zenner, 1997). Outside dominated boards may be

less likely to provide other stakeholders with excess resources, and they would be more likely to

optimize the level of stakeholder management. In other words, outside dominated boards’

should be in a better position to control excessive investment in stakeholder management.9

Board size is another major characteristic of corporate boards (Lipton & Lorsch, 1992;

Jensen, 1993; Yermack, 1996). Even though there is debate regarding the effect of board size on

its decisions, the commonly accepted idea is that small boards are better than large ones because

large boards place a greater emphasis on “politeness and courtesy”, making it easier for CEOs to

control. Empirical studies support this idea (e.g. Yermack, 1996; Eisenberg, Sundgren, and

Wells, 1998). If small boards are more effective in monitoring management, small boards may

be more likely to control excess resources diverted to stakeholder management.

Lastly, when the CEO also holds the title of board chair, CEO duality, power may

concentrate in the CEO’s position. Duality may allow the CEO to control information available

to other directors impeding effective monitoring (Jensen, 1993). Conversely, Brickley, Coles,

9
Other research has related board composition to stakeholder management. Johnson and Greening (1999) find that
outside dominated boards tend to pursue greater stakeholder management. Similarly, Kassinis and Vafeas (2002)
find that the likelihood of becoming an environmental lawsuit defendant decreases with the number of outside
directors.

14
and Jarrell (1997) show that CEOs are awarded the chair position as a normal part of the

succession process; successful CEOs later become CEO/Chair. While duality is likely to have an

impact on excess stakeholder management, the direction of the relation is difficult to predict.

Thus, more effective monitoring by the board is expected to reduce agency costs between

managers and shareholders by preventing managers from making excessive investment in

stakeholder management and using it as an entrenchment tool. Therefore, the board monitoring

hypothesis is as follows:

H2: Excess stakeholder management is negatively related to proxies for effective board
monitoring (i.e. smaller board size and more independent directors).

3.2.3. Institutional and blockholder ownership and agency costs

Institutional and blockholder investors also serve a monitoring role in mitigating agency

problems (Edwards & Hubbard, 2000). Empirical research supports this idea (Brickley, Lease, &

Smith, 1988; Hartzell & Starks, 2003; Holderness, 2003; Jiambalvo, Rajgopal, &

Venkatachalam, 2002; McConnell & Servaes, 1990).

Given their large financial stake, institutional investors have incentives, resources, and

the ability to monitor a firm’s stakeholder policy. Empirical studies have also explored the role

of blockholders in the conflict between stakeholder management and financial performance. For

example, institutional ownership has been examined as an important indicator of monitoring and

influencing CEOs’ attention to corporate social performance (Graves & Waddock, 1994; Wright

et al., 2002; Wright, Ferris, Sarin, & Awasthi, 1996). Johnson and Greening (1999) find that

institutional type matters to corporate social performance. Neubaum and Zahra (2006) document

that the frequency of institutional owners’ activism affects the institutional ownership-corporate

social performance relation.

15
 Contrary to these studies, we focus on the institutional investor role in preventing over-

investment in stakeholder management. A higher concentration of institutional investor

ownership should also lead to lower levels of investment in stakeholder management that is

unrelated to firm value. Consequently, the institutional ownership hypothesis is as follows:

H3: Excess stakeholder management is negatively related to the percentage of shares

held by institutional investors.

4. Sample selection and data

4.1. Sample selection

We obtain our initial sample from the KLD Statistical Tool for the Analysis of Trends in

Social and Environmental Performance (KLD) database, an annual statistical database of over 90

social and environmental indicators provided by KLD Research and Analytics, Inc. The database

reports social, environmental, and governance performance indicators for S&P 500, Domini 400

Social, and Russell 1000 (starting in 2001) companies between the years of 1991 to 2002. We

use the KLD database because it is a measure of social performance (relations with stakeholders)

that has been developed independently of this study’s researchers, and therefore, does not suffer

from researcher bias that might occur if we use our own definition of stakeholder management

and corporate social performance. Furthermore, the KLD database is a well established measure

of both stakeholder management and corporate social performance. Researchers have certified its

16
quality10. The database has been widely used in empirical studies.11. In addition, the KLD

database measures several different aspects of stakeholder management12.

Our initial KLD sample has 8,741 firms from 1991 to 2002. We match the KLD data with

COMPUSTAT accounting data, resulting in a matched sample composed of an unbalanced panel

of 7,652 firm year observations for 1,368 firms and a balanced panel of 3,864 firm year

observations for 322 firms between the years of 1991 and 2002.13 We match this set of firms to

Standard and Poor’s EXECUCOMP database, which includes annual compensation data from

proxy statements for the five highest paid executives for firms in the S&P 500, the S&P MidCap

400, and the S&P SmallCap 600. We lose one year of data because the EXECUCOMP data

begins in 1992. This results in an unbalanced panel of 6,295 firm year observations for 1,143

firms and a balanced panel of 3,319 firm year observations for 317 firms from 1992 to 2002.

Lastly, to account for the influence of internal governance mechanisms, we also obtain board of

director characteristics from the RiskMetrics IRRC (IRRC) database and institutional ownership

data from the Thomson 13F (13F) database. Due to data limitations in IRRC, board

characteristics are only available from 1996 onward, with board committee variables only

available from 1998. We obtain volume traded and shares outstanding data from the Center for

10
For example, Chatterji, Levine, and Toffel (2009) conclude that while the KLD database does not reflect all
available information on stakeholder management and corporate social performance, it is a good predictor of more
narrow measures such as compliance with environmental regulations.
11
See Agle, Mitchell, and Sonnenfeld (1999), Berman, Wicks, Kotha, and Jones (1999), Graves and Waddock
(1994), Hillman and Keim (2001), Johnson and Greening (1999), Turban and Greening (1996), Waddock and
Graves (1997), and Coombs and Gilley (2005).
12
Having several measures of what constitutes stakeholder management is important for two reasons. First, it is
hard to identify when a corporation is responsive to stakeholders because individuals view societal needs and
dictates differently. For example, one person may view diversity in hiring as the key indicator of social
responsiveness, while another may view a corporations environmental actions and policies as key. Second, we need
a measure that encompasses numerous stakeholders.
13
A primary problem with the KLD data is that the data lacks a numeric unique identifier (i.e. CUSIP) for years
prior to 1995 in which to merge with COMPUSTAT. We try several methods to obtain a COMPUSTAT unique
identifier (GVKEY) for the initial sample. First, we backfill early years of data (prior to 1995) with CUSIP’s from
the same firm if it appears in the database in a later year. Next, we attempt to merge companies with COMPUSTAT
using CUSIP, ticker, and the first 15 letters in the company name. Lastly, we hand verify our merge results from the
steps above and hand match firms with COMPUSTAT for any remaining firms not captured in previous steps.

17
Research in Securities Prices (CRSP) database. The final matched sample, after combining KLD,

COMPUSTAT, EXECUCOMP, IRRC, 13F, and CRSP data, contains an unbalanced panel of

3,632 firm year observations for 974 firms and a balanced panel of 1,666 firm year observations

for 238 firms from 1996 to 2002.14

4.2. Variable descriptions

We rely on the KLD database for stakeholder management and social issue performance

data, COMPUSTAT for accounting data, EXECUCOMP for managerial ownership,

compensation data, and CEO data, IRRC for board and CEO data, and 13F for institutional

ownership data, and CRSP for volume traded and shares outstanding data.

4.2.1. Deviation from expected stakeholder management

Enlightened value maximization posits that firms will invest in stakeholder management

(SM) until the marginal cost of doing so exceeds the marginal benefit to shareholders. This level

of investment in stakeholder management is each firm’s expected, or optimal, investment in

stakeholder management (SM*). However, while we can observe a firm’s actual investment in

stakeholder management, SM, SM* is unobservable. Therefore, we use two proxies for SM* to

measure the deviation of each firm from expected SM.

To begin with, we create a measure of the deviation of each firm from expected

stakeholder management (ESM), which is the residual from a first stage firm fixed-effects model

of SM on Tobin’s Q:

β 1

14
Data limitations on our set of instruments reduce the sample size to 3,128 firm year observations for 905 firms
from 1996 to 2002. The reduced sample is used in Section 4.2.

18
where SM is the firm’s stakeholder management score, Q is Tobin’s Q, and ESM = .

Accordingly, the residuals are a firm-specific proxy of deviations from expected investment in

SM, or the portion of SM that is orthogonal to, or unrelated to, firm value.15 To construct

measures for SM, we follow the procedure used in prior research in the area (Waddock &

Graves, 1997; Hillman & Keim, 2001; Coombs & Gilley, 2005), and construct a measure of the

firm’s stakeholder management (SM) performance using the KLD categories of employee

relations (EMP), diversity issues (DIV), product issues (PRO), community relations (COM), and

environmental issues (ENV). These five categories parallel the primary stakeholder groups with

regard to employees (including diversity initiatives), customers (product safety/quality), the

natural environment, the community, and suppliers (to the extent that certain diversity initiatives

are directed toward suppliers). We detail the calculation of the SM variables in Appendix A.

Earlier work on association between corporate arrangements and firm performance has used

Tobin’s Q as the measure of firm value16. Following Smith and Watts (1992), we calculate

Tobin’s Q as the market value of equity minus the book value of equity plus the book value of

assets all divided by the book value of assets.

As a second proxy for the deviation from expected SM, we assume that SM* is close to

the industry average for each firm. Therefore, we use industry adjusted SM (IASM) as an

additional measure of the deviation of each firm from expected stakeholder management:

SM 2

15
This model may omit many factors that are related to SM. Therefore, using the residuals from the first stage
regression as a proxy for expected investment in SM may exacerbate measurement error in the variable. However,
because we are using the residuals as a dependent variable in our analysis, measurement error is not a concern
because it is captured in the error term of our regression model and does not bias our coefficient estimates.
16
See Demsetz and Lehn, 1985; Morck, Shleifer, and Vishney, 1985; Lang and Stultz, 1994; Yermack, 1996;
Himmelberg, Hubbard, and Palia, 1999; Palia, 2001; Gompers, Ishii, and Metrick, 2003; Coles, Lemmon, and
Meschke, 2003; and Bebchuk, Cremers, Peyer, 2007.

19
where industry adjusted SM (IASM) is equal to the difference between each firm’s actual

investment in SM and the industry average SM (IAVGSM). Following Benson and Davidson

(2009), we use the average value of peer firms within each company’s 4-digit Global Industry

Classification System (GICS) industry group each year.17

4.2.2. Managerial ownership incentives

We use delta and vega as proxies for CEO equity-based compensation and ownership

incentives. Delta (DELTA) is defined as the dollar change in CEO portfolio wealth for a 1%

change in firm value. Vega (VEGA) is the dollar change in CEO portfolio wealth for a 1%

change in the annualized standard deviation of stock returns. Guay (1999) shows that option

vega is many times higher than stock vega. Following Knopf et al. (2002), Rajgopal and Shevlin

(2002) and Coles et al. (2006), we use the vega of the option portfolio to measure the total vega

of the stock and option portfolio.

We estimate each CEO’s portfolio of stock and options using data from the

EXECUCOMP database as in Core and Guay (2002). We detail the calculation of the CEO

portfolio delta and vega in Appendix B. We winsorize delta and vega at the upper and lower 1%

to reduce any possible impact from outliers, which is consistent with prior literature (Guay,

1999; Core and Guay, 1999; Coles et al. 2006). We also use log of delta and vega to account for

the high skewness and kurtosis in each of these variables.

17
We use 4-digit GICS industry group rather than the more common 2-digit SIC code or Fama-French (FF) industry
classification for several reasons. First, GICS categorization is based on both a firm’s operational characteristics and
information on investors’ perceptions as to what constitutes the firm’s main line of business. Second, Chan,
Lakonishok, and Swaminathan (2007) demonstrate that a 4-digit GICS code classification using 24 categories
achieves the same level of discrimination as the FF procedure using 48 categories. Finally, the ability to effectively
discriminate between industries using a smaller number of categories results in more industry peers each year than
the FF procedure, resulting in potentially more accurate industry averages. A breakdown of 4-digit GICS and FF
industry classifications by year for the KLD database is provided in the appendix (available from the authors upon
request).

20
4.2.3. Board monitoring

We proxy for effective monitoring by the board of directors using three measures: board

size, board independence, and whether the CEO also holds the title of chairman of the board

(COB). First, we measure board size (BRDSIZE) as the number of directors serving on the board

during the year. Next, we classify directors as insiders (employed by the firm), affiliated (e.g.

former employees, family members of employees, or those with business relations with the firm)

and independent (Baysinger & Butler, 1985). We then create a variable for the percentage of

outside directors serving on the board (BRDIND) calculated as the proportion of outside

directors relative to total directors on the board. Finally, we determine whether or not the CEO

holds the title of CEO and COB (DUALITY) and create a dummy variable equal to one in such

cases, and zero otherwise.

4.2.4. Institutional and blockholder ownership

We construct a measure of institutional investor ownership percentage (INSTOWN),

which is the percentage of shares held by institutions during the year.

4.2.5. Controls

We include several additional control variables to proxy for various firm specific factors

which have been shown to be determinants of stakeholder management, internal governance

structure, and firm value.

Cash. High cash balances may exacerbate agency problems (Jensen, 1986) leading to

inefficient investment. We control for cash which is the ratio of cash to total assets (CASH).

Capital structure (Leverage). The theoretical and empirical research has found that

leverage is positively related to firm value. However, Titman (1984) and Maksimovic and

21
Titman (1991) argue that some firms also consider the costs imposed on non-financial

stakeholders in undertaking relationship-specific investments when making capital structure

decisions. For example, research has shown that firms selling unique products (Titman and

Wessels, 1988), entering into bilateral relationships (Banerjee et al., 2008) or strategic alliances

(Kale and Shahrur, 2007) maintain or lower leverage after entering into agreements with

principle suppliers or customers. We proxy for the firm’s capital structure using the debt ratio

(TD/TA); we calculate it as the book value of total debt to the book value of total assets.

Firm size. Research has shown that firm size is positively related board size and CEO

compensation, but negatively related to firm value. We control for firm size using the log of sales

(LNSALES).

Firm Performance. We measure accounting performance using return on assets (ROA),

calculated as earnings before interest and taxes divided by total assets. As an additional measure

of financial performance, we use the 1-year total return to shareholders (TRS), including the

monthly reinvestment of dividends. This measure is obtained from the COMPUSTAT database.

Sample Selection. A potential problem with the KLD database is that the coverage of

firms in the 1990’s includes firms in the S&P 500 and selected firms from the Domini 400 Social

Index. This may lead to selection bias because the selection of firms in the Domini 400 Social

Index depends on corporate social performance. To account for selection bias, we include a

dummy variable (DS400) equal to 1 when the firm is in the Domini 400 Social Index.

4.2.6. Instruments

We use several instruments to proxy for various firm specific factors which have been

shown to be determinants of internal governance structure.

22
 Growth opportunities and information asymmetry. Jensen (1993) argues that the

monitoring of high growth firms is costly, while Fama and Jensen (1983) suggest that firms with

higher stock return volatility have higher levels of information asymmetry. Prior research has

suggested that the monitoring costs associated with higher levels of information asymmetry are

inversely related to board size and independence (Linck et al., 2008; Adams and Ferreira, 2007;

Raheja, 2005; Maug, 1997). Similarly, Demsetz and Lehn (1985) note that higher levels of

information asymmetry (as proxied by higher volatility) is associated with more managerial

discretion, necessitating higher levels of variable compensation. Following Linck, et al. (2008)

we proxy for growth opportunities and information asymmetry using the Tobin’s Q, the level of

R&D expenditures, and total firm risk. As in Smith and Watts (1992), we calculate Tobin’s Q

(Q) as the market value of equity minus the book value of equity plus the book value of assets all

divided by the book value of assets.18 R&D expenditures (R&D/TA) are the dollar value of R&D

expenditures scaled by total assets. Many firms in the COMPUSTAT database have missing

values for R&D. We set R&D expenditures equal to zero, when the value is missing. Total firm

risk is measured using the Black-Scholes volatility (BSVOL), which is the standard deviation

calculated over 60 months used in calculating Black-Scholes values for options. The measure is

obtained from the EXECUCOMP database.

Capital intensity. Previous research has found that managerial ownership and

compensation are related to the capital intensity of the firm. We include a variable for capital

intensity (CAP), measured as the net property, plant, and equipment to total assets.

18
We use Q rather than MKBK as in Linck, et al. (2008) to account for the problem of many firms having negative
or small values of book value of equity in the denominator. This leads to negative values of MKBK or abnormally
large values of MKBK that are driven by small book values of equity rather than large market values of equity.

23
 CEO characteristics. Hermalin and Weisbach (1998) suggest that firms will add insiders

to the board of directors as the CEO approaches retirement as part of the succession process. We

use CEO age (AGE) as a proxy for the length of time to retirement of the CEO.

Risk aversion. Following Coles, Naveen, and Naveen (2006) we include CEO tenure

(TENURE), measured as the length of time the CEO has been in the current position, and CEO

cash compensation (TCC), measured as salary plus bonus, as proxies for the CEO’s level of risk

aversion. CEOs with longer tenures may be entrenched, making them more likely to avoid risk

(Berger et al. (1997)). However, Guay (1999) argues that higher levels of cash compensation

make managers less risk averse because they have more money outside the firm and are better

diversified.

Turnover. Following Hartzell and Starks (2003), we employ turnover (TURNOVER), the

log of one plus the ratio of monthly volume to number of shares outstanding in the month prior

to the institutional ownership observation, as an instrument for institutional investor ownership

percentage.

4.3. Descriptive statistics

Table 1 presents descriptive statistics for our sample. The mean (median) deviation from

expected stakeholder management score (ESM) is 0.00 (0.00). The measure ranges from a

minimum score of −1.13 to a maximum score of 0.88. The mean (median) industry adjusted

stakeholder management score (IASM) is 0.02 (0.00). The measure ranges from a minimum

score of −1.57 to a maximum score of 1.64. The mean (median) stakeholder management score

(SM) is 0.07 (0.00). The measure ranges from a minimum score of −1.40 to a maximum score of

2.09. While deviations from expected stakeholder management are close to zero, it is interesting

24
to note that approximately 55% of the firms in our sample are in the Domini 400 Social Index

(DS400), whose selection depends on corporate social performance.

-----Insert Table 1 About Here-----

The mean (median) value for DELTA is $1,427,395 ($374,287) and for VEGA is

$218,507 ($117,385). Our sample boards average 10.81 directors (BRDSIZE). Approximately

33.67% of directors are independent (BRDIND), and the CEO is also Chair (DUALITY)

approximately 74% of the time. Institutional ownership percentage (INSTOWN) averages

61.60% of shares outstanding. Finally, our sample consists of large industrial firms. The mean

(median) value of total sales is $7.927 ($3.451) billion. However, the sample includes a broad

range of firms with total sales ranging from $34.06 million to $245.308 billion.

5. Analysis of the effect of internal governance mechanisms on the deviation from expected
stakeholder management

We begin by examining whether internal governance mechanisms are related to the

deviation from expected stakeholder management. Previous research has explored the relation

between SM and firm performance using pooled ordinary least squares regressions, which

assumes that a firm’s level of SM is exogenous to the firm (Hillman & Keim, 2001). However,

modeling the relation in this manner fails to control for unobserved firm heterogeneity, or

omitted variable bias. As a result, it is possible that these results are biased due to multiple

occurrences of the omitted variable across time periods. In the presence of unobserved firm

effects, firm fixed effects (FE) regression is commonly suggested. However, FE estimation is not

suitable for the unbalanced panel used in this study for several reasons. First, board structure is

somewhat persistent (Hermalin and Weisbach, 1998). For example, several of our primary

variables of interest, such as BRDSIZE and BRDIND, are relatively time invariant and cannot be

25
estimated with FE regression as it would be absorbed in the within transformation of the

variable. Second, FE estimation requires significant within panel variation for important right-

hand side variables to produce consistent and efficient estimates (Wooldridge, 2002, p. 286). For

example, the within standard deviation for BRDSIZE (1.11) is substantially smaller than the

between standard deviation (2.97). Furthermore, while our sample spans 7 years, on average

firms remain in our sample for less than 4 years and many firms are in our sample for only two

years. For example, firms added when KLD expanded its database to include the Russell 1000

database in 2001 have only 2 years of data. As noted by Baltagi (2005, p. 13), FE estimation is

inconsistent in the case of large N and small T. Finally, in cases where researchers are interested

in the inferring significance of key variables in the model, Wooldridge (2002, pg. 290) suggests a

t-statistic Hausman test computed as (δˆFE/ δˆRE)/{[se(δˆFE)]2-[se(δˆRE)]2}1/2 to determine whether a

random effects estimator is appropriate. While the overall Hausman (1978) test is significant at

the 1% level, the t-statistic Hausman tests are insignificant on all of the variables of interest,

supporting the use of the random-effects model in our analysis. Consequently, we use random-

effects (RE) GLS regression as the estimation method for our unbalanced panel.19

However, sample bias is also a concern given the unbalanced nature of our sample.

Wooldridge (2002) argues that sample bias is not a problem unless the selection is correlated

with the idiosyncratic error term of the model. To test this assumption, we add a sample indicator

(SAMPLE) if the firm exists for our entire 7 year sample period. An insignificant sample

indicator suggests that the imbalance in the panel does not lead to bias.

19
As noted by Mundlak (1978), one assumes that the researcher is making the assumption that the omitted variable,
ci, is uncorrelated with xit when using a random-effects model. If this assumption is violated, the random-effects
estimators are inconsistent. To minimize this issue, we include dummy variables for industry and year in our models
to control for part of the ci correlated with xit. Still, a limitation of using the random effects model in our context is
that we can only infer the significance of the relations for key variables (i.e. governance), rather than all variables in
our model.

26
 Specifically, we test whether changes in internal governance mechanisms affect excess

stakeholder management or are endogenously determined by the firm specific factors. The model

we test is as follows:

ESM α β β /

where expected stakeholder management (ESM) is a function of managerial ownership

incentives (DELTA and VEGA), board monitoring (BRDSIZE, BRDIND, DUALITY),

institutional ownership (INSTOWN), controls (CASH, TD/TA, LNSALES, ROA, TRS, DS400,

and SAMPLE), dummy variables for 4-digit GICS code, and dummy variables for year. The

definition of variables in regression equation (3) is as mentioned in section 3.2. The sign beneath

each variable indicates the expected relation between the dependent variable and relevant

independent variables.

Table 2, columns 1 and 2, report results of random-effects (RE) GLS estimates using the

unbalanced panel of regression equation (3).20 Here and throughout the table we compute the z -

statistics using robust standard errors clustered at the firm level (see Rogers, 1993; Wooldridge,

2002). Column 1 contains estimated results for regression equation (3). While signs on DELTA

and VEGA are as predicted, none of the estimated coefficients are significant. The estimated

coefficient for BRDSIZE is positive and significant at the 10% level (z = 1.90). As predicted,

20
Pooling tests for firm fixed effects and year fixed effects are significant at the 1% level, supporting the inclusion
of firm and time effects in the model. The conclusion of subject specific parameters in the model is also supported
by a modified Wald statistic for groupwise heteroskedasticity in the residuals of a fixed effect regression model,
following Greene (2003, p. 598). This statistic is consistent at the 1% level.

27
larger boards are associated with higher levels of investment in stakeholder management that is

unrelated to firm value. The estimated coefficients for BRDIND, DUALITY and INSTOWN are

insignificant. Column 2 contains estimated results for regression equation (3) replacing ESM

with IASM as a proxy for the deviation from expected investment in SM. The estimated

coefficient on DELTA is now positive and significant at the 5% level (z = 2.03). Similarly, the

estimated coefficient for BRDSIZE remains positive and significant at the 1% level (z = 3.06).

Larger boards are associated with greater deviations from expected investment in SM.

Furthermore, the estimated coefficient on BRDIND is now negative and significant at the 10%

level (z = −1.91). As predicted, more independent boards lead to smaller deviations from

expected investment in SM. The estimated coefficients on VEGA, DUALITY, and INSTOWN

remain not significant.

-----Insert Table 2 About Here-----

While we find some evidence that internal governance mechanisms are related to

deviations from expected SM, these deviations may reflect either an under- or over-investment in

SM. While a negative value of ESM (a negative residual) suggests an under-invested in SM, a

positive value of ESM (a positive residual) suggests an over-investment. Internal governance

mechanisms may influence under-investment, but our primary hypotheses predict that internal

governance mechanisms will be most effective at constraining over-investment, or excess SM.

To test these hypotheses directly, we first sort ESM into quartiles. Firm observations in the

bottom quartile, those with the most negative values, are classified as under-investing in SM.

Firm observations in the top quartile, those with the most positive values, are classified as over-

investing in SM. We classify firms in the middle two quartiles as near expected SM or normal

investment in SM firms and treat them as a benchmark. We then estimate a multinomial logit

28
model that predicts the likelihood that a firm will be in one of the two extreme quartiles as

opposed to the middle quartiles.21

Columns 3 and 4 contain results for a multinomial logit regression of equation (3) with

the exception of industry dummies. Column 3 contains estimated results for the under-

investment in SM firms relative to the normal investment in SM firms. The estimated

coefficients on DELTA and BRDIND are negative and significant at the 10% (z = −1.75) and 1%

(z = −2.65) levels, respectively. Higher CEO portfolio sensitivity to stock price and more

independent boards are associated with a lower relative risk of under-investment in SM. Column

4 contains estimated results for the over-investment in SM firms relative to the normal

investment in SM firms. The estimated coefficient on BRDSIZE is positive and significant at the

5% level (z = 2.56), while the estimated coefficients on BRDIND and INSTOWN are negative

and significant at the 5% levels (z = −2.02, −2.18). These results suggest that more effective

board monitoring (i.e. smaller board size and more independent directors) and higher

institutional ownership levels are associated with a lower relative risk of over-investment in SM

and provide some evidence that internal governance mechanisms are most effective at

constraining over-investment, or excess, SM.

Lastly, the deviation of observed SM from the optimal level of SM, SM*, may be

conditional upon the financing constraints faced by each firm. Under this assumption, SM is

more likely to deviate from SM* when managers are less financially constrained and agency

problems are more likely to exist. We use cash and leverage as proxies for financial constraints.

21
We use a multinomial logit model rather than an ordered logit model because we are uncertain of the ordinality of
the ESM measure. As noted by Long (1997), using a nominal model when the dependent variable is ordinal results
in a loss of efficiency since information is ignored. However, applying an ordinal model to a nominal dependent
variable results in biased estimates. Thus, in cases where there is a question about the ordinality of the dependent
variable, the loss of efficiency of using a nominal model is outweighed by the potential bias of using an ordinal
model.

29
Large cash balances may exacerbate agency problems (Jensen, 1986). As such, managers of

firms with large cash balances may have a tendency to overinvest in SM. Conversely, firms with

low leverage may be less financially constrained, which may cause managers to over-invest in

SM. We follow the procedure used in Biddle et al. (2009) to proxy for the financial constraints

faced by each firm. We rank firms into deciles based on cash and leverage (we first multiply

leverage by minus one so that it is decreasing in the level of financial constraint). We then create

a composite measure for the propensity to over-invest in stakeholder management (OVER),

which is the average of the ranked values of cash and negative leverage re-scaled so that the

values range between zero and one. Higher values for OVER reflect less financially constrained

firms, which may increase the likelihood that SM deviates from SM*; managers of these firms

may have a greater propensity to over-invest in SM. We test this by creating interaction terms

between each of our internal governance mechanism variables (DELTA, VEGA, BRDSIZE,

BRDIND, DUALITY, and INSTOWN) and OVER.

Specifically, we test whether changes in internal governance mechanisms, conditional on

whether or not the firm is financially constrained and more likely to over-invest in SM, affect

observed SM or are endogenously determined by the firm specific factors. The model we test is

as follows:

30
SM α β β

where stakeholder management (SM) is a function of managerial ownership incentives (DELTA

and VEGA), board monitoring (BRDSIZE, BRDIND, DUALITY), institutional ownership

(INSTOWN), interactions between internal governance mechanisms and OVER, controls

(LNSALES, ROA, TRS, DS400, and SAMPLE), dummy variables for 4-digit GICS code, and

dummy variables for year. The definition of variables in regression equation (4) is as mentioned

in section 3.2. We exclude CASH and TD/TA from our list of controls because they are used to

calculate OVER. The estimated coefficients (β1, β2, β3, β4, β5, and β6) measure the relation

between internal governance mechanisms and SM for the most financially constrained firms. The

sum of the coefficients (β1 + β7, β2 + β8, β3 + β9, β4 + β10, β5 + β11, β6 + β12) measure the relation

between internal governance mechanisms and SM for the least financially constrained firms. The

sign beneath each variable indicates the expected relation between the dependent variable and

relevant independent variables for both the interaction terms and the overall effect.

Column 5 contains results of random-effects (RE) GLS estimates for regression equation

(4). None of the estimated coefficients on the main effects (i.e. the most financially constrained

firms) for DELTA, VEGA, BRDSIZE, BRDIND, DUALITY, and INSTOWN are significant.

However, as predicted, the estimated coefficients on the interactions between OVER and VEGA,
31
BRDIND, and INSTOWN are negative and significant at the 10% level, while the estimated

coefficient on interaction between OVER and BRDSIZE is positive and significant at the 5%

level. This suggests that the relation between internal governance and investment in SM is

conditional upon whether a firm is more likely to over-invest, and suggests that these

mechanisms may be more effective at constraining excess SM. Furthermore, the overall relation

between internal governance and SM for the least financially constrained firms, as measured by

the sum of the coefficients on the internal governance mechanism variables and the interaction

terms between internal governance mechanisms and OVER, for VEGA and BRDIND is negative

and significant at the 10% and 1% levels respectively, and for BRDSIZE is positive and

significant at 1% level. However, while we find that the relation between INSTOWN and SM is

significantly greater for less financially constrained firms, the overall relation is not significant.

5.1. Exploring causality

The estimated coefficients in Table 2 may be biased as the various internal governance

mechanisms are endogenously formed (e.g. Hermalin and Weisbach, 2003). We address

endogeneity concerns in two ways. First, to ensure that causality runs from internal governance

to excess stakeholder management, we re-estimate regression equations (3) and (4) using

random-effects (RE) GLS while replacing contemporaneous internal governance variables with

their lagged values. Our results are similar to those reported in Table 2 (reported in the appendix

and available from the authors upon request).

While lagging the measurement of the independent variables partially controls for

simultaneity, it does not completely remedy the simultaneity problem. Our analysis to this point

has treated the internal governance variables as exogenous, but if any one of these variables is

determined simultaneously with excess stakeholder management it violates the least squares

32
regression assumption that the regressors are uncorrelated with the error term. To eliminate the

endogeneity problem from simultaneity bias, we endogenize DELTA, VEGA, BRDSIZE,

BRDIND, and INSTOWN given the existing literature on managerial ownership incentives

(Coles et al, 2006), board structure determinants (Linck et al., 2008), and institutional ownership

(Hartzell and Starks, 2003) by developing the following five regression equations:22

DELTA α β

β β β / β β

VEGA α β

β β β / β β

β 4

BRDSIZE α β

β β / β β

22
While DUALITY may also be endogenously formed, we treat it as exogenous because it is a binary variable.

33
BRDIND α β

β β / β β β

INSTOWN α β β

where the definition of variables is as mentioned in section 3.2 and the list of controls remains

the same as in regression equation (3) with the exception of SAMPLE, which is no longer

included as a control variable. The six equations, regression equations (3), and (5) – (9) are

solved using two-stage least squares (2SLS) and as a system of simultaneous equations using

three-stage least squares (3SLS).23

Table 3 reports results of 2SLS and 3SLS estimates of the system of six equations using

the unbalanced panel.24 Column 1 contains 2SLS results for regression equation (3) with the

23
In the absence of specification problems, the use of a systems procedure, such as 3SLS, is asymptotically more
efficient than a single-equation procedure such as 2SLS. But single-equation methods are more robust to
misspecification (Wooldridge, 2002 p. 222). Therefore, we run our system of equations (3), (5)-(9) using both 2SLS
and 3SLS.
24
A Davidson–MacKinnon (1993) test for endogeneity is significant at the 1% supporting the use of the 3SLS
model in Tables 3-5. However, when conducting 2SLS/3SLS the set of instruments, z, must also be highly correlated
with the endogenous regressors, xk, but uncorrelated with the disturbance process, u. The first condition, that the set
of instruments is sufficiently correlated with the endogenous regressors, is supported by estimated coefficients and F
statistics for the set of instruments that are significant at the 1% level, high Shea (1997) partial R2 values, and a
Kleibergen-Papp (2006) LM statistic that is significant at the 10% level. The latter condition, that the set of
instruments is uncorrelated with (orthogonal to) the disturbance process is supported by a non-significant Hansen-
Sargan J-statistic. A failure to reject the null hypothesis implies that our instruments also satisfy the orthogonality
condition. A difference-in-Sargan test, or C-statistic, suggests that TCC violates the orthogonality condition.
Therefore, we model TCC as an exogenous regressor in our models.

34
addition of TCC. The estimated coefficient on VEGA is negative and significant at the 5% level

(z = −2.22). CEOs with a larger portfolio vega (controlling for delta) have lower levels of

investment in stakeholder management that is unrelated to firm value. While board size was a

significant predictor of excess stakeholder management in Table 2, the estimated coefficient on

BRDSIZE is no longer significant in Table 3 after controlling for endogeneity. However, the

estimated coefficient on BRDIND remains negative and significant at the 1% level (z = −1.90),

which suggests that more independent boards lead to lower levels of investment in stakeholder

management that is unrelated to firm value. Finally, the estimated coefficients on DUALITY and

INSTOWN remain insignificant. Column 2 contains 3SLS results for regression equation (3)

with the addition of TCC. The estimated coefficient on VEGA remains negative and significant

at the 5% level (z = −2.09). CEOs with a larger portfolio vega (controlling for delta) have lower

levels of investment in stakeholder management that is unrelated to firm value. However, none

of the estimated coefficients on BRDSIZE, DUALITY, and INSTOWN are significant. Although

not the primary focus of our paper, the results in columns 4 and 7 for regression equations (6)

and (9), respectively, provide some additional useful information. For example, the positive and

significant estimated coefficient on ESM in column 4 indicates the convexity in the CEOs

incentive contract (VEGA) increases with the level of excess stakeholder management and that

these increases lead to reductions in ESM. Likewise, the negative and significant estimated

coefficient on ESM in column 7 indicates that firms with greater overinvestment in stakeholder

management have lower concentrations of institutional investors. This may provide one potential

reason for our finding of an insignificant monitoring function by institutional investors in our

analysis.

-----Insert Table 3 About Here-----

35
 Table 4 reports results of 2SLS and 3SLS estimates of the system of six equations using

the unbalanced panel and replacing ESM with IASM as a proxy of the deviation from expected

investment in SM. Columns 1 and 2 contain 2SLS and 3SLS results for regression equation (3)

with the addition of TCC, respectively. Our conclusions are unchanged using either 2SLS or

3SLS. Therefore, we only discuss the 3SLS results in columns 2-7. The estimated coefficient on

VEGA remains negative and significant at the 5% level (z = −2.69). CEOs with a larger portfolio

vega (controlling for delta) have smaller deviations from expected investment in SM. While

board size was a significant predictor of excess stakeholder management in Table 2, again the

estimated coefficient on BRDSIZE is no longer significant in Table 4 after controlling for

endogeneity. However, the estimated coefficient on BRDIND is now negative and significant at

the 1% level (z = −3.15), which suggests that more independent boards lead to smaller deviations

from expected investment in SM. The estimated coefficient on DUALITY is also now negative

and significant at the 5% level (z = −2.30). This finding appears consistent with prior research

showing that successful CEOs, such as those better at maximizing shareholder wealth, are

awarded the COB title (Brickley et al., 1997). Finally, the estimated coefficient on INSTOWN

remains insignificant. Again, the results in columns 6 and 7 for regression equations (8) and (9),

respectively, provide some additional useful information. For example, the positive and

significant estimated coefficient on IASM in columns 6 indicates that the percentage of

independent directors on the board (BRDIND) increases with the level of excess stakeholder

management and that these increases lead to smaller deviations from expected SM. Likewise, the

negative and significant estimated coefficient on IASM in column 7 indicates that firms with

larger deviations from expected stakeholder management have lower concentrations of

36
institutional investors. As noted earlier, this may provide one potential reason for our finding of

an insignificant monitoring function by institutional investors in our analysis.

-----Insert Table 4 About Here-----

5.2. Analysis of the effect of internal governance mechanisms on deviations from expected
investment in stakeholder management components

Although we find support for a relation between internal governance mechanisms and

deviation from expected investment in SM, it may also be the case that these mechanisms are

only related to deviations from the expected stakeholder strengths (better good relations) or

concerns (less bad relations), individual stakeholder dimension categories, or a broader definition

of stakeholder management. Table 5 reports results of 3SLS estimates for regression equation (3)

of the system of six equations using the unbalanced panel replacing ESM with the deviation from

expected investment in managing stakeholder strengths (ESMSTR) or concerns (ESMCON),

measures of deviation from expected investment in the 5 primary stakeholder dimension

categories of employee relations (EEMP), diversity issues (EDIV), product issues (EPRO),

community relations (ECOM), and environmental issues (EENV), or deviation from expected

investment in social issue participation (ESIP). The results form columns 1 and 2 for ESMSTR

and ESMCON, respectively, suggest that BRDIND is more effective at constraining excess

investment in strengths than concerns, but that INSTOWN is more effective at constraining

concerns. The results from columns (3) – (7) suggest that the relation between internal

governance mechanisms and deviation from expected investment in SM is largely consistent

across all dimensions. The only exception is ESMPRO, the product dimension, in which none of

the estimated coefficients for the internal governance mechanisms is significant. Lastly, while

the direction of estimated coefficients on the internal governance mechanisms in column 8 using

37
ESIP remain consistent with our previous results using ESM, the significance of the estimated

coefficients increases. This result may reflect that participating in social issues not related to the

firm’s direct relationship with primary stakeholders (i.e. not engaging in ‘sin’ industries such as

alcohol, tobacco, and gambling or refraining from doing business with countries accused of

human rights violations) is not simply a broader definition of social responsibility beyond the

primary stakeholders, but rather an indication of excess investment in SM (Hillman & Keim,

2001).

Overall, our results are consistent with both the managerial ownership incentive

hypothesis and board monitoring hypothesis after controlling for endogeneity. The convexity

provided by option based compensation (VEGA) appears to align managerial incentives with the

goals of shareholders, which leads to more value maximizing investment decisions. Furthermore,

effective monitoring by the board of directors, as proxied by a more independent board of

directors (BRDIND), also appears constrain investment in stakeholder management that is

unrelated to firm value. Furthermore, our results appear to be driven by firms with an excess

investment in SM or those with a greater propensity to over-invest in SM. Conversely, we are

unable to find support for the institutional ownership hypothesis. However, our 3SLS results

suggest that firms with higher levels of excess stakeholder management have lower levels of

institutional ownership, on average. Therefore, institutional investors may “vote with their feet”

rather than attempt to exert influence on managerial behavior in such situations. The limited

influence of institutional ownership over corporate managers may also be explained by the legal

and institutional constraints faced by institutional fund managers (Edwards and Hubbard, 2000).

38
5.3. Robustness tests

For robustness, we run several additional tests to determine if our results are driven by

regulated industries, outliers and influential observations, and omitted variables. Our conclusions

are unchanged and unreported (reported in the appendix and available from the authors upon

request).

5.3.1. Regulated industries

In theory, tradeoffs exist between four primary governance mechanisms: legal and

regulatory mechanisms, internal control mechanisms, external control mechanisms, and product

market competition (Jenson, 1993). Firms operating in different environments may substitute

higher levels of one for lower levels of another. For example, research has shown that the need

for internal control mechanisms (i.e. board independence) is less important in highly regulated

firms (banks and utilities) which operate in highly regulated industries (Booth, Cornett, and

Tehranian; 2002). While we industry adjust our measure of stakeholder management, which

should account for some of the variance across industries, our results may also be driven by

differences between regulated and unregulated industries. Therefore, we omit regulated utilities

(SIC codes 4910-4949), depository institutions (SIC codes 6000-6099) and holding or other

investment companies (SIC codes 6700-6799) from our sample. This results in the loss of 138

firms and 434 firm years.

5.3.2. Outliers and influential observations

We winsorize all continuous variables at the top and bottom 1% of observations and

rerun our analysis. We also rerun our analysis after dropping all observations with high DFITS

values and drop any of the continuous variables of interest (i.e. DELTA, VEGA, BRDSIZE,

39
BRDIND, DUALITY, and INSTOWN) with high DFBETA values.25 Our primary results are

unchanged and in many cases the significance of the estimated coefficients increases.

5.3.3. Additional measures of board effectiveness

We test for several additional governance variables which may proxy for board

effectiveness to determine whether our models suffer from an omitted variable bias. In addition

to the variables used in our analysis, we also include measures for board of director ownership

(DIRDOL and DIROWN) following Bhagat and Bolton (2008), the tenure of outside directors

(OUTTEN), the number of board meetings (NUMMTGS), the Gompers, Ishii, Metrick (2003)

index (GINDEX), characteristics of the nominating committee (CEONOM, NOMSIZE, and

NOMIND), and characteristics of the audit committee (AUDSIZE, and AUDIND). With the

exception of NUMMTGS (positive and significant for both ESM and IASM) and GINDEX

(positive and significant for ESM), none of these measures is a significant predictor of excess

stakeholder management.

6. Conclusions

In this paper, we examine the relation between stakeholder management, firm value, and

corporate governance. The goal of the corporation is to maximize shareholder wealth and this

goal cannot be achieved by ignoring the interests of other constituents (Jensen, 2002; Brickley,

Smith, and Zimmerman, 2002). However, to cater to the interests of various stakeholders

inevitably consumes a firm’s resources. Hillman and Keim (2001) document evidence that

building good relations with primary stakeholders (such as employees, customers, suppliers, and

25
DFITS and DFBETA are summary statistics of leverage values and residuals. Belsey, Kuh, and Welsch (1980)

suggest that a cutoff value of 2 and 2 indicate highly influential

j
√
observations.

40
communities) lead to increased shareholder wealth and consuming resources in social issue

participation that is unrelated to a firm’s primary stakeholders results in decreased shareholder

value. Even though Hillman and Keim (2001) do not explicitly use the word “excess stakeholder

management”, their empirical results support the notion that there should be an optimal level of

stakeholder management. Further, inefficient managers may have incentives to gain support from

stakeholders and use stakeholder management as an entrenchment strategy to avoid possible

turnovers (Cespa and Cestone, 2007). We propose that excess investment in stakeholder

management leads to agency costs and high quality corporate governance mechanisms, including

managerial ownership incentives, effective board monitoring, and institutional ownership, can

effectively restrain managers from over-investing in stakeholder management.

The random-effects (RE) GLS estimates and multinomial logit estimates show that large

boards are related to high levels of excess stakeholder management. However, more independent

boards tend to control deviations from expected investment in stakeholder management. We also

find similar conditional results when in settings where managers are less financially constrained

and prone to over-investment in stakeholder management. Our causality analyses—to ensure that

the causality runs from governance to stakeholder management policy— provide similar results.

Given that internal governance variables may be endogenously determined with excess

stakeholder management, we address the potential endogeneity issue by solving a six-equation

system using 3-stage least square regression. Our results support both the managerial incentive

and the board monitoring hypotheses after controlling for endogeneity. Specifically, we find that

CEOs with a high portfolio vega, more independent boards, and CEO duality effectively control

overinvestment in stakeholder management. We also find that firms with high levels of excess

stakeholder management have lower levels of institutional ownership which indicates that

41
institutional investors may “vote with their feet” rather than exert influence on a firm’s

stakeholder management policy. We further examine how the governance mechanisms influence

overinvestment in developing positive relations with stakeholders and in minimizing the negative

ones and find institutional ownership is negatively associated with excess focus on managing

stakeholder concerns. The results are robust with several tests. The limited influence of

institutional ownership on a firm’s stakeholder management policy may also be explained by the

regulatory constraints on institutional fund managers.

Our results show that good corporate governance is consistent with “Enlightened Value

Maximization” theory which says the goal of a corporation is to maximize shareholder wealth;

however, this goal can only be achieved by taking care of stakeholders without consuming

excess resources in stakeholder management. The results are also a reflection of stakeholder

salience, suggesting managers must consider power, legitimacy, and urgency (Mitchell, Agle,

and Wood, 1997) to determine the amount to invest in various stakeholders accordingly to avoid

investing in non-value increasing stakeholder management.

This study is important because we are the first to investigate whether and how

governance system controls value unrelated stakeholder management. From a practical point of

view, our results provide some guidelines for management and boards of directors in dealing

with various stakeholders and effectively monitoring management policy on stakeholder

management. Our results show that excess investment is rather uniform, driven by the

overinvestment in 4 of the 5 primary stakeholder dimension categories, but that excess

investment is even more pronounced when including social issues not related to the firm’s direct

relationship with primary stakeholders; management may want to look at social issue investment

and exercise care when dealing with social issue problems. The study also sheds light on the

42
dilemma faced by managers when called to serve an expanded role in society. Our results

suggest managers should always keep “optimal level of stakeholder management” in mind to

avoid either excessive or inadequate investment in stakeholder management in the pursuit of

shareholder wealth maximization.

43
References

Adams, R. B., & Santos, J. A., 2006. Identifying the effect of managerial control on firm
performance. Journal of Accounting and Economics, 41(1-2), 55-85.
Adams, R., Ferreira, D., 2007. A theory of friendly boards. Journal of Finance 62, 217–250.
Agle, B. R., Mitchell, R. K., & Sonnenfeld, J. A., 1999. Who matters to CEOs? An investigation
of stakeholder attributes and salience, corporate performance, and CEO values. Academy
of Management Journal 42, 507-525.
Agrawal, A., & Knoeber, C. R., 1996. Firm Performance and Mechanisms to Control Agency
Problems between Managers and Shareholders. The Journal of Financial and Quantitative
Analysis, 31(3), 377-397.
Amihud, Y., & Lev, B., 1981. Risk Reduction as a Managerial Motive for Conglomerate
Mergers. The Bell Journal of Economics, 12(2), 605-617.
Anderson, R. C., & Reeb, D. M., 2003. Founding-Family Ownership and Firm Performance:
Evidence from the S&P 500. The Journal of Finance, 58(3), 1301-1328.
Baltagi, B.H., 2005. Econometric Analysis of Panel Data. John Wiley and Sons.
Banerjee, S., Dasgupta, S., & Kim Y., 2008. Buyer-Supplier Relationships and the Stakeholder
Theory of capital structure. Journal of Finance, 63, 2507-2552.
Bartkus, B., Glassman, M., & McAfee, B., 2006. Mission Statement Quality and Financial
Performance. European Management Journal 24(1), 86-94.
Baysinger, B. D., & Butler, H. N., 1985. The Role of Corporate Law in the Theory of the Firm.
Journal of Law and Economics, 28(1), 179-191.
Bebchuk, L. A., Cremers, K. M., & Peyer, U. C., 2007. CEO Centrality. Working paper, Harvard
University.
Belsey, D. A., Kuh, E., & Welsch, R. E., 1980. Regression Diagnostics: Identifying Influential
Data and Sources of Collineartity. New York: Wiley.
Benson, B. W., & Davidson III, W. N., 2009. Reexamining the managerial ownership effect on
firm value. Journal of Corporate Finance, 15(5), 573-586.
Benson, B. W., & Davidson III, W. N., 2009. The Relation Between Stakeholder Management,
Firm Value, and CEO Compensation: A Test of Enlightened Value Maximization.
Financial Management, forthcoming.
Berger, P., Ofek, E., Yermack, D., 1997. Managerial entrenchment and capital structure
decisions. Journal of Finance 52, 1411–1438.
Berman, S. L., Wicks, A. C., Kotha, S., & Jones, T. M., 1999. Does stakeholder orientation
matter? The relationship between stakeholder management models and firm financial
performance. Academy of Management Journal 42, 488-506.
Berrone, P., Surroca, J., & Tribó, J., 2007. Corporate Ethical Identity as a Determinant of Firm
Performance: A Test of the Mediating Role of Stakeholder Satisfaction. Journal of
Business Ethics 76(1), 35-53.
Biddle, G., Hilary, G., & Verdi, R., 2009. How does financial reporting quality relate to
investment efficiency? Journal of Accounting and Economics 48, 112-131.
Bhagat, S., Bolton, B., 2008. Corporate governance and firm performance. Journal of Corporate
Finance, 14, 257-273.
Bhattacharya, C., Korschun, D., & Sen, S., 2009. Strengthening Stakeholder–Company
Relationships Through Mutually Beneficial Corporate Social Responsibility Initiatives.
Journal of Business Ethics, 85, 257-272
Bird, R.D., Hall, A., Momentè, F., & Reggiani, F., 2007. What Corporate Social Responsibility
44
 Activities are Valued by the Market? Journal of Business Ethics 76(2), 189-206.
Booth, J.R., Cornett, M.M. & Tehranian, H., 2002. Boards of directors, ownership, and
regulation. Journal of Banking and Finance, 26, 1973-1996.
Brammer, S., Brooks, C., & Pavelin, S., 2006. Corporate social performance and stock returns:
UK evidence from disaggregate measures. Financial Management 35, 97-116.
Brick, I. E., Palia, D., & Wang, C., 2005. Simultaneous estimation of CEO compensation,
leverage, and board characteristics on firm value. Working Paper, Rutgers University.
Brick, I. E., Palmon, O., & Wald, J. K., 2008. Too Much Pay Performance Sensitivity? Working
paper, Rutgers University.
Brickley, J. A., Coles, J. L., & Terry, R. L., 1994. Outside directors and the adoption of poison
pills. Journal of Financial Economics, 35(3), 371-390.
Brickley, J. A., Lease, R. C., Smith, C.W., 1988. Ownership Structure and Voting on
Antitakeover Amendments, Journal of Financial Economics 20, 267-291.
Brickley, J., Coles, J., Jarrell, G., 1997. Leadership structure: separating the CEO and chairman
of the board. Journal of Corporate Finance 3, 189–220.
Brickley, J.A., Smith Jr. , C.W. & Zimmerman, J.L., 2002. Business ethics and organizational
architecture. Journal of Banking and Finance, 26(9), 1821-1835.
Byrd, J. W., & Hickman, K. A., 1992. Do outside directors monitor managers?: Evidence from
tender offer bids. Journal of Financial Economics, 32(2), 195-221.
Carpenter, J. N., 2000. Does Option Compensation Increase Managerial Risk Appetite? The
Journal of Finance, 55(5), 2311-2331.
Carroll, A. B., 1993. Business and Society: Ethics and Stakeholder Management (South. Western
Publishing, Cincinnati.
Cespa , G., & Cestone , G., 2007. Corporate Social Responsibility and Managerial
Entrenchment. Journal of Economics & Management Strategy, 16(3), 741-771.
Chatterji, A. K., Levine, D. I., & Toffel, M. W., 2009. How well do social ratings actually
measure corporate social responsibility? Journal of Economics and Management Strategy
18(1), 125-169.
Cheung, W. A., & Wei, K. J., 2006. Insider ownership and corporate performance: Evidence
from the adjustment cost approach. Journal of Corporate Finance, 12(5), 906-925.
Cho, M., 1998. Ownership structure, investment, and the corporate value: An empirical analysis.
Journal of Financial Economics, 47(1), 103-121.
Clarkson, M. B. E., 1995. A Stakeholder Framework for Analyzing and Evaluating Corporate
Social Performance. The Academy of Management Review, 20(1), 92-117.
Cohen, M. A., Fenn, S. A., & Naiman, J. S., 1995. Environmental and Financial Performance:
Are they related? Washington D.C.: Investor Responsibility Research Center.
Cohen, R. B., Hall, B. J., & Viceira, L. M., 2000. Do executive stock options encourage risk-
taking. Working paper, Harvard University.
Coles, J. L., Daniel, N. D., & Naveen, L., 2006. Managerial incentives and risk-taking. Journal of
Financial Economics, 79(2), 431-468.
Coles, J. L., Lemmon, M. L., & Meschke, F., 2007. Structural Models and Endogeneity in
Corporate Finance: the Link Between Managerial Ownership and Corporate
Performance. Working paper, Arizona State University.
Coombs, J. E., & Gilley, K. M., 2005. Stakeholder management as a predictor of CEO
compensation: main effects and interactions with financial performance. Strategic
Management Journal 26, 827-840.

45
Core, J. E., & Larcker, D. F., 2002. Performance consequences of mandatory increases in
executive stock ownership. Journal of Financial Economics, 64(3), 317-340.
Core, J., & Guay, W., 1999. The use of equity grants to manage optimal equity incentive levels.
Journal of Accounting and Economics, 28(2), 151-184.
Core, J., & Guay, W., 2002. Estimating the Value of Employee Stock Option Portfolios and
Their Sensitivities to Price and Volatility. Journal of Accounting Research, 40(3), 613-
630.
Cotter, J.F., Shivdasani, A., & Zenner, M., 1997. Do Independent Directors Enhance Target
Shareholder Wealth during Tender Offers? Journal of Financial Economics 43, 195-218.
Davidson, R. and MacKinnon, J., 1993. Estimation and Inference in Econometrics. New York:
Oxford University Press.
Davidson, W. N., & Worrell, D. L., 1988. The impact of announcements of corporate illigalities
on shareholder returns. Acedemy of Management Journal 31, 195-200.
Davidson, W. N., Worrell, D. L., & El-Jelly, A., 1995. Influencing managers to change
unpopular behavior through boycotts and divestitures: A stock market test. Business and
Society 34, 171-196.
Davidson, W. N., Worrell, D. L., & El-Jelly, A., 1995. Influencing managers to change
unpopular behavior through boycotts and divestitures: A stock market test. Business and
Society 34, 171-196.
Davies, J., Hillier, D., & McColgan, P., 2005. Ownership structure, managerial behavior and
corporate value. Journal of Corporate Finance, 11(4), 645-660.
De Luque, M.S., Washburn, N.T., Waldman, D.A. & House, R.J., 2008. Unrequited profit: How
stakeholder and economic value relate to subordinantes’ perspective of leadership and
firm performance. Administrative Science Quarterly 53, 626-654.
DeFusco, R. A., Johnson, R. R., & Zorn, T. S., 1990. The Effect of Executive Stock Option Plans
on Stockholders and Bondholders. The Journal of Finance, 45(2), 617-627.
Demsetz, H., & Villalonga, B., 2001. Ownership structure and firm performance. Journal of
Corporate Finance, 7, 209–233.
Demsetz, H., 1983. The Structure of Ownership and the Theory of the Firm. The Journal of Law
and Economics, 26(2), 375.
Demsetz, H., Lehn, K., 1985. The structure of corporate ownership: Causes and consequences.
Journal of Political Economy 93, 1155-1177.
Donaldson, T., & Preston, L. E., 1995. The Stakeholder Theory of the Corporation: Concepts,
Evidence, and Implications. The Academy of Management Review, 20(1), 65-91.
Edwards, F.R., Hubbard, R.G., 2000. The growth of institutional stock ownership: a promised
unfulfilled. Journal of Applied Corporate Finance, 13(3), 92-104.
Eisenberg, T., Sundgren, S. & Wells, M.T., 1998. Larger board size and decreasing firm value in
small firms. Journal of Financial Economics, 48(1), 35-54.
Evan, W. M., & Freeman, R. E., 1988. A stakeholder theory of the modern corporation: Kantian
capitalism. Ethical theory and business, 3, 97–106.
Fama, E. F., & Jensen, M. C., 1983. Separation of Ownership and Control. The Journal of Law
and Economics, 26(2), 301-326.
Freeman, R. E., 1984. Strategic Management: A stakeholder approach. Boston: Pitman.
Freeman, R. E., 1994. The Politics of Stakeholder Theory: Some Future Directions. Business
Ethics Quarterly, 4(4), 409-421.
Freeman, R. E., 1999. Divergent stakeholder theory. Academy of Management Review, 24, 233–

46
 236.
Freeman, R. E., Wicks, A. C., & Parmar, B., 2004. Stakeholder Theory and "The Corporate
Objective Revisited ". Organization Science, 15(3), 364-369.
Friedman, A. L., & Miles, S., 2006. Stakeholders. Oxford University Press.
Friedman, M., 1970. The social responsibility of business is to create profits. New York Times
Magazine, September 13, 122-126.
Fung, M.K. (2009). Is innovativeness a link between pay and performance? Financial
Management 38(2), 411-429.
Godfrey, P. C., 2005. The Relationship Between Corporate Philanthropy and Shareholder
Wealth: A Risk Management Perspective. Academy of Management Review, 30(4), 777-
798.
Gompers, P., Ishii, J., & Metrick, A., 2003. Corporate governance and equity prices. Quarterly
Journal of Economics, 118(1), 107-155.
Graves, S. B., & Waddock, S. A., 1994. Institutional owners and corporate social performance.
Academy of Management Journal 37, 1034-1046.
Graves, S. B., & Waddock, S. A., 2000. Beyond built to last...Stakeholder relations in "Built-to-
Last" companies. Business and Society 105, 393-418.
Green, W. H., 2003. Econometric Analysis (5th ed.). Upper Saddle River, NJ: Prentice Hall.
Greening, D. W., & Turban, D. B., 2000. Corporate social performance as a competitive
advantage in attracting a quality workforce. Business and Society 39, 254-280.
Guay, W., 1999. The sensitivity of CEO wealth to equity risk: An analysis of the magnitude and
determinants. Journal of Financial Economics, 53(1), 43-71.
Hart, S. L., & Ahuja, G., 1996. Does it pay to be green? an empirical examination of the
relationship between emission reduction and firm performance. Business Strategy and the
Environment, 5(1), 30-37.
Hartzell, J. C., & Starks, L. T., 2003. Institutional Investors and Executive Compensation. The
Journal of Finance, 58(6), 2351-2374.
Hausman, J. A., 1978. Specification Tests in Econometrics. Econometrica, 46(6), 1251-1271.
Hermalin, B. E., & Weisbach, M. S., 1991. The Effects of Board Composition and Direct
Incentives on Firm Performance. Financial Management, 20(4), 101-112.
Hermalin, B., Weisbach, M., 1998. Endogenously chosen boards of directors and their
monitoring of the CEO. American Economic Review 88, 96–118.
Hermalin, B.E., Weisbach, M.S., 2003. Boards of directors as an endogenously determined
institution: A survey of the economic literature. FRBNY Economic Policy Review 9, 7–
26.
Hillman, A., & Keim, G., 2001. Shareholder value, stakeholder management, and social issues:
What's the bottom line? Strategic Management Journal, 22(2), 125-139.
Himmelberg, C. P., Hubbard, R. G., & Palia, D., 1999. Understanding the determinants of
managerial ownership and the link between ownership and performance. Journal of
Financial Economics, 53(3), 353-384.
Holderness, C. G., 2003. A Survey of Blockholders and Corporate Control. SSRN eLibrary.
Holderness, C. G., Kroszner, R. S., & Sheehan, D. P., 1999. Were the Good Old Days That
Good? Changes in Managerial Stock Ownership since the Great Depression. The Journal
of Finance, 54(2), 435-469.
Hubbard, R. G., & Palia, D., 1995. Benefits of Control, Managerial Ownership, and the Stock
Returns of Acquiring Firms. The RAND Journal of Economics, 26(4), 782-792.

47
Jensen, M. C., 1993. The Modern Industrial Revolution, Exit, and the Failure of Internal Control
Systems. The Journal of Finance, 48(3), 831-880.
Jensen, M. C., 2001. Value Maximization, Stakeholder Theory, and the Corporate Objective
Function. Journal of Applied Corporate Finance, 14, 8–21.
Jensen, M. C., 2002. Value Maximization, Stakeholder Theory, and the Corporate Objective
Function. Business Ethics Quarterly, 12(2), 235-256.
Jensen, M., & Meckling, W., 1976. Theory of the firm: Managerial behavior, agency costs, and
capital structure. Journal of financial economics, 3(4), 305–360.
Jiambalvo, J. J., Rajgopal, S., & Venkatachalam, M., 2002. Institutional Ownership and the
Extent to Which Stock Prices Reflect Future Earnings, Contemporary Accounting
Research 19, 117-145.
Johnson, R. A., & Greening, D. W., 1999. The effects of corporate governance and institutional
ownership types on corporate social performance. Academy of Management Journal 42,
564-576.
Ju, N., Leland, H. E., & Senbet, L. W., 2002. Options, Option Repricing and Severance Packages
in Managerial Compensation: Their Effects on Corporate Risk. Working paper,
University of Maryland.
Kale, J. R., & Shahrur H., 2007. Corporate Capital Structure and the Characteristics of Supplier
and Customer Markets. Journal of Financial Economics, 83, 321-365.
Karpoff, J. M., Lott, J. R., & Rankine, G., 1998. Environmental violations, legal penalties, and
contractor influence. Working paper, University of Washington.
Karpoff, J.M. & Lott, J.R., 1993. The reputational penalty firms bear from committing criminal
fraud. Journal of Law and Economics 36, 757-802.
Karpoff, J.M., Lee, D.S. & Vendrzyk, V.P., 1999. Defense procurement fraud, penalties and
contractor influence. Journal of Political Economy, 107, 809-842.
Kassinis, G. & Vafeas, N., 2002. Corporate Boards and Outside Stakeholders as Determinants of
Environmental Litigation. Strategic Management Journal, 23(5), 399-415.
Keay, A., 2009. Shareholder primacy: Can it survive? Should it survive? Working paper,
University of Leeds.
Kelly, K. & Davis, A., 2007. Goldman’s Green Streak is Questioned as Two Investors Seek
Focus on Profit. Wall Street Journal Online.(March 27, page c3).
Klassen, R., & Whybark, D., 1999. The impact of environmental technologies on manufacturing
performances. Academy of Management Journal 42, 599-615.
Kleibergen, F., & Paap, R., 2006. Generalized reduced rank tests using the singular value
decomposition. Journal of Econometrics, 133(1), 97-126.
Knopf, J. D., Nam, J., & Thornton, J. H., 2002. The Volatility and Price Sensitivities of
Managerial Stock Option Portfolios and Corporate Hedging. The Journal of Finance,
57(2), 801-813.
Konar, S., & Cohen, M., 2001. Does the market value environmental performance? Review of
Economics and Statistics 83, 281-289.
Lang, L. H. P., & Stulz, R. M., 1994. Tobin's q, Corporate Diversification, and Firm
Performance. Journal of Political Economy, 102(6), 1248-1280.
Laplume, A. O., Sonpar, K., & Litz, R. A., 2008. Stakeholder Theory: Reviewing a Theory That
Moves Us. Journal of Management, 34(6), 1152-1189.
Laurent, 2007. Neither Shareholder nor Stakeholder Management: What Happens When Firms
are Run for their Short-term Salient Stakeholder? European Management Journal, 25(2),

48
 146-162.
Lewellen, K., 2006. Financing decisions when managers are risk averse. Journal of Financial
Economics, 82(3), 551-589.
Linck, J., Netter, J., & Yang, T., 2008. The determinants of board structure. Journal of Financial
Economics, 87(2), 308-328.
Lipton, M. & Lorsch, J.W., 1992. A Modest Proposal for Improved Corporate Governance,
Business Lawyer (ABA), 48-59.
Loderer, C., & Martin, K., 1997. Executive stock ownership and performance Tracking faint
traces. Journal of Financial Economics, 45(2), 223-256.
Long, J.S., 1997. Regression models for categorical and limited dependent variables. Sage
Publications, Thousand Oaks.
Low, A., 2009. Managerial risk-taking behavior and equity-based compensation. Journal of
Financial Economics, 92(3), 470-490.
Maksimovic, V., & Titman, S., 1991. Financial Policy and Reputation for Product Quality.
Review of Financial Studies, 4, 175-200.
Maug, E., 1997. Boards of directors and capital structure: alternative forms of corporate
restructuring. Journal of Corporate Finance 3, 113–139.
McConnell, J. J., & Servaes, H., 1990. Additional evidence on equity ownership and corporate
value. Journal of Financial Economics, Journal of Financial Economics, 27(2), 595-612.
McConnell, J. J., Servaes, H., & Lins, K. V., 2008. Changes in insider ownership and changes in
the market value of the firm. Journal of Corporate Finance, 14(2), 92-106.
McConnell, J., & Servaes, H., 1995. Equity ownership and the two faces of debt. Journal of
Financial Economics, 39(1), 131-157.
McDonnelll, B., 2004. Corporate constituency statutes and employee governance. William
Mitchell Law Review, 30 (4), 1227-1259.
Mehran, H., & Rosenberg, J. V., 2007. The Effect of Employee Stock Options on Bank
Investment Choice, Borrowing, and Capital. Working paper, Federal Reserve Bank of
New York Staff Reports.
Mehran, H., 1995. Executive compensation structure, ownership, and firm performance. Journal
of Financial Economics, 38(2), 163-184.
Meznar, M. B., Nigh, D., & Kwok, C. C. Y., 1994. Effect of Announcements of Withdrawal
from South Africa on Stockholder Wealth. The Academy of Management Journal 37(6),
1633-1648.
Mitchell, R. K., Agle, B. R., & Wood, D. J., 1997. Toward a Theory of Stakeholder
Identification and Salience: Defining the Principle of Who and What Really Counts. The
Academy of Management Review, 22(4), 853-886.
Moneva, J. M., Rivera-Lirio, J. M., & Munoz-Torres, M. J., 2007. The corporate stakeholder
commitment and social and financial performance. Industrial Management & Data
Systems 107(1), 84 - 102.
Moore, G., 2001. Corporate Social and Financial Performance: An Investigation in the U.K.
Supermarket Industry. Journal of Business Ethics 34(3/4), 299-315.
Morck, R., Shleifer, A., & Vishny, R., 1988. Management ownership and market valuationAn
empirical analysis. Journal of Financial Economics, 20, 293-315.
Mundlak, Y., 1978. On the pooling of time series and cross section data. Econometrica, 46, 69-
85.

49
Neubaum, D.O. & Zahra, S.A., 2006. Institutional Ownership and Corporate Social
Performance: The Moderating Effects of Investment Horizon, Activism, and
Coordination. Journal of Management, 32(1), 108-131.
Ogden, S., & Watson, R., 1999. Corporate performance and stakeholder management: balancing
shareholder and customer interests in the U.K. privatized water industry. Academy of
Management Journal 42(5), 526-538.
Omran, M., Atrill, P., & Pointon, J., 2002. Shareholders versus stakeholders: corporate mission
statements and investor returns. Business Ethics: A European Review 11(4), 318-326.
Palia, D., 2001. The Endogeneity of Managerial Compensation in Firm Valuation: A Solution.
The Review of Financial Studies, 14(3), 735-764.
Parrino, R., Poteshman, A. M., & Weisbach, M. S., 2005. Measuring investment distortions
when risk-averse managers decide whether to undertake risky projects. Financial
Management, 21–60.
Pukthuanthong, K., Roll, R., & Walker, T., 2007. How employee stock options and executive
equity ownership affect long-term IPO operating performance. Journal of Corporate
Finance, 13(5), 695-720.
Raheja, C., 2005. Determinants of board size and composition: a theory of corporate boards.
Journal of Financial and Quantitative Analysis 40, 283–306.
Rajgopal, S., & Shevlin, T., 2002. Empirical evidence on the relation between stock option
compensation and risk taking. Journal of Accounting and Economics, 33(2), 145-171.
Rogers, W. H., 1993. Regression standard errors in clustered samples, Stata Technical Bulletin,
13, 19–23.
Rosenstein, S., & Wyatt, J. G., 1990. Outside directors, board independence, and shareholder
wealth. Journal of Financial Economics, 26(2), 175-191.
Ross, S. A., 2004. Compensation, Incentives, and the Duality of Risk Aversion and Riskiness.
The Journal of Finance, 59(1), 207-225.
Ruf, B. M., Muralidhar, K., Brown, R. M., Janney, J. J., & Paul, K., 2001. An Empirical
Investigation of the Relationship Between Change in Corporate Social Performance and
Financial Performance: A Stakeholder Theory Perspective. Journal of Business Ethics
32(2), 143-156.
Schrand, C., & Unal, H., 1998. Hedging and Coordinated Risk Management: Evidence from
Thrift Conversions. The Journal of Finance, 53(3), 979-1013.
Shea, J., 1997. Instrument Relevance in Multivariate Linear Models: A Simple Measure. Review
of Economics and Statistics, 79(2), 348-352.
Smith, C. J., & Watts, R. L., 1992. The investment opportunity set and corporate financing,
dividend, and compensation policies. Journal of Financial Economics, 32(3), 263-292.
Smith, C. W., & Stulz, R. M., 1985. The Determinants of Firms' Hedging Policies. The Journal
of Financial and Quantitative Analysis, 20(4), 391-405.
Starik, M., 1993. Is the environment an organizational stakeholder? Naturally. In Proceedings of
the Fourth Annual Meeting of the International Association for Business and Society
(Vol. 466, p. 471).
Sundaram, A. K., & Inkpen, A. C., 2004. The Corporate Objective Revisited. Organization
Science, 15(3), 350-363.
Tian, Y. S., 2004. Too much of a good incentive? The case of executive stock options. Journal of
Banking & Finance, 28(6), 1225-1245.
Titman, S, 1984. The Effect of Capital Structure on a Firm’s Liquidation Decision. Journal of

50
 Financial Economics, 13, 137-151.
Titman, S., and Wessels, R., 1988. The Determinants of Capital Structure Choice. Journal of
Finance, 43, 1-19.
Tong, Z., 2008. Deviations from optimal CEO ownership and firm value. Journal of Banking &
Finance, 32(11), 2462-2470.
Waddock, S. A., & Graves, S. B., 1997. The Corporate Social Performance-Financial
Performance Link. Strategic Management Journal 18(4), 303-319.
Wooldridge, J., 2002. Econometric Analysis of Cross Section and Panel Data. The MIT Press,
Cambridge.
Wright, P. et al., 1996. Impact of corporate insider, blockholder, and institutional equity
ownership on firm risk taking. Academy of Management Journal, 39(2), 441-463.
Wright,P., Kroll, M. & Elenkov, D., 2002. Acquisition returns, increase in firm size, and chief
executive officer compensation: the moderating role of monitoring. Academy of
Management Journal, 45(3), 599-608.
Yermack, D., 1996. Higher market valuation of companies with a small board of directors.
Journal of Financial Economics, 40(2), 185-211.

51
Table 1: Descriptive Statistics
This table displays descriptive statistics for the sample. Variables include deviation from expected stakeholder
management (ESM), industry adjusted stakeholder management (IASM), and stakeholder management (SM), the
dollar change in CEO portfolio wealth for a 1% change in firm value (DELTA), the dollar change in CEO portfolio
wealth for a 1% change in the annualized standard deviation of stock returns (VEGA), the number of directors
serving on the board during the year (BRDSIZE), the percentage of outside directors serving on the board
(BRDIND), whether or not the CEO holds the title of CEO and COB (DUALITY), the percentage of shares held by
institutions during the year (INSTOWN), cash to total assets (CASH), total debt to total assets (TD/TA), the log of
sales (LN SALES), earnings before interest and taxes to total assets (ROA), 1−year total return to shareholders
(TRS), a dummy variable equal to 1 if the firm is in the Domini 400 Social Index (DS 400), Tobin’s Q (Q), the ratio
of research and development expenses to total assets with missing values set equal to zero (R&D/TA), the standard
deviation of stock returns calculated over 60 months used in calculating the EXECUCOMP Black-Scholes values
for options (BSVOL), net property, plant, and equipment to total assets (CAP), the age of the CEO (AGE), the
length of time the CEO has been in the current position (TENURE), the salary and bonus compensation paid to the
CEO (TCC), and the log of one plus the ratio of monthly volume to number of shares outstanding in the month prior
to the institutional ownership observation (TURNOVER). Data are obtained from the KLD, COMPUSTAT,
EXECUCOMP, IRRC, and 13F databases and consist of an unbalanced panel of 3,632 firm-year observations for
974 firms from 1996 to 2002.

Variable N Mean sd Min. 25% Median 75% Max.

ESM 3632 0.00 0.21 -1.13 -0.10 0.00 0.10 0.88
IASM 3632 0.02 0.41 -1.57 -0.23 0.01 0.26 1.64
SM 3632 0.07 0.43 -1.40 -0.20 0.00 0.33 2.09
DELTA ($) 3632 1,427,395.00 3,857,328.00 6,013.78 149,407.60 374,287.60 973,694.00 29,100,000.00
VEGA ($) 3632 218,507.00 302,528.80 0.00 40,538.59 117,385.80 265,702.10 1,831,574.00
BRDSIZE 3632 10.81 3.03 3.00 9.00 11.00 12.00 29.00
BRDIND 3632 33.67% 16.42% 0.00% 21.43% 33.33% 44.44% 100.00%
DUALITY 3632 0.74 0.44 0.00 0.00 1.00 1.00 1.00
INSTOWN 3632 61.60 21.27 0.00 51.37 64.82 76.11 99.99
CASH 3632 0.06 0.08 0.00 0.01 0.03 0.08 0.58
TD/TA 3632 24.87 16.22 0.00 12.87 24.62 35.16 95.88
SALES ($Mil) 3632 7927.84 14577.13 34.06 1370.92 3451.00 8697.62 245308.00
ROA 3632 10.20 9.18 -84.38 5.07 9.38 14.50 93.00
TRS 3632 9.42 44.84 -95.32 -15.62 5.19 28.98 689.31
DS400 3632 0.55 0.50 0.00 0.00 1.00 1.00 1.00
Q 3128 2.18 1.73 0.63 1.19 1.58 2.47 28.33
R&D/TA 3128 185.54 568.19 0.00 0.00 0.00 99.10 5176.00
BSVOL 3128 0.37 0.18 0.12 0.25 0.33 0.43 1.53
CAP 3128 30.68 23.19 0.00 12.55 25.59 45.79 96.51
AGE 3128 56.10 6.70 34.00 52.00 56.00 61.00 86.00
TENURE 3128 8.19 7.38 0.00 3.00 6.00 11.00 52.00
TCC ($k) 3128 1,790.69 1,690.74 0.00 895.20 1,395.45 2,145.19 43,511.54
TURNOVER 3128 0.72 0.43 0.07 0.42 0.60 0.88 3.05

52
Table 2: Random−effects (RE) GLS regression and multinomial logit regression results of
deviation from expected and conditional stakeholder management
This table reports results of random−effects (RE) GLS and multinomial regression estimates of equation (3) and (4).
The dependent variable is deviation from expected stakeholder management (ESM), industry adjusted stakeholder
management (IASM), firms in the lowest quartile relative to the two middle quartiles of ESM (Under-investment vs.
Normal investment), firms in the highest quartile relative to the two middle quartiles of ESM (Over-investment vs.
normal investment), and stakeholder management (SM). Independent variables are the dollar change in CEO portfolio
wealth for a 1% change in firm value (DELTA), the dollar change in CEO portfolio wealth for a 1% change in the
annualized standard deviation of stock returns (VEGA), the number of directors serving on the board during the year
(BRDSIZE), the percentage of outside directors serving on the board (BRDIND), whether or not the CEO holds the
title of CEO and COB (DUALITY), the percentage of shares held by institutions during the year (INSTOWN), a proxy
for less financially constrained firms (OVER), cash to total assets (CASH), total debt to total assets (TD/TA), the log of
sales (LN SALES), ROA: measured as earnings before interest and taxes to total assets, 1−year total return to
shareholders (TRS), a dummy variable equal to 1 if the firm is in the Domini 400 Social Index (DS 400), and a dummy
variable equal to 1 if the firm exists for the entire sample period (SAMPLE). Data are obtained from the KLD,
COMPUSTAT, EXECUCOMP, IRRC, and 13F databases and consist of an unbalanced panel of 3632 firm−year
observations for 974 firms. All regressions include dummy variables for 4−digit GICS code and year (The coefficients
for industry and year are not reported). The z−statistics are reported using robust standard errors clustered at the firm
level (see Rogers, 1993; Wooldridge, 2002). Robust z−statistics are given in parentheses. Superscripts */**/***
indicate levels of significance of 10%, 5%, and 1%, respectively.

Method RE (GLS) RE (GLS) Multinomial Logit RE (GLS)

Under-investment vs. Over-investment vs.
Dependent Variable Pred. ESM IASM Normal investment Normal investment Pred. SM
Independent Variable Sign (1) (2) (3) (4) Sign (5)
DELTA (+) 0.00132 0.0132** −0.0754* −0.0677 −0.00166
(0.39) (2.03) (−1.75) (−1.61) (−0.12)
VEGA (−) −0.000309 −0.00161 0.0189 0.0140 0.00263
(−0.25) (−0.74) (0.93) (0.85) (0.75)
BRDSIZE (+) 0.00355* 0.0100*** 0.0246 0.0539** 0.000712
(1.90) (3.06) (1.24) (2.56) (0.11)
BRDIND (−) 0.0407 −0.0853* −0.889*** −0.735** 0.0558
(1.53) (−1.91) (−2.65) (−2.02) (0.55)
DUALITY (+/−) −0.00575 −0.00909 −0.0229 −0.113 0.0249
(−0.64) (−0.74) (−0.19) (−0.92) (0.81)
INSTOWN (−) −0.000167 −0.00000486 −0.00329 −0.00549** 0.000911
(−0.77) (−0.02) (−1.34) (−2.18) (1.41)
DELTA x OVER (+) 0.0230
(1.17)
VEGA x OVER (−) −0.0106*
(−1.75)
BRDSIZE x OVER (+) 0.0208**
(1.99)
BRDIND x OVER (−) −0.270*
(−1.80)
DUALITY x OVER (+/−) −0.0455
(−0.89)
INSTOWN x OVER (−) −0.00206*
(−1.94)
OVER −0.0475
(−0.18)
CASH −0.00913 0.150 1.172 1.636**
(−0.16) (1.62) (1.48) (2.14)
TD/TA −0.000344 −0.000382 0.00535 −0.00422
(−1.04) (−0.63) (1.53) (−1.09)
LN SALES −0.00196 −0.00818 0.330*** 0.359*** −0.00790
(−0.36) (−0.80) (5.78) (6.30) (−0.77)
ROA 0.000607 0.00105 −0.000697 0.00265 0.00130
(1.24) (0.97) (−0.11) (0.39) (1.24)

53
TRS −0.0000818 −0.000270*** 0.000631 −0.00177 −0.000118
(−1.02) (−2.97) (0.60) (−1.48) (−1.33)
DS400 −0.00626 0.211*** 0.334*** 0.259** 0.209***
(−0.65) (9.93) (2.89) (2.23) (9.96)
SAMPLE −0.00310 0.0320 0.0241
(−0.30) (1.12) (0.85)

β1 + β7 = 0 1.36
Β2 + β8 = 0 3.07*
Β3 + β9 = 0 16.29***
Β4+ β10 = 0 9.48***
Β5+ β11 = 0 0.80
Β6 + β12 = 0 4.12

Year Dummies Yes Yes Yes Yes Yes

Industry Dummies Yes Yes No No Yes

n 974 974 974 974 974 974

N 3632 3632 3632 3632 3632 3632
Within R2 0.0105 0.0337 0.0280
Between R2 0.0433 0.174 0.242
Overall R2 0.0305 0.132 0.222
Pseudo R2 0.0412 0.0412

54
Table 3: Two−stage least squares (2SLS) and three−stage least squares (3SLS) regression
results of deviation from expected stakeholder management
This table reports results of two-stage least squares (2SLS) and three-stage least squares (3SLS) regression estimates of
equations (3) and (5) - (9). The endogenous variables are deviation from expected stakeholder management (ESM), the
dollar change in CEO portfolio wealth for a 1% change in firm value (DELTA), the dollar change in CEO portfolio
wealth for a 1% change in the annualized standard deviation of stock returns (VEGA), the number of directors serving
on the board during the year (BRDSIZE), the percentage of outside directors serving on the board (BRDIND), and the
percentage of shares held by institutions during the year (INSTOWN). Exogenous variables include whether or not the
CEO holds the title of CEO and COB (DUALITY), cash to total assets (CASH), total debt to total assets (TD/TA), the
log of sales (LN SALES), earnings before interest and taxes to total assets (ROA), 1−year total return to shareholders
(TRS), a dummy variable equal to 1 if the firm is in the Domini 400 Social Index (DS 400), and the salary and bonus
compensation paid to the CEO (TCC). Instrumental variables include Tobin’s Q (Q), the ratio of research and
development expenses to total assets with missing values set equal to zero (R&D/TA), the standard deviation of stock
returns calculated over 60 months used in calculating the EXECUCOMP Black-Scholes values for options (BSVOL),
net property, plant, and equipment to total assets (CAP), the age of the CEO (AGE), the length of time the CEO has
been in the current position (TENURE), and the log of one plus the ratio of monthly volume to number of shares
outstanding in the month prior to the institutional ownership observation (TURNOVER). Data are obtained from the
KLD, COMPUSTAT, EXECUCOMP, IRRC, and 13F databases and consist of an unbalanced panel of 3128 firm-year
observations for 905 firms. All regressions include dummy variables for 4-digit GICS code and year (The coefficients
for industry and year are not reported). The z-statistics are given in parentheses. Superscripts */**/*** indicate levels of
significance of 10%, 5%, and 1%, respectively.

Method 2SLS 3SLS

Dependent Variable Pred. ESM ESM DELTA VEGA BRDSIZE BRDIND INSTOWN
Independent Variable Sign (1) (2) (3) (4) (5) (6) (7)
ESM −0.956 −18.06* −12.18 −0.381 −165.4***
(−0.18) (−1.95) (−1.27) (−0.54) (−4.26)
DELTA (+) 0.0120 0.00477 −0.314*** −0.0909 0.0721***
(0.55) (0.30) (−2.82) (−0.84) (8.91)
VEGA (−) −0.105** −0.0908** 0.485***
(−2.22) (−2.09) (6.08)
BRDSIZE (+) −0.00871 −0.00358
(−0.45) (−0.23)
BRDIND (−) −0.800* −0.415
(−1.90) (−1.19)
DUALITY (+/−) −0.0368 −0.0225 −0.0768***
(−1.38) (−1.29) (−9.75)
INSTOWN (−) 0.000850 −0.000788
(0.40) (−0.44)
CASH 0.321 0.231 −0.378 2.486*** −1.589* 0.0563 −11.24
(1.63) (1.28) (−0.84) (2.74) (−1.88) (1.02) (−1.00)
TD/TA 0.00131 0.00117 −0.00776*** 0.00798 −0.00796 0.000390 0.0521
(1.56) (1.46) (−3.30) (1.58) (−1.60) (1.15) (0.95)
LN SALES 0.0404* 0.0348* 0.206*** 0.550*** 0.860*** −0.0450*** −0.828
(1.73) (1.65) (4.43) (8.20) (12.73) (−9.90) (−1.33)
ROA 0.00151 0.00176** −0.00264 0.0220** −0.0126 0.000423 0.363***
(1.63) (2.08) (−0.42) (2.05) (−1.10) (0.53) (3.99)
TRS −0.000146 −0.0000970 0.00226*** −0.000263 −0.00386*** −0.000292*** −0.00509
(−0.80) (−0.60) (3.19) (−0.18) (−2.72) (−3.09) (−0.29)
DS400 −0.0469** −0.0368* −0.0241 −0.399** −0.0221 −0.0240** −1.912
(−2.16) (−1.80) (−0.29) (−2.49) (−0.14) (−2.21) (−1.22)
Q 0.268*** 0.0569** 0.0175 −0.0110***
(11.31) (1.98) (0.40) (−3.75)
RD/TA 0.000258 0.000376 0.000626 0.00000436
(1.32) (1.01) (1.63) (0.15)
BSVOL 1.407*** 0.105 −2.131*** 0.136***
(4.23) (0.15) (−2.97) (2.58)
CAP 0.00129 0.00363***
(0.78) (3.30)

55
TCC 0.0000206* 0.0000204** 0.000202***
(1.91) (2.15) (6.04)
AGE 0.00139***
(2.77)
TENURE 0.0793***
(17.11)
TURNOVER 12.07***
(6.33)

Year Dummies Yes Yes Yes Yes Yes Yes Yes

Industry Dummies Yes Yes Yes Yes Yes Yes Yes

n 905 905 905 905 905 905 905

N 3128 3128 3128 3128 3128 3128 3128

56
Table 4: Two−stage least squares (2SLS) and three−stage least squares (3SLS) regression
results of deviation from industry average stakeholder management
This table reports results of two-stage (2SLS) and three-stage least squares (3SLS) regression estimates of equations (3)
and (5) - (9). The endogenous variables are industry adjusted stakeholder management (IASM), the dollar change in
CEO portfolio wealth for a 1% change in firm value (DELTA), the dollar change in CEO portfolio wealth for a 1%
change in the annualized standard deviation of stock returns (VEGA), the number of directors serving on the board
during the year (BRDSIZE), the percentage of outside directors serving on the board (BRDIND), and the percentage of
shares held by institutions during the year (INSTOWN). Exogenous variables include whether or not the CEO holds the
title of CEO and COB (DUALITY), cash to total assets (CASH), total debt to total assets (TD/TA), the log of sales (LN
SALES), earnings before interest and taxes to total assets (ROA), 1−year total return to shareholders (TRS), a dummy
variable equal to 1 if the firm is in the Domini 400 Social Index (DS 400), and the salary and bonus compensation paid
to the CEO (TCC). Instrumental variables include Tobin’s Q (Q), the ratio of research and development expenses to
total assets with missing values set equal to zero (R&D/TA), the standard deviation of stock returns calculated over 60
months used in calculating the EXECUCOMP Black-Scholes values for options (BSVOL), net property, plant, and
equipment to total assets (CAP), the age of the CEO (AGE), the length of time the CEO has been in the current position
(TENURE), and the log of one plus the ratio of monthly volume to number of shares outstanding in the month prior to
the institutional ownership observation (TURNOVER). Data are obtained from the KLD, COMPUSTAT,
EXECUCOMP, IRRC, and 13F databases and consist of an unbalanced panel of 3128 firm-year observations for 905
firms. All regressions include dummy variables for 4-digit GICS code and year (The coefficients for industry and year
are not reported). The z-statistics are given in parentheses. Superscripts */**/*** indicate levels of significance of 10%,
5%, and 1%, respectively.

Method 2SLS 3SLS

Dependent Variable Pred. IASM IASM DELTA VEGA BRDSIZE BRDIND INSTOWN
Independent Variable Sign (1) (2) (3) (4) (5) (6) (7)
IASM 2.971** 2.328 1.459 0.212* −40.15***
(1.98) (0.66) (0.91) (1.76) (−7.87)
DELTA (+) 0.131** 0.0843 −0.305*** −0.0651 0.0666***
(2.09) (1.40) (−2.77) (−0.73) (9.73)
VEGA (−) −0.342** −0.326*** 0.603***
(−2.54) (−2.69) (6.73)
BRDSIZE (+) −0.00234 0.0138
(−0.04) (0.27)
BRDIND (−) −3.788*** −2.511**
(−3.15) (−2.19)
DUALITY (+/−) −0.191** −0.165** −0.0676***
(−2.50) (−2.30) (−8.99)
INSTOWN (−) −0.00101 −0.00351
(−0.17) (−0.68)
CASH 1.225** 1.032** −0.780 2.186** −1.403** 0.0808 −8.084
(2.18) (1.98) (−1.51) (2.42) (−2.08) (1.53) (−1.19)
TD/TA 0.00592** 0.00547** −0.00815*** 0.0142*** −0.00428 0.000524** 0.0716**
(2.47) (2.37) (−3.92) (3.55) (−1.34) (2.09) (2.21)
LN SALES 0.0742 0.0891 0.141** 0.601*** 0.906*** −0.0414*** 0.153
(1.11) (1.38) (2.46) (7.64) (15.58) (−9.30) (0.38)
ROA 0.00726*** 0.00826*** −0.0117* 0.00194 −0.0248*** −0.000364 0.445***
(2.76) (3.18) (−1.90) (0.15) (−3.15) (−0.61) (7.65)
TRS −0.000620 −0.000354 0.00308*** 0.00155 −0.00243** −0.000174** 0.00491
(−1.19) (−0.69) (4.63) (1.17) (−2.23) (−2.02) (0.47)
DS400 0.138** 0.166*** −0.842** −0.864 −0.315 −0.0815** 11.32***
(2.22) (2.79) (−2.01) (−0.87) (−0.68) (−2.34) (6.44)
Q 0.211*** 0.0319 −0.0210 −0.0146***
(8.73) (0.49) (−0.43) (−4.23)
RD/TA −0.000250 −0.000754 −0.000117 −0.0000477**
(−1.03) (−1.22) (−0.40) (−2.22)
BSVOL 1.326*** −1.490*** −3.128*** 0.0833***
(5.29) (−3.23) (−7.96) (2.85)
CAP −0.00148 −0.0101*
(−0.58) (−1.71)

57
TCC 0.0000570* 0.0000566** 0.000230***
(1.85) (2.07) (4.80)
AGE 0.00179***
(3.65)
TENURE 0.0841***
(16.67)
TURNOVER 8.993***
(7.51)

Year Dummies Yes Yes Yes Yes Yes Yes Yes

Industry Dummies Yes Yes Yes Yes Yes Yes Yes

n 905 905 905 905 905 905 905

N 3128 3128 3128 3128 3128 3128 3128

58
Table 5: Three−stage least squares (3SLS) regression results of deviation from expected
stakeholder management components
This table reports results of three-stage least squares (3SLS) regression estimates of equations (3) and (5) - (9). The
endogenous variables deviation from expected stakeholder strengths (ESMSTR), deviation in expected stakeholder
management concerns (ESMCON), deviation from expected investment in the 5 stakeholder dimension categories of
employee relations (EEMP), diversity issues (EDIV), product issues (EPRO), community relations (ECOM), and
environmental issues (EENV), and deviation from expected social issue participation (ESIP), the dollar change in CEO
portfolio wealth for a 1% change in firm value (DELTA), the dollar change in CEO portfolio wealth for a 1% change in
the annualized standard deviation of stock returns (VEGA), the number of directors serving on the board during the
year (BRDSIZE), the percentage of outside directors serving on the board (BRDIND), and the percentage of shares
held by institutions during the year (INSTOWN). Exogenous variables include whether or not the CEO holds the title
of CEO and COB (DUALITY), cash to total assets (CASH), total debt to total assets (TD/TA), the log of sales (LN
SALES), earnings before interest and taxes to total assets (ROA), 1−year total return to shareholders (TRS), a dummy
variable equal to 1 if the firm is in the Domini 400 Social Index (DS 400), and the salary and bonus compensation paid
to the CEO (TCC). Instrumental variables include Tobin’s Q (Q), the ratio of research and development expenses to
total assets with missing values set equal to zero (R&D/TA), the standard deviation of stock returns calculated over 60
months used in calculating the EXECUCOMP Black-Scholes values for options (BSVOL), net property, plant, and
equipment to total assets (CAP), the age of the CEO (AGE), the length of time the CEO has been in the current position
(TENURE), and the log of one plus the ratio of monthly volume to number of shares outstanding in the month prior to
the institutional ownership observation (TURNOVER). Data are obtained from the KLD, COMPUSTAT,
EXECUCOMP, IRRC, and 13F databases and consist of an unbalanced panel of 3128 firm-year observations for 905
firms. All regressions include dummy variables for 4-digit GICS code and year (The coefficients for industry and year
are not reported). The z-statistics are given in parentheses. Superscripts */**/*** indicate levels of significance of 10%,
5%, and 1%, respectively.
Dependent Variable Pred. ESMSTR ESMCON EEMP EDIV EPRO ECOM EENV ESIP
Independent Variable Sign (1) (2) (3) (4) (5) (6) (7) (8)
DELTA (+) 0.0271* 0.00394 0.0118*** 0.0259** −0.00547 0.00683* 0.0144*** 0.0217
(1.85) (0.92) (2.82) (2.04) (−1.14) (1.81) (4.44) (1.44)
VEGA (−) −0.111*** −0.0192** −0.0371*** −0.0841*** −0.00979 −0.0296*** −0.0354*** −0.127***
(−3.93) (−2.23) (−4.61) (−3.06) (−0.93) (−3.67) (−4.69) (−4.06)
BRDSIZE (+) −0.000644 −0.00528 −0.00619 −0.00535 0.00122 −0.00711* −0.00553* −0.00777
(−0.05) (−1.30) (−1.53) (−0.47) (0.25) (−1.88) (−1.90) (−0.56)
BRDIND (−) −0.879*** −0.130 −0.333*** −0.811*** 0.130 −0.152** −0.361*** −0.887***
(−3.33) (−1.55) (−4.57) (−3.18) (1.40) (−2.09) (−4.69) (−3.00)
DUALITY (+/−) −0.0453*** −0.0107** −0.0186*** −0.0408*** 0.00590 −0.0156*** −0.0210*** −0.0408***
(−3.13) (−1.99) (−5.13) (−2.95) (1.44) (−3.25) (−5.48) (−2.82)
INSTOWN (−) 0.000447 −0.00217*** −0.000515** 0.000577 0.000171 −0.000805** 0.000229 −0.0000961
(0.62) (−4.56) (−2.12) (0.52) (0.50) (−2.29) (0.87) (−0.13)
CASH 0.394*** 0.107* 0.132*** 0.288** −0.00260 −0.00926 0.115*** 0.342**
(3.01) (1.84) (3.13) (2.41) (−0.05) (−0.23) (3.01) (2.29)
TD/TA 0.00171*** 0.000704*** 0.000643*** 0.00144*** 0.000136 0.000344** 0.000599*** 0.00204***
(2.80) (2.58) (3.36) (2.74) (0.62) (1.97) (3.38) (2.88)
LN SALES 0.0465*** 0.0352*** 0.0192*** 0.0265* −0.00396 0.00309 0.0188*** 0.0315
(2.69) (5.43) (3.54) (1.81) (−0.61) (0.63) (4.89) (1.58)
ROA 0.000672 −0.0000587 0.000979*** 0.000616 −0.0000400 0.000458** −0.0000435 0.00228**
(0.94) (−0.14) (3.95) (1.06) (−0.17) (2.04) (−0.20) (2.56)
TRS −0.000252* −0.0000673 −0.000142*** −0.000227** 0.0000966** 0.00000879 −0.0000725* −0.000167
(−1.80) (−0.83) (−2.98) (−2.01) (2.10) (0.20) (−1.74) (−1.00)
DS400 −0.0275* 0.00606 −0.0130*** −0.0202 −0.0000947 −0.0187*** −0.0259*** −0.0490***
(−1.79) (0.80) (−2.58) (−1.49) (−0.02) (−4.02) (−5.54) (−2.71)
TCC 0.0000230*** 0.00000366** 0.00000661*** 0.0000187*** 0.00000277 0.00000479** 0.00000707*** 0.0000255***
(3.41) (2.05) (3.59) (3.08) (1.16) (2.54) (4.15) (3.59)

Year Dummies Yes Yes Yes Yes Yes Yes Yes Yes
Industry Dummies Yes Yes Yes Yes Yes Yes Yes Yes

n 905 905 905 905 905 905 905 905

N 3128 3128 3128 3128 3128 3128 3128 3128

59
[The Appendices are not a formal part of the paper. They have been
included for use by the referees and will be made available to readers
upon request.]

Appendix A: Calculating stakeholder management

To construct measures for SM, we follow the procedure used in prior research in the area
(Waddock & Graves, 1997; Hillman & Keim, 2001; Coombs & Gilley, 2005), and construct a
measure of the firm’s stakeholder management (SM) performance using the KLD categories of
employee relations (EMP), diversity issues (DIV), product issues (PRO), community relations
(COM), and environmental issues (ENV). These five categories parallel the primary stakeholder
groups with regard to employees (including diversity initiatives), customers (product
safety/quality), the natural environment, the community, and suppliers (to the extent that certain
diversity initiatives are directed toward suppliers). Of note, the adapted KLD measure for SM
excludes issues outside of the primary stakeholder domains, but included in the domain of
corporate social performance. Following (Hillman & Keim, 2001), we include these excluded
issues when creating the variable social issue participation (SIP). The SIP variable includes the
KLD categories of human rights and controversial business issues (i.e. alcohol/
tobacco/gambling exclusionary screens, military exclusionary screens, and nuclear power
exclusionary screens). The seven stakeholder and social issue areas, as well as the strength and
concern indicators by dimension are listed in Table A1.
-----Insert Table A1 About Here-----
To measure SM and SIP we sum the number of positive (strength) and negative (concern)
indicators assigned to a company in a given year by stakeholder and social issue dimension. The
strength (concern) indicators are binary variables. Each is assigned a value of 1 when the
company has strengths (concerns) in each dimension. However, the number of KLD indicators
used to measure strengths and concerns varies from year to year. Therefore, in each year, we
create dimension (i.e. community relations, diversity, etc.) strength (concern) scores by taking
the sum of strengths (concerns) for each dimension and scaling by the total number of strength
(concern) indicators by dimension for each year.1
We then create strength (concern) scores for SM and SIP by summing the relative
dimension strength (concern) scores for each year for each measure. Finally, we create an
aggregate SM and SIP score variable by taking the SM (SIP) strength variable minus the SM
(SIP) concern variable for each year.

1
For example, KLD uses 6 indicators for community strengths in 1995 and 7 in 2002. Therefore, we sum up the
total strength indicators in 1995 and divide by 6 to obtain a Community strength score for 1995. We sum up the total
strength indicators in 2002 and divide by 7 to obtain a Community strength score for 2002. If a company scores 3 in
1995 and 2002, its community strength scores would be 3/6 = .5 and 3/7 = .4286, respectively. The community
strength score in 2002 would be slightly lower than 1995, due to the additional strength indicator used in 2002.

A-1
Table A1: KLD ratings indicators
This table provides a description of the KLD rating indicators by category.
Community
Strengths Concerns
Charitable Giving Investment Controversies
Innovative Giving Negative Economic Impact
Non-US Charitable Giving Tax Disputes
Support for Education Other Concerns
Support for Housing
Volunteer Programs
Other Strengths
Diversity
Strengths Concerns
Board of Directors Controversies
CEO Non-Representation
Employment of the Disabled Other Concerns
Gay & Lesbian Policies
Promotion
Women & Minority Contracting
Work/Life Benefits
Gay & Lesbian Policies
Other Strengths
Employee Relations
Strengths Concerns
Health and Safety Union Relations
Retirement Benefits Health and Safety
Union Relations Retirement Benefits
Cash Profit Sharing Workforce Reductions
Other Concerns
Environment
Strengths Concerns
Beneficial Products & Services Agricultural Chemicals
Clean Energy Climate Change
Management Systems Hazardous Waste
Pollution Prevention Ozone Depleting Chemicals
Recycling Regulatory Problems
Other Strengths Substantial Emissions
Other Concerns
Human Rights
Strengths Concerns
Labor Rights Labor Rights
Relations with Indigenous Peoples Relations with Indigenous Peoples
Other Strengths Burma
Other Concerns

A-2
 Product
Strengths Concerns
Benefits the Economically Disadvantaged Antitrust
Quality Marketing/Contracting Controversy
R&D/Innovation Safety
Other Strengths Other Concerns
Controversial Business Issues
Alcohol Firearms
Licensing Manufacturer
Manufacture Retailer
Manufacturer of Products Necessary for Ownership by a Firearms Company
Alcoholic Beverages Ownership of a Firearms Company
Retailer
Ownership by an Alcohol Company
Ownership of an Alcohol Company
Gambling Military Weapons
Licensing Manufacturer of Weapons or Weapons Systems
Manufacturer Manufacturer of Components for Weapons or
Owner and Operator Weapons Systems
Supporting Products or Services Ownership by a Military Company
Ownership by a Gambling Company Ownership of a Military Company
Ownership of a Gambling Company
Nuclear Power Tobacco
Ownership of Nuclear Power Plants Licensing
Construction & Design of Nuclear Power Manufacturer
Plants Manufacturer of Products Necessary for Tobacco
Nuclear Power Fuel & Key Parts Products
Nuclear Power Service Provider Retailer
Ownership by a Nuclear Power Company Ownership by a Tobacco Company
Ownership of a Nuclear Power Company Ownership of a Tobacco Company

A-3
 Appendix B: Calculating CEO portfolio delta and vega

We use delta and vega as proxies for CEO equity-based compensation and ownership
incentives. Delta (DELTA) is defined as the dollar change in CEO portfolio wealth for a 1%
change in firm value:

# 0 .01

(B1)
where: d equals the dividend yield, m equals time to maturity, P equals the fiscal year closing
stock price, N(.) is the standard normal cumulative density function,

, X equals the exercise price, rf equals the risk-free rate, and σ equals
√
volatility.
Vega (VEGA) is the dollar change in CEO portfolio wealth for a 1% change in the
annualized standard deviation of stock returns:
1
√ # 0 .01
√2
(B2)
where: d equals the dividend yield, m equals time to maturity, P equals the fiscal year closing

stock price, , X equals the exercise price, rf equals the risk-free rate, σ
√
equals volatility, and we estimate each CEO’s portfolio of stock options as in Core and Guay
(2002). Guay (1999) shows that option vega is many times higher than stock vega. Following
Knopf et al. (2002), Rajgopal and Shevlin (2002) and Coles et al. (2006), we use the vega of the
option portfolio to measure the total vega of the stock and option portfolio.
We use data from the EXECUCOMP database to construct each CEO’s aggregate stock
holdings at the end of each fiscal year. EXECUCOMP reports the aggregate number of shares,
which includes both contractually unrestricted and restricted stock. We estimate each CEO’s
portfolio of stock options as in Core and Guay (2002). The procedure involves two steps,
determining the exercise price and time-to-maturity of new options, and estimating the exercise
price and time-to-maturity of previous option grants. We obtain the data for new grants from
EXECUCOMP, which reports the number of options granted for each grant series, the exercise
price for each series, the expiration date of each option, the volatility estimates for each firm year
calculated over the past 60 months, the firm’s average dividend yield over the past three years,
and the closing price of the firm’s stock for the fiscal year. These six inputs, along with the risk
free rate of interest, allow for the calculation of the incentive effect of executive stock option

B-1
grants each year1 We estimate the exercise price of the unexercisable options by finding the
difference between the fiscal year end stock price and value of unexercisable in-the-money
options, excluding the value of new option grants, to the number of unexercisable options,
excluding the number of new grants.2 To estimate the exercise price of exercisable options, we
take the difference between the fiscal year end stock price and the value of exercisable in-the-
money options to the number of unexercised exercisable in-the-money options. These
calculations yield average estimates for the exercise price of exercisable and unexercisable
options. We set the time-to-maturity of the unexercisable options equal to one minus the time-to-
maturity of the current year’s new option grants. The time-to-maturity of exercisable options is
set to three minus the time-to-maturity of the unexercisable options. When no grant is made in
the current year, the time-to-maturity of unexercisable and exercisable options is set to nine and
six years respectively, as in Core and Guay (2002).
We winsorize delta and vega at the upper and lower 1% to reduce any possible impact
from outliers, which is consistent with prior literature (Guay, 1999; Core and Guay, 1999; Coles
et al. 2006). We also use log of delta and vega to account for the high skewness and kurtosis in
each of these variables.

1
We use the risk-free rate of interest used by EXECUCOMP to calculate option values using its modified Black-
Scholes methodology This method uses a risk-free interest rate that is the approximate average yield that could have
been earned in a particular year by investing in a U.S. Treasury bond carrying a seven-year term. Other researchers
have employed a risk-free rate equal to the rate of interest on a ten-year constant-maturity Treasury bond (e.g. Palia,
2001; Brick, Palia, and Wang, 2005). We believe that matching the term on the risk free rate to the early exercise
behavior of executives (typically seven years) is more appropriate (see Carpenter, 1998; Huddart and Lang, 1997;
and Bizjak, Bettis, and Lemmon, 2003).
2
When the number of new options granted exceeds the number of unexercisable options, such as in the case of
immediate vesting of some or all new grants, the excess realizable value and number of options is deducted from the
number and realizable value of exercisable options.

B-2
 Appendix C: Additional tables and robustness tests

Table C1: GICS industry group and Fama-French 49 industry classification breakdowns
Panel A: GICS Industry Group Classification
GICS Code Industry Group Description 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Total
0 Missing 1 1 2 1 0 2 1 1 1 0 2 1 13
1010 Energy 30 31 31 29 29 29 30 28 26 26 57 51 397
1510 Materials 64 62 62 61 64 63 64 65 61 57 62 60 745
2010 Capital Goods 73 74 74 72 69 68 65 65 63 61 71 76 831
2020 Commercial & Professional Services 27 26 26 25 26 27 27 27 27 27 36 35 336
2030 Transportation 17 18 18 19 20 19 18 17 18 17 24 24 229
2510 Automobiles & Components 14 14 14 15 15 15 14 13 14 16 18 19 181
2520 Consumer Durables & Apparel 39 39 38 38 39 39 40 42 41 38 43 47 483
2530 Consumer Services 16 17 17 17 18 20 19 18 19 17 31 38 247
2540 Media 24 24 27 26 28 25 25 25 25 25 53 53 360
2550 Retailing 37 37 36 36 34 33 32 31 33 34 51 62 456
3010 Food & Staples Retailing 16 17 17 17 16 16 17 17 17 15 19 18 202
3020 Food, Beverage & Tobacco 25 26 26 26 26 26 26 26 28 27 31 35 328
3030 Household & Personal Products 13 13 12 11 10 8 10 10 10 10 11 12 130
3510 Health Care Equipment & Services 21 22 22 25 25 26 29 29 30 30 53 61 373
3520 Pharm., Biotechnology & Life Sciences 21 21 21 21 19 19 19 19 22 23 58 47 310
4010 Banks 34 30 30 31 33 30 31 34 32 33 66 83 467
4020 Diversified Financials 11 11 12 14 16 16 18 22 23 25 43 44 255
4030 Insurance 24 25 25 24 25 25 26 25 22 22 42 51 336
4040 Real Estate 3 3 3 3 3 3 2 2 2 2 28 41 95
4510 Software & Services 12 14 15 13 14 15 17 19 21 28 78 65 311
4520 Technology Hardware & Equipment 27 27 24 24 26 33 34 36 37 39 80 63 450
4530 Semiconductor Equipment 8 8 8 7 8 9 9 10 10 17 40 36 170
5010 Telecommunication Srvs 14 15 14 15 16 17 15 16 15 13 26 15 191
5510 Utilities 47 48 51 52 51 51 50 51 57 52 69 63 642
Total 618 623 625 622 630 634 638 648 654 654 1,092 1,100 8,538

C-1
 Panel B: Fama-French 49 Industry Classification
Industry Description 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Total
Agriculture 1 1 1 2 2 2 2 2 2 0 2 3 20
Food Products 18 19 19 18 18 18 18 18 19 18 19 22 224
Candy & Soda 1 1 1 1 1 1 1 1 2 2 3 3 18
Beer & Liquor 5 5 5 5 5 5 5 5 5 5 6 6 62
Tobacco Products 2 2 2 2 2 2 2 2 2 2 3 3 26
Recreation 5 5 5 5 5 4 4 4 4 4 4 4 53
Entertainment 4 4 4 3 3 3 3 3 4 2 13 14 60
Printing and Publishing 17 16 17 16 18 17 17 17 17 15 19 18 204
Consumer Goods 21 21 21 20 19 18 18 18 18 19 20 22 235
Apparel 10 10 10 10 10 11 11 11 11 11 14 14 133
Healthcare 4 4 5 5 4 4 5 4 4 4 13 16 72
Medical Equipment 8 9 9 10 11 12 13 13 12 12 16 16 141
Pharmaceutical Products 19 19 19 19 18 18 19 19 22 23 50 39 284
Chemicals 25 24 25 24 23 23 23 22 20 20 25 25 279
Rubber and Plastic Products 3 3 3 3 3 4 4 4 3 4 3 4 41
Textiles 3 3 3 3 4 4 4 5 5 4 3 3 44
Construction Materials 14 14 13 13 13 13 15 15 14 13 15 16 168
Construction 6 7 6 7 7 6 6 6 6 5 9 11 82
Steel Works Etc 13 13 13 12 12 12 13 14 13 11 11 10 147
Fabricated Products 0 0 0 0 0 0 0 0 0 0 1 1 2
Machinery 29 28 29 28 27 26 24 24 24 25 33 36 333
Electrical Equipment 8 8 8 8 9 9 9 9 8 8 10 9 103
Automobiles and Trucks 17 17 17 18 18 18 17 16 17 16 17 20 208
Aircraft 7 7 7 6 6 6 5 5 5 5 7 7 73
Shipbuilding, Railroad Equip. 4 4 4 3 3 3 3 3 3 3 4 3 40
Defense 1 2 2 2 1 1 1 1 1 1 1 2 16
Precious Metals 5 5 5 6 7 7 6 6 5 5 3 1 61
Non-Met. and Ind. Metal Mining 2 1 1 1 2 2 2 2 3 3 4 4 27
Coal 1 1 1 0 0 0 0 0 0 0 4 2 9
Petroleum and Natural Gas 27 28 27 26 26 26 27 25 23 22 40 38 335
Utilities 45 46 50 51 51 52 51 52 57 53 70 66 644
Communication 21 23 23 24 25 25 23 24 22 19 49 37 315
Personal Services 7 8 8 8 8 8 7 7 7 7 9 12 96
Business Services 8 7 9 9 10 11 12 13 13 16 41 44 193
Computer Hardware 13 13 13 13 14 17 17 18 17 18 33 21 207
Computer Software 14 16 14 12 13 15 17 19 20 25 68 51 284
Electronic Equipment 22 22 22 21 21 23 23 25 25 32 71 63 370
Measuring and Control Equip. 7 7 6 6 6 6 6 7 8 10 17 17 103
Business Supplies 27 27 26 26 26 23 24 25 24 22 22 21 293
Shipping Containers 3 3 2 3 3 3 4 4 4 4 4 6 43
Transport 17 18 18 19 20 19 18 17 19 18 28 28 239
Wholesale 17 17 16 16 15 14 15 15 18 18 23 24 208
Retail 45 46 46 45 43 43 44 43 45 44 68 76 588
Restaurants, Hotels, Motels 10 10 10 10 10 12 11 11 11 11 15 19 140
Banking 41 37 38 42 45 41 42 47 46 47 81 99 606
Insurance 26 27 27 27 29 31 33 32 29 29 56 66 412
Real Estate 0 0 0 0 0 0 0 0 0 0 1 2 3
Trading 6 6 6 6 8 10 9 10 11 13 54 66 205
Almost Nothing 9 9 9 8 6 6 5 5 6 6 10 10 89
Total 618 623 625 622 630 634 638 648 654 654 1,092 1,100 8,538

C-2
Table C2: Excluding regulated industries, continuous variables winsorized at 1%, outliers removed (high DFITS and high
DFBETA’s on governance variables)
Robustness Test Excluding Reg. Industries Winsorized at 1% High DFITS Removed High DFBETA’s on Gov. Removed
Method 2SLS 2SLS 2SLS 2SLS 2SLS 2SLS 2SLS 2SLS
Dependent Variable Pred. (ESM) (IASM) (ESM) (IASM) (ESM) (IASM) (ESM) (IASM)
Independent Variable Sign (1) (2) (3) (4) (5) (6) (7) (8)
DELTA (+) 0.00569 0.113** 0.0315** 0.152*** 0.0155 0.0876** 0.0135 0.102***
(0.30) (2.29) (2.06) (3.82) (1.02) (1.99) (0.77) (3.04)
VEGA (−) −0.0796** −0.237** −0.0541** −0.146** −0.0632** −0.207** −0.0369 −0.0992*
(−2.16) (−2.50) (−2.06) (−2.13) (−2.04) (−2.34) (−1.28) (−1.81)
BRDSIZE (+) −0.0116 −0.0147 −0.00469 −0.0152 0.00967 0.0103 −0.000555 −0.00652
(−0.76) (−0.37) (−0.32) (−0.40) (0.60) (0.27) (−0.04) (−0.23)
BRDIND (−) −0.666* −3.206*** −0.756** −3.204*** −0.645** −2.164*** −0.147 −1.614***
(−1.89) (−3.52) (−2.37) (−3.87) (−2.29) (−2.74) (−0.56) (−3.24)
DUALITY (+/−) −0.0358 −0.188*** −0.0455** −0.193*** −0.0408** −0.126** −0.0151 −0.119***
(−1.35) (−2.75) (−2.31) (−3.77) (−2.19) (−2.48) (−0.84) (−3.50)
INSTOWN (−) −0.000288 −0.00538 0.000470 −0.00262 0.000832 −0.00163 0.00141 −0.00152
(−0.17) (−1.26) (0.28) (−0.61) (0.52) (−0.40) (0.98) (−0.56)
CASH 0.246 0.942** 0.162 0.492 0.273** 0.710* 0.0831 0.337
(1.57) (2.33) (1.13) (1.32) (1.99) (1.86) (0.71) (1.53)
TD/TA 0.00114 0.00560*** 0.000508 0.00268* 0.000355 0.00215 0.000105 0.000990
(1.45) (2.76) (0.92) (1.86) (0.65) (1.42) (0.21) (1.06)
LN SALES 0.0350 0.0544 0.00642 −0.0177 0.00741 0.0406 0.0148 0.00347
(1.61) (0.97) (0.50) (−0.53) (0.44) (0.92) (0.89) (0.11)
ROA 0.00153* 0.00712*** 0.000613 0.00548** 0.00108 0.00630*** 0.000550 0.00485***
(1.81) (3.25) (0.61) (2.12) (1.64) (3.33) (0.78) (3.63)
TRS −0.000192 −0.000750* −0.000548** −0.00169*** −0.000200 −0.000417 −0.000164 −0.000703***
(−1.14) (−1.73) (−2.34) (−2.78) (−1.55) (−1.18) (−1.29) (−2.91)
DS400 −0.0413** 0.170*** −0.0212* 0.139*** −0.0260* 0.162*** −0.0142 0.200***
(−2.14) (3.41) (−1.83) (4.59) (−1.73) (3.78) (−1.01) (7.49)
TCC 0.0000161* 0.0000312 0.0000249* 0.0000452 0.0000196** 0.0000341 0.00000631 0.0000117
(1.87) (1.41) (1.65) (1.15) (2.00) (1.60) (1.04) (1.02)

Year Dummies Yes Yes Yes Yes Yes Yes Yes Yes
Industry Dummies Yes Yes Yes Yes Yes Yes Yes Yes

n 767 767 905 905 895 895 849 849

N 2694 2694 3128 3128 2942 2942 2574 2574
t statistics in parentheses
* p < 0.10, ** p < 0.05, *** p < 0.01

C-3
Table C3: (RE) GLS regressions testing lagged and additional governance variables

Dependent Variable Pred. ESMt+1 ESM

Independent Variable Sign (1) (2) (3) (4) (5) (6) (7) (8)
DELTA (+) −0.000538 0.00411 0.00246 0.00136 0.00173 0.00417 0.00888* 0.00240
(−0.12) (1.02) (0.66) (0.40) (0.50) (0.98) (1.77) (0.64)
VEGA (−) 0.00137 −0.0000901 0.00000860 −0.000323 −0.000457 −0.000511 −0.00106 0.0000404
(0.95) (−0.07) (0.01) (−0.26) (−0.37) (−0.36) (−0.64) (0.03)
BRDSIZE (+) 0.00166 0.00292 0.00292 0.00411** 0.00329* 0.00255 0.00433* 0.00335
(0.65) (1.30) (1.30) (2.16) (1.72) (0.98) (1.68) (1.37)
BRDIND (−) 0.0283 0.0535* 0.0452 0.0329 0.0426 0.0631* 0.103** 0.0463
(0.82) (1.68) (1.46) (1.19) (1.57) (1.75) (2.02) (1.25)
DUALITY (+/−) −0.00727 −0.00189 −0.000410 −0.00574 −0.00620 −0.00609 −0.00181 0.000443
(−0.59) (−0.18) (−0.04) (−0.64) (−0.68) (−0.51) (−0.15) (0.04)
INSTOWN (−) −0.000367 −0.0000981 −0.0000911 −0.000183 −0.000184 −0.0000756 −0.000193 −0.0000905
(−1.40) (−0.41) (−0.39) (−0.84) (−0.84) (−0.29) (−0.69) (−0.38)
DIRDOL (−) −0.00383
(−1.00)
DIROWN (−) −0.174
(−1.20)
OUTTEN (+/−) −0.000148
(−1.22)
NUMMTGS (+/−) 0.00278*
(1.83)
GINDEX (+) 0.00592**
(2.41)
CEONOM (+) 0.0106
(0.72)
NOMSIZE (+) −0.00242
(−0.54)
NOMIND (−) 0.0511*
(1.72)
AUDSIZE (+) −0.00166
(−0.33)
AUDIND (−) 0.00541
(0.17)
CASH −0.151* −0.0605 −0.0583 −0.0107 −0.0212 −0.0471 −0.0466 −0.0595
(−1.82) (−0.92) (−0.89) (−0.19) (−0.36) (−0.62) (−0.56) (−0.91)
TD/TA −0.000599 −0.000132 −0.000140 −0.000363 −0.000345 −0.000165 −0.000103 −0.000130
(−1.40) (−0.36) (−0.38) (−1.10) (−1.03) (−0.39) (−0.24) (−0.35)
LN SALES −0.00350 −0.00651 −0.00616 −0.00218 −0.00355 −0.00569 −0.0113 −0.00597
(−0.49) (−1.01) (−0.96) (−0.40) (−0.64) (−0.79) (−1.57) (−0.93)
ROA 0.00172** 0.00127** 0.00121** 0.000612 0.000706 0.00117* 0.00102 0.00122**
(2.45) (2.50) (2.37) (1.25) (1.44) (1.86) (1.54) (2.38)

C-4
TRS 0.000114 −0.000104 −0.000117 −0.0000823 −0.0000805 −0.000146 −0.000127 −0.000118
(1.34) (−1.21) (−1.38) (−1.02) (−1.00) (−1.57) (−1.16) (−1.39)
DS400 −0.0162 −0.00890 −0.00863 −0.00584 −0.00616 −0.00688 0.00129 −0.00831
(−1.35) (−0.76) (−0.74) (−0.61) (−0.64) (−0.54) (0.10) (−0.71)
SAMPLE −0.00340 −0.00367 −0.00240 −0.00330 −0.00365 0.00409 −0.00361
(−0.26) (−0.28) (−0.23) (−0.32) (−0.26) (0.28) (−0.27)

Year Dummies Yes Yes Yes Yes Yes Yes Yes

Industry Dummies Yes Yes Yes Yes Yes Yes Yes

n 748 905 905 967 954 844 730 905

N 2517 2732 2732 3568 3484 2386 2173 2730
Within R2 0.00865 0.0134 0.0140 0.0109 0.0115 0.0172 0.0155 0.0135
Between R2 0.0512 0.0501 0.0492 0.0447 0.0385 0.0483 0.0609 0.0499
Overall R2 0.0447 0.0425 0.0421 0.0313 0.0327 0.0493 0.0551 0.0422
Robust t statistics in parentheses
* p < 0.10, ** p < 0.05, *** p < 0.01

C-5
Table C4: (RE) GLS regressions testing lagged and additional governance variables

Dependent Variable Pred. IASMt+1 IASM

Independent Variable Sign (1) (2) (3) (4) (5) (6) (7) (8)
DELTA (+) 0.00715 0.0162*** 0.0158*** 0.0132** 0.0145** 0.0165** 0.0185** 0.0157***
(0.94) (2.59) (2.59) (2.03) (2.18) (2.52) (2.26) (2.58)
VEGA (−) −0.000293 −0.00272 −0.00270 −0.00162 −0.00218 −0.00275 −0.00375 −0.00267
(−0.16) (−1.28) (−1.27) (−0.74) (−1.00) (−1.13) (−1.34) (−1.26)
BRDSIZE (+) 0.00614 0.00871** 0.00867** 0.0100*** 0.00964*** 0.00912** 0.0103** 0.00832**
(1.47) (2.52) (2.50) (3.05) (2.90) (2.36) (2.49) (2.19)
BRDIND (−) −0.147*** −0.0694 −0.0712 −0.0853* −0.0983** −0.0779 −0.0758 −0.105*
(−2.62) (−1.44) (−1.46) (−1.90) (−2.21) (−1.42) (−1.06) (−1.81)
DUALITY (+/−) −0.0159 −0.00520 −0.00504 −0.00909 −0.0120 −0.00877 −0.00742 −0.00714
(−1.03) (−0.36) (−0.35) (−0.74) (−0.95) (−0.56) (−0.45) (−0.49)
INSTOWN (−) −0.000403 −0.00000109 0.000000814 −0.00000487 −0.0000456 −0.0000749 −0.0000736 −0.0000144
(−1.18) (−0.00) (0.00) (−0.02) (−0.14) (−0.20) (−0.18) (−0.04)
DIRDOL (−) −0.00116
(−0.22)
DIROWN (−) −0.153
(−1.29)
OUTTEN (+/−) −0.000000279
(−0.00)
NUMMTGS (+/−) 0.00409**
(2.02)
GINDEX (+) 0.00491
(1.07)
CEONOM (+) −0.0133
(−0.59)
NOMSIZE (+) −0.00610
(−0.96)
NOMIND (−) −0.0165
(−0.39)
AUDSIZE (+) 0.00166
(0.26)
AUDIND (−) −0.0466
(−1.15)
CASH −0.0246 0.0768 0.0775 0.150 0.118 0.103 0.0888 0.0766
(−0.23) (0.80) (0.81) (1.62) (1.30) (0.96) (0.71) (0.80)
TD/TA −0.000867 −0.0000134 −0.0000157 −0.000381 −0.000458 −0.0000365 0.0000995 −0.0000162
(−1.15) (−0.02) (−0.02) (−0.63) (−0.74) (−0.05) (0.13) (−0.03)
LN SALES 0.00349 −0.0143 −0.0143 −0.00818 −0.0107 −0.0107 −0.0156 −0.0146
(0.29) (−1.32) (−1.32) (−0.80) (−1.02) (−0.92) (−1.26) (−1.35)
ROA 0.00181 0.00187* 0.00185* 0.00105 0.00113 0.00206* 0.00190 0.00185*
(1.45) (1.82) (1.81) (0.97) (1.04) (1.68) (1.40) (1.82)

C-6
TRS 0.000000997 −0.000297*** −0.000301*** −0.000270*** −0.000271*** −0.000370*** −0.000279** −0.000303***
(0.01) (−3.09) (−3.17) (−2.97) (−2.98) (−3.70) (−2.40) (−3.18)
DS400 0.189*** 0.228*** 0.228*** 0.211*** 0.210*** 0.228*** 0.243*** 0.227***
(8.53) (9.33) (9.33) (9.93) (9.82) (9.20) (8.96) (9.31)
SAMPLE 0.0252 0.0251 0.0320 0.0311 0.0211 0.0270 0.0247
(0.83) (0.83) (1.12) (1.09) (0.68) (0.82) (0.82)

Year Dummies Yes Yes Yes Yes Yes Yes Yes Yes
Industry Dummies Yes Yes Yes Yes Yes Yes Yes Yes

n 757 921 921 973 960 860 744 921

N 2561 2784 2784 3620 3536 2435 2218 2782
Within R2 0.0233 0.0371 0.0373 0.0337 0.0351 0.0396 0.0378 0.0374
Between R2 0.157 0.171 0.171 0.174 0.175 0.164 0.177 0.171
Overall R2 0.128 0.138 0.137 0.132 0.133 0.135 0.151 0.138
Robust t statistics in parentheses
* p < 0.10, ** p < 0.05, *** p < 0.01

C-7