We examine how firms’ corporate social responsibility (CSR) performance affects CEO compensation structure. Traditional agency theory suggests that CEOs engage in CSR for their own interests at the expense of shareholders. A competing argument is that CEOs consider firms’ social performance as a business strategy to increase firm value and align their interests with those of shareholders. Our results support the latter prediction. We find that a firm’s social performance is negatively associated with the proportion of cash-based compensation, while it is positively associated with the proportion of equity-based compensation. These results are robust to the degree of corporate governance, and they are more pronounced for firms with high levels of inside director ownership and long director tenure. Overall, our findings highlight the positive impact of CSR performance on CEO compensation packages, implying that CEOs’ fiduciary behavior of engaging in CSR leads to mitigating agency problems and maximizing firm value.

Introduction

Prior literature shows that corporate social responsibility (CSR) has great impact on various aspects of accounting and finance. These studies show that a firm’s CSR activity improves operating and financial performance (Hillman & Keim, 2001; Jiao, 2010; Karpoff, Lott, & Wehrly, 2005; McGuire, Sundgren, & Schneeweis, 1988; Waddock & Graves, 1997), reduces the cost of capital (El Ghoul, Guedhami, Kwok, & Mishra, 2011; Sharfman & Fernando, 2008), and limits firms’ earnings management behavior (Kim, Park, & Wier, 2012). In line with this, some suggest the introduction of new standards on environmental reporting and environmental assurance service (Beets & Souther, 1999). Some studies, however, find no significant effect of CSR (Nelling & Webb, 2009) or its negative effect on firms’ financial performance (Brammer, Brooks, & Pavelin, 2006). Since a firm’s CSR performance is not the main goal of its business activity, mixed evidence from the prior studies raises the question of why CEOs intend to engage in CSR.2 Classic agency theory introduced by Jensen and Meckling (1976) argues that CEOs tend to pursue their own interests rather than to maximize shareholders’ value. For instance, CEOs tend to invest in CSR to hide their wrongdoings such as corporate misconduct (Hemingway & Maclagan, 2004), or to increase their own benefits such as strengthened reputation and bargaining power (Barnea & Rubin, 2010; Milbourn, 2003). A competing argument, on the other hand, posits that CEOs perceive CSR activity as a business strategy that improves firm performance and aligns their interest with those of shareholders. This is supported by Deng, Kang, and Low (2013), who argue that improving relationships with a firm’s stakeholders leads those stakeholders to be more willing to support a firm’s operation, contributing to increasing firm value. Under this argument, CEOs’ engagement in CSR would end up mitigating agency problems between managers and shareholders, rather than amplifying them. Empirically, though, it is challenging to test these two arguments, since the consequences of CEOs’ CSR activities, such as changes in their reputation level or increased firm value attributable to CSR performance, are not clearly observable through financial data. One indicator that shows CEOs’ motivation for CSR is CEO compensation. For example, if CEOs engage in CSR for their own interests, firms’ high social performance will be followed by high levels of CEO compensation (Barnea & Rubin, 2010; Borghesi, Houston, & Naranjo, 2014; Brown, Helland, & Smith, 2006; Hemingway & Maclagan, 2004; Krüger, 2015; Masulis & Reza, 2015; Milbourn, 2003).