Corporate Philanthropy as Signaling and Co-optation

April 2, 2012

This Article provides a new perspective on corporate philanthropy by examining a previously unnoticed mechanism through which corporate pro-sociality enhances firm value: signaling. In particular, cash donations can signal financial strength. A substantial and unexpected increase in the level of cash donations can signal that a firm’s insiders perceive the company’s future to be good enough to spend ultra-discretionary funds on unrelated third parties. The first contribution of this Article is in shifting focus from the traditional “buying goodwill” explanation for corporate philanthropy (i.e., companies engage in pro-social sacrifices because stakeholders are willing to pay more for corporate goodness) to a signaling explanation (i.e., pro-social sacrifices mitigate asymmetric information about a firm’s fundamentals). But corporate philanthropy is not unequivocally good for the company. This is where the Article’s second contribution comes in: examining the conditions under which corporate philanthropy decreases firm value. Under certain circumstances, managers can use their discretion over pro-social expenditures to co-opt corporate governance mechanisms, thereby increasing the level of agency costs. This occurs, for example, when managers cause companies to donate to charitable causes affiliated with independent directors. The Article next evaluates the legal implications of corporate philanthropy. In particular, the theoretical arguments presented here on how philanthropy can be good (signaling) or bad (co-optation) for the company strengthen the case for introducing some form of mandatory disclosure.

April 2012

No. 5