Corporate Governance and Environmental Risk ...

Corporate Governance and Environmental Risk Management: A Quantitative Analysis of “New Paradigm” Firms. Gordon L. Clark and James Salo. Oxford University Centre for the Environment, University of Oxford, South Parks Road. Oxford OX1 3QY, United Kingdom. [email protected], [email protected]. Phone: +44 078 1298 8909. Abstract. Corporations are increasingly dependant on intangible assets, such as brand image and corporate reputation, in order to remain competitive in the global marketplace. A firm’s brand image and corporate reputation can be severely damaged by negative “signals” released to the financial market as a result of poor performance or failings of corporate governance and environmental management. In some firms, management’s focus on developing and protecting these intangible assets has grown so important that it has led to the creation of a “new paradigm” of firm management. These “new paradigm” managers are more likely to proactively manage risks to corporate reputation or brand image than the traditional “classical model” of firm management. Three proprietary corporate performance databases are utilized to quantitatively determine if there are differences in the risk management practices of firms with high relative amounts of intangibles as a part of overall firm value, as opposed to firms with low dependence on intangibles. To allow this analysis, a unique quantitative indicator was developed to calibrate the importance of intangible assets in a comprehensive way for each corporation. The results suggest that “new paradigm” firms tend to manage corporate governance and environmental risks more aggressively then their “classical model” peers. In addition, it is found that a firm’s industry is more important than its home-nation in predicting the level of intangible assets for firm value and growth of investment in intangibles over time. These are key findings as they imply that the pressures driving risk management are not bound by geographic or legal boundaries such that market pressures can promote higher global standards without a global governance system. JEL Codes. G30, M14. Keywords. Intangible Assets, Brand Image, Corporate Management, Corporate Environmental Performance.

Reputation,

Risk

Acknowledgements. This paper was supported by the SSHRC funded Union/University Research Alliance at the University of Toronto. This work benefits from the use of proprietary corporate performance data that was generously provided by Credit Suisse First Boston (London) and Innovest Strategic Value Advisors (Toronto). The authors would foremost like to thank Giles Keating for James Salo’s CSFB summer internship, and Matthew Kiernan and Hewson Baltzell of Innovest Strategic Value Advisors for their continued contributions, and to Jonathon Ford for his insights. In addition, the authors would like to thank Dariusz Wójcik, Rob Bauer, Joshua Forgotson, Kim Farrant and Steven Altmann-Richer for their support. None of the above should be held responsible for any views or opinions expressed within this paper. Any errors or omissions are the responsibility of the author.

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1. Introduction The risk management practices of modern corporations differ significantly both in quality and quantity. These differences are growing in today’s marketplace, because risk is more significant and less understood then ever before. A major source of the growth in risk and its increased complexity has come from the rising importance of intangible assets (DeLoach 2000). Intangible assets create a significant source of risk because they make firms more vulnerable to outside actors that ultimately can affect financial performance.1 In response to the growing risk, the leadership of some firms dedicate significant resources to proactive risk-mitigation, while the leadership of other firms overlook, underestimate, or knowingly disregard the importance of intangibles and managing the risk exposures to them, and instead focus strictly on managing risks to the firm’s tangible assets. In this paper, these two divergent management styles are developed, a unique indicator is created to group firms by importance of intangibles, and evidence is found that suggests intangible assets play a role in determining the risk management practices of modern corporations. Intangible assets are becoming an essential element for sustained financial success of modern corporations in today’s competitive global marketplace. In order to continue to create attractive profit margins, managers are investing greater amounts of resources into the development and orchestration of these difficult-to-replicate intangible assets to differentiate themselves from the competition (Teece 2000). This is why intangible assets, as a proportion of corporate value, have grown from 17% in 1978 to 69% by the end of 1998 (Blair and Kochan 2000) and are now a key element determining market value of traditional businesses (Boulton et al 2000). In one survey, CEOs claimed that the importance of corporate reputation had grown rapidly over the previous 5 years and they expected that growth to continue (Haapaniemi 2000). The development and management of a successful global brand image and positive corporate reputation is one dominant method managers use to increase their firm’s intangible assets.2 However, with the development of a significant brand image, also brings with it a greater vulnerability to public scrutiny and increased expectations of both financial and “social” corporate behavior (Holt et al 2004). Globally recognized brands and their firms are seen by the public as powerful institutions that are capable of doing great good and/or causing significant harm. If a corporation does not meet the expectations of it’s stakeholder groups, it risks reputation damage, which can have negative impacts on the financial well being of the firm both from the consumer and the financial marketplaces.3 Over 90% of financial analysts agree that a company that fails to manage its reputation will suffer financially (Hill & Knowlton 2006). 1

Risk is also increasing as actors external to corporations are gaining power. In particular, financial and non-financial rating agencies, the media, regulators, and institutional investors have each, in their own way, taken control away from managers and added to the complexity of the risk that they are faced with. 2 For a review of the empirical findings on how strong brands provide firms with competitive marketing advantages see Hoeffler and Keller 2003. 3 One recent study has showed that consumers internationally choose one brand over another because of their social responsibility, in addition to their association with cultural ideals and differences they signal in product quality (Holt et al 2004). We would also expect institutional investors to be interested in reputation as there is evidence that corporate image is an important strategic factor that needs to be managed in order to maximize shareholder value in the long run (Gregory 2001).

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This research examines how the financial structure of firms, particularly level of investment in intangible assets, affects corporate risk management practices. It is found that firms with a greater dependence on intangibles are more likely to manage environmental and corporate governance risks than firms with a dominant tangible asset financial structure. A secondary objective of this research is to determine if there are major differences between intangible investment in specific home-nations or industries. It is shown that a firm’s industry has greater importance then a firm’s home-nation in determining the level of importance and increase in investment in intangible assets over time, suggesting that specific industries are more at risk to threats to intangibles then other industries or firms in particular home-nations and therefore are more keen to manage these risks. Corporate governance and environmental performance ratings are used as indicators of the management’s responsiveness to threats to intangible assets, particularly, corporate reputation and brand image. Corporate governance and environmental performance are justified as indicators of risk for this research, as both are increasingly linked to corporate financial performance,4 have particularly significant implications for a firm’s brand image and corporate reputation,5 and are becoming a central strategic management issues for corporate leadership.6 In 2003, 24% of CEOs surveyed by Hill and Knowlton stated that the handling of social and environmental issues was a central concern for the protection of corporate reputation. Another sign of managers’ growing interest in preventing threats to reputation and brand image is the recent emergence of a information market for performance ratings in a number of these “non-financial” areas7 and the creation of brand/reputation consultants and firms that manage Annual General Meetings to protect corporate reputation.8 Overall, poor corporate governance and environmental performance have become de facto negative 4

A number of recent studies have shown that there is a positive relationship between corporate environmental and corporate financial performance (Edwards 1998, Kiernan and Lievinson 1998, EPA 2000). A meta-analysis of the research findings of 52 past studies (which represent the population of prior quantitative inquiry) by Orlitzky et al found that corporate virtue in the form of social and environmental responsibility is likely to lead to stronger financial performance. While there have been limited studies examining the connection between corporate governance and financial performance, the studies that have been conducted have generally found a positive relationship (See Gompers et al 2003, Drobetz et al 2003, Derwall et al 2004, La Porta et al 2002, De Jong et al 2002, Black 2001). These performance improvements may be seen in greater firm profits, reduced costs, improved employee satisfaction and retention, consumer loyalty, and brand reputation both in domestic and broadly international markets (Gompers et al 2003, Porter and van der Linde 1995, Dowell 2000, EPA 2000). In addition, investors, including institutional investors, are willing to pay more for firms with strong governance practices (McKinsey & Company, 2000) and will avoid firms they know have poor corporate governance practices (Russell Reynolds Associates, 2000). 5 This has become increasingly true with growing frequency of firms’ poor governance practices or environmental failings appearing in the press. It seems that the media now actively targets both, particularly since the recent massive failures epitomized by Enron and Exxon Valdez. Companies that have had crises of reputation, such as Exxon after the Valdez oil spill and Texaco after being accused of race discrimination, have seen the market value of their shares drop by billions of dollars (Zingales 1998). Companies with strong corporate reputations recover financially from these crises quicker then those firms who do not have solid reputations (Knight and Pretty 2000). 6 Firms are also likely to act because CEOs and management strongly dislike having their names associated with wrongdoing in the media (Fama and Jensen 1983). 7 For more on this emerging information market see Salo 2005. 8 For example firms like PearlFisher (http://www.pearlfisher.com/), Misukanis & Odden (http://www.misukanisodden.com/) and Brunswick Group (http://www.brunswickgroup.com/).

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“signals” to the financial market alerting investors and consumers to poor corporate behavior. In the next section of this paper, the modern corporation’s rise to power and the development and evolution of the “struggle for control” of the firm are briefly recounted. The reasons for divergence in management styles between the more traditional “classical model” firm and the newly rising “new paradigm” firm is explained in the second half of the next section. The subsequent section to that details the development of the research sample, describes the proprietary data used, explains the creation of a unique quantitative indicator that is utilized to calibrate the significance of intangible assets for each firm, and details the quantitative methodology. Next, the results are examined by conducting a quantitative analysis first on the interactions between intangible assets and corporate governance, second between assets and environmental performance, and finally by differences in the level of intangibles between industry groups and home-countries. The paper concludes with an evaluative commentary on whether intangible assets, or more broadly, a firm’s financial structure, help to determine how actively the management tries to manage potential risks to brand image and corporate reputation and the implications of this relationship. 2. Management of the firm The modern day corporation has risen to power over the last 150 years and has become the world’s dominant economic institution, coordinating and motivating economic activity. The tremendous rise to power of the corporation as a business model results from its capacity to combine the capital, and thus the economic power, of unlimited numbers of individual people as investors. As early as the sixteenth century, these “joint stock companies” emerged to bypass the practical limitations of personal partnership firms that depended on the owners knowing each other and relied on mutual trust when pooling their money (Bakan 2004). Joint stock corporations allow firms to have a far greater number of owners since they do not require personal relationships between owners, and as a result give these corporations far greater access to and ability to accumulate capital. Since their creation however, joint stock corporations have been troubled by problems caused by the separation between ownership and management. Unlike personal partnerships where the firms were commonly both owned and managed by the partners, investors in joint stock firms may never have any direct contact or communication with the corporation they “own”. Managers are hired by the owners to run the firm, but without proper accountability structures in place, and due to the diluted ownership of the firm by hundreds of thousands of shareholders, the owners surrender the control of firm-level decision-making to the professional managers who administrate the firm on their behalf (Berle and Means 1933). As a result, managers become the dominant actor in the decision-making process and the owners’ role is reduced to that of capital providers awaiting the pay-off of managers’ decisions. This separation of ownership and control complicates oversight and creates greater potential for corruption (Bakan 2004). Ultimately, the shift of control from owners to managers allows for economically inefficient agency costs resulting from managers

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serving their own interests over those of the company’s shareholders (Fama 1965).9 The increasing distribution of ownership through the mid-twentieth century led to a even greater “cult of corrupt corporate managers” who were all too willing to serve their own interests ahead of the firm’s shareholders. This trend was at its apex in Anglo-American capital markets in the 1980s (Hebb 2006). A number of academic studies revealed that there is a significant loss of economic value resulting from these principal/agent problems in US corporations (Jensen and Meckling 1976). With the rise of shareholder awareness of these agency problems and a general public distrust of corporations’ ultimate objectives, a significant power struggle developed between owners and managers for control of the corporation.10 It has been argued that these agency problems have resulted from a lack of clarity regarding the purpose of the corporation (Jensen 2000). Until the early 1990s, Milton Friedman’s dictum that “the business of business is business” was sufficient to legitimize the ‘role of the corporation in society’ and protect managers’ autonomy from the backlash of the public perception that corporations are soulless, uncaring, impersonal and amoral (Clark et al 2006). This established logic effectively gave management permission to sideline external concerns from shareholders and public stakeholders about corporations’ long-term contributions to social welfare and responsiveness to public concerns through the 1980s. However, since the early 1990s the protective barrier surrounding this old adage has been severely weakened and the importance of corporate social citizenship has grown as the values of society have changed. Mechanisms in the market for corporate control that were promoted in the 1980s have now placed shareholder value firmly as the center goal of the modern corporation (Hebb 2006). A major influencing factor in the current reorientation in the logic of the management of corporations is the rise of institutional investors as a dominant market force. Their growth in influence since the 1980s has profoundly altered the balance of power between owners and managers by re-centralizing the power of uncountable investor/owners into a functional body that controls enough shares to demand that their concerns be heard by firm management (Clark 2000, Davis and Steil 2001, Hawley and Williams 2000, Monks 2001).11 Coalitions of owners, in the form of institutional investors, have been formed and now challenge corporations on issues including their governance structures and functioning and corporate strategies on dealing with climate change.12 For example, in 2006, 47 corporate governance and 38

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As discussed in Clark et al 2006, agency problems cause shareholders to risk chronic economic underperformance of cash flow compared with the total value of productive assets, higher-thanjustified retained earnings by corporate managers for use in self-investment, and finally lower-thanexpected dividends or rates of appreciation of corporate stock’s market price. This principal-agent problem is of central importance to the modern corporation and to capitalism in the marketplace today (see Platt and Zeckhauser 1987). 10 The struggle between owners and mangers for corporate power has a long history in both legal and economic literature (Roe 1994). 11 Since institutional investors act on behalf of their beneficiaries, who’s primary interest is the maximization of shareholder value of the corporations. 12 For example the Council of Institutional Investors is made up of 140 pension fund members with assets of over $3 trillion (US), who pressure firms on a number of issues to promote shareholder value (Council of Institutional Investors 2005). The Carbon Disclosure Project is supported by a group of 155 institutional investors representing investment groups holding over $21 trillion (US) which asks

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environmental resolutions were filed by the Interfaith Center on Corporate Responsibility (ICCR), a largely US-based coalition of faith-based institutional investors (ICCR 2006). With the rise to power of institutional investors, and the shifting of corporate control back to owners from managers, the accountability of firms is growing. Managers no longer can unilaterally conduct corporate decision-making. Institutional investors are now actively and powerfully influencing corporate decision-making and helping to push corporations to act in the best interest of “shareholder value”.13 Corporate engagement is being used by groups from outside the firm to actively force corporate management to raise standards across a range of issues including accountability, transparency, social and environmental standards. Institutional investors have used corporate engagement to enhance shareholder value against entrenched self-interested managers (Clark and Hebb 2004). Both private/quiet and loud/public mechanisms of corporate engagement are now commonly used by shareholders to influence corporate practices.14 While the preferred method of corporate engagement is direct private dialogue, out of the public view (Bogle 2005), institutional investors are also using more contentious approaches. These approaches include mounting dissident shareholder resolution campaigns to raise concerns publicly at annual general meetings (AGMs) and/or otherwise utilizing negative media against the corporation (Clark & Hebb 2004)15 and can lead to heightened scrutiny on a variety of social, environmental and corporate governance issues (Clark et al 2006). Overall, a number of recent changes in the market have led to an increased accountability of firm management and a broadening of the types of issues that managers must tackle to include social, environmental and corporate governance standards. 3. Firm Management: The Classical and the New Paradigm This paper argues that the management of firms has diverged into two separate frameworks, the “classical model” and the recently diverging “new paradigm”. Conceptualizing these two differing management models is essential to this research because they are the extreme forms of the two styles of corporate management that exist and which are quantitatively shown to manage risk differently. First, in this section, these two models are defined by their historical context, asset structure and resulting market positions. Second, how these differences will affect risk management behavior is discussed. The “classical model” was the traditional form of management that the 20th century Corporation followed. “Classical model” firms have a large amount of physical and tangible assets to be used in the production of revenue, commonly in the form of firms for information to allow them to assess the potential economic risks and opportunities to the corporation relating to climate change (Carbon Disclosure Project 2005). 13 See Clark 2000 for more on the rise of institutional investors and Clark and Hebb (2004) and Hawley and Williams (2000) on these institutions effects on collective welfare. Also, a recent UNEP (2005) report reviews the scale and scope of the institutional investment industry with particular focus on the potential role of social and environmental considerations could play in investment decision-making. 14 For a comprehensive overview of corporate engagement its growth and the factors driving it see Clark & Hebb 2005. 15 Shareholder resolutions and their effect on corporate performance are examined in detail in Clark et al 2006.

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plants, factories, equipment and organizational protocols, which they have inherited through mergers and acquisitions or accumulated over a significant period of time. That is to say that “classical model” firms tend to be older then “new paradigm” firms and have a financial composition that is made up primarily of tangible assets. They depend on the plants and equipment they own to drive the financial performance of the firm, as well as, to act as financial barriers to entry against potential competition.16 “Classical model” firms tend to focus on selling specific products, not services and as a result tend to have a limited ability to respond to changes in the market. In contrast to this, the “new paradigm” firms are relatively young – having been formed in the past 25 years through technological and/or organizational innovations (Zingales 2000) – or are firms that have shifted away from a “classical model” as the result of pioneering strategic firm management practices.17 The financial structure of these new “paradigm” firms differs significantly from “classical model” firms as they have two significant types of assets: tangible (e.g., manufacturing plants, equipment) and intangible (e.g., intellectual property, brand image). The managers of “new paradigm” firms continuously discount their firm’s tangible assets in favor of developing their intangible assets (Roberts 2004). Intangible assets include corporate knowledge, competence, intellectual property, brands, corporate reputation, and customer relationships (Teece 2002). To these “new paradigm” firms, the scale of their tangible assets is less important than organizational flexibility. Many of these firms take advantage of extensive international networks of suppliers and have a global market for their wares. They manage these supplier networks through contractual commitments that allow them to benefit from competition between potential suppliers for specified time-term contracts. “New paradigm” firms use their capacity for innovation and market leadership as a competitive advantage, as it allows them to quickly evolve to complement changing market tastes and preferences. The rise of these “new paradigm” firms has come from the growth in the value and impact of significance of intangible assets. This growth has resulted from the changing foundation of corporate competition and wealth creation that has come with the decreased cost of information flow, liberalization of product and labor markets, and deregulation of financial flows (Teece 2000). As corporations are becoming more reliant on the continuous innovation of products, processes and organizational designs for their financial survival and growth (Lev 2001), greater numbers are likely to evolve into a “new paradigm” model of management. In addition, the market has changed, further promoting “new paradigm” firms, because of the entrance of investors (particularly institutional investors as mentioned previously), insurers, and global competitors as powerful players in the organizational field who are more frequently engaging corporations and instigating a redefinition of the priorities of the firm toward optimizing shareholder value. This in conjunction with a continued public distrust of large corporations, particularly following the public collapses of Enron, Worldcom, Ahold, etc, and the hot spotlight of the media’s scrutiny of their widespread mismanagement. Many issues that previously were considered “social” in 16

These ‘sunk costs’ are costs that “are irrevocably committed to a particular use, and therefore not recoverable in the case of exit” (Mata 1991). Therefore, while acting as a protective barrier deterring competition from entry, or facilitating firm-specific expertise, they can also limit the extent of corporate flexibility of capital for use providing products and services. 17 Transitioning from the “Classical Model” to the “New Paradigm” might occur following exterior events (for example reputation disasters) or because of visionary leadership/management.

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nature have started to become key strategic management issues for corporations to deal with, thus pushing management towards a “new paradigm” style of risk mitigation. In its most extreme form, the management of “classical model” firms has an entrenched style and is disconnected from the rest of the world in many ways. Managers of these firms have a confrontational attitude towards suggestions from groups external to the firm including shareholders, regulators, insurers, etc, because these managers are accustomed to weak corporate governance management structures and practices that afforded them almost sole control of the firm and even opportunities to act in their own self interest. Therefore, the managers of these firms are only responsive to information that originates within the firm, or developed by the firm’s leadership. Managers try to keep as much information as possible private within the firm, avoiding transparency in order to limit the amount of information that could be leveraged against them. Therefore, the information is unavailable to investors, and to the global marketplace, in general, for evaluation. This causes an information asymmetry between firms’ managers and the market. In many cases, important performance information is not collected or analyzed at all. The ability of managers to remain entrenched in limiting the disclosure of information is diminishing. There has recently been a significant increase in disclosure requirements and the creation of a number of voluntary initiatives that have been forcing all firms to disclose greater amounts of information including “classical model” firms. This loss of information control by the firm allows for greater pressure and influence from groups outside of the firm. This means that firms are becoming more sensitive to the pressures and demands of shareholders, stakeholders, the media, and the public in general. Overall, this increased sensitivity to outside pressures has led to a more equal balance of power between corporate managers in industry and investor-shareholders. This development allows for better governmental oversight, more accountability, lower risk, and ultimately leads to greater shareholder value. These trends are promoting more firms to transition towards a “new paradigm” model. The management of “new paradigm” firms is far more responsive to these outside pressures because of the potential loss of value to their intangible asset holdings. “New paradigm” management understands that protecting intangibles like corporate reputation and brand image against risks is necessary and essential in order to have stable and sustainable financial performance in today’s marketplace. The divestment in corporations who were “supporting” the apartheid in South Africa in the early 1980s was perhaps the first major signal to large corporations that there was a significant financial ”risk” associated with being unresponsive to the interests of this new type of consumer and other groups outside of the firm, particularly institutional investors. “New paradigm” firms, therefore, are likely to be responsive to input from groups external to the firm, to actively participate in collaborations and voluntary initiatives, and to utilize non-financial performance ratings to inform their decision making and lower their risk profile. These “new paradigm” firms proactively do this in order to minimize risk to their intangible assets and in order to gain trust from their stakeholders.

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A hypothesis has been constructed in this paper in which there are two progressively divergent risk management models used by corporate managers. In the remainder of this paper, a method of testing this hypothesis is developed to draw conclusions and implications from. In order to do this, an indicator for classifying firms by how important intangible assets are to them is developed by utilizing proprietary financial data. The unique corporate performance data that allows the testing of the research question is introduced in the next section. The combination of the data from these three sources is the foundation of the database that is used for the quantitative analysis. In the end of the next section, the quantitative methodology used for determining how well the firms in these classes are managing risks to their intangible assets is outlined. It is expected that firms with a high dependence on intangible assets will manage risks better then firms who depend primarily on tangible assets. It is also expected that “classical model” firms are from tangible heavy industries like industrial manufacturing and utilities, whereas intangible-rich “new paradigm” firms would be from industries like media, banking/investment, and consumer goods & service companies. That is to say, it is expected that considerable differences in the significance of intangibles and therefore the risk management practices between industries. In the penultimate section of this paper, the results of the analysis are reported, first by the interactions between intangible assets and corporate governance, followed by the interactions between intangible assets and environmental performance, then change and convergence in performance are examined, and finally differences in the level of intangibles between industry groups and home-countries are examined. The conclusion discusses the results and the implications. 4. Calibration of intangible assets In order to begin to meet the remaining objectives of this paper, a criterion must be established for quantitatively distinguishing firms with relatively high amounts of intangibles from those firms with relatively low amounts of intangibles (firms that primarily hold tangible assets). This classification allows evaluation of differences in how firms manage potential risks to corporate reputation or brand image. In the section that follows, the quantitative strategy used is detailed, an overview of the data this research depends on is provided, and a justification of the data and methodology is presented. The strategy applied to answer this paper’s research questions is to conduct empirical analyses on quantitative data from three proprietary databases. They are: the Credit Suisse First Boston (CSFB) Holt database on corporate financial performance which provides data on intangible assets and financial structure, the Innovest database on corporate environmental performance, and the Deminor database on corporate governance performance. These last two databases provide quantitative ratings of corporate strategic risk management practices. Past research in corporate performance has not had a useful and comprehensive quantitative indicator of intangible assets. These studies have instead used very rough indicators like a firm’s industry or their ratio of research & development (R&D) and/or advertising expenses to total assets (for example see Doukas and Padmanabhan 2002) as classifying indicators to separate firms into high intangible and low intangible groups. This research benefits from the use of an advanced and 9

standardized firm-specific indicator of intangible assets, which are calculated using financial data from the CSFB Holt database on corporate financial performance. The CSFB Holt database is one of the most comprehensive financial performance databases available. CSFB Holt’s primary clients are institutional investors and money managers who pay subscriptions to access its information. Of importance fore this research is the fact that CSFB Holt has compiled and standardized corporate financial information for 17,000 firms globally (CSFB 2006), which can be used to accurately compare corporations against each other regardless of home-nation or industry.18 Innovest Strategic Value Advisors provided the corporate environmental performance data that is used in this research. Innovest assesses the environmental performance of approximately 90 percent of firms included in the world’s primary stock market indices: the S&P 500, the FTSE 350, the FTSE EuropeTop, the Nikkei and MSCI world indices. Innovest’s ratings are independently determined and unlike many rating agencies, investors not firms pay for the ratings. Innovest’s rating system is broken into four main categories and further into fifteen sub-categories that when are all combined provide the overall rating of the firm. Each of the Innovest rating scores and sub-scores for firms is directly comparable regardless of their industry and national jurisdiction. The four major categories are: “profit opportunities” which measures corporations’ current and potential for competitiveness with respect to environmental opportunities; “risk improvement” which estimates firms’ environmental risks and liabilities and evaluates how well they are being managed; “management performance” which evaluates the quality of essential environmental management practices including audit, disclosure, impact assessment etc; and “environmental strategy” which appraises corporations’ stated policies concerned with the integration of environmental performance into the firms’ business strategy, planning process, and corporate culture. Innovest ratings’ key strength is that its data collection is both based on intensive interviews with senior executives and comprehensive evaluation of public and private firm-specific information. This gives Innovest ratings the advantage of utilizing information that would not be available to its clients unless they were directly and intensively engaged with specific firms and creates a unique market niche that the firm can charge a premium for. Innovest promotes their data collection method and standardized ratings as an important “information market” that adds value to the investment process by introducing new information and decision criteria that is unrecognized by other rating agencies that base their evaluations on public information alone. Deminor Rating, a corporate governance-rating agency provided the third proprietary database. Deminor rates corporate governance standards and practices and sells the standardized rating information to institutional investors to inform their investment decisions. Deminor has rated firms listed in the FTSE Eurotop 300 Index on approximately 300 different governance criteria annually since 2000. Deminor ratings are exclusively based on publicly available information, with the major sources being corporate websites, news articles and stock exchange announcements. 18

Of particular interest to Holt’s clients is its financial evaluation of firms, which uses a cash flow methodology that allows for a more accurate assessment of firm value.

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For this research, the data used is limited to the scores of the four major categories and the overall corporate governance score. These four categories represent major pillars of corporate governance: ”Rights and Duties of Shareholders” estimates if shareholders can exert sufficient pressure on firms’ corporate decision making; ”Range of Takeover Defenses” evaluates the firms’ hostile takeover prevention amendments that shelter the management from threat of replacement; ”Disclosure on Corporate Governance” rates the availability and quality of information about the firms’ corporate governance and financial practices that are publicly available to shareholders; and ”Board Structure and Functioning” analyzes the firm composition, including diversity and experience of members, and the election practices as well as remuneration and board functioning. The ratings and values from three databases were organized and compiled into a single database to allow for empirical analysis.19 The data was prepared first by creating two research samples that included all firms that are both rated in either the corporate governance or environmental performance database and by CSFB Holt. These two samples include 164 and 274 firms respectively. Next a unique indicator was created to classify firms according to how important intangible assets were to them compared to tangible assets. A ratio using CSFB Holt’s value for Goodwill divided by the value for Plant Assets was chosen as the intangible importance indicator. Goodwill as defined by the CSFB Holt database is the amount that the firm’s purchase price exceeds the net tangible assets of the firm. Plant Assets is defined as the monetary value, after depreciation, of all of the firm’s tangible fixed assets used in the production of revenue. 5. Analysis

6. Conclusions and Implications The purpose of this research was to assess the relationship between intangible assets and differences in corporate risk management practices, an issue that has had no previous empirical examination. A summary of the major findings of this research is listed below and is followed by the overall implications of this research. I. There is an indirect and limited, but existing relationship between level of importance of intangibles and proactive management of risk. The bivariate analysis resulted in no direct correlations between the indicator of importance of intangibles and ratings of corporate governance and environmental performance. However, using a nonparametric median test methodology resulted in four instances where firms with a greater importance of intangibles scored higher those with a lower importance of intangibles with statistical significance. There was only one case where low intangible firms scored higher then high intangible firms, for industry specific risks. However, another one of the findings explains this by showing that particular industries have greater dependence on intangible assets.

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The use of these databases has been justified in past work (see Salo 2005) and used successfully in other research (see Wójcik 2004, Clark et al 2006, and Salo 2005a).

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II. The importance of intangibles as a part of firm value is growing, but not converging over time. The relative significance of intangibles grew overall in both samples (Increased 17.57 in the sample of 164 and 5.3 in the sample of 274 between 2000 and 2004). However, there was no significant evidence that the calculated intangibles metric converged between 2000 and 2004. In fact, in the sample of 164, the spearman’s rho beta indicator suggested a slight divergence in intangibles. This was contradicted by the alpha indicators, which were highly negative, suggesting convergence was occurring. Overall, it is reasonable to conclude that neither significant convergence nor divergence of importance of intangibles was happening for all the firms in the sample. This is unsurprising, as it would be expected that firms from industries with greater dependence on intangibles to have this importance continue to grow, while firms from other industries with little dependence on intangible assets will continue not to need to invest in them as significantly. III. Firms from specific industries tend to have similar levels of intangibles, which is not true of firms from particular home-nations. The difference in levels of intangibles between industry groups was statistically significant in nine cases within the sample of 164, and twice within the sample of 274. This finding suggests that a firm’s industry is strongly related to how important intangible assets are to the firm’s financial well being. Industries that had a high significance of intangible assets were Banks, Capital Goods, Consumer Services, Media, Food-Beverage & Tobacco and Insurance. Industries with low importance of intangibles include Utilities, Automobiles & Components, and Energy. IV. The change in importance of intangibles differs by industry, but not by homenation. The finding that industries vary in how important intangible assets are to them is supported by the results for change in intangible assets between 2000 and 2004. Whereas nations only had two occurrences where change in intangibles were different then the overall sample median with statistical significance in the two samples, there were twelve occurrences by industrial group. The industries with the greatest growth in importance of intangibles/tangibles ratio were TechnologyHardware & Equipment, Insurance, Telecommunication Services, and FoodBeverage & Tobacco. Industries with the least/negative growth in intangible/tangible ratio were Automobiles & Components, Diversified Financials, Software & Services, Utilities and Energy. V. There is no clear evidence of convergence intangible/tangible ratio between 2000 and 2004.

or

divergence

of

the

In summary, this research found that growing numbers of corporations are becoming more dependant on intangible assets to sustain their financial success (supporting the findings of Boulton et al 2000) and that firms in the samples are investing escalating amounts of their resources into developing intangible assets (confirming the finding of Blair and Kochan 2000). These findings support the theory that management is focusing on developing and protecting intangible assets to the point that more and more firms with the “new paradigm” financial structure are being created. The results suggest that increasing numbers of corporations will transition to the proactive “new paradigm” risk management style.

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The results, also, have shown that the financial structure and significance of intangible assets does affect the risk management practices of firms. In each case, where there are multiple statistically significant findings, the higher intangible class managed risk more effectively (with the exception of the industry specific risk for the reasons given previously). Therefore, this quantitatively proves that a dependency on intangible assets makes firms more likely to mitigate risks that threaten corporate reputation and brand image. In a sense, this important finding is unsurprising as firm’s with a greater brand image or highly visible corporate reputation have more to lose from these “negative signals” that poor corporate governance or environmental performance could release to the market. A number of important implications arise when one considers the fact that more firms are transitioning towards the “new paradigm” financial structure and, therefore, “new paradigm” style of risk management. This suggests that “new paradigm” firms are managing their risks in an increasingly proactive way. This agrees with the conclusions of past research that has shown that performance standards for corporate governance and environmental performance have been improving in recent years (for example see Salo 2005a and Wójcik 2006). The results, also, suggest that “new paradigm” firms are more responsive to the demands of outside actors/stakeholders (institutional investors, media, public opinion, etc). This has implications for the potential success of shareholder resolutions filed against firms at Annual General Meetings (AGMs). The results would suggest that filing resolutions against firms for “aspirational” reasons (high volume of intangible assets and relatively strong financial performance) would be more successful then “remedial” reasons (targeting of firms with high levels of tangible assets and relatively poor financial performance) (see Clark et al 2006). The rise in importance of intangible assets within general businesses is only a recent phenomenon. It would be expected that the relationship between significance of the intangible holdings of a firm and it’s risk management practices to become stronger as the understanding of the importance of intangibles grows within firm management, investment in intangibles increases and the measurement of intangibles improves within the marketplace. This supports Salo (2005) who suggests that an information market for non-financial corporate performance ratings will continue to grow into the future. Management and investors alike will use the performance rating data from this information market to assess risks to intangible assets and corporate reputation. With the increased availability and use of these sources of “non-financial” performance ratings, the promotion of environmental and corporate governance standards will accelerate.20 This supports the notion that increased disclosure and measurement promotes higher standards of performance, following Lowenstein’s (1996) “What gets measured gets managed” theory on corporate performance. In addition, it was found that typical “classical model” firms and “new paradigm” firms are from different industries within the marketplace. Typical “classical model” firms tend to be from tangible heavy industries like industrial manufacturing and utilities. The majority of “new paradigm” firms, on the other hand, are from modern 20

We would also expect this to become increasingly true as the managerial understanding of the threat that poor corporate governance and environmental performance pose to corporate reputation and brand image will grow paralleling management’s increased understanding of intangibles. This in addition to the potential financial performance advantages corporate governance and environmental performance have (Edwards 1998, Kiernan and Lievinson 1998, EPA 2000, McKinsey & Company 2000, Russell Reynolds Associates, 2000).

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industries like media, banking/investment, and consumer goods and services. This is a key finding, as the high intangible industries tend to be the “future economy industries”, the firms that are rising in power in the “new economy” as intangibles become more important. The fact that a firm’s industry is related to the firm’s level of dependence on intangibles is also significant. It suggests that the outside pressures which intangible assets make firms more vulnerable to are not geographically bound or dependant on individual nation’s legal regimes. The implications that have been developed here are considerable. Cumulatively, they suggest that intangible assets are causing market pressures to promote higher global standards of corporate governance and environmental performance, while also pushing for strong corporate reputation, shareholder value, and financial performance. These findings support the case for a win-win scenario where firm value is increased (because risk is decreased) and global standards of governance, environmental, and social performance are increased, regardless of geographical and legal boundaries, and without a global governance system.

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Table 1. Median values by level of intangibles Corporate Governance Performance - Deminor Rights & duties of shareholders Range of takeover defences Disclosure on corporate governance Board structure & functioning Environmental disclosure subscore Overall corporate governance

High

Medium

7.50** 4.50** 7.50 6.50 10.00 25.25**

Environmental Performance - Innovest (from sample of 274) Audit 5.00 Certification 4.00 Corporate governance 5.00 Training & development 5.00* Accounting & reporting 4.00 Management systems 5.00 Opportunity 6.10 Strategy 5.45 Historic liabilities 6.00 Industry specific risk 5.25 Leading & sustainability risk indicators 5.48 Operating risk 5.40 Performance 5.50 Products & materials 5.00 Strategic competence 5.00 Overall environmental 3.00 Authors calculations based on data provided by CSFB Holt, Innovest and Deminor Rating. Note: Significance at 10%(*), 5%(**) and 1%(***). Table 2. Change in intangible/tangible values by level of intangibles Corporate Governance Performance - Deminor (from sample of 164) Rights & duties of shareholders Range of takeover defences Disclosure on corporate governance Board structure & functioning Environmental disclosure subscore Overall corporate governance

High

Environmental Performance - Innovest (from sample of 274) Audit Certification Corporate governance Training & development Accounting & reporting Management systems Opportunity Strategy Historic liabilities Industry specific risk Leading & sustainability risk indicators Operating risk Performance Products & materials Strategic competence Overall environmental Authors calculations based on data provided by CSFB Holt, Innovest and Deminor Rating. Note: Significance at 10%(*), 5%(**) and 1%(***).

Table 3. Convergence of Ratings Corporate Governance Performance Deminor (from sample of 164) Rights & duties of shareholders Range of takeover defenses Board Structure & Functioning Disclosure on corporate governance Environmental disclosure subscore Overall corporate governance Intangibles/Plant (164)

Spearman’s Rho

(-)0.421** 0.018 (-)0.604** (-)0.730** (-)0.708** (-)0.099 0.191*

Low

Overall

(from sample of 164)

St.Dev. 2000

% of mean

1.17 1.51 1.42 1.38 3.06 3.06 4774.41

Environmental Performance - Innovest (from sample of 274) Audit (-)0.449** 2.64 Certification (-)0.223** 2.94 Corporate governance (-)0.500** 2.18 Training & development (-)0.297** 2.69 Accounting & reporting (-)0.448** 2.63 Management systems (-)0.440** 2.44 Opportunity (-)0.288** 1.56 Strategy (-)0.490** 2.37 Historic liabilities (-)0.321** 2.57 Industry specific risk (-)0.442** 2.25 Leading & sustainability risk indicators (-)0.519** 1.91 Operating risk (-)0.479** 2.08 Performance (-)0.509** 2.43 Products & materials (-)0.358** 2.50 Strategic competence (-)0.432** 2.37 Overall environmental (-)0.357** 1.87 Intangibles/Plant (274) -0.067 333.84 Authors calculations based on data provided by CSFB Holt, Innovest and Deminor Rating. Note: Significance at 10%(*), 5%(**) and 1%(***).

6.50* 1.00 7.50** 5.50* 10.00 22.00

7.00 1.00 7.50 6.50 10.00 22.50

7.00 3.50 7.50 6.00 10.00 23.00

6.25** 4.00 5.67* 6.00 5.00 7.00** 6.00 6.80 5.00 4.83** 5.58 5.48 5.50 5.50 6.00*** 3.50

4.63** 3.75 4.83** 5.00 5.00 5.00** 6.20 5.55 6.00 6.00** 5.50 5.50 6.00 5.00 5.00 3.00

3.00 5.00 4.00 5.00 5.00 5.00 5.25 6.00 5.60 6.00 5.00 5.50 5.50 5.00 5.00 3.00

Medium

Low

Overall

4.00* 1.75 4.00 3.00 5.00 12.75

3.50 0.00** 4.00 3.50* 5.00 12.00

4.00 2.00 4.00 3.00 5.00* 13.00

4.00 1.00 4.00 3.00 5.00 12.50

0.00 0.00 0.00 -0.45 -0.03 0.00 0.35 0.05 0.10 0.00 0.00** 0.15 0.30 0.00 0.00 0.02

0.00 (-)0.90* (-)0.27* 0.00 0.05 -0.13 0.00 0.30 0.00 0.00 0.20 0.20 0.00 -0.02 0.00 0.00

0.00** -0.67 -0.10 0.00 0.30 -0.10 0.00 0.20 0.00 0.03 0.20 0.02 0.10* -0.12 0.00 0.00

0.00 -0.53 -0.07 0.00 0.30 0.00 0.10 0.10 0.00 0.15 0.23 0.05 0.00 0.00 0.00 0.00

St.Dev. 2004

Abs. Change in St.Dev.

% of mean

Rel. Change in St.Dev

40.25 65.16 50.77 44.02 76.50 35.42 1013.40

1.22 3.43 1.22 0.96 2.45 5.62 189.80

18.09 79.91 20.22 13.25 23.10 28.52 23.10

0.05 1.92 -0.20 -0.42 -0.61 1.69 -4597.19

-22.16 14.75 -30.56 -30.76 -47.98 -12.32 -823.60

50.58 65.50 44.33 50.56 53.52 45.54 25.95 41.05 45.54 43.12 35.45 38.16 45.31 49.43 43.78 57.41 225.20

3.07 2.90 2.46 2.91 2.86 2.88 1.53 2.46 2.48 97.51 1.92 1.93 2.79 2.68 2.82 1.75 331.69

0.63 0.98 0.54 0.57 0.60 0.58 0.25 0.41 0.41 -9.76 0.34 0.33 0.54 0.60 0.53 0.49 2.57

0.43 -0.04 0.28 0.22 0.23 0.44 -0.03 0.09 -0.09 95.26 0.01 -0.15 0.36 0.18 0.45 -0.11 -2.14

-49.95 -64.52 -43.79 -49.99 -52.92 -44.97 -25.70 -40.64 -45.13 -52.88 -35.10 -37.83 -44.77 -48.83 -43.25 -56.93 -222.62

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Table 4. Median intangible values by Nation & Industry Median Nation Belgium Denmark Finland France Germany Ireland Italy Netherlands Norway Spain Sweden Switzerland United Kingdom

164 33.63

274 27.59

22.26* 0.14 4.97 73.48*** 37.90 37.77 21.70 16.01 0.97 13.60 86.79 44.58 28.64

98.72 432.14 8.02** 57.09 47.69 48.41 33.17 24.07 0.97 31.73 23.42 32.15 23.18

Industry Automobiles & Components 4.71*** Banks 56.29** Capital Goods 83.09** Commercial Services & Supplies 28.55 Consumer Durables & Apparel 36.38 Consumer Services 214.80 Diversified Financials 0.00 Energy 3.93*** Food & Staples Retailing 20.89 Food Beverage & Tobacco 138.88** Health Care Equipment & Services 106.94 Household & Personal Products 13.11 Insurance 193.26* Materials 27.40* Media 122.45*** Pharmaceuticals & Biotechnology 24.99 Real Estate Retailing 0.00 Retailing 75.31 Semiconductors & Semiconductor Equipment 1.77 Software & Services 101.66 Technology Hardware & Equipment 52.26 Telecommuinication Services 37.89 Transportation 4.28 Utilities 8.47** Authors calculations based on data provided by CSFB Holt, Innovest and Deminor Rating. Note: Significance at 10%(*), 5%(**) and 1%(***).

17.03 17.43 32.63 14.52 10.18 92.92* 0.00 27.40 59.68 43.47 35.83 0.38 35.16 32.23* 32.71 175.12 10.53 45.37 8.58 27.50 30.23 24.42 14.69 13.92

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Table 5. Change in intangible/tangible values by Nation & Industry Median Nation Belgium Denmark Finland France Germany Ireland Italy Netherlands Norway Spain Sweden Switzerland United Kingdom

164 17.57

274 5.30

0.00 0.06 130.76 34.05** 18.33 508.02 14.56 0.00 0.22 2.80 20.34 51.97 1.89

183.35 524.58 8.99 23.00 52.28 980.00 25.45** 0.00 0.22 33.78 54.63 26.75 7.63

Industry Automobiles & Components 1.47** Banks 26.81 Capital Goods 90.24 Commercial Services & Supplies 41.51 Consumer Durables & Apparel 39.52 Consumer Services -438.97 Diversified Financials 0.00** Energy (-)2.20* Food & Staples Retailing 11.44** Food Beverage & Tobacco 684.13*** Health Care Equipment & Services 223.52 Household & Personal Products 34.61 Insurance 160.20* Materials 23.75 Media 63.55 Pharmaceuticals & Biotechnology 15.46 Real Estate Retailing Retailing 1807.30 Semiconductors & Semiconductor Equipment 11.85 Software & Services 140.47 Technology Hardware & Equipment 62.30* Telecommuinication Services 17.36 Transportation 8.38 Utilities 9.70* Authors calculations based on data provided by CSFB Holt, Innovest and Deminor Rating. Note: Significance at 10%(*), 5%(**) and 1%(***).

15.74 5.44 17.94 15.49 9.38 22.37 50.22 107.90 71.68* 42.90 -0.32 12.75 20.43 11.06 10.16 -70.02 -0.95 0.00 6.75 1.10* 12.30 153.92** 3.91 8.93*

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