Why scandals aren’t bad for business in the long term

Too big to fail? Paul Wilkinson/Flickr, CC BY

HSBC has been receiving a lot of bad press recently, but it doesn’t seem to be hurting its stock performance. Should we be surprised by this? My research into corporate scandals shows that they tend to hurt companies in the short term, but have no long term impact.

The questions raised over HSBC’s Geneva subsidiary will likely affect the company in the short term. There are always investors who value ethics and they will penalise the bank for reports of money laundering and assisting wealthy customers avoid tax. Then there’s the reputational damage of having its offices searched, as a result of these charges, and the potential fines that could be incurred if found guilty. It may well have to close some businesses, refuse some customers, sell some assets and restructure the firm. All of these cost money that will adversely affect the bank’s asset base.

But HSBC is a “too big to fail” bank. The ripple effects of closing it would be devastating. So in the long run, this scandal is unlikely to affect it. In fact, research I’ve done into the long term effect of corporate scandals on share prices shows that they can even lead to better performance in some circumstances.

Scandals in the past

A paper recently published in the Journal of Applied Economics looked specifically into the effect of improper conduct, gross misbehaviour or failings by CEOs on stock market performance. Colleagues in the US and I looked at 80 corporate scandals between 1993 and 2011 involving financial or non-financial misdemeanours – breach of contract, bribery, conflicts of interest, fraud, price fixing and other white-collar crimes, as well as personal scandals such as a CEO having an affair, lies on CVs and harassment cases.

While the HSBC scandal that’s taking place right now is not centred on its CEO but the company’s practices more broadly, there are some parallels in terms of the effect that scandals have on businesses – and why HSBC will probably be fine in the long term.

Our investigation into scandals involving CEOs showed that investors react unfavourably to the announcement of corporate scandals. We found that share prices plummeted between 6.5% and 9.5% in the month after the misconduct was made public, collectively costing shareholders an average of US$1.9 billion per scandal-hit firm.

Clearly, investors value ethics and they place a premium on it. Thus, when something unethical comes to light, the company loses that premium and its share price drops instantaneously to reflect that loss.

The point of respite for investors, however, is that the damage is confined to the short run. In the long run following a scandal, the stock price performance of the firms we studied went on to match the performance of other similar firms that were scandal free.

Nonetheless, it requires more than a scandal to bring down a corporation. Unethical people are replaceable and unethical practices can be reformed. Companies can carry on after these people are replaced and show that safeguards are in place to prevent similar things from happening again.

Corrective actions

Our study showed that the operating performance of many scandal-hit firms went on to be better than other similar but unaffected firms in the years following the scandal. The corrective actions taken by the scandal-hit firms seems to benefit investors in the long run.

Companies respond to scandals by putting safeguards in place. HSBC have had a head start in this. As soon as the reports of its private banking failings surfaced, the bank was quick to inform the public that it has “completely overhauled its entire private banking business” and made reforms to meet strict new standards.

These kinds of responses allay investor fears and avoid further drops in a company’s stock price, ensuring that they rebound to the levels of their rivals. This is what we found in our study. Three years on from scandals, the share-price performance of firms matched those that had not been affected by scandals.

In general, corporate scandals can act as a catalyst to implement changes that benefit investors. We found that, if anything, the 80 companies in the study – including Apple, Hewlett Packard, IBM, JP Morgan and Yahoo – actually showed an improved operating performance in the years after a scandal.