Do anti‐bribery laws reduce the cost of equity? Evidence from the UK Bribery Act 2010

• Author: William Rees,Suhee Kim,Vathunyoo Sila
• Date: 01 March 2020
• DOI: http://doi.org/10.1111/jbfa.12434
• Published date: 01 March 2020

DOI: 10.1111/jbfa.12434

Do anti-bribery laws reduce the cost of equity?

Evidence from the UK Bribery Act 2010

Suhee Kim William Rees VathunyooSila

University of Edinburgh Business School,

Edinburgh, United Kingdom

Correspondence

SuheeKim, University of Edinburgh Business

School,29 Buccleuch Place, Edinburgh EH8 9JS,

UnitedKingdom.

Email:suhee.kim@ed.ac.uk

Abstract

We examine the impact of the UK Bribery Act 2010 on the implied

cost of equity. We find a significant reduction in the cost of equity

amongst UK firms with high bribery exposure after the passage of

the Bribery Act. We further show that the Bribery Act improves

internal control systems and increases stock liquidity of firms with

high bribery exposure. Our results suggest that more stringent anti-

bribery regulations are not always bad for the firm.

KEYWORDS

anti-bribery law, bribery, cost of equity, information asymmetry,

internal control, residual income valuation, stock liquidity

JEL CLASSIFICATION

G30, G38, K22

1INTRODUCTION

Corruption is prevalent worldwide and is commonly cited as a significant deterrent to economic growth (Bardhan,

1997; Sensson, 2005; Shleifer & Vishny, 1993). As a common form of corruption, corporate bribery is increasingly

becoming an important concern for policymakers as well as corporate stakeholders around the world (Cheung, Rau,

& Stouraitis, 2012; Karpoff,Lee, & Martin, 2017). The World Bank Institute estimates that $1 trillion a year is paid in

bribes (Rose-Ackerman,2004). In a survey of corporate managers in 125 countries, D’Souza and Kaufmann (2013) find

that more than 60% of participants believe that their competitors use bribes to secure a public contract. Similarly,the

Dow Jones State of Anti-Corruption Survey in 2014 finds that a third of companies claim to have lost business to unethical

competitors.

Becker (1968) models corporate misbehaviors as an economic decision that involvestrade-offs between benefits

and costs. Paying bribes in foreign countries may potentially benefit firms by helpingthem expedite through the inef-

ficient bureaucratic process (Huntington, 1968; Leff,1964). Indeed, Cheung et al. (2012) find that paying bribes brings

an average firm $11 per each dollar of bribe paid. Karpoff et al. (2017) estimate the costs and benefits of bribery and

find that, even after netting out expected financial and reputational costs, projects involvingbribes remain profitable

to firms. Zeume (2017) documents a decline in value of UK firms since the Bribery Act 2010 came into force due to

reduced growth opportunities and concludes that paying bribes is a necessary cost of doing business.

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and repro-

duction in any medium, providedthe original work is properly cited.

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2020 The Authors. Journal of Business Finance & Accounting published by John Wiley & Sons Ltd

438 wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2020;47:438–455.

KIM ET AL.439

Conversely, payingbribes can be costly to the firm. In addition to the risk of penalties and prosecutions (Murphy,

Shrieves, & Tibbs, 2009), corporate bribery may endanger the firm’s reputation and strain relations with stakehold-

ers (D’Souza & Kaufmann, 2013; Serafeim, 2014). Focus on paying bribesto win business c analso distract firms from

investing in value-enhancing long-term projects (Birhanu, Gambardella, & Valentini,2016). Furthermore, bribery may

make firms more opaque (see, e.g., Dass, Nanda, & Xiao, 2016). For instance, firms mayconceal transactions to divert

funds for paying bribes. These bribery-related activities can potentially lead to firms becoming risky to outside share-

holders. This motivates us to study the relation between bribery and risk to shareholders.

We use the firm’s cost of equity as a proxy for risk to shareholders, and estimate the cost of equity using the resid-

ual income valuation model (Easton & Sommers, 2007; O’Hanlon & Steele, 2000). This approach has several appeals.

First, we can estimate the cost of equity using only market and accounting variables, which are readily available for

our sample firms. Second, we avoid the issues associated with using analyst earnings forecast data, such as forecast

bias and timeliness (Guay, Kothari, & Shu, 2011; Lys & Sohn, 1990). Finally, although our analysis does not focus on

a firm’s growth rate, the residual income valuation model allows us to estimate the growth rate simultaneously with

the implied cost of equity.As the literature suggests that growth is an important motive for firms to engage in bribery

(Cheung et al., 2012; Karpoff et al., 2017; Zeume, 2017), we are able to takedirectly into account the effect of bribery

on firm growth when we estimate the effect of bribery on risk.

Identifying the effect of bribery on firm risk is challenging because bribes are usually undisclosed unless they are

detected, which is typically a rare event (Karpoff et al., 2017). To overcome this identification challenge, we use a

difference-in-difference design to exploit the significant improvement in bribery prevention generated by the UK

Bribery Act 2010 (hereafter “the Bribery Act”). The Bribery Act is the first UK legislation that explicitly addresses

bribery by corporations, and this legislation substantially increases the severity of penalties for corporationsthat pay

or take bribes, including cases where a corporation fails to preventbribery because its internal control system is inad-

equate (Zeume, 2017). Before introducing the Bribery Act, the UK lagged far behind other Organization for Economic

Co-operation and Development (OECD) countries in terms of bribery prevention; now, its legislation on bribery is

among the strictest.1Weargue that this significant change in the legal environment particularly affects firms that were

already operating in bribe-prone countries before the passage of the Bribery Act, and examine the law’s influence on

their cost of equity in a difference-in-difference setting.

Controlling for decline in the expected growth rate, we find that the Bribery Act is associated with a 4% reduction

in the implied cost of equity for firms with high bribery exposure.2Given that our model estimates the average cost

of equity for these firms to be 12.5%, this is an economically substantial reduction, amounting to almost one-third of

these firms’ cost of equity.Our results suggest that the Bribery Act significantly reduces the risk of firms that operate

in bribe-prone countries.

We perform several robustness checks to validate our main findings. We show that our results are not sensi-

tive to how we classify firms as having high exposure to bribery, nor to several alternative earnings measures. We

further show that our results hold when including loss observations in our sample and performing value-weighted

instead of equally-weighted regressions (Easton, 2007; Easton & Sommers, 2007). Because the UK contemporane-

ously changed its tax regime on foreign corporate income, we alleviate the concern that this mayhave driven our doc-

umented change in the cost of equity by directly controlling for each firm’s exposure to tax on foreign income; we still

find that the change in cost of equity is only prevalent among firms with high exposure to foreign bribery. Further,

we validate the parallel trend assumptions in our difference-in-difference design (Atanasov & Black, 2016; Roberts

& Whited, 2012) by repeating our analysis using several artificial eventyears, and also performing our analysis on an

entropy-balanced sample (Hainmueller, 2012; Hainmueller & Xu, 2013). Overall,these additional results support our

1SeeTransparency International, “The Bribery Act”: https://www.transparency.org.U.K./our-work/business-integrity/bribery-act/

2Weconstruct a measure of bribery exposure using TransparencyInternational’s Corruption Perceptions Index (CPI). TransparencyInternational assigns each

country a score between 0 and 100, with a higher score indicating less exposureto corruption. For each firm, we compute an average CPI score, weighted by

thefirm’s sales in different geographical segments. We classify “high bribery-risk” firms as those whose weighted CPI score is less than or equal to the sample’s

25thpercentile.