Corporate Culture and Compliance: A Study of the Pharmaceutical Industry

Abstract

We consider how corporate culture affects regulatory compliance activities across functions within a firm and investigate the economic consequences of a weak compliance culture. We examine a group of publicly traded pharmaceutical companies over the period of 2003 to 2013 that are required to comply with the Security and Exchange Commission (SEC) financial reporting regulations and are subject to the requirements of the Food and Drug Administration (FDA) Good Manufacturing Practices (GMP). We rely on the internal control environment to identify the first channel through which a weak compliance culture affects both operational and financial non-compliance and document that firms with a “weak” compliance culture, as reflected by internal control deficiencies, are more likely to have both FDA inspection failures (operational non-compliance) and accounting restatements (financial non-compliance). We also document a contemporaneous association between operational non-compliance and financial non-compliance, even after controlling for the internal control environment. We consider firm-level characteristics that will influence the development of the firm’s compliance culture, and find that the association between our non-compliance measures is stronger for firms with weaker shareholder rights. We also demonstrate economically meaningful implications of cross-functional non-compliance. We find when a firm has operational non-compliance that (1) the stock market reacts more negatively to accounting restatements and (2) the likelihood of CEO turnover following a restatement is higher. Taken together, we infer from our findings that the culture of integrity surrounding organizational non-compliance influences compliance behavior across the entire firm, and that compliance deficiencies generate considerable market and governance consequences for a firm and its managers.

Keywords: Financial Reporting, Operations, FDA, Compliance, Corporate Culture

JEL Classification: M41, L65