There is consensus among economists that legal protections for investor rights have a positive impact on corporate value. The intuition is that investors are willing to pay a higher price for a firm’s stock when there are laws in place that limit the ability of the firm’s “insiders” (e.g., the CEO) to divert company profits or start self-serving projects.
While the notion is generally accepted that greater protection of shareholders leads to higher equity value, we do not know yet how individual legal rules and institutions contribute to creating value for investors. In our paper, we study the impact of one salient investor protection mechanism on equity valuation, namely shareholders’ right to sue their corporation, managers, and directors. Shareholders’ right to sue is important to study because shareholder-initiated lawsuits are often in the public eye, and academics have debated for many years whether these lawsuits are ultimately beneficial for shareholders. On the one hand, shareholders’ right to sue is seen as a key governance mechanism that allows outside investors to retain influence over managers. On the other hand, critics contend that shareholders’ right to sue may reduce equity value, as the threat of shareholder lawsuits fails to discipline managers, who are insulated against out-of-pocket liability risk, while imposing at the same time large litigation costs (direct and indirect) on the corporation.
In our recent paper, we argue that the impact of shareholders’ right to sue on equity value can be gauged by measuring stock price changes around certain judicial turnover events, particularly those where the ideology (e.g., pro-business) of the exiting judge is different from the ideology (e.g., pro-shareholder) of the entering judge. As such ideology may shape a judge’s decision to dismiss a shareholder lawsuit when it is filed, a change in judge may alter shareholders’ ex-ante propensity to sue, and hence the threat to managers of being sued.
If the right to sue is beneficial to shareholders, we should observe that shareholder-friendly judicial turnover is associated with stock price increases. Instead, we find the opposite: Share values decline after a more pro-shareholder judge takes the bench.
This raises the question of how shareholder suits destroy equity value. One possibility is consistent with the view in the literature that shareholder lawsuits impose on a corporation large costs such as settlement amounts or attorney fees, while failing to discipline managers. While we find support for this view, a back-of-the-envelope calculation suggests that the surge in the expected costs of future litigation after shareholder-friendly judicial turnover accounts for about 15 percent of the ex-ante loss in equity value that we document.
A second possibility is that that the increased likelihood of shareholder suits damages the overall system of checks and balances (both law-based and market-based) that protects investors. We provide support for this “worsening deterrence” hypothesis by showing that managers’ ability to extract private benefits from the company increases when the courts become more shareholder-friendly. Specifically, we document an increase in opportunistic (“lucky”) CEO option grants, and a weakening of the link between CEO pay and performance
Why would corporate governance weaken as shareholders’ right to sue strengthens? We posit that a drop in the threat of a takeover, which ensures “competitive efficiency among corporate managers and thereby affords strong protection to the interest of vast numbers of small, non-controlling shareholders” (Manne (1965)), may be a by-product of higher shareholder litigation risk. A lawsuit brought by the target’s shareholders during the acquisition process (whether or not it is related to the acquisition) delays the completion of the deal and may increase the target shareholders’ bargaining power in negotiating the terms of the acquisition. This ultimately worsens the conditions of the deal for potential acquirers, who as a result may not initiate or complete the acquisition.
Our intuition is that managers’ perceived threat of a takeover may represent a more effective governance tool than the threat of shareholder litigation. The reason is that, while the managers of a corporation may be (and typically are) insulated against shareholder lawsuits via liability insurance, no such insurance exists that limits a manager’s exposure to the loss of private benefits from, say, having to leave the company after an acquisition. So, if shareholder lawsuits diminish the threat of a takeover, they may lead to equity value loss.
To establish that shareholder lawsuits lead to equity value loss because they impede the market for corporate control, we proceed in two steps. First, we document that a firm headquartered in a district whose court becomes more shareholder-friendly faces a lower likelihood of becoming an acquisition target. Moreover, initiated deals have a significantly lower probability of being completed when the courts’ friendliness toward target shareholders increases.
In the second step of our analysis, we compare two types of potential targets. Management in the first type has limited exposure to the threat of takeover, due to either corporate charter provisions (e.g., poison pills) or state laws (e.g., business combination laws) that deter potential acquirers. Management in the second type of firm is instead fully exposed to the governance role of the markets. We argue that, if the decline in equity value that we document is due to the deterioration of the disciplining role of the takeover threat, it should be particularly pronounced among firms of the second type, as these firms may experience the largest decline in the likelihood of being taken over. Our results are consistent with this view. Furthermore, for firms of the first type, our results indicate that increasing shareholders’ right to sue is actually value-enhancing.
In conclusion, our research project highlights that a strong right to sue hurts the value of equity in the average U.S. company. Perhaps more important, the reason is not a surge in litigation costs, but a reduction in the threat of being taken over. That reduction impairs the disciplining role of the markets, and ultimately leads to weaker corporate governance and lower share values.
 For brevity we refer to this right as “Shareholders’ right to sue”.
This post comes to us from professors Stefano Cassella at Tilburg University’s School of Economics and Management and Antonino Emanuele Rizzo at Nova School of Business and Economics. It is based on their recent paper, “Do Shareholders Gain from Their Right to Sue? Evidence from Federal Judge Turnover,” available here.