Business Courts May Improve Firm Performance

A central goal of corporate law is to prevent managers from putting their own interests ahead of those of shareholders.  Such self-serving behavior can take many forms, ranging from illegal self-dealing transactions to self-entrenchment in the face of hostile takeover attempts.  Moreover, while the law may prohibit such conduct, the relevant norms are often notoriously vague and fact-intensive, which makes them difficult for courts to apply.

Against this background, high-quality courts should improve firm performance in at least two ways.  First, such courts should make it easier to police transactions designed to transfer wealth from firms to managers.  Second, by limiting managers’ ability to entrench themselves, high-quality courts can strengthen the market for corporate control and thereby increase managers’ incentives to maximize shareholder wealth.

But does access to high-quality courts for corporate litigation actually improve firm performance?  The existing empirical literature does not answer this question, perhaps because the role of courts is notoriously difficult to assess:  Even if one can show that a highly proficient judicial system goes hand in hand with high-performing firms, this does not establish a causal link.  After all, it may simply be the case that states with high-performing firms have higher tax revenues and therefore tend to spend more on their courts.  In that case, high-performing firms may lead to high-quality courts and not the other way around.  In addition, states with high-quality courts may also tend to have other high-quality institutions, which makes it difficult to isolate the role of courts.

In my recent paper, “Business Courts and Firm Performance,” I rely on a multiple-events difference-in-difference approach to avoid these problems and gain a better understanding of the relationship between courts and firm performance.

Starting in 1992, almost half of all states created so-called business courts.  These courts are designed to avoid some of the problems plaguing regular state courts.  In particular, they offer speedy proceedings and judges experienced in business matters.  Importantly, when a state creates a business court, that court does not benefit all local firms alike.  All firms that are headquartered in the relevant state gain a better forum for external litigation.  However, when it comes to litigating a corporation’s internal affairs, the impact of business courts depends on where firms are incorporated.  Firms that are both headquartered and incorporated in the state creating the business court also gain a better forum for litigating their internal corporate affairs.  By contrast, firms incorporated outside of their headquarters state often litigate their internal affairs in their state of incorporation and therefore stand to gain much less on this dimension from improvements in the courts of the headquarters state.  For example, public corporations that are headquartered in Florida but incorporated in Delaware will often litigate their internal affairs in Delaware’s excellent Chancery Court, regardless of whether or not Florida creates a business court.

This differential impact makes it possible to use a so-called multiple-events, difference-in-difference approach.  Put very simply, I am comparing the impact of the creation of business courts on two types of firms, both of which are headquartered in the state creating the court: (1) those firms that are incorporated locally as well and are therefore likely to use the new business court to litigate their internal affairs, and (2) those firms that are incorporated elsewhere and hence much less likely to use the business court for this purpose.

The results are broadly consistent with the claim that the creation of business courts benefits firm performance.  I find that the creation of business courts is associated with a 2.8 to 3.8 percentage point increase in firm performance as measured by return on assets.  Moreover, the creation of a business court is associated with a 0.3 to 0.5 percentage point higher likelihood of being the target in a completed takeover with positive abnormal returns for the target’s shareholders.  These results are both economically and statistically significant.

This post comes to us from Professor Jens Dammann of the University of Texas at Austin School of Law. It is based on his recent paper, “Business Courts and Firm Performance,” available here.