Firms faced with a class action lawsuit experience reputational and financial penalties. [1] However, research has focused solely on the consequences for the defendant and, to our knowledge, no studies have examined whether the repercussions of alleged malfeasance range beyond the company sued. Thus, it remains unexplored whether litigation risks extend beyond the sued firm and whether there are spillover risks associated with doing business with that firm.

Prior research has found that corporate culture, governance practices, and even bankruptcy risks extend beyond the traditional boundaries of firms that share directors or are linked with business partners through contracts. In keeping with this literature, we hypothesize that these spillover effects extend to litigation and are more likely to occur when an otherwise innocent firm has a substantial link with a sued company. We investigate one such link: a joint venture (JV).

A significant number of public firms enter into JVs, creating a jointly owned entity. This new entity allows both firms to partake in a mutually beneficial arrangement for economic profit while sharing in the necessary expenditures and control of the new entity. The public views the JV as representing both companies, and investors may perceive the companies as sharing successes and setbacks. Our data show that joint ventures are common, with a quarter of all public companies in our sample maintaining such an alliance.

Existing research offers evidence that most investors view JVs favorably. [2] [3] [4] JV announcements prompt positive returns of about 0.25 percent, and managers are typically awarded cash bonuses for initiating these deals. [5] Anecdotal evidence, however, suggests that there are repercussions to a firm in a JV when its partner is in trouble. For example, in 2008, a class action was brought against Morgan Stanley for violating the 1934 Securities Exchange Act, resulting in a significant share-value loss upon the lawsuit announcement.  When that lawsuit was filed, Duke Energy’s stock price declined significantly, although Duke was not involved in the lawsuit or named in the complaint. The company did, however, have a JV with Morgan Stanley. Overall, little is known about the potential ramifications to members in a JV from their association with their partner firms, particularly with respect to litigation risk.

To assess how litigation exposure may create actual and potential harmful spillover effects, we use a firm’s JV in conjunction with class action lawsuits. We use the JV to determine whether one partner’s class action lawsuit results in a spillover effect on the innocent partner’s valuation, litigation risk, financial policies, and investment decisions.

We first identify the wealth implications for the sued firms and their JV partners around the date of the lawsuit announcement. We find that partners that were not sued suffer a significant reduction in their market capitalization through their association with the sued partner. According to our estimates, firm value declines by about 0.44 percent (an average of $55 million) when their JV partner is sued. The reduction in value is greater when the two firms are equal owners in the JV, indicating that both firms have similar control and power over decision-making in the relationship.

We further explore whether the spillover effect extends beyond the immediate wealth effect for the non-sued partner firms. Using difference-in-difference (DiD) estimation, we compare the changes in future lawsuit probability for non-sued firms when they are partners of sued firms (treatment group) and partners of firms that are not sued (control group). The results indicate a significant increase in the likelihood of future litigation for non-sued firms when they have entered into a JV with a partner who has been sued. The economic effect suggests that the non-sued partners are 34 percent more likely to be sued in the future. Our tests show that non-sued partners respond to this additional legal threat by reining in their exposure to risk. Innocent JV partners experience a decrease in the volatility of their stock returns, cash flows, and underlying assets. They also tend to reduce dividends to shareholders and are more conservative with their financial reporting. With regard to investment decisions, non-sued partners are more likely to decrease their investment spending and are less likely to engage in acquisitions after their JV partner is sued.

Overall, our evidence indicates that fraud penalties extend beyond the sued firm. When a firm faces a class action lawsuit, investors also penalize its innocent partners in a joint venture. Our research shows that non-sued joint venture partners face non-trivial spillover effects with respect to their financial and investment policies. Specifically, the non-sued firms change these policies to try to mitigate the adverse effects of any potential lawsuits against them.

ENDNOTES

[1] Karpoff, J.M., Lee, S., Martin, G.S., 2008. The cost to firms of cooking the books. Journal of Financial and Quantitative Analysis 43, 581-611

[2] McConnell, J., Nantell, T.J., 1985. Corporate combinations and common stock returns: The case of joint ventures. Journal of Finance 40, 519-536

[3] Chan, S.H., Kensinger, J.W., Keown, A.J., Martin, J.D., 1997. Do strategic alliances create value? Journal of Financial Economics 46, 199-221.

[4] Johnson, S.A., Houston, M.B., 2000. A Reexamination of the motives and gains in joint ventures. Journal of Financial and Quantitative Analysis 35, 67-85.

[5] Fich, E.M., Starks, L.T. and Yore, A.S., 2014. CEO deal-making activities and compensation. Journal of Financial Economics, 114, 471-492.

This post comes to us from professors Eliezer M. Fich at Drexel University, Rachel Gordon at Towson University, and Adam S. Yore at the University of Missouri at Columbia. It is based on their recent article, “Class Action Spillover Effects on Joint Venture Partners,” available here.