Shareholder litigation is an important way for shareholders to affect corporate governance. Legal protection of shareholders can mitigate agency problems that arise from the separation of ownership and control. In particular, litigation enables shareholders to deter and find remedies for management self-dealing and moral hazard problems. However, shareholder litigation has its own limitations. It can impose substantial costs on firms, such as attorney fees and cash settlements. It can also undermine managers’ careers and discourage them from pursuing risky but potentially value-increasing projects, reduce investment efficiency, and lead to higher external financing costs and a loss of corporate reputation. The ultimate impacts of shareholder litigation on corporate policies and firm value will reflect the tension among these factors, and the net effects of shareholder litigation are best determined empirically. In a new study, we investigate the governance effects of shareholder litigation on corporate cash policy. We choose to focus on firm cash, because its amount and use are typically at the discretion of managers and so prone to agency problems.
Prior research finds that cash-rich firms are more likely to be the targets of shareholder lawsuits, possibly because attorneys can extract better settlement terms (Jones, 1980; Romano, 1991). This evidence indicates that an investigation of the effects of shareholder litigation on corporate cash policy is susceptible to endogeneity bias due to reverse causality; that is, corporate cash holdings may drive shareholder litigation rather than the other way round. To overcome this empirical challenge, we exploit the staggered adoption of universal demand (UD) laws, which hinder shareholders’ rights to initiate derivative lawsuits, by 23 states in the United States from 1989-2005. This serves as a quasi-natural experiment that can identify the relation between shareholder litigation and corporate cash holdings and its implication for shareholder value.
Derivative lawsuits, which are filed by shareholders on behalf of the corporation, typically allege that directors and officers breached their fiduciary duties. Unlike in a securities class-action lawsuit, whatever the directors and officers agree to pay in a derivative lawsuit goes to the corporation after covering the plaintiff’s attorney fees. Thus, the primary goal of a derivative lawsuit is presumably to introduce corporate governance reforms. UD laws require shareholders to obtain board approval prior to launching a derivative lawsuit. However, boards rarely grant such approval, because the defendants in the lawsuits usually include board members. Thus, the procedural obstacle imposed by UD laws can effectively hinder shareholders from challenging managerial misconducts.
Using a sample of 74,842 firm-year observations of 6,408 U.S. public firms between 1985 and 2010, we ﬁnd that weakened rights to file shareholder litigation following the passage of UD laws leads to smaller corporate cash reserves. Shareholders also assign a higher value to each dollar of corporate cash holdings following enactment of a UD law. Our evidence suggests that lower shareholder litigation risk motivates managers to pursue a more aggressive cash policy that enhances shareholder value. We further discern the channels through which the adoption of UD laws lead to a decrease in the level of cash holdings while increasing the value of cash to shareholders. Our analysis indicates that firms deploy cash for investment and engage in risk-increasing but potentially value-enhancing activities following the adoption of UD laws. Moreover, we find that the increase in corporate investment and its profitability following the adoption of UD laws is concentrated among firms with high growth opportunities and financially constrained firms. Collectively, our evidence highlights the dark side of shareholder litigation, which induces ﬁrms to pursue a conservative liquidity policy that hampers shareholder value.
Besides contributing to the finance literature, our research can have important implications for corporate managers, investors, and regulators. In recognition of potential adverse impacts of frivolous shareholder lawsuits on ﬁrm operations through increased litigation expenses and compliance costs and managerial distraction, policy makers have recently introduced a series of legal reforms, such as the Lawsuit Abuse Reduction Act of 2017 and the Fairness in Class Action Litigation Act of 2017, to impose mandatory sanctions for frivolous legal claims. In this context, our research provides empirical evidence that helps policy makers to make informed decisions on shareholder litigation rights.
This post comes to us from professors Hien T. Nguyen at the Vietnam National University – Ho Chi Minh City, Lingna Sun at the Louisiana Tech University, and Hieu V. Phan at the University of Massachusetts – Lowell. It is based on their recent paper, “Shareholder Litigation Rights and Corporate Cash Holdings: Evidence from Universal Demand Laws,” available here.