CEO Networks and Shareholder Litigation

Academics, notably in sociology and economics, have long understood that social settings are primary drivers of information transmission and economic outcomes, from hiring decisions to product adoption to resource allocation. However, only recently has there been large-sample empirical evidence to support the intuition that social settings around individuals – networks comprised of connections among people – are important for firm and market outcomes. Our recent paper, “CEO Networks and Shareholder Litigation,” investigates whether executive networks are important in the context of securities class action (SCA) lawsuits.

Recent literature presents evidence that executive networks enable more efficient information flows, leading to positive outcomes, but also enable and protect suboptimal behaviors. For example, greater connectedness between executives and market participants lowers information asymmetries between contracting parties and markets, lowering a firm’s cost of debt and equity, improving stock liquidity, and improving reporting quality. On the other hand, it has also been shown that more powerfully networked executives are protected from internal and external discipline. CEOs with greater network reach and influence are less likely to be dismissed following a spate of poor firm performance or fraudulent activity, and firms led by such CEOs take on more risk, are more likely to receive bailouts, and are more likely to engage in aggressive earnings management. This dual nature of network power raises an interesting question: Would firms led by better connected CEOs be more or less likely to be targets of SCA lawsuits?

Communication between institutional shareholders and firm executives is a common and important governance mechanism. If networks enable more efficient information flows, then it is a reasonable conjecture that firms led by connected CEOs would be less likely to be targeted, since shareholders would be better able to directly or indirectly gather information about managers, evaluate the accuracy of firm disclosures, and better understand the viability of firm projects. Conversely, if better connected CEOs are more likely to obfuscate, engage in earnings manipulation, commit fraud, or be resilient to internal or external discipline, then firms led by better connected CEOs may be more likely to be subject to SCA suits. Empirical studies necessarily focus on outcomes, e.g. hostile takeover attempts, proxy fights, and lawsuits. These events reflect a failure to resolve issues via private communication. Executive connections may embolden managers to resist institutional shareholder demands, thus increasing the probability of litigation.

There is a vast literature documenting the importance of institutional investors in monitoring management on behalf of investors and their role in providing greater investor protection (e.g. Shliefer and Vishny, 1997). Long-term, sophisticated, investors have greater incentives to promote better firm governance and reap long-term benefits from doing so. They have been shown to be more active and successful in promoting governance reform (Coffee, 1991; Black and Coffee, 1994, Gillan and Starks, 2000). When management is particularly resistant to governance reform, SCA suits are known to be an effective means by which shareholders monitor defendant firm management and improve governance (Romano, 1991; Ferris et all, 2007, Cheng et al., 2010).

Our paper presents evidence that firms led by CEOs with greater network power and influence are more likely to be targets of SCA suits. It is possible that more powerful CEOs are simply more visible and therefore more likely to be targeted via frivolous lawsuits led by individual plaintiffs who attempt to win quick settlements. However, we find that suits brought against firms with better connected CEOs are led by institutional plaintiffs and are thus less likely to be frivolous. Interestingly, such suits are more likely to be dismissed or, subject to the lawsuit surviving a motion to dismiss, result in lower settlement amounts even though they are led by institutional plaintiffs.

On the surface, these results appear to be contrary to the findings of Cheng et al. (2010) that suits led by institutional plaintiffs are less likely to be dismissed and typically result in larger settlement amounts. If, however, the primary motive of the suit is to improve firm governance, then the suits do indeed appear to be successful; more connected CEOs are more likely to leave the firm, willingly or otherwise, and the percentage of the board comprised of independent directors increases in the years immediately following the suit. Further, shareholders appear to value the SCA filings. Cumulative abnormal stock returns around the announcement of a lawsuit are highest for firms led by CEOs with the greatest network power and influence, strongly suggesting that SCA filings serve as an alternative governance mechanism for disciplining entrenched executives. The differences in cumulative abnormal returns between firms led by CEOs in the top and bottom quartiles of network power are statistically significant and economically large, between 8.2 percent and 4.5 percent, depending upon the metric used to measure network influence.

To date, there has been little or no empirical evidence to support the notion that networks censure or discipline suboptimal behaviors (Burt, 1997). Our paper is the first to our knowledge to present large-sample empirical evidence that networks serve as an extra-firm disciplinary mechanism. Romano (1991) posits that lawsuits may be an effective governance mechanism if the suits damage the reputation of managers such that they have fewer opportunities in the future or a lower value in the labor market. Since our measures of network power are directly derived from employment data, we are able to document that, regardless of whether the CEO leaves the firm subject to an SCA filing, CEOs are invited to sit on fewer boards and suffer meaningful decreases in network power in the years following the suits. SCAs led by institutional plaintiffs are costly to connected CEOs not only with regard to future compensation, but also in terms of CEO power and influence.

This post comes to us from professors William R. McCumber and Lingna Sun at Louisiana Tech University. It is based on their recent paper, “CEO Networks and Shareholder Litigation,” available here.