Several decades of research have found that capital structure and financing decisions are influenced not only by market frictions such as taxes and bankruptcy costs but also by conflicts between managers and shareholders. In a new paper, we test whether and to what extent limited rights for shareholders to file derivative lawsuits influence firms’ capital structure and financing decisions.
To examine changes in firms’ capital structure and financing decisions, we exploit the staggered passage of Universal Demand (UD) laws by 23 U.S. states. These laws limit shareholders’ ability to file a derivative lawsuit on behalf of a firm by forcing them to make a demand on the board of directors before filing the lawsuit. UD laws limit shareholder rights because the demand requirement enables the board of directors to prevent or block a potential lawsuit. By contrast, from a management perspective, UD laws are associated with a lower litigation risk in the event of potential wrongdoing. Supporting this notion, the number of derivative lawsuits dropped by a third following the passage of UD laws whereas the number of lawsuits remains virtually unchanged (Appel 2016).
Why do UD laws affect firms’ capital structure and financing decisions?
Shareholder rights contribute to the development of capital markets because better protected investors feel more confident about increasing funds available through external financing. As a consequence, fewer shareholder rights are associated with smaller capital markets (e.g., La Porta et al. 1997; La Porta et al. 1998). UD laws have a negative effect on fund availability because these laws limit shareholder rights.
Prior literature has emphasized primary strategies for enforcing shareholder rights and monitoring managers through increasing shareholders’ “voice” and ability to “exit” (Bharath et al. 2013; Maug 1998). “Voice” includes the filing of lawsuits and voting on management turnover. “Exit” refers to the sale of shares. UD laws have a direct effect on shareholder rights by limiting the voice option because shareholders have fewer opportunities to file lawsuits. By contrast, the rights of debt holders are based on contractual agreements and, thus, are not affected by UD laws directly.
We argue that limited shareholder rights following the passage of UD laws should lead to a lower supply of equity capital, given that shareholders are less likely to provide capital in the event of limited shareholder rights. This should lead to a higher likelihood of debt financing and, thus, a higher level of financial leverage.
First, we find a significant increase in firms’ financial leverage for firms incorporated in states that passed UD laws compared with firms incorporated in states without such laws. Second, we find that the observed change in firms’ financial leverage is attributable to a lower likelihood of equity financing and a higher likelihood of debt financing. Third, we find that firms’ affected by UD laws have a higher likelihood of obtaining loans and a lower likelihood of bond offerings.
We show that the observed results are attributable to lower stock-market liquidity and higher shareholder-manager agency conflicts. Our findings suggest that limits on the ability of shareholders to file derivative lawsuits on behalf of a firm are associated with a lower supply of equity capital due to limited shareholder rights and, thus, a higher risk of managerial wealth expropriation.
Our paper makes several contributions to the literature. First, it adds to research on the influence of shareholder rights on capital structure and financing decisions. While prior literature (e.g., La Porta et al. 1997; La Porta et al. 1998, Rajan and Zingales 1995) shows that limiting shareholders’ voting power reduces the supply of equity capital, we find that fewer opportunities to file a lawsuit affect the willingness of shareholders to provide funding and, thus, firms’ capital structure and financing decisions.
Second, while prior literature (e.g., Crane 2011) examines the consequences of actual lawsuits against companies as well as corporate directors and officers on firms’ financing decisions, we provide evidence on the influence of corporate officers’ and directors’ personal litigation risk. By focusing on derivative lawsuits, we are able to separate the impact of litigation risk on corporate officers and directors from that on a firm overall.
Finally, we contribute to the literature on the influence of shareholder litigation rights on managerial decision-making. While prior studies examine the influence of UD-law passage on disclosure (Bourveau et al. 2018) and the cost of external financing (e.g., Ni and Yin 2018), we show that the passage of a UD law affects actual financing decisions, leading to a higher likelihood of debt financing.
Appel, I. 2016. Governance by Litigation. Working Paper.
Bharath, S. T., S. Jayaraman, and V. Nagar. 2013. Exit as Governance: An Empirical Analysis. The Journal of Finance 68 (6): 2515–2547.
Bourveau, T., Y. U.N. Lou, and R. Wang. 2018. Shareholder Litigation and Corporate Disclosure: Evidence from Derivative Lawsuits. Journal of Accounting Research 56 (3): 797–842.
Crane, A. D. 2011. The Litigation Environment of a Firm and its Impact on Financial Policy. Working Paper.
La Porta, R., F. Lopez‐de‐Silanes, A. Shleifer, and R. W. Vishny. 1997. Legal Determinants of External Finance. The Journal of Finance 52 (3): 1131–1150.
La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. W. Vishny. 1998. Law and Finance. Journal of Political Economy 106 (6): 1113–1155.
Maug, E. 1998. Large Shareholders as Monitors: Is There a Trade-Off between Liquidity and Control? The Journal of Finance 53 (1): 65–98.
Ni, X., and S. Yin. 2018. Shareholder Litigation Rights and the Cost of Debt: Evidence from Derivative Lawsuits. Journal of Corporate Finance 48: 169–186.
Rajan, R. G., and L. Zingales. 1995. What Do We Know about Capital Structure? Some Evidence from International Data. The Journal of Finance 50 (5): 1421–1460.
This post comes to us from Dr. Benedikt Downar at Technical University of Munich (TUM) and Mario Keiling, a PhD student and research assistant at TUM. It is based on their recent paper, “Shareholder Rights and Capital Structure: Evidence from Derivative Lawsuits,” available here.