Shareholder lawsuits have long prompted intense debate. Despite increased corporate democracy and shareholder rights, some commentators argue that shareholder litigation is still a shareholder’s best option to bring about changes. Shareholder litigation can impose personal liability on corporate managers and directors for breach of the duties of care (negligence) and loyalty (conflict of interest). However, there is a collective action problem associated with shareholder lawsuits, and some argue that the principal beneficiaries of shareholder lawsuits are attorneys.
In a recent study, we move the debate on shareholder lawsuits forward by studying the impact of shareholder litigation threats on CEOs’ employment. Most variation in CEO wealth stems from changes in the value of stock and option holdings, so the incentives arising from the CEO’s compensation are partly delegated to the equity markets. In contrast, because directors themselves must make decisions about firing a CEO (“CEO turnover”), those decisions are a direct reflection of board policies.
Deterrence effects arising from both shareholder litigation and CEO turnover policies may discipline CEO decision-making. When the disciplinary effect from shareholder litigation shifts, CEO turnover policies may change as well, with the nature of the changes depending on how the threat of litigation and other corporate governance mechanisms interact. To understand the relation between the two, we examine what happens to CEO turnover decisions when there is a disturbance to shareholder litigation rights.
The empirical setting of our study is the staggered adoption of universal demand (“UD”) laws. The UD laws were adopted by states between 1989 and 2005 and impose procedural hurdles that restrict shareholder lawsuits alleging a breach of fiduciary duty by directors or officers. Prior research shows that the procedural requirements imposed by the UD laws reduce the incidence of derivative suits. Thus, we use the adoption of UD laws as a quasi-natural experiment to identify the causal effect of changes in the threat of shareholder litigation.
While litigation rights are likely to influence the design and effectiveness of other shareholder governance mechanisms, the nature of this relation is not clear. On one hand, the threat of shareholder litigation may substitute for other forms of governance. Shareholders who view strong shareholder litigation rights as a safety net might take a passive approach to monitoring managers directly. If a reduced threat of shareholder litigation weakens shareholders’ ability to bring corrections ex post, shareholders, especially outside blockholders, might be prompted to take action. Therefore, following the reduction in shareholder litigation rights, we would expect strengthened board monitoring and shareholder activism, which we measure as increased sensitivity of CEO turnover to poor firm performance.
On the other hand, if the threat of potential shareholder litigation increases the accountability of managers and directors, stronger shareholder litigation rights could enhance monitoring by the board of directors and increase the effectiveness of other forms of shareholder activism, i.e., complementing other governance mechanisms. In this case, an environment of weakened shareholder litigation rights provides less discipline for directors and managers, potentially reducing the likelihood that poor performance leads to CEO turnover.
Using a sample of S&P 1500 firms over the 1992-2005 period, we document that the sensitivity of CEO turnover to poor firm performance increases significantly following the adoption of UD laws, supporting the idea that greater CEO turnover-performance sensitivity may substitute for the disciplinary role of shareholder litigation. This result suggests that other governance mechanisms may be effective in holding CEOs accountable when there is a reduction in the threat of shareholder litigation. We also find evidence that CEO turnover-performance sensitivity increases in years two and beyond following the adoption of UD requirements, consistent with gradual governance changes.
Next, we examine the role of large blockholders. With the reduction in shareholder litigation rights, large blockholders likely have greater incentives to engage with management and the board of directors to effect changes. Consistent with this expectation, we find that the increase in CEO turnover-performance sensitivity after the adoption of UD laws is concentrated among companies with existing blockholders. Further analyses show that our primary results are strongest when blockholder ownership is greater than 10 percent.
We also examine the impact of the ex-ante litigation risk faced by the firm. Firms with higher ex-ante litigation risk are more likely to face real threats of shareholder derivative suits before the adoption of a UD law and therefore experience a larger reduction in litigation risk after the UD law’s adoption. We find that CEO turnover-performance sensitivity increases more post UD for firms with higher operating uncertainty, our proxy for litigation risk.
Finally, we examine changes in shareholder votes for management-sponsored items in the proxy materials of annual shareholder meetings following the adoption of UD laws. Prior research shows that passive investors are more likely to vote with management. If shareholders are more actively involved in direct monitoring after the state’s adoption of UD requirements, then votes supporting management proposals at the annual meeting should decrease. Indeed, we find that the average percentage of votes supporting management proposals decreases after UD laws are adopted.
Shareholder litigation rights and corporate governance are distinct mechanisms for ensuring the alignment of firm decision-making with shareholders’ interests. Our evidence shows that shareholder derivative suits and active monitoring in the form of CEO turnover policies are substitute governance mechanisms. Thus, our findings suggest that board policies on CEO turnover might serve to counter a potential increase in management entrenchment when shareholder litigation rights are weakened. Our study contributes to the debate on the role of shareholder litigation in corporate governance.
This post comes to us from professors Rachel M. Hayes and Xiaoxia Peng at the University of Utah’s David Eccles School of Business and Xue Wang at The Ohio State University’s Fisher College of Business. It is based on their recent article, “Shareholder Lawsuits and CEO Turnover Decisions,” available here.