Securities litigation has become a major source of risk to businesses. From 2007 to 2016 the number of securities class actions (SCAs) filed each year increased by roughly 70 percent in the U.S. and by 115 percent worldwide (PricewaterhouseCoopers, 2017).
Many studies (e.g., Gande and Lewis, 2009; Hadlock and Sonti, 2012) show that stock prices drop when a firm or its peers are sued. However, a less researched question is how firms respond to a perceived increase in litigation risk (or ex-ante litigation risk). We are particularly interested in the effect of that risk on firms’ liquidity, on which theory offers two opposing views and prior studies provided different results (Crane, 2011; Arena and Julio, 2015).
On the one hand, firms exposed to shareholder litigation risk have a strategic motive to reduce liquidity to lower the expected payoffs to potential litigants, either by lowering a firm’s likelihood of becoming a litigation target because lawsuits often target firms with deep pockets (Gillan and Panasian, 2015), or by allowing the firm to limit the payoffs to litigants after lawsuits are filed. Crane (2011) reports evidence consistent with this view.
On the other hand, exposure to litigation risk gives rise to a precautionary savings motive, an effect that dates back to Keynes (1936) and Miller and Orr (1966). Under this view, an increase in litigation risk increases a firm’s demand for cash because it provides liquidity when the firm may not have sufficient funds to meet its obligations or invest because litigation not only consumes cash, but often increases the costs of external financing and hedging (e.g., insurance). Consequently, firms exposed to higher litigation risk are likely to increase their cash holdings. Arena and Julio (2015) find evidence supporting the precautionary savings motive, which is different from the finding of Crane (2011) and based on a different litigation measure and sample.
Testing these opposing arguments, however, is empirically challenging because ex-ante litigation risk is not directly observable, and actual litigation can be due to alleged firm behavior. To address these challenges, we exploit the passage of a law in 2003 that introduced SCAs in Korea in phases. Korea’s approach is unique in that the law was first applied in January 2005 to large firms with total assets of at least KRW 2 trillion (roughly $1.67 billion) at the end of 2004 and then expanded to all Korean firms in January 2007. This change in Korea’s litigation system provides a quasi-natural experiment for our tests. The introduction of SCAs in phases across varying asset thresholds allows us to conduct a difference-in-differences (DID) and a regression discontinuity (RD) analysis to help identify the effect of litigation risk on corporate liquidity.
Our sample comprises shares of non-financial Korean companies that were in the Korea Composite Stock Price Index (KOSPI) at the time the law was enacted. The main analysis was conducted from 2000-2005 (with the period 2000-2002 being the pre-event period and the period 2003-2005 being the post-event period). In the DID analysis, the first difference is before and after the law’s passage in 2003, and the second difference is between treatment firms (with at least KRW 2 trillion in assets) and all other firms (the control group). Regression DID shows that that the increase in litigation risk led treatment firms to increase their cash holdings significantly around the law’s passage relative to control firms. A dynamic DID analysis shows that the divergence in the trend of cash holdings between treatment and control firms occurred after, but not before, the law’s passage. The results indicate that firms respond to an increase in litigation risk by increasing their internal liquidity, consistent with the precautionary savings motive. We confirm the above baseline finding in several robustness checks, including a regression discontinuity (RD) analysis and a propensity score matched sample.
We also find that firms’ liquidity response to the perceived securities litigation risk is concentrated in companies that were not covered by directors’ and officers’ (D&O) liability insurance and in companies with more financial constraints before the legal change.
We then extend our analysis from firms’ internal liquidity to stock market liquidity because SCAs may reduce adverse selection in trading, which should in turn result in higher stock liquidity (e.g., Copeland and Galai, 1983; Glosten and Milgrom, 1985; Easley and O’Hara, 1987). Specifically, the increase in litigation risk facilitated by SCA introduction helps discipline company insiders (managers and controlling shareholders) and deter frauds (the ex-ante governance effect). As a result, informed trading likely decreases, and firms’ transparency likely improves, which lowers the risk to minority investors (who are often uninformed) in investing in the company’s stock. In addition, if wrongdoing occurs, SCAs provide a more efficient legal recourse to protect investors from losses (the ex-post compensation effect). Therefore, uninformed minority investors are expected to have greater confidence in a firm, and are more likely to invest in its stock, after the introduction of SCAs, which results in a higher stock liquidity for the firm.
Our results suggest that stock liquidity significantly increases after SCA introduction in treatment firms compared with control firms, and the result is concentrated in firms that did not carry D&O insurance before SCA introduction. The results are consistent with the view that D&O insurance protection weakens the disciplinary effects of SCAs.
Arena, M., Julio, B., 2015. The effects of securities class action litigation on corporate liquidity and investment policy. Journal of Financial and Quantitative Analysis 50, 251–275.
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Crane, A.D., 2011. The litigation environment of a firm and its impact on financial policy. Working Paper, Rice University.
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Gande, A., Lewis, C.M., 2009. Shareholder-initiated class action lawsuits: Shareholder wealth effects and industry spillovers. Journal of Financial and Quantitative Analysis 44, 823–850.
Gillan, S.L., Panasian, C.A., 2015. On lawsuits, corporate governance, and directors’ and officers’ liability insurance. Journal of Risk and Insurance 82, 793–822.
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PricewaterhouseCoopers (PWC), 2017. A rising tide or a rogue wave? 2016 Securities litigation study.
This post comes to us from professors Tommaso Oliviero at the University of Naples Federico II, Min Park at the University of Bristol, and Hong Zou at the HKU Business School of University of Hong Kong. It is based on their recent article, “Liquidity Effects of Litigation Risk: Evidence from a Legal Shock,” available here.