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«Abstract I show shareholder litigation rights are an important tool for mitigating agency conflicts. To empirically identify the effects of ...»

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Governance by Litigation∗

Ian Appel†

January 2015


I show shareholder litigation rights are an important tool for mitigating agency

conflicts. To empirically identify the effects of litigation, I use the staggered adoption

of universal demand (UD) laws in 23 states between 1989 and 2005. These laws

impose a significant obstacle to lawsuits against directors and officers for breach of

fiduciary duty. UD laws are associated with increased use of governance provisions

(e.g., classified boards) that entrench managers or otherwise limit shareholder voice.

I also document fewer institutional blockholders, changes to financial policies and CEO compensation, and impaired performance for firms subject to UD. Overall, my findings cast doubt on the traditional notion that shareholder lawsuits primarily benefit attorneys rather than corporations or their shareholders.

JEL Classification: G34, G38, K22, K41 ∗ I thank the members of my dissertation committee: Todd Gormley, Donald Keim, and Michael Roberts. I also thank Christine Dobridge, Erik Gilje, Itay Goldstein, Jessica Jeffers, Doron Levit, Hao Liang, Michael Lee, Jonathan Karpoff, Michelle Lowry, Jillian Popadak, Sang Byung Seo, Eric Talley as well as seminar participants at Wharton, Financial Research Association, Conference on Empirical Legal Studies at Berkeley, Olin Corporate Finance Conference, Academic Conference on Corporate Governance at Drexel, and LBS Trans-Atlantic Doctoral Conference. I thank Moshe Cohen and Todd Gormley for sharing data used in this paper. Grace Chung and Jeyhun Park provided research assistance. I gratefully acknowledge financial support from the Jacobs Levy Equity Management Center for Quantitative Financial Research. The title of this paper is borrowed from Chapter 10 of Corporate Governance: Promises Kept, Promises Broken by Jonathan Macey. All errors are, of course, my own.

† The Wharton School, University of Pennsylvania. ianappel@wharton.upenn.edu A rich literature in financial economics studies inefficiencies arising from the separation of ownership and control. Factors that help to resolve agency problems include managerial labor markets (Fama (1980)), legal protections (La Porta, López de Silanes, Shleifer, and Vishny (1998)), and the market for corporate control (Grossman and Hart (1980)). However, shareholders generally exert little influence over these aspects of corporate governance. Rather, they are primarily confined to three fundamental rights associated with equity ownership: voice, exit, and litigation. While the voice and exit have recently received considerable attention in the literature (Edmans (2014)), the roleof shareholder lawsuits in corporate governance remains unclear. In this paper, I examine whether litigation rights serve as a mechanism to mitigate agency conflicts.

I focus on a particular type of shareholder lawsuit, known as a derivative action, that alleges a breach of fiduciary duty by directors or officers.1 Corporate law in the U.S.

requires fiduciaries to exhibit prudent judgment (the duty of care) and refrain from selfserving conduct (the duty of loyalty). Derivative lawsuits serve as an ex post enforcement mechanism for these duties. Between 2000 and 2009, over 13% of firms in my sample faced at least one derivative lawsuit. Yet, there are several reasons why the effects of these lawsuits on firms may be minimal, if not negative. First, shareholders may be able to adequately exert governance through alternative mechanisms (e.g., voice and exit), making litigation rights redundant. In addition, the “business judgment rule” largely shields managers from liability for corporate decisions. Even when not protected by this legal doctrine, directors and officers face a very small chance of personal liability due to the pervasive use of exculpatory charter provisions, indemnification contracts, and directors and officers (D&O) insurance (Black, Cheffins, and Klausner (2006)). Finally, financial recoveries from derivative lawsuits tend to be low while legal fees are often high.

In fact, some critics maintain that the primary beneficiaries of litigation are lawyers rather than corporations or shareholders (Romano (1991)).

Others argue derivative lawsuits confer benefits that potentially outweigh their costs.

First, most settlements include reform of corporate governance practices. In fact, such reforms are often the primary goal of litigation (Erickson (2010)). For example, a 2008 settlement from a derivative lawsuit against the directors of Schering-Plough implemented These lawsuits are called “derivative” because shareholders sue directors or officers on behalf of the corporation. Further institutional background is provided in the next section.

annual director elections and removed supermajority voting requirements, while a 2005 settlement involving OM Group featured the termination of the CEO and appointment of two shareholder-nominated directors. In addition to settlements, derivative lawsuits may confer the benefit of future deterrence by imposing non-pecuniary costs (e.g., reputational penalties) on directors and officers.2 Such costs may, in turn, discourage certain behaviors by managers.

Quantitatively assessing the effects of derivative litigation poses a significant challenge.

One possible empirical strategy is to match firms facing litigation to a control group. This approach suffers from two main drawbacks. First, lawsuits are an equilibrium outcome and not randomly assigned. While a matching strategy minimizes ex ante observable differences between groups, breaches of fiduciary duties are also inextricably linked to managerial preferences that are unobservable to the econometrician (e.g., value of private benefits, sensitivity to reputational risk, etc.). Second, and perhaps more importantly, the matching strategy limits analysis to the realization of a lawsuit and cannot account for variation attributable to the deterrence function of litigation.

In this paper, I empirically identify the effects of shareholder lawsuits using variation generated by universal demand (UD) laws at the state of incorporation level. These laws present a significant obstacle to derivative lawsuits. Specifically, UD laws require shareholders to seek board approval prior to initiating derivative litigation. The board rarely grants this approval, however, because lawsuits typically name the directors themselves as defendants. I use UD laws as the “treatment” in a difference-in-differences framework. I include firm, industry-year, and state-of-location-year fixed effects in the main specification to control for time-invariant heterogeneity across firms and time-varying differences across industries (e.g., demand shocks) and headquarters locations (e.g., local economic conditions). This identification strategy addresses the two main shortcomings of the matching strategy. First, because UD laws are adopted at the state of incorporation level, they are largely unrelated to the characteristics of individual firms. Second, UD laws decrease the threat of future litigation and therefore account for deterrence effects.

I first show UD laws affect the incidence of derivative litigation. To do so, I assemble a database of over 900 derivative lawsuits involving public corporations using SEC filings Brochet and Srinivasan (2014), Ferris et al. (2007), Fich and Shivdasani (2007), Karpoff, Lee, and Martin (2008) provide empirical evidence of indirect costs associated with litigation. Helland (2006) finds contrasting results.

and other sources. I find UD laws are associated with a decrease in derivative litigation of approximately 0.7 percentage points, a drop of over one third relative to the sample mean. The magnitude of this effect is consistent with anecdotal evidence on the effect of UD laws discussed in the next section. I argue this estimate is, if anything, a lower bound on the change to the threat of future litigation.

Next, I turn attention to the effect of UD laws on the governance structures of firms.

I use the entrenchment index proposed by Bebchuk, Cohen, and Ferrell (2009) as the primary governance outcome. I find UD laws are associated with about a 10% increase in the entrenchment index, indicating increased use of antitakeover provisions relative to the control group. The change in governance structures is largely driven by increased use of poison pills, supermajority voting requirements, and classified boards. I obtain qualitatively similar results for the GIM index (Gompers, Ishii, and Metrick (2003)), which considers a wider array of governance provisions. UD laws are also associated with a drop in the presence of large institutional blockholders. Additional evidence points to this being a consequence of the increased use of antitakeover provisions.

I also consider the effect of litigation on different corporate policies that are potentially sensitive to agency conflicts. First, UD laws are associated with a shift in the composition of CEO pay that reduces sensitivity to firm performance. Specifically, the ratio of cash compensation to total compensation increases by approximately 6%. However, this is offset by a decline in equity-linked compensation, leaving total pay unchanged. Second, I find evidence of a decline in share repurchases following UD, but no change in cash dividends.

While this result may support the idea that managers retain cash to engage in “empire building,” there is no change to measures of firm size or investment. Rather, I find lower debt issuance and book leverage, consistent with managers either attempting to reduce firm risk or otherwise lessen the disciplining effects of debt.

Finally, I show UD laws are associated with weaker accounting performance. Specifically, ROA declines by approximately 0.8 percentage points for firms subject to UD.

Consistent with the idea that shareholder voice and exit may substitute for litigation rights, I find the drop in profitability is driven by firms with low institutional ownership.

The effect is also stronger for small firms, which may have weaker external governance mechanisms (e.g., monitoring by regulators) and firms with high cash flows, which may be more prone to agency conflicts (Jensen (1986)).

The interpretation of the results rests on the assumption that the adoption of UD laws is independent of unobserved variables that influence corporate policies and outcomes.

Political economy factors are of particular concern in this regard. For instance, it may be the case that firms incorporated in a particular state lobbied for the statutes in response to heightened risk of litigation. To address this concern, I restrict the sample of treated firms to Pennsylvania, where UD was implemented by the state supreme court in Cuker v. Mikalauskas (1997). The effects of lobbying are likely muted for this sample of firms since UD was not enacted by legislators as a matter of public policy, but by the courts for the sake of consistency with judicial precedent. This test yields results similar to the main analysis.

This paper builds on the literature that studies the effects of shareholder litigation.

The bulk of this literature focuses on class action lawsuits (e.g., DuCharme, Malatesta, and Sefcik (2004); Hanley and Hoberg (2012); Hopkins (2014); Arena and Julio (2014);

Lowry and Shu (2002)). Derivative litigation is the specific focus of Ferris et al. (2007).

A related line of literature considers the effects of fiduciary duties and director liability on firm policies and stock returns (e.g., Becker and Strömberg (2012); Donelson and Yust (2014); Grinstein and Rossi (2014)). I contribute to this literature by offering a novel identification strategy to study litigation that accounts for its deterrence effects.

My results suggest such effects influence multiple dimensions of corporate behavior and ultimately impair performance.

I also offer new insights into the broader literature on corporate governance. A voluminous literature studies the relation between governance indices and different corporate policies and outcomes (e.g., Bebchuk, Cohen, and Ferrell (2009); Chava, Livdan, and Purnanandam (2009); Cremers and Nair (2005); Gompers, Ishii, and Metrick (2003)). Other papers study factors that lead to firms implementing anti-takeover provisions in the first place (e.g., Schoar and Washington (2011); Field and Karpoff (2002)). I complement these papers by showing that the threat of litigation can also shape the governance structures of firms by restraining the adoption of provisions that entrench managers or otherwise limit shareholder voice.

Finally, this paper is related to previous work on the effects of antitakeover laws.

In their seminal paper, Bertrand and Mullainathan (2003) argue business combination (BC) laws reveal managerial preferences to “enjoy the quiet life.” Other papers have analyzed the effect of BC laws on innovation (Atanassov (2013)), use of debt (Francis et al.

(2010); Garvey and Hanka (1999)), executive compensation (Bertrand and Mullainathan (1999)), diversifying acquisitions (Gormley and Matsa (2014b)), payout policy (Francis et al. (2011)), and differential effects based on industry competition (Giroud and Mueller (2010)). This paper provides a new environment to study the nature of agency conflicts that arise from shocks to corporate governance. One advantage of UD laws is that their relatively recent enactment allows researchers to test the implications of different agency theories using datasets that do not overlap with the period most BC laws were adopted.

1 Institutional BackgroundA. Derivative Lawsuits

From a legal perspective, a corporation is a creature of statute that exists independently of its shareholders. Thus, if directors or officers engage in behavior that harms the corporation, the corporate entity itself can initiate litigation. A derivative lawsuit entails shareholders suing directors and officers on behalf of the corporation to address a breach of fiduciary duty. By way of example, suppose a manager wastes corporate assets by overpaying for an acquisition after failing to perform adequate due diligence. The primary recipient of harm from this action is the corporation because it (not the shareholders) was the owner of the wasted assets. Shareholders may be injured as well (e.g., by a lower stock price), but this injury is indirect in nature since it results from damage to the corporation.

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