Derivative Lawsuits as a Corporate Governance Mechanism: Empirical Evidence on Board Changes Surrounding Filings

Abstract

Legal rights of investors have been recognized as an essential component of corporate governance. We assess the efficacy of these rights by an examination of the corporate governance effects of 215 shareholder derivative lawsuits filed in U.S. courts over the period, 1982-1994. We find significant negative stock price reactions at the filings of derivative lawsuits, with important cross-sectional variability in the cumulative abnormal returns (CARs). We observe that larger firms with higher R&D expenses, larger boards, and greater insider board representation tend to experience more negative CARs. We also find that the incidence of derivative suits is higher for firms with a greater likelihood of managerial agency problems. Most importantly, we find that derivative suits are associated with significant improvements in the boards of directors, which have been recognized as a critical aspect of corporate governance. We find that firms, whose managers lose derivative lawsuits, have smaller boards, a higher percentage of outside directors on their boards, and a greater departure rate among board directors in the periods following the filings of lawsuits. These findings suggest that shareholder derivative lawsuits have the intended benefits, affirming the useful role of U.S. courts in producing better corporate governance.