Growing Out of Trouble? Corporate Responses to Liability Risk

Abstract

This paper analyzes corporate responses to the risk of large, adverse shocks. In particular, we study how a typical firm responds to an exogenous increase in liability risk arising from its workers’ exposure to newly identified carcinogens. We find that firms, particularly those with weak balance sheets, tend to respond to such risks by undertaking aggressive growth through the acquisition of large, unrelated businesses with relatively high operating cash flows. By diversifying the firms’ operations, the growth likely reduces expected costs of financial distress for shareholders, but also may be motivated by managers’ personal exposure to their firms’ risk. Consistent with an agency conflict driving some of this growth, the acquisitions are associated with negative abnormal returns and the extent of growth is related to firms’ external governance, managerial stockholdings, and institutional ownership. The results suggest that the risk of large, adverse shocks can have a substantial impact on firms’ financing and investment decisions, and that corporate governance can be particularly important when firms encounter a negative shock.