Litigating Dividends or Not? The Case of Derivative Lawsuits

Abstract

Recent anecdotal evidence suggests that high litigation risk may induce firms to cut dividends. By comparison, litigation can be an effective governance tool for shareholders to force firms to distribute cash. Therefore, it is unclear how litigation risk affects dividend payouts on average. To address this issue, we exploit the staggered adoption of universal demand (UD) laws across various U.S. states as quasi-exogenous shocks. We find that firms increase dividend payouts significantly after UD laws raise the hurdle of filing derivative lawsuits. In particular, the adoption of UD laws discourages the emission of cash dividends while encourages the initiation of share repurchases. The main effect is more pronounced for firms faced with higher litigation risk, that are more financially distressed, and operating in more competitive product markets. Our overall findings suggest that excessive threats of derivative lawsuits may dampen financial flexibility and deter the distribution of cash to shareholders.