Litigating payouts or not? Evidence from universal demand laws

Abstract

Anecdotal evidence suggests that high litigation risk may induce firms to reduce payouts. By contrast, litigation can be an effective governance tool for shareholders to claim payouts. To examine which view dominates, we exploit the staggered adoption of universal demand (UD) laws across various U.S. states, which raise the hurdle of filing derivative lawsuits and reduce the ex-ante litigation risk of affected firms as quasi-exogenous shocks to examine the effect of litigation risk on firms' payouts. We find that the adoption of UD laws leads to a significant increase in a firm's payouts, i.e., higher litigation risk discourages payouts. In particular, reduced litigation risk discourages the emission of cash dividends and 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 that operate 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.