Litigation Risk and Executive Compensation

Abstract

Standard principal-agent theory predicts that the pay-performance sensitivity (PPS) decreases in the risk of the firm. An alternative literature argues that entrenched executives as in weak governance firms use compensation contract to extract the rent, which renders risk irrelevant. This paper uses event study approach to test both principal-agent model and CEO power theory by examining how litigation events affect executive compensation. We examine how the litigation event affects both executive compensation incentive (PPS) and the compensation composition (equity pay versus cash pay). Consistent with principal-agent model prediction, we find that, after the initiation of litigation, PPS drops, performance-invariant component of the compensation (cash) increases and performance sensitivity component compensation (equity) decreases. Complementing analysis using litigation settlement as risk decreasing event provides further evidence that PPS increases after settlement and compensation shifts from cash back to equity. To test CEO power theory, we partition the event firms into firms with good and bad corporate governance. We find that the PPS in firms with bad corporate governance increases after lawsuit and decreases after the settlement, consistent with the story that litigation brings the bad compensation practice of poorly governed firms under the and forces firms to discipline their CEOs more during the litigation period. Overall, our empirical evidence shows that for the overall sample and particularly for the subsample of firms with good corporate governance, compensation pattern changes around corporate litigation are consistent with the predictions of standard principal agent theory. That being said, CEO power does seem to also play a role, as firms with bad corporate governance exhibit a pattern that is more consistent with a limelight effect around the litigation events.