Shareholder Rights and Capital Structure: Evidence from Derivative Lawsuits

Abstract

We examine how changes in shareholder rights influence firms’ capital structure. We exploit the staggered passage of Universal Demand (UD) laws in 23 US states over a twenty-year period as an exogenous decrease in shareholder rights. UD laws introduced a significant hurdle for shareholders to file a derivative lawsuit on behalf of the firm. Since litigation by shareholders is a major avenue for enforcing shareholder rights, the passage of UD laws reduces investor protection. Using a difference-in-differences design, we find a higher financial leverage for firms incorporated in states which passed a UD law compared to firms incorporated in states that have no UD law. We also find a lower likelihood of equity financing and a higher likelihood of debt financing following the passage of UD laws. For debt financing, we find that firms tend to use loans, instead of bonds, following the passage of a UD law. Examining the underlying mechanism, we find that the shift from equity to debt financing is attributable to a lower stock market liquidity, caused by more severe agency conflicts between shareholders and managers, which arise due to restrictions in shareholder rights.