The Litigation Environment of a Firm and its Impact on Financial Policy

Abstract

Theory suggests that management may be able to increase firm value through the strategic use of debt when facing contingent liabilities. This paper examines whether managers strategically use financial policy when facing the risk of one such liability – litigation claims. I find that greater litigation exposure leads firms to choose higher leverage. I show that this leverage increase is brought on by an active decision to repurchase shares. These repurchases appear to be financed with a combination of excess cash and short term debt as they coincide with a significant decrease in cash holdings and an increase in short term liabilities. These firms also increase their use of operating leases, which, due to their priority in bankruptcy, have similar characteristics to secured debt. Finally, the effects seem to be stronger for firms with a higher probability of bankruptcy. These results run counter to anecdotal suggestions that firms may adjust financial policy to build a war chest in anticipation of litigation and they suggest that firms use capital structure strategically to increase shareholder value.