Universal Demand Laws Research Articles

Shareholder litigation rights and corporate payout policy: Evidence from universal demand laws

This study exploits the staggered adoption of universal demand (UD) laws, which place significant obstacles to derivative lawsuits and thus, undermine shareholders’ rights by 23 states in the United States (U.S.) from 1989 to 2005 as a quasi-natural experiment to examine the effects of shareholder litigation rights on corporate payout policy. Weakened litigation rights for shareholders materially increase firms’ payout ratios. The effect is more pronounced for firms exposed to higher shareholder litigation risk ex-ante, firms with higher institutional holdings, and ones financially unconstrained. Overall, the findings are consistent with lower shareholder litigation threats motivating firms to increase dividend payouts.

The Governance Role of Auditors: Evidence from Derivative Lawsuits

This paper examines whether external auditors play a unique governance role distinct from other mechanisms of corporate governance. We exploit the staggered adoptions of the Universal Demand (UD) laws by U.S states, which have been shown to result in the decline of various corporate governance mechanisms. We examine whether auditors step up their monitoring when outside shareholders place a greater demand on external monitoring, yet other governance mechanisms decline. We find that external auditors are more likely to issue going-concern opinions to financially distressed firms after their incorporation states have adopted the UD laws. Further, the increased propensity to issue going-concern opinions is driven by auditors’ reputation and litigation concerns. The effect is stronger when alternative governance mechanisms are weak, and it is not attenuated by auditors’ financial ties to clients. We also find evidence of greater auditor monitoring after the passage of UD laws using two alternative outcomes, i.e., the reporting of internal control weakness and the length of audit reporting lag. Overall, our findings suggest the unique monitoring role of external auditors as they step up their oversight of the audited firms in the lapse of other monitors.

Shareholder Litigation and Workplace Safety

We examine how shareholder litigation affects workplace safety. To identify a causal impact, we exploit the staggered adoption of Universal Demand (UD) laws by U.S. states, which lowers shareholder derivative litigation risk. Using establishment-level injury data and a Covid-19 exposure dataset in the U.S., we find that weakened shareholder litigation rights compromise workplace safety. The impact is more pronounced for firms with weak governance, in less competitive, low union coverage or low skilled industries. Furthermore, firms incorporated in UD law states exhibit higher Covid-19 exposure, more negative sentiments and greater uncertainty about the impact of the virus on their operations than firms incorporated in non-UD law states. Overall, our findings suggest that the threat of shareholder litigation incentivizes corporate officials to invest more in workplace safety. This conclusion has timely policy implications for Covid-19 safety at workplaces.

Peer Effects in Corporate Governance Practices: Evidence from Universal Demand Laws

Abstract Firms in the same networks tend to have similar corporate governance practices. However, disentangling peer effects, where governance practices propagate from one firm to another, from selection effects, where firms with similar preferences self-select into linked groups, is difficult to do. Studying board-interlocked firms, we utilize the staggered adoption of universal demand laws across states to identify and estimate causal peer effects in governance policies. We find support for the existence of peer effects in the adoption of antitakeover provisions. The impact of universal demand laws on the governance experience of interlocking directors likely explains these effects.

The dark side of shareholder litigation: Evidence from corporate takeovers

AbstractExploiting staggered adoption of the universal demand (UD) laws by 23 states between 1989 and 2005 that makes filing shareholder derivative litigations more difficult, we show that reduced litigation threats improve corporate takeover efficiency. Using a difference‐in‐differences approach, we find that acquirers experience higher announcement returns and better postmerger operating performance after the UD laws. Further analysis suggests that acquirers make suboptimal merger decisions to avoid litigation. Taken together, we show that litigation risk can distort managers’ incentives and destroy value ex ante.

Universal demand laws and the monitoring demand for accounting conservatism

AbstractWhile prior research holds the consensus that accounting conservatism can serve as an effective monitoring device, it is not clear whether shareholders can successfully enforce managers’ adherence to accounting conservatism when directors fail to fulfill their fiduciary duties. We attempt to answer the question by exploiting staggered enactments of the universal demand (UD) laws in 23 US states. UD laws raise procedural hurdles for shareholders to file derivative lawsuits against managers and directors who allegedly breach their fiduciary duties. For firms incorporated in states that adopt UD laws, restrictions on shareholder litigation rights weaken directors’ incentives to monitor managers. We predict and find a decrease in conditional conservatism following the enactment of UD laws. The decline in conditional conservatism exists only for firms with low institutional ownership, low external equity dependence, or high ex‐ante derivative lawsuit risk. The main result is attributable to both the direct channel (through restriction of shareholder litigation rights) and the indirect channel (through the deployment of management‐friendly governance provisions). Our findings suggest that shareholders cannot successfully demand accounting conservatism when directors lack the incentives to monitor managers.

The Unintended Consequences of Adopting Universal Demand Laws on Employee Safety

Universal demand (UD) laws impose obstacles on shareholders who wish to file derivative lawsuits. In this paper, we examine the negative consequences of the staggered adoption of UD laws: threatening employee safety. Using the workplace safety data from OSHA, we find that firms experience a 27% increase in employee injuries following the adoption of UD laws, especially for those launching new products or taking risky investments. Besides, we show that the negative effect is also significantly asymmetric: firms with weaker labor unions or establishments located in low-income counties exhibit a greater increase in employee injuries. Such an asymmetric effect is likely driven by firms’ monopoly power in the labor market. Finally, we reveal that adoption of UD law leads to deterioration in integrity-related culture and reductions in organization capital.

Shareholder Litigation Rights and Firm Productivity

This paper analyzes the impacts of decreased shareholder litigation risk on firm productivity. Shareholder litigation provides shareholders a mechanism to enforce rights and mitigate agency conflicts. We use a staggered state-level adoption of universal demand (UD) laws as an exogenous shock that suppressed the number of shareholder derivative lawsuits. We show that the resulting deterioration in corporate governance, coupled with increased managerial attention, had mixed effects on productivity. Adverse effects resulting from lower litigation risk are primarily observed in firms facing financial constraints and low takeover threats. Conversely, firms with incentivized management achieved a higher productivity growth.

Shareholder Litigation and Bank Risk

Does a decline in shareholder litigation enhance managers’ monitoring efforts by ensuring adequate firm risk management? We explore how state Universal Demand laws (which limit shareholder litigation as a mechanism to discipline managers, UD law hereafter), affects bank holding companies’ (BHCs) risk. Using a difference-in-differences analysis, we show that BHCs reduce their tail risk exposures after the implementation of the UD laws and that this is achieved by improving loan asset quality. Indeed, BHCs appear to apply stricter contract terms for syndicate loans to risky and opaque borrowers. We also show that UD law implementation leads to changes in BHC board composition by increasing the proportion of outside directors, the number of independent directors in audit committees, and the number of independent directors with financial expertise.

The Impact of Private Channel on Information Disclosure - Evidence from Board Network and R&D Narrative

Firms weigh the costs of public disclosure against the benefits of information transparency when disseminating narrative R&D information. In this paper, we examine whether firms with private information dissemination channels will reduce their public disclosure of narrative R&D information by investigating the effect of director network connections on firms’ narrative R&D disclosure. Consistent with our expectation, we find that firms with better-connected directors disclose less narrative R&D information. This association is stronger for firms with: (1) higher litigation risk, (2) larger proprietary costs, (3) more opportunities to interact with directors at other firms, and (4) weaker corporate governance. We also find that narrative R&D information flows through director networks to information users such as institutional investors and industry peers. Our results remain robust to employing the staggered adoption of the Universal Demand laws and the Inevitable Disclosure Doctrine as quasi-natural experiments, addressing the Reg FD effect, measuring the content of narrative R&D disclosure, and using alternative measures of board networks. Collectively, our findings suggest that director connections may serve as a private channel of disseminating narrative R&D information, substituting for the public channel of disclosure.

Shareholder litigation rights and stock price crash risk

We study the impact of shareholder-initiated litigation risk on a firm's stock price crash risk. Our empirical analysis takes advantage of the staggered adoption of universal demand laws, which led to an exogenous decline in derivative litigation risk. We find that a decline in the threat of derivative litigation reduces crash risk and that information hoarding associated with earnings management is a channel through which litigation risk affects crash risk. The relationship is also moderated by how exposed firms are to the other primary form of shareholder litigation, namely securities class-action lawsuits.

Shareholder Litigation and Conservative Accounting: Evidence from Universal Demand Laws

We use the staggered adoption of the Universal Demand Laws (UD Laws) to examine the effect of an exogenous reduction in shareholders' ability to litigate on the extent of accounting conservatism. On average, we find an increase in reporting conservatism post UD. The increased conservatism is concentrated in firms contemplating equity issuance, with high proportion of monitoring investors, and high corporate governance quality. In contrast, firms with specific short-term incentives for aggressive accounting, such as those narrowly beating benchmarks, those with abnormal insider trading and those likely to violate debt covenants, weakly governed firms, and firms with high ex ante litigation risk decrease reporting conservatism after UD. Our results suggest that the relation between the litigation environment and reporting conservatism is complex and dependent on specific characteristics and unique circumstances of the firms.

The Effect of Managerial Litigation Risk on Earnings Warnings: Evidence from a Natural Experiment

ABSTRACTWe examine the causal effect of managerial litigation risk on managers’ disclosure of earnings warnings in the face of large earnings shortfalls. Exploring the staggered adoption of universal demand (UD) laws as an exogenous decrease in litigation risk, we find that the adoption leads to a decrease in managers’ issuance of earnings warnings, especially among firms facing a higher litigation risk prior to the adoption. In contrast, we find no change in managers’ tendency to alert investors of impending large positive earnings surprises. Collectively, our results provide causal evidence that higher litigation risk incentivizes managers to issue more earnings warnings. Our results differ from Bourveau et al.’s finding of an increase in the frequency of management earnings forecasts after the adoption of UD laws. We reconcile our findings with theirs by demonstrating that the effect of adopting UD laws on management earnings forecasts depends critically on forecast horizon: The adoption increases long‐horizon forecasts, but decreases short‐horizon forecasts.

Shareholder Litigation and Corporate Innovation

We investigate whether and to what extent shareholder litigation shapes corporate innovation by examining the staggered adoption of universal demand laws in 23 states from 1989 to 2005. These laws impose obstacles against shareholders filing derivative lawsuits, thereby significantly reducing managers’ litigation risk. Using a difference-in-differences design and a matched sample, we find that, following the passage of the laws, firms invested more in research and development, produced more patents in new technological classes and more patents based on new knowledge, generated more patents with significant impacts, and achieved higher patent value. Our findings suggest that the external pressure imposed by shareholder litigation discourages managers from engaging in explorative innovation activities. This paper was accepted by David Simchi-Levi, finance.

The Need to Validate Exogenous Shocks: Shareholder Derivative Litigation, Universal Demand Laws and Financial Reporting Decisions

Several recent studies argue that the adoption of universal demand (UD) laws represent an exogenous decline in litigation risk by increasing the procedural hurdles associated with shareholder derivative litigation. This study examines how UD laws affect the incidence of derivative litigation risk and related decisions. We show that the adoption of UD laws had no meaningful impact on derivative litigation from 1996-2015. We also find no evidence that UD laws affect aggressive accounting, voluntary disclosure, executive compensation, or corporate governance decisions. Collectively, our findings cast doubt on the validity of using UD laws as an exogenous shock to litigation risk.

The Effect of Managerial Litigation Risk on Earnings Warnings: Evidence from a Natural Experiment

We examine the causal effect of managerial litigation risk on managers’ disclosure of earnings warnings in the face of large earnings shortfalls. Exploring the staggered adoption of universal demand (UD) laws as an exogenous decrease in litigation risk, we find that the adoption leads to a decrease in managers’ issuance of earnings warnings, especially among firms facing a higher litigation risk prior to the adoption. In contrast, we find no change in managers’ tendency to alert investors of impending large positive earnings surprises. Collectively, our results provide causal evidence that higher litigation risk incentivizes managers to issue more earnings warnings. Our results differ from Bourveau et al.’s (2018) finding of an increase in the frequency of management earnings forecasts after the adoption of UD laws. We reconcile our findings with theirs by demonstrating that the effect of adopting UD laws on management earnings forecasts depends critically on forecast horizon: The adoption increases long-horizon forecasts, but decreases short-horizon forecasts.

Does shareholder litigation affect the corporate information environment?

Using the staggered adoption of universal demand (UD) laws in the United States, we show that the reduction in shareholder litigation risk deteriorates firms’ stock price informativeness. This reduction in stock price informativeness is due to firms changing the way they invest rather than obfuscating or withholding firm-specific information. We also show that the reduction in litigation risk is associated with higher investment-price sensitivity. Overall, despite causing a deterioration in firms’ information environment, the reduction in litigation risk does not appear to harm shareholder wealth. Our paper offers novel insights into the net economic benefits of shareholder litigation laws.

Shareholder Litigation and Conservative Accounting: Evidence from Universal Demand Laws

ABSTRACT We use the staggered adoption of the Universal Demand Laws (UD Laws) to examine the effect of an exogenous reduction in shareholders' ability to litigate on the extent of accounting conservatism. On average, we find an increase in reporting conservatism post-UD. The increased conservatism is concentrated in firms that contemplate equity issuance, with a high proportion of monitoring investors, and high corporate governance quality. In contrast, firms with specific short-term incentives for aggressive accounting—such as those narrowly beating benchmarks, those with abnormal insider trading, and those likely to violate debt covenants—weakly governed firms, and firms with high ex ante litigation risk decrease reporting conservatism after UD. Our results suggest that the relation between the litigation environment and reporting conservatism is complex and dependent on specific characteristics and unique circumstances of the firms.

Shareholder litigation rights and capital structure decisions

We exploit the staggered adoption of the universal demand (UD) laws across U.S. states, which impedes shareholder rights to initiate derivative lawsuits, as a quasi-natural experiment to examine the relation between shareholder litigation rights and firm capital structures. We find that weaker shareholder litigation rights due to the UD laws adoption lead to higher financial leverage, which enhances firm value. Furthermore, the positive relation between the UD laws adoption and financial leverage is more pronounced for firms exposed to higher shareholder litigation risk ex ante or financially constrained firms. Our evidence is consistent with lower shareholder litigation threats motivating firms to increase financial leverage.

Shareholder Rights and Capital Structure: Evidence from Derivative Lawsuits

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.