We exploit the staggered adoption of universal demand (UD) laws, which hinders shareholders’ rights to initiate derivative lawsuits, by 23 states in the United States from 1989-2005 as a quasinatural experiment to examine the effects of shareholder litigation as a corporate governance mechanism on corporate cash holdings and its implication for shareholder value. We find that reduced derivative lawsuit risk following the passage of UD laws leads to lower level and higher value of cash. Further analysis indicates investment as a channel through which UD laws affect the level and value of cash. Our evidence highlights the dark side of shareholder litigation, which induces firms to pursue a conservative liquidity policy that hampers shareholder value.

Introduction

Shareholder litigation, together with shareholder voice and exit, has been considered a channel through which shareholders exert corporate governance (Ferris et al., 2007; Edmans, 2014; Pukthuanthong et al., 2017). La Porta et al. (1998) argue that legal protection of shareholders can mitigate agency problems that arise from the separation of ownership and control. In particular, litigation enables shareholders to deter ex-ante and find remedies ex-post to managers’ self-dealing and moral hazard problems. Ferris et al. report that shareholder litigations strengthen the power of the board of directors, while Romano (1991) and Bhagat et al. (1987) suggest that shareholder litigation can deter managerial misconduct. Shareholder litigation has its own limitations. It can impose substantial costs on firms, such as attorney fees and cash settlements. In addition to its direct negative financial ramifications, shareholder litigation may raise managers’ career concerns and discourage them from pursuing risky but potentially value-increasing projects (Lin et al., 2016), reduce corporate takeover efficiency (Chu and Zhao, 2016), and lead to higher external financing costs and a loss of corporate reputation (Deng et al., 2014). Bhagat et al. (1998) and Ferris et al. (2007) find that, on average, defendant corporations experience a significant decline in their market value of equity at the time of the shareholder litigation filing. Their finding raises a question about the net benefits of litigation as a governance mechanism to shareholders of the target firms. There are two major forms of shareholder litigation: securities class action and derivative lawsuits. A securities class action lawsuit usually involves a subset of shareholders who bought or sold a company’s shares within a specific period and is initiated in response to a sudden decrease in stock price due to some alleged securities fraud. Any cash settlement in the securities class action lawsuit belongs to the shareholders. In contrast, a derivative lawsuit is filed by shareholders on behalf of the corporation, which typically alleges that directors and officers breach their fiduciary duties. Unlike in a securities class action lawsuit, whatever the directors and officers agree to pay in a derivative lawsuit goes to the corporation after paying the plaintiff’s attorney fees. Thus, the primary goal of a derivative lawsuit is presumably to introduce corporate governance reforms. Consistent with this proposition, Ferris et al. (2007) find an increase in both the departure rate of board directors and outside representation following derivative lawsuits.