Growing Out of Trouble? Managerial Responses to Risk of Corporate Liability

Abstract:     
This paper analyzes the importance of agency conflicts arising from managers' exposure to their firms' risk. In particular, we study how a typical firm responds to an exogenous increase in liability risk arising from its workers' exposure to newly identified carcinogens. We find that such firms, particularly those with weak balance sheets, tend to undertake aggressive growth through acquisitions. The acquired firms tend to be large, unrelated businesses with relatively high operating cash flows, recent growth, and total payouts. These deals are associated with high takeover premiums and negative abnormal returns. These findings appear to result from a managerial agency conflict: the extent of the growth is related to firms' external governance, managerial stockholdings, and institutional ownership. Overall, the evidence suggests that managerial risk aversion can have a substantial impact on corporate financing and investment decisions, and that corporate governance can be particularly important when firms encounter a negative shock.

Awarded CRA International Award for the Best Corporate Finance Paper, WFA 2009.

Keywords: carcinogens, legal liability, acquisitions, payout policy, capital structure, managerial agency

JEL Classifications: D21, G32, G34, K13

Working Paper Series