Liquidity Effects of Litigation Risk: Evidence from a Legal Shock

Abstract

Theory offers two diverging views on the effects of ex-ante litigation risk on corporate liquidity proxied by cash holdings. Ex-ante litigation risk, however, is difficult to measure. We test the liquidity effects of ex-ante litigation risk exploiting the phase-by-phase introduction of securities class actions (SCAs) in Korea. Following the increase in litigation risk, firms significantly increase their internal liquidity, especially in firms without D&O insurance coverage or those that are financially constrained. The results hold robustly in differences-in-differences and regression discontinuity designs. We also find that the increase in ex-ante SCA risk improves firms’ stock market liquidity especially in firms that do not carry D&O insurance. Taken together, the results are consistent with the notion that litigation risk has important effects on firms’ internal and stock liquidity.

Keywords: liquidity, cash holdings, litigation risk, class action, difference-in-differences, regression discontinuity

JEL Classification: G30, G32, K22