Shareholder Litigation and Corporate Default Risk

Abstract

This study examines the effects of shareholder litigation on corporate default risk. Exploiting the staggered adoption of the universal demand (UD) laws by 23 U.S. states between 1989 and 2005 as an exogenous shock to derivative litigation, we find that weakened shareholder litigation rights due to the implementation of UD laws increase corporate default risk measured by expected default frequency (EDF). The positive relation between UD laws and EDF is more pronounced for financially constrained firms. Our results are robust to credit ratings as the alternative measure of default risk and different endogeneity tests including propensity score analysis and entropy balancing. The results also extend to the 1999 ruling of the Ninth Circuit Court of Appeals on securities class action lawsuits. Further channel analyses show that the increase in corporate default risk following the passage of UD laws can be explained by the deterioration in corporate governance, the increase in firm performance volatility, the reduction in corporate strategy conformity, and the increase in the cost of capital. We find no evidence that the UD laws contribute to corporate risk-taking, suggesting that our results are driven by erratic and arbitrary decision-making rather than difficult decision-making, such as risky investments. Overall, our study highlights the importance of shareholder litigation rights as an external governance mechanism in mitigating firm-level default risk.

JEL Classification: G33, G38, K40