Do Courts Matter for Firm Value? Evidence from the U.S. Court System

Courts provide an important link between the legal system and economic development. Our paper, Do Courts Matter for Firm Value? Evidence from the U.S. Court System, which is publicly available on SSRN, studies if and how courts affect firm value. We distinguish between two main channels through which courts can impact firm value. First, courts may benefit firms by providing efficient and competent resolution of cases thus reducing legal uncertainty and litigation costs, a hypothesis we refer to as the efficiency channel. Alternatively, courts can affect firm value by transferring resources from plaintiffs such as customers or employees to shareholders (or vice versa), a business attitude channel.

The key challenge in measuring the impact of courts on firms is to isolate the impact of laws from that of courts, the institutions that enforce those laws. Any study comparing measures of court characteristics across states or countries is invariably comparing not just different courts, but different laws, firms, or political and social environments.

The U.S. court system provides a laboratory to overcome this challenge. Most cases are handled by state courts, but there are important exceptions. If a civil lawsuit features parties from different U.S. states, the so-called “diversity of citizenship” grants federal courts jurisdiction over the case. In diversity cases, federal courts are bound to apply the same substantive law as the state court in whichever state the original case was based in. This so-called “Erie doctrine” has been a well-established rule ever since the landmark case of Erie Railroad Co. v. Tompkins in 1938. As a result, the difference between trying a case in federal or state courts does not lie in different laws, but solely in differences among courts. The diversity jurisdiction therefore allows us to evaluate the impact of courts on firm value while controlling for the applicable laws. [1]

A naıve comparison of cases featuring diversity of citizenship tried in either state or federal court would inevitably lead to a biased estimate of court characteristics on firm value. Both plaintiffs and defendants aim to steer cases into favorable courts, a practice known as “forum shopping”. Forum shopping is pervasive and whether a party is successful in setting the forum can greatly impact the outcome at trial. Any attempt to examine the effect of courts on legal outcomes based on actual cases therefore suffers from parties’ ability to influence court choice.

To resolve this further issue, we exploit a U.S. Supreme Court ruling which changed the ability of parties to move cases between forums. In the case of Hertz Corp. v. Melinda Friend (Hertz), the U.S. Supreme Court ruled on the conditions under which a corporation is deemed a citizen of a state for the purpose of diversity jurisdiction. On February 23, 2010, the court decided that a corporation should be deemed a citizen of at most two states: The state of incorporation and the state in which its officers guide the firm’s day to day activities, its “nerve center.” The judges ruled that this corporate nerve center is at the firm’s headquarters. After the ruling, firms were able to reliably claim diversity of citizenship in state courts which were not their headquarters or incorporation state. At the same time, firms that were only marginally active in their headquarters state lost the ability to claim diversity of citizenship when sued in that state. Those firms were therefore “pinned” into their headquarters state courts through the ruling. The ruling in Hertz therefore changed firms’ ex ante exposure to different courts.

We examine the stock performance of a sample of U.S. nonfinancial firms on the day of the ruling in Hertz. We focus on firms that lost the ability to move cases into federal courts in their headquarters state, namely those with small operations in their headquarters state. Using both an academic ranking of courts by Choi, Gulati, and Posner (2009) and a ranking produced by the U.S. Chamber of Commerce, we find that exposure to different courts is systematically connected to firm value. A firm exposed to a state court at the top tercile of the U.S. Chamber of Commerce ranking experiences a positive abnormal return of 0.45% compared to a firm exposed to a court from the bottom tercile. This translates into an $8.7 million increase in equity value for the median firm in our sample. In addition, we use differences between the two rankings to investigate whether this value effect is driven by court efficiency or rather court attitude towards businesses. We find that while a business-friendly court increases firm value, pure court efficiency does not.

Our finding that courts’ business attitude matters for firm value implies that forum shopping between various courts is a profitable practice for both firms and plaintiffs. To investigate this prediction, we look at geographic variation in the exposure to the ruling in Hertz. Before Hertz, federal circuits across the U.S. employed different interpretations of corporate citizenship, creating a circuit split. The divergent interpretation created geographic variation in the consequences of Hertz. We use this geographic variation to identify firms that experienced a reduction in the ability of potential plaintiffs to sue in a favorable forum. We find that affected firms exhibit positive abnormal returns on the event date. Firms therefore benefit when their plaintiffs have less choice in picking a favorable court. If firms benefit when their plaintiffs lose flexibility to forum shop, the opposite should happen when firms themselves lose flexibility to select favorable courts. We identify instances where the ruling in Hertz caused firms, rather than plaintiffs, to lose flexibility in picking favorable courts. We find that those firms experienced negative abnormal returns on the event date. These results indicate that the observed forum shopping in legal cases is indeed a value-maximizing strategy and further underline our finding that differences between courts matter for firm value even inside a highly developed legal system such as the United States.

The full paper is available for download here.