Lawyer CEOs

Irena Hutton is Associate Professor of Finance at Florida State University. This post is based on a recent paper authored by Professor Hutton; M. Todd Henderson, Professor of Law at the University of Chicago; Danling Jiang, Associate Professor of Finance at SUNY Stony Brook; and Matthew Pierson, Florida State University.

We contribute to the literature on the value of CEOs with specialized professional skills by examining the effect of CEOs with law degrees on corporate litigation. We hypothesized that the combination of legal training and acquired risk aversion makes lawyer CEOs effective at managing corporate litigation risk.

We identify the educational background of about 3,500 CEOs paired to nearly 2,400 publicly-traded firms in the S&P 1500. In this sample about 9 percent of CEOs have law degrees. This non-trivial number of lawyers in top executive positions that are customarily held by individuals with business degrees suggests that legal training has value in the executive labor market.

To study the effect of lawyer CEOs on litigation, we rely on a large sample of over 70,000 lawsuits filed against our sample firms in Federal District courts during 1992-2012. We focus on nine common types of litigation: antitrust, employment civil rights, contract, environmental, intellectual property, labor, personal injury, product liability, and securities.

Consistent with our hypothesis, firms run by CEOs with legal expertise are indeed associated with less corporate litigation. In the baseline analyses of all nine litigation types, firms run by CEOs with legal training exhibit statistically significant lower frequency of antitrust, employment civil rights, contract, labor, securities, and personal injury litigation. The reduction in lawsuit frequency is economically significant and ranges from about 16 to 74 percent relative to the unconditional mean litigation. Further, CEOs with legal expertise, conditional on experiencing litigation, are also associated with less lost or settled litigation.

These results are robust to different specifications and controls for firm characteristics such as size, leverage, profitability, market-to-book, return, and return volatility, as well as year and industry fixed effects. The results are also robust to the effect of CEO age and tenure with the firm. Moreover, legal training does not appear to be a proxy for ability or ambition as in placebo tests: alternative measures of high level of academic achievement such M.B.A., Ph.D., and M.D. degrees, or a degree from an Ivy League institution, are not associated with litigation reduction. Further, we find that presence and influence of other gatekeepers, such as directors with legal training and in-house general counsel elevated to the position of top-5 highest paid officers, do not crowd out the influence of the CEO.

We implement several identification strategies to determine whether our results are due to the active management of the litigation risk by the CEO or simply by CEO-firm matching. The matching between lawyer CEOs and firms can arise if risk averse J.D.’s gravitate to firms with low litigation risk or if firms hire CEOs with legal training as window dressing during periods of intense litigation for the company. While these actions need not be mutually exclusive, we find that litigation reduction is, at least in part, consistent with active management by the CEO. First, we use an instrumental variable regression, in which CEO type is instrumented with the variable based on the potential pool of executives with legal expertise located in the 50-mile radius of the firm’s headquarters. The instrumented CEO type remains a strong predictor of litigation frequency. Our second identification strategy exploits the differential effect of a shock to the litigation environment on firms with and without lawyer CEOs. We use the passage of the Sarbannes-Oxley Act in 2002 as a shock to compliance and litigation. The act was designed to curb financial malfeasance by improving financial disclosure, increasing personal accountability of top managers and other firm monitors, in addition to setting more severe criminal penalties for white-collar crime. We find that during the key events of the Act’s passage, firms with lawyer CEOs experience a positive market reaction while firms without lawyer CEOs experience the opposite. This finding confirms the greater value of CEO legal expertise during the periods of high compliance standards and more stringent legal enforcement.

We then focus on the effect of the CEOs with legal expertise on firm policies and find evidence consistent with the active management of litigation risk. First, CEOs with legal training are associated with the greater future presence of directors with legal expertise, who may also contribute to litigation reduction. Second, CEOs with legal training tend to implement more cautious earnings management policies. We provide evidence that lawyer CEOs are associated with less earnings management in industries with high litigation risk. Third, firms with lawyer CEOs have more conservative investment firm policies characterized by lower R&D and investment in tangible assets and less total and idiosyncratic return volatility. These results confirm the findings from other causality tests that the reduction of firm litigation can be attributed to the actions of CEOs with legal expertise to lower litigation propensity ex ante.

If litigation reduction is so economically significant and potentially valuable, why do CEOs with J.D. degrees represent less than one tenth of the CEO pool? We examine their effect of firm value and find that CEOs with legal training are associated with higher firm value, but only in a subset of high litigation, high growth, or pharmaceutical firms. Outside of this setting, however, the effect of CEOs with legal training on firm value is negative, perhaps because the benefits of litigation reduction in a low litigation risk setting are offset by their overly cautious firm policies that negatively affect cash flows and growth.

In summary, the contributions of this paper are two-fold. First, we are among the first to document that CEOs with legal expertise are effective at managing litigation risk by, in part, setting more risk-averse firm policies. Second, our paper demonstrates that these actions are value enhancing only when firms operate in an environment with high litigation risk or high compliance requirements.

The complete paper is available for download here.

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