Managerial Liability and Corporate Innovation: Evidence from a Legal Shock

Liandong Zhang is Professor of Accounting, Singapore Management University. This post is based on a recent paper by Professor Zhang; Yuyan Guan, Associate Professor at City University of Hong Kong; Liu Zheng, Associate Professor at City University of Hong Kong; and Hong Zou, Associate Professor of Finance at University of Hong Kong.

Innovation is vital to the development of core competitive advantages of a firm and to the economic growth of a country (Solow, 1957). By nature, innovation is a risky, costly, and long-term process fraught with failures (Holmstrom, 1989). A salient difficulty that has long been noted by both academics and practitioners is that risk-averse company directors and officers (D&Os) tend to be reluctant to commit to investment in risky research and developments (R&D) even though such investments may create long-term value (Aghion, Van Reenen and Zingales, 2013; Barton and Wiseman, 2015). As Jensen has highlighted, an important source of D&Os’ reluctance is the potential litigation risk. In particular, some investors may have a low tolerance of innovation failures and the resulting lackluster performance, and may challenge a firm’s innovation inefficiency, as can be seen from the following example.

“Novatel has managed its R&D investments recklessly and without a clear aim and purpose. Over the past five years, Novatel has spent approximately $264 million on R&D. Despite this enormous investment, shareholders are left to wonder why the value of their stock has declined by 75%, approximately $150 million, over the same period. Moreover, we believe the Company has failed to monetize the true worth of its intellectual property portfolio.”

—From the open letter by a group of Novatel shareholders, April 4, 2014

The culture of D&Os’ increasingly risk-averse decision-making and the short-termism of some investors is a problem that exists not only in the U.S. but also in many other countries. Realizing this problem and in order to encourage entrepreneurship and innovation, Australia revised its Insolvency Law by lowering directors’ personal liability for corporate insolvency in December 2015. This is part of the Australian Federal Government’s Innovation Package and represents an effort to overhaul its director liability framework.

Against this backdrop, our paper exploits the sudden change in Nevada’s corporate law in 2001 that significantly lowered D&Os’ legal liability as a quasi-exogenous shock to study how managerial legal liability affects corporate innovation. As a measure to increase state income and address the growing budget deficit in the near term and to find a niche to compete with Delaware in attracting firm incorporations in the long run, Nevada swiftly revised its corporate law in 2001 that significantly lowered D&Os’ legal liability. The law change, which was first discussed on May 22, 2001, passed by the legislators on June 3, and signed by the Governor into law on June 15, 2001, represents a quasi-exogenous shock to firms incorporated in Nevada before the law change. The short legislation process made it difficult for non-Nevada firms to anticipate the law change and reincorporate in Nevada before the law change. After reviewing the legislation process, legal scholars (e.g., Barzuza, 2012) conclude that the law change is a state response to its exacerbating budget problem and a result of Nevada’s newly formulated competition strategy, and hence it is not due to Nevada firms’ lobbying. These features of the legislation make the 2001 Nevada law change a desirable shock for our analysis.

After the law change in 2001, Nevada’s Corporate Law offers D&Os comprehensive protection from liabilities, including breaches of duty of good faith, the duty of loyalty, and duty of care; D&Os in Nevada-incorporated firms are liable only for intentional misconduct, fraud, or a knowing violation of law. This change in law led some legal scholars to proclaim Nevada’s Corporate Law as “lax” and “liability-free” (e.g., Barzuza, 2012). In contrast, before the law change in 2001, Nevada’s Corporate Law, by default, imposes the same fiduciary duties on D&Os (unless such duties are waived by the company with shareholder approval).

Risk-averse D&Os have concerns over taking on risky activities (e.g., innovation) (Smith and Stulz, 1985). The uncertain and failure-prone natures of innovation projects increase the volatility and downside risk of company shares. Moreover, because innovation projects are generally idiosyncratic and of low transparency, investors are likely to form different opinions regarding the long-term value of these projects, leading to high stock turnovers. Empirical evidence in the law and economics literature suggests that stock return volatility, stock turnover, and downside risk increase the likelihood of shareholder litigation because these measures are directly related to the incentives of plaintiffs’ attorneys to file suits (e.g., Alexander, 1991; Jones and Weingram, 1996; Kim and Skinner, 2012). Litigation often incurs substantial costs in the form of managerial time, distraction and reputation, and legal fees for the defendants. Consequently, it is important to note that litigation does not have to be successful ex post to serve as a deterrent and to impose liability risk on D&Os ex ante. In addition, the merits of lawsuit cases generally do not always affect resolutions and thus the foremost incentive for D&Os is to minimize the likelihood of becoming a litigation target (e.g., Alexander, 1991; Romano, 1991; Jensen, 1993; Baker and Griffith, 2010). Therefore, to minimize downside risk and thereby the likelihood of litigation, managers may shy away from valuable innovation projects and focus on routine projects (Jensen, 1993). We expect that Nevada’s law change in 2001 helps allay D&Os’ concerns over potential litigation costs and encourage them to invest more funds, effort, and human capital in valuable innovation projects, leading to more and better innovations.

An alternative view from agency theory predicts the opposite. D&Os may shirk from taking on (risky) value-increasing activities such as innovation after shareholder discipline is weakened by Nevada’s 2001 change in Corporate Law. In addition, the business judgment rule also protects D&Os from certain litigation (e.g., derivative suits alleging the breach of duty of care) because it sets a significant bar for shareholders to successfully hold a firm’s D&Os liable for losses caused to the company in duty-of-care cases. These possibilities add tensions to the effect of Nevada’s 2001 law change on innovation and make it ultimately an empirical issue.

Using a difference-in-differences analysis over the period around Nevada’s 2001 law change, we find that firms incorporated in Nevada before the law change (i.e., the treatments firms) exhibit an increase in innovation as measured by the number of patents applied for (and eventually granted) and the total number of non-self-citations relative to matched control firms incorporated outside Nevada. In addition, we find that the effect is stronger for firms facing higher ex ante litigation risk or operating in more innovative industries. We further perform a dynamic analysis to verify that these differences in innovations between treatment and control firms do not exist in the year before the law change and therefore they do not reflect a pre-event trend. Overall, our results suggest that disciplining D&Os through legal liabilities may entail a cost: it may discourage corporate innovation.

The complete paper is available here.

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