Shareholder Protection and the Cost of Capital

Joel F. Houston is the Eugene F. Brigham Chair in Finance at the Warrington College of Business at the University of Florida; Chen Lin is the Stelux Professor in Finance at The University of Hong Kong; and Wensi Xie is Assistant Professor at The Chinese University of Hong Kong. This post is based on their recent article, forthcoming in the Journal of Law and Economics.

Do the legal environment and the level of shareholder protection meaningfully influence the cost of capital? To shed some light on this issue, our recent article Shareholder Protection and the Cost of Capital (which is forthcoming in the Journal of Law and Economics) explores how changes in shareholders’ rights affect their required risk premium, which in turn generates important influences on both corporate valuations and the overall depth of financial markets. Intuitively, when outside shareholders invest in jurisdictions with stronger investor protections, they recognize that insiders are less likely to divert firm resources for their own private benefits. Shareholders factoring this lower risk of expropriation into their valuation model are therefore willing to pay more for firms’ equity, which in turn enables firms to obtain external financing with better terms.

Specifically, we focus on shareholders litigation rights, which entitle them to make legal claims against corporate management. To isolate the effects of shareholder litigation rights, we employ a quasi-natural experiment where we examine the impact of staggered state-level changes in universal demand (UD) laws on firms’ cost of capital. Since the late 1980s, 23 states in the U.S. have adopted these universal demand laws. The adoption of UD laws has significantly weakened shareholders’ litigation rights by raising procedural hurdles to pursue derivative lawsuits. (Davis 2008; Erickson 2010). When a firm’s management breaches its fiduciary duties by causing injuries to the firm, individual shareholders are entitled to bring a derivative suit against the manager to remedy wrongdoing on behalf of the corporation. The universal demand laws, however, impose a “universal demand requirement” to every derivative lawsuit, meaning that the plaintiff shareholder must first make a demand on the board of directors to take corrective actions before proceeding with litigation. This requirement places a significant obstacle to derivative suits because directors are usually the defendants in these suits and hence almost always refuse to proceed with litigation. Moreover, the shareholder can no longer circumvent the demand procedure by arguing demand futility on the grounds that directors have a conflict of interest. Using information on companies’ derivative lawsuits collected from their SEC 10-K filings, we confirm that the occurrence of derivative litigations drops materially following the passage of UD laws. In this regard, UD laws weaken shareholder litigation rights by making it more difficult for shareholders to seek remedies and enforce fiduciary duties through derivative suits.

Methodologically, the staggered adoption of UD laws on a state level over time allows us to employ a difference-in-differences approach. Compared to conventional cross-country analyses, this empirical design has at least two advantages to further alleviate concerns related to omitted factors. First, the diff-in-diff approach allows us to control for firm and year fixed effects throughout our analyses. In our subsequent robustness tests, we conduct the analyses in a more rigorous way by adding industry-year and operating-state-year fixed effects. Second, reverse causality is less of a concern in our setting, since the passage of these laws occurs at the state-of-incorporation level, and hence they are less likely to be driven by individual firm characteristics.

Our primary sample consists of about 5,000 public firms in the U.S. from 1985 through 2013. For each firm, we apply an accounting-based discounted dividend valuation model to estimate its annual cost of capital. Following Hail and Leuz (2006, 2009), we employ four different models, and back out the cost of capital estimate as the implied rate of return that equates the stock price and the present value of future earnings. Compared with realized stock returns, the implied cost of capital (ICOC) measures estimated from the accounting-based models capture the ex-ante rate of return and attempt to explicitly separate the cost of capital effects from the cash flow effects (Hail and Leuz 2009). Based on these estimates, our baseline analyses suggest that following the passage of UD laws, the implied cost of capital for firms incorporated in the state rises on average by 26 basis points, an increase of 5% above the sample median. Importantly, we demonstrate that the findings are not confounded by pre-existing trends between the treated and control firms.

Building on our basic findings, we further explore three potential channels through which UD laws influence firms’ cost of capital: (1) information disclosure, (2) risk-taking, and (3) insider trading. First, changes in the legal environment may influence the cost of capital through its effects on information quality. We assess whether the UD laws shape (a) the overall stock price informativeness, and (b) the information content of corporate disclosure. Following the passage of the UD laws, managers are better insulated from shareholder litigation for expropriating activities and financial misreporting, which in turn discourages them from disclosing information in an accurate and timely fashion. We find evidence supporting this channel. The UD laws are shown to result in a dramatic decline in the stock price informativeness (measured by price non-synchronicity) and the information quality of voluntary 8-Ks (measured by instantaneous market reaction to 8-K announcement), indicating a lower quality of corporate disclosure and an overall less informative environment.

Second, we show that firms become riskier following the enactment of UD laws, which also contributes to a higher cost of capital. Specifically, we find that a firm’s stock return volatility, exposure to market risks (as measured by the stock beta from the CAPM model), implied asset volatility, and expected default probability (derived from the Merton’s Distance to Default (DD) model) all increase significantly with the UD laws in place. This is consistent with notion that with less threats of being sued for the potential bad outcomes of their business decisions, managers are encouraged to invest in riskier projects that otherwise would be passed up, resulting in higher firm risks and greater exposure to systematic market risk. These higher risks, however, are not accompanied with higher cash flows, as we find that UD laws do not raise subsequent cash flows.

Regarding the third channel, we find that informed insiders trade more aggressively when the litigation risks are lowered with the adoption of the UD laws. In particular, we show that UD laws lead to increased insider trading volumes and larger transaction values, suggesting that corporate insiders adopt more active trading strategies when they face less disciplinary litigation threat due to changes in the legal environment. To the extent that these shifts increase investor’s expectation of being expropriated by corporate insiders with private information, outside disadvantaged investors will demand a higher rate of return for holding stocks with greater insider trading activities and private information, which contributes to a higher cost of capital.

Overall, our findings support the notion that UD laws place significant obstacles to shareholder lawsuits, leading shareholders to face intensified agency conflicts and greater expropriation risks, which in turn lead them to require a higher rate of return.

The complete article is available here.

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