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.
