The Need to Validate Exogenous Shocks: Shareholder Derivative Litigation, Universal Demand Laws and Firm Behavior

Sara Toynbee is Assistant Professor of Accounting at the University of Texas at Austin McCombs School of Business. This post is based on a recent paper, forthcoming in the Journal of Accounting & Economics, by Ms. Toynbee; Dain C. Donelson, Professor of Accounting at the University of Iowa Tippie College of Business; John McInnis, Professor of Accounting at the University of Texas at Austin McCombs School of Business; and Laura Kettell, PhD Student in Accounting at the University of Texas at Austin McCombs School of Business.

As researchers in finance and accounting seek to identify causal relationships in “real-world” data, they often turn to legal changes to provide a quasi-exogenous shocks. As a recent example, a growing number of academic use the adoption of universal demand (UD) laws to examine the causal effect of litigation risk on various firm outcomes (e.g., Bourveau et al. 2018; Appel 2019; Huang et al. 2021). These studies argue that UD laws increase the procedural hurdles associated with derivative litigation; however, there is little empirical evidence that UD adoption significantly lowers derivative litigation risk. Drawing on institutional features of derivative litigation and UD laws, our paper, “The Need to Validate Exogenous Shocks: Shareholder Derivative Litigation, Universal Demand Laws and Firm Behavior” examines the validity of UD adoption as a shock to litigation risk.

UD standardizes the procedures for derivative litigation, requiring all plaintiffs to “demand” that the board bring derivative action against managers. However, even if a board refuses demand, a shareholder can still assert the refusal was improper. UD was designed to focus litigation on boards’ justifications for demand refusal, not curtail derivative litigation (see Coffee,1993). In addition, states generally passed UD laws as part of broader revisions to the Model Business Corporations Act (MBCA), which was updated in 1989 to include the UD requirement (Model Business Corporation Act, 2016). There is little evidence that legislators and attorneys viewed UD as a material part of the reforms (see, e.g., Jacobs Law LLC, 2004 discussing law passage in Massachusetts). Further, not all states enforce UD requirements (Mark and Weber, 2014). Overall, it is not clear UD significantly lowered litigation risk.

We construct a comprehensive dataset of derivative litigation against U.S. public companies from 1996-2015. Our descriptive evidence suggests that, when acting as a standalone governance mechanism, derivative litigation most often deals with “non-financial reporting” issues such as excessive compensation, inappropriate mergers and acquisitions, and related party transactions. This evidence can inform scholars interested in derivative litigation, as prior evidence from the legal literature is often limited to a specific court and time period (e.g., Thompson and Thomas, 2004; Erickson, 2010).

We then test whether the likelihood of derivative litigation changes after UD adoption. Utilizing a staggered differences-in-differences design with firm and industry-year fixed effects, we find no significant effect of UD adoption on derivative litigation over this sample period. Reconciling our results to prior studies, we show that derivative litigation in states adopting UD is rare, both before and after UD adoption, and that any effect of UD on derivative litigation is not pervasive across states (i.e., there are heterogeneous treatment effects). More importantly, any difference across states appears to be driven by violations of the parallel trends assumption, which is necessary for causal interpretation of the findings.

While we examine the effect of UD on realized derivative litigation, it is possible that managers perceive a litigation risk reduction and change the underlying behavior that might lead to litigation (e.g., engage in more aggressive accounting; adopt lower quality corporate governance). To mitigate concerns that such behavior changes drive the insignificant results in our litigation tests, we examine whether UD affects firm outcomes in four areas—aggressive accounting choices, voluntary disclosure, executive compensation, and corporate governance. We find changes for some of these outcomes, but the results are highly sensitive and do not hold under additional scrutiny. We note two general issues with these findings. First, slight changes to the model affect significance of the results. Second, for many of the outcomes, we find evidence that there was a change in the outcome before UD laws were adopted. Overall, we find UD adoption is likely not a suitable setting to measure changes in litigation risk and highlight the sensitivity of existing findings to relatively minor research design changes.

Our study is timely given there are over twenty recent published and working papers in accounting and finance that use UD adoption as an exogenous reduction litigation risk. As such, we urge caution to researchers using UD as an “exogenous shock” to litigation risk. Overall, our study highlights the importance of researchers carefully considering institutional features when using a particular legal setting to measure changes in litigation risk.

The complete paper is available for download here.

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