Federal Judge Ideology: A New Measure of Ex Ante Litigation Risk

• Author: KAI WAI HUI,REEYARN ZHIYANG LI,ALLEN HUANG
• DOI: http://doi.org/10.1111/1475-679X.12260
• Published date: 01 May 2019
• Date: 01 May 2019

DOI: 10.1111/1475-679X.12260

Journal of Accounting Research

Vol. 57 No. 2 May 2019

Printed in U.S.A.

Federal Judge Ideology: A New

Measure of Ex Ante Litigation Risk

ALLEN HUANG ,∗KAI WAI HUI ,†

AND REEYARN ZHIYANG LI ‡

Received 16 May 2016; accepted 15 November 2018

ABSTRACT

Drawing on the political theory of judicial decision making, our paper pro-

poses a new and parsimonious ex ante litigation risk measure: federal judge

ideology. We find that judge ideology complements existing measures of lit-

igation risk based on industry membership and firm characteristics. Firms

in liberal circuits (the third quartile in ideology) are 33.5% more likely to

be sued in securities class action lawsuits than those in conservative circuits

(the first quartile in ideology). This result is stronger after the U.S. Supreme

Court’s ruling in the Tellabscase. We next show that the effect of judge ideol-

ogy on litigation risk is greater for firms with more sophisticated sharehold-

ers and with higher expected litigation costs. Furthermore, judicial appoint-

ments affect litigation risk and the value of firms in the circuit, highlighting

∗Department of Accounting, Hong Kong University of Science and Technology;†Faculty of

Business and Economics, The University of Hong Kong; ‡Accounting and Taxation,University

of Mannheim.

Accepted by Christian Leuz. We appreciate the insightful comments and constructive sug-

gestions of an anonymous referee. We also thank Ray Ball, Jannis Bischof, Gilles Hilary, S.P.

Kothari, Karen Nelson, Jeff Ng, Adam Pritchard, Douglas Skinner, T. J. Wong, participants

at the 2016 AAA Annual Meeting, the 2016 MIT Asia Conference in Accounting, the 2018

Wuhan University Luojia Accounting Research Symposium and the 2018 Journal of Account-

ing Research Conference, and seminars at the Chinese University of Hong Kong, Fudan Uni-

versity, Hong Kong Polytechnic University, KAIST, Shanghai University of Finance and Eco-

nomics, Southwest University of Finance and Economics, Xiamen University, the University of

Hong Kong (Faculty of Law), Hong Kong University of Science and Technology, University of

Mannheim. We especially thank Tarek Hassan, Stephan Hollander, Laurence van Lent, and

Ahmed Tahoun for sharing the political donations data and Iris Jiang from Cornerstone Re-

search for her invaluable insights. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

431

CUniversity of Chicago on behalf of the Accounting Research Center,2019

432 A.HUANG,K.W.HUI,AND R.Z.LI

the economic consequences of political appointments of judges. Finally, us-

ing our new measure, we document that litigation risk deters managers from

providing long-term earnings guidance, a result that existing measures of liti-

gation risk cannot show.

JEL codes: K22; K40; K41

Keywords: securities litigation; litigation risk; federal courts; judge ideology

1. Introduction

Litigation is costly to firms. The question of how the risk of securities class

action lawsuits affects corporate decisions has attracted a great deal of re-

search interest in the accounting and finance literature.12 Prior studies

generally use industry membership (e.g., Francis, Philbrick, and Schipper

[1994a, b]), either alone or in conjunction with firm characteristics, such as

size, stock turnover, and returns, as measures of ex ante litigation risk (e.g.,

Johnson, Kasznik, and Nelson [2001], Field, Lowry, and Shu [2005], Rogers

and Stocken [2005]). However, these measures are also likely to capture

industry and firm characteristics unrelated to ex ante litigation risk. Con-

sequently, such measures can induce spurious relations, which affect their

results (Kim and Skinner [2012]). Our study proposes a new measure that

better captures ex ante litigation risk by exploiting firms’ external litigation

environment: federal judge ideology.

It is documented in both legal and political science studies that ideology

is among the most important of judges’ personal attributes influencing civil

liberties and economic lawsuit outcomes (Johnston [1976], Tate [1981],

Segal and Cover [1989], Staudt, Epstein, and Wiedenbeck [2006]). Specif-

ically, political theory of judicial decision making argues that the materials

available to judges do not usually provide sufficient clarity for resolving

1Federal securities class action lawsuits generally involve violations of the Securities Ex-

change Act of 1934 (commonly known as the Exchange Act). Although shareholders can

file class action and derivative lawsuits in state courts, these generally cover a narrow range

of misbehavior, that is, almost entirely limited to two contexts—acquisitions and self-dealing

transactions—and focus largely on the duties and liabilities of directors, not officers; they also

carry less severe penalties and are of diminishing importance (Thompson and Sale [2003],

Thompson and Thomas [2004]). In addition, state derivative lawsuits typically follow the fil-

ing of a federal securities class action suit; they do not uncover new facts and often result in

poor quality settlements, and thus add little significant value beyond federal securities class

actions (Choi, Erickson, and Pritchard [2017]). Due to the importance of federal securities

class action lawsuits, we focus on the risk of such lawsuits throughout this paper. Please refer

to subsection 3.2 for a detailed discussion.

2For example, prior studies examine litigation risk in financial reporting and disclosure

decisions (e.g., Skinner [1994, 1997], Johnson, Kasznik, and Nelson [2000], Field, Lowry, and

Shu [2005], Rogers and Van Buskirk [2009]), cash-holding and investment decisions (Arena

and Julio [2015]), executive compensation (Peng and R¨

oell [2008], Laux [2010]), initial pub-

lic offering (IPO) underpricing (Lowry and Shu [2002]), institutional monitoring (Cheng

et al. [2010]), and auditor resignation (Shu [2000]).

JUDGE IDEOLOGY AND LITIGATION RISK 433

disputes (Grundfest and Pritchard [2002]). As such, judges’ individual

characteristics can influence legal outcomes. Judges, like other government

officials, take advantage of their ability to shape case outcomes and project

their views of justice onto society (Richards and Kritzer [2002], Cross

[2007]). Through judicial votes, judges advance personal ideological pref-

erences, which generally fall along the conventional liberal-to-conservative

continuum in U.S. politics (see George [1998] for a review).

The most widely adopted measure of judge ideology is the appointing

president’s political affiliation (Goldman [1999], Pinello [1999]). Presi-

dents almost always appoint judges whose ideology reflects that of their

political party (Dorsen [2006], Federal Judicial Center [2006]). Judges ap-

pointed by Democratic presidents are more liberal on the bench than those

appointed by Republican presidents (Goldman [1975], Sunstein, Schkade,

and Ellman [2004], Cross [2007]). For example, using presidential

party affiliation as the measure, Tate [1981] finds evidence that judges’

personal attributes explain 72–87% of their voting behavior, with ideology

having the largest influence. In economic cases, studies show that a liberal

(Democratic) ideology is more likely to result in outcomes that are antibusi-

ness or proeconomic underdog, that is, that favor the “have-nots” over the

“haves,” such as labor unions and employees over firms, and government

regulations over the free market (Goldman [1966], Ryan and Tate [1975],

Segal and Spaeth [1996]). In the political science literature, researchers

apply the “liberal versus conservative” coding protocol to securities class ac-

tion lawsuits (brought by investors or shareholders who suffered economic

injury as a result of securities fraud). Findings indicate that liberal judges

are more likely to vote in favor of investors (plaintiffs), while conservative

judges are more likely to vote in favor of firms (defendants); as such, lib-

eral judges pose a higher litigation risk to firms than conservative judges

(Grundfest and Pritchard [2002], Sullivan and Thompson [2004], Spaeth

[2006], Fedderke and Ventoruzzo [2016]).3

Our study also shows that the political appointments of judges have eco-

nomic consequences for firms. Prior research has documented how the

characteristics and quality of securities laws and their enforcements affect

firms (see review by La Porta, Lopez-de-Silanes, and Shleifer [2008]). How-

ever, the outcomes of securities law enforcement depend heavily on the

judicial system (Hay and Shleifer [1998]). In the United States, courts han-

dle private enforcement of securities laws, and public enforcements such as

3In line with the above definitions, ideological differences between liberals (Democrats)

and conservatives (Republicans) in the context of securities class action lawsuits are also re-

flected in the debates that took place during the passage of the Private Securities Litigation

Reform Act of 1995 (PSLRA). The PSLRA includes a diverse assortment of provisions to pro-

tect firms against perceived abuses in securities class action lawsuits, such as raising the burden

of proof for plaintiffs. When the Republican-controlled Congress passed the PSLRA in 1995,

all opposition votes to the bill were from Democratic congress members. Democratic Presi-

dent Clinton initially vetoed the bill, before Republicans overrode the veto and enacted the

law.