Shareholder Litigation and Corporate Disclosure: Evidence from Derivative Lawsuits

• Author: RENCHENG WANG,YUN LOU,THOMAS BOURVEAU
• DOI: http://doi.org/10.1111/1475-679X.12191
• Date: 01 June 2018
• Published date: 01 June 2018

DOI: 10.1111/1475-679X.12191

Journal of Accounting Research

Vol. 56 No. 3 June 2018

Printed in U.S.A.

Shareholder Litigation and

Corporate Disclosure: Evidence

from Derivative Lawsuits

THOMAS BOURVEAU,

∗YUN LOU,

†AND RENCHENG WANG

‡

Received 7 December 2015; accepted 31 October 2017

ABSTRACT

Using the staggered adoption of universal demand (UD) laws in the United

States, we study the effect of shareholder litigation risk on corporate disclo-

sure. We find that disclosure significantly increases after UD laws make it

more difficult to file derivative lawsuits. Specifically, firms issue more earn-

ings forecasts and voluntary 8-K filings, and increase the length of manage-

ment discussion and analysis (MD&A) in their 10-K filings. We further assess

the direct and indirect channels through which UD laws affect firms’ disclo-

sure policies. We find that the effect of UD laws on corporate disclosure is

driven by firms facing relatively higher ex ante derivative litigation risk and

higher operating uncertainty, as well as firms for which shareholder litigation

is a more important mechanism to discipline managers.

∗Hong Kong University of Science and Technology; †Singapore Management University;

‡University of Melbourne.

Accepted by Philip Berger. Weare grateful for the constructive comments and suggestions

from an anonymous reviewer.We appreciate the feedback from Pat Akey, Mary Billings (discus-

sant), Francois Brochet, Brian Cadman, Xia Chen, Qiang Cheng, Ed deHaan, Fabrizio Ferri,

Denis Gromb, Rachel Hayes, Gilles Hilary, Justin Hopkins, Charles Hsu, Ian Gow, Bin Ke,

Christian Leuz, Xi Li, Yinghua Li, Hai Lu, Russell Lundholm, Greg Miller, Clemens Otto, Sug-

ata Roychowdhury, Jordan Schoenfeld, Nemit Shroff, Douglas Skinner, Florin Vasvari, Holly

Yang, Liandong Zhang, and seminar participants at HEC Paris, National Singapore University,

Nanyang TechnologicalUniversity, Singapore Management University, Tilburg University, the

2016 Utah Winter Accounting Conference, and the 2016 European Accounting Association

Annual Congress. We thank Bill McDonald and Stephen Brown for sharing the data on firms’

historical states of incorporation and MD&A sections in 10-K filings with us. We also thank

Reeyarn Zhiyang Li for his excellent research assistance on 8-K filings. All errors are our own.

797

Copyright C, University of Chicago on behalf of the Accounting Research Center,2017

798 T.BOURVEAU,Y.LOU,AND R.WANG

JEL codes: G10; M41

Keywords: corporate governance; derivative lawsuits; corporate disclosure;

shareholder litigation; universal demand laws

1. Introduction

Corporate governance is a nexus of mechanisms to ensure that managers’

interests are aligned with those of shareholders (Jensen [1993], Shleifer

and Vishny [1997]). Prior literature shows that lawsuits brought by share-

holders play an important role in reducing agency conflicts between man-

agers and shareholders (e.g., Cheng et al. [2010]). After all, shareholders

can effectively discipline managers only if they pose a credible threat to

managers. Shareholders also require timely and reliable disclosure to effi-

ciently monitor managers (Armstrong, Guay, and Weber [2010]). But how

exactly shareholder litigation interacts with corporate disclosure to align

managers’ and shareholders’ interests is not entirely understood (Arm-

strong, Guay, and Weber [2010]). In this paper, we exploit unexpected

regulatory changes that affect shareholders’ ability to pursue derivative law-

suits to examine the effect of shareholder litigation on a firm’s disclosure

decisions.1

Specifically, we use the staggered adoption of universal demand (UD)

laws across different U.S. states as a source of exogenous variation in the

threat of derivative lawsuits to identify the causal effect of changes to share-

holder litigation risk on corporate disclosure. UD laws require derivative

plaintiffs (i.e., shareholders) to make a demand on a firm’s board of di-

rectors before filing a derivative lawsuit. The board of directors usually re-

fuses this request since most of the members are named as defendants in

the lawsuit. Hence, the adoption of UD laws imposes a significant hurdle

for shareholders to file derivative lawsuits. Consequently, the litigation risk

pertaining to derivative lawsuits has decreased significantly following the

passage of UD laws (Appel [2016]).

Derivative lawsuits are lawsuits brought by shareholders in the name of

the firm to sue its management. They are a mechanism to enforce man-

agers’ fiduciary duties and force managers to compensate the firm for the

damage they allegedly caused. The settlements of derivative lawsuits often

come at significant costs to managers. First, derivative lawsuits may lead to

direct pecuniary costs (Erickson [2010]) and reputational penalties (Bro-

chet and Srinivasan [2014]). Second, the settlements of derivative lawsuits

often contain corporate governance reforms that reduce managerial en-

trenchment. For example, Ferris, Jandik, and Lawless [2007] find that the

1An important difference between our study and the prior literature on the relation be-

tween shareholder litigation and corporate disclosure (e.g., Johnson, Kasznik, and Nelson

[2001]) is that our study does not exclusively rely on the assumption that corporate disclosure

can trigger shareholder litigation. We argue that shareholder litigation can also influence cor-

porate disclosure indirectly through its role as a governance tool.

SHAREHOLDER LITIGATION AND CORPORATE DISCLOSURE 799

settlements of derivative lawsuits are followed by an increase in the number

of independent directors. Thus, derivative lawsuits not only have a direct

impact on managers but also have an indirect effect on the firm’s corpo-

rate governance structure.

We hypothesize that the decrease in the derivative litigation risk can af-

fect firms’ disclosure policies directly through changes in expected costs

and benefits related to potential derivative lawsuits and indirectly via the

role of derivative lawsuits as a corporate governance tool. First, the change

in expected litigation costs such as monetary payoffs and reputational dam-

age can alter managers’ incentives to disclose information. Specifically,

managers trade off costs and benefits when deciding whether to disclose

private information. On the one hand, managers may voluntarily disclose

bad news because such disclosures may prevent litigation in cases of large

stock price declines (Skinner [1994]). If so, when the threat of deriva-

tive lawsuits decreases, the marginal benefit of disclosing bad news also

decreases. As a result, managers may opportunistically reduce bad news

disclosure. On the other hand, managers may avoid voluntarily disclos-

ing forward-looking information because such disclosures may invite future

shareholder lawsuits (Johnson, Kasznik, and Nelson [2001], Rogers and

Stocken [2005]). Hence, when the decreased derivative litigation risk re-

duces the marginal cost of such disclosures, managers may be more willing

to disclose.

Second, the reduction in the threat of derivative lawsuits can also affect

disclosure policies indirectly through the role of derivative lawsuits as a

corporate governance mechanism. Appel [2016] argues that derivative

lawsuits play an important role in disciplining managers. He shows that

a decrease in the derivative litigation risk can weaken firms’ corporate

governance quality and lead to an increase in governance provisions (e.g.,

classified boards) that entrench managers. This creates two opposing

effects on firms’ disclosure policies. On the one hand, the decrease in

the derivative lawsuit risk can reduce shareholders’ ability to discipline

managers using shareholder litigation rights, which in turn increases

shareholders’ demand for more information to monitor managers. For

example, for firms where derivative lawsuits are a more important gov-

ernance tool for shareholders to discipline managers, the demand for

corporate disclosure should be stronger following the decrease in the

derivative litigation risk. On the other hand, the reduction in the threat

of derivative lawsuits can lead to more managerial entrenchment, which

may affect managers’ incentives for disclosure. For example, entrenched

managers may want to stay opaque and share less information with the

capital markets in order to enjoy private benefits (e.g., Ferreira and Laux

[2007]).

Therefore, it is unclear ex ante whether and how the decrease in the

derivative lawsuit risk can affect firms’ disclosure policies. Our main

empirical finding is consistent with an increase in corporate disclosure

in response to a reduction in the threat of derivative lawsuits due to the