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Shareholder Litigation Rights and Corporate Acquisitions

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Chune Young Chung (정준영), Incheol Kim, Monika K. Rabarison, Thomas Y. To & Eliza Wu — Journal of Corporate Finance, Vol. 62 (2020) 101599. doi:10.1016/j.jcorpfin.2020.101599

Research Question

Do shareholder class action lawsuits discipline managers' acquisition decisions, or do they merely divert executive attention toward minimizing legal risk rather than maximizing shareholder wealth? The finance literature recognizes that agency problems can lead managers to conduct empire-building acquisitions, and shareholder litigation is often cited as an important external governance mechanism that should constrain such behavior. Yet the empirical evidence on whether the threat of class action litigation actually improves acquisition outcomes has remained sparse.

This paper addresses the question directly by exploiting the U.S. Ninth Circuit Court of Appeals ruling on July 2, 1999 — In re: Silicon Graphics Inc. Securities Litigation — as a quasi-natural experiment. The ruling imposed a stricter "deliberate recklessness" standard for class action plaintiffs in Ninth Circuit states (Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington), reducing class action filings in those states by 43% while filings in other circuits increased by 14%. This exogenous reduction in litigation threat enables a clean difference-in-differences (DID) identification strategy.

Data and Methodology

The sample covers 2,549 corporate acquisitions announced between 1996 and 2003 from the Securities Data Company (SDC) M&A database, requiring a minimum deal value of USD 1 million and full ownership transfer. The treatment group consists of acquiring firms headquartered in Ninth Circuit states; the control group consists of firms headquartered elsewhere. Accounting data are from Compustat, market data from CRSP, and governance data from ExecuComp and Riskmetrics.

The main dependent variable is the acquirer's five-day cumulative abnormal return (CAR) around the announcement date, CAR(−2, +2), calculated using the market model with CRSP value-weighted returns. The DID coefficient of interest is β on the interaction term Treat × Post, where Treat = 1 for Ninth Circuit firms and Post = 1 for post-1999 deals. Propensity score matching (PSM) is used to construct a matched control sample and address observable differences between treatment and control groups. Corporate governance is measured using four proxies: the E-index, institutional blockholder concentration, CEO ownership, and CEO duality.

Key Results

Main Effect: Announcement Returns

After the Ninth Circuit ruling, acquirers in treatment states experienced five-day CARs that were 1.32 percentage points lower than those of acquirers in other states (Table 3, Column 2; t = −2.96, significant at 1%). This negative market reaction represents a loss of approximately USD 28 million in shareholder value for the median Ninth Circuit acquirer. Using the PSM matched sample, the coefficient on Treat × Post is −2.18 percentage points (significant at 1%), confirming robustness to selection bias. Results hold across multiple sensitivity tests: excluding tech firms, excluding the bubble years 1999–2000, excluding Silicon Valley firms, and using a border-state identification strategy.

Mechanism: Empire Building with Overvalued Equity

The value destruction is transmitted through two channels. First, after the ruling, Ninth Circuit firms acquired significantly larger targets (OLS coefficient on Treat × Post = 0.046**, Table 5 Column 1), consistent with empire-building motives. Second, they were significantly more likely to use stock as the method of payment (probit coefficient = 0.297**, Table 5 Column 2), with the two-stage PSLM confirming both results jointly. These findings support the hypothesis that managers, freed from litigation threat, funded larger deals using overvalued equity.

Earnings Management and Managerial Optimism

Two additional tests illuminate the overvalued equity channel. In the quarter before acquisitions, firms in Ninth Circuit states exhibited significantly higher abnormal accruals for stock deals (Table 7 Panel B: Treat × Post = 2.328***, t = 6.66) but not cash deals, indicating upward earnings manipulation to boost pre-announcement stock prices. Furthermore, management EPS forecast errors increased by 2.15 cents in Ninth Circuit states post-ruling (absolute forecast error: Treat × Post = 2.150*, t = 1.75; directional error: 1.931**, t = 2.27), indicating that managers became systematically over-optimistic when announcing future earnings surrounding M&A deals.

Heterogeneity: Corporate Governance Quality

Consistent with shareholder litigation being most valuable as a governance backstop for poorly governed firms, the value destruction from the ruling is concentrated in acquirers with weaker internal governance (Table 6). The negative effect on CARs is significant for firms with high E-index scores (−1.045*, weaker governance) but not for firms with low E-index scores (−0.675, ns). Similarly, the effect is significant for firms with fewer institutional blockholders (−1.748**, t = −2.22), lower CEO ownership (−1.407***, t = −2.91), and CEO duality (−1.638**, t = −2.13). The reduced threat of litigation provides the greatest freedom to self-serving managers precisely where board monitoring and ownership alignment are already weak.

CEO Turnover and Managerial Entrenchment

The reduced threat of class action litigation also decreases CEO accountability after bad deals: the likelihood of forced CEO replacement following value-destroying acquisitions falls by 3.4 percentage points in Ninth Circuit states post-ruling (Table 7 Panel C, Column 4; marginal effect = −0.039, significant at 1%). This finding underscores that litigation threat previously served as an important disciplinary lever for removing underperforming managers — one that internal governance mechanisms failed to replicate once the external check was weakened.

Implications for Institutional Investors

This paper has direct implications for how stewardship teams and proxy advisors should assess M&A risk within their portfolios.

  • Litigation environment as a governance variable. Regulatory changes that reduce shareholder litigation rights — whether through court rulings, legislative reform, or forum selection bylaws — meaningfully weaken external governance in ways that internal mechanisms do not fully compensate for. Investors should incorporate litigation environment into their governance assessments.
  • M&A announcement as a governance signal. Negative market reactions around M&A announcements, particularly in weakly governed firms, may signal empire-building behavior. The paper shows that acquirers with high E-index, low blockholder concentration, low CEO ownership, and CEO duality are most likely to engage in value-destroying acquisitions when litigation threat falls.
  • Earnings guidance and stock-financed deals warrant heightened scrutiny. Managers who manipulate pre-deal EPS forecasts upward and then use the resulting stock overvaluation to fund acquisitions impose losses on target and acquirer shareholders alike. Monitoring earnings guidance optimism in the quarters before large acquisitions — especially equity-financed ones — is a practical early warning signal.
  • Voting against director accountability provisions. The finding that reduced litigation threat decreases forced CEO turnover after poor acquisitions suggests that board accountability provisions (separation of CEO and chair roles, removal of classified boards, majority voting) serve as partial substitutes for external litigation discipline. Proxy advisors should weigh these provisions more heavily for firms in jurisdictions with restricted shareholder litigation rights.

Selected References

  1. Jensen, M.C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review, 76(2), 323–329.
  2. Masulis, R.W., Wang, C., & Xie, F. (2007). Corporate governance and acquirer returns. Journal of Finance, 62(4), 1851–1889.
  3. Crane, A.D., & Koch, A. (2018). Shareholder litigation and ownership structure. Journal of Financial and Quantitative Analysis, 53(6), 2663–2699.
  4. Chu, Y., & Zhao, J. (2019). The dark side of shareholder litigation: Evidence from corporate takeovers. Financial Management, 48(2), 581–612.
  5. Houston, J.F., Lin, C., & Xie, W. (2019). Shareholder protection and the cost of capital. Journal of Law and Economics, 62(4), 581–619.