The Effect of Litigation Risk on Managerial Risk-Taking

Publicly-traded firms always face the risk of litigation from their shareholders. Managers’ perceptions of that risk may influence their strategic decision-making, yet little is understood about how. In this paper, we view litigation as a shareholder monitoring mechanisms that can affect managers’ perceptions and subsequent decision-making processes, and we investigate the effect of shareholder litigation risk on managerial risk-taking. Specifically, we propose that the risk of shareholder litigation will lead managers to be more risk-averse. Treating the staggered adoption of Universal Demand (UD) law in 23 U.S. states from 1989 to 2005 as an exogenous change reducing the potential for shareholder litigation, we investigate the causal effect of shareholder litigation on managerial risk-taking on a sample of large U.S. publicly- traded firms, some exposed to the UD law, others not. Further, we investigate the moderating effect of CEO incentive alignment by proposing that the level of CEO firm-performance contingent pay strengthens the relationship between UD law adoption and managerial risk- taking. By doing so, we shed additional light on the relationship between two corporate governance mechanisms: CEO incentive alignment and shareholder monitoring.