XXV Edition

1-2 December 2016"

How Do Firms Weather Increasing Legal Risk: Some New Evidence

Oliviero Tommaso, University of Naples Federico II
Park Min, University of Exeter
Zou Joe Hong, University of Hong Kong

There are two competing arguments on the effects of litigation risk on firms’ cash holding policy - i.e., the precautionary cash hoarding hypothesis that predicts more cash holdings and the strategic bargaining hypothesis that predict less cash holdings. We examine this issue by exploiting the passage of a law in 2003 that introduced shareholder class actions in Korea to a group of firms. We find that firms affected by the law hoard more cash in anticipation of increasing shareholder litigation risk, which is more consistent with the precautionary cash hoarding hypothesis. The result is concentrated in firms that carry no D&O insurance before the law change or firms that carry D&O insurance but pay a higher price. Additionally we find that firms that are exposed to high litigation risk appear to issue more equity to accumulate cash, and experience an improvement in performance after the passage of the law. Our evidence adds to the inconclusive literature on the effect of litigation risk on cash holdings, and is relevant to the debate over the deterrence and remedy value of securities class actions in the US.

Area: Capital Structure and Corporate Finance

Keywords: Liquidity; Litigation; Investor protection

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