Corporate Governance and Shareholder Litigation

By Kalchev, Georgi | IUP Journal of Corporate Governance, April 2009 | Go to article overview

Corporate Governance and Shareholder Litigation


Kalchev, Georgi, IUP Journal of Corporate Governance


Introduction

Many theoretical and empirical papers address the monitoring mechanisms that shareholders engage in to ensure that managers represent their interests. Some mechanisms to monitor the managers have large shareholders (Schleifer and Vishny, 1986), effective boards of directors (Fama and Jensen, 1983), executive stock ownership (Jensen and Meckling, 1976), etc.

However, one area that has been studied relatively little is shareholder litigation. Shareholders can sue managers for breach of their fiduciary duties to them, inaccurate disclosure, fraud-on-the-market, etc. Shareholders resort to litigation when corporate governance has failed to represent their interests and resolve their grievances. Thus, it represents the ultimate failure of governance and the ultimate expression of shareholder activism. Shareholders have been suing with increasing frequency in recent years. Ever since the corporate scandal of Enron, corporate failures have been receiving increased media attention. The Sarbanes-Oxley Act, passed by the Congress in 2002, devised new rules for corporate governance and litigation.

Shareholder litigation is directly linked to corporate governance. Since litigation is the result of governance failure, good governance should be associated with less shareholder litigation and bad governance with more litigation. If managers genuinely represent shareholders' interests (which is the goal of good governance), shareholders would not have a reason to sue. It is when managers fail in their duties to the shareholders that the latter sue the former. Thus, it is an interesting empirical question whether good corporate governance results in less litigation and vice versa. No study seems to have sufficiently answered this question in a large representative sample.

This study utilizes both the Institutional Shareholder Services (ISS) securities litigation database and the Investor Responsibility Research Center (IRRC) governance database, to examine the effects of quality of governance on the probability of being sued. These two major databases are appropriately matched in order to obtain governance variables and to measure their influence on the incidence of securities related to litigation. Recently, there has been an increased interest in corporate governance. The IRRC database is the same database used by a successful and well-known study of stock returns and governance by Gompers et al. (2003).

The question to be answered ultimately is whether better corporate governance leads to a lower probability of shareholder litigation and a more successful resolution of the significant agency problems between shareholders and managers. Gompers et al. (2003) suggested that elimination of governance defense provisions may produce significant gains in equity returns. Perhaps, similar elimination and improvement of corporate governance may lead to less litigation, making both shareholders and managers beneficiaries, increasing investor wealth. This paper provides some empirical insights on the above.

The question remains open. Will better governance be the magic fix that will make managers accountable to shareholders? Does better corporate governance mechanisms make shareholders better off? Looking at past relationships between governance measures and litigation will reveal whether they relieve the agency problems at all or not. It also tests whether corporate governance has any predictive power with regard to securities litigation. This is an opportunity to test the importance of corporate governance for the overall efficiency of the economic system. It provides more insight into the corporate form of organization, which is so dominant in American businesses. An examination of the state of securities litigation in the US reveals important insights of interest to both practitioners and academics.

We construct a governance index based on principal components. While the Gompers et al. (2003) index assigns equal weights to all the variables, the principal components index assigns different weights to the variables. …

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