1 Empirical Studies of Corporate Law Sanjai Bhagat Professor of Finance, University of Colorado at Boulder and Roberta Romano Allen Duffy/Class of 1960 Professor of Law, Yale University, NBER and ECGI for “Handbook of Law and Economics” edited by A. Mitchell Polinsky and Steven Shavell Harvard Law School Cambridge, MA

2 Stock Market Response for Defendant Corporations by Opponent type

3 Shareholder Wealth Implications of Corporate Lawsuits Table 1, Panel A: Announcement period abnormal returns for defendant corporations by opponent type. –At filing: Large negative impact when government is the plaintiff. –On settlement: Large positive impact when another corporation is the plaintiff. Table 1, Panel B: Announcement period abnormal returns at filing for plaintiff corporations by opponent type: –Non-positive market reaction for plaintiffs in most cases. –Positive impact in antitrust cases when other side is another corporation. Table 1, Panel C: Announcement period abnormal returns for defendant corporations by type of legal issue. –Large negative impact on filing for –Environment suits –Fraud of government –Financial reporting fraud

4 Stock Market Response for Plaintiff Corporations by Opponent type

5 Stock Market Response for Defendant Corporations by Type of Legal Issue

6 Shareholder Wealth Implications of Corporate Lawsuits –Bhagat, Brickley and Coles (JFE, 1994) –Bhagat, Bizjak, and Coles (FM, 1998) –Bhagat and Romano (ALER, 2002a & 2002b) –Costs and benefits of Filing a lawsuit Settling Going to trial Likely to be a function of Type of suit (antitrust, disclosure laws, etc.) The opposition (government, another corporation, etc.)

7 Shareholder Wealth Implications of Corporate Lawsuits Suits involving Corporations and Government Entities –Net Present Value (NPV) = Present value of benefits – Present value of costs. –Corporate managers take actions in litigation that have positive NPV, and eschew courses of action that have negative NPV. Reasonable approximation assuming Alignment of management incentives with shareholders. Firms’ low cost of access to capital markets. –Government decision-makers unlikely to use the NPV rule.

8 Shareholder Wealth Implications of Corporate Lawsuits Suits involving Corporations and Government Entities –Government decision-makers unlikely to use the NPV rule. Less constrained by financial and legal resources. Incentive to overspend legal resources in a suit. –Some cases define agency or government powers. –Visibility associated with winning can affect survival and funding of government unit. –Opposing corporations face free-rider problems. Winning a suit and establishing a legal precedent can provide benefits for many firms, but the entire cost of the suit is absorbed by the litigating corporation. –Coase Theorem: Private litigants have an incentive to settle a dispute when doing so would be mutually economically beneficial.

9 Shareholder Wealth Implications of Corporate Lawsuits Suits involving Corporations and Government Entities –Government decision-makers unlikely to use the NPV rule. Litigation-related financial distress costs (terminated trade credit, lower market value of warranties) is an important determinant of the change in shareholder wealth for corporations. While government agencies face the possibility of decreased funding or elimination, they do not face the usual costs of financial distress. Sued firms risk debarment from government contracts, an exclusion that potentially represents a huge loss. Government lawsuits can attract large publicity, resulting in larger reputational losses.

10 Shareholder Wealth Implications of Corporate Lawsuits Interfirm Suits (involving corporations as plaintiffs and defendants) –Corporate managers take actions in litigation that have positive NPV, and eschew courses of action that have negative NPV. –Importance of financial distress costs (fdc). Direct fdc in bankruptcy: legal + administrative fees: Small. Indirect fdc prior to bankruptcy: Large.

11 Shareholder Wealth Implications of Corporate Lawsuits Interfirm Suits (involving corporations as plaintiffs and defendants) Indirect fdc prior to bankruptcy: Large. Costs include –Lower sales. –Inability to do business with customers and suppliers on favorable terms. –Greater difficulty of raising funds or obtaining credit. –Distraction of management. –Inefficient investment policy. (“underinvestment.doc” With risky debt outstanding, managers sometimes pass up profitable opportunities.

12 Shareholder Wealth Implications of Corporate Lawsuits Suits involving corporations and private citizens –Reduced access to capital markets by most private citizens imply reduced ability to litigate, and smaller wealth effects on firms. –Some suits filed by individuals foreshadow a mass tort, a class action, or multiple follow-on suits, or motivate government litigation. In such cases, wealth implication on corporation could be substantial.

13 Shareholder Wealth Implications of Corporate Lawsuits Legal Issue affects cost of a lawsuit and behavior in suit settlement and trial. –Certain types of violations carry large penalties. Trebling of damages in antitrust suits. Large punitive damage awards. Class action or multiple follow-on suits. –Differing reputational costs. High for product-liability and environmental cases. “Low” for antitrust cases. –Differing impact on other customers and suppliers. Plaintiff in a patent infringement dispute might be more likely to incur the costs of a trial to prevent the defendant from profiting and to discourage other firms from violating the patent. Plaintiff in a breach of contract suit may be more likely to settle a suit to maintain good relations with the defendant-supplier and other potential suppliers who could observe the formal dispute.

14 Shareholder Wealth Implications of Corporate Lawsuits Conclusions –Lawsuits are not a value-enhancing way for corporations to settle their disagreements with other corporations. –The market appears to impose a higher sanction on firms than actual legal sanctions. KL (1993, 1999): criminal restitution, civil penalties and court costs comprise only about 7 percent of the shareholder wealth loss. Remaining 93 percent can be attributed to the reputational loss suffered by the defendant firms.