Litigation risk and firm performance: The effect of internal and external corporate governance

• Published date: 01 July 2020
• DOI: http://doi.org/10.1111/corg.12319
• Date: 01 July 2020

ORIGINAL ARTICLE

Litigation risk and firm performance: The effect of internal and

external corporate governance

Wuqing Wu

1

| Fei Peng

1

| Yuan George Shan

2

| Lu Zhang

2,3

1

Department of Accounting, School of

Business, Renmin University of China, Beijing,

China

2

Department of Accounting and Finance,

UWA Business School, The University of

Western Australia, Crawley, Western Australia,

Australia

3

Department of Accounting, School of

Economics and Management, Zhejiang Ocean

University, Zhoushan, China

Correspondence

Yuan George Shan, Department of Accounting

and Finance, UWA Business School, The

University of Western Australia, M250,

35 Stirling Highway, Crawley WA 6009,

Australia.

Email: george.shan@uwa.edu.au

Funding information

Social Science Foundation of Beijing, Grant/

Award Number: 17GLB022; National Natural

Science Foundation of China, Grant/Award

Number: 71871216

Abstract

Research Question/Issue: We argue that findings regarding litigation risk in the

United States are not applicable in the Chinese context because Chinese firms are

more dependent on debt financing for their operations compared with US firms.

Thus, we raise the following research questions to test potential differences: Is litiga-

tion risk associated with firm performance? Does effective internal control of gover-

nance improve the performance of lawsuit firms? Do financial analysts improve the

performance of lawsuit firms? Does debt financing mediate the effect of litigation

risk on firm performance?

Research Findings/Insights: Our results indicate that litigation claims for large mone-

tary amounts are negatively associated with firm performance, whereas internal gov-

ernance and analyst following moderate the negative effects of litigation risk. We

further examine the mediating effect of debt financing on the relationship between

litigation risk and firm performance, finding that litigation risk is negatively associated

with firm performance through excessive leverage, increased cost of debt, reduced

bank borrowing, and trade credit.

Theoretical/Academic Implications: By empirically testing the mediation effect of

debt financing, this study enhances the understanding of the underlying causes of

the association between a firm's litigation risk and its performance.

Practitioner/Policy Implications: The findings will help firm managers to review liti-

gation risks, better understand the economic mechanisms of litigation risk, and pro-

mote risk control to regulate their behaviors. We also find that financial analysts can

correct the adverse effects of litigation risk; thus, we recommend that the financial

analyst profession be further normalized.

KEYWORDS

corporate governance, external corporate governance, firm performance, internal corporate

governance litigation risk

JEL CLASSIFICATIONS

G30; K15; K41

Received: 17 April 2019 Revised: 6 April 2020 Accepted: 8 April 2020

DOI: 10.1111/corg.12319

210 © 2020 John Wiley & Sons Ltd Corp Govern Int Rev. 2020;28:210–239.wileyonlinelibrary.com/journal/corg

1|INTRODUCTION

Most research on litigation risk has focused on developed economies

such as the US stock market and two major forms of shareholder liti-

gation: securities class actions (Arena & Julio, 2015; Cheng, Huang,

Li, & Lobo, 2010) and derivative lawsuits (Bourveau, Lou, &

Wang, 2018; Ferris, Jandik, Lawless, & Makhija, 2007; Nguyen,

Phan, & Sun, 2018; Ni & Yin, 2018; Yuan & Zhang, 2016). However,

the findings of these studies are not necessarily generalizable to other

countries, particularly those following a civil law system and develop-

ing economies such as China, where securities lawsuits are less com-

mon than in the United States.

Securities lawsuits occur more commonly in the United States

because the Securities and Exchange Commission (SEC) Rule 10b-5

safeguards investors' legal right of action against listed firms and firm

directors for material misstatements or fraud (Arena & Ferris, 2018).

The legal protection of shareholders' rights is recognized as an essen-

tial element of corporate governance (Shleifer & Vishny, 1997). Cheng

et al. (2010) find that shareholder litigation plays an important corpo-

rate governance role by alleviating agency conflict between managers

and shareholders. Bourveau et al. (2018) and Nguyen et al. (2018) sug-

gest that the primary role of the derivative lawsuit as a corporate gov-

ernance tool is to signal corporate governance reform. However, the

findings in countries operating under civil law systems differ. For

example, Arena and Ferris (2018) state that corporate laws in coun-

tries with civil law systems do not enable the initiation of class action

litigation as easily as does US corporate law. The authors find that the

sample of lawsuits in their study is not dominated by securities class

actions and that corporate litigation risk is lower for firms located in

countries with civil law and less developed judiciary and legal systems.

Dash and Raithatha (2018) suggest that securities class action lawsuit

processes are not applicable to most emerging economies because

they have different regulatory mechanisms and their economic and

institutional development are at different stages.

We argue that the findings from US studies do not apply in the

Chinese context. China is an appropriate research setting for examin-

ing the relationship between litigation risk and firm performance for

several reasons. First and most importantly, capital structures in the

United States and China are different. The proportion of internal

financing of firms in the United States is approximately 53%, whereas

the proportion of debt financing is 21.47% (Beck, Demirgüç-Kunt, &

Maksimovic, 2008). However, in China, external financing accounts

for more than 80% of corporate financing (Zheng, 2004) of which

67.10% is debt financing.

1

These statistics suggest that Chinese firms

are more dependent on debt financing for their operations compared

with US firms.

Second, Chinese courts and their jurisdictions differ from those

in the United States. The court system in China was established in

accordance with the Constitution of the People's Republic of China,

the Criminal Procedure Law of the People's Republic of China, and

the Administrative Procedure Law of the People's Republic of China.

Under this legal structure, the monetary amount involved in com-

mercial litigation, rather than the details of the lawsuit itself,

determines the level of court in which a case is processed (Firth,

Rui, & Wu, 2011).

Third, although China has experienced astonishing economic

growth in recent decades, its legal system remains relatively underde-

veloped and highly capricious (Allen, Qian, & Qian, 2005; Firth

et al., 2011). Thus, China is striving to strengthen government legisla-

tion and improve the investment and market environment, providing

an appropriate setting in which to examine the effect of corporate

governance, including internal controls and external supervision

mechanisms, on the relationship between litigation risk and firm per-

formance. These explorations are not only to China but also to other

countries transitioning from state control to a market-oriented

economy.

Litigation in China is an expensive way of resolving conflicts

between shareholders and firms (or boards of directors). Contempo-

rary research focuses on the effect of litigation risk on certain aspects

of business operations and rarely investigates the relationship

between litigation risk and overall firm financial performance. This

means that firms may not pay sufficient attention to the risk of litiga-

tion and may implement their own risk control mechanisms to reduce

litigation risk (Mao & Meng, 2013; Wang, Jiang, & Xin, 2016).

Because China provides a useful setting in which to test the

abovementioned potential differences, we pose the following

research questions. First, is litigation risk associated with firm perfor-

mance? We predict a negative relationship between litigation risk and

firm performance because litigation is often correlated with lower firm

value (Lin, Zhou, Shu, & Liu, 2013) and leads to a deterioration in rela-

tionships between firm's customers and suppliers, thus influencing the

firm's business activities (Koh, Qian, & Wang, 2014). Second, does

effective internal control of governance improve the performance of

lawsuit firms? We predict a positive association here because internal

corporate governance mechanisms (CGMs) can reduce conflicts of

interest between managers and shareholders (Shan, 2013, 2015) and

further moderate the adverse effects of litigation risk on firm operat-

ing performance. Third, do financial analysts improve the performance

of lawsuit firms? We predict a positive association because the finan-

cial analyst is viewed as an important information intermediary in the

financial market, playing the monitoring role of an external advisor

(Chen, Cumming, Hou, & Lee, 2016; Hu, Wang, Tao, & Zou, 2016;

Wu, Jie, & Su, 2017). Fourth, does debt financing mediate the effect

of litigation risk on firm performance? We predict that debt financing

will have a mediating effect because debtholders of firms at risk of liti-

gation are likely to re-evaluate their financial positions (Rajan &

Winton, 1995) and increase future borrowing costs (Deng, Willis, &

Xu, 2014).

We use a dataset containing 15,297 firm-year observations for all

Chinese listed firms on the Shanghai Stock Exchange and the

Shenzhen Stock Exchange for the period 2007–2016. Our focus is on

civil litigation. Unlike in US research on corporate lawsuits, the 2,045

lawsuits in our sample include not only securities class actions but also

other types of lawsuits: arbitration, criminal proceedings, civil litiga-

tion, and administrative litigation.

2

Our main empirical finding indi-

cates that litigation risk is negatively associated with firm

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