Conclusions
We use the staggered adoption of UD laws, which hinder shareholders’ right to initiate derivative lawsuits, by 23 states in the United States over the period 1989-2005 as a quasi-natural experiment to identify the relation between shareholder litigation as a corporate governance mechanism and corporate cash holdings. We find that firms incorporated in the states that adopted UD laws decrease cash reserves but increase investments and firm risk following the passage of the laws. We further find that the value of cash to shareholders increases following the adoption of UD laws and the effect of UD laws on the value of cash is stronger for financially constrained firms. The results of our analysis suggest that firms are concerned about the risk of derivative lawsuits so they hold larger cash reserves for precautionary purpose. The adoption of UD laws imposes hurdles to derivative lawsuits, which decrease the risk of shareholder litigation. Reduced derivative lawsuit threat motivates firms to lower cash reserves while deploying cash for investment in risk-increasing but value-enhancing projects, leading to an increase in the value of cash. Our evidence highlights the dark side of shareholder litigation, particularly derivative lawsuits, which induces conservative corporate policies and adversely affects shareholder value.
