The interaction of law and corporate decisions

This dissertation studies the interaction of law and corporate decisions. The first essay investigates the litigation risk hypothesis (LRH) of the Initial Public Offering (IPO) underpricing puzzle based on evidence from the Private Securities Litigation Reform Act of 1995 (PSLRA). Lowry and Shu (2002) construct a simultaneous equations system and find evidence supporting the LRH. On one hand, issuers expecting higher litigation risk will underprice their IPOs more as a form of insurance against future lawsuits (insurance effect). On the other hand, issuers with higher IPO underpricing have a better chance of deterring lawsuits (deterrence effect). Using the passage of the Private Securities Litigation Reform Act in 1995 as a stronger instrumental variable than the one used in their studies, we find empirical results countering the insurance effect of the LRH and find that the reported systematic link between litigation risk and IPO underpricing is mainly driven by the choice of their instrumental variable. Furthermore, using a slightly different sample period than theirs, we find no significant deterrence effect of the LRH either prior to or following the enactment of the PSLRA. Their results are not persistent in our sample period. In summary, our results are against the LRH for both insurance effect and deterrence effect. We additionally show that the PSLRA did reduce IPO firms' litigation risk and that there is less "deep pocket" digging and less "racing to the courthouse" in the post-PSLRA period.; In the second essay, we study the role that the legal environment might play in recent corporate scandals. Some legislators believe the PSLRA, instead of deterring frivolous lawsuits as it was intended to, deterred meritorious lawsuits and resulted in many of the recent corporate frauds. They further argue that the Sarbanes-Oxley Act of 2002 (SOA) is an important counter to the PSLRA. Using several event study approaches, we investigate shareholder reaction to a series of legislative events related to the passage of the PSLRA and the SOA. From the shareholders' point of view, we find both statistically and economically significant negative abnormal returns during the passage of the PSLRA in the group of high litigation risk firms that are more likely to face meritorious lawsuits; conversely, there is no significant stockholder reaction to the passage of PSLRA in the group of high litigation risk firms which are likely to face frivolous lawsuits. Furthermore, shareholders of both groups react negatively and significantly to the passage of the SOA. Our results suggest that shareholders believed the PSLRA would deter meritorious lawsuits instead of frivolous lawsuits as it was intended to. In addition, the PSLRA reduces the important legal monitoring achieved by meritorious lawsuits and increases the incidence of fraud. Even more disappointing, shareholders did not believe the recently passed SOA would counter the effect of the PSLRA by bringing better protections for investors against corporate fraud.