Corporate alliances and mergers and acquisitions (M&As) are the alternative strategies for external growth that expand firms’ boundaries. A recent report by KPMG suggests that about half of the responding CEOs said they plan to form a new alliance to enhance their corporate performance and growth, while four out of ten plan to make a new acquisition. Given the increasing significance of corporate alliances (i.e., strategic alliances and joint ventures) in recent decades, it is worth investigating how firms select between corporate alliances and M&As to realize their external expansion demands. In our recent paper, we examine this issue by employing the staggered adoption of universal demand (UD) laws which significantly reduce the threat of shareholder derivative lawsuits.
Firms often face legal challenges following rapid expansion through M&A, such as alleging a breach of security law, accounting malpractice, and director misbehavior. In contrast, corporate alliances involve relatively low litigation risk as the scope for shareholder wealth destruction is generally considerably lower in alliances. Further, forming alliances allows firms to put less capital at risk and rely on partners’ financial and knowledge capital. Would alliance be preferred over M&As when firms face high litigation risk? What would be the implications for shareholder wealth if firms choose alliances rather than M&As to expand their boundaries under shareholder litigation threats? The answers to these questions are unclear.
Prior studies have heated debates on the function of shareholder litigation in managers’ decision making. As shareholder litigation can lead to direct pecuniary loss and reputational damages of managers, it serves as one of the governance channels that discipline managers for maximizing shareholder wealth. On the other hand, managers may have incentives to play it safe due to the concern of potential costs of litigation. Motivated by risk aversion, managers might be prone to making less risky decisions on corporate investments and liquidity policies.
To examine the impact of shareholder litigation risk on firms’ expansion strategies, we exploit the unexpected changes in regulatory rules related to shareholders’ ability to file derivative lawsuits against management. The staggered passage of UD laws across states in the U.S. imposes a “universal demand” requirement and creates exogenous shocks to litigation risk. That is, shareholders must seek board approval prior to initiating derivative litigation. Since derivative lawsuits typically name the directors as defendants, boards rarely grant this approval. Therefore, the adoption of UD laws significantly increases the burden on shareholders attempting to file a derivative lawsuit and reduces the threat of derivative litigation alleging a breach of fiduciary duty by directors and officers.
Using the difference-in-differences (DID) approach for a sample of U.S. public firms over the period of 1984 to 2010, we find that firms under the threat of litigation tend to choose corporate alliances over M&A. This finding suggests that shareholder litigation risk play a significant role in determining firms’ decisions on external growth strategies. The impact remains economically and statistically significant when excluding potential impacts from other legislation, merger waves, and corporate governance.
The underlying influential mechanism could be twofold. First, managers may take a risk-averse approach to external growth when facing litigation threats. In addition to the risks mentioned above, M&A deals may involve valuation uncertainty, information asymmetry, and unexpected integration costs, leading to deal inefficiency and failure and thus inducing litigation. M&A-related litigation may also result from managers engaging in self-serving acquisitions (e.g., empire-building acquisitions) that lead to large-scale destruction of shareholder wealth, which could trigger shareholder claims for compensation. However, the litigation risk of alliances tends to be lower than that of M&As, because the deal risks could be shared among alliance partners. Also, less injection of financial resources is required in alliances, making them less likely to cause large wealth destruction when they fail. Therefore, alliances offer a low-risk choice for firms’ external expansion when managers are concerned about the litigation risk and behave conservatively.
The second mechanism involves firms’ conservative liquidity policy when facing the threat of litigation. Previous studies suggest that firms tend to increase their cash reserves as a precautionary measure under litigation threats, further restricting firms’ investments. Compared to M&As, alliances require relatively fewer financial resources, as firms can partly rely on their partners’ capital and spread risks across their alliance partners. For instance, alliance partners may pool their resources, giving them access to the assets of other firms with less capital involvement and lower transaction costs. Moreover, alliances may be preferred over M&As when external financing is limited. Firms can rely on their alliance partners for some financial resources, which may help to relax their financial constraints. Therefore, when firms’ liquidity is constrained due to the precautionary cash reverses under litigation threats, alliances provide a low-cost choice for firms’ external expansion.
These two influential mechanisms are supported by a series of cross-sectional tests in our empirical analysis. Using CEO compensation option and vega as proxies for managerial risk-taking incentives, we find that the impact of shareholder litigation risk on firms’ choice of alliances over M&A is significantly stronger for firms with low CEO risk-taking incentives. This finding supports the managerial risk-aversion mechanism. Further, we use Kaplan and Zingales index, Standard & Poor’s investment rating, firm size, and dividend payout as proxies for financial constraint, and find that financially constrained firms are more likely to be affected by the shareholder litigation risk when selecting alliances over M&A. This finding supports the conservative liquidity policy mechanism. Our findings support that both mechanisms are in play—alliances offer a low-risk, low-cost alternative to M&A for firms facing litigation risk.
What is the wealth implication on shareholders when firms choose alliances as the alternative to M&A? To answer this question, we examine the impact of litigation threats on the performance of alliances participants. We use the three-day cumulative abnormal stock returns around the alliance announcements and the long-term operating performance of the alliance partners. We find alliance participants experience better performance once the litigation threats are reduced. The finding suggests that as managers become less concerned about shareholder litigation and have more financial resources (due to less conservative liquidity management), they can improve their deal selection. It further implies that the selection of alliances under litigation threats is inefficient.
Overall, our findings suggest that firms substitute alliances for M&A as an external expansion strategy when facing high litigation risk. This finding is consistent with the view that managers become more risk-averse and choose less risky deals under litigation threats while maintaining financial slack in anticipation of litigation-related costs. Additionally, we find that alliances formed under reduced litigation risk due to the adoption of UD laws could experience higher alliance announcement returns and improved long-term performance. This finding reveals that firms can improve their deal selection and make better alliance choices once litigation threats are reduced. Our study is a step forward in understanding the decision-making process of firms’ expansion strategies. It highlights the importance of corporate alliances as a potential solution for addressing managers’ concerns about shareholder litigation.
Chenchen Huang is a Lecturer at the University of Southampton
Neslihan Ozkan is a Professor at the University of Bristol
Fangming Xu is an Associate Professor at the University of Bristol
This post is adapted from their paper, “Shareholder Litigation Risk and Firms’ Choice of External Growth” available on SSRN.
The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.
