Litigation risk and agency costs: Evidence from Nevada corporate law

Abstract

In 2001, Nevada significantly limited the personal legal liability of corporate officers and directors. We use this exogenous shock to implement a differencesin- differences design that examines the impact of officer and director litigation risk on agency costs. We find decreased firm value, especially for firms with lower levels of investor protection and the highest expected agency costs. We also find that managerial incentives are reduced as measured by lower chief executive officers’ pay-for-performance sensitivity. Finally, we find an adverse impact on operating performance and increased error-based restatements for Nevada firms subsequent to the change. Our findings emphasize that officer and director litigation risk is an important governance mechanism.