The impact of perceived litigation risk : evidences from the U.S. federal district court

Abstract

This study introduces a novel ex-ante securities litigation risk proxy based on federal district courts' dismissal rates (hereafter "court dismissal rate") and explores how heterogenous pleading standards among the U.S. federal district courts affect headquartering firms' disclosure and bank loan pattern. Constructed as the number of cases dismissed in the recent years scaled by that of cases filed in the same period, court dismissal rate has a strong predictive power over the likelihood of sued firms headquartering in the jurisdiction passing the motion-to-dismissal process, indicating that historical court dismissal information can be used to predict future litigation outcomes and can be easily obtained by managers to form headquartering firms' perception on the pleading standard (stringency) of district courts. Using this measure of ex-ante litigation risk, firstly, I find robust evidence that misreporting firms headquartered in lenient court jurisdictions are more likely to make voluntary restatements, confirming the defensive disclosure hypothesis that firms in stringent legal environment are more likely to hide misbehaviors in fear of litigation cost. Secondly, interest rates are significantly lower for the firms headquartered in lenient court jurisdictions. The effect is stronger when borrowers have less information asymmetry issues and diminishes after the Supreme Court's Tellabs decision that homogenizes court pleading standards. These results indicate that lenders consider the benefit of high pleading standard in curtailing frivolous lawsuits to outweigh the cost of financial misreporting incentives. Finally, I find firms headquartered in stringent courts have annual reports with higher readability. This study contributes to the literature on (1) measurement of ex-ante litigation risk and (2) the impact of litigation risk on corporate disclosure and finance.