The Litigation Environment of a Firm and its Impact on Financial Policy∗

Several studies have documented the impact of litigation on shareholders. Lawsuits can have significant explicit costs and have been shown to cause negative stock price reactions when filed. However, little is known about how firm managers respond to this costly reality. Anecdotal evidence suggests firms may adjust financial policy to build a war chest in anticipation of litigation. Alternatively, firms may increase the probability of bankruptcy to reduce the payoffs to potential litigants and protect shareholder assets. By looking at changes to a firm’s litigation environment, I test whether and how a firm’s risk of litigation impacts its overall financial policy. I find that higher litigation exposure leads firms to choose higher leverage. I show that this leverage increase is brought on by an active decision to repurchase shares. These repurchases appear to be financed with a combination of excess cash and short term debt as they coincide with a significant decrease in cash holdings and an increase in short term liabilities. Furthermore, these results appear to be stronger in firms that are financially distressed and face a higher chance of bankruptcy due to litigation. I show that these findings are not the result of changes in an industry equilibrium brought about by the financial distress of other sued firms, but rather a strategic response to an increase in litigation risk. These results are consistent with the idea that firms strategically take action in the face of increased litigation risk to shield their assets from potential fees, judgements, and settlements due to litigation.