Do Courts Matter For Firm Value? Evidence From The U.S. Court System

Stefano Colonnello
Otto-von-Guericke Universität Magdeburg; Halle Institute for Economic Research

Christoph Herpfer
Ecole Polytechnique Fédérale de Lausanne – Swiss Finance Institute

April 12, 2016

Abstract:

We estimate the link between the court system and firm value by exploiting a U.S. Supreme Court ruling which changed firms’ exposure to different courts. We find that exposure to courts which are highly ranked by the U.S. Chamber of Commerce increases firm value. The effect is driven by courts’ attitude towards businesses more than by their efficiency and is more pronounced for firms in industries with high litigation risk. We also test whether firms benefit from the ability to steer lawsuits into friendly courts, so-called forum shopping. We provide evidence that a reduction in firms’ ability to forum shop decreases firm value, whereas a reduction in plaintiffs’ ability to forum shop increases firm value.

Do Courts Matter For Firm Value? Evidence From The U.S. Court System – Introduction

Economists recognize the importance of the legal environment. Examples include the work on shareholder rights (La Porta, Lopez de Silanes, Shleifer, and Vishny, 1998) and legal formalism (Djankov, La Porta, Lopez de Silanes, and Shleifer, 2003). We analyze a key link between the legal system and economic development: The value of courts for the business sector. Whereas it is not surprising that different countries in different stages of development feature legal institutions of varying quality (Hay and Shleifer, 1998) and that specific court proceedings pose significant risk to individual firms (Bhagat, Brickley, and Coles, 1994), it is unclear to what extent the court system as such creates value for firms.

Two questions arise in the context of courts and firm value: The first question concerns the magnitude of the impact courts have on firm value. The second question is the economic channel through which courts create value for firms. One potential channel is that efficient and competent resolution of cases reduces legal uncertainty and litigation costs. Alternatively, courts can increase firm value by moving resources from plaintiffs such as customers or employees to shareholders.

Firm Value

Our paper makes two key contributions. First, we disentangle the effect of courts from confounding factors both on the state level, such as different laws, and on the case level, such as case specific details. We exploit a U.S. Supreme Court ruling as an exogenous shock to firms’ exposure to different state courts to quantify the link between court characteristics and shareholder value. We find strong evidence that differences between courts matter for firm value even inside a highly developed legal system such as the U.S. one. Using a ranking of state courts produced by the U.S. Chamber of Commerce, we find that firms exposed to state courts at the top tercile of this ranking experience a positive abnormal return of 0.45% compared to firms exposed to courts from the bottom tercile on the day of the ruling.

The second contribution is to identify the economic channel that links court characteristics to firm value. We present evidence that, in the U.S., it is courts’ attitude towards business rather than their efficiency which drives their impact on firm value. We further show that the effects of courts on firm value are strongest for firms in industries with high legal risk from operations.

Previous studies of the impact of the legal system have mainly taken two forms: Cross-country comparisons of aggregate data or event studies around the announcement (or resolution) of lawsuits. Both approaches are not suitable for our goal of estimating the impact of courts on firm value. The key challenge is to isolate the impact of courts from the impact of the law. Any study comparing measures of court quality across states is invariably also comparing different laws, firms, or political and social environments. Event studies that focus on the impact of lawsuits on firm value, in contrast, cannot distinguish between the role of courts and the merits of a case.

Firm Value

We provide a solution to the above identification challenges and link the impact of the court system across various U.S. states to firm value, keeping the applied laws constant. We obtain identification from the two-layer structure of state and federal courts in the U.S., combined with an event study around a U.S. Supreme Court ruling. To understand our proposed solution, consider an ideal experimental setup in which identical firms, which face identical lawsuits, are randomly assigned to different courts. These different courts then have to apply the exact same laws. Since firms, lawsuits and laws are identical in such a setup, the only difference between two firms assigned to different courts lies in their respective courts. A simple event study of stock price reactions would then be able to estimate the impact of courts on firm value. The two key features of such an idealized setup are that firms, laws and lawsuits are identical, and that assignment to courts is random.

The U.S. court system features a setup which fulfills the first assumption, namely that firms and laws are the same across two different court systems. The U.S. judiciary is comprised of two layers: Federal and state courts. Most cases are handled by state courts, but there are important exceptions. If a civil lawsuit features parties from different U.S. states, their so-called “diversity of citizenship” grants federal courts jurisdiction over the case. Diversity jurisdiction has been a long-standing feature of U.S. law, rooted in the constitution and practiced in various forms since the Judiciary Act of 1789. Importantly, in diversity cases federal courts are bound to apply exactly the same law as the state court in whichever state the original case was based in. This so-called “Erie doctrine” has been a well-established rule ever since the landmark case of Erie Railroad Co. v. Tompkins in 1938.2 As a results of the Erie Doctrine, the difference between trying a case in federal or state courts does not lie in different laws, but solely in differences among courts. The diversity jurisdiction therefore allows us to evaluate the impact of courts on firm value while controlling for the applicable laws.

Firm Value

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