Shareholder Litigation Rights and Financial Fraud Risk: New Evidence from Exclusive Forum Provisions

Abstract

This paper examines the effect of shareholder litigation rights on the firm’s exposure to financial fraud risk. We define fraud risk as the likelihood that a firm may experience financial statement manipulations at the organizational level. We look at fraud risk as it helps us go beyond the level of fraud detected at the firm level, which has been the focus of a large stream of prior research. Following the Business Judgement Rule, we argue firms that fall short of shareholder expectations experience a higher risk of shareholder litigation. Thus, managers will generally attempt to demonstrate superior performance to the shareholders in the presence of excessive litigation pressure, increasing the risk of financial statement fraud for these firms. Consistent with our presumption, we observe a reduction in multi-forum litigation followed by EFP adoption to curtail the financial fraud risks among these firms. Our results remain consistent when fraud risk is measured using Benford’s Score and the discretionary accruals, consistent with the earnings management literature. Although shareholder litigation is expected to lower the risk of financial risk of fraud , our findings suggest that increasing litigation threats may worsen financial fraud risks among firms. Overall, the findings of this paper contribute to the existing literature by showing that it is not the quantity but the quality of litigation that matters in enhancing organizational outcomes.