Managerial Liability and Corporate Innovation: Evidence from a Legal Shock

Abstract

Despite a longstanding debate over the pros and cons of imposing legal liability on directors and officers (D&Os), how D&O liability affects corporate innovation is rarely studied. We study this question by exploiting Nevada’s 2001 corporate law change that dramatically lowered D&O legal liability and helped Nevada become the second most popular state for out-of-state incorporations. We find that firms incorporated in Nevada exhibit an increase in innovation outputs relative to matched control firms after the law change, particularly for firms facing higher litigation risk or operating in more innovative industries. The results are mainly driven by exchange-listed firms that are subject to better governance than over-the-counter (OTC) listed firms. Lower D&O liability also enables firms to pursue more risky, but potentially more rewarding, explorative innovation. Therefore, while holding D&Os liable may be overall desirable as prior studies suggest, it also entails a cost by discouraging innovation in some firms.