Corporate Governance, Monitoring and Litigation as Substitutes to Solve Agency Problem

A Securities Class Action lawsuit is initiated by a large class of shareholders against managers whom they suspect of wrongdoing. This paper proposes that Securities Class Action litigation is an ex post substitute for effective ex ante governance and monitoring. To elaborate this idea, I outline a model in which shareholders see a noisy signal of possible managerial fraud. Since the signal is imperfectly informative, and with costly litigation, shareholders' decision of whether to sue or not is based on the signal as well as the governance and monitoring mechanisms in place in the company. If the signal comes from a strong governed, vigilantly monitored company, shareholders are more likely to attribute it to noise. However if it comes from a company with poor controls in place, then the managers are more likely to have committed fraud and the shareholders sue with a higher probability. I test this idea using various measures of governance and monitoring, and find that firms with high total and abnormal compensation are more likely to be sued. I also find that firms with large institutional blockholders are less likely to be sued, suggesting that blockholders play a monitoring role. However my results find no evidence that outsider-dominated boards or small boards provide effective ex ante governance as a substitute to ex post litigation.