Litigation risk in light of board independence, firm complexity, and monitoring costs

We investigate the impact of board independence on the firm’s securities litigation risk using litigation data for Standard & Poor's (S&P) 1500 firms over the period 1998 to 2017. We address endogeneity concerns by considering a three-front analyses: conditional fixed-effects logit model, linear probability model (LPM) with firm fixed effects, and two-stage instrumental variables (IV). In the IV approach, we use the proportion of independent directors in the counties of firms’ headquarters and the proportion of independent directors in the firms’ industry standard industrial classification (SIC 2-digit) as instruments for board independence. Based on the premise of agency theory, our findings indicate that board independence has a negative impact on securities litigation risk. The effectiveness of this impact is also analyzed in light of the firm’s complexity and monitoring cost. The results show that board independence effectiveness is negatively related to the firm’s monitoring cost but is positively influenced by the firm’s complexity.We proxy the monitoring cost by the standard deviation of returns and R&D expenditures. Firm complexity is proxied by size, age, and operations overseas.Our empirical findings have important implications for policy makers and regulators. In general, our robust statistical results indicate internal governance requirements do not need to be necessarily the same for all types of firms. To optimize the outcome, we recommend establishing a set of firm-specific internal governance requirements that are based on the firms’ operational environment and complexity. Our results challenge the notions of ‘one-size-fits-all governance remedies’ to reduce litigation risk and are robust across several alternatives and nested variations, including considerations of endogeneity and heterogeneity.