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Incentive contracting in the shadow of litigation risk: Evidence from universal demand laws

Author

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  • Humphery-Jenner, Mark
  • Islam, Emdad
  • Nanda, Vikram
  • Rahman, Lubna

Abstract

We hypothesize and show that the impact of a regulatory shock depends both on the shock itself and on how firms respond, which can itself depend on the firm's governance attributes. To explore this, we use the staggered passage of Universal Demand (UD) laws, which insulate managers from derivative lawsuits. We find that, on average, firms respond to UD laws by increasing risk-taking incentives (vega), thereby compensating for weaker external discipline, and incentivizing valuable risky investments. Corporate governance, institutional ownership, and CEO power influences the likelihood of adjusting compensation. The firms that do boost vega subsequently experience greater innovation, and a stronger market response to new product announcements. Our results help to reconcile extant findings on the effects of UD laws by showing that the beneficial impact of the laws is conditional on firms’ strengthening their CEOs’ risk-taking incentives, a choice affected by their latent governance arrangements.

Suggested Citation

  • Humphery-Jenner, Mark & Islam, Emdad & Nanda, Vikram & Rahman, Lubna, 2025. "Incentive contracting in the shadow of litigation risk: Evidence from universal demand laws," Journal of Banking & Finance, Elsevier, vol. 171(C).
    • Handle: RePEc:eee:jbfina:v:171:y:2025:i:c:s0378426624002668
    DOI: 10.1016/j.jbankfin.2024.107352
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    Keywords

    Litigation risk; Universal demand laws; Compensation; Governance;
    All these keywords.

    JEL classification:

    • G3 - Financial Economics - - Corporate Finance and Governance
    • K22 - Law and Economics - - Regulation and Business Law - - - Business and Securities Law
    • O32 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Management of Technological Innovation and R&D
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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