Anaya Nolan
Universal Demand Laws (UD laws) are a set of laws enacted by 23 states between 1989 and 2005 that require shareholders to make a demand on the board before suing for breach of fiduciary duty or initiating other derivative actions. UD laws are designed to reduce the threat of derivative lawsuits, which are lawsuits filed by shareholders on behalf of a corporation to remedy or prevent wrongdoing by the corporation. These laws have been the subject of debate, with some arguing that they decrease the ability of shareholders to litigate and monitor the board, while others claim that they increase reporting conservatism and affect the distribution of firm welfare. The impact of UD laws on litigation risk and corporate payouts is still being studied, with conflicting findings across different firms and industries.
| Characteristics | Values |
|---|---|
| Purpose | To examine the effect of an exogenous reduction in shareholders' ability to litigate on the extent of accounting conservatism |
| Litigation risk | Shareholders can file derivative lawsuits on behalf of the corporation to remedy or prevent wrongdoing by the corporation |
| Effect on litigation | The adoption of UD laws raises the hurdle of filing derivative lawsuits and reduces the ex-ante litigation risk of affected firms |
| Effect on payouts | Reducing the ex-ante threat of derivative lawsuits induces firms to increase payouts |
| Effect on workplace safety | Reduced litigation threat increases workplace injury rates |
| Effect on accounting conservatism | There is an increase in reporting conservatism post-UD |
| Effect on corporate governance | UD laws decrease the ability of shareholders to litigate and effectively monitor the board |
| Number of states that have adopted UD laws | 23 |
| Time period of adoption | Between 1989 and 2005 |
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What You'll Learn
Shareholder litigation
Universal Demand Laws (UD laws) are a set of laws enacted by 23 states between 1989 and 2005 that require shareholders to make a demand on the board of directors before suing for breach of fiduciary duty or initiating other derivative actions. Shareholder litigation is a process where shareholders bring lawsuits against firms, typically through securities class action lawsuits or derivative lawsuits.
Securities class action lawsuits are usually initiated by a group of shareholders who have traded a firm's shares within a specific period and suffered a sudden stock price decline. The objective of these lawsuits is to recover financial losses due to alleged securities fraud. On the other hand, derivative lawsuits are filed by shareholders on behalf of the firm, alleging that officers and directors breached their fiduciary duties. The main objective of derivative lawsuits is to push defendant firms to improve corporate governance.
The enactment of UD laws has been associated with a decrease in shareholder litigation. This is because UD laws increase the procedural hurdles associated with shareholder derivative litigation, making it more difficult for shareholders to initiate legal action. However, it is important to note that even if a board refuses a shareholder's demand, the shareholder can still bring a derivative action and assert that the refusal was improper.
Several studies have examined the impact of UD laws on shareholder litigation. Some studies suggest that UD laws do not materially alter derivative litigation risk. For example, a study examining the impact of UD laws from 1996 to 2015 found no meaningful impact on derivative litigation. Additionally, this study found no evidence that UD laws affected aggressive accounting, voluntary disclosure, executive compensation, or corporate governance decisions.
Another study by Appel (2019) found that the enactment of UD laws across adopting states was associated with a significant increase in the E-Index, which captures the sum of provisions restricting shareholder voting power and anti-takeover provisions. This suggests that UD laws may have a negative impact on shareholder litigation rights and the ability of shareholders to monitor the board.
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Corporate governance
Universal Demand (UD) laws are an increasingly popular proxy for exogenous variation in corporate governance mechanisms. They require that shareholders make a formal demand on the board of directors before initiating legal action for breach of fiduciary duty or other derivative actions. These laws were enacted by 23 states between 1989 and 2005.
The impact of UD laws on corporate governance has been the subject of recent academic research. One key finding suggests that UD laws decrease the ability of shareholders to litigate and monitor the board effectively. This is because the board has the power to refuse or otherwise dispose of the demand, potentially without further recourse for shareholders.
Additionally, UD laws have been found to significantly impact not only directly affected firms but also legally unaffected firms with board interlocks to the affected firms. This propagation effect suggests that corporate practices, particularly management entrenchment measures, can spread from UD-affected to unaffected firms.
The enactment of UD laws has also been associated with an increase in the E-Index, which captures the sum of provisions restricting shareholder voting power and antitakeover provisions. This indicates that UD laws may facilitate management entrenchment by encouraging the adoption of anti-takeover provisions.
Furthermore, the staggered adoption of UD laws across states has allowed researchers to study the peer effects of corporate governance practices. It has been found that firms in the same networks tend to have similar corporate governance practices. This could be due to peer effects, where governance practices propagate from one firm to another, or selection effects, where firms with similar preferences self-select into linked groups. Disentangling these two effects is challenging but crucial for understanding the dynamics of corporate governance.
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Workplace safety
Universal demand laws are enacted to ensure workplace safety and protect the safety and health of workers. In the United States, the Department of Labor (DOL) administers and enforces federal laws that cover workplace activities for about 165 million workers and 11 million workplaces.
The Occupational Safety and Health Administration (OSHA) is a federal agency that sets and enforces protective workplace safety and health standards. The Occupational Safety and Health (OSH) Act, enacted in 1970, created OSHA and is responsible for regulating safety and health conditions in most private industries, including construction, agriculture, maritime, and general industry.
Under the OSH law, employers have a legal responsibility to provide a safe workplace for their employees. This includes ensuring the workplace is free from serious recognized hazards, providing safe tools and equipment, using warning signs for potential hazards, establishing operating procedures, and providing safety training in a language that workers understand. Employers must also comply with the General Duty Clause of the OSH Act, which reinforces the requirement to maintain a workplace free of serious hazards.
Employees, on the other hand, have the right to speak up about hazards without fear of retaliation. They are entitled to receive workplace safety training and can file confidential complaints with OSHA if they believe working conditions are unsafe. OSHA also administers the Whistleblower Protection program, which protects workers from any adverse action taken by employers in response to reports of injuries or safety concerns.
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Accounting conservatism
Universal Demand (UD) laws require that shareholders make a demand on the board before suing for breach of fiduciary duty or other derivative actions. They were enacted by 23 US states between 1989 and 2005.
UD laws raise procedural hurdles for shareholders wishing to file derivative lawsuits against managers and directors who allegedly breach their fiduciary duties. This shift in power from shareholders to managers weakens the directors' incentives to monitor managers.
Several studies have examined the effect of UD laws on accounting conservatism. One study by Chen, Li, and Xu (2017) found a decrease in conditional conservatism following the enactment of UD laws. This decline was only observed in firms with low institutional ownership, low external equity dependence, or high ex-ante derivative lawsuit risk. The authors suggest that shareholders cannot successfully demand accounting conservatism when managers possess extensive power and directors lack the incentives to monitor managers.
Another study by Manchiraju, Pandey, and Subramanyam (2021) found an increase in reporting conservatism post-UD, particularly in firms that contemplate equity issuance, have a high proportion of monitoring investors, and high corporate governance quality. In contrast, firms with specific short-term incentives for aggressive accounting decreased reporting conservatism after UD.
Overall, while accounting conservatism can serve as an effective monitoring device, the enactment of UD laws appears to have a complex and varied impact on the extent of conservatism in financial reporting.
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Insider trading
Universal Demand (UD) laws require that shareholders make a demand on the board before suing for breach of fiduciary duty or other derivative actions. They were enacted by 23 states between 1989 and 2005.
UD laws have been the subject of debate regarding their effectiveness in deterring insider trading. Insider trading refers to the buying or selling of a company's stock by individuals with access to non-public, material information about that company. This can provide these individuals with an unfair advantage in the market and harm other shareholders.
Several studies have examined the impact of UD laws on insider trading. Some research suggests that UD laws decrease the ability of shareholders to litigate and monitor the board, which may reduce the deterrence of insider trading. The threat of derivative lawsuits is meant to deter insiders from engaging in opportunistic trading. However, UD laws can make it harder for shareholders to bring such lawsuits, reducing the litigation risk for insiders.
Empirical findings on the effectiveness of UD laws in deterring insider trading are mixed. While some studies find that UD laws are associated with more profitable insider trades, particularly in smaller firms with higher information asymmetry and lower institutional monitoring, others suggest that UD laws lead to a decrease in abnormal returns following sales, resulting in abnormal dollar loss avoidance.
The impact of UD laws on the timing and opportunism of insider trades has also been analysed. The reduction in litigation risk may encourage insiders to time their sales more opportunistically, selling when prices are inflated and large price declines are likely. This results in an increase in the ratio of opportunistic sales to routine sales.
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Frequently asked questions
Universal demand laws (UD laws) are a set of laws enacted by 23 states between 1989 and 2005 that require shareholders to make a demand on the board before suing for breach of fiduciary duty or initiating other derivative actions.
Research suggests that the enactment of UD laws is associated with a significant increase in the E-Index, a widely-used entrenchment index that captures the sum of provisions restricting shareholder voting power and antitakeover provisions.
Universal demand laws impose a "universal demand" requirement, which makes it necessary for plaintiff shareholders to seek approval from the board and allow the board to take corrective actions before initiating a derivative lawsuit. This raises the hurdle for filing such lawsuits and reduces the ex-ante litigation risk of affected firms.
Reducing the threat of derivative lawsuits by implementing UD laws has been found to induce firms to increase payouts, especially for those facing higher litigation risk, financial distress, and operating in competitive product markets.
