Securities Litigation and Corporate Tax Avoid - 2021 - Journal of Corporate Fina

Journal of Corporate Finance 66 (2021) 101546
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Journal of Corporate Finance

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Securities litigation and corporate tax avoidance

Matteo P. Arena a, Bin Wang b, *, Rong Yang c
a
Department of Finance, Marquette University, 303C Straz Hall, Milwaukee, WI 53201-1881, United States of America
b
Department of Finance, Marquette University, 312 Straz Hall, Milwaukee, WI 53201-1881, United States of America
c
Department of Accounting and Finance, Rochester Institute of Technology, A319 LOW, Rochester, NY 14623, United States of America
A R T I C L E I N F O A B S T R A C T
Keywords: We examine whether litigation risk is systematically related to corporate tax avoidance. We find
Securities class action litigation that the exogeneous reduction in the threat of securities class action litigation due to the 1999
Corporate lawsuits ruling of the Ninth Circuit Court of Appeals effectively increases corporate tax avoidance, which
Tax avoidance
is consistent with the notion that the threat of shareholder litigation plays a disciplinary role in
curbing managerial rent extraction from tax avoidance activities. This finding is robust to
alternative model specifications including two placebo tests and propensity score matching. We
further find that labor union and alternative external governance mechanisms such as analyst
coverage and institutional ownership mitigate this effect. Overall, our paper provides a significant
contribution to the understanding of the relation between corporate governance and tax
avoidance.
1. Introduction
Anecdotal evidence suggests that tax-related accounting irregularities trigger securities class action lawsuits. In some instances, tax
irregularities are associated with managerial rent extraction. For example, in June 2005, Dennis Kozlowski, former chair and chief
executive officer of Tyco International, was convicted of crimes, including securities fraud and grand larceny, stemming from his
activities at Tyco. Investigation revealed that Kozlowski, along with Tyco’s general counsel, misappropriated more than $600 million
through a racketeering scheme involving stock and tax fraud, authorized bonuses, and falsified expense accounts. Tyco stockholders
filed a securities lawsuit, which was settled in 2007 for a record $3 billion.
Besides the anecdotal evidence, accounting and finance research provides evidence that managers can use tax avoidance strategies
to disguise managerial rent extraction that deviates from the goal of shareholder value maximization (e.g., Desai and Dharmapala,
2006, 2009). Law and finance literature show that the threat of securities litigation is an important governance mechanism that can
mitigate agency conflicts (e.g., Romano, 1991; Appel, 2016; Crane and Koch, 2016). In this paper, we connect these two research
strands by exploring for the first time the governance effects of shareholder litigation on tax planning decisions. Using the exogeneous
shock to litigation risk caused by the 1999 ruling by the Ninth Circuit Court of Appeals in In re: Silicon Graphics Inc. Securities
Litigation (hereafter, the 1999 ruling), we empirically show that the reduction in litigation risk has a significant effect on corporate tax
avoidance.
This study focuses on litigation rights in securities class actions. Securities class action lawsuits are designed to overcome the
prohibitive cost for individual shareholders to sue companies. The Ninth Circuit’s 1999 ruling requires shareholders’ attorneys to
* Corresponding author.
E-mail addresses: matteo.arena@marquette.edu (M.P. Arena), bin.wang@marquette.edu (B. Wang), rong.yang@rit.edu (R. Yang).
https://doi.org/10.1016/j.jcorpfin.2019.101546
Received 28 January 2019; Received in revised form 30 September 2019; Accepted 3 November 2019
Available online 15 November 2019
0929-1199/© 2019 Elsevier B.V. All rights reserved.
M.P. Arena et al. Journal of Corporate Finance 66 (2021) 101546
provide proof of “deliberate recklessness” rather than “mere recklessness,” which is sufficient in other circuits to file a class action
securities lawsuit. This ruling modified the institutional balance between shareholders and management by reducing plaintiffs’ access
to securities class action litigation and lowering the risk of securities litigation faced by firms headquartered in the Ninth Circuit. The
exogenous change in litigation risk due to the 1999 ruling provides us with a natural experiment to test the effect of litigation risk on
tax avoidance (e.g., Chu, 2017).1
The impact of shareholder litigation risk on corporate tax avoidance is twofold. On the one hand, the threat of shareholder liti
gation, as a governance mechanism can have a mitigating effect on tax avoidance. Corporate tax research suggests that the complexity
of tax avoidance activities can be used to mask managerial rent extraction, which eventually hurts shareholder value. For instance, Kim
et al. (2011) find that managers use complex tax avoidance transactions to facilitate rent extraction and bad news hoarding, leading to
stock price crashes. Large price declines would then trigger the filing of lawsuits against a company’s management. This line of
research suggests that the threat of securities litigation could constrain corporate tax avoidance by disciplining the management to act
in the interests of shareholders.
On the other hand, shareholder litigation could encourage value-enhancing tax avoidance. According to the argument in Armstrong
et al. (2015), tax avoidance does not necessarily result in opportunities for managerial diversion. Rather, tax avoidance, which can
improve a firm’s after-tax cash flow, is one of the many risky but value-enhancing investment opportunities available to managers.
Managers who pursue their personal welfare are sometimes inclined to select a level of tax avoidance that departs from the level
optimal for shareholders. For example, in the absence of monitoring, managers who prefer a quiet life may underinvest in tax
avoidance. Consistent with this view, Armstrong et al. (2015) and Rego and Wilson (2012) find that on average, equity incentives, an
important governance mechanism, are positively related to corporate tax avoidance. Therefore, it is plausible that the threat of
shareholder litigation could align managers’ incentives with those of shareholders thereby inducing managers to engage in tax
avoidance that increases firm value.
To empirically investigate the impact of securities litigation rights on tax avoidance, we implement a difference-in-differences
(DID) approach. This method mitigates endogeneity concerns that affect other studies on the impact of governance mechanisms on
corporate tax avoidance (e.g., Desai and Dharmapala, 2006; Armstrong et al., 2015). We assemble data for a large sample of U.S. firms
from 1994 to 2004. Following the literature (e.g., Dyreng et al., 2008; McGuire et al., 2014), we construct four measures of tax
avoidance: (1) effective tax rate (ETR), (2) unexplained book-tax difference (MPBT), (3) ETR differential (ETR_DIF), and (4) discre
tionary permanent book-tax difference (DTAX). It is important to consider all four measures for two reasons. First, as stated by Hanlon
and Heitzman (2010), the legality of tax-avoidance practices is usually known after the fact. The different proxies used in this study
capture a wide range of tax-avoidance activities, from moderate to aggressive tax-avoidance transactions. Second, as the 1999 ruling
intended to curb frivolous lawsuits while retaining the disciplinary effect of class action litigation on firms committing egregious
misdeeds, the different tax planning proxies allow us to better assess the potential changes in tax avoidance after the court decision.2
Through our empirical analysis, we find that, as it becomes harder to initiate securities class action lawsuits against firms head
quartered in the Ninth Circuit, firms engage more aggressively in tax avoidance. The results are consistent with the notion that firms
with lower exposure to litigation risk are likely to become more opportunistic in their tax planning. We conduct several robustness tests
including two placebo tests and propensity score matching (PSM). Our main results remain qualitatively and quantitatively unaltered
under these alternative specifications. Overall, we find that on average, firms make a concerted effort to alter their tax planning
strategies in response to a change in the litigation environment.
Nevertheless, there could be alternative explanations for our findings. For example, after the 1999 ruling, the reduced likelihood of
frivolous litigation could also lead managers to engage in more aggressive tax planning strategies. Securities class action lawsuits are
frequently initiated by law firms on behalf of the shareholders following a significant drop in stock prices even when there is limited
evidence of financial accounting irregularities (Macey and Miller, 1991). The plaintiffs’ attorneys are often the only winners in these
frivolous lawsuits. These non-meritorious lawsuits are likely to distract managers from engaging in their normal business, which in
turn could hurt shareholders’ interests (Rhode, 2004). In the same vein, due to the threat of frivolous lawsuits, managers are less likely
to explore risky and complex tax planning strategies. Therefore, it is plausible that an increase in tax avoidance after the 1999 ruling is
a response to the reduction in the risk of frivolous lawsuits rather than a decrease in the governance effects of shareholder litigation. To
distinguish between governance effects and frivolous litigation, we examine whether our results are driven by firms that are more
susceptible to frivolous litigation. Our results provide no evidence supporting this frivolous litigation view.
Next, we examine governance effects of shareholder litigation as a function of firms’ announcement returns. The market reaction
around the 1999 ruling announcement date should depend on a firm’s reliance on shareholder litigation as a governance mechanism.
In other words, if there are alternative governance mechanisms in place, the market reaction to the ruling, which weakens shareholder
litigation rights, should be small. We find some evidence that governance effects are weaker in firms with muted market response to the
ruling, supporting the view that shareholder litigation serves as a governance tool.
We also substantiate our main findings with cross-sectional evidence. We begin by examining the impact of alternative governance
mechanisms on the relation between shareholder litigation risk and tax avoidance. Previous literature has shown that analysts and
institutional investors play an important role in corporate governance by exerting external monitoring over managers (e.g., Yu, 2008;
1
We discuss the institutional background of the Ninth Circuit’s 1999 ruling in Appendix A.
2
The Private Securities Litigation Reform Act (PSLRA) was enacted in 1995 to make it more difficult to initiate litigation in an attempt to limit
frivolous lawsuits. However, the legislation had a minimal effect in curbing lawsuits as the additional requirements for filing a class action lawsuit
became only marginally stricter. In fact, the number of securities lawsuits filings continued to increase after 1995 (e.g., Choi et al., 2009).
2
Hartzell and Starks, 2003). We expect that the governance effect of shareholder litigation is weaker in the presence of alternative
monitoring mechanisms. Consistent with our predictions, we find that the effect of shareholder litigation is less pronounced in firms
with greater analyst coverage and higher institutional ownership. We also investigate the impact of labor unions. Chyz et al. (2013)
find that labor unions constrain managers’ ability to participate in aggressive tax strategies because unions are more risk-averse than
managers. We expect a substitution effect between shareholder litigation and labor unions. Consistent with our prediction, we find that
firms with strong unions are less likely to engage in tax avoidance after the 1999 ruling.
In the last section, we perform additional robustness tests by including firm fixed effects and excluding high-tech firms. It is possible
that our results are driven by stable unobservable firm characteristics such as corporate culture. In addition, the 1999 ruling coincided
with a technology bubble that disproportionately affected firms located within the Ninth Circuit. Our results could be driven by the
tech bubble rather than the 1999 ruling. We also control for the pre-existing litigation environment, as previous court decisions may
affect empirical results in studies such as ours that revolve around a law change or a specific court decision (Karpoff and Wittry, 2018).
Our results are robust to these alternative specifications. Overall, we find that firms are more likely to engage in tax avoidance when
the governance role of shareholder litigation is weakened.
Our study makes three main contributions. First, to the best of our knowledge, this paper is the first to examine the role of
shareholder litigation risk in curbing corporate tax avoidance. Responding to the recent call for research on the determinants of tax
aggressiveness in an agency framework (Hanlon and Heitzman, 2010), this study provides important insights into whether firms alter
their tax planning in response to a shock to the corporate litigation environment. While the finance literature has examined the role of
securities litigation in insider trading (e.g., Griffin et al., 2004), IPO pricing (e.g., Hao, 2011), debt contracting (e.g., Deng et al., 2014),
and corporate financial policies (e.g., Arena and Julio, 2015), there is scant evidence on how the ex-ante threat of litigation, as a
governance mechanism, affects corporate tax avoidance. This study also contributes to the ongoing debate in the corporate governance
and tax literature about whether and how governance mechanisms and corporate tax avoidance are linked (e.g., Armstrong et al.,
2015).
Second, using the DID method, we demonstrate a causal relation between securities litigation risk and corporate tax avoidance
behavior, mitigating the endogeneity concern that affects prior studies in the corporate governance and tax literature. Existing studies
examining the association between corporate governance and tax avoidance have not established causality and have garnered mixed
results. For example, Desai and Dharmapala (2006) find a negative association between equity-based compensation and tax avoidance,
whereas Rego and Wilson (2012) and Armstrong et al. (2015) find evidence that risk-taking equity incentives are positively related to
tax avoidance. As indicated by Hanlon and Heitzman (2010), a reliable measure of corporate governance is difficult to obtain because
corporate governance is endogenous.
Finally, given the significant impact of corporate tax on government revenue and the overall economy, and recent tax controversies
involving large corporations such as Apple and Starbucks, this study has policy implications regarding the preservation of shareholder
litigation rights as a way of constraining tax avoidance.3 This study also helps us understand why some firms avoid paying more taxes
than others from the perspective of shareholder litigation.
The remainder of the paper is organized as follows. In Section 2, we discuss hypotheses development. In Section 3, we describe our
research design and sample selection. In Section 4, we discuss our main results. Section 5 presents robustness tests. Section 6 concludes.
2. Hypotheses development
Securities litigation is one of the main external disciplinary forces in corporate governance. Recent studies provide direct evidence
that the threat of securities litigation can mitigate agency problems arising from the separation of ownership and control. For example,
Crane and Koch (2016) find that due to the reduction in the threat of shareholder litigation after the 1999 ruling in the Ninth Circuit,
ownership became more concentrated and shifts from individuals to institutions. Their findings suggest that the ownership structure
alterations substitute for the weakened governance due to a decrease in litigation risk. In the same vein, Appel (2016) uses states’
staggered adoption of universal demand laws as a shock to the litigation environment and finds that shareholder litigation rights play
an important role in corporate governance, especially when the alternative governance mechanisms are weak.4
Corporate tax research suggests that the complexity of tax avoidance activities can be used to mask managerial rent extraction (e.g.,
Desai and Dharmapala, 2006, 2009). Managers’ opportunistic behaviors facilitated by tax avoidance can lead to future stock price
crashes, which could trigger securities lawsuits (e.g., Kim et al., 2011). According to the governance effects of shareholder litigation,
the ex-ante litigation risk can constrain managers from engaging in tax avoidance by curtailing rent extraction. In other words, the
weakening of shareholder litigation rights by the 1999 ruling could create opportunities for tax-avoidance-related rent-seeking ac
tivities. Therefore, we predict a negative relation between the threat of shareholder litigation and corporate tax avoidance.
Conversely, it is plausible that the threat of securities litigation is positively associated with tax avoidance. The traditional view of
corporate tax avoidance suggests that shareholder value increases as tax avoidance transfers resources from the government to
3
http://fortune.com/2016/03/11/apple-google-taxes-eu/
4
Existing literature also provides ex-post evidence that lawsuits often tilt corporations toward improving the effectiveness of corporate gover
nance (Arena and Ferris, 2017). For instance, Farber (2005) and Marciukaityte et al. (2006) find that firms involved in fraud cases act to improve
their governance practices by increasing the number of independent directors and the frequency of audit committee meetings. Ferris et al. (2007)
find that boards of firms involved in lawsuits are likely to increase the number of independent directors. Humphery-Jenner (2012) finds that the
CEOs of firms targeted by securities class action lawsuits experience a reduction in compensation and, in some cases, are removed from their post.
3
shareholders and results in an increase in after-tax cash flows. According to this view, tax avoidance does not necessarily create op
portunities for managerial diversion. Similarly, Armstrong et al. (2015) argue that tax avoidance is just one of many risky but value-
enhancing investment opportunities available to managers. In the absence of effective monitoring, self-motivated managers may
choose a level of tax avoidance that diverges from what is optimal for the shareholders. Consistent with this line of reasoning,
Armstrong et al. (2015) and Rego and Wilson (2012) find that on average, equity incentives, which align managerial incentives with
those of shareholders, are positively related to corporate tax avoidance. Therefore, given the governance role of shareholder litigation,
we predict a positive relation between the threat of shareholder litigation and corporate tax avoidance.
Given the contrasting arguments, we propose the following competing hypotheses:
H1a. All else being equal, the threat of securities litigation is negatively associated with corporate tax avoidance.
H1b. All else being equal, the threat of securities litigation is positively associated with corporate tax avoidance.
Next, we investigate the mechanisms that may moderate the governance effects of litigation risk on tax planning activities:
alternative external governance mechanisms (analyst coverage and institutional ownership) and labor unions. The strength of a firm’s
external monitoring mechanisms such as analyst coverage and institutional ownership affects the level of tax avoidance. For example,
Allen et al. (2016) find that higher analyst coverage demands for more-transparent information and increases the visibility of
aggressive tax planning behavior, which in turn reduces tax aggressiveness. Khurana and Moser (2013) find that institutional investors
with long-term investment horizons play an important role in constraining tax avoidance activities if such activities encourage
managerial rent extraction and reduce corporate transparency. Given the possible substitution effect between shareholder litigation
and other governance mechanisms, we formulate the following hypothesis:
H2. All else being equal, if litigation risk is negatively associated with corporate tax avoidance, the effect of the threat of securities
litigation on corporate tax avoidance is less pronounced for firms with greater analyst coverage and higher institutional ownership.
Recent studies find that labor unions differ in incentives, political motivation, and risk preferences from other stakeholders (e.g.,
Faleye et al., 2006; Leung et al., 2012). Agrawal (2012) shows that labor union pension funds have become increasingly active in
corporate governance matters. Chyz et al. (2013) show that, by providing increased monitoring over managers, labor unions play an
important role in curbing aggressive tax avoidance behavior. As labor unions provide an alternative disciplinary mechanism that could
limit aggressive tax planning, we propose the following hypothesis:
H3. All else being equal, if litigation risk is negatively associated with corporate tax avoidance, the effect of the threat of securities
litigation on corporate tax avoidance is less significant for firms with a workforce represented by stronger labor unions.
3. Sample selection and research design
3.1. Sample selection
Our initial sample includes all U.S. firms in Compustat spanning from 1994 through 2004. We select the sample period with the goal
of generating an adequate number of observations centering on the event of the 1999 ruling without including years too temporally
distant and therefore irrelevant to the event. We start our window in 1994 to avoid the confounding effect of two tax regulatory events
in 1993 that could potentially bias our results: 1) the enactment of FAS 109, Accounting for Income Taxes, which changed the ac
counting standard for corporate income taxes; and 2) the increase in the statutory corporate income tax rate from 34% to 35%.
Following prior literature on tax avoidance, we exclude utilities (SIC codes 4900–4949) and finance companies (SIC codes
6000–6999). We then drop observations without information in Compustat that we need to construct our variables. In addition, we
require firms to exist both prior to and after the 1999 ruling. We obtain historical headquarters data from Compact Disclosure and the
CRSP-Compustat Merged database. As we have four different measures to proxy for corporate tax avoidance as discussed below, our
final sample size varies upon data availability.
3.2. Research design
We examine the effect of securities litigation risk on corporate tax avoidance using the DID method. By decreasing the threat of
shareholder litigation risk faced by firms headquartered in the states that comprise the Ninth Circuit, the 1999 ruling enables us to
employ the DID approach to establish the causal relation between the threat of litigation and corporate tax avoidance. Our treated
firms are those located in states included in the Ninth Circuit as they are subject to the 1999 ruling. We present our baseline regression
model below.
TaxAvoidanceilt= = αt + αl + αind + β × Treatmentlt + γ’Xilt + εilt (1)
where i denotes a firm; l denotes a state where a firm’s headquarters is located; t denotes a year; αt, αl, and αind are year, state, and
4
industry fixed effects, respectively; and ε is the error term. TaxAvoidance is the dependent variable, defined by each of the four
measures of tax avoidance: effective tax rate (ETR), the book-tax difference (MPBT), ETR differential (ETR_DIF), and discretionary
permanent book-tax difference (DTAX). Treatment is a dummy variable that equals one in year t if a firm is headquartered in a state that
is subject to the Ninth Circuit ruling, and zero otherwise.5 Our treatment effect is thus defined based on the geographic location of a
firm’s headquarters. β is the DID coefficient of interest for identifying the treatment effect of the 1999 ruling. X includes a vector of
determinants of corporate tax avoidance. Standard errors are clustered at the state level because the ruling applies at the state level.
Following the existing literature, we use four measures to capture the extent of tax aggressiveness. Our first measure is effective tax
rate (ETR), defined as total income tax expense divided by pre-tax book income less special items. ETR captures tax-avoidance ac
tivities that result in permanent tax savings. Higher ETR means lower tax aggressiveness. However, ETR reflects tax-avoidance ac
tivities that affect net income but not those that defer cash tax payments to later periods because total tax expense includes both current
tax expense and deferred tax expense (McGuire et al., 2014). We also employ three book-tax difference measures.6 The first one is the
Manzon and Plesko (2002) book-tax difference (MPBT), which captures book-tax difference explained by different tax and accounting
rules as well as by economic factors.7 Higher MPBT indicates more aggressive tax planning. The second one is the ETR differential
(ETR_DIF), which is defined as the total book-tax difference less the temporary book-tax difference. Higher ETR_DIF indicates more tax
aggressiveness. The third one is discretionary permanent book-tax difference (DTAX) as used in Frank et al. (2009). DTAX excludes
temporary differences in book and cash taxes that can be explained by earnings management activity and nondiscretionary items, and
focuses on permanent differences. Frank et al. (2009) argue that these permanent differences are more reflective of the goal of a tax
shelter than temporary differences. In addition, Wilson (2009) states that the permanent book-tax differential is more indicative of
actual cases of tax sheltering. Higher DTAX indicates more aggressive tax avoidance.
Following the existing literature, we include an extensive list of control variables that are used to explain tax avoidance (e.g., Chen
et al., 2010; Hoi et al., 2013; Chyz et al., 2013; McGuire et al., 2014). These control variables include cash holdings (Cash); return on
assets (ROA); financial leverage (Leverage); income from foreign operations (FI); property, plant, and equipment (PPE); intangible
assets (Intangible); income reported under the equity method (Eqinc); discretionary accruals (Disc_accr); a Delaware indicator (Dela
ware); firm size (Size); and the market-to-book ratio (MB). We control for cash holdings (Cash) to capture tax planning incentives given
that firms with more cash are less likely to defer taxes. We also include return on assets (ROA) to control the impact of profitability on a
firm’s incentive to avoid income taxes. We use financial leverage (Leverage) to capture the effect of a tax shield arising from debt
because prior studies find that higher levels of debt are negatively associated with the effective tax rate (e.g., Graham, 1996). We
include income from foreign operations (FI) as a control because multinational firms with more operations overseas have more op
portunities to engage in tax planning (e.g., Rego, 2003). The differences in financial and tax accounting treatment on a firm’s in
vestment activities also affect its book-tax differences (e.g., Chen et al., 2010). Therefore, we include property, plant, and equipment
(PPE), intangible assets (Intangible), and income reported under the equity method (Eqinc) in our model. We control for discretionary
accruals (Disc_accr) because Frank et al. (2009) find that abnormal accruals are positively related to aggressive tax avoidance.8 The
Delaware incorporation indicator is also included in the baseline model because prior studies find that U.S. firms have engaged in
Delaware-based tax avoidance activities (e.g., Dyreng et al., 2013). Last, we include firm size (Size) and the market-to-book ratio (MB)
to control for size and value-related firm characteristics. We winsorize all continuous variables at the 1% and 99% percentiles.
Appendix B provides detailed variable definitions.
3.3. Summary statistics
Table 1 presents the descriptive statistics for the variables included in the multivariate analysis. Table 1, Panel 1 reports the full
sample statistics. Due to the variation in data availability and variable construction, the number of firm-year observations ranges from
23,914 (ETR) to 11,981 (MPBT). These statistics are generally consistent with the findings in prior studies. For example, the mean
value of DTAX is about 0.023, which is consistent with Frank et al. (2009). We also report summary statistics for firms located in the
Ninth Circuit and in other circuits in Panels B and C, respectively. Consistent with the findings in Crane and Koch (2016), firm
characteristics differ in value across the various circuits of the U.S. Appeals Court.
4. Empirical results
4.1. Baseline DID regressions
Table 2 presents the baseline results of the DID analysis. In columns (1)–(4), the dependent variables are ETR, MPBT, ETR_DIF, and
DTAX, respectively. The coefficient estimates of β for the ETR regression is negative and significant at the 1% level, indicating that the
5
As the ruling was made in the middle of the year, we do not include the observations in 1999 and we do not assign it to either the pre or post
period. Including the observations from 1999 in either the pre or post group does not change our results.
6
Mills (1998) finds that firms with large book-tax differences are more likely to be audited by the IRS. Wilson (2009) finds that book-tax dif
ferences are larger for firms accused of engaging in tax shelters than for a matched sample of non-accused firms.
7
MPBT = (Domestic income – (current federal tax expense/0.35) – state income taxes – other income taxes – equity income)/Lagged total assets.
8
Hopkins (2018) finds that shareholder litigation affects corporate earnings management. The inclusion of Disc_accr in the baseline regression can
also alleviate the concern that our results are driven by the quality of financial reporting.
5
Table 1
Summary statistics.
N Mean Median Std Dev 25th Pctl 75th Pctl
Panel A: Total
ETRi,t 23,914 0.241 0.303 0.189 0.001 0.380
MPBTi,t 11,184 0.023 0.014 0.060 − 0.005 0.040
ETR_DIFi,t 21,089 − 0.123 0.001 0.431 − 0.082 0.016
DTAXi,t 18,020 0.023 0.019 0.173 − 0.018 0.076
Cashi,t 23,914 0.249 0.103 0.415 0.026 0.325
ROAi,t 23,914 − 0.051 0.053 0.492 − 0.092 0.135
Leveragei,t 23,914 0.178 0.082 0.265 0.000 0.269
FIi,t 23,914 0.006 0.000 0.029 0.000 0.000
PPEi,t 23,914 0.579 0.454 0.505 0.224 0.789
Intangiblei,t 23,914 0.138 0.038 0.239 0.000 0.179
Eqinci,t 23,914 0.000 0.000 0.005 0.000 0.000
Disc_accri,t 23,914 0.020 0.005 0.379 − 0.070 0.091
Delawarei,t 23,914 0.592 1.000 0.492 0.000 1.000
Sizei,t-1 23,914 4.676 4.599 2.213 3.141 6.161
MBi,t-1 23,914 0.814 0.757 1.027 0.180 1.369
Panel B: Ninth circuit

ETRi,t 5277 0.208 0.228 0.192 0.000 0.369
MPBTi,t 2410 0.028 0.014 0.078 − 0.009 0.049
ETR_DIFi,t 6031 − 0.154 − 0.006 0.412 − 0.220 0.019
DTAXi,t 5157 0.023 0.024 0.211 − 0.034 0.106
Cashi,t 6790 0.362 0.229 0.476 0.067 0.492
ROAi,t 6790 − 0.114 0.001 0.483 − 0.229 0.110
Leveragei,t 6790 0.132 0.019 0.247 0.000 0.184
FIi,t 6790 0.005 0.000 0.031 0.000 0.000
PPEi,t 6790 0.468 0.338 0.433 0.174 0.629
Intangiblei,t 6790 0.126 0.023 0.245 0.000 0.145
Eqinci,t 6790 0.000 0.000 0.005 0.000 0.000
Disc_accri,t 6790 0.014 0.000 0.396 − 0.093 0.103
Delawarei,t 6790 0.692 1.000 0.462 0.000 1.000
Sizei,t-1 6790 4.708 4.665 2.120 3.282 6.072
MBi,t-1 6790 0.951 0.887 1.049 0.282 1.542
Panel C: Other circuits

ETRi,t 18,637 0.251 0.316 0.186 0.018 0.381
MPBTi,t 9571 0.025 0.015 0.061 − 0.003 0.041
ETR_DIFi,t 19,241 − 0.109 0.000 0.415 − 0.073 0.015
DTAXi,t 16,351 0.023 0.019 0.174 − 0.018 0.074
Cashi,t 22,456 0.211 0.080 0.377 0.021 0.259
ROAi,t 22,456 − 0.049 0.041 0.462 − 0.090 0.123
Leveragei,t 22,456 0.191 0.107 0.269 0.002 0.289
FIi,t 22,456 0.005 0.000 0.029 0.000 0.000
PPEi,t 22,456 0.596 0.473 0.514 0.237 0.810
Intangiblei,t 22,456 0.144 0.046 0.241 0.000 0.191
Eqinci,t 22,456 0.000 0.000 0.005 0.000 0.000
Disc_accri,t 22,456 0.018 0.004 0.377 − 0.071 0.088
Delawarei,t 22,456 0.572 1.000 0.495 0.000 1.000
Sizei,t-1 22,456 4.571 4.460 2.221 3.008 6.077
MBi,t-1 22,456 0.729 0.682 1.047 0.100 1.290
This table reports summary statistics for the baseline sample between 1994 and 2004. Panel A presents the summary statistics for the entire baseline
sample. Panel B reports the summary statistics for firms subject to the 1999 Ninth Circuit ruling in In re: Silicon Graphics. Panel C reports the summary
statistics for firms in states not in the Ninth Circuit. Please refer to Appendix B for variable definitions and descriptions.
treatment firms experience an increase in corporate tax avoidance after the ruling, relative to control firms. In columns (2)–(4), where
the dependent variables are MPBT, ETR_DIF, and DTAX, the positive sign of β suggests that treatment firms in the Ninth Circuit are
more likely to engage in tax avoidance activities than control peers after the 1999 ruling. Therefore, our results support the hypothesis
that firms that face lower litigation risk exhibit a higher level of tax aggressiveness. In addition, the coefficients of the control variables
have signs consistent with the existing literature.
Our results are also economically significant. For example, in column (1), the 1999 ruling treatment causes an increase in tax
avoidance of 1.4% relative to non-Ninth Circuit firms. The difference in the effective tax rate between treatment and control firms is
1.4%. In comparison, Chen et al. (2010) find a 0.5% difference in the effective tax rate between family- and non-family-owned firms.
4.2. Placebo tests
We conduct two placebo tests to assure that our results are not driven by non-parallel trends before the ruling or by unobserved
6
Table 2
Difference-in-differences regression: the impact of litigation laws on corporate tax avoidance.
Variables (1) (2) (3) (4)
ETRi,t MPBTi,t ETR_DIFi,t DTAXi,t
Treatment − 0.014*** 0.004** 0.007* 0.020***

(− 2.77) (2.41) (1.83) (7.58)
Cashi,t − 0.016*** 0.015*** − 0.027*** 0.010*
(− 2.86) (3.66) (− 4.06) (1.95)
ROAi,t 0.086*** 0.140*** 0.774*** 0.231***
(12.55) (9.48) (37.23) (20.68)
Leveragei,t 0.017** 0.009** 0.021* − 0.002
(2.35) (2.13) (1.97) (− 0.24)
FIi,t 0.150*** − 0.302*** − 0.226*** 0.105**
(3.31) (− 10.69) (− 4.68) (2.30)
PPEi,t 0.005 0.018*** − 0.007* 0.006
(0.90) (7.29) (− 1.70) (0.92)
Intangiblei,t 0.036*** − 0.000 − 0.011 0.091***
(5.92) (− 0.06) (− 0.72) (10.39)
Eqinci,t 1.046*** − 1.112*** − 0.442** − 1.947***
(2.83) (− 5.48) (− 2.03) (− 8.42)
Disc_accri,t 0.013*** 0.007** 0.006 0.014***
(3.91) (2.52) (1.00) (2.69)
Delawarei,t − 0.018*** 0.006*** − 0.001 0.008***
(− 4.27) (3.06) (− 0.45) (2.74)
Sizei,t-1 0.024*** − 0.006*** 0.003 − 0.005***
(22.26) (− 6.10) (1.48) (− 5.31)
MBi,t-1 − 0.033*** 0.008*** − 0.029*** 0.001
(− 17.90) (4.44) (− 8.38) (0.28)
Year FE YES YES YES YES
State FE YES YES YES YES
Industry FE YES YES YES YES
Observations 23,914 11,981 25,272 21,508
Adj. R-squared 0.310 0.198 0.869 0.210
This table presents a difference-in-differences estimation of the effect of the 1999 Ninth Circuit ruling on corporate tax avoidance. Each column has a
different measure to capture corporate tax avoidance activities, including ETR, MPBT, ETR_DIF and DTAX. The main variable of interest, Treatment, is
an indicator variable that equals one if a firm is subject to the Ninth Circuit’s 1999 ruling in a given year after 1999 and zero otherwise. Please refer to
Appendix B for definitions of other variables. We report in parentheses t-values adjusted for heteroscedasticity and state-level clustering. *, **, and ***
indicate significance levels of less than 0.10, 0.05 and 0.01, respectively, based on a two-tailed test.
characteristics that affect tax avoidance differently for firms in the Ninth Circuit compared to other firms. In the first placebo test, we
replace the actual event year (1999) with a pseudo-event year (1996) and rerun the baseline DID regressions using a four-year window
(two years pre- and two years post-event).9 We select that specific pseudo-event year and testing window for two reasons: 1) a pseudo-
event year that is far away from the actual event year may not well serve our purpose of investigating whether the non-parallel trends
exist; and 2) the sample period should end before the actual event year so that the actual event would not confound this placebo test.
Treatment_pseudo_year is defined as an indicator variable that equals one if a firm is subject to the pseudo-ruling in a given year after
1996 and zero otherwise. The results in Table 3 show that the coefficients on Treatment_pseudo_year are either not statistically sig
nificant or have the opposite sign, indicating that the fictional ruling that occurred in 1996 does not have any significant effect on tax
avoidance. The results suggest that the parallel trend assumption is likely satisfied, i.e., the results are unlikely to be driven by un
observed trend differences between the treated and control groups.
Following Crane and Koch (2016), we perform a second placebo test using pseudo-Ninth Circuit states. We randomly assign states
not in the Ninth Circuit to the Ninth Circuit. Treatment_pseudo_state is defined as an indicator variable that equals one if a firm is subject
to the 1999 ruling of the pseudo-Ninth Circuit Court in a given year after 1999 and zero otherwise. We repeat this procedure 2000
times to generate a distribution of coefficient estimates and present the results in Fig. 1. These results provide further support for our
finding that the reduction in the threat of securities litigation due to the 1999 ruling in the Ninth Circuit results in a significant increase
in tax avoidance, on average. For example, in the ETR graph (Panel A of Fig. 1), the true coefficient estimate on Treatment (− 0.014)
from column (1) of Table 2 lies to the left of the entire distribution of coefficient estimates from the placebo test. More specifically, the
estimated true coefficient on Treatment in the ETR regression (− 0.014) is approximately five standard deviations (0.011) below the
mean of the estimated coefficients (0.0022) from the placebo test and is much smaller than the minimum estimated coefficient
(− 0.0045). Taken together, these results provide further confirmation that it is the Ninth’s Circuit’s 1999 ruling that leads to our main
finding.
9
We also use year 1993 as an alternative placebo year and run the same tests on a ten-year window (five years pre- and five years post-event). We
find consistent results.
7
Table 3
A placebo test: pseudo–ruling year.
Variables (1) (2) (3) (4)
Treatment_pseudo_year 0.005 0.003 − 0.005 − 0.008

(1.40) (0.55) (− 0.69) (− 0.92)
Cashi,t 0.000 0.009 − 0.042*** − 0.014**
(0.07) (1.20) (− 5.27) (− 2.05)
ROAi,t 0.102*** 0.096*** 0.813*** 0.229***
(9.23) (4.06) (33.12) (21.26)
Leveragei,t 0.015 0.005 0.047*** 0.011
(1.44) (0.74) (4.06) (0.83)
FIi,t 0.026 − 0.254*** − 0.365*** 0.098
(0.38) (− 5.40) (− 6.47) (1.37)
PPEi,t − 0.001 0.017*** − 0.019** − 0.004
(− 0.18) (5.46) (− 2.64) (− 0.71)
Intangiblei,t 0.033*** − 0.001 − 0.057*** 0.053***
(3.28) (− 0.07) (− 2.81) (4.20)
Eqinci,t 0.726 − 0.943*** − 0.106 − 1.650***
(1.56) (− 2.74) (− 0.36) (− 4.94)
Disc_accri,t 0.026** 0.003 0.018 0.033**
(2.25) (0.39) (1.01) (2.30)
Delawarei,t − 0.015*** 0.005** 0.004 0.015***
(− 3.42) (2.41) (0.80) (3.81)
Sizei,t-1 0.026*** − 0.006*** − 0.002 − 0.007***
(18.30) (− 6.12) (− 0.78) (− 4.43)
MBi,t-1 − 0.034*** 0.009*** − 0.034*** − 0.004
(− 12.54) (2.79) (− 7.05) (− 1.35)
Observations 9016 5039 9151 8050
Adj. R-squared 0.374 0.131 0.832 0.205
This table presents the placebo test results. The pseudo—ruling year is 1996. The sample period is from 1994 to 1998. Each column has a different
measure to capture corporate tax avoidance activities, including ETR, MPBT, ETR_DIF and DTAX. The main variable of interest, Treatment_
pseudo_year, is an indicator variable that equals one if a firm is subject to the pseudo–ruling of the Ninth Circuit Court of Appeals in a given year after
1996 and zero otherwise. Please refer to Appendix B for definitions of other variables. We report in parentheses t-values adjusted for hetero
scedasticity and state-level clustering. *, **, and *** indicate significance levels of less than 0.10, 0.05 and 0.01, respectively, based on a two-tailed
test.
4.3. Propensity score matching (PSM) results
One may argue that the differences in firm characteristics between treatment and control firms could partially drive our main
results. To alleviate such a concern, we further examine whether our results hold if we use a matched sample based on a propensity
score matching (PSM) method. We identify a group of control firms that are comparable to treatment firms based on observable firm-
level characteristics. For each of the treatment firms, we find a matched control firm using the nearest neighbor propensity score
matching. The matching is based on observable firm characteristics in both 1998 and 1994. To create the matched sample, we start by
estimating the likelihood of being a treatment firm in 1999 using a probit model:
Prob(Treatment = 1)i,j = a1 Xi,t− 1 + a2 Xi,t− 5 + δj + εi,j (2)
where i indexes the firm and j indexes the industry. Xi,t-1 is a vector of baseline control variables in 1998, and Xi,t-5 represents the same
baseline control variables in 1994. δj denotes the industry fixed effects to account for any unobservable industry differences. We then
use the regression results of a probit model and match each treatment firm to a control firm based on the closest estimated propensity
score. Appendix C reports the effectiveness of the matches. The results presented in the appendix indicate that the matches are effective
in narrowing the difference between treatment and control firms in firm characteristics of interest. To further mitigate the concern that
treatment and control firms are not perfectly matched, we control for firm-level characteristics in the multivariate regressions.
Table 4 presents PSM regression results. We find that the treatment effect continues to hold for all tax-avoidance proxies. As
indicated by the magnitude of coefficient estimates of Treatment, the treatment effect is stronger relative to the ones that use the whole
sample in the baseline regressions except for DTAX. These results provide additional supporting evidence for the hypothesis that firms
8
Fig. 1. A placebo test: Pseudo–Ninth circuit states.

This figure shows the results of a placebo test that randomly assigns non-Ninth Circuit states to the Ninth Circuit. This procedure is repeated 2000
times and the distribution of the estimated coefficients on Treatment_pseudo_state from the placebo test is reported in this figure. The true coefficient
estimates from Table 2 are labeled for comparison. Variable definitions are presented in Appendix B.
are more likely to engage in tax avoidance activities in response to the reduction in litigation risk as a result of the 1999 ruling.
4.4. Governance effects versus frivolous litigation
As remarked in many law studies, lawsuits are often frivolous.10 Frivolous litigation only benefits the plaintiffs’ attorneys and
distracts managers from conducting normal business, which in turn imposes large costs on the firm. Managers exposed to the threat of
such lawsuits are less likely to engage in risky and complex tax avoidance. Therefore, it is possible that after the 1999 ruling, tax
avoidance responds to a reduction in the threat of frivolous lawsuits, but not to a decrease in the governance effect of shareholder
litigation.
To differentiate the governance effects from the threat of frivolous lawsuits, we examine whether the treatment effect is more
pronounced among firms that are more susceptible to frivolous litigation. Following prior studies (e.g., Johnson et al., 2000) that
propose a set of measures to capture a firm’s exposure to lawsuits without merit, we adopt the following measures: high return
volatility (High Volatility), low minimum stock returns (Low Min_Ret), low cumulative stock returns (Low Cum_Ret) and low stock
turnover (Low Turnover). High Volatility is an indicator variable that equals one if the standard deviation of daily returns in a firm-year
10
For example, Helland (2006) finds that directors and officers who are accused of fraud suffer no reputational penalty when facing securities class
actions, calling into question the merits of private securities class actions. Romano (1991) points out that the attorneys’ incentives do not always
align with the shareholders’ interests, and in most suits, the plaintiffs’ bar is the true beneficiary of the litigation. Cheng et al. (2010) point out that
one potential cost incurred by shareholder litigation is the diversion of management’s attention from its primary responsibilities.
9
Table 4
Difference-in-differences regression: propensity-score-matched (PSM) sample.
Variables (1) (2) (3) (4)
Treatment − 0.015** 0.007* 0.014* 0.013***

(− 2.30) (1.73) (1.76) (3.01)
Cashi,t − 0.020*** 0.004 − 0.039*** − 0.002
(− 3.16) (0.55) (− 4.08) (− 0.26)
ROAi,t 0.119*** 0.079*** 0.803*** 0.113***
(3.80) (2.77) (25.29) (7.42)
Leveragei,t 0.000 − 0.005 0.040*** 0.013
(0.02) (− 0.68) (3.08) (1.55)
FIi,t − 0.045 − 0.247*** − 0.056 0.409***
(− 0.34) (− 4.80) (− 0.60) (5.53)
PPEi,t − 0.010 0.032*** − 0.015*** 0.006
(− 1.00) (4.76) (− 3.66) (0.95)
Intangiblei,t 0.054** 0.006 − 0.041** 0.034**
(2.03) (0.55) (− 2.64) (2.41)
Eqinci,t 0.399 − 0.807** 0.313 − 1.161***
(0.43) (− 2.19) (0.83) (− 2.77)
Disc_accri,t 0.006 − 0.007 0.020** 0.009
(1.10) (− 0.97) (2.54) (1.01)
Delawarei,t 0.002 0.001 0.003 − 0.003
(0.24) (0.34) (0.77) (− 0.63)
Sizei,t-1 0.025*** − 0.009*** − 0.005*** − 0.004**
(7.23) (− 8.01) (− 3.07) (− 2.54)
MBi,t-1 − 0.041*** 0.012*** − 0.023*** − 0.005
(− 4.76) (3.27) (− 7.10) (− 1.20)
Observations 3209 2054 3369 3027
Adj. R-squared 0.418 0.189 0.844 0.178
This table presents a difference-in-differences estimation of the effect of the 1999 Ninth Circuit ruling on corporate tax avoidance. The regression is
estimated based on a PSM sample. In each column, we have a different measure to capture corporate tax avoidance activities, including ETR, MPBT,
ETR_DIF and DTAX. The main variable of interest, Treatment, is an indicator variable that equals one if a firm is subject to the Ninth Circuit’s 1999
ruling in a given year after 1999, and zero otherwise. Please refer to Appendix B for definitions of other variables. We report in parentheses t-values
adjusted for heteroscedasticity and state-level clustering. *, **, and *** indicate significance levels of less than 0.10, 0.05 and 0.01, respectively, based
on a two-tailed test.
is in the top quintile and zero otherwise. Low Min_Ret is an indicator variable that equal one if the minimum monthly return in a firm-
year is in the bottom quintile and zero otherwise. Low Cum_Ret is an indicator variable that equals one if the cumulative return in a
firm-year is in the bottom quintile and zero otherwise. Low Turnover is an indicator variable that equals one if the stock turnover
(average daily trading volume divided by the number of shares outstanding) in a firm-year is in the bottom quintile and zero otherwise.
We then interact each of these measures with the main variable Treatment.
If the “frivolousness” view prevails, we should observe a statistically significant interaction term with the same sign as the main
effect Treatment. The results are reported in Table 5.11 In most cases, the point estimates of the interaction term are insignificant and, in
some cases (Low Min_Ret and Low Turnover for DTAX), we find the treatment effect is actually weaker for those firms. The only
exception is seen in column (1) of Panel C, in which the treatment effect is stronger for those firms when ETR is used as the measure of
tax avoidance. Taken together, our results largely support the “governance” view. However, we cannot completely rule out the
“frivolousness” view.
4.5. Stock market reaction
In this section, we examine the treatment effect in relation to the stock market reaction around the date of the 1999 ruling. The
market reaction should depend on a firm’s reliance on shareholder litigation as a governance mechanism. Namely, the market reaction
to the 1999 ruling should be more (less) pronounced among firms with weaker (stronger) alternative governance mechanisms.
To measure this market reaction, we use a firm’s three-day cumulative abnormal returns (CARs), centered on the day of the 1999
ruling. The market model is used to estimate abnormal returns. To capture the extent of market response, we follow Crane and Koch
(2016) and construct an indicator variable, Zero_CAR, which equals one if a firm’s CAR falls within the cross-sectional interquartile
range, and zero otherwise. We expect the governance effects to be weaker in firms with less-significant market reaction. The results
11
The results are reported in Table 5. For brevity, we only report the coefficients of Treatment and the interaction term of interest. All control
variables are included in the estimation.
10
Table 5
Difference in difference regression: governance effects versus frivolous litigation.
Variables (1) (2) (3) (4)
Panel A
Treatment × High Volatility − 0.004 − 0.006 − 0.014 − 0.018
(− 0.21) (− 0.42) (− 1.16) (− 1.08)
Treatment − 0.009 0.003 0.015*** 0.025***
(− 1.51) (1.33) (4.03) (6.65)
Panel B
Treatment × Low Min_Ret − 0.008 0.005 − 0.012 − 0.018*
(− 0.48) (0.82) (− 1.43) (− 1.68)
Treatment − 0.011* 0.002 0.014*** 0.025***
(− 1.99) (0.73) (3.94) (8.82)
Panel C
Treatment × Low Cum_Ret − 0.004** 0.001 − 0.001 − 0.001
(− 2.28) (0.47) (− 0.58) (− 0.57)
Treatment − 0.010** 0.002 0.015*** 0.024***
(− 2.30) (1.04) (3.74) (8.45)
Panel D
Treatment × Low Turnover − 0.010 − 0.002 − 0.010 − 0.015**
(− 0.71) (− 0.35) (− 1.08) (− 2.07)
Treatment − 0.011** 0.002 0.012*** 0.023***
(− 2.04) (1.22) (3.30) (6.72)
Observations 23,914 11,981 25,272 21,508
Controls Included Included Included Included
All double interaction terms Included Included Included Included
This table presents a difference-in-differences estimation of the effect of the 1999 Ninth Circuit ruling on corporate tax avoidance. The main variables
of interest are the interaction terms between Treatment and High Volatility, Low Min_Ret, Low Cum_Ret, and Low Turnover, respectively. Each column
has a different measure to capture corporate tax avoidance activities, including ETR, MPBT, ETR_DIF and DTAX. Treatment is an indicator variable
that equals one if a firm is subject to the Ninth Circuit’s 1999 ruling in a given year after 1999, and zero otherwise. High Volatility is an indicator
variable that equals one if the standard deviation of daily returns in a firm-year is in the top quintile, and zero otherwise. Low Min_Ret is an indicator
variable that equals one if the minimum monthly return in a firm-year is in the bottom quintile, and zero otherwise. Low Cum_Ret is an indicator
variable that equals one if the cumulative return in a firm-year is in the bottom quintile, and zero otherwise. Low Turnover is an indicator variable that
equals one if the stock turnover (average daily trading volume divided by the number of shares outstanding) in a firm-year is in the bottom quintile,
and zero otherwise. We then interact each of these measures with the main variable Treatment. Baseline regression control variables are included but
not reported for brevity. We also control the interaction term between Ninth Circuit (Post 1999) and frivolous litigation exposure variables. Ninth
Circuit takes a value of one if the firm is subject to the Ninth Circuit’s 1999 ruling. Post 1999 takes a value of one if the observation is after 1999. Please
refer to Appendix B for definitions of other variables. We report in parentheses t-values adjusted for heteroscedasticity and state-level clustering. *, **,
and *** indicate significance levels of less than 0.10, 0.05 and 0.01, respectively, based on a two-tailed test.
presented in Table 6 provide some evidence in support of our prediction. The significant coefficient estimates on Treatment × Zero_CAR
in columns (1) and (3) indicate that the treatment effect is weaker among firms with a muted market response to the ruling.
4.6. Cross-sectional heterogeneity
4.6.1. External governance mechanisms: analyst coverage and institutional ownership

In this subsection, we examine whether there is a complement or substitution effect between litigation risk and other monitoring
channels. Specifically, we analyze whether the response of tax avoidance to a change in litigation risk is affected by alternative external
governance mechanisms such as analyst coverage and institutional ownership. We use High Analyst and High IO to capture the strength
of these alternative monitoring forces. High Analyst is an indicator that equals one if the number of analysts following a firm is above
the median value in a given year and zero otherwise. High IO is an indicator that equals one if a firm’s institutional ownership is above
the median value in a given year and zero otherwise. Panels A and B of Table 7 present the results of DID analyses with an interaction
between Treatment and High Analyst and between Treatment and High IO, respectively.
The interaction between Treatment and High Analyst is significant but carries the opposite sign of the Treatment coefficient for all tax
avoidance measure. The only exception is ETR_DIF for which the coefficient estimate is not significant. The interaction between
Treatment and High IO delivers similar results for ETR and MPBT. For the ETR_DIF and DTAX, the results are not significant. Overall, the
results are consistent with hypothesis H2, indicating that analyst coverage and institutional ownership, as alternative external
governance mechanisms, moderate the association between litigation risk and corporate tax planning activities.
4.6.2. Labor unions

We then gauge the treatment effect on tax avoidance in the presence of strong labor unions. As presented in Section 2, we expect
11
Table 6
Difference in difference regression: the role of market reaction.
Variables (1) (2) (3) (4)
Treatment × Zero_CAR 0.015** 0.003 − 0.010* 0.001

(2.13) (1.10) (− 1.68) (0.19)
Treatment − 0.016*** 0.001 0.019*** 0.019***
(− 3.04) (0.51) (4.87) (4.78)
Zero_CAR 0.011*** 0.002 − 0.002 0.001
(3.33) (0.85) (− 0.64) (0.24)
Ninth Circuit × Zero_CAR 0.006 − 0.010*** 0.007 − 0.007
(0.80) (− 3.30) (1.38) (− 1.42)
Post 1999× Zero_CAR 0.004 − 0.002 0.002 − 0.006
(1.23) (− 0.81) (0.52) (− 1.20)
Cashi,t − 0.029*** 0.015*** − 0.044*** 0.007
(− 4.37) (3.56) (− 9.88) (1.39)
ROAi,t 0.132*** 0.130*** 0.665*** 0.208***
(11.67) (8.64) (17.85) (15.61)
Leveragei,t 0.008 0.011** 0.018 − 0.001
(1.34) (2.36) (1.03) (− 0.07)
FIi,t 0.088* − 0.300*** − 0.169*** 0.135***
(1.99) (− 9.68) (− 3.09) (2.78)
PPEi,t − 0.001 0.018*** − 0.017** − 0.001
(− 0.15) (7.33) (− 2.31) (− 0.15)
Intangiblei,t 0.040*** − 0.000 − 0.011 0.089***
(5.71) (− 0.09) (− 0.61) (9.82)
Eqinci,t 0.446 − 1.055*** − 0.202 − 2.107***
(1.10) (− 4.80) (− 0.66) (− 8.54)
Disc_accri,t 0.009*** 0.008*** − 0.003 0.014***
(2.90) (3.32) (− 0.61) (3.08)
Delawarei,t − 0.010** 0.005*** − 0.001 0.005*
(− 2.55) (2.94) (− 0.44) (1.92)
Sizei,t-1 0.013*** − 0.005*** 0.005** − 0.004***
(9.86) (− 5.19) (2.58) (− 3.53)
MBi,t-1 − 0.032*** 0.008*** − 0.031*** − 0.002
(− 13.44) (3.69) (− 13.00) (− 0.53)
Observations 21,760 11,638 22,986 20,822
Adj. R-squared 0.311 0.192 0.844 0.206
This table presents a difference-in-differences estimation of the effect of the 1999 Ninth Circuit ruling on corporate tax avoidance. The main variable
of interest is the interaction term between Treatment and Zero_CAR. Each column has a different measure to capture corporate tax avoidance activities,
including ETR, MPBT, ETR_DIF and DTAX. Treatment is an indicator variable that equals one if a firm is subject to the Ninth Circuit’s 1999 ruling in a
given year after 1999, and zero otherwise. Ninth Circuit takes a value of one if the firm is subject to the Ninth Circuit’s 1999 ruling. Post 1999 takes a
value of one if the observation is after 1999. Zero_CAR equals one if a firm’s market reaction to the 1999 ruling falls with the cross-sectional
interquartile range. Cross-sectional variation in the treatment effect is indicated by the interaction between Treatment and Zero_CAR. Please refer
to Appendix B for definitions of other variables. We report in parentheses t-values adjusted for heteroscedasticity and state-level clustering. *, **, and
*** indicate significance levels of less than 0.10, 0.05 and 0.01, respectively, based on a two-tailed test.
labor unions to have a mitigating effect on the relation between litigation risk and tax avoidance. To measure the power of labor
unions, we utilize the industry level union coverage as in Chyz et al. (2013). We extract the data from the Union Membership and
Coverage Database (UMCD).12 The database reports annual unionization rates for the three-digit Census Industry Classification (CIC)
industries from 1983 to 2016. We then merge our sample and UMCD by matching the three-digit CIC to the four-digit SIC. To define the
binary variable, Strong Union, we use the median value of unionization coverage as the cutoff point. Strong Union equals one when a
firm’s union coverage is above the median and zero otherwise. The main variable of interest in this analysis is the interaction term
between Treatment and Strong Union.
Panel C of Table 7 presents the results on the effect of labor unions on the association between securities litigation and tax
avoidance. We find that the treatment effect generally becomes weaker when union coverage is higher, suggesting a substitution effect
between litigation risk and labor unions, consistent with H2. More specifically, for three tax avoidance measures (ETR, MPBT, and
DTAX), the coefficients on Treatment × Strong Union are significant, both economically and statistically, and have a sign opposite of the
Treatment coefficient. For the regressions of ETR_DIF, the coefficient on Treatment × Strong Union is negative but not statistically
significant. Overall, our results provide evidence that labor unions constrain managers from engaging in tax aggressiveness, and thus
12
The database is available at www.unionstats.com.
12
Table 7
Cross-section heterogeneity: the impact of analyst coverage, institutional ownership, and labor unions.
Variables (1) (2) (3) (4)
Panel A
Treatment × High Analyst 0.030** − 0.010** 0.002 − 0.011**
(2.15) (− 2.46) (0.37) (− 2.20)
Treatment − 0.031*** 0.011*** 0.006 0.026***
(− 3.48) (4.97) (1.17) (6.05)
Panel B
Treatment × High IO 0.021* − 0.011*** 0.006 0.006
(1.82) (− 2.96) (0.86) (0.89)
Treatment − 0.026*** 0.011*** 0.002 0.017***
(− 4.81) (5.54) (0.37) (4.45)
Panel C
Treatment × Strong Union 0.018** − 0.008* − 0.011 − 0.016**
(2.13) (− 1.70) (− 1.18) (− 2.10)
Treatment − 0.026*** 0.008** 0.016** 0.041***
(− 2.78) (2.60) (2.07) (6.20)
All double interaction terms Included Included Included Included
This table presents a difference-in-differences estimation of the effect of the 1999 Ninth Circuit ruling on corporate tax avoidance. The main variable
of interest is the interaction term between Treatment and High Analyst (High IO, Strong Union). Treatment is an indicator variable that equals one if a
firm is subject to the Ninth Circuit’s 1999 ruling in a given year after 1999 and zero otherwise. High Analyst is an indicator that equals one if the
number of analysts is above the median value in a given year, and zero otherwise. High IO is an indicator that equals one if a firm’s institutional
ownership is above the median value in a given year, and zero otherwise. Strong Union is an indicator that equals one if a firm is in an industry whose
union coverage is above the median value across all industries in a given year, and zero otherwise. Ninth Circuit takes a value of one if the firm is
subject to the Ninth Circuit’s 1999 ruling. Post 1999 takes a value of one if the observation is after 1999. Each column has a different measure to
capture corporate tax avoidance activities, including ETR, MPBT, ETR_DIF and DTAX. Baseline regression control variables are included but not
reported for brevity. We also control the interaction term between Ninth Circuit (Post 1999) and the variables that capture the strength of alternative
mechanisms. Please refer to Appendix B for definitions of other variables. We report in parentheses t-values adjusted for heteroscedasticity and state-
level clustering. *, **, and *** indicate significance levels of less than 0.10, 0.05 and 0.01, respectively, based on a two-tailed test.
support H3.
5. Robustness tests
This section presents a discussion of several robustness tests. Specifically, we control for the possible effect of the high-tech bubble,
the pre-existing legal environment, and unobservable firm characteristics.
5.1. High-tech firms
A large number of high-tech firms are headquartered in California. Many of the high-tech start-ups that went public in the late 90s
and early 2000s were hit hard by the bursting of the tech bubble and many had to defend themselves from IPO allocation lawsuits (Hao,
2011). We control for this possible confounding effect by rerunning the baseline regression without high-tech firms. We define high-
tech firms as those in the Fama-French Electronics, Computers, and Pharmaceutical industries.13 We present the results in Panel A of
Table 8. The treatment coefficients for all the tax avoidance variables remain statistically significant with expected signs. These results
confirm that our results are not driven by the legal repercussions of the high-tech bubble.
5.2. Pre-existing legal environment
As shown by Karpoff and Wittry (2018), a firm’s pre-existing legal context has a first-order effect in empirical studies, such as ours,
which use a specific law or court decision for identification. In this section, we apply Karpoff and Wittry’s (2018) approach by con
trolling for court decisions that might have affected the risk of securities litigation at the state or federal level prior to the 1999 ruling.
Using Lexis-Nexis, we search for decisions by the highest court in each state (either the Supreme Court or the Court of Appeals) be
tween the beginning of our sample period and the 1999 ruling (i.e., 1994–1998). Decisions related to securities lawsuits by these courts
have the potential to affect the securities litigation environment in their specific jurisdiction. We identified one court decisions that
13
High-tech firms are those whose SIC code is one of the following: 2830, 2831, 2833, 2834, 2835, 2836, 3570, 3680, 3681, 3682, 3683, 3684,
3685, 3686, 3687, 3688, 3689, 3695, 7373, 3622, 3661, 3662, 3663, 3664, 3665, 3666, 3669, 3679, 3810, or 3812.
13
Table 8
Robustness checks: high tech firms, prior court decisions, and firm fixed effects.
Variables (1) (2) (3) (4)
Panel A: Excluding high tech firms

Treatment − 0.013** 0.004*** 0.009** 0.015***
(− 2.34) (3.54) (2.12) (4.45)
Panel B: Prior court decision
Treatment − 0.015*** 0.004** 0.007* 0.020***
(− 3.12) (2.33) (1.79) (7.83)
Prior_Court_Decision_1996 − 0.015** − 0.000 0.001 0.002
(− 2.46) (− 0.19) (0.32) (0.20)
Panel C: Firm fixed effects
Treatment − 0.009** 0.001 0.001 0.016***
(− 2.05) (0.34) (0.35) (3.31)
This table presents the results of the robustness checks. In Panel A, we exclude high-tech firms. High-tech firms are those in the Fama-French
Electronics, Computers, and Pharmaceutical industries. In Panel B, we include a prior court decisions indicator. In Panel C, we include firm fixed
effects. Each column has a different measure to capture corporate tax avoidance activities, including ETR, MPBT, ETR_DIF and DTAX. The main
variable of interest, Treatment, is an indicator variable that equals one if a firm is subject to the Ninth Circuit’s 1999 ruling in a given year after 1999,
and zero otherwise. Please refer to Appendix B for definitions of other variables. We report in parentheses t-values adjusted for heteroscedasticity and
state-level clustering. *, **, and *** indicate significance levels of less than 0.10, 0.05 and 0.01, respectively, based on a two-tailed test.
likely affected litigation risk in specific states before 1999. This decision was San Leandro Emergency Medical Group Profit Sharing
Plan v. Philip Morris Cos., 75 F.3d 801 (2d Cir.1996), in which the Second Circuit (covering New York, Vermont, and Connecticut)
dismissed the plaintiff’s appeal by ruling that the absence of financial disclosure by the defendant firm does not make previous
company statements misleading, and that fraud needs to be proved with sufficient particularity.
To empirically control for this court decision, we introduce the indicator Prior_Court_Decision_1996, which takes the value of one for
the firms headquartered in the states of New York, Vermont, and Connecticut after 1996, and zero otherwise. Panel B of Table 8
presents the results of DID regressions that include the aforementioned court decision indicator variable. The Treatment variable re
mains statistically significant for all tax-avoidance proxies. These results indicate that our main findings persist after controlling for the
pre-existing legal environment.
5.3. Unobservable firm characteristics
One may also argue that unobservable firm-level characteristics could drive our main results. For example, corporate culture could
play an important role in shaping a firm’s tax planning strategy. Liu (2016) finds that firms with a culture that does not value ethical
behavior are more likely to engage in corporate misconduct, such as earnings management and accounting fraud. To mitigate this
concern, we include firm fixed effects in our baseline regressions to absorb the effect of unobservable firm characteristics. The results in
Panel C of Table 8 provide moderate support for our findings.
Overall, these robustness analyses generate results consistent with the baseline findings and support the hypothesis that the shock
to the threat of securities litigation causes a significant change in how firms shape their tax planning strategies.
6. Conclusion
In this paper, we use an agency theory framework to investigate the impact of a reduction in shareholders’ legal rights on corporate
tax avoidance activities. To the best of our knowledge, this study is the first to test the association between securities class action
litigation risk and corporate tax avoidance. Using an exogenous shock to the corporate litigation environment caused by the 1999
ruling of the Ninth Circuit Court of Appeals as a natural experiment, we find that a reduction in the threat of securities litigation
encourages the companies headquartered in the Ninth Circuit to engage in more aggressive tax planning. We also document that such
an association between securities litigation risk and corporate tax avoidance is moderated by analyst coverage, institutional owner
ship, and the strength of labor unions. Specifically, firms with more analyst coverage, higher institutional ownership, and stronger
labor unions are less likely to alter their tax planning based on the reduced threat of securities litigation after the 1999 ruling. In
addition, our findings are robust to different model specifications.
Our paper provides a significant contribution to the understanding of the relation between corporate governance and tax avoid
ance. Overall, our results indicate that securities class action litigation risk matters in corporate tax decisions by demonstrating that
securities lawsuits are an effective disciplining tool to constrain management from aggressive corporate tax planning strategies.
14
Appendix A. Institutional background
Under the Securities Act of 1933 and the Securities Exchange Act of 1934, all publicly listed firms in the United States are exposed
to the risk of securities class action lawsuits. In 1995, Congress passed the Private Securities Litigation Reform Act (PSLRA) to reduce
frivolous securities class action lawsuits by requiring plaintiffs to provide proof that executives intentionally defrauded investors.
Despite the passing of PSLRA, which provides more discretion to individual judges, securities lawsuit filings have continued to increase
(e.g., Choi et al., 2009), and corporate lawsuit costs have remained high (e.g., Karpoff et al., 2008). Moreover, even after the ratifi
cation of the PSLA, the financial repercussions of corporate lawsuits have remained significant. Firms with greater exposure to se
curities litigation are likely to hold significantly more cash in anticipation of future settlements and other related costs (Arena and
Julio, 2015), pay higher audit fees (Shu, 2000), disclose their financial reporting differently (Skinner, 1994), undertake aggressive
growth through acquisitions (Gormley and Matsa, 2011), underprice their initial public offerings more aggressively (Lowry and Shu,
2002), and experience a higher cost of debt (Arena, 2018).
On July 2, 1999, the Ninth Circuit Court of Appeals issued a ruling (In re: Silicon Graphics Inc. Securities Litigation), which requires
plaintiffs’ attorneys to prove “deliberate recklessness” instead of the “mere recklessness” that is sufficient in other circuits to file a class
action securities lawsuit. As a result, the pleading standard for securities class action lawsuits in the Ninth Circuit is stricter than in all
other circuits. The SEC and other critics warned that the Ninth Circuit’s interpretation would be harmful to investors “because it will
discourage the filing of meritorious suits” (Johnson et al., 2000). This ruling affects firms headquartered in the states of the Ninth
Circuit (Alaska, Arizona, California, Idaho, Hawaii, Montana, Nevada, Oregon, and Washington). Crane and Koch (2016) find that the
1999 ruling has a significant effect on corporate litigation risk. Specifically, they show that from 1998 to 2000, the number of lawsuits
in the Ninth Circuit declined by 29%, while in all other circuits the drop was only about 1%. In short, the 1999 ruling issued by the
Ninth Circuit Court of Appeals reduced access to class action legal recourse, thereby lowering the risk of securities litigation for firms
headquartered in the Ninth Circuit.
Appendix B. Variable definitions
Variables Definitions
Treatment An indicator variable that equals one if a firm is headquartered in the Ninth Circuit and is thus subject to the 1999 ruling in a given
year after 1999, and zero otherwise.
ETRi,t GAAP effective tax rate: TXT/(PI–SPI). TXT is total income tax expense, PI is pre-tax book income, and SPI is income from special
items. We truncate ETR to the range [0, 1].
MPBTi,t The Manzon and Plesko (2002) book-tax difference, which equals (PIDOM-TXFED-TXS-TXO-ESUB), scaled by lagged assets; PIDOM
is US domestic financial income, TXFED is US domestic taxable income, TXS is state income taxes, TXO is other income taxes, and
ESUB is equity in net loss.
ETR_DIFi,t The ETR differential based on Frank et al. (2009), which equals (BI -(CFTE+CFOR)/STR)-(DTE/STR)), scaled by lagged assets; BI is
pre-tax book income; CFTE is the current federal tax expense; CFOR is the current foreign tax expense; DTE is the deferred tax
expense; and STR is the statutory tax rate.
DTAXi,t Discretionary permanent book-tax difference for firm i in year t.
Cashi,t Cash holding for firm i, year t, defined as cash and marketable securities (CHE) divided by lagged assets (AT).
ROAi,t Return on assets for firm i, year t, measured as operating income (PI-XI) scaled by lagged assets (AT).
Leveragei,t Leverage for firm i, year t, measured as long-term debt (DLTT) scaled by lagged assets (AT).
FIi,t Foreign income (PIFO) for firm i, year t, scaled by lagged assets (AT). Missing values in PIFO are set to zero.
PPEi,t Property, plant, and equipment (PPENT) for firm i, year t, scaled by lagged assets (AT).
Intangiblei,t Intangible assets (INTAN) for firm i, year t, scaled by lagged assets (AT).
Eqinci,t Equity income in earnings (ESUB) for firm i, year t, scaled by lagged assets (AT).
Disc_accri,t Absolute discretionary accruals for firm i, year t, where discretionary accruals are computed using the modified Jones model.
Delawarei,t An indicator variable that is equal to one if a firm is incorporated in Delaware, and zero otherwise.
Sizei,t-1 Natural logarithm of the market value of equity (PRCC_F × CSHO) for firm i at the beginning of year.
MBi,t-1 Natural logarithm of market-to-book ratio for firm i, at the beginning of year t, measured as market value of equity (PRCC_F × CSHO),
scaled by book value of equity (CEQ).
High Volatilityi,t An indicator variable that equals one if the standard deviation of daily returns in a year is in the top quintile and zero otherwise.
Low Min_Reti,t An indicator variable that equals one if a firm.’s minimum monthly return in a year is in the bottom quintile and zero otherwise.
Low Cum_Reti,t An indicator variable that equals one if the cumulative return in a firm-year is in the bottom quintile and zero otherwise.
Low Turnoveri,t An indicator variable that equals one if the stock turnover (average daily trading volume divided by the number of shares
outstanding) in a firm-year is in the bottom quintile and zero otherwise.
Zero_CAR An indicator variable that equals one if a firm’s market reaction to the 1999 ruling falls with the cross-sectional interquartile range.
The cumulative abnormal returns are calculated using the market model with an estimation period of 100 days ending 20 days before
the announcement.
High Analyst An indicator that equals one if the number of analysts is above the median value in a given year, and zero otherwise.
High IO An indicator that equals one if a firm’s institutional ownership is above the median value in a given year, and zero otherwise.
Strong Union An indicator that equals one if a firm is in an industry whose union coverage is above the median value across all industries in a given
year, and zero otherwise.
Ninth Circuit An indicator that equals one if the firm is subject to the Ninth Circuit’s 1999 ruling and zero otherwise.
Post 1999 An indicator that equals one if the observation is after 1999 and zero otherwise.
Prior_Court_Decision_1996 An indicator variable that equals one if a firm is headquartered in New York, Vermont, or Connecticut after 1996, and zero otherwise.
15
Appendix C. Propensity score matching effectiveness test
This appendix reports the effectiveness of the propensity matches based on control variables in the baseline regression model. The
matching is based on observable firm characteristics in both 1998 and 1994.
Control Treated T-statistics p > |t|
ETRi,t 0.244 0.263 − 0.019 0.429

ETRi,t-5 0.243 0.260 − 0.740 0.461
MPBTi,t 0.022 0.028 − 0.620 0.537
MPBTi,t-5 0.021 0.024 − 0.310 0.755
ETR_DIFi,t − 0.246 − 0.141 − 0.880 0.378
ETR_DIFi,t-5 − 0.098 − 0.061 − 0.590 0.559
DTAXi,t 0.038 0.048 − 0.420 0.676
DTAXi,t-5 0.026 0.039 − 0.550 0.585
Cashi,t-1 0.211 0.181 1.060 0.291
ROAi,t-1 − 0.162 − 0.078 − 0.920 0.359
Leveragei,t-1 0.179 0.153 0.700 0.485
FIi,t-1 0.014 0.013 0.210 0.832
PPEi,t-1 0.540 0.549 − 0.140 0.892
Intangiblei,t-1 0.145 0.152 − 0.290 0.776
Eqinci,t-1 0.000 0.001 − 0.650 0.518
Disc_accri,t-1 − 0.088 − 0.004 − 1.090 0.275
Delawarei,t 0.627 0.630 − 0.050 0.958
Sizei,t-1 5.096 5.049 0.140 0.887
MBi,t-1 0.272 0.379 − 0.890 0.376
Cashi,t-5 0.309 0.273 0.650 0.518
ROAi,t-5 − 0.039 0.012 − 0.790 0.431
Leveragei,t-5 0.179 0.160 0.620 0.539
FIi,t-5 0.014 0.013 0.400 0.687
PPEi,t-5 0.539 0.638 − 1.710 0.088
Intangiblei,t-5 0.168 0.128 1.400 0.164
Eqinci,t-5 0.001 0.001 − 0.480 0.629
Disc_accri,t-5 0.072 0.104 − 0.380 0.702
Delawarei,t-5 0.627 0.636 − 0.140 0.890
Sizei,t-5 5.761 5.508 0.850 0.396
MBi,t-5 1.030 0.937 0.960 0.336
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17

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Journal of Corporate Finance 66 (2021) 101546

Contents lists available at ScienceDirect

Journal of Corporate Finance

Securities litigation and corporate tax avoidance

3. Sample selection and research design

3.1. Sample selection

3.2. Research design

3.3. Summary statistics

4.1. Baseline DID regressions

Panel B: Ninth circuit

Panel C: Other circuits

4.2. Placebo tests

ETRi,t MPBTi,t ETR_DIFi,t DTAXi,t

Treatment − 0.014*** 0.004** 0.007* 0.020***

ETRi,t MPBTi,t ETR_DIFi,t DTAXi,t

Treatment_pseudo_year 0.005 0.003 − 0.005 − 0.008

4.3. Propensity score matching (PSM) results

Fig. 1. A placebo test: Pseudo–Ninth circuit states.

4.4. Governance effects versus frivolous litigation

ETRi,t MPBTi,t ETR_DIFi,t DTAXi,t

Treatment − 0.015** 0.007* 0.014* 0.013***

4.5. Stock market reaction

ETRi,t MPBTi,t ETR_DIFi,t DTAXi,t

4.6. Cross-sectional heterogeneity

4.6.1. External governance mechanisms: analyst coverage and institutional ownership

4.6.2. Labor unions

ETRi,t MPBTi,t ETR_DIFi,t DTAXi,t

Treatment × Zero_CAR 0.015** 0.003 − 0.010* 0.001

ETRi,t MPBTi,t ETR_DIFi,t DTAXi,t

5.1. High-tech firms

5.2. Pre-existing legal environment

ETRi,t MPBTi,t ETR_DIFi,t DTAXi,t

Panel A: Excluding high tech firms

5.3. Unobservable firm characteristics

Appendix A. Institutional background

Appendix B. Variable definitions

Appendix C. Propensity score matching effectiveness test

Control Treated T-statistics p > |t|

ETRi,t 0.244 0.263 − 0.019 0.429

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Treatment − 0.014* 0.004 0.007* 0.020***