Mathematical analysis of civil litigation and empirical research of corporate governance

Well-designed corporate governance is of great significance to reasonably allocate internal rights and obligations, strengthen external supervision, enhance product competitiveness and ensure corporate sustainable development. It is found that, there are many factors affecting corporate governance, including internal factors such as ownership structure and its nature [1], Creditor investors [21], institutional investors [2], board of directors and independent directors [3], executive characteristics and incentives [4], as well as information disclosure [5], product market [6], control market [7], manager market [8], government regulation [9] and other external factors. Corporate governance is a process in which investors (including stockholders and creditors), management, employees and the public and other stakeholders constantly bargain and adjust dynamically. Any sudden shock or environment change may have a profound influence on corporate governance.

From the perspective of law, a company is a collection of a series of contract sets. Under the background of labour division and exchange, a company always comes into a contract with external investors, upstream and downstream manufacturers and social consumers through express or implied terms, and bears a contractual obligation thereof. Due to product flaws or financial distress, any suspension and change of the original contract without any prior consent will give rise to a breach of contract and civil disputes or litigation. For listed companies that are sued for damages, civil litigation often worsens managerial myopia and force major shareholders to seek short-term profits [22], and weaken the supervision and restraint mechanism of major shareholders on senior managers. Senior managers of the sued company will divert part of time and energy originally used for production and operation to litigation activities, which results in weakening corporate resource allocation efficiency; in addition to senior managers, civil litigation will also hinder the disputing parties, such as consumers in product disputes, bank creditors in capital lawsuits and suppliers in product chain from playing a continuous supervisory role. Potential huge compensation caused by civil litigation will result in economic interest outflow from the sued company, and give rise to principal-agent conflict between senior managers and major stakeholders. In accordance with mandatory information disclosure requirement, information disclosure concerning civil litigation will trigger a reputation crisis to the sued company. In order to reduce the impact of litigation disclosure, the sued company will make good use of lengthy and obscure text information to reduce its readability on the basis of meeting the requirement of timely information disclosure [23], and increase information asymmetry and related agency costs between the sued company and external investors. The above shows that huge compensation and reputation shock caused by civil litigation will reduce corporate governance of the sued company. Therefore, we put forward the following hypothesis:

H1: There is a negative correlation between civil litigation and corporate governance, that is, civil litigation may reduce corporate governance of the sued company.

In judicial practice, there are many causes for civil action. In accordance with the nature of legal correlation and types of litigants, civil litigation can be divided into capital, product and others three categories.

According to the provisions on the cause of action of civil cases (Fa[2011]No.41), the notice of the Supreme People’s Court on increasing the cause of action of civil cases (Fa[2018]No.344), the cause of action can be divided into 43 categories, including personality disputes, marriage and family inheritance disputes, and property disputes, etc.

H2: Compared with product litigation, the negative correlation between capital litigation and corporate governance is stronger.

Prior studies have found that corporate financing structure is closely related to corporate governance [24], which has an important impact on corporate governance and, to some extent, even determines the mode of corporate governance [25]. In social financing structure dominated by bank credit, debt plays an important role in corporate governance. For example, debt can restrain senior managers from abuse of free cash flow [12], reduce agency costs, and prevent inappropriate corporate investment and financing, dividend distribution and other behaviours through agreements such as protective clauses, so as to improve corporate governance [26]. In order to improve corporate governance, employee stock ownership plan (ESOP) or senior managers incentive contract [27] and mandatory Chief Executive Officer (CEO) change [28] are adopted.

When the company falls into civil disputes, debt financing of the sued company will change greatly. First of all, civil litigation usually leads to debt decline of the sued company. It is found that there is a significant negative correlation between securities litigation and external financing [29], securities litigation will give rise to a decline of corporate external financing. With the increasing huge compensation, the asset-liability ratio of the sued company decreases significantly [30]. Because of high attorney fees, liquidated damages and other upfront expenses brought by civil litigation, as well as possible subsequent loss compensation and settlement fees, the sued company need to plan for a large amount of preventive cash reserves in the short term [10]. In the short term, the large amount of cash outflow will reduce the financial freedom of the sued company, and even make it into the plight of capital shortage. Under the circumstances, the sued company often falls into adverse situations, due to banks’ reluctance to lend and increasing interest rates and guarantees. In extreme cases, banks will reduce credit line and call in a loan before the schedule. Secondly, civil litigation will result in debt structure change of the sued company. The reputation shock brought by civil litigation will reduce the bargaining power of the sued company in front of upstream and downstream manufacturers, resulting in the decrease of the total OL, such as shortening the period of accounts receivable of the sued company by suppliers, requiring much more discount, sales rebate and other preferential measures by sellers (customers), or extending the days of accounts receivable, etc. With the increasing possibility of losing the lawsuit, the probability of opportunistic behaviour of upstream and downstream manufacturers is increasing [31], which may lead to further reduction of total OL. Besides, the uncertainty and potential huge compensation brought by civil litigation will weaken the solvency of the company involved in the lawsuit, which will reduce its ability to obtain credit support in financing activities or bear higher financing costs due to higher risk premium. Prudential banks often take measures, such as tightening risk exposure, reducing credit line and suspending loans. The impact of debt decline on corporate governance is mainly manifested in the following two aspects: First, as far as OL are concerned, the opportunistic behaviours of upstream and downstream manufacturers caused by the potential huge compensation undermine the integrity and continuity of the former original production chain, and affect the normal production and operation activities and financial status of the sued company. In addition, OL decline weakens the information transition and mutual supervision between upstream and downstream manufacturers. Second, in terms of financial liabilities, less financial liabilities caused by civil litigation lead to bank creditors unable to obtain more effective information, which results in increasing information asymmetry; the decline of FL also weakens the supervision and restraint of bank creditors on the abuse of free cash flow and senior managers’ risk-taking behaviour. The above analysis shows that civil litigation affects corporate governance of the sued company. In this regard, we put forward the following hypothesis:

H3: Civil litigation affects corporate governance through debt financing. In other words, debt financing plays an intermediary role in the correlation between civil litigation and corporate governance.

Focusing on the intermediary role of debt financing between civil litigation and corporate governance, this paper further analyses and compares the difference between OL and FL. Usually, an company and its upstream and downstream manufacturers form an informal contract based on reputation in the frequent supply of raw materials, intermediate products and product sales activities [32]. With the increase of transaction frequency and gradual decrease of information asymmetry, there is often a kind of mutual trust between the two parties, and the OL represented by accounts payable, bill payable and other payables will be increasing. When an company falls into civil disputes, creditors of OL usually do not participate in corporate governance of the sued company due to short-debt period and high adjustment cost [33]; only when the litigation is likely to lead to bankruptcy, reorganisation, takeover of the enterprise, or ineffective internal supervision led by shareholders, can creditors of OL actively participate in corporate governance [34] and claim residual property, which is the same as other ordinary creditors (such as banks). Compared with OL, most of the FL has longer term and larger amount, and bank creditor have higher supervision and incentive and more strict risk control measures. When a company is involved in litigation disputes, compared with the creditor of OL such as suppliers, bank creditors often actively take measures, such as reducing credit line, terminating the loan, requiring prepayment, etc., to reduce credit risk loss of the company involved in the lawsuit. The reduction of FL weakens the supervision and restraint of bank creditors, which is not conducive to corporate governance of the sued company. Therefore, this paper puts forward the following hypothesis:

H4: Compared with OL, FL play a stronger intermediary role in civil litigation and corporate governance.

We choose A-share listed companies (excluding financial insurance companies) from 2011 to 2018 as research sample, and at the same time, the samples are eliminated based on the following criteria: (1) companies listed for <1 year and (2) companies with missing data. Finally 982 samples were collected. Lawsuits data is sorted out manually, legal environment data is from «Marketization Index of China’s Provinces: National Economic Research Institute (NERI) Report», the data of other main variables and control variables are from China Stock Market Accounting Research (CSMAR) database and Wind database. Further, we winsorize 1% data of all continuous variables in order to control the influence of extreme values on the regression results.

This paper uses the data of listed companies sued from 2011 to 2018, and uses multiple regression to conduct empirical analysis. In order to test the hypothesis, the following model is constructed (1) Gi,t=α+α1LRiski,t−1+α2CVsi,t+∑Industryi+∑Yeart+ εi,t {G_{i,t}} = \alpha+ {\alpha _1}{LRisk}_{i,t - 1} + {\alpha _2}CV{s_{i,t}} + \sum{Industry}_i + \sum{Year}_t + \;{\varepsilon _{i,t}} (2) Mdebti,t=C+α1LRiski,t−1+α2CVsi,t+∑Industryi+∑Yeart+ εi,t {Mdebt}_{i,t} = C + {\alpha _1}{LRisk}_{i,t - 1} + {\alpha _2}CV{s_{i,t}} + \sum{Industry}_i + \sum{Year}_t + \;{\varepsilon _{i,t}} (3) Gi,t=C+α1LRiski,t−1+α2Mdebti,t+α3LRiski,t−1*Mdebti,t+ α4CVsi,t+∑Industryt+∑Yeart+ εi,t \matrix{{{G_{i,t}}} \hfill & {= C + {\alpha _1}{LRisk}_{i,t - 1} + {\alpha _2}{Mdebt}_{i,t} + {\alpha _3}{LRisk}_{i,t - 1}*{Mdebt}_{i,t} + \;{\alpha _4}CV{s_{i,t}}} \hfill\cr{} \hfill & {+ \sum{Industry}_t + \sum{Year}_t + \;{\varepsilon _{i,t}}} \hfill\cr}

Among them, G is dependent variable, LRisk is independent variable, Mdebt is intermediary variable and CVs are control variables. Considering that it takes a certain time for civil litigation to have an impact on corporate governance, litigation risk (LRisk) lags a period of time. Model (1) tests the impact of civil litigation on corporate governance, Model (2) tests the impact of civil litigation on debt financing and Model (3) adds intermediary variable (Mdebt) and its cross term with litigation risk (LRisk*Mdebt) on the basis of Model (1). The intermediary variable is measured by FL and OL, Model (1), (2) and (3) test the mediating role of debt financing.

Table 2 is the descriptive statistical results of the main variables. As shown in Table 2, in terms of dependent variable (G), the mean of corporate governance index of listed company is 0.0314, the maximum is 2.1878 and the minimum is −1.0274, indicating that there are great differences in corporate governance indexes of different listed companies. The mean of LRisk is 2.6402, the large gap between the maximum and the minimum indicates that litigation risk faced by listed companies is quite different. Compared with OL, FL of listed companies are quite different. From other variables, listed companies are not the same considering the legal environment, internal strategy and growth.

Table 3 shows the statistics of civil lawsuits in which listed companies participated as defendants from 2011 to 2018. During this period, a total of 3305 cases involving 83.967 billion yuan were filed against listed companies. Among them, there were 606 capital cases involving 45.828 billion yuan, accounting for 54.58% of the total amount involved in the period, and 290 product cases, involving 18.019 billion yuan, accounting for 21.46% of the total amount in the period. From the perspective of judicial local protectionism, a total of 1712 cases of listed companies were tried by People’s Courts in the prefecture where the sued listed companies were incorporated, involving 55.577 billion yuan, accounting for 66.19% of the total amount involved in the period, while the remaining 1593 cases were tried by People’s Court outside the prefecture where the sued listed companies were incorporated.

Taking litigation risk as the independent variable, corporate governance of the sued company as dependent variable, and debt financing as the intermediary variable, the regression results are shown in Table 6. Considering the differences between OL and FL in terms of debt maturity, financing amount and risk control, this paper tests the mediating role of FL and OL. Column (1) of Table 6 verifies the negative correlation between litigation risk and corporate governance of the sued enterprise; taking into account of both columns (2) and (5), we find that there is a significant negative correlation between litigation risk and FL, but no significant correlation between litigation risk and OL. Column (3) shows that after adding the interactivity of litigation risk and FL, the litigation risk coefficient is still negative at the level of 5%, and the negative correlation between litigation risk and corporate governance still holds. The coefficient of FL is significantly positive at the level of 1%, and the coefficient of interaction between litigation risk and FL is significantly negative at the level of 10%. This proves that debt financing, especially FL, plays an intermediary role, that is, litigation risk affects corporate governance of the sued company through FL, which verifies Hypotheses 3 and 4.

In order to further explore the influence factors of civil action on corporate governance, we investigate the influence of judicial local protectionism on the correlation between civil litigation and corporate governance from the perspective of judicial justice.

At present, China’s economy and society are in a transitional period, and judicial local protectionism still exists [39]. Taking civil cases as an example, People’s court can exercise its discretion within the scope permitted by laws and regulations. If the case involves local company, it can actively compete with other courts for jurisdiction; timely control the process and rhythm of case acceptance, trial and execution; selectively adopt or exclude the evidence involved in the case; and interpreted the cited or applicable laws, regulations, rules expansively or contractible; select execution time, mode and strength of the case judgment or ruling. The People’s court will try its best to favour its local company and protect local interests in the whole litigation activities, so as to achieve the same effect as the local government’s “‘selective law enforcement”’ [40]. When the case involves local state-owned company or is inextricably linked with the government, it is often difficult for the court to remain neutral, and the judicial local protectionism is more serious. In this regard, this paper constructs a dummy variable (LP) to join the regression. If the domicile of the sued listed company or its main place of business and the jurisdiction of the court belong to the same prefecture, the dummy variable is 1, otherwise it is 0, so as to explore the influence of judicial local protectionism. The regression results are shown in column (2) of Table 5.

It can be seen from Table 5 that the negative correlation between litigation risk and corporate governance still holds. Compared with the prefecture where justice is much more fairer, judicial local protectionism weakens the negative correlation between civil litigation and corporate governance. The reason behind this lies in that if civil disputes are submitted to the court where the company is located for trial, local court is likely to exercise its discretion within the scope permitted by laws and regulations, or favour local company and protect local interests by controlling the process or rhythm of case acceptance, trial and execution. Under the protection of the local court, the possibility of the sued company to win is increased [41], the compensation liability is reduced or even exempted, and the impact on corporate reputation is also lighter. Thus, the cash outflow pressure faced by the sued company is reduced, which reduces the bank creditors’ worry about the solvency of the sued enterprise, and reduces the possibility of early loan withdrawal and loan break. In addition to less impact on financial liabilities, the bias of local courts also alleviates the impact of civil disputes on the supply and marketing correlation between the sued company and its upstream and downstream manufacturers, resulting in insignificant changes in OL. Therefore, judicial local protectionism reduces the fluctuation of debt financing and reputation impact of the sued company, and weakens the negative correlation between civil litigation and corporate governance.