Litigation Risk and Firm Performance: A Mediation Effect via Debt Financing

Fei Peng
Department of Accounting
School of Business
Renmin University of China
rbspengfei@163.com

Yuan George Shan

Department of Accounting and Finance
UWA Business School
The University of Western Australia
george.shan@uwa.edu.au

Wuqing Wu
Department of Accounting
School of Business
Renmin University of China
wwq@ruc.edu.cn
Lu Zhang
Department of Accounting and Finance
UWA Business School
The University of Western Australia
lu.zhang@research.uwa.edu.au

Abstract
Manuscript Type: Empirical
Research Question/Issue: The objective of this study is to investigate how litigation risk
influences firm financial performance. Specifically, we attempt to explore four important
research questions: Does litigation risk affect firm performance? Does the concurrence of
litigation risk and internal control of governance improve firm performance? Does the
concurrence of litigation risk and analyst following improve firm performance? Does debt
financing mediate the impact of litigation risk on firm performance?
Research Findings/Insights: Our results indicate that a large monetary amount of a claim in
litigation is negatively associated with firm performance, while internal governance and
analyst following offset the negative impact of litigation risk. We further examine debt
financing as a mediator in the relationship between litigation risk and firm performance, and
find that litigation risk negatively affects firm performance through excessive leverage,
increased cost of debt, reduced bank borrowing and trade credit.
Theoretical/Academic Implications: This study offers empirical evidence that enhances
understanding of the causes underlying the association between a firm’s litigation risk and its
performance through testing the mediation effect of debt financing.

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Practitioner/Policy Implications: The findings assist firm management to review litigation
risks, have better understanding of the economic mechanisms of litigation risk, and promote
risk control to regulate their own behaviour. The findings also reveal that financial analyst
can correct the adverse effects of litigation risk, and that debt financing has a mediation effect
on the relationship between litigation risk and firm performance.

Keywords
litigation risk, corporate governance, firm performance, debt financing, mediation effect

JEL Classification
G30, K15, K41

1. Introduction

Most extant literature on litigation risk focuses on contexts in developed economies (e.g., on

the US stock market) and considers two major forms of shareholder litigation: securities class

action (e.g., Arena & Julio, 2015; Cheng, Huang, Li & Lobo, 2010) and derivative lawsuits

(e.g., Bourveau, Lou & Wang, 2018; Ferris, Jandik, Lawless & Makhija, 2007; Nguyen, Phan

& Sun, 2018; Ni & Yin, 2018; Yuan & Zhang, 2016). However, the findings of these studies

are not necessarily globally generalizable, particularly not to civil-law countries and

developing economies, where security lawsuits are less common than they are in the US.

These security lawsuits occur more commonly in the US because the Securities and

Exchange Commission (SEC) Rule 10b-5 safeguards a legal right of action to investors

against listed firms and firm directors for material misstatements or frauds (Arena & Ferris,

2018). The legal protection of shareholders’ rights is recognized as an essential element of

corporate governance (Shleifer & Vishny, 1997). Cheng et al. (2010) find that shareholder

litigations play an important corporate-governance role by moderating agency conflicts

between managers and shareholders. Bourveau et al. (2018) and Nguyen et al. (2018) suggest

that the primary role derivative lawsuits play as a corporate-governance tool is to signal

corporate-governance reform. However, Arena and Ferris (2018) state that corporate laws in

civil-law countries do not allow the initiation of class-action litigation as easily as does US

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corporate law. They find that the sample of lawsuits in their study is not dominated by

securities class action, and that corporate litigation risk is lower for firms located in civil-law

countries and countries with less developed judiciary and legal systems. Dash and Raithatha

(2018) suggest that the process of securities class-action lawsuits is not applicable to market

regulations in most emerging economies because they have different regulatory mechanisms

and their economic and institutional development is at different stages.

China’s legal system is a large civil-law system that is heavily influenced by the German

legal structure (Firth, Rui & Wu, 2011; Lu, Pan & Zhang, 2015; Shan & Round, 2012).

Although its legal system was influenced by a European legal system, the legal system China

is often perceived as being underdeveloped and highly capricious (Allen, Qian & Qian, 2005),

and continues to have unique characteristics that correspond with its regulations and capital

markets (Shan & Round, 2012). The Chinese legal environment is continuously being

improved, and relevant regulations have been introduced to maintain order in the market

(Firth et al., 2011). Mechanisms of judicial intervention have been widely implemented in

China, and using legal avenues for dispute resolution has become common for enterprises.

The total monetary amount of litigation cases involving listed firms in China increased from

RMB9.8 billion in 2007 to RMB44.693 billion in 2016. For a considerable number of listed

firms in China, the expenses resulting from litigation exceeded the previous year’s net profit

and even operating income, posing a major threat to the firm’s ongoing operations (Mao &

Meng, 2013), which demonstrates that litigation cases have gradually become a risk factor

that cannot be ignored by Chinese firms; this is particularly true for the defendant firm.

Bhagat, Bizjak and Coles (1998) find that the average loss of a defendant firm’s market value

is 0.997%; however, there is no significant change in the market value of the plaintiffs. There

are further similar research findings for the Chinese capital market. For example, it has been

found that a litigation announcement lowers the stock prices of the firms involved, and the

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defendant’s stock return rate drops more significantly (Firth et al., 2011).

We argue that findings about firm litigation risk in the context of the US cannot be used to

explain firm litigation risk in China for the following reasons. First, securities class-action

lawsuits and contingent legal fees are restricted (Palmer & Xi, 2009, p. 270), which means

that litigation is not expected to play a role as a corporate-governance mechanism in China.

Second, a firm’s litigation announcement will cause investor scepticism of the firm’s

operation and risk control, which will result in a negative market reaction, reducing the value

of the firm (Arena & Julio, 2015; Firth et al., 2011). However, this influence is significant but

not long term in China because legal consciousness in China is insufficient, and information

explosion means that the Chinese public does not tend to remember litigation cases. For

example, in 2014, Wuliangye Yibin, one of the most famous Chinese manufacturers of

alcoholic beverage, was sued in a securities dispute for producing false financial statements,

and for using information asymmetry to embezzle the rights and interests of small and

medium shareholders. The lawsuit involved 259 investors filing for a total of RMB24.7

million. In 2014, Wuliangye Yibin reached a mediation agreement to pay compensation of

RMB16.22 million. This lawsuit received widespread public attention, and the firm’s net

profit fell 26.81% according to its 2014 annual report. However, the negative effect of this

litigation on the firm has gradually disappeared. Its net profit returned to growth, and the

firms seems to have benefitted from the improvement of its management structure and sales

channels, increasing its net profit by 5.85% in 2015, 9.85% in 2016, and 42.58% in 2017.

This case demonstrates in China, the occurrence of litigation against a firm leads to a sharp

decrease in the value of the defendant firm, but that this negative influence is not long term,

and can be mitigated by good business management.

Third, Chinese courts and their jurisdictions are established through the Chinese

Constitution, the Law of Criminal Procedure, the Law of Civil Procedure and the Law of

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Administrative Procedure. Under this legal structure, the monetary amount of commercial

litigation rather than the issue of lawsuit at hand dictates in which type of court the case will

be heard (Firth et al., 2011).

In China, litigation is an expensive way of resolving conflicts between shareholders and

the firm (or the board of directors of the firm), which means it is a suboptimal solution for

conflict resolution. However, current research focuses on the effect of litigation risk only on

certain aspects of business operations, and rarely investigates the relationship between

litigation risk and overall firm financial performance. This means that firms may not pay

sufficient attention to the risk of litigation, and may implement their own risk-control

mechanisms and economic behaviour to reduce litigation risk (Mao & Meng, 2013; Wang,

Jiang & Xin, 2016). The present study provides new and insightful evidence to fill the gap in

the literature on the effect of litigation risk on firm performance in China by. The study

attempts to answer the following four important research questions. First, does litigation risk

affect firm performance? We predict a negative effect of litigation risk on firm performance

because litigation often lowers firm value (Lin, Zhou, Shu & Liu, 2013), and leads to a

deterioration of relationships between a firm’s customers and suppliers, thus affecting the

business activities of the firm (Koh, Qian & Wang, 2014). Second, does the concurrence of

litigation risk and internal control of governance improve firm performance? We predict a

positive association here because internal-governance mechanisms can reduce conflicts of

interest between managers and shareholders (Shan, 2013, 2015), and therefore lower

litigation risk. Third, does the concurrence of litigation risk and analyst following improve

firm performance? We predict a positive association here because a financial analyst is

treated as an important information intermediary in the financial market who plays the role of

an external advisor (Hu, Wang, Tao & Zou, 2016; Wu, Jie & Su, 2017). Fourth, does debt

financing mediate the impact of litigation risk on firm performance? We predict that debt

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financing will have a mediating effect because debtholders of defendant firms are likely to

reevaluate the defendant firm’s financial position (Rajan & Winton, 1995) and increase future

borrowing costs (Deng, Willis & Xu, 2014).

We use a dataset containing 16,601 firm-year observations for all Chinese listed firms on

the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE) during the

period 2007–2016. Unlike other research on corporate lawsuits, the 1,802 lawsuits in our

sample considers no only securities class actions but also other types of lawsuits, including

arbitration, criminal proceedings, civil litigation and administrative litigation. 1 Our main

empirical finding indicates that litigation risk is negatively associated with firm performance.

We argue that this negative association results from the damaged reputation that litigation

confers on defendant firms. Further, we find that strong internal governance can reduce the

negative effect of litigation risk, in a context where derivative lawsuits being used as a

corporate-governance tool is restricted. We also consider the role of a financial analyst as an

external advisor, and find that analyst following intensity offsets the negative effect of

litigation risk on firm performance. More importantly, we provide evidence of a mediation

effect of debt financing on the relationship between litigation risk and firm performance, and

our results reveal that debt size, cost of debt and debt structure have a negative partial

mediation effect on firm performance, while leverage has a complete mediation effect on firm

performance.

This study contributes to the literature in three ways. First, to the best of our knowledge,

this is the first study to offer empirical evidence that enhances understanding of the

mechanisms of the association between a firm litigation risk and firm performance by testing

the mediation effect of debt financing. Accordingly, we explore the relationship between

litigation risk and firm performance by considering four proxies of debt financing (i.e., debt

size, cost of debt, debt structure and leverage) as potential mediators.

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 Second, prior studies suggest that strong internal governance can decrease the negative

effect of litigation risk (Jensen, 1993; Johnson, Nelson & Pritchard, 2002; Zhang & Wu,

2014), we thus use corporate governance index as moderator to examine whether it can offset

the negative effects of litigation risk on firm performance. We also include financial analyst

as a proxy for external-governance advisor who is an information intermediary and financial

expert who can decrease information asymmetry and transfer accurate information to the

public (Jiang, 2010).

Third, we focus on China as a natural laboratory to test the hypotheses proposed in this

study. Unlike studies that examine litigation risk in the US (e.g., Arena & Julio, 2015;

Bourveau et al., 2018; Cheng et al., 2010; Ferris et al., 2007; Nguyen et al., 2018; Ni & Yin,

2018; Yuan & Zhang, 2016), our study analyses the effect of litigation risk in China, where

lawsuit procedures are different from what they are in common-law and civil-law countries.

As noted, in China, the court that will hear a case of corporate litigation depends on the

monetary amount of the dispute (Firth et al., 2011).

We organize the reminder of this study as follows. Section 2 presents the development of

the hypotheses motivating our empirical analyses. Section 3 outlines the research method

adopted, including details of the data and sample, model specification, and variable

measurement. Section 4 presents the results and discussion, and Section 5 presents the

robustness checks. Section 6 concludes with a summary, implications of the research and

limitations of this study.

2. Literature Review and Hypothesis Development

2.1 Litigation risk and firm performance

The issues relating to legal shareholder protection have been widely explored since La Porta,

Lopez-de-Silanes, Shleifer and Vishny (1998). Prior studies (e.g., Defond & Hung, 2004;

Porta et al., 1998; Reese Jr & Weisbach, 2002; Seetharaman, Gul & Lynn, 2002) note that

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firms face the lowest litigation risk in common-law countries and have the highest litigation

risk in French civil-law countries, whereas litigation risk in German and Scandinavian civil-

law countries have a medium level of litigation risk. Compared with firms in French civil-law

countries, firms in common-law countries have a more dispersed shareholder ownership (La

Porta, Lopez-de-Silanes & Shleifer, 1999), have a higher Tobin’s Q (La Porta, Lopez-de-

Silanes, Shleifer & Vishny, 2002), and can enter a new market or industry more easily

(Djankov, La Porta, Lopez-de-Silanes & Shleifer, 2002). La Porta et al. (2002) find evidence

of higher valuation of firms in common-law countries that have stronger legal protection of

minority shareholders. For listed firms in common-law countries, once they are sued for

infringement by another organisation or shareholders, the uncertainty and high financial risk

caused by the litigation will have a series of negative effects on the normal operations and

performance of the firm for several reasons. First, litigation lawsuits undermine the reputation

of the defendant firm and release risk signals to investors, creditors, external auditors and

other stakeholders, thus affecting the financial activities and normal operations of the firm.

For example, Koh et al. (2014) state that strong social performance is more valuable as an

insurance mechanism for firms with higher litigation risk. Godfrey, Merrill and Hansen (2009)

use a sample of firms that have experienced negative legal or regulatory action, and find a

decrease in firm value as a result of the negative event. Firms with higher litigation risk pay

slightly higher gross spreads (Qing, 2011) and underprice their initial public offering by a

greater amount as a form of insurance, which is referred to as ‘insurance effect’ (Lowry &

Shu, 2002). For external auditors and creditors, potential civil litigation is an important factor

affecting the pricing of audit fees (Krishnan & Krishnan, 1997; Shu, 2000; Venkataraman,

Weber & Willenborg, 2008), and empirical evidence finds that creditors are more likely to

provide loans with a short period and high interest rate that have weak legal protection and

poor debt contract enforcement (Diamond, 2004). Second, litigation against a firm also leads

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to a loss of corporate economic interests (Engelmann & Cornell, 1988). If a defendant firm

loses a case, it will face high compensation and litigation costs, and the pending litigation

will also create contingent liabilities, which may lead to the outflow of future economic

benefits and increase the financial risk of the firm. Therefore, a firm involved in a litigation

case has a lower firm value (Lin et al., 2013). In addition, it has been found firms involved in

litigation disputes have weak corporate-governance mechanisms, and lack effective risk

control and discipline in important economic issues (Beasley, Carcello, Hermanson &

Lapides, 2000). Further, a firm being involved in litigation with customers or suppliers can

have a deleterious effect on relationships with these parties, which can negatively affect cost

control and product sales, and thus negatively affect the normal production and operation

activities of the firm (Koh et al., 2014). Accordingly, we form the first hypothesis as follows:

Hypothesis 1. Ceteris paribus, litigation risk is negatively associated with firm

performance.

2.2 Litigation risk, corporate governance and firm performance

Lengthy and costly litigation cases signal to external stakeholders (e.g., shareholders,

customers, vendors and lenders) that a firm has insufficient risk control, which in turn leads

to having a damaged corporate reputation, and then negatively affects firm performance.

However, strong corporate governance can promote the legitimate operation of firms,

strengthen the implementation of laws and regulatory systems, thus decreasing the negative

view of firms that have higher litigation risk, and re-establishing their good reputation. For

example, Beck, Demirguc-Kunt and Maksimovic (2005) investigate the effect of financial,

legal and corruption problems on firm growth, and find that financial and institutional

development can weaken the negative effects of financial, legal and corruption challenges on

firm growth. Moreover, strong internal control enables firms to adjust production rapidly and

continuously, which creates strong financial performance to compensate for the outflow of

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economic benefits resulting from litigation. In addition, Johnson et al. (2002) find that

accounting conservatism and corporate governance are negatively correlated with the firm’s

probability of litigation. Previous studies show that internal control improves accounting-

information quality (Altamuro & Beatty, 2010; Doyle, Ge & McVay, 2007), earnings quality

(Doyle et al., 2007), and information-disclosure quality (Fang & Jin, 2008; Yang & Mao,

2011), has a positive effect on corporate performance (Jensen, 1993) and the cash-holding

value of the firm (Zhang & Wu, 2014), and reduces corporate risk (Bargeron, Lehn & Zutter,

2010). Thus, a positive internal-control environment can allow firms with high litigation risk

to improve their corporate image, and maintain normal operations to offset promptly the

economic losses caused by litigation, thus decreasing the negative effect of litigation risk on

firm performance. Accordingly, we form the second hypothesis as follows:

Hypothesis 2. Ceteris paribus, the concurrence of litigation risk and internal control is

likely to increase firm performance.

2.3 Litigation risk, analyst following and firm performance

As an important external supervisory influence, financial analysts are responsible for

reducing short-sighted investment decisions, improving the firm’s information environment,

and reducing the uncertainty of financial reporting (Jensen & Meckling, 1976). Analyst

following is also associated with less managerial manipulation (Fairfield & Whisenant, 2001)

and lawsuit engagement (Hanley, Weiss & Gerard, 2012), implying that analyst following

reduces litigation and operating risks. Pan, Dai and Lin (2011) find that firms with a high

level of analyst following are less likely to experience a decrease in firm value caused by

opaque information, which confirms financial analysts’ positive role in risk detection and

investor protection. Thus, analyst following promotes firm regulation of its own behaviours,

decreases distrust of defendant firms caused by high litigation risks, and thus has a positive

effect on firm performance (Fairfield & Whisenant, 2001; Hanley et al., 2012). Accordingly,

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we form the third hypothesis as follows:

Hypothesis 3. Ceteris paribus, the concurrence of litigation risk and analyst following is

likely to increase firm performance.

2.4 Influence mechanism of litigation risk on firm performance

The existing literature suggests a relationship between litigation risk and debt financing.

Chava, Agnes Cheng, Huang and Lobo (2010) find a positive effect of shareholder litigation

on the cost of equity capital for defendant firms. Deng et al. (2014) extend this work by

further establishing a link between bank loans and shareholder litigation for defendant firms,

suggesting that after a lawsuit has been filed against a firm, the firm’s lending bank will

adversely (for the firm) adjust the contract terms of the bank loan because of the firm’s

damaged credibility. A lawsuit being filed against a firm sends a negative signal to

stakeholders about the defendant firm’s default risk and increases uncertainty about the firm’s

prospects. Consequently, banks as the debtholders of defendant firms are likely to reevaluate

the defendant firm’s financial condition, and monitor the firm more vigilantly by increasing

the covenants and collateral requirements (Rajan & Winton, 1995), requiring up-front

charges and increasing future borrowing costs (Deng et al., 2014). In addition, the reputation

damage caused by a lawsuit allegation may disrupt the firm’s supply chain and sales

distribution, and result in higher contracting costs or lower sales. Previous studies have

investigated the effect of debt financing on firm performance. For example, Murphy,

Shrieves and Tibbs (2009) provide some empirical evidence on financial misconduct and find

that the alleged offenders suffer from higher risk and lower future profitability. Other

research on firms targeted by SEC enforcement actions concludes that alleged violations lead

to a substantial loss in firm value (Dechow, Sloan & Sweeney, 1996; Karpoff, Lee & Martin,

2008). The present study uses data of Chinese listed firms because the emerging Chinese

market differs distinctly in firm behaviour in the debt market. A report from the China

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Banking Association in 2009 indicates that the market accounts for 7.11% of the total amount

of corporate loans in China. Dobson and Kashyap (2006) note that ‘virtually all debt

financing in China is done through the banks’ (p. 117). For defendant firms involved in

lawsuits, heavy reliance on bank loans is more likely to lead to a more pronounced effect on

firm performance. Thus, debt financing seems to mediate the path between litigation risk and

firm performance. Accordingly, we formulate the fourth hypothesis as follows:

Hypothesis 4. Ceteris paribus, debt financing mediates the effect of litigation risk on

firm performance.

3. Research Method

3.1 Data collection

The sample contains all publicly listed firms on the SHSE and the SZSE from 2007 to 2016.

We select year 2007 as the first year for this research because the new Chinese Accounting

Standards based on the International Financial Reporting Standards were adopted in that year.

The financial data are sourced from the China Stock Market & Accounting Research database,

and the litigation risk data are obtained from the Chinese Research Data Services Platform.

As shown in Table 1 Panel A, the initial sample has 23,121 observations, we exclude 408

and 93 observations for financial institutions and B-share (foreign share) firms, respectively,

because they are subject to different regulations and market-trading mechanisms. We further

delete 1,166 observations for special-treatment (ST) firms facing imminent danger of

delisting, and remove 5,393 firm-years observations that have missing data. Our final sample

contains 16,6012 firm-year observations. Table 1 Panel B reports the observation breakdown

by the four major types of lawsuits faced by firm defendants in China (i.e., 159 cases of

arbitration, 22 cases of criminal proceedings, 1,608 cases of civil litigation, and 13 cases of

administrative litigation). The total firm-year observations with lawsuits consist of 1,802.

[Insert Table 1 about here]

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3.2 Model specification

Following the methods of Chakravarthy (1986) and Deng et al. (2014), we develop

Equations (1–1), (1–2) and (1–3) to test Hypotheses 1, 2 and 3, respectively. Firm and year

fixed effects are considered, and the robust standard errors are clustered by firm for all

analyses.

𝑅𝑂𝐴𝑖,𝑡 (𝑅𝑂𝐸𝑖,𝑡 ) = 𝛼1 + 𝛼2 𝐿𝑖𝑡𝑖𝑔𝑎𝑡𝑖𝑜𝑛 𝑅𝑖𝑠𝑘𝑖,𝑡 + ∑ 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠 +𝜀𝑖,𝑡

Equation (1–1)

𝑅𝑂𝐴𝑖,𝑡 (𝑅𝑂𝐸𝑖,𝑡 ) = 𝛽1 + 𝛽2 𝐿𝑖𝑡𝑖𝑔𝑎𝑡𝑖𝑜𝑛 𝑅𝑖𝑠𝑘𝑖,𝑡 + 𝛽3 𝐶𝐺𝐼𝑖,𝑡 + 𝛽4 𝐿𝑖𝑡𝑖𝑔𝑎𝑡𝑖𝑜𝑛 𝑅𝑖𝑠𝑘𝑖,𝑡 × 𝐶𝐺𝐼𝑖,𝑡

+ ∑ 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠 +𝜀𝑖,𝑡

Equation (1–2)

𝑅𝑂𝐴𝑖,𝑡 (𝑅𝑂𝐸𝑖,𝑡 ) = 𝛾1 + 𝛾2 𝐿𝑖𝑡𝑖𝑔𝑎𝑡𝑖𝑜𝑛 𝑅𝑖𝑠𝑘𝑖,𝑡 + 𝛾3 𝐹𝑜𝑙𝑙𝑜𝑤𝑖𝑛𝑔 𝐼𝑛𝑡𝑒𝑛𝑠𝑖𝑡𝑦𝑖,𝑡−1

+ 𝛾4 𝐿𝑖𝑡𝑖𝑔𝑎𝑡𝑖𝑜𝑛 𝑅𝑖𝑠𝑘𝑖,𝑡 × 𝐹𝑜𝑙𝑙𝑜𝑤𝑖𝑛𝑔 𝐼𝑛𝑡𝑒𝑛𝑠𝑖𝑡𝑦𝑖,𝑡−1 + ∑ 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠 +𝜀𝑖,𝑡

Equation (1–3)

3.3 Variable measurement

Appendix A provides the definitions of all variables used in this study. In Appendix A Panel

A, we use return on assets (ROA) and return on equity (ROE) as proxies for firm financial

performance. ROA is defined as net income divided by total assets, and ROE is defined as net

income divided by total shareholders’ equity. In Appendix A Panel B, we present the

measurements for litigation risk corporate governance and analyst-following intensity. The

measure for litigation risk (Litigation Risk) is calculated as the monetary claim at year t

against the defendant in a litigation deflated by the defendant’s total assets at year t. To scale

this number up, we multiply it by 100. We use corporate governance index (CGI) proposed

by Wang and Shan (2018) to measure corporate governance. CGI is a sum of 14 internal

governance factors, the definition of each factor is provided in Appendix A. Following Wu

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and Wan (2018), we use the average number of annual analyst reports (Following Intensity)

as a proxy for analyst-following intensity, which is measured at year t–1 to avoid any

endogeneity problem arising between variables. Appendix A Panel C presents the control

variables. Based on prior literature, the control variables are as follows: 1) percentage of

shares owned by the largest shareholder (Ownership Concentration) (Mehran, 1995); 2) sales

growth (Sales Growth) (Brush, Bromiley & Hendrickx, 2000; Kim & Skinner, 2012); 3)

natural logarithm of total assets (Size) (Hall & Weiss, 1967); 4) natural logarithm of cash

flow from operation activities (Cash Flow) (Brush et al., 2000).

3.4 Mediation effect of debt financing

We examine Hypothesis 4, the mediation role of debt financing on the relationship between

litigation risk and firm performance. Specifically, we test four aspects of debt financing: debt

size, financial leverage, cost of debt, and debt structure. In China, most listed firms rely on

one of these four aspects for financing. Therefore, the banks become plaintiffs who bring

legal action against listed firms in more than one-third of filed litigation cases (Liu, Zhang &

Zhou, 2016). When a firm’s litigation risk increases, the bank as its debtholder re-evaluates

the firm’s default risk and is more likely to reduce the loan amount and/or charge higher

interest rates. Thus, a firm with high litigation risk may face higher costs of debt financing,

which is extremely detrimental to a highly leveraged firm. To pay off its debt, a firm might

need to reduce its cash holdings, cut expenditure on research, or be unable to fully invest in

its growth opportunities, thus resulting in a lower profitability (Jarrad, Sandy & Maxwell,

2014). In addition, litigation risk exposes a firm to actions arising from customers and

suppliers (Harland, Brenchley & Walker, 2003). Suppliers may require prepayment for

providing goods or services, and customers may be less willing to make a prepayment to the

firm for ordered goods or services. These actions from suppliers and customers cause the firm

to have lower cash reserves, and thus a higher level of financial distress. Thus, litigation risk

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affects firm profitability indirectly through debt financing, and debt financing as a mediator

explains how litigation risk affects firm financial performance. Appendix A Panel D presents

the definition of the four proxies of debt financing.

Following Baron and Kenny (1986) and Wen and Ye (2014), we use a procedure

developed by Sobel (1982) to test the mediation roles of the four proxies of debt financing:

𝑅𝑂𝐴𝑖,𝑡 = 𝛽0 + 𝛽1 𝐿𝑖𝑡𝑖𝑔𝑎𝑡𝑖𝑜𝑛 𝑅𝑖𝑠𝑘𝑖,𝑡 + ∑ 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠 +𝜀𝑖,𝑡

Equation (2–1)

𝐷𝑒𝑏𝑡𝑖,𝑡 = 𝛼0 + 𝛼1 𝐿𝑖𝑡𝑖𝑔𝑎𝑡𝑖𝑜𝑛 𝑅𝑖𝑠𝑘𝑖,𝑡 + ∑ 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠 +𝜀𝑖,𝑡

Equation (2–2)

𝑅𝑂𝐴𝑖,𝑡 = 𝛽0′ + 𝛽1′ 𝐿𝑖𝑡𝑖𝑔𝑎𝑡𝑖𝑜𝑛 𝑅𝑖𝑠𝑘𝑖,𝑡 + 𝛽2 𝐷𝑒𝑏𝑡𝑖,𝑡 + ∑ 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠 +𝜀𝑖,𝑡

Equation (2–3)

The procedure of the mediation test is presented in Figure 1. We begin with Equation (2–

1) to examine the overall effect of Litigation Risk on ROA, which is denoted by coefficient 𝛽1 .

The effect of Litigation Risk on Debt is captured by 𝛼1 in Equation (2–2), while 𝛽1′ in

Equation (2–3) denotes the direct effect of Litigation Risk on ROA after controlling for the

mediator Debt. Based on the definition of a mediator by Baron and Kenny (1986), we

consider debt as a mediator if: 1) Litigation Risk significantly accounts for ROA (𝛽1 ≠ 0); 2)

Litigation Risk significantly accounts for Debt (𝛼1 ≠ 0); 3) Debt significantly predicts ROA

after controlling for Litigation Risk (𝛽2 ≠ 0).

[Insert Figure 1 about here]

We first test the total effect of Litigation Risk on ROA (𝛽1 ), and proceed to further tests

only if 𝛽1 is statistically significant. We then test the indirect effect of Litigation Risk on ROA

through Debt, estimated by 𝛼1 and 𝛽2 . If the indirect effect (𝛼1 and 𝛽2 ) is significant and the

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direct effect (𝛽1′ ) of Litigation Risk on ROA is also significant, it suggests that the effect of

Litigation Risk on ROA decreases by a nontrivial amount with the inclusion of Debt, but not

to zero, thus a partial mediation occurs (Preacher & Hayes, 2004). Another possibility could

be a significant indirect effect (𝛼1 and 𝛽2 ) and an insignificant direct effect (𝛽1′ ) of Litigation

Risk on ROA, implying a complete mediation effect. If either of the 𝛼1 and 𝛽2 coefficient is

not statistically significant, or neither of them is significant, we further conduct the Sobel test

with a null hypothesis that the indirect effect (𝛼1 × 𝛽2 ) equals zero (or equivalent, 𝛽1 − 𝛽1′ =0).

A critical ratio Z3 is yielded using (𝛼1 × 𝛽2 ) divided by the standard error of indirect effect

(𝑠𝛼1𝛽2 )2, in order to compare with the critical value from a standard normal distribution. A

rejection of a null hypothesis in Sobel test indicates the existence of a mediation effect.

4. Results and Discussion

4.1 Descriptive statistics

Table 2 reports the descriptive statistics for the key variables. The dependent variable ROA

has a mean (median) of 0.0452 (0.0419) within a range between −0.2014 and 0.1964, and

ROE has a mean (median) of 0.0749 (0.0764) within a range between −0.6567 and 0.3861.

The average monetary claim amount is 0.0463% of the total assets for defendant firms, and

the highest monetary claim amount in the sample could be 3.46 times larger than a firm’s

total assets. Following Intensity has a standard deviation of 1.1025, indicating that analyst-

following intensity varies significantly across firms over the period. The mean CGI is 4.2566

within a range between 0 and 13. This suggests that most listed firms have some form of

governance in place, yet the extent of governance varies. The mean of Size, Ownership

Concentration and Cash Flow are 17.4938, 35.9886 and 18.9345, respectively, indicating that

the firms in our sample are large firms with high ownership concentration and relatively high

operating cash flow. The statistics for control variables are within a reasonable range.

[Insert Table 2 about here]

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 To reduce the bias of the estimated coefficients of the equations, we conduct several tests

as follows. First, the continuous variables are winsorised at the 1 st and 99th percentiles

because susceptible influence of outlying observations can be caused during ordinary least

squares estimation (Wooldridge, 2013). Second, we adopted both Pearson and Spearman’s

rank correlations to examine the threat of multicollinearity. The correlation values among the

variables used in the equations (not tabulated in this paper) are all below 0.7. We also

calculate variance inflation factor values and the results (not tabulated in this paper) are

below the critical value of 10 (Gujarati, 2003). Consequently, the variables in this study are

not subject to threat of multicollinearity.

The model-fit reports in Table 3 show adjusted R 2 s of 0.0938, 0.0419, 0.1026, 0.0559,

0.0907 and 0.0458 for each column, respectively. The F-statistics for all columns are

statistically significant.

4.2 Regression analysis for Hypothesis 1

Table 3 Columns 1 and 2 present the regression results for Hypothesis 1. We explore how

litigation risk affects firm financial performance by regressing Litigation Risk on ROA and

ROE. The coefficient of Litigation Risk is negatively associated with ROA in Column 1 (α2 =

–0.00607, p < 0.01) and ROE in Column 2 (α2 = –0.00918, p < 0.1). Thus, Hypothesis 1 is

supported, which means that a firm with higher litigation risk will lower its financial

performance. Litigation risk may raise concerns of the defendant firm’s debtholders, disrupt

its relationships with suppliers and customers, weaken its competitive market position and

increase uncertainty in its operations, which leads to a decrease in profitability and

correspondingly a decrease in firm value (Yuan & Zhang, 2015).

4.3 Regression analysis for Hypothesis 2

We examine the interactive effect of internal governance and litigation risk on firm financial

performance to test Hypothesis 2. As shown in Table 3 Columns 3 and 4, the coefficient of

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the interactive term of CGI × Litigation Risk (𝛽4 = 0.00238, 𝑝 < 0.01; 𝛽4 = 0.00835, 𝑝 <

0.01) is significantly positive in Columns 3 and 4. The results indicate that strong internal

governance can effectively mitigate the negative effect of litigation risk on profitability, and

are consistent with the findings of Mao and Meng (2013) which suggests that the

enhancement of internal governance mechanism is necessary for regulatory compliance

purpose. As firms with strong internal control suffer less from legitimacy compared with

firms with weak internal control, they are more likely to recover from their financial losses

and be able to restore a damaged reputation (Chakravarthy, DeHaan & Rajgopal, 2014). Thus,

Hypothesis 2 is supported.

4.4 Regression analysis for Hypothesis 3

We examine the interactive effect of analyst following and litigation risk on firm financial

performance to test Hypothesis 3. The coefficient of the interactive term Following Intensity

× Litigation Risk is positively (𝛾4 = 0.006, 𝑝 < 0.01; 𝛾4 = 0.01345, 𝑝 < 0.01) related to

ROA and ROE. The results suggest that a high level of analyst following has a significant

effect on reducing the negative effect of litigation risk on profitability, and confirm the

external supervisory role of the financial analyst. Thus, Hypothesis 3 is supported.

For the control variables, the sign and significance level of firm characteristics are

consistent with the findings of Equations 1–1 and 1–2, suggesting that firms with high

ownership concentration, high sales growth, small size and a high free cash flow level

perform better financially.

Overall, we conclude that there is a negative association between litigation risk and firm

financial performance, but that adequate corporate governance and analyst following can

decrease the negative effect of litigation risk and firm financial performance.

[Insert Table 3 about here]

4.5 Test of the influence mechanism

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Table 4 presents the results of the mediation effect of debt financing on the relationship

between Litigation Risk and ROA. The mediation analysis for Debt Size and Leverage is

presented in Table 4 Panel A (i.e., Column 1 presents the regression of Litigation Risk on

ROA, and Column 3 identifies the mediation effect of Debt Size). The coefficients of

Litigation Risk are negative in Columns 1 and 3, yet the magnitude and significance level of

the coefficient of Litigation Risk (𝛽1′ = −0.0089, 𝑝 < 0.1) in Column 3 are lower than those

(𝛽1 = −0.0102, 𝑝 < 0.05) in Column 1. A negative effect of Litigation Risk on Debt Size

(𝛼1 = −0.0433, p < 0.1) in Column 2 means that defendant firms with high litigation risk are

less likely to obtain loan support, while a strong positive relationship (𝛽2 = 0.0296, 𝑝 < 0.01)

between Debt Size and ROA in Column 3 suggests that a defendant firm with high litigation

risk performs worse financially because of a lack of adequate loan support. Thus, debt size

partially mediates the negative effect of litigation risk on firm performance as reflected by the

ROA of 12.51%. For Columns 4 to 6, the indirect effect of Litigation Risk on ROA (𝛼1 =

0.0861, 𝑝< 0.01; 𝛽2 = –0.1194, p < 0.01) is significant, and the direct effect of Ligation Risk

on ROA is insignificant (𝛽1′ = –0.004, p > 0.1), indicating a complete mediation effect of

96.29%. Thus, it seems an increase in litigation risk forces a firm to raise its financial

leverage, yet an excessive amount of financial leverage increases the probability of

operational failure.

[Insert Table 4 about here]

Table 4 Panel B reports the mediation tests of Cost of Debt and Debt Structure on ROA.

For Cost of Debt, the coefficient 𝛼1 is insignificant (𝛼1 = 0.0035, p > 0.1), thus we conduct a

Sobel test to confirm the partial mediation effect (z-statistic = –1.074). The result suggests a

high defendant firm faces higher costs of debt financing, which partially accounts for lower

firm performance of 16.13%. For Debt Structure, a significant indirect effect of Ligation Risk

on ROA (𝛼1 = –0.0150, p < 0.05; 𝛽2 = –0.0797, p < 0.01), with the inclusion of Debt Structure

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and a significant direct effect of Litigation Risk on ROA (𝛽1′ = –0.0090, p < 0.1) indicates a

partial mediation effect of 11.69%. This means that high litigation risk decreases the

probability of making credit purchases by suppliers or receiving advance payments from

clients. However, such trade credits (as a source of finance) may be important for a defendant

firm with high litigation risk in achieving greater profitability.

5. Robustness Checks

We conduct a variety of sensitivity analyses to ensure the robustness of the results. First, we

note that endogeneity issues may exist (Brown, Beekes & Verhoeven, 2011; Koh et al., 2014).

Firms with poor financial performance may face a severe free cash flow problem or even a

going-concern threat, which in turn exacerbates the incidence of overdue debt and default.

We thus employ two-stage least squares (2SLS) to address endogeneity issues by introducing

an instrumental variable (IV). Following prior studies (Ali & Kallapur, 2001; Francis,

Philbrick & Schipper, 1994; Koh et al., 2014; Matsumoto, 2002), the Standard Industrial

Classification codes 2833–2836 (biotechnology), 3570–3577 and 7370–7374 (computers),

3600–3674 (electronics), and 5200–5961 (retailing) are selected to represent industries by a

high level of litigation risk. Industrial Litigation Risk is proxied as an IV that codes as 1 if a

firm’s primary industry belongs to one of those industries, and 0 otherwise. The 2SLS

regression results (not tabulated in this paper) are consistent with the primary findings in

Table 3 Column 1.

Second, to check the robustness of the primary results presented in Table 3, we use an

alternative measure for litigation risk—a dichotomous variable Litigation Dummy—that is

coded as 1 if a firm is a defendant in year t, and 0 otherwise. As shown in Table 5, Litigation

Dummy is statistically and negatively associated with ROA (α2 = –0.00499, p < 0.01 in

Column 1), and the two concurrence effects for CGI × Litigation Dummy and Following

Intensity × Litigation Dummy are statistically and positively related to ROA (β4 = 0.00223, p

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< 0.01 in Column 2; γ4 = 0.00112, p < 0.05 in Column 3). These results confirm the findings

in Table 3 Columns 1, 3 and 5, and indicate that governance mechanisms and financial

analyst contribute incremental effects to improve firm performance.

[Insert Table 5 about here]

Third, the number of observations with lawsuits is very small compared with the number

of observations without lawsuits. 4 To avoid the results being disturbed by sample size, we use

the propensity score matching (PSM) analysis to match the sample. The propensity scores are

estimated based on a probit regression at the listed-firm level with the dependent variable

being a binary variable equal to 1 for defendant firms, and 0 for firms without lawsuits. We

use a set of control variables, i.e., ownership concentration, sales growth, size and cash flow,

as matching dimensions. We incorporate industry and year fixed effects to absorb any time-

specific and industry-specific heterogeneity not captured by firm characteristics. Because the

number of firms without lawsuits significantly exceeds the number of defendant firms, we

use the three nearest neighbouring firms without lawsuits that come from the same industry

year. The probit model is estimated across 4,765 samples with no missing data for all of the

matching-dimension variables. Table 6 reports the firm financial performance analysis using

the PSM.

As shown in Table 6, Litigation Risk is statistically and negatively associated with ROA

(α2= –0.00413, p < 0.1 in Column 1), and the two concurrence effects of CGI × Litigation

Risk and Following Intensity × Litigation Risk are all statistically and positively related to

ROA (β4 = 0.00221, p < 0.1 in Column 2; γ4 = 0.00663, p < 0.05 in Column 3). Thus, the

findings in Table 3 Columns 1, 3 and 5 are robust.

[Insert Table 6 about here]

6. Conclusion

This study explores how litigation risk influences firm financial performance. We find that a

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large monetary amount of a claim in litigation is associated with low profitability, while

internal governance and external governance advisor can effectively mitigate the negative

effect of litigation risk on firm performance. Using debt size, leverage, cost of debt and debt

structure as proxies, we further examine the role of debt financing as a mediator in the

relationship between litigation risk and firm performance, and find that litigation risk

negatively affects firm performance through excessive leverage, increased cost of debt,

reduced bank borrowing and trade credit.

Three implications may be drawn from this study. First, this study assists firm

management to review litigation risk, better understand the economic mechanisms of

litigation risk, and promote their risk control to regulate their own behaviour. Second, this

study demonstrates that loan size and financing costs have a mediation effect on the

relationship between litigation risk and firm performance, which indicates that the market

plays a role in firm governance (Bourveau et al., 2018; Nguyen et al., 2018). Accordingly, the

government should consider relaxing the intervention of bank credit decision making, and

advancing a more market-oriented allocation of credit resources. Third, the results show that

financial analyst can correct the adverse effects of litigation risk. It should be noted that due

to the existence of this corrective force, measures should also be taken to prevent the abuse of

power and conspiracy by the analyst.

This paper has two limitations. First, the study covers only the four major categories of

corporate disputes in China (i.e., arbitration, criminal proceedings, civil litigation and

administrative litigation). Future research should consider other types of lawsuits (e.g., patent,

antitrust, fraud and labour) (Arena & Ferris, 2018). Second, the study examines the role of a

financial analyst as an external advisor who can directly or indirectly affect the quality and

quantity of financial-information dissemination, thereby influencing investors’ investment

decisions. Legal counsel provides legal advice to ensure compliance with applicable laws,

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rules and regulations, and ensures the firm’s conduct is maintained within the boundaries of

the law to protect the interests of the firm (Rezaee, 2009). Future research should examine the

role of legal counsel as an additional external advisor.

Endnotes

1
There are four levels of courts in China: the Supreme People’s Court being the highest, followed by the higher
People’s Courts at the provincial level, and the intermediate and basic People’s Courts at the local-government
level. Chinese courts and their jurisdictions are established through the Chinese Constitution, the Law of
Criminal Procedure, the Law of Civil Procedure and the Law of Administrative Procedure. the monetary amount
of commercial litigation rather than the issue of lawsuit at hand dictates in which type of court the case will be
heard (see Firth et al., 2011).
2
This sample size comes down to 14,309 observations when merging with data on analyst following intensity,
and to 11,530 observations when merging with data on corporate governance.
3
Based on Sobel (1982) and Preacher and Hayes (2004), the standard error of indirect effect is calculated as:
𝑠𝛼1𝛽 =√𝛽22 𝑠𝛼 12 + 𝛼12 𝑠𝛽22 + 𝑠𝛼21 𝑠𝛽22 . The critical ratio Z for a two-tailed normal distribution is calculated as: Z=
2

(𝛼1 ∗ 𝛽2 )/𝑠𝛼1𝛽 .
2
4
As shown in Table 1, the observations of litigation are 1,802, and the observations without litigation are
14,799.

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FIGURE 1 Mediation effect test procedure

TABLE 1 Sample and data

Panel A: Observations No. of observations

SHSE and SZSE listed companies (2007–2016) 23,121
Less: Observations for financial firms (408)
Less: Observations for B-share (foreign share) firms (93)
Less: special treatment (ST) firms (1,166)
Less: Observations due to missing data (5,393)
Total firm-year observations 16,601

Panel B: Observations with lawsuits No. of observations

Arbitration 159
Criminal proceedings 22
Civil litigation 1,608
Administrative litigation 13
Total firm-year observations 1,802

TABLE 2 Descriptive statistics

VARIABLES N Mean Std. Dev. Min Median Max
ROA 16,061 0.0452 0.0527 –0.2014 0.0419 0.1964
ROE 16,061 0.0749 0.1117 –0.6567 0.0764 0.3861
Litigation Risk 16,061 0.0463 0.3609 0.0000 0.0000 3.4635
Following Intensity 14,309 1.0534 1.1025 0.0000 1.0000 4.3235
CGI 11,530 4.2566 2.6394 0.0000 4.0000 13.0000
Sales Growth 16,061 0.3795 1.3168 –0.7360 0.0951 11.4987
Ownership Concentration 16,061 35.9886 15.2103 8.9751 34.2577 75.0045
Size 16,061 17.4938 4.9343 10.2295 20.2122 25.3168
Cash Flow 16,061 18.9345 1.6350 14.5954 18.8899 23.3173

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TABLE 3 Regression results of the litigation risk, corporate governance and analyst following a, b, c
Dep. Var.= ROA ROE ROA ROE ROA ROE
(1) (2) (3) (4) (5) (6)
Litigation Risk –0.00607*** –0.00918* –0.01715*** –0.04127*** –0.00826*** –0.00839
(–2.78) (–1.68) (–3.96) (–3.41) (–3.48) (–1.16)
– [H1] – [H1]
CGI –0.00145*** –0.00242**
(–3.68) (–2.31)
CGI × Litigation Risk 0.00238*** 0.00835***
(2.85) (3.98)
+ [H2] + [H2]
Following Intensity 0.00133*** 0.00308***
(2.96) (2.83)
Following Intensity × Litigation Risk 0.0060*** 0.01345***
+ [H3] + [H3]
(3.10) (3.11)
Ownership Concentration 0.00069*** 0.00074*** 0.00082*** 0.00156*** 0.00065*** 0.00131***
(6.12) (7.83) (6.14) (5.10) (5.89) (5.19)
Sales Growth 0.00199*** 0.00437*** 0.00175*** 0.00577*** 0.00184*** 0.00561***
(4.46) (5.14) (3.21) (4.34) (4.03) (5.19)
Size –0.00155*** –0.00239*** –0.00141*** –0.00253*** –0.00150*** –0.00287***
(–14.95) (–11.19) (–11.39) (–9.35) (–13.88) (–11.25)
Cash Flow 0.00719*** 0.01324*** 0.00695*** 0.01431*** 0.00690*** 0.01381***
(13.75) (15.40) (11.56) (9.96) (12.96) (10.81)
Firm fixed effect Yes Yes Yes Yes Yes Yes
Year fixed effect Yes Yes Yes Yes Yes Yes
Adj R2 0.0938 0.0419 0.1026 0.0559 0.0907 0.0458
F-statistic 94.53*** 51.89*** 49.79*** 35.96*** 57.91*** 43.05***
Observation 16,061 16,061 11,530 11,530 14,309 14,309

Note:
a
The first row (number) represents the estimated coefficient, the second row (number in parentheses) represents the t-value
of significance and the third row represent expected sign and hypothesis.
b
The definition for variables is presented in Appendix A.
c*
if p < .10; **if p < .05; ***if p < .01. All tests are two-tailed.

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TABLE 4 Mediation effect testa, b, c
Panel A: Mediation of debt size and leverage
Dep. Var.= ROA Debt Size ROA ROA Leverage ROA
(1) (2) (3) (4) (5) (6)
Litigation Risk –0.0102** –0.0433* –0.0089* –0.0107*** 0.0861*** –0.0004
(–2.02) (–1.87) (–1.78) (–9.76) (22.03) (–0.39)
Debt Size 0.0296***
(7.97)
Leverage –0.1194***
(–59.71)

Sobel test 𝛽1 = –0.0102** 𝛽1 = –0.0107***

𝛼1 = –0.0433*, 𝛽2 = 0.0296*** 𝛼1 = 0.0861***, 𝛽2 = –0.1194***
𝛽1′ = –0.0089* 𝛽1′ = –0.0004
No Sobel test is required No Sobel test is required

Mediation effect Partial mediation effect Complete mediation effect

Proportion of total effect mediated 12.51% 96.29%

Panel B: Mediation of cost of debt and debt structure

Dep. Var.= ROA Cost of Debt ROA ROA Debt Structure ROA
(1) (2) (3) (4) (5) (6)
Litigation Risk –0.0102** 0.0035 –0.0086* –0.0102** –0.0150** –0.0090*
(–2.02) (1.08) (–1.78) (–2.02) (–2.23) (–1.79)
Cost of Debt –0.4698***
(–18.59)
Debt Structure 0.0797***
(6.22)

Sobel test 𝛽1 = –0.0102** 𝛽1 = –0.0102**

𝛼1 = 0.0035, 𝛽2 = –0.4698*** 𝛼1 = –0.0150**, 𝛽2 = 0.0797***
𝛽1′ = –0.0086* 𝛽1′ = –0.0090*
Sobel test z-stat = –1.074 < –0.97 No Sobel test is required

Mediation effect Partial mediation effect Partial mediation effect

Proportion of total effect mediated 16.13% 11.69%

Note:
a
The first row (number) represents the estimated coefficient, the second row (number in parentheses) represents the t-value
of significance.
b
The definition for variables is presented in Appendix A.
c*
if p < .10; **if p < .05; ***if p < .01. All tests are two-tailed.

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TABLE 5 Regression results of the litigation dummy, corporate governance and analyst following a, b, c
Dep. Var.= ROA ROA ROA
(1) (2) (3)
Litigation Dummy –0.00499*** –0.01767*** –0.00804***
(–2.72) (-3.95) (–3.20)
CGI –0.00148***
(–3.73)
CGI × Litigation Dummy 0.00223***
(2.83)
Following Intensity 0.00112**
(2.45)
Following Intensity × Litigation Dummy 0.00340**
(2.42)
Ownership Concentration 0.00071*** 0.00084*** 0.000667***
(6.19) (6.23) (6.01)
Sales Growth 0.00199*** 0.00172*** 0.00185***
(4.46) (3.15) (4.02)
Size –0.00146*** –0.00131*** –0.00142***
(–13.73) (–10.39) (–13.03)
Cash Flow 0.00725*** 0.00703*** 0.00695***
(13.81) (11.63) (12.97)
Firm fixed effect Yes Yes Yes
Year fixed effect Yes Yes Yes
Adj R2 0.0687 0.0741 0.0665
F-statistics 92.06*** 45.67*** 56.43***
Observations 16,061 11,530 14,309

Note:
a
The first row (number) represents the estimated coefficient, the second row (number in parentheses) represents the t-value
of significance and the third row represent expected sign and hypothesis.
b
The definition for variables is presented in Appendix A.
c*
if p < .10; **if p < .05; ***if p < .01. All tests are two-tailed.

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TABLE 6 Regression results of the PSM test for the litigation risk, corporate governance and analyst
following a, b, c

Dep. Var.= ROA ROA ROA

(1) (2) (3)
Litigation Risk –0.00413* –0.0149* –0.00549
(–1.66) (–1.90) (–1.23)
CGI 0.00196
(0.85)
CGI × Litigation Risk 0.00221*
(1.83)
Following Intensity 0.00428
(1.49)
Following Intensity × Litigation Risk 0.00663**
(2.06)
Ownership Concentration 0.000753*** 0.000641 0.0012**
(3.47) (1.38) (2.41)
Sales Growth 0.00203*** –0.00169 –0.000475
(2.71) (–0.61) (–0.21)
Size –0.00129*** –0.00121* –0.00122*
(–5.96) (–1.77) (–1.91)
Cash Flow 0.00692*** 0.00958** 0.0113***
(6.12) (2.46) (3.47)
Firm fixed effect Yes Yes Yes
Year fixed effect Yes Yes Yes
Adj R2 0.0536 0.0649 0.0856
F-statistics 18.73*** 3.47*** 3.87***
Observations 4,765 998 1,380

Note:
a
The first row (number) represents the estimated coefficient, the second row (number in parentheses) represents the t-value
of significance and the third row represent expected sign and hypothesis.
c
The definition for variables is presented in Appendix A.
d*
if p < .10; **if p < .05; ***if p < .01. All tests are two-tailed.

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