Shareholder Access to Manager-Biased Courts and the Monitoring/Litigation Tradeoff

Adequate access to courts by minority shareholders is commonly viewed as an important element of a good corporate governance system. Should shareholders be provided with easy access to courts when judges are unlikely to punish guilty managers? It might seem that having an extra instrument of protection is always better as long as it provides some protection against managerial self-dealing. We present a model which shows that facilitating shareholder litigation in a system where courts are biased towards managers can actually lower efficiency, as it can lead to either excessive litigation or excessive monitoring. The latter effect arises when litigation is very costly for the firm, but cheap for an individual shareholder. In this case, easy litigation does not lead to a greater reliance on the judiciary and results in more, rather than less, concentrated ownership. This is the effect of the optimal adjustment of the ownership structure to an increase in shareholders ’ willingness to bring suits when courts are manager-biased. Our model implies that removing impediments to shareholder litigation in countries where courts are reluctant to protect shareholders may increase the cost of corporate governance there. JEL classification: G32, G34, K41