Litigation risk and firm performance: The effect of internal and external corporate governance

Research Question/Issue: We argue that findings regarding litigation risk in the United States are not applicable in the Chinese context because Chinese firms are more dependent on debt financing for their operations compared with US firms. Thus, we raise the following research questions to test potential differences: Is litigation risk associated with firm performance? Does effective internal control of governance improve the performance of lawsuit firms? Do financial analysts improve the performance of lawsuit firms? Does debt financing mediate the effect of litigation risk on firm performance?. Research Findings/Insights: Our results indicate that litigation claims for large monetary amounts are negatively associated with firm performance, whereas internal governance and analyst following moderate the negative effects of litigation risk. We further examine the mediating effect of debt financing on the relationship between litigation risk and firm performance, finding that litigation risk is negatively associated with firm performance through excessive leverage, increased cost of debt, reduced bank borrowing, and trade credit. Theoretical/Academic Implications: By empirically testing the mediation effect of debt financing, this study enhances the understanding of the underlying causes of the association between a firm's litigation risk and its performance. Practitioner/Policy Implications: The findings will help firm managers to review litigation risks, better understand the economic mechanisms of litigation risk, and promote risk control to regulate their behaviors. We also find that financial analysts can correct the adverse effects of litigation risk; thus, we recommend that the financial analyst profession be further normalized.