It comes as no surprise that a firm facing a class-action lawsuit experiences reputational and financial consequences. But what happens to companies that do business with those companies?
A new study led by Drexel University’s Eliezer Fich, PhD, shows that when a company is sued, the lawsuit can affect other companies they’ve partnered with.
Until now, academic research has focused solely on how much a lawsuit affects the companies that are the targets of lawsuits. But this new research looked at how litigation risks extend beyond the company named in a lawsuit to those they’ve formed joint venture partnerships with.
To assess the risks involved for otherwise innocent firms, Fich, a professor in Drexel’s LeBow College of Business, and his coauthors—Rachel Gordon, PhD, of Towson University and Adam S. Yore, PhD, of the University of Missouri—investigated what the effects are for companies involved in joint ventures with the firm being sued. Their findings are reported in the working paper, “Class Action Spillover Effect on Joint Venture Partners” and featured in a post on Columbia Law School’s blog.
“Existing research finds that corporate culture, governance practices and even bankruptcy risks spread beyond the traditional boundaries of firms that are connected via shared directors or through contracts,” said Fich. “With this literature as a backdrop, we hypothesize that these spillover effects extend to litigation and are more likely to occur when an otherwise innocent firm has an important commercial relationship with a sued company.”
That “important commercial relationship” for the researchers is a joint venture entity. Many public firms enter into joint ventures, creating a new partnership that is viewed favorably by the public and allows the two firms to share the costs and profits of the business enterprise. But that’s not the only things they share, according to the researchers.
“We study joint ventures to examine whether one partner’s class action lawsuit triggers spillover effects on the innocent partner’s valuation, litigation risk, financial policies and investments decisions,” said Fich.
The authors examined over 6,700 unique firms focusing on companies participating in a joint venture in which one of the partners is sued. Their main findings are as follows:
- The innocent company’s value decreases by at least $55 million—just by being part of a joint venture with the sued firm.
- The reduction in firm value is greater when the two firms are equal owners in the joint venture.
- Once a partner is sued, non-sued partners are 34 percent more likely to be sued in the future.
- In response to the heightened risk for a future lawsuit, the non-sued partners minimize their exposure to risk and, as a result, experience a decrease in the volatility of their stock returns, cash flows and underlying assets. They also become more conservative with their financial reporting.
- Non-sued firms are less likely to pursue acquisitions once their joint venture partner firm has been sued.
“Our research shows that non-sued partners face non-trivial spillover effects with respect to their financial and investment policies,” the authors wrote. “As a result, these firms change their policies to try to mitigate the adverse effects of any potential lawsuits against them.”
The full paper can be downloaded at this link.
To schedule an interview with Eliezer Fich, contact Niki Gianakaris, executive director, Media Relations, at 215-895-6741 or ngianakaris@drexel.edu
