Does Litigation Risk Change CEOs’ Tournament Incentives to Withhold Bad News?

Abstract

We examine the relationship between CEO tournament incentives and crash risk. We argue that litigation risk is an unneglectable factor in this relationship as it mitigates CEO myopia regarding bad news hoarding. Using federal judge ideology to measure the exogenous litigation risk, we find that when litigation risk is high, CEO tournament incentives are negatively associated with crash risk. This result suggests that the benefit of hiding bad news to enhance short-term performance diminishes with litigation risk. Additionally, this result is more pronounced when CEOs have more opportunities to compete for other positions with higher pay in the industry. Finally, we show that CEO tournament incentives are associated with less delay of bad news disclosures, earnings management, and forecast optimism when litigation risk is high. Our study contributes to the literature by providing one possible solution to the previous puzzling findings regarding CEO tournament incentives and crash risk.