An Integrated Analysis of the Corporate General Counsel's Impact on Accounting Choices and Legal Risk

Abstract

Companies are increasingly relying on highly paid corporate general counsels (GCs) to help manage the risks of costly regulatory sanctions and shareholder lawsuits associated with their firms' accounting and overall business practices. While recent research documents the role of the GC on specific decisions in isolation, whether and how GCs fulfill their intended role of managing their firms' expected legal costs remains an open question. I document several ways in which GCs affect the expected legal costs associated with their firms' accounting choices.

The analysis is based on the insight that the expected legal costs associated with the firm's accounting choices depend on three factors: (1) the extent to which the firm undertakes legally risky accounting practices, (2) the likelihood that such practices are detected by outsiders, and (3) the severity of penalties outsiders impose on the firm upon detection. Managers can affect the first factor by taking the external legal environment as given and altering their internal decisions accordingly, whereas managers can affect the latter two factors by altering the firm's external legal environment through their influence on the intensity of outside monitoring and enforcement. I provide evidence that the GC decreases the firm's expected legal costs via all three factors.

First, firms with an influential GC (GC firms) display a preference for real earnings management relative to accrual earnings management and GC firms accelerate the recognition of losses in earnings, both of which entail less legal risk. Second, firms that make aggressive accounting choices are less likely to be targeted by SEC enforcement actions in the presence of an influential GC. This finding indicates that GCs are able to advise their firms about how to use accounting discretion in a way that avoids unwanted regulatory scrutiny. Third, GC firms are less likely to be sued following a restatement announcement. When their firms are sued, the lawsuits are more likely to be dismissed and the settlement amounts are lower. These findings indicate that the GC's advocacy is associated with a reduction in the severity of penalties outsiders impose on the firm when improper accounting choices are discovered.

The analyses culminate with an examination of the GC's effect on the firm's overall corporate risk and the market's assessment of the GC's contribution to the firm. I find that GC firms are associated with lower corporate risk as measured by the volatility of future stock returns and lower levels of future risky investments in the form of capital expenditures and research and development expenditures. Finally, the market responds favorably in years that firms appoint a GC to the top management team, consistent with the market perceiving the net impact of GCs' activities to be value enhancing.