Universal Demand Laws and Compensation

How do firms respond to a regulatory induced increase in managerial entrenchment? We use the staggered passage of Universal Demand (UD) laws as a natural experiment with which to answer this question. Universal demand laws insulate managers from derivative litigations, thereby entrenching them from a form of external discipline, which would facilitate shirking and reduces managerial discipline. We hypothesize and show that firms respond to this by increasing risk-taking incentives. This effect is stronger in firms with more institutional investors (who might pressure for compensation changes) but weaker in high competition industries (where competition itself can mitigate a deterioration in governance). Institutional investors also help to prevent entrenched managers taking advantage of UD laws’ insulating effect. We take steps to mitigate endogeneity, identification, and other econometric concerns.