Shades of grey: Risk-related agency conflicts and corporate innovation

We investigate how risk-related agency conflicts affect valuable risky investments. Using an exogenous negative shock to shareholders' litigation rights from an unanticipated court ruling that exacerbates risk-related agency conflicts by shielding managers from shareholders' governance through litigation, we show that innovation inputs and quality decline significantly for treated firms. Small firms lacking counteracting governance mechanisms, such as institutional investors, suffer significantly, while large firms with high institutional investments emerge unscathed. Our results are consistent with theories that predict managerial incentives for 'playing safe' lead to value-destroying and risk-reducing actions, especially when counteracting incentive mechanisms are muted.