Spillover Effects in Securities Litigation

Courtesy of Dain Donelson, Rachel Flam, and Christopher Yust

When a firm is sued, do its peers respond to the litigation by changing their own behavior? In our recent paper, we examine the spillover effect of securities litigation on industry peers. We focus on investor reactions and changes in peers’ disclosure and financial reporting. We predict that when managers observe a lawsuit against a peer firm, they may believe their own firm’s litigation risk has increased and alter their behavior in response. This issue is important because private litigation serves a corporate governance role that can reduce agency costs by constraining managerial behavior. Thus, the potential spillover effect provides insight into both the reach of private litigation and the determinants of management disclosure and financial reporting choices.

For clarity of exposition, we refer to “focal” firms as other firms in the same industry as the sued firm and the “peer” firm as the industry firm that is subject to a securities class action filing.

Prior research finds spillover evidences with respect to market reactions. For example, Gleason et al. (2008) documents a “contagion” effect, whereby restatements at a firm are related to stock price drops in its peers. Based on this evidence, we further investigate whether investors and firms respond to securities class action litigation against an industry peer. Specifically, we examine the following hypotheses:

  • Do investors in focal firms price an increase in litigation risk?
  • Do focal firms alter their voluntary disclosure and mandatory financial reporting practices?
  • Do these changes by focal firms affect their future rate of litigation?

In our analyses, we explore two sources of variation in investor and firm responses: (1) the merits of the peer firm litigation (i.e., whether the litigation is relatively meritorious, and thus eventually settled, or non-meritorious, and thus eventually dismissed), and (2) the likelihood that the focal firms are engaged in financial reporting misconduct (i.e., whether the focal firm has relatively high or low financial reporting quality and is, therefore, a relatively good or bad firm).

We are motivated to explore the first source of variation based on prior research indicating that sophisticated market participants are able to distinguish case merits relatively quickly and long before the ultimate legal resolution. For example, insurers of directors and officers increase policy premiums and lenders increase interest rates for defendant firms after the filing date, and results are driven by firms whose cases eventually settle. Investors also monitor the litigation process, and their expectations about the ultimate case outcome drive changes in the ex-ante cost of capital for the sued firm. The distinction between meritorious and non-meritorious cases is especially important because nearly all direct and indirect costs of litigation are restricted to cases that eventually settle. Based on this evidence, we expect that responses to litigation will be concentrated in cases where the peer firm eventually settles the securities class action, so we split the sample based on the ultimate resolution of the peer firm’s securities litigation.

Further, we explore the second source of variation, i.e. the likelihood that focal firms are engaged in financial reporting misconduct. Since litigation risk differs by firm, firms vary in how to respond to the incidence of litigation against a peer firm. In particular, focal firms with lower financial reporting quality are at an increased risk of litigation given that most securities litigation after the passage of the Private Securities Litigation Reform Act of 1995, involve accounting allegations. As a result, focal firms with higher (lower) financial reporting quality are likely to have larger benefits (costs) of voluntary disclosure under heightened litigation risk. Hence, we split the sample into relatively low and high financial reporting quality firms, which we measure using the F-Score.

In our first empirical analysis, we test whether there is an investor response to litigation against an industry peer. On average, we find that focal firms experience negative abnormal returns of -0.17 percent, with returns remaining negative through 60 days after peer litigation. When we partition the sample based on case outcome, we find that investors initially respond more strongly to cases that get settled later. In the three days centered on the peer lawsuit filing date, focal firms with settling peer cases experience abnormal returns -0.25 percent, while focal firms with dismissing cases experience less negative returns of -0.08 percent, and this difference is statistically significant. When we condition returns on firm type, with respect to financial reporting quality, we find that the investor response is significantly more negative for focal firms that have a greater likelihood of misreporting. Over 60 trading days, negative returns for lower quality firms are -2.7 percent versus -1.1 percent for higher quality firms, and these differences are statistically significant. Moreover, investors anticipate negative effects in firms with lower financial reporting quality even prior to the peer firm litigation.

Next, we turn to the responses from the non-sued industry peers. We initially focus on voluntary disclosure—specifically, management earnings guidance—because prior research suggests that firms may use disclosure to signal their quality in an attempt to lower their own litigation risk. We examine the frequency of voluntary disclosure, the frequency of “earnings warnings” (where managers issue a forecast that is below the current analyst consensus), and the timeliness of management guidance. On average, we find that firms respond to litigation against a peer firm by issuing more earnings warnings and less timely guidance.

When we partition the sample based on case merit, we find limited evidence that managers differentiate on case outcomes when responding to peer litigation. While results are concentrated in the focal firms with meritorious peer litigation, we cannot statistically conclude that firm disclosure behavior varies with case merits. However, when we partition the sample based on firm financial reporting quality, we find strong evidence that different types of firms behave very differently. Firms with lower financial reporting quality, and thus at greater risk of both being sued and facing higher costs upon being sued, generally respond to litigation against a peer firm by becoming less forthcoming and relatively more optimistic. In other words, somewhat inconsistent with the findings that more timely bad news disclosures reduce litigation risk, focal firms with lower quality financial reporting appear to unambiguously decrease the quality of their voluntary disclosure.

While the majority of prior research on litigation and disclosure focuses on voluntary disclosure, we also examine whether focal firms adjust their mandatory financial reporting following litigation against a peer firm. We find strong evidence that focal firms improve the quality of their financial reporting in the years following peer litigation, and these results hold regardless of case merit.

If managers respond to peer litigation in an attempt to deter litigation against their own firm, this naturally raises the question: are these changes successful? In our final set of tests, we investigate this question. We first examine the unconditional likelihood of litigation and find that industry peers are less likely to be sued than the general population. This result may appear surprising given the frequency of industry litigation “waves” and industry litigation spillover, but this counterintuitive finding could be consistent with focal firms observing the exogenous increase in their own litigation risk and proactively making changes to ward off this litigation. Next, we directly examine whether voluntary and mandatory reporting changes are associated with the decrease in litigation risk. While decreased voluntary disclosure reduces the risk of dismissed litigation, improved financial reporting quality reduces (increases) the risk of litigation that is eventually dismissed (settled), suggesting a more nuanced relation between changes in financial reporting quality and future litigation.

In conclusion, our study investigates spillover effects in securities class action litigation and finds that both investors and firms respond to litigation against a peer firm. Our findings suggest a nuanced relation between financial reporting changes and litigation, voluntary disclosure, and financial reporting. Additionally, our study raises interesting questions for future research. First, researchers may want to consider why plaintiffs’ lawyers continue with cases that are very likely to be losers, particularly considering that they work on a contingency basis and there is evidence in the form of stock returns on which to base their decision to voluntarily dismiss the case. Second, future research may want to consider whether an over-adjustment of disclosure or financial reporting could actually draw the attention of plaintiffs’ lawyers, rather than deter litigation.

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