This Article examines a basic question in corporate law: Do the legal merits matter in stockholder litigation? A connection between engaging in wrongful behavior and liability in a shareholder lawsuit is essential if lawsuits are to play a role in deterring wrongful behavior. Yet skeptics of shareholder litigation have raised doubts about the degree to which such suits track actual malfeasance. The challenge is that managerial wrongdoing is almost never observable. While researchers can identify claims and--to some degree--evaluate their merits, such studies are limited to examining instances of wrongdoing that are actually litigated. We develop a novel approach to overcome this limitation in the context of one of the most notable corporate scandals of the twenty-first century: stock options backdating. Options backdating involves falsifying incentive option grant dates in order to increase the value of the options to executives. The manipulation of grant dates leaves a measurable statistical fingerprint, which we used to estimate the likelihood of backdating among not only companies sued for the practice, but across a sample of thousands of firms that used option compensation. We compare the likelihood that firms backdated with the incidence and disposition of shareholder derivative and securities class action lawsuits. We find that many firms that likely engaged in backdating were never sued and that even firms publicly named as backdaters in the press were not universally sued. Instead, plaintiffs' attorneys were selective in targeting firms with more egregious patterns of backdating. We also examine the motion to dismiss, settlements, and the use of special litigation committees, and we find that the probability of backdating is important for the latter two. These results are an important contribution to the shareholder litigation literature and are particularly timely and important for the unfolding debate over fee-shifting bylaws.
INTRODUCTION I. DERIVATIVE LITIGATION AND OPTIONS BACKDATIN A. Do the Merits Matter in Stockholder Litigation? B. The Backdating Scandal II. DATA AND METHODOLOGY A. Methodology for Identifying Backdating Activity B. Description of Backdating Variables C. Data on Litigation over Backdating III. RESULTS A. Targeting B. Dismissal C. Settlement D. Special Litigation Committees IV. IMPLICATIONS FOR CORPORATE LAW A. Filing of Derivative Claims B. Dismissal and Settlement of Claims C. Special Litigation Committees CONCLUSION INTRODUCTION
Corporate managers are deterred from wrongdoing by both public and private enforcement. While some types of corporate malfeasance may result in criminal or civil sanctions at the hands of the government, the staff and budget of regulators are limited. For this reason, corporate law relies heavily on private enforcement through state law derivate suits and federal securities class actions. (1) The efficiency and effectiveness of private enforcement are therefore of central concern for corporate law.
A threshold question is whether the merits of legal claims matter in stockholder litigation. Private enforcement relies heavily on the plaintiffs' bar to identify and prosecute promising cases. Since suits are initiated by plaintiffs' attorneys and settled by corporate managers using firm or insurance company dollars, the risk of strike suits and collusive settlements is high. (2) The problem confronting efforts to answer this question is that the merits of claims of corporate malfeasance are generally unobservable. To get around this problem, prior research on stockholder litigation has relied on variables that can be observed and are assumed to correlate with legal merit: the presence of an accounting restatement, for example, or a parallel SEC investigation. Such measures are noisy proxies for the merits of cases. Moreover, such a strategy restricts the researcher to legal claims actually litigated and omits cases of malfeasance that never resulted in a claim being filed. This is a significant omission, as the deterrence function of litigation depends critically on the probability that bad acts reliably lead to litigation.
This Article takes a novel approach to studying stockholder litigation by identifying a context in which it is possible to quantify breaches of duty across a large universe of firms, both sued and unsued. Specifically, we study cases arising out of the stock options backdating scandal. Backdating involved the falsification of the grant dates for stock options used to compensate key employees in order to covertly increase the employees' compensation. (3) Executive stock options typically set an exercise price (4) equal to the stock price on the day the option was issued, and as a result, options issued on days when the stock price happened to be low were more valuable to executives. (5) By falsifying grant dates, backdaters were able to create an appearance that grants were issued on dates in the past when the stock price happened to be low, while accounting for them as though they had been issued on the falsified date. Backdating involved the manipulation of stock option grants with statistically measurable consequences: grants were more likely to be issued on favorable dates. Because of this practice, and because option grants are publicly reported, we are able to calculate the likelihood that individual firms engaged in manipulative practices over a very large sample. This methodology provides a measure of the merits (6) of potential backdating claims that is both more precise and available for a larger universe of firms than in other types of litigation.
The data for this study includes hand-collected data on private shareholder litigation--both derivative suits under state law and class actions under the federal securities laws--alleging options backdating. For derivative suits, we have collected extensive information on each case, including the full set of claims pre-consolidation, the decision on the motion to dismiss, the use and recommendations of special litigation committees, and information about attorneys' fees and settlement. We supplement this data with information about the presence of securities class actions from public reports, public lists of SEC investigations, and the disclosure of backdating activities in media and analyst reports.
We combine this legal data with data on option grants and statistical simulation to estimate both the probability that a firm engaged in backdating and the extent to which the executive recipients of option grants benefited from that backdating. These measurements provide a more precise picture of the merits than in other shareholder litigation contexts. It is possible, therefore, to produce a firm-level, ex ante estimation of the merits of backdating claims for a large sample of firms. Armed with these estimates of merit, we investigate whether shareholder litigation, in the aggregate, targets the "right" firms, how the merits affect the progress and disposition of the litigation, and whether the recoveries correlate to the merits of the claim.
We find that a majority of firms that likely engaged in backdating were never publicly linked to the practice. Among those firms publicly alleged to have engaged in backdating--in analyst reports or news coverage--a majority, but not all, were named in a derivative suit. Even fewer firms were targets of securities class actions. The sued firms were more likely to have backdated and have higher total reversal around likely-backdated option grants than the publicly implicated but unsued firms. Similarly, firms targeted in class actions, which were a subset of the firms sued derivatively, show more egregious patterns of backdating than firms subject only to derivative claims and also larger stock price drops when backdating activity was revealed. These results suggest that the incidence of lawsuits--even controlling for public revelations of backdating and SEC investigations--was linked to merits-related measures of backdating activity.
We also find that sued firms differ from unsued firms along other dimensions. Derivatively sued firms were larger than implicated but unsued firms. Additionally, firms that were targets of SEC investigations were more likely to face both class action and derivative suits. We observe a race-to-the-courthouse effect in derivative litigation, with multiple lawsuits targeting a single firm and making similar allegations. This effect was strongest among large firms and firms investigated by the SEC, though the number of complaints was not otherwise related to our measures of merit.
We find no strong predictors of the disposition of the motion to dismiss in either derivative or class action suits. None of the covariates is significant in our regressions for either derivative or class action claims, and even a sensitive non-parametric test does not distinguish the merits of dismissed claims from non-dismissed claims. This may reflect that the motion to dismiss often turns on legal rules that are not directly related to the alleged wrongful activity, such as demand on the board in the derivative context. (7)
We find some evidence that the size of settlements is related to the merits of cases. For shareholder derivative suits, we use the size of attorneys' fees as a proxy for the settlement amount, and we find that fees are related to the level of backdating activity. For class action suits, we find no relationship between settlement amounts and either the backdating probability or the total value extracted through backdating. However, we do find that when the SEC conducted an investigation, cases had larger settlements.
We also examine the use of special litigation committees (SLCs) as a tool to regain corporate control over derivative litigation. We find that the use of SLCs was both strongly related to the...