Fraud in the new-issues market: empirical evidence on securities class actions.

• Author: Bohn, James

Introduction

On Friday morning, April 2, 1993, Philip Morris announced its plans to slash the average price of its Marlboro line of cigarettes by forty cents per pack.(1) Philip Morris also reported that the price cut would reduce projected earnings of its tobacco products for 1993 by nearly forty percent relative to the previous year.(2) The stock market responded quickly to the events of this day, later labelled "Marlboro Friday": Philip Morris's common stock lost nearly twenty-five percent of its value, plummeting from $64.125 per share at the close of trading on April 1 to $49.375 per share by the close of trading on April 2. Less than five hours after Philip Morris's announcement, plaintiffs filed the first of ten class-action lawsuits alleging fraud violations under section local of the Securities Exchange Act of 1934 and Rule 10b-5 with respect to the Marlboro brand.(3) Each separate class action claimed that Philip Morris had used fraudulent statements to augment the price of Philip Morris's common stock.(4) Among the plaintiffs' attorneys firms leading the several class actions was Milberg, Weiss, Bershad, Hynes & Lerach,(5) which prior to the Philip Morris suit had earned millions through settlements of other suits against newly public firms whose securities had performed poorly in aftermarket trading.(6) Unlike the vast majority of securities litigation, however, the class-actions against Philip Morris did not end in settlement.(7) Rather, almost two years later, the U.S. District Court for the Southern District of New York dismissed the case, finding no evidence of fraud on Philip Morris's part.(8) In its decision, the court pointed out that Milberg, Weiss's initial complaint alleged that Philip Morris - a cigarette company - had engaged in conduct "`to create and prolong the illusion of [Philip Morris'] success in the toy industry.'"(9) More importantly, the short time span between Philip Morris's Marlboro Friday announcement and the first class-action filing - less than five hours - led the district court to question the diligence of the plaintiffs, attorneys in investigating the presence of actual fraud on Philip Morris's part.(10) Rather than turning on the presence of any fraud, Milberg, Weiss's case seemed to depend primarily on the size of Philip Morris's common stock price decline.

The Philip Morris case illustrates a much-debated phenomenon in the securities industry: The frivolous lawsuit.(11) Opportunistic plaintiffs, attorneys continuously monitor securities prices, probing for recent offerings that perform poorly in the aftermarket. Once a security's price suffers a decline sufficient to generate a potential damages award large enough to cover the expected costs of litigation, plaintiffs' attorneys bring suit, hoping for a swift settlement. Defendants of such suits - including the issuer, directors and officers of the issuer, auditors, attorneys, and underwriters - almost always settle. Several factors compel settlement, including: the risk aversion of the directors and officers, the existence of directors and officers' insurance, and the desire of the issuer and underwriters to minimize negative publicity and to mitigate the costs of defending against a prolonged frivolous suit.(12)

Recently, Congress responded to the problem of frivolous securities-fraud suits by enacting the Private Securities Litigation Reform Act of 1995(13) (Reform Act) over President Clinton's veto.(14) Through the Reform Act, Congress attempted to curtail the ability of plaintiffs, attorneys to rely upon professional plaintiffs, class representatives and to increase the ability of institutional investors to take control of securities-fraud class actions.(15) In addition, class-action complaints must now plead the alleged fraud with particularity, and courts are required to review such complaints for violation of Federal Rule of Civil Procedure 11.(16) Soft information projections are also given greater protection through an expanded safe harbor provision under the Reform Act.(17) A question remains, however, as to the general nature of securities class actions. As the Philip Morris case demonstrates, some frivolous securities class actions do occur. But do frivolous suits predominate? Is there any evidence of merit-based enforcement actions.

Many scholars view class-action suits with a mixture of approbation and skepticism. Some perceive class actions as playing an enforcement role and contend that class actions serve as an important check on management and ensure the adequacy of corporate disclosure.(18) Under this enforcement theory, shareholder litigation complements the SEC's own policing activities,(19) providing plaintiffs and plaintiffs' attorneys with an incentive to ferret out misleading disclosures and safeguard the integrity of financial markets. Detractors of the recent Reform Act, for example, contend strenuously that the majority of suits are indeed merit based and that restricting securities-fraud suits exposes unsuspecting shareholders to the sharp practices of misleading issuers.(20) Others, however, view the class action as a mechanism for plaintiffs' attorneys to extract rents from the corporate treasuries of defendant firms and insurance companies.(21) They argue that the overwhelming desire of defendants to avoid trial inevitably results in strike suits seeking a favorable settlement.

Whether securities-fraud suits are merit based or strike-suit based assumes a particular significance in the new-issues market. The cost of strike suits is especially burdensome for companies going public for the first time. Although larger, more established companies may enjoy alternative sources of funding, new growth companies often must resort to the public equity markets.(22) Furthermore, new-growth companies often have volatile stock prices and lack a disclosure track record, making them particularly vulnerable to strike suits. On the other hand, the danger to investors is also especially acute during initial public offerings (IPOs). Much uncertainty surrounds the issuance of a private companies equity.(23) Investors generally possess only limited information on the value of an IPO; the issuing firm's managers themselves may have only rough estimates of an IPO's fundamental value.(24) As a result, agency problems exist at the time a firm goes public:(25) owners of the firm have an incentive to inflate the prospects of the firm to ensure the success of the IPO. In addition, insiders seeking to sell part of their holdings also have an incentive to inflate the offer price and increase their receipts from the sale of their shares.

Because of the importance of securities-fraud actions to the new-issues market, this Article examines the incidence of securities class actions and reports their effect on the performance of IPOs from 1975 to 1986.(26) This Article tests the enforcement versus strike-suit theories of class actions and provides insights into the incentives of plaintiffs, attorneys in the IPO context.(27)

Several authors have studied shareholder suits in other contexts.(28) Professor Romano analyzed a sample of 139 suits consisting of both derivative and direct shareholder suits.(29) Because Romano did not treat the suits arising out of IPOS as a separate category, her article did not assess the impact of shareholder lawsuits on the new-issues market. Professors Drake and Vetsuypens,(30) and Professor Alexander(31) each specifically addressed the issue of shareholder litigation arising out of misstatements in IPO prospectuses.(32) Alexander found some evidence that shareholder suits, at least against computer-related IPOs, were frivolous. Lawsuit IPO firms in her sample eventually settled for essentially the same percentage of their maximum potential damages award.(33) From this finding, Alexander concluded that the merits do not affect the settlement amount. The small size of Alexander's sample (seventeen IPOs),(34) however, makes it difficult to draw inferences about the incidence of litigation or the significance of her findings. Drake and Vetsuypens examined ninety-three IPOs which faced securities class actions between 1969 and 1990.(35) A number of authors have suggested that underwriters may underprice IPOS to avoid lawsuits.(36) To test this theory, Drake and Vetsuypens compared the initial returns of firms that experienced a lawsuit against a control group of IPO firms. They found no evidence that firms experiencing lawsuits had less underpricing than firms not experiencing suits.(37) Furthermore, unlike Alexander, they found that the settlement percentage of the aftermarket losses varied widely among the lawsuit IPO firms.(38) Drake and Vetsuypens's study does not provide insights into the incidence of shareholder litigation. Moreover, because their sample is composed of cases with reported decisions or settlements, it is biased toward cases involving important decisions and those cases which were not dropped by plaintiffs.

This Article seeks to extend the previous empirical shareholder litigation work and provide a broad-based examination of securities class actions in the new-issues market. Because we look at the entire sample of equity IPOs from 1975 to 1986, we avoid the small sample size problems of Alexander's study and the bias problems of Drake and Vetsuypens's work. Importantly, unlike other previous empirical work, we focus not only on those firms that were sued but also on those firms that were not sued. In fact, 3396 IPOs in our sample of 3519 IPOs were not subjects of lawsuits. Through a comparison of the differences between the two sets of firms, we hope to test more accurately the enforcement versus strike-suit theories. Part I introduces the enforcement versus strike-suit theories of securities class actions. Part II describes the empirical sample of IPOs used in our study. We provide several summary statistics of the IPO sample and the incidence of suits in...