INTRODUCTION I. THE COSTS AND BENEFITS OF SECURITIES CLASS ACTION SETTLEMENTS II. LITERATURE REVIEW III. EMPIRICAL ANALYSIS OF THE IMPACT OF SECURITIES CLASS ACTIONS ON DEFENDANTS' FINANCIAL HEALTH AND STOCK MARKET PERFORMANCE A. Description of Data B. Summary Statistics C. Multivariate Regressions 1. Model Specification 2. Regression Results CONCLUSION INTRODUCTION
The ongoing Great Recession has triggered numerous proposals to improve the regulation of financial markets and, most importantly, the regulation of organizations such as credit rating agencies, underwriters, hedge funds, and banks, whose behavior is believed to have caused the credit crisis that spawned the economic collapse. (1) Not surprisingly, some of the reform efforts seek to strengthen the use of private litigation. (2) Private suits have long been championed as a necessary mechanism not only to compensate investors for harms they suffer from financial frauds but also to enhance deterrence of wrongdoing. (3) However, in recent years there has been a chorus calling for reform, singing a distinctly deregulatory tune and calling for serious restraints on private litigation as a vehicle for protecting Investors. (4) In this revisionist story, securities class action suits were cast as the villain that placed U.S. capital markets at a serious competitive disadvantage without producing any net benefits for institutional investors, whose trading makes them not only dominant participants in securities markets but also important beneficiaries of successful securities class action settlements. (5) It is interesting to note, though, how quickly a crisis can change the discourse of public debate on the value of private litigation. Now it seems likely that reform will occur. While we are hopeful that the recession will ultimately abate, a significant question nonetheless remains: which of these two views of securities class actions should guide the formation of public policy with respect to the role of private litigation in the greater constellation of financial market regulatory mechanisms? In this Article, we provide evidence addressing this very issue.
THE COSTS AND BENEFITS OF SECURITIES CLASS ACTION SETTLEMENTS
The costs and benefits of securities class actions for the past two decades have been central to the formulation of policy regarding private suits. The extensive hearing record compiled before Congress's enactment of the monumental Private Securities Litigation Reform Act of 1995 (PSLRA) (6) was filled with empirical data purporting to capture the effects of securities class actions. (7) Since the PSLRA's enactment, there have been scores of empirical studies exploring different aspects of securities class actions and the impact of the PSLRA on the conduct and outcome of these suits. Much like how the Pentagon once purported to measure progress in the Vietnam War by comparative body counts, so has much of the securities litigation literature sought to evaluate the value of securities class actions, and in turn the PSLRA, by capturing data bearing on dismissal rates and settlement amounts (pre- and post-PSLRA), the outcomes associated with different types of suits and lead plaintiffs, and even the variation of attorneys' fees across categories of suits. Since we have produced some of this literature, it is in our self-interest to say these are important inquiries, and we genuinely believe they are. We also believe, however, that the full measure of the costs and benefits of securities class actions requires a broader inquiry than has been pursued in scholarly literature.
To be sure, some studies have examined the direct effects of suits. These studies report that firms involved in securities fraud incur a substantial reputational loss, as measured by declines in the short-term market value of their securities following revelation of their prior transgresstons.(8) Moreover, firms frequently terminate executives linked to such misrepresentations. (9) Each of these outcomes provides its own disciplining force and ought to be weighed on the positive side of securities class actions. But is there a hidden dark side to the successful prosecution of a securities class action? Do the revelation of earlier misstatements, the initiation of a private suit, and the payment of a substantial settlement weaken the defendant firm so that, from the point of view of well-received financial metrics, the firm is permanently worse off as a consequence of the settlement?
In part, the answer to this question depends on why the fraud occurred in the first place. In general, the motivations for false financial reporting are not hard to divine. Mainly, it is a harmful mixture of overoptimism, greed, and a perceived need to play catch-up. Executive suites are populated more often than not by risk-seeking, selfconfident individuals. (10) Many claim that stock options are necessary to incentivize managers who are, unlike the firms' diversified owners, overinvested in the firm, and hence do not share the same risk preference as the firm's owners. Moreover, absent some skin in the game, managers will impose substantial agency costs on the firm by attempting to maximize their own utility by, for instance, shirking in their duties. (11) However, the literature supports the view that the virtue of stock options is also a vice, as compensation based on firm value is associated with abnormal accounting accruals and even fraud as executives try to make sure they catch the golden goose. (12) So there can be too much of a good thing.
Pure greed can motivate insider trading as well. In addition to defrauding the investors on the other sides of these trades, insiders have strong incentives to distort the flow of information to the market to maximize their gains in these transactions. Such distortions lead quickly to frauds that affect the entire universe of traders and often result in enforcement actions against the perpetrators.
Much fraudulent reporting arises from the so-called "last period problem," (13) in which, faced with the possibility of failing to meet the expectations of the "Street," executives opt for accounting chicanery to borrow that missed nickel per share from the future in the wild, unsupported belief that in the next fiscal period, they will incur unforeseen good fortune that will balance out the unforeseen bad fortune of the current period. When the next period arrives and there is not good fortune, but rather more unforeseen bad fortune, managers borrow even more against the future to cover the ten cents per share that they are already down, and so forth, exponentially. Thus, it is the combination of overoptimism and overinvestment in the firm that frequently leads managers to make false financial reports.
In this Article, we focus on the cost side of securities class actions. We examine whether firms involved in settled securities class actions experience long-term weaknesses in their performance, as measured by standard metrics of financial performance and position in the period before the first misstated report (which begins the class period for the resulting securities class action). To test this hypothesis, we compare the subject firms with a matched cohort of firms. We select cohorts by using standard industry classification and by matching classes within the discrete industry by asset size.
Our ultimate focus, however, is the impact of the suit and the settlement on the firm's vitality. While no doubt exaggerated, there is a good deal of commentary that litigation not only weakens companies financially and makes them less competitive but actually leads to bankruptcy. Although commentators level these claims at litigation generally (particularly product liability claims and punitive damage awards), the securities class action is not immune to such claims. The argument is that the sums needed to defend the suit and pay the settlement do not come solely from an insurance policy but also from the corporation itself. (14) On top of this cost impact, there is the deflection of executive attention and the depression of morale and reputation. In combination, these various impacts are harmful to the financial health of the firm. We therefore hypothesize that well-recognized financial metrics bearing on the firm's financial performance and position will reflect the ill effects of revelation of earlier false financial reports. We look for evidence of such adverse effects in the post-lawsuit, as well as post-settlement, years, and pay special attention to any correlation between the settlement size vis-a-vis the defendant firm's asset size and financial metrics.
We also examine other potential effects of securities fraud class action suits on the future health of the targeted firms. For example, scholars have said much about the benefits of the PSLRA's lead-plaintiff provision. (15) We therefore consider whether the nature of the lead plaintiff has an indirect effect on the future health of the firm being sued. Congress designed the lead-plaintiff provision to stop the class action's representative from being decided by a race to the courthouse, which was the predominant practice prior to PSLRA. Now, the court appoints the most adequate plaintiff, who is presumed to be the petitioning party with the most significant financial loss associated with the alleged fraud. (16) A perceived benefit of the institutional lead plaintiff at the helm is that it would not only serve as a governor on the initiation of the suit but, as an institutional investor, would also be equally engaged in crafting a responsible settlement at the suit's conclusion. (17) Several plaintiffs' law firms sought to make institutional clients lead plaintiffs by championing those clients' balanced approach to settlement, rather than gearing up for the type of scorched-earth policy that would have appealed to General Sherman (but would have made him unpopular in Atlanta). The...