Institutional Monitoring Through Shareholder Litigation

Our paper, Institutional Monitoring through Shareholder Litigation, forthcoming in the Journal of Financial Economics, investigates the effectiveness of using securities class action lawsuits in monitoring defendant firms. We compare differences in (1) immediate litigation outcomes (including the probability of surviving the motion to dismiss and the settlement amount), and (2) subsequent governance improvement (specifically changes in board independence), across class action lawsuits led by institutions versus individuals. We find that securities class actions with institutional owners as lead plaintiffs are less likely to be dismissed and have larger monetary settlements than class actions with individual lead plaintiffs. We also find that after the lawsuit filings, defendant firms with institutional lead plaintiffs experience greater improvement in their board independence than defendant firms with individual lead plaintiffs.

Our paper is motivated by the lack of evidence on the effectiveness of institutional investors exercising their monitoring power through litigation. Such evidence is much needed because the Private Securities Litigation Reform Act of 1995 (PSLRA) established a preference of granting lead plaintiff status to plaintiffs with the largest financial stake in the class action, thus providing institutions an opportunity to critically affect the litigation by serving as the lead plaintiffs. Given the costs of serving as a lead plaintiff and the free rider problem, institutional investors may not want to lead class action lawsuits even if they hold the largest financial stake in the defendant firm. Consequently, it is important to provide empirical evidence on the effectiveness of institutional monitoring through class action litigation. In addition to documenting the implications of the lead plaintiff provision in the PSLRA Act, our findings also underscore the important monitoring role of institutions, from both an immediate disciplining of management as well as a long-term corporate governance perspective.

We believe a theory of why and under what conditions institutions will choose to lead a class action is important. Because of the free-rider problem, we propose that institutions will step forward to lead the class actions only when their net benefits are higher than attorney agency costs. We discuss the costs and benefits for institutional owners and develop surrogates for their incentive to serve. Our determinants model provides insights regarding institutions’ incentives to serve as the lead plaintiff. We also use this model to control for endogeneity in investigating monitoring effectiveness.

Using a sample of 1,811 securities class actions filed between 1996 and 2005, we find that when the likelihood of winning is high, the potential damage is large, and the defendant firm is important to the institutional owners, institutional owners are more likely to step forward to serve as the lead plaintiff. Specifically, we find that institutional investors are more likely to serve as the lead plaintiff when the lawsuit involves an accounting-related allegation, has an accounting firm as the co-defendant, has a longer class period, has a larger negative market reaction to the revelation event, and has a larger potential investor loss. The probability of having an institutional lead plaintiff is also higher when the defendant firm has a larger market capitalization, has a higher level of institutional holdings, and is operating in a high-tech industry.

After controlling for these determinants of having an institutional lead plaintiff in our multivariate regression analysis, we find that relative to lawsuits with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements. Further analysis indicates that all types of institutions show significantly better litigation outcomes with public pension funds generating the largest settlement amount. We also find that within three years of filing the lawsuit, defendant firms with institutional lead plaintiffs experience greater improvement in board independence than defendant firms with individual lead plaintiffs. These results are robust to controlling for regulatory changes in the NYSE, NASDAQ and SEC corporate governance requirements during the sample period and for determinants of having an institutional lead plaintiff.

The paper is available here.