Large corporate scandals, such as those involving Enron, WorldCom, and Volkswagen were widely publicized in the media, but represent only the tip of the iceberg. Academics and practitioners both predict that a significant number of firms engages in fraud each year. Fraud not only causes directly measurable losses in corporate value, but has other, far-reaching effects on society, such as welfare loss due to foregone taxes and loss of trust in (corporate) leadership.
We examine class action lawsuits, the indictment of the firm and of its officers/directors by a large group (i.e., class) of shareholders, and whether the firm suffers from value declines in its assets and from (lasting) reputational damage. We also investigate whether litigation conveys valuable information to the market and how the competitive landscape changes both for indicted firms and their direct competitors. If a large shareholder or a group of investors becomes concerned with the firm’s operations and management, and takes legal steps to assert their claims, it may affect a firm’s outlook, competitive position, its risk premium, and hence discounted value. The extant literature on corporate fraud is predominantly concerned with the effects of prosecuted fraud, be it the stock market reaction, firm operating performance, or executive turnover. Our paper contributes to the discussion by examining fraud allegations, thus not restricting our investigation based on the eventual case outcome.
We evaluate the role of securities class action litigation as a corporate governance device and study the effect of class action litigation filings on the stock market performance of indicted firms and their peer companies. Our sample covers 2,910 firms in the period starting in 1996 and ending in 2019, which enables us to examine the long-term consequences after the litigation cases are closed. This paper examines all indictments and not merely the settled fraud cases, enabling us to measure the direct effects of litigation, including the effects on firms which are subsequently acquitted. We use data on class action filings to identify firms indicted for fraud (following a lack of transparency with respect to price-sensitive information, lack of care in product development, accounting fraud, embezzlement, etc.) Class actions are civil lawsuits initiated by investors and thus represent cases where corporate actions and management decisions exceed the tolerance threshold of shareholders and are hence not corporate problems arising from bad luck or an honest mistake. We focus on class actions for two reasons. First, relative to lawsuits where an individual shareholder claims to be harmed, there is broad consensus about managerial or corporate misconduct among shareholders in class action suits. Indicted firms in class action suits may erode trust and are potentially value destroying. Second, it is the enforcement channel with the lowest attrition rate in terms of data quality.
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