Corporate Fraud and the Consequences of Securities Class Action Litigation

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.

When the case is closed and the firm pays a settlement fee, this does not mean that the firm admits guilt; a settlement is an agreement between parties to settle for damages without being found legally guilty (a court verdict of guilt virtually never occurs in class action suits). Still, a settlement may indicate that the defendant is morally guilty. We will distinguish among “fraudulent” firms that settle voluntarily (under supervision of the court), that are required to settle by court (settlement by court order), and against which the case is dismissed by the court. We assume that a claim was meritorious if the company agrees to pay a settlement (voluntary or after a court order).

Our results show that fraud is indeed widespread. We find that the median number of new filings each year amounts to 134, the propensity of fraud being the highest in the technology, services, financial, and healthcare industries. We also find a higher propensity of fraud around stock market bubbles and busts, for example, the number of filings was around 240 during the recent stock market surge (2016-2019), or about 80% higher than the median. The industry distribution of new filings also varies over time: the technology industry experienced its highest number of new filings after the dot-com bubble (2001); the financial industry experienced a high number of new filings during the financial crisis starting in 2008.

We explore the factors that signal possible fraud. Smaller and risky companies are more often indicted as are firms with higher external financing needs. Firms with a less sophisticated ownership base (proxied by the lower-than-average institutional holdings) and lower transparency (lower analyst coverage) are also more often accused of fraud. The results of institutional ownership and the degree of transparency indicate that litigation can act as a substitute governance mechanism.

We also analyze how the litigation process is eventually closed. We document that firms are more likely to settle the case quickly the less resilient the firm is to investor pressure and the worse its operational performance is. Our findings indicate that the announcement that a company is taken to court has a non-trivial effect on its stock price. In the 20-day window before and after the day of the filing of a lawsuit, the average firm experiences an abnormal return drop of 12.3%. It appears that the information released on the day of the indictment and during the previous month (when the class is built) is sufficient for investors to assess if a lawsuit is meritorious, as firms that will (ultimately) end up paying damages exhibit a 14.6-20.6% negative cumulative average abnormal return (CAAR), while this figure amounts to 7.2% for companies that are eventually cleared of all charges (when the case is dismissed). The difference between the returns of firms that ex post settle or are acquitted represent absolute losses of $516m to $932m for the former and $384m for the latter. The fact that the drop in value of a prosecuted firm is substantially larger than the eventual penalty (the settlement) suggests that a lawsuit significantly reduces a firm’s reputation. To assess whether the value drop of firms against which the charges are dismissed depends on a selection issue, we construct a matching sample of similar firms that are not indicted. The litigation effect is confirmed by the control sample analysis: their abnormal returns are zero in the period around the filing date of the respective treated firm. We also study returns around the closure of court proceedings to identify a possible reversal effect once a case reaches the end phase in terms of dismissal or settlement. We find no significant upward price movements in the period surrounding the day that the final order is issued by the court or in the overall period of the lawsuit. Strikingly, this is also the case for acquitted firms. This result suggests that the drop in reputation is factored into prices at the initiation of the lawsuit and is not undone when the dismissal of the case is made public. Examining the long-term consequences on firm performance (up to three years after the case closure), we find that litigation significantly negatively affects profitability and operational expenses of the indicted firms. Overall, this suggests that indicted firms experience a value loss due to fraud. If a settlement is reached, the damage of past fraud can be partially recuperated by the shareholders. However, the reputational damage has lasting tangible effects captured by lower future cash flows (following losses in the product market, increased sourcing costs, etc.) and an increase in firm risk (reflected in a higher cost of capital). The share price drop at the indictment is not undone over a period up to three years after the case closure. Remarkable is that the above dollar value losses of acquitted firms last for such a lengthy period. This loss can be quantified as the market value drop for firms that are ultimately acquitted and amounts to $384 million, on average. For firms that end up paying a settlement, the reputational loss is the difference between the settlement amount and the market value drop. In monetary terms, it is $872 million (=932.0-60.5) and $497 million (=516.1-19.2) for voluntary and ordered settlements, respectively.

We also analyze what type of factors relate to the share price response to an indictment. First, larger firms and less financially constrained firms are more resilient to share price declines around the indictment. The better market reaction may reflect investors’ perception that these firms can weather the litigation process better. Second, turning to governance characteristics, we find little impact of the corporate governance mechanisms on the stock market responses except for the presence of investment companies. Their holdings mitigate the stock price decline, which suggests that some institutions can improve firms’ resilience to adverse events, possibly through activism. Third, considering the investment activities of firms, we find no significant link between past acquisitions and the market reaction to indictment.

We also investigate whether the share price declines are due to altered cash flows valuations by examining the operations and financial policies over the three years after the indictment. We find that a class action suit reduces profitability and increases operational expenses. The cost of capital increases and sophisticated investors decrease their positions. We conclude that the lasting stock price fall indeed reflects a less prosperous outlook for the indicted firm.

Trading in the stock of indicted firms is abnormally high around the litigation date: we find that more sophisticated investors (financial institutions) decrease their positions in indicted firms by 2%. Given that institutions do not usually adjust their portfolio positions, a  reduction of  2% is economically significant. We also test whether investors can take advantage of the litigation information when it reaches the stock market. Constructing long-short portfolios with stocks of indicted firms (short) and peer firms without litigation (long), we find that an investor can earn significant returns trading around litigation events. The risk-adjusted alpha amounts to an annual 6.39%.

Finally, we investigate the peer effects of litigation. Indictment may be good or bad news for competitors: investors may be distrustful of peer companies when they expect them to suffer from similar problems as indicted firms (a contagion effect); but competitors’ businesses may benefit if distrusting customers switch to their products and services (a competitive effect). We find evidence of both contagion and competitive effects, with the former effect dominating.

Overall, our study contributes insights into the role of securities class action as an alternative corporate governance device and its implications for the stock market, firms’ operating performance, and the wider industry. Our findings are relevant for investors, regulators, as well as corporate decision makers to understand the consequences of class action litigation on firms, and the market.