Executive Summary:
Securities class-action lawsuits have become more highly contentious as of late. Plaintiff's attorneys claim they keep Wall Street accountable. Business executives complain that suits are lining lawyer's pockets to the detriment of shareholders. Financial services firms are being waylaid by lawsuits as stock and fund prices have dropped, owing to subprime-related investment activity. In a forthcoming Journal of Financial and Quantitative Analysis paper*, SMU Cox finance professor Amar Gande and co-author Craig Lewis reveal that investors penalize firms even before the announcement of a securities class-action lawsuit against those same firms. Investors in fact rationally anticipate an event, for example, the recent Fidelity Investments lawsuit or a poor earnings announcement by a firm, based on industry conditions and firm-specific factors.
The research study entitled "Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers" shows that investors update the prospects of a lawsuit on a firm as more information becomes available. The authors find that "investors partially anticipate lawsuits based on firm-specific and industry-specific information and capitalize losses prior to the filing on a lawsuit." According to Gande, "The extent of anticipation is substantial-the magnitude of shareholder losses is understated on average by about a third if one were to focus only on the lawsuit filing date and ignore prior capitalization of shareholder losses."
Gande explains, "Suppose investors expect a firm to be sued in the future with a 90% probability. If investors are rational, you would expect them to capitalize shareholder losses to the extent of 90%. That is, 90% of the shareholder losses would have already occurred prior to a lawsuit being filed on that firm. Focusing on what happened when a lawsuit is filed against that company would miss accounting for previously capitalized shareholder losses." Such partial anticipation was found to be prevalent even during the dotcom boom-bust cycle as well as in the early 2000s when some investment banking firms were allegedly manipulated allocation of IPOs to investors.
Triggers for Being Sued
From their study of 1,915 securities class-action lawsuits from the period 1996 through 2003, then whittled down to 605 filings due to the research criteria, the authors find that certain industry conditions and firm-specific factors determine the propensity of a firm to be sued. "If you have been sued before, there's a good chance you will be sued again," Gande relays. "In other words, history repeats. Also the litigation environment is important. If there are numerous lawsuits in an industry, then chances are high for a firm to be sued in that industry," he mentions. Firms in certain industries are also more likely than firms in other industries to be sued. For example, financial services and technology firms are more likely to be sued than regulated firms (utility companies). Gande states, "A financial firm's assets are comprised of human capital (employees) and financial capital (money) whereas a utility company has more tangible assets and is regulated by federal/state agencies.
Many firm-specific factors also influence the propensity to be sued. Larger firms have a lower incidence of being sued since they have the "deep pockets" to vigorously defend against potential lawsuits. Gande adds: "Past performance is an important variable. If a firm is doing poorly, the likelihood of being sued is higher." A link to CEO compensation is also documented in this study. If a firm is doing poorly and the CEO receives a bonus, that is a recipe for disaster. Gande says, "If a firm has a negative return on assets and the CEO gets a bonus, it increases the probability of that firm being sued."
Gande says that investors learn from the earnings announcements, lawsuit filings and the behavior of firms in a given industry to form their expectations about any firm to be sued in the same industry. "With the first firm in an industry to be sued, investors may be forgiving, giving the benefit of the doubt. Perhaps it was a firm-specific issue like a production problem, or a key manager being let go," he says. "But if they observe that more firms in that industry are being sued, then the likelihood of being sued goes up for all other firms in the same industry."
If investors are beating down the stock price of a company in response to a lawsuit filing on that company, then chances are good that the entire industry may also take a hit. Gande refers to this as the industry spillover effect. It is similar to the neighborhood effect when home values decline due to foreclosures. One foreclosure can be excused, versus when more foreclosures are added over time. There have been over 170 subprime lending lawsuits filed in federal court since the first quarter of 2008. Industry spillover effects play a significant role in their findings and analysis.
"The idea that investors anticipate an event and update their valuation of a company's stock price holds true for any event, not just lawsuits," says Gande. It could be earnings announcements, financial crisis-related events, sub-prime lending lawsuits, or a host of other events such as merger/acquisition announcements that companies typically report.
What's Captured
"Suppose your firm is the fourth firm to be sued in an industry. Before your firm is sued, if say there's a 90% chance of being sued, then 90% of the losses will have been already been reflected in your firm's stock price," Gande expresses. "What's then left for the announcement? It's only the residual effect of 10%, which in relative terms is not that big of a surprise."
Most research studies focus on the lawsuit filing date and document the residual effect of the 10% in the above situation. This study considers the whole picture by examining what happened to the firm's stock price not just on the lawsuit filing date but also in response to the previous three lawsuits in the same industry. This study would state in this situation that 90% of shareholder losses were partially anticipated and only 10% of the shareholder losses occurred on the lawsuit filing date, given investor expectations about the likelihood of that firm being sued.
"We're saying you need to take this expanded view of what is happening," Gande explains. "Our study is about private litigation which is generally considered as a necessary supplement to government enforcement actions, such as those conducted by the Securities and Exchange Commission (SEC). People often complain that SEC fines associated with enforcement actions are relatively small. But there is a penalty for firms in terms of shareholder losses reflecting lost customers, sales, and reputation." If SEC enforcement is seen as an event for a particular firm, their study suggests that such enforcement actions may be partially anticipated by investors based on similar enforcement actions against other firms in the same industry. Ultimately, the penalties to firms, measured by the shareholder losses, prior to and on the SEC enforcement action date will likely be much higher if you use their methodology.
Lehman Brothers recently announced considerable losses in mid-June. Based on the research findings, Gande expects multiple class-actions lawsuits given that they were not expected to perform as poorly prior to their recent earnings announcement. There goes the neighborhood again.
"Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillover" by Amar Gande of SMU Cox School of Business, and Craig Lewis of Vanderbilt University, is forthcoming in Journal of Financial and Quantitative Analysis.
Written by Jennifer Warren |
