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Corporate Governance: The Harvard Law School Corporate Governance Blog
Shareholder Lawsuits and Stock Returns
By Harvard Law School Program on Corporate Governance
(Editor?s Note: This post comes to us from Amar Gande of the Edwin L. Cox School of Business, Southern Methodist University, and Craig M. Lewis of the Owen Graduate School of Management, Vanderbilt University.)
In our forthcoming Journal of Financial and Quantitative Analysis paper, Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers, we analyze shareholder initiated class action lawsuits and the associated stock price reaction. Our analysis uses a comprehensive sample obtained from the Securities Class Action Lawsuit Clearinghouse (see here) at Stanford University (which tracks federal securities class action lawsuits since 1996). This service reports that 1,915 class action lawsuits were filed over the period 1996 through 2003 with litigation peaking in 2001 when 493 suits were filed. Not only do we examine price reactions on the lawsuit filing date, but we consider the possibility that these lawsuits signal that comparable firms are susceptible to similar lawsuits. If true, we expect these comparable firms to have negative stock price reactions that are significantly related to the probability of being sued.
We develop an econometric model for the propensity to be sued based on both firm and industry-specific factors. We show that shareholder wealth losses on the date that the filing of a lawsuit is announced are understated because investors partially anticipate these lawsuits and capitalize part of the losses in advance. In this regard, our methodology is consistent with the literature on conditional event study methods that emphasizes the role of explicitly conditioning for the expected information (i.e., partial anticipation of lawsuits) in estimating announcement effects, and suggests that the probability of an event (i.e., of being sued) is, as we find in this study, significantly related to the event date announcement effect. While other studies have examined whether investors partially anticipate corporate events, such as acquisitions and debt offerings, they are based only on firm-specific information. In contrast to these studies, we incorporate spillover effects based on industry specific information, such as the litigation environment, to determine both the propensity of a firm to be sued and the associated shareholder losses. We focus on the relation between investor reactions and the probability of being sued and demonstrate that prior expectations about the likelihood of being sued are significant determinants of the anticipated losses prior to the filing of an actual lawsuit and on the lawsuit filing date.
Our main findings are as follows. First, we find that investors partially anticipate lawsuits based on firm-specific and industry-specific information and capitalize losses prior to the filing of a lawsuit. Second, we show that filing date effects understate the magnitude of shareholder losses on average by approximately a third. Finally, we demonstrate that prior expectations about the likelihood of being sued are important determinants of the losses that investors capitalize in anticipation of being sued and of the losses on the lawsuit filing date. In particular, we show that the more likely a firm is to be sued, the larger is the partial anticipation effect (shareholder losses capitalized prior to a lawsuit filing date) and smaller is the filing date effect (shareholder losses measured on the lawsuit filing date). Our evidence suggests that previous research that typically focuses on the filing date effect understates the magnitude of shareholder losses, and such an understatement is greater for firms with a higher likelihood of being sued.
The full paper is available for download here.
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