A Secondary Market Test of the Merits of Class Action Securities Litigation: Evidence from the Reputation of Corporate Directors

Abstract

Corporations in the United States have come under intense scrutiny for how they report their finances. Enforcement of financial regulation in the United States depends on both the actions of the SEC and private citizens. Because of limited enforcement resources, the SEC argues that private suits are necessary to police corporate behavior and ensure firms obey security laws. Critics of shareholder suits argue that the majority of cases are frivolous and impose a heavy cost on firms while providing little in the way of deterrence. This study utilizes a secondary market to examine the merits of shareholder class actions. Specifically, it examines the reputational penalty paid by officers and directors accused of fraud. Given the amount of discretion and hidden information implicit in corporate management, directors have a considerable interest in maintaining a reputation for trustworthiness. I examine the market for new outside directorships. If private securities class actions are meritorious, directors and officers should pay a reputational penalty when they sit on a board of a company where the officers and directors are accused of fraud. There is little evidence of a negative impact associated with allegations of fraud. Using various definitions of board positions as a proxy for the reputation of directors who are accused of fraud, I find that the net number of board positions is consistently increased. Only shareholder class actions in the top quartile of settlements or in which the SEC has initiated a case do directors appear to suffer a reputational penalty when a board they serve on is accused of fraud. The results call into question the merits of private securities class actions.