Disclosing Adverse Earnings News and Litigation: The Importance of Large Market Declines

Abstract

This study finds that large market-wide declines in stock prices are associated with higher litigation incidence and settlements even though market-wide events are legally irrelevant. The probability of litigation nearly doubles (from 0.29% to 0.55%), and the amount of settlements also doubles (from $5.0 million to $10.1 million) when earnings disclosures occur during a large market decline, even after controlling for the firm’s market-adjusted return. Further, judges with (without) specialized experience in securities litigation are more (less) likely to dismiss cases triggered by disclosures during large market declines. This pattern is consistent with experienced judges recognizing and dismissing weaker cases. Finally, managers are less likely to disclose adverse news at the end of trading days with large market declines. While we cannot definitively identify the motive behind this pattern, it is consistent with managers recognizing increased litigation risk during large market declines.