Fraud and Firm Performance: Evidence from Fraud on the Market and Securities Class Action Lawsuits

Abstract

We investigate the argument that securities frauds are preceded by surprisingly good firm performance but are followed by rapid negative investor response by studying the longterm stock performance of a sample of 430 firms that disclosed securities fraud and experienced class action lawsuits filed between 1989 and 1999. Estimating Fama-French (F-F) three-factor model-based monthly abnormal returns for three events, alleged fraud commission (FC), fraud disclosure (FD), and initial class action filing (CA), we find significant upward price drift during the five-year pre-FC horizon and weak evidence of a negative drift for up to five years following CA. The observed pre- and post-event abnormal returns cannot be explained by changes in systematic risk (F-F factor loadings), suggesting that the effects of fraud are confined primarily to changes in expected cash flows rather than changes in discount rates. Further, we find positive abnormal trading volume and return volatility during the pre-FC horizon but a significant deterioration in market quality, as evidenced by a persistent negative abnormal drift in relative trading volume and a sustained increase in return volatility, for up to five years following CA.