Implication of Securities Class Actions for Cost of Equity Capital and Shareholder Wealth

Abstract

We investigate the effects of the filing of securities class actions on firms' cost of equity capital and shareholder wealth. We posit that class action litigation increases perceived uncertainties about the firm and leads to an increase in its cost of equity capital. Using three models for estimating the cost of equity capital, we document increases in firms' cost of equity capital following filing of the class actions. Our analysis indicates that the majority of the value loss following filing of class actions arises from the increase in the cost of equity capital while only a small fraction of the loss arises from downward revisions of future earnings. We also find that the increases in the cost of equity capital are higher when accounting issues and audit firms are involved, when the lawsuits have higher merit, and when firms are smaller. Finally, we document that the settlement amounts are not significantly higher than the short-term market value loss resulting from the filing, suggesting that investors do not receive a significant net benefit from filing a class action lawsuit.