Securities class actions and conditional conservatism: Evidence from two legal events

Abstract

AbstractWe use two US court rulings as exogenous shocks to firms' litigation environment and examine the changes in conservative financial reporting following these court decisions. The Silicon Graphics ruling in 1999 imposed a heightened pleading standard and discouraged the filing of shareholder lawsuits against firms with headquarters in the Ninth Circuit. The Tellabs ruling in 2007, however, effectively reversed the Silicon Graphics ruling and made it easier to file securities litigation against Ninth Circuit firms. We predict and find that the reduced litigation risk following the Silicon Graphics ruling discourages conservative reporting for Ninth Circuit firms. By contrast, the elevated threat of shareholder lawsuits following the Tellabs ruling encourages conservative reporting for Ninth Circuit firms relative to non‐Ninth Circuit firms. The disciplining effect of the threat of shareholder lawsuits on conservatism is stronger for firms facing higher ex ante litigation risk. The litigation‐risk‐induced increase (decrease) in reporting conservatism leads to higher (lower) firm valuations.