Securities Class Actions Research Articles

The impact of SOX on securities fraud class action dismissals

Many have criticised the high cost of implementing the provisions of the Sarbanes–Oxley Act of 2002 (SOX — eg complying with Section 404, implementing enhanced corporate governance measures). In this paper, we investigate a potential benefit of SOX, an increase in the frequency of successful motions to dismiss in securities fraud class action lawsuits. A securities class action lawsuit is a significant event for a publicly traded company. The potential for damages and the adverse publicity from securities litigation is significant and the utilisation of scarce resources to defend, as well as the ensuing settlement amounts, can be substantial. A court's decision to grant or deny a request for dismissal either absolves the defendant from future legal liability, or virtually assures that settlements will be made or damages will be paid. If the corporate governance, oversight, and disclosure enhancing provisions of SOX are successful, we would expect the likelihood of successful motions to dismiss would increase. Based on our empirical analyses, it appears as though the frequency of defendants’ successful motions to dismiss securities class action lawsuits has increased, suggesting that although the cost of complying with SOX may be great, at least one of its benefits may exceed its costs.

Do Underwriters Have an Information Advantage? Evidence from Institutional Investor Holdings Around IPO-Related Securities Class Action Announcements

Do Underwriters Have an Information Advantage? Evidence from Institutional Investor Holdings Around IPO-Related Securities Class Action Announcements

The Lead Plaintiff Provisions of the PSLRA after a Decade, or 'Look What's Happened to My Baby'

In 1995, my colleague John Beckerman and I had an experience shared by very few legal academics. We wrote an article recommending dramatic changes in manner securities class actions are organized and saw Congress enact into law a bill that included essentially all recommendations we had made. The article was Let Money Do Monitoring: How Institutional Investors Can Reduce Agency Costs in Securities Class Actions, 104 Yale L.J. 2053 (1995); law was Private Securities Litigation Reform Act of 1995 (PSLRA); relevant now generally known as the lead plaintiff provisions, prescribe procedures for selection of lead plaintiffs and lead counsel in securities class actions. In this Essay, I recount some aspects of unique history of lead plaintiff provisions and reflect on what has happened in decade or so that they have been in effect. The Essay has six parts. Part I describes questions that led Professor Beckerman and me to undertake research concerning dynamics of securities class actions and summarizes our findings and recommendations. Part II sets forth our perspective on how our recommendations came to be enacted into law. Part III describes post-enactment developments that have been consistent with our expectations - most notably, emergence of institutional investors as major players in securities class action litigation and related increase in investors' recoveries. Part IV describes post-enactment developments that we did not anticipate, including one precipitated by emergence of Internet and another that involves difficulty, which we should have anticipated, that courts have had in deciding which class member has largest loss and therefore is presumptive lead plaintiff. In Part V, we conclude that even had Congress followed a more deliberative process before enacting our recommendations into law, it probably would not have come up with a substantially better approach for organizing process by which lead plaintiffs and lead counsel are appointed in securities class actions. In Part VI, we recommend that Congress clarify language of statute in one minor respect and that courts make changes in how they deal with two administrative issues relating to securities class action litigation.

FURTHER EVIDENCE ON INSIDER TRADING AND THE MERITS OF SECURITIES CLASS ACTIONS

AbstractTo provide further evidence on the merits of securities class actions, we examine insider transactions immediately before and during the class period, using a larger and newer data set. We show that insiders reduce their stock sales by an abnormal amount immediately before the class period. Alternative measures of insider transactions and analysis of data before the enactment of the Private Securities Litigation Reform Act of 1995 provide consistent results. These new findings indicate that class actions, on average, have merit. Our data also reestablish a previous empirical result that there is no abnormal selling during the class period.

Intellectual Property Litigation Clearinghouse: Data Overview

The Intellectual Property Litigation Clearinghouse (IPLC) will be a comprehensive online information source on IP lawsuits. Modeled on the renowned Stanford Securities Class Action Clearinghouse, the IPLC will host general statistical information, as well as text-searchable dockets, complaints, select motions, judicial opinions, and related data.

Statement of the Financial Economists Roundtable on the International Competitiveness of U.S. Capital Markets

The Committee on Capital Markets Regulation issued an Interim Report (known as the “Paulson Report”) near the end of 2006 that concluded that the U.S. “is losing its leading competitive position as compared to stock markets and financial centers abroad.” This report was quickly followed by a study, which reached similar conclusions, that was commissioned by New York Mayor Michael Bloomberg and Senator Charles Schumer and prepared by McKinsey & Co.At its July 2007 annual meeting, the Financial Economists Roundtable (FER) — a group of senior financial economists at universities and other organizations recognized as having made significant contributions to the finance literature—discussed the issues raised by the Report and decided to publish its own report. The report makes the following four policy recommendations: Securities class action suits —Abolish enterprise liability under rule 10b‐5 in situations arising out of security purchases and sales in the secondary trading market among outside shareholders, while retaining managerial and firm liability where the company itself or its insiders (officers and directors) transact to their own benefit. Imposing massive liability on a company that is not a party to the securities transactions and does not benefit from the fraud does not serve a deterrence function since it is the continuing shareholders of the corporation who bear the burden of what the company must pay if found guilty, either directly or indirectly through insurance premiums. Shareholder rights—Require all corporations to obtain shareholder approval to adopt a poison pill, regardless of whether a company has a staggered board. This requirement would conform to the broad principle that the board of any company should not be able to deny its shareholders the opportunity to decide on the merits of a takeover bid, and it would help restore the market for corporate control as an effective disciplinary mechanism for poorly performing boards and managers. Compliance costs associated with SOX §404—Adopt a statutory amendment that makes it optional for a company to adopt the §404 procedures for a management assessment and auditor attestation of the effectiveness of its internal controls, with the requirement that if the company chooses not to comply it must explain why in its financial statements. Thus, in effect, the FER effectively recommends that the market be allowed to determine the value of §404 compliance. If a company chooses not to comply, the market will assess its explanation for non‐compliance and will value the company accordingly. Maintaining open markets—Allow both foreign and U.S. firms to choose to report in conformity with either IFRS or U.S. GAAP. The FER recognizes both IFRS and U.S. GAAP as high‐quality accounting standards that provide reasonable foundations for financial reporting for investors. Allowing both foreign and U.S. firms to adopt whichever of these standards they believe to be the most cost‐effective provides an opportunity for the market and investors themselves to sort out which reporting standard best serves their interests.

Incentivizing Institutional Investors to Serve as Lead Plaintiffs in Securities Fraud Class Actions

By enacting the Private Securities Litigation Reform Act of 1995 (PSLRA), Congress sought to put institutional investors in charges of securities class actions. In an important respect, this effort has failed. Although pension funds for public sector employees and labor unions often volunteer to serve as lead plaintiffs, private institutional investors do not. The participation of public sector and union funds may also reflect political contributions and ideological beliefs, rather than the PSLRA. The passivity of private sector funds and the importance of ideology and political contributions as motivations for public sector and union funds reflects the incentives created by the PSLRA, which prohibits bonus payments for lead plaintiffs and encourages investors to free-ride. This Article sets out three possible amendments to the PSLRA designed to give investors of all types selective incentives to serve as lead plaintiffs. One would give lead plaintiffs bonuses tied to the size of their holdings. The second proposal would sell 20% of the class-wide recovery to the class member willing to pay the most for it, while also requiring the lead plaintiff to pay half the class' attorneys' fees from this portion. The third proposal would auction off 30% of the recovery, while requiring the lead plaintiff to pay 100% of the class' attorneys' fees. The second and third proposals would encourage lead plaintiffs to set class counsel's fees at efficient rates.

Evidence on the Tradeoff Between Real Manipulation and Accrual Manipulation

I study whether managers use real and accrual manipulations as substitutes in managing earnings, and I study the order that managers make these decisions. I find that managers determine real manipulation before accrual manipulation. Based on this result, I use an empirical model that captures the sequentiality of real and accrual manipulations to test the tradeoffs between the two. The results of the broad sample tests are consistent with managers using real and accrual manipulations as substitutes. In a small sample test examining firms subject to securities class action lawsuits, I examine whether real and accrual manipulations change over time with changes in litigation risk. Consistent with managers using real and accrual manipulations as substitutes, I find that managers switch from accrual manipulation to real manipulation after lawsuit filings.

Executive pay and shareholder litigation*

The paper examines the impact of executive compensation on private securities litigation. We find that incentive pay in the form of options increases the probability of securities class action litigation, holding constant a wide range of firm characteristics. We further document that there is abnormal upward earnings manipulation during litigation class periods and that insiders exercise more options and sell more shares during class periods, but that this activity is largely driven by pre-existing option holdings of the managers. Our results suggest that option-based compensation may have the unintended side effect of giving executives an incentive to focus excessively on the short term share price. Copyright 2008, Oxford University Press.

Disclosure Quality and its Effect on Litigation Risk

This paper examines the relationship between the quality of disclosure in companies' 10-K filings and the risk of securities class action litigation. I use a dataset containing 10-K documents filed electronically with the SEC in the period 1996-2005. Using two content analysis software programs that analyze the categories of words used in these filings, I find that firms that use more numbers, past and future words, and other informative words are less likely to be sued, even after controlling for the common determinants of lawsuits. In order to avoid subjective choice of word categories, I use principal components analysis to identify the major components of disclosure in company filings. When these components are used in regressions, one component named 'informativeness' has significant power to explain subsequent lawsuits. Finally, in cross-sectional tests, I find support for the theory that firms with good boards and managers who are not entrenched have better disclosure practices. Further, monitoring by institutional investors, independent boards and analysts appears to induce better corporate disclosure.

Why the World No Longer Puts its Stock in Us

Fewer foreign companies are offering their equities securities in the United States, indicating that the United States is losing its position as the global leader in capital formation. This essay analyzes the reason for this change in capital raising behavior and argues that this trend can not be explained sufficiently by the Sarbanes-Oxley Act or securities class action litigation. Instead, foreign companies - and to a greater extent US companies - are raising capital away from the United States because of more liquid foreign markets, more robust securities regulation in certain foreign markets, better trading opportunities on foreign exchanges, and a greater willingness by US investors to seek out investment opportunities in foreign markets. An examination of the rising number of Rule 144A/Regulation S offerings, the shrinking percentage of foreign company shares held as American Depositary Receipts and the growing amount of foreign equity securities owned by US investors provides evidence that the movement of foreign companies away from the US equity markets began in the early-1990s. US regulators should acknowledge that the United States is no longer a unique market and respond to this trend in two ways. First, US regulators should open the US markets to greater foreign competition by removing barriers that prevent foreign financial service providers, especially stock exchanges, from doing business with US investors. Second, US regulators should devote more resources to raising the regulatory standards of foreign markets to ensure US investors receive suitable protection when they invest abroad. To accomplish this second goal, US regulators must seek stronger cooperative links with foreign regulators and move to a mutual recognition regime to induce foreign regulators to adopt standards more in line with US practice.

Revisiting Birnbaum: Changed Conditions and the Providence of the Purchaser-Seller Rule

The long-simmering dispute over exploitation of the private securities litigation system boiled over in the mid 1990s. Fueled by concerns that opportunistic plaintiffs’ lawyers filed class actions on news of any substantial decrease in share prices and that the resultant settlements rarely reflected the merits of the underlying suit, the corporate lobby looked to Washington for relief. Congress responded in 1998 with the Securities Litigation Uniform Standards Act. The Uniform Standards Act preempted certain state law securities class actions. By preempting these causes of action, Congress ensured that the Reform Act’s chosen set of rules and remedies, rather than those of the states, would be applied to covered securities class actions. Perhaps unsurprisingly, plaintiffs responded by testing the bounds of Uniform Standards Act preemption. If plaintiffs could avoid preemption, they could avoid the Reform Act’s strict standards. Of the myriad techniques attempted, the pleading of “holding claims” proved particularly resistant to Uniform Standards Act preemption. Holding claims are those in which plaintiffs assert that they have been fraudulently induced to hold onto their shares. Since the Supreme Court’s landmark adoption of the Birnbaum doctrine in 1975, plaintiffs who allege fraud due to induced holding have had no standing to bring Rule 10b-5 civil suits. Thus, those who can only allege that they were induced to forebear the sale of their securities have no standing to seek civil damages under 10b-5. At the time of the decision, the Birnbaum doctrine appeared to be a resounding loss for holding plaintiffs and other non-purchaser-sellers, resigning them to state court where common law fraud theories, derivative litigation, Blue Sky laws, and various other state causes of action would be their only relief. But in an ironic reversal of fortunes, the Uniform Standards Act turned the holding claim into a sword for plaintiffs to wield. According to some courts, since holding claims were not legitimate 10b-5 claims, they were left unpreempted by the Uniform Standards Act. By construing their claims as holding actions or other non-purchaser-seller frauds, plaintiffs could evade the Reform Act’s strict standards and keep their claims in state court. And most importantly, typical purchaser-seller securities claims could often be asserted as holding claims. Thus, purchaser-turned-holding claims and other non-purchaser-seller claims soon flocked to state court, sheltered from federal preemption and primed to make use of more liberal rules of procedure for what would otherwise be 10b-5 claims. Scholarship discussing this troubling migration of securities claims to state court has focused on whether the scope of Uniform Standards Act preemption should be broad enough to rein in holding and other non-purchaser-seller claims. Courts have had equal trouble interpreting the Uniform Standards Act in a manner that best resolves the complex policy issues arising out of the preemption question. Little effort, however, has been spent reflecting on the impact of the Uniform Standards Act and the Reform Act on the providence of the Birnbaum rule itself. This Note suggests that the recent statutory reforms have significantly altered the balance of equitable considerations weighed by the Supreme Court in its original treatment of non-purchaser-seller securities fraud claims. Unsurprisingly, the difficulties posed by the Uniform Standards Act and the Reform Act arise because Birnbaum’s conclusions were drawn in a different legal context, and thus the issue may be best treated by revising the Birnbaum rule with an eye to the post-Uniform Standards Act securities law landscape.

Reputational Penalties and the Merits of Class‐Action Securities Litigation

Abstract If private securities class actions alleging fraudulent behavior by officers or directors of a company are meritorious, directors and officers should pay a reputational penalty when they sit on a board of a company whose officers and directors are accused of fraud. I find little evidence of a negative effect 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 in shareholder class actions in the top quartile of settlements or in which the Securities and Exchange Commission 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.

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

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.

Securities Litigation and its Lawyers: Changes During the First Decade After PSLRA

Congress enacted the Private Securities Litigation Reform Act of 1995 (PSLRA or the Act) to address problems plaguing securities class action litigation. This Article surveys the empirical evidence on the impact of the PSLRA, examining the specific categories of reforms introduced by the Act. We look at the existing evidence relating to: substantive changes in the definition of fraud necessary to bring a securities class action; the Congressional efforts to empower lead plaintiffs relative to the plaintiffs' attorney bar; and the direct sanctioning of lawyers authorized in the Act. Given the PSLRA's focus on changing the incentives and behavior of plaintiff lawyers, we also provide preliminary data on the role of the lead plaintiff law firm. We report that while the market concentration of plaintiff law firms based on settlement amounts did not change appreciably after the enactment of the PSLRA, the tendency of top tier law firms to associate with lower tier firms did increase significantly in the post-PSLRA period. We also report that institutional investors taking on the role of lead plaintiffs in the post-PSLRA period tended to develop repeat relationships with select top tier law firms. Our survey of the existing evidence and study of new evidence relating to the role of plaintiff law firms leads us to raise several questions for possible new lines of research into the effectiveness of the PSLRA.

Changing Structures in Korean Corporate Governance; a review of recent legislation affecting Boards of Directors

Since the financial crisis of 1997, the Korean Commercial Code has been dramatically reformed to address several problems in the Korean corporate governance structure. The main purpose of legal reform in Korea has been to restrain small groups of controlling shareholders who exercise practical power over the corporate management. Especially in 1998, 1999, 2000, the Korean Company Law has been considerably revised to restrain controlling shareholders’ practical power. To name just a few: such matters as the Liability of Shadow Directors, the Introduction of Outside Directors, Committees in Board of Directors, Adopting Accumulative Voting, etc., have been newly inserted. The legal reform in Korea is coming to a close with the enforcement of the Korean Securities Class Action that was strongly opposed by the Federation of Korean Industries in January 2005. However, view of the general public is that changes to the antiquated management ruling system by controlling shareholders have not been successfully implemented. The process of legal reform is therefore likely to continue beyond the next presidential election.

Market Efficiency, Crashes and Securities Litigation

In Basic, Inc. v. Levinson the United States Supreme Court effectively affirmed the efficient market hypothesis by ruling that a plaintiff who purchased securities on an open and developed market can be presumed to have relied on the integrity of the market price. Although the Court confined its analysis to the question of reliance, and explicitly avoided any question of damages, Justice White worried in his dissent that one could not be separated from the other. In this paper, we argue that Justice White's concerns were well founded. In light of theoretical and empirical research in finance, we show that the failure to understand the differing implications of the efficient market hypothesis for proving reliance and assessing damages introduces a significant plaintiff bias in securities class action litigation. Furthermore, although Congress attempted to address this bias by passing Private Securities Litigation Reform Act of 1995, the steps it took are unlikely to be effective.

Markets and Monitors: The Impact of Competition and Experience on Attorneys' Fees in Securities Class Actions

Setting compensation for plaintiffs' attorneys in securities class actions is a perennial problem traditionally addressed through ex post judicial monitoring. This paper examines empirically two aspects of this problem. The first involves attempts to introduce market mechanisms into fee setting, either through auctioning the lead counsel position or through competition to represent institutional lead plaintiffs under the Private Securities Litigation Reform Act. The second is the adequacy of existing monitoring mechanisms, particularly whether the participation of repeat players is correlated with attorneys' fee awards. The paper finds that lead counsel auctions and the participation of public pension funds as lead plaintiffs are correlated with lower fee requests and awards. There is, however, no significant correlation for another type of frequent institutional plaintiff, union pension funds. There is also some evidence that judicial experience with securities class actions and institutional objections to attorneys' fee requests are negatively correlated with fee awards.

D&O liability in the post-Enron era

In today's post-Enron environment, directors and officers face unprecedented scrutiny and liability exposure. For a variety of reasons, the size of settlements in securities class actions against directors and officers has exploded in recent years, with no end in sight. Plus, now more than ever directors and officers are being routinely named as defendants not only in securities class action lawsuits, but also in a host of other types of claims, including shareholder derivative suits, single-plaintiff opt-out suits, ERISA (Employee Retirement Income Security Act of 1974) tagalong actions, and regulatory, criminal and bankruptcy proceedings. The existence of these parallel proceedings further complicates the defence of the claims and escalates even higher the defendants' liability exposure. Finally, to make a bad situation worse, some defendant directors and officers are now being required by institutional investor plaintiffs and regulators to make large payments from their personal assets to resolve these claims, without insurance or indemnification reimbursement from their directors' and officers' insurer or their company. Each of these sobering dynamics is discussed in this paper. Although directors and officers should redouble their commitment to sound corporate governance practices and should confirm the existence of state-of-the-art insurance and indemnification protection in response to this environment, ultimately one must ask if the benefits of serving as an outside director of a US public company still outweigh the risks. Unfortunately, the answer to that question is not entirely clear today.

Management Forecasts and Litigation Risk

We examine the influence of the ex ante risk of class action securities litigation on firms’ decisions to issue management earnings forecasts as well as the characteristics of those forecasts. We find that litigation risk is positively associated with the likelihood of issuing a forecast for both good- and bad-news firms. While the association is marginally stronger for firms with bad earnings news, our results suggest that litigation risk is unlikely to explain the observed preponderance of bad-news forecasts. We examine the effect of litigation risk on the amount of the total earnings news released in the forecast, on forecast horizon, and on forecast precision. These results indicate that higher litigation risk is associated with a higher proportion of news being released when firms have bad news. Finally, higher litigation risk is associated with forecasts being released earlier and being more precise.