Company litigation risk may be disagreeable to its execs but benefits investors by spurring openness, study finds
“Lower litigation risk reduces the likelihood and frequency of earnings forecasts”
"The securities class action system is spinning out of control," warns the U.S. Chamber of Commerce in a recent report ominously entitled "A Rising Threat." Citing a more than 50% one-year increase in filings against companies in 2017 (to a level that was sustained in 2018), the Chamber complains that "the number of lawsuits is skyrocketing, and has reached levels not seen before the enactment of the Private Securities Litigation Reform Act."
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The PSLRA, passed by overwhelming bipartisan majorities in 1995, represented Congress' response to an upsurge of private shareholder lawsuits against companies over alleged securities fraud. The 1995 law introduced an assortment of procedural hurdles to curb potentially frivolous suits, and is widely believed to have succeeded.
Has the time arrived, as the Chamber and others contend, for major action to further limit securities litigation? Those who believe so will do well to consider research in the current issue of The Accounting Review, a peer-reviewed journal from the American Accounting Association.
While by no means taking a stand on calls for action, the research offers what is arguably the most persuasive evidence to date on a persistent question highly relevant to that issue: Does the risk of shareholder securities litigation spur corporate disclosure and the benefits to investors that accrue from it, or does it inhibit disclosure?
“Lower litigation risk reduces the likelihood and frequency of earnings forecasts,” conclude the study’s authors, Joel F. Houston of the University of Florida, Chen Lin of the University of Hong Kong, and Sibo Liu and Lai Wei of Lingnan University in Hong Kong.
In sum, the availability of litigation as an option serves to benefit not only aggrieved shareholders but investors in general by encouraging increased openness by companies.
That this is the case has been anything but obvious. As the authors of the new study explain, “Theoretically, litigation threats can have two opposing effects on corporate disclosure practices…On the one hand, potential lawsuits that target misstatement can limit information disclosures for which firms may later be held accountable…On the other hand, lawsuits that focus on insufficient disclosure can encourage firms to make more informative earnings forecasts ex ante.”
These opposite effects suggest an inherent research challenge. In the words of the study, the “relation between litigation and voluntary disclosure…is subject to reverse causality. While litigation risk as a disciplining force can influence corporate policies such as voluntary disclosure, voluntary disclosure can also affect litigation risk by varying the probabilities of class action lawsuits.”
To avoid this potential confusion, the researchers seek out a quasi-natural experiment, a situation in which a change in litigation risk applies to one group of companies and not to another. Firms in one group can then be matched with similar firms in the other, so that an intergroup difference in firms’ responses to the event can be attributed with a high degree of confidence to a change in the risk of being sued by shareholders.
The professors find an excellent natural experiment in a 1999 ruling of the U.S. Ninth Circuit Court of Appeals that exclusively covered companies in California and eight other Mountain and Pacific states. “This ruling,” they write, “unexpectedly adopts a more stringent interpretation of the pleading standards enacted in the 1995 Private Securities Litigation Reform Act compared to the other circuits. It requires plaintiffs to plead facts…to strongly infer that the defendants were ‘deliberately reckless’ in making the alleged misstatement or omitting any material statement. By contrast, in the other circuits proving mere recklessness is sufficient…Accordingly, firms located in the Ninth Circuit states would expect a relative decrease in litigation.”
Indeed, that is what occurred: “The number of class action lawsuits decreases 50 percent more in the Ninth Circuit Court compared to the other courts of appeals, suggesting that firms located in the nine states of the Ninth Circuit would expect a much lower probability following the ruling.”
And the result of this lowered expectation, the professors find, was diminished disclosure among Ninth Circuit firms. While the two groups were about equally likely to issue at least one earnings forecast per year before the ruling, the Ninth Circuit firms were on average about 6% less likely to do so afterward. And three years after the ruling, firms in the Ninth Circuit averaged one less forecast per year than firms located elsewhere (2.5 vs. 3.5 per year), whereas the mean frequencies of the two groups were about equal before the appeals court decision.
Additional persuasive evidence is provided by the effect of a 2007 U.S. Supreme Court decision that, the professors write, “instituted a more uniform standard on securities class actions across circuit courts…revers[ing] the relatively tough pleading standards…in the Ninth Circuit…Consistent with this reversal, we observe an opposite change in the quantity of [management] earnings forecasts compared to the effects surrounding the original ruling. Specifically, the firms in the Ninth Circuit Court became more likely to make earnings forecasts, which is...consistent with the notion that corporate disclosure strategies are often designed to deter litigation.”
The study’s findings on the effects of the 1999 decision derive from data involving 467 Ninth Circuit corporations and an equal number of outside firms matched to them on company characteristics and pre-ruling disclosure practices. The researchers analyzed changes in disclosure activities from the four years prior to the ruling to the four years after it.
In addition to the above analyses, the professors investigated the effects of another natural experiment – a 2001 change in Nevada corporate law that also effectively lowered litigation risk. They note that “consistent with the findings using the Ninth Circuit Court ruling, we find that the Nevada firms were less likely to make earnings forecasts when the litigation environment becomes more favorable.”
Moreover, the new study’s findings bear an important resemblance to those reported by other researchers in the May issue of The Accounting Review. The earlier study focused on still another natural experiment, the 2010 Supreme Court ruling in Morrison vs. National Australia Bank which eliminated the right of shareholders who purchased shares on foreign exchanges to pursue lawsuits in U.S. courts. It found that following the decision firms with a higher percentage of shares traded on foreign exchanges experienced greater reductions in the incidence and frequency of management forecasts, indicating, the authors wrote, “a positive relationship between litigation and disclosure.”
Beyond the value of the new research to policy-makers and regulators, does it have a lesson for corporate managers as well? Prof. Houston’s response recalls doctors’ common admonitions that a medicine may taste bad but still be good for you. As he puts it, “To the extent that openness between managers and shareholders is a plus, litigation risk can be a company plus as well, unsavory to many managers though it may be.”
The new study, entitled "Litigation Risk and Voluntary Disclosure: Evidence from Legal Changes," is in the September/October issue of The Accounting Review, a peer-reviewed journal published six times yearly by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Auditing: A Journal of Practice and Theory, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, Journal of Financial Reporting, The Journal of the American Taxation Association, and Journal of Forensic Accounting Research.