Do Defendant Companies Financially Underperform Following Securities Lawsuit Settlements?
Most securities lawsuits settle. The common assumption is that once the cases are settled, the litigation wraps up and everybody moves on. But does the litigation have a lingering effect on the defendant company? Is there a "hidden dark side" for companies that settle securities lawsuits?
That is the question asked in a March 18, 2010 paper entitled "Lying and Getting Caught: An Empirical Study of the Effect of Securities Class Action Settlements on Targeted Firms" (here) by Cincinnati Law Professor Lynn Bai, Duke Law Professor James Cox, and Vanderbilt Law Professor Randall S. Thomas. (Hat Tip to the Class Action Countermeasures blog, which has a post about this paper here.):
Through their research, the authors sought to discover whether getting hit with a securities a lawsuit and then subsequently entering into a settlement "weakens the defendant firm so that from the point of view of well-received financial metrics the firm is permanently worse off as a consequence of the settlement."
In order to examine this question, the authors examined 480 companies that were defendants in settled post-PSLRA securities class action lawsuits. The authors then examined whether there is any change in the defendants’ financial well-being and stock performance relative to their peer group over time.
The authors compared the defendants’ performance with that of comparable companies over several time periods. "Comparable" companies consisted of those with the same SIC Code and the same asset size but that had not been involved in a securities class action lawsuit during the relevant time periods.
The authors compared the defendant companies to the comparable companies using seven performance criteria, including asset turnover; return-on-assets: the ratio of Earnings Before Income and Tax payments to total assets; the current ratio; the Altman Z-Score (a bankruptcy prediction measure); the market to book ratio; and the one-year stock price return. The authors looked at changes in defendants’ performance according to these measures over time using multivariate regressions.
The authors’ research produced a number of results which even they characterized as "puzzling." On the one hand, companies that settled securities class action lawsuits experienced no decline in sales opportunities, but did "experience a reduced level of operating efficiency while the lawsuit was pending (but not after it was settled)."
More significantly however, the authors did also observe that "defendant firms experience liquidity problems post-settlement and worsening Altman-Z scores." The authors wrestle with how to interpret these latter findings. On the one hand, the deterioration of the Altman Z-scores could suggest that "settlements drive firms toward financial distress (i..e., settlements are causally related to the worsening situation)," but on the other hand these data could suggest that "the financial deterioration observed in earlier time periods continues downward." Or perhaps it could be some combination.
The authors concede that their analysis could support alternative conclusions, but they nevertheless offer their own interpretations as well. Among other things, they note that "while uncertainty persists about the precise connection between the settlements and financial distress, there is no uncertainty that firms that are involved in securities class action litigation experience statistically greater risks of financial distress than their cohort firms."
The authors also conclude that their findings "lend strong support for the view that such suits are better directed toward the officers, advisors and other individuals who bear responsibility for the fraudulent representation(s) that spawned the suit."
Discussion
The authors’ findings about the post-litigation performance of companies settling securities class action lawsuits are interesting. With full recognition that the question of the causation for that diminished performance is uncertain, the conclusion that companies experiencing securities suits perform worse than there peers is relevant information, both from an investment and a D&O insurance underwriting standpoint.
One implication of the authors’ analysis is particularly interesting to me, because one factor implicitly contributing to the negative post-litigation performance is the financial burden the litigation and the settlement imposed on the company. This implication (if indeed my interpretation is valid) seems at odds with other recent research, particularly that of Stanford Law Professor Michael Klausner, who in a recent article published with a colleague concluded that "on the whole D&O insurance pays substantial portions of settlements in a large majority of cases, and that both corporate and individual defendants are highly protected."
There seems to be a tension in the analysis between these two academic studies, since if it is the case that D&O insurance substantially protects corporate defendants in securities class action lawsuits, why should there be lingering negative financial effects on the defendants companies?
Perhaps the answer may be that the reason for the negative performance relative to the companies’ peers post-litigation may not be financially related, but may be operationally related, and the same below standard operational performance post-litigation in some cases may be related to the factors that led to the litigation in the first place.
An alternative explanation may be that while the D&O insurance funds a "substantial portion" of settlements, that still leaves a substantial portion unfunded, and the burden on the companies to fund the difference harms them financially. The authors even note that their analysis insurance in consistent with the conclusion that insurance "provided less than full coverage of the settlement amounts and that the defendants paid the discrepancy out of their current assets. The settlement payment exacerbated liquidity constraints, making the defendants more vulnerable to liquidity crunches and prone to bankruptcy."
In other words, it may be that once the case is settled, everyone may move on to other things, but the company is left financially impaired in a way that undermines its future performance – which obviously harms the interests of the company’s shareholders. All of which does leave you wondering about the ultimate value of a process carried out in the name of shareholders but that leaves shareholders’ interests indelibly impaired. .
Did either of the studies consider post-lawsuit disclosures by the company and the possibility that the experience of the lawsuit caused management to be more or less forthcoming or positive in their disclosures?
Your last paragraph is right on point, but the 'perfect market' folks will tell you that the information is already baked into the price for the shareholders who buy after the suit is filed.
This is correlation, not causation. The comparables are biased. The comparables should be companies that experienced similar stock drops, similar deterioration of earnings, similar changes in management, etc. The saying that "there's no such thing as only one bad quarter" comes to mind. Downward spirals are tough to change.
agree with the 10:00 AM poster, but the point can be expressed more strongly. the companies subject to securities suits are a subset of companies that disclosed worse-than-expected news (that they allegedly omitted to disclose during a prior period)? therefore, does it not seem obvious that such companies would perform worse, post-suit, than companies as a whole? the conclusion that the suits cause underperformance (where, in fact, underfperformance occasions the suits) seems somewhere between laughably and wilfully ignorant.
After reading Kevin's description of this study concerning the post settlement performance of companies sued for securities fraud and his own evaluation of the paper I don't know whether to characterize them both as silly or stupid. They're probably a combination of both. Almost everything about the study and the associated commentary ignores the basic realities of the circumstances that surround the vast majority of securities fraud litigations. Most companies end up being sued for securities fraud––and then end up( with the help of directors and officers liability insurance)paying a settlement––because they have lied to the marketplace about the quality of the corporation's business or its products or finances. Frequently the revelation of the truth results and not only a sharp drop in the stock price but adverse financial revelations,a drop in revenues and cash flow, violation of bank or lending covenants and management shakeups. So are we surprised that companies with these characteristics suffer “ greater risks of financial distress” after they later settle a lawsuit. Of course they face such risks because they were lying about the nature of their business earlier--to cover up flaws in products,performance or the business model itself. Often such companies face a" liar's discount" in the marketplace as a consequence of their prior bad conduct. It's not the lawsuit or the settlement of the lawsuit that injures the company-0r impairs it ongoing performance of financial condition-it is the misconduct, the lying and the financial falsification of the executives that got the company sued in the first place that undermines the future performance and financial health of the company. We should not be surprised that companies that have committed securities fraud––whether it's stuffing the channel, lying about their products, or falsifying their financials, " perform worse than their peers”. What is it about such companies and their managements that would cause us to believe that they would perform better than their peers? Kevin's conclusion that this flawed study suggests that suits are better directed at the individuals who perpetrated the misconduct i.e. the officers of the company-- and that this would somehow spare the corporate entity the financial distress of the settlement -ignores the b reality of the indemnification obligation of the company which in virtually every case causes the company to fund the bulk of any settlement on behalf of the officers directors and then only to the extent it has not been paid for by directors and officers liability insurance, a contributor which would have no material adverse impact on the corporate entity. Underlying the study and Kevin's commentary on it is the notion somehow that suits brought on by half of shareholders merely transfer money from one group of shareholders to another and therefore really don't benefit anyone-- but harm the company. Not only does this ignore the reality that the bulk of the settlement monies in these cases comes from directors and officers insurance but it completely misses the point that the vast majority of settlement proceeds go to former shareholders of the company––those investors who purchased the shares of the company at an inflated price during the fraud period but who in most instances, out of anger , frustration, or even for tax considerations later sell the shares at a loss and have no further interest in the corporate entity. These are former shareholders not current shareholders with the equivalent of a tort claim against the company. I normally am not moved to comment on the academic work done concerning securities lawsuits but the simplistic nature of this study is so obvious that I could not resist pointing out these shortcomings. It may well be that there are many defects with securities fraud class action lawsuits but any financial underperformance of companies that follow settling such lawsuits a corporation and its high officers and directors is not one of them.