A recent article by three academics raising the question whether corporate securities lawsuit defendants underperform financially after their case settles has generated significant commentary on this site. In this post, the professors respond to the commentary.
The article in question is 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.
The article describes the professors’ research in which they 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."
My initial post about the article provoked an unusual amount of reader commentary, including a comment about the academic’s research and analysis posted by former plaintiffs’ securities attorney, Bill Lerach. With Mr. Lerach’s consent, I republished his comment as a separate guest post, here.
The professors have prepared and submitted a response to the various comments about their paper. Here is the professors’ response:
The comments seem to have concentrated on the possible alternative causation of the underperformance of defendant companies involved in securities class actions, i.e., these companies had financial problems prior to the lawsuit and it was likely that these pre-existing problems prompted the companies’ management to lie, and thus, it should not be surprising to see that these companies underperform their peers after settlement. We do not deny that this could be an alternative explanation to the underperformance that we have seen in the data, and indeed we have explicitly talked about this alternative explanation at a number of places in our paper. However, our study has also revealed empirical evidence that is inconsistent with this intuitive explanation, and we thought we should report such evidence in the paper so that people can think about them and perhaps follow up with more research.
First, we are not seeing deterioration (post-lawsuit and post-settlement compared to pre-class period) in the defendant firms’ sales numbers. This holds true both in terms of defendant firms’ absolute sales numbers and relative performance to their peers. We know that sales reflect the bottom line of the financial health of a company and the robust sales shown in the data are inconsistent with the story that these firms are deteriorating on their own independent of the lawsuit.
Second, we are seeing deterioration in liquidity in post-settlement period but not in the post-lawsuit-but-pre-settlement period. If the liquidity constraint is caused primarily by other factors such as banks’ withdrawal of credit as a result of revelation of fraud (as Bill Lerach suggested), why are we seeing significant constraints only in the post-settlement period?
Thirdly, although the average Altman Z-scores for defendant firms were lower in post-lawsuit and post-settlement periods compared to the pre-class period, the inferiority was more prominent in the post-settlement periods. The significantly lower Altman z-score in post-settlement periods seems consistent with the heightened liquidity constraint we observe in the post-settlement period. Again, we do not rule out the possibility that defendant firms are deteriorating on their own, but we want to point out that the data can also be consistently explained by an alternative hypothesis, i.e., lawsuit and settlement had an independently negative effect on the financial health of the defendant firms.
The comments are legitimate and we appreciate the interest that people have shown in this topic. We have certainly thought about the causation issue in our research, but we could not explain completely what we were seeing in the data by the hypothesis that defendant firms were destined to underperform even if they were not dragged into a lawsuit. We have dutifully reported what we saw in the data.
I would like to thank the professors for taking the time to prepare a thoughtful response and for their willingness to have the comments posted on this site. My thanks to all of the readers who have engaged in this dialog. Further comments are still very much welcome.