UNIVERSITY OF MICHIGAN

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1 UNIVERSITY OF MICHIGAN JOHN M. OLIN CENTER FOR LAW & ECONOMICS STOCK PRICE REACTIONS TO SECURITIES FRAUD CLASS ACTIONS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT STEPHEN P. FERRIS & A.C. PRITCHARD PAPER # THIS PAPER CAN BE DOWNLOADED WITHOUT CHARGE AT: MICHIGAN JOHN M. OLIN FOUNDATION WEBSITE AT THE SOCIAL SCIENCE RESEARCH NETWORK ELECTRONIC PAPER COLLECTION

2 STOCK PRICE REACTIONS TO SECURITIES FRAUD CLASS ACTIONS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT Stephen P. Ferris Department of Finance College of Business University of Missouri-Columbia A.C. Pritchard Law School University of Michigan Acknowledgements October, 2001 StockMTDArt15.doc We are grateful for helpful comments from Robert Conroy and Paul Mahoney, as well as participants at the Law and Economics Workshop at the University of Michigan Law School, the 2000 Annual Meeting of the American Law and Economics Association, and the Law and Finance Conference at the University of Virginia Law School. Tim Foley and Shin-hua Liu provided excellent research assistance. Pritchard is grateful for the research support provided by the Cook Fund of the University of Michigan Law School.

3 Stock Price Reactions to Securities Fraud Class Actions Under the Private Securities Litigation Reform Act Abstract: We study the stock market s reaction to three events in the litigation process: (1) the revelation of potential fraud; (2) the filing a lawsuit; and (3) the judicial resolution of the lawsuit. We find a large and statistically significant negative reaction to the first event, and a smaller but still statistically significant reaction to the second. We find no significant reaction to the resolution of the motion to dismiss. We find little overlap between the variables that previous research has found to be correlate with the incidence of the litigation and the variables that correlate with the resolution of the motion to dismiss. We also find little overlap between the variable that correlate with the outcome of the motion to dismiss and the variables that explain the variance in stock market returns for these dates. We conclude that the outcome of litigation is not generally anticipated by stock market participants and that market returns are not influenced by the outcome of litigation. Keywords: securities fraud; litigation; corporate fraud JEL Classifications: K22 A securities fraud class action is a critical event in the life of a corporation. Companies face few liability exposures that can match the magnitude of securities fraud liability; the firm and its officers can face liability ranging into the hundreds of millions of dollars. For example, Cendant Corporation recently agreed to pay a record $2.38 billion to settle claims of accounting fraud, the largest settlement ever in a securities fraud class action. 1 Potential liabilities of this magnitude are presumably material to the market s valuation of a public company. Congress, concerned that the specter of potentially enormous damages in securities fraud class actions was encouraging meritless strike suits, attempted to discourage weak suits when it adopted the Private Securities Litigation Reform Act of 1995 ( Reform Act ). 2 The Reform Act makes it more difficult to bring securities fraud class actions by requiring plaintiffs to plead 1 Cendant Corp. Agrees to Record Payment To Settle All Financial Fraud Allegations, 31 Sec. Reg. & L. Rep (Dec. 13, 1999). 2 Pub. L. No , 109 Stat. 737 (1995). 1

4 fraud (including facts showing fraudulent intent) with particularity and by staying discovery while motions to dismiss are pending, thereby depriving plaintiffs of access to the sources most likely to provide the facts necessary to plead fraud with particularity. The goal of the Reform Act is to provide a more rigorous screen for sorting meritorious from non-meritorious cases through the mechanism of the motion to dismiss. The Reform Act has resulted in an increased percentage of securities fraud class actions being dismissed. 3 Given the Reform Act s promise of greater efficiency in screening cases, is the market able to anticipate the result of the litigation, either at the revelation of the bad news generating the lawsuit, or at the time of filing? This paper presents the findings of an empirical study of the stock market s reaction to cases in which a judge evaluates allegations of securities fraud by deciding a motion to dismiss under the Reform Act regime. We conduct an event study for our sample of defendant firms at three separate points in the litigation process: (1) the revelation date of the potential fraud giving rise to the lawsuit; (2) the notice date for the filing of the first complaint; and (3) the decision date of the district court for the initial motion to dismiss brought by the issuer. To provide an insight into the market s ability to distinguish meritorious from non-meritorious claims, we divide our sample into two subsamples based on whether the company s initial motion to dismiss the suit was granted ( winners ) or denied ( losers ). Our analysis will allow us to determine if the market is able to distinguish meritorious from non-meritorious securities fraud class actions at various stages in the litigation process. We also conduct a series of multivariate regression analyses, beginning with a logit analysis. The logit model uses the outcome of the motion to dismiss as our dependent variable and attempts to build a model to predict which motions to dismiss will be granted and which will 3 See David M. Levine & Adam C. Pritchard, The Securities Litigation Uniform Standards Act of 1998: The Sun Sets on California s Blue Sky Laws, 54 Bus. Law. 1, (1998). 2

5 be denied. For our independent variables, we draw from prior studies of securities fraud litigation and enforcement actions by the Securities and Exchange Commission. These variables have been shown to correspond to the incidence of class action litigation and the likelihood of fraud. We then examine the nature of the market s response at select points in the litigation process by estimating a cross-sectional ordinary least squares regression. In these models, the dependent variable is the abnormal return calculated over the three day period surrounding the event. Our event study analysis reveals a strong negative price reaction of approximately 25% around the revelation date of the bad news spawning the lawsuit. The reaction to the subsequent event, the notice of suit filing is much smaller, but remains statistically significant. We find no statistically significant reaction, however, for the decision date on which the issuer s motion to dismiss the complaint is resolved. This result holds for both the winners and losers subsamples as well as the entire sample and across a variety of event windows. Nor do we find a statistically significant reaction for the subset of firms that make a public announcement of the court decision. We conclude that the information contained in the decision regarding the motion to dismiss is either considered immaterial by market participants or is too costly to obtain. The major findings of our logit regression are that share turnover, the abnormal return around the revelation date, the prior year s raw return, free cashflow, board independence and board size are significant factors in the likelihood that a motion to dismiss will be granted. Surprisingly, the type of allegation contained in the complaint is statistically insignificant. Our cross-sectional study of market returns suggests that there are certain firm-level characteristics which explain variability in firm performance around the events of interest. We find that the firm s beta, skewness of returns, free cashflow, the debt ratio, the market-to-book ratio, equity holdings by institutional investors and the percentage of independent directors are 3

6 significant in explaining the cross-sectional variability in returns over the event period. We proceed as follows. Section 1 provides background on securities fraud class actions and prior research in this area. Section 2 describes our data and methods. Section 3 presents our main empirical findings. We summarize our main findings in Section 4. I. FRAUD AND SECURITIES FRAUD CLASS ACTIONS A. Class Actions The typical securities fraud class action involves an alleged misrepresentation regarding the company s operations, financial performance or future prospects that inflates the price of the company s stock in secondary trading markets. In these so-called fraud on the market class actions, plaintiffs attorneys sue the corporation and its officers under Rule 10b-5 of the Securities Exchange Act. 4 The plaintiffs are classes of investors who have paid too much for their shares or (less frequently) sold their shares for too little because of price distortion caused by the misstatements. In the typical case, the corporation being sued has neither bought nor sold its securities, and accordingly, has not gained from the fraud. Nonetheless, fraud-on-the-market suits allow investors to recover their losses from the corporation based on its managers misstatements. Given the volume of trading in secondary trading markets, the potential damages recoverable in such suits can be a substantial percentage of the corporation s total capitalization, easily reaching hundreds of millions of dollars. Thus, securities fraud class actions impose a punitive sanction that could substantially harm a company s stock price. This sanction makes sense when a company actually has engaged in fraud. The premise of the Reform Act, however, is Congress s belief that the targeting of class actions was only loosely tied to the incidence of fraud. Plaintiffs lawyers were filing suits citing a laundry list of cookie-cutter complaints against companies within hours or days of a substantial drop in 4 17 C.F.R b-5. 4

7 the company s stock price. 5 Moreover, plaintiffs lawyers had incentives to file frivolous lawsuits in order to conduct discovery in the hopes of finding a sustainable claim not alleged in the complaint. 6 This may have been a viable strategy for plaintiffs lawyers. Sorting fraud from mere business reversals is difficult. The external observer may not know whether a drop in a company s stock price is due to a prior misstatement about the company s prospects fraud or a risky business decision that did not pan out bad luck. Unable to distinguish the two, plaintiffs lawyers must rely on the limited publicly-available objective indicia in deciding whether to sue. 7 Thus, a substantial stock price drop following previous optimistic statements may well bring a lawsuit. Congress enacted the Reform Act based on its belief that the existing procedures for securities fraud class actions did not do enough to discourage weak cases. 8 Accordingly, Congress adopted procedural rules for securities fraud litigation that make it much easier for defendants to have those cases dismissed at an early stage in the proceedings without incurring the expense of discovery. The pleading standard established by the Reform Act requires plaintiffs to specify in their complaint each statement alleged to have been misleading and the reasons why the statement is misleading. 9 In addition, the pleading standard requires plaintiffs to state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. 10 By requiring plaintiffs to plead the facts supporting their case and 5 H.R. Rep. No , at 16 (1995). 6 S. Rep. No , at 14 (1995). 7 See Jordan Eth & Michael Dicke, Insider Stock Sales in Rule 10b-5 Corporate Disclosure Cases: Separating the Innocent from the Suspicious, 1 Stan. J. L. Bus. & Fin. 97, 111 (1994). 8 H.R. Rep. No , at U.S.C. 78u-4(b)(1). 10 Id. 78u-4(b)(2). 5

8 demonstrate the defendants awareness of the misrepresentation, the motion to dismiss becomes a substantive challenge to the merits of the lawsuit. Thus, the court s decision on the motion to dismiss can be construed as a judicial assessment of the likelihood that the company has engaged in fraud. B. Prior Research This study examines potential determinants of market reactions to securities fraud class actions. We look to prior empirical research to help us select control variables for our regression analyses. Prior work relevant to this study can be sorted into three principal categories: (1) studies that focus on the market impact of lawsuit filings; (2) studies that attempt to identify the factors that correlate with the incidence of securities fraud class actions; and (3) studies that attempt to identify factors that correlate with the incidence of fraud, using enforcement actions brought by the SEC as a proxy for fraud. The following studies, unless otherwise noted, are based on pre-reform Act data. B. 1. Market Reactions to Fraud Suits The first set of studies focuses on the market s reaction to the filing of a fraud lawsuit. Robert Kellogg reports significant price declines when the misstatement is uncovered, as well as in the months prior to disclosure. 11 Francis et al. found an average 17% negative abnormal return for a sample of sued firms when they revealed an adverse earnings report. 12 Niehaus & Roth found an abnormal negative return of 21.5% upon the revelation of the negative information leading to the lawsuit. 13 Roberta Romano found a statistically significant negative price reaction 11 Robert L. Kellogg, Accounting activities, security prices, and class action lawsuits, 6 Journal of Accounting and Economics 185 (1984). 12 Jennifer Francis, Donna Philbrick and Katherine Schipper, Shareholder Litigation and Corporate Disclosures, 32 Journal of Accounting Research 137(1994) 13 Greg Niehaus & Greg Roth, Insider Trading, Equity Issues and CEO Turnover in Firms Subject to Securities Class Actions, (unpublished manuscript, 1999). 6

9 to the filing of a class action suit against the corporation, but no significant reaction to the subsequent report of the filing in the Wall Street Journal (which happened, on average, two weeks after filing). 14 She also found no significant abnormal returns for the dismissal or settlement of the claims in her overall sample. Bohn and Choi find that the filing of lawsuits alleging disclosure violations in connection with a sample of IPOs produce a statistically significant 3.33% negative abnormal return for defendant firms. 15 Bhagat et al. report a similar percentage decline for filings of suits alleging disclosure violations. 16 In sum, these studies support the finding of significant price reactions to the revelation of adverse news, potentially indicating fraud, and subsequent lawsuit filings accusing companies of fraud. Other studies focus on the process by which the market incorporates information relating to lawsuits. Griffin finds a long-term negative drift for stock prices following the announcement of the misrepresentation that forms the basis for the lawsuit. 17 Based on this evidence, he concludes that the market does not fully incorporate the bad news at its announcement. In related work, Griffin et al. find that a significant negative response to the announcement of the filing of a securities fraud class action, as well as a longer term negative price drift after the announcement. 18 They conclude that information relating to class actions is costly to obtain. Feroz et al. find a much stronger reaction to news of the filing of an SEC enforcement 14 Robert Romano, The Shareholder Suit: Litigation without Foundation? 7 Journal of Law, Economics & Organization 55 (1991). 15 James Bohn & Stephen Choi, Fraud in the New-Issues Market: Empirical Evidence on Securities Fraud Class Actions, 144 U. Pa. L. Rev. 903 (1996). 16 Sanjai Bhagat, John Bizjack, and Jeffrey L. Coles, The Shareholder Wealth Implications of Corporate Lawsuits, 27 Financial Management 5 (1998). 17 Paul A. Griffin, Financial and Stock Price Performance Following Shareholder Litigation, 2 Journal of Financial Statement Analysis 5 (1996). 18 Paul A. Griffin et al., Stock Price Response to News of Securities Fraud Litigation: Market Efficiency and the Slow Diffusion of Costly Information, (Working Paper No. 208, John M. Olin Program in Law and Economics, Stanford Law School, 2000). 7

10 action: companies announcing an investigation by the SEC had a 6% negative return, even though the accounting errors giving rise to the investigation had been previously announced. 19 Similarly, Cross et al. find that financial statement lawsuits filed by the SEC produce a larger negative reaction than private lawsuits. 20 Given the resource constraints faced by the SEC s enforcement division, the agency is likely to focus its efforts on cases with the strongest evidence of fraud. These findings suggest that the credibility of the allegations may affect the market s assessment of the likelihood and severity of the alleged fraud. B. 2. Explaining the Incidence of Class Action Several studies have attempted to identify financial factors that lead to the filing of securities fraud class actions. Jones finds that larger firms are more likely to be sued by their shareholders. 21 Francis et al. compare certain financial characteristics of sued firms with a matched sample of non-sued firms from the same industries. 22 They find that sued firms have greater assets, higher dividend payouts, and higher systematic risk, but lower overall return volatility. Beck and Bhagat find that the sued firms were more likely to have large price drops and had significantly higher betas than a matched sample of non-sued firms. 23 Griffin, based on a sample of settled cases from , finds that earnings per share and return on equity drop 19 Ehsan H. Feroz, Kyungjoo Park & Victor S. Pastena, The Financial and Market Effects of the SEC s Accounting and Auditing Enforcement Releases, 29 Journal of Accounting Research 107 (Supp ). 20 Mark L. Cross, Wallace N. Davidson and John H. Thornton, The Impact of Directors and Officers Liability Suits on Firm Value, 56 Journal of Risk and Insurance 128 (1989) 21 Thomas M. Jones, An Empirical Examination of the Incidence of Shareholder Derivative and Class Action Lawsuits, , 60 B.U. L. Rev. 204 (1980). 22 Jennifer Francis, Donna Philbrick and Katherine Schipper, Determinants and outcomes in class action securities litigation. Working Paper, University of Chicago, Graduate School of Business (1994). 23 James D. Beck and Sanjai Bhagat, Shareholder Litigation: Share Price Movements, News Releases, and Settlement Amounts, 18 Managerial and Decision Economics 563 (1997). 8

11 significantly in the year prior to the lawsuit. 24 Jones and Weingram find that trading volume, market capitalization, and share price declines in the year prior to litigation and on the revelation date are major determinants of litigation risk. 25 In a companion paper, they find that insider trading and seasoned equity offerings do not increase litigation risk, but that accounting restatements and SEC enforcement actions do increase a firm s probability of facing a class action suit. 26 Niehaus & Roth found that insider managers are net sellers of their firm s stock during the class period, but the sales do not significantly differ from their prior selling practices. 27 Other studies focus on the effect of corporate governance characteristics on the incidence of suit. Jones finds a U-shaped relation for corporate board size and the incidence of shareholder litigation; large boards and small boards were both correlated with litigation. 28 He also found that the proportion of outside directors negatively correlated with incidence of suit, but only limited support for a negative relation between the existence of an audit committee and the incidence of suit and an unexpectedly positive relation between the presence of an attorney on the board and incidence of suit. Strahan, looking at firms sued between 1991 and 1998, finds that a number of agency cost variables correlate with class action filings: sued firms are larger and younger, with lower market-to-book ratios, were less likely to pay dividends, report higher 24 Paul A. Griffin, Financial and Stock Price Performance Following Shareholder Litigation, 2 Journal of Financial Statement Analysis 5 (1996). 25 Christopher L. Jones & Seth E. Weingram, The Determinants of 10b-5 Litigation Risk (Working Paper No. 118, John M. Olin Program in Law and Economics, Stanford Law School, 1996). 26 Christopher L. Jones & Seth E. Weingram, The Effects of Insider Trading, Seasoned Equity Offerings, Corporate Announcements, Accounting Restatements, and SEC Enforcement Actions on 10b-5 Litigation Risk, (Working Paper No. 139, John M. Olin Program in Law and Economics, Stanford Law School, 1996). 27 Greg Niehaus & Greg Roth, Insider Trading, Equity Issues and CEO Turnover in Firms Subject to Securities Class Actions, (unpublished manuscript, 1999). 28 Thomas M. Jones, Corporate Board Structure and Performance: Variations in the Incidence of Shareholder Suits, 3 Research in Corporate Social Performance and Policy 345 (1986). 9

12 levels of intangible assets and have greater risk. 29 By contrast, Strahan finds no evidence that corporate governance variables had an effect on the likelihood of a lawsuit: there are no differences for insider holdings, board composition, large blockholdings or institutional holdings when he compares his sued firms to a control sample. Johnson et al. construct a model that explains forty-one percent of the variance in the incidence of litigation for a sample of hightechnology and pharmaceutical firms. 30 They find that firms with greater assets, more activelytraded shares, low prior-year returns and large stock price drops are more likely to be sued. They also find that the CEO s influence over the board, the issue of debt or equity, and sales by insiders all influence the likelihood of a lawsuit. Leverage also has a positive influence on the likelihood of suit when interacted with the other governance variables. Beta, skewness of returns and monitoring (a factor obtained from the interaction of a number of corporate governance variables, including the presence of an audit committee, a Big Six auditor and a block shareholder) do not have a significant effect on the likelihood of litigation. B. 3. Explaining the Incidence of Fraud The final set of studies focuses on firms that have been named by the SEC in enforcement actions. Dechow et al. find that firms accused by the SEC of manipulating earnings are more likely to have insider-dominated boards, CEOs who also serve as board chairman and/or are the firm s founder, but are less likely to have audit committees or outside blockholders. 31 Beasley, in a study of firms accused by the SEC of committing financial statement fraud, finds that fraud 29 Philip E. Strahan, Securities Class Actions, Corporate Governance and Managerial Agency Problems, Working Paper, Federal Reserve Bank of New York (1998). 30 Marilyn F. Johnson, Ron Kasznik & Karen K. Nelson, Shareholder Wealth Effects of the Private Securities Litigation Reform Act of 1995 (forthcoming, Journal of Accounting Research, 2000). 31 Patricia M. Dechow, Richard G. Sloan & Amy P. Sweeney, Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC, 13 Contemporary Accounting Research 1 (1996). 10

13 firms have a lower percentage of outside directors on their boards. 32 He also found that fraud was inversely related to outside director ownership and tenure, but positively related to board size and the number of other directorships that outside directors held. The presence of an audit committee had no effect on the incidence of fraud. Beneish finds that insiders sell holdings at inflated prices during fraud periods, but no evidence that fraud is motivated by demand for external financing or avoidance of debt covenant violations. 33 Related studies look at other potential proxies for the incidence of fraud. Summers and Sweeney, studying financial statement frauds reported in the Wall Street Journal, find that fraud company insiders are selling their stock. They also find that fraud companies have a high inventory relative to sales, high growth rates, and high return on assets in the year before the occurrence of the fraud. 34 These findings suggest that insiders might commit fraud to maintain the appearance of success during a financial downturn. Kinney and McDaniel examine firms that have corrected previous earnings statements. 35 They find that such firms are smaller than their industry mean, are less profitable, have lower growth, and carry more debt. II. SAMPLE AND EMPIRICAL METHODOLOGY A. Sample Selection Our initial sample consists of motions to dismiss brought by an issuer defendant decided under the Reform Act from its enactment on December 22, 1995 to December 31, The 32 Mark S. Beasley, An Empirical Analysis of the Relation Between the Board of Director Composition and Financial Statement Fraud, 71 Accounting Review 443 (1996). 33 Messod D. Beneish, Incentives and Penalties Related to Earnings Overstatements that Violate GAAP, 74 Accounting Review 425 (1999). 34 Scott L. Summers & John T. Sweeney, Fraudulently Misstated Financial Statements and Insider Trading: An Empirical Analysis, 73 Accounting Review 131 (1998). 35 William R. Kinney, Jr. & Linda S. McDaniel, Characteristics of firms correcting previously reported quarterly earnings, 11 Journal of Accounting & Economics 71 (1989). 11

14 fraud revelation and filing dates were initially collected from the complaints and the decision dates are obtained from the opinions deciding the motions to dismiss. 36 The fraud revelation date was initially defined as the last day of the class period specified in the complaint. The mean number of days between revelation and filing is 71.6 days for our sample with a median of 25 days; the mean delay between revelation and decision is days, with a median of 447 days. For issuers that had more than one motion to dismiss decided (eleven issuers), only the earliest decision is included. For these cases, the earlier decision is a dismissal without prejudice (thus allowing the plaintiff to amend her complaint). We believe that the market is likely to have anticipated the information contained in the later decision, which will frequently be a dismissal with prejudice. Fourteen issuers were excluded for lack of a CUSIP number. We use the daily stock return database from the Center for Research in security prices (CRSP) to undertake our event study analysis, which requires the exclusion of issuers for which this data is not available. Additional governance and trading data is obtained from the Standard and Poor s Compustat database and the New York Stock Exchange Trade and Quote monthly CD. Our final sample consists of 89 cases. A Nexis search was then done of the Major Newspapers and Newswire databases for windows around each of the three event dates to determine whether other news concerning the corporation may confound the signal sent by our litigation event, such as a positive earnings report or new contract announcement at the time of the filing. Firms were dropped from the event study for a particular event if a story reported news of sufficient magnitude and 36 The complaints were obtained from the Stanford Securities Class Action Clearing House ( The opinions were obtained from Lexis and Westlaw, as well as by contacting individual attorneys who practice in the area. Insofar as our collection methods failed to uncover some of the opinions, it is likely that the missing opinions are summary denials of motions to dismiss with no written opinion. Although we think that the number of omitted cases is small, our numbers may reflect a bias toward cases that result in dismissal, for which judges are more likely to issue a written opinion. Any bias in our sample is unlikely to affect our results. 12

15 sufficiently close in time (within three days) that it was likely to affect the stock price (e.g., an earnings announcement). The news stories generated by the Nexis search also allowed us to refine our revelation dates to correspond with the first trading day that the bad news was available to the market. The stories also provided us with the first wire service announcements of the filing of the lawsuits. 37 We use this filing notice date for our event studies because analysts are unlikely to have access to this information before the filing is announced on the wire. We collected additional governance data from the proxy statement closest in time prior to the revelation date. We also collected data on the fraud allegations from the complaints. Table 1 provides an industry distribution of the companies in our final sample. TABLE 1 TWO DIGIT SIC CODE DECOMPOSITION OF SAMPLE SIC Code Industry Type Number Percent of Sample 1000 Agriculture, Mining, Construction Textiles, Furniture, Chemicals and Paper Plastics, Metals, Machinery and Electronics Transportation and Communications Wholesale and Retail Trade Finance, Insurance and Real Estate Business and Miscellaneous Services Health, Educational, Engineering and Accounting Services Consistent with prior studies of securities fraud class actions, firms in the high technology sector are well represented in our sample, with 3000-series SIC codes, which includes Computer Equipment and Electronic Equipment, constituting more than a quarter of our sample. Companies in Business Services, a hodgepodge category for industries including such firms as advertising agencies, credit reporting, and janitorial and secretarial services, are equally well represented. 37 The Reform Act requires plaintiffs attorneys to give notice within 20 days of the filing of a complaint by means of a widely circulated national business-oriented publication or wire service. 15 U.S.C. 78u-4(a)(3)(A)(i). Wire notice is the norm. 13

16 We create subsamples of winners and losers, based upon the court s decision concerning the motion to dismiss. Of the 89 cases in our final sample, courts granted the motion to dismiss in 42 of the cases and denied the motion in 47. We coded cases in which the court granted the motion to dismiss only in part as a motion denied because the company still faced liability. We coded both dismissals with prejudice and dismissals without prejudice as motions granted. While companies granted dismissals without prejudice continue to face potential liability if the plaintiff is able to successfully amend his complaint, the dismissal without prejudice provides a strong signal of the court s assessment of the case s merits. Nonetheless, the dichotomy that we adopt, while essential for our statistical analysis, necessarily disguises real differences in potential liability. B. Methodology Our empirical analysis consists of two parts. The first part examines the stock price reaction to three events: (1) a public revelation of possible fraud, (2) the notice of filing of a lawsuit and (3) the court s announcement of its decision resolving a motion to dismiss. The second part uses a number of control variables in a series of regression analyses to examine influences on the resolution of the motion to dismiss and determinants of the cross-sectional variation in the market s reaction to these events. 1. Stock price event studies. Initially, we undertake an event study to determine the market impact of an announcement of a potential fraud (i.e., the revelation date). 38 In a typical case, the revelation date will be the day the company reveals that it is restating earnings for a prior period or that it is having difficulties bringing a product to market. This event study sheds light on the impact of fraud on a company and the selection of defendants by plaintiffs attorneys. We predict a strong negative stock price reaction to the revelation of fraud plaintiff s lawyers choose the cases in which they file suit based, in part, on the extent of the negative price reaction. Large price declines suggest large potential damages, which in turn suggest large attorneys fees. 38 We use a common event methodology approach. See John D. Martin, Samuel H. Cox and Richard D. MacMinn, The Theory of Finance: Evidence and Applications, Dryden Press, New York, 1988, p

17 The stock price reaction at the revelation date is not limited to a reassessment of the company s valuation in light of the revelation, but presumably also includes the market s assessment of the company s potential for liability. Market participants are likely to know that the disclosure of potential fraud brings with it a possible securities fraud class action with enormous liability exposure. Accordingly, we also conduct an event study to determine the impact of filing suit, to determine if the filing itself provides new information, or if market participants have fully anticipated the potential for liability. We predict a weaker negative price reaction to the filing of the lawsuit because the market may well have anticipated the likelihood of suit. Finally, we study the market s reaction to the court s decision on the issuer s motion to dismiss the lawsuit. Our main focus here is whether the market reacts differently for our winners and losers subsamples. We predict a positive price reaction for those cases in which the motion to dismiss is granted, and a negative reaction to decisions denying motions to dismiss. We also use our winners and losers subsamples to examine the ability of market participants to anticipate the likely outcome of the litigation. Cases in which the complaint is ultimately upheld by the court may contain evidence of such pronounced fraud, for example, an earnings restatement accompanied by the dismissal of a chief financial officer, that it is transparent to the financial markets and the market reacts immediately. 39 For those cases that are ultimately dismissed, by contrast, the evidence of fraud may be limited or inconsequential, so the market reaction may be weaker at the time of revelation. 2. Regression Analysis We complete our analysis of the valuation impact of decisions resolving motions to dismiss by conducting a number of cross-sectional regressions on the excess returns calculated around the three announcement periods of interest. We include an indicator variable for the eventual resolution of the motions to dismiss. A positive coefficient on this variable at the revelation date and the filing notice date would be consistent with market 39 We caution, however, that our sample may be biased toward weaker cases. In the very strongest cases, issuers may recognize that a motion to dismiss would be futile, so they work to settle the case rather than moving to have it dismissed. 15

18 participants ability to anticipate litigation outcomes, and a positive coefficient at the decision date would support the conclusion that litigation outcomes are material events for the valuation of securities. Our remaining independent variables proxy for three different phenomena: (1) susceptibility to lawsuit; (2) information asymmetry; and (3) type of allegation. 40 To get an assessment of the importance of these variables to the outcome of the lawsuit against our sample firms, we first conduct a logit regression using these variables as our independent variables with the outcome of motion to dismiss as our dependent variable. Our hypothesis is that variables with significant coefficients in the logit analysis will be more likely to have significant coefficients in the cross-sectional regressions of the market returns. The first set of financial variables attempts to capture the firm s susceptibility to a lawsuit. Prior research has found that share turnover, firm size, beta and skewness of returns correlate with the incidence of suit, while the prior year s return is negatively correlated. We predict similar relations to the market s reaction to the revelation of adverse news and the filing of suit, except for firm size. While larger firms are more vulnerable to suit, they may be better able to bear the fixed expenses of defending a lawsuit. Other financial variables attempt to capture potential agency problems that may also correlate with susceptibility to lawsuit. As noted in the financial economics literature, Jensen s free cashflow, the ratio of debt-to-equity, and the firm s market-to-book ratio can all be used to capture the potential for agency conflict within the corporation. The incidence of fraud may be correlated with agency problems between the managers and shareholders, so these variables might reflect the market s assessment of the possibility that the mangers have committed fraud. On the other hand, these variables may also reflect market participants prediction regarding the manager s ability to respond to this adverse development. We hypothesize that free cashflow will be inversely related to the announcement period returns because it suggests greater managerial discretion. We predict that the debt ratio will be positively related because of the discipline that will be required to satisfy debt obligations. The market-to-book ratio might 40 A complete specification of the variables is included in the Appendix. 16

19 reflect the market s assessment of managerial efficiency in using the resources available to the firm. Weak managers may have greater incentive to commit fraud to create the appearance of competence and thereby retain their positions. The market returns to the revelation, notice of suit filing and resolution of the motion to dismiss can also be explained by the degree of information asymmetry between the firm and investors. We attempt to capture this asymmetry with our second set of independent variables. We calculate the percent of insider and institutional equity holdings for each of the firms in our sample. We hypothesize that insider equity holdings will be inversely related to announcement period returns since more closely held firms are less likely to disclose information, producing a greater information asymmetry between investors and management. Insider domination may also exert pressure on accounting controls. We predict that institutional equity holdings, however, will be positively related to market returns. Securities analysts are more likely to follow companies held by a high percentage of institutional investors. This external monitoring of the corporation may reduce the information asymmetry and the negative market response to the revelation of fraud. We also calculate the percentage of independent directors on the boards of our sample firms. More independent boards may be better monitors of management. We include an indicator variable if the firm has a Big 5 auditor, which may be correlated with higher quality audits. We predict positive relation with market returns for both of these variables. Finally, we include an indicator variable for firms in which the role of Chairman and CEO are combined. The combination of these roles may reflect management entrenchment, so we predict a negative coefficient. Our final set of variables captures the type of allegation being made against the firm. We include indicator variables for allegations of a sale of securities by the firm (either an offering or a merger), accounting violations, and stock sales by insiders. Accounting violations may provide objective evidence of fraudulent intent, while sales of stock by the firm and insiders may reflect a motive to commit fraud. Our hypothesis is that complaints containing allegations of these types will be less likely to be dismissed. Accordingly, we predict negative coefficients for each of these variables. 17

20 III. EMPIRICAL FINDINGS AND DISCUSSION A. Stock Price Returns 1. Raw Returns. In Table 2, we have calculated the percent cumulative abnormal returns (CAR) for event windows surrounding each of the three dates critical in the litigation: the revelation date of the fraud, the filing notice date of the first complaint and the decision date on the motion to dismiss. 41 Results are presented for the entire sample and for subsamples based on whether the motion to dismiss was granted or denied. TABLE 2 EVENT STUDY RESULTS AROUND THE REVELATION, FILING AND DECISION DATES Revelation Date Aggregate Sample CAR Z statistic Percent Negative [-1, +1] *** 0.87 Motion Denied Subsample [-1,+1] *** 0.58 Motion Granted Subsample [-1,+1] *** 0.85 Notice of Complaint Filing Date Aggregate Sample CAR Z statistic Percent Negative [-1, +1] *** 0.66 Motion Denied Subsample [-1,+1] *** 0.58 Motion Granted Subsample [-1,+1] *** 0.75 Decision Date Aggregate Sample CAR Z statistic Percent Negative [-1, +1] [0,+5] Motion Denied Subsample [-1,+1] [0,+5] Motion Granted Subsample [-1,+1] [0,+5] NOTE Excess returns are calculated using market model parameters estimated over the period: 18

21 Day 260, Day-11. Statistical significance at the one, five and ten percent levels is indicated by ***, **, * respectively. For the revelation date we observe consistently negative reactions for the aggregate sample, as well as both subsamples. These reactions are on the order of 25% over a three-day period surrounding the revelation, an extremely large negative reaction to the revelation of fraud. The overall negative reaction is predictable, in that plaintiffs lawyers will select cases that are most likely to generate a strong market reaction. Larger reactions create larger damages claims and signal a greater likelihood of fraud. Hence, the market reacts negatively for the overwhelming majority firms in our sample. A test of the mean differences in CARs between the winner and loser subsamples is statistically insignificant. The similar results for the two subsamples suggest that the market is not able to assess the likelihood of fraud and hence is unable to anticipate the ultimate outcome. The filing date produces a smaller, but still strongly statistically significant market reaction. This suggests that investors find additional relevant information in the fact that a lawsuit has been filed. This result implies that market participants are uncertain at the time of revelation whether a lawsuit will be filed. Consequently, the risk of litigation is not fully incorporated into the firms stock prices at that time. This interpretation is supported by the more strongly negative reaction and greater percent negative for the motion granted subsample. These cases presumably have weaker evidence of fraud, making it more of a surprise when a lawsuit is filed. An analysis of the three-day returns surrounding the decision date suggests that the decision is a non-informational event. Given that the sample is nearly evenly divided between winners and losers, this result is not surprising. When we create subsamples based on the outcome, however, we observe that the market reacts positively for the motion denied subsample, and negatively for the motion granted subsample; these results are the opposite of that predicted, but are statistically insignificant. We considered the finding that the decision does not produce a significant market reaction to be notable, however, in light of the presumptively material information that it conveys about the firm s potential liability. Accordingly, we decided to 19

22 investigate further. Our review of the news stories surrounding the decision date suggested that there may be a substantial lag before the news of the decision reaches market participants (unlike the revelation and filing dates, which were promptly reported). Of the 89 firms in our sample, only fifteen had reports of the court decision (unsurprisingly, only two of these reports were for denials). We therefore re-ran our event study for the decision date using a longer event window (from day 0 to day +5). The results continued to remain statistically insignificant for the entire sample as well as the winners and losers subsamples. We next reran our event studies for the subset of firms that reported the decision. The results are again insignificant, even when we drop the two firms that reported denials. Perhaps the market is discounting the good news of the dismissal due to the lack of prejudice. To test this possibility, we ran an additional event study (not tabulated) of motions to dismiss granted with prejudice. These results were again insignificant for the -1, +1 event window, with both the prejudice subsample and non-prejudice subsample producing negative returns. Expanding the event window to 0,+5 results in statistically significant results for prejudice subsample, but not the subsample without prejudice. The prejudice firms have negative returns, however, and the non-prejudice firms are positive, exactly the opposite of what theory would predict. We cannot explain these anomalous results, other than to attribute them to the small sample size. In sum, our event studies suggest that the market responds strongly to the revelation of potential fraud and the subsequent filing of suit, but does not respond to news of the resolution of the motion to dismiss. The news may be difficult for securities analysts to obtain, given that there is no requirement of disclosure, as there now is for the filing of suit. Moreover, the news may be difficult to process, requiring an understanding of the workings of the legal system. Nonetheless, we find the lack of a significant market reaction to the resolution of the motion to dismiss to be a surprising result, in light of the magnitude of the potential liability of a securities fraud class action and the significant negative reaction to the filing of suit. 20

23 2. Correlations between Returns. Table 3 investigates the extent to which the market anticipates subsequent decision making by both plaintiffs (filing complaints) and the court (granting or denying the motion to dismiss). Correlation coefficients are reported for the relationship between CARs across different event days. Two correlation coefficients are estimated, the Pearson Product Moment and the Spearman (in parentheses). Both measures provide similar results. TABLE 3 CORRELATION OF CARS BETWEEN EVENT DATES Pearson (Spearman) Correlation Coefficients. CARs estimated between days 1 and +1 Panel A: Entire Sample Filing Notification Date Revelation Date (0.117) Filing Notification Date Decision Date 0.344** (0.216**) (0.097) Panel B: Granted Subsample Filing Notification Date Revelation Date (0.133) Filing Notification Date Decision Date 0.384** (0.124**) (0.173) Panel C: Denied Subsample Filing Notification Date Revelation Date (0.033) Filing Notification Date Decision Date * (-0.102) 0.212* (0.155) NOTE: Statistical significance at the five and ten percent levels is indicated by ** and * respectively. 21

24 We find a moderate positive statistically significant correlation between the market response at the time of revelation and the decision date. This finding is consistent with the market anticipating (to some degree) the resolution of the lawsuit. We see a slightly different picture when we look at the correlations for our winners and losers subsamples. The statistically significant positive relationship continues for the subsample in which the motions are granted, but the motion denied subsample reflects a negative correlation (albeit not as strongly significant) for the revelation date and decision date returns. This difference in the correlations suggests that the market response to the charge of fraud at the time of revelation discriminates to some extent based on the strength of the potential case against the firm, despite the fact that our event studies found similar returns for the two subsamples at the revelation date. We do not find a consistently significant correlation between the returns for the revelation date and the filing date, or the returns from the filing date and the decision date. 3. Univariate Comparisons. Table 4 compares a series of variables intended to serve as proxies for agency conflict between the shareholders and managers. The variables are means, measured over the three years prior to the year the alleged fraud was revealed. The decision on the motion to dismiss (granted/denied) again provides the basis for splitting the sample into two subsamples, which we then compare. 22

25 TABLE 4 UNIVARIATE COMPARISONS OF AGENCY AND INFORMATION ASYMMETRY VARIABLES Variable Motion Granted: Mean (median) Share turnover (2.744) Size (168.1) Beta (1.327) Prior year s return (0.050) Free cashflow (0.028) Debt ratio (0.390) Market-to-book (2.746) Insider equity holdings (0.104) Institutional equity ownership (0.430) Percentage independent directors (0.571) Board size 7.89 (7) Motion Denied: Mean (Median) (2.687) (287.49) (1.192) (0.050) (0.046) (0.400) (2.158) (0.134) (0.360) (0.444) 7.57 (7) Difference t-statistic (Wilcoxon z) (0.651) 1.901* (-1.335) (0.112) ** (2.331**) (1.221) 2.205** (1.994**) 1.893* (-1.899*) 2.011** (1.891*) 2.112** (1.993*) (0.103) NOTE. All variables are estimated around the time of the revelation date.. Insider and institutional equity ownership data is obtained from Compact Disclosure. Statistical significance at the one, five and ten percent levels in indicated by ***, ** and * respectively. No test statistic is provided for skewness since as the third moment, t and z statistics can not be calculated. Comparing variables associated with the incidence of suit for the two subsamples (share turnover, size, beta, skewness of returns and prior year s return), we find a statistically significant difference only for the mean beta, with the winners subsample being slightly more volatile. As the difference is significant only at the ten percent level, and the medians do not show a statistically significant difference, we are reluctant to give much, if any, importance to this difference. Overall, the comparison of this subset of variables suggests that these variables, while useful in predicting the incidence of filing, provide little information on the merits of the 23

26 lawsuit. Comparing our proxies for potential agency conflict, we note that firms that succeeded with their motions to dismiss have less free cashflow than the firms whose motions were denied, suggesting that reducing the amount of free cashflow subject to managerial discretion is an important tool for managerial discipline. We also find a higher ratio of market-to-book for the winners subsample, which suggests that managers of firms with greater growth opportunities may have less incentive to commit fraud. Superior growth opportunities may reduce the pressure on managers to engage in fraud to create the appearance of prosperity. Our proxies for potential information asymmetry also show statistically significant differences. Insiders hold a smaller percentage of the winners equity, which is consistent with a lesser incentive to withhold information for profitable trading. By contrast, institutional shareholders hold a greater percentage of the winners equity, consistent with a reduced scrutiny from analysts and professional investors. These investors apparently encourage greater accountability. 42 Our next set of variables proxy for the quality of monitoring provided by the firms corporate governance structure. Firms that succeed in having their motions granted have a higher percentage of independent directors, suggesting that independence does produce closer monitoring. The size of the board, which is sometimes argued to also reflect quality of monitoring (large boards may be unwieldy), does not differ between the two subsamples. 42 This result offers some insight into why the lead plaintiff provision of the Reform Act, which is intended to encourage institutional investors to monitor class actions, has largely failed. If institutional investors are well represented among the firm s investors, allegations of fraud are less likely to succeed, so institutional investors will be less willing to participate in the prosecution of the lawsuit. 24

27 TABLE 5 OUTCOMES BY TYPE OF ALLEGATION Panel A: Securities Issuance/Merger Securities/Merger Denied Granted Row Total Z statistic Yes No Column total Panel B: Accounting Misstatement Accounting Denied Granted Row Total Z statistic Yes No Column total Panel C: Insider Trading Insider Trading Denied Granted Row Total Z statistic Yes ** No Column total Table 5 compares the type of allegations in the complaints against the motions granted and motions denied subsamples. Plaintiffs who included allegations of insider trading or a securities issue/merger were more successful in resisting motion to dismiss, when compared with those complaints that lacked such allegations. Only for the insider trading variable, however, does the difference in proportion rise to the level of statistical significance. Notably, allegations of accounting violations, which appear in 39% of the cases, do not appear to have improved plaintiffs likelihood of success, as a higher percentage of complaints without such allegations survived the motion to dismiss. Unsurprisingly, there is no statistically significant difference between the percentage (proportion) of MTD denials with accounting allegations and the percentage of granted MTDs with accounting allegations. This result, while counterintuitive, is consistent with the finding of Johnson et al. that allegations of accounting fraud in post-reform Act complaints have no correlation with accounting quality Regression Analysis of Motion to Dismiss Resolutions We now move to a 43 Marilyn F. Johnson et al., Do the Merits Matter More? Characteristics of Securities Fraud Class Actions Under the Private Securities Litigation Reform Act (unpublished manuscript, 2001). 25

28 multivariate framework to explore the influence of our variables on the resolution of motions to dismiss. These variables have been found in prior research to explain the incidence of lawsuit filings and SEC enforcement actions. Do they also help explain the judicial resolution of securities fraud class actions? TABLE 6 RESOLUTION OF THE MOTION TO DISMISS Variable Hypothesized Model 1 Model 2 Model 3 Sign Share Turnover? * * * Size? Beta? Revelation date * * * return Skewness of returns? Prior year s raw ** ** ** return Free cashflow * * * Debt ratio Market-to-book Insider equity holdings Institutional equity holdings Percentage * independent directors Board size * Big 5 auditor Chair/CEO combined Securities Issuance Accounting violation Insider sales Table 6 presents the presents the results of our logit regressions using the resolution of the motion to dismiss as our binary dependent variable; cases for which the motion to dismiss was granted are coded as 1, motions denied are coded as 0, so positive coefficients on the independent variables correlate with the likelihood of dismissal. The first model presents 26

29 regression results using as independent variables our predictors for the incidence of suit, as well as proxies for potential agency conflict and information asymmetry. The second model adds several corporate governance characteristics. Our hypothesis is that firms with stronger monitoring environments are less likely to have engaged in fraud and therefore more likely to succeed with their motion to dismiss. Our third model adds indicator variables for allegations found in the complaint. Our hypothesis is that the presence of these types of allegations may signal stronger evidence of fraudulent intent, making the court less likely to dismiss. Looking first at the financial variables, we find one surprise. Share turnover produces a statistically significant negative coefficient, despite the fact that legal doctrine would suggest that it should be irrelevant to the resolution of the motion to dismiss (although it is relevant to the question of damages). Size, beta and the skewness of returns are also equally irrelevant from a doctrinal perspective and are insignificant. The return surrounding the revelation date, which one would expect to be more negative for firms more likely to have committed fraud, is positive and consistently significant. Perhaps plaintiffs attorneys look for bigger price drops when the evidence of fraud is thinner to maintain the expected value of their claims. If so, we would expect larger price drops for cases that are dismissed. The prior year s return is also positively correlated with dismissal, suggesting that judges are more forgiving to issuer defendants who have generally been performing well. Turning to our proxies for potential agency conflict, only free cashflow produces a statistically significant coefficient with the predicted negative sign; the debt ratio and the marketto-book ratio are both insignificant, although their signs are in the predicted positive direction. These proxies apparently do not closely track the factors that judges consider in assessing the merits of cases. Debt ratio may reflect two different phenomena with conflicting effects on the propensity for fraud: (1) a high debt ratio is consistent with managers accepting a disciplined 27

30 financial structure; or (2) eroding financial performance may cause the value of equity to decline, thereby increasing the debt-to-equity ratio. A similar story can be told for the marketto-book ratio: a high market-to book ratio may reflect substantial growth opportunities, but it may also put pressure on managers to maintain that favorable stock market valuation. The variables capturing the ownership characteristics of the firms equity are insignificant. Among our variables for governance characteristics, percentage of independent directors and board size are significant, suggesting that the monitoring of these directors may dampen managerial propensity for fraud. Our indicator variables for the presence of a Big 5 auditor and a combination of the CEO and board chair positions are insignificant. Finally, none of our variables for the type of allegation achieves statistical significance. Our indicator variables may be too coarse to capture when these allegations are likely to be persuasive to courts. The results, however, do indicate that the mere presence of any of these types of allegation is not a proxy for merit. 5. Stock Price Reactions. Table 7 reports the results of our ordinary least squares regressions using the three-day returns surrounding the various events as the dependent variable. Since the CARs serve as our dependent variable, market wide factors have already been purged from the returns. Any remaining variation must be attributable to firm or industry-wide factors. We use the same model specifications for this analysis as we used in our logit regressions. Our hypothesis is that variables that are significant in explaining the resolution of the motion to dismiss will also be significant in explaining the market s response to our litigation events. In other words, we hypothesize that market participants understand how securities fraud class actions operate and incorporate that understanding into their valuation of firms. TABLE 7 REGRESSION ANALYSES OF CARS 28

31 Panel A: Revelation Date Variable Hypothesized Model 1 Model 2 Model 3 Sign MTD granted * Share turnover Size? Beta * * * Skewness of returns * * ** Prior year s return Free cashflow ** * * Debt Ratio * ** * Market-to-book ** ** * Insider equity holdings Institutional equity holdings * * * Percentage independent * directors Board size Big 5 auditor Chair/CEO combined Securities issued Accounting violation Insider sales Adjusted R NOTE: Statistical significance at the five and ten percent levels is indicated by ** and * respectively. 29

32 Panel B: Filing Notification Date Variable Hypothesized Model 1 Model 2 Model 3 Sign MTD granted Share turnover Size Beta * * * Skewness of returns * ** Prior year s return Free cashflow * ** * Debt ratio * * * Market-to-book * ** * Insider equity holdings Institutional equity holdings * * Percentage independent * directors Board size Big 5 auditor Chair/CEO combined Securities issued Accounting violation Insider Sales Adjusted R NOTE: Statistical significance at the five and ten percent levels is indicated by ** and * respectively. 30

33 Panel C: Decision Date Variable Hypothesized Model 1 Model 2 Model 3 Sign MTD granted) * * Share turnover Size Beta * * * Skewness of returns * ** Prior year s return Free cashflow * * * Debt Ratio * * * Market-to-book * ** * Insider equity holdings Institutional equity holdings * * Percentage independent * directors Board size Big 5 auditor Chair/CEO combined Securities issued Accounting violation Insider sales Adjusted R NOTE: Statistical significance at the five and ten percent levels is indicated by ** and * respectively. Panel A shows the results from the regression for the revelation date. Our strongest proxy for the merit of the complaint, the subsequent resolution of the motion to dismiss, is significant at the ten percent level in Model 1, but loses statistical significance altogether in Models 2 and 3. This suggests that the likely outcome of litigation is either unclear to the market participants or not an important determinant of firm value. In each of the three models, the amount of free cashflow is inversely related to the market response, while the debt ratio is positive, suggesting that firms which allow managers greater discretion pay a heavier toll when potential fraud is revealed. We also find consistently statistically significant results for the firms market-to-book ratio, suggesting that growth opportunities influence the market s reaction to possible fraud. The debt ratio, the market-to-book ratio and the percent equity held by 31

34 institutional investors are all significant in these regressions. These findings suggest that the market valuation of a firm in the presence of bad news is driven by a variety of factors and that the projected outcome of litigation may not be the most important of those factors. For our variables previously found to be correlated with the incidence of litigation, firms with higher betas produce more negative returns, as do firms with skewed returns. Firm size and the prior year s returns, however, are insignificant. When we introduce our corporate governance variables in Model 2, our adjusted R 2 declines, suggesting that these variables do not increase the explanatory power of our model. Moreover, only the percentage of independent directs produces a statistically significant coefficient. Board size, significant in the logit regressions, is insignificant here. We conclude that this set of corporate governance characteristics does not play an important role in market participants reassessment of firm value upon the revelation of potential fraud. Our final model includes indicator variables for the type of allegations in the subsequently-filed complaint. None are statistically significant, suggesting that the market either is unable to anticipate the type of complaint that will be filed, or does not consider the information material. The fact that none of these variables were significant in the logit regression for the motion to dismiss outcomes supports the latter contention. Overall, we conclude that the market s reassessment of the value of the firm upon the revelation of the bad news is driven more by assessments of its business than the prospect of litigation. Panel B presents the results of similar regressions surrounding the filing notice date. The statistically significant negative abnormal returns for the filing notice date reported earlier in this study suggests that the market considers the filing of the lawsuit to be significant. Moreover, on the filing date market participants are likely to be focused on the impact of the lawsuit on the firm, while at the revelation date they may be more concerned with reevaluating the firm s business prospects. The regressions for the filing date CARs present a potentially clearer picture of the market s reaction to the possibility of litigation. Nonetheless, the variable for the decision on the motion to dismiss is now insignificant in all three models. This result further undercuts 32

35 the hypothesis that the market is able to anticipate the result of litigation. Moreover, the variables for type of allegation continue to remain insignificant, suggesting that the content of the complaint is not material information to market participants. This is unsurprising, given the dearth of evidence that the type of allegation correlates with merit. Of the remaining variables, the pattern of significance or insignificance from the revelation date returns continues to hold. Panel C presents the results of the regression for the decision date. Despite the fact that the results from the event study were insignificant, the indicator variable for the outcome of the motion to dismiss is significant (at the ten percent level) for two out of three of the model specifications, with the sign in the predicted positive direction. This finding offers limited evidence that the market does take this litigation development into account. The other variables in the model follow the pattern of the two prior regressions, with beta, skewness, free cashflow, debt ratio, market-to-book and institutional equity holdings and board independence generally continuing to be significant, with the remaining variables remaining insignificant. IV. CONCLUSION Our study sheds light on the impact of securities fraud and securities fraud class actions on securities markets. Consistent with prior studies, we find that the revelation of potential fraud and the filings of a class action lawsuit correlate with statistically significant abnormal returns. The returns from the date that the decision on the motion to dismiss is announced are not, however, statistically significant, suggesting that this information either costly to obtain or not material. When we examine the determinants of resolutions of motions to dismiss, we find that few of the variables that predict the likelihood of a lawsuit filing, such as firm size and beta, are correlated with this proxy for lawsuit outcome. This finding suggests that the selection of firms by plaintiffs lawyers is not driven entirely by considerations of merit. This conclusion is bolstered by the insignificance of the type of allegation. Share turnover, an important element of damages, but not liability, is unexpectedly significant. Free cashflow, the percentage of 33

36 independent directors and board size are also significant, suggesting that managerial discretion and board monitoring are important determinants of the likelihood of fraud. Our study also provides insights into the ability of the markets to anticipate judicial decisions. We find little evidence that the market is able to anticipate the outcome of potential litigation. We also find little evidence that the variables that are important to the resolutions of motions to dismiss are important in explaining the cross-sectional variability in stock returns surrounding the various dates. Market participants appear to be more influenced by variables affecting business performance when they value a company in the presence of a potential fraud. We conclude that the resolution of securities fraud litigation is not a central concern for the valuation of companies. 34

37 APPENDIX Share turnover: The number of shares traded over the 120 trading days (6 months) preceding the filing of the MTD divided by the number of shares outstanding. Size: The log of the market value of equity at the close of the year preceding the year of the filing. Beta: The slope coefficient in a regression model of stock returns against the value-weighted CRSP return index estimated over day (-10) and day (-259) relative to the filing date of the MTD. Skewness of returns: Estimated as the third moment of the return distribution and is a measure of the tendency of the deviations from the mean to be larger in one direction than in the other. Prior year s return: The compounded raw return over the 250 trading days (one year) between day (-10) and day (-259) relative to the filing date of the MTD. Free cashflow: This represents cashflow that is subject to managerial discretion and hence subject to waste by managers. Larger amounts of free cashflow are positively related to a greater probability of agency conflict. We calculate as per Lehn and Poulsen (1989) and then standardize by the firm s total assets. Debt ratio: The debt ratio is the firm s total liabilities standardized by total assets. Debt serves as to discipline managers, reducing free cashflow because of the need to service the debt. Greater proportions of debt in the firm s capital structure are hypothesized to reduce agency conflict. Market-to-book ratio: The firm s market-to-book ratio is estimated as the book value of assets plus the market value of common equity less the book value of common equity divided by the book value of assets. Greater market to book means a more attractive firm and one that is highly valued. Insider equity holdings: The percent of shares outstanding held by individuals classified as managers or executives of the firm. Greater ownership by managers may entrench management and increase the probability of insider trading, thus exacerbating agency problems for outside shareholders. Institutional equity ownership: The percent of shares outstanding held by institutional investors such as mutual or pension funds. Institutions such as mutual and pension funds can serve as external monitors and reduce agency conflict. Percentage independent directors: The number of directors classified as independent using Yermack s (1999) classification divided by board size. 35

38 Board size: The number of directors assigned to a company s board of directors. 36