Disclosure and Litigation

For example, “For the public company, securities litigation seems to follow surprising news as vultures follow the African lion.” Ehrlich C. , “A Guide to Minimizing Corporate Exposure in Securities Lawsuits,” The National Law Journal, March 8, 1993, p. S14. See also Gilpin , “Stock Dive Brings on Lawsuits,” The New York Times, November 28, 1993, p. 14F. On frivolous lawsuits, see Alexander J. , “Do the Merits Matter? A Study of Settlements in Securities Class Action,” Stanford Law Review, 43/3 (February 1991): 497–598; and Adler , “A Frivolous Securities Suit Claims Another Victim: Me,” The Wall Street Journal, September 15, 1993, p. A23.

While in the 1960s and 1970s, managers' voluntary disclosures (beyond those in quarterly and annual financial statements) were predominantly good news (i.e., causing increases in stock prices), in the last decade the majority of managers' disclosures were bad news, mostly warnings of earnings or sales disappointments. It stands to reason that the increase in the frequency of litigation in the 1980s had a major effect on this change in disclosure behavior. For evidence on recent disclosure trends, see Kasznik R. Lev B. , “To Warn or Not to Warn: Management Disclosures in the Face of an Earnings Surprise,” The Accounting Review (January 1995), pp. 113–134.

The scarcity of facts concerning securities litigation was recently noted by Senator Christopher Dodd: “Consequently, after a long hearing that lasted well into the afternoon, we found no agreement on whether there is in fact a problem, the extent of the problem, or the solution to the problem. In my experience with this subcommittee, I've never encountered an issue where there is such disagreement over the basic facts. We often argue about policy, we argue about ideology, we often argue about politics, but it is rare that we spend so much time arguing about basic facts.” Private Litigation Under the Federal Securities Laws: Hearings Before the Subcommittee on Securities of the Senate Committee Banking, Housing and Urban Affairs, 103d Cong. 1st Sess. 280 (1993).

The firm size effect on litigation is well known (see, for example, Francis Philbrick Schipper , “Determinants and Outcomes in Class Action Securities Litigation,” University of Chicago, September 1993): Large firms are sued more frequently than small ones, presumably because of the formers' deeper pockets and the larger number of shareholders-plaintiffs available. There is also a pronounced industry factor in litigation—high-tech and young firms are sued more frequently than other companies, see Kasznik Lev , op. cit., and Dunbar F. , “Recent Trends in Securities Class Action Suits,” National Economic Research Associates, Inc., August 1992.

The lawsuits dealt with here are known in the legal terminology as 10b-5 litigations, since they are generally brought under Rule 10b-5, adopted by the SEC in 1942. This rule establishes liability for the public dissemination of fraudulent information and for the omission of material information.

Following are examples of statements to this effect: “Securities class action suits are usually filed after a negative disclosure by the management of a company leads to a drop in the company's stock price.” Dunbar F. , op. cit., p. 1. “If a prospect's stock price drops on the announcement of lower-than-expected earnings, a suit is filed within hours.” Burton J. , “Legalized Extortion,” Barron's, August 15, 1994, p. 41 (emphasis mine).

I term these as cases, since the number of firms in the sample is somewhat smaller than 589, as some firms had several quarterly earnings announcements that triggered large price declines during 1988–1990.

This newsletter is published by Investors Research Bureau, Inc., Cresskill, New Jersey, and provides information on securities' litigation.

Securities Class Action Alert, does not reproduce, of course, the entire complaint and other legal briefs filed by plaintiffs, rather it includes a brief summary of the case and plaintiffs' allegations.

A two-week period was specified, since in most cases several law firms file suits against a given company shortly after the disappointing announcement. There is a growing tendency to file suit quickly after the event in an attempt to gain the status and compensation of “lead lawyer” in the case.

A low litigation frequency relative to bad news was found in another study on lawsuits which also used Securities Class Action Alert ( Francis J. Philbrick D. Schipper K. , “Shareholder Litigation and Corporate Disclosures,” Journal of Accounting Research (1994), pp. 137–164). The authors of that study identified 51 “at risk” firms (i.e., firms that sustained 20 percent or greater declines in earnings and sales) and found that only one of these firms was the target of a shareholder lawsuit. Also, a study by a plaintiff law firm, submitted to the Senate Subcommittee on Securities, indicates that during 1986 to 1992, the average rate of lawsuits filed against companies sustaining a one-day stock price decline of 10% or more, was 4.7%. Since in many cases multiple lawsuits are filed on a given event, the 4.7% overstates the number of companies sued.

Of the 20 matched pairs of firms (litigated and control), six operate in the computers and industrial machinery industry (SIC code 35), three are financial institutions (code 60), three in retail (codes 53 and 59), two in software developing (code 73), and one pair in each of the following industries: Chemicals (code 28), instruments (code 38), utilities (code 49), investment trusts (code 67), health services (code 80), and educational services (code 82).

The institutional bailout was probably a major factor in the sharp price decline of the litigated firms (see Table 1).

There is, in general, a high correlation between size of institutional ownership in a company and the number of analysts following it.

Strictly speaking, the returns are not added. Rather, the first day return plus 1 is multiplied by the second day return plus 1, and then 1 is subtracted from the result. This product of daily returns reflects daily compounding.

This statement holds only “on the average.” A small number of the litigated firms did manage to resume growth and attract back institutional investors.

The median growth rate is preferred over the average to mitigate the effect of a few extreme observations (outliers).

Voltaire , Poéme sur le désastre de Lisbonne (1756).

Capital letters X, Y, and Z are substituted in the following quotations for specific names of companies, industries or products, to avoid identification of sample companies. The underscorings and parenthetical comments are mine.

This statement was made by the company's CEO in late 1989. In the following fiscal year, 1990, the company reported a loss.

It should be noted that Francis, Philbrick Schipper , op. cit., concluded from their study that there is “no evidence of differences in optimism across the two sets of disclosures” (p. 3). While they did find that litigated firms issued more positive and fewer negative statements than the non-litigated firms, the difference was not statistically significant. One reason for the difference between their conclusion and mine can be the disclosure examination period: They examined managers' disclosures over one year before the disappointing earnings, while I examined two years. On the other hand, the Francis et al. sample (45 litigated and 53 control firms) is larger than mine.

There is however a duty to disclose new information when an insider trades on such information. On the legal obligation to correct previous disclosures, see Rosenblum R. , “An Issuer's Duty Under Rule 10b-5 to Correct and Update Materially Misleading Statements,” Catholic University Law Review (Winter 1991), pp. 289–330.

NYSE Listed Company Manual, §202.05.

A different conclusion (i.e., that warnings are not effective in deterring litigation) was reached by Francis , op. cit. A warning, however, while not a foolproof litigation deterrent, might nevertheless affect the consequences of litigation, such as the verdict or the size of settlement. This is yet an unexplored issue.

Such stock price increases may, of course, be consistent with other, nonsignaling explanations. For example, the price increases often associated with stock split announcements may be due to decreased transaction costs and the consequent increase in the demand for the stock by individual investors, brought about by the post-split lower stock prices. For elaboration, see Lakonishok Lev , “Stock Splits and Stock Dividends: Why, Who and When,” Journal of Finance (September 1987), pp. 913–932.

See Lev B. , “Financial Disclosure Strategy,” California Management Review, 34/4(Summer 1992), pp. 9–32, for a discussion of financial signaling as part of a disclosure strategy.

Rosenblum , ibid., pp. 301, 302 and 305; emphasis mine.)

Judge Kaufman in SEC v. Bausch & Lomb, Inc., 565 F. 2d 8, 9 (2d. Cir. 1977). Quoted by Sonsini L. Berger D. in “Recent Developments Concerning the Disclosure Obligations of Issuers Under the Federal Securities Laws,” April 1993. On the hazards of selective disclosures to analysts, see Coffee J. , “Disclosures to Analysts are Risky,” The National Law Journal, February 1 and February 8, 1993.

See Kasznik Lev , op. cit., and Skinner D. , “Why Firms Voluntarily Disclose Bad News,” Journal of Accounting Research (Spring 1994), pp. 38–60.

Even ignoring these benefits of disclosure, it is doubtful whether a no disclosure policy is effective against litigation. Many shareholders' (10b-5) lawsuits allege omission of information (i.e., no disclosure of relevant information) as well as the dissemination of false information. A no disclosure policy may also violate stock exchange regulations calling for the immediate public reporting of relevant information (e.g., the NYSE requirement mentioned in reference no. 23).

See Lev , “Information Disclosure Strategy,” op. cit., for elaboration on the costs and objectives of disclosure, and the means by which these objectives can be achieved.