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1 May 2015 CFA Institute Journal Review

The Effect of Securities Litigation on External Financing (Digest Summary)

  1. Richard D. Long

Evaluating the access and cost of external financing for firms that have had securities litigation filings, the authors show that companies with a recent history of securities litigation have reduced access to external financing. These companies are also found to have a reduction in capital investments in the three years after a litigation filing.

What’s Inside?

Corporate financial fraud and associated securities litigation continue to increase in the United States. The authors question whether these litigations negatively affect a company’s subsequent access to external financing. They also wonder what effect securities litigation may have on a company’s future investment activity. Legal actions that the authors include in the definition of securities litigation include financial misrepresentation, stock price manipulation, insider trading, option backdating, and violations tied to mergers and acquisitions.

How Is This Research Useful to Practitioners?

The authors reach four main conclusions. First, the amount of external financing as a percentage of assets is significantly reduced in the three years following a litigation filing. Equity financing is more negatively affected than debt financing. Second, firms with numerous cases of litigation experience a greater negative impact on subsequent financing. This finding is also true in cases of severe litigation, which is defined as a case either lost or settled. Third, firms with high information asymmetry are more negatively affected in accessing external financing after a litigation event. That is, firms that are less subject to external monitoring, including small stocks, volatile stocks, and those with fewer institutional owners and external board members, have a more negative reaction to litigation. Fourth, securities litigation is linked to a significant decrease in a firm’s subsequent investing activities, which include capital expenditures and research and development. Because investors fear the outcome of litigation or the agency issues raised by those legal actions, the cost of both equity and debt capital rises, which increases the hurdle rate and reduces the number of potentially profitable projects. The authors believe these results are consistent with an increase in the cost of capital for the firms. They conclude that “financial wrongdoing” is costly to a firm in both the short term and the longer term.

It is useful to realize that there are long-term indirect costs associated with securities litigation beyond legal costs and settlement expenses. Investors should factor in these costs. In the long run, the reduction in future investments, including capital expenditures and research and development, is likely to reduce growth rates and stock price appreciation. The short-run negative stock price reaction at the time of the filing of the litigation typically far exceeds the amount of eventual fines, settlements, and legal costs.

How Did the Authors Conduct This Research?

The authors construct a sample of 11,354 securities lawsuits filed between 1987 and 2009. The data are obtained from the University of Michigan’s Inter-University Consortium for Political and Social Research and Stanford University’s Securities Class Action Clearinghouse databases. The data samples are then merged with Compustat data on litigation filings, debt and equity issuance, and firm characteristics. The sample excludes firms whose stock price was less than $5 and firms from regulated industries, such as finance and utilities.

The authors then examine and quantify the access to capital and level of capital expenditures for sample firms for the three years following the filing of the litigation. Three years is determined to be the average length of the typical legal action studied.

Abstractor’s Viewpoint

The authors use well-framed questions, substantial databases, and thorough analysis in their research. The findings are not surprising but are quite useful for investors as a verification of the assumed consequences for firms that have been subject to securities litigation. The authors systematically verify the costs to companies that have had such litigation actions. These costs include decreased access to external financing, an increase in the cost of capital, and a decrease in long-term investment activities in the years following the legal filings.

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