PSLRA and Litigation Backed Investor Speculation

Abstract

Following sharp drops in securities prices, newer investors may allege they purchased their shares based on fraudulent information from management in order to recover their losses in court, albeit at the expense of current and long-term shareholders. Inherently, following the release of information, the stock is worth more to new investors who have the option to sue, than it is for existing shareholders who do not; with the option value dependent on the uncertainty surrounding the information's accuracy. We examine how changes to this option, through the passage of the Private Securities Litigation Reform Act (PSLRA) in 1995, affected investors' incentive to speculate and drive up prices. While previous studies have documented a positive reaction to the proposed legislation, we found that the reaction was significantly negative for firms with higher market to book ratios, even when scaled by each firms' average market to book. Furthermore, we find that the reaction of firms in the highest valuation quartile was significantly more negative than the returns in the other quartiles, even after controlling for other factors previously found to be significant factors in explaining the markets' response to the changes.

Keywords: PSLRA, Law and Finance, Securities Litigation, Bubbles

JEL Classification: G38, E62