Litigation Settlements, Market Expectations, and Financial Distress Costs

Abstract

This study examines stock returns around announcements of litigation settlements to investigate the market expectations of corporate litigation outcomes and the importance of financial distress costs. Prior research regards a settlement as an exogenous shock; however, this study draws from analytical models in the economics literature to analyze how the market forms expectations prior to settlements and how these expectations affect market reactions after the announcement of a settlement. Consistent with the implications of these models, we find that returns around settlements are more positive when higher-stakes lawsuits are settled. We also find evidence of the existence of financial distress costs, although our results contradict a conclusion drawn in prior research — that the primary benefit of litigation settlements is the unexpected relief from financial distress.

Keywords: litigation settlements, financial distress

JEL Classification: G14, G33, K41, M40