Is Everything Securities Fraud?

Abstract

Securities litigation is a virtually inevitable fact of life for any public company. Often, investors sue because the firm’s managers engaged in fraud that directly harmed the shareholders – say, by doctoring the firm’s financials, or lying about known business prospects. However, shareholders also sue their companies when those companies engage in conduct that primarily harms a different set of constituents. When a drug on the market proves to have dangerous side effects, a faulty car battery bursts into flames, or an oil rig explodes, it’s difficult to say that the most direct victims are the companies’ shareholders. Yet shareholders commonly sue under the federal securities laws based on precisely this kind of conduct, on the ground that the managers should have better disclosed the underlying facts, and investors were harmed by the resulting drop in stock price because they did not.

This paper assesses the pervasiveness, attributes, and impact of these lawsuits. I find that roughly 16% of securities class actions arise from conduct where the most direct victims are not shareholders. However, I find that these cases have roughly a 20% lower likelihood of being dismissed, and settle for significantly higher amounts. These results persist even when controlling for variables such as firm size, class period duration, court expertise, and indicia of merits of the lawsuit, such as institutional investors as lead plaintiffs, earnings restatements within the class period, and whether the complaint cited an SEC investigation. These lawsuits are also more likely to be brought against large defendant firms, more likely to involve an institutional investor as a lead plaintiff, and much more likely to involve a non-SEC investigation or inquiry than cases where the primary victims are shareholders. I argue that although these cases may have deterrence value, the fact that they are likely to be more successful and lucrative may diminish incentives for shareholders to monitor their managers to prevent them from pursuing profitable conduct that harms outsiders.