Do the Merits Matter Less after the Private Securities Litigation Reform Act?

Abstract

This essay provides evidence on the impact of the Private Securities Litigation Reform Act of 1995 (PSLRA) by examining all initial public offerings (IPO) from 1990 to 1999 and IPO-related securities class action litigation involving a mix of Section 11 and Rule 10b-5 antifraud claims. Others have provided evidence that the PSLRA increased the significance of certain merit-related factors, such as the presence of an accounting restatement, in determining the incidence and outcomes of securities fraud class actions. The increase in the importance of merit-related factors, however, is consistent with two possible hypotheses. First, the PSLRA may have reduced solely the incidence of nuisance litigation. Second, the PSLRA may have reduced the incidence of both nuisance litigation as well as a subset of the pre-PSLRA meritorious claims where the additional costs imposed by the PSLRA made such claims unprofitable from the perspective of plaintiffs' attorneys. This essay uses pre-PSLRA claims that resulted in non-nuisance outcomes to test between these hypotheses. The essay provides evidence that the pre-PSLRA non-nuisance claims lacking obvious "hard evidence" indicia of fraud (an accounting restatement or SEC action) would have faced (a) a lower probability of suit in the post-PSLRA period and (b) a greater likelihood of receiving a dismissal or low-value settlement in the post-PSLRA period. In determining the welfare implications of blocking frivolous suits, policymakers should therefore consider the negative impact of the PSLRA in also discouraging a significant fraction of non-nuisance litigation.

Keywords: Securities litigation, class actions, litigation risk, accounting fraud

JEL Classification: K23, K42