Close to 40 percent of all companies listed on major U.S. stock exchanges have been targeted by a securities class action lawsuit at least once between 1996 and 2017, according to the Stanford Securities Class Action Clearinghouse. These lawsuits are not only common but increasingly popular, with a record number of cases filed in the past two years. Given their prevalence, understanding the economic implications of the current securities litigation system is important.
Securities class action lawsuits can be socially beneficial if they deter wrongdoing, curb managerial rent extraction, and compensate injured shareholders. However, class actions have a widely discussed dark side: law firms have an incentive to bring weak lawsuits in the hope of securing a large settlement (e.g., , ). Faced with the prospect of entering a long and resource-intensive legal dispute, and faced with the risks of an imperfect judicial process, firms may be willing to settle cases even if the allegations are untrue. This type of meritless litigation is socially wasteful: It does not punish wrongdoing, it hurts corporate shareholders, it may distract managers from running their companies, and it is a burden on the judicial system.
The aim of our paper is to provide novel, large-scale evidence on the economic costs of meritless class action litigation. Such evidence is important: Without a good understanding of these costs, it is impossible to design optimal policy and to accurately evaluate the trade-offs inherent in any piece of regulation meant to curb meritless litigation. So far, large-scale evidence on the economic costs of meritless class action litigation is surprisingly scarce, and our results indicate that such costs may be substantially higher than commonly thought.
We find that meritless securities class action lawsuits disproportionately target firms that generate valuable innovations. This is an important finding, because ex post punishment for successful innovators creates disincentives for all firms to innovate ex ante, according to most standard models. Given that successful innovation is a key driver of economic growth, meritless class action litigation is potentially a hidden tax on innovation and may distort firms’ incentives to invest in it.
A key empirical challenge is identifying firms that create valuable innovation. To overcome this challenge, we build on recent work by Kogan et al. (2017) (, KPSS). KPSS propose a new firm-level measure of the quality of innovation (“innovation success”). The measure is derived from stock-market reactions to new patent grants and captures the private economic value of innovations. Another challenge is to measure lawsuit merit, which is inherently unobservable. We address this challenge by showing that our results are robust to a variety of proxies for lawsuit merit that have been proposed in the literature.
The core finding in our paper is that successful innovators (measured using the KPSS innovation success measure) are substantially more likely to be the target of a meritless class action lawsuit than other firms in the same industry and year. Hence, meritless lawsuits fall disproportionately on successful innovators. We also find that, on top of making a lawsuit more likely, innovation success is associated with greater losses to shareholders from a meritless class action filing. While the average successful innovator loses about 3.0 percent of its market capitalization in the seven days around such a filing, the average non-successful innovator loses only 1.9 percent. This shows that meritless litigation is especially costly for firms with valuable future growth opportunities. If successful innovators were smaller than their peers, higher percentage losses would not necessarily translate into higher dollar losses. In fact, however, successful innovators are generally much larger, and the corresponding dollar losses in the seven days around a filing are $148 million for the average successful innovator but only $12 million for the average non-successful innovator.
Combined, these findings suggest that more successful innovation is associated with both a greater probability of being subject to a meritless class action lawsuit and a greater loss from being sued. The expected costs of meritless class actions are thus particularly high for the most innovative firms. To the best of our knowledge, our paper is the first to establish this fact.
We address potential endogeneity concerns using a range of different approaches (see our complete paper for details), including (i) a rich set of control variables, (ii) alternative proxies for lawsuit merit, (iii) exploiting the timing of patent grants and lawsuit filings, (iv) different sets of fixed effects, and (v) instrumental variable regressions. Our regressions make sure that general trends in variables such as innovation intensity, litigation propensity, and dismissal standards, across both time and industries, are not causing our results. While we do find a positive link between meritless lawsuits and innovation success, we do not find a statistically significant link for meritorious cases, which suggests that there is no relation between successful innovation and class action lawsuits more broadly. In sum, our findings suggest that the U.S. securities class action system imposes a substantial implicit tax on innovative firms in the form of meritless litigation.
We estimate the incremental cost of successful innovation, measured as a loss in shareholder value due to increased meritless class action litigation for a one-standard-deviation change in innovation success, to be around $1.1 million per year for the average firm in our sample. (We believe our estimates are, if anything, conservative, and likely to underestimate the true costs of meritless litigation following successful innovation.) To put this number in perspective, it represents 3.6 percent of the increase in profits due to the innovation over the next five years. Interpreted as a tax on profits, this number is economically significant.
An important implication of our results is that this implicit tax decreases the marginal benefit of producing successful technological innovation ex ante, which may lead firms to innovate less than they optimally would. Less investment in innovative activities leads to reduced firm growth and reduced growth in aggregate productivity, as well as less knowledge spillovers, which further slows economic growth (e.g., ).
As a final step in our paper, we examine why successful innovators have an elevated risk of being targeted. The answer, we propose, is that firms that innovate successfully become more profitable, make additional investments in capital and labor, and generate additional sales. Importantly, all three features make a firm more attractive as a litigation target. First, higher profits imply that firms have deeper pockets. Second, managers who invest in capital and labor, and are therefore busy growing their firm, cannot afford to waste time. Finally, firms who are about to launch new products are particularly vulnerable to bad publicity stemming from a lawsuit.
We also propose, test, and find evidence for an additional reason: successful innovators use more optimistic language in their annual reports and more forward-looking statements in the MD&A section of their annual reports after a successful patent is granted. This is intuitive, given that successful innovations are expected to generate substantial value during the 10 years of a patent’s protection, and given that managers will speak more, and more optimistically, about innovations expected to add substantial value to the firm. Unfortunately, for innovating firms, forward-looking and optimistic statements are likely to increase litigation risk. First, relative to statements about current events, forward-looking statements, even if made in good faith, are more likely to be proven wrong ex post, and may therefore be easier to attack. Second, Rogers et al. (2011) () provide direct evidence of a link between optimistic language and subsequent litigation.
We consider additional explanations, but find less support for them in the data. In particular, we do not find evidence that firms that innovate successfully are more likely to experience events that tend to prompt litigation, such as large stock drops or missed earnings targets.
In sum, we contribute novel evidence to show that meritless securities class action lawsuits impose substantial economic costs on innovative U.S. firms. The resulting distortions in firms’ incentives to innovate may have important implications for economic growth and the competitiveness of the U.S. economy.
 Romano, Roberta, 1991, The shareholder suit: Litigation without foundation? Journal of Law, Economics, & Organization 7, 55-87.
 Bondi, Bradley J., 2010, Facilitating economic recovery and sustainable growth through reform of the securities class-action system: Exploring arbitration as an alternative to litigation, Harvard Journal of Law & Public Policy 33, 607.
 Kogan, Leonid, Dimitris Papanikolaou, Amit Seru, and Noah Stoffman, 2017, Technological innovation, resource allocation, and growth, Quarterly Journal of Economics 132, 665-712.
 Bloom, Nicholas, Mark Schankerman, and John Van Reenen, 2013, Identifying technology spillovers and product market rivalry, Econometrica 81, 1347-1393.
 Rogers, Jonathan L., Andrew Van Buskirk, and Sarah L. C. Zechman, 2011, Disclosure tone and shareholder litigation, The Accounting Review 86, 2155-2183.
This post comes to us from Professor Elisabeth Kempf at the University of Chicago’s Booth School of Business and Professor Oliver Spalt at Tilburg University and CentER, both of whom contributed equally. It is based on their recent article, “Taxing Successful Innovation: The Hidden Cost of Meritless Class Action Lawsuits,” available here.