How Investor Attention Affects Fraud Discovery and Value Loss in Securities Class Actions

A securities class action is a complex event characterized by scarce information, high uncertainty, and increased information asymmetry between stakeholders and firms.  In our paper “The Effect of Investor Attention on Fraud Discovery and Value Loss in Securities Class Action Litigation,” we argue that investor attention helps to disseminate information regarding fraudulent activity and to shape the market’s reaction to the lawsuit filing.  Specifically, we find that higher investor attention improves learning about fraudulent activity and exacerbates the negative effect of the litigation event.  As more investors learn about fraudulent activity, the negative effect of litigation on a firm’s reputational capital increases.

Cumulative losses experienced by firms in litigation have two main direct and indirect components.  The direct losses of class action litigation include legal fees such as settlement disbursements, attorney’s fees, financial penalties imposed by the judicial system, and litigation insurance premiums.  These costs are a function of the severity of the lawsuit, plaintiff type, industry litigiousness, and size. These direct costs, although sizable, are covered by litigation insurance coverage to a certain extent.  Indirect costs, on the other hand, refer to damage to their reputation due to the lawsuit.  We estimate these indirect costs as a function of the severity of the alleged fraudulent activity and the likelihood of discovery by investor attention.  Specifically, the central argument of our study is that, as more information about the lawsuit is disseminated through the investor community, the reputational damages increase.

We begin with examining how investor attention affects the speed of information diffusion and fraud discovery.  We find that information about the upcoming litigation reaches the public and firms’ investors as early as two months before the actual filing.  In addition, higher investor attention accelerates fraud discovery and lawsuit filing. Our findings show that a 10 percent increase in investor attention accelerates the lawsuit filing by approximately 12 (13 percent of average filing delay in our sample) days.

Next, we study the effect of investor attention on the losses associated with lawsuit filing.  The losses associated with litigation are largely due to damaged corporate reputational capital, which we believe to be a function of investor attention.  Higher investor attention causes faster dissemination of information about the lawsuit and alleged fraudulent activity.  Upon receiving such information, investors assess the probability of the unfavorable verdict and potential damages from the litigation.  They also learn about the firm’s alleged wrongdoing and update their beliefs regarding the credibility of the firm.  Consequently, we hypothesize that investor attention affects the investor response to lawsuit filing and magnifies total losses from litigation.

Confirming the above hypothesis, we find that higher investor attention increases short-term losses (measured by abnormal returns around the filing announcement) in the form of negative abnormal returns to filing announcements.  Our results show that a 10 percent increase in investor attention causes an additional 2.2 percent (65.1 percent of our sample average) loss in firm value at the announcement of the lawsuit filing.  Furthermore, these short-term negative abnormal returns at the lawsuit filing date are not simply an overreaction and cause long-term reputational damages.  Taking a closer look at the firm’s long-term value losses, as measured by changes in Tobin’s Q, we also find that when investor attention is low, the filing of the lawsuit has no effect on the long-term value losses.  Surprisingly, our findings also show that the severity of the fraud has no effect on the total value losses.

Our paper makes three important contributions.  First, it illustrates the process of information diffusion in securities class action litigation.  Our results explain how investors receive and process the information about the lawsuit filing.  Second, our paper also identifies an important factor in determining the course of the legal process and driving the amount of short-term and, most importantly, long-term damages suffered by firms in class action litigation.  Our results suggest that investor attention is a more prominent driver of value losses than the severity of the lawsuit.  In addition, investor scrutiny is not limited to investors simply following the firm’s stock performance.  In the litigation process, attention provides the investors with important information about a firm’s future cash flows and operations and helps to shape the market response to the upcoming lawsuit. Finally, our findings contribute to the literature on investor attention. We use Google Trends data to measure investor attention and find that Google searches affect the fraud discovery and cumulative losses associated with litigation, even controlling for media coverage and trading volume. We conclude that in the litigation setting Google searches better convey the information about the firm and the lawsuit and are superior to other measures of investor attention.

This post comes to us from Anna Abdulmanova, a PhD candidate at the University of Missouri, Professor Stephen Ferris at the University of Missouri, Professor Narayanan Jayaraman at the Georgia Institute of Technology, and Pratik Kothari, a PhD candidate at the University of Missouri. It is based on their recent article, “The Effect of Investor Attention on Fraud Discovery and Value Loss in Securities Class Action Litigation,” available here.