Securities class actions (SCA) are an important governance mechanism in the U.S. securities market, but there is a significant debate about their costs and benefits to investors. SCA are intended to serve two key functions in investor protection: disciplining and deterring fraud and compensating aggrieved investors. On the one hand, SCA are more efficient and powerful than individual securities suits and, thus, can enhance investor protection. As for deterrence, there is growing evidence that lowering directors’ and officers’ (D&Os) liability risk using corporate charter provisions, D&O insurance coverage, or liability law changes can exacerbate agency problems by reducing managerial vigilance and increasing risk taking. SCA can enhance shareholder welfare by overcoming these problems.

On the other hand, the negative market reactions to events that increase SCA risk indicate that SCA can be costly to shareholders.[1] There are several reasons for this. First, SCA in the U.S. are often criticized because a substantial portion of the total recovery goes to attorney fees rather than compensating aggrieved shareholders. Second, the potential discipline and deterrence of SCA to individual wrongdoers can be undermined if most cases are settled out of court prior to trial, and the settlement costs are largely covered by D&O insurance. Third, a significant number of U.S. SCA suits are frivolous despite legal reforms that increased the hurdle of bringing a SCA (for example, the 1995 Private Securities Litigation Reform Act). Fourth, SCA can reduce management incentives to undertake positive net present value (NPV) investments that are innovative but risky and increase the difficulty of attracting and retaining high-caliber outside directors. Put another way, reducing SCA risk can be beneficial, particularly for growth firms with risky investment opportunities.

We contribute to this debate by assessing the effects of the introduction of U.S.-style SCA to China in 2020. China introduced SCA to enhance investor protection and combat financial fraud by listed companies. SCA were first proposed in deliberations of China’s revised Securities Law in December 2019. The revised Securities Law was passed on December 28, 2020, and became effective on March 1, 2020. Item 3 of Article 95 permits SCA suits in response to misrepresentations. A government established not-for-profit investor protection institution must serve as lead plaintiff if commissioned by more than 50 investors,[2] and the “implied opt-in and express opt-out” principle ensures that most eligible plaintiffs are included in an SCA suit. However, the law provides no detail on how SCA should be implemented. This was clarified and implemented by the Supreme People’s Court (SPC)’s Provisions on Several Issues Concerning Representative Actions Arising from Securities Disputes (hereafter the “SPC 2020 Regulation”) issued at the end of July 2020 following pilot studies in three lower intermediate courts.

SCA in China is intended to adapt U.S.-style SCA to reduce frivolous suits and litigation costs. First, before investors can sue a firm, the defendant needs to have received a regulatory sanction from the China Securities Regulatory Commission (CSRC), stock exchanges, or other government agencies due to violations in information disclosure or financial reporting. This prerequisites helps reduce frivolous SCA suits. Second, the SPC 2020 Regulation also stipulates that SCA must be filed in the intermediate court in the city where the listing stock exchange is, which reduces forum shopping and helps overcome potential local protectionism. Third, investor protection organizations are granted access to the ownership records held at the securities registration and clearing institutions to determine and register with the court the names of eligible investors unless investors expressly opt out of the class action. There are also the plaintiff-friendly court fee arrangements. In SCA, the case acceptance fee is not required to be paid in advance. A plaintiff whose case is denied by the court can request a reduction in court fees. Where an investor protection institution, as the lead plaintiff, moves to freeze the defendant’s assets to secure its ability to pay, the court can choose not to request that security be posted. These institutional differences provide a unique opportunity to study the impact of U.S.-style SCA in a different environment. These built-in designs, among others, help reduce frivolous suits and lower the cost of SCA.

By regulation in China, a firm can face a securities class action once it has received a regulatory sanction. Therefore, we define high-exposure firms as those that received a regulatory sanction by the end of 2019. We examine the one-day stock market reaction to the announcement of the SPC 2020 Regulation. We find that, on average, stock returns respond positively to the formal adoption of SCA. The average one-day abnormal return is 0.89 percent for firms that are more exposed to SCA and 0.68 percent for other firms. Both findings are statistically significant as is their difference.

We also find that stocks of firms that are also listed in the U.S. do not react significantly to SCA adoption in China presumably because they are already subject to SCA in the U.S. Interestingly, stocks of sample firms that are cross-listed in Hong Kong, Singapore, and London react positively to SCA adoption, perhaps because those jurisdictions do not allow SCA. These findings are different from U.S. studies (Johnson et al., 2000; Rizzo, 2018) that indicate increasing the threat of SCA reduces shareholder value. Therefore, investors appear to view China’s introduction of SCA as beneficial. This is intriguing because the deterrence function of private remedy has traditionally been weak in China.

We conduct additional cross-sectional tests that link market reactions to SCA adoption with firm characteristics before the SCA adoption for higher exposure firms. We find that the formal adoption of SCA appears more beneficial for high-exposure firms with weaker disclosure quality and poorer corporate governance. The results are expected because shareholders of such firms can benefit more from the deterrence and compensatory functions of SCA. We also find that the wealth effects of SCA are higher for firms that did not carry D&O insurance, which is consistent with the notion that D&O insurance can reduce the deterrence of shareholder litigation and thereby reduce managerial vigilance. Furthermore, consistent with U.S.-based evidence such as Johnson et al. (2000), the wealth effects of SCA adoption are lower for firms that innovate more. Presumably, SCA risk reduces management’s desire to pursue innovations that are inherently risky and can result in high stock return volatility.

We also conduct a difference-in-differences analysis of how high-exposure firms respond to SCA adoption by altering their behaviors compared with other firms as the control group. We use years 2018 and 2019 as the pre-adoption period and year 2020 (the most recent year for which we have data) as the post-adoption period. Preliminary results indicate that firms with higher SCA exposure are more likely to respond by initiating D&O insurance, switching to more reputable auditors, and improving financial reporting. These improvements are consistent with the patterns in short-term stock market event-study reactions and suggest the deterrence effect of SCA on firms’ opportunistic behaviors.

We offer a timely preliminary assessment of the recent formal introduction of securities class action litigation in China’s large and rapidly evolving economy. The SCA adoption is likely to play an important role in protecting investors and deterring fraud in China. On November 13, 2021, a Chinese court ruled in favor of investors in the first securities class action and awarded damages totaling $385.51 million against Kangmei Pharmaceuticals.[3] Our study sheds new light on the debate over the benefits and costs of U.S.-style SCA for investor protection. The Chinese SCA experience is relevant for other developing securities markets.

ENDNOTES

[1] See Johnson, M.F., Kasznik, R., Nelson, K.K. (2000). Shareholder wealth effects of the private securities litigation reform act of 1995. Review of Accounting Studies, 5(3), 217-233. Rizzo, A.E. (2018). Afraid to take a chance? The threat of lawsuits and its impact on shareholder wealth. Working Paper.

[2] There are two such investor protection institutions, the China Securities Investor Service Centre (CSISC) and the Securities Investor Protection Fund (SIPF).

[3] Reuters. November 13, 2021. Chinese court rules against Kangmei in ‘milestone’ case. Available at https://www.reuters.com/business/healthcare-pharmaceuticals/chinese-court-rules-against-kangmei-milestone-case-2021-11-12/.

This post comes to us from Warren Bailey at Cornell University, Fudan University – Fanhai International School of Finance, and China Institute of Economics and Finance; Hui Ma at Tongji University – School of Economics and Management; Rongli Yuan at Renmin University of China; and Hong Zou at The University of Hong Kong – HKU Business School. It is based on their recent paper, “Does the Threat of Securities Class Actions Add Value for Shareholders? Evidence from China’s 2020 Adoption of Securities Class Actions,” available here.