Many academics, managers, lawyers, and others believe that nonmeritorious securities fraud class actions – those that will be dismissed or settled for nuisance amounts – damage corporate reputations. For example, litigation public relations experts claim that individuals adopt a “guilty until proven innocent” view of litigation (Thurber 2023), so the effect of a lawsuit on a company’s “reputation and stock price—even a lawsuit it views as frivolous—can be dire” (Weidlich 2004). Similar claims motivated the enactment of the Private Securities Litigation Reform Act of 1995 and recent attempts at legal reform, such as the Fairness in Class Action Litigation Act and Lawsuit Abuse Reduction Act, which the U.S. House of Representatives passed in 2017. However, these claims contradict survey findings that only misconduct damages corporate reputation and seem paradoxical: Why would market participants be fooled by weak cases when critics can easily see through them?
In a new paper, we examine that question. We match firms that were sued with firms that were also subject to bad economic outcomes and had similar litigation risk but were not sued. We then use a generalized difference-in-differences design to examine the effect of securities class actions on corporate reputation. We use a relatively direct proxy for corporate reputation based on Fortune’s “Most Admired Companies” list. Contrary to common claims, we find a consistent lack of evidence that dismissed cases or nuisance settlements damage reputation. In contrast, when settlements appear meritorious, we find economically significant reputational damage that is largest for the strongest cases. Further, this reputational damage occurs nearly immediately after the filing rather than at the case resolution.
These findings are robust to numerous alternative specifications and proxies for corporate reputation. For example, we reach similar findings when we estimate our tests only in the sample of sued firms, use entropy balancing instead of a matched sample, or include additional control variables for reputation-rebuilding activities or potential confounding events. Further, we reach similar findings when we use a proxy for reputational damage by examining whether firms lose Fortune’s reputation coverage. We also reach similar findings using market-based proxies for reputational damage by testing for investor responses to earnings announcements). That is, investors only view the credibility of earnings as decreasing for firms whose cases are meritorious.
We show that reputational damage measured using Fortune data is associated with lower stock returns on the date the suit is filed, validating the proposition that changes in this measure of corporate reputation are relevant to investors’ assessment of firm valuation. Further, we test possible reasons for our results. Textual analysis reveals that the initial legal complaints provide information on case merits associated with the ultimate reputational damage firms experience. In addition, we find abnormally high searches of sued firms’ SEC filings around litigation dates, consistent with the proposition that litigation increases firm scrutiny.
Finally, we show that commonly used, indirect measures of corporate reputation based on stock returns are highly problematic in the securities class action setting and may explain the common belief that nonmeritorious cases damage corporate reputations. Specifically, investor harm (i.e., damages) is related to large, negative stock returns and is a required element in securities litigation. Because plaintiffs’ lawyers do not file cases without large, negative returns, returns-based indirect measures will find reputational damage for every securities class action filing. Thus, market value declines alone should not be considered evidence of reputational damage in securities litigation.
Our study has several important implications for managers, policymakers, and academics. Managers may feel more confident pursuing quick settlements for nonmeritorious cases, knowing reputational damage is unlikely. At the same time, the fact that actual misconduct is associated with economically significant reputational damages should further deter managers from committing fraud. Policymakers could consider the potential benefits of procedural reforms to deter nonmeritorious securities class actions because a significant majority appear nonmeritorious, which would free up judicial resources. Academics are encouraged to use more direct measures of reputation where available and to be cautious when using stock returns as a proxy for reputational damage in related settings. Further, academics should focus on meritorious litigation when examining the effect of litigation on firm outcomes.
Thurber, R. (2023). What is litigation PR, and how can you control lawsuit news? Reputation.CA. April 7, https://www.reputation.ca/what-is-litigation-pr/.
Weidlich, T. (2004). PR gavel-to-gavel. PRweek, 7(12), 1.
This post comes to us from Professor Dain C. Donelson at the Tippie College of Business at the University of Iowa and professors Antonis Kartapanis and Christopher G. Yust at Mays Business School at Texas A&M University. It is based on their recent article, “The Merits of Securities Litigation and Corporate Reputation,” forthcoming in Contemporary Accounting Research and available here.