Public companies face a wide range of legal claims, yet the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) have questioned whether public companies provide sufficient disclosure to warn investors of potential losses from these claims. More broadly, legal exposure factors into debates about risk disclosure, as the most consequential impact of a lawsuit may not stem from direct costs assessed by the courts but rather from how a case’s outcome affects a firm’s operations and prospects.
In a recent study, we provide insight into (1) the scope and dynamic landscape of firms’ legal exposure, (2) the drivers of existing disclosure practices, and (3) the value of taking a holistic view of legal threats to firms’ strategic trajectories. To do so, we collect a sample of 178,334 lawsuits filed against 222,913 defendants (representing 5,533 unique public companies) in federal district court from 2006 through 2021. Less than 0.6 percent of these cases stem from securities class action claims. The most frequent claims allege civil rights discrimination, breach of contract, theft of intellectual property, labor law violations, and racketeering.[1]
Corporate litigation varies considerably across time, industry, firm, and suit type. For example, overall lawsuit filings trend upward with opioid-related racketeering claims in 2017-2018 but trend downward in 2020 with COVID pandemic-related delays. Time-series and cross-sectional variation also reflect changing social, political, economic, and regulatory climates. For example, the number of antitrust cases falls after the 2007 Supreme Court decision in Bell Atlantic vs. Twombley, rises during the later years of the Obama administration, and declines during the Trump administration. Environmental suits surge in response to the Deepwater Horizon oil spill in 2010 but steadily decrease in the decade following the disaster. Within civil rights claims, we detect a sharp rise in recent years of website accessibility lawsuits under the Americans with Disabilities Act. Within IP claims, we observe a peak and subsequent decline in patent cases surrounding the passage of the America Invents Act in 2011.
We find that 2.7 percent of lawsuit-defendants disclose non-securities litigation in their SEC filings at any point during or after the legal process. In contrast, more than 90 percent of defendants facing securities class action lawsuits disclose the litigation. We also observe the rate of disclosure for non-securities cases declines over our sample period. For cases that the firm lost, the decline in disclosure rate falls from a peak of 11.0 percent in 2010 to 4.4 percent in 2020. This decline in disclosure coincided with a decline in SEC scrutiny. In particular, the frequency of SEC comment letters related to legal risk and contingencies peaked in 2010 when the FASB considered enhanced disclosure requirements and then dropped significantly once the FASB abandoned the project.
Examining the determinants of lawsuit disclosure, we find that materiality, public and private enforcement, the quality and quantity of information available to firms’ stakeholders (including the desire to control the narrative surrounding the lawsuit), and firm characteristics factor into managers’ decisions to disclose these claims. Collectively, our evidence suggests that managers consider numerous factors beyond those considered in the authoritative guidance on contingent liability disclosure in deciding whether to disclose a lawsuit.
As noted earlier, the impact of litigation can extend well beyond the direct costs assessed by the court, affecting a firm’s operations and strategic trajectory (consider the recent antitrust cases against Jet Blue that forced an end to its alliance with American Airlines and that ended its merger with Spirit Airlines). Moreover, some argue that the true costs of litigation stem from the legal, reputational, and time costs associated with a lawsuit filing, regardless of the outcome. While individual claims may differ in nature and severity, their cumulative impact — in terms of resources spent, management distraction, and tactical pivots undertaken — can introduce investor and management uncertainty.
Consistent with these notions, our final set of analyses provide evidence of a link between aggregate legal exposure and stock return volatility. Notably, even when limiting attention to non-securities cases that are not disclosed to investors, the link between pending cases and volatility remains significant. Existing guidance related to reporting loss contingencies focuses on the materiality of individual lawsuits (or the aggregation of lawsuits that share the same factual issues), the specific relief sought, and the estimate of direct costs. Yet, these findings suggest value in taking a holistic view when considering the role that litigation plays in shaping the strategic trajectory of the firm and, thus, when assessing firm risk.
Collectively, we provide new evidence on the frequency of litigation filed in federal district courts, the factors that shape its disclosure, and its relevance to financial statement users at both the individual lawsuit level and the aggregate level. In so doing, we shed light on alleged corporate misbehavior of interest in many current contexts. This paves the way for future investigation into an array of current issues, including climate change, civil rights discrimination, cybersecurity, fair pay practices, big tech monopoly power, and intellectual property protection. Such exploration could inform a broader discussion about the relevance and usefulness of registrants’ risk disclosures, as well as a greater understanding of the litigation environment faced by firms in many under-researched contexts.
ENDNOTE
[1] This excludes personal injury cases, which are the most numerous, but that concentrate in specific industries and firms. Approximately two-thirds of over 300,000 cases were filed against firms in the healthcare industry, and over 75 percent of all personal injury cases were filed against just eight companies during our sample period. For a host of reasons, we analyze those claims separately.
This post comes to us from Mary Brooke Billings at New York University, Robert W. Holthausen at the University of Pennsylvania, Christine Petrovits at the College of William and Mary’s Mason School of Business, and Danye Wang at the University of Iowa. It is based on their recent article, “Incidence, Disclosure, and Risk of Corporate Litigation: Insights from Federal Court Filings,” available here.