Securities law precedents, legal liability, and financial reporting quality
Benedikt Franke, Allen H Huang, Reeyarn Z Li, Hui Wang
Review of Finance, Volume 28, Issue 2, March 2024, Pages 413–445, https://doi.org/10.1093/rof/rfad032
Securities class actions are a major source of legal liability for US firms and should deter financial misreporting by increasing expected litigation costs for violating securities law. However, the common law doctrine of stare decisis grants judicial precedent a pivotal role in defining what constitutes violations of securities law. We investigate the effect of regional variations in securities law precedents on firms’ legal liabilities associated with financial misreporting and reporting decisions. Our results indicate that the deterrence of securities lawsuits depends on courts’ interpretations of written securities laws in previous rulings, subsequently altering firms’ reporting behavior.
We introduce a novel measure capturing the case law from each US Court of Appeals—the circuit courts—pertaining to financial misreporting. We begin by collecting circuit court rulings between 1999 and 2021 that have precedential value for future securities class action lawsuits related to financial misreporting. Subsequently, we code a ruling as defendant-friendly if it sides with the firm alleged to have violated a securities law, or not defendant-friendly otherwise. The findings reveal substantial variations in defendant friendliness across circuits and over time, consistent with the differing interpretations of identical securities laws and evolving judicial attitudes. Case-level analyses confirm that lower trial courts are more likely to dismiss cases when their home circuits accrue defendant-friendly rulings, underscoring the effect of precedents on firms’ regional litigation environments.
At the firm level, defendant-friendly precedents reduce the likelihood of lawsuits against misreporting firms. This effect is concentrated in non-egregious financial misreporting, consistent with the notion that courts’ attitudes are more influential when it is challenging to judge and establish managerial deceptive intentions in a court. Investors’ negative reactions to misreporting announcements are smaller for firms in circuits with more defendant-friendly precedents. This pattern suggests that investors expect lower litigation costs for misreporting firms in more defendant-friendly environments. Moreover, managers appear to anticipate the mitigating effects of defendant-friendly precedents on litigation costs, thus curtailing preventative actions and engaging in more aggressive misreporting.
By shedding light on firms’ heterogenous exposure to legal liabilities under the same statute, our study highlights the underexplored role of the judiciary in financial markets. With political polarization among legislators impeding the passage of new laws, the judicial interpretations of existing statutes may gain even more importance. Our method of measuring courts’ attitudes by using a comprehensive collection of relevant precedents is well grounded in legal theory and can be employed by future studies to assess firms’ litigation risks in other types of lawsuits.