SEC Investigations and Securities Class Actions: An Empirical Comparison

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday December 21, 2012 at 9:58 am
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Editor’s Note: The following post comes to us from Stephen J. Choi, Murray and Kathleen Bring Professor of Law at New York University School of Law, and Adam C. Pritchard, Professor of Law at University of Michigan.

In our paper, SEC Investigations and Securities Class Actions: An Empirical Comparison, we compare investigations by the SEC with securities fraud class action filings involving public companies. Critics of securities class actions commonly contrast those suits with enforcement actions brought by the SEC. According to those critics, the SEC is superior to plaintiffs’ lawyers both in targeting defendants and securing sanctions against them. With respect to targeting, critics of securities class actions claim that the settlement dynamics of class actions encourage plaintiffs’ lawyers to bring a high proportion of non-meritorious suits. If companies must pay substantial costs when they are unjustifiably targeted, the deterrent value of class actions is diluted. With regard to sanctions, class action settlements are almost always paid by the company and its directors’ & officers (D&O) insurance; the corporate officers responsible for the fraud rarely contribute. By contrast, SEC enforcement actions commonly lead to payments from the responsible officers; the SEC also has the authority to bar individuals from serving as directors and officers of public companies, a career death sentence for the individual subjected to a bar. Critics of class actions argue that the combination of more precise targeting of suits and more individual sanctions yields a stronger deterrent punch for SEC enforcement relative to class actions.

We think that critics contrasting securities class actions and SEC enforcement actions may be comparing apples to oranges. The comparisons ignore a critical institutional detail: SEC enforcement actions are brought only after the SEC has done a substantial investigation into the alleged wrongdoing. That investigation is aided by the SEC’s subpoena power, which yields cooperation from defendants even when it is not explicitly invoked. By contrast, plaintiffs filing securities class actions are barred from seeking discovery from defendants while a motion to dismiss is pending. Accordingly, instead of looking at SEC enforcement actions, we shift the focus to SEC investigations. Comparing SEC investigations with class actions involving public companies allows us to compare public and private enforcement on a more level playing field.

We use a number of metrics to compare SEC investigations and private class action filings. We employ an event study around the first public announcement of the underlying securities law violation and the first public announcement of an SEC investigation or class action filing. Given the need to prove loss causation and damages, we predict the class action will target larger stock price drops. We find that the market reacts significantly more negatively to announcements of securities law violations that lead to a stand-alone class action filing as opposed to a stand-alone SEC investigation.

We assess several measures that capture how the market views a company after an announcement of a potential securities law violation. We are interested in market perceptions of the level of information asymmetry, the reliability of management, and accuracy of disclosures. Our measures include changes in institutional ownership, analyst forecast dispersion, stock turnover, and the bid-ask spread. We find that when a company faces both an SEC investigation and class action filing there is significantly greater loss of market confidence relative to situations in which there is only an SEC investigation or a class action filing. Moreover, we also find no evidence that stand-alone class actions have weaker market indicia of disclosure unreliability than stand-alone SEC investigations. Indeed, two of our measures—decrease in institutional ownership and stock turnover—show a stronger correlation with stand-alone class actions than with stand-alone SEC investigations.

We also assess the consequences for companies and their officers that flow from SEC investigations and class actions. For this analysis, we compare the monetary sanctions: civil penalties and settlements. We find that the combination of both an SEC investigation and a class action filing is more likely to produce a settlement than an investigation or class action filing standing alone. We also find stand-alone class actions are more likely to produce a settlement, and settlements are bigger, relative to stand-alone SEC investigations. The dynamics of settlement in class actions make it unlikely that individual officers will contribute to the settlement of class actions, so settlements may be only weakly tied to individual deterrence. We therefore look to an alternative measure of consequences for corporate officers: executive turnover. We find that CEOs and CFOs are more likely to resign under circumstances related to a stand-alone class action filing as opposed to a stand-alone SEC investigation.

Overall, the evidence we present here undercuts the conventional wisdom with regard to the relative merits of SEC enforcement and securities fraud class actions. Clearly, the strongest cases are those in which the SEC and the class action bar are both proceeding against a company. The more surprising result of our study, however, is that when the SEC or the class action bar goes alone, class actions are more closely associated with unreliable disclosures than are SEC investigations. Moreover, stand-alone class actions appear more likely to result in settlements, and those settlements are of greater magnitude, than stand-alone SEC investigations, and officers are more likely to be terminated. Our findings cast doubt on the claim that SEC investigations are superior to class actions in targeting fraud and imposing sanctions on companies.

The full paper is available for download here.


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