Study finds class actions deter financial wrongdoing

Posted on: October 13th, 2011 by Steve Larson
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New research by finance and accounting professors at Rutgers and Emory Universities’ business schools finds that class action lawsuits are a strong deterrent to misrepresenting corporate financial results and other wrongdoing.  And, in many instances, class actions are a stronger deterrent than SEC enforcement actions.

The research found statistically and economically significant deterrence associated with both SEC enforcement and class action lawsuits, according to Simi Kedia, Ph.D., MBA, associate professor of finance at Rutgers University School of Business.  The study, a working paper presented at conference and now being circulated for comment before publication, measured the effectiveness of the two primary methods of federal securities regulatory and law enforcement: “public” enforcement by the Securities and Exchange Commission; and, “private” enforcement through securities class action lawsuits.

A recent story by the New York Times’ Gretchen Morgenson reported on why private lawsuits are particularly important at a time when federal failure to enforce the law is considered one cause of our on-going financial-economic crisis and of public discontent with government: “When federal authorities don’t fulfill their obligation to enforce the law, they essentially give an imprimatur to the financial entities to do whatever they want and disregard the law,” said Kathleen C. Engel, a professor at Suffolk University Law School in Boston.  “To the extent there are places where shareholders and borrowers can pursue claims, they are really serving the function of the government.  They are our private attorneys general.”

“Lawsuits have long been a crucial method for shareholders to recover losses.  A February letter to the Securities and Exchange Commission from the general counsel of the California Public Employees’ Retirement System noted that private litigants in the 100 largest securities class action settlements had recovered $46.7 billion for defrauded shareholders.”

The new study found that in cases where both the SEC and class action lawsuits take action, on average private lawsuits precede SEC action by 297 days.

Not surprisingly, the strongest deterrence effect was found when both SEC proceedings and class actions are launched.

“Class action lawsuits can have positive externalities by curbing aggressive reporting behavior of peer firms,” the paper by Dr. Kedia and her colleagues states.  Indeed, class action lawsuits recover far more money — twice as much or more — from wrongdoers than SEC actions, according to sources cited by the professors.  And, in most situations, the deterrence value of class actions (in the absence of SEC enforcement) is actually stronger than that of the SEC when acting without a corresponding class action.

This first study to validate the enforcement value of class actions through empirical research was conducted by Dr. Kedia and Shivaram Rajgopal, Ph.D., Chartered Accountant and Schaefer Chaired Professor of Accounting at Emory University’s Goizueta Business School, with Jared Jennings, a doctoral student at the University of Washington’s school of business.  Their paper, entitled “The Deterrence Effects of SEC Enforcement and Class Action Litigation,” reports their analysis of 474 SEC actions alleging financial statement misrepresentation and 1,111 class action lawsuits alleging violations of Generally Accepted Accounting Procedures during 1996 through 2006.  The paper was first circulated for comment in June.

Among other findings, the professors reported:

* “The SEC publicly targets a very small fraction of firms — in our sample only 0.74% of firms were subject to SEC enforcement.  At these low levels of enforcement, a substantial fraction of misreporting is likely to go undetected.  Therefore, if potential miscreants consider the probability of detection to be too low, they are unlikely to change their behavior.”

* “Securities class action action litigation for alleged reporting irregularities is more likely against an average firm — in our sample 1.28% of firms are subject to class action litigation.  The greater likelihood of class action litigation, combined with higher monetary sanctions, likely renders lawsuits as a potentially effective way to deter reporting irregularities at peer firms.”