Stock market signals and consequences of securities class actions lawsuits: a microstructure perspective

Abstract

We perform a microstructure analysis of trading activities pre- and post-class period end-dates of securities class action lawsuits. We posit that these events are likely to significantly impact the spreads of affected firms, in addition to the well documented market capitalization loss that spurs the legal action. We detect neither meaningful widening of spreads nor change in put-call ratios ahead of the class period end-date, suggesting no microstructure or option open interest signal of the upcoming event. However, we present strong evidence of a significant degradation in market quality post the class period end-date based on widening spreads lasting for at least 60 trading days. We also document a trading volume spike and share price decline around the event date. Our research shows the impact on shareholders extends beyond the capitalization loss through wider spreads for defendant firms, while the same is not true for a control sample.

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Notes

  1. 1.

    D&O insurance indemnifies officers and directors of a corporation, or the corporation itself, for defense costs and potential losses a policy holder suffers related to legal action in connection with alleged acts or omissions pertaining to their actions in their capacity as directors and officers. Class action lawsuits under Rule 10b-5 of the Securities Exchange Act of 1934 are normally covered under these policies.

  2. 2.

    Note that even a $30 million market capitalization loss would not necessarily mean the entire amount is potentially recoverable via litigation. That would only be the case if ALL investors had purchased the shares at peak prices during the class period. In practice, only a small number of investors are eligible to participate in securities class action lawsuits thus the potential settlement is often a small fraction of the overall market capitalization loss.

  3. 3.

    § 240.10b-5 Employment of manipulative and deceptive devices. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. (Sec. 10; 48 Stat. 891; 15 U.S.C. 78j) [13 FR 8183, Dec. 22, 1948, as amended at 16 FR 7928, Aug. 11, 1951].

  4. 4.

    For more information see https://wrds-www.wharton.upenn.edu/pages/support/applications/event-studies/event-study-research-application/.

  5. 5.

    We calculate abnormal return as the difference between the daily return for each stock and the return of the S&P500 index. The returns were averaged for each day relative to the reference date (class period end or filing date) and then summed in order to obtain cumulative returns for a given period.

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Acknowledgements

All authors contributed to the study conception and design. Material preparation and data collection were performed by Antonio Figueiredo and Richard Holowczak. Analysis and study design were performed by Antonio Figueiredo, Shahid Hamid, and Richard Holowczak. The first draft of the manuscript was written by Antonio Figueiredo with contributions by Shahid Hamid, and all authors commented on previous versions of the manuscript. All authors read and approved the final manuscript.

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Figueiredo, A., Hamid, S.S. & Holowczak, R. Stock market signals and consequences of securities class actions lawsuits: a microstructure perspective. Rev Quant Finan Acc (2021). https://doi.org/10.1007/s11156-021-00957-6

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Keywords

  • Market quality
  • Microstructure
  • Liquidity
  • Spread
  • Litigation

JEL Classification

  • G14
  • G18
  • G38