Far from frivolous: The power of strong lawsuits

Insider trading erodes confidence in the stock market and reduces investor participation in a market they figure is rigged on behalf of the rich and powerful. Can shareholder lawsuits deter this self-serving behavior? According to Associate Professor of Accountancy Yinghua Li, the answer is yes, depending on who brings suit.

Insider trading makes for scandalous headlines, whether it’s Martha Stewart, founder and CEO of her own TV and publishing empire, being convicted of securities fraud or Raj Rajaratnam, founder of hedge fund management firm the Galleon Group, heading to prison on multiple counts of fraud and illegal trades. The practice has long made for box office hits, too: Think of the infamous “greed is good” line from 1987’s “Wall Street” or the excesses that abounded in 2013’s “The Wolf of Wall Street.” For the average investor, though, deals in which corporate leaders use material, private information to enrich themselves have more serious consequences.

The practice can erode confidence in the stock market and reduce other investors’ participation in a market they figure is rigged on behalf of the rich and powerful. What, if anything, can deter such self-dealing? Yinghua Li, associate professor of accountancy at the W. P. Carey School of Business, and colleagues from the Hong Kong Polytechnic University and Yeshiva University, found some answers when they looked at whether shareholder lawsuits, intended to discipline management, did in fact deter company executives from making insider trades. Li’s team found that so-called “opportunistic” sales by insiders declined significantly after lawsuits were filed, but only when the lawsuits had high merits and were rigorously pursued.

In those cases, the value of shares traded fell an average of 82.6 percent from the benchmark period to the period after the lawsuits were filed. The lawsuits’ deterrence effect also spilled over, they found, going beyond trades by executives of the targeted company and reducing the trades by leaders of the company’s peer firms. The latest research grew out of earlier work by Li and colleagues on the effectiveness of shareholder lawsuits in monitoring companies suspected of securities violations. That research showed that lawsuits against businesses had the most chance of success when institutional investors took the role of lead plaintiffs. Lawsuits with individuals as the lead plaintiff, on the other hand, resulted in more dismissals and lower settlement amounts. The research also showed that lawsuits led by institutional investors, more so than ones led by individuals, prompted the defendant firms to discipline managers and improve the independence of their boards of directors.

Costs vs. benefits of insider trading

Li and her colleagues next delved further into the world of shareholder lawsuits by looking at whether such lawsuits could deter insider trading. The prospect of a strong case against the insiders, the team theorized, would make top executives, directors and officers decide that the financial benefits of selling stock were not worth the cost of being dragged into the lawsuits or of losing their jobs. As perceived financial and reputational costs rose, the team believed, insiders would be less likely to sell stock based on information not yet available to other investors. “We’re basically trying to understand more about the private litigation system, which is available to more investors” than the public system with its limited resources, Li said. “We wanted to look at how firms modify their behaviors.” Prior studies on insider trading focused on estimating the perceived risk and the likelihood that a business would be sued.

Li’s team wanted to know the effect of actual legal cases on behavior, both in the firms targeted by insider-trading lawsuits and in their peer firms. “It’s important to know the effects of actual lawsuits, because we know the litigation system is very, very costly,” Li said. “We have a lot of settlements that go into the pockets of the lawyers, so some people think this is a waste of money and resources. It also takes a lot of time away from management so that they cannot focus on their firm’s core operations.” Using data from actual court cases was just one of the ways that Li’s team’s research broke new ground. The team analyzed data from the Securities Class Action Services and other databases involving 1,611 class-action lawsuits filed between 1996 and 2009. For each lawsuit, they identified a benchmark period before the class period, a class-action period during which outside investors unknowingly suffered losses, and a post-filing period. They then compared trading volumes after the lawsuit filing and those in the benchmark period. They also furthered research on shareholder lawsuits by developing a new measure.

They called it a composite lawsuit strength index, theorizing that the stronger the lawsuit, the more likely insiders would be to pull back on their trading. Besides noting whether the lawsuit alleged insider trading, their index included accounting-related characteristics such as whether the lawsuit claimed serious accounting irregularities, whether it also named an audit firm and whether it involved an earlier financial restatement. Combining the actual cases with the lawsuit strength index, they found that strong lawsuits did indeed create a significant deterrent effect against insider trading in the targeted firms. Weak lawsuits, or those bearing few of the index’s characteristics, made little difference in the number of insider sales. To distinguish between routine trades that were likely made to balance a portfolio and opportunistic trades that could indicate felonious intent, Li and her colleagues also looked for patterns in the timing of trades. They found little difference in the amount of trades that happened regularly, but a significant drop in opportunistic ones occurring after the lawsuit filing. Skeptics have pointed to other reasons for the decline in insider trading after lawsuits, including a drop in the company’s stock price, the exercising of stock options and executive turnover. Li’s team controlled for these factors, and still found that strong lawsuits deterred insider trading.

Peer firms take notice

The team also advanced the research by looking not just at specific deterrence, in which enforcement is aimed at certain individuals, but at general deterrence, in which offenders are held up as examples to their peers. “If this only works for sued firms, then the potential impact is more limited,” Li said. “But if … all the other firms are also trying to restrain from engaging in such opportunistic behaviors, this will have definitely higher social benefits.” To see whether lawsuits against specific companies had a general effect on peer firms, the team identified peer firms that are in the same industry as the targeted firms.

They found a spillover effect, in which peer firms also showed reduced trading volumes. Even lower-scoring and potentially frivolous lawsuits deterred trades among peer firms, which probably perceived increased risk in those lawsuits. “We do have evidence showing private litigation can be a very powerful and effective tool for constraining insider trading, but only when they are properly enforced,” Li said. Frivolous lawsuits, on the other hand, will have limited social value because of their limited impact on targeted companies’ misbehaviors. Li suggests that future research could look at whether private, investor-led lawsuits deter more insider trading than enforcement actions brought by government agencies such as the U.S. Department of Justice and the U.S. Securities and Exchange Commission. “Before we started the project, we had so many allegations that private lawsuits are frivolous, that they are launched by lawyers who just are mainly interested in pursuing personal benefit,” Li said. “So it’s definitely good news to find that the litigation system does work, and if the system is properly implemented, the lawsuits that are filed do have true merits.”

Bottom line

Various stakeholders in the issue of shareholder lawsuits over insider trading could learn from the research, Li said. Specifically:

• Chief executive officers, chief operating officers, chief financial officers and company directors should pay special attention to the fact that courts frequently treat insider trading as evidence of intent to commit fraud. Executives who want to reduce their company’s risk of lawsuits will refrain from making opportunistic trades.
• Auditors and other accounting professionals can examine corporate leaders’ behavior in assessing the risk of working with a firm. If they determine the firm is a higher risk, they can step up their auditing efforts.
• Investors can better appreciate the value of shareholder lawsuits, not just for seeking compensation for damages but for promoting more responsible behavior by corporate leaders and those at peer firms. Institutional investors, in particular, can look at increasing their participation in strong lawsuits and pushing for more change in a company.
• Regulators and other public agencies can look at private lawsuits as complementary to their own enforcement efforts. Given limited resources, they can focus on the stronger lawsuits.