1. 1 Event Studies and Shareholder Wealth Implications of Corporate Lawsuits

2. 2 Event Study  Event study focuses on the movement of stock prices due to unexpected actions by l Managers l Investors l Policy makers that might affect firm values.  Benchmark for evaluating the benefit of corporate or securities laws is whether they improve investor welfare.  Hence, natural fit between the event study methodology and the economic efficiency of corporate and securities laws.

3. 3 Event Study  Share Price: Time- and risk-discounted present value of all future cashflows.  In a semi-strong efficient market: Only an unanticpated event can change share price.  Change in share price = Expected changes in l Future cashflows, or l Riskiness of these cashflows.

4. 4 Four Component Parts of Event Study  Defining the event and announcement day(s).  Measuring the stock’s return during the announcement period.  Estimating the expected return of the stock during this announcement period (in the absence of the announcement).  Computing the abnormal return (actual return minus expected return) and measuring its statistical and economic significance.

5. 5 Defining the event and announcement day  Day of public announcement of the event, for example, a tender offer. Potential problems: l Leakage prior to public announcement. Some researchers address this by considering returns prior to public announcement. Problems; –Leakage over how many days/weeks/omths? –Noise-to-signal increases with announcement period. l Uncertainty over success of tender offer. Final resolution may not be known for months or years. l If market is semistrong form inefficient, market is unable to immediately (same day) understand and incorporate the impact of announcement on the company’s value; the market needs more time (days/months/years) to understand and incorporate… l Some events have several distinct event dates.

6. 6 Events with Several Distinct Event Dates  Enactment of a Statute Introduction of bill. Committee hearings. Vote by legislative chambers. Executive signature. Resolution of ambiguity by courts/agencies.  Can consider entire period from introduction to signature/resolution of ambiguity. But, noise-to-signal increases with analysis period.  Can consider only the “five” events. Introduces researchers’ bias/priors on what a significant/relevant event is.

7. 7 Measuring the stock’s return  Share price, close of 4/11/02: $54.00  Share price, close of 4/12/02: $59.00  Share price, close of 4/13/02: $62.00 If announcement at 11am on 4/12/02 Announcement day return = ((59-54)/54)*100% If announcement at 5:30pm (after close of trade) on 4/12/02 Announcement day return = ((62-59)/59)*100%

8. 8 Estimating the Expected Return  Statistical models of expected return The constant expected returns model: R it = μ i + ε it. where R it is the return for stock i over time period t, μ i is the expected return for stock i, and ε it is the usual error term. The market model: R it = a i + b i * R mt + ε it where, a i and b i are firm-specific parameters, and R mt is the market return for the period t.

9. 9 Estimating the Expected Return  Economic models Capital Asset Pricing Model (CAPM) R it = R f + β i * (R mt - R f ) + ε it where, R f is the riskfree rate and β i is the beta or systematic risk of stock i. Arbitrage Pricing Theory R it =  0 +  i1 F 1t +  i2 F 2t +... +  in F nt + ε it where, F 1, F 2,..., F n are the returns on the n factors that generate returns, and  are the factor loadings. Statistical models not based on theory. Economic models are theory- based.

10. 10 Statistical Significance of Abnormal Return  Abnormal return = Actual return – Expected return  Statistical significance of abnormal return measured by a t- statistic.  t-statistic of abnormal return = (abnormal return)/(standard deviation of abnormal return)  Standard deviation of abnormal return can be measured from prior returns of the stocks (time-series), or the return of the stocks during the announcement period (cross-section).

11. 11 Statistical Power of Event Studies  Null Hypothesis: Event has no impact on firm value.  Alternate Hypothesis: Event increases firm value by 1%.  Under the assumption the alternate hypothesis is true, the power of the event study is the probability of observing a statistically significant test statistic.  MacKinlay (1998): Table 2, Figures 3a, 3b, and 4.

12. 12 Statistical Power of Event Studies  MacKinlay (1998): Table 2, Figures 3a, 3b, and 4. For a one day announcement window, a sample size of 25 firms, and a two-sided test with a 5% significance level, the probabilities of detecting an abnormal return of 0.5%, 1.0%, and 2.0%, are 24%, 71% and 100%, respectively. · If the sample size were increased to 50 firms, the probabilities of detecting an abnormal return of 0.5%, 1.0%, and 2.0%, are 42%, 94% and 100%, respectively. · If the sample size were increased to 100 firms, the probabilities of detecting an abnormal return of 0.5%, 1.0%, and 2.0%, are 71%, 100% and 100%, respectively. · For a two days announcement window (or equivalently, doubling of the standard deviation of the event day abnormal return), and a sample size of 25 firms, the probabilities of detecting an abnormal return of 0.5%, 1.0%, and 2.0%, are 10%, 24% and 71%, respectively. · For this two days announcement window and a sample size of 50 firms, the probabilities of detecting an abnormal return of 0.5%, 1.0%, and 2.0%, are 14%, 42% and 94%, respectively. · For this two days announcement window and a sample size of 100 firms, the probabilities of detecting an abnormal return of 0.5%, 1.0%, and 2.0%, are 24%, 71% and 100%, respectively.

13. 13 Statistical Power of Event Studies  Power of event study diminishes as The sample size decreases. The event period increases. As economic magnitude of event decreases.  Why does the power of event study diminish as sample size decreases?

14. Statistical Power of Event Studies Average annual standard deviation (%) Number of stocks in portfolio Diversifiable risk Nondiversifiable risk 49.2 23.9 19.2 1102030401000

15. 15 Statistical Power of Event Studies  Can an event study be conducted with just one firm? This question is relevant for corporate managers involved in court cases or regulatory injunctions involving only one firm. Does not invalidate event study methodology. Statistical power likely to be low. Announcement period return reflects effect of event and effect of unrelated information item(s). (In large sample effect of unrelated item cancels out.)

16. 16 Shareholder Wealth Implications of Corporate Lawsuits  Bhagat, Brickley and Coles (JFE, 1994)  Bhagat, Bizjak, and Coles (FM, 1998)  Costs and benefits of Filing a lawsuit Settling Going to trial Likely to be a function of Type of suit (antitrust, breach of contract, etc.) The opposition (government, another corporation, etc.)

17. 17 Shareholder Wealth Implications of Corporate Lawsuits Suits involving Corporations and Government Entities  Net Present Value (NPV) = Present value of benefits – Present value of costs.  Corporate managers take actions in litigation that have positive NPV, and eschew courses of action that have negative NPV. Reasonable approximation assuming Firms’ low cost of access to capital markets. Informational efficiency of stock markets. Performance-contingent management compensation.  Government decision-makers unlikely to use the NPV rule.

18. 18 Shareholder Wealth Implications of Corporate Lawsuits Suits involving Corporations and Government Entities  Government decision-makers unlikely to use the NPV rule. Less constrained by financial and legal resources. Incentive to overspend legal resources in a suit. l Some cases define agency or government powers. l Visibility associated with winning can affect survival and funding of government unit. Opposing corporations face free-rider problems. Winning a suit and establishing a legal precedent can provide benefits for many firms, but the entire cost of the suit is absorbed by the litigating corporation. Coase Theorem (Private litigants have an incentive to settle a dispute when doing so would be mutually economically beneficial.)

19. 19 Shareholder Wealth Implications of Corporate Lawsuits Suits involving Corporations and Government Entities  Government decision-makers unlikely to use the NPV rule. Coase Theorem (Private litigants have an incentive to settle a dispute when doing so would be mutually economically beneficial.) Government agencies do not have the same incentives as private parties to reach cost-effective and efficient outcomes. Litigation-related financial distress costs (terminated trade credit, lower market value of warranties) is an important determinant of the change in shareholder wealth for corporations. While government agencies face the possibility of decreased funding or elimination, they do not face the usual costs of financial distress. Sued firms risk debarment from government contracts, an exclusion that potentially represents a huge loss. Government lawsuits can attract large publicity, resulting in larger reputational losses.

20. 20 Shareholder Wealth Implications of Corporate Lawsuits Interfirm Suits (involving corporations as plaintiffs and defendants)  Corporate managers take actions in litigation that have positive NPV, and eschew courses of action that have negative NPV.  Importance of financial distress costs (fdc). Direct fdc in bankruptcy: legal + administrative fees: Small. Indirect fdc prior to bankruptcy: Large. Costs include l Lower sales l Inability to do business with customers and suppliers on favorable terms l Greater difficulty of raising funds or obtaining credit. l Distraction of management. l Inefficient investment policy. ( “underinvestment.doc”)

21. 21 Shareholder Wealth Implications of Corporate Lawsuits Suits involving corporations and private citizens  Reduced access to capital markets by most private citizens imply reduced ability to litigate, and smaller wealth effects on firms.  Some suits filed by individuals foreshadow a mass tort, a class action, or multiple follow-on suits, or motivate government litigation. In such cases, wealth implication on corporation could be substantial.

22. 22 Shareholder Wealth Implications of Corporate Lawsuits Legal Issue affects cost of a lawsuit and behavior in suit settlement and trial.  Certain types of violations carry large penalties. Trebling of damages in antitrust suits. Large punitive damage awards. Class action or multiple follow-on suits.  Differing reputational costs. High for product-liability and environmental cases. “Low” for antitrust cases.  Differing impact on other customers and suppliers. Plaintiff in a patent infringement dispute might be more likely to incur the costs of a trial to prevent the defendant from profiting and to discourage other firms from violating the patent. Plaintiff in a breach of contract suit may be more likely to settle a suit to maintain good relations with the defendant-supplier and other potential suppliers who could observe the formal dispute.

23. 23 Shareholder Wealth Implications of Corporate Lawsuits Bhagat-Romano (American Law & Economics Review, 2002, go to “Research Links” on http://leeds.colorado.edu/faculty/bhagat) Table 1, Panel A: Announcement period abnormal returns for defendant corporations by opponent type.  At filing: Large negative impact when government is the plaintiff.  On settlement: Large positive impact when government is the plaintiff. Table 1, Panel B: Announcement period abnormal returns for plaintiff corporations by opponent type.  Non-positive market reaction for plaintiffs in most cases.  Positive impact in antitrust cases when other side is another corporation. Table 1, Panel A: Announcement period abnormal returns for defendant corporations by type of legal issue.  Large negative impact on filing for l Environment suits l Fraud of government l Financial reporting fraud

24. 24 Shareholder Wealth Implications of Corporate Lawsuits Bhagat-Romano (American Law & Economics Review, 2002, go to “Research Links” on http://leeds.colorado.edu/faculty/bhagat) Conclusions l Lawsuits are not a value-enhancing way for corporations to settle their disagreements with other corporations. l The market appears to impose a higher sanction on firms than actual criminal sanctions, and the reputational losses are of equal magnitude for civil fines as criminal ones. –Karpoff and Lott (1993, 1999): criminal restitution, civil penalties and court costs comprise only about 7 percent of the shareholder wealth loss. Remaining 93 percent can be attributed to the reputational loss suffered by the defendant firms. The market thus appears to impose significant costs on firms for engaging in criminal conduct.