The Impact of Securities Class Actions on Firm Governance and Operating Performance

Abstract

Prior research has found that after the filing of a securities class action managers take corrective actions. The general conclusion of these studies is that securities class actions result in management making improvements within the firm, which helps to reduce agency problems. However, little evidence exists as to whether these changes are beneficial to the firm. In this study I examine this issue by analysing the effect securities class actions have on management’s decisions and operating performance. Consistent with prior research I find that managers take corrective actions post filing. These changes include: increasing leverage and the proportion of outsiders on the board, and decreasing dividends and board size. Post filing CEO’s are also more likely to be replaced and not hold the position of chairman of the board. Unique evidence of a significant fall in operating performance, during the two years prior to the filing of the class action, is found. Four explanations are offered for why this decline might occur: managerial wrong doing, agency problems, losses required for the filing and information leaking. I find no evidence to suggest that the filing of a securities class action has any significant impact on operating performance. This suggests that class actions do not have the undesirable effect of damaging firm performance. Since operating performance bottoms out the year of the filing, securities class actions may act as a turning point for the performance of a firm. Finally, I analyse the relationship between the corrective actions taken and abnormal operating performance in order to determine how effective securities class actions are at inciting improvements in the firm. I find that changes in leverage have a positive effect on operating cash flows and free cash flows the year following the change. The one year lag in the cumulative changes in leverage also has a positive effect on EBIT and EBITDA. Although not conclusive, these results suggest that securities class actions do not damage operating performance and instead result in performance enhancing improvements. My study therefore adds credence to the use of securities class actions as a disciplinary mechanism.