What is the impact of litigation on stock prices?

Posted by on February 4, 2010 in Investment Information

There are certain things that do, indeed, go up during economic down times: unemployment rates, welfare rolls, collective insecurity and litigation. Litigation is a boom business during recessions. Suddenly, parties cannot overlook their differences knowing that another pay cheque or deal is coming since they have dried up and Court awards or settlement monies are seen as potential sources of income for litigants.

Litigation rarely, if ever, brings down a publicly traded business. Either the business is too large or the Courts limit damages based on ability to pay. After all, an overly large punitive award means little if the business itself is forced to file bankruptcy. However, what effect, if any, does litigation actually have on stock prices?

Surprisingly, studies suggest that litigation chill is one reason why initial public offers (IPOs) are consistently under-priced. The largest litigation risk in IPOs are fraudulent misrepresentation. If the issue price of the IPO is lower than it should be, it should, theoretically speaking, lower than quantum of damages which have to be paid if the allegations are proven to have merit. Studies show that IPO lawsuits can cost a new issuer up to 20% of the proceeds raised not to mention the undefinable loss of reputation and goodwill.

Perhaps the most interesting development in IPO securities litigation is the rise of class-action lawsuits against issuers of exchange traded funds, particularly of the leveraged variety. Among the allegations of numerous lawsuits against leveraged ETF issuers is that they failed to warn investors of the risk and the leverage component does not work properly since there is not a perfect tracking match. None of the allegations have been proven.

Litigation will not wipe out the leveraged ETF market but Court awards and settlements may put a dent in the earnings of ETF issuers which are  publicly traded companies (for example, iShares is owned by BlackRock, a publicly traded firm). Shareholder discontent or investors thinking twice about investing in the stock of an ETF issuer ending up on the wrong side of too many lawsuits may, in and of itself, force some issuers to be more cautious in issuing products or force regulators to act. This  is what class-action litigation, ideally, is supposed to do; it is a private remedy to drive public policy.

On a non IPO basis, I could not find any resarch that showed a consistent pattern of the effect of litigation on stock price. This is because litigation can be speculative (the ambulance chasers), perhaps have some merit but is a tough case to prove (the effect of a garage dump on a community), has merit but will take years to wind its way through the Court (asbestos related litigation when it first commenced) or the market simply brushes it off as the price of doing business (Nokia suing Apple in October 2009 did little to Apple’s prospects).

To quote Philip Morris’ latest annual report: “we and our subsidiaries record provisions in the consolidated
financial statements for pending litigation when we determine that an unfavorable outcome is probable and the amount of the loss can be reasonably estimated.
” And therein lies the problem. In other words,  the effect litigation on the financial statements relies on: (a) the business reasonably believe they will lose; (b) the business can estimate the loss; and (c) the loss is of a material nature to report it to the public market.

This is analogous to financial institutions believing they had sufficient controls in their proprietary trading pre 2007.  Risk is a subjective concept.

The issue is that it is hard for anyone to accurately predict if they can win in Court or, if they lose, what the damages will be. Even the most seasoned of litigators will tell you that if a lawsuit has made it to trial, neither side knows the outcome because both sides believe it has a strong enough case to go before Judge and jury.   Suits with poor merits tend to settle or be abandoned relatively quickly. Cases with merit tend to become unpredictable affairs.

The exception to the rule seemed to be a small window of time when public opinion and shifting regulatory landscape line up against an industry (tobacco, asbestos) and it is clearer that loss may occur. However, given the relative gridlock of government these days, these conditions tend not to exist for most industries.

The end result seems to be that the markets are just as surprised about litigation’s impact on a stock price as the lawyers on the losing end. The knee-jerk reaction would be to attempt to invest in an industry that is not as prone to litigation but today’s markets darlings become tomorrow’s defendants.

Just a quick congrats to Canadian Finance Blog which celebrated its one year anniversary this week. Congrats and keep up the good work.

3 Comments on What is the impact of litigation on stock prices?

By Tom @ Canadian Finance Blog on February 4, 2010 at 9:21 am

Thanks for the mention. It’s been an exciting year!

By Michael James on February 4, 2010 at 9:54 am

My recollection of the 15% underpricing of IPOs is that it is designed to put quick money in the pockets of “friends and family”. Retail investors usually aren’t able to buy at the IPO price. They have to buy in the open market, usually after the price has already risen (in the cases where it rises at all). Those who are given access to stock at the IPO price are selected by the company (usually the CEO) and the IPO syndicate. I always thought of the 15% as a way for a group of people to make easy money for themselves and their friends at the expense of their own companies.

By admin on February 4, 2010 at 10:48 am

Michael- there is always that factor. People forget that IPO’s are exit and liquidity events for many of the insiders and there is a transfer of wealth from the public to the owner-managers (which is both good and bad).

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