A Model of Market Reactions to Corporate Litigation
Eric Terry
Ted Rogers School of Business Management
Ryerson University
Incomplete version: May 24, 2009
I would like to thank Jeremy Clark, Cherie Metcalf, and participants at the 2008 meeting
of the Canadian Economics Association for their helpful comments and suggestions.
Send correspondence to: Eric Terry, Ted Rogers School of Business Management,
Ryerson University, 350 Victoria Street, Toronto ON, Canada M5B 2K3; Phone: 416-979-5000
ext.2452; Email: eterry@ryerson.ca.
A Model of Market Reactions to Corporate Litigation
Abstract
When a settlement to corporate litigation is announced, the stock price of the defendant tends to
fall significantly; conversely, if the case goes to trial, the defendant’s stock price tends to rise
slightly when the judgment is announced, even when the firm is found liable (Haslem, 2005).
These market reactions are difficult to reconcile with existing models of the trial vs. settlement
decision. We present a model in which corporate defendants vary in culpability. Though
defendant type is revealed to the plaintiff through the discovery process, this information is not
known by market outsiders. In additional to potential monetary penalties, corporate defendants
also face the risk of damage to the firm’s reputation and goodwill and the possibility of future
lawsuits. An equilibrium is derived in which firms that exercise less care tend to settle and firms
that exercise more care tend to go to trial. The model predicts that market outsiders will tend to
react negatively to settlements. Additionally, for reasonable parameter values, it predicts that the
market will react positively on average to trial judgments, even when the defendant loses.
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A Model of Market Reactions to Corporate Litigation
1. Introduction
It is well-known that the parties in a legal dispute will be inclined to settle vs. going to trial if
they: (i) agree about the likelihood of potential trial outcomes and (ii) are either risk averse or
risk neutral (cf. Shavell, 1982). Settlement reduces both litigation costs and the risk associated
with an uncertain trial result. Three general arguments have been used to explain why some
lawsuits go to trial. The first reason is that one or both sides have information relevant to the
trial outcome that the other side does not have. A number of asymmetric information models of
the settlement vs. trial decision have been developed, most notably the screening model of
Bebchuk (1984) and the signaling model of Reinganum and Wilde (1986). A second argument is
that one or both two sides may interpret information from their own biased point of view, with
the result of this “self-serving bias” being that the parties disagree about the likelihood of
potential trial outcomes (Babcock, Loewenstein, Issacharoff, and Camerer, 1995).
A final
argument invokes prospect theory, under which both parties are risk-seeking over the losses
domain and so are willing to trade off litigation costs against the opportunity to minimize their
losses by prevailing at trial (Terry, 2008).
Empirically, it has been found that the stock price of the defendant tends to fall
significantly when a settlement to corporate litigation is announced; conversely, if the case goes
to trial, the defendant’s stock price tends to rise slightly when the judgment is announced, even
when the firm is found liable (Haslem, 2005). These market reactions are difficult to reconcile
with the above models of the trial vs. settlement decision. The screening model of Bebchuk
(1984) is potentially consistent with these stock prices reactions if the information asymmetry
were over the amount of the potential settlement rather than the probability of prevailing at trial.
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However, as Hay (1995) notes, discovery rules generally force both sides to disclose any
privileged information that they process before trial, and so such informational asymmetries
would be unlikely to persist until trial.
In cases involving a corporate defendant, (Haslem, 2005) suggests that good managers
may prefer trial in order to reveal information about their abilities and judgment to the market
whereas bad managers may be willing to settle sub-optimally in order to keep this information
hidden. However, the empirical evidence for this argument is weak, with most of the proxy
variables used to measure agency costs found to be insignificant. Furthermore, because lawsuits
occur irregularly and can be very costly, one would expect that much better mechanisms could
be found for good managers to reveal information about their performance.
In this paper, we present a model in which corporate defendants vary in culpability.
Though defendant type is revealed to the plaintiff through the discovery process, this information
is not known by market outsiders. In additional to potential monetary penalties, corporate
defendants also face the risk of damage to the firm’s reputation and goodwill and the possibility
of future lawsuits. An equilibrium is derived in which firms that exercise less care tend to settle
and firms that exercise more care tend to go to trial. The model predicts that market outsiders
will tend to react negatively to settlements. Additionally, for reasonable parameter values, it
predicts that the market will react positively on average to trial judgments, even when the
defendant loses.
The paper is organized as follows. Section 2 presents the model and solves for its
equilbiria. Section 3 examines the market reactions in equilibrium. Finally, section 4 concludes
the paper.
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2. The Model
The model involves three risk-neutral parties: a potential plaintiff who has suffered some injury,
a firm that may have been negligent in causing this injury, and a financial market that prices the
firm’s shares. We assume that there are two types of firms. Firms that usually exercise care in
their dealings with other parties will be denoted as type c (or “careful”) firms. Firms that often
display negligence toward other parties will be referred to as type n (or “negligent”) firms.
Without loss of generality, it is assumed that the potential defendant has an equal probability of
being a careful or negligent firm.
At the point in time when the injured party must decide whether to file suit or not, the
potential plaintiff does not know the firm’s type. However, if a suit is filed, the firm’s type will
be revealed to the plaintiff during the ensuing discovery process. Once the discovery process is
complete, the defendant can choose to offer to settle for the minimal amount that is acceptable to
the plaintiff – which equals her expected gain from going to trial.1 If no settlement offer is made
by the defendant, the plaintiff must then choose whether between dropping the suit and
proceeding to trial. If the case goes to trial, there is a probability pi that a defendant of type i will
be found liable and be ordered to pay damages in the expected amount of Di. It is assumed that
pc ≤ pn and Dc ≤ Dn , i.e., a careful firm is less likely than a negligent firm to be found liable at
trial and/or expects to pay less damages if found liable.
Litigation costs of Cp and Cd will be expended by the plaintiff and defendant,
respectively, in the case of a trial. For simplicity, it is assumed that no costs are incurred by
either party if either a settlement is reached or the suit is dropped. Under these assumptions, the
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expected gain from trial for the plaintiff is pi Di − C p and so this represents the amount of any
settlement offer made by the defendant.
The defendant firm is assumed to choose the actions that maximize its market value. The
financial market is unable to observe directly firm type or to determine firm type from the
amount of any settlement offer.2 However, if the case does proceed to trial, the market will learn
the firm’s type from the open court proceedings. As well, the market may be able to infer firm
type if a separating equilibrium results. Let V represent the value of the firm apart from litigation
costs. The cost of future litigation against the firm is captured by two components: Ai represents
future litigation costs that are independent of the outcome of the current legal proceedings and bi
is a proportional measure of the future litigation costs that are related to the net gain by the
plaintiff in the current proceedings. It assumed that Ac < An and bc ≤ bn , i.e., a careful firm faces
lower future litigation costs than a negligent firm. Note that the variables Ai and bi could also
include the impact of any reduction in the firm’s reputation and goodwill that is caused by this
litigation.
Under these assumptions, the market value of the firm if a trial ensues will be
Vi = V − Di − Cd − Ai − bi ( Di − C p )
if the plaintiff prevails and
Vi = V − Cd − Ai + bi C p
if the defendant prevails. If a settlement offer of pi Di − C p is made and accepted, the firms
market value will be
Vi = V − ( pi Di − C p ) − As − bs ( pi Di − C p ) ,
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where the market sets As = ws An + (1 − ws ) Ac and bs = ws bn + (1 − ws )bc according to the fraction
of firms who settle, ws, that are negligent (vs. careful). Similarly, the value of the firm if the
plaintiff withdraws the suit is Vi = V − Aw , where the market sets Aw = ww An + (1 − ww ) Ac
according to the fraction of firms for which the suit is dropped, ww, that are negligent (vs.
careful). Finally, the value of the firm if the plaintiff does not file suit is Vi = V − A . The
complete form of the litigation game is given in Figure 1.
Insert Figure 1 about here
2.1. Equilibrium
Assume that pn Dn > C p . Otherwise, all possible payoffs to the plaintiff from litigating are nonpositive and so the unique equilibrium is that the plaintiff does not file suit. Consider first the
case of a negligent firm. If no settlement offer is made, the expected payoff to the plaintiff of
going to trial is pn Dn − C p > 0 and so the plaintiff would proceed to a trial. Because
E[Vn | trial] = V − pn Dn − Cd − An − bn ( pn Dn − C p )
< V − ( pn Dn − C p ) − An − bs ( pn Dn − C p ) ,
= Vn | settlement
the firm will strictly prefer to settle than to offer no settlement and then have the case go to trial.
Note that this result holds irrespective of the choice made by careful firms.
Now consider the case of a careful firm. If pc Dc ≤ C p , the plaintiff would choose to drop
the suit if no settlement offer was made. Therefore, if the firm were to offer no settlement, then
Vc | no settlement = V − Ac
> V − ( pc Dc − C p ) − As − bs ( pc Dc − C p )
= Vc | settlement,
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and so the firm will choose not to offer settlement. (Note that Aw = Ac because only careful
firms would refuse to settle in this equilibrium.) If pc Dc > C p , the plaintiff would proceed to
trial if no settlement offer was made. Consequently, the careful firm will prefer not to offer
settlement if
E[Vc | trial] > Vc | settlement
⇔ V − pc Dc − Cd − Ac − bc ( pc Dc − C p ) > V − ( pc Dc − C p ) − A − b ( pc Dc − C p )
⇔ Cp <
An − Ac + (bn − bc ) pc Dc − 2Cd
bn − bc + 2
(1)
(This analysis uses the fact that As = A and bs = b if the careful firm were instead to settle in
equilibrium.) Therefore,
Proposition 1. Suppose that pc Dc > C p . If inequality (1) holds, a separating equilibrium exists
in which the plaintiff files suit and the case is settled for negligent defendants but goes to trial for
careful firms. Otherwise, a pooling equilibrium results in which the plaintiff files suit and both
types of firms settle out of court.
Inequality (1) underscores the importance of the variables Ai and bi in the model. If there were
no difference between negligent and careful firms in terms of future litigation (or reduction in the
firm’s reputation and goodwill caused by this litigation), i.e., An = Ac and bn = bc , then the both
types of firms would prefer to settle out of court in equilibrium.
Because the focus in this paper is on market’s reaction to announcements of settlement
and trial outcomes, we will focus on the equilibrium that involves careful firms going to trail
rather than the one in which suits against them are dropped.
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2.2. Comments
Before proceeding to examine the implied market price reactions in this equilibrium, a few
comments should be made regarding the model.
The assumption that the defendant firm focuses on its market value can be justified on
several different levels. First, the market value of the firm determines the price at which it can
raise additional capital. Second, the value of stock options and other forms of managerial
compensation are often dependent on the firm’s share price. Third, the market sets the price at
which existing shareholders can sell some of their shares. The model could made more realistic
by making the firm maximize some weighted average of the firm’s true value and market value,
as in the dividend signaling paper of Miller and Rock (1985). However, this added complexity
would not qualitatively change the main results of the paper in any significant way.
Similarly, the assumption that firm type is completely revealed to the plaintiff in
discovery is not crucial to the model. As long as the plaintiff has some ability to distinguish
between careful and negligent firms after the discovery process is completed, a mixed
equilibrium similar to Png (1987) will result in which that exercise less care will tend to settle
(but sometimes go to trial) and firms that exercise more care tend to (but not always) go to trial.
This would reduce size of the market reactions to settlement vs. trial that are shown in the next
section, but would not change their direction.
Finally, the assumption that there are no costs associated with either discovery or
settlement is common in the literature (cf. Bebchuk, 1984); Reinganum and Wilde,1986; and
Png,1987) and can be relaxed without any significant change to the model.
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3. Market Price Reactions
If inequality (1) holds and therefore a separating equilibrium results, the market value of the firm
when the lawsuit is announced will be
V0 = V − ⎡⎣ ( pn Dn + pc Dc ) + ( An + Ac ) + (bn pn Dn + bc pc Dc ) + Cd − (1 + bn + bc )C p ⎤⎦ / 2 .
Therefore, the change in market value when a settlement is announced would be
∆Vn = − ⎡⎣ ( pn Dn − pc Dc ) + ( An − Ac ) + (bn pn Dn − bc pc Dc ) − Cd − (1 + bn − bc )C p ⎤⎦ / 2
Similarly, the change in market value following a trial outcome would be
∆Vc | win = ⎡⎣ ( pn Dn + pc Dc ) + ( An − Ac ) + (bn pn Dn + bc pc Dc ) − Cd − (1 + bn − bc )C p ⎤⎦ / 2
if the defendant has prevailed at trial and
∆Vc | lose = ⎡⎣ ( pn Dn + [ pc − 2]Dc ) + ( An − Ac ) + (bn pn Dn + bc [ pc − 2]Dc ) − Cd − (1 + bn − bc )C p ⎤⎦ / 2
if the defendant has lost the trial.
Without further restrictions, none of these market price reactions has a definite sign.
Table 1 shows the computed market reactions for representative parameter values that satisfy
inequality (1). Note that the results are independent of the unit of measure chosen (e.g., $
thousands vs. millions). The two firm types have different probabilities of losing at trial in cases
1-3. In case 1, the two types of firm face the same size of potential damages and the trial
outcome has the same impact on their market value. In case 2, the firms still face the same size
of potential damages but the trial outcome has a differential impact on their market values.
Finally, the two types of firms differ in terms of both the size of potential damages and impact of
the trial outcome on their market value in case 3. In cases 4 and 5, the two types of firm have the
same likelihood of losing at trial but face different levels of potential damages. In case 4, the
trial outcome has the same impact on the firm’s market value but the two firms face different
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levels of future litigation. In case 5, the two firms face the same level of future litigation but the
trial outcome has a differential impact on their market values.
Across these five representative scenarios, the market reaction to settlements is uniformly
negative and the market reaction to a victory in court by the defendant is always positive. In
cases 2-5, the market reaction to a loss at trial is positive. These results are consistent with the
empirical evidence discussed earlier. However, the market reaction to a loss at trial is negative
in case 1, which shows that the model can explain negative market reactions to trial losses in
individual cases.
4. Conclusions
We have presented a model in which corporate defendants vary in culpability.
Though
defendant type is revealed to the plaintiff through the discovery process, this information is not
known by market outsiders. In additional to potential monetary penalties, corporate defendants
also face the risk of damage to the firm’s reputation and goodwill and the possibility of future
lawsuits. An equilibrium was derived in which firms that exercise less care tend to settle and
firms that exercise more care tend to go to trial. The model predicts that market outsiders will
tend to react negatively to settlements. Additionally, for reasonable parameter values, it predicts
that the market will react positively on average to trial judgments, even when the defendant
loses.
10
References
Babcock, Linda, and George Loewenstein. 1997. “Explaining Bargaining Impasse: The Role of
Self-Serving Biases,” 11 Journal of Economic Perspectives 109-26.
Babcock, Linda, George Loewenstein, Samuel Issacharoff, and Colin Camerer. 1995. “Biased
Judgments of Fairness in Bargaining,” 85 American Economic Review 1337-43.
Bebchuk, Lucian Arye. 1984. “Litigation and Settlement under Imperfect Information,” 15
RAND Journal of Economics 404-15.
Haslem, Bruce. 2005. “Managerial Opportunism during Corporate Litigation,” 60 Journal of
Finance, 2013-41.
Hay, Bruce L. 1995. “Effort, Information, Settlement, Trial,” 24 Journal of Legal Studies 29-62.
Miller; Merton H., and Kevin Rock. 1985. “Dividend Policy under Asymmetric Information,” 4
Journal of Finance, 1031-1051.
P'ng, I. P. L. 1983. “Strategic Behavior in Suit, Settlement, and Trial,” 14 Bell Journal of
Economics 539-50.
Png, Ivan P. L. 1987. “Litigation, Liability, and Incentives for Care,” 34 Journal of Public
Economics 61-85.
Reinganum, Jennifer, F., and Louis L. Wilde. 1986. “Settlement, Litigation, and the Allocation
of Litigation Costs,” 17 RAND Journal of Economics 557–66.
Shavell, Steven. 1982. “Suit, Settlement, and Trial: A Theoretical Analysis under Alternative
Methods for the Allocation of Legal Costs,”11 Journal of Legal Studies 55-81.
Shavell, Steven. 1993. “Suit versus Settlement when Parties Seek Nonmonetary Judgments,” 22
Journal of Legal Studies 1-13.
Terry, Eric. 2008. “Trial and Settlement under Cumulative Prospect Theory,” Working paper,
Ted Rogers School of Business Management, Ryerson University.
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Notes
1. Because no informational asymmetry between the plaintiff and defendant exists when
settlement is offered, any offer below this amount is certain to be rejected by the
defendant and therefore is equivalent to no offer being made by the defendant.
Conversely, any offer above this minimal amount is clearly suboptimal for the defendant
and so can be omitted from the analysis.
2. This would be the case if the market does not know the values of pnDn and pcDc.
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Table 1
Market Reactions for Selected Inputs
Case 1
Case 2
Case 3
Case 4
Case 5
pn
0.75
0.75
0.75
0.5
0.5
pc
0.25
0.25
0.25
0.5
0.5
Dn
1.0
1.0
2.0
1.0
2.0
Dc
1.0
1.0
1.0
1.0
1.0
An
1.0
2.0
1.0
2.0
0.0
Ac
0.0
0.0
0.0
0.0
0.0
bn
1.0
1.0
1.0
0.5
3.5
bc
1.0
0.5
0.5
0.5
0.5
Cp
0.2
0.2
0.2
0.2
0.2
Cd
0.2
0.2
0.2
0.2
0.2
Settlement
-0.80
-1.31
-1.56
-0.80
-1.38
Wins trial
1.30
1.69
1.94
1.55
2.13
Loses trial
-0.70
0.19
0.44
0.05
0.63
Parameters
Outcome for firm
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Figure 1. Extensive form of the game.
14