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Is the Outcome of a Securities Class Action a Reliable Signal of Accounting Irregularity? Nana Y. Amoah Old Dominion University Alex P. Tang Morgan State University Feb. 2011 Motivations • Dismissal of several class actions raises questions about the appropriateness of securities litigation as a signal of accounting irregularity. • 65.9% (1,396) of 2119 class actions over the period 1996-2005 were dismissed (Simmons and Ryan, 2007). • Fich and Shivdasani (2007) note that it cannot be confirmed that fraud has occurred as a result of a securities lawsuit. • Effect of PSLRA on securities lawsuit outcome. Motivations • Proponents of litigation reform argue that only settled lawsuits are a credible signal of accounting irregularity. • Critics argue that the litigation process is widely abused and settlements are excessive and do not reflect the wrongdoing. • No clear evidence of fraud in settlements. • Debate on effectiveness of securities litigation as a governance mechanism (Rogers and Buskirk, 2009). Figure 1: Timeline of Filing and Resolution of Securities Lawsuit Restating Firm Announces Irregularity Or Error (Irreg=1/0) Defendants File Motion to Dismiss the Lawsuit (Dismiss=1/0) Securities Lawsuit is Settled (Settlement=S) TIME Restatement Triggers Securities Lawsuit (Litig = 1/0) Class Certification and Discovery Accounting Irregularity and Litigation Outcome (Related Research & Hypotheses) • Negative association between fraud and restatement announcement returns (Palmrose, Richardson and Scholz, 2004; Lev, Ryan and Wu, 2007). • Restatements due to accounting irregularity are more likely to trigger securities lawsuits. • Positive association between accounting irregularity and restatement-induced securities lawsuit (Hennes, Leone and Miller, 2008; Amoah and Tang, 2010). • Accounting irregularity is defined similarly to Hennes, Leone and Miller (2008). Accounting Irregularity and Litigation Outcome (Related Research & Hypotheses) • Under the PSLRA, meritorious securities lawsuits are less likely to be dismissed (Choi and Thompson, 2006). • Restatement-induced lawsuit centered on accounting irregularity provides an inference of scienter and should be more likely to be settled. • Accounting irregularity is associated with greater shareholder losses, thus, settlement amount should be positively associated with accounting irregularity. Hypotheses (Accounting Irregularity and Litigation Outcome) • H1: Ceteris paribus, settled restatement-induced lawsuits are positively associated with accounting irregularity. • H2: Ceteris paribus, the settlement amount of a restatement-induced lawsuit is positively associated with accounting irregularity. CEO Turnover and Litigation Outcome (Related Research & Hypotheses) • Likelihood of CEO turnover increases with securities litigation (Niehaus and Roth,1999; Collins, et. al, 2008). • SEC and DOJ enforcement action positively associated with termination of executive officers implicated in the fraud (Karpoff, Lee and Martin, 2008) . • CEOs have access to material non-public adverse information and should be culpable when financial statements are false and misleading. Hypothesis (CEO Turnover and Litigation Outcome) • Thus, when restating firms settle securities lawsuits, it is likely that CEOs are culpable in the alleged fraud. • H3: Ceteris paribus, settled restatement-induced securities lawsuit is positively associated with CEO turnover. Sample Selection Procedure Description Restatements from 1997-2005 in GAO (2002) and GAO (2007) databases Number 2309 Deleting repeated restatements (322) Missing Compustat and CRSP data (860) Technical restatements, income increasing restatements and missing restatement and litigation data (432) Restating sample 695 Litigation firms 185 Distribution of Restatements by fiscal year Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total Restating firms 31 26 35 43 36 93 96 130 205 695 Litigation firms 18 19 23 22 20 42 15 16 10 185 Settlement firms Dismissed Lawsuits (%) Settled Lawsuits (%) 14 14 17 17 14 31 11 8 7 133 22% 26% 26% 23% 30% 26% 27% 50% 30% 28% 78% 74% 74% 77% 70% 74% 73% 50% 70% 72% Distribution of Litigations by fiscal year Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total Litigation firms 15 20 22 24 19 40 15 16 14 185 Settlement firms 13 14 16 17 14 31 13 8 7 133 Descriptive Statistics of Continuous Variables (Restating Firms) Variable R(-1,1) Mean -0.067 Median -0.027 Std. Dev. 0.155 t-stat (p-value) <0.001 Wilcoxon (p-value) <0.001 Lev 0.241 0.204 0.230 <0.001 <0.001 LnA 6.289 6.165 2.157 <0.001 <0.001 ROA 0.025 0.056 0.179 <0.001 <0.001 Frequency of Binary Variables (Restating Firms) Variable Number of firms Percentage Irregularity 177 26% Revenue 213 31% Litig 185 27% Dismiss 52 8% Settle 133 19% Chi-Sq (p-value) 167.31 (<0.001) 104.12 (<0.001) 151.98 (<0.001) 502.56 (<0.001) 264.81 (<0.001) Univariate Results - Irregularity and No-Irregularity Restating Subsamples Binary Variables Variable Revenue Pred. Sign + Litig + Dismiss ? Settle + Irregularity= 1 Observations (N=177) (percentage) 92 (51.98%) 88 (49.72%) 13 (7.34%) 75 (42.37%) No-Irregularity= 0 Observations (N=518) (percentage) 121 (23.36%) 97 (18.73%) 39 7.53%) 58 (11.20%) Chi-Square (p-value) 50.83a (0.008) 64.87a (<0.001) 0.01 (0.936) 82.86a (<0.001) Continuous Variables Pred. Sign - Irregularity= 1 (N=177) Mean -0.103 No-Irregularity= 0 (N=518) Mean -0.055 Lev +/- 0.249 0.239 LnA +/- 6.811 6.086 +/- 0.040 0.020 Variable R(-1,1) ROA Difference in Mean (p-value) -0.048a (0.001) 0.010 (0.638) 0.725a (<0.001) 0.020 (0.147) Descriptive Statistics of Continuous Variables (Litigation Firms) Variable R(-1,1) Mean -0.197 Median -0.154 Std. Dev. 0.204 t-stat p-value <0.001 Wilcoxon p-value <0.001 LnS 16.864 16.730 1.673 <0.001 <0.001 Lev 0.266 0.257 0.207 <0.001 <0.001 LnA 7.622 7.437 2.020 <0.001 <0.001 ROA 0.075 0.082 0.097 <0.001 <0.001 Frequency of Binary Variables (Litigation Firms) Variable Number of firms Percentage Irregularity 88 48% Revenue 103 56% Dismiss 52 28% Settle 133 72% Chi-Sq (p-value) 0.27 (0.605) 2.89 (0.089) 35.85 (<0.001) 35.85 (<0.001) Univariate Results - Irregularity and No-Irregularity Litigation Subsamples Binary Variables Variable Revenue Pred. Sign + Dismiss - Settle + Irregularity= 1 Observations (N=88) (percentage) 54 (61.36%) 13 (14.77%) 75 (85.23%) No-Irregularity= 0 Observations (N=97) (percentage) 49 (51.58%) 38 (40.0%) 57 (60.0%) Chi-Square (p-value) 1.78 (0.182) 14.46 (0.936) 14.46a (<0.001) Continuous Variables - Irregularity= 1 (N=88) Mean -0.185 No-Irregularity= 0 (N=97) Mean -0.207 Lev +/- 0.251 0.279 LnA +/- 7.666 7.582 ROA +/- 0.079 0.072 LnS + 17.098 16.458 Variable R(-1,1) Pred. Sign Difference in Mean (p-value) 0.022 (0.465) -0.028 (0.374) 0.084 (0.780) 0.392 (0.599) 0.640 (0.111) Analysis of Accounting Irregularity IRREG 0 1 R( 1,1) 2 Re v 3 Litig 4 Dismiss 5 LnS 6Settle 7 ROA 8 Lev 9 LnA....(1) Logistic Regressions of Accounting Irregularity (Restating Sample) Variable Logit Coeff. Effect Size Logit Coeff. Effect Size Intercept (?) -1.852a (37.01) - -1.873a (36.98) - 0.177 (0.08) 19.3% R(-1,1) (+) Model Logit Coeff. -1.854a (36.23) Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size - -1.866a (35.77) - -2.278a (46.38) - 0.512 (0.62) 66.9% 0.595 (0.80) 1.000a (23.81) 81.3% Revenue (+) Litig (+) 1.330a 278.2% (42.18) 1.327a (31.36) 276.9% Dismiss (?) Settle (+) ROA (+/-) Lev (+/-) LnA (+/-) ModChiSq (P-value) H-L ChiSq (P-value) -0.182 (0.10) -0.132 (0.10) 0.058 (1.36) 57.49a (<0.01) 4.25 (0.83) -16.7% -12.3% 5.9% -0.305 (0.28) -0.031 (0.01) 0.060 (1.44) 54.00a (<0.01) 9.25 (0.32) 171.9% -26.3% -3.1% 6.1% 0.357 (1.03) 1.675a (55.28) -0.128 (0.05) -0.143 0.058 (1.37) 71.84a (<0.01) 5.18 (0.74) 42.9% 433.9% -12.0% -13.4% 6.0% 0.334 (0.81) 1.758a (44.33) -0.257 (0.19) -0.037 (0.01) 0.060 (1.40) 69.83a (<0.01) 12.42 (0.13) 39.7% 480% -22.6% -3.7% 6.1% 0.030 (0.01) 1.381a (24.75) -0.055 (0.01) -0.003 (0.00) 0.083 (2.58) 93.23a (<0.01) 12.62 (0.13) 3.1% 297.7% -5.3% -0.3% 8.6% Logistic Regressions of Accounting Irregularity (Litigation Sample) Model Variable Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Logit Coeff. Effect Size Intercept (?) -1.692b (5.05) - -1.656b (5.10) - -1.392b (3.85) - -1.748b (5.28) - -3.941c (3.74) - R(-1,1) (+) 1.022 (1.64) 178.0% 1.022 (1.65) 177.7% 1.048 (1.71) 185.3% 1.288 (2.15) 262.7% Revenue (+) 0.427 (1.66) 53.2% 0.441 (1.76) 55.4% 0.213 (0.28) 23.7% 0.278b (4.88) 32.1% -1.277 (1.56) -72.1% 0.343 (1.11) 40.9% LnS (+) Settle (+) 1.412a (13.35) 310.6% ROA (+/-) 1.292a (12.00) 1.124 (0.47) -0.913 (1.18) 264.1% 0.073 (0.72) 7.6% 207.6% -59.9% 1.481a (14.70) 0.841 (0.25) -0.720 (0.70) 339.9% 0.064 (0.55) 6.6% 131.9% -51.3% 1.430a (13.52) 0.994 (0.35) -0.676 (0.60) 317.9% 0.080 (0.84) 8.3% 170.2% Lev (+/-) -0.716 (0.68) -51.1% -49.1% LnA (+/-) 0.086 (0.99) 9.0% Model ChiSq (P-value) H-L ChiSq (P-value) 19.56a (<0.01) 11.71 17.05a (<0.01) 6.61 18.14a (<0.01) 4.12 19.90a (<0.01) 3.91 8.36c (0.079) 4.05 (0.17) (0.58) (0.85) (0.87) (0.85) Analysis of CEO Turnover CEO1 0 1 R( 1,1) 2 Re v 3 Litig 4 Dismiss 5Settle 6 ROA 7 Lev 8 LnA....(2i) CEO2 0 1 R( 1,1) 2 Re v 3 Litig 4 Dism iss 5Settle 6 ROA 7 Lev 8 LnA....(2ii) CEO3 0 1 R( 1,1) 2 Re v 3 Litig 4 Dismiss 5Settle 6 ROA 7 Lev 8 LnA....(2iii) Logistic Regressions of CEO Turnover CEO1 Logit Coeff. CEO1 Effect Size CEO1 Logit Coeff. CEO1 Effect Size CEO2 Logit Coeff. CEO2 Effect Size CEO3 Logit Coeff. CEO3 Effect Size -3.104a (12.90) - -2.574a (8.39) - -1.947a (7.28) - -1.541b (4.37) - R(-1,1) (+) 0.965 (0.95) 162.5% 1.298 (1.63) 266.2% -0.162 (0.04) -14.9% 0.561 (0.45) 75.2% Revenue (+) 0.450 (1.44) 56.9% 0.243 (0.38) 27.5% 0.454 (2.05) 57.4% 0.297 (0.87) 34.6% Litig (+) 1.642a (12.22) 416.5% 0.851 (1.87) 2.173a (18.25) -3.283 (2.40) 0.061 (0.00) 0.011 (0.01) 134.2% 0.155 (0.11) 1.206a (9.03) -2.600 (2.18) 0.324 (0.19) 0.053 (0.34) 16.8% 1.039b (5.42) 1.844a (19.58) 0.612 (0.12) 0.189 (0.06) -0.054 (0.33) 182.6% Variable Intercept (?) Dismiss (?) Settle (+) ROA (+) Lev (+) LnA (+/-) 0.158 (0.03) 0.041 (0.14) 17.1% 4.2% 778.3% -96.2% 6.3% 1.1% 234.1% -92.6% 38.2% 5.4% Model ChiSq (P-value) H-L ChiSq 23.38a (<0.01) 3.34 33.35a (<0.01) 10.17 29.68a (<0.01) 6.59 35.22a (<0.01) 3.83 (P-value) (0.91) (0.25) (0.58) (0.87) 532.4% 84.4% 20.8% -5.2% Logistic Regressions of SEC Enforcement Action Variable Intercept (?) R(-1,1) (+) Revenue (+) Litig (+) Logit Effect Coeff. Size a -3.181 (39.27) 0.725 106.5% (0.64) 0.630b 87.7% (4.32) Logit Coeff. -2.869a (34.79) 0.953 (1.09) Effect Size - Model Logit Coeff. -3.114a (38.97) Effect Size - 159.5% 0.512c (2.82) Settle (+) LnA (+/-) ModChiSq (P-value) H-L ChiSq (P-value) 15.4% Logit Coeff. -12.186a (13.47) 0.190 (0.03) 0.233 (0.18) Effect Size 21.0% 26.2% 1.284a 261.0% (11.81) Dismiss (?) Lev (+/-) Effect Size - 66.9% LnS (+) ROA (+/-) Logit Coeff. -12.191 (13.46) 0.143 (0.02) 0.147 15.8% (0.02) -0.001 -0.00% (0.00) 0.059 6.0% (0.60) 35.28a (<0.01) 6.61 (0.58) 0.836 (2.63) 1.875a (24.47) 0.162 (0.02) -0.002 (0.00) 0.031 (0.17) 36.06a (<0.01) 6.52 (0.59) 130.6% 552.3% 17.6% -0.2% 3.2% 0.706 (2.11) 1.391a (15.16) 0.295 (0.07) -0.00 (0.00) 0.050 (0.44) 37.32a (<0.01) 5.21 (0.73) 0.590a (8.11) 80.4% 0.575a (7.54) 77.8% -1.786 (0.32) -2.549c (2.97) 0.212 (1.67) 18.96a (<0.01) 10.58 (0.23) -83.2% -1.701 (0.30) -2.487c (2.81) 0.222 (1.77) 19.13a (<0.01) 6.30 (0.61) -81.7% 102.5% 301.9% 34.3% -0.2% 5.1% -92.2% 23.7% -91.7% 24.9% Results • Settled lawsuit positively associated with accounting irregularity consistent with our first hypothesis (H1). • Positive association between settled lawsuit and CEO turnover (Supports H3). • Weak evidence of a positive association between accounting irregularity and settlement amount. • Results for settled lawsuit are robust with SEC enforcement action as the fraud measure. • Strong evidence of a positive association between settlement amount and SEC enforcement action. Conclusions • Settled lawsuit is an appropriate signal of accounting irregularity. • CEOs of settlement firms are implicated in the alleged fraud that triggered the lawsuit. • Findings are contrary to Beneish (1999) who find that SEC enforcement action is not effective in discouraging management fraud. Contributions • First study that examines the relation between accounting irregularity and securities litigation outcome. • Highlights the importance of distinguishing between dismissed and settled lawsuits in litigation studies. • Contributes to the debate on whether securities litigation is an effective governance mechanism. • Extends studies linking restatement and restatement-induced securities lawsuit to CEO turnover (such as Desai, Hogan, and Wilkins, 2006 & Collins, Reitenga and Sanchez, 2008).