Why shareholder lawsuits are bad news for competitors

When a company is sued by shareholders, other companies in the same industry often see a drop in their own stock price and start to behave more transparently, presumably to avoid similar lawsuits.

A new study from Dain Donelson, professor of accounting at the University of Iowa’s Tippie College of Business, looked at the spillover effects of shareholder lawsuits on different companies in the same industry as the firm being sued. So, for instance, if Computer Chip Manufacturer A is sued, what’s the impact on the stock price of Chip Manufacturer B?

The study finds:

—Firms see their own stock price drop about 2.5% when a competitor is sued by investors, and the effects last for at least 60 days following the legal filing. Donelson said the changes in the stock price vary depending on the perceived merits of the suit. Those that will eventually be dismissed have no measurable impact on competitors’ stock price. In contrast, those lawsuits that will eventually settle, or, in other words, have merit, result in competitor stock price drops of about 5%.

How are shareholders able to intuit what cases have merit and which do not? Donelson said researchers don’t know, but shareholders seem to see cases that settle as a proxy for fraud. In that case, shareholders are most worried that these cases may represent industry-wide problems and the company in which they own stock may have engaged in similar misconduct.

—Companies also become more transparent after a competitor is sued, issuing more earnings guidance statements and sales forecasts, for instance. Their communications also become shorter and easier to understand, with more plain language and less jargon. “These are messages designed to tell investors, we don’t do what they’re doing,” Donelson said.

Are these disclosure changes successful at reducing investor concerns? Donelson said that these industry peers are less likely to be sued in the future, implying the increased transparency may help mitigate the spread of litigation.

Donelson’s study, “Spillover Effects in Disclosure-Related Securities Litigation,” was co-authored with Rachel Flam of the London Business School and Christopher Yust of Texas A&M. It was published in The Accounting Review.