Public ownership, firm governance, and litigation risk

University of Chicago Law Review

Volumn 76, Issue 1, 2009, Pages 335-366

  Talley, Eric L ^a,b  

^a Department of Law ^*

^b UNIVERSITY OF CALIFORNIA   (United States)

Author keywords

[No Author keywords available]

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EID: 66249125698     PISSN: 00419494     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Conference Paper

References (74)

1. See Per Strömberg, The New Demography of Private Equity, in Anuradha Gurung and Josh Lerner, eds, The Global Economic Impact of Private Equity Report 2008 3, 13 figures 1A and 1B (World Economic Forum 2008), online at http://www.weforum.org/pdf/cgi/pe/Full-Report.pdf (visited Jan 11, 2009).
2. Sarbanes-Oxley Act of 2002, Pub L No 107-204,116 Stat 745, codified in relevant part at 15 USC § 7201 et seq.
3. See, for example, Ehud Kamar, Pinar Karaca-Mandic, and Eric Talley, Going-private Decisions and the Sarbanes-Oxley Act of 2002: A Cross-country Analysis, 25 J L, Econ, & Org *3 (forthcoming 2009), online at http://ssrn.com/abstract=901769 (visited Jan 11, 2009);
4. Robert P. Bartlett III. Going Private but Staying Public: Reexaming the Effect of Sarbanes-Oxley on Firms' Going-private Decisions, 76 U Chi L Rev 7, 33-38 (2009) (examining data on companies' going-private decisions and concluding that only small-cap and medium-cap companies have done so to avoid SOX requirements).
5. See, for example, Ehud Kamar, Pinar Karaca-Mandic, and Eric L. Talley, Sarbanes-Oxley's Effect on Small Firms: What Is the Evidence?, in Susan M. Gates and Kristin J. Leuschner. eds, In the Name of Entrepreneurship? The Logic and Effects of Special Regulatory Treatment for Small Business 143, 165 table 5.3 (RAND 2007), online at http://www.rand.org/pubs/monographs/2007/ RAND-MG663.pdf (visited Jan 11,2009) (offering a concise summary of the literature on the effects of SOX on small firms and large firms);
6. Maurice R. Greenberg, Regulation, Yes; Strangulation, No, Wall St J AlO (Aug 21, 2006) (highlighting the negative reaction to SOX compliance among public corporation executives);
7. Alan Murray, For Sarbanes-Oxley Bashers, Some Perspective, Wall St J A2 (Nov 16,2005) (acknowledging the costs of SOX for smaller firms and the complaints from businesses of all sizes, but questioning whether the costs of regulation can really explain larger firms going private).
8. See Kamar, Karaca-Mandic, and Talley, Sarbanes-Oxley's Effects on Small Firms at 145-50 (cited in note 4).
9. See Robert Serio and Matthew Kahn, Private Rights of Action and the Sarbanes-Oxley Act of 2002, 38 Sec Reg & L Rep 668, 669-71 (Apr 2006) (highlighting possible implied causes of action arising out of SOX).
10. See 28 USC § 1658.
11. See SOX § 308, 116 Stat at 784-85, codified at 15 USC § 7246.
12. See, for example, SOX § 302(a), 116 Stat at 777, codified at 15 USC § 7241(a) ("The [SEC] shall, by rule, require ... that the principal executive officer ... and the principal financial officer ... certify [ ] each annual or quarterly report.");
13. SOX § 404(a), 116 Stat at 789, codified at 15 USC § 7262(a) (requiring each annual report to contain an internal control report, which states an internal control structure for financial reporting and contains an assessment of the effectiveness of that control structure).
14. See, for example, NYSE, Listed Company Manual §§ 201-04, online at http://www.nyse.com/lcm/lcm-section.html (visited Jan 11, 2009) (requiring NYSE-listed companies to disclose, among other things, material news developments, annual financial statements, and interim earnings reports).
15. See, for example, John C. Coates IV, The Goals and Promise of the Sarbanes-Oxley Act, 21 J Econ Perspectives 91, 92 (Winter 2007) (noting the "variety of long-term benefits" promised by SOX, including the fact that "[ijnvestors wiU face a lower risk of losses from fraud and theft, and benefit from more reliable financial reporting, greater transparency, and accountability");
16. Lawrence A. Cunningham, The Sarbanes-Oxley Yawn Heavy Rhetoric, Light Reform (and It Just Might Work), 35 Conn L Rev 915, 955-56 (2003) (alluding, somewhat skeptically, to the requirement that the CEO and CFO design internal controls, and then certify their integrity, as an example of a provision that lawmakers hoped would inspire better corporate governance by taking the defense of ignorance off the table).
17. See, for example, The Corporate Library, Securities Litigation Risk Analyst, online at http:// www.thecorporatelibrary.com/info.php?id=49 (visited Jan 11, 2009) (advertising software that predicts the likelihood of a securities class action against a company using factors like the company's "governance risk").
18. Consider Stanley B. Block, The Latest Movement to Going Private: An Empirical Study, 14 J Applied Fm 36, 37 (Spring/Summer 2004) (reporting that firms that had recently gone private most often cited as their primary reason the cost of being public, in both dollars and time).
19. See, for example, Shane A. Johnson, Harley E. Ryan, Jr, and Yisong S. Tian, Managerial Incentives and Corporate Fraud: The Sources of Incentives Matter *5 (European Finance Association 2006 Zurich Meetings, Feb 2008), online at http://ssrn.com/abstract=395960 (visited Jan 11, 2009);
20. Eric L. Talley and Gudrun Johnsen, Corporate Governance, Executive Compensation and Securities Litigation *4 (University of Southern California Law School Olin Law & Economics Working Paper No 04-7, May 2004), online at http://ssrn.com/abstract=536963 (visited Jan 11, 2009) ("[W]e estimate that each 1% increase in the fraction of a CEO's contract devoted to medium- to long-term incentives (rather than short-term compensation) predicts a 0.3% increase in expected litigation and a $3.4 million dollar increase in expected settlement costs.");
21. Bin Ke, Do Equity-based Incentives Induce CEOs to Manage Earnings to Report Strings of Consecutive Earnings Increases? *2 (14th Annual Conference on Financial Economics and Accounting, Feb 2004), online at http:// ssrn.com/abstract-446540 (visited Jan 11,2009) (concluding that executives with high equity-based compensation are more likely to manage earnings reports to ensure there is a string of consecutive earnings increases for their own personal gain).
22. See M. Todd Henderson, Alan D. Jagolinzer, and Karl A. Muller, Scienter Disclosure (University of Chicago Law School Olin Law & Economics Working Paper No 411, July 2008), online at http://ssrn.com/abstract- 1137928 (visited Jan 11, 2009).
23. Id at *2-3 (finding that insiders may voluntarily disclose information prior to strategic trades in order to mitigate future litigation risks).
24. See Joshua D. Angrist and Alan B. Krueger, Instrumental Variables and the Search for Identification: From Supply and Demand to Natural Experiments, 15 J Econ Perspectives 69, 69-70 (Autumn 2001). For similar reasons I have also deliberately excluded the incidence of earnings restatements and of federal civil/criminal litigation as a predictor of subsequent litigation. To be sure, both controls are highly predictive of later or contemporaneous shareholder suits, but they too are likely to be plagued by endogeneity problems and could therefore bias the estimates of the governance variable coefficients.
25. Paul Gompers, Joy Ishii, and Andrew Metrick, Corporate Governance and Equity Prices, 118 Q J Econ 107 (2003).
26. See id at 114-19 (explaining the statistical methodology behind the construction of their dataset).
27. See also id at 112 table 1 (listing the governance variables used in the study);
28. id at 145-50 (providing detailed information on each of the variables). For example, if a company maintained a poison pill, that factor would count as a point in the GIM index and would be added to other points that the company might have accrued in other measures (such as blank-check preferred stock, golden parachutes, and so forth).
29. Id at 115 ("Thus the Governance Index [ ] is just the sum of one point for the existence (or absence) of each provision."). High scorers were deemed to be "nondemocratic," giving little power to shareholders, and vice versa for low scorers. Id at 116 (grouping firms with a GIM index greater than or equal to fourteen in the "Dictatorship Portfolio" and firms with a GIM index less than or equal to five in the "Democracy Portfolio").
30. Id at 144.
31. Id at 128.
32. Gompers, Ishii, and Metrick, 118 Q J Econ at 129 (cited in note 18).
33. Id at 133-34.
34. Id at 134-37 (examining data on corporate acquisitions and finding that nondemocratic firms have done so at a higher rate potentially to stave off "empire collapse").
35. See, for example, Lucian Arye Bebchuk, Alma Cohen, and Allen Ferrell, What Matters in Corporate Governance? *1-5 (Harvard Law School Olin Law, Economics & Business Discussion Paper No 491, Sept 2004), online at http://ssrn.com/abstract-593423 (visited Jan 11, 2009) (analyzing a subset of the GIM index consisting of six factors-four that concern shareholder voting power and two measures taken in preparation to hostile takeovers-and concluding that these six factors are largely responsible for the relation between performance and corporate governance).
36. See, for example, Robert M. Bowen, Shivaram Rajgopal, and Mohan Venkatachalam, Accounting Discretion, Corporate Governance and Firm Performance *20 n 11 (14th Annual Conference on Financial Economics and Accounting, Jan 2003), online at http://ssrn.com/abstract=367940 (visited Jan 11, 2009) (considering several board characteristics and the GIM index as separate measures of governance).
37. See, for example, Lawrence D. Brown and Marcus L. Caylor, Corporate Governance and Firm Performance *3-4 (Working Paper, Dec 2004), online at http://ssrn.com/abstract=586423 (visited Jan 11, 2009) (considering the GIM in conjunction with proxies for board monitoring, institutional ownership, managerial ownership, incentive compensation by bonus or stock options, and auditor expertise).
38. See Jay C. Hartzeil and Laura T Starks, Institutional Investors and Executive Compensation, 58 J Fin 2351,2352 (2003).
39. See Robert Daines, Ian Gow, and David Larcker, Rating the Ratings: How Good Are Commercial Corporate Governance Ratings? *29 (Stanford Law School Olin Law & Economics Working Paper No 360, June 2008), online at http://ssrn.com/abstract=1152093 (visited Jan 11, 2009).
40. Significantly, Daines, Gow and Larcker report that most commercial ratings do not perform well as predictors even of standard shareholder value measures. Id at *21-26.
41. See generally, for example, Stephen J. Choi, Do the Merits Matter Less after the Private Securities Litigation Reform Act?, 23 J L, Econ, & Org 598 (2007) (looking at the impact of the Private Securities Litigation Reform Act of 1995 (PSLRA) on meritorious securities litigation and concluding that although the PSLRA has reduced the incidence of "nuisance suit litigation," it has also worked to reduce more meritorious litigation aimed at smaller companies and companies engaged in fraud whose existence is not evinced in pre-filing "hard evidence");
42. Marilyn F. Johnson, Karen K. Nelson, and A.C. Pritchard, Do the Merits Matter? The Impact of the Private Securities Litigation Reform Act, 23 J L, Econ, & Org 627 (2007) (looking at the same question and finding evidence that, post-PSLRA, plaintiffs' attorneys are more precisely targeting firms likely to have committed fraud).
43. The SCAA is now published by RiskMetrics Group and is referred to as Securities Class Action Services. See RiskMetrics Group, http://sca-issproxy. com/Login.php (visited Jan 11, 2009).
44. For a description of the SCAA, see RiskMetrics, Securities Class Action Services 1-2, online at https/www.riskmetrics.com/sites/default/ files/SCAS-Research-Filing.pdf (visited Jan 11, 2009).
45. For a description of the CRSP database, see Database Guides, Center for Research in Security Prices (Chicago Booth School of Business), online at http://www.crsp.chicagobooth.edu/documentation/ (visited Jan 11, 2009).
46. By most estimates, there are around 12,000 to 15,000 publicly traded companies in the United States, and historically there have been around 200 to 220 class actions filed per year, which would yield a prediction of around a 1.3 to 1.8 percent litigation rate. See Walkers Research, online at http://www.walkersresearch.com (visited Jan 11, 2009) (subscription required).
47. See, for example, NYSE, Listed Company Manual at § 303A.10 (cited in note 10) ("Listed companies must adopt and disclose a code of business conduct and ethics for directors, officers and employees, and promptly disclose any waivers of the code for directors or executive officers"); id at § 303A.09 (requiring that NYSE-listed companies adopt corporate governance guidelines that at a minimum address director qualification standards, director responsibilities, director access to management and independent advisors, director compensation, director orientation and education, management succession, and annual performance reviews of the board).
48. It would, in principle, also be possible to use a conditional logit (fixed-effects) approach here. However, because there is not a considerable amount of variation among the governance variables over time, I report on a random-effects estimator throughout.
49. There are some "right-hand side" variables that are measured not in binary fashion but rather in a continuous fashion. In order to remain consistent in how I report later results, I will report all results in odds ratios. Although this leads to some cumbersome interpretations for nonbinary variable coefficients, it elucidates the lion's share of them.
50. The omitted category in the capitalization rankings contains firms that appear neither in the Russell 1000 nor the S&P small- and medium-cap indices. Because this omitted category constitutes a mixture of middling to small-cap firms that are not in an index, the mid-cap order statistic coefficients have an interpretation that is more challenging. Alternatively controlling for (logged) capitalization does not significantly improve the predictiveness of the baseline model beyond these indicator measures of capitalization.
51. Throughout the analysis, I measure volatility in any year as the standard deviation of the logged monthly gross returns during the year. This is consistent with standard asset-pricing approaches in option-pricing theory. See Mark Grinblatt and Sheridan Titman, Financial Markets and Corporate Strategy 280-83 (McGraw-Hill 2d ed 2002). Although there is nothing sacrosanct about using stock volatility (for example, public debt holders, preferred shareholders, and even option holders can also be securities fraud plaintiffs), this measure is directly tied to derivatives prices, and the presence of common shareholders in such suits is nearly ubiquitous
52. One word of caution: for the "CEO Is Chairman" regression, the CL data is more limited, and I was forced to drop some of the capitalization variables from the baseline regression. However, even if one drops all control variables, the "CEO Is Chairman" factor never appears to play any appreciable predictive role.
53. See, for example, Gretchen Morgenson, Soviet-style Proxies, Made in the U.S.A., NY Times C1 (June 25, 2006).
54. Recall that SOX did not require companies to adopt business ethics codes; rather, § 406 requires them to disclose whether they have adopted one consistent with the criteria laid out in the section. See SOX § 406(a), 116 Stat at 789, codified at 15 USC § 7264(a). Listing requirements at the SRO level subsequently required all issuers to adopt one.
55. See, for example, NYSE, Listed Company Manual at § 303A.10 (cited in note 10).
56. See Harvey L. Pitt and Karl A. Groskaufmanis, Minimizing Corporate Civil and Criminal Liability: A Second Look at Corporate Codes of Conduct, 78 Georgetown L J 1559, 1560 (1990).
57. Although it is often plaintiffs' attorneys (and not shareholders) who make an initial decision to bring class actions, an availing governance code might still augur against litigation risk by inducing greater information revelation to the market sooner, which in turn can undermine the viability of a later securities fraud action.
58. Even though the value of the odds ratio seems modest, remember that this variable is measured continuously from 0 percent to 100 percent, and thus the coefficient measures the odds ratio difference of a move of 1 percent in outside board representation.
59. Estimating this same model for companies that do not have an outside majority yields a nearly identical coefficient estimate and standard error.
60. See, for example, Julie Creswell, A Board in Need of an Emily Post, NY Times C1 (Sept 7, 2006) (discussing the controversy over Hewlett-Packard obtaining phone records to determine the source of board leaks and the role that Tom Perkins, an outside director, played in publicizing it).
61. My results on multiple board service are a bit distinct from those found in a recent paper that concentrates more directly on board attributes per se. See Stephen P. Ferris, Murali Jagannathan, and A.C. Pritchard, Too Busy to Mind the Business? Monitoring by Directors with Multiple Board Appointments, 58 J Fin 1087,1107-08 table VlII (2003) (using a matched sample approach to consider the effect of multiple board service for firms sued between 1996 and 1998). Ferris, Jagannathan, and Pritchard find essentially no significant difference. See id at 1109. The longer panel and later time period studied here, along with somewhat more controls, may be playing part of the role in explaining the difference in results. In addition, my results consider multiple board service in terms of a dummy variable (that is, service on four or more boards), which may pick up the especially experienced board members.
62. Principal component analysis is a method within statistics to understand the structure of a dataset by asking how much of a contribution each variable makes to the overall variation of the data. For example, in the above dataset, if the percentage of women on a board were always 50 percent of the percentage number of outside board members, then those two variables would be completely replicative of one another. It would, in principle, be possible to throw one of them out and lose no informational content in the data. Similarly, principal component analysis analyzes the covariance relationships among the variables to determine how well the dataset can be simplified in terms of a smaller number of synthesized variables (sometimes known as "factors"). It was developed first by Karl Pearson over a century ago. See generally Karl Pearson, On Lines and Planes of Closest Fit to Systems of Points in Space, 2 The London, Edinburgh, and Dublin Philosophical Mag and J Sci 559 (July-Dec 1901), online at http://stat.smmu.edu.cn/history/pearson1901.pdf (visited Jan 11. 2009).
63. See I.T. Jolliffe, Principal Component Analysis 111-49 (Springer-Verlag 2d ed 2002).
64. See Table Id. As noted in Part II in the litigation-risk analysis, I deliberately exclude the existence of restatements, compensation, and federal civil/criminal litigation as right-hand side variables, for fear that their endogeneity and the lack of reliable instruments will bias governance coefficients. These factors, however, have been shown to be predictive of litigation.
65. See, for example, Michael A. Peřino, The Milberg Weiss Prosecution: No Harm, No Foul? *30 (St John's Legal Studies Research Paper No 08-0135, May 2008), online at http://ssrn.com/abstract=1133995 (visited Jan 11, 2009).
66. As noted below, the total number of governance matches varies depending on the governance characteristic of interest. See Part III. A.
67. It is also possible that the truncation point is not at zero, given the relative paucity of monetary settlement around zero. As a robustness check, I also experimented with a two-stage Tobit (sometimes known as Heckman approach) specification, which yields qualitatively similar results (not reported here).
68. It should be noted from Table 2a that classified/staggered boards did face a greater estimated exposure to filings, though the estimated coefficient was not statistically significant.
69. Of these individually significant variables, a principal components analysis (similar to that of the previous Part) also lends support to a three-factor specification.
70. Of course, it is far from clear that the mandates of SOX were intended as much to reduce litigation exposure as to make firms better governed generally. But to the extent that securities litigation is an imperfect substitute for good governance, one might expect (or at least hope) that securities litigation rates would also be sensitive to tools that implement good governance.
71. See NYSE. Listed Company Manual at § 303A.09 (cited in note 10).
72. Likely due to data restrictions, the noise in estimating this coefficient ebbs in and out of significance.
73. It might also be the case that the settlements in cases involving staggered boards are more likely to be skewed toward governance reforms rather than pure cash payments. Although my data did not allow for testing this claim, it does appear to be a growing trend in securities litigation. See, for example, Bristol-Myers Squibb Agrees to Record Securities Litigation Settlement with Sweeping Data Disclosure Requirements Announces Labaton Sucharow, Bus Wire (Jan 23, 2006).
74. As noted in the Introduction, however, my analysis is not capable of testing these causal claims directly.