Stock Price Response to News of Securities Fraud Litigation: Market Efficiency and the Slow Diffusion of Costly Information

Abstract

This study distinguishes between announcements that precipitate federal class action securities fraud litigation, such as earnings surprises and restatements, and the later announcement that an issuer has been named as a defendant in such a lawsuit. The study documents a statistically significant negative short-term price response to the litigation announcement as well as a negative response that persists for several weeks subsequent to the litigation announcement. The response over shorter and longer horizons is more pronounced for smaller firms and for firms with less analyst coverage. Also, passage of the Private Securities Litigation Reform Act of 1995 reduced the cost of obtaining information about the initiation of these lawsuits and is correlated with a more rapid price response, particularly among smaller issuers and those with less analyst coverage. Although these findings are hardly dispositive of the debate, they present a case study of a price pattern that is far more consistent with a costly-information explanation of stock market price formation than with any behavioral model of which we are aware. These findings also suggest that careful examination of market microstructure and information cost considerations can usefully explain patterns that might otherwise seem inconsistent with the efficient market hypothesis.