Has Anything Changed?

While securities litigation has been increasing as a long-term trend, there is no increase in the number of filings or the size of settlements as a result of either Enron or Sarbanes-Oxley. The only marked change is in the number of cases that judges dismiss.

This absence of change in no way suggests that the Act is ineffective. It was designed as a deterrent to fraud. To measure its success, the real question is whether it will reduce the amount of fraud committed, such that fewer filings occur in the future. The Act's major levers to deter fraud are increased accountability of management and board members, new criminal penalties, and increased oversight requirements. However, it also included an extension of the time to file securities class action suits to 2 years after the disclosure of fraud. Therefore, it may take several years of ongoing monitoring to assess The Act's effectiveness.

Did Enron or the Act Increase Filings?

Filings in 2001 and 2002 exceeded the previous peak level reached in 1998. Federal courts received 280 filings in 2002, down nearly 45% from the all-time high of 503 filings in 2001. However, the 2001 statistic is deceptive because it includes 303 laddering claims, alleging unfair IPO allocation practices and manipulation of the early aftermarket by newly public companies and their underwriters. Excluding the laddering cases, 2001 filings totaled 200. Similarly, in 2002, the revelation of analyst conflicts of interest added 40 filings against investment banks that recommended certain stocks. Federal courts received 123 filings during January-late June 2003, consistent with an annual rate of 246 filings, roughly in line with the trend rate in recent years.

The heightening of public anger at corporations following the revelation of the Enron scandal has had little if any impact on filings. From November 2001 through late June 2003, filings occurred at an annual rate of 212, which is within the range of recent years' annual filings, after excluding the filings associated with analyst conflict-of-interest.

While it is still early to evaluate the impact of the Act from its passage through late June 2003, filings came in at an annual rate of 214, as compared with the average of 208 for 1996-2001 (excluding 2001 laddering and 2002 analyst filings). Some expected that the Act's extension of the statute of limitations would increase filings; Sarbanes-Oxley extended the time to file from 1 year to 2 years after the discovery of a violation, and from 3 to 5 years after its occurrence. The absence of any substantial effect of the Act on filings suggests that the plaintiffs' bar is efficient enough to file claims within the old limits.

Although there is no statistically significant impact of the Act on filings, there is a significant increasing trend in filings since 1991. Indeed, taking a snapshot of cases filed in 1995 and those filed in 2002 reveals that the likelihood of a public company being sued rose approximately 40% from 1995 to 2002, controlling for the number of public companies in each year. Over 2% of public companies will face a securities class action suit in any given year. This percentage is strikingly high – it means that one in 50 companies will face a suit in any year.

The Dismissal Rate Has Fallen Since the Act

Fully 80% of federal securities class action lawsuits end in settlement. Approximately 19% of cases are dismissed, and about 1% end in judgments. The only marked change since Sarbanes-Oxley has been in the rate of dismissals, which has fallen by about half. The lower rate of dismissals suggests that either judges are taking more time to weigh whether to dismiss a case or are more reluctant to dismiss plaintiffs' claims.

Top Settlements Are on the Rise, But …

Plaintiff recoveries relative to losses are declining. Some extraordinarily large settlements have caused a rapid increase in average settlement values in recent years, yet plaintiffs have been typically recovering less, controlling for the characteristics of any given case. Average settlements more than tripled from $8.6 million in 1996 to $27.0 million in the first half of 2003. Yet, the median settlement has increased more modestly, from $3.9 million to $5.5 million, a 41% increase. Big settlements may grab headlines, but in the first half of 2003, 70% of settlements were below $10 million, while only 5% exceeded $100 million.

With the crash of the bull market of the 1990s, investor losses ballooned from an average of $140 million in 1996 to $1 billion in 2002, then fell back to $623 million in the first half of 2003. The bad news for investors is that despite rising settlements, their recovery in relation to investor losses is low and falling. The median percentage of losses paid in settlement fell from a high of 7.2% in 1996 to 2.7% in 2002, and then rose modestly to 2.9% in the first half of 2003.

Explaining Settlements

We have built a statistical model to explain the value of settlements, using data on cases since the passage of the Private Securities Litigation Reform Act of 1995 (PSLRA). This model allows us to find some of the factors that determine for how much a case will settle.

One striking finding is that, despite the rise in average settlements, they have been falling. In constant dollars, settlements have been declining by approximately 8% per year, controlling for the characteristics of the lawsuits. Recent public anger at corporate fraud has not affected settlements: there is no statistically significant change in settlements following either Enron or the Act, controlling for other characteristics of the lawsuits.

Investor losses are the single most powerful determinant of settlements. On average, a 1% increase in investor losses results in a 0.4% increase in settlements, such that settlements increase far less than one-for-one with investor losses. One of the major objectives of PSLRA, involving institutional investors as lead plaintiffs, has had a marked impact on settlements – they are about 20% higher in cases where the lead plaintiff is an institutional investor. This may reflect the retention of more effective plaintiffs' counsel, the institutional investor's more effective supervision and contribution to strategy or both. Alternatively, it may reflect a tendency for institutional investors to become involved primarily in more serious cases, in terms of either the merit of allegations or the size of potential damages.

Other characteristics that increase average settlements include:

• The inclusion of securities other than common stock;
• The defendant company's market capitalization;
• An accounting firm named as a codefendant;
• The presence of accounting issues in the allegations;
• Accounting irregularities admitted by the defendant;
• Restatements of financials;
• The presence of potential Section 11 claims.

Conclusion

The goal of Sarbanes-Oxley is not to change the nature of litigation, but to deter fraud. The Act facilitates criminal litigation against company directors and officers, enhances the accountability of accountants, and allows more time for fraud to be detected or litigation initiated. Effectively, it takes aim at executives' incentives to commit fraud, and increases the incentives of executives, independent directors and accountants to ensure that no violation goes undetected.

The bursting of the stock market bubble of the 1990s, and the aftermath of recent scandals, may be the single most powerful influence on securities litigation going forward. In a rapidly rising stock market and a rapidly growing company, false accounting has a chance of going undetected; but in the face of more modest growth, accounting gimmicks may be difficult to sustain. It is often said that current policy is invariably designed to prevent the last crisis. Should the near future bring less dramatic growth, this alone may limit fraud and filings; the impact of Sarbanes-Oxley may be secondary.

While securities litigation has been increasing as a long-term trend, there is no increase in the number of filings or the size of settlements as a result of either Enron or Sarbanes-Oxley. The only marked change is in the number of cases that judges dismiss.

This absence of change in no way suggests that the Act is ineffective. It was designed as a deterrent to fraud. To measure its success, the real question is whether it will reduce the amount of fraud committed, such that fewer filings occur in the future. The Act's major levers to deter fraud are increased accountability of management and board members, new criminal penalties, and increased oversight requirements. However, it also included an extension of the time to file securities class action suits to 2 years after the disclosure of fraud. Therefore, it may take several years of ongoing monitoring to assess The Act's effectiveness.

Did Enron or the Act Increase Filings?

Filings in 2001 and 2002 exceeded the previous peak level reached in 1998. Federal courts received 280 filings in 2002, down nearly 45% from the all-time high of 503 filings in 2001. However, the 2001 statistic is deceptive because it includes 303 laddering claims, alleging unfair IPO allocation practices and manipulation of the early aftermarket by newly public companies and their underwriters. Excluding the laddering cases, 2001 filings totaled 200. Similarly, in 2002, the revelation of analyst conflicts of interest added 40 filings against investment banks that recommended certain stocks. Federal courts received 123 filings during January-late June 2003, consistent with an annual rate of 246 filings, roughly in line with the trend rate in recent years.

The heightening of public anger at corporations following the revelation of the Enron scandal has had little if any impact on filings. From November 2001 through late June 2003, filings occurred at an annual rate of 212, which is within the range of recent years' annual filings, after excluding the filings associated with analyst conflict-of-interest.

While it is still early to evaluate the impact of the Act from its passage through late June 2003, filings came in at an annual rate of 214, as compared with the average of 208 for 1996-2001 (excluding 2001 laddering and 2002 analyst filings). Some expected that the Act's extension of the statute of limitations would increase filings; Sarbanes-Oxley extended the time to file from 1 year to 2 years after the discovery of a violation, and from 3 to 5 years after its occurrence. The absence of any substantial effect of the Act on filings suggests that the plaintiffs' bar is efficient enough to file claims within the old limits.

Although there is no statistically significant impact of the Act on filings, there is a significant increasing trend in filings since 1991. Indeed, taking a snapshot of cases filed in 1995 and those filed in 2002 reveals that the likelihood of a public company being sued rose approximately 40% from 1995 to 2002, controlling for the number of public companies in each year. Over 2% of public companies will face a securities class action suit in any given year. This percentage is strikingly high – it means that one in 50 companies will face a suit in any year.

The Dismissal Rate Has Fallen Since the Act

Fully 80% of federal securities class action lawsuits end in settlement. Approximately 19% of cases are dismissed, and about 1% end in judgments. The only marked change since Sarbanes-Oxley has been in the rate of dismissals, which has fallen by about half. The lower rate of dismissals suggests that either judges are taking more time to weigh whether to dismiss a case or are more reluctant to dismiss plaintiffs' claims.

Top Settlements Are on the Rise, But …

Plaintiff recoveries relative to losses are declining. Some extraordinarily large settlements have caused a rapid increase in average settlement values in recent years, yet plaintiffs have been typically recovering less, controlling for the characteristics of any given case. Average settlements more than tripled from $8.6 million in 1996 to $27.0 million in the first half of 2003. Yet, the median settlement has increased more modestly, from $3.9 million to $5.5 million, a 41% increase. Big settlements may grab headlines, but in the first half of 2003, 70% of settlements were below $10 million, while only 5% exceeded $100 million.

With the crash of the bull market of the 1990s, investor losses ballooned from an average of $140 million in 1996 to $1 billion in 2002, then fell back to $623 million in the first half of 2003. The bad news for investors is that despite rising settlements, their recovery in relation to investor losses is low and falling. The median percentage of losses paid in settlement fell from a high of 7.2% in 1996 to 2.7% in 2002, and then rose modestly to 2.9% in the first half of 2003.

Explaining Settlements

We have built a statistical model to explain the value of settlements, using data on cases since the passage of the Private Securities Litigation Reform Act of 1995 (PSLRA). This model allows us to find some of the factors that determine for how much a case will settle.

One striking finding is that, despite the rise in average settlements, they have been falling. In constant dollars, settlements have been declining by approximately 8% per year, controlling for the characteristics of the lawsuits. Recent public anger at corporate fraud has not affected settlements: there is no statistically significant change in settlements following either Enron or the Act, controlling for other characteristics of the lawsuits.

Investor losses are the single most powerful determinant of settlements. On average, a 1% increase in investor losses results in a 0.4% increase in settlements, such that settlements increase far less than one-for-one with investor losses. One of the major objectives of PSLRA, involving institutional investors as lead plaintiffs, has had a marked impact on settlements – they are about 20% higher in cases where the lead plaintiff is an institutional investor. This may reflect the retention of more effective plaintiffs' counsel, the institutional investor's more effective supervision and contribution to strategy or both. Alternatively, it may reflect a tendency for institutional investors to become involved primarily in more serious cases, in terms of either the merit of allegations or the size of potential damages.

Other characteristics that increase average settlements include:

• The inclusion of securities other than common stock;
• The defendant company's market capitalization;
• An accounting firm named as a codefendant;
• The presence of accounting issues in the allegations;
• Accounting irregularities admitted by the defendant;
• Restatements of financials;
• The presence of potential Section 11 claims.

Conclusion

The goal of Sarbanes-Oxley is not to change the nature of litigation, but to deter fraud. The Act facilitates criminal litigation against company directors and officers, enhances the accountability of accountants, and allows more time for fraud to be detected or litigation initiated. Effectively, it takes aim at executives' incentives to commit fraud, and increases the incentives of executives, independent directors and accountants to ensure that no violation goes undetected.

The bursting of the stock market bubble of the 1990s, and the aftermath of recent scandals, may be the single most powerful influence on securities litigation going forward. In a rapidly rising stock market and a rapidly growing company, false accounting has a chance of going undetected; but in the face of more modest growth, accounting gimmicks may be difficult to sustain. It is often said that current policy is invariably designed to prevent the last crisis. Should the near future bring less dramatic growth, this alone may limit fraud and filings; the impact of Sarbanes-Oxley may be secondary.