The Shareholder Wealth Implications of Corporate Lawsuits

The Shareholder Wealth Implications of Corporate LawsuitsAuthor(s): Sanjai Bhagat, John Bizjak and Jeffrey L. ColesSource: Financial Management, Vol. 27, No. 4 (Winter, 1998), pp. 5-27Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3666410 .

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The Shareholder Wealth Implications of

Corporate Lawsuits

Sanjai Bhagat, John Bizjak, and Jeffrey L. Coles

Sanjai Bhagat is a Professor of Finance at the University of Colorado. John Bizjak is an Assistant Professor of Finance at Portland State University. Jeffrey L. Coles is a Professor of Finance and is one of the Dean's Council of 100 Distinguished Scholars at Arizona State University.

This paper examines lawsuits in which at least one side, plaintiff or defendant, is a corporation. We provide evidence on the relative frequency of the legal issues involved and on the incidence of suits according to whether the other party is another firm, a government entity, or a non- corporate private entity. To explore the direct and indirect costs and benefits to firms involved in different types of legal disputes, we examine the stock market reaction to filing and settlement announcements. We find that the characteristics of the suit, such as the legal issue and type of opponent, and firm characteristics, such as firm size and proximity to bankruptcy, have power to explain cross-sectional variation in these wealth effects.

* The modern corporation interacts with the external environment in many ways. Examples of external interfaces include: suppliers of raw materials, labor, and intermediate products in input markets; suppliers of funds in capital markets; customers in final product markets; and executives in managerial labor markets. Another important external connection is to other firms, private parties that are not corporations, and governments, all by way of the system of legal rules and institutions. In this regard, it is widely perceived that litigation is playing an increasingly important role in society. In the business community, in particular, managers claim to face increasing use of the legal system in running the firm and have expressed concern over the risks and costs associated with legal disputes.

Involvement of business in litigation appears to be borne out in the data. Out of more than four million federal lawsuits filed between 1971 and 1991, nearly 2.5 million involved at least one business entity (Wall Street Journal, December 3, 1993, B1). Furthermore, a

recent Rand study (Dungworth and Pace, 1990) of Fortune 1000 companies found that contract disputes between firms constituted the largest single category of federal civil suits. On the basis of their survey of corporate legal department budgets, Economic Analysis Group, Ltd., Craig Consulting Co., and Endispute, Inc. estimate that salaries to in-house lawyers and fees to outside counsel for the 1,000 largest public companies hit $20 billion in 1991.' Furthermore, large liability or settlement payments can dwarf such direct legal costs. For example, some mass torts, such as the breast- implant cases against Dow Corning and the Dalkon Shield cases against A.H. Robins, have threatened the very existence of the defendant firms.

On the other hand, it is possible that these estimates of legal risks and costs to business and society are overstated, reflecting political agendas or resulting from overreaction to media coverage of a few spectacular cases. One can point to the fact that many of the enormous damage awards emphasized by the

The authors thank seminar participants at Georgetown University Law Center, the 1997 FMA Annual Meeting, Charlotte Bond, two anonymous referees, and the Editors for helpful comments. Coles thanks the Dean's Council of 100 for financial support.

Forbes (February 17, 1992, p. 40), citing statistics from a Rand study on tort litigation, estimates the direct costs of all lawsuits, including those involving business, to be as high as $117 billion a year. Another estimate (Forbes, February 17, 1992, p. 41) places the costs of litigation as high as 2.5% of GNP.

Financial Management, Vol. 27, No. 4, Winter 1998, pages 5 - 27



6 FINANCIAL MANAGEMENT / WINTER 1998

media are later overturned on appeal or significantly reduced in a settlement.2 In addition, not all types of litigation have been on the rise. The number of federal civil suits involving corporations has declined by 12% since 1986 (Dungworth and Pace, 1990).

Much of the reason for disagreement about the risks and costs to both firms and society of legal disputes arises from a lack of empirical evidence on the costs and benefits to parties that become involved in a lawsuit. Such information would be required to address any of the really large questions, such as whether actual or potential lawsuits affect shareholder wealth enough to deter management from taking inappropriate actions, whether frivolous suits and excessive judgements hamper American firms as they compete against their foreign counterparts, and whether our legal system prevents products from being developed and marketed. While it would be ideal to have reliable data to address these and similar issues, at a much more basic level very little is known about corporate litigation as an economic phenomenon.3 Even so rudimentary a statistic as the total number of lawsuits filed each year against the major exchange-listed firms is unknown.

The purpose of this paper is to provide basic information on the topography of the legal landscape in which corporations operate. We collect and analyze a large sample of lawsuits in which at least one side, plaintiff or defendant, is a corporation. In particular, we provide evidence on the relative frequency of the legal issues involved and the type of opponent, as well as on the incidence of suits through time. To estimate the implications of litigation for shareholder wealth, we examine the abnormal stock market reaction to filing and settlement announcements. Market returns, in the absence of substantial market frictions, will reflect rational expectations as to the prospects of the firm in the legal dispute (Coles, 1992). While it is true that we have some evidence on the effects on shareholder wealth of interfirm litigation,4 we know of no large-sample examination of the implications for shareholder wealth of suits involving other types of opponents, such as government agencies or

noncorporate private parties, whether these suits differ substantially from interfirm suits, and whether the wealth effects differ across the wide spectrum of possible legal issues.

We find that no matter who brings a lawsuit against a firm, be it a government entity, another firm, or a private citizen, defendants experience economically meaningful and statistically significant wealth losses upon the filing of the suit. The average wealth loss for a defendant corporation is 0.97% of the market value of the equity, or $15.96 million. Furthermore, we find some evidence that the identity of the plaintiff has an effect on the wealth effects upon filing. Defendants involved in government suits suffer larger declines in shareholder wealth (-1.73%) than defendants involved in lawsuits with other firms (-0.75%) or with private parties (-0.81%). These results are consistent with the hypothesis that government agencies have more leverage and resources at their disposal to use in a legal battle and/or the type of suit most frequently filed by government agencies, such as an environmental action, is typically more serious. In fact, we do find that certain types of litigation are more costly for defendants. Environmental suits (-3.08%), product-liability suits (-1.46%), and violations of security laws (-2.71%) result in significantly greater wealth losses for defendant firms, as compared to disputes involving antitrust (-0.81%) or breach of contract (-0.16%) issues. It appears that, at least for some types of suits, the actual or potential lawsuit is associated with a large decline in shareholder wealth. In addition, controlling for the opposing party and the legal issue, the defendant firm's abnormal return on the announcement of a filing is significantly positively related to the size of the defendant firm and, in some specifications, significantly negatively related to the defendant firm's proximity to bankruptcy. One possible explanation for this effect of firm size is that larger firms have more bargaining power or more resources to devote to the legal dispute (e.g., because of better access to the capital markets or "deeper pockets"). The results on proximity to bankruptcy, while not as strong, are consistent with other work that has identified potential bankruptcy costs as an important indirect cost of a legal dispute.5

For plaintiff firms, the results are different in that there are no significant wealth effects associated with

2Jury awards are not the last word in lawsuits that involve both compensatory and punitive damage awards. Remittances, post- trial motions, appeals, and settlements reduce many award amounts. The Shanley and Peterson (1987) study by the Rand Institute for Civil Justice found that many of the compensatory and punitive damage awards were later reduced or overturned in a post-trial action. In 20% of the federal civil disputes included in their sample, there was a reduction of the original damage award. The largest adjustments were in awards at the high end of the distribution--40% of the awards over $10 million were later reduced or overturned. In addition, the study found that cases that involved punitive damage awards were more likely to involve post-trial adjustments. 3See Jacobs (1995). 4See Bhagat, Brickley, and Coles (1994), Bizjak and Coles (1995), and Engelmann and Cornell (1988),

5See Bhagat, Brickley, and Coles (1994), Bizjak and Coles (1995), and Cutler and Summers (1988). Furthermore, if proximity to financial distress impinges on litigation decisions, it will also affect decisions more directly related to bankruptcy. See, for example, Chatterjee, Dhillon, and Ramirez (1996) on how Chapter 11 debt restructurings are related to financial distress, Opler (1993) on financial innovations motivated by financial distress costs, and John (1993) on managing financial distress.



BHAGAT, BIZJAK, & COLES I THE SHAREHOLDER WEALTH IMPLICATIONS OF CORPORATE LAWSUITS 7

lawsuit filings. This is consistent with most other studies, such as Engelmann and Cornell (1988) and Bhagat, Brickley, and Coles (1994), but not Bizjak and Coles (1995). In addition, the identity of the defendant and the legal issue are not related to the stock price change of the plaintiff when a suit is filed.

Our results indicate that when a defendant firm settles a suit with another firm, the defendant benefits from a significant wealth increase. It is surprising that, in contrast, we can detect no significant wealth change for defendants upon the announcement of a settlement when the opponent is a government entity or a noncorporate private party. In addition, the wealth effect of a settlement for the defendant is unrelated to the legal issue. For plaintiff firms, the wealth implications of settlements appear to be trivial. On average, we find no significant wealth gains or losses to plaintiff firms who settle a lawsuit, and neither the legal issue nor the identity of the opposing party has any power in explaining variation in those returns.

This is the first study to examine a large sample of corporate lawsuits involving a wide spectrum of legal issues and several different types of opponents. Two basic contributions follow from this analysis. First, understanding the risks and determinants of the potential costs and benefits of a legal dispute provides guidance for firms as they formulate both the legal and other components of corporate strategy. In terms of general corporate strategy, firms will want to understand the nature and costs of potential litigation before making a business decision, such as whether to enter a new product market. Our results provide some evidence on the risks and overall costs to companies of operating in a business environment where litigation is becoming an increasingly common method of resolving conflicts. Second, there seems to be little agreement on the most basic characteristics of the legal landscape. Yet, any proposals for reform of the legal system, as that system involves corporations, must proceed from a reliable, generally accepted base of information. In this context, our data set and analysis contribute towards a better characterization and understanding of the legal environment.

The remainder of the paper is organized as follows. Section I provides a review of the prior literature that is most relevant for our analysis. We also discuss how costs and benefits in the various stages of suit, settlement, and trial are likely to vary by the type of dispute or identity of the opposing party. Section II provides a description of the sample used in the analysis. In particular, we characterize the incidence of litigation filings and settlements by legal issue and type of opponent. Section III identifies the shareholder wealth effects of filings and settlements. In Section IV, we test the power of various characteristics of the suit

and the opposing parties, firm size, and the costs of financial distress to explain cross-sectional variation in the effect of filings and settlements on shareholder wealth. Section V concludes.

I. Motivation and Prior Research

Legal scholarship typically presents the results of in-depth case studies. These small-sample studies provide evidence on the characteristics of the particular case(s) and often explore the institutional setting in rich detail. More recently, empirical work has used market data to identify and measure the implications of interfirm lawsuits. The basic idea is that by observing the stock price reaction to various actions in the litigation process, such as filings, settlements, and verdicts, we can make inferences about the benefits, costs, and risks of those actions (at least as the market perceives them). This makes sense in the context of a frictionless market, as investors trade to the point that stock returns reflect rational expectations as to the prospects of the firm in the legal dispute (Coles, 1992).

A. Prior Research

The primary focus in the literature based on market data has been on "leakages" in the litigation process. For example, Cutler and Summers (1988) examine the Pennzoil/Texaco lawsuit and find significant costs to both parties in the dispute, with the losses for Texaco being larger than the gains for Pennzoil. The combined drop in value for the two firms was $2 billion. They attribute the loss mainly to an increase in the Costs of financial distress for Texaco. Engelmann and Cornell (1988) study the wealth implications around filings, settlements, and verdicts for a sample of five interfirm disputes. They too observe combined wealth losses, or leakages, to the litigating parties.

These case studies have been extremely valuable in suggesting what is potentially important in lawsuits. Unfortunately, it is usually inappropriate to extrapolate these results to make more general inferences based on such small samples. This has motivated researchers to examine larger samples of legal disputes. The cost of doing so, because the data collection costs can be so large, is a loss of intimate knowledge of some of the characteristics and institutional detail associated with the individual cases. The benefit is the gain in inferential power associated with a large number of observations. For example, large-sample studies should yield more precise estimates of the effects on shareholder wealth of various types of lawsuits. Furthermore, with large samples it is possible to examine the determinants of cross-sectional variation



8 FINANCIAL MANAGEMENT/ WINTER 1998

in litigation-related changes in shareholder wealth. In this spirit, Bhagat, Brickley, and Coles (1994) study

a wide panorama of interfirm lawsuits. They examine the market reaction to lawsuit filings and settlements for a large sample of interfirm disputes, but find that a relatively coarse classification of legal issue has little power to explain variation in wealth effects. Bhagat, Brickley, and Coles (1994) observe combined wealth losses arising from lawsuit filings and find that these losses are the result of the increased probability of financial distress for the defendant firm. In addition, they find that defendant firms gain upon the announcement of a settlement. Ellert (1976) examines the market responses to announcement of legal challenges to mergers, under Section 7 of the Clayton Act, by the Federal Trade Commission and the Department of Justice during the period 1950-1972. During the month of the announcement of the suit, the market adjusts the defendant firm's value downward by about 2.0%. Bizjak and Coles (1995) analyze a more homogeneous but still large sample of interfirm disputes-i.e., private antitrust suits. To our knowledge, their paper is the only study to find a positive stock market reaction to plaintiffs upon any sort of lawsuit filing. They also find that the joint wealth effects associated with the announcement of a

filing tend to be negative and that losses in value in antitrust disputes are attributable to court-imposed behavioral restraints, the likelihood of follow-on suits, and an increased likelihood of financial distress. Moreover, Bizjak and Coles confirm that factors which affect the costs of litigation also affect behavior in suit, settlement, and trial. In their sample of antitrust lawsuits, the parties are more likely to settle when the suit involves potential restrictions on the defendant's business practices and when there is the potential for financial distress. In an attempt to measure the impact of litigation costs on other decisions, Drake and Vetsuypens (1993) examine IPO underpricing. They test the hypothesis that the underpricing of the equity offered is based in part on the desire to avoid lawsuits and to reduce exposure when a lawsuit is filed. Finally, Karpoff and Lott (1993) study a homogeneous sample of corporate defendants accused of fraud. They find that such firms suffer significant wealth losses at the announcement of the accusation. The authors attribute most of these shareholder-wealth losses to reputation costs in the form of higher input and/or lower output prices.

In summary, previous research reports mixed results on whether characteristics of the suit influence the shareholder wealth of the disputants in a suit and no results whatsoever on whether the type of opposing party affects the prospects for a litigant. These studies, however, generally have relied on small and/or relatively homogeneous samples. A large sample with more

substantial variation in firm and suit characteristics, however, provides a better opportunity for the legal issue at hand and characteristics of the opposing party to play a role in explaining the wealth effects of such legal disputes. There are several factors why the costs and benefits of suit, settlement, and trial are likely to be a function of the legal issue and the opposition.

B. Suits Involving Firms and Government Entities

If firms apply the net-present-value (NPV) rule to decisions in suit, settlement, and trial, then managers take actions in litigation that have positive net present value, but eschew courses of action that have negative NPV. This is likely to be a reasonable approximation given firms' relatively costless access to capital markets, the informational efficiency of stock markets, and the ways in which shareholders connect managerial wealth to firm performance, e.g., through performance-contingent, managerial compensation.6 Using the NPV rule as a basis for comparison, it seems very unlikely that government litigants have the same incentives as corporate opponents. Restated, it is likely that government decision-makers operate on a different margin and face a different litigation calculus.

To begin, the source of funding for many government litigants, as both defendants and plaintiffs, is legislative appropriation, not the market. If government agencies are less constrained in terms of financial and legal resources, they will have an advantage in pursuing a lawsuit or defending against a suit. In addition, government agencies can have an incentive to overapply legal resources. For example, many government cases define agency and government powers. Furthermore, visibility that is associated with successful outcomes in litigation can affect the survival and funding of the government unit. In both instances, we would expect a greater expenditure of resources on the government's behalf.7 6See Bizjak, Brickley, and Coles (1994) for a discussion of the conditions under which managers are likely to follow the NPV rule in litigation decisions. Also see Bizjak, Brickley, and Coles (1993) and Hirshleifer (1993) for analysis of a similar problem in a more general setting. 7Compounding the problem, a rational response by the opposing party can be to increase resources in fighting the legal battle because some phases of litigation have features akin to the prisoners' dilemma game. For example, during trial a larger expenditure of legal effort by one side could increase the marginal benefit to the other side of greater legal effort, and vice versa. The result could be overexpenditure (relative to the efficient outcome) by both parties. An illustration of this in the context of wage bargaining is presented in Ashenfelter and Bloom (1990). They show how the costs and benefits of legal representation are structured so that each side expends legal resources in the hope of exploiting the other side, and each side realizes that failing to do so opens up the possibility of being exploited.



BHAGAT, BIZJAK, & COLES / THE SHAREHOLDER WEALTH IMPLICATIONS OF CORPORATE LAWSUITS 9

In addition, opposing firms face free-rider problems on certain types of suits when fighting a government agency, as compared to a private party, which reduce their ability to absorb costs or extract benefits from the lawsuit. For example, winning a suit and establishing a legal precedent can provide benefits for many other firms, but the entire cost of the suit is absorbed by the litigating firm. Hence, net of legal costs, a greater potential for loss exists when a government agency files a lawsuit (as opposed to another firm or a private citizen), and less potential for gain exists when the government is the defendant in a lawsuit.8

Along the same lines, private litigants have incentives to settle a dispute when doing so would be mutually beneficial. Moreover, in the absence of transaction costs and income effects, efficient outcomes, as suggested by the Coase (1960) Theorem, would be obtained. We expect settlements between private parties to result in cost savings and benefits to both parties. Once again, however, government litigants may not have the same incentives as private parties to reach cost-effective and efficient outcomes when litigating a dispute. The implications for settlement behavior are that government authorities may choose not to settle even if the settlement might be more efficient and cost effective for both the agency and the other party. For example, an agency, such as the Securities and Exchange Commission (SEC), may be more concerned with obtaining a legal ruling on a new statute, and the associated legal precedent, rather than settling the case and reaching a private agreement with a particular firm-even if a settlement would be more cost efficient.

A separate issue concerns the possibility of financial distress, or even bankruptcy, which is more important for the firm than for the government in litigation decisions. As Bhagat, Brickley, and Coles (1994) and Cutler and Summers (1988) find, the possibility of litigation-related financial distress is an important determinant of the change in shareholder wealth associated with initiating litigation. In addition, Bizjak and Coles (1995) find that the potential for financial distress leads to an increased likelihood of settling a dispute. While government agencies do face the possibility of decreased funding or elimination, obviously they do not face the usual indirect costs of financial distress, such as terminated trade credit or lower market value of warranties.

Finally, there are at least two more reasons government-

brought lawsuits may have different valuation effects than other lawsuits. Firms sued by a government agency risk suspension or debarment from government contracts, an exclusion that potentially represents a huge loss. Additionally, government lawsuits can attract large amounts of publicity, raising the cost of the suit or resulting in large reputational losses (Karpoff and Lott, 1993).

C. Lawsuits Between Firms and Private Citizens

In a similar manner, incentive differences between firms and private citizens will have implications for the wealth effects of suit, settlement, and trial. Like government agencies, businesses often have better access to the capital markets and more financial and legal resources at their disposal than most individuals. All else equal, the greater resources available to firms will tend to raise the potential costs of interfirm legal conflicts and increase the benefits to settling the dispute. On the basis of this argument, just as we expect the wealth effects for firms upon filing and settlement to be larger for firm-government conflicts than for interfirm conflicts, we might expect the wealth effects to be larger for interfirm suits than for corporate suits in which the opponent is a non-firm private party.

On the other hand, one could argue for the opposite conclusion. For example, some suits filed by individuals foreshadow a mass tort, a class action, or multiple follow-on suits, or motivate government litigation. In addition, some private suits receive government backing. Thus, the wealth implications of a filing or settlement when the opponent is a non-corporate private party could be substantial. In conclusion, it is ambiguous as to whether non-corporate private parties are more formidable opponents than firms and government agencies.

D. Legal Issue

In addition to variation in the characteristics of the opposing party, another factor that is likely to affect the cost of a lawsuit and behavior in suit settlement and trial is the legal issue involved. The probability distribution of outcomes, attorneys' fees and court costs, the nature of judicial penalties (such as injunctive relief), and the applicable legal standard all depend on the issue at hand.

For example, certain types of violations carry relatively large penalties. In antitrust actions, trebling of damage awards is a possibility, and in some types of suits, punitive damage awards are relatively frequent and/or large. As a second example, some suits are more likely to be associated with a class action or give rise to multiple follow-on suits. Furthermore, such differences can motivate the parties to expend different

8On the other hand, some government entities may be exploitable. Dennis Kirschbaum (Executive Director of the Public Risk Management Association), Wade Lambert, quoted in "Legal Beat: More Are Suing City Hall, Straining Local Budgets," Wall Street Journal (Nov. 8, 1994), Bi, claims that "People are just recognizing that public entities are an easy target."




amounts of resources in fighting the dispute. Indeed, in the case of antitrust disputes, Elzinga and Wood (1988) show that direct legal costs differ according to the applicable statute (e.g., the applicable section of the Clayton Act or Sherman Act) and according to whether the complaint alleges a vertical or horizontal merger violation.

Other considerations, as well, imply variation in litigation prospects by legal issue. For example, a firm involved in a patent infringement dispute might be more likely to incur the costs of a trial to prevent the defendant from profiting from its behavior and to discourage other firms from violating the patent. In contrast, a firm involved in a breach of contract case may be more likely to settle and avoid a costly trial in order to maintain a good relationship with a supplier who has brought the suit or with a potential supplier who could observe a formal dispute. Furthermore, different legal issues are likely to be associated with varying reputational effects. For example, reputational costs are likely to be negligable for antitrust suits but high for product-liability cases. To the extent that considerations such as these shape the prospects of the defendant and plaintiff in litigation, the value of the dispute to each party and the market reaction associated with a filing or settlement announcement will differ by the legal issue involved. We expect heterogeneity in legal issues to drive some of the variation in shareholder wealth changes associated with filing and settlement announcements.

II. Characteristics of the Sample of Corporate Lawsuits

Our sample of legal disputes consists of filings and settlements announced in the Wall Street Journal (WSJ) during the period 1981 through 1983. WSJ data are used because we are able to specify with reasonable precision when the stock market first receives information about the particular event. We report no data on verdicts hereafter because there were so few verdict (or dismissal) announcements and the market is likely to have information about the case that could suggest the verdict in advance of it. The sample was collected by conducting a comprehensive reading of the entire WSJ Index for the years 1981 through 1983.

This sample period is somewhat dated. The reason, in part, is that this paper is the second part of a research agenda focusing on lawsuits in which at least one party is a corporation. The results from the first prong of this research project were published in Bhagat, Brickley, and Coles (1994). That work focused exclusively on the one third (approximately) of the sample in which the opponent is another firm, analyzing those data in isolation of other types of suits. In this larger companion study, we

include the Bhagat, Brickley, and Coles (1994) suits as a basis of comparison for the bulk of the sample in which the suits involve other types of opponents, such as government entities or private parties that are not corporations. In addition, the analysis in this study is more detailed, both for the interfirm suits and the suits involving only one firm, than that in our prior study. We have not altered the original sample because the sample collection costs are so high. For example, compilation of the data required a comprehensive reading of the WSJ Index. Nevertheless, this particular source appears to be appropriate-to our knowledge no other consistent database exists that lists the initiation of lawsuits against corporations.

We recorded the first reported announcement of any lawsuit filing, settlement, or verdict involving a firm on the Center for Research in Security Prices (CRSP) Daily Returns File. Included are both stated intent to file or settle and actual filings and settlements. We then collected and read the corresponding articles from the WSJ. We exclude observations from the final sample whenever the article gives any indication that the market already knows about the event. The reason is that, if information about the suit has already been made available to the market, any announcement period return will be attenuated and our experiment will underestimate the wealth implications of litigation events. Accounting data come from the COMPUSTAT tapes.

Table 1 displays the number of observations for filings against defendants (Panel A) and defendant settlements (Panel C) categorized by year and by the type of opposing party (plaintiff). The largest number of filings are interfirm disputes, followed by private and government lawsuits. Settlement observations are most common for interfirm and private conflicts, with the fewest number of settlements for government disputes.

Table 1 also lists the number of observations for plaintiff filings (Panel B) and settlements (Panel D) categorized by year and type of defendant. Similar to the defendant sample, the largest number of filing announcements occur for interfirm and private disputes, followed by suits against the government. The largest number of the few settlement observations occurs for interfirm conflicts.

In the plaintiff and defendant subsamples, the trend in the number of filings announced is increasing through time. The Pearson goodness-of-fit test (z2 = 7.10, p = 0.029) and Wilcoxon signed-rank test (p = 0.0001) reject the null hypothesis that the rate of filings in the combined plaintiff and defendant samples is the same across the three years in the sample. The positive trend is driven by an increase over the three years in suits with a non-corporate private opponent, an increase from 1981 to 1982 in suits with government opponents, and an increase from 1982 to 1983 in suits with corporate opponents. These results are consistent




Table 1. Descriptive Statistics for Filings and Settlements by Type of Opponent and Year This table furnishes descriptive statistics for filings and settlements according to whether the firm is a defendant or a plaintiff, by type of opponent and by year. The sample consists of firms contained in the CRSP Daily Returns File that reported a lawsuit filing or settlement in the Wall Street Journal during the period 1981-1983. A firm enters the sample each time it is named as either a defendant or a plaintiff in a filing or a settlement of a lawsuit. Data are presented in the format: number/row percentage/column percentage.

Panel A. Filings Against Defendants by Plantiff Type by Year: 2,

= 17.62, p = 0.024

1981 1982 1983 Total

Another Firm 69/28.87/49.29 69/28.87/37.70 101/42.26/34.24 239/100.00/38.67

Government 18/16.36/12.86 26/23.64/14.21 66/60.00/22.37 110/100.00/17.80

Private, Non-Firm 43/19.46/30.71 69/31.22/37.70 109/49.32/36.95 221/100.00/35.76

Foreign 2/40.00/1.43 1/20.00/0.55 2/40.00/0.68 5/100.00/0.81 Other 8/18.60/5.71 18/41.86/9.84 17/39.53/5.76 43/100.00/6.96

Total 140/22.65/100.00 183/29.61/100.00 295/47.73/100.00 618/100.00/100.0

Panel B. Filings by Planttiffs by Defendant Type by Year: ,

= 1.81, p = 0.986

1981 1982 1983 Total

Another Firm 41/23.84/70.69 63/36.63/63.00 68/39.53/66.02 172/100.00/65.90 Government 5/19.23/8.62 12/46.15/12.00 9/34.62/8.74 26/100.00/9.96

Private, Non-Firm 10/19.61/17.24 20/39.22/20.00 21/41.18/20.39 51/100.00/19.54

Foreign 0/0.00/0.00 1/50.00/1.00 1/50.00/0.97 2/100.00/0.77 Other 2/20.00/3.45 4/40.00/4.00 4/40.00/3.88 10/100.00/3.83 Total 58/22.22/100.00 100/38.13/100.00 103/39.46/100.0 261/100.00/100.00

Panel C. Defendant Settlements by Plantiff Type by Year: j = 2.86, p = 0.827

1981 1982 1983 Total


Private, Non-Firm 3/25.00/30.00 3/25.00/50.00 6/50.00/46.15 12/100.00/41.38

Foreign 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 Other 1/100.00/10.00 0/0.00/0.00 0/0.00/0.00 1/100.00/3.45

Total 10/34.48/100.00 6/20.69/100.00 13/44.83/100.00 28/100.00/100.00

Panel D. Plantiff Settlements by Defendant Type by Year: 2,

= 5.00, p = 0.544

1981 1982 1983 Total


Private, Non-Firm 0/0.00/0.00 1/50.00/33.33 1/50.00/16.67 2/100.00/16.67

Foreign 0/0.00/0.00 0/0.00/0.00 1/100.00/16.67 1/100.00/8.33 Other 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 Total 3/25.00/100.00 3/25.00/100.00 6/50.00/100.00 12/100.00/100.00

with the conventional wisdom that the rate of litigation involving at least one corporation is increasing through time. Nevertheless, this result should be interpreted with some caution, as this sample covers a limited time period and only a subset of the universe of suits.

Table 2 tabulates defendant and plaintiff filings and settlements by legal issue and year. The filing and settlement announcements cover a wide range of legal issues. Some of the most common types of disputes

involve issues of corporate governance, antitrust, breach of contract, and patent infringement. "SEC- type" suits, which include violations of disclosure laws, for example, and "FTC-type" suits, such as exclusive dealing and other anti-competitive violations, also are reasonably frequent. Also, a significant number of cases do not fit into any of our categories. Examples of cases included in the "other" category include illegal campaign contributions, slander/libel, gender/age discrimination, and illegal activities, such




Table 2. Descriptive Statistics for Filings and Settlements by Type of Legal Issue and Year This table furnishes descriptive statistics for filings and settlements according to whether the firm is a defendant or a plaintiff, by type of legal issue and by year. The sample consists of firms contained in the CRSP Daily Returns File that reported a lawsuit filing or settlement in the Wall Street Journal during the period 1981-1983. A firm enters the sample each time it is named as either a defendant or a plaintiff in a filing or a settlement of a lawsuit. Data are presented in the format: number/row percentage/column percentage.

Panel A. Filings Against Defendants by Legal Issue by Year: / = 34.07, p = 0.005

1981 1982 1983 Total

Antitrust 18/29.03/12.86 16/25.81/8.74 28/45.16/9.49 62/100.00/10.03

Breach of Contract 13/25.49/9.29 9/17.65/4.92 29/56.86/9.83 51/100.00/8.25

Corporate Governance 43/25.29/30.71 54/31.76/29.51 73/42.94/24.75 170/100.00/27.51

Environment 6/19.35/4.29 9/29.03/4.92 16/51.61/5.42 31/100.00/5.02

FTC-Type Suits 3/10.71/2.14 4/14.29/2.19 21/75.00/7.12 28/100.00/4.53

Patent Infringement 11/31.43/7.86 15/42.86/8.20 9/25.71/3.05 35/100.00/5.66

Product Liability 12/29.27/8.57 8/19.51/4.37 21/51.22/7.12 41/100.00/6.63

SEC-Type Suits 9/18.75/6.43 22/45.83/12.02 17/35.42/5.76 48/100.00/7.77

Other 25/16.45/17.86 46/30.26/25.14 81/53.29/27.46 152/100.00/24.60

Total 140/22.65/100.00 183/29.61/100.00 295/47.73/100.00 618/100.00/100.00

Panel B. Filings by Plantiffs by Legal Issue by Year: j = 19.86, p = 0.135

1981 1982 1983 TotalI Antitrust 4/22.22/6.90 7/38.89/7.00 7/38.89/6.80 18/100.00/6.90



Environment 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00

FTC-Type Suits 4/23.53/6.90 3/17.65/3.00 10/58.82/9.71 17/100.00/6.51



SEC-Type Suits 7/46.67/12.07 4/26.67/4.00 4/26.67/3.88 15/100.00/5.75

Other 13/19.40/22.41 32/47.76/32.00 22/32.84/21.36 67/100.00/25.67

Total 58/22.22/100.00 100/38.31/100.00 103/39.46/100.00 261/100.00/100.00

Panel C. Defendant Settlements by Legal Issue by Year: f2 = 8.63, p = 0.854

1981 1982 1983 Total

Antitrust 1/33.33/10.00 1/33.33/16.67 1/33.33/7.69 3/100.00/10.34



Environment 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00

FTC-Type Suits 0/0.00/0.00 0/0.00/0.00 1/100.00/7.69 1/100.00/3.45



SEC-Type Suits 0/0.00/0.00 0/0.00/0.00 1/100.00/7.69 1/100.00/3.45

Other 3/25.00/30.00 3/25.00/50.00 6/50.00/46.15 12/100.00/41.38

Total 10/34.48/100.00 6/20.69/100.00 13/44.83/100.00 29/100.00/100.00

as bribery and fraud. In the sample of filings against defendant firms, there has been a reduction in the proportion of corporate governance suits through time and an increase in the proportion of other cases (Table 2, Panel A: X2 = 34.07, p = 0.005). The Appendix

provides a specific example of a lawsuit for each broad

legal issue. Table 3 characterizes the sample in terms of the

relation between the legal issue and the type of opponent. For filing announcements, there is a




Table 2. Descriptive Statistics for Filings and Settlements by Type of Legal Issue and Year (Continued)

Panel D. Plantiff Settlements by Legal Issue by Year: j = 8.00, p = 0.433

1981 1982 1983 Total

Antitrust 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00


Corporate Governance 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 Environment 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00

FTC-Type Suits 0/0.00/0.00 0/0.00/0.00 1/100.00/16.67 1/100.00/8.33



SEC-Type Suits 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 Other 1/33.33/33.33 1/33.33/33.33 1/33.33/16.67 3/100.00/25.00

Total 3/25.00/100.00 3/25.00/100.00 6/50.00/100.00 12/100.00/100.00

Table 3. Descriptive Statistics for Filings and Settlements by Type of Legal Issue and Type of Opponent This table furnishes descriptive statistics for filings and settlements according to whether the firm is a defendant or a plaintiff, by type of legal issue and by type of opponent. The sample consists of firms contained in the CRSP Daily Returns File that reported a lawsuit filing or settlement in the Wall Street Journal during the period 1981-1983. A firm enters the sample each time it is named as either a defendant or a plaintiff in a filing or a settlement of a lawsuit. Data are presented in the format: number/row percentage/column percentage.

Panel A. Filings Against Defendants by Legal Issue by Plantif Type: j = 310.38, p = 0.000

Another Private, Firm Foreign Government Non-Firm Other Total

Antitrust 42/67.74/17.57 0/0.00/0.00 18/29.03/16.36 2/3.23/0.90 0/0.00/0.00 62/100.00/10.03 Breach of Contract 38/74.51/15.90 2/3.92/40.00 5/9.80/4.55 5/9.80/2.26 1/1.96/2.33 51/100.00/8.25

Corporate 54/31.76/22.59 0/0.00/0.00 7/4.12/6.36 93/54.71/42.08 16/9.41/37.21 170/27.51/100.00 Governance

Environment 0/0.00/0.00 2/6.45/40.00 25/80.65/22.73 2/6.45/4.65 16/9.41/37.21 31/5.02/100.00

FTC-Type Suits 21/75.00/8.479 0/0.00/0.00 3/10.71/2.73 3/10.71/1.36 1/3.57/2.33 28/4.53/100.00 Patent 29/82.86/12.13 0/0.00/0.00 0/0.00/0.00 4/11.43/1.81 2/5.71/4.65 35/5.66/100.00 Infringement Product Liability 12/29.27/5.02 0/0.00/0.00 14/34.15/12.73 12/29.27/5.43 3/7.32/6.98 41/6.63/100.00

SEC-Type Suits 6/12.50/2.51 0/0.00/0.00 7/14.58/6.36 33/68.75/14.93 2/4.17/4.65 48/7.77/100.00 Other 37/24.34/15.48 1/0.66/20.00 31/20.39/28.18 67/44.08/30.32 16/10.53/37.21 152/24.60/100.00 Total 239/38.67/100.00 5/0.81/100.00 110/17.80/100.00 221/35.76/100.00 43/6.96/100.00 618/100.00/100.00

statistically significant variation in issue by type of opponent in both the defendant (X2 = 310.38, p = 0.000) and plaintiff (x2 = 70.95, p = 0.000) samples. In relative terms, for interfirm disputes some of the most frequently adjudicated issues are corporate governance, patent infringement, breach of contract, and antitrust. In contrast, a relatively large number of the cases filed by the government against firms are over environmental, product liability, and antitrust issues. The largest number of nonfirm, private cases involve corporate control and SEC-type suits.

For the most part, the plaintiff and defendant firms are similar in size. In the total sample of 919 filings and settlements, the average market value of equity is $3.39 billion for defendant firms and $4.07 billion for plaintiff firms. The hypothesis that defendants and plaintiffs are equal in size, as measured by the market value of equity, cannot be rejected (F = 0.96, p = 0.33). The average market value of the corporate defendant based on who files the suit is $1.53 billion for government suits, $4.85 billion for interfirm disputes, and $1.87 billion for suits brought by private parties that are not




Table 3. Descriptive Statistics for Filings and Settlements by Type of Legal Issue and Type of Opponent (Continued)

Panel B. Filings By Plantifs by Legal Issue by Opponent Type: j = 70.95, p = 0.000

Another Private, Firm Foreign Governmment Non-Firm Other Total

Antitrust 15/83.33/8.72 1/5.56/50.00 1/5.56/1.96 1/5.56/1.96 0/0.00/0.00 18/100.00/6.90

Breach of Contract 21/80.77/12.21 0/0.00/0.00 2/7.69/7.69 3/11.54/5.88 0/0.00/0.00 26/100.00/9.96


Environment 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00

FTC-Type Suits 12/70.59/6.98 0/0.00/0.00 3/17.65/11.54 21/1.76/3.92 0/0.00/0.00 17/100.00/6.51

Patent 46/83.64/26.74 0/0.00/0.00 1/1.82/3.85 4/7.27/7.84 4/7.27/40.00 55/100.00/21.07

Infringement

Product Liability 7/77.78/4.07 0/0.00/0.00 1/11.11/3.85 0/0.00/0.00 1/11.11/10.00 9/100.00/3.45

SEC-Type Suits 8/53.33/4.65 0/0.00/0.00 5/33.33/19.23 2/13.33/3.92 0/0.00/0.00 15/100.00/5.75

Other 35/52.24/20.35 1/1.49/50.00 12/17.91/46.15 15/22.39/29.41 4/5.97/40.00 67/100.00/25.67

Total 172/65.90/100.00 2/0.77/100.00 26/9.96/100.00 51/19.54/100.00 10/3.83/100.00 261/100.00/100.00

Panel C. Defendant Settlements by Legal Issue by Opponent: j = 25.98, p = 0.207


Antitrust 2/66.67/16.67 0/0.00/0.00 1/33.33/25.00 0/0.00/0.00 0/0.00/0.00 3/100.00/10.34

Breach of Contract 1/100.00/8.33 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 1/100.00/3.45


Environment 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00

FTC-Type Suits 0/0.00/0.00 0/0.00/0.00 1/100.00/25.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00

Patent 2/100.00/16.67 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 2/100.00/6.90

Infringement


SEC-Type Suits 0/0.00/0.00 0/0.00/0.00 1/100.00/25.00 0/0.00/0.00 0/0.00/0.00 1/100.00/3.45

Other 4/33.33/33.33 0/0.00/0.00 0/0.00/0.00 7/58.33/58.33 1/8.33/100.00 12/100.00/41.38

Total 12/41.38/100.00 0/0.00/0.00 4/13.79/100.00 12/41.38/100.00 1/3.45/100.00 29/100.00/100.00

Panel D. Plantiff Settlements by Legal Issue by Opponent: j = 9.00, p = 0.703


Antitrust 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00

Breach of Contract 1/100.00/12.50 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.0.000.00 1/100.00/8.33


Environment 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00

FTC-Type Suits 1/100.00/12.50 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 1/100.00/8.33

Patent 4/66.67/50.00 0/0..00 00 00 0/0.00/0.00 2/33.33/100.00 0/0.00/0.00 6/100.00/50.00

Infringement


SEC-Type Suits 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00 0/0.00/0.00

Other 1/33.33/12.50 1/33.33/100.00 1/33.33/100.00 0/0.00/0.00 0/0.00/0.00 3/100.00/25.00

Total 8/66.67/100.00 1/8.33/100.00 1/8.33/100.00 2/16.67/100.00 0/0.00/0.00 12/100.00/100.00




firms. The hypothesis that the defendants are equal in size, as measured by the market value of equity, for different plaintiff types is rejected (F = 6.50, p = 0.002). For corporate plaintiffs, the average market value of the plaintiff's equity by type of defendant is $2.91 billion for government lawsuits, $3.60 billion for interfirm suits, and $4.97 billion for non-firm private opponents. The hypothesis that the corporate plaintiffs are equal in size, as measured by the market value of equity, by type of opponent cannot be rejected (F = 0.50, p = 0.610).9

III. Wealth Effects

In this section, and in Section IV, we focus on the implications for shareholder wealth of the different types of legal conflicts. The decisions to violate the law, enforce the law by litigation, or settle depend ultimately on the rewards and penalties involved. By examining the stock price reactions upon important dates, such as filings and settlements, we can obtain an estimate of the effect of the event upon the value of the firm, as perceived by the market, and, perhaps, some sense about the incentives for plaintiffs to sue and defendants not to violate the law.

We utilize standard event-study techniques to measure the wealth effects of lawsuit filings and settlements for firms in our sample. For each event, we define day 0 as the WSJ announcement date and day -1 as the previous trading day; together they make up the announcement period. The cumulative abnormal returns (CARs) for the announcement period are calculated by subtracting from the announcement- period stock return of the firm a benchmark return specific to that firm. A benchmark is used in order to remove the effects of general market movements from the stock returns of the individual firm. Specifically, for each firm, we estimate the parameters of the standard market model using an ordinary-least-squares (OLS) regression over the 150-day period from day -171 to day -22. Using these parameter estimates and inserting the market return over the event window yields the benchmark return. For the Fisher sign test, Wilcoxon signed-rank test, and Kruskal-Wallis test, we use CARs. Otherwise, when the assumptions of the statistical test require that the errors are homoskedastic, as do the Wilcoxon-rank-sum test and the parametric tests, we use standardized prediction errors (SPEs).1'0

A. Filings

Table 4 provides a summary of the CARs for defendants and plaintiffs in the full sample of lawsuit filings and settlements. For both defendants and plaintiffs, the CARs provide evidence of the expected wealth transfer and any direct and indirect costs of the conflict. Defendants experience a loss on average of 0.97% of the market value of their equity, which is statistically significant (p = 0.0001). This stock price decline is equivalent to an economically significant loss of $15.96 million in shareholder wealth. The median decline in defendant abnormal returns is 0.62%, which is equivalent to a $1.11 million drop in shareholder wealth. The majority of defendants, roughly 60%, experience negative returns upon the filing announcement. The Wilcoxon signed-rank test (p = 0.000) and binomial Fisher sign test (p = 0.000) indicate that defendant returns are negative upon filings.

Somewhat surprisingly, but consistent with other studies, plaintiffs experience negative, although statistically insignificant, returns upon lawsuit filings. The average wealth decline for plaintiffs is 0.14% (p = 0.250). The mean dollar value of the wealth change to plaintiff stockholders is -$3.68 million, and the median change is -$48,010. A majority of plaintiffs, 52%, experience a wealth decrease upon filings, though this proportion is not statistically significant (Wilcoxon signed-rank p = 0.39). One possibile explanation for the negative returns to plaintiffs is that any expected benefit from a settlement or judgment is offset by litigation costs. A second explanation is that the filing of the lawsuit reveals additional negative information about the firm."1

The results for the defendant sample are consistent with the notion that plaintiffs can and do damage defendants in a lawsuit. Moreover, for this large heterogeneous sample of suits it appears that plaintiffs

9At this juncture, a caveat is warranted. Our sample is not necessarily representative of the distribution of suits filed, settled, or tried in state and federal courts. First, the distribution of lawsuits in our sample is subject to the biases of WSJ reporting. Most of the cases reported in the WSJ probably involved large firms or what the Journal perceives as important legal issues. Second, in constructing our sample we require that at least one have returns data contained on the CRSP Tapes. "'The SPE is the CAR normalized by the standard deviation of

the forecast error from the estimated benchmark model. We do not discuss the parametric event-study statistical tests in detail because of the general familiarity with these techniques. The reader is referred to the appendix of Dodd and Warner (1983) for a detailed description. "See Bizjak, Brickley, and Coles (1994) for a discussion of the incentives to litigate when the filing reveals to the market information not related to the suit about the plaintiff. Coles (1992) gives two examples of how litigation events can convey ancillary information to the market. First, if the market does not yet know about the existence of the dispute, a filing or settlement could suggest to the market that the plaintiff has been injured. This would not be new information in some cases (e.g., a large chemical spill upstream from a town and a brewery (plaintiff)), but could be news in other cases (e.g., violation of terms of a complex contract and corresponding loss of (hard to measure) gains to trade). Second, events in litigation could provide information about the economic health of the disputants. For example, the filing could indicate an inability (or unwillingness) of the defendant to comply with the law or the terms of a contract.




Table 4. Cumulative Abnormal Returns for Defendants and Plaintiffs The sample consists of firms contained in the CRSP Daily Returns File that reported a lawsuit filing or settlement in the Wall Street Journal during the period 1981-1983. A firm enters the sample each time it is named as either a defendant or a plaintiff in the filing or a settlement of a lawsuit. This table reports abnormal stock returns around lawsuit filings and settlements for defendants and plaintiffs for the full sample, which includes interfirm lawsuits, government suits, and suits brought by private parties.

Panel A. Filings Defendants Plantiffs

Average CAR -0.97% -0.14% Median CAR -0.62% -0.08%

Z-Statistic -6.51*** -1.15

Wilcoxon Signed-Rank p-Value 0.0001 0.39 Number Positive 256 126

Fisher Sign Test p-Value 0.0001 0.36

Sample Size 618 261 Panel B. Settlements

Defendants Plantiffs

Average CAR 0.96% -0.79% Median CAR -0.26% -0.56%

Z-Statistic 0.89 -1.40

Wilcoxon Signed-Rank p-Value 0.62 0.11 Number Positive 12 3

Fisher Sign Test p-Value 0.46 0.14

Sample Size 29 12

***Significant at the 0.01 level.

damage defendants either by imposing legal costs or through a potential transfer of wealth. The joint defendant and plaintiff results also seem to indicate that there are leakages in the lawsuit- that is, it appears that defendant losses more than offset plaintiff gains. Additionally, the results suggest that, in general, lawsuits are likely to provide some deterrence to violation of the law.

Overall, the evidence from our relatively broad sample is consistent with the few previous large- sample studies of interfirm disputes. Both Bhagat, Brickley, and Coles (1994) and Bizjak and Coles (1995) find significant negative returns to defendants upon filings. In addition, Bhagat, Brickley, and Coles find negative and insignificant returns to plaintiffs upon fillings. Bizjak and Coles find a positive and significant wealth increase for plaintiffs in their sample of antitrust lawsuits, but their nonparametric test results seem to indicate that the wealth increases may be concentrated within a few firms or with particular types of lawsuits.

B. Settlements

Table 4 also summarizes the CARs for defendants and plaintiffs when settlements are announced. For defendants, the two-day cumulative return is a positive

0.96%, while the median CAR is a negative 0.26%. Neither CAR is statistically significant. Concurrently, plaintiffs experience negative returns upon the announcement of a settlement. Both the average and median CARs are negative, but neither is statistically significant.

Unlike previous research, we do not find significant positive wealth gains for our full sample of settlement announcements for defendants or plaintiffs. Both Engelmann and Cornell (1988) and Bhagat, Brickley, and Coles (1994) find an increase in shareholder wealth for defendants upon settlement announcements. As we will see below, the difference between our results and previous work could be due to the heterogeneity of the sample. The gains to settlement may be dependent upon the opposing litigant in the dispute or the gains from settlements may be realized only in certain types of disputes.

C. Further Discussion

These results warrant further discussion and interpretation. First of all, the announcement-period return is likely to provide an estimate of the wealth implications of the suit that is attenuated toward zero. The reason is that for some sample observations, information about the forthcoming suit may already




have reached the market and therefore already be reflected in the market price of the firm's stock. We attempt to reduce the severity of this problem in our sample design by excluding cases in which there was any indication in the Wall Street Journal article that information about the suit had previously reached the market. Nevertheless, for example, if some sample filings have been anticipated, our estimate of an average loss to defendants of 0.97% of the market value of the equity understates the expected decline in shareholder wealth associated with the litigation (see Coles, 1992, on anticipation effects).

Second, any inferences concerning the deterrence effect of the wealth decline must be interpreted with caution. For example, a very negative market reaction for the defendant upon filing would not necessarily indicate that a particular sort of suit (e.g., an antitrust suit brought by the Department of Justice) provides a relatively large deterrence effect as compared to other types of suits. Perhaps only the most severe violations are detected and pursued, while other firms violate antitrust law and get away with it. This point can be restated in a framework in which litigation opportunities are provided or supplied by potential defendants as a negative function of the expected wealth loss and demanded by potential plaintiffs as a positive function of the expected wealth gain. Our estimates of the announcement-period effects for defendants and plaintiffs provide only a sense for the location in one dimension (price) of the intersection of supply and demand. The obvious identification problem undermines any attempt to make inferences about the marginal deterrence effect of a larger expected wealth loss for the defendant (i.e., the slope of the supply curve). Moreover, the fact that we observe filings at all suggests that deterrence is imperfect.

Third, we report the average market response associated with the announcement of a filing or settlement. Under what circumstances would a manager use such information? Virtually no litigation situation is an average situation. Each suit presents a unique set of costs and benefits, and managers deciding whether to launch or defend a suit will consider the specific costs and benefits of their situation, rather than the average market response to a collection of suits that may or may not share similar characteristics. We address this concern in two ways. Below, we control for numerous characteristics of the individual suits and use observations on those characteristics to explain cross-sectional variation in the market reactions to filings and settlements. By doing so we show how certain characteristics are relevant for the valuation consequences of a lawsuit. In addition, while no suit will be exactly the same as the one that might arise, it is precisely information on a wide spectrum of

suits that is most useful for the ex ante formulation of corporate strategy. For example, in deciding whether and how to enter a new product market, a sense for the possible litigation risk (wealth effects, likely opponent, statute, etc.) on grounds of antitrust and product liability issues would be useful to the manager.

IV. Determinants of Variation in Wealth Effects

We now examine some of the sources of cross- sectional variation in plaintiff and defendant returns associated with the filing and settlement announcements. In doing so, we provide evidence on how the legal issue, the parties involved in the dispute, and the characteristics of the firm affect the costs of a lawsuit.

A. Filing Wealth Effects: By Identity of

Opposing Party and Legal Issue

Two potential sources of heterogeneity in a lawsuit are: 1) the party who is on the opposing side of the conflict and 2) the legal issue in question. In legal disputes, the probability distribution of outcomes, attorneys' fees and court costs, the nature of judicial penalties, and the potential benefits of the lawsuit potentially can depend on who brings the suit and the type of violation in question. To provide evidence on the implications for shareholder wealth of variation in suit characteristics, Table 5 presents average abnormal returns upon filing for defendants and plaintiffs classified according to the identity of the opposing party and by legal issue.

Table 5 illustrates that upon lawsuit filings defendants experience the largest wealth declines when the lawsuit is brought by a government agency. For suits involving a federal, state, or local government agency, the average abnormal return is a negative 1.73% (Z = -4.99, p = 0.000), which is equivalent to a very substantial drop in shareholder equity value of $32.20 million. For interfirm disputes, the average CAR for defendants is a negative 0.75% (Z = -3.31, p = 0.001), which is equivalent to a wealth decline of $7.56 million. For private disputes in which only one side is a firm, the average stock price change is a negative 0.81% (Z = -2.67, p = 0.008), which is equivalent to a loss in shareholder value of $16.62 million. In all three cases, the Wilcoxon signed-rank test and the Fisher sign test are consistent with a significant negative wealth effect for defendants. For all three classifications, the wealth effects upon filings for defendants are consistent with the results for the full sample. On the other hand, while the largest wealth decline occurs for suits filed by government agencies, the standard F-test does not allow for rejection of the null hypothesis that the SPE is the same across




Table 5. Cumulative Abnormal Returns for Tests Based on Type of Opponent and Legal Issue The sample consists of firms contained in the CRSP Daily Returns File that reported a lawsuit filing or settlement in the Wall Street Journal during the period 1981-1983. A firm enters the sample each time it is named as either a defendant or a plaintiff in a filing or a settlement of a lawsuit. This table reports cumulative abnormal returns around lawsuit filings for defendants and plaintiffs classified by opposing party and by legal issue.

Panel A. Defendant Abnormal Returns for Filings by Opponent Type a

Opponent Number CAR (%) Z-Statistic Wilcoxon Signed-Rank p-Value Another Firm 239 -0.75% -3.31*** 0.00

Government 110 -1.73 -4.99*** 0.00

Private, Non-firm 221 -0.81 -2.67*** 0.00

Panel B. Plaintiff Abnormal Returns for Filings by Opponent Type b

Opponent Number CAR (%) Z-Statistic Wilcoxon Signed-Rank p-Value Another Firm 172 -0.25% -0.60 0.92

Government 26 -0.44 -0.80 0.31

Private, Non-firm 51 0.71 0.34 0.93

Panel C. Defendant Abnormal Returns for Filings by Legal Issue c

Legal Issue Number CAR (%) Z-Statistic Wilcoxon Signed-Rank p-Value Antitrust 62 -0.81% -1.52 0.25

Breach of Contract 48 -0.16 -0.59 0.50

Corporate Governance 154 0.08 0.64 0.35

Environment 27 -3.08 -5.32*** 0.01

FTC-Type Suits 27 -0.14 0.28 0.94

Patent Infringement 33 -1.50 -2.42** 0.01

Product Liability 38 -1.46 -3.12*** 0.00

SEC-Type Suits 46 -2.71 -4.49*** 0.01

Other 135 -1.26 -4.03*** 0.01

Panel D. Plaintiff Abnormal Returns for Filings by Legal Issue d

Legal Issue Number CAR (%) Z-Statistic Wilcoxon Signed-Rank p-Value Antitrust 17 0.13% 0.39 0.64

Breach of Contract 26 0.28 0.13 0.99

Corporate Governance 53 -0.44 -0.46 0.54

Environment 0

FTC-Type Suits 17 -0.57 -1.22 0.51

Patent Infringement 51 -0.31 -0.53 0.80

Product Liability 8 0.11 -1.00 0.99

SEC-Type Suits 15 -0.67 -0.44 0.30

Other 62 0.51 0.64 0.99

***Significant at the 0.01 level. **Significant at the 0.05 level.

aHypothesis that the average SPE is the same for all categories: F = 1.28, p = 0.28. bHypothesis that the average SPE is the same for all categories: F = 0.19, p = 0.38. cHypothesis that the average SPE is the same for all categories: F = 2.36, p = 0.017. dHypothesis that the average SPE is the same for all categories: F = 0.23, p = 0.98.

different categories (F = 1.28, p = 0.28). Nevertheless, at this point we emphasize that this is a univariate test that does not control for legal issue, firm size, or other potentially important variables.

Regardless of the identity of the defendant, the

average stock returns for plaintiffs reveals no abnormal performance around lawsuit filings. In the case of suits filed against a private party, the average stock return is a positive 0.71%, which is not statistically significant (Z = 0.34, p = 0.352). For lawsuits filed against a




government agency or another firm, the plaintiff CARs are -0.44% and -0.25%, respectively, and neither return is statistically significant (Z = -0.80, p = 0.424, and Z = -0.60, p = 0.549). Furthermore, the standard F-test does not allow rejection of the null hypothesis that the average SPE is the same for each lawsuit in the different categories (F = 0.19, p = 0.83).

Table 5 also presents the announcement-period returns for defendant firms for lawsuit filings by type of issue. All but corporate governance suits have negative returns. Environmental, patent infringement, product liability, and securities suits all have negative and statistically significant returns at the 0.05 level or better. In addition, the lawsuits we classify as "other" have significantly negative filing day abnormal returns. The standard F-test rejects the null hypothesis that the SPE is the same for each type of lawsuit filing (F = 2.36, p = 0.017). The finding of a significant difference in filing returns is consistent with the notion that there is heterogeneity in legal issue and that the type of violation has differential implications for expected wealth transfers and legal costs.

The difference in abnormal returns for different legal issues is also consistent with the finding that government suits tend to be more costly to defendants. The majority of environmental and product liability disputes in our sample are filed by government agencies. Both of these types of lawsuits have significant negative announcement-period returns. In addition, a large number of our unclassified suits, which have significantly negative CARs, are initiated by the government.

For interfirm disputes, the negative announcement- period wealth effects for defendants appear to be the result of patent infringement cases, SEC-type violations, product liability disputes, and unclassified suits. A large number of lawsuits filed by private parties involve corporate governance issues and alleged violations of the securities laws. In addition, a large number of private filings are listed as unclassified. The negative defendant wealth effects for the overall sample of non-firm, private filings appear to be a result of cases involving securities law violations or cases that are not classified.'2

Table 5 also presents the filing announcement abnormal returns for the sample of plaintiff returns categorized by opposing party and legal issue.

Consistent with the overall plaintiff results, none of the categories reveals a significant wealth effect upon filing announcements. The standard F-test fails to reject the null hypothesis that the average SPE is the same for the different types of lawsuits (F = 0.23, p = 0.98). The standard F-test also fails to reject the null hypothesis that the average SPE is the same for the different types of opposing litigants (F = 0.19, p = 0.83). These results are consistent with those in the prior literature. With the exception of Bizjak and Coles (1995), no paper finds a significant abnormal return to the plaintiff firm on the announcement of a filing.

B. Settlement Wealth Effects: By Type of Opponent and Legal Issue

Table 6 presents the stock return results for settlement announcements categorized by the identity of the opposing litigant. Defendants who settle a dispute with another firm experience a positive abnormal return of 3.66%. This return is significant (Z = 3.29, p = 0.006) and translates into a $4.23 million increase in stockholder value. The nonparametric test results, however, are not statistically significant. Neither CAR is statistically significant for settlement announcements with government authorities or private parties. The CARs are -0.68% and -1.06%, respectively (Z = -0.22, p = 0.839 and Z = -1.72, p = 0.111). The standard F-test, however, rejects the null hypothesis of no difference in the SPEs (F = 3.16, p = 0.06) at the 0.10 level.13

Table 6 also presents the wealth effects upon settlement announcements for plaintiff firms categorized by opposing party. While, for the most part, plaintiffs experience negative abnormal returns for the different categories upon the announcement of a settlement, none of the results is statistically significant. There are too few observations in the different categories to perform meaningful statistical tests of significance.

Settlement results categorized by type of lawsuit are presented in Table 6. For the defendant sample, there is no statistically significant return upon settlement. In addition, the standard F-test fails to reject the null hypothesis of no difference in settlement returns by legal issue. Similarly, for plaintiffs none of the categories demonstrates statistically significant returns upon settlement announcements. In addition,

12Characteristics of the suit or of the firm that have wealth implications for lawsuits could be correlated with the opposing party. For example, it is possible that firms near bankruptcy might be more likely to be involved in a suit with the government. In this case, larger wealth losses to defendants on filings would be the result of an increase in financial distress and not because they are litigating against a government agency. We control for characteristics of the lawsuit and of the firm in the regression analysis presented later in the paper.

13We pooled the sample of government and private disputes and ran a difference of means test between this new non- firm group and the interfirm group. The CAR for settlement announcements for the non-firm group is -0.97% and for parametric tests is not statistically significant (Z = -1.60, p = 0.129). The difference in CAR, however, is statistically significant for nonparametric tests (Wilcoxon sign-rank test p = 0.05). In addition, the difference in means test rejects the null hypothesis of no difference in the SPEs of the two groups (F = 6.30, p = 0.02).




Table 6. Cumulative Abnormal Returns for Tests Based on Type of Opposing Party and Legal Issue

The sample consists of firms contained in the CRSP Daily Returns File that reported a lawsuit filing or settlement in the Wall Street Journal during the period 1981-1983. A firm enters the sample each time it is named as either a defendant or a plaintiff in a filing or a settlement of a lawsuit. This table reports cumulative abnormal returns around lawsuit settlements for defendants and plaintiffs classified by opposing party and by legal issue.

Panel A. Defendant Abnormal Returns for Settlements by Opponent Type a

Opponent Number CAR (%) Z-Statistic Wilcoxon Signed-Rank p-Value Another Firm 12 3.66% 3.29*** 0.23

Government 4 -0.68 -0.22 0.63

Private. Non-firm 12 -1.06 -1.72* 0.08

Panel B. Plaintiff Abnormal Returns for Settlements by Opponent Type b

Opponent Number CAR (%) Z-Statistic Wilcoxon Signed-Rank p-Value Another Firm 8 -0.77% -1.26 0.38

Government 1 0.01 0.00

Private. Non-firm 2 -0.56 -0.43 0.50

Panel C. Defendant Abnormal Returns for Settlements by Legal Issue c

Legal Issue Number CAR (%) Z-Statistic Wilcoxon Signed-Rank p-Value Antitrust 3 0.48% 0.39 0.25

Breach of Contract 1 -0.63 -0.24

Corporate Governance 3 1.15 0.41 1.00

Environment 0

FTC-Type Suits 1 -0.68 -0.31

Patent Infringement 2 6.94 2.43 0.50

Product Liability 6 -0.68 -0.91 1.00

SEC-Type Suits 1 -0.38 -0.18

Other 11 1.40 0.99 0.37

Panel D. Plaintiff Abnormal Returns for Settlements by Legal Issued

Legal Issue Number CAR (%) Z-Statistic Wilcoxon Signed-Rank p-Value Antitrust 0

Breach of Contract 1 -0.48 -0.08

Corporate Governance 0

Environment 0

FTC-Type Suits 1 -0.18 -0.05

Patent Infringement 6 -0.08 0.44 0.56

Product Liability 1 -2.54 -1.00

SEC-Type Suits 0

Other 2 -2.24 -1.35 1.00

***Significant at the 0.01 level. *Significant at the 0.10 level.

"Hypothesis that the average SPE is the same for all categories: F = 3.16, p = 0.06. bHypothesis that the average SPE is the same for all categories: F = 0.19, p = 0.83. cHypothesis that the average SPE is the same for all categories: F = 0.37, p = 0.91. dHypothesis that the average SPE is the same for all categories: F = 0.61, p = 0.67.



BHAGAT, BIZJAK, & COLES /ITHE SHAREHOLDER WEALTH IMPLICATIONS OF CORPORATE LAWSUITS 21

the F-test fails to reject the null hypothesis of no difference in returns by legal issue. The results are consistent with our failure to find any significant plaintiff settlement announcement results in the pooled sample and in the categorization by opposing litigant.

C. Multivariate Analysis of Defendant Firm Wealth Effects for a Filing Announcement

In order to isolate the effects and measure the relative importance of opponent and legal issue on the defendant firm wealth change associated with the announcement of the filing of a lawsuit, we regress the announcement-period CAR of the defendant named in the suit on dummy variables for legal issue and opponent, as well as two other explanatory variables. We include both issue and opponent dummies because the type of lawsuit and who brings the dispute could be related. For example, environmental suits tend to be filed by government authorities. In this case, it is important to distinguish whether the opposing party or the type of lawsuit is of primary importance.

We also control for firm size for three reasons. First, large firms may have access to greater legal resources and may enjoy scale economies in fighting a lawsuit. Second, larger defendants can be more visible defendants, in which case the market is more likely to anticipate the filing. Finally, if lawsuits tend to imply the same dollar value transfer from defendant to plaintiff, using the cumulative abnormal return as a measure of wealth effect will imply that the CARs of larger firms are attenuated towards zero. All three of these reasons suggest a positive relation between the defendant CAR and firm size. We measure firm size by the natural logarithm of the book value of firm assets.

The initiation of litigation, the filing, seems to imply an expected transfer of wealth from defendant to plaintiff. If the expected transfer of wealth is the only implication of the legal dispute, then the joint wealth effect upon filing should be zero. The empirical evidence, however, suggests that much more is at stake. The evidence of asymmetric wealth changes documented in this and other studies demonstrates that plaintiffs gain far less than defendants lose and suggests that litigation involves more than a dollar transfer from defendant to plaintiff. Accordingly, in some specifications we control for the litigation-related costs of financial distress. This approach, which was suggested by Cutler and Summers (1988) in their study of the Texaco/Pennzoil conflict, has been implemented by Bhagat, Brickley, and Coles (1994) and Bizjak and Coles (1995).

To estimate the change in financial distress associated with a filing, we use a measure of the probability of bankruptcy multiplied by a proxy for the level of intangibility of a firm's assets. To estimate

proximity to bankruptcy, we use the model of Ohlson (1980). This model relies on accounting data from the COMPUSTAT tapes to estimate a probability of firm bankruptcy within the next two years. For a given proximity to bankruptcy, the increase or decrease in the likelihood of financial distress will be larger the more the firm derives value from intangible assets, such as growth opportunities. Thus, we multiply the probability of bankruptcy and the ratio of the defendant's market value of equity to book value of equity. For a more complete description of this approach, see Bhagat, Brickley, and Coles (1994) and Bizjak and Coles (1995).14

Tables 7 and 8 present different regression specifications that measure the influence of opponent, legal issue, firm size, and costs of financial distress on the defendant wealth change associated with a lawsuit filing. The dependent variable in all specifications is the defendant CAR upon announcement of the filing of the lawsuit. Several different specifications are tested to check the robustness of our results. In all regressions in Table 7, the White (1980) test rejects the null hypothesis of homoskedasticity, so all t- statistics are reported based on White (1980) standard errors. In Table 8, we check for robustness by repeating the analysis in Table 7 using Koenker-Bassett (1978) robust regression.

The estimated coefficients associated with the dummy variables for opposing party and legal issue are roughly consistent with the results reported in Table 5. When dummy variables for the type of opponent are included on their own, the estimated coefficient for suits filed by the government is negative and significant (Table 7, Model 1: p = 0.033; Table 7, Model 4: p = 0.031). The estimated value of the coefficient, -0.016, in Models 1 and 4 of Table 7, suggests that defendants suffer an additional 1.60% loss in shareholder wealth when the plaintiff is the government, relative to non-firm, private plaintiffs. These results are further confirmed in the robust regressions presented in Table 8. Models 1 (p = 0.028) and 4 (p = 0.007) yield statistically and economically significant negative coefficient estimates for the government dummy.

In specifications that include dummies for both opponent and legal issue (i.e., Models 3 and 6 in Tables 7 and 8), however, the significance of the government dummy declines. Part of the reason appears to be the ability of dummy variables for types of suits disproportionately brought by government to explain variation in the CARs. For example, in Tables 7 and 8 the coefficients on environmental and product liability suits are negative and tend to be statistically

14The Ohlson (1980) model was used in a similar manner by Burgstahler, Jiambalvo, and Noreen (1989).



22 FINANCIAL MANAGEMENT/ WINTER 1998

Table 7. Regression Results for Defendant-Firm Regressions Estimated coefficients for regressions of two-day cumulative abnormal returns for the defendant firm associated with a filing regressed on variables measuring plaintiff type, legal issue, firm size, and the potential costs of financial distress associated with the suit (t-statistics in parentheses). The sample consists of defendant firms contained in the CRSP Daily Returns File with lawsuit filings reported in the Wall Street Journal during the period 1981-1983.

Dependent Variable: Defendant CAR Upon Filing

Independent Variable 1 2 3 4 5 6

Intercept -0.085*** -0.082*** -0.080*** -0.071*** -0.069*** -0.068*** (-4.15) (-3.97) (-3.99) (3.45) (-3.27) (-3.27)

Dummy: Plantiff is a Firm -0.002 -0.002 -0.003 -0.003 (-0.38) (-0.53) (-0.57) (-0.60)

Dummy: Plaintiff is a -0.016** -0.010 -0.016** -0.010 Government Entity (-2.14) (-1.48) (-2.16) (-1.34)

Dummy Variable for Legal Issue:

Antitrust -0.003 -0.001 -0.003 -0.001

(-0.47) (-0.18) (-0.58) (-0.23)

Corporate Governance 0.005 0.003 0.006 0.003 (0.79) (0.46) (0.89) (0.64)

Environmental Litigation -0.029** -0.023* -0.031** -0.025* (-2.28) (-1.68) (-2.44) (-1.85)

SEC-Type Violations -0.029** -0.030*** -0.030** -0.035** (-2.20) (-2.37) (-2.31) (-2.47)

Patent Infringement -0.012 -0.013 -0.014" -0.014" (-1.41) (-1.48) (-1.66) (-1.65)

Breach of Contract -0.004 -0.004 -0.005 -0.004

(-0.57) (-0.51) (-0.64) (-0.52)

Product Liability -0.014** -0.013" -0.014** -0.012" (-2.00) (-1.82) (-2.08) (-1.83)

FTC-Type Violations 0.000 0.000 -0.001 -0.001 (0.03) (0.39) (-0.18) (-0.10)

Log of the Book Value of Total 0.005*** 0.005*** 0.005*** 0.004*** 0.004*** 0.004*** Firm Assets (3.92) (3.96) (4.01) (3.38) (3.42) (3.50)

Bankruptcy Probability of the -0.050 -0.056 -0.056 Defendant * Defendant's (-1.12) (-1.34) (-1.28) Market-to-Book Ratio

Number of Observations 457 457 457 443 443 443

Adjusted R2 0.047*** 0.072*** 0.074*** 0.060*** 0.092*** 0.093***

***Significant at the 0.01 level. **Significant at the 0.05 level. *Significant at the 0.10 level.

significant. Furthermore, tests for the joint significance of the coefficients on the government dummy and the environmental and product liability dummies always reject the null hypothesis of no explanatory power for the three variables at p = 0.020. These results are consistent with the notion that government agencies have more leverage and resources at their disposal to use in a legal battle and/or the type of suit most frequently filed by government agencies, such as an

environmental action, is typically more serious. It is noteworthy that securities law violations

(SEC-type suits) are associated with very negative and statistically significant coefficient estimates. Such violations appear to be associated approximately with an extra 3.0% wealth decline for defendant shareholders on the announcement of a filing. In Table 7, no p-value exceeds p = 0.028, and in Table 8 no p- value exceeds p = 0.0003.



BHAGAT, BIZJAK, & COLES/THE SHAREHOLDER WEALTH IMPLICATIONS OF CORPORATE LAWSUITS 23

Table 8. Regression Results for Koenker-Bassett Robust Regressions Estimated coefficients for Koenker-Bassett (1978) robust regressions of two-day cumulative abnormal returns for the defendant firm associated with a filing regressed on variables measuring plaintiff type, legal issue, firm size, and the potential costs of financial distress associated with the suit (t-statistics in parentheses). The sample consists of defendant firms contained in the CRSP Daily Returns File with lawsuit filings reported in the Wall Street Journal during the period 1981-1983.

Dependent Variable: Defendant CAR Upon Filing

Independent Variable 1 2 3 4 5 6

Intercept -0.080*** -0.065*** -0.063*** -0.061*** -0.040***" -0.035** (-4.79) (-3.99) (-3.90) (3.64) (-2.53) (-2.16)

Dummy: Plantiff is a Firm 0.000 -0.004 -0.000 -0.004 (0.09) (-0.82) (-0.35) (-0.87)

Dummy: Plaintiff is a -0.012"* -0.009* -0.015** -0.007

Government Entity (-2.21) (-1.68) (-2.74) (-1.23)

Dummy Variable for Legal Issue:

Antitrust -0.001 0.002 -0.001 -0.001

(-0.16) (0.40) (-0.21) (-0.09)

Corporate Governance 0.005 0.004 0.007 0.003 (1.00) (0.72) (1.37) (0.64)

Environmental Litigation -0.019** -0.012 -0.020** -0.017** (-2.37) (-1.42) (-2.58) (-2.02)

SEC-Type Violations -0.033*** -0.034*** -0.028*** -0.028*** (-4.26) (-4.37) (-3.70) (-3.70)

Patent Infringement -0.007 -0.007 -0.008 -0.009 (-0.95) (-0.81) (-1.13) (-1.11)

Breach of Contract -0.003 0.001 -0.002 -0.001

(-0.46) (0.81) (-0.22) (-0.13)

Product Liability -0.007 -0.005 -0.007 -0.007 (-0.95) (-0.66) (-0.93) (-0.90)

FTC-Type Violations 0.000 0.002 0.001 0.001 (0.05) (0.19) (0.09) (0.07)

Log of the Book Value of Total 0.005"*** 0.004*** 0.004*** 0.004*** 0.002** 0.002** Firm Assets (4.31) (3.76) (3.85) (3.44) (2.44) (2.33)

Bankruptcy Probability of the -0.102*** -0.128*** -0.123*** Defendant * Defendant's (-5.74) (-8.28) (-7.85) Market-to-Book Ratio

Number of Simplex Iterations 8 15 19 9 19 22 for Convergence for e = 0.01

Number of Simplex Iterations 5 16 20 6 17 23 for Convergence for 0 = 0.99

***Significant at the 0.01 level. **Significant at the 0.05 level.

*Significant at the 0.10 level.

The estimated coefficient on firm size is positive and highly significant in all 12 specifications in Tables 7 and 8. Larger defendants suffer less substantial declines in value, measured in percentage terms, on the announcement of a filing than do smaller defendants.

The results on costs of financial distress as a source of value decline for defendants are mixed. In none of

the three relevant specifications in Table 7 is the coefficient of our proxy for costs of financial distress significant. On the other hand, in Models 4, 5, and 6 in Table 8, the estimated coefficients are all negative and highly significant. When outlier observations have less weight, a significant and negative correlation exists between the costs of financial distress and the value




decline. Thus, the results on costs of financial distress are consistent with the prior evidence reported in Bhagat, Brickley, and Coles (1994), Bizjak and Coles (1995), and Cutler and Summers (1988).

An important question is whether the costs of financial distress for defendants are offset by relief in financial distress for plaintiffs. Furthermore, do the legal issue and type of opponent explain plaintiff returns in a multivariate specification? We repeat the statistical analysis of Table 7 for our sample of plaintiff firms. None of the coefficient estimates is significant. The results appear to indicate that losses incurred by defendants in a lawsuit, at least those associated with financial distress, are not offset by gains to plaintiffs associated with plaintiff relief from financial distress. In addition, legal issue and type of opponent have little explanatory power.'"5

If lawsuit filings impose explicit and implicit costs for defendants, then a settlement should result in relief from these costs. For example, when a lawsuit is settled, managers no longer have to divert time to the dispute, the defendant may gain relief from financial distress associated with the lawsuit, or the defendant could face a lower probability of future follow-on suits. To try to explain defendant and plaintiff cross-sectional returns upon a settlement announcement, we repeat the analysis in Table 7 for the sample of defendant and plaintiff settlement announcements. For defendants the only regression equation that is significant and which contains any significant coefficient estimates is the specification that includes dummy variables for type of dispute. In this instance, the only significant variable is the dummy for patent infringement cases. The estimate is negative and significant at the 0.05 level or better in all four regressions that include the term. In addition, the regressions themselves are significant at 0.10 level or better when including the dummy for patent infringement. None of the other coefficient estimates is significant. We also repeat the analysis for plaintiffs, but no coefficient estimate or model specification is statistically significant. It is likely that our inability to explain variation in the CARs is due in part to small sample size.

We conclude this presentation of the empirical evidence with a caveat. The collection of evidence in

this paper is intended to give some sense for the legal realities facing the manager of the modern corporation. We acknowledge, however, that changes in the legal environment after the sample period reduce the applicability of some of the results to the legal landscape of the late 1990s. For example, since 1983, the US Sentencing Commission has changed sentencing guidelines for federal crimes (May 1991) and the Department of Defense has cracked down on procurement fraud. Changes such as these may imply that government suits are even more serious (e.g., involve more extreme wealth implications for defendants) than even our data suggest. Other potentially important changes include large punitive damage awards and legislative and judicial responses to the perception that such awards have grown too large. In this regard, a number of states have moved toward tort reform and the US Supreme Court has handed down five or six major decisions affecting the ability of lower courts to impose large punitive awards. Finally, though this list is hardly exhaustive, how vigorously antitrust and environmental laws are enforced varies with political fashion.

V. Summary and Conclusions

This paper provides basic facts and analysis of lawsuits in which at least one side, plaintiff or defendant, is a corporation. We also provide statistics on the relative frequency of the legal issues involved and the relative frequency of suits according to whether the opponent is another firm, a government entity, or a non-corporate private entity. Government entities tend to file a disproportionate number of environmental and product liability suits; other firms file many of the antitrust, breach of contract, and patent infringement actions; and non-firm private parties file over issues involving corporate governance and securities law violations. In addition, we examine the direct and indirect costs and benefits to firms involved in different types of legal battles. In particular, to estimate the implications of litigation for shareholder wealth, we examine the abnormal stock market reaction to filing and settlement announcements. We find that no matter who brings a lawsuit against a firm, be it a government entity, another firm, or a private citizen, defendants experience economically meaningful and statistically significant wealth losses upon the filing of the suit. The average wealth loss for a defendant is 0.97% of the market value of the equity, or $15.96 million. In contrast, the wealth implications for plaintiff firms, and for both defendants and plaintiffs upon settlement, tend to be much smaller. One immediate implication is that we are unable to detect in our data evidence of strong incentives for plaintiffs to sue.

5Selection bias may be one potential reason why we do not find significant results for plaintiff firms upon lawsuit filing announcements. With any voluntary corporate event, such as the filing of a lawsuit, the manager of the firm has control over the type, timing, and magnitude of any public announcement. The fact that the sample is chosen based on only voluntary actions may produce a distorted representation of the true population. Regressions that do not account for sample selection biases can produce downward-biased coefficient estimates. The downward-biased coefficient estimates could explain our inability to pick up cross-sectional differences in plaintiff returns upon the filing announcement.



BHAGAT, BIZJAK, & COLES I THE SHAREHOLDER WEALTH IMPLICATIONS OF CORPORATE LAWSUITS 25

We show that the characteristics of the suit, such as legal issue, type of opponent, and firm characteristics (e.g., proximity to bankruptcy) have power to explain cross-sectional variation in defendant wealth effects associated with a filing announcement. Defendants involved in government suits suffer larger declines in shareholder wealth (-1.73%) than defendants involved in lawsuits with other firms (-0.75%) or with other private parties (-0.81%). In addition, we find that certain types of litigation are more costly for defendants. Environmental suits (-3.08%), product liability suits (-1.46%), and violations of security laws (-2.71%) result in significantly greater wealth losses for defendant firms, as compared to disputes involving antitrust, breach of contract, and other issues. It appears that, at least for some types of suits, the actual

or potential lawsuit is associated with a large decline in shareholder wealth and potentially a corresponding nontrivial deterrence effect. Finally, controlling for opposing party and legal issue, we find that the defendant wealth effect on announcement of a filing is significantly positively related to the size of the firm and, in some specifications, significantly negatively related to the firm's proximity to bankruptcy. One possible explanation for this effect of firm size is that larger firms have more bargaining power or more resources to devote to the legal dispute (e.g., because of better access to the capital markets or "deeper pockets"). The results on proximity to bankruptcy, while not as strong, are consistent with other work that has identified potential bankruptcy costs as an important indirect cost of a legal dispute. U

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Appendix. Examples of Lawsuit Filing Announcements by Legal Issue

The appendix contains, for each broadly defined legal issue, representative examples of the legal disputes included in this study. Each example contains a brief description of the disputants, the issues involved in the suit, and any remedies (e.g., injunctive relief or monetary damages) sought against the defendant. The source of each case is the Wall Street Journal. Each lawsuit was placed into one of nine separate categories. The taxonomy of legal issues are antitrust, breach of contract, corporate governance, environmental, Federal Trade Commission-type suits, patent infringement, product liability, securities lawsuits, and other types of suits that did not fit into any of the above categories.

Antitrust

On January 1, 1983, the WSJ reported that Southern Pacific Co. filed an antitrust lawsuit in federal court against American Telephone & Telegraph and its Bell operating units. The suit alleges that AT&T and its operating companies refused certain local connections necessary to Southern Pacific's Sprint telephone and satellite service and charged "unreasonable and discriminatory" rates for other connections. Sprint claimed as damages lost sales and that AT&T's conduct restricted its ability to expand its market share. Sprint was seeking unspecified treble damages as a result of AT&T's alleged anticompetitive actions.

Breach of Contract

On August 8, 1983, the WSJ announced that Consumers Power Co. filed a lawsuit against Dow Chemical. The suit alleges that Dow violated a contract to buy steam from Consumers's nuclear power plant in Midland, Michigan. Consumers was seeking court enforcement of the contract provision that would require Dow to pay $440 million for reneging on the agreement. Dow used the steam to run its manufacturing complex in Midland and was supposedly Consumers's largest customer.

Corporate Governance

On August 2, 1983, the WSJ reported that Puritan Fashions Corp. and its directors were being sued by shareholder Harry Lewis. The suit alleges that Puritan paid its former chief executive officer, Carl Rosen, salary and benefits that were "grossly excessive, amounting to a waste of corporate assets." Lewis' suit claims that the former CEO's hand-picked board's $4 million payment to Mr. Rosen in 1982 was excessive. The payment was made after the board learned that the CEO had cancer. The $4 million payment was in addition to other compensation, insurance, and pension funds provided by the company. The suit also alleges that the other nine board members received excessive pay. The case is a derivative action, which means that the board could be forced to repay some of the "excess" compensation to the company.

Environmental

On July 2, 1983, the WSJ reported that the Justice Department filed a lawsuit against Shell Oil Company. The government was seeking $1.85 billion to cover the costs of cleaning up hazardous chemicals that allegedly contaminated US Army facilities on land leased by Shell near Denver's Rocky Mountain Arsenal. Shell was producing pesticides at the site.

Federal Trade Commission Violations

On May 3, 1983, the WSJ reported that Mattel Inc. had filed a lawsuit against Atari Incorporated. The suit alleges that Atari had developed cartridges compatible with Mattel's video games by obtaining trade secrets from former Mattel employees who were now working for Atari. Mattel alleged that in the last several months Atari had lured three employees away in order to develop cartridges compatible with Mattel's Intellivision




game in time for the Christmas season. Mattel was seeking an injunction to block Atari from developing the cartridges and exploiting Mattel's trade secrets. Mattel was also seeking $40 million in punitive damages.

Patent Infringement

On June 17, 1982, the WSJ reported that General Electric filed two patent-infringement suits against Emerson Electric Company in Kansas and Arkansas. One of the suits alleges that Emerson infringed on GE's torsion-flex mountings for electrical motors. The torsion-flex technique helps insulate motor mounts from vibration. The other suit covers violation of three patents pertaining to "electrical motor switches and terminal assemblies." GE did not disclose what damages or relief it was seeking in the lawsuit.

Product Liability

On April 4, 1983, the WSJ reported that the Food and Drug Administration would seek Justice Department action against Eli Lilly & Company. The suit alleges that Lilly failed to fully disclose information about the effects of its anti-arthritis drug, Oraflex. Specifically, the company failed to reveal information about several deaths that were associated with the drug. Oraflex is a once-a-day arthritis remedy that was expected to have strong sales prospects in the United States. The FDA action was taken following 72 deaths in this country and Britain associated with the drug. No specifics about the legal action sought by the FDA were provided. Federal drug laws allow civil action, such as seeking injunctive relief or monetary damages, as well as criminal prosecution of the company and its employees.

Securities Suits

On March 3, 1983, the WSJ reported that Geraldine Rubin had filed a lawsuit against Long Island Lighting Company. Ms. Rubin, a former shareholder in the company, alleged that the prospectus covering a preferred stock offering contained false and misleading information. She claims that the prospectus indicated that dividends paid on the preferred shares would be considered capital gains for tax purposes. The dividends paid on the shares, however, were taxed as ordinary income. Because of the misrepresentation of the dividends' tax status, Ms. Rubin maintains that she paid a price higher than the price she and other investors would have paid if they had known about the true tax status of the dividends. Ms. Rubin was also asking the court to certify the suit as a class action.

Other Types of Lawsuits

On March 28, 1983, the WSJ reported that Paradyne Corporation was charged by the Securities and Exchange Commission with using fraud and deceit to win a $100 million federal contract. The 1981 contract for a nationwide computer network was the largest ever awarded by the Social Security Administration. The government alleges that Paradyne won the contract by putting its name on another company's computer and that their information- encoding machine was "nothing more than an empty box with blinking lights." Since the contract was awarded, Paradyne had made four stock offerings worth a total value of $53.7 million. The government was conducting both a civil and criminal investigation. No specific remedies were mentioned.

On July 7, 1983, Thomas Feaheny, vice president of vehicle research at Ford Motor Company, filed a lawsuit against Ford Motor Company and its senior executives. Mr. Feaheny alleged that senior executives at Ford embarked on a scheme to deny him compensation and promotion opportunities after a failed attempt to fire him. Mr. Feaheny was seeking $80 million in actual damages and $250 million in punitive damages. The actual damage figure was arrived at under the assumption that Mr. Feaheny might have become president of Ford and on profits that he would have made if the company had not denied him the opportunity to purchase a division of FMC.



Documents

The Shareholder Wealth Implications of Corporate Lawsuits