Saturday, April 7, 2018
On Friday, Elisabeth Kempf presented her new paper, co-authored with Oliver Spalt, at Tulane’s Freeman School of Business, Taxing Successful Innovation: The Hidden Cost of Meritless Class Action Lawsuits. Here is the abstract:
Meritless securities class action lawsuits disproportionally target firms with successful innovations. We establish this fact using data on securities class action lawsuits against U.S. corporations between 1996 and 2011 and the private economic value of a firm's newly granted patents as a measure of innovative success. Our findings suggest that the U.S. securities class action system imposes a substantial implicit “tax” on highly innovative firms, thereby reducing incentives to innovate ex ante. Changes in investment opportunities and corporate disclosure induced by the innovation appear to make successful innovators attractive litigation targets.
Using dismissal as a proxy for meritless – a point to which I will return – Kempf and Spalt find that firms that are granted valuable patents are more likely to be targeted by a class action lawsuit than other firms in the following year, and that the difference is driven by meritless lawsuits. The finding persists even controlling for firm size, sales growth, stock price returns, and volatility. They also find that these lawsuits disproportionately cause a drag on the firm’s stock price performance, constituting a hidden “tax” on innovation.
In many ways, I suspect the core finding of the paper is accurate, though I do question the ultimate conclusion, and I think that in future drafts – the version on SSRN is a very early one – other relationships should be tested.
To start, obviously the definition of “meritless” is a controversial one, and speaking as a former plaintiff-side class-action attorney, I do take issue with treating all dismissed cases as meritless ex ante. That said, the authors test using alternative measures of merit and reach the same results. The one I find particularly convincing is the test using the nature of the lead plaintiff, institutional versus individual – it’s not pretty, but in my experience, very often a good rule of thumb for the ex ante merit of a case is the identity of the lead plaintiff.
The authors also do not distinguish between Section 11 and Section 10(b) lawsuits, or control for circuits where lawsuits are filed (though they do control for location of firm headquarters). Section 11 lawsuits are easier to bring, and certain circuits have long had a reputation for imposing more stringent pleading standards – it is possible that a closer examination of these variables will lead to different or more nuanced conclusions.
The authors offer a number of explanations for their findings, including that innovative firms are more likely to make optimistic/forward looking statements, which they conclude attracts plaintiffs’ attorneys looking for an easy target. On this, I both agree and disagree. I do not agree that plaintiffs’ firms treat these statements as easy “gets” – the PSLRA and the safe harbor ensure that they are not, and every plaintiffs’ attorney knows that. But these statements may nonetheless influence the firm’s stock price, such that the firm is more likely to experience a stock price drop when the rosy predictions do not materialize.* And that drop is what will attract the attention of a plaintiffs’ firm, which may then latch on to the forward-looking statements and the – yes, puffery – if there’s nothing else to grasp.
Which brings me to my final observation. Much of the discussion at Prof. Kempf’s presentation focused on whether she could prove her ultimate point, namely, that securities lawsuits constitute a type of tax on innovation that may ultimately deter firms from innovating in the first place. Even if the paper is correct that securities fraud lawsuits do impose a tax on innovative firms, the question remains: will that tax deter innovation? Or will it deter overclaiming by innovative firms? Because if the latter, then – you know. Yay.
*The authors find that “innovative” firms are no more likely to experience a large stock price drop in reaction to a negative earnings announcement than other firms, but they have not – yet – tested to see whether these firms are more likely to experience a large stock price drop in reaction to other types of announcements.