The Securities Litigation Reform and Market Reactions to Analyst Recommendation Revision
Wang, Huabing "Barbara", Academy of Accounting and Financial Studies Journal
Complementing prior literature on regulatory changes (e.g., Gintschel & Markov, 2004), we examine the impact of the Securities Litigation Reform (SLR) on analyst research impact. SLR, namely, the Private Securities Litigation Reform of 1995 (PSLRA) and the Securities Litigation Uniform Standards Act of 1998 (SLUSA), gives public companies a safe harbor for forward-looking information. We define the impact of analyst recommendation revisions as the three-day abnormal returns starting on the revision date. Using a fixed effect model with analyst-firm effect fixed, we find that SLR has a significant price-impact increasing effect on analyst recommendation revisions, after controlling for recommendation-level characteristics and analyst experiences.
Our results might be driven by contemporaneous factors. To exclude compounding influences, as in Johnson, Kasznik & Nelson (2001), we examine how SLR effect varies for firms with different ex ante litigation risk. We show that firms with higher ex ante litigation risk experience larger increases following PSLRA (both upgrades and downgrades) and SLUSA (downgrades only), largely in consistent with the analyst impact increasing effect of SLR.
The remainder of the paper is organized as follows. In Section 2, we discuss the background of the SLR, review related literature, and develop hypotheses. Section 3 describes our sample selection process and research methodology. The main results, their interpretations, and robustness checks are contained in Section 4. Section 5 concludes.
SLR AND THE IMPACT OF ANALYST RESEARCH
In the late 1980s, strike suits, the often meritless class action lawsuits filed in response to a drop in a stock's price and alleging that some disclosure (or failure to make disclosure) was either false or misleading, began to mushroom. According to an article in Forbes (1), in the decade prior to 1995 more than half of the 150 top high-tech companies in Silicon Valley had been sued for securities fraud. Ninety-three percent settled, paying an average settlement of $8.6 million. Consequently, it is understandable that many public companies, especially those high-technology firms, chose to refrain from disclosing beyond the minimum required by securities laws. According to a National Investor Relations Institute survey conducted in the summer of 1995, only 20 percent of companies responded to the survey indicated that they "routinely" or "occasionally" forecast quarterly or annual results. (2) Thus, investors did not always have access to the important information known to the management that could affect their investment decisions. Besides, since trial lawyers usually obtained the lion's share out of the final settlement, it was argued that these lawsuits only benefited lawyers yet harmed the interest of shareholders as a whole.
In response to this, Congress proposed PSLRA, aimed at amending the federal securities laws to curb certain abusive practices in private securities litigation. The legislation was passed by both Houses of Congress in mid 1995 and eventually reached President Clinton in mid-December. President Clinton vetoed the legislation, yet both the House and Senate overrode the veto, and the legislation became law on December 22, 1995. The new law made it tougher to bring federal securities claims against public companies. The most important yet controversial aspect of the new law is the safe harbor provision. Section 102 of the law states that it provides certain issuers of securities a safe harbor from liability for forward-looking statements regarding a security's projected performances or operations, if: (1) the statement is immaterial or is identified as a forward-looking statement and accompanied by certain cautionary statements; or (2) the plaintiff fails to prove that the statement was made with either actual knowledge of its false or misleading nature by a natural person, or actual approval by an executive officer. …