Academic journal article Quarterly Journal of Finance and Accounting

The Effect of the Private Securities Litigation Reform Act of 1995 on the Cost of Equity Capital

Academic journal article Quarterly Journal of Finance and Accounting

The Effect of the Private Securities Litigation Reform Act of 1995 on the Cost of Equity Capital

Article excerpt

Introduction

In 1995 Congress passed the Private Securities Litigation Reform Act (PSLRA) overriding a veto of the Act by President Clinton. PSLRA dramatically changed the private securities legal environment by increasing restrictions on plaintiffs' ability to sue firms and auditors for securities fraud and limiting damage awards to plaintiffs. The purpose of this paper is to examine whether PSLRA had a significant impact on the quality of financial information supplied by firms to capital markets, as proxied by the firms' cost of equity capital.

PSLRA was a response to a perceived explosion in securities litigation which proponents argued was hampering economic growth. An important legal change brought by PSLRA was the elimination of joint and several liability and its replacement with proportionate liability. Prior to PSLRA, plaintiffs could collect the full amount of damages from any defendant found guilty of securities fraud regardless of the level of the defendant's culpability. Under the proportionate liability provisions of PSLRA, however, wrongdoers are responsible only for their fair share of the damages. Auditors and firms are jointly and severally liable only when they knowingly violate securities laws. The passage of PSLRA was, thus, a major victory for auditors and proponents of tort liability reform (Arthur Andersen et al., 1992).

Opponents of PSLRA (which included the plaintiffs' bar, consumer groups, and state securities regulators) argued that PSLRA would discourage not just frivolous lawsuits but also meritorious lawsuits (King and Schwartz, 1997). Seligman (1994) observes that private litigation is often the most effective deterrent for preventing corporate officers and others from defrauding shareholders. Restrictions that make it harder for litigants to file meritorious lawsuits reduce the incentives of corporate officers to disclose information truthfully (Seligman, 1994).

Lee and Mande (2003) argue that PSLRA also negatively impacted audit quality. They suggest that the replacement of joint and several liability with proportionate liability by PSLRA decreased the litigation risk for defendants with deep pockets, including the large accounting firms. They show that due to the reduction in the litigation risk of the large accounting firms after PSLRA, the audit quality of the large accounting firms decreased.

This paper sheds light on the debate about whether PSLRA had a positive or a negative effect on securities markets. In contrast to prior research that has examined stock market reaction to the passage of PSLRA, this study examines whether firms' cost of equity capital is affected by the change in the legal environment following PSLRA. The cost of equity capital is used to proxy for the quality or credibility of financial reporting. We argue that if the passage of PSLRA resulted in a decrease in the quality of financial information due to a reduction in audit quality and/or a reduction in the incentives of management to report truthfully, we should see an increase in firms' cost of capital after passage. Furthermore, because the reduction in audit quality can be expected to be the greatest for Big 6 auditors (1) (Lee and Mande, 2003), after PSLRA, we should see a more pronounced increase in the cost of equity capital for client-firms of Big 6 auditors compared to client-firms of non-Big 6 auditors. Finally, after PSLRA, we should expect firms facing high levels of litigation risk to experience a higher increase in the cost of equity capital than other firms. This is because firms in high litigation prone sectors were provided the greatest relief from litigation due to the passage of PSLRA and, in turn, should experience the greatest decrease in the incentives of managers to report truthfully. (See, also, Johnson et al., 2000.)

Our results are consistent with these arguments. We find that after the enactment of PSLRA, firms' cost of equity increases as hypothesized. …

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