One of the shorthand expressions sometimes used to refer to shareholder class action litigation is to call them “stock drop lawsuits.” Securities suits do indeed involve stock drops. But how often do stock drops actually result in lawsuits? That is the interesting questions asked in the following guest post from Stanford Law School Professor Michael Klausner and Sam Blake Curry and Jason Hegland of Stanford Securities Litigation Analytics. I would like to thank the authors for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ article.
One often hears that “whenever there is a stock drop, there will be a lawsuit.” This of course is an overstatement. But how much of an overstatement is it? In this post, we answer that question in some detail. We identify all net-of-market stock drops of specified sizes in 2017 for common shares listed on the New York Stock Exchange and the NASDAQ, and we determine what fraction of those stock drops led to securities class actions.[i] We then look at the distribution of net-of-market stock drops that led to lawsuits. We choose 2017 because it is long enough ago for nearly all potential lawsuits to have materialized,[ii] and recent enough to capture current practices among plaintiffs’ counsel in deciding to file lawsuits.
How Common Are Large Stock Drops?
We begin by looking at the universe of single-day, net-of-market stock drops of 10% or more in the price of common shares.[iii] We sort firms into quartiles by market capitalization as of the time of the drop, and we look at the distribution of stock drops among firms in each quartile.[iv] Figure 1 shows counts of stock drops above 10% among firms in each quartile. As shown in that figure, within each quartile, the frequency of stock drops decreases as the size of the drop increases, which is not surprising. In addition, the number of stock drops of a given size range declines as one compares firms across size quartiles. For example, taking drops in the 10% to 15% range, there were 1,794 drops in the smallest quartile of firms, 563 in the second quartile, 374 in the third quartile, and 154 in the largest quartile. This pattern recurs for each stock-drop range.
Figure 1: Number of Stock Drops By Market Cap Quartile
Figure 2 focuses on the number of firms that experience stock drops of these sizes (as opposed to the number of stock drops shown in Figure 1). The same patterns within and across size quartiles appears. Taking stock drops of over 20% across quartiles as an example, 250 firms in the smallest quartile experienced at least one drop of that size, 157 firms among the second quartile of firms did, 83 among third firms did, and 27 among the largest firms did.
Figure 2: Number of Companies With Stock Drops By Market Cap Quartile*
*Quartile ranges are set at the beginning of 2017. Companies are assigned to quartiles, however, based on their size immediately before a stock drop. Therefore, if a company had more than one stock drop in 2017, it could appear in more than one quartile as its market capitalization changed. A company with multiple drops in a given range is counted only once in that range.
How Often Do Stock Drops Become Lawsuits?
We now come to the central question we want to answer: How many of the stock drops in Figure 1 led to lawsuits? Figure 3 answers that question.[v] We link stock drops to lawsuits based on the dates of corrective disclosures alleged in complaints.[vi]
Not surprisingly, the fraction of stock drops that led to lawsuits increases along two dimensions. First, within each quartile of company size, larger stock drops are more likely to lead to lawsuits. For example, among companies in the second quartile of market capitalization, only 1.8% of stock drops in the 10 to 15 percent range lead to lawsuits, while 13.9% of drops over 20 percent lead to lawsuits. Second, stock drops of a given percentage are more likely to lead to lawsuits when they occur among larger companies than when they occur among smaller companies. Looking across company size, a 15 to 20 percent stock drop for example has only a 2.6% likelihood of resulting in a lawsuit for a company in the second quartile, and a 27.7% likelihood in the largest quartile. Again, this is not surprising. All other factors being equal, the larger the dollar value of shareholder losses, the more attractive a lawsuit will be for a plaintiffs’ lawyer. Larger shareholder losses are highly correlated with larger settlements and larger attorneys’ fees.
Figure 3: Percentage of Stock Drops that Led to Lawsuits
Are any of the results in Figure 3 surprising? Perhaps. First, it is clear that the statement with which we opened this post is not true. There are many large stock drops that do not lead to lawsuits. Take, for example, third quartile companies with 15% to 20% drops. These are reasonably large companies with substantial stock drops. Yet only 6.3% of those stock drops lead to lawsuits. The largest companies do get sued more often, but not as much as one might have thought. Among the top quartile of firms, only 13% of stock drops in the 10% to 15% range lead to lawsuits.
How Large Are Stock Drops That Lead To Lawsuits?
We now look at the same question but from a different perspective. We focus on the 2017 stock drops that did become the subject of lawsuits. For this analysis, we cover all 2017 stock drops that led to lawsuits, including those below 10%. We again partition lawsuit-related stock drops by quartile of company size.
Figure 4 shows the distribution of lawsuit-related stock drops across stock drop and company size. Lawsuits filed against smaller companies primarily come from very large percentage drops, while lawsuits against larger companies are based more often on smaller drops. Half of the stock drops tied to lawsuits against the smallest quartile of companies are greater than 20%, while a large majority of the drops that become lawsuits for the top quartile are in the 0-10% range. This reflects, first, what we saw in Figures 1 and 2: Large firms tend to experience relatively few large stock drops, and smaller firms tend to experience many. And, second, it reflects the fact that a small percentage drop in a large company stock amounts to a large enough dollar value to attract a plaintiffs’ lawyer.
Figure 4: Sizes of Lawsuit-Relaed Stock Drops By Company
Figure 4 shows the distribution of stock drops involved in lawsuits, measured in percentage terms. Defendant companies are divided by quartile of market capitalization. In order to include all stock drops that led to lawsuits, we have added the range of 0 to 10% drops, which are omitted from the previous figures.
In Figure 5, we take the highest stock drop involved in each lawsuit, and we plot the distribution of those drops—that is, we omit all but the highest drop in each lawsuit.[vii] We again partition by quartile of company size. The first chart shows the distribution of stock drops measured in percentage terms, and the second chart shows the distribution of dollar value drops. For lawsuits against firms in the smallest size quartile, the median stock drop was 33%. The 25th and 75th percentile drops were 19% and 55%, respectively. The distributions of percentage drops fall as company size increases. In the largest quartile, the median drop is roughly 9%, and the interquartile range is fairly narrow, running from about 5% to 16%. As the bottom chart shows, however, the dollar value of lawsuit-related stock drops increases as company size increases. Median dollar-value stock drops are $16 million, $55 million, $171 million, and $1.1 billion, respectively, across the four quartiles
Figure 5: Distribution of Suit-Related Drop Sizes by Company Size—Percentage Drop and Dollar Value Drop
|In the box-and-whisker plots below, each box represents the 25th to 75th percentiles of each distribution, with the bold line displaying the median. The “whiskers” show the range between the smallest and largest stock drops in percentage terms, with outliers omitted.|
So, what have we learned? No one really believes the casual assertion that all net-of-market stock drops lead to lawsuits, but it may be surprising to some that so few lead to lawsuits, especially so few stock drops of significant size among reasonably large companies. For firms in the largest quartile of size, 60% of net-of-market stock drops over 20% do not result in lawsuits, and for firms in the third quartile, over 80% do not lead to lawsuits. For smaller percentage drops and smaller companies, the likelihood of a lawsuit is substantially lower.
Looking at the relationship between stock drops from the perspective of lawsuits filed, we see that the median net-of-market stock drop among all lawsuits is $175 million, which reflects a median percentage drop of 14.9%. The dollar values of lawsuit-related stock drops rise as company size rises, so that the average drop in lawsuits against top quartile firms is $1.1 billion, reflecting a drop of 9%.
These findings suggest that the decision to file a lawsuit is a lot more than a knee-jerk response to a stock drop. Many large stock drops do not result in lawsuits. On the other hand, do 40% of stock drops larger than 20% in large companies reflect underlying securities fraud, as opposed to simply bad news? That seems unlikely.
[ii] From 2007 through 2016, 99% of suits were filed within two years of the end of their class period, meaning within two years of the last stock drop that formed the basis of the suit. 95% of all corrective disclosures had their respective lawsuits filed within two years. So, in all likelihood, nearly all lawsuits related to 2017 stock drops have been filed by now.
[iii] To calculate net-of-market returns, we subtracted the daily return of the Russell 3000 Index from the daily return of each stock. For simplicity, we will refer to net-of-market drops simply as stock drops.
[iv] We establish market capitalization quartiles as of the beginning of 2017, and then sort firms into those quartiles based on their size immediately prior to a stock drop.
[v] All data on lawsuits in this post is from the Stanford Securities Analytics database. https://sla.law.stanford.edu/. We omit lawsuits with solely a Section 11 claim from this tabulation. The liability rule and the damage measure for Section 11 claims do not require plaintiffs to identify a stock price drop caused by alleged corrective disclosure. So, the statistics given here are for stock drops that led to cases with Section 10(b) claims, some of which included Section 11 claims as well. Also, where there are two stock drops larger than 10% that lead to the same lawsuit, we count that as two drops leading to lawsuits. To the extent both together were necessary to motivate plaintiffs’ attorneys to bring suits, these percentages are therefore slight overestimates of the percentage of drops that lead to suits.
[vi] Because a disclosure could occur during the trading day or after markets close, we take the largest stock drop between the day of a disclosure and the first trading day after a disclosure.
[vii] Lawsuits in 2017 had an average of 2.1 stock drops related to a corrective disclosure.