Litigating crashes? Insights from security class actions

Abstract

Investors tend to litigate large stock price declines, i.e., file ‘stock‐drop lawsuits’. However, it is less clear whether the ex‐ante threat of security class actions can deter stock price crashes in the first place. To answer this question, we exploit the 1999 ruling of the Ninth Circuit Court of Appeals that discourages security class actions as a quasi‐exogenous shock, and find that reducing the threat of security class actions leads to a significant increase in stock price crash risk measured by negative skewness of stock returns. We reveal that the main effect is partially driven by a reduction in the timeliness of bad news disclosure and worsened earnings quality, which is consistent with the view that bad news hoarding serves as the key factor in the formation of a stock price crash. Our overall findings highlight the importance of security class actions in deterring the occurrence of firm‐level negative tail events on the financial market.