What Counts as Fraud? An Empirical Study of Motions to Dismiss Under the Private Securities Litigation Reform Act

Abstract

This article presents the findings of a study of the resolution of motions to dismiss securities fraud lawsuits since the passage of the Private Securities Litigation Reform Act in 1995. Our sample consists of decisions on motions to dismiss in securities class actions by district and appellate courts in the Second and Ninth Circuits for cases filed after the passage of the Reform Act to the end of 2002. These circuits are the leading circuits for the filing of securities class actions and are generally recognized as representing two ends of the securities class action spectrum. Post-PSLRA, the Second Circuit applies the least restrictive pleading standard to securities claims and the Ninth Circuit applies the most restrictive.The Ninth Circuit's post-PSLRA reputation as being a tougher venue in which to win securities fraud class actions is born out by a significantly higher dismissal rate. The differences between the two circuits are also reflected in factors that correlate with dismissal. For example, allegations of violations of accounting principles other than revenue recognition correlate negatively with dismissal in the Second Circuit. This coefficient, however, is insignificant in our regressions for the Ninth Circuit. Allegations of revenue recognition violations are insignificant in both circuits, whether or not the issuer has been forced to restate those revenues. The circuits part ways on other factors as well: the Second Circuit is significantly less likely to dismiss cases with allegations of false forward-looking statements, a surprising result given the stringent standards for such statements imposed by the PSLRA. The Ninth Circuit is significantly less likely to dismiss complaints with allegations of '33 Act violations and the Second Circuit is more likely to dismiss cases brought by the Milberg Weiss firm. When it comes to insider trading, however, the two circuits are both skeptical and the allegations correlate with dismissal in both circuits.

Measuring securities litigation risk

“…10 Johnson et al (2007) find that abnormal insider selling is more strongly associated with litigation after PSLRA, consistent with their prediction that the Act's more stringent pleading requirements encourages lawyers to focus on more objective evidence of managerial malfeasance. See also Pritchard and Sale (2005), who discuss the role of insider trading and securities issuances in litigation after PSLRA. 11 Consider two economy-wide events that occur during our sample period-the large shock to prices of technology stocks in 2001 and the financial crisis of 2007-2008.…”

Earnings quality and Rule 10b-5 securities class action lawsuits

“…13 Prior research on the effects of the PSLRA has found that plaintiffs' lawyers attempt to satisfy the ''strong inference'' pleading requirement, 14 as a key mechanism deployed by the Congress, by alleging that the defendants have violated accounting principles. 15 A typical allegation states that the firm and its managers ignored generally accepted accounting principles, provided numbers were not supported by those principles, and thereby, intentionally misled the investing public (Pritchard and Sale, 2005). Grundfest and Perino (1997) and Beck and Bhagat (1997) find that misrepresentations in annual reports including defective reporting of sales, earnings and assets constitute the dominant types of allegations made by plaintiff shareholders under Rule 10b-5.…”

“…Our findings are robust to using signed or unsigned abnormal returns. 14 The Congress's stated purpose in enacting PSLRA was to discourage weak or frivolous securities fraud suits (Pritchard and Sale, 2005). 15 See PriceWaterhouseCoopers (2000), Securities Litigation Study, www.10b5.com (2000).…”

“…Given the heightened pleading standards introduced by the PSLRA combined with the SEC's focus on curbing earnings management, the increase in the prevalence of suits with merit-related indicia (i.e. circumstances indicating) evidence of fraud such as earnings restatements 6 and SEC action or insider trading (Choi, 2007;Johnson et al, 2007) is not surprising as these class actions have a higher probability of surviving a motion to dismiss in a post-PSLRA environment (Pritchard and Sale, 2005). Allegations typically accuse corporate managers of inflating reported earnings (lowering earnings quality) to benefit from earnings-based executive compensation contracts and executive option grants (Bergstresser and Philippon, 2006;Kuang, 2008;Kedia and Philippon, 2009).…”

The Screening Effect of the Private Securities Litigation Reform Act

“…Pritchard and Sale (2005) study how judges in the Second and Ninth Circuits apply the PSLRA to resolve motions to dismiss securities fraud complaints. They find that complaints are significantly more likely to be dismissed in the Ninth Circuit.…”