The Pricing Effects of Securities Class Action Lawsuits and Litigation Insurance

The price reactions to corrective disclosures often serve as a benchmark for settlements in securities class action lawsuits. When the firm bears litigation costs, this benchmark creates a feedback effect that exacerbates the price reaction to news that contradicts managers’ earlier reports. Litigation insurance provides value in this setting by reducing the need for investors to price the effects of anticipated litigation. Insurance also affects how changes in the litigation environment impact the firm, with some changes having opposite effects on the frequency of lawsuits against uninsured and insured firms. The pricing behavior of rational investors eliminates the valuation impact of the portion of settlements paid to the investors, similar to dividends. The valuation impact of litigation arises from transaction costs, such as attorney fees, which the firm can mitigate by constraining misreporting and by purchasing insurance. (JEL G14, G30, K22, M41).