Securities Law Precedents, Legal Liability, and Financial Reporting Quality

In the U.S., securities class actions (SCAs) are one of the most significant sources of legal liability for firms, allowing investors to potentially recoup investment losses caused by securities law violations. Although every legal system has a legislature that passes new securities laws and statutes, the doctrine of stare decisis grants judicial precedents a pivotal role in defining what qualifies as a securities law violation in the U.S. common-law system. Under the doctrine, each court should apply the principles and rules established in its own or a higher court’s prior rulings when deciding a case. Thus, the collection of rulings affects private enforcement of securities law and shapes firms’ litigation environment.

In a forthcoming article at the Review of Finance, we exploit the variations in securities law precedents across the U.S. Courts of Appeals—the circuit courts—to investigate how regional courts’ historical rulings influence firms’ legal liabilities related to financial misreporting. Despite the Supreme Court having ultimate jurisdiction over all cases, circuit courts effectively act as arbiters for the majority of SCAs. Each circuit establishes precedents through rulings on cases with distinct facts. Because case facts and random factors, such as the case sequence or judge assignments, affect ruling outcomes, each circuit’s precedent evolves in an idiosyncratic and path-dependent manner. The resulting different interpretations of the same securities law induce within-country and over-time variations in firms’ expected litigation costs associated with securities law violations.

Prior studies on the consequences of court rulings typically rely on a prominent ruling from the Supreme Court or a circuit court. However, legal theory provides that the collection of rulings, rather than a single case, defines the applicable law. Each ruling contributes to the law by covering specific aspects relevant to the courts’ interpretation of the statute. To analyze the impact of circuit courts’ securities law precedents, we introduce a novel cross-sectional and time-series measure capturing each circuit’s case law history concerning financial misreporting.

We first collect data on 321 circuit court rulings between 1999 and 2021 that have precedential value for future SCAs from the Stanford Securities Class Action Clearinghouse, Federal Judicial Center, and Google Scholar Case Law search. We read the opinions and classify 127 rulings as most relevant to financial misreporting because they cover allegations of violation of Generally Accepted Accounting Principles (GAAP), which we denote as GAAP precedents. We label the remaining 194 rulings, which mostly cover allegations related to management forecasts or the omission of material information, as non-GAAP precedents. Next, we code a ruling as defendant-friendly if it sides with the defendant firm, i.e., affirms a district court’s dismissal of a case alleging securities law violations, and not defendant-friendly otherwise. Lastly, we aggregate the outcomes of existing precedents in a circuit at each point in time to construct a defendant friendliness measure capturing each circuit’s evolving attitude toward defendants. To account for variations in precedents’ importance, we assign each precedent a weight based on its number of district court citations relative to the number of citations received by other precedents in the same circuit. Summary statistics of our defendant-friendliness measure confirm that there are substantial variations across circuits and over time, consistent with a divergence of interpretations of the same securities laws and evolving judicial attitudes.

Our empirical analysis begins by validating the relevance of circuit court precedents using case-level examinations. It shows that district courts tend to cite precedents from their home circuit and give particular weight to home-circuit GAAP precedents, especially in cases involving alleged GAAP violations. We also find that district courts are more likely to dismiss cases when their home circuits accumulate defendant-friendly rulings during the pending window of a district court case. Further analyses at the firm level demonstrate that defendant-friendly GAAP precedents reduce the likelihood of lawsuits against firms engaged in financial misreporting. This effect is particularly strong in non-egregious cases, in which managerial intent to deceive is more difficult to judge and establish in court.

Moreover, our research explores the market’s reaction to restatement announcements and identifies a smaller negative market response for firms in circuits with more defendant-friendly precedents. This pattern aligns with the expectation of lower litigation costs for these firms, particularly in cases of non-egregious misreporting. Finally, we examine how managers respond to defendant-friendly precedents, revealing that firms in such circuits invest less in internal controls and compliance, pay lower fees to general counsel and auditors, and exhibit more internal control weaknesses. These firms also engage in more aggressive earnings management, highlighting that managers consider court attitudes into financial reporting decisions.

In summary, our study contributes to the understanding of how legal systems influence capital market development within a single country and under the same statute. It showcases significant variations in judicial precedents and their impact on firms’ misreporting-related legal liability and financial reporting quality. Additionally, it introduces a comprehensive measure of courts’ attitudes towards securities law violations based on circuit courts’ ruling histories, offering insights into within-country variations specific to securities law. Lastly, prior studies typically use a single circuit court ruling, such as In re Silicon Graphics Inc., to examine the effect of judicial decisions on firms and assume that other circuits experience no concurrent change in legal liability. By considering rulings from all circuit courts over an extended period, our research provides generalizable results on how circuit court rulings affect firms’ legal liability and financial reporting quality. In revealing firms’ heterogenous exposure to legal liability under the same statute, our results highlight the under-explored role of the judiciary in financial markets. Our findings have important implications for regulators and investors, aiding informed enforcement and investment decisions. As political polarization among legislators impedes the passage of new laws, the importance of judicial interpretations of existing statutes may grow even further.