DETERMINANTS OF INVESTOR REACTION TO ANNOUNCEMENT OF SEC 10B-5 LAWSUIT

Abstract

The Private Securities Litigation Reform Act (PSLRA) of 1995 requires SEC 10b-5 lawsuits to cite facts supporting a strong inference of fraud but there is little evidence of an association between the market’s reaction to SEC 10b-5 lawsuit filing announcement and lawsuit filing attributes that give rise to an inference of fraud. Using a sample of 296 SEC 10b-5 lawsuits between 1996 and 2005, this study examines the relation between lawsuit attributes used to form fraud inferences and 3-day abnormal returns around SEC 10b-5 lawsuit announcement. We report a more adverse market reaction to SEC 10b-5 lawsuit announcement when the auditor of the firm is charged in the lawsuit. We also document the ‘deep pocket effect’ in the announcement returns with a more negative market reaction for larger firms as well as firms with lower leverage. Collectively, the results suggest that auditor liability is considered as a strong inference of fraud and investor anticipation of litigation costs influence the market’s reaction to securities lawsuits in the post-PSLRA period.