Introduction

Extant studies have examined the impact of shareholder lawsuits on sued firms' corporate governance changes following the lawsuits. The overall evidence suggests that sued firms have enhanced their corporate governance measures in the post-lawsuit periods.2 Romano (1991) provides the first comprehensive analysis of shareholder class action suits. She finds that top management turnover is higher among sued firms prior to and during the lawsuit. Ferris, Jandik, Lawless, and Makhija (2007) find improvements in the board of directors, including an increase in the proportion of external directors, following a derivative lawsuit. McTier and Wald (2009) document that sued firms are more likely to reduce the e-index, a measure of entrenchment formulated by Bebchuk, Cohen, and Ferrell (2009).

The shareholder lawsuits also have a negative impact on the employability of CEO and board members. McTier and Wald (2009) find that a sued firm is more likely to replace its CEO. Fich and Shivdasani, 2007 E. Fich and A. Shivdasani, Financial fraud, director reputation, and shareholder wealth, Journal of Financial Economics 86 (2007), pp. 306–336. Article |  PDF (265 K) | View Record in Scopus | Cited By in Scopus (25)Fich and Shivdasani (2007) examine whether directors of firms that are sued experience an increase or decrease in outside directorships on other companies' boards. They find that outside directorships decline following a securities class action, and interpret their finding as an indication that these suits have a negative reputational effect on the outside directors of the corporation that has been sued.

Many class action lawsuits are restatement related. Collins, Reitenga, and Sanchez (2008) find that CFO turnovers are affected by restatements, but only when the restatement firm is the target of a class-action suit. They interpret this evidence as consistent with class-action securities litigation being a significant externally-imposed governance measure that explains ex post settling-up associated with the restatement event. Similar result has also been obtained by Hennes, Leone, and Miller (2008).

It appears that the ex post corporate governance responses taken by restating firms hinge upon if a restatement firm is sued or not; which suggests that the ex-ante governance structure of restatement and consequently sued firms could be different from that of restatement but not sued firms. This conjecture is the first motivation for our study. We examine and compare, in this study, the governance structures between two groups of restating firms: sued firms and not-sued firms.

Second, our study is motivated by the intent of the Private Securities Litigation Reform Act of 1995 (PSLRA). PSLRA implements new rules on securities class action lawsuits. A significant change under the PSLRA is the raising of pleading standards.3 PSLRA raises the specificity and strength of the factual allegations that must be contained in the plaintiff's complaint to reduce the number of frivolous lawsuits that survive motions to dismiss (Choi & Thompson, 2006).

The PSLRA requires plaintiffs pleading a securities fraud case to describe their allegations in detail. Under this standard, shareholders cannot simply claim that, for example, because a firm restated its results and the stock price subsequently declined, the top executives must have known beforehand that the numbers are wrong. In addition, plaintiffs must demonstrate intents to defraud. Firms with weaker corporate governance structures may give managers greater leeway to engage in fraud. Consequently, investors may rely on class actions as an ex post mechanism to compensate for weak ex-ante corporate governance (Romano, 1991). Our sample period starts after the passage of the PSLRA. We expect that restating firms with weaker corporate governance will be more likely subjected to class action lawsuits.

Since the passage of the PSLRA, majority of securities class action lawsuits are based on accounting allegations (Cornerstone Research, 2008). Between 2002 and 2007, the percentages of class actions centered on accounting allegations have increased from 70% to 92% (Cornerstone Research, 2008).4 Johnson, Nelson, and Pritchard (2007) study the class action lawsuits in the computer hardware and software industries. They find that in the pre-PSLRA period, slightly more than one in four lawsuits (27.4%) contains an accounting allegation. In the post-PSLRA period, more than half of the lawsuits (57.3%) contain an accounting allegation.

In addition to being on the increase, securities class action lawsuits based on accounting allegations have more serious consequences compared to other types of class action lawsuits. Griffin, Grundfest, and Perino (2004) find that compared to other types of class action lawsuits, the market reacts more negatively to announcement of class action lawsuits centered on accounting allegations. The decision to initiate a securities class action emanating from accounting allegations therefore has serious valuation implications for the class action firm.

Using a sample of firms that have restated financial statements between 1997 and 2002, we examine the relation between board and audit committee governance measures and restatement-induced securities class action lawsuits. Weak boards and audit committees of restating firms could provide direct evidence to strengthen not only class action allegations but also shareholders' perception of the merit of class action allegations. Weak boards and audit committees of restating firms indicate a greater probability that management has opportunity to intentionally misstate the financial statements and this evidence increases the merit of the allegations in restatement-induced class actions, which in turn reduces the likelihood that the class action would be dismissed.

Because of the risks and costs involved in litigation, we expect that when shareholders perceive that their allegations against a restating firm has more merit and is less likely to be dismissed, they would be more likely to initiate the litigation. Further, although restating firms generally acknowledge violation of Generally Accepted Accounting Principles (GAAP) and admit material misstatement of financial statements, not all restatements result in class action lawsuits. If not all restatements result in restatement-induced class actions, then shareholders' perception of the merit of the class action or strength of the board and audit committee could explain the likelihood that shareholders would initiate a restatement-induced class action. Accordingly, we expect that after controlling for the restatement characteristics, restating firms with weaker boards and audit committees would be more likely to be subject to restatement-induced securities class action lawsuits.

To investigate the impact of the board and audit committee on shareholder litigation following restatements, we use logistic regression models to examine the association between probability of restatement-induced class action lawsuits and measures of board and audit committee monitoring effectiveness. We examine the period following passage of the PSLRA but prior to the SOX because post-SOX we do not expect any appreciable variability in the board and audit committee data. We find that firms with more independent boards are less likely to experience shareholder litigation following restatements.

The present study extends the literature in two areas. First, we hypothesize and find the connection between corporate governance measures and the probability of restatement-induced class action lawsuits. Second, by examining the interrelations of the board and audit committee governance measures and restatement-induced class action lawsuits, this study complements studies such as (Peng and Roell, 2008), (Lev et al., 2008) and (Johnson et al., 2007), which investigate determinants of securities class actions following the passage of PSLRA.

The remaining chapters proceed as follows: We develop the hypotheses in Section 2. The research design and sample selection are described in Section 3. Section 4 contains the empirical results. We summarize and conclude in Section 5.