Event Studies and

1

• Event Studies and
• Shareholder Wealth Implications of Corporate
  Lawsuits

2
Event Study

• Event study focuses on the movement of stock
  prices due to unexpected actions by
• Managers
• Investors
• Policy makers
• that might affect firm values.
• Benchmark for evaluating the benefit of corporate
  or securities laws is whether they improve
  investor welfare.
• Hence, natural fit between the event study
  methodology and the economic efficiency of
  corporate and securities laws.

3
Event Study

• Share Price Time- and risk-discounted present
  value of all future cashflows.
• In a semi-strong efficient market Only an
  unanticpated event can change share price.
• Change in share price Expected changes in
• Future cashflows, or
• Riskiness of these cashflows.

4
Four Component Parts of Event Study

• Defining the event and announcement day(s).
• Measuring the stocks return during the
  announcement period.
• Estimating the expected return of the stock
  during this announcement period (in the absence
  of the announcement).
• Computing the abnormal return (actual return
  minus expected return) and measuring its
  statistical and economic significance.

5
Defining the event and announcement day

• Day of public announcement of the event, for
  example, a tender offer. Potential problems
• Leakage prior to public announcement. Some
  researchers address this by considering returns
  prior to public announcement. Problems
• Leakage over how many days/weeks/omths?
• Noise-to-signal increases with announcement
  period.
• Uncertainty over success of tender offer. Final
  resolution may not be known for months or years.
• If market is semistrong form inefficient, market
  is unable to immediately (same day) understand
  and incorporate the impact of announcement on the
  companys value the market needs more time
  (days/months/years) to understand and
  incorporate
• Some events have several distinct event dates.

6
Events with Several Distinct Event Dates

• Enactment of a Statute
• Introduction of bill.
• Committee hearings.
• Vote by legislative chambers.
• Executive signature.
• Resolution of ambiguity by courts/agencies.
• Can consider entire period from introduction to
  signature/resolution of ambiguity. But,
  noise-to-signal increases with analysis period.
• Can consider only the five events. Introduces
  researchers bias/priors on what a
  significant/relevant event is.

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Measuring the stocks return

• Share price, close of 4/11/02 54.00
• Share price, close of 4/12/02 59.00
• Share price, close of 4/13/02 62.00
• If announcement at 11am on 4/12/02
• Announcement day return ((59-54)/54)100
• If announcement at 530pm (after close of trade)
  on 4/12/02
• Announcement day return ((62-59)/59)100

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Estimating the Expected Return

• Statistical models of expected return
• The constant expected returns model
• Rit µi eit. where Rit is the return
  for stock i over time period t, µi is the
  expected return for stock i, and eit is the usual
  error term.
• The market model
• Rit ai bi Rmt eit where, ai and bi
  are firm-specific parameters, and Rmt is the
  market return for the period t.

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Estimating the Expected Return

• Economic models
• Capital Asset Pricing Model (CAPM)
• Rit Rf ßi (Rmt - Rf) eit where, Rf
  is the riskfree rate and ßi is the beta or
  systematic risk of stock i.
• Arbitrage Pricing Theory
• Rit d0 di1F1t di2F2t ... dinFnt
  eit where, F1, F2,..., Fn are the returns on
  the n factors that generate returns, and d are
  the factor loadings.
• Statistical models not based on theory. Economic
  models are theory-based.

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Statistical Significance of Abnormal Return

• Abnormal return Actual return Expected return
• Statistical significance of abnormal return
  measured by a t-statistic.
• t-statistic of abnormal return
• (abnormal return)/(standard deviation of abnormal
  return)
• Standard deviation of abnormal return can be
  measured from
• prior returns of the stocks (time-series), or
• the return of the stocks during the announcement
  period (cross-section).

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Statistical Power of Event Studies

• Null Hypothesis Event has no impact on firm
  value.
• Alternate Hypothesis Event increases firm value
  by 1.
• Under the assumption the alternate hypothesis is
  true, the power of the event study is the
  probability of observing a statistically
  significant test statistic.
• MacKinlay (1998) Table 2, Figures 3a, 3b, and 4.

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Statistical Power of Event Studies

• MacKinlay (1998) Table 2, Figures 3a, 3b, and 4.
• For a one day announcement window, a sample size
  of 25 firms, and a two-sided test with a 5
  significance level, the probabilities of
  detecting an abnormal return of 0.5, 1.0, and
  2.0, are 24, 71 and 100, respectively.
•                       If the sample size were
  increased to 50 firms, the probabilities of
  detecting an abnormal return of 0.5, 1.0, and
  2.0, are 42, 94 and 100, respectively.
•                      If the sample size were
  increased to 100 firms, the probabilities of
  detecting an abnormal return of 0.5, 1.0, and
  2.0, are 71, 100 and 100, respectively.
•                       For a two days
  announcement window (or equivalently, doubling of
  the standard deviation of the event day abnormal
  return), and a sample size of 25 firms, the
  probabilities of detecting an abnormal return of
  0.5, 1.0, and 2.0, are 10, 24 and 71,
  respectively.
•                       For this two days
  announcement window and a sample size of 50
  firms, the probabilities of detecting an abnormal
  return of 0.5, 1.0, and 2.0, are 14, 42 and
  94, respectively.
•                       For this two days
  announcement window and a sample size of 100
  firms, the probabilities of detecting an abnormal
  return of 0.5, 1.0, and 2.0, are 24, 71 and
  100, respectively.

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Statistical Power of Event Studies

• Power of event study diminishes as
• The sample size decreases.
• The event period increases.
• As economic magnitude of event decreases.
• Why does the power of event study diminish as
  sample size decreases?

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Statistical Power of Event Studies
Average annualstandard deviation ()
49.2
Diversifiable risk
23.9
19.2
Nondiversifiablerisk
Number of stocksin portfolio
1
10
20
30
40
1000
15
Statistical Power of Event Studies

• Can an event study be conducted with just one
  firm? This question is relevant for corporate
  managers involved in court cases or regulatory
  injunctions involving only one firm.
• Does not invalidate event study methodology.
• Statistical power likely to be low.
• Announcement period return reflects effect of
  event and effect of unrelated information
  item(s). (In large sample effect of unrelated
  item cancels out.)

16
Shareholder Wealth Implications of Corporate
Lawsuits

• Bhagat, Brickley and Coles (JFE, 1994)
• Bhagat, Bizjak, and Coles (FM, 1998)
• Costs and benefits of
• Filing a lawsuit
• Settling
• Going to trial
• Likely to be a function of
• Type of suit (antitrust, breach of contract,
  etc.)
• The opposition (government, another corporation,
  etc.)

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Shareholder Wealth Implications of Corporate
Lawsuits

• Suits involving Corporations and Government
  Entities
• Net Present Value (NPV) Present value of
  benefits Present value of costs.
• Corporate managers take actions in litigation
  that have positive NPV, and eschew courses of
  action that have negative NPV. Reasonable
  approximation assuming
• Firms low cost of access to capital markets.
• Informational efficiency of stock markets.
• Performance-contingent management compensation.
• Government decision-makers unlikely to use the
  NPV rule.

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Shareholder Wealth Implications of Corporate
Lawsuits

• Suits involving Corporations and Government
  Entities
• Government decision-makers unlikely to use the
  NPV rule.
• Less constrained by financial and legal
  resources.
• Incentive to overspend legal resources in a suit.
• Some cases define agency or government powers.
• Visibility associated with winning can affect
  survival and funding of government unit.
• Opposing corporations face free-rider problems.
  Winning a suit and establishing a legal precedent
  can provide benefits for many firms, but the
  entire cost of the suit is absorbed by the
  litigating corporation.
• Coase Theorem (Private litigants have an
  incentive to settle a dispute when doing so would
  be mutually economically beneficial.)

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Shareholder Wealth Implications of Corporate
Lawsuits

• Suits involving Corporations and Government
  Entities
• Government decision-makers unlikely to use the
  NPV rule.
• Coase Theorem (Private litigants have an
  incentive to settle a dispute when doing so would
  be mutually economically beneficial.) Government
  agencies do not have the same incentives as
  private parties to reach cost-effective and
  efficient outcomes.
• Litigation-related financial distress costs
  (terminated trade credit, lower market value of
  warranties) is an important determinant of the
  change in shareholder wealth for corporations.
  While government agencies face the possibility of
  decreased funding or elimination, they do not
  face the usual costs of financial distress.
• Sued firms risk debarment from government
  contracts, an exclusion that potentially
  represents a huge loss.
• Government lawsuits can attract large publicity,
  resulting in larger reputational losses.

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Shareholder Wealth Implications of Corporate
Lawsuits

• Interfirm Suits (involving corporations as
  plaintiffs and defendants)
• Corporate managers take actions in litigation
  that have positive NPV, and eschew courses of
  action that have negative NPV.
• Importance of financial distress costs (fdc).
• Direct fdc in bankruptcy legal administrative
  fees Small.
• Indirect fdc prior to bankruptcy Large. Costs
  include
• Lower sales
• Inability to do business with customers and
  suppliers on favorable terms
• Greater difficulty of raising funds or obtaining
  credit.
• Distraction of management.
• Inefficient investment policy. (underinvestment.d
  oc)

21
Shareholder Wealth Implications of Corporate
Lawsuits

• Suits involving corporations and private citizens
• Reduced access to capital markets by most private
  citizens imply reduced ability to litigate, and
  smaller wealth effects on firms.
• Some suits filed by individuals foreshadow a mass
  tort, a class action, or multiple follow-on
  suits, or motivate government litigation. In such
  cases, wealth implication on corporation could be
  substantial.

22
Shareholder Wealth Implications of Corporate
Lawsuits

• Legal Issue affects cost of a lawsuit and
  behavior in suit settlement and trial.
• Certain types of violations carry large
  penalties.
• Trebling of damages in antitrust suits.
• Large punitive damage awards.
• Class action or multiple follow-on suits.
• Differing reputational costs.
• High for product-liability and environmental
  cases.
• Low for antitrust cases.
• Differing impact on other customers and
  suppliers.
• Plaintiff in a patent infringement dispute might
  be more likely to incur the costs of a trial to
  prevent the defendant from profiting and to
  discourage other firms from violating the patent.
• Plaintiff in a breach of contract suit may be
  more likely to settle a suit to maintain good
  relations with the defendant-supplier and other
  potential suppliers who could observe the formal
  dispute.

23
Shareholder Wealth Implications of Corporate
Lawsuits

• Bhagat-Romano (American Law Economics Review,
  2002, go to Research Links on
  http//leeds.colorado.edu/faculty/bhagat)
• Table 1, Panel A Announcement period abnormal
  returns for defendant corporations by opponent
  type.
• At filing Large negative impact when government
  is the plaintiff.
• On settlement Large positive impact when
  government is the plaintiff.
• Table 1, Panel B Announcement period abnormal
  returns for plaintiff corporations by opponent
  type.
• Non-positive market reaction for plaintiffs in
  most cases.
• Positive impact in antitrust cases when other
  side is another corporation.
• Table 1, Panel A Announcement period abnormal
  returns for defendant corporations by type of
  legal issue.
• Large negative impact on filing for
• Environment suits
• Fraud of government
• Financial reporting fraud

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Shareholder Wealth Implications of Corporate
Lawsuits

• Bhagat-Romano (American Law Economics Review,
  2002, go to Research Links on
  http//leeds.colorado.edu/faculty/bhagat)
• Conclusions
• Lawsuits are not a value-enhancing way for
  corporations to settle their disagreements with
  other corporations.
• The market appears to impose a higher sanction on
  firms than actual criminal sanctions, and the
  reputational losses are of equal magnitude for
  civil fines as criminal ones.
• Karpoff and Lott (1993, 1999) criminal
  restitution, civil penalties and court costs
  comprise only about 7 percent of the shareholder
  wealth loss. Remaining 93 percent can be
  attributed to the reputational loss suffered by
  the defendant firms. The market thus appears to
  impose significant costs on firms for engaging in
  criminal conduct.