The capital-market effects of introducing private rights of action in securities regulation: Evidence from the United Kingdom

Few topics in the corporate and securities law literature are as controversial as securities class actions—that is, actions in which shareholders in public firms seek to collectively obtain compensation for damages resulting from false or misleading statements in corporate disclosures. Several commentators think that these actions are an important mechanism to protect investors in the securities market, which can in turn enhance firms’ value and liquidity (see, eg, Seligman 1994; Fox 2009; Sale and Thompson 2015). But others argue that the actions do not effectively compensate investors, are often frivolous, and do not adequately deter misbehavior (e.g., Grundfest, 1995; Alexander, 1996; Cox, 1997; Pritchard, 1999; Siegel, 2005; Coffee, 2006; Helland, 2006; Klausner, Hegland, and Goforth, 2013; Rose, 2010; Caskey 2014).

One important limitation of this discussion, however, is that there is little empirical evidence on the effects of introducing private rights of action in the legal system—a limitation that is in large part explained by the scarcity of legal changes that permit such an analysis. The most direct evidence in this area is provided by the studies that examine the impact of the US Supreme Court decision in Morrison v. National Australia Bank Ltd. 561 U.S. 247 (2010), which reduced the potential exposure of US listed foreign firms to securities litigation (see Bartlett, 2015; Licht et al., 2017). But since Morrison reduced, but did not eliminate, the risk of securities class actions, it is still unclear whether permitting the actions produces negative, positive, or insignificant economic outcomes.

In a recent paper, I contribute to this debate by examining the impact of the adoption of private rights of action (‘PRAs’) in the United Kingdom, a jurisdiction that provides a unique empirical setting for several reasons. First, the rights were made available to investors at different points in time in the London Stock Exchange’s (‘LSE’) Main Market (‘MM’, the primary stock market managed by LSE) and the Alternative Investment Market (‘AIM’, LSE’s junior market for less liquid firms, which is generally subject to lighter regulation). This implementation feature thus provides two separate events to examine the same question, which allows for stronger inferences. Second, the adoption of PRAs in MM also involved two distinct events because the rights were initially available only to investors that purchased securities and suffered a loss as a result of misstatements in periodic financial reports, but a few years later, the rights were made available to investors who purchased, sold, or held securities in the issuer and that experienced damages as a result of misstatements in periodic or non-periodic disclosures, or as a result of delays in the disclosure of material information. This enhancement of the rights, therefore, provides yet another opportunity to examine their impact. And third, the United Kingdom is one of the largest financial markets in the world, which implies that examining this jurisdiction is especially relevant not only because it provides a special empirical setting, but also because of the economic significance that market has on its own.

This paper focuses on the impact of PRAs on market liquidity and firm value because PRAs may enhance the confidence of public investors in the capitals market, which in turn may increase the ease with which investors sell their shares and the price of the shares (see, eg, Seligman 1994; Fox 2009; Sale and Thompson 2015). And, in fact, the results are consistent with that hypothesis: shortly after PRAs were implemented, the firms affected by the reforms experienced a significant increase in liquidity and stock returns in relation to a control group of firms that were relatively unaffected by the reforms. This finding has important policy implications not only because it provides an assessment of the benefits of private rights of action in the United Kingdom in particular, but also because it provides suggestive evidence on the potential consequences of eliminating or significantly curbing PRAs in jurisdictions that have considered doing so—including, notably, the United States (eg, Pritchard, 1999; Rose, 2010; Note, 2018).

It is worth noting that PRAs may also affect four additional variables: (i) firms’ production of voluntary disclosures (in the form of management guidance), (ii) the informativeness of corporate disclosures, (iii) audit fees, and (iv) the propensity of firms to replace capital investment with cash holdings. On the one hand, PRAs may incentivize managers to increase the incidence of voluntary disclosures and the informativeness of corporate disclosures as strategies to avoid lawsuits alleging that the firm did not disclose material information or that the disclosures were not timely (eg, Skinner, 1994, 1997; Ayers and Kaplan, 1998; DeFond and Subramanyam, 1998; Francis and Krishnan, 2002; Field et al., 2005; Qiang, 2007; Fox, 2009; Li, Wasley, and Zimmerman, 2016). But on the other hand, PRAs may induce auditors to charge higher fees to compensate the greater risk of litigation (Shu, 2000), and incentivize firms to replace their capital investments with cash holdings in order to create a buffer for future litigation costs—which, in turn, may reduce firm productivity (eg, Arena and Julio, 2015). The results of these analyses are presented in the online appendix, which, however, show that the data generally do not support any of these hypotheses.

Fernán Restrepo is an Assistant Professor of Law at the UCLA School of Law.