Long-term performance of distressed firms: The role of class-action lawsuits

Does shareholder litigation pay off for investors over long horizons and how much does the type of allegation matter? We study whether a disciplining effect occurs for distressed firms and their managers and examine two different groups of allegations. Allegations of violations of duty of loyalty effect individuals only, but duty of care pertains to the corporate entity. After litigation we observe a general transformation in firm characteristics and risk exposures, which is consistent with theory. Although generally negative,short- and long-term performance effects differ substantially betweentypes of allegations. We observe performance reversals only in firms with individual directors accused of insider trading. Effects are similar for firms with triggering events that precede the initiation of a lawsuit. At the same time we fail to observe a simultaneous decrease in financial health in the form of their expected default frequency. Our results have important implications for regulator and institutional investor decision-making and monitoring strategies: whether to use litigation to exert control on managers, even inthe presence of dual holdings of debt and equity.