By: Will Bass
The benefits of initiating a securities class action extend beyond merely providing an opportunity to remedy the instant case of misconduct. A new study, Evidence on Contagion in Earnings Management, found that class-action lawsuits can deter companies from engaging in financial manipulation. By highlighting and punishing bad behavior, these lawsuits can dissuade corporate peers from committing similar transgressions.
The new study, which was recently released in The Accounting Review’s November issue, was conducted by academics at Rutgers University Business School, Nanyang Business School in Singapore and Columbia University Business School. It examined the accounting restatements of 2,249 companies between the years of 1997 and 2008. Aimed at investigating the effect that regulatory action, securities class actions and negative media reports have on future misconduct, the study uncovered a pattern of mimetic responses among corporate America’s financial wrongdoers.
The study revealed a strong correlation between earnings manipulation by companies and the percentage of corporate peers who had announced restatements for similar misconduct within the last 12 months. That is, when one corporation misstated its earnings and issued a restatement, corporate peers were more likely to emulate the bad behavior by fudging their own numbers and, ultimately, issue their own restatements. Importantly, the study also demonstrated that the opposite is true, as well. Companies were less likely to mimic accounting misconduct when a company in the same industry faced shareholder litigation, regulatory action or high-profile news reports exposing such misconduct.
Data from the study revealed that copy-cat companies often emulated the original wrongdoer’s type of misconduct to a remarkable degree. That is, “[f]ollow on restatements often occurred in the same corporate accounts that the initial case involved, like revenue manipulation, expense account fudging, and massaging of inventory, assets or restricting accounts.”
In addition to the type of misconduct, companies appeared to attach importance to the author of the restatement and the severity of the transgression that it revealed. The study uncovered a positive correlation between the size and visibility of the original wrongdoer and the degree to which those wrongdoings influenced their corporate peers’ behavior. A company was found to be more likely to mimic a bad behavior when it was implemented by a high-profile corporate peer, as opposed to a smaller or less visible peer. Respectively, a company was found to be less likely to mimic financial misconduct when a peer’s restatement was extreme and revealed substantial misconduct. Therefore, the study determined that class-action lawsuits and news reports that illuminate financial misconduct discourage additional violations because corporate peers view such transgressions as too risky to emulate.
As succinctly stated by the New York Times, “what this study hammers home is this: Accountability counts. Whether it comes from a regulator, a shareholder lawsuit or a journalistic enterprise, our capital markets and our investors need more of it, not less.” Gretchen Morgenson Earnings Misstatements Come in Bunches, Study Says, N.Y. Times, Oct. 23, 2015.