We use a sample of firms that restated their financial statements over the period 1997–2002 to examine the influence of the board and audit committee on restatement-induced class action lawsuits. The focus of our study is to 1) examine the monitoring role of board and audit committee in restatement-induced litigation following passage of the PSLRA, 2) provide evidence on whether board and audit committee monitoring is a restatement-induced litigation merit factor and 3) provide evidence on whether PSLRA is achieving its objective of making merit a factor in the filing of restatement-induced litigation.
Logistic regression of the probability of restatement-induced class action lawsuits shows that firms are less likely to experience restatement-induced shareholder litigation when they have more independent boards. There is evidence that when restating firms experience more negative restatement announcement valuation effects, shareholders are more likely to file a securities class action lawsuit. Another result that emerges from this study is the finding of a positive relation between firm size and probability of restatement-induced securities class actions which indicates that deep pocket effects influences the decision to file restatement-induced class actions. We also document evidence of revenues restatements being positively associated with restatement-induced securities class action lawsuits. Our results are robust to distinguishing restatements as either errors or irregularities and controlling for the effects of the restatement initiator and Blue Ribbon Recommendations, adding credence to our findings.
Contrary to expectations, we do not find any significant result for the audit committee variables. Audit committee measures are fully independent audit committee, audit committee meetings and alternative definitions of audit committee financial expertise. Our results suggest that having financial experts on the audit committee or corporate audit committees composed of only independent directors does not influence shareholders' perception of the class action lawsuit's merit. The results also suggest that board and audit committee activity during the misstatement period does not influence the perceived merit of a restatement-induced class action lawsuit.
A possible reason for the insignificant result is that shareholders may be focusing on the proportion of independent directors on the board rather than a fully independent audit committee as a credible signal of the seriousness of the misstatement and the merit of the restatement-induced class action. Shareholders may not be influenced by the audit committee independence measure because an audit committee that is not fully independent but with majority independent members could effectively monitor management. Further, accounting or financial expertise on the audit committee could differentiate restating firms from non-restating firms, however, among restating firms, it appears there may not be any significant differences. Given that boards are visible and have primary oversight over management, it is not surprising that shareholders focus on it and this may explain the targeting of the firm, its officers and directors in the securities fraud allegations.
We also do not find any significant result for our measure of restatement materiality (size of the restatement), which is contrary to our hypothesis. The inconsistent result for the restatement materiality variable in the present study and in Palmrose and Scholz (2004) could be due to the restatement announcement return variable in the model capturing the effects of the restatement materiality and pervasiveness measures as well as the restatement disclosure dollar loss measure. The market reaction to restatement announcement should influence the merit of the litigation and shareholders' decision to initiate a securities class action because it sums up the effects of restatement materiality and pervasiveness measures as well as the effect of shareholder losses. The results of Lev et al. (2008) also supports this argument because they also include the market reaction to restatement announcement in their restatement-induced litigation regression model and do not find any significant result for the current size of restatement or lagged size of restatement, which are their restatement materiality measures.
Our finding that the board independence measure is negatively associated with probability of restatement-induced class action lawsuits suggests a positive relation between board independence and perceived merit of a restatement-induced class action lawsuit. Accordingly, the lower the proportion of independent directors, the higher the perceived merit of the restatement-induced class action lawsuit. Board independence can influence the perceived merit of a restatement-induced class action lawsuit in two ways. First, restating firms with lower proportions of independent directors may be perceived by shareholders as being more likely to have intentionally misstated their financial statements. Second, a lower board independence measure also provides shareholders with more data to file a securities class action with greater specificity and strength pursuant to PSLRA.
Our results also imply that restating firms could limit the likelihood of being subject to restatement-induced class action lawsuits if they increase the proportion of independent directors on their boards consistent with the SEC's rules. This is because if a restating firm increases the proportion of independent directors on its board, shareholders would have a more positive perception of the firm's financial reporting credibility thereby mitigating the likelihood that they would initiate a class action lawsuit.
Further analysis of the role of the board and audit committee on settlement amount provides some preliminary evidence suggesting that class action firms with weaker boards and audit committees are more likely to pay larger damages to shareholders in the settlement. Specifically, we find some evidence of larger dollar settlements among firms with less independent boards and audit committees as well as less financial expertise (AccExp, FinExp, and MajFinexp) on the audit committees.
Taken together, the empirical results support the view that board independence is a merit factor in restatement-induced class action litigation and PSLRA appears to be achieving its objective of limiting the filing of frivolous lawsuits, specifically restatement-induced class actions. Our results for board independence also support the efficacy of the SEC's revised definition of director independence. The results suggest that directors satisfying the SEC's new director independence rules, which are revised and include more stringent director independence criteria, are perceived as more effective at monitoring management. Finally, our results imply that board independence under the SEC's revised rules influences shareholders' perception of the merit of a restatement-induced class action lawsuit and that restating firms with more independent boards are less likely to be subject to restatement-induced securities class action. One limitation of the study is that we use pre-SOX data. The use of pre-SOX data provides variability in the audit committee data in order to obtain meaningful regression results
