Class action lawsuits hit innovative companies the hardest

Corporate America has long complained that many class action suits are frivolous and an unfair tax on business. Lawyers have a financial incentive to file meritless suits because companies are often willing to settle—even when allegations are false—to save time, money, and public image. Lawmakers in Congress have wrestled with this issue for years without resolution.

But research suggests more reason to address it: the costs of such litigation weigh disproportionately on the most innovative US corporations, according to Chicago Booth’s Elisabeth Kempf and Tilburg University’s Oliver Spalt. Using data on more than 40,000 lawsuits filed between 1996 and 2011 against 6,111 companies, the researchers find that frivolous lawsuits tended to focus on highly innovative businesses, which represented juicy targets—and cost the average company in this group $1.1 million a year, or about 4 percent of annual profit gains.

To sort companies by innovation level, the researchers used a scale developed by MIT’s Leonid Kogan, Northwestern University’s Dimitris Papanikolaou, Stanford’s Amit Seru, and Indiana University’s Noah Stoffman. It measures how a company’s stock responds in the days following a patent grant, a gauge of how valuable the innovation of the company is.

Kempf and Spalt counted a lawsuit as meritless if it was dismissed by a federal court and wasn’t settled. Their study finds that when such a lawsuit was filed, the targeted company experienced a 2 percent drop in market value from three trading days before to three trading days after the filing. While this is a significant drop, Kempf and Spalt argue that it understates the true cost of a frivolous suit because a company’s stock often started to fall in advance of a lawsuit filing. Expanding the window to 30 days before and 30 days after a suit was filed, the researchers find an even greater average share-price drop: 18 percent.

These results are for the average company in the study’s sample. When the researchers broke out businesses that ranked in the top third of their industry peer group based on the corporate-innovativeness gauge, the results were even more dramatic. “The corresponding dollar losses in the seven days around a meritless lawsuit filing are $148 million for the average successful innovator, but only $12 million for the average nonsuccessful innovator,” the researchers write.

And as frivolous suits target the most advanced companies, the resulting costs may affect corporate decisions about whether to innovate and list their shares. The current US securities class action system, they argue, poses a threat to economic growth and competitiveness.