The authors discovered that frequently the long-term damage done to the firm that is sued impacts its viability going forward, a factor that could have negative consequences for investors who are still exposed via their holdings with the company. One way around this would be to target the suit to individuals most at fault  an idea that is more practical than ever in the era of multimillion-dollar compensation packages for high-level financial employees.

Class actions hurt the reputation of the corporation, distract the attention of the management and, to the extent that settlement is reached, this money may come, at least partially, out of the corporations pocket, rather than the pocket of the insurance company, says Bai.

She adds: The lawsuit may impose financial distress on the part of the corporation and hurt its financial well-being. From the shareholders' point of view, they have brought the action hoping to be compensated in the form of a large settlement, but they are ultimately the owners of the corporation and, as such, they bear the full negative consequence that the class action may bring to the corporation.

The new paper by Bai, Cox and Thomas examines two competing views on class-action suits against the current backdrop of consideration of new financial regulation reforms. One traditional school of thought says that the threat of such suits is a necessary deterrent that assures sound practices by financial firms. The other adheres to a deregulatory philosophy that such suits place American companies at a competitive disadvantage in the global financial marketplace while doing little to help the overall position of investors.

Audio clip of Lynn Bai discussing investor impact from lawsuits



The research looked at the impact class-action suits had on 480 companies that were defendants in recent class action suits who had settled the litigation brought against them. Those defendants were compared to companies in the same industries and of similar sizes on key financial parameters such as sales, operating income, liquidity, financial distress levels and stock market performances.

The study revealed evidence of deterioration in the defendants' operating efficiency and short-term liquidity as well as a higher propensity of filing bankruptcy after the lawsuit, relative to their peers. Moreover, stock prices plummeted upon the filing of the lawsuit and had not recovered even years after the lawsuits had been settled.

As one example of the kind of troubles these companies experience, consider what the study showed in regards to increases in risks of bankruptcy.

"The Altman's Z-score is a measure of the overall financial distress level of a company and is widely accepted as a powerful predictor of bankruptcy in the near-future," Bai says. "We found that our defendents had significantly lower Z-scores than comparable companies that were not involved in class-action lawsuits, which was a new finding."