DO THE MERITS MATTER? EMPIRICAL EVIDENCE ON SHAREHOLDER SUITS FROM OPTIONS BACKDATING LITIGATION

This Article examines a basic question in corporate law: Do the legal merits matter in stockholder litigation? A connection between engaging in wrongful behavior and liability in a shareholder lawsuit is essential if lawsuits are to play a role in deterring wrongful behavior. Yet skeptics of shareholder litigation have raised doubts about the degree to which such suits track actual malfeasance. The challenge is that managerial wrongdoing is almost never observable. While researchers can identify claims and to some degree evaluate their merits, such studies are limited to examining instances of wrongdoing that are actually litigated. We develop a novel approach to overcome this limitation in the context of one of the most notable corporate scandals of the twenty-first century: stock options backdating. Options backdating involves falsifying incentive option grant dates in order to increase the value of the options to executives. The manipulation of grant dates leaves a measurable statistical fingerprint, which we used to estimate the likelihood of backdating among not only companies sued for the practice, but across a sample of thousands of firms that used option compensation. We compare the likelihood that firms backdated with the incidence and disposition of shareholder derivative and securities class action lawsuits. We find that many firms that likely engaged in backdating were never sued and that even firms publicly named as backdaters in the press were not universally sued. Instead, plaintiffs' attorneys were selective in targeting firms with more egregious patterns of backdating. We also examine the motion to dismiss, settlements, and the use of special litigation committees, and we find that the probability of backdating is important for the latter two. These results are an important contribution to the shareholder litigation literature and are particularly timely and important for the unfolding debate over fee-shifting bylaws.