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Private suits have long been championed as a necessary mechanism not only to compensate investors for harms they suffer from financial frauds but also to enhance the deterrence of wrongdoing. But many critics have claimed that there is a hidden dark side to the successful prosecution of a securities class action. In this paper, we shed light on these issues by examining whether the revelation of earlier misstatements, the initiation of private suit, and the payment of a substantial settlement, weaken the defendant firm so that the firm is permanently worse off as a consequence of the settlement.

We find that defendant firms that settle securities class actions experience no significant declines in sales opportunities as a result of the lawsuit and settlement, but do experience a reduced level of operating efficiency while the lawsuit was pending (but not after it is settled). Most significantly, we also observe that defendant firms experience liquidity problems post-settlement and worsening Altman Z-scores (and a greater propensity to file bankruptcy) during that time period as well. Beginning with the filing of the class action, firm share prices are punished to the extent that investor returns do not recover.

We conclude that there is something in our results for both sides of the debate regarding the effects of securities litigation. One side could point toward our findings as evidence that the litigation is not a zero sum game for wrongdoers where only the insurer pays. On the other hand, others would claim that settlements, if not the entire litigation process, are a menace because they drain funds from the corporation that could better be directed toward strengthening its financial position.