Does the presence of a general counsel in top management affect securities class action lawsuits?

• Published date: 01 March 2024
• Author: Audrey Wen‐Hsin Hsu,Sophia Liu
• Date: 01 March 2024
• DOI: http://doi.org/10.1111/corg.12527

ORIGINAL ARTICLE

Does the presence of a general counsel in top management

affect securities class action lawsuits?

Audrey Wen-Hsin Hsu | Sophia Liu

The Department of Accounting at National

Taiwan University, Taipei, Taiwan

Correspondence

Sophia Liu, The Department of Accounting at

National Taiwan University, Taipei, Taiwan.

Email: htliu@ntu.edu.tw

Funding information

National Science and Technology Council of

Taiwan

Abstract

Research Question/Issue: This study investigates the effect of the presence of a

firm's general counsel on the top management team on the likelihood that a US pub-

licly traded company is targeted by a securities class action (SCA).

Research Findings/Insights: Using a US sample of class action lawsuits against pub-

licly traded companies, we provide evidence that firms whose top management

includes the general counsel (TMC) are less likely to be involved in SCAs. We further

investigate the association of the presence of a TMC with the subsequent four litiga-

tion outcomes: market reaction to the lawsuits, duration of the lawsuit process, dis-

missal of the lawsuit, and the settlement approved by the courts. We find that firms

with a TMC experience more favorable consequences on all four dimensions of litiga-

tion outcomes. The results hold after controlling for endogeneity, unobserved firm-

related omitted variable bias, and monitoring mechanisms.

Theoretical/Academic Implications: The findings support that establishing a TMC

acts as an effective governance mechanism in reducing corporate litigation risk and

adverse legal outcomes.

Practitioner/Policy Implications: Our evidence suggests that a TMC can help moni-

tor operating and financial decisions. This study suggests that Section 307 of the

Sarbanes–Oxley Act (SOX) works in terms of explicitly emphasizing the general coun-

sel's responsibility. Thus, this study offers insights to policymakers who are interested

in enhancing the function of the governance mechanism by which a corporate gen-

eral counsel can influence the capital market.

KEYWORDS

corporate general counsel, corporate governance, litigation risk, securities class actions

1|INTRODUCTION

This study examines whether the presence of a general counsel on

the top management team (here, a top management counsel, or TMC)

deters the ex ante occurrences of securities class actions (hereafter

SCAs) and improves the ex post outcomes of SCAs. We examine

whether the likelihood of SCAs is lower for firms that appoint a TMC

relative to firms that do not promote a general counsel (GC) to top

management.

Over time, general counsels are the gatekeepers of corporate

operating and financial decisions to ensure that firms operate within

the bounds of the law (DeMott, 2005; Kwak et al., 2012). They play a

gatekeeping role in monitoring compliance within the organization

and represent shareholders' interests. However, in the early 2000s,

there was a concern that GCs facilitate accounting scandals. To

address the concern, the Securities and Exchange Commission (SEC)

adopted Section 307 of the Sarbanes–Oxley Act of 2002 (SOX) to

reestablish general counsels' governance responsibilities in firms'

Received: 2 December 2021 Revised: 20 October 2022 Accepted: 7 March 2023

DOI: 10.1111/corg.12527

Corp Govern Int Rev. 2024;32:275–296. wileyonlinelibrary.com/journal/corg © 2023 John Wiley & Sons Ltd. 275

financial and operating decisions. Section 307 requires general coun-

sels to report evidence of their firms' material violation of securities

laws “up-the-ladder”to the CEO, the audit committee, and the board

of directors. It is expected that Section 307 reestablished the GC's

gatekeeping functions and improved the internal governance for

transparent financial reporting.

Prior studies provide mixed evidence on the economic conse-

quences of a TMC. Kwak et al. (2012) find that firms with a TMC are

more likely than other firms to issue credible forward-looking fore-

casts. Mamun et al. (2021) find that firms with a TMC have lower

stock price crash risk than other firms. Their findings support the argu-

ments that a TMC has legal and monitoring expertise. However, given

that the GC reports to the CEO and the GC's appointment and com-

pensation are influenced by the CEO, the GCs may support the CEO's

decisions rather than acting as an effective monitor. Studies find that

firms with a TMC are associated with an increase in tax aggressive-

ness (e.g., Abernathy et al., 2016) and an increase in firm credit risk

(Ham & Koharki, 2016). The results suggest that when GCs are pro-

moted to top management (i.e., become TMCs), they may place less

emphasis on their gatekeeping responsibilities and more emphasis on

strategic and development responsibilities. However, little is known

about overall litigation risks and litigation outcomes in the presence of

GCs in a firm's top management. To shed further light on the mixed

evidence in the literature, we investigate whether the presence of a

TMC is negatively associated with the initiation of lawsuits and subse-

quent litigation outcomes.

SCAs under Rule 10b-5 of the Securities Exchange Act of 1934

intend to compensate plaintiff shareholders for economic losses

caused by a firm's intentional misrepresentation, reckless negligence,

or failure to disclose adverse information. Specifically, when firms

intentionally omit negative information or make a falsely positive

announcement in the financial reports, investors suffer economic

losses because they rely on the financial reports. We argue that firms

with a TMC can reduce the initiation of lawsuits for two reasons. First,

a TMC can improve the monitoring role by enhancing the transpar-

ency of financial disclosures. Managers should respond proactively

with greater disclosure and transparency to reduce the likelihood of

the omission of value-relevant information and consequently lower

litigation risks. Kwak et al. (2012) find that firms with a TMC are more

likely to enhance the transparency of the firm. Second, a TMC can dis-

courage managers from omission of important adverse information.

Mamun et al. (2021) find that firms with a TMC mitigate bad news

hoarding and have lower stock price crash risk than firms without a

TMC. Thus, we expect that a TMC lowers the likelihood of a firm

being sued.

As Section 307 of SOX requires that firms have in-house GCs, we

investigate our hypotheses during the post-SOX period to ensure all

firms have a GC. Mamun et al. (2021) suggest that using the post-

SOX period avoids the sample selection issue related to the decision

to have a GC. We examine whether the likelihood of SCAs is nega-

tively associated with the appointment of a GC to top management

using a sample of firms from ExecuComp over 2003–2014. Consistent

with our hypothesis, we find that firms with a TMC are negatively

associated with the likelihood of SCAs. Furthermore, we find that the

defendant firms' litigation outcomes, measured as market reactions to

the lawsuit filings, the probability of dismissals, the duration of the liti-

gation process, and the amount of any settlement, are also more

favorable when they have a TMC.

We contribute to the literature as follows. First, we directly docu-

ment that TMCs are effective monitors. Our findings are in line with

prior studies that have demonstrated that the presence of a TMC

reduces insiders' trading profit (Jagolinzer et al., 2011), facilitates vol-

untary disclosure (Kwak et al., 2012), and reduces stock price crash

risk (Mamun et al., 2021). If firms appoint GCs to top management,

our study shows that the billions of dollars of direct costs and indirect

costs involved in class action lawsuits may be avoided. Second, we

contribute to the litigation literature. Prior studies such as Kim and

Skinner (2012) do not explore the role of GCs in relation to the initia-

tion of lawsuits. A theoretical work investigates the internal gover-

nance of firms in relation to lawsuits (Acharya et al., 2011); our study

empirically provides evidence that such internal governance by GCs

effectively reduces the likelihood of SCAs. Third, our findings also

offer policy implications for insurance companies. Firms usually enter

into insurance to protect themselves from the direct and indirect costs

of lawsuits. Litigation insurers can identify such observable corporate

features as having a TMC and price litigation insurance accordingly.

The remainder of this study is organized as follows. Section 2pro-

vides a literature review and develops hypotheses. Section 3outlines

the research design and sample selection. Section 4documents the

empirical findings. Section 5discusses additional analyses, and we

conclude in Section 6.

2|LITERATURE REVIEW AND

HYPOTHESIS DEVELOPMENT

2.1 |Class action lawsuits

Securities class action lawsuits arise under the anti-fraud provision of

the federal securities laws, including the Securities Act of 1933 and

Section 10(b) of the Securities and Exchange Act of 1934; plaintiff

shareholders allege and prove the intentional or reckless material mis-

representation or omission by the defendant firm in connection with

the purchase or sale of securities that lead to economic losses. As

shareholder litigation against public companies is common and costly

to the defendants, in 1995, Congress passed the Private Securities Lit-

igation Reform Act (PSLRA) to address perceived abuses in securities

class action lawsuits. The PSLRA created a safe-harbor provision for

managers to make forward-looking statements and made it more diffi-

cult for plaintiffs to initiate SCAs by requiring plaintiffs to plead and

prove that the defendant acted with a conscious intent to defraud

investors. Even after the passage of the PSLRA, the incidence of SCA

filings increased. Cornerstone Research (2019) reports that from 1997

through 2018, 215 class actions were filed each year on average.

Based on the statistics of Cornerstone Research (2019), for exam-

ple, in 2019, nearly all the SCA fillings (98%) were related to

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