Settlement Incentives Under the Securities Exchange Act of 1934: Do the Merits Matter?

This paper investigates settlement incentives in securities litigation when a plaintiff seeks to recover damages from multiple co-defendants (here an auditor and a manager/firm). We extend previous research in two ways. First, we model how U.S. securities law creates a special case of joint and several liability, under which auditors' liability is conditioned, not only on their own fault, but also on the fault of the manager. Second, we allow the plaintiff to proceed sequentially against the defendants, rather than requiring simultaneous settlement negotiations. Our model provides three findings. First, when the manager has sufficient wealth to pay all damages and his litigation costs, the plaintiff proceeds first against the manager and collects a settlement based on the manager's fault (i.e., the probability that the manager produced misstated financial statements). This settlement also reflects the fact that under joint and several liability, the manager can be held liable in court for the total amount of damages. After the manager settles, the plaintiff settles with the auditor for an amount which reflects the residual damages not paid by the manager and the fault level of both defendants. In this case the manager pays the majority of the total settlement. Second, we find that when the manager's wealth is sufficiently constrained, the plaintiff proceeds against the auditor first. In addition to the fault of the manager, the auditor's settlement reflects both his own fault (i.e., the probability of nonconformance to GAAS) and the total amount of damages. The plaintiff then proceeds against the manager for the residual (up to the manager's wealth level). In this case the auditor may pay the larger share of the total settlement. Third, we find that the auditor's share of the total settlement can exceed the actual merits of the case when either litigation is costly and/or the manager's wealth is constrained. These findings support the claims of the accounting industry about the settlement/merits disparity.