If you’ve been investing for a long time, you’ve likely gotten at least one letter or email from a law firm about a class-action suit against a company you once held stock in. In many instances, these lawsuits are inconsequential and often get resolved with minimal input from the investors.
But not every lawsuit is about crossing T’s and dotting I’s. Sometimes, lawsuits involve significant accusations regarding a company’s products, accounting methods or management behavior that can negatively affect the firm’s stock price (and public reputation). This article examines how different business lawsuits affect stock prices and what investors should do if a core holding gets slapped with one.
Understanding the Types of Lawsuits
Companies are sued in a variety of ways, but most fall under the umbrella of these four categories:
- Class Action Lawsuits: A class legal action where individuals come together to sue the same entity because they’ve all been affected by the same harm. The purpose is to allow relatively minor claims to be pooled together under one representative plaintiff. Securities class action lawsuits are more manageable to prosecute than each person suing individually, often creating a stronger case for victims.
- Patent Infringement Suits: This lawsuit occurs when a patent holder accuses another party (in this case, a public company) of using their invention without permission. This can happen if someone creates, uses, sells or imports a product or process covered by the patent. If found guilty of infringement, the defendant may be ordered to pay damages to the patent holder and may be prohibited from continuing to use the infringing product or process.
- Regulatory Investigations: If a government body like the Securities and Exchange Commission (SEC) or Environmental Protection Agency (EPA) believes a company is violating laws or regulations, it might file a lawsuit to prevent further infractions. The type of suspected lawbreaking will determine which body initiates the lawsuits, e.g., the SEC for securities litigation like insider trading.
- Employment-Related Lawsuits: Employment lawsuits can severely damage a company’s reputation and force it to pay large sums of cash in settlements. They are often brought for discriminatory practices, sexual harassment, wrongful terminations or wage or employee misclassifications.
How a Lawsuit Impacts a Stock’s Price
No matter the type of lawsuit, legal action can drastically affect a company’s stock price if the allegations are severe. Here are a few factors to consider and an example for each.
Immediate Market Reactions
When a lawsuit against a company first reaches the public, the initial reaction is often significant selling volume. The lawsuit details take longer to digest than the headline. Still, market sentiment can become a steamroller and lead to more selling before the lawsuit can be properly evaluated. Negative sentiment breeds more negative sentiment and a stock can drop quickly.
While not necessarily a typical lawsuit, accounting issues at Super Micro Computer Inc. (NASDAQ: SMCI) caused a sudden and steep stock decline. When accounting firm Ernst and Young dropped SMCI as a client due to financial reporting concerns, the market response was forceful and shares dropped from $49 to $33 within two trading sessions. The stock quickly rebounded once new auditors were hired, closing back above $40 by the end of November. However, accounting issues always cause concerns among investors and SMCI is a great example of what can happen when irregularities appear in the books.
Long-Term Implications
Over a longer time frame, a company facing stiff legal action can suffer from financial and reputational damage. Fines, penalties and restitution can significantly strain a company’s cash flow and reputation damage from a lawsuit can result in declines in sales or customer traffic. A recent study showed that a company facing litigation can expect an average stock price decline of 5% following the announcement. The longer and more severe the litigation, the more reputation (investor confidence) will suffer.
Not every lawsuit ends in pain for the company, however. Guilty findings or penalties can negatively impact the stock price, but a settlement or dismissal can have the opposite effect. If a lawsuit is dismissed or settled out of court for a reduced sum, investor sentiment can flip quickly and the stock could rebound (as was the case with SMCI once new accountants were hired).
Market Context and Comparison
The industry or sector can also affect the reaction to stock prices. For example, a lawsuit at a startup in the biotech sector might have a drastic impact since it's a fledgling company with minimal legal and financial resources to potentially defend itself. However, a lawsuit against a large-cap bank with the cash and lawyers to fight has a higher chance of being settled. And the higher the odds of settlement or dismissal, the less reaction the stock will have in the long term.
Recent Examples
Here are three recent examples of major company litigation and how their value was correspondingly affected:
Lawsuit Against Johnson & Johnson
Johnson & Johnson Inc. (NYSE: JNJ) is no stranger to litigation. The health care conglomerate made headlines for the wrong reasons in the early 1980s when Chicago residents began dying from tainted Tylenol. However, this was later proved to be tampered with by an unrelated person (who was never caught).
A more serious and ongoing legal matter for JNJ is the talcum powder lawsuits, which total more than 61,000 as of this writing. JNJ talcum powder was found in some studies to cause cancer due to asbestos contamination and the company has paid out more than $8 billion in claims. The company’s stock hit an all-time high above $180 per share in April 2022 but has spent the last two-plus years trading in a steadily declining range as lawsuits continue to mount. The company has twice tried to settle all claims through the bankruptcy of a subsidiary; however, both attempts were denied in court.
Emissions Lawsuit Against Volkswagen
German carmaker Volkswagen (OTC: VLKAF) faced severe legal repercussions for falsifying emissions records on vehicles manufactured between 2009 and 2015. In early 2016, the company settled with the Federal Trade Commission (FTC) and agreed to spend up to $14.7 billion to replace or modify more than 500,000 vehicles or leases for American drivers.
Volkswagen shares were hit almost immediately by the emissions fraud allegations. Shares peaked at $260 in March 2015 before falling drastically as the company prepared for litigation. The stock bottomed out under $120 per share by September 2015 and didn’t regain the $260 level until February 2021.
Fraud Lawsuit Against Theranos
Theranos was a biotech company founded by Stanford graduate Elizabeth Holmes that sought to simplify blood testing. Holmes claimed to diagnose a host of diseases and conditions with just a few drops of blood using the company's Edison system. However, the system regularly provided inaccurate results and Theranos attempted to conceal its faulty equipment while silencing potential whistleblowers.
Walgreens, which initially partnered to distribute the tests, sued Theranos in 2017 and the two sides settled shortly after. However, the SEC brought charges against Holmes for shareholder litigation and Theranos was shut down in 2018. Holmes was found guilty of four counts of fraud and sentenced to 11 years in prison. The company, once valued as a multi-billion-dollar Silicon Valley jewel, is worthless today and other competitors are now working on their blood testing systems.
Lawsuits Often Negatively Impact a Company’s Stock Price, But Resolution Matters More Than Headlines
If a company is sued by a customer, shareholder or regulatory agency, it's never good news. Litigation can drag down a company’s stock price, even if the allegations are minor or frivolous. But the initial reaction isn’t always the correct one. If a company resolves the lawsuit quickly through a judgment win or settlement, it could boost the stock price beyond previous highs. However, if the allegations are severe and damaging to reputation and the bottom line, the stock price could see multiple years of poor performance.
Frequently Asked Questions
Do lawsuits make stocks go down?
Yes, litigation often negatively influences a company’s stock, with declines averaging about 5% following the lawsuit announcement.
What factors can affect a stock's price?
The type and severity of the lawsuit have an outsize impact on the reaction to the stock price. Major accounting scandals like Enron or fraudulent products like Theranos destroyed the firm’s value practically overnight.
Do shareholders get paid in a class-action lawsuit?
Securities class action suits are brought by a group that has harmed a company or firm similarly, such as a defective product or wage dispute. Shareholders are sometimes the plaintiffs in class action lawsuits against the companies they own and they receive compensation if the lawsuit is successful.
About Dan Schmidt
Dan Schmidt is a finance writer passionate about helping readers understand how assets and markets work. He has over six years of writing experience, focused on stocks. His work has been published by Vanguard, Capital One, PenFed Credit Union, MarketBeat, and Fora Financial. Dan lives in Bucks County, PA with his wife and enjoys summers at Citizens Bank Park cheering on the Phillies.