the economic impact of superfund’s litigation on the value of the firm: an empirical analysis

The Economic Impact of Superfund's Litigation on the Value of the Firm: An Empirical Analysis

Michael Muoghalu and John E. Rogers

ABSTRACT

The authors use a standard event-study methodology to evaluate the capital market reaction to superfund lawsuits brought against firms between 1980 and 1990. The results of the time series study indicate that the firms, on the average, suffered a statistically significant loss of 1.30 percent ($30.17 million) of their market value over the two-day event interval. The magnitude of the penalty varies among the industries examined, with the greatest impact falling on the pollution management industry. The lawsuit appears to have significant information effect, with the losses providing some indication that the lawsuits could impose costly constraints on the firn~s.

Introduction

Prior to 1980, hazardous waste disposal was regulated by the Clean Air and Water Acts of 1977 and the Resource Conservation and Recovery Acts of 1976. Each Act permitted the Environmental Protection Agency (EPA) and private groups to bring lawsuits against polluters to force compliance and restitution. In 1980, the Comprehensive Environmental Response Compensation and Liability Act (CERCLA), commonly known as the Superfund, brought all releases of hazardous wastes under a single regulation and established trust funds for emergency responses to dump site disasters. The Superfund Act also expanded the right of plaintiffs to sue "responsible parties" to force cleanups, monetary compensation for personal damages, and reparations for environmental damages. Additional concerns with the control of hazardous waste problems led to the broadening of the Superfund legislation under the Superfund Amendment and Reauthorization Act (SARA) of 1986. t

Michael Muoghalu is Assistant Professor of Finance, Pittsburg State University, Pittsburg, KS 66762. John E. Rogers is Assistant Professor of Finance, Pittsburg State University, Pittsburg, KS 66762.

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JOURNAL OF ECONOMICS AND FINANCE

Although the problem of hazardous waste has received considerable publicity in the popular media, only limited empirical work has been performed to analyze the economic significance of lawsuits on the value of the firms. The small body of research on hazardous waste has focused on site selection implications (Smith and Desvousges 1986 and Magorian and Morell 1982), efficiency of environmental statutes (Opaluch and Kashmanian 1985 and Barnett 1985), insurance liability implications (Katzman 1988 and Segerson 1989), and deterrent effects of lawsuits (Muoghalu, Robison and Glascock 1990). Other' environmental analysts, concerned with consumer welfare, have used various economic techniques to measure the impact of pollution and have recently focused on developing systems to deter pollution optimally. Baumol and Oates (1988) provide an excellent discussion and review of pollution taxes, subsidies, marketable permits, and direct controls as used in achieving optimal behavior by polluters. The primary thrust of all these studies is consumer welfare.

While hazardous waste statutes are fairly specific on required actions toward environmental restitution by polluters, lawsuits are sometimes necessary to force compliance. It is the economic consequences of such litigations that this study addresses. One method for measuring the economic impact of hazardous waste mismanagement is to evaluate the legal cost of the ensuing lawsuits. The use of the lawsuit dollar figures tends to create some dilemma for the analyst. The lawsuit claim figures are usually available, but are unreliable measures of the cost of the lawsuit because the amount for which a firm is sued is often different from the settlement amount. The disparity between the two is often wide and generally unpredictable, so that one cannot be effectively used as a proxy for the other. The settlement figure, which is a better measure Of the explicit cost of the lawsuit, is rarely available. Most settlements are done out of court so that the terms are not public information. Lawsuit valuation studies using these dollar figures are therefore fraught with problems, creating the need for an alternative estimation strategy.

Another method for determining the economic costs of hazardous waste mismanagement is to examine the performance of the company's stock returns during the relevant period around the Superfund lawsuit. After a lawsuit is filed, the market assesses the potential consequences (the probability of the firm losing the suit, the expected size of the damage award, the discounted change in operating and non- operating costs associated with abating pollution to settle the suit or avoid future suits, coverage provided by environmental insurance, and the loss of public goodwill) and imputes these to the stock price. The stock price consequently reflects the investment community's evaluation of the implicated firm based on the expected overall costs. These costs are captured in the form of abnormal returns z, which represent the change in the expected present value of future profits of the firm.

This study uses a capital market approach 3 to assay the economic impact of Superfund litigation on shareholder's welfare. Specifically, a standard event-time method is used to examinethe changes in shareholder's wealth following their firm's implication in a Superfund lawsuit. By focusing on shareholder's welfare rather than consumer's welfare and by using a capital market methodology rather than a more traditional economic or accounting framework, the authors aim to overcome some

74

The Economic lmpact of Supe~fund's Li~ation on the Value of the Firm

of the traditional difficulties often encountered in obtaining and using quoted lawsuit dollar figures in valuation studies. The event study method used in this analysis provides a basis for directly measuring the burden imposed on firms and their stockholders.4

The underlying assumption of this study is that the capital market is efficient so that the abnormal return captures all expected costs (implicit and explicit) of the lawsuit. This standard assumption of capital market studies is based on Fama (1970), which contends that security prices fully reflect all available information. Recent studies by Hartigan, Perry, and Kamma (1986), Muoghalu, Robison and Glascock (1990), Wier (1983), Binder (1985), Hughes, Magat and Ricks (1986), Garbade, Sibler and White (1982) and Maloney and McCormick (1982) have made similar assumptions in addressing regulatory, lawsuit, and environmental issues. The findings have been consistent, so the basic concept is being extended to the hazardous waste (Superfund) concerns.

A study of stock return movements around the date of the first public disclosure of the firm's involvement in a Superfund lawsuit will achieve the objective of capturing the market assessment of the overall economic impact of the mismanagement. Settlement of a Superfund lawsuit should produce abnormal returns to the firm only if the market does not anticipate the outcome. The economic impact of the two events on the value of the firm is the underlying focus of this analysis. This study further measures the economic impact of the litigation on the value of the firm in both relative and absolute terms.

Data Collection and Sample Selection

The emphasis of this study is on lawsuits brought against firms for hazardous waste mismanagement over the period 1980 to 1990. A firm is included in the sample if it is named as a defendant or co-defendant in a Superfund related litigation requiring the firm to make any required restitutions. The study is limited to hazardous wastes generated by concerns other than nuclear power plants and reported to the public through the print media, so that distinct dates of such reports are available as a matter of public record. Data collection is further limited to those firms whose stocks are traded on either the New York Stock Exchange (NYSE) or the American Stock Exchange (AMEX) and whose daily stock return information are available on tapes constructed by theCenter for Research in Security Prices (CRSP) for 360 trading days before and 60 trading days after each event.

The single index market model 5 is used to predict the expected return, while the CRSP value weighted index 6 serves as the proxy for the market return. In deriving the abnormal returns and the test statistics, the Cumulative Prediction Error (CPE) technique is utilized as explained in Dodd and Warner (1983). A total of 168 observations made up the original sample and were further screened to satisfy additional requirements designed to minimize noise from extraneous or contemporaneous events. A total of 97 observations met the requirements for the initial lawsuits sample and 64 observations for the court decisions/settlements sample,

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To assess the specific impact of the Superfund lawsuits on stockholder's returns, each sample is further partitioned on the basis of the dominant industry affiliations, as evidenced by their Standard Industrial Classification (SIC) code. The subsamples include Petro-Chemical firms (47), Pollution Management firms (11), and "Others" (39).

Methodology

The crux of the event study technique, as applied in this study, is the determination of whether and to what extent a Superfund lawsuit or its disposition (market events) has unanticipated effects on the price of the firm's common stock. That is, an attempt is made to establish whether the lawsuit (initial or settlement) produced "abnormal returns" that are significantly below those that could havebeen predicted from the firm's normal relationship with the market. Unanticipated events, such as a lawsuit, can change the stock price of the firm by changing the profit potential and riskiness of the firm. Wier (1982) and Garbade, Sibler and White (1982) use the basic framework to analyze the market reaction to antimerger and antitrust lawsuits, respectively. Schweitzer (1989) discusses the fundamentaIs of the technique and presents an extensive annotated bibliography of various studies relying on the technique. For a detailed review of the CPE methodology the reader is directed to Dodd and Warner (1983).

Abnormal Return Generating Process

The test period (event window) of 121 days is the period being analyzed for changes in stockholder's return as a result of the lawsuits or court decisions/settlements. The 61 days are comprised of 30 days preceding the event date, the event date 7 (t = 0), and 30 days following the event date. There are two basic reasons for the choice of the 61-day test period. The first is the efficient market/rational expectations hypothesis, which posits that security prices reflect all available information (Fama (1970). Unanticipated information, such as a Superfund lawsuit against a firm, will result in a change in the firm's stock price around the event. The stock price change is an unbiased estimate of the ceteris paribus value of the expected change in the firm's future cash flows. The second reason is the desire to limit, and possibly filter out, the influence of confounding factors. The choice of a relatively short test period satisfies the need for a trade-off in the length of the test period and sample size. Event date uncertainty is an acknowledged problem that can interfere with the ability to detect abnormal performances in event-time studies, and it is well discussed in literature (Brown and Warner 1985, Dyckman, Philbrick, and Stephan 1984, and Dodd and Warner 1983). To adjust for this problem a two-day event interval (days t = -1 and t = 0) is used, which minimizes the possibility of missing significant changes that are statistically undiscernible when split between the two dates, s

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The Economic Impact of SupeO~und's Litigation on the Value of the Firm

Cumulative Prediction Error (CPE) Methodology

The event-time (CPE) method detailed in Dodd and Warner (1983), Hite and Owers (1983), and Glascock and Davidson (1985), is used to generate expected returns to holding securities. Investor's reaction to the announcement of the lawsuit or settlement is obtained by predicting the normal return for each firm on each day and then subtracting the predicted return from the actual return. Specifically, investor's reaction for periods t = -60 to t = +60 is measured as the prediction error below:

Pe , + (1)

where oq and Bj are the intercept and slope parameters of a market model estimated over the period t = -360 to t = -61, P~t is the rate of return on security j for day t, and R~t is the return on the CRSP value-weighted index of all NYSE and AMEX common stocks on day t, which is assumed to be the rate of return of the market portfolio. 9 Similarly, the cumulative prediction error (CPEj), defined as:

ru c e e j = (2)

t'Tll

measures the cumulative abnormal return to stock j from day T1j to day T2j. Averaging these CPE's across firms results in the mean cumulative prediction error (MCPE), given by:

N

]=1

where N is the number of securities under analysis. The MCPE is the relevant measure of abnormal return for a given sample, and in the absence of unexpected information has an expected value of zero.

The test statistic recommended by Dodd and Warner is used to determine whether CPEj or MCPE are statistically different from zero, and by inference, whether the announcement of a lawsuit or lawsuit settlement has a substantive impact on equity prices. The test statistic for the abnormal return of security j at time t is defined as:

SPEj , - PEj,, (4)

where sit is the square root of the estimated population error variance as described in standard regression textbooks such as Theil (1971 ;134-136). More generally, the test statistic for a sample of N securities over the period t = Ttj to t = TEj is:

N

scP (5) Z - j=l

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where

SCPEj = t - rlj ~/T2j- T,j + 1

is the standardized cumulative prediction error (SCPEj) over the interval t = T 0 to t = T2j, and where the adjustment factor (TEj-TIj+I) is the number of days in the interval tested. Under the null hypothesis of no abnormal performance, both SPEjt and Z are unit normal. Hence, if the absolute values of SPEjt or Z exceed the appropriate percentile of the standard normal density function, then it is permissible to reject the null hypothesis and infer the existence of significant abnormal returns.

Alternative Estimation of Dollar Cost of Lawsuits

To understand relationships.

(1)

(2)

(3)

(4)

this section it may be useful to review some fundamental

The stock price at any time is the per share present value of all expected future cash flows (profits and/or risks) for the given firm. The percentage change in stock price is therefore equal to the percentage change in the present value of all expected future cash flows. The percentage change in stock price is given by the event-time study framework as abnormal returns. Using the CPE methodology, abnormal return is measured by the mean cumulative prediction error (MCPE), and represents the proportionate change in the market value of the firm.

These relationships imply that the total dollar costs of the lawsuits is equal to the decrease in the value of the firm as a result of the lawsuit. Since the CPEjt is the capital market measure of the change in the market value of firm j at time t resulting from a given event, the total value of the lawsuit for the sample of N firms is:

Total Value of Lawsuit = ~_~ MKTVALy PEj , (7) j=l =-I

where PEjt is the percentage loss of value by firm j at time t, and MKTVALj is the market value of firm j at day -02.

Results

The results of the CPE analysis as well as a comparative performance evaluation of the total sample and subsamples for both the initial lawsuits and settlements are presented below. Using the derived abnormal returns, the dollar values of the lawsuits are estimated and discussed. Table 1 (Panel A) contains a summary of the results for the total sample of initial lawsuits on the stock prices of firms implicated

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The Economic Impact of Superfund's Litigation on the Value of the Firm

in hazardous waste mismanagement lawsuits. The total sample results indicate that lawsuits on average reduced the market value o f the implicated firms by 1.2275 percent (z = -3.9474) over the two-day event interval (t = -01 to t = 00). The results further suggest that the abnormal per formance is almost evenly split between the two days. The significant negative abnormal return on the day pr ior to the publication date (t = -01) suggests that the news o f the f i rm's implication in the lawsuit might have been available to investors, possibly through wire-service release. The significant abnormal return on the publication date (t = 00) is an indication o f continued investor reaction to the information or a t ime-of-day phenomenon . No other interval shows any significant abnormal return, implying that lawsuits are evaluated when the information becomes publicly available. The results also show that 56 .7 percent o f all f irms in the sample earned negative abnormal returns during the two-day event interval.

T ~ L E 1

MEAN CUMULATIVE PREDICTION ERRORS (MCPE) AND TEST STATISTICS (Z-TEST) FOR THE TOTAL SAMPLE OF FIRMS SUED FOR HAZARDOUS WASTE

MISMANAGEMENT (DUMPING): INITIAL SUPERFUND LAWSUIT AND SUIT DECISION/SETTLEMENT

Panel A Panel B INITIAL LAWSUIT LAWSUIT SETTLEMENT

N = 97 N = 64

INTERVAL MCPE Z-TEST MCPE Z-TEST -30 to 30 1.2052 0.8781 -1.3176 -0.3057 -10 to 10 -I. 1733 -0.8883 -0.1139 0.2130

-02 to -01 -0.3339 -0.6556 0.2253 1.0581 -01 to -0I -0.6116 -2.6076* -0.0359 0.1600

00 to 120 -0.6159 -2.9816" -0.2688 -0.7144 -01 to 00 -1.2275 -3.9474* -0.3047 -0.3927 01 to 10 0.2173 0.7342 -0.5982 -0.9130 01 to 30 1.2881 1.2383 - 1.5685 -0.9832

Percentage of firms earning negative abnormal returns during the two-day event interval: Initial Lawsuit= 58.0%, Suit Settlement = 52.0%. No return is statistically significant for the public disclosure of the suit settlement, implying that the market may have correctly anticipated the outcome. The MCPE represents the proportionate change in the value of the firm over the indicated time interval.

* Significant at alpha = 0.005 (one tail test)

The CPE results o f the market reaction to the first public disclosure o f the final court decision/settlement are presented in Table 1 (Panel B). There is no evidence o f any statistically significant abnormal per formance for any interval dur ing the test period. Comparat ive return analysis for the total sample and subsamples under various intervals (not shown) indicates only random abnormal return distribution, fol lowing the public disclosure o f the settlement. The returns suggest that the market may have already capitalized the expected outcome o f the lawsuit in the stock

79


returns. Owing to the nature o f the lawsui t p roceed ings and thei r p ro t r ac tedness , the

ou tcome o f the lawsui t is in some instances a mat te r o f pub l i c specu la t ion long

be fo re the actual dec i s ion /se t t l ement becomes pub l i c knowledge . F u r t h e r analys is o f this sample shows no sys temat ic re turn pat tern . The non - s ig -

n i f icance o f the re turns indicates that the marke t may be eff ic ient in va lu ing hazardous was te lawsui ts . The announcement o f the cour t dec i s ion / se t t l emen t

therefore p rov ides no new informat ion to inves tors . Signif icant marke t reac t ion

w o u l d occur only i f se t t lement is d i f ferent than ant ic ipated. The results fur ther shows

that 52 .0 percen t o f all f i rms in the total s ample earned nega t ive abnorma l re turns

dur ing the t w o - d a y event interval .

The C P E results for the initial lawsuit sample on a tw o-da y incrementa l bas is for

the pe r iod -10 to 10 are presented in Tab le 2. The re is no ev idence o f cons is ten t in fo rmat ion leakage o r over reac t ion by the market . Addi t iona l runs made to test the

robustness o f the mode l show no s ignif icant devia t ions , l~ Thus the o b s e r v e d

negat ive re turn is not the resul t o f a few f i rms with ex t r ao rd ina ry p o o r pe r fo rma nc e s

but ra ther a la rge n u m b e r o f f i rms with mode ra t e negat ive re turns .

TABLE 2

TWO-DAY INTERVAL ABNORMAL RETURN (MCPE) OF THE TOTAL SUPERFUND LAWSUIT SAMPLE

INTERVAL MCPE Z-TEST SAMPLE SIZE

- 10 to -09 -0.2033 -0.5194 97 -09 to -08 -0.0494 -0.1644 97 -08 to -07 0.0410 -0.2257 97 -07 to -06 -0.0858 -0.5277 97 -06 to -05 -0.0923 -0.3403 97 -05 to -04 -0.3211 -1.1360 97 -04 to -03 -0.1042 -0.8004 97 -03 to -02 0.4352 1.4361 97 -02 to -01 -0.3339 -0.6556 97 -01 to 00 -1.2275 -3.9474** 97 00to 01 -0.3362 -1.1119 97 01 to 02 0.0346 0.2781 97 02 to 03 -0.3276 -0.7581 97 03 to 04 -0.2131 -0.3570 97 04 to 05 -0.1197 -0.3852 97 05 to 06 0.2947 1.0201 97 06 to 07 0.2090 0.4679 97 07 to 08 -0.0023 -0.1867 97 08 to 09 0.1312 0.9312 97 09 to 10 0.1034 0.9057 97

** Significant at alpha = 0.001 (one tail test)

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The Economic Impact of Superfund's Litigation on the Value of the Firm

TABLE 2-A

TWO-DAY INTERVAL ABNORMAL RETURN (MCPE) OF THE TOTAL RCRA LAWSUIT SAMPLE

INTERVAL MCPE Z-TEST SAMPLE SIZE

-10 to -09 0.1297 1.5069 36 -09 to -08 0.6742 2.2772 36 -08 to-07 1.0950 2.5192 36 -07 to -06 0.4166 1.1830 36 -06 to -05 -0.0322 -0.2481 36 -05 to-04 -0.0006 -0.4849 36 -04 to -03 0.0198 -0.2035 36 -03 to-02 -0.3635 -0.5148 36 -02 to -01 -0.7884 -0.8374 36 -01 to oo -0.8454 -1.5935 36 oo to Ol -0.3463 -0.7764 36 Ol to 02 0.5551 1.6030 36 02 to 03 0.2331 0.7506 36 03 to 04 -0.3113 -1.1728 36 04 to 05 -1.8460 -0.6888 36 05 to 06 -0.3341 -0.2173 36 06 to 07 -0.3562 -0.4820 36 07 to 08 -0.5199 -1.0903 36 08 to 09 -0.1230 -0.2680 36 09 to 10 0.1495 0.6205 36

** Significant at alpha = 0.001 (one tail test)

Table 3 reveals the abnormal return distribution for the total sample and subsamples of the initial lawsuits on a comparative basis. The subsample results indicate varying capital market sensitivities to the different industries. The pollution management industry suffered a loss of about 6.31 percent (z = 6.99) of its market value while the petro-chemical industry lost only 0.4 percent (z = 1.08) over the same period (event interval). The pre-event (t = -60 to t = -02) return analysis shows no evidence of significant information leakages prior to the lawsuits for either the total sample or the industry subsamples. With a significant impact of the lawsuit occurring on the day preceding the date of the first public disclosure of the lawsuit on the print media, it is suggestive that other more timely sources (wire service, etc.) are available to the investors and are, perhaps, properly used.

The large statistically significant abnormal return for the pollution management industry suggests that certain industry characteristics also influence the magnitude o f the abnormal returns. This is not surprising given that the industry's major function is waste disposal. Other factors that are unique to the sample and might have contributed to its performance include the small sample size, the small firm size and the publicity issue. Of all the industries in the total lawsuit sample, the pollution management industry, on the average, has the smallest firm size (in terms of assets, market values ($812 million), cash flows and the level of diversification). Furthermore, any adverse publicity will predispose the firms to increased regulatory and public awareness of the firm's practices, thereby increasing the probability of

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additional lawsuits. All these factors are implicit in the market valuation process as earlier mentioned. The factor that may have contributed to the non-significant abnormal returns for the petro-chemical industry is the large operat ing base (market value) o f the firms in the subsample. The subsample includes such conglomerates as Exxon, Shell Oil Company , and Occidental Petroleum. The average market value o f the firms in this subsample is $4 .80 billion.

TABLE 3

COMPARATIVE MEAN CUMULATIVE PREDICTION ERROR (MCPE) AND STATISTICS (IN PARENTHESIS) FOR THE INITIAL LAWSUIT: TOTAL SAMPLE

AND SUBSAMPLES PARTITIONED TO REFLECT MAJOR INDUSTRY AFFILIATIONS OF THE FIRMS BASED ON STANDARD INDUSTRIAL

CLASSIFICATIONS (SIC)

INTERVAL

-60 -60 -30 -01 01 to to to to to

SAMPLE 60 -02 30 00 60

TOTAL 1.0391 1.3642 1.2052 - 1.2275 0.9025 n = 97 (0.5354) (0.5967) (0.8781) (-3.9474)** (0.8930) #PETRO-CHEM -1.4504 -1.5012 1.7620 -0.3932 0.4440 n = 47 (-0.2734) (-0.7989) (0.8952) (-1.0497) (0.5467) POLLUTION -8.5916 -1.8389 -7.3404 -6.3134 -0.4393 n = 11 (-0.9115) (-0.2281) (-1.2943) (-6.9906)** (-0.0062) OTHERS -0.5908 -0.4077 2.0332 -0.6400 0.4569 n = 39 (0.0529) (0.8047) (-0.1130) (-I.6016)* (0.4602)

Significant alpha level: *** = 0.001, ** = 0.025 (One tail test)

# Petro-chemical industry subsample is a combination of the Chemical industry and Petroleum industry subsamples. The firms in the two industries are examined jointly because it is frequently difficult to distinguish between them. Furthermore, both industries are surcharged for the upkeep of the Superfund operations. Event window has been expanded to include t-60 and t+60 to explore potential information leakages prior to the public disclosure of the events. No significant leakage has been observed (t=-60 to t=-02), therefore lawsuit impact appears to be isolated within the two-day event interval (t~-01 to t =00).

The dollar impact o f the lawsuits and the associated statistics are shown in Table 4 for the total sample o f 97 firms. Since the analysis above indicates that the impact o f the mismanagement lawsuit becomes a factor in the valuation o f the firm only f rom the day when the news o f the lawsuit is capitalized by the market (day t = - 01), the stock price on day -02 can be used in determining the market value o f the firm pr ior to the lawsuit. The market value o f the firm on day -02 therefore proxies the value o f the f i rm, free o f the immediate effects o f the filing o f the lawsuit. The market value is given as the product o f the average stock price on day -02 and the most current number o f stocks outstanding for a given firm.

The average impact o f a hazardous waste mismanagement lawsuit on firms in the sample is -43 .37 million dollars with a standard deviation o f 204.54 million dollars.

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The Economic Impact of Supeo~und's Litigation on the Value of the Firm

Further analysis shows the average impact for the pollution management, petro- chemical, and "others" industries to be -95.57, -41.41, and -30.99 million dollars, respectively. These penalties are large enough to suggest reduced profitability from hazardous waste mismanagement or increased effectiveness o f the Superfund Act, even though they may not be enough to deter effectively additional pollution. Because the market valuation method is used, the average impact corresponds to a net return (net present value) of -$43.365 million, which represents the amount by which the value of the firm has decreased as a result of the lawsuit. Consistent with the standard valuation process, shareholder's wealth can only be maximized when firms engage in positive net present value ventures. Corporate managers should therefore avoid behavior patterns that could predispose them to Superfund lawsuits unless treating the waste will cost more than the projected clean-up costs, on a time value basis. I f the average impact is broadly interpreted as deterrent effects, then deterrence is strongest for the pollution management industry and weakest for the petro-chemical industry. Alternatively, these figures suggest that the pollution management industry has the most to gain by improper treatment o f hazardous wastes. These findings are consistent with those of Muoghalu, et al. (1990) who found deterrence to be dependent on proper initial treatment costs, the perceived probability of being caught, the number of years until caught, and the expected abnormal returns.

TABLE 4

DOLLAR VALUE OF THE LAWSUITS AND RELEVANT STATISTICS

Total Impact of the Lawsuits examined = - $4206.40 million Total Number of Firms Examined = 97.00 Average Impact per Lawsuit = - $ 43.37 million Standard Deviation for Impact = $ 204.54 million Largest Negative Impact of Lawsuit = - $1339.18 million Largest Positive Impact of Lawsuit = $ 382.54 million

Summary and Conclusion

Using a capital market technique, the authors found that the stockholders are significantly penalized for their f irm's involvement in a Superfund lawsuit. The magnitude of the penalty varies among the industries examined, with the greatest impact falling on the pollution management industry. The capital market measure of the average cost of the lawsuits in this sample is $43 million, which is far in excess of the $12.5 million estimated by EPA as the average cleanup costs of a site. Given the magnitude o f this disparity, firms appear to have enough reason to operate within the provisions of the law. In addition, the market reaction to the public disclosure of the court decision/ settlement shows that the capital market may be efficient in anticipating the outcome of these lawsuits.

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The study indicates that there are statistically significant negative abnormal returns for the two-day event interval of the Superfund lawsuits. The shareholders, on the average, suffered a loss of 1.23 percent (z = -3.9474) in the value o f their ownership interest in the firm over the two-day event interval. The presence of significant negative abnormal returns, which is a capital market measure of both explicit and implicit costs of the lawsuit, implies that shareholders suffered a reduction in welfare following the corresponding decrease in the value of the firms. The lawsuit therefore appears to have a significant information effect, with the negative abnormal returns providing some indication that the lawsuits could impose costly constraints on the implicated firms.

This study represents the first step in evaluating the economic impact o f Superfund lawsuits and appears to overcome the traditional difficulties encountered in obtaining and using quoted dollar values of lawsuits. By relying on independently generated capital market data, the study provides an alternative valuation of hazardous waste lawsuits. The economic impact of hazardous waste regulation violation can therefore be estimated using a capital market approach rather than waiting for the dollar figures o f lawsuit, which are not routinely available or when available do not reflect all relevant economic costs. The alternative valuation approach discussed here seems to provide some solution to the di lemma posed by the inconsistencies between the initial lawsuit dollar figures and the settlement figures by generating market-based values. In addition, the technique offers some insights into the economic costs o f Superfund lawsuits in both relative and absolute terms, and provides information beyond the bookkeeping cost of the lawsuits or the EPA estimate of the cleanup costs.

NOTES

~The key liability provisions of CERCLA and its amendment SARA require that any facility owner or operator, waste generator, transporter, etc. past or present, shall be liable for the cost of remediating an area of the environment contaminated. The party may also be liable to individuals for personal damages and to the federal/state government for damages to the "natural resources". CERCLA also has the following provisions which contributes to its comprehensiveness: i. Liability without fault--strict liability, ii. Joint and several liability, and iii. Retroactive liability. For more complete discussion of the Superfund, Clean Water Act and the other environmental statutes, see Freedman (1987) and Katzman (1988).

ZThe stockholder's losses (abnormal returns) are referred to as penalties rather than simply fines because the reduction in profits will include the fines, legal fees, additional abatement expenditures, and public ill-will resulting from the dumping.

3For basic information on the application of event-study methodology, see Schweitzer (1989), and for detailed discussions see Dodd and Warner (1983), and Brown and Warner (1985).

4Both explicit and implicit costs of toxic waste mismanagement should be reflected by changes in the stock prices of the implicated firms. A negative change in the value of the firm is a measure of penalties imposed on the stockholders for their firms involvement in hazardous waste mismanagement.

84

The Economic lmpact of SupeU~und's Litigation on the Value of the Firm

Yrhe market model is used because Brown and Warner (1985) find that the residuals (prediction errors) generated from this procedure provide well behaved statistical tests. RolI (1979) also indicates that residual analysis will give unbiased estimates of any information value in an event, when the intercept is estimated from the data, as is the case with the market model.

~ CRSP value-weighted return (with dividends) is calculated as: 3/t - V H + dividend

Vt_l where: Vt=market value of the index at time t, etc.

7The event-date is proxied by the Wall Street Journal first publication date for the lawsuit or its disposition.

8A two-day return period has been used in a number of studies in which strong information leakages on the day prior to the publication date are suspected as in Shane et al. (1983) and Dann (1981).

9Additional tests were performed (not shown) to adjust for serial correlation in the prediction errors and also tested for beta stability.

'~ the model was estimated using both the equally-weighted and value-weighted indexes as proxies for the return on the market. The choice of the index had only minor impact on the results. Second, a two-beta analysis was conducted to adjust for the potential bias that may result from estimating the market model with a large proportion of the sample coming from the petro-chemical industry. When a single industry accounts for a significant percentage of the full sample, any returns earned by the industry that are not correlated with the market's return create a systematic variation, unaccounted for in the standard model. Estimation of a two beta model as in Glascock and Davidson (1985) removes such bias. To test for this bias, the following modified market model was estimated:

where bj2 is the estimated industry parameter, and all other variables are as previously defined. The results derived are not quantitatively different from the standard market model. Therefore, the results are not reported.

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the economic impact of superfund’s litigation on the value of the firm: an empirical analysis

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