The impact of product recalls on shareholder wealth
While product recalls are primarily associated with harms to consumers, investors in the companies that recall products are often subject to financial harm. In particular, news of a product recall frequently causes the subject company’s stock price to fall and thus diminish the value of investors’ holdings. Product recalls can have longer term effects on shareholders, including altering the company’s financial profile, hurting its performance in the market and harming its reputation. The company may also find itself facing potentially costly securities fraud litigation.
In a typical securities fraud action related to a product recall, the company is alleged to have misled investors about the safety of its products before the recall, thereby bolstering the stock prices until the truth about the product is revealed through the news of the recall. When the public and shareholders hear the news, the company’s stock price may drop, often sharply. Many smaller companies have been forced into bankruptcy as a result of product recalls, which effectively eliminates the value of their investors’ holdings and precludes recovery through litigation. Even with larger companies that are better able to sustain the losses associated with a product recall, the effects of a drop in the company’s stock price can be significant. With approximately 32% of workers in the United States contributing to a 401(k) plan, tens of millions of people are invested in companies that recall products, whether they know it or not (often through index funds offered by their retirement plans). Accordingly, a product recall has the ability to harm millions of investors and not just those who actively invest in the company.
Vioxx: A cautionary recall tale
Vioxx, a pain reliever launched in 1999, was one of the most heavily promoted prescription drugs in history, with sales in 80 countries and a global market of 80 million patients. On Sept. 30, 2004, its manufacturer, Merck & Company, announced that it was withdrawing the drug from the market after data from a clinical trial showed that the drug produced an increased risk for heart attacks and strokes. In response to this news, the company’s stock price dropped by than 26% that day, reducing the company’s market capitalization by approximately $25 billion. At the time of the recall, millions of people in the United States had taken Vioxx, which allegedly caused approximately 140,000 heart attacks resulting in an estimated 60,000 deaths. Merck allegedly knew about and intentionally concealed these risks during clinical trials and after the drug was on the market. In 2007, Merck paid $4.85 billion to resolve personal injury litigation and then paid a $950 million fine to resolve criminal charges in 2011.
In addition to the consumers physically harmed by Vioxx, Merck’s shareholders lost billions of dollars following the news of the recall and the subsequent stock drop. In response, investors filed securities fraud litigation against Merck and certain of its officers, directors, and employees on behalf of themselves and other investors who purchased the company’s shares during the five years preceding the recall. The plaintiffs alleged that Merck made materially false and misleading statements to the public about Vioxx’s cardiovascular safety profile and knowingly or recklessly omitted material facts about Vioxx’s safety. After more than a decade of litigation, the action settled for $1.062 billion in 2016. As such, the Vioxx litigation is a cautionary tale of how companies that place potentially dangerous products on the market compound not only the costs associated with harms to consumers, but also the risk associated with subsequent shareholder litigation.
Research finds product recalls harm shareholders
Recent academic research supports the notion that product recalls have a detrimental effect on companies stock prices and thus shareholder wealth. Reviewing 296 product recall announcements over a 10-year period, researchers found a significant negative reaction of company share prices in response to product recalls, and that such impacts are felt most acutely in the automotive and pharmaceutical industries. Unsurprisingly, investors reacted more strongly to recalls associated with higher risks of injury or death and the authors noted that shareholders are interested in how the company handles a recall (whether it appeared to “care”).
Because the failure to handle a recall properly can have short- and long-term financial consequences, management should take extra care in how they handle their products and any recalls, not just out of respect for consumers but to mitigate the harms to the company’s investors.
*Motley Rice LLC represented individuals in personal injury litigation and served as counsel to several institutional investors who filed individual, or “opt-out,” actions in the Vioxx securities litigation.
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