How Shareholder Litigation Affects Firm Disclosure

Litigation allows shareholders to seek remedies for fiduciary breaches by managers or directors, such as when there has been a misrepresentation of financial results or illegal insider trading. Twitter, for example, faces a derivative lawsuit alleging that executives provided misleading financial statements to hide poor performance while selling millions of dollars in personally held stock. [1] The threat of shareholder litigation can help constrain managerial opportunism and deter misconduct, thus serving as an important governance mechanism. Specifically, the threat of litigation can encourage managers to provide more detailed or transparent financial information to the market. In turn, enhanced information has been associated with reductions in both information asymmetry and agency problems.

Despite such potential benefits, there are concerns about the efficacy of litigation. Academics and business columnists alike have argued that settlements are often cosmetic and that some derivative lawsuits may be frivolous or motivated by attorney fees. [2, 3] If so, the threat of litigation may be ineffective at limiting managerial misbehavior. Furthermore, a high threat of litigation may even encourage managers to provide less detailed information if they fear certain disclosure could be interpreted as misleading ex post and used against them in court. [4]

To study these issues, we examine changes to firms’ information environments in response to the adoption of universal demand (UD) laws at the state level. Between 1989 and 2003, 23 states adopted UD requirements. Universal demand laws require that shareholders send a letter to the board identifying the alleged wrongdoing and demand that the board take corrective action or file the suit itself. The caveat with such a requirement is that boards can deny the request, thus creating a procedural hurdle to initiating litigation. Without UD laws, shareholders can get the demand requirement waived if they can demonstrate there is reasonable doubt that the board could make an independent, good faith decision on the merits of the lawsuit.

We exploit these features using a difference-in-differences (DiD) econometric strategy by comparing changes in the information environment over time between firms incorporated in states that have enacted UD laws (the treatment group) and firms incorporated in states that have not (the control group).

We provide robust evidence that UD laws lead to a deterioration in firms’ information environments. First, we explore whether managers that face a lower litigation threat reduce their firm’s financial reporting transparency. To proxy for financial statement disclosure quality, we use the measure developed by Chen et al. (2015). [5] Our results show that firms provide less detailed financial reports when facing a lower threat of litigation. In particular, firms become less likely to disclose information about comprehensive income and non-recurring items – two categories which are prone to manipulation. [6]

If changes in reporting quality affect the information environment, they should be reflected in measures of information asymmetry and stock market quality. Our evidence indicates that the precision of equity analysts’ forecasts declines and error increases after the adoption of UD laws. We also find an increase in bid-ask spreads and the probability of informed trade (PIN), and a reduction in trading volume. These results imply that UD laws lead to a higher level of information asymmetry among analysts and in the trading environment.

Given the decline in transparency and higher information asymmetry, and lower litigation threat, we examine whether managers personally benefit through insider trading activities. We find that the profitability of insider trading increases substantially after states pass UD laws.

As a final analysis, we study whether UD laws affect other control mechanisms that can serve to align managerial incentives. With a more opaque information environment and fewer derivative lawsuits to attract regulators’ attention, managers may be more likely to manipulate accounting statements. We show that the probability that a firm faces an enforcement action by the Securities and Exchange Commission or the Department of Justice declines after the passage of a UD law, despite evidence of higher earnings management. These results suggest that UD laws lower the probability that regulators uncover financial misconduct, thus weakening an important external control mechanism.

Overall, our findings suggest that reducing the risk of litigation prompts managers to deliberately weaken the transparency of their firm’s information environment for personal gain. In this vein, our work delivers compelling evidence highlighting the role of shareholder lawsuits as an effective mechanism to monitor management and curb agency problems.

ENDNOTES

[1] http://fortune.com/2016/10/26/twitter-shares-lawsuit/

[2] Romano, R., 1991. The shareholder suit: litigation without foundation? Journal of Law, Economics, & Organization, 7(1), pp.55-87.

[3] https://www.nytimes.com/2014/08/23/business/possible-deal-in-hp-suit-may-mean-big-payoffs-for-the-lawyers.html?_r=0

[4] Johnson, M.F., Kasznik, R. and Nelson, K.K., 2001. The impact of securities litigation reform on the disclosure of forward‐looking information by high technology firms. Journal of Accounting Research, 39(2), pp.297-327.

[5] Chen, S., Miao, B. and Shevlin, T., 2015. A new measure of disclosure quality: The level of disaggregation of accounting data in annual reports. Journal of Accounting Research, 53(5), pp.1017-1054.

[6] Sherman, H.D. and Young, S.D., 2001. Accounting minefields. Harvard Business Review, 129135.

This post comes to us from Professor Audra Boone at Texas Christian University’s M. J. Neeley School of Business, Professor Eliezer Fich at Drexel University’s LeBow College of Business, and Thomas Griffin, a PhD candidate at Drexel University’s LeBow College of Business. It is based on their recent article, “Shareholder Information and Litigation Environment,” available here.