Liability for Non-Disclosure in Equity Financing

Albert H. Choi is Paul G. Kauper Professor of Law at the University of Michigan and Kathryn E. Spier is Domenico De Sole Professor of Law at Harvard Law School. This post is based on their recent paper.

Under the current US securities laws, when a company raises capital by selling securities to outside investors, the company must disclose material information it possesses to the prospective investors. In case the company fails to do so, the investors can bring suit against the company to recover compensatory damages. Presumably, such a liability regime deters companies from withholding material information and ensures that the outside investors will receive necessary material information from the company so as to make an informed decision as to whether to purchase the offered security. At the same time, though, critics have argued that the private enforcement regime, especially the class action system, is too costly and encourages indiscriminate lawsuits against even innocent companies. To what extent do such a liability regime induce the company to disclose all material information to the investors? Is such a private liability regime necessary in the first place? If so, in what form? Should the investors be allowed to bring class actions or be required to bring suit on an individual basis, as some advocates have argued? What is the role of the plaintiff class action lawyers? In a recent paper, we attempt to answer some of these questions with the help of game theory.

The paper presents a model in which a firm, initially owned by an entrepreneur, sells stock to the outside investors while deciding whether to disclose certain material information the firm (and the entrepreneur) possesses to the prospective investors. The investors make rational inferences based on the firm’s decision to disclose and, in case it is revealed that the firm hid material information, the investors can bring suit against the firm to recover damages. Notably, the damage payment received by the outside investors is offset in part by the reduced value of their equity stake. When the entrepreneur must commit enough of her own resources to the venture, the entrepreneur (and the firm) will disclose material information to the outside investors even without any liability system. In case the entrepreneur does not need to expend sufficient resources, holding the firm liable is necessary to deter the firm (and the entrepreneur) from withholding bad news. The equilibrium probability of non-disclosure depends on the frequency with which the entrepreneur is privately informed (the degree of adverse selection) and the level of liability. Full deterrence may require damages that are supra-compensatory in the sense that that the damage payments exceed the overcharge to the investors, in part, to offset the insufficient deterrence that stems from the reduced share price that the investors suffer.

After presenting the baseline model, the paper also examines various extensions. In the first extension, the entrepreneur is held personally liable for withholding information from investors. Since the damage award is paid by the entrepreneur rather than the firm, the firm’s equity value is unaffected by the lawsuit. We show that the level of liability required to deter non-disclosure is smaller than in the baseline model. The second extension allows for the liability system to falsely find uninformed (and non-disclosing) firms liable. With false convictions, it becomes more difficult to deter the informed firm (and the entrepreneur) from strategically not disclosing its information. Furthermore, when inefficient, strategic non-disclosure is fully deterred with sufficiently high damages, only the uninformed (and innocent) firms get sued in equilibrium. In the third extension, the analysis allows for positive litigation costs. We first show that with costly litigation, because the overall cost of strategic non-disclosure is higher, we actually can get better deterrence against strategic non-disclosure. Positive litigation costs can, however, also reduce overall social welfare, especially when the liability system does not deter inefficient, strategic non-disclosure. In such circumstances, it may be social welfare enhancing to eliminate liability altogether.

The analysis leads to a number of normative and positive implications. On the normative side, while the current liability regime is mandatory, the paper examines the possibility of allowing the firm (and the entrepreneur) to either impose a liability waiver or a class action waiver on the investors. The paper shows that the firms’ choice of liability system may or may not align with the socially optimal choice. When the investors expect to recover from strategically non-disclosing firms ex post, this will reduce the fraction of equity capital they demand from the firm: it will lower the financing cost for the firm. Uninformed firms will prefer having a liability system so as to lower the financing cost even when the system does not generate any deterrence benefit. That is, when the firms are given a choice to opt out of liability, they may utilize that flexibility too infrequently. With respect to class action waivers, the paper focuses on the economies of scale benefit of the class action system. (Our analyses on class actions and class action waivers more generally are available here and here.) When class actions increase the investors’ net returns from litigation by lowering per-investor litigation cost, similar to the case of liability waiver, the uninformed firms will prefer having a class action system so as to enjoy the benefit of a lower financing cost. Given that class actions can lower the deadweight loss from litigation, this can improve social welfare. However, when allowing class actions turns a non-credible lawsuit into a credible one, particularly when the deterrence benefit is small or absent, this will reduce social welfare.

With respect to the positive and empirical implications, first, the results imply that as the fraction of outside ownership rises, investors are less inclined to bring private securities lawsuits against the firm. This may explain why large, long-term institutional investors are much less likely to bring or actively participate in private securities actions. Second, with respect to initial public offerings, as the level of deterrence gets weaker, over-pricing at the initial public offerings becomes more frequent, but with rational investors, the (average) size of overpricing gets smaller. This result gives us another way of measuring the level of deterrence offered by the private securities actions. Third, the model shows that, when the size of litigation recovery is small and/or the degree of adverse selection is small, the firms (and the entrepreneurs) are much less likely to be deterred and the investors are much more likely to accept strategic non-disclosure as given. Finally, the extensions show that as more liability is imposed not on the firm but on the entrepreneur, we get better deterrence, while the possibility of false positives will lead to more “innocent” firms being prosecuted.

The full paper is available here.

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