Private Litigation in Financial Markets: Information Processing, Informed Trading, and Financial Misreporting

Abstract

In this paper, I study the effects of private litigation in a model featuring a myopic manager who can misreporting private information, a speculator who processes the financial report and trades on the acquired information, and a market maker who competitively prices the firm. Private litigation rights reinforce the incentives for the speculator to process and trade on financial information. This in turn increases the value relevance of financial reporting and exacerbates the manager's misreporting incentives, countering the deterrence effect arising from reputational costs of litigation. I show that private litigation exacerbates (deters) misreporting and further increases (decreases) the absolute trading volume around earnings announcements and litigation insurance premiums if the reputational costs are low (high). In addition, I identify conditions under which market efficiency can decrease with private litigation. These results provide a basis for novel empirical predictions and have important regulatory implications.

Keywords: private litigation, information processing, informed trading, financial misreporting, market efficiency

JEL Classification: G12, G14, K22, K42, M41, M48