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

Abstract

In this paper, I study the effects of private litigation rights on informed trading, financial misreporting, and market efficiency in a variant of the Kyle (1985) model featuring a myopic manager, a speculator who processes the financial report and then trades on the information, and a competitive market maker. Private litigation rights provide the speculator with downside protection against investment losses from misreporting, inducing her to trade more aggressively on information inferred from financial reporting. The resulting increase in value relevance exacerbates the manager's misreporting incentives, countering the deterrence effect arising from reputational costs of litigation and giving rise to a tradeoff that determines the net effect of litigation rights on misreporting. 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). Market efficiency increases with litigation rights when reputational costs are high but can decrease when they are low. Litigation rights further strengthen the speculator's incentives to process financial reports. 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