The Impact of Litigation Risk on Discretionary Disclosure

Posted: 14 Feb 1997

See all articles by Patricia J. Hughes

Patricia J. Hughes

Deceased

Mandira Roy Sankar

University of Southern California - Leventhal School of Accounting

Date Written: December 1996

Abstract

This paper analyses the impact of expected litigation related costs on a manager's discretionary disclosure choice. We examine two aspects of disclosure choice: disclosure versus nondisclosure of certain information and misrepresentation of information disclosed. In our model a manager maximizes his firm's stock price, less any litigation related costs in a three period setting. After receiving a noisy private signal about his firm's future cash flow, the manager must determine whether or not to disclose it and how much to bias his information, if he does make a disclosure. If there is a sufficient drop in the firm's stock price between the disclosure date and the date when the realized cash flow is revealed, the firm faces a class action lawsuit and suffers damages and reputation loss. We assume that the manager may have either a high or low cost of litigation related reputation loss, and the firm's reputation cost type is private information, which is unknown to investors in the capital market. Therefore, the market uses a probability distribution over reputation cost types to determine stock price. In a biased disclosure equilibrium the low reputation cost manager biases up and the high reputation cost manager biases down his signal before disclosing it. We also find that, in the absence of any other costs or uncertainties, the manager will always prefer to bias and disclose rather than withhold his private information. Nondisclosure of unfavorable signals can occur in an equilibrium, when we assume that there is some probability that the firm did not receive information.

JEL Classification: M41, M45, K22

Suggested Citation

Hughes (deceased), Patricia J. and Sankar, Mandira Roy, The Impact of Litigation Risk on Discretionary Disclosure (December 1996). Available at SSRN: https://ssrn.com/abstract=2878

Mandira Roy Sankar (Contact Author)

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States
213-740-1846 (Phone)
213-747-2815 (Fax)

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