Shareholder Litigation and Market Information: Effects of the Endorsement of the Fraud-on-The-Market Doctrine on Market Information

Abstract

This paper examines changes in market information after the Supreme Court endorsement of the fraud-on-the-market rule in 1988. The fraud-on-the-market doctrine materially reduces plaintiffs burden of proof reliance in shareholder litigation brought under Rule 10b-5 of the federal securities law. The Supreme Court endorsement of this doctrine is a turning point in its widespread acceptance. To investigate the effect of this change in the liability regime on firms disclosure incentives, we partition our sample of earnings surprises into quartiles based on the magnitude of the year-to-year change in earnings. For the quartile of observations with the most negative earnings changes, we find material declines, after 1988, in forecast errors in each of the last six months preceding the earnings announcement date. We also examine voluntary disclosure behavior of bad news firms, and find evidence of an increase in disclosure of bad news. Moreover, we find strong evidence which suggests that bad news firms warn investors on a more timely basis in the post-1988 period. For the good news quartile, in contrast, we do not find significant differences along any of these dimensions. The fact that these findings occur for the lowest quartile of earnings changes, but not for the highest quartile, suggests support for our interpretation that these changes represent firms response to a material change in the legal environment. If, after 1988, firms perceive higher expected legal costs associated with failure to disclose negative information, a rational response would be to increase the timeliness with which negative information is disseminated.

JEL Classification: M41, K22