Corporate Non-Disclosure Disputes: equilibrium settlement where increasing legal liability encourages voluntary disclosures

Abstract

How should a court resolve a shareholder-management dispute after an unexpected price drop, when it is suspected that at an earlier time management chose not to update (disclose to) the market about a material event that was privately observed? An earlier fundamental result in this area (Dye, 2017) has shown that if the court chooses to make public that it will increase awards of damages to try and deter non-disclosure, then this may have the perverse effect that management may rationally choose to disclose less. Schantl and Wagenhofer (2024) call this the pure-insurance effect shareholders receive from higher damages payments. They show that the result may be relaxed if management also face a fixed exogenous reputational cost from non-disclosure. In this research we probe the increased-damages versus reduced-disclosure result via a different route. We introduce a dynamic continuous-time model of management's equilibrium disclosure decision and show that as awards of damages increase this has in a dynamic setting a hitherto unrecognized effect: management rationally switch their disclosure strategy. We characterize the range of damage awards, which we term the legal consistency zone, in which increased awards of damages evoke an endogenous increase in voluntary disclosure.