Shareholder Litigation, Market Efficiency, and Financial Misreporting

This paper studies the economic effects of endowing a large investor with litigation rights for her incentives to acquire and trade on private information. Litigation rights insure the investor against investment errors arising from both corporate misreporting and imperfect private information. This leads her to trade more aggressively such that prices reflect more private information. However, under certain circumstances the investor's ex ante incentives to acquire information weaken. We show that litigation rights improve (impair) market efficiency if the investor's information acquisition costs are high (low). We also establish that a myopic manager's incentives to misreport financial information are inversely proportional to market efficiency, implying that litigation rights lead to less (more) misreporting for high (low) information acquisition costs. We discuss testable empirical predictions.