A fundamental feature of the financial reporting landscape is that investors want a firm’s management to diligently and faithfully report on its firm’s affairs. In the event of fraudulent material misstatement or omission of information, the federal securities laws provide investors with the right to take legal action. The conventional view is that heightened legal damages discourage managerial misreporting (e.g., Caskey 2010; Evans and Sridhar 2002; Francis, et al. 1994; Grundfest and Perino 1997; Johnson, et al. 2001; Kasznik and Lev 1995; Skinner 1994; Trueman 1997; Spindler 2008).
However, the efficacy of securities litigation at deterring fraudulent management and compensating aggrieved shareholders currently is been vigorously debated. Within this debate, a commonly held view is that securities actions can serve an important deterrence role, but only a minor compensatory role, when there is greater out-of-pocket liability for culpable managers that misreport (e.g., Alexander 1996; Coffee 2006; Langevoort 2007). Further, as Coffee (2006, 1565) warns, the “deeper problem in securities fraud is the impact of fraud on investor confidence and thus the cost of equity capital.”
This paper studies the effect of legal penalties on financial reporting behavior. We examine a model featuring an entrepreneur and a representative investor in a primary market setting. The entrepreneur is endowed with a project but does not have any private wealth and therefore issues a report to raise capital from investors to finance the project. The key features of our model are that the entrepreneur is more optimistic than investors about the firm’s prospects, the entrepreneur bears the damages associated with misreporting his privately observed information, and investors anticipate these damages when pricing the firm’s stock.
Our primary finding it that the connection between the strictness of the legal environment and the entrepreneur’s reporting behavior is more subtle than the conventional view suggests. We show that an increase in expected legal penalties for misreporting that are imposed on the entrepreneur does not necessarily lead to more truthful reporting, but in fact can lead to more misreporting. Further, assuming investors’ beliefs are correctly calibrated, this misreporting leads to overinvestment and a reduction in expected social welfare. To remedy this disconcerting relation and ensure that heightened legal penalties appropriately deter managerial misreporting, we suggest changes in the investor compensatory function and support the view that the Securities and Exchange Commission (SEC) should administer a schedule of fines on fraudulent management.
To focus on the deterrence effect of securities actions, we model the securities laws as imposing legal damages on the entrepreneur when he reports fraudulently and the project is financed but fails. Investors anticipate the possibility of these legal damages when determining their equity stake in the firm. Accordingly, the legal remedies under the federal securities laws not only punish an entrepreneur for deviant reporting, which we term the punishment effect, but also assuage investors in the event of an unsuccessful outcome, which we term the compensation effect.
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Managerial Reporting, Overoptimism, and Litigation Risk
