The Quality of Discretionary Disclosure Under Litigation Risk

Abstract

We present a model of managerial discretionary disclosure under litigation risk. In our model, the manager bears a personal cost of litigation in addition to the costs prescribed by the legal system. Investors share litigation damages with their attorneys and therefore are less than fully insured against market losses. We find that the interaction between the manager's level of aversion to litigation and investors' degree of insurance determines the quality of the manager's disclosure. This is a “cheap-talk” model similar to that of Crawford and Sobel [1982]. Like C&S, we find that, in general, the manager's and investors' preferences do not coincide and that there is a partition equilibrium that is consistent with managers providing a range forecast of earnings. In our setting, we are able to extend C&S and determine what condition is necessary for congruence of preferences resulting in full disclosure and informationally efficient security prices, consistent with managers providing point estimates of earnings. We also address a suggestion of C&S to test the robustness of the partition equilibrium by relaxing the assumption that investors have complete knowledge of the manager's preferences, and we find that, in general, the partition equilibrium is robust. We also show that under restrictive conditions, when the preferences of the manager are not known, a biasing equilibrium exists, consistent with managers providing biased forecasts of earnings.

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