Paper: arXiv 2410.13878

Authors: Miles B. Gietzmann, Adam J. Ostaszewski

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.

Complexity vs Empirical Score

  • Math Complexity: 8.5/10
  • Empirical Rigor: 2.0/10
  • Quadrant: Lab Rats — theoretically deep, empirically untested

Why this score: The paper provides a rigorous mathematical framework utilizing continuous-time stochastic calculus and ODEs to analyze corporate disclosure incentives and legal liabilities. However, it is purely theoretical and completely lacks empirical backtesting or real-world data validation.

Research Flowchart

  flowchart TD
    A["Research Question: Does higher legal liability always reduce voluntary disclosure?"] --> B["Input: Dye (2017) result, shareholder-management dispute, continuous-time framework"]
    B --> C["Methodology: Develop dynamic continuous-time game model"]
    C --> D["Computational Process: Solve equilibrium disclosure strategies under varying damage awards"]
    D --> E["Key Finding: Identified 'Legal Consistency Zone' where higher damages increase disclosure"]
    E --> F["Outcome: Proved dynamic setting & damage awards reverse the pure-insurance effect"]