Liability for Non-Disclosure in Equity Financing

Abstract

This paper analyzes the effects of holding firms liable for non-disclosure of material information when raising capital. A privately-informed entrepreneur may choose to withhold material information from prospective investors. After cash flows are realized, investors may sue the firm ex post for the entrepreneur's (alleged) non-disclosure. Any damage award received by investors is partially offset by the reduced value of their equity stake. Absent liability, entrepreneurs have an excessive incentive to withhold bad news and pursue socially-wasteful projects. Liability for non-disclosure deters the entrepreneur and prevents misallocation of capital. The socially-optimal damage award may be supra-compensatory, exceeding the overcharge paid by the investors. Court errors decrease social welfare by weakening deterrence while litigation costs may either increase social welfare by strengthening deterrence or decrease social welfare through wasteful litigation spending or by discouraging meritorious lawsuits. Liability and class-action waivers, holding entrepreneurs personally liable for investor losses, and empirical implications are also analyzed.