The Impact of Litigation Risk on the Commission and Detection of Financial Misreporting

Although securities class action lawsuits are one of the most important disciplinary tools to curtail misreporting, studies on their role in financial misreporting suffer from a partial observability problem. This paper uses the US Supreme Court ruling in Tellabs v. Makor that resulted in an increase in litigation risk for certain firms as a natural experiment. We exploit this setting to disentangle the effect of litigation risk on the commission and detection of misreporting. We find that increased litigation risk reduces acts of misreporting while also increasing the rate of detection of misreporting. Cross-sectional analyses confirm that the effect of Tellabs v. Makor is stronger for firms facing higher exposure to class action lawsuits, such as firms with greater institutional ownership and firms with aggressive financial reporting practices, indicating that litigation risk is likely the main mechanism driving the ruling’s effect. Furthermore, the positive association between litigation risk and the detection of misreporting is concentrated among firms led by low-ability CEOs, in line with the intuition that these CEOs are less capable of evading detection. An additional analysis based on a bivariate probit model further corroborates findings from our main analyses. Our study extends the literature on the effects of legal precedents on financial reporting quality and has implications for regulators and investors.