Capital Market Effects of Shareholders' Litigation Rights : Implications for Market Efficiency and Misreporting Incentives

This paper studies the market-level effects of litigation rights in an imperfectly competitive capital market with a market maker, an information-acquiring investor, and liquidity traders. Litigation rights have the following equilibrium effects. (i) The investor acquires more private information and trades more aggressively on average. (ii) Upon a negative aggregate order flow, the market maker prices the firm's stock away from fundamentals, introducing a nonmonotonicity into pricing. (iii) Market efficiency improves, due to the investor's stronger information search and trading incentives. (iv) The cost of capital increases (decreases) if market liquidity is large (small). (v) Managerial misreporting incentives strengthen (weaken) for less (more) complex or innovative firms. Overall, I show that the market-level effects can complement and must not always counter the firm-level deterrence effect associated with private litigation