In 2007, shares in GlaxoSmithKline fell when a published study found that its blockbuster diabetes drug, Avandia, increased the risk of heart attack. Then things got worse: Files came to light showing that the company knew about this side effect and had concealed it. In 2012 the firm pled guilty to withholding information and was fined $3 billion.
No one likes to deliver bad news, least of all CEOs whose pay and prospects are tied to their firm’s stock price. It’s human nature to delay that reckoning; after all, something might happen to make the problem go away. But openness is the price of using public capital; to level the playing field for all investors, firms are obliged to disclose anything they learn that could affect their market value.
And hiding such information can be costly. On top of the $3 billion fine, Glaxo faced more than 50,000 private lawsuits, most of which it settled under confidential terms. Today a number of tech firms, including Twitter and Snap, face shareholder litigation over charges that they exaggerated their user base and growth prospects.
In fact, because of the legal risk, firms do share a lot of adverse information, often sooner than required by the SEC. Early disclosure shrinks the amount of time a stock trades above its true value and so reduces investor anger when the truth comes out — as it is wont to do, generally, one way or another. Ripping off the bandage, many managers believe, helps deter lawsuits.
In this way, the threat of litigation improves transparency in capital markets. You’d think, however, that businesses would rather not have that stick hanging over their heads. You might be wrong. A remarkable paper by Iván Marinovic, associate professor of accounting at Stanford Graduate School of Business, and Felipe Varas of Duke University shows that legal liability benefits companies and may even provide a strategic advantage.
No News Is Good News
The notion that firms would cheerfully bear legal risk in a world of professional whistle-blowers and ambulance-chasing lawyers sounds far-fetched indeed. But, as this study demonstrates, intuition is a faulty guide in thinking about the effects of regulation in dynamic markets.
To untangle the incentives involved, Marinovic and Varas built a game-theory model in which firms face a steady flow of new information, favorable and unfavorable, and must decide what to disclose and when. The news could be anything: a technical advance or new business opportunity, a logjam in a supply chain, the failure of a secret project, and so on.
Surely CEOs, whose goal it is to maximize their stock price over time, will be more eager to share good tidings than bad, right? In fact, empirically, the opposite is true: Firms tend to delay disclosure of positive information. The model shows why:
“Disclosure is costly,” Marinovic says. There’s the expense of preparing and disseminating information. If the news plays in a firm’s favor, there’s a credibility issue; it might need to hire accountants or lawyers to certify that the numbers are accurate. But most important, he says, information has proprietary value, and public disclosure erodes that value.
Examples abound: If a new process yields a competitive advantage, rivals will try to copy it. Customers may resent paying high prices if they find out a product is selling at a fat margin. A labor union will take a harder line in negotiations if it learns a company’s prospects have improved. An oil firm might be reluctant to publicize a discovery in an environmentally sensitive area.
Combine that fact with legal liability, Marinovic says, and you get a strange dynamic: If the threat of a lawsuit is credible and the penalties severe — so investors believe that bad news will be revealed — then silence is interpreted as a good sign. No news becomes good news. That, in turn, relieves the pressure on a company to expose its competitive advantages.
To fully grasp this, imagine a world where shareholders can’t sue. “Obviously, managers will be less inclined to disclose areas of concern,” he says. “But investors know that, so they assume companies are worse than they say they are. And firms are aware of that, so they have to reveal their strengths to justify their projections. It’s called unraveling.”
By contrast, litigation risk fosters trust in capital markets. Now, by merely saying nothing, a company can signal that its outlook is good without giving away the details. “Basically, the threat of legal action eliminates wasteful disclosure,” he says.
So, Sue Me!
That’s a timely insight. In 2013 the SEC began to encourage whistle-blowers by awarding them up to 30% of the damages in a lawsuit. It’s a powerful spur for conscience-stricken employees — as a recent $83 million payout to three Bank of America executives makes clear. But it also hatched a cottage industry of outsiders who dog companies and monitor their disclosures for actionable slip-ups.
“Managers are complaining about ‘frivolous’ litigation,” Marinovic says, and serial whistle-blowers are often viewed with disdain. (The Wall Street Journal accused one person of being “in it for the money” — an odd rebuke to find in the business press.)
Now, Republicans in Washington want to rein in lawsuits. The U.S. House has passed a bill that would make it much harder to certify class actions. And the new head of the SEC, appointed by Donald Trump, is mulling changes that could prevent shareholders from suing companies altogether, by allowing forced arbitration of disputes.
This shift is seen as part of a pro-business agenda, and it’s supported by groups like the Chamber of Commerce. But maybe they haven’t thought through all the repercussions.
What this study suggests, paradoxically, is that a vigilant legal environment — lawyers, citizen-gadflies, and all — may be good for business. “If the goal is to keep investors informed,” Marinovic says, “litigation risk is an efficient way to accomplish that. The threat of shareholder lawsuits actually reduces the burden of disclosure on firms.”