Damages and Materiality: Effects on voluntary disclosure

Abstract

How should a court resolve a shareholder--management dispute following a materially significant price decline when it is suspected that management, at an earlier point in time, failed to update the market by disclosing a privately observed material event? A foundational result in this literature (Dye, 2017) shows that if a court publicly commits to increasing damages awards in an effort to deter nondisclosure, the policy may have a perverse effect: management may rationally choose to disclose even less. Schantl and Wagenhofer (2024) attribute this outcome to the pure insurance effect, whereby shareholders benefit from higher damages payments. They show that this result may be mitigated if management also face a fixed, exogenous reputational cost of nondisclosure. However, these reputational costs are independent of the model's equilibrium; furthermore, they assume that the court eventually observes the true state of the world with certainty (delayed omniscience by the court), and do not account for standards of materiality, which differ across legal systems. In contrast, we develop a dynamic continuous-time model in which both damages and materiality standards are endogenous. We show that, as damages awards increase, a previously unrecognized dynamic effect emerges: management rationally switch to a candid (full) disclosure strategy. Moreover, raising the materiality threshold induces this switch earlier, thereby increasing the extent of voluntary disclosure. Our analysis therefore demonstrates that regulators should recognize the complementary effects of damages and materiality standards. We further characterize what we term the legal consistency zone, in which higher damages awards, coupled with an appropriately chosen materiality standard, endogenously increase voluntary disclosure.