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Albert H. Choi & Kathryn E. Spier, Liability for Non-Disclosure in Equity Financing (U. Mich. L. & Econ. Research Paper No. 22-007, 2022).

Abstract: The paper analyzes the effects of holding firms liable for non-disclosure of material information when raising capital. We develop a model in which a privately-informed entrepreneur can choose to withhold information from prospective investors when issuing and selling stock and the investors can bring suit against the firm ex post for (alleged) non-disclosure. The damage payment received by the investors is partially offset by the reduced value of their equity stake. The analysis shows that the equilibrium depends on, among others, (1) the amount of personal capital the entrepreneur has to commit, (2) the frequency with which the entrepreneur is privately informed (the degree of adverse selection), (3) the size of damages payment, and (4) the cost of litigation. Court errors decrease social welfare by weakening deterrence while litigation costs may increase social welfare by deterring the inefficient types or decrease social welfare through wasteful litigation spending. The effects of liability or class action waivers and holding entrepreneurs personally liable for non-disclosure are also explored, and various normative and empirical implications are discussed.