Securities regulators frequently punish firms for their managers’ misreporting. They argue that this would enhance firms’ long-term value by mitigating underinvestment in compliance mechanisms, such as internal controls over financial reporting. Opponents of corporate penalties argue that the penalties would harm the very same investors already harmed by misreporting. We evaluate these arguments in a model with a capital market-oriented misreporting manager and a board of directors that invests in internal control quality. We identify governance transparency and board dependence as key factors that moderate the firm-value effects of corporate penalties. Internal control underinvestment occurs only if the board is severely dependent and if its choice of internal controls is opaque. Then corporate penalties curb internal control underinvestment, but they only improve long-term firm value if, additionally, internal control costs are sufficiently small (e.g., in small and less complex firms). Overall, our differentiated results have implications for regulatory enforcement policies and empirical studies on the firm-value effects of public enforcement.

Empirical studies on the relationship between shareholder litigation and corporate disclosure obtain mixed results. We develop an economic model to capture the endogeneity between disclosure and litigation. Equilibrium disclosure is determined by two countervailing effects of litigation, a deterrence effect and an insurance effect. We derive four key results. (i) Decreasing litigation risk leads to less disclosure of very bad news, due to a weakening of the deterrence effect, but to more disclosure of weakly bad news, due to a weakening of the insurance effect. (ii) Given a sufficiently large information asymmetry, litigation risk dampens (boosts) overall disclosure of bad news for low (high) litigation risk firms. (iii) Capital markets respond more to the disclosure of bad news than of good news if the deterrence effect is strong, which arises if both insiders’ penalties and litigation risk are high. (iv) In an extension, we highlight real effects of litigation on corporate innovation and establish that innovation first decreases and then increases (strictly decreases) with litigation risk if insiders’ penalties are small (large). We reconcile our findings with results from a large set of U.S.-based empirical studies and make several novel predictions.

This paper studies strategic interactions between public and private enforcement of accounting regulation and their consequences for the deterrence of financial misreporting. We develop an economic model with a manager, a public enforcement agency, and an investor and derive equilibrium strategies for manipulative effort, routine investigative effort, and costly private litigation. Our main results are as follows. (i) Strengthening private enforcement unambiguously enhances deterrence, whereas strengthening public enforcement can exacerbate misreporting, due to a crowding out of private enforcement. We provide conditions under which (ii) the enforcer's investigation incentives first increase and then decrease in the strength of private enforcement, (iii) public and private enforcement are strategic substitutes, (iv) the number of enforcement actions is misleading about public enforcement effectiveness, and (v) strengthening private enforcement decreases litigation risk. We also discuss implications of our results for empirical research.

This paper studies firms' financial reporting incentives in the presence of strategic credit rating agencies and how these incentives are affected by the level of competition in the rating industry and by rating agencies' role as gatekeepers to debt markets. We develop a model featuring an entrepreneur who seeks project financing from a perfectly competitive debt market. After publicly disclosing a financial report, the entrepreneur can purchase credit ratings from rating agencies that strategically choose their rating fees and rating inflation. We derive the following core results: (1) More rating industry competition leads to stronger corporate misreporting incentives if ratings are sufficiently precise or if rating agencies assume a gatekeeper role. Under imperfect rating industry competition, (2) agencies' gatekeeper role primarily weakens firms' misreporting incentives, which then influences rating agencies' strategies, and (3) firms' misreporting and rating agencies' rating inflation can be strategic complements when agencies assume a gatekeeper role. (4) Regulatory initiatives aimed at increasing rating industry competition or at weakening rating agencies' gatekeeper role improve investment efficiency as long as corporate misreporting incentives are not significantly strengthened.