Taking a Financial Position in Your Opponent in Litigation

Abstract: We explore a model of litigation where the party bringing the lawsuit, the plaintiff, can acquire a financial position in the target firm, the defendant. The plaintiff gains a strategic advantage by taking a short financial position in the defendant’s stock. First, the plaintiff can turn what would otherwise be a negative expected value claim (including a frivolous one) into a positive expected value one. Second, the short financial position raises the minimum amount the plaintiff is willing to accept in settlement, thereby increasing the settlement amount. Conversely, taking a long position in the defendant’s stock puts the plaintiff at a strategic disadvantage. When the capital market is initially unaware of the lawsuit, the plaintiff can profit both directly and indirectly from its financial position. When the defendant is privately informed of the merit of the case, the plaintiff balances the strategic benefits of short position against the costs of bargaining failure and trial. Short selling by the plaintiff can, under certain circumstances, benefit both the plaintiff and the defendant and also reduce the rate of litigation.