Title: Disclosure Tone and Shareholder Litigation (Subscription or fee required.)
Author: Jonathan L. Rogers (University of Chicago), Andrew Van Buskirk (Ohio State University), and Sarah L.C. Zechman (University of Chicago)
Publisher: The Accounting Review, vol. 86, no. 6
Date Published: November 2011
Firms that issue overly optimistic disclosures face an increased likelihood of being sued by shareholders, this paper finds. Although managers often see a need to paint their firms in a more positive light, this study warns that too much unfounded hype can lead to a courtroom showdown — and that officers and directors of companies should work hard to ensure that their firms’ communication remains grounded in reality.
The researchers decided to study the tone of corporate disclosures — in particular, optimism — because plaintiff allegations in typical disclosure-related securities lawsuits tend to center on the same premise: Investors allege that their expectations about a company’s value were improperly raised by upbeat messages from the firm. These disclosures can take the form of press releases, earnings announcements, media interviews, presentations at conferences, and SEC filings.
The researchers obtained litigation data from Woodruff-Sawyer & Company, a San Francisco–based insurance brokerage firm. For a lawsuit to be included in the study, it had to have been filed in federal court against a corporation, alleging fraud involving the defendant’s stock price, and including charges of material misrepresentations or omissions regarding the true value and potential of the firm.
Because the researchers were focusing on the relationship between discretionary disclosures and litigation risk, they did not include lawsuits concerning mergers and acquisitions, earnings restatements, and initial public offerings. The final sample consisted of 165 lawsuits filed between 2003 and 2008, and the periods of managers’ alleged misconduct ranged from one month to five years. Slightly more than half of the lawsuits involved five industries: chemicals and allied products, electronics, business services, insurance carriers, and financial analysis. The researchers augmented the survey data with information from several corporate and legal databases, including Compustat and the Center for Research in Security Prices.
They began their analysis by looking at plaintiff complaints in a random selection of 20 of the 165 lawsuits in the sample. Their initial goal was to determine which type of communication was cited most consistently, reasoning that statements in this form of communication were the ones most likely to expose a firm to the risk of litigation.
Out of almost 300 unique communications cited in this subset of lawsuits, earnings announcements popped up the most, appearing in 18 of the 20 lawsuits. In the full sample, more than half of the damage periods cited in the suits — the damage period is the window of time during which a firm is accused of improper conduct — began on the date of an earnings announcement, suggesting that a press release or conference call tied to the announcement contained the first alleged misrepresentation. Accordingly, the authors focused on earnings announcement disclosures.
Next, the researchers explored whether plaintiffs targeted firms’ positive statements, based on an analysis of the wording that was cited in the complaints. Using three dictionary-based text analysis programs, all of which have been employed in previous studies to parse corporate language, the researchers separately considered the tone of the quoted statements and the tone of the rest of the earnings announcements.
In 91 percent of the earnings announcements that were analyzed, the portion quoted by plaintiffs was much more optimistic than the non-quoted portion. “To our knowledge,” the authors write, “this is the first concrete evidence for the intuition that plaintiffs target optimistic language when bringing actions against [a] firm.”
But because every firm is likely to make some optimistic statements, even if the overall tone of the company’s communication is neutral or downbeat, the researchers conducted further analyses to determine whether the disclosures of sued firms are unusually optimistic. They compared the tenor of sued firms’ earnings announcements during the damage period to that of disclosures issued at the same time by firms that were not sued but were in the same industry and facing similar economic circumstances — for example, companies of similar size and performance. The two groups of firms were statistically indistinguishable in several categories, including book-to-market value, return on assets, earnings growth, and the likelihood of incurring a loss. Sued firms experienced higher stock turnover and had a slightly larger analyst following, presumably making their corporate statements more broadly known.
The researchers obtained 628 earnings announcements for the 165 sued firms and 625 announcements for the 165 matched firms that were not sued. Again, they identified many similarities between the two groups: The press releases issued were about the same length and cited comparable returns on assets, earnings growth, and incidence of losses.
But after controlling for a number of performance-related and other traits, the researchers found that sued firms used substantially more optimistic language in their announcements. The authors also found that a change of just one standard deviation in the “optimism score” given to each earnings announcement translated into a 75.9 percent increase in the likelihood of being sued.
“These results indicate a strong link between disclosure tone and litigation,” the authors write. “The difference in tone between sued and non-sued firms’ disclosures is consistent with plaintiff allegations that managers issued overly optimistic disclosures during the damage period.”
Finally, the researchers examined the combined effect of optimistic language and insider trading. A victorious securities lawsuit requires plaintiffs not only to provide evidence of a material misrepresentation but also to prove intent to deceive. Because the legal system recognizes abnormal and significant levels of the sale of company stock by insiders as one way of demonstrating managers’ knowledge of wrongdoing, many lawsuits include these allegations. The analysis found that a combination of optimistic disclosures and insider selling increases the probability of being sued.
“Firms can mitigate litigation risk by ensuring that optimistic statements are not contradicted by insider selling,” the authors write. “On the other hand, we find no evidence that insider selling, on its own, exposes the firm to increased litigation risk; insider selling is only associated with litigation when firm disclosures are optimistic.”
As the authors point out, firms are unlikely to stop issuing earnings announcements. To lessen the company’s risk, the researchers advise managers to make sure that the tone of the announcement is not at odds with the reality of the company’s situation or potential. When necessary, managers should dampen the tone of their disclosures by decreasing their use of sunny language or by complementing their positive statements with less-favorable assertions.
Firms should also consider employing restricted trading periods and SEC-sanctioned Rule 10b5-1 plans that help managers guard against accusations of insider selling, the authors write, while working to ensure that managers’ trading decisions align with their public statements.
“While our study is not aimed at showing whether managers of sued firms intentionally or recklessly mislead investors with overly optimistic statements, our results indicate that sued firms’ disclosures are consistently more optimistic than [those of] non-sued firms in similar circumstances, in accord with the typical plaintiff allegation,” the authors conclude.
Firms that use unusually optimistic language in their disclosures to shareholders are more likely to be sued than similarly performing peer companies. Specifically, overly positive statements in earnings announcements — whether in press releases, conference calls, media interviews, or meetings with investors — are most often cited in plaintiffs’ complaints.