Does a firm’s disclosure behavior change after being
subjected to class-action shareholder litigation?
Does the outcome of the lawsuit affect the firm’s
response to being sued?
These questions are the subject of the recent study “Shareholder
Litigation and Changes in Disclosure Behavior” by
University of Chicago Graduate School of Business professors
Jonathan L. Rogers and Andrew Van Buskirk. The authors
examined changes in the disclosure behavior of firms
involved in 827 disclosure-related class-action securities
litigation cases filed between 1996 and 2005. In these cases,
plaintiffs typically allege that they purchased shares at prices
that were inflated because of managerial misrepresentation
or failure to disclose adverse information.
Prior research suggests that the threat of private securities
litigation can influence corporate disclosure behavior, but little
is known about the behavioral changes of companies that are
actually subjected to litigation.
Using various measures of voluntary disclosure, the authors
compared the sample firms’ disclosure choices before and
after litigation. After taking into account changes in economic
performance and other factors, the authors found that firms
reduce their level of voluntary disclosure after being sued.
This result seems inconsistent with the intentions of regulators
and litigants who seek enhanced corporate transparency.
“We think it is important to understand whether the existing
regulatory environment encourages managers to voluntarily
disclose information to the market, or if the environment
actually inhibits discretionary disclosure,” says Rogers.
Given that regulators are interested in timely and informative
disclosures, it is troubling that the current environment
results in exactly the opposite for firms that have been sued.
Degrees of Disclosure
How do firms decide what information to disclose outside the
required quarterly and annual reports?
Virtually all firms disclose more information to the public
than what is required by the Securities and Exchange Commission
(SEC).
“Investors want information about the firm and generally
prefer that managers provide updates more frequently than
once per quarter,” notes Van Buskirk. “For example, firms often
issue press releases telling shareholders about store openings,
new customers, new executives, or next quarter’s earnings.”
Prior research provides evidence that by effectively communicating
with investors, firms may reap such rewards as
improved access to capital markets and a lower cost of capital.
Such benefits provide an incentive for firms to voluntarily
provide information to the markets on a timely basis. However,
while firms are usually very willing to disclose good news, they
may be reluctant to share negative news.
“If it’s the middle of the quarter and the firm loses a major
customer, investors would like to know right away, but managers
may wish to withhold the bad news for as long as possible,”
says Rogers.
Certain regulatory features exist to counter firms’ tendencies
to be opportunistic with their disclosures. For example, a
company’s annual report must be audited by a public accounting
firm. Additionally, shareholders can sue firms that disclose
misleading information. Therefore, when managers are
deciding how much information to disclose and how optimistic
or pessimistic to be, they need to consider both the
benefits of providing good news as well as the potential costs
of providing unduly optimistic information.
In their study, Rogers and Van Buskirk examine firms that
are alleged to have either withheld material information or
provided misleading disclosures.
“We wanted to look at firms that were involved in disclosure-
related litigation because we viewed them as having the
best understanding of the relation between litigation and
disclosure as a result of actually going through the process,”
says Van Buskirk.
Whether an improvement in disclosure actually occurs
depends on how the firm views the relation between litigation
risk and disclosures, and whether that view changes as a result
of the litigation process. Rogers and Van Buskirk suggest that
the process of being sued enhances the firm’s understanding
of how disclosure choices affect the actual costs of litigation
and the expected costs of future litigation.
Several forces might encourage managers to provide more
information to the market following litigation.
“For example, a policy of timely disclosure is likely to limit
the ability of potential litigants to claim that the firm withheld
adverse information and provide a buffer from the sizeable
market reactions that can result from infrequent disclosures,”
says Rogers.
Given the benefits of increased transparency, why would
firms decrease disclosure following litigation?
Firms do not face a legal obligation to immediately disclose
all material information to the public. However, if they choose
to make a public disclosure, SEC regulations require the firm
to update the markets if the information becomes inaccurate.
If a firm wants to minimize its obligation to update information,
it could limit the amount of
information voluntarily disclosed.
“Firms must also be aware of the
tendency for relatively innocuouslooking
disclosures to be viewed as
misleading when judged with the
benefit of hindsight following a large
stock price decline,” says Rogers.
For example, a firm may issue an
earnings forecast that, although
unbiased when issued, turns out to
be optimistic after the fact.
Van Buskirk explains: “There’s a lot of money to be made
in shareholder litigation. After a large drop in the firm’s stock
price, shareholders may examine every press release, earnings
forecast, and conference call transcript to see if anything
seems misleading and therefore grounds for a lawsuit. With
the benefit of hindsight, managers can be accused of lying
even if the managers were providing the best information
they had at the time.”
Disclosure Choices
Rogers and Van Buskirk obtained information on firms
involved in class action shareholder litigation from the San
Francisco�based insurance brokerage firm Woodruff-Sawyer.
The data included the date of the lawsuits, the lawsuit’s allegations,
the beginning and ending dates of the claimed damage
period, and whether the lawsuit was settled, dismissed, or
pending. The final sample contained 827 lawsuits filed against
788 firms concentrated in business services, chemical and
allied products, electronics, machinery, and computer equipment.
Of the 827 lawsuits, 610 were resolved through settlement
or dismissal, while 217 lawsuits remained open as of July
2006. On average, it took approximately 706 days from the
time of the filing to resolve a suit.
The authors used five direct measures of disclosure: conference
call frequency; forecast frequency; forecast horizon;
forecast precision; and forecast specificity.
For the sample firms, Rogers and Van Buskirk found four
key indicators of reduced disclosure: 1) firms reduce the
number of conference calls hosted; 2) when firms choose to
issue earnings forecasts, those forecasts are issued for shorter
horizons and 3) are less likely to be quantitative; and 4) when
quantitative forecasts are issued, these forecasts are less precise.
“Our direct measures of disclosure provide consistent evidence
that firms reduce the amount of information that they
provide to the market after being sued,” notes Rogers.
The authors also studied indirect measures of a firm’s disclosure
policy. Firms are not limited to providing information
via conference calls or earnings forecasts. As a result, Rogers
and Van Buskirk supplemented their direct disclosure measures
with several indirect measures that are intended to capture a
multitude of disclosure channels. For example, the authors
used the market’s response to earnings announcements as a
comprehensive measure of disclosures.
Van Buskirk notes, “The stock market reaction to a firm’s
earnings announcement can be thought of as a measure of how
surprised investors were by the news. We argue that better
voluntary disclosures will reduce the amount of surprise at
each earnings announcement.”
Similar to the direct measures of disclosure, the authors
find lower voluntary disclosure after litigation.
Of the 610 resolved lawsuits in the sample, 348 were settled
or judged in favor of the plaintiffs, while the rest were dismissed
or withdrawn. The dismissed or withdrawn suits represent
situations in which plaintiffs were unable to provide sufficient
evidence of wrongdoing, which tend to be resolved faster than
settled lawsuits.
The change in disclosure behavior is more pronounced for
settled cases than dismissed cases. Compared to firms whose
cases were dismissed, firms that settled their lawsuits experienced
a larger reduction in the number of conference calls
hosted and the number of forecasts provided. When settled
firms chose to issue a forecast, the reduction in precision was
stronger than the reduction for dismissed firms.
“Results from this analysis suggest that managers who
were involved in longer and more costly lawsuits make more
pronounced reductions in their discretionary disclosure,”
says Rogers.
The Regulatory System
“Assuming that regulators and investors want more information
about firms, these parties should want a firm to change its
behavior in a positive way and begin providing better quality
information and more information,” says Van Buskirk. “The
fact that you see just the opposite result would cause me to
rethink whether it was a good regulatory system that produced
that outcome.”
Rogers adds: “It’s troubling that our findings suggest that
the U.S. regulatory environment may actually discourage
companies from providing informative disclosures.”
While it is important to have a regulatory system that
encourages managers to tell the truth and punishes those who
do not, it is also necessary to allow room for mistakes made in
good faith regarding the future performance of the company.
"Shareholder Litigation and Changes in Disclosure Behavior." Jonathan L. Rogers and Andrew Van Buskirk.