Upbeat claims in earnings reports and other SEC filings by public companies tend to encourage investor lawsuits, according to a new study.
Overly optimistic-sounding language makes a major difference in whether or not shareholders initiate lawsuits against companies, according to research in the current issue of The Accounting Review, published by the American Accounting Association. For example, Bank of New York Mellon was recently sued by a pension fund for claiming to “provide superior client service, strong investment performance and the highest fiduciary standards...and deliver top-tier returns to our shareholders.” The bank has also been sued for overcharging for foreign currency trading transactions by the Justice Department and officials and attorneys general in New York, Florida and Virginia who oversee state pension funds.
Another recent shareholder suit, against Lockheed Martin, complained about a presentation by the firm's CEO in which he committed to "double-digit growth this year [through] great leadership" and spoke of "confidence in our ability to do that because we deliver superior value," only two months before the company's stock fell 9 percent in a single day.
Complaints about such corporate self-congratulation and optimism are a common feature of securities lawsuits, but are also hotly debated, with some judges dismissing expansive or optimistic language cited by plaintiffs as immaterial and defendants labeling it mere "puffery."
However, the new study, from Jonathan L. Rogers and Sarah L. C. Zechman of the University of Chicago, and Andrew Van Buskirk of Ohio State University, found that companies on the receiving end of shareholder lawsuits used substantially more optimistic language in their earnings announcements than did companies that hadn’t been sued. Managers, the study concluded, "can reduce litigation risk by dampening the tone of their earnings announcements either by decreasing their use of positive language or by tempering their optimism with statements that are less favorable."
The research focused on 165 companies sued in federal court for alleged fraud involving the price of their common stock and a matching group of 165 firms similar to the defendant companies but not the targets of lawsuits. The professors analyzed all of the earnings announcements issued within the damage period of the lawsuits, ranging up to five years. "Earnings announcements," they noted, "are an important (perhaps the most important) source of alleged misrepresentations." In all, 628 earnings announcements from the sued firms were analyzed, along with 625 from non-sued firms.
To analyze the documents' language, the professors employed three word lists that have been developed in other research for the purpose of characterizing discourse as optimistic or pessimistic. Quantifying the results and comparing sued companies to non-sued companies, they were able to draw conclusions about the degree of optimism and pessimism in the reports of each group.
The two groups had similarly negative stock returns over comparable periods, from just before and after the damage period for sued firms and over a roughly analogous period for those not sued. Notable too, the professors found, is that the two groups proved to be similar across many economic characteristics that were not part of the matching criteria, for example, in their book-to-market ratios, volatility, and return on assets.
Where the two groups sharply contrasted, though, was in measures of upbeat language. In general, the earnings announcements of the sued companies were more optimistic than those of the companies that had not been sued, during a comparable period regardless of whether those earnings announcements were actually cited in the plaintiff complaint.
Given the possible advantages that companies may realize in making upbeat statements, do the study's findings suggest that firms have to walk a fine line linguistically in issuing reports and statements? "It's not a matter of walking a fine line," said Van Buskirk. "The lesson here is simpler: when you disclose, you need to do it truthfully."
The research sheds light on why investors would respond to an optimistic tone if there are no enforcement mechanisms to lend credibility to that tone. “Our results indicate that shareholder litigation could be an effective ex post mechanism to assure investors that managers are not simply engaging in cheap talk when they use optimistic language," said the study’s authors. They found that, "after controlling for a host of performance-related and other firm characteristics, a change of one standard deviation in the aggregate optimism factor is associated with a 75.9 percent increase in the likelihood of being sued."
"Roughly what that means is that, all else being equal, a highly upbeat tone in earnings statements and other company reports is over 75 percent more likely to get the company sued than a moderately upbeat tone," said Rogers.
The chance of a lawsuit increases much more, the research found, when an upbeat tone is combined with the selling of shares by top company executives. "The relation between optimism and litigation is approximately four times larger for situations with abnormal insider sales than for those without," said the study. "Optimistic language is associated with litigation risk even in the absence of abnormal insider selling, while abnormal insider selling is a meaningful predictor of litigation only when that selling is accompanied by unusually optimistic disclosure tone."
While the study’s authors conceded that every firm is likely to make some optimistic statements, they rejected the notion that their findings merely reflect the propensity of plaintiff lawyers to "target any firm that experiences unexpectedly poor results and, with the benefit of hindsight, choose the most optimistic statements they can find and assert that the statements were misleading."
To rule out that possibility, they compared the tone of the sued companies’ earnings announcements during the damage period defined by the plaintiffs with the tone of disclosure made by companies that had not been sued at the same time, in the same industry, and with similar economic circumstances.
“Disclosure tone is certainly not the sole determinant of litigation risk,” said the study’s authors. “What we view as important, however, is that disclosure tone is both associated with litigation risk and under the discretion of management. In contrast to variables that are correlated with litigation risk but inflexible (e.g., firm size or industry membership), monitoring and adjusting disclosure tone could provide a straightforward means of reducing litigation risk.”
