The Risks of Disclosure: Increased litigation costs following disclosure post-PSLRA

What role does public disclosure by a defendant firm play in the outcome of securities fraud class actions? In a recent article we study this question and find when a defendant firm discloses more via press releases and conference calls, it is more likely to experience an adverse outcome in litigation. While the possibility of private legal liability likely improves the quality and integrity of disclosure, it may also make firms reluctant to release information to financial markets. These compelling findings should be of interest to companies and legal practitioners as they evaluate corporate disclosure decisions and policies, as well as to legal scholars and lawmakers by improving our understanding of the relation between disclosure and private litigation.

Prior scholarly research has shown that certain types of disclosure – particularly preemptive disclosure of bad news – can reduce the risk and cost of litigation. (Skinner, 1997; Field et al., 2005; Donelson et al. 2012). We provide new insights regarding the relationship between disclosure and litigation by studying the outcome of litigation in the context of the Private Securities Litigation Reform Act (PSLRA) of 1995. In particular, we examine the judge’s decision to dismiss a lawsuit or allow it to proceed, which is effectively the dispositive decision in these lawsuits since nearly all non-dismissed cases will subsequently settle. We rely on the framework of the PSLRA to derive our predictions. With the goal of screening out meritless lawsuits early in the litigation process, the PSLRA imposed strict requirements for what plaintiffs must allege in federal securities class action complaints. Under the PSLRA, plaintiffs must specify with particularity each misleading statement made by the defendant firm and create a strong inference of scienter prior to the discovery phase of the lawsuit. These requirements amplify the importance of public disclosures in the litigation process. Based on the nature of these requirements, we argue that each additional disclosure made by the sued firm during the class period increases the chances that the plaintiffs will satisfy the difficult PSLRA pleading standards, thereby surviving the motion to dismiss and obtaining a settlement.

We measure disclosure by counting all press releases and conference calls issued by a defendant firm during the class period. We use a comprehensive measure of disclosure since a judge can consider all of a firm’s public disclosures in deciding the outcome of a motion to dismiss. It is not uncommon for a judge’s opinion to analyze each allegedly misleading disclosure one-by-one to determine if it satisfies the pleading requirements. Therefore, each additional statement available for plaintiffs to include in the complaint potentially increases the likelihood that the case is able to proceed. While we focus on the legal cost of disclosures that managers affirmatively make, we also recognize that managers can be liable for what they do not say. Specifically, Rule 10b-5 prohibits the omission of material facts. However, there is only liability when the omission causes other statements that were made to be misleading (17 C.F.R. 340.10b-5 (b)). For example, it is not uncommon for plaintiffs to point to a positive earnings announcement or forecast and allege that the defendants already knew of, but did not disclose, related negative news at the announcement date, thus marking the positive release false or misleading. But the plaintiffs could likely not allege a material omission if the defendants had never disclosed the positive news. In fact, outside of mandatory SEC filings, the law rarely imposes an affirmative duty to speak that is not in connection with previous or concurrent statements. We also construct a measure of the number of disclosures cited in a lawsuit complaint and find that it is positively associated with our overall disclosure measures, and the overall measures are significantly positively related to the likelihood of a settlement even after controlling for the number of disclosures cited in the complaint.

To provide further support for our findings, we run our tests on a sample of lawsuits that occurred prior to the passage of the PSLRA. In this period, we do not find evidence of a significant relationship between a defendant firm’s disclosure and an adverse outcome. This lack of evidence is consistent with our explanation that the relationship between disclosure and litigation that we observe in the post-PSLRA period results from the stringent provisions of the PSLRA.

We also include a measure of forward-looking disclosures in our analyses and find this specific type of disclosure decreases the likelihood of an adverse outcome. This finding is consistent with provisions of the PSLRA that protect such statements and with prior research that has focused on these preemptive disclosures. Our general result that more disclosure by the defendant firm increases the likelihood of an adverse outcome continues to hold in these tests, suggesting that non-forward-looking disclosures seem to be driving our results. Finally, since prior research has often focused on the endogenous relationship between disclosure and litigation risk, we show that our results are robust to including a measure of ex ante litigation risk.

To summarize, our results indicate that more disclosure can harm firms through private securities litigation. We note, however, that we study only one consequence of increased disclosure, and firms likely weigh all the costs and benefits when making disclosure decisions. Regardless, our findings suggest the PSLRA may have had a chilling effect on corporate public disclosure. Whether the cost of reduced disclosure exceeds the benefits of reduced fraud is an important question of public policy. Our results call for further study on how private enforcement of securities laws in the U.S. affects disclosure decisions by firms.

BIBLIOGRAPHY

Donelson, D., J. Mcinnis, R. Mergenthaler, and Y. Yu. 2012. The timeliness of bad earnings news and litigation risk. The Accounting Review 87: 1967-1991.

Field, L., M. Lowry and S. Shu. 2005. Does disclosure deter or trigger litigation? Journal of Accounting and Economics 65: 487-507.

Skinner, D. 1997. Earnings disclosures and stockholder lawsuits. Journal of Accounting and Economics 23: 249.

This post comes to us from Joshua Cutler, Assistant Professor at the University of Houston, Angela Davis, Associate Professor of Accounting at the University of Oregon, Lundquist College of Business and Kyle Peterson, Assistant Professor of Accounting at the University of Oregon, Lundquist College of Business.