The Readability of Company Responses to SEC Comment Letters

The Securities and Exchange Commission published its Plain English Handbook in 1998 with a goal of promoting “clearer and more informative disclosure documents” (SEC 1998).  Warren Buffet authored the preface, where he states, in part:

For more than forty years, I’ve studied the documents that public companies file. Too often, I’ve been unable to decipher just what is being said or, worse yet, had to conclude that nothing was being said. If corporate lawyers and their clients follow the advice in this handbook, my life is going to become much easier. (SEC 1998).

Consistent with the SEC’s goal, a number of studies provide evidence suggesting that more readable disclosures facilitate information processing by investors and other market participants.  For example, Lee (2012) finds that less readable 10-Q reports impede the market response to earnings news, suggesting that low disclosure readability could contribute to post earnings announcement drift.  Similarly, Lehavy, Li, and Merkley (2011) find that less readable 10-K filings are associated with greater analyst forecast dispersion and lower analyst forecast accuracy, suggesting that less readable disclosures are associated with greater user uncertainty.

In a study forthcoming in Review of Accounting Studies, we investigate the implications of the readability of the language used by companies to respond to SEC comment letters that reference 10-K filings.  Sarbanes-Oxley Section 408 formalizes the SEC’s filing review process and requires the SEC to review each registrant’s filings at least once every three years. SEC comment letters are issued when the SEC identifies issues where a company “can improve its disclosure or enhance its compliance with the applicable disclosure requirements.”[1] Companies are required to respond to the comments that are raised in the SEC’s initial letter until the SEC is satisfied – company responses could include the company providing additional information to the SEC or offering to restate filings or amend disclosures. The full conversation between the SEC and the company is made available to the public shortly after the SEC issues the “no further comments” letter.

Relative to prior work that investigates various implications of disclosure readability, our setting offers important empirical advantages because the disclosures we investigate (company responses to SEC comment letters) are preceded by a prompt (the initial set of comments from the SEC). The availability of the prompt allows us to control for a number of contextual factors and better isolate the effects of disclosure readability from the effects of disclosure content. This is a difficult task where disclosures are not preceded by a prompt (e.g., earnings announcements, 10-K filings, etc.).

Our models include controls for the readability of the SEC’s initial comment letter, the readability of the referenced 10-K filing, the number of comments in the SEC’s initial comment letter, the number of filings referenced in the SEC’s initial comment letter, several additional contextual factors derived from the SEC’s initial letter, and several company and auditor characteristics. Using multiple measures of disclosure readability (the Bog index, the Fog index, and the Flesch Reading Ease index), we find consistent evidence that less readable company responses are associated with longer SEC processing times (days from the company response to the subsequent letter from the SEC) and a higher incidence of restatements and amendments stemming from the filing review.

Collectively, our results suggest that comment letter outcomes are less favorable when companies write less readable responses to SEC comment letters. More generally, our results suggest that readability is an important component of corporate disclosures and that companies should strive to follow the SEC’s guidance on the use of plain English.

Despite the empirical advantages of our setting, we acknowledge that concerns about the effects of unobservable factors (e.g., omitted variables, strategic obfuscation, etc.) persist. Thus, we encourage future work that exploits settings that facilitate the investigation of the link between disclosure readability and various corporate outcomes.

ENDNOTE

[1] See https://www.sec.gov/divisions/corpfin/cffilingreview.htm for more information about the Filing Review Process.

REFERENCES

Lee, Y‐J. 2012. The effect of quarterly report readability on information efficiency of stock prices. Contemporary Accounting Research 29 (4): 1137–1170.

Lehavy, R., F. Li, and K. Merkley. 2011. The effect of annual report readability on analyst following and the properties of their earnings forecasts. The Accounting Review 86 (3): 1087–1115.

SEC: Securities and Exchange Commission. 1998. A Plain English Handbook: How to Create Clear SEC Disclosure. SEC Office of Investor Education and Assistance. Washington, D.C.: Government Printing Office.

This post comes to us from professors Cory A. Cassell at the University of Arkansas, Lauren M. Cunningham at the University of Tennessee, and Ling Lei Lisic at Virginia Tech. It is based on their recent article, “The Readability of Company Responses to SEC Comment Letters and SEC 10-K Filing Review Outcomes,” available here.