Financial misconduct can lead to significant financial and reputational penalties for a firm and its managers, including hefty fines from regulators and steep drops in stock price. In fact, recent research finds that firms accused of fraud lose an average of 38 percent of their value when the news is announced, two-thirds of which is attributed to lost reputation (Karpoff, Lee, and Martin 2008). How, then, can managers best mitigate this financial and reputational damage?   Prior research points to a few solutions: firing guilty parties, improving corporate governance, and cooperating with regulators.  While these are undeniably important, there may be other, more subtle ways to mitigate the damage. In our paper, we identify one: altering the “tone” of language in corporate disclosures.

For many investors, such disclosures are the primary source of information about the firm. Much of the quantitative information provided in periodic regulatory filings (e.g., 10-K, 10-Q, or 8-K) is highly regulated in the form of financial statements or footnote disclosures. However, managers do have significant discretion in the qualitative piece of their disclosures – for instance, the explanation of financial results in the Management Discussion and Analysis (MD&A) section or the description of major corporate events in a press release. A robust stream of research has shown that managers use that discretion, particularly with respect to disclosure tone, to convey important information to investors. We follow prior research in defining disclosure tone as the type and frequency of select words used in corporate filings.  For instance, a disclosure would be considered to have a positive tone if the number of positive words (e.g., “conclusive,” “effective,” “reward, “upturn”) exceeds the number of negative words (e.g., “unforeseen,” “disappointing,” “layoffs,” “stressful”).

In our study, we argue that managers could use the tone in corporate disclosures to reduce the negative effects of financial misconduct allegations.  This could occur in one of two ways. On one hand, managers could strategically manipulate disclosure tone to obfuscate bad news by describing the firm using abnormally positive words. If managers are successful in convincing stakeholders that the misconduct is not markedly detrimental, then the firm likely avoids much of the negative consequences of the regulatory enforcement.

Alternatively, managers may use the tone of corporate disclosures as a public mea culpa. In this scenario, managers use more negative words, uncertain words (e.g., “ambiguous,” “probable,” “risk,” “volatile”), or litigation words (e.g., “adjudicate,” “lawsuit,” “plaintiff,” “whistleblower”) in their disclosures to signal bad news. If they act quickly, managers can temper investor expectations and limit the one-time stock price drops that occur upon disclosure of the alleged financial misconduct. Moreover, forthcoming disclosures can enhance a firm’s reputation for credible reporting, which in turn decreases information asymmetry and the firm’s cost of capital.  Therefore, managers using abnormally negative tone during the enforcement process may alleviate the negative outcomes from financial misconduct.  Ultimately, managers must make a choice regarding their disclosure strategy around financial misconduct allegations and, given the opposing predictions, it is initially unclear which choice they will make.

To investigate this question, we use a sample of 232 firms punished by the Securities and Exchange Commission (SEC) or Department of Justice (DOJ) for financial misrepresentations (“offending firms”).  We examine changes in the tone of corporate disclosures for these firms as compared with a sample of firms that do not engage in financial misconduct (“non-offending firms”) and closely match the offending and non-offending firms in terms of financial performance, size, age, complexity, and other financial measures. We are particularly interested in changes to corporate disclosures during what we call the “Enforcement Period,” as compared with corporate disclosures before the financial misconduct began. If we imagine a timeline of all public events related to a firm’s financial misconduct, the Enforcement Period would begin immediately after the financial misconduct ceases at the firm. It would then encompass numerous events, including the initial and subsequent disclosures of the allegations to investors, the filing of a class action lawsuit or restatement (if applicable), and the informal and formal investigations by regulators. The Enforcement Period concludes with the imposition of a penalty against the firm or its managers by the SEC or DOJ.  In our study, the Enforcement Period lasts an average of 4.7 years, and the disclosures during this period are especially crucial to investors as they learn about the misconduct and its implications for the future of the firm.

We present evidence showing that offending firms, as compared with non-offending firms, substantially increase their use of negative and litigation language in corporate disclosures during the Enforcement Period. We measure the change in corporate disclosure language as the average proportion of negative (litigation) words to total words used in disclosures during the Enforcement Period as compared with the same proportion of these words used in corporate disclosures before the financial misconduct began (i.e., a period of normal corporate disclosures). Using these measures, we also find that the change in disclosure tone is most pronounced in the first half of the Enforcement Period, with increases in negative and litigious words of 37.6 and 28.2 percent, respectively.  This is interesting because the public announcement of financial misconduct is rare in the early months of the Enforcement Period, and its use during that period suggests that managers of offending firms are using disclosure tone as a mechanism to signal that bad news is coming.  Furthermore, we see that the shift towards more negative language early in the Enforcement Period is driven by the subset of offending firm managers that are later found to be complicit in the crime. That is, managers ultimately found to be guilty of financial misconduct by the SEC or DOJ alter their disclosure tone substantially more than other managers do, presumably because they have foreknowledge of the financial misconduct and have greater incentives to manage disclosure tone in anticipation of the negative publicity.  Altogether, we find evidence suggesting that managers use disclosure tone to provide information that is more forthcoming to investors during the Enforcement Period.

Our paper also examines whether managing disclosure tone is effective at mitigating the negative consequences of an enforcement action. We show an association between the tone used in disclosures and the incidence and magnitude of offending firms’ monetary penalties assessed by regulators. First, we find that offending firms that ultimately receive no penalty from the SEC or DOJ increase the proportion of negative words used during the Enforcement Period 43.5 percent more than do offending firms that are penalized.  Furthermore, we find that as offending firms increase the proportion of negative words used in their corporate disclosures during the Enforcement Period, the amount of fines is reduced. We also find some evidence that using more negative language during the Enforcement Process has a positive reputational effect (i.e., a smaller decline in firm value due to lost reputation following the financial misconduct).

Our findings suggest that managers use disclosure tone to provide more forthcoming information to investors following financial misconduct, which contradicts much of the current research on the strategic use of disclosure tone around bad news events.  Furthermore, the more pessimistic language in corporate disclosures appears to reduce the incidence and magnitude of firms’ monetary penalties assessed by regulators.  This suggests the SEC and DOJ reward the use of more pessimistic language during the enforcement process, which has practical implications for firms recovering from periods of financial misconduct.  Collectively our results suggest that there are likely significant financial and reputational benefits to being forthcoming in disclosures around negative events, especially those related to financial reporting.

This post comes to us from professors Rebecca Files at the University of Texas at Dallas, Alex Holcomb at the University of Texas at El Paso, Gerald S. Martin at American University’s Kogod School of Business, and Paul Mason at Baylor University. It is based on their recent paper, “Damage Control: Changes in Disclosure Tone after Financial Misconduct,” available here.