Regulation affecting managers’ disclosure of news in U.S. organizations has been affected by three main changes over the past three decades: (a) The Private Securities Litigation Reform (PSLR) Act, 1995, which protected managers from litigation arising from the disclosure of forecasted numbers that didn’t turn out to be accurate, (b) Regulation Fair Disclosure (Reg F.D.), adopted by the Securities and Exchange Commission (SEC) in 2000, which stopped managers from disclosing news to a select group of people, and (c) Sarbanes-Oxley Act (SOX), 2002, which expanded the scope, accuracy, and completeness of disclosures to stakeholders.
Managers tend to either withhold news, especially bad news, (Skinner, 1994, 1997) or disclose news in a timely manner (Kothari and others, 2009), but prior research has been inconsistent in determining when that is true or why. For example, Frankel and others (1995) found that managers were more likely to disclose news if their organization accessed capital markets for financing.
In a new paper, we have attempted to resolve this long-standing debate by arguing that it all depends on the cost-benefit trade-off that managers face. We specifically look at managers in organizations facing financial distress and argue that such managers find that that the potential costs of withholding news seem low, while the potential benefits seem high.
We begin by enumerating the key reasons why the benefits seem high. First, in distressed organizations, managers may consider taking a ‘big bath’ (i.e., managing earnings through one-time write-offs in bad years so that the results look worse than they are while making future results look better) in their financial reports since investor expectations of organizations’ performance are already low. In such cases, they may not want to attract additional scrutiny by disclosing news. If managers of distressed organizations disclose the bad news, investors may demand a higher return to compensate them for the higher risk (Fama and French, 1989). Second, the timely disclosure of bad news to stakeholders may create panic. Though organizations enter into explicit contracts with some stakeholders, there are several implicit relations that are self-enforcing and without any legal standing (Bowen and others, 1995). One example is a promise by the supplier of continued availability of parts to an organization. If suppliers receive bad news emanating from an organization, it may cause them to cease future dealings with that organization.
Moreover, even if they are in violation of securities laws, managers in distressed organizations may also want to sell their equity stakes since their stock holdings face continued decline, and the disclosure of bad news may cause a further crash. If the distress is transitory and there is upcoming good news, managers may again want to withhold it so that they can purchase stock at low prices. There is prior evidence of managers in distressed organizations strategically coordinating financial disclosures to engage in insider trading (Beneish and others, 2012). Finally, since distress periods are known to trigger shareholder dissidence resulting in a high litigation risk, managers of distressed organizations would have incentives to withhold news.
Next, we enumerate the key reasons why the potential costs of withholding information seem low. First, if managers perceive the distressed organization to be a sinking ship, they know that their position in the organization probably won’t last long enough for them to face penalties for withholding news, and they may also never get any bonuses linked to stock price performance. Moreover, if they have convinced stakeholders that distress is industrywide and outside of their control, they may not be held accountable. Thus, the incremental employment and reputational costs for managers that continue to run distressed firms may be small.
In our paper, we find that, as financial distress intensifies, there is a lower likelihood and frequency of management earnings forecasts, which indicates that managers may be withholding (bad) news in distressed years. However, interestingly, we also find that in years when there is no distress, there is a higher frequency of management earnings forecasts as the financial health of the firm worsens, indicating that managers tend to disclose news promptly when times are generally good.
This post comes to us from professors Hrishikesh Desai at Arkansas State University and Daniel Schaupp at WHU – Otto Beisheim School of Management. It is based on their recent paper, “Play for time when the ship is threatening to sink? Voluntary disclosure choices under going concern uncertainty,” available here.