Jan 18th 2012
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Last month, when a pension fund owning stock in Bank of New York Mellon brought suit against that financial behemoth, the fund not only took aim at the bank's allegedly fraudulent currency trading, but it cited a variety of upbeat claims in its SEC filings that the plaintiff considered highly doubtful – for example, that of "provid[ing] superior client service, strong investment performance, and the highest fiduciary standards . . . and deliver[ing] top-tier returns to our shareholders."
Similarly, 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" – all this 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 also a hotly debated one, with some judges dismissing expansive or optimistic language cited by plaintiffs as immaterial and defendants labeling it mere "puffery."
Yet now, a study recently published in an accounting journal finds that, puffery or not, such language makes a major difference in whether or not shareholders initiate lawsuits against companies. According to the current issue of The Accounting Review, published by the American Accounting Association (AAA), research shows that "sued firms use substantially more optimistic language in their earnings announcements than do non-sued firms." Managers, the study concludes, "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."
Further, the research sheds light on a major issue for investors – namely, "Why would investors respond to an optimistic tone if there are no enforcement mechanisms to lend credibility to 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."
The study's authors, Jonathan L. Rogers and Sarah L.C. Zechman of the University of Chicago, and Andrew Van Buskirk of The Ohio State University, find 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," Rogers explained.
And the chance of a lawsuit increases much more, the research reveals, when an upbeat tone is combined with selling of shares by top company executives. In the words of the study, "The relation between optimism and litigation is approximately four times larger for situations with abnormal insider sales than for those without." Still, "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."
Although the professors concede that "every firm is likely to make some optimistic statements," they reject the "cynical" 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 compare "the tone of the sued firms' earnings announcements during the damage period [defined by the plaintiffs] to the tone of disclosure made by non-sued firms at the same time, in the same industry, and experiencing similar economic circumstances."
The research focuses 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 analyze all earnings announcements issued within the damage period of the lawsuits, which ranged up to five years. "Earnings announcements," they note, "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 language in the documents, 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 add, "is that the two groups proved similar across many economic characteristics that were not part of the matching criteria" – for example, book-to-market ratios, volatility, and return on assets.
Where the two groups sharply contrasted, though, was in measures of upbeat language. In general, "sued firms' earnings announcements are more optimistic than [those of] non-sued firms 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," comments Van Buskirk. "The lesson here is simpler: when you disclose, you need to do it truthfully."
In the words of the study, "Disclosure tone is certainly not the sole determinant of litigation risk. 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."