The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

The tone public companies use in their disclosure statements can affect the companies’ susceptibility to securities class action litigation, according to a recent academic study. The authors found that firms hit with securities litigation generally used more optimistic language in their disclosure statements than did firms that were not sued. Based on these findings, the authors conclude that managing “disclosure tone” could provide “a straightforward means of reducing litigation risk.”

In their November 2011 paper “Disclosure Tone and Shareholder Litigation” (here), University of Chicago Business School Professors Jonathan Rogers and Sarah L.C. Zechman and Ohio State Business School Professor Andrew Van Buskirk set out to determine whether or not corporate managers’ use of optimistic language increases litigation risk. Using statistical techniques, they examined the extent to which differences in qualitative language are systematically related to differences in litigation risk.

The authors began by examining a range of plaintiffs’ complaints, in order to determine which disclosure channels are likeliest to affect the probability of litigation. Based on their review, the authors determined that the earnings announcements are the most consistently cited type of communication referenced in plaintiffs’ complaints.

The authors then used dictionary-based measures of optimism to analyze the tone used in the portions of earnings announcement that plaintiffs chose to quote in their class action complaints. In order to determine whether or not the sued firm’s disclosures were “unusually optimistic” the authors compared the tone of the sued firms’ earnings announcements to the tone of disclosures made my non-sued firms at the same time, in the same industry and experiencing similar economic circumstances. The authors concluded that the firms that are hit with securities class action lawsuits use “substantially more optimistic language in their earnings announcements than do non-sued firms.”

The authors also took a look at the combined effect of optimistic language and insider trading. The evidence they reviewed “is consistent with optimism and insider selling jointly affecting litigation risk.” The interaction between optimism and “abnormal insider selling” is “associated with an increase probability of being sued.” The authors found no evidence that insider selling on its own exposes the company to increased litigation risk; insider selling is “only associated with litigation when firm disclosures are optimistic.”

The authors’ conclusions suggested to them some ways that companies can try to mitigate litigation risk. That is, though disclosure tone “is certainly not the sole determinant of litigation,” disclosure tone “is both associated with litigation risk and under the discretion of management.” All of which led the authors to conclude that “monitoring and adjusting disclosure tone could provide a straightforward means of reducing litigation risk” – that is, “managers can reduce litigation risk by dampening the tone of disclosure.” On the other hand, the authors also note that shareholder litigation can be “an effective ex post mechanism” to assure investors that managers “are not simply engaging in cheap talk when they use positive language.”

One final note about the authors’ methodology. In order to quantify the tone used in firms’ disclosures, the authors used a form content analysis that relies on a pre-specified word list. The analysis simply counts the occurrence of words characterized defined as optimistic or pessimistic based on prior research and linguistics theory. However, rather than relying on a single categorization, the authors used three different libraries of words, each of which was used to study firm disclosures. The word counts using the three measures were then compared against a benchmark standard that was based upon a control group of non-sued firms. The sued firms “optimism” was then compared against the benchmark standard. The authors also applied control variable to isolate the effect of a firm’s optimism that is driven by management discretion, rather than by the firm’s economic circumstances.

Discussion

On the one hand, the authors’ analysis might seem simply confirm a common sense proposition that companies that are hype-ish with their disclosures are likelier to get sued. But a closer reading of the authors’ analysis suggests that the authors have established a more specific and more important conclusion. That is, the authors’ analysis establishes that there is a direct statistical relationship between a firm’s use of unusually optimistic language and the likelihood of the firm being sued. This statistical relationship has two important implications.

First, the existence of this relationship could have important D&O insurance underwriting implications. D&O insurance underwriters interested in selecting away from companies that are likelier to be sued in securities class action lawsuits will want to develop tools to help them identify disclosure statements that are unusually optimist. The key here is that the predictive relationship is based on the use of unusually optimistic language. That is, in order for an underwriter to use the existence of the relationship as a risk selection tool, the author would have to have a developed ability to determine what constitutes unusual optimism.

In connection with the D&O underwriting implications of the authors’ analysis, it is also significant to note the added relationship the authors found about the interaction of optimistic disclosure and unusual insider trading. The two factors together had a combined predictive effect. In other words, the presence of insider selling in combination with overly optimistic disclosure is particularly predictive of securities litigation risk.

The other significant implication of the authors’ analysis has to do with their conclusions about how companies might mitigate their securities litigation risk. There is definitely some good news in the authors’ report. That is, companies that are interested in trying to control their securities litigation risk exposure can reduce their litigation risk by managing their disclosure language. The authors’ conclusion in this regard are consistent with larger messages that many of us who advocate securities litigation loss prevention have been preaching for year – that is, that companies can control their securities litigation exposure by managing the disclosure process, in order to avoid the kinds of statements that attract the unwanted attention of class action securities lawyers.

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A June 5, 2008 proposal by the Financial Accounting Standards Board that could require public companies to disclosure more about their litigation risks is generating a storm of controversy. As discussed in Zusha Elinson’s June 24, 2008 Law.com article entitled "GC’s Bristle at Proposed Disclosure Rules" (here), under the proposed revision to FASB Statement No. 5 (which can be found here), "the threshold for reporting potential loss from a lawsuit would be lowered from ‘probable’ to anything but ‘remote.’" Companies would have to "estimate just how much legal threats might cost and the likely outcome" and "disclose more details about the underlying litigation and the reasoning behind their predictions."

As discussed at length in in the Point of Law blog (here), there are a number of concerns about these proposed changes. Among other things, they are concerned that the new rules could force companies to lay out their litigation strategies for opponents to see; potentially waive the attorney client privilege; and even lead to more securities fraud cases if litigation turns out worse than estimated.

It certainly doesn’t take much creativity to imagine circumstances in which a company that finds itself the unfortunate recipient of an unexpected runaway jury verdict subsequently gets hit with a follow on securities lawsuit filed by plaintiffs’ lawyers alleging on behalf of shareholders that the company failed to disclose its true exposure to the underlying litigation.

Similarly, it is easy to imagine companies eager to avoid this litigation threat finding themselves challenged to produce defensive disclosure that does not simultaneously compromise their litigation position or their settlement negotiation strategy.

An additional concern that might challenge companies faced with the new disclosure requirements would arise from questions surrounding available insurance coverage in connection with the litigation. Companies involved in serious litigation sometimes find themselves unable to establish what amount of its legal expense and even settlement or judgment amounts might be covered by insurance.

Since the ultimate financial impact on the company from litigation could well depend on as yet incomplete negotiations with their insurers, the estimate of the financial impact from the litigation could be particularly uncertain. Indeed, compelling disclosure under these circumstances might not only compromise their position in the underlying litigation but it could potentially compromise their position with respect to their insurers as well.

The comment period for the proposed revision closes on August 8.

Additional concerns regarding the proposed new rules are noted on Professor Larry Ribstein’s Ideoblog (here).

Special thanks to Walter Olson at the Point of Law blog (here) for providing links to the proposed revised rules.

 Trade Marks: There are innumerable examples in William J. Bernstein’s entertaining new book “A Splendid Exchange: How Trade Shaped the World” (here) demonstrating that the world was “flat” long before its more recent evocation. I found the following a particularly interesting example:

On September 5, 1833, the American clipper Tuscany appeared at the mouth of India’s Hooghly River, took on a river pilot, and headed upstream to Calcutta. The news of its arrival was swiftly relayed upriver, throwing that city, whose name is synonymous with sweltering heat, into a state of excitement. The Tuscany carried a new and priceless cargo: more than a hundred tons of crystal-clear New England ice.

What makes this such a compelling example of the "flattening" of the world is what happened after the overseas introduction of this highly desirable but locally unavailable product:

The first heavy, inefficient steam-driven mechanical refrigerators, produced by dozens of inventors under numerous patents, were used in fixed ice-making plants far from natural ice sources –in the Caribbean, south of the Mason-Dixon Line, in West Coast cities, and particularly in the Argentinean and Australian meatpacking plants. Tudor’s Calcutta trade, which grew steadily more profitable for nearly half a century following his initial delivery in 1833, came to an abrupt end a few years after the opening of the city’s first artificial ice plant in 1878.

The elimination of the Calcutta ice trade may well have devastated the New England ice producers at the time. But in the end, the overall benefits of innovation and increased trade opportunities far outweighed the consequences from the loss of the long-forgotten ice trading monopoly. Changing needs, transport costs, and technological innovation continue to alter existing trade patterns, producing winners and losers at every turn.

Because sudden change can devastate beneficiaries of existing arrangements, the need to protect the status quo can sometimes seem necessary and even urgent. Bernstein’s book shows not only that trading societies have faced these problems repeatedly throughout human history, but how societies that have accepted and faced these problems have prospered.

A good short review of Bernstein’s book can be found here.

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