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.



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.