Accounting study examines earning reports claims, lawsuits
Andrew Van Buskirk
Last year, 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 cited a variety of upbeat claims in its Securities Exchange Commission filings that the plaintiff considered highly doubtful. The fund singled out the banks claims of "provid[ing] superior client service, strong investment performance and the highest fiduciary standards...and deliver[ing] top-tier returns to our shareholders."
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 co-authored by Fisher Assistant Professor of Accounting Andrew Van Buskirk and Jonathan L. Rogers and Sarah L. C. Zechman of the University of Chicago in a leading 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 study, titled "Disclosure Tone and Shareholder Litigation," in the November/December issue of The Accounting Review, “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? The 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 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."
The study's authors 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." 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."
In all, 628 earnings announcements from the sued firms were analyzed along with 625 from non-sued firms. To analyze the documents' language, 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.