Litigation Risk and Corporate Voluntary Disclosure: Evidence from Two Quasi-Natural Experiments

Abstract

We examine the effect of litigation risk on corporate voluntary disclosure using two quasi-natural experiments, which have substantial and opposing impacts on the litigation risk of firms headquartered in the Ninth Circuit. We find that firms in the Ninth Circuit decrease (increase) the quantity and quality of their voluntary disclosure, relative to control firms, when their litigation risk is lowered (elevated). The pre-treatment test shows an indistinguishable trend between treatment and control firms. A battery of robustness checks indicates that our results are not driven by alternative explanations. We hypothesize and find that the impact of litigation risk is more pronounced when firms have bad news and that firms are more likely to preempt bad news through voluntary disclosures when litigation risk is elevated. Overall, results from both experiments suggest that litigation risk causally increases corporate voluntary disclosure.

Keywords:

• Litigation risk
• Voluntary disclosure
• The Ninth Circuit Court
• SGI

JEL classification:

• G3
• G38
• M41

Acknowledgements

We acknowledge helpful comments from two anonymous reviewers, Hervé Stolowy (the editor), Zhaoyang Gu, Allen Huang, Bin Ke, Clive Lennox, Chen Lin, and seminar participants at Nanyang Technological University and Shanghai University of Finance and Economics. All errors are our own.

Supplemental Data and Research Materials

Supplemental data for this article can be accessed on the Taylor & Francis website, https://doi.org/10.1080/09638180.2018.1559071.

Notes

1 Our use of the US data may limit the generalizability of our results. We however believe that the following points help to alleviate the concern and justify our choice of the US setting. First, the research question how litigation risk influences corporate disclosure is likely relevant and interesting globally. Second, the US has the largest economy and the largest capital market in the world. Therefore, results based on the US data are likely to be economically important worldwide. Third, the US capital market has a wealth of information, allowing us to easily obtain information on managerial voluntary disclosures.

2 Please refer to the online appendix for a detailed discussion about the institutional setting.

3 The SGI ruling was followed by the burst of the internet bubble while Tellabs ruling the financial crisis of 2008.

4 See https://money.cnn.com/2018/04/11/news/europe-class-action-lawsuits-legal/index.html (Last accessed: Dec. 6th, 2018)

5 See http://www.asiaone.com/business/are-class-actions-good-investors-and-singapore-markets (Last accessed: Dec. 6th, 2018)

6 See https://www.hkreform.gov.hk/en/publications/rclassactions.htm (Last accessed: Dec. 6th, 2018)

7 While prior study (i.e., Field et al., 2005) uses a simultaneous equations methodology to deal with this issue, this methodology is subject to limitations and concerns. For example, Field et al. (2005) acknowledge that the effectiveness of this approach hinges on the appropriateness of the identifying variable, which should be directly correlated with either litigation risk or voluntary disclosure, but not directly correlated with the other. Failure to satisfy this requirement will lead to biased coefficient estimates.

8 Our inferences remain unchanged if the standard errors are clustered at the industry level or at the state level.

9 Using this definition, preannouncements have negative forecast horizons. Our results are robust to the sample excluding the preannouncements.

10 Bourveau et al. (2018), Appel, Gormley, and Keim (2016) and Crane and Koch (2018) show that firms may change their corporate governance in response to changes in litigation risk. It is therefore possible that the impact of litigation risk on voluntary disclosure goes through corporate governance. We find that several coefficients in Table 3 exhibit lower absolute value after we control for institutional ownership, which seems to suggest that concurrent changes in corporate governance are responsible for the changes in voluntary disclosure.

11 In un-tabulated analyses, we show that our results are robust to the sample using the firm-forecast observations.

12 In un-tabulated analyses, we use a constant composition sample requiring the firms exist over the whole sample period. And we find similar results of the treatment effect with our baseline regression models. The drawback of such a sample is the potential concerns for survivorship bias.

13 The PSLRA of 1995 was enacted to provide corporations a safe harbor from frivolous lawsuits. It provides that a company is not liable with respect to any forward-looking statement if (1) the forward-looking statement is identified as forward-looking and is accompanied by ‘meaningful cautionary statements’ identifying important factors that could cause actual results to differ materially from those in the forward-looking statement or is immaterial; or (2) the plaintiff fails to prove that the forward-looking statement was made with actual knowledge that the statement was false or misleading. Under this situation, a company will be more likely to issue range forecasts rather than point ones, because range forecasts could be defended as more ‘cautionary statements’, and help the firm avoid the finding of ‘deliberate recklessness’.

Additional information

Funding

Dong acknowledges the financial support from the National Natural Science Foundation of China [No.71401095], and the Ministry of Education of P.R. China under the project of Key Research Institute of Humanities and Social Science in University [No.18JJD790011]. Zhang acknowledges the financial support from Singapore Ministry of Education for providing research funding [RG75/16, and RG163/17].