Saturday, July 26, 2014
One of the classic arguments against private securities liability – and in particular, Section 10(b) fraud-on-the-market liability, with its high potential damages – is that it overdeters issuers, thus stifling voluntary disclosures rather than encouraging them. This was in fact the theory behind the PSLRA’s safe harbor: the statute makes it particularly difficult for private plaintiffs to bring claims based on projections of future performance, in part because of Congress’s fear that expansive liability would dissuade issuers from making projections at all.
Two new empirical studies challenge this common wisdom.
The first, Private Litigation Costs and Voluntary Disclosure: Evidence from Foreign Cross-Listed Firms, by James P. Naughton et al., uses the Supreme Court’s decision in National Australia Bank v. Morrison as a natural experiment. That decision abruptly removed the specter of private Section 10(b) liability based on securities sold on a foreign exchange. The authors compare voluntary earnings guidance offered by firms whose securities are cross-listed in the US and abroad before and after Morrison to determine how the diminished threat of liability affects issuer behavior.
As it turns out, the authors found that earnings guidance decreased for those firms whose securities are cross-listed, as compared to counterparts whose securities are listed solely in the United States. The authors also found that the effect was stronger for firms whose home country had a weak regulatory structure – i.e., firms that did not expect that enforcement in their home country would fill the void left by Morrison. Finally, the authors found stronger effects for firms with a greater proportion of non-US listed shares – i.e., firms most affected by the Morrison decision.
The second study, Carrot or Stick? The Shift from Voluntary to Mandatory Disclosure of Risk Factors, by Karen K. Nelson and Adam C. Pritchard, analyzes “risk factor” disclosures. Under the PSLRA, issuers are insulated from liability for false projections of future performance if the projections are accompanied by sufficiently detailed “cautionary statements,” i.e., descriptions of the variables that could cause actual results to differ from the projections. In this study, the authors compared risk factor disclosures by firms with a high risk of litigation to firms with low litigation risk, and found that higher litigation risk was correlated with more detailed risk disclosures that were more frequently updated from year to year and were presented in more readable language. The effect was strongest prior to 2005, when risk disclosure was voluntary; after 2005, when the SEC made risk disclosure mandatory, the effect recedes, although higher risk firms continue to provide more risk factor disclosure. The authors also show that investors absorb this information: for higher risk firms, there is a correlation between risk factor disclosures and investors’ post-disclosure risk assessments.
These two studies together provide interesting evidence that firms react to the specter of private liability by increasing, rather than decreasing, disclosures. Moreover, the Nelson/Pritchard study in particular concludes that these increased disclosures are in fact meaningful to investors.