Disclosure Tone and Shareholder Litigation

Abstract

We examine the relation between disclosure tone and shareholder litigation to determine whether managers’ use of optimistic language increases litigation risk. Using both general-purpose and context-specific text dictionaries to quantify tone, we find that plaintiffs target more optimistic statements in their lawsuits and that sued firms’ earnings announcements are unusually optimistic relative to other firms experiencing similar economic circumstances. These findings are consistent with optimistic language increasing litigation risk. In addition, we find incrementally greater litigation risk when managers are both unusually optimistic and engaging in abnormal selling, consistent with insider sales signaling an intent to mislead underlying the manager’s optimistic statements. Finally, we find that insider selling is associated with litigation risk only when contemporaneous disclosures are unusually optimistic.

Keywords: Securities litigation, disclosure, tone, earnings announcements, insider trading

JEL Classification: G38, K22, M41, M45