An Unintended Benefit of the Risk Factor Mandate of 2005

Abstract

The risk factor disclosure mandate effective in 2005 was intended to provide the market with useful information on firm risk. Recently, investors and regulators have expressed concerns that this section has become “boilerplate.” However, because mandatory risk factor disclosure can be used as “meaningful cautionary language” under the safe harbor provision of the Private Securities Litigation Reform Act, the mandate results in an exogenous increase in the legal protection of forward-looking statements made by firms that started to provide risk factors disclosure due to the mandate. Using a difference-in-differences design, we find that after the 2005 risk factor mandate, these firms are more willing to provide forward-looking statements, particularly positive ones, in the Management’s Discussion and Analysis section of their 10-K filings, and that they are more willing to provide management forecasts, their earnings forecasts have higher precision, and have longer horizons, compared to other firms, all of which are consistent with reduced managerial concern about litigation risks from voluntary disclosure. Cross-sectional tests show that the increase in forward-looking disclosure is greater at firms in which forward-looking statements are more susceptible to potential litigation. Further analyses indicate that firms that started to provide risk factors due to the mandate have experienced a decrease in analyst forecast errors and dispersion, and a decrease in bid-ask spreads. Overall, our study suggests that the 2005 risk factor mandate has an unintended benefit — it has spurred the voluntary disclosure of forward-looking information.

Keywords: Risk Factor, Voluntary Disclosure, Management Forecast, Boilerplate, Regulation S-K

JEL Classification: M40, M41, M48, K22