The Unintended Benefit of the Risk Factor Mandate of 2005

Abstract

In 2005, the SEC mandated that firms disclose risk factors to provide useful information about firm risk. Although not intended by regulators, mandatory risk factor (RF) disclosure may constitute “meaningful cautionary language” as defined in the Private Securities Litigation Reform Act, and provide legal protection for forward-looking statements (FLS). Using both a difference-in-differences design and a two-stage least squares approach, we find that firms that had not previously disclosed risk factors (late RF disclosers) became more willing to provide qualitative FLS, particularly positive ones, than other firms. This finding is consistent with our prediction that, for late RF disclosers, the mandate reduces managers’ perceived litigation risk. We also find that these firms experience an improvement in their information environment. A path analysis reveals that the mandate improves firms’ information environment both directly, and indirectly through the mechanism of prompting more disclosure of positive FLS, illustrating an unintended benefit of the 2005 RF mandate. Cross-sectional tests show that the RF mandate induces a larger increase in positive FLS disclosure for firms whose managers perceive a higher level of benefit from safe harbor protection availed by the provision of meaningful cautionary statements.

Keywords: risk factor disclosure; litigation risk; forward-looking statements; voluntary disclosure; information environment

JEL Classification: K22; M41; M43