Of Fogs and Bogs: Does Litigation Risk Make Financial Reports Less Readable?

Abstract

We predict that firms’ attempts to reduce litigation risk can inadvertently worsen financial report readability by increasing reports’ size, complexity, and altering their linguistic characteristics. We find that litigation risk reduces report readability. Readability worsens after firms experience a securities class action. This persists for several years after lawsuit resolution. To alleviate endogeneity concerns, we show that the litigation experience of a firm’s managers and directors at other firms impacts readability. We also find that firms adjust readability around litigation flashpoints. Using an SEC rule change as an exogenous shock, we show that adjustments to readability can moderate firm litigation risk.

Keywords: Readability, Transparency, Securities Class Actions, Litigation Risk, Plain English Rule

JEL Classification: G30, G38, K22