A League of Their Own? Financial Analysts' Responses to Restatements and Corrective Disclosures

Abstract

While much has been written about the ability of financial analysts to predict periodic earnings, little has been documented on the behavior of analysts around irregular events. Such events can have significant effects on earnings and market capitalization. This study examines the response of First Call financial analysts to company restatements and corrective disclosures that lead to an allegation of securities fraud. The sample comprises 847 companies that have been sued in a federal securities class action from 1994 through 2001 with requisite stock price and company data. This study, first, documents that the number of analysts covering a firm declines significantly in the months following a corrective disclosure, which supports the view that analysts are less interested in following companies with bad news. Second, while there is evidence that analysts downgrade some firms ahead of the news, the biggest revision by far occurs in the month of a corrective disclosure, thereby suggesting that many analysts simply react to the news and/or the accompanying price change. Third, analyst forecast error decreases significantly in the corrective disclosure month but not before. Holdings by institutions also decrease in the corrective disclosure month but not before. On the other hand, other informed parties such as insiders and short sellers are unusually active several months prior to a corrective disclosure. These individuals, apparently, act ahead of the news that may lead to such an event. A regression analysis indicates that after controlling for firm size, coverage, temporal effects, and industry, analyst forecast error just prior to an announcement is reliably greater for firms with higher pre-disclosure net insider selling. In sum, when it comes to a corrective disclosure that leads to securities litigation, financial analysts are more likely to react to rather than anticipate the bad news. While this behavior may be consistent with analysts' incentives and employment contracts, it is certainly at odds with the response of certain other informed parties, which suggests that they are able to use prospective bad news advantageously before a corrective disclosure event.