Disclosure Quality and its Effect on Litigation Risk

Abstract

This paper examines the relationship between the quality of disclosure in companies' 10-K filings and the risk of securities class action litigation. I use a dataset containing 10-K documents filed electronically with the SEC in the period 1996-2005. Using two content analysis software programs that analyze the categories of words used in these filings, I find that firms that use more numbers, past and future words, and other informative words are less likely to be sued, even after controlling for the common determinants of lawsuits. In order to avoid subjective choice of word categories, I use principal components analysis to identify the major components of disclosure in company filings. When these components are used in regressions, one component named 'informativeness' has significant power to explain subsequent lawsuits. Finally, in cross-sectional tests, I find support for the theory that firms with good boards and managers who are not entrenched have better disclosure practices. Further, monitoring by institutional investors, independent boards and analysts appears to induce better corporate disclosure.