The Power of Words in Capital Markets: SEC Comment Letters on Foreign Issuers and the Impact of Domestic Enforcement

Abstract

In this paper, we examine the language tone of comment letters issued to foreign firms listed on US stock exchanges and the impact of domestic enforcement. We find that the tone of SEC reviews has capital market implications following the dissemination of comment letters. Using a textual analysis methodology, we gauge SEC linguistic nuance by creating a customized wordlist for the US regulatory context. We evaluate alternative measures of tone and present evidence that our discipline-specific tone measure outperforms the frequently-cited dictionaries employed in analyses of corporate narratives. We document that negative-tone regulatory language, in contrast to positive, produces significant investor reactions. We further demonstrate that negative market reactions are amplified relative to the strength of domestic enforcement environments. Finally, we find that negative-tone measures generate the same directional capital effect on both US GAAP and non-US GAAP filers; however, when we consider only the important comment letters, the market reaction is more negative for foreign firms which apply the US GAAP. We offer important implications for enforcement agencies, companies, lenders and investors.