The unintended benefit of the risk factor mandate of 2005

Congress enacted the PSLRA to encourage firms to disclose more forward-looking information. Before the PSLRA, managers were reluctant to disclose any FLSs for fear of being sued by shareholders if their predictions turned out to be wrong. The PSLRA addresses this fear by providing litigation immunity—the safe harbor provision—for FLSs that are “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement” (15 USC §§ 77z-2(c)(1)(A)(i)). This provision can significantly lower companies’ litigation costs by facilitating the dismissal of plaintiff challenges at the pleading stage—before the costly and time-consuming discovery process (i.e., the Stay of Discovery, 15 USC §§ 78u-4(b)(3)(b)).

Since the enactment of the PSLRA, judicial decisions on whether the safe harbor provision should apply in lawsuits related to FLSs often hinge on the cautionary language. Judges take a hard look at this language and dismiss plaintiffs’ complaints only if it is truly meaningful (Ericson and Kinser 2015). Although the PSLRA does not provide an explicit definition of meaningfulness, legislative history and court decisions provide some guidance. During the passage of the PSLRA, Congresswoman Eschoo stated, “There is no liability for forward-looking statements as long as these statements are accompanied by specific warnings that their predictions may not come true” (141 Congressional Record 35,569 (1995)). Courts usually require that cautionary language be specific, updated, and tailored to the risks of the projections to trigger the safe harbor provision.^8,9

Meeting these criteria is not a trivial task and can lead to substantial costs for firms. First, disclosing detailed “warnings,” such as specific risks a firm faces with its supply chain, important customers, key personnel, or product development, can inform and benefit competitors and thus carries significant proprietary costs (Verrecchia 1983). In a guide for preparing annual reports, Ernst & Young (2018) cautions clients to consider “the risk of significant competitive harm” when disclosing risk factors. Researchers find that firms with higher proprietary costs disclose less specific risk factors in general (Hope et al. 2016), and that proprietary cost is an important determinant of whether firms disclose large customers (Ellis et al. 2012) or key employees (Israelsen and Yonker 2017), which are common RF topics (Campbell et al. 2014). Second, the disclosure of risk factors can increase the firm’s risk as assessed by the market and thus the firm’s cost of capital (Heinle et al. 2018). Consistent with this prediction, studies show that the market reacts negatively to the disclosure of new risk factors (Kravet and Muslu 2013; Campbell et al. 2014; Filzen 2015; Beatty et al. 2019). Furthermore, the firm must expend a great deal of time and effort to detail its risk factors, especially factors that are tailored enough and specific enough to qualify as meaningful cautionary statements (Austin and Bernard 2016; Wachtell et al. 2016; McClane 2019). The RF section is usually one of the longest in 10-Ks (Dyer et al. 2017), constituting 12% of the 10-K’s length on average (Section 4.1 provides details). Keenly aware of the role of risk factors in providing legal protection, Gelfond et al. (2018) advise legal counsels to tailor RF disclosure to the specific company, to talk to not only top management but also people with different specialties within the company, to review the risk factors of competitors, and to consider the significance and probability of each risk.

Despite the substantial costs of preparing and disclosing sufficiently meaningful cautionary statements, some companies voluntarily disclosed risk factors before the mandate in order to avail themselves of the safe harbor provision (SEC 2004).¹⁰ Others chose not to disclose risk factors, and avoided lawsuits by providing few FLSs or more conservative discussions about future operations (Rogers and Van Buskirk 2009).

To improve the 10-K’s informativeness, the SEC began mandating the disclosure of “the most significant factors that make an investment in a registrant’s securities speculative or risky,” in a new section of the 10-K (Item 1A, titled “Risk Factors”), from December 1, 2005, onward (item 503(c) of Regulation S-K).¹¹ The regulation stipulates that risk factors must be specific to firms and “explain how the risk affects the issuer or the securities.” Since the mandated RF disclosures might qualify as meaningful cautionary statements under the PSLRA, firms that began to provide RF disclosure could now invoke the safe harbor provision for their FLSs (Hazen 2011; White 2013; Shearman and Sterling 2014). In numerous class action lawsuits, district and circuit courts have upheld RF disclosures as being sufficient to meet the requirements of meaningful cautionary language.¹² Thus, it is not surprising that despite the RF mandate’s stated intention to prompt firms to provide information about their risks, firms write RF disclosures in a manner that is designed to minimize legal risk rather than to maximize informativeness (Brusch and McGough 2016). The firms’ emphasis on legal protection explains why investors often complain that RF disclosures “do not provide clear, concise and insightful information” (IRRC Institute 2016). Meredith Cross, the director of the SEC’s Division of Corporate Finance, pointedly comments that RF disclosures have become “mind-numbing” and are in need of fixing (Johnson 2010).¹³ Such concerns have led two former SEC chairwomen, Mary Schapiro and Mary Jo White, to call for a cost–benefit analysis of the mandate (Johnson 2010; White 2013).

A number of studies examine the usefulness of the information provided in firms’ RF disclosures. Campbell et al. (2014) find that the amount of RF disclosure provided by a firm is positively correlated with the firm’s fundamental risk and the market’s assessment of that risk. Hope et al. (2016) show that the market’s reaction to 10-K filings increases with the specificity of a firm’s RF disclosure. Similarly, Kravet and Muslu (2013) find that RF disclosure reflects market-based measures of risk.

However, some evidence shows that the mandate has reduced the usefulness of information to investors. Nelson and Pritchard (2016) find that RF disclosures reflect firms’ systematic and idiosyncratic risk in the voluntary regime but not in the mandatory regime. They find that after the mandate, low- and high-risk firms provide RF disclosure of similar quality, and that the mandatory RF disclosures of low-risk firms convey little useful information. They conclude that although the mandate has led to a substantial convergence in RF disclosure, it has not increased the amount of useful information for investors. Similarly, Beatty et al. (2019) find that although the length of RF disclosures has increased, the association between RF disclosure length and a firm’s underlying risk has decreased since the financial crisis and since firms have started receiving SEC comment letters.

In contrast to studies that focus on the information content of RF disclosures, we focus on the 2005 RF mandate’s effect on managers’ perceptions of litigation risk and their subsequent decisions to issue voluntary FLSs. We argue that after the mandate, managers perceive a reduction in litigation risk associated with providing FLSs, for two reasons. First, RF disclosure can lower litigation costs if the firm is sued by its shareholders. As discussed in Section 2.2, the mandated RF disclosures are similar to the meaningful cautionary language of the PSLRA (e.g., the PSLRA’s conference committee report 1995; SEC 2004; Nelson and Pritchard 2007; Olazabal 2011). Thus, after the RF mandate, managers might believe that if their firm is sued by its shareholders for misleading FLSs, courts are more likely to dismiss the lawsuit because of the PSLRA’s safe harbor provision (Coffee 1996; Horwich 2010; Shearman and Sterling 2014; McCann 2018). Second, RF disclosure can reduce the tendency of shareholders and their attorneys to bring lawsuits against the firm. Investors are less likely to feel wronged and entitled to financial compensation when FLSs are accompanied by cautionary disclaimers (Asay and Hales 2018), and thus are less likely to sue the firm. Plaintiffs’ attorneys, who stand to receive millions or even billions of dollars, get paid on a contingent-fee basis only (Fitzpatrick 2010). That is, they must first work hundreds or thousands of hours on a case without compensation and are only awarded attorney fees if and when they prevail in court or when the defendants agree to settle (Baker et al. 2015). Not surprisingly, plaintiffs and their attorneys are less likely to file lawsuits when they perceive a lower chance of prevailing (de Figueiredo 2005).

According to the risk compensation literature, when agents perceive greater safety (i.e., reduced risk), they exhibit riskier behavior (Hedlund (2000) provides a review). For example, Peltzman (1975) shows that people drive faster after regulations require manufacturers to install safety devices, such as seat belts, on automobiles. Similarly, Phillips et al. (2011) find that cyclists ride faster when they are required to wear a helmet. In the economic sphere, DeLong and Saunders (2011) and Calomiris and Jaremski (2019) find that banks increased their risk-taking behavior after the introduction of deposit insurance in the early twentieth century. In our setting, risk compensation theory predicts that if managers perceive lower litigation risk after the 2005 mandate, they will be more willing to take litigation risk in providing forward-looking disclosure.

However, it is possible that the 2005 RF mandate does not reduce managers’ perceived litigation risk sufficiently to result in an increase in firms’ FLSs. There are two reasons for this. First, whether courts interpret RF disclosures as meaningful cautionary language is uncertain (Pritchard and Sale 2005; Horwich 2010; Olazabal 2011). Even if judges consider the risk factors, they might refuse to dismiss lawsuits on the grounds of the safe harbor provision if they find that the cautionary language is not pertinent to the allegation.¹⁴ Thus, managers might not view RF disclosures as being reliable in reducing litigation costs. Second, the RF mandate only affects firms that did not voluntarily provide risk factors before the mandate and these firms might not expect a large legal benefit from the safe harbor provision. Presumably, in the pre-mandate period, these firms chose not to provide RF disclosures because the legal benefit of doing so was less than the cost. For example, they may have disclosed FLSs but avoided securities litigation even without the safe harbor provision due to a track record of consistently meeting their projections; or they may not have provided FLSs for reasons unrelated to litigation risk, such as high proprietary costs or complex business operations that made FLSs difficult to forecast (Verrecchia 1983; Waymire 1985). Because their FLS decision is driven by non-litigation-risk concerns, these firms might not increase their FLSs despite the lower perceived litigation risk after the mandate. Taken together, whether the 2005 mandate leads to an increase in voluntary disclosure practices among late RF disclosers is an empirical question.

Intuitively, when firms are more willing to take litigation risk in providing FLSs, they disclose a larger amount of FLSs. Furthermore, optimistic statements carry a significantly higher litigation likelihood and lead to larger shareholder damage in lawsuits than pessimistic statements do (e.g., Skinner 1997; Cao and Narayanamoorthy 2010; Rogers et al. 2011; Cutler et al. 2019).¹⁵ Thus, we hypothesize the following:

Even if late RF disclosers provide more positive FLSs following the mandate, it is unclear whether these additional FLSs are informative for investors. On the one hand, the SEC has long recognized the investor demand for FLSs and has encouraged and guided companies to provide FLSs in the MD&A section of 10-K filings (SEC 1989, 2003, 2020; Levitt 1996).¹⁶ Studies note the benefits of forward-looking disclosure in general (see review by Core 2001; Healy and Palepu 2001; Leuz and Wysocki 2016). In particular, Li (2010) and Muslu et al. (2015) find that FLSs in the MD&A section disclose information about a firm’s future performance, such as its earnings and liquidity, and mitigate the potential mispricing of accruals. On the other hand, a concern raised during the passage of the PSLRA is that firms might use the safe harbor provision as a “license to lie,” because it might offer protections even when managers make knowingly false projections (141 Congressional Record 1995; Levitt 1995; Senate Report 1995; Coffee 1996; Horwich 2010; McCann 2018).¹⁷ Managers generally have incentives to make optimistic disclosures. For example, studies find that managers sometimes positively bias their voluntary disclosures to lower the cost of capital, cover up earnings management, or increase their own compensation (Aboody and Kasznik 2000; Lang and Lundholm 2000; Huang et al. 2013). If late RF disclosers perceive higher legal protection after the 2005 RF mandate, they might feel free to provide intentionally or unintentionally false FLSs, which can worsen their information environment. This tension leads to our next hypothesis:

In addition to the mandate’s average effect on forward-looking disclosure, we examine the variation in the strength of this effect to provide further support for the mechanism through which the mandate affects forward-looking disclosure. As the 2005 RF mandate induces more FLSs due to managers’ perception of legal protection, the effect should be stronger when managers perceive a higher level of legal benefit from meaningful cautionary statements, such as when firms’ FLSs are more likely to be the target of lawsuits. Hence, we make the following prediction:

To test our hypotheses, we obtain firms’ 10-K filings from the SEC’s Edgar database, their financial data from Compustat, and their stock price data from the Center for Research in Security Prices (CRSP). We use the 10-K filings in the following two periods: 2000–2004 and 2006–2010 (i.e., five years before and five years after the effective date of the RF mandate).¹⁸ We exclude Compustat fiscal year 2005 from the sample period because the mandate took effect for fiscal years ending after December 1, 2005, and affected firms with a fiscal year-end from December 2005 to May 2006 but not others (i.e., firms with a fiscal year-end from June to November 2005).¹⁹ Before the mandate, some firms voluntarily disclosed risk factors, usually in Item 1 (Business) of their 10-K filings.^20,21 Beginning in 2005, it was required that RF disclosures be provided in Item 1A (503(c) of Regulation S-K). We define a firm as an early RF discloser if it disclosed risk factors in the pre-mandate period (January 1, 2000, to December 1, 2005) and as a late RF discloser if it did not. To determine whether a firm disclosed risk factors before the mandate, we search for RF-related phrases in its 10-K filings (Section 4.1 provides details).

Our main analysis focuses on firms that we can identify as late or early RF disclosers from 2000 to 2005 and their 35,641 10-K filings during the sample periods (2000–2004 and 2006–2010). We remove 10-Ks in which we cannot find an MD&A section or that lack the necessary financial data in Compustat and CRSP. This requirement reduces the sample size to 23,709. We further exclude smaller reporting companies, as they are exempt from the RF mandate.²² We obtain a final sample of 21,455 firm–year observations for 4410 unique firms. Some of our empirical tests require variables constructed using analyst forecasts from First Call and thus have different sample sizes.

In this section, we define the main variables used in our analyses. To measure forward-looking disclosure, we use the amount and tone of FLSs in the firms’ 10-K MD&A section. Following Li (2010), we define FLSs as sentences that contain one or more of the following words: “will,” “should,” “can,” “could,” “may,” “might,” “expect,” “anticipate,” “believe,” “plan,” “hope,” “intend,” “seek,” “project,” “forecast,” “objective,” and “goal.”^23,24 To measure the amount of FLSs, we use the natural log of one plus the number of words in the FLSs (FLS _ Amt). To measure the tone of a firm’s FLSs (i.e., the level of textual optimism), we use the natural log of one plus the number of positive words scaled by the number of negative words (FLS _ Tone).²⁵ To identify positive and negative words, we use the word list constructed by Loughran and McDonald (2011).

We use a DiD research design to test H1—that late RF disclosers provide more FLSs, particularly positive ones, after the 2005 RF mandate, relative to early RF disclosers. We compare the change in the forward-looking disclosure behavior of late RF disclosers from the pre-2005 period to the post-2005 period with that of early RF disclosers.²⁶

We classify firms as early RF disclosers or late RF disclosers in two steps. First, we search for phrases that indicate that a firm might have disclosed risk factors in its 10-K filings during the pre-mandate period from January 1, 2000, to December 1, 2005. To construct the list of phrases, we read a random sample of 100 RF disclosures in the 10-K filings from the pre-mandate period. The list of phrases includes “risk factor,” “cautionary statement,” “private securities litigation reform act,” “business risk,” “forward-looking statement,” “forward looking statement,” “factors that may affect future results,” and “factors affecting future performance.”²⁷ Next, we search for these phrases in the 10-K filings from our pre-mandate period and read each filing that contains such phrases to determine whether they actually are RF disclosures. Of the 22,023 10-Ks from 2000 to 2005, 10,037 have RF disclosures, which belong to 3084 early RF disclosers.²⁸ We classify the remaining sample of 1326 firms (i.e., firms that did not have RF disclosures in their pre-mandate 10-K filings) as late RF disclosers.

One assumption of the DiD research design is that early RF disclosers (control firms) experience a smaller increase in legal protection for FLSs after the 2005 RF mandate than late RF disclosers (treatment firms). We provide two pieces of evidence to support this assumption. First, early RF disclosers have similar levels of legal protection for FLSs in both periods due to their pre-mandate RF disclosures, whereas late RF disclosers receive legal protection for FLSs only after the mandate. We verify that the post-2005 RF disclosures of early disclosers are of the same length as their pre-2005 disclosures. Their RF disclosure length, on average, is 12.41% and 12.14% of their 10-K filings in 2005 and 2004, respectively, which is not statistically different. Our finding is consistent with that of Nelson and Pritchard (2016) and suggests that the pre-2005 RF disclosures of early disclosers satisfy the RF mandate. In contrast, late RF disclosers began disclosing their risk factors only in 2005. Their RF disclosure length, on average, was 9.74% of their 10-K filings that year. Second, late RF disclosers’ post-mandate RF disclosures have similar qualities to those of early RF disclosers. The SEC scrutinizes firms’ RF disclosures and sends comment letters, asking for more details, to firms whose disclosures are deemed too generic (Campbell et al. 2014; Brown et al. 2018). We find that after 2005, late RF disclosers are as likely to receive SEC comment letters about risk factors as early RF disclosers, which indicates that the two groups provide RF disclosures of similar quality (not tabulated).²⁹ This finding is consistent with that of Nelson and Pritchard (2016), who show that the informativeness of the RF disclosures provided by early and late RF disclosers is not statistically different after the 2005 mandate. Overall, the evidence confirms that late RF disclosers experience a significant increase in legal protection after 2005, whereas early RF disclosers do not.³⁰

We test H1 (i.e., whether late RF disclosers provide more FLSs and more positive FLSs after 2005 relative to early RF disclosers) using the following regression: where the amount and tone of FLSs and the amount of positive FLSs (FLS _ Amt, FLS _ Tone, and FLS _ Pos, respectively) are the dependent variables; LateRF is an indicator variable that equals one for late RF disclosers and zero for early RF disclosers; and Post is an indicator variable that equals one in the post-2005 period, and zero otherwise.³¹ Following Li (2010), we control for other determinants of voluntary disclosure (Controls): profitability (ROA), past stock returns (RET), accruals (Accruals), firm size (Size), market-to-book ratio (MtoB), return volatility (RetVol), earnings volatility (EarnVol), special items (SPI), firm age (FirmAge), business complexity measured by the number of business and geographic segments (SEG _ Bus and SEG _ Geo), and Delaware incorporation (DE). To control for time trends in disclosure and other unobservable time-invariant industry or firm characteristics that might affect voluntary disclosure, we include year fixed effects and alternatively industry and firm fixed effects in the model. We provide detailed variable definitions in the Appendix. All of the t-statistics are based on standard errors clustered at the firm level.

In Eq. (1), β₁ captures the average difference between the forward-looking disclosures of the late and early RF disclosers before the mandate. Our coefficient of interest is β₂, which captures the average difference between the change in the forward-looking disclosure behavior of the late and early RF disclosers from the pre-mandate period to the post-mandate period. H1 predicts a positive coefficient of β₂. That is, we expect late RF disclosers to exhibit a greater increase than early RF disclosers in both the amount and optimism of their forward-looking disclosures after the RF mandate.

Panel A of Table 1 reports the summary statistics of the dependent and control variables. Panel B of Table 1 compares the firm characteristics of the late and early RF disclosers in 2004, the year before the RF mandate. The late RF disclosers are larger, older, more profitable, and less likely to be incorporated in Delaware than the early RF disclosers. They also have higher accruals, more geographic segments, higher stock returns, lower market-to-book ratios, lower return volatility, and lower earnings volatility. In a sensitivity test, we use a propensity score matched sample in which each late RF discloser is matched with an early RF discloser based on firm characteristics in 2004, and find similar results (tabulated in Internet Appendix Table IA6; Section 4.6.1 provides a detailed discussion).

In Table 2, we report the results of the univariate analysis of the differences between the changes in the FLSs for the late and early RF disclosers. We present the statistics for the late and early RF disclosers in Columns (3) and (6), respectively. The general trends in FLSs are captured in the early RF disclosers, which are not affected by the RF mandate (Column (6)). Their FLSs become longer (FLS _ Amt) and more optimistic (FLS _ Tone) over time, but their amount of positive FLSs (FLS _ Pos) does not change. We present the results of the univariate DiD analysis in Column (7). The results show that the late RF disclosers produce more FLSs and more optimistic FLSs, post mandate, than the early RF disclosers do (DiD coefficients based on FLS _ Amt, FLS _ Tone, and FLS _ Pos are all significant at the 1% level). Overall, the univariate results indicate that late RF disclosers show a greater willingness to be exposed to litigation risk after the mandate than early RF disclosers do. These results support H1.

Next, we present the results of our Eq. (1) regression in Columns (1) and (3) of Table 3. In this regression, we control for other economic factors and industry fixed effects. Consistent with H1, we find that the estimated coefficients of LateRF × Post are positive and significant at the 1% and 5% levels for FLS _ Amt and FLS _ Tone, respectively. This finding indicates that late RF disclosers increase both the amount and level of optimism of their FLSs after the mandate. These increases are economically significant. The results of the regression that uses POST instead of year fixed effects (tabulated in Internet Appendix Table IA5) show that, on average, the late RF disclosers exhibit a 67% increase in the amount of FLSs—from 1482 words in 2004 to 2479 words post mandate. In contrast, the early RF disclosers only exhibit an 11% increase in FLSs in the same period—from 2363 words in 2004 to 2627 words post mandate. Our tone results show a similar pattern. On average, the late RF disclosers exhibit a 5.2% increase in optimism in their FLSs from their 2004 level to their post-mandate average (0.018 + 0.024 scaled by their average FLS _ Tone of 0.802 in 2004). In contrast, the early RF disclosers exhibit only a 2.2% increase over the same period (0.018 scaled by their average FLS _ Tone of 0.803 in 2004). The estimated coefficients of our control variables show that firms with lower return on assets, more accruals, higher market-to-book ratios, and more special items have more positive FLSs, consistent with the results of previous studies (e.g., Li 2010).

To determine whether this increase in optimism is driven by an increase in the amount of positive FLSs or a decrease in the amount of negative FLSs, we use the amount of positive FLSs, FLS _ Pos (i.e., the natural log of one plus the number of positive words in the FLSs of the MD&A section of the 10-K filings), as the dependent variable. The estimated coefficients of LateRF × Post are positive and statistically significant at the 1% level (Column (5) of Table 3). This finding indicates that the increase in optimism among late RF disclosers is driven by a greater willingness to disclose forward-looking good news, which these firms would have withheld had the safe harbor provision arising from the RF disclosures not been present.³²

To better control for unobservable firm characteristics that might affect voluntary disclosure, we rerun our analyses, replacing industry fixed effects with firm fixed effects. In this specification, we omit two firm invariant control variables, LateRF and DE, from the estimation. Although including firm fixed effects in the regression diminishes the explanatory power of some of the control variables (such as Accruals), our main results from Columns (2), (4), and (6) of Table 3 remain consistent. That is, the estimated coefficients of LateRF × Post (0.357 for FLS _ Amt, 0.030 for FLS _ Tone, 0.490 for FLS _ Pos) are statistically significant at the 1% level. Overall, the results of our regressions support the prediction that late RF disclosers provide a larger amount of, and more optimistic, FLSs after the 2005 RF mandate. This result suggests that they are more willing to take litigation risk.

To examine whether the 2005 RF mandate takes the forward-looking disclosure practice of late RF disclosers to the same level as that of early disclosers, we test whether the level of FLS _ Amt, FLS _ Tone, and FLS _ Pos are different between early and late RF disclosers in the post-mandate period (i.e., we test if β₁ + β₂ = 0). The F-test results (reported in Table 3) indicate that after the RF mandate, early RF disclosers still provide a higher total amount of FLSs than late RF disclosers (significant at the 0.01 level), but the two groups are not different in the tone of their FLSs or in the amount of positive FLSs. These results are consistent with the conjecture that early and late RF disclosers enjoy a similar level of legal protection for FLSs after the 2005 RF mandate.

In the previous section, we used the 2005 RF mandate as an exogenous shock and a DiD research design to examine whether the mandate increases the amount of positive FLSs among late RF disclosers. Following Petacchi (2015), we now use an alternative research design—a 2SLS model in which the 2005 mandate serves as an instrumental variable—to validate the results of the DiD analyses. We estimate a first-stage regression that identifies exogenous changes in RF disclosure characteristics due to the 2005 mandate and use the predicted RF disclosure characteristics to explain the amount of positive FLSs. Unlike the DiD analyses, this method explicitly shows that the RF mandate results in a strong enough shock to RF disclosure to affect managers’ perceived litigation risk. We focus on the length and specificity of RF disclosure because the PSLRA considers cautionary statements as meaningful (to invoke the safe harbor provision) only when they contain comprehensive, specific information (Nelson and Pritchard 2016). The focus on disclosure length and specificity is consistent with court rulings in which judges scrutinize whether RF disclosures are concrete enough and specific enough to constitute meaningful cautionary statements (Rosen and Carey 2016), and with the SEC’s recommendation that firms make their cautionary statements “substantive and tailored to the specific projections” to protect FLSs (Hunt 1998). To the extent that managers perceive longer and more specific RF disclosures as offering greater legal protection, we expect the relations between the disclosure length and specificity of risk factors and the amount of firms’ positive FLSs to be positive.

We use the following first-stage regression to identify exogenous changes in the length and level of specificity of RF disclosures due to the 2005 mandate:

To measure RF disclosure length (RF _ Length), we use the natural log of one plus the number of words in the RF disclosure, scaled by the number of words in the 10-K filing. To measure RF disclosure specificity (RF _ Specificity), we follow Hope et al. (2016) and use the proportion of words in the RF disclosure that are identified by the Named Entity Recognition Technique as “specific names” in seven entity categories: (1) names of persons, (2) names of locations, (3) names of organizations, (4) quantitative values in percentages, (5) money values in dollars, (6) times, and (7) dates. We control for the following firm characteristics: ROA, RET, Total _ Accruals, SIZE, MtoB, RetVol, EarnVol, SPI, Firm _ Age, SEG _ Bus, SEG _ Geo, DE, and industry and year fixed effects.

Columns (1) and (3) of Table 4 report the first-stage regression results for RF _ Length and RF _ Specificity, respectively. Although the length and level of specificity of RF disclosures increase surrounding the time of the RF mandate, the magnitude of these increases is much larger for late RF disclosers. The results of the regression with POST instead of year fixed effects (tabulated in Internet Appendix Table IA8) show that late RF disclosers experience increases in RF disclosure length and specificity that are 5.2 times ((0.624 + 0.148)/0.148) and 3.7 times ((0.345 + 0.128)/0.128) those of early RF disclosers, respectively. LateRF × Post is significant at the 1% level in both columns. The estimated coefficients of the control variables are intuitive and consistent with the results in the literature (e.g., Campbell et al. 2014). RF disclosures tend to be longer and more specific when firms are larger, when their performance is poorer, and when they have more volatile earnings and stock returns.

In the second stage, we regress FLS _ Pos on the predicted values from the first-stage regressions (Pred _ RF _ Length and Pred _ RF _ Specificity). We report the results in Columns (2) and (4) of Table 4. Consistent with our prediction, the coefficients of Pred _ RF _ Length and Pred _ RF _ Specificity are positive and significant at the 1% level, indicating that firms increase their positive FLSs more when their disclosure length and specificity are higher. In particular, one standard deviation increases in Pred _ RF _ Length and Pred _ RF _ Specificity are associated with 0.228 (0.850 × 0.268) and 0.247 (1.470 × 0.168) increases in FLS _ Pos, respectively, equal to increases of 27.6% and 30.2% in the number of positive words in FLSs (median FLS _ Pos is 2.639, meaning that FLSs have a median of 13 positive words), respectively. Therefore, the results of the 2SLS model confirm our DiD analysis findings: late RF disclosers provide a larger amount of positive FLSs after the mandate, compared to early RF disclosers.

To further understand the implication of the mandate’s effect on firms’ voluntary disclosure, we ask whether the increase in the amount of FLSs provides investors with more useful information or inconsequential or misleading information (H2). We first use the DiD design to test whether late RF disclosers experience an improvement in their information environment compared to early RF disclosers after the mandate: where, following the literature (e.g., Campbell et al. 2014), we use the bid-ask spread (Spread, the average daily bid-ask spread in percentage) to measure a firm’s information environment.³³ We control for determinants of the information environment: market-to-book ratio (MtoB), the number of analysts following (Analyst), firm size (Size), profitability (ROA), the number of shareholders (Shareholder), institutional ownership (IO), stock price (Price), return volatility (RetVol), and earnings volatility (EarnVol). To control for time trends and other unobservable time-invariant industry or firm characteristics that might affect the information environment, we include industry and year fixed effects in the model. We provide detailed variable definitions in the Appendix.

The results in Table 5, Panel A, show that compared to early RF disclosers, late RF disclosers experience a decrease in bid-ask spreads after the mandate. The estimated coefficients for LateRF × Post are negative and statistically significant at the 1% level. Replacing year fixed effects with POST in the regression, we find that the bid-ask spread of late RF disclosers decreases by 41.5% more than the bid-ask spread of early RF disclosers (i.e., −0.245/−0.591; tabulated in Internet Appendix Table IA10).

Note that the RF mandate can directly affect the information environment of late RF disclosers through RF disclosure itself (Campbell et al. 2014; Filzen 2015; Hope et al. 2016). We therefore perform a path analysis that allows us to separate the RF mandate’s direct and indirect effects on the information environment. A path analysis uses a structural equation system to model how a source variable affects an outcome variable directly and indirectly through mediating variables (Wright 1934; Parker and Kyj 2006; Bhattacharya et al. 2012). We use RF disclosure length as the source variable in the path analysis. To quantify the relative importance of the direct and indirect paths, we follow Bhattacharya et al. (2012) and do not include control variables.³⁴

Panel B of Table 5 shows the path analysis results. The Pearson correlation between RF _ Length and Spread, which measures the total effect of RF length on the bid-ask spread, is −0.19. This result is consistent with the assertion that the overall effect of RF disclosure on firms’ information environment is positive. The direct path coefficient, p[RF _ Length, Spread], is −0.15 (significant at the 0.01 level). The path coefficient for the indirect path—the product of p[RF _ Length, FLS _ Pos] and p[FLS _ Pos, Spread] (both significant at the 0.01 level)—is −0.04 (0.296 × −0.135). That is, additional RF disclosure improves firms’ information environment both directly, and indirectly through the increase in positive FLSs. Following Bhattacharya et al. (2012), we estimate the relative importance of the direct and indirect paths as the ratio of each path coefficient to the total correlation. The direct path contributes 78.9% to the total effect of RF _ Length on Spread. More importantly, the indirect path contributes 21.1% of the total effect. These results suggest that a considerable portion of the RF mandate’s effect on the information environment of late RF disclosers is through additional positive FLSs. This finding dispels the concern that firms use the RF disclosure’s safe harbor protection as a license to lie, and points to an unintended benefit of the RF mandate for investors.

If the 2005 RF mandate influences firms’ voluntary forward-looking disclosures through managers’ perception of litigation risk, we expect the effect to be stronger when managers perceive a higher level of legal benefit from meaningful cautionary statements (H3). We measure legal benefit three ways.

First, securities class action lawsuits are more likely to target firms whose FLSs turn out to be overly optimistic (Rogers et al. 2011). We therefore identify firms that are more susceptible to large unexpected negative events—namely, firms that have more volatile earnings (Graham et al. 2005; Dichev and Tang 2009), that are in competitive industries (Lev 1983; Zang 2012), or that invest in highly uncertain projects (Wedig 1990; Chan et al. 2001; Shi 2003). To measure earnings volatility, we use the standard deviation of earnings over the previous five years (EarnVol). To measure industry competition, we use the Herfindahl index (Competition, the sum of the squared market shares of the ten largest companies in the industry, multiplied by negative one; a larger value denotes a more competitive industry). To measure investment in uncertain projects, we use R&D expenditure intensity (R & D).

Second, we explore the variation in the legal protection of risk factors that arises from the judicial system. Huang et al. (2019) show that when judges have more liberal ideology, they are more likely to make pro-plaintiff decisions in securities class action lawsuits. We expect firms that reside in a more pro-plaintiff circuit to demonstrate a higher need for meaningful cautionary language in their legal defense and to thus experience stronger effects from the RF mandate. To measure how pro-plaintiff the court is, we use the ideology of the judges of the circuit court that has jurisdiction over the state of the firm’s headquarters (Judge _ Ideology, the probability of a randomly selected three-judge panel from the circuit being dominated by those appointed by Democratic presidents).³⁵

For our cross-sectional tests, we estimate Eq. (1) separately for the subsamples of firms that have above versus below sample median values of EarnVol, Competition, R & D, and Judge _ Ideology, and for the subsamples of firms whose PastLawsuit equals one versus zero. We compare the coefficients of LateRF × Post across these samples. H3 predicts that the coefficients of LateRF × Post are larger in the subsamples of firms that have above sample median values of EarnVol, Competition, R & D, and Judge _ Ideology, and whose PastLawsuit equals one.

We find that the estimated coefficients of LateRF × Post are positive and significant in all of the subsamples. However, the coefficients are significantly larger when firms’ FLSs are more susceptible to potential litigation (in Columns (2), (4), and (6) of Table 6, for above sample median values of EarnVol, Competition, and R & D, respectively); when meaningful cautionary statements have a greater impact on potential lawsuit outcomes (in Column (8), for an above sample median value of Judge _ Ideology); and when managers are more familiar with the role of meaningful cautionary statements in lawsuits (in Column (10), where PastLawsuit is equal to one). All of these are consistent with H3. These results support those of our earlier analyses and indicate that the RF mandate affects FLSs by changing managers’ perception of legal protection.