The Painful Price of Puffy CFO Projections

Plaintiffs’ lawyers in securities cases love to target the puffy sentiments of press releases and conference calls -- when those words precede falling earnings or a plunging stock price. Regulators, too, of course, routinely go after over-optimistic comments, once the official reports have exposed the too-favorable language as misleadingly positive.

So it may not be surprising that a study in The Accounting Review, published by the American Accounting Association, determines that companies that are sued tend to use “substantially more optimistic language in their earnings announcements than do non-sued firms.” But the study also says that CFOs and other managers “can reduce litigation risk by dampening the tone of their earnings announcements [whether] by decreasing their use of positive language or by tempering their optimism with statements that are less favorable.”

And indeed, their work suggests a formula for reducing that risk. Jonathan L. Rogers and Sarah L. C. Zechman of the University of Chicago, and Andrew Van Buskirk of Ohio State University, the study’s authors, find that "after controlling for a host of performance-related and other firm characteristics,” making a small adjustment of “one standard deviation in the aggregate optimism factor” can lead to “a 75.9% increase in the likelihood of being sued."

Says Rogers, “Roughly what that means is that, all else being equal, a highly upbeat tone in earnings statements and other company reports is over 75% more likely to get the company sued than a moderately upbeat tone."

Touting, Yet Selling Stock

Further, the chance of a lawsuit increases much more, the research reveals, when CFOs or others tout a situation with an upbeat tone on the one hand, while, on the other, company executives are selling their own shares.

"The relation between optimism and litigation is approximately four times larger for situations with abnormal insider sales than for those without," the study says. Still, it adds, "optimistic language is associated with litigation risk even in the absence of abnormal insider selling, while abnormal insider selling is a meaningful predictor of litigation only when that selling is accompanied by unusually optimistic disclosure tone." 

The professors note that making optimistic statements isn’t bad in and of itself. And they reject what they call any “cynical” suggestion that their findings reflect only the tendency of lawyers for investors to "target any firms that experience unexpectedly poor results and, with the benefit of hindsight, choose the most optimistic statements they can find and assert that the statements were misleading." 

628 Earnings Announcements

Their research focuses on 165 companies sued in federal court for alleged fraud involving the stock price, and a matching group of 165 that are similar to the defendant companies, but aren’t targeted in suits. In all, 628 earnings announcements from the sued firms were analyzed, along with 625 from non-sued firms. Studying “the damage period,” of up to five years after the company’s comments, they note: "Earnings announcements are an important (perhaps the most important) source of alleged misrepresentations."