Publicly-traded firms in the U.S. are legally required to disclose the material risks they face. Although the regulation was designed to protect investors, research by HKUST’s Allen H. Huang and Amy Y. Zang shows that it has unintended benefits for firms too. Working with a graduate of HKUST’s Accounting Ph.D. program, they explored how the legal language of mandatory risk disclosures provides businesses with a safeguard against litigation—to the ultimate benefit of all.

Investing is naturally a risky business, but what investors fear most is uncertainty, which stems from a lack of knowledge. In 2005, the US Securities and Exchange Commission made it mandatory for firms to disclose the most significant risk factors (RFs) impacting their future prospects. Although the mandate’s goal was to protect shareholders, one outcome has been a glut of legalistic language in RF disclosures, designed—often under lawyers’ advice—to forestall legal action from investors in the event of underperformance.

Preparing lengthy reports is costly for firms. For investors, there is also a risk that firms will use the 2005 mandate as a “license to lie” in their forward-looking statements (FLSs), exploiting the safe-harbor protection afforded by the new legal environment. And there could be a further negative result: an abundance of “boilerplate” clauses in RF disclosures—generic risk warnings that can be virtually copied and pasted from one disclosure to another. “[Boilerplate] causes both market participants and regulators to complain about ‘disclosure overload’,” state the authors.

Considering these potential drawbacks, the HKUST researchers set out to determine the actual effect of mandatory disclosure on the market since 2005. They compared two groups of firms: those that had been disclosing their RFs voluntarily before the mandate, and those that started to do so after the law came into effect. In this way they answered the empirical question of “whether the 2005 mandate leads to an increase in voluntary disclosure practices.” In other words, has the law actually improved the information environment of US firms and investors?

Their central finding was that “late disclosers,” who previously avoided disclosing risks, have issued a larger number of FLSs since the mandate. As the authors state, “managers perceive lower litigation risk in providing FLSs because they treat the mandated RF disclosures as meaningful cautionary language.” That is, firms that were once hesitant to publicly acknowledge their risks are now more confident to issue predictions of their future performance, because the language of mandatory disclosures provides real legal protection against litigious investors.

This perception represents a major change in managers’ attitudes, as the threat of litigation in connection to inaccurate forecasts is very real. As the authors note, “57% of [securities class action] lawsuit filings from 2004 to 2018 involved allegations concerning misleading qualitative FLSs.” Managers with past experience of shareholder litigation are especially aware of the benefits of declaring RFs in robust legal language—and indeed, the study found that previously sued late disclosers were particularly forthcoming in issuing FLSs after the 2005 mandate.

Predictions can, of course, be either optimistic or pessimistic. An interesting finding is that the greater publication of FLSs since 2005 has mainly been driven by an increase in positive FLSs, with little change in the amount of pessimistic forecasts. This disclosure effectively enhances the information environment for investors, making the market better informed—an unintended benefit of the original legislation. In short, when everyone has to declare their risks, the market becomes more efficient for all participants.