Risk Management

Upbeat Words in Earnings Statements Can Get You Sued, Research Shows

Companies that use overly optimistic language in earnings releases are 75% more likely to get sued after their stock performs poorly than companies...
Sarah JohnsonJanuary 30, 2012

CFOs should carefully vet the words their companies use in earnings releases and other publicly disseminated documents about financial results — or those words could come back to haunt them.

Academic researchers recently concluded that companies that use overly optimistic language in earnings releases are 75% more likely to be sued after their stock performs poorly than companies that used more moderate language before a stock dip. Shareholder lawsuits following negative stock returns that cite CEOs, CFOs, and the company as defendants will often quote text in quarterly updates to back up the claim that the executives used materially misleading statements.

The researchers based their conclusion on a review of 165 companies that were accused of securities fraud in federal court. The cases alleged that the companies made material misrepresentations and omissions about their financial health and their future prospects. The academics compared those firms to another 165 companies with similar characteristics and economic declines that were not sued. Those that were hit with court documents had used more upbeat language in their earnings releases. “The results suggest that executives’ optimistic language can result in them getting sued,” says Jonathan Rogers, an associate accounting professor at the University of Chicago. His paper appeared in the American Accounting Association’s Accounting Review.

Although the researchers didn’t break out which words in particular kept cropping up in the suits they reviewed, “strong” did seem to be used frequently by the sued firms to describe how some areas were performing. Other examples could be an executive quoted as saying he is “very pleased” with the company’s historical results or a company mentioning customer-satisfaction scores that are better than those of its competitors.

While such derivative lawsuits are unlikely to reach the trial stage, they create a distraction for the CFOs and other managers cited in them, and can cost a company in terms of time, legal fees, and, possibly, settlement agreements, Rogers notes.

To lessen their risk, the researchers suggest managers “dampen the tone of their earnings announcements either by decreasing their use of positive language or by tempering their optimism with statements that are less favorable.” They don’t suggest that companies eliminate optimistic words altogether.

Many derivative suits will cite phrases pulled from these publicly available documents as a way to support the argument that a company and its managers were misleading. However, attorneys representing companies are usually able to get the courts to disregard such statements by calling them “puffery” and insisting the language should not be considered a material statement of fact. That doesn’t always happen, though, causing some uncertainty over how these cases will play out, the researchers note.

Another way to lessen the risk of litigation, the researchers suggest, is to make sure that company insiders are not selling their company stock in a way that would contradict any optimistic tone used in company releases. Insider sell-offs don’t necessarily raise a company’s litigation risk but could help fuel arguments used in shareholder litigation, they note.

Another defense, of course, is truth. Truthful, honest executives are less likely to be sued. Executives always need to be careful of the tone they use, whether in written form or in their talks with investors. And consistency may be key for expressing the truth to investors, some of which are more likely to notice a shift than others.

Hedge-fund managers, for example, will go to every sell-side conference to see if a certain CFO’s body language changes, looking for hints as to where the company is headed, says Beth Saunders, Americas chairman of FTI Consulting’s Strategic Communications practice. Her company helps executives prepare for interactions with shareholders. “A really good CFO shows believability,” she says. “Whether you are saying good or bad things, the only way you can be believable is to be who you are.”