Risk Management

Disclose Earlier, Cut Your Damages Later

Revealing the possibility of bad news before it becomes a certainty can mitigate damages in the event of a securities class-action lawsuit, suggest...
David KatzFebruary 22, 2006

What did we know, and when did we know it?

In slightly different form, that phrase became notorious during the Watergate era. Today, suggests a new study, it can also guide senior finance executives in assessing the legal risks that their companies would face should they be forced to restate financial results.

Those risks can arise when a company discloses an omission or misrepresentation of material information later than it might have, according to David Tabak, a senior vice president at New York-based NERA Economic Consulting. In his working paper “Risk Disclosures and Damages Measurement in Securities Fraud Cases,” Tabak suggests that if plaintiffs in a securities class-action lawsuit prove that tardy disclosure caused them to lose money, the damages they collect could well be higher.

Indeed, those legal risks appear to be on the rise, triggered by the current surge in restatements. According to shareholder advisory firm Glass, Lewis & Co., 971 public companies restated their earnings in the first 10 months of 2005 compared with 619 in all of 2004, USA Today reported late last year.

Given the increasing potential for shareholder lawsuits, Tabak believes that top managers should give greater weight to the option of revealing the possibility of bad news before it becomes a certainty. The realization of such perils as an adverse interest-rate movement, a product failure, or an impending government probe “could easily lead to a large decline in a company’s stock price” — a greater decline, he asserts, than what would have occurred earlier if the company had merely disclosed the probability that an event would take place.

That reasoning figures prominently in the damages assessment of a securities-fraud case. Courts begin that assessment by gauging “the artificial inflation” of the company share price over its “true value,” according to Tabak. The true value, he notes, is what “the price would be if defendants corrected any previous misrepresentations or unlawful omissions of information.”

In other words, a company that makes such a disclosure would enable the market to factor the risk into the company’s share price. At the time of the disclosure, since there would be little or no artificial share-price inflation, the company would have little or no liability.

On the other hand, a company that fails to make such a disclosure, or that spreads disinformation, would not allow the market to take the risk into account, and investors might pay too much for their shares. Later, once the misrepresentation is revealed and the share price drops, those investors might very well sue to recover their financial loss.

Risks do not always turn into reality, of course. A company might make a disclosure and experience some decline in its share price; later, when the possible bad news hasn’t come to pass, managers might rue that the share price took a hit. But such regret might be a small price to pay for the good night’s sleep that comes from knowing that a shareholder suit isn’t in the offing.