Why do firms keep silent about upcoming earnings disappointments?

Abstract

I investigate why the majority of firms do not issue earnings warnings in the face of upcoming earnings disappointments. SEC Rule 10b-5 imposes a duty on managers to correct or update when they discover that prior disclosures are misleading. I posit that managers assess the 10b-5 duty to disclose based on private information about optimism and misstatements embedded in their prior disclosures. Specifically, I hypothesize that managers who did not issue forecasts or managers who previously issued non-optimistic forecasts are more likely to be silent about upcoming earnings disappointments than managers who previously issued optimistic forecasts. I also hypothesize that managers who perceive that prior disclosures include misstatements that are difficult to verify in the court are more likely to remain silent than are managers who perceive that prior disclosures include misstatements that are easy to verify in the court. My results support these hypotheses. In additional tests, after controlling for the endogeneity between warnings and the likelihood of litigation, I find that earnings warnings issued by managers who perceive that they are not bound by a duty to disclose increase litigation risk. I also find that warnings by firms with misstatements containing less verifiable information do not reduce settlement costs when these firms are sued. Overall, my evidence indicates that when managers perceive that they have no duty to disclose, their earnings warnings are likely to have an adverse impact on litigation risk and, thus, managers are likely to remain silent to avoid this outcome.