They are among the most common of corporate communications to investors: forward-looking statements about company prospects, accompanied by warnings that these projections could differ materially from actual future results.
Commonplace though such cautionary disclaimers are, there is much controversy about their value.
Do they do more to foster useful information-sharing, or to give companies a license to lie? Do they keep investors from being unduly swayed by forward-looking statements, or are they more like water off a duck’s back?
The questions arise from a 1995 federal law, the Private Securities Litigation Reform Act (PSLRA). Specifically, the crux of the matter is a provision that offers companies a safe harbor from investor claims that forward-looking statements were misleading.
Such claims, the act provides, can be summarily dismissed in court if forward-looking statements were identified as such and were accompanied by cautionary disclaimers.
Now, a study in The Accounting Review, a journal of the American Accounting Association, suggests that the disclaimers do less to protect investors from being misled than to protect the companies that mislead them.
“Cautionary disclaimers provide nonprofessional investors little protection from the economic harm that can result from undue reliance on forward-looking statements,” write the study’s co-authors, H. Scott Asay of the University of Iowa and Jeffrey Hales of Georgia Institute of Technology.
In contrast, such disclaimers “reduce the extent to which participants feel they have been wronged and reduce the extent to which they believe they should be entitled to financial compensation for their losses.”
In sum, the professors add, “rather than countering decreased litigation risk with increased investor protections, cautionary disclaimers seem to tilt the balance even further in the direction of decreased litigation risk for firms.”
One key finding is that when nonprofessional investors are presented with either of two press releases announcing earnings results for the same company, one containing optimistic forward-looking statements and the other not, the former elicits a markedly higher valuation of the company.
The finding, the authors observe, “is consistent with regulatory concerns that investors may not sufficiently distinguish between the reliability of backward- and forward-looking statements.”
The research also finds that, although disclaimers alert investors to the potential of being misled by forward-looking statements, they have little or no effect on investors’ valuation of the company issuing the statements.
The study’s findings derive principally from two experiments carried out with subjects enlisted through a crowd-sourcing internet marketplace often used in social-science research.
In the first experiment, 241 participants were presented with brief background information about a hypothetical company described as “one of the world’s premier beverage companies, refreshing consumers for more than 60 years.”
Participants were asked how low or high they would value the firm’s common stock on a scale from zero to 100, after which they were presented with the company’s press release on its latest quarterly earnings.
The press release revealed results that fell short of expectations, but countered this disappointment with forward-looking statements providing reasons for future improvement. Half of the press releases also included a 120-word disclaimer cautioning readers not to place “undue reliance” on forward-looking projections, while the remaining press releases included no such warning.
Asked to respond on a scale of 1 (strongly disagree) to 7 (strongly agree) to a statement that the information in the press release was reliable, participants who received disclaimers averaged 4.86. Those who did not averaged 5.36 — a highly significant statistical difference.
But when participants were asked to provide revised valuations of the beverage company, the drop from their earlier estimates was roughly the same for the two groups.
That led the professors to observe that “cautionary disclosures are viewed by nonprofessional investors as informative warnings, but they have difficulty translating that belief into a change in how they view the prospects of the firm when making a valuation judgment.”
In the second experiment, 200 participants were given the same background information and earnings press release that were used in experiment 1. Once again, half of the press releases included a cautionary disclaimer about forward-looking statements and half lacking a disclaimer.
In addition, all participants were asked to assume that the press release had led them to increase their investment in the company and that its optimistic projections had failed to materialize resulting in a stock-price decline and a substantial personal investment loss.
Finally, half of the subjects in each group were informed that available evidence suggested management knew at the time of the press release that its positive forward-looking statements were false or misleading. The other subjects were told the statements reflected management’s true beliefs.
When told that forward-looking statements were made in good faith, participants indicated only mild feelings that they were entitled to financial compensation, regardless whether the earnings press release included a cautionary disclaimer.
But, when told management knew the statements to be false or misleading, not only did participants feel more strongly that they deserved compensation. they felt as such significantly more if there was no disclaimer than they did if there was one (4.35 versus 3.86 on a the 1-7 scale).
In other words, even when companies use forward-looking statements to mislead investors and it results in investment losses, cautionary disclaimers reduce feelings of being wronged and being entitled to compensation.
What might be done to better protect investors? The professors conclude that “collectively, our set of findings on disclaimers provides support for the recent erosion of safe harbor that has been occurring in courts, and together suggests that litigation reform may be needed to more effectively balance the needs of investors with protections afforded to firms.”
The study, “Disclaiming the Future: Investigating the Impact of Cautionary Disclaimers on Investor Judgments Before and After Experiencing Economic Loss,” is in the July issue of The Accounting Review.