Tone Management and Litigation Concerns in CEOs’ Early Years

Although over-optimistic disclosures have been found to increase the likelihood of shareholder litigation, this finding has been largely ignored in the context of newly appointed CEOs’ disclosure choices. Addressing this gap, our study examines the variation in CEOs’ tone management strategies in their early years of tenure, here as stimulated by their ex ante litigation concerns (in addition to the well-documented career concerns). Based on a textual analysis of the 10-K filings of US nonfinancial firms during 1993–2022, we use the abnormal tone of earnings-related disclosures to measure strategic tone—a linguistic tool used by managers to influence the perceptions of capital market participants. We find that high litigation concerns are, on average, associated with a greater downward tone management (or over-pessimism) in CEOs’ early years, even after controlling for the ‘big bath’ phenomenon, as well as a tendency to manage earnings upward on account of career concerns. Furthermore, this over-pessimism is found to be uninformative about future earnings or operating cash flow. This suggests that managers employ this over-pessimistic strategy in response to their high litigation risk exposure rather than to inform market participants about their firms’ prospects. Finally, we document that a rich firm information environment—which renders low information asymmetry between firms and outside stakeholders (thus attenuating CEOs’ information advantage)—dampens new CEOs’ tendency to adopt this particular disclosure strategy.