Risk Factor Disclosure Complexity and Litigation Risk : Evidence from Textual Analysis

Risk factor disclosures were mandated as a discussion of risks faced by the firm. However, industry has criticized them as being unclear and uninformative. A major reason cited for this is firms’ defensive approach to risk factor disclosures, which involves discussing all possible risks to shield them from potential shareholder lawsuits. Using Liberal court, an exogenous measure of litigation risk, I examine the direct impact of litigation risk on the complexity of risk factor disclosures. I predict and find that, when firms anticipate a higher risk of shareholder litigation, their risk factor disclosure language shows more complexity, an effect which is stronger for bad news firms. In further tests, I find that this complexity is associated with greater information asymmetry, thus closing the link between complex risk factor disclosures and informativeness. Overall, my results are consistent with the argument that firms use risk factor disclosures to seek safe harbor from litigation and in the process, make the language complex and less informative