Litigation Risk and the Optimism in Long-horizon Management Forecasts of Bad News and Good News

This study investigates the framework of how litigation risk affects management forecasting of bad news and good news differently, resulting in differential optimism in these forecasts. I argue that distinct stock price patterns following these two types of management forecasts expose them to differential litigation risk ex post. While optimistic management forecasts of good news attract lawsuits, truthful rather than optimistic forecasts of bad news are more likely to trigger immediate lawsuits. As a result, managers adjust the optimism in bad and good news forecasts differently to reduce litigation risk. Consistent with my hypotheses, I find that ex ante litigation risk increases the optimism in bad news management forecasts but does not change the optimism in good news management forecasts, and the optimism in bad news management forecasts is higher than that in their good news counterparts. In addition, I use RegFD as a natural setting to demonstrate how arguably exogenous shocks amplify this effect. It appears that litigation risk in the pre-RegFD period is not sufficient to affect management forecasting behavior, and my findings only exist in the post-RegFD period. Last, I present evidence that is consistent with investors correctly perceiving and responding to the relative bias in bad new and good news management forecasts.