Strategic silence has long been regarded as a precise weapon in the world of interpersonal communication, a way to let a point resonate or force an opponent into speech. But in the business world, strategic silence can have devastating effects. Matthew Cedergren, an accounting professor at Wharton, examines the correlation between management behavior and potential for litigation.

In their study, “Strategic Silence, Insider Selling and Litigation Risk,” Cedergren and co-author Mary Brooke Billings, an accounting professor at New York University’s Stern School of Business, find that plaintiffs considering a lawsuit against a firm give serious weight to whether the manager went above and beyond normal reporting and disclosure requirements each quarter.

An edited transcript of the conversation appears below.

The Link between Disclosure and Litigation

My research focuses on the interaction among firm disclosure behavior, insider trading and litigation outcomes. I examine the kind of settings that lead managers to provide forecasts with their quarterly earnings release or whether they decide to withhold those forecasts, and whether incentives or the desire to reduce the likelihood of litigation play a role in that. What are the determinants of whether management decides to go above and beyond providing the normal required accounting disclosures every quarter and provide more qualitative or more subjective forecasts of the company’s future prospects?

“The main takeaway for managers who are aware of an upcoming earnings disappointment is that warning ahead of time can save a lot of headaches down the road in terms of litigation.”

In a recent study, my co-author and I examined a sample of firms that announced disappointing quarterly earnings and whether or not firm managers gave any warning about it prior to the announcement. We find that when company managers sell more of their own shares in the firm, after the prior quarter’s earnings announcement, they’re much less likely to warn about the current quarter’s earnings disappointment so as not to dampen the share price when they sell. We call this behavior “strategic silence.” What’s more interesting is when we bring litigation into the story. We find the likelihood the firm will get sued after the earnings disappointment is related to both strategic silence and insider selling, and there’s an interactive effect between the two, meaning that silence and selling enhance the effect of each other in predicting litigation.

Key Takeaways

The main takeaway for managers who are aware of an upcoming earnings disappointment is that warning ahead of time can save a lot of headaches down the road in terms of litigation, especially if they’re planning to divest or sell off some of their own holdings in the firm after the earnings announcement. This is a key behavior that potential plaintiffs look for when deciding whether or not to initiate class action litigation against the firm.

What’s Next

We’re now looking at what happens to the firm’s disclosure and trading behavior after the firm gets sued. We know from our prior study that silence and inside selling both affect the likelihood of the firm getting sued. But what happens to that behavior after the lawsuit? Does the lawsuit instigate changes in whether or not managers are much more likely to warn of an earnings shortfall after they get sued? Are firms much more likely to have their managers engaging in selling prior to an earnings shortfall? Does a lawsuit actually instigate changes in behavior in these dimensions?