Carrot or Stick? The Shift from Voluntary to Mandatory Disclosure of Risk Factors

This study investigates risk factor disclosures, examining both the voluntary, incentive-based disclosure regime provided by the safe harbor provision of the Private Securities Litigation Reform Act as well as the SEC's subsequent mandate of these disclosures. Firms subject to greater litigation risk disclose more risk factors, update the language more from year to year, and use more readable language than firms with lower litigation risk. These differences in the quality of disclosure are pronounced in the voluntary disclosure regime, but converge following the SEC mandate as low-risk firms improved the quality of their risk factor disclosures. Consistent with these findings, the risk factor disclosures of high-litigation-risk firms are significantly more informative about systematic and idiosyncratic firm risk when disclosure is voluntary but not when disclosure is mandatory. Overall, the results suggest that for some firms voluntary disclosure of risk factors is not a substitute for a regulatory mandate.