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

This study investigates risk factor disclosures under the voluntary, incentive-based disclosure regime provided by the safe harbor provision of the Private Securities Litigation Reform Act and the SEC’s subsequent disclosure mandate. 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. 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 mandated. Overall, the results suggest that for some firms voluntary disclosure of risk factors is not a substitute for a regulatory mandate.