Safe Harbor Law Boosts Corporate Information Flow

Two and a half years ago, Congress passed a controversial "safe harbor" law. It is part of the Private Securities Litigation Reform Act of 1995, which is aimed at reducing frivolous shareholder lawsuits. The safe harbor law instituted a variety of safeguards, including legal protection for executives making financial projections. So long as they made cautionary statements about factors that could affect actual performance, executives--who had become increasingly wary about disclosing information--could be more generous with forecasts. The law also required plaintiffs to prove that incorrect forecasts had been purposely misleading. Critics feared the new law would license executives to stretch the truth with rosy profit projections in order to drive up stock prices.
       What has happened since the law took effect? Have management forecasts of corporate performance become overblown and inaccurate? Two Stanford Business School faculty members, Karen Nelson and Ron Kasznik, both assistant professors of ac-counting, believe that the new law has had a positive effect. Their conclusions are based on a recently completed study of 547 computer, software, and drug firms. With Marilyn Johnson, assistant professor of accounting at University of Michigan Business School, Kasznik and Nelson examined 1,178 earnings and sales forecasts issued by these firms during 1994 and 1996, the years immediately surrounding the reform act's passage.
       Although the Securities and Exchange Commission reported last year that the new law had little effect on corporate disclosure, the researchers found otherwise. "We discovered that there was a significant post-act increase in both the frequency of firms issuing forecasts and the average number of forecasts firms issued," says Nelson. The increase in forward-looking disclosures is primarily attributable to managers issuing more long-horizon forecasts of good news and short-horizon forecasts of bad news.
       There is also evidence that managers provided more detailed forecasts after the safe harbor law passed, particularly for computer and software firms. The researchers suggest that managers were less hesitant to disclose certain details, such as narrower ranges of expected future earnings and sales, because of the protection afforded by the safe harbor law.
       "We also looked at what actually happened compared to what managers said would happen," says Nelson. They found that the increase in disclosure was not accompanied by a deterioration in the quality of the information released. Despite critics' fears, forecasts issued after enactment of the safe harbor law were no more optimistically biased than those issued previously, according to the study. "Investors have been clamoring for more forward-looking information," says Nelson. "It appears that with the new safe harbor law, companies are responding."

By BARBARA BUELL

"The Impact of Securities Litigation Reform on the Disclosure of Forward-Looking Information by High-Technology Firms," Marilyn Johnson, Ron Kasznik, and Karen K. Nelson, GSB Research Paper #1471, January 1998.

Forecasts were no more optimistically biased than those issued previously.