Political Uncertainty and Firm Disclosure

Audra Boone is the C.R. Williams Professor in Financial Services at the Neeley School of Business at Texas Christian University. This post is based on a recent paper authored by Dr. Boone; Abby Kim, Financial Economist at the U.S. Securities & Exchange Commission (SEC); and Joshua White, Assistant Professor of Finance at Vanderbilt University’s Owen Graduate School of Management. The views expressed in the post are those of Dr. Boone and do not necessarily reflect those of the Securities and Exchange Commission, the Commissioners, or the Staff.

Recently, there has been an increasing focus on how political uncertainty affects economic activity. Elections, in particular, generate uncertainty regarding future governmental policies that could impact firm cash flows. Academic research shows that firms often respond by reducing capital raising and investment activities (e.g., Baker et al., 2016; Jens, 2017). Importantly, declines in real activity can have negative long-term consequences for the firm and its investors. Therefore, it is important to understand the actions managers can take to mitigate such effects.

In our paper, Political Uncertainty and Firm Disclosure, recently made public on SSRN, we examine how political uncertainty affects a firm’s mandatory and voluntary disclosure properties. We posit that a reduction in real activities prior to an election could influence a firm’s information environment through a corresponding decline in required public disclosures. Consequently, there would be less ongoing information produced by firms during periods of heightened political uncertainty, thereby exacerbating information asymmetries between managers and investors. Given that managers likely possess better information on how government policy changes could impact firm cash flows, we study whether managers alter their disclosure properties to ameliorate the effects of political uncertainty.

In our analyses, we investigate the uncertainty generated from U.S. gubernatorial elections during portions of the past three decades. Governors hold significant executive powers, such as appointments and budgetary development, that affect local firms through taxes, incentives, and employment. Therefore, policies at the state level can significantly impact firm profit. Moreover, the staggered nature of governor election cycles across states and years generates cross-sectional variation in political uncertainty, yielding a set of control firms to account for macroeconomic factors or other time trends that could affect disclosure.

We first assess variation in market quality measures to verify that security prices reflect elevated uncertainty during election periods. Using panel data regressions, we find that firms headquartered in election states experience deteriorations in firm-level stock and option volatility, liquidity, and information asymmetry during the four months prior to a governor election. Significant declines in market quality begin as early as July and generally begin to rebound shortly after the election outcome in November. This evidence confirms the heightened uncertainty associated with the election and offers one motivation for why managers would respond by altering disclosure properties.

For our disclosure analysis, we employ the frequency and properties of material events reported on SEC Form 8-K. Such disclosures arise from both mandatory events, as specified by the SEC, and from voluntary information that managers choose to supply to the capital markets. Additionally, we examine voluntary disclosure via management earnings forecasts, which are an important source of value-relevant information.

Using a difference-in-differences approach, we find that, on average, firm-level mandatory disclosure frequency and clarity declines prior to a governor election. Content analysis reveals that firms in election states provide fewer mandatory disclosures of events corresponding to investment and capital raising during this period. These declines are consistent with prior work documenting reductions in real activities for firms exposed to a governor election. Consequently, the capital markets receive less ongoing information about firm activities thru mandatory SEC disclosures.

A different trend emerges in voluntary disclosure patterns. Managers tend to supply more discretionary 8-K disclosures during the months just prior to an election. The preponderance of this increase stems from Regulation Fair Disclosure filings that contain information such as material developments involving key products, customers, or employees. We also observe a higher propensity for election firms to issue annual management earnings forecasts, and these forecasts tend to be timelier with no reduction in accuracy. Thus, managers adjust information flow dynamically in response to fluctuations in transitory uncertainty associated with political uncertainty. This finding is novel because prior work predominantly focuses on managerial response to exogenous, but permanent, changes in the information environment (Armstrong et al., 2014; Balakrishnan et al., 2014).

We next investigate whether the degree to which managers adapt their voluntary disclosure during election periods is related to changes in mandatory disclosure. We find that managers of firms in election states with increases or no decline in year-over-year mandatory disclosure filings supply additional voluntary disclosure. Yet, managers do not curtail discretionary disclosure when firms have fewer mandatory filings during an election year. These findings indicate that voluntary disclosure complements mandatory information in this setting.

Our final tests examine whether altering disclosure patterns attenuates declines in market quality due to political uncertainty. We find that firms increasing their mandatory and voluntary disclosure experience less deterioration in market quality measures prior to an election. Although this test does not establish a causal relationship, the association suggests that greater information transfer benefits firms and investors during periods of elevated policy uncertainty. Collectively, our study demonstrates that managers take actions to ameliorate the effects of transitory uncertainty shocks through public disclosures.

The complete paper is available for download here.

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