Seasoned equity issuers’ prospectus filings: How informative is their tone?

• Published date: 01 May 2022
• Author: Rongbing Huang,Hong Qian,Santhosh Ramalingegowda
• Date: 01 May 2022
• DOI: http://doi.org/10.1111/fire.12296

DOI: 10.1111/fire.12296

ORIGINAL ARTICLE

Seasoned equity issuers’ prospectus filings: How

informative is their tone?

Rongbing Huang1Hong Qian2Santhosh Ramalingegowda3

1Department of Economics, Finance, &

Quantitative Analysis, Coles College of

Business, KennesawState University,

Kennesaw,Georgia, USA

2Department of Accounting and Finance,

School of Business Administration,Oakland

University, Rochester, Michigan, USA

3J.M. Tull School of Accounting, TerryCollege

of Business, University of Georgia, Athens,

Georgia, USA

Correspondence

RongbingHuang, Department of Economics,

Finance,& Quantitative Analysis, Coles Col-

legeof Business, Kennesaw State University,

Kennesaw,GA, USA.

Email:rhuang1@kennesaw.edu

Qianacknowledges financial support from

theFaculty Research Fellowship at Oakland

University.We thank Michael Goldstein (the

editor)for useful comments. Special thanks are

owedto Jay Ritter and an anonymous referee

fordetailed and insightful comments. We also

thankColes College’s two anonymous referees

fortheir comments on an earlier version of this

papersubmitted to the Coles Working Paper

Series.

Abstract

Seasoned equity issuers file Forms S and 424B with the

Securities and Exchange Commission. We find that 424B

filings’ weak-modal tone is positively related to offer price

discounts and negatively related to offer-day stock returns.

Increases in cautionary (weak-modal, uncertain, and neg-

ative) tone from the initial to final filing are followed by

lower abnormal stock returns. Preliminary evidence indi-

cates that cautionary tone relates positively to litigation risk

and increased after the passage of the Sarbanes-Oxley Act.

Our findings suggest that the cautionary tone of seasoned

equity issuers’ prospectuses has negative information con-

tent, which is gradually incorporated into the stock prices.

KEYWORDS

disclosure, SEO, textual analysis, tone

JEL CLASSIFICATION

G14, G18, G24

1INTRODUCTION

When firms conduct seasoned equity offerings (SEOs) in the United States, they file Form S (preliminary prospectus)

and Form 424B (final prospectus) with the Securities and Exchange Commission (SEC). In this paper,we use textual

analysis to identify uncertainty words (e.g., may,could,approximately,believe,risk),weak-modal words (a subset of the

uncertainty words), and negativewords (e.g., loss,adversely) in the prospectus filings for a sample of SEOs from 1998 to

2016.1Three tone measures are then defined as the proportions of the three types of words in each prospectus. We

1These word lists were created byLoughran and McDonald (2011) in a business context. The Loughran and McDonald word lists have become increasingly

popularin recent studies (e.g., Berns et al., 2022; Ertugrul et al., 2017; X. Huang et al., 2014).

Financial Review. 2022;57:369–395. wileyonlinelibrary.com/journal/fire ©2022 The Eastern Finance Association 369

370 HUANG ETAL.

view a higher value of each measure as reflecting more cautionary tone. We find that the uncertain and weak-modal

tone measures and their changes during the registration period (i.e., from the initial S filing to the 424B filing) are pos-

itively related to the offer price discount. The weak-modal tone measure and its change during the registration period

are negatively related to the issuer’s stock return on the offer date. The changes in all of the three tone measures dur-

ing the registration period are negatively related to the abnormal stock return during the ten days after the SEO.We

also find that the tone of SEO prospectuses became more cautionary after the passage of the Sarbanes-Oxley Act of

2002 and that SEO firms in industries with higher litigation risk use more cautionary language.

Security issuance prospectuses disclose all material information, including both hard and soft information, that

primary-market investors need to know before buying the securities. Theytypically contain planned or final offering

terms, business descriptions, financial statements, risk disclosures, and forward-looking statements. Textual analy-

sis is increasingly important for uncovering soft information in corporate disclosures (Li, 2010a; Loughran& McDon-

ald, 2016, 2020). In contrast to hard information such as quantitative information in financial statements, the tone of

prospectuses can be viewed as a type of soft information.

Several papers haveexamined the tone of prospectuses for initial public offerings (IPOs). Loughran and McDonald

(2013) document that the proportions of uncertainty and negative words in S-1 filings are positivelyrelated to under-

pricing, absolute offer price revisions, and subsequent return volatility.Ferris et al. (2013) find that the proportion of

negativewords in IPO prospectuses is positively related to underpricing. However, to the best of our knowledge, there

is little prior research on the tone of SEO prospectuses. Whereas mandatory disclosures (e.g., 10-Ks and 10-Qs) and

analyst coverageare typically unavailable prior to IPO prospectus filings, they are often readily available prior to SEO

prospectus filings. Furthermore, unlike IPO firms, SEO firms have stock prices prior to the offering that presumably

already reflect any hard or soft information implied by the 10-K and 10-Q documents. Therefore, on average, SEO

investors likelyincur lower information production costs than IPO investors.

However,SEO firms can still reveal new information in the prospectuses. Chemmanur et al. (2020) suggest that SEO

underwriters play an important role in disseminating information to institutional investors. The tone of SEO prospec-

tuses may be informativeto primary- and/or secondary-market participants. If such issuer-revealed information is not

reflected in the secondary-market price immediately prior to the offer,it is important to know whether the issuer and

underwriters incorporate it into the offer price and how the secondary market reacts to it. Our paper sheds light on

the informativeness of the tone of SEO prospectuses, the interaction between the primary and secondary markets,

and the efficiency of SEO pricing.

Initial S filings for SEOs often do not provide a file price range, the number of shares filed, or some other details.

However, 424B filings contain important updates and supplemental information to the initial S filings, including the

offer price and the number of shares offered. These updates in the 424B filings may reflect information uncoveredby

underwriters through due diligence and information collected from primary-market investors, typically institutional

investors,during the roadshow. The tone of 424B filings, especially in the updated risk disclosures and forward-looking

statements, likely also contains important information that is not yet incorporated into the stock price at themarket

close of the day before the offer.

The literature suggests that cautionary tone reflects uncertainty (e.g., Loughran& McDonald, 2013). However, it is

possible that cautionary tone also captures negative information about future stock performance. Toavoid potential

investor lawsuits, managers want to inform investors about negative future outcomes in companyfilings (Field et al.,

2005; Hanley & Hoberg, 2012; Skinner,1997). Negative words help to convey negative information. However, instead

of discussing negative information in a straightforward manner or in absolute pessimistic tone, managers might use

weak-modal or uncertainty words to obfuscate negative information.2

2Uncertaintyand negative information content can be related. Holding the expected cash flows constant, greater uncertainty implies a higher discount rate

and a lower stock price. If a disclosure’s cautionary tone captures uncertainty that has not been reflected in the stock price, there should be a negative

abnormalreturn when the disclosure becomes public.