The effect of trade secrets protection on disclosure of forward‐looking financial information

• Date: 01 March 2020
• Published date: 01 March 2020
• DOI: http://doi.org/10.1111/jbfa.12418

DOI: 10.1111/jbfa.12418

The effect of trade secrets protection on disclosure

of forward-looking financial information

Yan L i1Yutao Li2

1Faculty of Business and Economics, University

of Melbourne

2Dhillon School of Business, University of

Lethbridge

Correspondence

YutaoLi, Dhillon School of Business, University

ofLethbridge Calgary Campus, 345 – 6 Ave S.E.

Calgary,Alberta, Canada, T2G 4V1.

Email:yutao.li@uleth.ca

Fundinginformation

Universityof Lethbridge, Grant/Award Number:

CREDO2017-2019

Abstract

Using the recognition of the Inevitable Disclosure Doctrine (IDD) by

US state courts as an exogenous shock to the risk of losing trade

secrets, this study examinesthe effects of trade secrets on disclosure

of forward-looking financial information. We find that management

earnings forecast frequency and forecast horizon increases after the

US state where a firm is headquartered starts to recognize IDD. We

also find that the effect of IDD recognition on management forecasts

is more pronounced for firms that have larger market shares, higher

product market competition, more intensive R&D, shorter distance

to their industry rivals, and more employeeswho possess knowledge

of the firms’ trade secrets.

KEYWORDS

competition, inevitable disclosure doctrine, knowledge economy,

knowledge workers, management forecasts, product market com-

petition, proprietary cost, R&D intensity, trade secrets, voluntary

disclosure

1INTRODUCTION

Information about a firm’s future prospects is valuable, because it can help to reduce information asymmetry in the

capital market and enhance firm valuation (Grossman, 1981; Milgrom, 1981). However,firms are unwilling to reveal

private information about their future profitability as such revelations mayenable their rivals to gauge future industry

demand and adopt operationaland marketing strategies that threaten the disclosing firms’ competitive advantage (e.g.,

Ali, Klasa, & Yeung,2014; Clinch & Verrecchia, 1997; Darrough & Stoughton, 1990; Li, 2010; Verrecchia, 1983, 1990;

Wagenhofer,1990).

While competitors can use the disclosing firm’s forward-looking financial information to envisage how much they

should produce, developing an effective plan to enter the disclosing firm’s product market space would require addi-

tional information, such as operational and marketing strategies,business plans, technical innovations, customer lists,

price lists and/orcost information, that is, information about a firm’s trade secrets. Trade secrets are a firm’s most valu-

able assets (Shapiro & Hassett, 2005) and play a crucial role in maintaining a firm’s competitiveadvantage (e.g., Barney,

1991; Flammer & Ioannou, 2015; Grant, 1996; Helfat et al., 2007; Kogut & Zander,1992; Mahoney & Pandian, 1992;

Png, 2017). Despite the importance of trade secrets for sustaining a firm’s competitive advantage, there has been no

J Bus Fin Acc. 2020;47:397–437. wileyonlinelibrary.com/journal/jbfa c

2019 John Wiley & Sons Ltd 397

398 LI ANDLI

study examining how trade secret information affects a firm’s incentives to disclose forward-looking financial infor-

mation. In this study, we use the staggered adoption of the Inevitable Disclosure Doctrine (IDD)by individual states

in the US to capture firms’ risk of losing trade secrets to rivals and examine the impact of tradesecret information on

firms’ incentives to provide forward-looking financial information, one of the most important types of information for

investors (Beyer,Cohen, Lys, & Walther,2010).

Almeling, Synder,Sapoznikow, McCollum, and Weader (2010) report that more than 75% of the trade secret cases

in US state courts and over 50% of the cases in US federalcourts involve an existing or former employee. The adoption

of the IDD by state courts allows an employer to obtain an injunction prohibiting a former employeefrom working for

a competitor.For example, in the court case of PepsiCo, Inc. vs. V. Redmond, the 7th Circuit ruling states that ‘Plaintiff

PepsiCo, Inc., sought a preliminary injunction against defendants William Redmond and the Quaker Oats Company

to prevent Redmond, a former PepsiCo employee, from divulging PepsiCo tradesecrets and confidential information

in his new job with Quaker and from assuming any duties with Quaker relating to beverage pricing, marketing and

distribution. The district court agreed with PepsiCo and grantedthe injunction. We now affirm that decision’ (PepsiCo,

Inc. v. Redmond, 1995, p. 1263). As adoption of IDD requires a delicate balance between protecting the interest of

employees and that of employers(Friedman, Landes, & Posner, 1991), state courts in the US exhibit different attitudes

in acceptance or rejection of the doctrine (Kahnke,Bundy, & Liebman, 2008). Recent studies show that the adoption of

the IDD significantly reduces employee mobility and knowledge spillovers (Png & Samila, 2015), decreases the risk of

a firm losing its competitive position in its product market (e.g., Klasa, Ortiz-Molina, Serfling, & Srinivasan, 2018; Png,

2017),increases barriers to entry (Gao & Wang, 2018), and enhances firm value (e.g., Castellaneta, Conti, & Kacperczyk,

2017; Klasa et al., 2018; Qiu & Wang, 2018).

We argue that trade secret protection laws can directly and indirectly affect firms’ incentives to provide forward-

looking financial information. First, the adoption of the IDD can reduce the risk that competitors obtain trade secrets

and design effectiveproduction plans or strategies to meet the future industry demand revealed in the disclosing firm’s

forecasts of future profitability, thus lowering the proprietary costs of disclosing forward-looking financial informa-

tion. In particular,in today’s knowledge economy, trade secrets have made products highly differentiated (Crittenden,

Crittenden, & Pierpont, 2015; Hannah, Parent, Pitt, & Berthon, 2014; Reitzig, 2004), and simply knowing the aggre-

gated demand for products is not sufficient for competitors to initiate effective operational plans to gain the market

share of the disclosing firm. For example,in the soft drink market, making information public about the future demand

for soft drinks maynot hurt the disclosing firm’s future profitability if its competitors do not have information about the

firm’s trade secrets on formulas, which are tailored to the tastes of specific consumers (for example,the soft drink for-

mulas for Pepsi vs. Coca Cola). In other words, in order to win the market share of the disclosing firm, competitors will

need both trade secrets and forward-looking financial information to initiate production plans or developentry strate-

gies. The adoption of the IDD better preserves trade secrets within the disclosing firm and therefore makes it more

difficult for rival firms to initiate effective production and/ordevelop strategies.1As a support, Png’s (2017) analytical

model predicts that strengthened trade secret protection laws deter competitors from developingsimilar products or

reverse engineering products that are similar to those protected bytrade secrets.

Second, adoption of the IDD could affect firms’ competitive position indirectly by reducing the agency costs

between shareholders and managers. As IDD adoption could reduce managers’ outside opportunities and managers

are bonded with their firms to a greater extent (Garmaise,2011; Png & Samila, 2015), managers tend to focus on long-

termperformance rather than short-term myopic behavior (Brochet, Loumioti, & Serafeim, 2015) and on strengthening

their firms’ competitive position.2Based on these arguments, we predict that IDD adoption leads to more disclosure of

forward-lookingfinancial information (H1). On the other hand, reduced outside opportunities would potentially induce

1Enhancedtrade secret protection law also reduces a firm’s incentives to reveal proprietary information on their 10Ks filings (Glaeser, 2018; Li, Lin, & Zhang,

2018),further adversely affecting rivals’ ability to gain access to proprietary information and develop operational and marketing strategy effectively.

2We thank the referee for suggesting the possible alternative mechanism through which the IDD affects firms’ competitive position and management

forecasts.

LI ANDLI 399

managerial myopicbehavior, for example, more earnings management to meet or beat short-term earnings targets and

reduction of discretionary spending including R&D and SG&A (Chen, Zhang, & Zhou, 2018). As a result of managerial

myopia, firms would experience poor long-term performance and not be able to maintain their competitive position,

resulting in less frequent management forecasts. Therefore, the effect of the IDD on management forecasts remains

an empirical question.

To empirically test the effect of IDD on management forecasts, we follow Bertrandand Mullainathan (2003) and

Armstrong, Balakrishnan, and Cohen (2012) and apply a difference-in-difference design based on the staggered recog-

nition of the IDD by US state courts. We use the frequency of management earnings forecasts and forecast horizons

to capture firms’ incentives to disclose forward-looking financial information (Ali et al., 2014; Huang, Jennings, & Yu,

2016; Li, 2010). More specifically,we analyze whether recognition of the IDD by state courts increases the frequency

and horizon of management earnings forecasts for firms in these states over the 1998–2011 period.3We find that

recognition of the IDD leads to more frequent management earnings forecasts and forecasts with longer horizons.

These results support the hypothesis that the protection of trade secrets potentially strengthens firms’ competitive

position and reduces the proprietary costs of disclosing forward-looking financial information. Our main results are

also robust to alternative research design including comparing forecasts of firms that located in the states recogniz-

ing the IDD during our sample period with those of firms in neighboring states and examining the timing effect of IDD

recognition on management forecasts.

Clinch and Verrecchia (1997) and Verrecchia (1983, 1990) suggest that information about future profitability is

most useful to competitors when the information is disclosed by firms that produce the most output of an industry,

i.e., when the proprietary content of forward-looking information is higher. If tradesecret protection law reduces the

proprietary costs of disclosing forward-looking financial information, we expect the effect of the IDD on management

forecasts to be stronger among firms with higher market shares (H2). Wefind evidence consistent with this prediction

that the effect of the IDD is significant in firms with market shares in the top 75th percentile of their industry, and is

not significant for firms in the bottom 25th percentile.

Competition affects a firm’s incentives to voluntarily disclose information (Clinch & Verrecchia,1997; Verrecchia,

1983, 1990) and trade secrets are crucially important in maintaining a firm’s competitive position in a product mar-

ket (Eisenhardt & Martin, 2000; Flammer & Ioannou, 2015; Helfat et al., 2007). We predict that IDD recognition has

a greater effect on the proprietary costs of the management forecasts of firms that face greater product market com-

petition (H3) and firms that have more trade secrets (H4). We use the product fluidity index developed byHoberg,

Phillips, and Prabahala (2014) and industry concentrationratio to gauge product market competition. We find that the

effect of IDD recognition on management earnings forecasts is greater when firms face higher product market com-

petition. Using distance to rivals (Klasa et al., 2018) to measure employees’ access to job opportunities of competing

firms, we find that the effect of the IDD is significant only in the subsample of firms with relatively shorter distance

to their rivals; using the intensity of R&D and the proportion of employees possessing trade secrets as proxiesfor the

importance of tradesecrets, we find that IDD recognition leads to more frequent earnings forecasts and earnings fore-

casts with longer horizons in firms with extensiveR&D expenditures and a larger proportion of employees with access

to trade secrets.

Toassess whether the increased management forecast frequency and horizon is due to the impact of the IDD on

managers’ incentives, we analyze the effect of the IDD on management forecasts conditioning on CEO duality, CEO

age and CEO tenure. We do not find conclusive evidence to support that the IDD affects management forecasts by

enhancing interest alignment between CEOs and shareholders. Finally,we find that after IDD recognition, stock trad-

ing liquidity around the announcement of earnings forecasts increases significantly, implying that management fore-

casts become more informative.

3We treat firms headquartered in states that recognized the IDD before 1998 as IDD firms for everyyear in our sample period. This approach follows prior

studieson the staggered adoption of state laws (e.g., Armstrong, Balakrishnan, & Cohen, 2012; Klasa, Ortiz-Molina, Serfling, & Srinivasan, 2018).