The credit relevance of litigation materiality disclosures

This study examines whether a firm's summary statement about the materiality of pending litigation provided within Item 3 (Legal Proceedings) and/or the contingency notes of its annual report captures credit-relevant information about the firm's litigation contingencies. This aggregated and forward-looking disclosure appears to reveal either (1) the more uncertain and unfavorable information that pending litigation is potentially material or (2) the more certain and favorable information that pending litigation is not expected to be material. If textual variation in this seemingly boilerplate disclosure indeed captures relevant information about a firm's litigation, then it should be associated with measures of credit uncertainty and the cost of debt capital. Using a hand-collected and manually-analyzed sample of materiality statements from the litigation disclosures (Item 3 and/or contingency notes) in the 2010 annual reports of S&P500 firms, I find that firms disclosing pending litigation is potentially material have greater credit uncertainty (more bond rating disagreement), worse credit quality (worse bond ratings), and a higher cost of debt capital (higher bond yields) than firms disclosing pending litigation is not expected to be material. The nature (e.g., class action status) and not necessarily the quantity of the lawsuits relative to the firm's size as well as the potential threat of shareholder litigation are determinants of this materiality disclosure. And, for the small minority of S&P500 firms that separately disclosed litigation-related charges in the subsequent period, I find that firms disclosing pending litigation is potentially material accrue a larger litigation-related charge than firms disclosing pending litigation is not expected to be material. These findings suggest that a firm's general litigation materiality disclosure captures credit-relevant information about the firm's pending litigation -- specifically, information about the importance of the litigation and expected litigation losses.