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We examine the effect of litigation risk on managers' decision to issue earnings forecasts. We use a new ex ante measure of litigation risk, namely, the Directors and Officers liability insurance premium. This choice bypasses significant problems associated with the estimation of ex ante litigation risk in prior studies. By using this measure of litigation risk, our results are more intuitively appealing. We find that when faced with ex ante litigation risk, managers with bad news are more likely to issue an earnings warning. For good news firms, we do not see this effect. We also examine three forecast characteristics: forecast horizon, extent of news revealed and forecast precision. Firms with higher litigation risk tend to issue earnings forecasts earlier if they have bad news but not so when they have good news. They also reveal less news in the forecasts if they have good news. As litigation risk increases, bad news earnings forecasts become more precise. Good news earnings forecasts, however, tend to become less precise relative to bad news forecasts. This differential effect of litigation risk on management earnings forecasts, based on the direction of news, has not been documented by previous studies.
We examine whether the post-earnings announcement drift (PEAD) varies cross-sectionally with short-horizon return predictability from order flows, which characterizes the information environment and reflects the extent to which information is efficiently impounded in prices. We first demonstrate that this proxy for market efficiency (developed by Chordia, Roll, and Subrahmanyam 2008) captures the degree of market frictions that limit arbitrage activities. We then present evidence that the inverse of short-horizon return predictability is negatively associated with the PEAD and remains statistically and economically significant after controlling for a wide range of explanatory variables used in prior research. Finally, although we find that profits of implementing the PEAD trading strategy are significantly reduced by transaction costs, we demonstrate that profits continue to remain statistically and economically significant for the less efficient firms that face otherwise higher barriers to arbitrage. Our results indicate that short-horizon return predictability from order flows better explains stock returns after earnings announcements.