At Watchdog Research our team analyzes public company disclosures and summarizes that information in an easy-to-use report. Our reports include 29 different categories, and each one is assigned a green, yellow, or red flag. These flags have helped our D&O Subscribers assess and price risks into their premiums in a way that is easy to understand for their clients.
Categorizing the data allows our team to see patterns in the data from the past that allow us to make reasonable predictions about the future. Two members of our team, Joseph Burke PhD and Joseph Yarbrough, PhD, analyzed our data to see which data points corresponded with an increased risk of securities litigation and published their findings on Google Scholar.
There are many interesting facets to their paper, but one of the most interesting was identifying six flags that were leading indicators of securities litigation. These flags all corresponded with a statistically significant increased risk of litigation the year after they were assigned.
1. Yellow Flag for Non-Audit Fees
When a company reports on its audit fees, they will distinguish between audit fees and non-audit fees. Non-audit fees consist of fees paid for something other than the independent audit. High non-audit fees can potentially compromise the independence of the auditing firm.
Importantly, a spike in non-audit fees could indicate that the company is experiencing some sort of problem that they are attempting to address internally with the help of their auditor. For example, Under Armour had a dramatic spike in non-audit fees the year before they revealed they were under investigation by the SEC, resulting in a damaging lawsuit.
2. Yellow Flag for Cybersecurity Breach
Cybersecurity is an area of increasing concern to companies. A significant breach can lead to immediate negative effects on stock price, loss of goodwill, customer complaints, and lawsuits. But the problems are not merely immediate, they can create long lasting problems and create an elevated risk of a damaging lawsuit for a least a year.
3. Yellow Flag for a Beneish M-Score
The Beneish M-Score is a statistical model that uses financial ratios of certain accounting data to determine the probability that a company is manipulating its financial results. The model became known when some students at Cornell used it to assert that Enron was manipulating its results.
There are tools online that will allow anyone to measure a company’s Beneish M-Score for themselves, we also provide one in every Watchdog Report (if there is adequate information for the analysis).
4. Red Flag for CFO Change
CFO changes are common and can be a sign of a healthy corporate culture. But rapid changes are a cause for concern, especially when the reason for the departure is vague.
Once again Under Armour is emblematic; within a year of being appointed CFO, the new hire resigned for “personal reasons.” The next year, Under Armour was embroiled in litigation.
5. Red Flag for Securities Class Action Litigation
Once an event happens once, it is more likely to happen again. Our research indicates a securities class action suit more than doubles a company’s chance of having a securities lawsuit the following year.
This is no surprise to those familiar with insurance, but what may be surprising is that there is another flag which has a stronger predictive factor.
6. Red Flag for Revisions
Over twenty percent of companies that filed a revision were subject to a new lawsuit the following year. One would expect that a lawsuit would follow quickly on the heels of a restatement, but our research shows that a restatement is often only the beginning of a company’s legal woes.
If you want to understand how this research was conducted or dig deeper into the details, we encourage you to look at our research report, available for free on google scholar. Oftentimes, companies will have multiple flags related to litigation, our Gray Swan Event Factor estimates every company’s probability of incurring a securities class action suit over the next 12 months.
Retail Investors get free access to our Watchdog Reports. Institutional Investors and those interested in our Gray Swan Event Factor can subscribe, or call our subscription manager, at 239-240-9284.
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