How Markets Punish Material Weaknesses

A new report examines shortcomings that lead to losses in share price; Sarbanes-Oxley requirements are understood poorly by investors, say some observers.

Not surprisingly, companies that disclosed a material weakness were treated more kindly by the market if they filed their annual reports on time. On average, the day after an on-time disclosure, company share prices dropped 0.31 percent relative to market movement; after 7 days, 0.85 percent; after 30 days, 2.91 percent; and after 60 days, 4.12 percent. Even “using the 15-day or 45-day extension didn’t seem to bother investors as much,” Glass Lewis found.

And as for late filers? Companies that let their deadline pass “without filing a management report or auditor opinion on the effectiveness of internal controls,” the study found, saw their share prices drop an average of 2.13 percent after one day; after 7 days, 2.89 percent; after 30 days, 3.81 percent; and after 60 days, 7.01 percent.

Average Share Price Movement by Filing Time,
Relative to Market, vs. Seven Days before Announcement
Filing Time of 10-K 1 day after 7 days after 30 days after 60 days after
On Time -0.31% -0.85% -2.91% -4.12%
15-Day Extension 0.14% -0.45% -0.30% -2.67%
45-Day Extension -0.95% 0.04% -2.43% -3.28%
Late Filer -2.13 -2.89% -3.81% -7.01%
Sources: Glass Lewis, FactSet.

Glass Lewis observes that as investors spend time vetting the facts and figures accompanying disclosures of control deficiencies — that is, as the underlying reasons “sink in” during the first 7, or 30, or 60 days — some of them invariably sell off stock of the company in question.

That’s not true for everyone, however. Michael Crofton, president and chief executive officer of The Philadelphia Trust Co., which manages $1.5 billion in assets for institutional and individual investors, says he uses deficiency disclosures to help identify buying opportunities.

Irrational market reactions, such as temporary stock dips caused by material-weakness disclosures, can be “opportunistic points of entry,” says Crofton. Many of these reactions, he contends, are due to stock dumping by hedge funds, performance-driven mutual funds, or other investors overly concerned with near-term gains. If Philadelphia Trust’s analysis indicates that a company is fundamentally sound, adds Crofton, during the dips he’ll snatch up shares that may have been too expensive at pre-disclosure prices.


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