Now that calendar year accelerated filers are putting the finishing touches on their internal control reports required by Sarbanes-Oxley Act Section 404, many are wondering how many companies will disclose one or more material weaknesses, and what the marketplace reaction will be.

Trying to forecast the number and impact is like forecasting earthquakes in California; we know they’re going to happen, but we don’t know how many or how severe they will be. In recent years, however, seismologists have sharpened their tools, and some believe they can predict with reasonable accuracy the timing and size of the next quake.

And while I’m hopeful that’s the case (especially because one of my sons lives in California), those tools really don’t help much when it comes to internal control reporting—we lack our own brand of industry seismologists.

In fact, no one I know is prepared to act as “internal control seismologist.” Even Securities and Exchange Commission Chief Accountant Donald Nicolaisen, who is uniquely positioned, has said: “I have heard widely differing predictions about the number of registrants who will report material weaknesses in internal controls. These predictions vary from a few percent to 10 percent, 20 percent or even more. I personally think it's too early to predict.” That was several months ago, and—because this is the first year of reporting under 404—we’re really not in a better position to make any reasonable predictions, and won’t be until a significant number of reports become available.

The same goes for market reaction; here too, we won’t know until it happens. But we can, however, make some reasonable assumptions about what to expect.

Type Of Company

From what I’ve heard, read, and discussed over the past year, the investor community expects smaller, younger public companies to have more difficulty with their internal controls than larger, well-established companies. If indeed investors, analysts, rating agencies and others don’t expect perfection—or at least a clean 404 report from management and the auditor—then there should be less adverse reaction to a small company reporting a material weakness.

Conversely, we might expect more of a reaction should a large company do so.

Another element that might be factored into the investor community’s reaction is the level of sophistication of the company and its industry. One would expect few if any problems with a “plain vanilla” widget maker, as compared to a company with hundreds of subsidiaries or business units in disparate industries located world-wide.

Nature Of The Weakness

This might be the most significant matter in the marketplace’s reaction. Consider a reported weakness in a company’s control environment, involving issues such as the integrity and ethical values of management, or the “tone at the top” of the organization. Or, where the audit committee is deemed deficient. Another serious matter: companies at which the CFO or chief accounting officer lacks the knowledge or experience to competently address the accounting and reporting issues the company faces.

One would expect, and I do, that these problems will be looked upon with concern.

On the other hand, an issue with controls in one particular location, or one particular account, or perhaps certain process or IT controls, might be viewed as having lesser consequence—these controls might be able to be fixed relatively easily, whereas repairing tone at the top is a colossal, complex undertaking that could penetrate all corners of the enterprise.

How Weaknesses Are Disclosed

How investors look at such weaknesses may well depend on the way in which they are disclosed. SEC officials, notably Donald Nicolaisen and Division of Corporation Finance Director Alan Beller, for months have been encouraging registrants to fully and clearly disclose any material weaknesses. Most recently, SEC Deputy Chief Accountant Andrew Bailey urged companies to “provide complete, robust, and transparent disclosures—don’t try to ‘disguise’ or ‘pretty up’ your material weaknesses.”

I suspect that those companies that follow this advice will do better in the marketplace than those that don’t. But more important will be the company’s disclosure regarding actions being taken to fix the problem. Almost certainly, if a company states that the problem existed as of year end but has since been fixed, we can expect little adverse reaction. The next-best disclosure would be a clear discussion of how the company is moving to remediate the weakness, a time frame for getting it done, and a convincing message signaling that management takes its responsibilities to do so seriously.

But if the disclosure is unclear, and there’s little indication that weaknesses will soon be corrected, we can expect a harsher reaction.

Further Reactions

There are at least two additional factors the marketplace might consider. One is that investors might not really care about the 404 reports. They might decide that with a “clean” audit opinion on the annual financial statements, they already have the desired comfort level with the reported numbers. And insofar as looking to the internal control report for comfort on the quarterly numbers going forward, they might take heed of the caution that the 404 report is as of year end, and one can’t project the conclusions to future periods. Thus, they might decide that a 404 report as of year end doesn’t provide much more comfort on future quarterly financial statements beyond that provided by the auditor’s review of those statements.

The second is that investors might care a great deal about the 404 reports, because—even if investors discount the additional comfort the reports might provide on annual or quarterly financial statements—the 404 reports might be seen as providing a “window” on managements’ concern with or ability to execute their governance responsibilities. In other words, existence of a material weakness might send a signal that management just doesn’t care enough to get it right, didn’t plan appropriately to get it right, or simply isn’t able to get it right. For some investors, any of these possibilities may be major negative; they may see it as evidence that the company is not run well, regardless of whether the weaknesses were found by management or the company’s auditor.

Of course, like two tectonic plates shifting during an earthquake, these two predictive factors pull in opposite directions. I guess that makes me no better than the doctor who tells an expecting couple that the baby will be a boy, while writing down in a journal—to be shown later, if necessary—that it’s going to be a girl.

Interestingly, we have begun seeing some live data, limited as it is. Several large companies announced that they indeed will be reporting material weaknesses in their 404 reports. They’ve come out early with this disclosure—perhaps in light of urging by SEC officials for timely disclosure, or on advice of their lawyers, who might see a legal imperative or strategic advantage to do so.

And the market’s reaction to those companies’ disclosures has been negligible. According to an analysis conducted by Raisch Financial Information Services of Newton, Mass., one company’s closing stock price the day after disclosing that it expected to report a material weakness in its 404 report was flat, a second company’s next-day close was up 2.0 percent, and a third company was down 6.4 percent after its disclosure. Of course, without isolating this variable we don’t know whether there’s any cause-and-effect relationship—or lack thereof—between the disclosure and stock price, but we certainly haven’t seen significant losses in market capitalization after these preemptive disclosures.

Like predicting earthquakes, we don’t know how many companies will report a material weakness, nor do we know the marketplace’s reaction. My expectation is that the ground indeed will move a significant number of times—but most of the movement will consist of mild tremors, and we won’t see huge chunks of earth falling into the sea. For what it’s worth, there’s my prediction. We’ll soon know for sure.

The column solely reflects the views of its author, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.

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