Material Adverse Effect a Warning Sign for Stocks

There are important phrases that investors need to recognize as major red flags. Unfortunately, in filings made to the Securities and Exchange Commission and legal boilerplates, companies often try to obscure these phrases in an attempt to lessen their impact on the market. Fortunately, by recognizing a few key phrases, casual readers will be alert to some very important information that will help avoid investment mistakes. One of these key phrases is "material adverse effect."

Here we'll take a look at what this statement means and why investors shouldn't ignore it. (See also: Advanced Financial Statement Analysis.)

A material adverse effect usually signals a severe decline in profitability or the possibility that the company's operations or financial position may be seriously compromised. This is a clear signal to investors that there is something wrong.

For example, suppose that Industrial Blowdart Inc. has a major customer that represents 25% of annual sales. If that client takes its business elsewhere, the decision will have a material adverse impact on Blowdart's sales, profitability and ability to stay in business. The company's material adverse effect might read as follows: "One customer accounts for more than 25% of our annual sales. The loss will have a material adverse effect on Blowdart's profits and will remain an ongoing concern."

Or, suppose that Blowdart has a critical line of credit that it uses to finance working capital (i.e., inventory or accounts receivable). If the bank refuses to renew the line of credit, the difficulty or inability to find another lender will have a material adverse impact on Blowdart's operating cash flow and ability to operate normally, let alone continue as a viable business.

Generally accepted accounting principles (GAAP) allow flexibility in determining what must be defined and disclosed as a material adverse event. However, despite SEC action in 1999 and the increased scrutiny that companies are under, many continue to use their own definitions in order to manage earnings.

A piece of information is material if it is reasonable to expect that disclosure of that information will impact the company's stock price. Companies and their accountants continue to find ways to manage earnings by coming up with their own definitions of materiality. This involves establishing a numerical threshold (say, 5%) and deciding that anything that falls below the threshold will not impact the bottom line, is immaterial and thus does not require discussion. There are also cases in which companies, in order to hide their mistakes, net items against each other to keep below their numerical thresholds. The reason for this deception is earnings management. (See also:  What Is Earnings Management?)

In 1998, the SEC brought a case against W.R. Grace & Co. claiming that from 1991 to 1995 the company used a $60 million "reserve" of immaterial items to smooth earnings—with the full knowledge of the company's auditors. The SEC alleged that this use of reserve was not in line with GAAP. In 1999, W.R. Grace agreed to cease and desist its use of this practice and pay $1 million into a fund related to GAAP education.

Unfortunately, many companies continued to net immaterial items in order to hit earnings targets. The netting takes place in the Other Income/Expense line of the income statement. Items that are used to net are gains/losses on investments and restructuring reserves.

In 1999, the SEC attempted to prevent companies from hiding material items by establishing the following rules:

• An intentional misstatement, even if it involves an immaterial amount, is material because of the intent to mislead.
• Numerical thresholds alone are unacceptable.
• Management must also weigh qualitative matters if the misstatement will hide a change in earnings or concerns a key business segment.
• The company cannot net items. Netting results in a misstatement of the company's financial statement.

Material adverse effect is not an early warning signal, but rather a sign that a situation has already deteriorated to a very bad stage. Usually, this is the result of an accumulation of events over time that compound to a point where a critical limit is crossed. Closely following a company's operating results over time will alert investors to potential material adverse effects. This kind of awareness requires a great deal of effort, time and experience.

Assume, for example, that Blowdart's financial condition has deteriorated to the point where it is in default of its loan covenants. This is a material adverse event because it means that if the company and the bank cannot agree on how to restructure the loan, the loan could be called, requiring immediate repayment. This would put Blowdart out of business.

If you followed Blowdart stock, you would know it was having problems. You would also have to dig through the SEC filings to find the loan agreements and then read those complex documents in order to find the relevant loan covenants and the metrics used to determine whether the borrower was in compliance or default.

It is possible that Blowdart and its bankers can restructure the loans and get the company through the difficult times. Conversely, if the bank wants to exit the relationship, Blowdart needs to find another lender, which may not be easy to do because of the company's recent operating history or current adverse economic conditions.

In this hypothetical situation, investors need to review this stock in light of their own risk aversion. While the outcome might even be 60/40 in favor of a successful loan renegotiation, you may not want to deal with the added risk. If so, sell the stock. However, if you have studied the company and industry closely and feel that there are some strong fundamental reasons for owning the stock for the long term, you may decide to hang on to it.

Government regulations require companies to disclose material events. The phrase material adverse effect can be found in the following:

• The notes to financial statements, referred to as footnotes, found in a company's 10-Qs and 10-Ks and in the auditor's opinion, which relate to the issue that could cause the material adverse effect. For example, the material adverse effect statement would appear in Blowdart's financial statement notes that discuss accounts receivables, or customer concentration and its debt and credit facilities. (See also: Footnotes: Start Reading the Fine Print.)
• Press releases may contain a material adverse effect phrase if the release deals with financing issues or if the company is announcing a material event.
• The management's discussion and analysis (MD&A) in a company's annual report may contain some reference to the material adverse effect.

Discussing every business detail in a company's financial statements is difficult. A balance is needed between required disclosures and tedious reporting burdens. Corporations should stay on the side of overdisclosure because investors value transparency more than the illusion of steady earnings.