A SUMMARY OF A PORTION OF SEC REGULATION 10 (B)5 AS IT PERTAINS TO DISCLOSURE

IN THE UNITED STATES, as nowhere else in the world, written disclosures are comprehensive and reliable. As a matter of fact, the very comprehensiveness and reliability of these disclosures make them essential working tools for all types of creditors and investors, from commercial-bank lending officers to individual common-stock investors. The key disclosure documents for creditors of, and investors in, public companies are those issued pursuant to rules and regulations promulgated by the Securities and Exchange Commission.³⁶

These frequently crucial documents disclose information in two forms—financial statements and narratives. Financial statements are discussed in the next two chapters, “Financial Accounting” and “Generally Accepted Accounting Principles.” Our primary interest in this chapter is in narrative disclosure.

Principal documents of the paper trail are as follows:³⁷

Form 10-K is the official annual business and financial report that must be filed by most companies with the SEC.

Form 10-Q is the quarterly financial report filed by most companies with the SEC that includes disclosure of certain material and extraordinary events that occurred during the reported three-month period.

Form 8-K is a report to the SEC, within fifteen days of the occurrence of a reportable event, of unscheduled material events or corporate changes.

Annual reports to stockholders are the most important way most public corporations communicate directly with stockholders.

Quarterly reports to stockholders are statements many companies mail every three months directly to their stockholders.

Annual-meeting proxy statements are documents mailed to stockholders soliciting their votes for election of directors and other matters, such as the appointment of independent auditors. If a company does not solicit “proxies,” information that would otherwise have been disclosed in proxy statements is disclosed in Part II of Form 10-K.

Merger proxy statements are issued when stockholders are to vote on an asset-conversion matter—for example, merger, consolidation, sale of assets or liquidation. If new securities are to be issued as part of the asset-conversion event, the merger proxy statement also serves as a prospectus for the new issue of securities, and is registered as an S-14 Registration.

Prospectuses are part of registration statements and are issued when securities are to be offered publicly, either for cash or in an exchange-of-securities transaction where no stockholder vote is sought. Principal registration forms are the S-1 (a generalized form) and the S-7, a short form used by seasoned companies with relatively healthy operating histories. Preliminary prospectuses are known as “red herrings.”

Cash tender offer circulars are sent, or otherwise made available, to stockholders when a publicly announced offer is made to buy shares for cash from the general list of stockholders.

The use of SEC disclosures is the key to our financial-integrity approach. Indeed, there seems to be an almost symbiotic relationship between SEC-prescribed disclosures and our approach in that the SEC seems to make special efforts to provide the types of information that are most important to us, as is demonstrated by the examples of actual disclosures that are contained in Appendix IV.

The presence or absence of encumbrances is almost always spelled out in SEC documents to those who carefully read financial statements (including footnotes), especially audited financial statements. SEC disclosures also permit insights into management character, at least insofar as their relationships with security holders are concerned. Information about these matters is contained either in proxy statements for annual meetings, or when proxies are not solicited, in Part II of Form 10-K, the company’s annual report filed with the SEC. The proxy statement and Part II of the 10-K contain descriptions of management remuneration, certain transactions with insiders, and in proxy statements where shareholder votes are solicited, proposals designed to insulate management in office.³⁸ Also, financial statements, Form 10-K and Part II of Form 10-Q (the quarterly report filed with the SEC) contain disclosures on litigation. All these items give evidence to analysts about management attitudes and management character.

Neither academics, whether economists or finance professors, nor securities traders seem to appreciate just how useful these documents are. This failure can perhaps be explained by the fact that most of the critics have had virtually no experience in preparing the documents required by the SEC. Document preparation has been left largely to investment bankers, practicing lawyers, accountants and members of corporate managements. Although firsthand experience as a document preparer is not essential to understanding the uses and limitations of the paper trail, an investor (or critic) ought to comprehend how the preparers go about composing the materials that they must file with the SEC or mail to securities holders.

The first thing to remember is that there are few liars among document preparers. Virtually no professional accountant, lawyer, investment banker or, especially, independent auditor wants even to be suspected of misleading investors, much less of fraud. The professionals whom we know and work with do not wish to risk their livelihoods and reputations for the benefit of third parties, such as managements and large stockholders.³⁹ As a general rule, the information gleaned from the paper trail is truthful and reliable in stating whatever it purports to state.

This is not to say that all these documents are complete and accurate; there is short-cutting, but much of it is inadvertent. It is sometimes difficult for competent and honest document preparers to make appropriate judgments as to what are material disclosures. However, in our experience, important nondisclosures do not occur frequently. Some short-cutting is undoubtedly deliberate, but the outright frauds or possible frauds—Equity Funding, Stirling Homex, National Student Marketing, and Westec—are few and far between.

Second, in preparing documents, there are two well-established rules: Follow the required form so that specific regulations are complied with, and don’t run afoul of antifraud provisions of the securities laws. These antifraud provisions make it unlawful in connection with the purchase or sale of any security for any person, directly or indirectly, “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”⁴⁰ The typical preparer of documents, therefore, is going to try to disclose, as truthfully as possible, everything he thinks is factually relevant. He will do this to avoid trouble, both from government regulators and from private securities holders whose attorneys may bring class-action suits, either derivatively or directly, to redress their grievances.

Understanding this is a large part of understanding why the paper trail is so useful. In most commercial and economic transactions, any sensible participant has to worry about the truthfulness of the other parties to the transactions. This is rarely a consideration for followers of the paper trail who rely on written disclosures. It is as if the person contemplating the purchase of a used car could know that the salesman who says “This auto was only driven on Sunday by a little old lady going to church” is telling the truth. Being able to rely on the truthfulness of disclosures about publicly held corporations is of enormous help to any creditor or investor in coming to financial judgments.

THE DOCUMENTS AND HOW TO READ THEM

In order to take full advantage of disclosure, the reader ought to have an understanding of what is contained in principal disclosure documents. The first and most important thing to do is to read them. Almost anyone, after carefully reading, say, five 10-K’s and four merger proxy statements, will have good insight into how their contents can help him in an investment program. Second, the reader should obtain copies of the forms and the general regulations for the preparation of forms. Reading such materials will give good insight into what preparers go through to produce the various key documents. Investors pursuing an in-depth study of these forms can obtain copies of them as well as general instructions and guides for their preparation from the SEC itself, from other sources, including the Federal Securities Law Reporter (a loose-leaf service published by Commerce Clearing House in Chicago), and from financial printers such as Bowne and Appeal.

There are other SEC filings that are occasionally important, but these are beyond the scope of this brief chapter. These include offering circulars under Regulation A; filings by insiders concerning their shareholdings and changes in holdings (Forms 3 and 4); and Form 144, filed by holders desiring to sell restricted stock under Rule 144. Form 13F, to be filed quarterly commencing in 1979 by institutional investment managers exercising discretion over accounts holding more than $100,000,000 of marketable equity securities, describes the securities held in those portfolios. Notices of various filings can be found in the SEC News Digest, a daily summary of SEC activities, including rules and related matters, announcements, registrations and filings in connection with tender offers and 5 percent ownership; the SEC Docket, a weekly compilation of the full text of SEC releases; and the Official Summary, a monthly summary of securities transactions and holdings reported by insiders, taken from Forms 3 and 4 as filed.

OBTAINING THE DOCUMENTS

Some documents—for example, annual reports, annual-meeting proxy statements, prospectuses and cash tender offers—are publicly distributed. The investor who wants to study any of these can easily pick up a copy from a broker. He can also obtain copies by writing to the issuer.

Writing to the issuer is probably the easiest way of obtaining copies of materials that are filed with the SEC but are not publicly distributed, such as 10-K’s, 8-K’s, 10-Q’s and Schedules 13D and 14D. Schedules 13D are filed within ten days by persons who have acquired 5 percent or more of an outstanding security issue (or who, once having acquired 5 percent, acquire an additional 2 percent within a twelve-month period).⁴¹ Schedules 14D, whose informational requirements are similar to those of Schedules 13D, are filed by offerers prior to the making of a cash tender offer for 5 percent or more of a class of securities. There are other ways to obtain these documents, however. The SEC has copies of materials filed on microfiche cards, in its main office in Washington and (except for Schedules 13D and 14D) in its regional offices, that are available to the public in public reference rooms. There are also services that, for a fee, will acquire and mail these materials.⁴²

WHAT THE PAPER TRAIL DOES FOR THE OUTSIDE INVESTOR

Once all this information has been gathered, how useful is it? How limited? Though it is not particularly useful for the trader who seeks immediate market performance, we think it is extremely useful for all other investors, whether they be control buyers or passivists, who have a modicum of training in what to look for. The paper trail is especially useful in allowing those using the financial-integrity approach to arrive at very meaningful judgments most of the time.

This does not mean that the paper trail is perfect. Certainly it will not tell the creditor or investor everything he wants to know. Even so, unless the outsider has some special know-how or know-who, we think it is so good that he would do well to restrict his investments to securities covered by the paper trail. In fact, when we advise European clients about U.S. investments, we frequently recommend securities to them, rather than, say, real estate, precisely because the paper trail exists, and the disclosures it provides mean that other things being equal, an investment will involve a lesser element of risk than one in any non-SEC filing enterprise.

For the followers of the financial-integrity approach, the paper trail is excellent, as we noted above, for pointing to securities that because of poor financial position or insider avarice are unattractive at any price. But it is also highly useful in a more positive sense: an investor can obtain quite reliable assurances that a company’s financial position is strong and that insiders are not overreaching, or based on past performance, are likely to overreach in the future.

In effect, much of the entire SEC narrative-disclosure process and many of the disclosures of financial accounting are directed toward informing investors about corporate obligations. Stockholder annual reports, 10-K’s, 10-Q’s, 8-K’s, and where issued, other documents will give investors strong clues to the encumbrances attached to a business entity. Particularly important in this regard are audited financial statements, including the auditor’s certification and the footnotes to the financials. Descriptions of on-balance-sheet debt and footnote descriptions of encumbrances, including balance-sheet items, pension-plan obligations and contingent liabilities, tend to be carefully and accurately done.⁴³

Auditors’ certificates are particularly important as attestations that have become increasingly carefully worded in recent years. Such attestations are either “clean”—presented without qualification—or “subject to” certain conditions. Additionally, there are what in effect are nonattestations, namely “adverse opinions” or “disclaimers of opinions.” Clean opinions, as distinct from certain but not all subjectto opinions, adverse opinions or disclaimers of opinions, are important in giving comfort to investors following the financial-integrity approach; such investors are unlikely to be interested in a junior security on the basis of an opinion subject to a serious qualification (such as “subject to the ability to continue as a going concern”), or on the basis of an adverse opinion or of a disclaimer of opinion.

The encumbrances that are missed by the paper trail tend to be those that sometimes even the insiders are unaware of. One example is a business that enjoys a strong financial position only because it fails to make needed expenditures to modernize, expand or replace outdated facilities. In such cases, a strong financial position is deceptive, and the strong balance sheet will tend to be dissipated in future years as the business suffers large operating losses, embarks on massive catch-up capital-expenditure programs, or both. (This is precisely what happened in the cement industry in the late 1950’s and early 1960’s.) Nonetheless, it has been our experience that most of the time, the paper trail does disclose enough, so that the investor’s estimate of what the total encumbrances will prove to be are relatively accurate.

The paper trail is also fairly good in giving clues about insider overreaching. Proxy statements for annual meetings at which directors are elected contain disclosures about management remuneration, ⁴⁴ about borrowings by insiders from the company, and about certain transactions—dealings and participations between the company and its insiders. In addition, the long-term record of management is revealed, and this is helpful to analysts who tend to believe that behavior patterns probably do not change much, if at all. For example, since the management of Rapid American Corporation forced out minority shareholders of Schenley Industries in 1971 at what we believed, from examining the 1971 proxy material, was a grossly unfair price (as one of us testified in court), we have concluded that we would rather not be an outside investor or creditor in any company controlled by the Rapid American management, albeit there was nothing illegal about the Schenley Industries force-out.

True, much past insider overreaching may escape disclosure in the documents of the paper trail. Certainly the documents as they exist today leave few clues concerning such matters as the prevalence of widespread nepotism at levels below parent-company officers and directors. Yet, there appear to be sufficient data, so that the outside investor can make reasonable judgments about the character of the insiders, at least insofar as it affects actual or proposed investments.

An investor may decide that a security meeting the criteria of a financial-integrity approach is attractive because of additional considerations. The paper trail will help him uncover these other attractions, perhaps providing hints that future earnings might increase dramatically; that large cash distributions to stockholders are likely; that a company is a takeover candidate; that it is likely to be liquidated or recapitalized in whole or in part; or that a security is priced inexpensively compared with other companies, based on its history.

The paper trail can provide information that is crucial to assessing each of these factors. The knowledge gained from it about a company’s business and operations provides a reasonable basis for making judgments about future earnings, cash returns and risk. Information about who owns the company’s stock, who is acquiring it and what resources the company has may tell whether or not it is a likely candidate for a takeover, or for a liquidation or recapitalization.

Finally, data on the existing asset base, historic earnings, cash returns and percentage yields on the security are essential to a determination of whether the security is underpriced on a comparative basis. True, the paper trail does not provide all the necessary information for this last determination; it does not tell the price of the security relative to others, nor does it generally identify other comparable securities. Such information is readily obtainable from other sources, though, including trade association directories, Moody’s, Standard and Poor’s and the Directory of Companies Filing Annual Reports with the Securities and Exchange Commission.

As we stated before, the paper trail enables an investor using the financial-integrity approach to pinpoint those securities that are unattractive at any price. The statement that everything has a price at which it is a bargain is, as a practical matter, simply not true when it comes to investment. Junior securities—especially those that are pure residuals, such as common stocks and warrants—may be in such a hopeless position that they are likely never to have a value high enough to compensate for the costs of ownership. This may happen in one of two situations. The first is where the financial position of the company is so bad that whether the company is in bankruptcy or not, the entire business has to belong to the creditors.⁴⁵ For reasons that are examined in Chapter 16, even a tax-loss carry-forward will not impart value to junior securities in such a situation unless it exceeds the creditor claims. The second situation in which equity securities should be avoided at any price is that of a going concern with an entrenched management whose prime objective is to milk the company for personal benefits at the expense of the security holders. By far the best way to pinpoint such a situation is to follow the paper trail.

WHAT THE PAPER TRAIL DOESN’T DO

The principal shortcoming of the paper trail stems from the fact that it is designed and used to provide material disclosures of hard information. Soft information, such as company forecasts, company budgets and valuation appraisals of assets—for example, possible and probable petroleum reserves or real estate holdings—are rarely disclosed. ⁴⁶ This is principally because much soft information is a tool for stock market manipulation.

Sometimes this soft information may be vital to understanding a business, either as an asset-conversion enterprise or as a going concern. For example, in early 1976 Tishman Realty announced liquidation plans. Without knowing the prices at which Tishman’s real properties could be sold, there was no realistic basis for judging the merits of Tishman as an investment; and without real estate appraisals of the individual properties, it was extremely difficult to approximate these prices. Another example is Duplan Corporation, which in early 1976 found itself in serious financial trouble, its very viability threatened unless it could become profitable in six months to a year. Here, management forecasts and budgets were crucial to anyone contemplating becoming an investor in or creditor of Duplan.

There are many other kinds of information besides management forecasts, budgets and asset appraisals that the paper trail fails to disclose. For example, there are no disclosures of merger and acquisition discussions that never reach a definitive state. There rarely will be information about comparative cost analysis, comparative security prices or comparative market penetrations within an industry. Ordinarily, outsiders do not know what a company ought to spend on plant equipment or inventory in order to remain competitive. The paper trail rarely includes disclosures of detailed special studies in areas such as marketing or engineering. Nor will there be information about long-festering internal disputes among management. Occasionally, even obviously material hard information may be lacking: for example, companies may provide only consolidated financial statements in situations where such statements would be less informative than consolidating or company-only statements. (In consolidating or company-only statements, information about the parent company and individual subsidiaries is disclosed, whereas such information is not shown separately in consolidated statements.)

There may even be situations that the paper trail misses entirely. An example would be a very small acquisition that does not require a stockholder vote. If such a vote were required, proxy statements would be mailed to shareholders. Without a proxy or 8-K filing, the financial statements and descriptions of the companies being acquired would not be available at all from SEC filings. Skimpy information about small transactions involving the listing of newly issued securities can be obtained from the acquiring company’s stock exchange listing application, which is available from the exchange itself or from brokerage-house libraries.

It is important to note, of course, that the lack of soft information on the paper trail is a much less serious shortcoming for the long-term investor than it is for the trader. For the trader, a near-term earnings forecast or dividend action may be the only disclosure of interest. The long-term investor, especially the investor whose analysis rests on the financial-integrity approach, is resource-conscious; the hard information disclosed by the paper trail is of great importance to him in virtually all his evaluations. Furthermore, for this investor an apparent low price relative to an estimate of the resources in the business can compensate for the risks inherent in knowing less about a company than would be optimal. This safety valve does not exist for the trader who is seeking the best possible near-term market performance.

HOW GOOD IS THE PAPER TRAIL?

The SEC paper trail provides the investor with a stereotyped format. The disadvantage of the stereotyped format, of course, is that following a form frequently results in inadequate descriptions of reality and inadequate weighting of what is important. The principal advantage is that the reader can be assured that the professional preparers are striving to see that the documents do not omit material statements and do not contain material misstatements. In addition, the investor who uses stereotyped documents becomes a very practiced reader and can obtain vast quantities of information merely by skimming, because he knows what to look for and where to look for it.

On balance, our appraisal is that most of the time the paper trail is excellent. We have reached this conclusion in large part on the basis of our experience in conducting in-depth analyses for companies that retain us. In these situations, the companies provide all the data we want and do studies to generate any necessary data that is otherwise unavailable. Invariably, these in-depth analyses have been materially easier to do and more meaningful for users when we have had SEC documents available as a source of information and as a check against other information received. We are sure this holds true also for virtually all other analysts doing comparable studies. This points up, incidentally, one of the more important social and economic benefits to the United States from the paper trail: It has uplifted the standards of analysis, making it infinitely easier to conduct meaningful analyses for all sorts of appraisers, from commercial-bank lenders to government officials, who may not be interested in securities markets per se or common stock investing at all.

Of course, the paper trail is always going to be more useful for some kinds of companies than for others. For example, for large, stable, dividend-paying companies, such as Graham and Dodd’s theoretical list of the one hundred highest-quality issuers, the paper trail probably imparts more information to outside investors than they care to know. On the other hand, in areas where Generally Accepted Accounting Principles are not an overly useful tool—such as in the analysis of extractive industries, real estate development companies and emerging issuers—the nonaccounting disclosures of the paper trail are not going to be too useful either. For the whole range of companies in-between, however, the paper trail is a godsend.

Anyone who follows the paper trail must, of course, appreciate what it cannot do for him. First and foremost, much of the world is unknown and unpredictable. Thus, forecasting will always be an art. Second, the paper trail is probably not of much help in gaining insight into immediate timing and immediate performance in the stock market. Obviously, there is no way the paper trail is going to disclose intimate secrets of activists and their plans, which are frequently formulated no place else but in their minds. Nor does it provide anyone with know-who, even though it does tend to give the background that makes it easier to obtain.

The paper trail does not provide full disclosure, and never can. Like any other analytical tool, it has its limitations. But for the investor who concentrates on our approach, the paper trail is going to be the essential starting point for his analysis almost all of the time. In some instances, the paper trail is all he will ever need.