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andardized and open to serious abuses. Dupli- cate committees often appear; an undignified scramble for deposits takes place; persons with undesirable reputations and motives can easily inject themselves into the situation. The new bankruptcy legislation of 1938 introduced some improve- ment into this situation by subjecting the activities and compensation of 14 The remedial legislation was an outgrowth of a trust indenture study made by the S.E.C. and was greatly stimulated by the opinion delivered by Judge Rosenman in 1936 denying the claims of holders of National Electric Power (secured) debentures to hold the trustee of the issue accountable for the huge losses suffered by them. The judge held that the exculpatory clauses saved the trustee in this case but that the whole system of indenture trusteeship was in need of radical reform. protective committees to court scrutiny. (In the case of railroads a com- mittee cannot take part in a proceeding without prior permission from the I.C.C.) Further legislation will probably be enacted regulating in more detail the formation as well as the subsequent conduct of protec- tive committees. A Recommended Reform. The whole procedure might readily be clarified and standardized now that the trustee under the indenture is expected to assume the duty of actively protecting the bond issue. The large institutions which hold these positions have the facilities, the expe- rience, and the standing required for the successful discharge of such a function. There seems no good reason, in the ordinary case, why the trustee should not itself organize the protective committee, with one of its executive officers as chairman and with the other members selected from among the larger bondholders or their nominees. The possible con- flict of interest between the trustee as representative of all the bondhold- ers and the protective committee as representative of the depositing holders only will be found on analysis rarely to be of more than
uch a function. There seems no good reason, in the ordinary case, why the trustee should not itself organize the protective committee, with one of its executive officers as chairman and with the other members selected from among the larger bondholders or their nominees. The possible con- flict of interest between the trustee as representative of all the bondhold- ers and the protective committee as representative of the depositing holders only will be found on analysis rarely to be of more than techni- cal and minor consequence. Such a conflict, if it should arise, could be solved by submission of the question to the court. There is no difficulty about awarding sufficient compensation to the trustee and its counsel for their labors and accomplishment on behalf of the bondholders. This arrangement envisages effective cooperation between the trustee and a group of bondholders who in the opinion of the trustee are quali- fied to represent the issue as a whole. The best arrangement might be to establish this bondholders’ group at the time the issue is sold, i.e., with- out waiting for an event of default to bring it into being, in order that there may be from the very start some responsible and interested agency to follow the affairs of the corporation from the bondholders’ standpoint, and to make objections, if need be, to policies which may appear to threaten the safety of the issue. Reasonable compensation for this serv- ice should be paid by the corporation. This would be equivalent in part to representation of the bondholders on the board of directors. If the time were to arrive when the group would have to act as a protective commit- tee on behalf of the bondholders, their familiarity with the company’s affairs should prove of advantage. Chapter 19 PROTECTIVE COVENANTS (Continued) Prohibition of Prior Liens. A brief discussion is desirable regarding certain protective provisions other than those dealing with the ordinary events of default. (The matter of saf
ivalent in part to representation of the bondholders on the board of directors. If the time were to arrive when the group would have to act as a protective commit- tee on behalf of the bondholders, their familiarity with the company’s affairs should prove of advantage. Chapter 19 PROTECTIVE COVENANTS (Continued) Prohibition of Prior Liens. A brief discussion is desirable regarding certain protective provisions other than those dealing with the ordinary events of default. (The matter of safeguarding conversion and other participating privileges against dilution will be covered in the chapters dealing with Senior Securities with Speculative Features.) Dealing first with mortgage bonds, we find that indentures almost always prohibit the placing of any new prior lien on the property. Exceptions are sometimes made in the case of bonds issued under a reorganization plan, when it is recognized that a prior mortgage may be necessary to permit raising new capital in the future. Example: In 1926 Chicago, Milwaukee, St. Paul, and Pacific Railroad Company issued $107,000,000 of Series A Mortgage 5% bonds and, jun- ior thereto, $185,000,000 of Convertible Adjustment Mortgage 5s, in exchange for securities of the bankrupt Chicago, Milwaukee, and St. Paul Railway Company. The indentures permitted the later issuance of an indefinite amount of First and Refunding Mortgage Bonds, which would rank ahead of the Series A Mortgage 5s.1 Equal-and-ratable Security Clause. When a bond issue is unse- cured it is almost always provided that it will share equally in any mort- gage lien later placed on the property. Example: The New York, New Haven, and Hartford Railroad Com- pany sold a number of debenture issues between 1897 and 1908. These bonds were originally unsecured, but the indentures provided that they should be equally secured with any mortgage subsequently placed upon the property. In 1920 a first and refunding mortgage was authorized by 1 In 1933 the St. Paul was granted pe
unse- cured it is almost always provided that it will share equally in any mort- gage lien later placed on the property. Example: The New York, New Haven, and Hartford Railroad Com- pany sold a number of debenture issues between 1897 and 1908. These bonds were originally unsecured, but the indentures provided that they should be equally secured with any mortgage subsequently placed upon the property. In 1920 a first and refunding mortgage was authorized by 1 In 1933 the St. Paul was granted permission to issue some of the new first and refunding bonds, to be held as collateral for short-term loans made by the United States government. [242] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. the stockholders; consequently the earlier issues have since been equally secured with bonds issued under the new mortgage. They still carry the title of “debentures,” but this is now a misnomer. There is, however, an issue of 4% debentures, due in 1957, which did not carry this provision and hence are unsecured. In 1939 the (unsecured) debenture 4s, due 1957, sold at one-third the price of the (secured) debenture 4s, due 1956, e.g., 5 vs. 16.2 Purchase-money Mortgages. It is customary to permit without restriction the assumption of purchase-money mortgages. These are liens attaching only to new property subsequently acquired, and their assump- tion is not regarded as affecting the position of the other bondholders. The latter supposition is not necessarily valid, of course, since it is possi- ble thereby to increase the ratio of total debt of the enterprise to the total shareholder’s equity in a manner which might jeopardize the position of the existing bondholders. Subordination of Bond Issues to Bank Debt in Reorganization. In the case of bonds or notes issued under a reorganization plan it is sometimes provided that their claim shall be junior to that of present or future bank loans. This is done to facilitate ba
supposition is not necessarily valid, of course, since it is possi- ble thereby to increase the ratio of total debt of the enterprise to the total shareholder’s equity in a manner which might jeopardize the position of the existing bondholders. Subordination of Bond Issues to Bank Debt in Reorganization. In the case of bonds or notes issued under a reorganization plan it is sometimes provided that their claim shall be junior to that of present or future bank loans. This is done to facilitate bank borrowings which oth- erwise could be effected only by the pledging of receivables or invento- ries as security. An example of this arrangement is afforded by Aeolian Company Five-year Secured 6% Notes, due in 1937, which were issued under a capital readjustment plan in partial exchange for the Guaranteed 7% Preferred Stock of the company. The notes were subordinated to $400,000 of bank loans, which were later paid. Safeguards against Creation of Additional Amounts of the Same Issue. Nearly all bonds or preferred issues enjoy adequate safe- guards in respect to the creation of additional amounts of the issue. The customary provisions require a substantial margin of earnings above the requirements of the issue as thus enlarged. For example, additional 2 In exceptional cases, debenture obligations are entitled to a prior lien on the property in the event that a subsequent mortgage is placed thereon. Example: National Radiator Corpora- tion Debenture 61/2s, due 1947, and the successor corporation’s income debenture 5s, due 1946. In a second reorganization, effected in 1939, these debentures were replaced by stock. Here is an excellent example of the relative unimportance of protective provisions, as com- pared with profitable operations. New York Edison Company First Lien and Refunding Mortgage Bonds may not be issued, except for refunding purposes, unless consolidated net earnings for a recent 12-month period have been at least 13/4 times the annual interest charges on th
corporation’s income debenture 5s, due 1946. In a second reorganization, effected in 1939, these debentures were replaced by stock. Here is an excellent example of the relative unimportance of protective provisions, as com- pared with profitable operations. New York Edison Company First Lien and Refunding Mortgage Bonds may not be issued, except for refunding purposes, unless consolidated net earnings for a recent 12-month period have been at least 13/4 times the annual interest charges on the aggregate bonded indebtedness of the com- pany, including those to be issued. In the case of Wheeling Steel Corpo- ration First Mortgage bonds the required ratio is 2 times.3 Provisions of this kind with reference to earnings-coverage are prac- tically nonexistent in the railroad field, however. Railroad bonds of the blanket-mortgage type more commonly restrict the issuance of additional bonds through a provision that the total funded indebtedness shall not exceed a certain ratio to the capital stock outstanding, and by a limitation upon the emission of new bonds to a certain percentage of the cost or fair value of newly acquired property. (See, for example, the Baltimore and Ohio Railroad Company Refunding and General Mortgage Bonds and the Northern Pacific Railway Company Refunding and Improvement Bonds.) In the older bond issues it was customary to close the mortgage at a rela- tively small fixed amount, thus requiring that additional funds be raised by the sale of junior securities. This provision gave rise to the favorably situated “underlying bonds” to which reference was made in Chap. 6. In the typical case additional issues of mortgage bonds may be made only against pledge of new property worth considerably more than the increase in debt. (See, for examples: Youngstown Sheet and Tube Com- pany First Mortgage, under which further bonds may be issued to finance 75% of the cost of additions or improvements to the mortgaged proper- ties; New York Edison Company, Inc., F
es. This provision gave rise to the favorably situated “underlying bonds” to which reference was made in Chap. 6. In the typical case additional issues of mortgage bonds may be made only against pledge of new property worth considerably more than the increase in debt. (See, for examples: Youngstown Sheet and Tube Com- pany First Mortgage, under which further bonds may be issued to finance 75% of the cost of additions or improvements to the mortgaged proper- ties; New York Edison Company, Inc., First Lien and Refunding Mort- gage, under which bonds may be issued in further amounts to finance additions and betterments up to 75% of the actual and reasonable expen- diture therefor; Pere Marquette Railway Company First-mortgage bonds, which may be issued up to 80% of the cost or fair value, whichever is the lower, of newly constructed or acquired property.) These safeguards are logically conceived and almost always carefully observed. Their practical importance is less than might appear, however, because in the ordinary instance the showing stipulated would be needed anyway in order to attract buyers for the additional issue. 3 For similar provisions in the case of preferred stocks see Consolidated Edison Company of New York $5 Preferred, General Foods Corporation $4.50 Preferred and Gotham Silk Hosiery Company 7% Preferred. Working-capital Requirements. The provisions for maintaining working capital at a certain percentage of bonded debt, and for a certain ratio of current assets to current liabilities, are by no means standardized. They appear only in industrial bond indentures.4 The required percentages vary, and the penalties for nonobservance vary also. In most cases the result is merely the prohibition of dividends until the proper level or ratio of working capital is restored. In a few cases the principal of the bond issue may be declared due. Examples: 1. Sole penalty, prohibition of dividends. B. F. Goodrich First 41/4s, due 1956, and Wilson and Company First
ets to current liabilities, are by no means standardized. They appear only in industrial bond indentures.4 The required percentages vary, and the penalties for nonobservance vary also. In most cases the result is merely the prohibition of dividends until the proper level or ratio of working capital is restored. In a few cases the principal of the bond issue may be declared due. Examples: 1. Sole penalty, prohibition of dividends. B. F. Goodrich First 41/4s, due 1956, and Wilson and Company First 4s, due 1955, require cur- rent assets to equal total indebtedness, i.e., net quick assets to equal funded debt. In the case of West Virginia Pulp and Paper First 41/2 s, due 1952, subsidiary preferred stocks are included with funded debt. The provisions of Fairbanks, Morse and Company Debenture 4s, due 1956, require that current assets equal (a) 110% of total liabilities and (b) 200% of current liabilities. In the case of Wheeling Steel First 41/2 s, due 1966, and Republic Steel General 41/2 s, due 1956, current assets must equal 300% of current liabilities, and net current assets must equal 50% of the funded debt. 2. Failure to meet requirement is an event of default. Skelly Oil Deben- ture 4s, due 1951, and Serial Notes, due 1937–1941. Here the company agrees to maintain current assets equal to at least 200% of current liabilities. In the case of Continental Steel 41/2s, due 1946, the required ratio is 115%. Among former examples may be cited American Machine and Foundry 6s, due 1939, which had a twofold provision: the first prohibit- ing dividends unless net current assets equal 150% of the outstanding bond issue, and the second requiring unconditionally that the net current assets be maintained at 100% of the face value of outstanding bonds. In the case of United States Radiator Corporation 5s, due 1938, the company agreed at all times to maintain net working capital equal to 150% of the outstanding funded debt. It would appear to be sound theory to require regularly so
39, which had a twofold provision: the first prohibit- ing dividends unless net current assets equal 150% of the outstanding bond issue, and the second requiring unconditionally that the net current assets be maintained at 100% of the face value of outstanding bonds. In the case of United States Radiator Corporation 5s, due 1938, the company agreed at all times to maintain net working capital equal to 150% of the outstanding funded debt. It would appear to be sound theory to require regularly some protec- tive provisions on the score of working capital in the case of industrial 4 Ashland Home Telephone First 41/2s, due 1961, are a public-utility issue with a peculiar, and rather weak, provision relating to net current assets. bonds. We have already suggested that an adequate ratio of net current assets to funded debt be considered as one of the specific criteria in the selection of industrial bonds. This criterion should ordinarily be set up in the indenture itself, so that the bondholder will be entitled to the main- tenance of a satisfactory ratio throughout the life of the issue and to an adequate remedy if the figure declines below the proper point. The prohibition of dividend payments under such conditions is sound and practicable. But the more stringent penalty, which terms a deficiency of working capital “an event of default,” is not likely to prove effective or beneficial to the bondholder. The objection that receivership harms rather than helps the creditors applies with particular force in this connection. Referring to the United States Radiator 5s, mentioned above, we may point out that the balance sheet of January 31, 1933, showed a default in the 150% working-capital requirement. (The net current assets were $2,735,000, or only 109% of the $2,518,000 bond issue.) Nevertheless, the trustee took no steps to declare the principal due, nor was it asked to do so by the required number of bondholders. In all probability a receiver- ship invoked for this re
es with particular force in this connection. Referring to the United States Radiator 5s, mentioned above, we may point out that the balance sheet of January 31, 1933, showed a default in the 150% working-capital requirement. (The net current assets were $2,735,000, or only 109% of the $2,518,000 bond issue.) Nevertheless, the trustee took no steps to declare the principal due, nor was it asked to do so by the required number of bondholders. In all probability a receiver- ship invoked for this reason would have been considered as highly inju- rious to the bondholders’ interests. But this attitude would mean that the provision in question should never have been included in the indenture.5 Voting Control as a Remedy. We have previously advanced and dis- cussed the suggestion that the bondholders’ right to the appointment of trustees in the event of any default might well be replaced by a right to receive voting control over the enterprise. Whatever the reader’s view as to the soundness of this suggestion as applied to default in payment of interest or principal, we imagine that he will agree with us that it has merit in the case of “secondary” defaults, e.g., failure to maintain working cap- ital as agreed or to make sinking-fund payments; for the present alterna- tives—either to precipitate insolvency or to do nothing at all—are alike completely unsatisfactory. 5 Similar situations existed in 1933 with respect to G. R. Kinney (shoe) Company 71/2s, due 1936, and Budd Manufacturing Company First 6s, due 1935. Early in 1934, the United States Radiator Corporation asked the debenture holders to modify the provisions respecting both working-capital maintenance and sinking-fund payments. No substantial quid pro quo was offered for these concessions. Characteristically, the reason given by the company itself for this move was not that the bondholders were entitled to some remedial action but that the “techni- cal default under the indenture” interfered with projected bank b
ing Company First 6s, due 1935. Early in 1934, the United States Radiator Corporation asked the debenture holders to modify the provisions respecting both working-capital maintenance and sinking-fund payments. No substantial quid pro quo was offered for these concessions. Characteristically, the reason given by the company itself for this move was not that the bondholders were entitled to some remedial action but that the “techni- cal default under the indenture” interfered with projected bank borrowings by the company. Protective Provisions for Investment-trust Issues. Investment- trust bonds belong in a special category, we believe, because by their nature they lend themselves to the application of stringent remedial pro- visions. Such bonds are essentially similar to the collateral loans made by banks on marketable securities. As a protection for these bank loans, it is required that the market value of the collateral be maintained at a certain percentage in excess of the amount owed. In the same way the lenders of money to an investment trust should be entitled to demand that the value of the portfolio continuously exceed the amount of the loans by an adequate percentage, e.g., 25%. If the market value should decline below this figure, the investment trust should be required to take the same action as any other borrower against marketable securities. It should either put up more money (i.e., raise more capital from the stockholders) or sell out securities and retire debt with the proceeds, in an amount sufficient to restore the proper margin. The disadvantages that inhere in bond investment generally justify the bond buyer in insisting upon every possible safeguard. In the case of investment-trust bonds, a very effective measure of protection may be assured by means of the covenant to maintain the market value of the portfolio above the bonded debt. Hence investors in investment-trust issues should demand this type of protective provision, and—what is equally
t with the proceeds, in an amount sufficient to restore the proper margin. The disadvantages that inhere in bond investment generally justify the bond buyer in insisting upon every possible safeguard. In the case of investment-trust bonds, a very effective measure of protection may be assured by means of the covenant to maintain the market value of the portfolio above the bonded debt. Hence investors in investment-trust issues should demand this type of protective provision, and—what is equally important—they should require its strict enforcement. Although this stand will inflict hardship upon the stockholders when market prices fall, this is part of the original bargain, in which the stockholders agreed to take most of the risk in exchange for the surplus profits.6 A survey of bond indentures of investment trusts discloses a signal lack of uniformity in the matter of these protective provisions. Most of them do require a certain margin of asset value over debt as a condition to the sale 6 If the market value of the assets falls below 100% of the funded debt, a condition of insol- vency would seem to be created which entitles the bondholders to insist upon immediate remedial action. For otherwise the stockholders would be permitted to speculate on the future with what is entirely the bondholders’ capital. But even this apparently simple point is not without its difficulties. In 1938, holders of Reynolds Investing Company 5s endeavored to have a trustee appointed on grounds of insolvency, but stockholders claimed that the mar- ket price of certain large security holdings was less than their real value. After considerable delay, trustees were appointed, pursuant to an agreement among the various interests. Note that Guardian Investors Corporation 5s, due 1948, have been “under water” nearly all the time since 1932 and sold as low as 24, without any remedial steps being taken. of additional bonds. The required ratio of net assets to funded debt varies from 120% (e.g
f insolvency, but stockholders claimed that the mar- ket price of certain large security holdings was less than their real value. After considerable delay, trustees were appointed, pursuant to an agreement among the various interests. Note that Guardian Investors Corporation 5s, due 1948, have been “under water” nearly all the time since 1932 and sold as low as 24, without any remedial steps being taken. of additional bonds. The required ratio of net assets to funded debt varies from 120% (e.g., General American Investors) to 250% (e.g., Niagara Shares Corporation). The more usual figures are 125 or 150%. A similar restric- tion is placed upon the payment of cash dividends. The ratio required for this purpose varies from 125% (e.g., Domestic and Foreign Investors) to 175% (which must be shown to permit cash dividends on Central States Electric Corporation common). The modal figure is probably 140 or 150%. But the majority of issues do not require at all times and uncondition- ally the maintenance of a minimum excess of asset value above bonded indebtedness. Examples of such a covenant may indeed be given, e.g., General Public Service Corporation Convertible Debenture 5s, due 1953; American European Securities Company Collateral 5s, due 1958; and Affiliated Fund, Inc., Secured Convertible Debenture 41/2s and 4s, due 1949, all of which require maintenance of a 125% ratio of asset value at market to funded debt. In the case of Affiliated Fund, the remedy pro- vided is the immediate sale by the trustee of pledged collateral and the retirement of bonds until the required ratio is restored. In the other cases more elaborate machinery is invoked to declare the entire issue due and payable. We would suggest that provisions of this type—preferably those most simple of application—be a standard requirement for investment- trust bond issues.7 SINKING FUNDS In its modern form a sinking fund provides for the periodic retirement of a certain portion of a senior issue through
diate sale by the trustee of pledged collateral and the retirement of bonds until the required ratio is restored. In the other cases more elaborate machinery is invoked to declare the entire issue due and payable. We would suggest that provisions of this type—preferably those most simple of application—be a standard requirement for investment- trust bond issues.7 SINKING FUNDS In its modern form a sinking fund provides for the periodic retirement of a certain portion of a senior issue through payments made by the cor- poration. The sinking fund acquires the security by call, by means of sealed tenders, or by open-market purchases made by the trustee or the corporation. In the latter case the corporation turns in the bonds to the sinking fund in lieu of cash. The sinking fund usually operates once or 7 Another type of remedy appeared in the indenture securing the Reynolds Investing Company 5s, which provided that if at any time the net value of the assets should fall below 110% of the bond issue, the latter should be due and payable on the next interest date. The same difficulty arose in applying this provision as in the case of the solvency question discussed above. Note also the case of Alleghany Corporation Collateral Trust 5s, due 1949. The offering circular indicated that a coverage of 150% would be compulsory. Yet the indenture provided that failure to maintain this margin would not constitute an event of default but would result only in the prohibition of dividends and in the impounding by the trustee of the income from the pledged collateral. twice a year, but provisions for quarterly and even monthly payments are by no means unusual. In the case of many bond issues, the bonds acquired by the sinking fund are not actually retired but are “kept alive,” i.e., they draw interest, and these interest sums are also used for sinking- fund purchases, thus increasing the latter at a compounded rate. Example: An important instance of this arrangement was supplied
nd in the impounding by the trustee of the income from the pledged collateral. twice a year, but provisions for quarterly and even monthly payments are by no means unusual. In the case of many bond issues, the bonds acquired by the sinking fund are not actually retired but are “kept alive,” i.e., they draw interest, and these interest sums are also used for sinking- fund purchases, thus increasing the latter at a compounded rate. Example: An important instance of this arrangement was supplied by the two issues of United States Steel Sinking Fund 5s, originally totaling $504,000,000. Bonds of the junior issue, listed on the New York Stock Exchange, were familiarly known in the bond market as “Steel Sinkers.” By adding the interest on bonds in the fund, the annual payments grew from $3,040,000 in 1902 to $11,616,000 in 1928. (The following year the entire outstanding amounts of these issues were retired or provided for.) Benefits. The benefits of a sinking fund are of a twofold nature. The continuous reduction in the size of the issue makes for increasing safety and the easier repayment of the balance at maturity. Also important is the support given to the market for the issue through the repeated appear- ance of a substantial buying demand. Nearly all industrial bond issues have sinking funds; the public-utility group shows about as many with as without; in the railroad list sinking funds are exceptional. But in recent years increasing emphasis has been laid upon the desirability of a sink- ing fund, and few long-term senior issues of any type are now offered without such a provision.8 Indispensable in Some Cases. Under some circumstances a sinking fund is absolutely necessary for the protection of a bond. This is true in general when the chief backing of the issue consists of a wasting asset. Bonds on mining properties invariably have a sinking fund, usually of substantial proportions and based upon the tonnage mined. A sinking fund of smaller relative size is reg
ility of a sink- ing fund, and few long-term senior issues of any type are now offered without such a provision.8 Indispensable in Some Cases. Under some circumstances a sinking fund is absolutely necessary for the protection of a bond. This is true in general when the chief backing of the issue consists of a wasting asset. Bonds on mining properties invariably have a sinking fund, usually of substantial proportions and based upon the tonnage mined. A sinking fund of smaller relative size is regularly provided for real estate mortgage bonds. In all these cases the theory is that the annual depletion or depre- ciation allowances should be applied to the reduction of the funded debt. Examples: A special example of importance was the large Interbor- ough Rapid Transit Company First and Refunding 5% issue, due 1966, which was secured mainly by a lease on properties that belong to the City 8 During 1933 the Interstate Commerce Commission strongly recommended that railways adopt sinking funds to amortize their existing debt. The Chicago and North Western Railway thereupon announced a plan of this kind, the details of which were not particularly impressive. of New York. Obviously it was essential to provide through a sinking fund for the retirement of the entire issue by the time the lease expired in 1967, since the corporation would then be deprived of most of its assets and earning power. Similarly with Tobacco Products 61/2s, due in 2022, which depended for their value entirely upon the annual payments of $2,500,000 made by American Tobacco Company under a lease expiring in 2022. The absence of a sinking fund under conditions of this kind invari- ably leads to trouble. Examples: Federal Mining and Smelting Company supplied the unusual spectacle of a mining enterprise with a large preferred-stock issue ($12,000,000); and furthermore the preferred stock had no sinking fund. Declaration of a $10 dividend on the common in 1926 led to court action to protect the preferred
y upon the annual payments of $2,500,000 made by American Tobacco Company under a lease expiring in 2022. The absence of a sinking fund under conditions of this kind invari- ably leads to trouble. Examples: Federal Mining and Smelting Company supplied the unusual spectacle of a mining enterprise with a large preferred-stock issue ($12,000,000); and furthermore the preferred stock had no sinking fund. Declaration of a $10 dividend on the common in 1926 led to court action to protect the preferred stock against the threatened breakdown of its position through depletion of the mines coupled with the distribution of cash earnings to the junior shares. As a result of the litigation the com- pany refrained from further common dividends until 1937 and devoted its surplus profits to reducing the preferred issue, which was completely retired in 1939. Iron Steamboat Company General Mortgage 4s, due 1932, had no sinking fund, although the boats on which they were a lien were obvi- ously subject to a constant loss in value. These bonds to the amount of $500,000 were issued in 1902 and were a second lien on the entire prop- erty of the company (consisting mainly of seven small steamboats oper- ating between New York City and Coney Island), junior to $100,000 of first-mortgage bonds. During the years 1909 to 1925, inclusive, the com- pany paid dividends on the common stock aggregating in excess of $700,000 and by 1922 had retired all of the first-mortgage bonds through the operation of the sinking fund for that issue. At this point the 4s, due 1932, became a first lien upon the entire property. In 1932, when the com- pany went into bankruptcy, the entire issue was still outstanding. The mortgaged property was sold at auction in February 1933 for $15,050, a figure resulting in payment of less than 1 cent on the dollar to the bond- holders. An adequate sinking fund might have retired the entire issue out of the earnings which were distributed to the stockholders. When the enterpris
sinking fund for that issue. At this point the 4s, due 1932, became a first lien upon the entire property. In 1932, when the com- pany went into bankruptcy, the entire issue was still outstanding. The mortgaged property was sold at auction in February 1933 for $15,050, a figure resulting in payment of less than 1 cent on the dollar to the bond- holders. An adequate sinking fund might have retired the entire issue out of the earnings which were distributed to the stockholders. When the enterprise may be regarded as permanent, the absence of a sinking fund does not necessarily condemn the issue. This is true not only of most high-grade railroad bonds and of many high-grade utility bonds but also of most of the select group of old-line industrial preferred stocks that merit an investment rating, e.g., National Biscuit Preferred, which has no sinking fund. From the broader standpoint, therefore, sinking funds may be characterized as invariably desirable and sometimes but not always indispensable. Serial Maturities as an Alternative. The general object sought by a sinking fund may be obtained by the use of serial maturities. The retire- ment of a portion of the issue each year by reason of maturity corresponds to the reduction by means of sinking-fund purchases. Serial maturities are relatively infrequent, their chief objection resting probably in the numerous separate market quotations that they entail. In the equipment- trust field, however, they are the general rule. This exception may be explained by the fact that insurance companies and other financial institutions are the chief buyers of equipment obligations, and for their special needs the variety of maturity dates proves a convenience. Serial maturities are also frequently employed in state and municipal financing. Problems of Enforcement. The enforcement of sinking-fund provi- sions of a bond issue presents the same problem as in the case of covenants for the maintenance of working capital. Failure to make a
ception may be explained by the fact that insurance companies and other financial institutions are the chief buyers of equipment obligations, and for their special needs the variety of maturity dates proves a convenience. Serial maturities are also frequently employed in state and municipal financing. Problems of Enforcement. The enforcement of sinking-fund provi- sions of a bond issue presents the same problem as in the case of covenants for the maintenance of working capital. Failure to make a sink- ing-fund payment is regularly characterized in the indenture as an event of default, which will permit the trustee to declare the principal due and thus bring about receivership. The objections to this “remedy” are obvi- ous, and we can recall no instance in which the omission of sinking-fund payments, unaccompanied by default of interest, was actually followed by enforcement of the indenture provisions. When the company contin- ues to pay interest but claims to be unable to meet the sinking fund, it is not unusual for the trustee and the bondholders to withhold action and merely to permit arrears to accumulate. More customary is the making of a formal request to the bondholders by the corporation for the postponement of the sinking-fund payments. Such a request is almost invariably acceded to by the great majority of bondholders, since the alternative is always pictured as insolvency. This was true even in the case of Interborough Rapid Transit 5s, for which—as we have pointed out— the sinking fund was an essential element of protection.9 9 The plan of voluntary readjustment proposed in 1922 postponed sinking-fund payments on these bonds for a five-year period. About 75% of the issue accepted this modification. The suggestion made in respect to the working-capital covenants, viz., that voting control be transferred to the bondholders in the event of default, is equally applicable to the sinking-fund provision. In our view that would be distinctly preferable to the
out— the sinking fund was an essential element of protection.9 9 The plan of voluntary readjustment proposed in 1922 postponed sinking-fund payments on these bonds for a five-year period. About 75% of the issue accepted this modification. The suggestion made in respect to the working-capital covenants, viz., that voting control be transferred to the bondholders in the event of default, is equally applicable to the sinking-fund provision. In our view that would be distinctly preferable to the present arrangement under which the bondholder must either do nothing to protect himself or else take the drastic and calamitous step of compelling bankruptcy. The emphasis we have laid upon the proper kind of protective provi- sions for industrial bonds should not lead the reader to believe that the presence of such provisions carries an assurance of safety. This is far from the case. The success of a bond investment depends primarily upon the success of the enterprise and only to a very secondary degree upon the terms of the indenture. Hence the seeming paradox that the senior secu- rities that have fared best in the depression have on the whole quite unsat- isfactory indenture or charter provisions. The explanation is that the best issues as a class have been the oldest issues, and these date from times when less attention was paid than now to protective covenants. In Appendix Note 34 on accompanying CD, we present two examples of the opposite kind (Willys-Overland Company First 61/2 s, due 1933, and Berkey and Gay Furniture Company First 6s, due 1941) wherein a combination of a strong statistical showing with all the standard protec- tive provisions failed to safeguard the holders against a huge subsequent loss. But while the protective covenants we have been discussing do not guarantee the safety of the issue, they nevertheless add to the safety and are therefore worth insisting upon. Sinking-fund payments have been suspended without penalty in the case of numerous rea
/2 s, due 1933, and Berkey and Gay Furniture Company First 6s, due 1941) wherein a combination of a strong statistical showing with all the standard protec- tive provisions failed to safeguard the holders against a huge subsequent loss. But while the protective covenants we have been discussing do not guarantee the safety of the issue, they nevertheless add to the safety and are therefore worth insisting upon. Sinking-fund payments have been suspended without penalty in the case of numerous real estate issues, under the provisions of various state mortgage moratorium laws. Example: Harriman Building First 6s, due 1951. No sinking-fund payments were made between 1934 and 1939 by virtue of the New York Moratorium Law. Chapter 21 SUPERVISION OF INVESTMENT HOLDINGS Traditional Concept of “Permanent Investment.” A generation ago “permanent investment” was one of the stock phrases of finance. It was applied to the typical purchase by a conservative investor and may be said to have embraced three constituent ideas: (1) intention to hold for an indefinite period; (2) interest solely in annual income, without reference to fluctuations in the value of principal; and (3) freedom from concern over future developments affecting the company. A sound investment was by definition one that could be bought, put away, and forgotten except on coupon or dividend dates. This traditional view of high-grade investments was first seriously called into question by the unsatisfactory experiences of the 1920–1922 depression. Large losses were taken on securities that their owners had considered safe beyond the need of examination. The ensuing seven years, although generally prosperous, affected different groups of invest- ment issues in such divergent ways that the old sense of complete secu- rity—with which the term “gilt-edged securities” was identified—suffered an ever-increasing impairment. Hence even before the market collapse of 1929, the danger ensuing from neglect of invest
ences of the 1920–1922 depression. Large losses were taken on securities that their owners had considered safe beyond the need of examination. The ensuing seven years, although generally prosperous, affected different groups of invest- ment issues in such divergent ways that the old sense of complete secu- rity—with which the term “gilt-edged securities” was identified—suffered an ever-increasing impairment. Hence even before the market collapse of 1929, the danger ensuing from neglect of investments previously made, and the need for periodic scrutiny or supervision of all holdings, had been recognized as a new canon in Wall Street. This principle, directly opposed to the former practice, is frequently summed up in the dictum, “There are no permanent investments.” Periodic Inspection of Holdings Necessary—but Troublesome. That the newer view is justified by the realities of fixed-value investment can scarcely be questioned. But it must be frankly recognized also that this same necessity for supervision of all security holdings implies a rather serious indictment of the whole concept of fixed-value investment. If risk [253] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. of loss can be minimized only by the exercise of constant supervisory care, in addition to the painstaking process of initial choice, has not such invest- ment become more trouble than it is worth? Let it be assumed that the typical investor, following the conservative standards of selection herein recommended, will average a yield of 31/2% on a diversified list of corpo- rate securities. This 31/2% return appears substantially higher than the 21/2% obtainable from long-term United States government bonds and also more attractive than the 2 or 21/2% offered by savings banks. Never- theless, if we take into account not only the effort required to make a proper selection but also the greater efforts entailed by the subsequent repeated ch
llowing the conservative standards of selection herein recommended, will average a yield of 31/2% on a diversified list of corpo- rate securities. This 31/2% return appears substantially higher than the 21/2% obtainable from long-term United States government bonds and also more attractive than the 2 or 21/2% offered by savings banks. Never- theless, if we take into account not only the effort required to make a proper selection but also the greater efforts entailed by the subsequent repeated check-ups, and if we then add thereto the still inescapable risk of depreciation or definite loss, it must be confessed that a rather plausi- ble argument can be constructed against the advisability of fixed-value investments in general. The old idea of permanent, trouble-free holdings was grounded on the not illogical feeling that if a limited-return invest- ment could not be regarded as trouble-free it was not worth making at all. Superiority of United States Savings Bonds. Objectively consid- ered, investment experience of the last decade undoubtedly points away from the fixed-value security field and into the direction of (1) United States government bonds or savings-bank deposits; or (2) admittedly spec- ulative operations, with endeavors to reduce risk and increase profits by means of skillful effort; or (3) a search for the exceptional combination of safety of principal with a chance for substantial profit. For all people of moderate means United States Savings Bonds undoubtedly offer the most suitable medium for fixed-value investment. In fact we are inclined to state categorically that, on the basis of 1940 interest yields, their superiority to other issues makes them the only sensible purchase of this type. The rea- son is, of course, that it is not possible to obtain a significantly higher return on investment issues (save for a few obscure exceptions) without injecting an element of principal risk which makes the commitment unsound. In addition the holder’s redempti
ffer the most suitable medium for fixed-value investment. In fact we are inclined to state categorically that, on the basis of 1940 interest yields, their superiority to other issues makes them the only sensible purchase of this type. The rea- son is, of course, that it is not possible to obtain a significantly higher return on investment issues (save for a few obscure exceptions) without injecting an element of principal risk which makes the commitment unsound. In addition the holder’s redemption right before maturity is a very valuable feature of the bonds. If only small investors as a class would resolutely reject the various types of “savings plans,” with their multifari- ous titles, now being offered to them with an ostensible “sure income return” of 4 to 6%, and thankfully take advantage of the 2.90% available on United States Savings Bonds, we are convinced that they would save in the aggregate an enormous amount of money, trouble and heartbreak. But even if the ordinary investment problems of most investors could be thus simply disposed of, many investors would remain who must con- sider other types of fixed-value investment. These include: (1) institu- tional investors of all kinds, e.g., savings and commercial banks, insurance companies, educational and philanthropic agencies; (2) other large investors, e.g., corporations and wealthy individuals; (3) those with mod- erate income derived wholly from investments, since the maximum annual return ultimately obtainable from United States Savings Bonds is limited to $2,500 per annum.1 It is true also that many smaller investors will for one reason or another prefer to place part of their funds in other types of fixed-value investment. The second alternative, viz., to speculate instead of investing, is entirely too dangerous for the typical person who is building up his cap- ital out of savings or business profits. The disadvantages of ignorance, of human greed, of mob psychology, of trading costs, of weighting
from United States Savings Bonds is limited to $2,500 per annum.1 It is true also that many smaller investors will for one reason or another prefer to place part of their funds in other types of fixed-value investment. The second alternative, viz., to speculate instead of investing, is entirely too dangerous for the typical person who is building up his cap- ital out of savings or business profits. The disadvantages of ignorance, of human greed, of mob psychology, of trading costs, of weighting of the dice by insiders and manipulators,2 will in the aggregate far overbalance the purely theoretical superiority of speculation in that it offers profit pos- sibilities in return for the assumption of risk. We have, it is true, repeat- edly argued against the acceptance of an admitted risk to principal without the presence of a compensating chance for profit. In so doing, however, we have not advocated speculation in place of investment but only intelligent speculation in preference to obviously unsound and ill- advised forms of investment. We are convinced that the public generally will derive far better results from fixed-value investments, if selected with exceeding care, than from speculative operations, even though these may be aided by considerable education in financial matters. It may well be that the results of investment will prove disappointing; but if so, the results of speculation would have been disastrous. The third alternative—to look for investment merit combined with an opportunity for profit—presents, we believe, a suitable field for the tal- ents of the securities analyst. But it is a dangerous objective to hold before the untrained investor. He can readily be persuaded that safety exists 1 This is based on the maximum $7,500 permitted each year to one individual. After the tenth year of continued investment, an annual income of $2,500 would accrue via the matu- rity of a $10,000 unit each year and its replacement by a new $7,500 subscription. 2 This
ith an opportunity for profit—presents, we believe, a suitable field for the tal- ents of the securities analyst. But it is a dangerous objective to hold before the untrained investor. He can readily be persuaded that safety exists 1 This is based on the maximum $7,500 permitted each year to one individual. After the tenth year of continued investment, an annual income of $2,500 would accrue via the matu- rity of a $10,000 unit each year and its replacement by a new $7,500 subscription. 2 This factor has been greatly reduced by the operation of the Securities Exchange Act of 1934. where there is only promise or, conversely, that an attractive statistical showing is alone sufficient to warrant purchase. Having thus considered the three alternative policies open to those with capital funds, we see that fixed-value investment in the traditional field of high-grade bonds and preferred stocks remains a necessary and desirable activity for many individuals and corporate bodies. It is quite clear also that periodic reexamination of investment holdings is neces- sary to reduce the risk of loss. What principles and practical methods can be followed in such supervision? Principles and Problems of Systematic Supervision; Switching. It is generally understood that the investor should examine his holdings at intervals to see whether or not all of them may still be regarded as entirely safe and that if the soundness of any issue has become question- able, he should exchange it for a better one. In making such a “switch” the investor must be prepared to accept a moderate loss on the holding he sells out, which loss he must charge against his aggregate investment income. In the early years of systematic investment supervision, this policy worked out extremely well. Seasoned securities of the high-grade type tended to cling rather tenaciously to their established price levels and fre- quently failed to reflect a progressive deterioration of their intrinsic posi- tion until some t
ter one. In making such a “switch” the investor must be prepared to accept a moderate loss on the holding he sells out, which loss he must charge against his aggregate investment income. In the early years of systematic investment supervision, this policy worked out extremely well. Seasoned securities of the high-grade type tended to cling rather tenaciously to their established price levels and fre- quently failed to reflect a progressive deterioration of their intrinsic posi- tion until some time after this impairment was discoverable by analysis. It was possible, therefore, for the alert investor to sell out such holdings to some heedless and unsuspecting victim, who was attracted by the rep- utation of the issue and the slight discount at which it was obtainable in comparison with other issues of its class. The impersonal character of the securities market relieves this procedure of any ethical stigma, and it is considered merely as establishing a proper premium for shrewdness and a deserved penalty for lack of care. Increased Sensitivity of Security Prices. In more recent years, however, investment issues have lost what may have been called their “price iner- tia,” and their quotations have come to reflect promptly any materially adverse development. This fact creates a serious difficulty in the way of effective switching to maintain investment quality. By the time that any real impairment of security is manifest, the issue may have fallen in price not only to a speculative level but to a level even lower than the decline in earnings would seem to justify.3 (One reason for this excessive price decline is that an unfavorable apparent trend has come to influence prices even more severely than the absolute earnings figures.) The owner’s nat- ural reluctance to accept a large loss is reinforced by the reasonable belief that he would be selling the issue at an unduly low price, and he is likely to find himself compelled almost unavoidably to assume a speculative p
ive level but to a level even lower than the decline in earnings would seem to justify.3 (One reason for this excessive price decline is that an unfavorable apparent trend has come to influence prices even more severely than the absolute earnings figures.) The owner’s nat- ural reluctance to accept a large loss is reinforced by the reasonable belief that he would be selling the issue at an unduly low price, and he is likely to find himself compelled almost unavoidably to assume a speculative position with respect to that security. Exceptional Margins of Safety as Insurance against Doubt. The only effective means of meeting this difficulty lies in following counsels of perfection in making the original investment. The degree of safety enjoyed by the issue, as shown by quantitative measures, must be so far in excess of the minimum standards that a large shrinkage can be suffered before its position need be called into question. Such a policy should reduce to a very small figure the proportion of holdings about which the investor will subsequently find himself in doubt. It would also permit him to make his exchanges when the showing of the issue is still compara- tively strong and while, therefore, there is a better chance that the market price will have been maintained. Example and Conclusion. As a concrete example, let us assume that the investor buys an issue such as the Liggett and Myers Tobacco Com- pany Debenture 5s, due 1951, which earned their interest an average of nearly twenty times in 1934–1938, as compared with the minimum requirement of three times. If a decline in profits should reduce the cov- erage to four times, he might prefer to switch into some other issue (if one can be found) that is earning its interest eight to ten times. On these assumptions he would have a fair chance of obtaining a full price for the Liggett and Myers issue, since it would still be making an impres- sive exhibit. But if the influence of the downward trend of earnings has d
arly twenty times in 1934–1938, as compared with the minimum requirement of three times. If a decline in profits should reduce the cov- erage to four times, he might prefer to switch into some other issue (if one can be found) that is earning its interest eight to ten times. On these assumptions he would have a fair chance of obtaining a full price for the Liggett and Myers issue, since it would still be making an impres- sive exhibit. But if the influence of the downward trend of earnings has depressed the quotation to a large discount, then he could decide to retain the issue rather than accept an appreciable loss. In so doing he would have the great advantage of being able to feel that the safety of investment was still not in any real danger. 3 Many railroad bonds have proved an exception to this statement since 1933. Note, for example, that Baltimore and Ohio Railroad First 4s, due 1948, sold at 1091/2 in 1936, although the margin over total interest charges had long been much too small. In 1938 these bonds sold at 341/4. Such a policy of demanding very high safety margins would obviously prove especially beneficial if a period of acute depression and market unsettlement should supervene. It is not practicable, however, to recom- mend this as a standard practice for all investors, because the supply of such strongly buttressed issues is too limited, and because, further, it is contrary to human nature for investors to take extreme precautions against future collapse when current conditions make for optimism.4 Policy in Depression. Assuming that the investor has exercised merely reasonable caution in the choice of his fixed-value holdings, how will he fare and what policy should he follow in a period of depression? If the depression is a moderate one, his investments should be only mildly affected marketwise and still less in their intrinsic position. If conditions should approximate those of 1930–1933, he could not hope to escape a severe shrinkage in the qu
hen current conditions make for optimism.4 Policy in Depression. Assuming that the investor has exercised merely reasonable caution in the choice of his fixed-value holdings, how will he fare and what policy should he follow in a period of depression? If the depression is a moderate one, his investments should be only mildly affected marketwise and still less in their intrinsic position. If conditions should approximate those of 1930–1933, he could not hope to escape a severe shrinkage in the quotations and considerable uneasiness over the safety of his holdings. But any reasoned policy of fixed-value investment requires the assumption that disturbances of the 1930–1933 amplitude are nonrecurring in their nature and need not be specifically guarded against in the future. If the 1921–1922 and the 1937–1938 experiences are accepted instead as typical of the “recurrent severe depression,” a carefully selected investment list should give a reasonably good account of itself in such a period. The investor should not be stampeded into selling out hold- ings with a strong past record because of a current decline in earnings. He is likely, however, to pay more attention than usual to the question of improving the quality of his securities, and in many cases it should be possible to gain some benefits through carefully considered switches. The experiences of the 1937–1938 “recession” offer strong corrobo- ration of the foregoing analysis. Practically all senior securities that would have met our stringent requirements at the end of 1936 came through the ensuing setback without serious damage marketwise. But bonds that have sold at high levels despite an inadequate over-all earnings coverage— particularly a large number of railroad issues—suffered an enormous shrinkage in value. (See our discussion in Chap. 7 and also Appendix Notes 11 and 13, pages 740 and 742 on accompanying CD.) 4 We must caution the reader, however, against assuming that very large coverage of interest ch
ve met our stringent requirements at the end of 1936 came through the ensuing setback without serious damage marketwise. But bonds that have sold at high levels despite an inadequate over-all earnings coverage— particularly a large number of railroad issues—suffered an enormous shrinkage in value. (See our discussion in Chap. 7 and also Appendix Notes 11 and 13, pages 740 and 742 on accompanying CD.) 4 We must caution the reader, however, against assuming that very large coverage of interest charges is, in itself, a complete assurance of safety. An operating loss eliminates the margin of safety, however high it may have been. Hence, inherent stability is an essential require- ment, as we emphasize in our Studebaker example given in Chap. 2. Sources of Investment Advice and Supervision. Supervision of securities involves the question of who should do it as well as how to do it. Investors have the choice of various agencies for this purpose, of which the more important are the following: 1. The investor himself. 2. His commercial bank. 3. An investment banking (or underwriting) house. 4. A New York Stock Exchange firm. 5. The advisory department of a large trust company. 6. Independent investment counsel or supervisory service. The last two agencies charge fees for their service, whereas the three preceding supply advice and information gratis.5 Advice from Commercial Bankers. The investor should not be his own sole consultant unless he has training and experience sufficient to qual- ify him to advise others professionally. In most cases he should at least supplement his own judgment by conference with others. The practice of consulting one’s bank about investments is widespread, and it is undeni- ably of great benefit, especially to the smaller investor. If followed consis- tently it would afford almost complete protection against the hypnotic wiles of the high-pressure stock salesman and his worthless “blue sky” flotations.6 It is doubtful, however, if the commer
to qual- ify him to advise others professionally. In most cases he should at least supplement his own judgment by conference with others. The practice of consulting one’s bank about investments is widespread, and it is undeni- ably of great benefit, especially to the smaller investor. If followed consis- tently it would afford almost complete protection against the hypnotic wiles of the high-pressure stock salesman and his worthless “blue sky” flotations.6 It is doubtful, however, if the commercial banker is the most suitable adviser to an investor of means. Although his judgment is usu- ally sound, his knowledge of securities is likely to be somewhat superfi- cial, and he cannot be expected to spare the time necessary for a thoroughgoing analysis of his clients’ holdings and problems. Advice from Investment Banking Houses. There are objections of another kind to the advisory service of an investment banking house. An institution with securities of its own to sell cannot be looked to for entirely impartial guidance. However ethical its aims may be, the compelling force of self-interest is bound to affect its judgment. This is particularly true 5 A growing number of Stock Exchange firms now supply investment advice on a fee basis. 6 Under S.E.C. supervision the “blue-sky flotation” of the old school has largely disappeared from interstate commerce, its place being taken by small but presumably legitimate enter- prises which are sold to the public at excessively high prices. Numerous other types of fraud are still fairly prevalent, as can be seen from the 1938 report of the Better Business Bureau of New York City. when the advice is supplied by a bond salesman whose livelihood depends upon persuading his customers to buy the securities that his firm has “on its shelves.” It is true that the reputable underwriting houses consider themselves as bound in some degree by a fiduciary responsibility toward their clients. The endeavor to give them sound advice and to sell
Numerous other types of fraud are still fairly prevalent, as can be seen from the 1938 report of the Better Business Bureau of New York City. when the advice is supplied by a bond salesman whose livelihood depends upon persuading his customers to buy the securities that his firm has “on its shelves.” It is true that the reputable underwriting houses consider themselves as bound in some degree by a fiduciary responsibility toward their clients. The endeavor to give them sound advice and to sell them suitable securities arises not only from the dictates of good business prac- tice but more compellingly from the obligations of a professional code of ethics. Nevertheless, the sale of securities is not a profession but a business and is necessarily carried on as such. Although in the typical transaction it is to the advantage of the seller to give the buyer full value and satisfac- tion, conditions may arise in which their interests are in serious conflict. Hence it is impracticable, and in a sense unfair, to require investment banking houses to act as impartial advisers to buyers of securities; and, broadly speaking, it is unwise for the investor to rely primarily upon the advice of sellers of securities. Advice from New York Stock Exchange Firms. The investment depart- ments of the large Stock Exchange firms present a somewhat different picture. Although they also have a pecuniary interest in the transactions of their customers, their advice is much more likely to be painstaking and thoroughly impartial. Stock Exchange houses do not ordinarily own secu- rities for sale. Although at times they participate in selling operations, which carry larger allowances than the ordinary market commission, their interest in pushing such individual issues is less vital than that of the underwriting houses who actually own them. At bottom, the invest- ment business or bond department of Stock Exchange firms is perhaps more important to them as a badge of respectability than for the
ng and thoroughly impartial. Stock Exchange houses do not ordinarily own secu- rities for sale. Although at times they participate in selling operations, which carry larger allowances than the ordinary market commission, their interest in pushing such individual issues is less vital than that of the underwriting houses who actually own them. At bottom, the invest- ment business or bond department of Stock Exchange firms is perhaps more important to them as a badge of respectability than for the profits it yields. Attacks made upon them as agencies of speculation may be answered in part by pointing to the necessary services that they render to conservative investors. Consequently, the investor who consults a large Stock Exchange firm regarding a small bond purchase is likely to receive time and attention out of all proportion to the commission involved. Admittedly this practice is found profitable in the end, as a cold business proposition, because a certain proportion of the bond customers later develop into active stock traders. In behalf of the Stock Exchange houses it should be said that they make no effort to persuade their bond clients to speculate in stocks, but the atmosphere of a brokerage office is perhaps not without its seductive influence. Advice from Investment Counsel. Although the idea of giving investment advice on a fee basis is not a new one, it has only recently developed into an important financial activity. The work is now being done by special depart- ments of large trust companies, by a division of the statistical services, and by private firms designating themselves as investment counsel or investment consultants. The advantage of such agencies is that they can be entirely impartial, having no interest in the sale of any securities or in any commis- sion on their client’s transactions. The chief disadvantage is the cost of the service, which averages about 1/2% per annum on the principal involved. As applied strictly to investment funds thi
ments of large trust companies, by a division of the statistical services, and by private firms designating themselves as investment counsel or investment consultants. The advantage of such agencies is that they can be entirely impartial, having no interest in the sale of any securities or in any commis- sion on their client’s transactions. The chief disadvantage is the cost of the service, which averages about 1/2% per annum on the principal involved. As applied strictly to investment funds this charge would amount to about 1/7 or 1/8 of the annual income, which must be considered substantial. In order to make their fees appear less burdensome, some of the pri- vate investment consultants endeavor to forecast the general course of the bond market and to advise their clients as to when to buy or sell. It is doubtful if trading in bonds, to catch the market swings, can be carried on successfully by the investor. If the course of the bond market can be predicted, it should be possible to predict that of the stock market as well, and there would be undoubted technical advantages in trading in stocks rather than in bonds. We are sceptical of the ability of any paid agency to provide reliable forecasts of the market action of either bonds or stocks. Furthermore we are convinced that any combined effort to advise upon the choice of individual high-grade investments and upon the course of bond prices is fundamentally illogical and confusing. Much as the investor would like to be able to buy at just the right time and to sell out when prices are about to fall, experience shows that he is not likely to be bril- liantly successful in such efforts and that by injecting the trading element into his investment operations he will disrupt the income return on his capital and inevitably shift his interest into speculative directions. It is not clear as yet whether or not advice on a fee basis will work out satisfactorily in the field of standard high-grade investments, because of t
e to buy at just the right time and to sell out when prices are about to fall, experience shows that he is not likely to be bril- liantly successful in such efforts and that by injecting the trading element into his investment operations he will disrupt the income return on his capital and inevitably shift his interest into speculative directions. It is not clear as yet whether or not advice on a fee basis will work out satisfactorily in the field of standard high-grade investments, because of their relatively small income return. In the purely speculative field the objection to paying for advice is that if the adviser knew whereof he spoke he would not need to bother with a consultant’s duties. It may be that the profession of adviser on securities will find its most practicable field in the intermediate region, where the adviser will deal with problems aris- ing from depreciated investments, and where he will propose advanta- geous exchanges and recommend bargain issues selling considerably below their intrinsic value. This page intentionally left blank PART III SENIOR SECURITIES WITH SPECULATIVE FEATURES Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. This page intentionally left blank I n tr oduc tion to P ar t III “BLOOD AND JUDGEMENT ” BY J. EZR A MERKIN I f the names of Graham and Dodd are a talisman for value investors, they are practically a sacrament for those who focus on bankrupt com- panies. After all, bankruptcy, or distressed, investing is perhaps the purest form of value investing, the natural home for those who take Gra- ham and Dodd seriously. In effect, distressed investing is a form of value investing at a substantial discount. The former astronaut and airline CEO Frank Borman has opined that “capitalism without bankruptcy is like Chris- tianity without hell.” Not only is bankruptcy an inherent feature of the landscape of risk,
nt for those who focus on bankrupt com- panies. After all, bankruptcy, or distressed, investing is perhaps the purest form of value investing, the natural home for those who take Gra- ham and Dodd seriously. In effect, distressed investing is a form of value investing at a substantial discount. The former astronaut and airline CEO Frank Borman has opined that “capitalism without bankruptcy is like Chris- tianity without hell.” Not only is bankruptcy an inherent feature of the landscape of risk, but the term “distressed investing” might ultimately be redundant for the true disciple of Graham and Dodd. Because the average observer does not view the securities of bankrupt or nearly bankrupt com- panies as a classic safe haven, we need to understand a bit more about the authors’ understanding of “investing” and how that matches up with the characteristics of distressed investing. In that light, it will become apparent that distressed investing is a classic Graham and Dodd discipline. Today, you can easily go online and buy 100 shares of Microsoft or Apple, and we would say that those who do so have invested in those companies. Graham and Dodd would demur. They view investment as “a convenient omnibus word, with perhaps an admixture of euphemism— that is, a desire to lend a certain respectability to financial dealings of I am deeply grateful for the assistance of Jerome Balsam, general counsel at Gabriel Capital Group, in preparing this introduction. [265] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. miscellaneous character.” (p. 100) For the authors, investment is to be contrasted with speculation, and they argue: “It should be essential, therefore, for anyone engaging in financial operations to know whether he is investing or speculating and, if the latter, to make sure that his speculation is a justifiable one.” (p. 101) Thus, the authors caution that “bonds should be bought on a depression basis” b
, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. miscellaneous character.” (p. 100) For the authors, investment is to be contrasted with speculation, and they argue: “It should be essential, therefore, for anyone engaging in financial operations to know whether he is investing or speculating and, if the latter, to make sure that his speculation is a justifiable one.” (p. 101) Thus, the authors caution that “bonds should be bought on a depression basis” because an investment cannot be sound unless it can withstand true adversity. (p. 154) Think about that!—on a depression basis. Moreover, while Graham and Dodd favor the reader with 727 pages of analysis, examples, charts, and advice, they caution that “stock speculation,” that is, probably the majority of security purchases and sales made by Americans today, “does not come within the scope of this volume.” (p. 29) At nearly seven decades’ remove from Graham and Dodd’s second edition, and even further from the Great Crash of 1929, the language, let alone the permanent frame of mind, of disciplined austerity does not come easily to the contemporary investor (let alone speculator). Many repeat the mantras of value investing; few—even among those who appreciate their wisdom—practice them consistently. It is easy to get caught up with the crowd when the market is booming, harder to think about what securities are really worth. The temptation to speculate recurs regularly, as animal spirits send markets soaring beyond valuations that the fundamentals would justify. It is not easy to stay on the sidelines while others are busy getting rich. In our generation, perhaps the ultimate example of speculation for the sake of speculation came with the dot-com boom. It is then that pru- dence and caution give way to excitement, and propositions that would ordinarily sound ridiculous become strangely plausible. It’s just like when Big Julie, in the classic Broadway musical Guys and Dolls, cha
send markets soaring beyond valuations that the fundamentals would justify. It is not easy to stay on the sidelines while others are busy getting rich. In our generation, perhaps the ultimate example of speculation for the sake of speculation came with the dot-com boom. It is then that pru- dence and caution give way to excitement, and propositions that would ordinarily sound ridiculous become strangely plausible. It’s just like when Big Julie, in the classic Broadway musical Guys and Dolls, challenged Nathan Detroit to a game of craps played with dice that had no dots, other than those Big Julie claimed he could see. Early in 2000, near the top of the market, Arthur J. Samberg, head of the well-regarded hedge fund Pequot Capital Management and a top- notch technology investor, shared his four favorite stocks with the Bar- ron’s Roundtable. (They were Critical Path, Double Click, Kana Communications, and Message Media.) The Graham and Dodd who cau- tioned that “the notion that the desirability of a common stock was entirely independent of its price seems inherently absurd” (p. 359) would have blanched when Samberg said: I’ll give you no numbers. I’ll give you no prices. I am not going to tell you which ones are going to succeed or fail. I think they are all pretty good companies, and if you bought a package of these stocks over the next three to four years, you would do very well I hear this stuff all the time, about how it is a bubble, it’s ridiculous. If you just use the numbers to do this stuff, number one, you won’t buy them, which is probably a good thing for some people. But you will never understand the amount of change that’s going on, and how much is still ahead of us. How the authors would have protested! I’ll give you no numbers? But numbers are the raw material of the Graham and Dodd search for value. I’ll give you no prices? Whether a security is a good buy or not is a func- tion of its price relative to its value. Almost any security, regardless of i
numbers to do this stuff, number one, you won’t buy them, which is probably a good thing for some people. But you will never understand the amount of change that’s going on, and how much is still ahead of us. How the authors would have protested! I’ll give you no numbers? But numbers are the raw material of the Graham and Dodd search for value. I’ll give you no prices? Whether a security is a good buy or not is a func- tion of its price relative to its value. Almost any security, regardless of its characteristics, can be cheap or dear: it all depends how much you have to pay for it.1 Distressed investors inevitably declare their allegiance to Graham and Dodd. They take comfort with the authors’ ascetic posture and believe in their mantras. They do not dream of “ten-baggers,” though, on rare occa- sions, they may come. The idea is to find valuable assets or inherently 1 Mason Hawkins and Staley Cates of the Longleaf family of funds, among the most successful Gra- ham and Dodd acolytes of our era, emphasize what they call the price-to-value ratio of the stocks they buy. They “talk so frequently about buying companies at ‘60% of intrinsic value or less’ it sounds almost like a religious chant. But their method works.” Steven Goldberg, “Want to Win at Fund Invest- ing? Learn from Longleaf,” Kiplinger.com, May 22, 2007. profitable companies that have nonetheless leveraged themselves up to levels of debt unsustainable by their cash flows.2 Graham and Dodd’s margin of safety sends investors to scrutinize the balance sheet and projected earnings. They perform the analytical func- tion that the authors endorse, apply the same skills, study the same doc- uments. For them, the balance sheet is the main thing, far more than earnings, if for no other reason than necessity, as most bankrupt compa- nies no longer have earnings. Graham and Dodd devote Part VI of the 1940 edition, nearly 70 pages, to balance sheet analysis. In the context of equity investing, the authors prize st
s investors to scrutinize the balance sheet and projected earnings. They perform the analytical func- tion that the authors endorse, apply the same skills, study the same doc- uments. For them, the balance sheet is the main thing, far more than earnings, if for no other reason than necessity, as most bankrupt compa- nies no longer have earnings. Graham and Dodd devote Part VI of the 1940 edition, nearly 70 pages, to balance sheet analysis. In the context of equity investing, the authors prize stocks that sell below their current asset, or liquidating, value. They preach: “When a common stock sells per- sistently below its liquidating value, then either the price is too low or the company should be liquidated.” (p. 563) If you buy a security below liqui- dation value, you should not get hurt, even if liquidation is in the offing. This is true for shareholders; how much more so for creditors, who pre- cede shareholders in the hierarchy of claims. The Varieties of Bankruptcy I would like to suggest a typology of bankruptcy investing, consistent, I believe, with Graham and Dodd’s approach. We will find that there are two types of bankruptcies, which are, in effect, three. First, there are (1) liquida- tions, which are the purest Graham and Dodd exercise of all, as the investor buys a security to create a workout that is entirely (or nearly entirely) cash. It is a rate-of-return play, as the investor makes a judgment that the balance sheet will support cash distributions above those implied by the current prices of the securities. What’s more, these distributions will be received soon enough to create a rate of return that justifies the risk involved. Second, there are reorganizations, which come in two flavors: (2) those producing a mélange of cash and securities and (3) those in which 2 This is especially true for reorganizations, more so than for liquidations, a distinction on which I shall elaborate presently. the investor’s goal is control of the reorganized comp
se implied by the current prices of the securities. What’s more, these distributions will be received soon enough to create a rate of return that justifies the risk involved. Second, there are reorganizations, which come in two flavors: (2) those producing a mélange of cash and securities and (3) those in which 2 This is especially true for reorganizations, more so than for liquidations, a distinction on which I shall elaborate presently. the investor’s goal is control of the reorganized company. In the second type of bankruptcy, “cash and securities” can consist of a bewildering array of paper: senior debt, senior subordinated debt, mezzanine debt, junior debt, preferred stock, and equity. The third type of bankruptcy, in which the investor seeks control, is a polar opposite of a liquidation, in that the hope is to achieve profit from seizing control of a going concern rather than reaping the proceeds of the sale of its parts. The first and third types of bankruptcy are conceptually simpler to structure, unlike the cash and securities reorganizations, which have an intermediate goal (get some cash out of the business at the outset and then hope it will prove prof- itable going forward) but the greatest structural complexity. In almost all cases of distressed investing, holding periods start at a year or two and can stretch longer—considerably longer when the investor takes a controlling position in the company. Whereas Charles Dickens once wrote to a friend that the character he most enjoyed por- traying was “the rogue who transforms himself in a blink of an eye and thereby instantly earns his eternal reward,” it is not the nature of a dis- tressed investment to realize its goals in the blink of an eye or even in the turn of a quarter or two. The process is necessarily drawn out, and investors cannot easily wait till the end of the process to buy because the product is often illiquid, all the more so when the investor wishes to accumulate enough securities to ac
cter he most enjoyed por- traying was “the rogue who transforms himself in a blink of an eye and thereby instantly earns his eternal reward,” it is not the nature of a dis- tressed investment to realize its goals in the blink of an eye or even in the turn of a quarter or two. The process is necessarily drawn out, and investors cannot easily wait till the end of the process to buy because the product is often illiquid, all the more so when the investor wishes to accumulate enough securities to achieve control. In effect, the bankruptcy investor acts as the incubator, buying tad- poles and selling frogs. In liquidations, the frogs are very green: the investor receives cash and, sometimes, a small amount of senior debt; in reorganizations, on the other hand, the investor may receive a mélange, or what I like to call a “grab bag,” of cash, senior debt, junior debt, and new equity in a reorganized company. At the extreme, where the frogs are greenest—in a liquidation—the investor is essentially creating cash at a discount, weighted for time and risk. As the investor moves from liquidation to reorganization to control reorganization, he or she moves away from classic Graham and Dodd balance sheet analysis toward more speculative endeavors. Distressed investors combine a financial analysis of a company’s capi- tal structure with a legal analysis of the rights and prerogatives of bond- holders at each level of the capital structure. As the authors noted, litigation can be necessary “to cut the Gordian knot” when “creditors . . . belong to several classes with conflicting interests.” (p. 234) Blending the financial and legal analysis is crucial. As distressed investors contemplate an investment, their financial flexibility is defined and limited by the legal remedies made available by specific covenants and broader con- tract and bankruptcy law; simultaneously, their legal rights are circum- scribed by what is financially achievable.3 In other words, distressed investors c
“to cut the Gordian knot” when “creditors . . . belong to several classes with conflicting interests.” (p. 234) Blending the financial and legal analysis is crucial. As distressed investors contemplate an investment, their financial flexibility is defined and limited by the legal remedies made available by specific covenants and broader con- tract and bankruptcy law; simultaneously, their legal rights are circum- scribed by what is financially achievable.3 In other words, distressed investors cross-reference the legally permissible with the financially doable. When they find the desired fit, they invest. A few examples of recent (and not so recent) coups in distressed investing give an idea of what takes place in the field. These examples also suggest that, while individual investors may have success picking stocks, it is far more difficult for them to partake in distressed investing. Doing well in the bankruptcy process often entails expenditures of time and resources that are beyond their capabilities. Liquidations Texaco: A Quasi-bankruptcy In the standard liquidation, senior creditors are paid off as best as the company’s assets will allow; sometimes, unsecured creditors are fortu- 3 When Graham and Dodd wrote Security Analysis, the Bankruptcy Act of 1898, also known as the “Nelson Act,” was the law of the land. While bankruptcy procedure has since changed, with the 1978 adoption of the Bankruptcy Code and some subsequent amendments, most recently the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, these legal changes do not undermine the general principles laid out by the authors. nate enough to receive a meaningful distribution too. In the rare cases when even unsecured creditors are paid in full, the equity is not wiped out. The very unusual story of Texaco—founded in 1901 as Texas Fuel Company, eventually merged into Chevron a century later—offers useful lessons about liquidations, even though Texaco was not liquidated and, notwithstand
Prevention and Consumer Protection Act of 2005, these legal changes do not undermine the general principles laid out by the authors. nate enough to receive a meaningful distribution too. In the rare cases when even unsecured creditors are paid in full, the equity is not wiped out. The very unusual story of Texaco—founded in 1901 as Texas Fuel Company, eventually merged into Chevron a century later—offers useful lessons about liquidations, even though Texaco was not liquidated and, notwithstanding its bankruptcy filings, was never insolvent. Ultimately, Texaco is most significant as an example of the use of the Bankruptcy Code as an escape hatch, to evade legal or contractual liabilities.4 Distressed investing generally involves buying debt instruments of a troubled company, because in most bankruptcies the equity is wiped out. That is not always the case, however, and sometimes an astute investor can find riches in the equity of a distressed company, as demonstrated by Carl Icahn in the case of Texaco. Here’s what led the oil giant to bankruptcy. In 1984, Texaco acquired Getty Oil Company, but it was sued by Pennzoil, which contended that Texaco had interfered with its prior con- tract to buy part of Getty. The following year, a jury determined Texaco was wrong and awarded Pennzoil $10.3 billion. To appeal the judgment, Texaco would have had to post a multi-billion-dollar security bond, which it could not do. Therefore, in 1987, Texaco filed for protection from its creditors under Chapter 11 of the Bankruptcy Code. This was not a real bankruptcy but rather a nearly sui generis use of bankruptcy law to fend off legal obligations. Although Texaco was legally bankrupt, it was never insolvent. Upon the heels of the filing, Texaco’s stock fell from nearly $32 to $28.50 before rebounding to $31.25. As an oil analyst put it at the time, “While Texaco will be in bankruptcy, Texaco won’t be a bank- rupt company.”5 Time magazine summarized the benefits to Texaco of this unc
s under Chapter 11 of the Bankruptcy Code. This was not a real bankruptcy but rather a nearly sui generis use of bankruptcy law to fend off legal obligations. Although Texaco was legally bankrupt, it was never insolvent. Upon the heels of the filing, Texaco’s stock fell from nearly $32 to $28.50 before rebounding to $31.25. As an oil analyst put it at the time, “While Texaco will be in bankruptcy, Texaco won’t be a bank- rupt company.”5 Time magazine summarized the benefits to Texaco of this unconventional bankruptcy: 4 Time, “Bankruptcy as an Escape Hatch,” March 5, 1984. 5 Janice Castro, “A Break in the Action,” Time, April 27, 1987. Taking advantage of liberalized bankruptcy laws enacted in 1978, which no longer require corporations to demonstrate that they are insolvent,6 the oil giant is immune, for the moment, from far more than the debili- tating bond judgment. Pennzoil can no longer slap liens, as it was report- edly preparing to do, on up to $8 billion in Texaco assets. With $3 billion already in reserve, Texaco no longer has to pay $630 million worth of annual interest on $7 billion in normal business debts. Nor is it required to pay dividends on 242.3 million outstanding common shares, an esti- mated saving this year of nearly $727 million.7 Eventually, Texaco was able to settle with Pennzoil for a massive, but at least manageable, $3 billion, and it emerged from bankruptcy.8 Most of the distressed investing community focused on Texaco’s senior securi- ties, such as preferred stock and bonds. Icahn, who had owned Texaco stock before the bankruptcy, increased his holdings dramatically after the Chapter 11 filing, eventually raising his stake to 16.6% of the com- pany. Obviously, he was banking that the reorganization of Texaco would not wipe out the equity. It was a very good call. After conducting an unsuccessful proxy fight and making a play for the entire company, Icahn successfully negotiated for a special dividend of $8 per share to stock- holders,
h as preferred stock and bonds. Icahn, who had owned Texaco stock before the bankruptcy, increased his holdings dramatically after the Chapter 11 filing, eventually raising his stake to 16.6% of the com- pany. Obviously, he was banking that the reorganization of Texaco would not wipe out the equity. It was a very good call. After conducting an unsuccessful proxy fight and making a play for the entire company, Icahn successfully negotiated for a special dividend of $8 per share to stock- holders, for a total of $1.9 billion. In addition, Texaco announced a $500 million stock buyback. At the end, Icahn had made $1.1 billion, or a return of over 75%.9 6 Texaco is but one example of how the Bankruptcy Code may be used as an escape hatch. Crucially, in NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984), the Supreme Court held that a company may use section 365(a) of the code, which permits the bankruptcy trustee to assume or reject executory con- tracts, to escape from the terms of a collective-bargaining agreement by which it had been bound. 7 Ibid. 8 For an overview of the Texaco bankruptcy and Icahn’s subsequent jousting with the company, see Mark Potts, “With Icahn Agreement, Texaco Emerges from Years of Trying Times,” Washington Post, February 5, 1989, p. H2. 9 Michael Arndt, “Texaco, Icahn Make a Deal,” Chicago Tribune, January 30, 1989, p. C3. Maybe the best bankruptcy investment of all is to try the case that sends the company into bankruptcy. Forbes pegs the net worth of Joseph Jamail, Jr., the plaintiff’s lawyer in Pennzoil v. Texaco, at $1.5 billion. Texaco’s unusual situation can be summarized in one sentence, often repeated by Graham and Dodd disciple Warren Buffett: A great invest- ment opportunity occurs when a marvelous business encounters a one- time huge, but solvable, problem. The tale also serves as an example of how perceptions had changed since Graham and Dodd’s day. Here was a bankruptcy in which the equity was not wiped out—and no one expected it
oseph Jamail, Jr., the plaintiff’s lawyer in Pennzoil v. Texaco, at $1.5 billion. Texaco’s unusual situation can be summarized in one sentence, often repeated by Graham and Dodd disciple Warren Buffett: A great invest- ment opportunity occurs when a marvelous business encounters a one- time huge, but solvable, problem. The tale also serves as an example of how perceptions had changed since Graham and Dodd’s day. Here was a bankruptcy in which the equity was not wiped out—and no one expected it to be wiped out—whereas Graham and Dodd had argued that bondholders would be best off not enforcing their rights to the hilt because “receivership” (to say nothing of “bankruptcy”) was so dreaded a word on Wall Street that “its advent means ordinarily a drastic shrinkage in the price of all the company’s securities, including the bonds for the ‘benefit’ of which the receivership was instituted.” (p. 230) By illuminating bankruptcy, they made it not so scary. This change in perceptions is not to the discredit of the authors. Indeed, they probably were indispensable to the shift, in light of their role in educating the investing public. Call it the Graham and Dodd Heisenberg effect. In light of Graham and Dodd, the game shifted, all the way to Carl Icahn. The effect may be similarly present in the authors’ relatively concise discussion of distressed invest- ing. Their brevity is readily understandable not only because the field has grown since Graham and Dodd published but because the themes sounded throughout their work are inherently applicable to this mode, such that dedicating a chapter to distressed investing as such would have been nearly superfluous. Grab Bag Reorganizations In Graham and Dodd’s terminology, we move away from investment toward speculation when we shift focus from liquidations to reorganiza- tions that include cash plus a bag of securities. At the end of the reor- ganization process, the investor may hold several kinds of paper, each of which may be valu
hemes sounded throughout their work are inherently applicable to this mode, such that dedicating a chapter to distressed investing as such would have been nearly superfluous. Grab Bag Reorganizations In Graham and Dodd’s terminology, we move away from investment toward speculation when we shift focus from liquidations to reorganiza- tions that include cash plus a bag of securities. At the end of the reor- ganization process, the investor may hold several kinds of paper, each of which may be valued differently. Adelphia Communications Because companies often issue different classes of debt, bankruptcy liti- gation commonly involves a battle among the different classes of credi- tors. The bankruptcy of Adelphia Communications offers an example of intercreditor strife and of how an accurate projection of the outcome can lead to outsize returns. John Rigas, the son of Greek immigrants, founded Adelphia in 1952, which rose to become one of the largest cable companies in the United States. Rigas was a pioneer in the industry, inducted into the Cable Tele- vision Hall of Fame in 2001. He also became a billionaire, owner of the Buffalo Sabres, and philanthropic hero of Coudersport, Pennsylvania, where his business empire got started. As the company grew, Rigas did not run a tight ship. At one point, Adelphia’s debt reached 11 times its market capitalization, compared to ratios of 1.28 for Comcast and 0.45 for Cox Communications.10 The whole edifice unraveled when an invest- ment analyst figured out that the company was liable for $2.3 billion in off-balance-sheet loans to Rigas family members, which they used to buy Adelphia stock. Eventually, Adelphia filed for Chapter 11, and, in August 2007, Rigas went to federal prison for conspiracy, securities fraud, and bank fraud. Adelphia’s bankruptcy featured intercreditor disputes over the pro- ceeds. Even after the company’s assets had been sold to Time Warner and Comcast—this being a reorganization, not a liquidation—there wa
alyst figured out that the company was liable for $2.3 billion in off-balance-sheet loans to Rigas family members, which they used to buy Adelphia stock. Eventually, Adelphia filed for Chapter 11, and, in August 2007, Rigas went to federal prison for conspiracy, securities fraud, and bank fraud. Adelphia’s bankruptcy featured intercreditor disputes over the pro- ceeds. Even after the company’s assets had been sold to Time Warner and Comcast—this being a reorganization, not a liquidation—there was still intense litigation between the bondholders of the holding company, Adelphia, and of a large subsidiary, Century Communications. Eventually, the Century bondholders agreed to a 3% decrease in their recovery in exchange for the support of several large bondholders for the plan of reorganization. For the most part, the plan maintained the structural 10 These figures, and certain other details, come from Devin Leonard, “The Adelphia Story,” Fortune, August 12, 2002. integrity of the Century bonds, while enabling Adelphia to emerge from bankruptcy. The plan was eventually approved, notwithstanding some remaining opposition from Adelphia bondholders. A contemporaneous increase in cable valuations, as well as strong results from industry lead- ers Time Warner and Comcast, helped Adelphia to garner the votes it needed in support of the plan. Those who bought Century bonds at the bottom and held them through a contentious and protracted legal process enjoyed a return of over 400%. In general, creditors received a combination of cash and Time Warner Cable Class A common stock, with percentage recoveries as of August 31, 2007, varying from 100% for cer- tain trade claims to 99.6% for senior subordinated notes, 94.7% for some senior notes, 83.7% for senior discount notes, 70.7% for other senior notes, and a variety of other percentages down to 0% for Adelphia com- mon stock, preferred stock, and convertible preferred stock.11 Winn-Dixie Stores As it filed for bankruptcy in Feb
general, creditors received a combination of cash and Time Warner Cable Class A common stock, with percentage recoveries as of August 31, 2007, varying from 100% for cer- tain trade claims to 99.6% for senior subordinated notes, 94.7% for some senior notes, 83.7% for senior discount notes, 70.7% for other senior notes, and a variety of other percentages down to 0% for Adelphia com- mon stock, preferred stock, and convertible preferred stock.11 Winn-Dixie Stores As it filed for bankruptcy in February 2005, Winn-Dixie was the eighth- largest food retailer in the United States, with revenues of $9.9 billion. The company was founded by William Milton Davis in 1914, and at the time of the bankruptcy Davis’s heirs still owned 35% of the common stock. Winn- Dixie’s Chapter 11 filing was precipitated by overexpansion and severe competition, primarily fueled by Publix Super Markets and Wal-Mart Stores. There was doubt whether the Florida-based company could emerge, but there were also reasons for optimism. The new CEO was the well-respected Peter Lynch, formerly the president and COO of Albertson’s. As he asserted his leadership and operations stabilized, vendors cautiously supported the reorganization plan. The company closed or sold a third of its stores, downsizing distribution operations and headcount. 11 Information on Distribution to Certain Classes of Claims (available at www.adelphiarestructuring.com). Still, vendors were reluctant to extend credit to Winn-Dixie, so the company was unable to enjoy the “float” available to grocery stores that turn over inventory before they have to pay for it. Some investors con- cluded that the company was likely to receive credit, unwind pent-up working capital, and once again take advantage of the float as it emerged from bankruptcy. In addition, they looked forward to the com- pany’s ability, as part of the supermarket industry, to operate with nega- tive working capital and receive significant fees for shelf space. Moreover,
mpany was unable to enjoy the “float” available to grocery stores that turn over inventory before they have to pay for it. Some investors con- cluded that the company was likely to receive credit, unwind pent-up working capital, and once again take advantage of the float as it emerged from bankruptcy. In addition, they looked forward to the com- pany’s ability, as part of the supermarket industry, to operate with nega- tive working capital and receive significant fees for shelf space. Moreover, Winn-Dixie had long-term leases at below-market rents. Man- agement’s strategy, which included leasing space to Boston Markets rather than operating its own roasted chicken counters, made sense to investors. Thus, those who invested in Winn-Dixie were less concerned than much of Wall Street that the company would fritter away its cash. During the second quarter of 2006, Winn-Dixie bonds were available at under 60 cents on the dollar, as the company was then effectively valued at under $450 million, or approximately 5% of revenue. This was a rare contemporary example of being able to buy a company for net working capital, or one whose mark-to-market enterprise value was under 10% of revenue. Graham and Dodd surely would have approved. Winn-Dixie emerged from bankruptcy in December 2006. By the end of the second quarter of 2007, on the heels of its emergence, the company’s enterprise value had tripled to $1.4 billion. Bradlees At the conclusion of a grab bag reorganization, creditors may find them- selves in a very different position from the one they occupied at the out- set. As Graham and Dodd note, voting control over the corporation can pass in bankruptcy to the bondholders, who will then become equity holders in the new entity that enjoys a statutory fresh start. (p. 238) Thus, even though most distressed investments are made in debt rather than equity, there is an important equity component to the bankruptcy process. (The authors point out that debt may, of course, be e
find them- selves in a very different position from the one they occupied at the out- set. As Graham and Dodd note, voting control over the corporation can pass in bankruptcy to the bondholders, who will then become equity holders in the new entity that enjoys a statutory fresh start. (p. 238) Thus, even though most distressed investments are made in debt rather than equity, there is an important equity component to the bankruptcy process. (The authors point out that debt may, of course, be exchanged for equity under voluntary reorganization plans too. [pp. 236–237]) An example was Bradlees, a retailer that emerged from bankruptcy in early 1999. Bondholders received cash, new notes, and equity. The stock was hammered in the aftermath of the diminution in demand for all dis- tressed securities at the end of 1998. At the bottom, Bradlees had nearly $138 of sales per share of common stock, in contrast with the conced- edly more successful Wal-Mart’s $31. In the second quarter of 1999, Wall Street woke up to the disparity, and Bradlees was the best-performing over-the-counter stock of that three-month period. The new bonds shot up in value too. By July, the total Bradlees postbankruptcy securities package had reached an aggregate value of $1.55 (see table), in contrast with a March low of 62 cents. By August 1999, Bradlees’ stocks alone were worth far more than the old bonds. As the table shows, the equity portion of these grab bags can be volatile, but they can be rewarding to the patient investor. Bradlees’ Grab Bag Date 6/30/98 12/31/98 2/5/99 3/15/99 3/31/99 5/6/99 5/21/99 5/26/99 6/3/99 6/23/99 6/30/99 7/8/99 Old Bonds 0.78 0.50 - - - - - - - - - - Cash - - 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 Certificates - - 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06 New Notes - - 0.22 0.22 0.22 0.22 0.26 0.26 0.26 0.27 0.27 0.27 Stock - - 0.26 0.14 0.20 0.53 0.58 0.51 0.57 0.84 0.86 1.02 Total 0.78 0.50 0.74 0.62 0.68 1.01 1.10 1.03 1.09 1.37 1.39
o the patient investor. Bradlees’ Grab Bag Date 6/30/98 12/31/98 2/5/99 3/15/99 3/31/99 5/6/99 5/21/99 5/26/99 6/3/99 6/23/99 6/30/99 7/8/99 Old Bonds 0.78 0.50 - - - - - - - - - - Cash - - 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 Certificates - - 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06 0.06 New Notes - - 0.22 0.22 0.22 0.22 0.26 0.26 0.26 0.27 0.27 0.27 Stock - - 0.26 0.14 0.20 0.53 0.58 0.51 0.57 0.84 0.86 1.02 Total 0.78 0.50 0.74 0.62 0.68 1.01 1.10 1.03 1.09 1.37 1.39 1.55 Most distressed investors did not hold on for the entire ride because they knew Bradlees was no Wal-Mart but they could not predict when Wall Street would recognize Bradlees’ deficiencies. As the masters taught, it is difficult to hold a stock for more than a 200% gain “without a dan- gerous surrender to ‘bull-market psychology.’” (p. 324) Stated otherwise, be an investor, not a speculator. Eventually, competition caught up with Bradlees, which filed a second bankruptcy petition in December 2000 and, this time around, was liquidated.12 Reorganization as Avenue to Control As we move further down the ladder from classic Graham and Dodd investing to something approaching speculation, we look at reorganiza- tions that lead to control of the company. Warren Buffett has often bought debt for a rate of return rather than for the creation of equity and obtaining of control. He seems reluctant to complete the trip and become a completely integrated bankruptcy investor. Others, however, have pushed on for ownership and control. Guinness Peat Aviation For Graham and Dodd, low-grade bonds, together with preferred stock, were Wall Street’s orphans. “The investor [in the Graham and Dodd sense of the term] must not buy them, and the speculator generally prefers to devote his attention to common stocks.” (p. 323) And yet, the authors note, the large supply of these securities and the lack of demand may make their price attractive. An example of an attractive low-grade bond, and a fasc
ave pushed on for ownership and control. Guinness Peat Aviation For Graham and Dodd, low-grade bonds, together with preferred stock, were Wall Street’s orphans. “The investor [in the Graham and Dodd sense of the term] must not buy them, and the speculator generally prefers to devote his attention to common stocks.” (p. 323) And yet, the authors note, the large supply of these securities and the lack of demand may make their price attractive. An example of an attractive low-grade bond, and a fascinating case study of the evolution of distressed investing, is Guinness Peat Aviation (GPA), which served as a precursor of today’s common prepackaged bankruptcies, or “prepacks.” That’s an arrangement in which the debtor and creditors agree upon a reorganization plan before the bankruptcy fil- ing, thereby making it much easier and more cost-efficient to file a bank- ruptcy petition and obtain confirmation in court. In GPA’s case, the bankruptcy filing never proved necessary. GPA was an Ireland-based commercial aircraft sales and leasing com- pany founded in 1975. At its peak, it had 280 aircraft on lease to 83 air- 12 Reuters, “Bradlees Files for Bankruptcy,” December 26, 2000. lines. In 1990, the company placed a stunning order for 700 new aircraft, valued at $17 billion. GPA, however, was a victim of bad timing. It floated an IPO in 1992, during the downturn in the airline industry that followed the 1991 Gulf War. The IPO failed to close, and GPA, with some $10 bil- lion in debt thanks to the huge order, was in serious trouble. Its debt cratered to about half its face value, which is the point at which dis- tressed investors became involved. They snapped up bonds at yields 700 to 950 basis points over Treasuries because they liked the value of the airplane collateral. Eventually, GPA was rescued by its larger competitor GE Commercial Aviation Services. It was a great deal for the rescuer because it could refinance GPA’s debt with the benefit of General Elec- tric’s AA
t thanks to the huge order, was in serious trouble. Its debt cratered to about half its face value, which is the point at which dis- tressed investors became involved. They snapped up bonds at yields 700 to 950 basis points over Treasuries because they liked the value of the airplane collateral. Eventually, GPA was rescued by its larger competitor GE Commercial Aviation Services. It was a great deal for the rescuer because it could refinance GPA’s debt with the benefit of General Elec- tric’s AAA rating. It was a great deal for distressed investors because once GE assumed GPA’s obligations, GPA’s bonds became unsecured debt at the bottom of GE’s balance sheet and still traded nearly at par. Overnight, the bonds nearly doubled in value. MCI WorldCom One of the spectacular corporate collapses early in this century occurred at WorldCom, the once and future MCI. From at least as early as 1999 and going into 2002, financial officers at the telecommunications com- pany booked routine business costs as capital expenditures, which understated expenses and thus resulted in an overstatement of income by at least $9 billion. “In just a few years WorldCom erased $200 billion in market value and shed thousands of jobs. By July 2002, the fraud and lax supervision forced WorldCom into bankruptcy.”13 In December 2002, Michael Capellas was hired as the new CEO of the company as it sought to reorganize. A federal court overseeing the Secu- rities and Exchange Commission’s case against MCI WorldCom appointed a former SEC chairman, Richard Breeden, as the company’s “corporate 13 Stephanie N. Mehta, “MCI: Is Being Good Good Enough?” Fortune, October 27, 2003. monitor.” Thus, Capellas and his management team needed to simultane- ously deal with regulatory constraints, clean up the errors and fraud of their predecessors, and try to do business in a highly competitive market. Mark Neporent, the chief operating officer of Cerberus Capital Man- agement, one of the distressed investors inv
dCom appointed a former SEC chairman, Richard Breeden, as the company’s “corporate 13 Stephanie N. Mehta, “MCI: Is Being Good Good Enough?” Fortune, October 27, 2003. monitor.” Thus, Capellas and his management team needed to simultane- ously deal with regulatory constraints, clean up the errors and fraud of their predecessors, and try to do business in a highly competitive market. Mark Neporent, the chief operating officer of Cerberus Capital Man- agement, one of the distressed investors involved in the bankruptcy, served as cochairman of the Official Creditors’ Committee.14 With com- petitors of the reorganizing MCI seeking to exclude the company from federal contracts, Neporent testified to the Senate Judiciary Committee with respect to the benefits of the reorganization process: It is beyond doubt that MCI’s reorganization plan provides creditors with a much greater chance of recovery than does liquidation, which would literally throw away billions of dollars of value. MCI’s going-concern value is estimated to be approximately $12 billion to $15 billion, while its liqui- dation value is only $4 billion. Not surprisingly, representatives of 90% of MCI’s debt have quickly and efficiently resolved their internecine differ- ences—exactly as contemplated by the Bankruptcy Code—and have given their support to MCI’s proposed reorganization plan.15 By 2005, the reorganized MCI was back on its feet again, and its post- bankruptcy owners sold the company to Verizon for about $8.4 billion, comfortably more than the liquidation value averted by reorganization. MCI was a case in which reorganization as a means of obtaining control helped to unlock the value of the company’s assets. Distressed Investing A fundamental question about value investing in general, and distressed investing in particular, is why should bargains be available? If the market is 14 Graham and Dodd were concerned that protective committees organized by investment bankers may fail to protect investor
4 billion, comfortably more than the liquidation value averted by reorganization. MCI was a case in which reorganization as a means of obtaining control helped to unlock the value of the company’s assets. Distressed Investing A fundamental question about value investing in general, and distressed investing in particular, is why should bargains be available? If the market is 14 Graham and Dodd were concerned that protective committees organized by investment bankers may fail to protect investor interests impartially. They saluted the 1938 bankruptcy legislation that subjected the activities and compensation of protective committees to court scrutiny. (pp. 240–241) Today, of course, the activities of creditors’ committees, which play a major role in reorganizations, are closely supervised. 15 Neporent’s testimony is available at judiciary.senate.gov. efficient, as academic theory would hold, why is today’s price not neces- sarily the very best guess at a security’s true value? Even though they were professors, Graham and Dodd looked at reality rather than theory, and they rejected the Efficient Market Hypothesis (EMH) developed at the University of Chicago before it had a name, let alone an acronym. They famously analogized the market to a voting machine, producing results that are the product partly of reason and partly of emotion, rather than an exact and impersonal weighing machine. (p. 70) The authors relied on a “twofold assumption: first, that the market price is frequently out of line with the true value; and, second, that there is an inherent tendency for these disparities to correct themselves.” (pp. 69–70) Before anyone from the Chicago School has a coronary, let’s hear some more from Graham and Dodd on the first assumption: “As to the truth of the former state- ment, there can be very little doubt—even though Wall Street often speaks glibly of the ‘infallible judgment of the market’ and asserts that ‘a stock is worth what you can sell it for—neither more
ently out of line with the true value; and, second, that there is an inherent tendency for these disparities to correct themselves.” (pp. 69–70) Before anyone from the Chicago School has a coronary, let’s hear some more from Graham and Dodd on the first assumption: “As to the truth of the former state- ment, there can be very little doubt—even though Wall Street often speaks glibly of the ‘infallible judgment of the market’ and asserts that ‘a stock is worth what you can sell it for—neither more nor less.’” (p. 70) If the market gets the “correct” price “wrong” in ordinary investing, such error occurs even more frequently in distressed investing. As implied by the very name distressed investing, purchasers of distressed securities search for bargains made available by the unhappiness of sell- ers who bought those securities in happier times. In Graham and Dodd’s day, when a stock stopped paying dividends, many institutional holders were compelled by their charters to sell. (pp. 127–128 on accompanying CD) Today, the same is true of bonds when the issuer stops paying the coupon. Thus, when a company experiences distress, there are many forced sellers clamoring for the narrow exit doors, and there are not enough buyers to widen the door and hold up the “correct” price. Even the institutions that are not legally bound to sell when a coupon is missed will often do so anyway. At many institutions, the idea of a work- out department is the telephone: pick it up and sell the security. Against this background, the distressed specialist is making a judgment that the securities retain value greater than that ascribed to them by the market or even their current owners. Wall Street, moreover, is constitutionally predisposed to overdo things. The stereotype imagines a Wall Street populated by bulls and bears. In reality, the Street itself is neither bull nor bear but shark, con- stantly shifting direction in an eternal search for food. This feeding process involves massive shi
y. Against this background, the distressed specialist is making a judgment that the securities retain value greater than that ascribed to them by the market or even their current owners. Wall Street, moreover, is constitutionally predisposed to overdo things. The stereotype imagines a Wall Street populated by bulls and bears. In reality, the Street itself is neither bull nor bear but shark, con- stantly shifting direction in an eternal search for food. This feeding process involves massive shifts of capital, which, inevitably, is sometimes misallocated. As Sir John Templeton reportedly put it, “Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die on euphoria.”16 The bankruptcy investor lives off these misallocations. He or she is long the downstream product of what the Wall Street shark wants to sell. In good times, Wall Street permits the raising of debt and thereby the retirement of stock, leading to an acquisition boom. Euphoria in Wall Street’s debt-creation machine leads to a crash, and that is when the bankruptcy investor supplies fresh equity and retires debt, frequently at a discount. To be sure, things have changed since Graham and Dodd’s time. Technological advances and the democratization of finance arguably make the market more efficient. After all, in 1940, you could not instan- taneously track the prices of myriad securities via a Bloomberg terminal or the Internet. You could not construct elaborate Excel spreadsheets and instantaneously adjust all the figures by changing one number. You could not receive e-mail alerts whenever there was news about the com- panies you followed. And there were not thousands of professionals hunched over computer terminals all day competing for investment bar- gains. The late, legendary Leon Levy advised novices in the business to assume that the decisions they are making today are simultaneously being made by others at hundreds of offices around the country. As a 16 Bill Miller, “Good T
aneously adjust all the figures by changing one number. You could not receive e-mail alerts whenever there was news about the com- panies you followed. And there were not thousands of professionals hunched over computer terminals all day competing for investment bar- gains. The late, legendary Leon Levy advised novices in the business to assume that the decisions they are making today are simultaneously being made by others at hundreds of offices around the country. As a 16 Bill Miller, “Good Times Are Coming!” Time, March 8, 2005. result, there is a good argument to be made that the markets are more rational today than when Graham and Dodd wrote. In fact, Graham him- self made that argument, during the final year of his life. “In the old days any well-trained security analyst could do a good professional job of selecting undervalued securities through detailed studies,” he told an interviewer in 1976, “but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”17 In other words, Professor Graham feared that his work had been so successful as to render itself obsolete. Not quite. Little did the professor know that he was just getting started. Graham and Dodd Today Graham and Dodd recognized that things change. In the opening para- graph of their preface to the second edition, six years after the first edi- tion, they observed that “things happen too fast in the economic world to permit the authors to rest comfortably for long.” (p. xli) Sometimes the authors were restless, appearing to be decades ahead of their time. The Risk Insight A prime example of Graham and Dodd’s prescience has found practical application in an important sector of modern securities markets. Though the authors, skeptical as always of the rationality of markets, said that “security prices and yields are not determined by any exact mathemati- cal calculatio
s happen too fast in the economic world to permit the authors to rest comfortably for long.” (p. xli) Sometimes the authors were restless, appearing to be decades ahead of their time. The Risk Insight A prime example of Graham and Dodd’s prescience has found practical application in an important sector of modern securities markets. Though the authors, skeptical as always of the rationality of markets, said that “security prices and yields are not determined by any exact mathemati- cal calculation of the expected risk, but they depend rather upon the popularity of the issue” (p. 164), they also laid the theoretical foundation, upon which the edifice was constructed decades later, for high yield investing. It was the authors who said, “If we assume that a fairly large 17 Kenneth L. Fisher, 100 Minds That Made the Market (New York: Wiley, 2007), p. 61. Fisher goes on to observe of this late-in-life conversion: “Ironically, Graham’s adoption of ‘the efficient market’ was just before computer backtests would poke all kind of holes in that theory.” proportion of a group of carefully selected low-priced bonds will escape default, the income received on the group as a whole over a period of time will undoubtedly far exceed the dividend return on similarly priced common stocks.” (p. 327) Others appropriated that idea to help sell junk bonds, especially the low-grade original issue bonds that took Wall Street by storm in the 1980s. But there is little doubt that Graham and Dodd would have disap- proved of such bonds. It’s one thing to buy fallen angels—once investment-grade bonds whose issuers had fallen on hard times. Those were usually senior securities that even in the case of a bankruptcy could lay claim to some assets. Original issue junk had no such backing. Should those bonds falter, there may not be any recovery at all. During the 1980s, a significant percentage of the high yield bond market consisted of securities that had never been sold directly to investors but
d have disap- proved of such bonds. It’s one thing to buy fallen angels—once investment-grade bonds whose issuers had fallen on hard times. Those were usually senior securities that even in the case of a bankruptcy could lay claim to some assets. Original issue junk had no such backing. Should those bonds falter, there may not be any recovery at all. During the 1980s, a significant percentage of the high yield bond market consisted of securities that had never been sold directly to investors but were parts of packages of securities and cash given to sell- ing shareholders in acquisitions. The investment bank Drexel Burnham Lambert perfected this strategy, creating such instruments as zero- coupon bonds (paying no interest for, say, five years) or “pay-in-kind (PIK) preferreds,” which, instead of paying cash interest, just issued more pre- ferred stock. Almost no one thought these securities were worth their nominal value, but selling shareholders generally approved the transac- tions. As the decade ended, however, the junk bond market collapsed and so did several of Drexel’s deals. These problems, coupled with Drexel’s legal difficulties with the SEC and prosecutors, led to the firm’s bankruptcy filing in 1990. Jeffrey Lane, former president of Shearson Lehman Hutton, observed: “This is the nature of the financial service business. You go into a steady decline, and then you fall off a cliff.” It is one thing to buy fallen angels, former investment-grade bonds whose issues had fallen on hard times, and quite another to issue an angel that never took wing. Fallen angels were usually senior securities that could always lay claim to some assets, even in the case of a bank- ruptcy. The Drexel-designed securities that were exchanged lacked even this saving grace. They were probably very good examples of what Gra- ham and Dodd most disapproved of in the financial markets. In the ensuing collapse, most of them had no recovery at all. Graham and Dodd had the insight that t
fallen on hard times, and quite another to issue an angel that never took wing. Fallen angels were usually senior securities that could always lay claim to some assets, even in the case of a bank- ruptcy. The Drexel-designed securities that were exchanged lacked even this saving grace. They were probably very good examples of what Gra- ham and Dodd most disapproved of in the financial markets. In the ensuing collapse, most of them had no recovery at all. Graham and Dodd had the insight that the difference between the risk-free rate of return and the yields offered by securities of varying risk created investment opportunities, especially if a diversified portfolio could lock in high returns while reducing the overall risk. In almost any kind of investing, returns have at least some (if not a mathematically exact) connection to the risk-free rate of return, with investors demand- ing higher returns for greater risk. The premium that investors demand for high yield bonds over the safety of Fed Funds offers a good snapshot for the market’s appetite for risk, as seen in this two-decade survey: ARE YOU GETTING PAID TO TAKE RISK? 14 12 10 8 6 4 2 0 A two-decade survey of the spread between the Merrill Lynch High Yield (MLHY) Index and the Fed Funds Rate. When the spread is high, high yield bonds are said to be cheap. The chart shows this spread over time by subtracting the risk-free Fed Funds rate from the riskier Merrill Lynch High Yield (MLHY) Index. The spread serves as a proxy for the returns available for opportunistic cap- ital, including in the field of distressed investing. Unlike, say, venture capital, with which the investor is seeking a pot of gold (albeit with some diver- sification so that the occasional winner offsets the losers), the chart is rel- evant to the large segment of any portfolio designed to create a rate of return for opportunistic capital. That rate of return available is effectively tethered to the risk-free rate, and the sp
serves as a proxy for the returns available for opportunistic cap- ital, including in the field of distressed investing. Unlike, say, venture capital, with which the investor is seeking a pot of gold (albeit with some diver- sification so that the occasional winner offsets the losers), the chart is rel- evant to the large segment of any portfolio designed to create a rate of return for opportunistic capital. That rate of return available is effectively tethered to the risk-free rate, and the spread shown in the chart is the simplest, and perhaps best, measure of where markets have priced it over the last two decades. The yields move in tandem most of the time, but the real opportuni- ties come when they move in opposite directions—that is, when the spread expands, it is time to buy; when it compresses, to sell. Note the vast expansion in the spread from 1989 to 1991, which reflected some weakness in the economy and led to the reelection defeat of George H. W. Bush even though things had begun to improve before Election Day 1992. The spread was very narrow during the stock market boom of 1998, began to expand as the dot-com bubble reached its peak, and exploded after the bubble burst. The spread, which had expanded to under 1,200 basis points by the end of 2002, had shrunk to about 700 basis points by the end of 2003, less than 400 by the start of 2006, and under 200 in early 2007. This powerful compression of yields served as a springboard for a revaluation for all asset classes for which the High Yield Index is a proxy. When the spread is at its widest, as in 1991 or 2002, investors are paid handsomely for risk. When the spread is at its narrowest, as in early 2007, the market is too sanguine about risk, and it becomes time to sell. Of course, it is very difficult to predict where the spread will move tomorrow or next week, but opportunistic investors recognize diversions from the norm. When the spread is particularly wide, they go fishing; when it is particularly
sses for which the High Yield Index is a proxy. When the spread is at its widest, as in 1991 or 2002, investors are paid handsomely for risk. When the spread is at its narrowest, as in early 2007, the market is too sanguine about risk, and it becomes time to sell. Of course, it is very difficult to predict where the spread will move tomorrow or next week, but opportunistic investors recognize diversions from the norm. When the spread is particularly wide, they go fishing; when it is particularly narrow, they stay close to home and mend their nets. The way life works, of course, is that at times of wide spreads, with huge opportunities available for alternative investment, it is extremely difficult to raise capital in the area. Thus, once the spread narrows and opportunities are fewer, money flows into alternatives. As Leon Levy was wont to say: When you have the ideas, you can’t get the money; when you can get the money, you don’t have the ideas. In this respect, investors in the distressed investing sector do not behave so differently from retail stock market investors. First Principles and Paradigm Shifts It is easy to acknowledge that seemingly immutable rules can become obsolete, but difficult to know when that is the case. In the spring of 1951, the Dow Jones Industrial Average stood at about 250. Professor Graham told his class at Columbia University Business School that the Dow had traded below 200 at some time during every full year since its inception in 1896. With Professor Graham’s best student ever—supposedly, the only one ever to receive an A+ from the master—about to graduate that sum- mer, the professor suggested that maybe the student would benefit from delaying his investing career until after the Dow had completed its pre- dictable decline to under 200, which had yet to happen in 1951. Showing how richly he deserved the A+, Warren Buffett declined the advice, and a good thing it was because the Dow did not return to 200 that year or in any year s
Professor Graham’s best student ever—supposedly, the only one ever to receive an A+ from the master—about to graduate that sum- mer, the professor suggested that maybe the student would benefit from delaying his investing career until after the Dow had completed its pre- dictable decline to under 200, which had yet to happen in 1951. Showing how richly he deserved the A+, Warren Buffett declined the advice, and a good thing it was because the Dow did not return to 200 that year or in any year since.18 “I had about ten thousand bucks” when Professor Gra- ham gave his advice, Buffett told the Wall Street Journal. “If I had taken his advice, I would probably still have about ten thousand bucks.”19 A few years later, in 1958, equity dividend yields fell below bond yields for the first time. A sensible investor putting money to work at the 18 Kenneth Lee, Trouncing the Dow: A Value-Based Method for Making Huge Profits (New York: McGraw- Hill, 1998), pp. 1–2. 19 In Berkshire Hathaway’s 2000 annual report, Buffett said of his experience in Graham’s class that “a few hours at the feet of the master proved far more valuable to me than had ten years of supposedly original thinking.” time could hardly credit the change as part of a permanent new reality. To the contrary, it must have seemed a mandate to short the stock mar- ket. Think of all the money lost over all the years by the true believers who have argued: “This time is different.” Yet the seasoned professionals of that time were cautious and wrong, and the irreverent optimists were right. This time, it really was different. From the safe perspective of a half century, it seems incontrovertible that a new valuation benchmark had been established. So when can one safely conclude that “this time is different,” espe- cially in light of all the times that it really is not different? In 1951, Profes- sor Graham’s rule of 200 had held for 55 years. Once breached, it never again proved true, but who would have had Buffett’s
ere cautious and wrong, and the irreverent optimists were right. This time, it really was different. From the safe perspective of a half century, it seems incontrovertible that a new valuation benchmark had been established. So when can one safely conclude that “this time is different,” espe- cially in light of all the times that it really is not different? In 1951, Profes- sor Graham’s rule of 200 had held for 55 years. Once breached, it never again proved true, but who would have had Buffett’s foresight and audacity to conclude that it could safely be ignored? The 1958 investor who waited for the century-old relationship between dividend yields and bond market yields to reassert itself is still waiting too. Once reversed, that relationship has moved ever farther apart. Still, if Graham and Dodd’s bible cannot be understood today without commentary, the attitude embodied in this work is timeless. As long as investors remain human, and thus subject to greed, fear, pressure, doubt, and the entire range of human emotions, there will be money to be made by those who steel themselves to overcome emotion. As long as the human tendency to march in herds persists, there will be opportuni- ties for contrarians who are unafraid to stand alone. Think of Graham and Dodd as embodying the spirit of Hamlet, Prince of Denmark, who declared: “Blest are those/Whose blood and judgement are so well com- mingled,/That they are not a pipe for Fortune’s finger/To sound what stop she please.”20 20 Hamlet, Act III, Scene 2. Chapter 22 PRIVILEGED ISSUES WE COME now to the second major division of our revised classification of securities, viz., bonds and preferred stocks presumed by the buyer to be subject to substantial change in principal value. In our introductory discussion (Chap. 5) we subdivided this group under two heads: those issues which are speculative because of inadequate safety, and those which are speculative because they possess a conversion or similar privilege which
Hamlet, Act III, Scene 2. Chapter 22 PRIVILEGED ISSUES WE COME now to the second major division of our revised classification of securities, viz., bonds and preferred stocks presumed by the buyer to be subject to substantial change in principal value. In our introductory discussion (Chap. 5) we subdivided this group under two heads: those issues which are speculative because of inadequate safety, and those which are speculative because they possess a conversion or similar privilege which makes possible substantial variations in market price.1 SENIOR ISSUES WITH SPECULATIVE PRIVILEGES In addition to enjoying a prior claim for a fixed amount of principal and income, a bond or preferred stock may also be given the right to share in benefits accruing to the common stock. These privileges are of three kinds, designated as follows: 1. Convertible—conferring the right to exchange the senior issue for common stock on stipulated terms. 2. Participating—under which additional income may be paid to the senior security holder, dependent usually upon the amount of common dividends declared. 3. Subscription—by which holders of the bond or preferred stock may purchase common shares, at prices, in amounts, and during periods, stipulated.2 1 In the 1934 edition we had here a section on investment-quality senior issues obtainable at bargain levels. Although these were plentiful in the 1931–1933 period, they have since grown very scarce—even in the market decline of 1937–1938. To save space, therefore, we are now omitting this section. 2 There is still a fourth type of profit-sharing arrangement, of less importance than the three just described, which made its first appearance in the 1928–1929 bull market. This is the so- called “optional” bond or preferred stock. The option consists of taking interest or dividend payments in a fixed amount of common stock (i.e., at a fixed price per share) in lieu of cash. [289] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw
ve space, therefore, we are now omitting this section. 2 There is still a fourth type of profit-sharing arrangement, of less importance than the three just described, which made its first appearance in the 1928–1929 bull market. This is the so- called “optional” bond or preferred stock. The option consists of taking interest or dividend payments in a fixed amount of common stock (i.e., at a fixed price per share) in lieu of cash. [289] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. Since the conversion privilege is the most familiar of the three, we shall frequently use the term “convertible issues” to refer to privileged issues in general. Such Issues Attractive in Form. By means of any one of these three provisions a senior security can be given virtually all the profit possibil- ities that attach to the common stock of the enterprise. Such issues must therefore be considered as the most attractive of all in point of form, since they permit the combination of maximum safety with the chance of unlimited appreciation in value. A bond that meets all the requirements of a sound investment and in addition possesses an interesting conver- sion privilege would undoubtedly constitute a highly desirable purchase. Their Investment Record Unenviable: Reasons. Despite this impressive argument in favor of privileged senior issues as a form of investment, we must recognize that actual experience with this class has not been generally satisfactory. For this discrepancy between promise and performance, reasons of two different kinds may be advanced. The first is that only a small fraction of the privileged issues have actu- ally met the rigorous requirements of a sound investment. The conversion feature has most often been offered to compensate for inadequate secu- rity.3 This weakness was most pronounced during the period of greatest For example, Commercial Investment Trust $6 Convertible Preference, Optional Ser
n generally satisfactory. For this discrepancy between promise and performance, reasons of two different kinds may be advanced. The first is that only a small fraction of the privileged issues have actu- ally met the rigorous requirements of a sound investment. The conversion feature has most often been offered to compensate for inadequate secu- rity.3 This weakness was most pronounced during the period of greatest For example, Commercial Investment Trust $6 Convertible Preference, Optional Series of 1929, gave the holder the option to take his dividend at the annual rate of one-thirteenth share of common instead of $6 in cash. This was equivalent to a price of $78 per share for the common, which meant that the option would be valuable whenever the stock was selling above 78. Similarly, Warner Brothers Pictures, Inc., Optional 6% Convertible Debentures, due 1939, issued in 1929, gave the owner the option to take his interest payments at the annual rate of one share of common stock instead of $60 in cash. It may be said that this optional arrangement is a modified form of conversion privilege, under which the interest or dividend amounts are made separately convertible into common stock. In most, possibly all, of these issues, the principal is convertible as well. The separate convertibility of the income payments adds somewhat, but not a great deal, to the attractive- ness of the privilege. 3 The Report of the Industrial Securities Committee of the Investment Bankers Association of America for 1927 quotes, presumably with approval, a suggestion that since a certain percentage of the senior securities of moderate-sized industrial companies “are liable to show substantial losses over a period of five or ten years,” investors therein should be given a participation in future earnings through a conversion or other privilege to compensate for this risk. See Proceedings of the Sixteenth Annual Convention of the Investment Bankers Association of America, pp. 144–145, 1927
tion of America for 1927 quotes, presumably with approval, a suggestion that since a certain percentage of the senior securities of moderate-sized industrial companies “are liable to show substantial losses over a period of five or ten years,” investors therein should be given a participation in future earnings through a conversion or other privilege to compensate for this risk. See Proceedings of the Sixteenth Annual Convention of the Investment Bankers Association of America, pp. 144–145, 1927. vogue for convertible issues, between 1926 and 1929.4 During these years it was broadly true that the strongly entrenched industrial enterprises raised money through sales of common stock, whereas the weaker—or weakly capitalized—undertakings resorted to privileged senior securities. The second reason is related to the conditions under which profit may accrue from the conversion privilege. Although there is indeed no upper limit to the price that a convertible bond may reach, there is a very real limitation on the amount of profit that the holder may realize while still maintaining an investment position. After a privileged issue has advanced with the common stock, its price soon becomes dependent in both direc- tions upon changes in the stock quotation, and to that extent the contin- ued holding of the senior issue becomes a speculative operation. An example will make this clear: Let us assume the purchase of a high-grade 31/2% bond at par, con- vertible into two shares of common for each $100 bond (i.e., convertible into common stock at 50). The common stock is selling at 45 when the bond is bought. First stage: (1) If the stock declines to 35, the bond may remain close to par. This illustrates the pronounced technical advantage of a convert- ible issue over the common stock. (2) If the stock advances to 55, the price of the bond will probably rise to 115 or more. (Its “immediate conversion value” would be 110, but a premium would be justified because of its advantage o
for each $100 bond (i.e., convertible into common stock at 50). The common stock is selling at 45 when the bond is bought. First stage: (1) If the stock declines to 35, the bond may remain close to par. This illustrates the pronounced technical advantage of a convert- ible issue over the common stock. (2) If the stock advances to 55, the price of the bond will probably rise to 115 or more. (Its “immediate conversion value” would be 110, but a premium would be justified because of its advantage over the stock.) This illustrates the undoubted speculative pos- sibilities of such a convertible issue. Second stage: The stock advances further to 65. The conversion value of the bond is now 130, and it will sell at that figure, or slightly higher. At this point the original purchaser is faced with a problem. Within wide limits, the future price of his bond depends entirely upon the course of the common stock. In order to seek a larger profit he must risk the loss of the profit in hand, which in fact constitutes a substantial part of the present market value of his security. (A drop in the price of the common 4 Prior to the appearance on Feb. 16, 1939, of Release No. 208 (Statistical Series) of the S.E.C., no comprehensive compilation of the dollar volume of privileged issues has been made and regularly maintained. That release gave data on a quarterly basis for the period from Apr. 1, 1937, through Dec. 31, 1938, and additional data have since been published quarterly by the S.E.C. Further evidence of the volume of this type of financing over a much longer period is presented in Appendix Note 35, p. 770 on accompanying CD. could readily induce a decline in the bond from 130 to 110.) If he elects to hold the issue, he places himself to a considerable degree in the posi- tion of the stockholders, and this similarity increases rapidly as the price advances further. If, for example, he is still holding the bond at a level say of 180 (90 for the stock), he has for all practic
Further evidence of the volume of this type of financing over a much longer period is presented in Appendix Note 35, p. 770 on accompanying CD. could readily induce a decline in the bond from 130 to 110.) If he elects to hold the issue, he places himself to a considerable degree in the posi- tion of the stockholders, and this similarity increases rapidly as the price advances further. If, for example, he is still holding the bond at a level say of 180 (90 for the stock), he has for all practical purposes assumed the status and risks of a stockholder. Unlimited Profit in Such Issues Identified with Stockholder’s Position. The unlimited profit possibilities of a privileged issue are thus in an important sense illusory. They must be identified not with the ownership of a bond or preferred stock but with the assumption of a common stock- holder’s position—which any holder of a nonconvertible may effect by exchanging his bond for a stock. Practically speaking, the range of profit possibilities for a convertible issue, although still maintaining the advan- tage of an investment holding, must usually be limited to somewhere between 25 and 35% of its face value. For this reason original purchasers of privileged issues do not ordinarily hold them for more than a small fraction of the maximum market gains scored by the most successful among them, and consequently they do not actually realize these very large possible profits. Thus the profits taken may not offset the losses occasioned by unsound commitments in this field. Examples of Attractive Issues. The two objections just discussed must considerably temper our enthusiasm for privileged senior issues as a class, but they by no means destroy their inherent advantages nor the possibili- ties of exploiting them with reasonable success. Although most new con- vertible offerings may have been inadequately secured,5 there are fairly frequent exceptions to the rule, and these exceptions should be of prime interest to the alert
d by unsound commitments in this field. Examples of Attractive Issues. The two objections just discussed must considerably temper our enthusiasm for privileged senior issues as a class, but they by no means destroy their inherent advantages nor the possibili- ties of exploiting them with reasonable success. Although most new con- vertible offerings may have been inadequately secured,5 there are fairly frequent exceptions to the rule, and these exceptions should be of prime interest to the alert investor. We append three leading examples of such opportunities, taken from the utility, the railroad, and the industrial fields. 1. Commonwealth Edison Company Convertible Debenture 31/2s, Due 1958. These bonds were offered to shareholders in June and September 1938 at par. The statistical exhibit of the company gave every assurance that the debentures were a sound commitment at that price. They were convertible into 40 shares of common stock until maturity or prior redemption. 5 This criticism does not apply to convertible bonds issued from 1933 to date, the majority of which meet our investment standards. In September 1938 the debentures could have been bought on the New York Stock Exchange at par when the stock was selling at 241/2. At these prices the bonds and stock were selling very close to a parity, and a slight advance in the price of the stock would enable the holder of the bond to sell at a profit. Less than a year later (July 1939) the stock had risen to 313/8, and the bonds to 1243/4. 2. Chesapeake and Ohio Railway Company Convertible 5s, Due 1946. These bonds were originally offered to shareholders in June 1916. They were convertible into common stock at 75 until April 1, 1920; at 80 from the latter date until April 1, 1923; at 90 from the latter date until April 1, 1926; and at 100 from the latter date until April 1, 1936. Late in 1924 they could have been bought on a parity basis (i.e., with- out payment of a premium for the conversion privilege) at price
bonds to 1243/4. 2. Chesapeake and Ohio Railway Company Convertible 5s, Due 1946. These bonds were originally offered to shareholders in June 1916. They were convertible into common stock at 75 until April 1, 1920; at 80 from the latter date until April 1, 1923; at 90 from the latter date until April 1, 1926; and at 100 from the latter date until April 1, 1936. Late in 1924 they could have been bought on a parity basis (i.e., with- out payment of a premium for the conversion privilege) at prices close to par. Specifically, they sold on November 28, 1924, at 101 when the stock sold at 91. At that time the company’s earnings were showing continued improvement and indicated that the bonds were adequately secured. (Fixed charges were covered twice in 1924.) The value of the conversion privilege was shown by the fact that the stock sold at 131 in the next year, making the bonds worth 145. 3. Rand Kardex Bureau, Inc., 51/2s, Due 1931. These bonds were orig- inally offered in December 1925 at 991/2. They carried stock-purchase warrants (detachable after January 1, 1927) entitling the holder to pur- chase 221/2 shares of Class A common at $40 per share during 1926, at $42.50 per share during 1927, at $45 per share during 1928, at $47.50 per share during 1929, and at $50 per share during 1930. (The Class A stock was in reality a participating preferred issue.) The bonds could be turned in at par in payment for the stock purchased under the warrants, a pro- vision that virtually made the bonds convertible into the stock. The bonds appeared to be adequately secured. The previous exhibit (based on the earnings of the predecessor companies) showed the follow- ing coverage for the interest on the new bond issue: Year Number of Times Interest Covered 1921 (depression year) 1.7 1922 (depression year) 2.3 1923 6.7 1924 7.2 1925 (9 months) 12.2 Net current assets exceed twice the face value of the bond issue. When the bonds were offered to the public, the Class A stock was quoted
the bonds convertible into the stock. The bonds appeared to be adequately secured. The previous exhibit (based on the earnings of the predecessor companies) showed the follow- ing coverage for the interest on the new bond issue: Year Number of Times Interest Covered 1921 (depression year) 1.7 1922 (depression year) 2.3 1923 6.7 1924 7.2 1925 (9 months) 12.2 Net current assets exceed twice the face value of the bond issue. When the bonds were offered to the public, the Class A stock was quoted at about 42, indicating an immediate value for the stock-purchase warrants. The following year the stock advanced to 53, and the bonds to 1301/2. In 1927 (when Rand Kardex merged with Remington Typewriter) the stock advanced to 76, and the bonds to 190. Example of an Unattractive Issue. By way of contrast with these examples we shall supply an illustration of a superficially attractive but basically unsound convertible offering, such as characterized the 1928–1929 period. National Trade Journals, Inc., 6% Convertible Notes, Due 1938. The company was organized in February 1928 to acquire and publish about a dozen trade journals. In November 1928 it sold $2,800,000 of the fore- going notes at 971/2. The notes were initially convertible into 27 shares of common stock (at $37.03 per share) until November 1, 1930; into 25 shares (at $40 a share) from the latter date until November 1, 1932; and at prices that progressively increased to $52.63 a share during the last two years of the life of the bonds. These bonds could have been purchased at the time of issuance and for several months thereafter at prices only slightly above their parity value as compared with the market value of the equivalent stock. Specif- ically, they could have been bought at 971/2 on November 30, when the stock sold at 341/8, which meant that the stock needed to advance only two points to assure a profit on conversion. However, at no time did the bonds appear to be adequately secured, despite the attractive
the bonds. These bonds could have been purchased at the time of issuance and for several months thereafter at prices only slightly above their parity value as compared with the market value of the equivalent stock. Specif- ically, they could have been bought at 971/2 on November 30, when the stock sold at 341/8, which meant that the stock needed to advance only two points to assure a profit on conversion. However, at no time did the bonds appear to be adequately secured, despite the attractive picture presented in the offering circular. The cir- cular exhibited “estimated” earnings of the predecessor enterprise based on the 31/2 years preceding, which averaged 4.16 times the charges on the bond issue. But close to half of these estimated earnings were expected to be derived from economies predicted to result from the consolidation in the way of reduction of salaries, etc. The conservative investor would not be justified in taking these “earnings” for granted, particularly in a hazardous and competitive business of this type, with a relatively small amount of tangible assets. Eliminating the estimated “earnings” mentioned in the preceding paragraph the exhibit at the time of issuance and thereafter was as follows: Year Price range of bonds Price range of stock Prevailing conversion price Times interest earned Earned per share on common 1925 1.73* $0.78* 1926 2.52* 1.84* 1927 2.80* 2.20* 1928 100 -971/2 357/8-30 $37.03 1.69† 1.95 1929 99 -50 345/8- 5 37.03 1.86† 1.04 1930 42 -10 63/8- 1/2 37.03-$40 0.09† 1.68(d) 1931 101/2- 5 1 40.00 Receivership * Predecessor enterprise. Pre-share figures are after estimating federal taxes. † Actual earnings for last 10 months of 1928 and succeeding calendar years. Receivers were appointed in June 1931. The properties were sold in August of that year, and bondholders later received about 81/2 cents on the dollar. Principle Derived. From these contrasting instances an investment principle may be developed that sh
86† 1.04 1930 42 -10 63/8- 1/2 37.03-$40 0.09† 1.68(d) 1931 101/2- 5 1 40.00 Receivership * Predecessor enterprise. Pre-share figures are after estimating federal taxes. † Actual earnings for last 10 months of 1928 and succeeding calendar years. Receivers were appointed in June 1931. The properties were sold in August of that year, and bondholders later received about 81/2 cents on the dollar. Principle Derived. From these contrasting instances an investment principle may be developed that should afford a valuable guide to the selec- tion of privileged senior issues. The principle is as follows: A privileged sen- ior issue, selling close to or above face value, must meet the requirements either of a straight fixed-value investment or of a straight common-stock specula- tion, and it must be bought with one or the other qualification clearly in view. The alternative given supplies two different approaches to the pur- chase of a privileged security. It may be bought as a sound investment with an incidental chance of profit through an enhancement of principal, or it may be bought primarily as an attractive form of speculation in the common stock. Generally speaking, there should be no middle ground. The investor interested in safety of principal should not abate his require- ments in return for a conversion privilege; the speculator should not be attracted to an enterprise of mediocre promise because of the pseudo- security provided by the bond contract. Our opposition to any compromise between the purely investment and the admittedly speculative attitude is based primarily on subjective grounds. Where an intermediate stand is taken, the result is usually con- fusion, clouded thinking, and self-deception. The investor who relaxes his safety requirements to obtain a profit-sharing privilege is frequently not prepared, financially or mentally, for the inevitable loss if fortune should frown on the venture. The speculator who wants to reduce his risk by operating in c
compromise between the purely investment and the admittedly speculative attitude is based primarily on subjective grounds. Where an intermediate stand is taken, the result is usually con- fusion, clouded thinking, and self-deception. The investor who relaxes his safety requirements to obtain a profit-sharing privilege is frequently not prepared, financially or mentally, for the inevitable loss if fortune should frown on the venture. The speculator who wants to reduce his risk by operating in convertible issues is likely to find his primary interest divided between the enterprise itself and the terms of the privilege, and he will probably be uncertain in his own mind as to whether he is at bot- tom a stockholder or a bondholder. (Privileged issues selling at substan- tial discounts from par are not in general subject to this principle, since they belong to the second category of speculative senior securities to be considered later.) Reverting to our examples, it will be seen at once that the Common- wealth Edison 31/2s could properly have been purchased as an investment without any regard to the conversion feature. The strong possibility that this privilege would be of value made the bond almost uniquely attrac- tive at the time of issuance. Somewhat similar statements could be made with respect to the Chesapeake and Ohio and the Rand Kardex bonds. Any of these three securities should also have been attractive to a specu- lator who was persuaded that the related common stock was due for an advance in price. On the other hand the National Trade Journals Debentures could not have passed stringent qualitative and quantitative tests of safety. Hence they should properly have been of interest only to a person who had full confidence in the future value of the stock. It is hardly likely, however, that most of the buying of this issue was motivated by the primary desire to invest or speculate in the National Trade Journals common stock, but it was based rather on the attr
was due for an advance in price. On the other hand the National Trade Journals Debentures could not have passed stringent qualitative and quantitative tests of safety. Hence they should properly have been of interest only to a person who had full confidence in the future value of the stock. It is hardly likely, however, that most of the buying of this issue was motivated by the primary desire to invest or speculate in the National Trade Journals common stock, but it was based rather on the attractive terms of the conversion privilege and on the feeling that the issue was “fairly safe” as a bond investment. It is precisely this compromise between true investment and true speculation that we disapprove, chiefly because the purchaser has no clear-cut idea of the purpose of his commitment or of the risk that he is incurring. Rules Regarding Retention or Sale. Having stated a basic principle to guide the selection of privileged issues, we ask next what rules can be established regarding their subsequent retention or sale. Convertibles bought primarily as a form of commitment in the common stock may be held for a larger profit than those acquired from the investment stand- point. If a bond of the former class advances from 100 to 150, the large premium need not in itself be a controlling reason for selling out; the owner must be guided rather by his views as to whether or not the common stock has advanced enough to justify taking his profit. But when the purchase is made primarily as a safe bond investment, then the lim- itation on the amount of profit that can conservatively be waited for comes directly into play. For the reasons explained in detail above, the conservative buyer of privileged issues will not ordinarily hold them for more than a 25 to 35% advance. This means that a really successful invest- ment operation in the convertible field does not cover a long period of time. Hence such issues should be bought with the possibility of long-term holding in mind b
ly as a safe bond investment, then the lim- itation on the amount of profit that can conservatively be waited for comes directly into play. For the reasons explained in detail above, the conservative buyer of privileged issues will not ordinarily hold them for more than a 25 to 35% advance. This means that a really successful invest- ment operation in the convertible field does not cover a long period of time. Hence such issues should be bought with the possibility of long-term holding in mind but with the hope that the potential profit will be real- ized fairly soon. The foregoing discussion leads to the statement of another investment rule, viz.: In the typical case, a convertible bond should not be converted by the investor. It should be either held or sold. It is true that the object of the privilege is to bring about such conver- sion when it seems advantageous. If the price of the bond advances sub- stantially, its current yield will shrink to an unattractive figure, and there is ordinarily a substantial gain in income to be realized through the exchange into stock. Nevertheless when the investor does exchange his bond into the stock, he abandons the priority and the unqualified claim to principal and interest upon which the purchase was originally premised. If after the conversion is made things should go badly, his shares may decline in value far below the original cost of his bond, and he will lose not only his profit but part of his principal as well. Moreover he is running the risk of transforming himself—generally, as well as in the specific instances—from a bond investor into a stock speculator. It must be recognized that there is something insidious about even a good convertible bond; it can easily prove a costly snare to the unwary. To avoid this danger the investor must cling determinedly to a conservative viewpoint. When the price of his bond has passed out of the investment range, he must sell it; most important of all, he must not con- sider his j
running the risk of transforming himself—generally, as well as in the specific instances—from a bond investor into a stock speculator. It must be recognized that there is something insidious about even a good convertible bond; it can easily prove a costly snare to the unwary. To avoid this danger the investor must cling determinedly to a conservative viewpoint. When the price of his bond has passed out of the investment range, he must sell it; most important of all, he must not con- sider his judgment impugned if the bond subsequently rises to a much higher level. The market behavior of the issue, once it has entered the speculative range, is no more the investor’s affair than the price gyrations of any speculative stock about which he knows nothing. If the course of action here recommended is followed by investors generally, the conversion of bonds would be brought about only through their purchase for this specific purpose by persons who have decided independently to acquire the shares for either speculation or supposed investment.6 The arguments against the investor’s converting convertible issues apply with equal force against his exercising stock-purchase warrants attached to bonds bought for investment purposes. A continued policy of investment in privileged issues would, under favorable conditions, require rather frequent taking of profits and replace- ment by new securities not selling at an excessive premium. More con- cretely, a bond bought at 100 would be sold, say, at 125 and be replaced by another good convertible issue purchasable at about par. It is not likely that satisfactory opportunities of this kind will be continuously available or that the investor would have the means of locating all those that are at hand. But the trend of financing in recent years offers some promise that a fair number of really attractive convertibles may again make their appearance. Following the 1926–1929 period, marked by a flood of priv- ileged issues generally of po
say, at 125 and be replaced by another good convertible issue purchasable at about par. It is not likely that satisfactory opportunities of this kind will be continuously available or that the investor would have the means of locating all those that are at hand. But the trend of financing in recent years offers some promise that a fair number of really attractive convertibles may again make their appearance. Following the 1926–1929 period, marked by a flood of priv- ileged issues generally of poor quality, and the 1930–1934 period, in which the emphasis on safety caused the virtual disappearance of conver- sion privileges from new bond offerings, there has been a definite swing of the pendulum towards a middle point, where participating features are at times employed to facilitate the sale of sound bond offerings.7 Most of those sold between 1934 and 1939 either carried very low coupon rates or immediately jumped to a prohibitive premium. But we incline to the view that the discriminating and careful investor is again likely to find a reasonable number of attractive opportunities presented in this field. 6 In actual practice, conversions often result also from arbitrage operations involving the purchase of the bond and the simultaneous sale of the stock at a price slightly higher than the “conversion parity.” 7 For data regarding the relative frequency of privilege issues between 1925 and 1938, see Appendix Note 35, p. 770 on accompanying CD, and the S.E.C. statistical releases referred to in a footnote on page 291. Chapter 23 TECHNICAL CHARACTERISTICS OF PRIVILEGED SENIOR SECURITIES IN THE PRECEDING chapter privileged senior issues were considered in their relationship to the broader principles of investment and speculation. To arrive at an adequate knowledge of this group of securities from their practical side, a more intensive discussion of their characteristics is now in order. Such a study may conveniently be carried on from three successive view
l releases referred to in a footnote on page 291. Chapter 23 TECHNICAL CHARACTERISTICS OF PRIVILEGED SENIOR SECURITIES IN THE PRECEDING chapter privileged senior issues were considered in their relationship to the broader principles of investment and speculation. To arrive at an adequate knowledge of this group of securities from their practical side, a more intensive discussion of their characteristics is now in order. Such a study may conveniently be carried on from three successive viewpoints: (1) considerations common to all three types of privilege—conversion, participation, and subscription (i.e., “warrant”); (2) the relative merits of each type, as compared with the others; (3) technical aspects of each type, considered by itself.1 CONSIDERATIONS GENERALLY APPLICABLE TO PRIVILEGED ISSUES The attractiveness of a profit-sharing feature depends upon two major but entirely unrelated factors: (1) the terms of the arrangement and (2) the prospects of profits to share. To use a simple illustration: Company A Company B 4% bond selling at 100 4% bond selling at 100 Convertible into stock at 50 (i.e., two Convertible into stock at 331/3 shares of stock for a $100 bond) (i.e., three shares of stock for a $100 bond) Stock selling at 30 Stock selling at 30 1 This subject is treated at what may appear to be disproportionate length because of the growing importance of privileged issues and the absence of thoroughgoing discussion thereof in the standard descriptive textbooks. [299] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. Terms of the Privilege vs. Prospects for the Enterprise. The terms of the conversion privilege are evidently more attractive in the case of Bond B; for the stock need advance only a little more than 3 points to assure a profit, whereas Stock A must advance over 20 points to make conversion profitable. Nevertheless, it is quite possible that Bond A may turn out to be the more
s. [299] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. Terms of the Privilege vs. Prospects for the Enterprise. The terms of the conversion privilege are evidently more attractive in the case of Bond B; for the stock need advance only a little more than 3 points to assure a profit, whereas Stock A must advance over 20 points to make conversion profitable. Nevertheless, it is quite possible that Bond A may turn out to be the more advantageous purchase. For con- ceivably Stock B may fail to advance at all while Stock A may double or triple in price. As between the two factors, it is undoubtedly true that it is more prof- itable to select the right company than to select the issue with the most desirable terms. There is certainly no mathematical basis on which the attractiveness of the enterprise may be offset against the terms of the priv- ilege, and a balance struck between these two entirely dissociated ele- ments of value. But in analyzing privileged issues of the investment grade, the terms of the privilege must receive the greater attention, not because they are more important but because they can be more definitely dealt with. It may seem a comparatively easy matter to determine that one enterprise is more promising than another. But it is by no means so easy to establish that one common stock at a given price is clearly preferable to another stock at its current price. Reverting to our example, if it were quite certain, or even reasonably probable, that Stock A is more likely to advance to 50 than Stock B to advance to 33, then both issues would not be quoted at 30. Stock A, of course, would be selling higher. The point we make is that the market price in general reflects already any superiority that one enterprise has demonstrated over another. The investor who prefers Bond A because he expects its related stock to rise a great deal faster than Stock B, is exercis- ing independent judgment in a
quite certain, or even reasonably probable, that Stock A is more likely to advance to 50 than Stock B to advance to 33, then both issues would not be quoted at 30. Stock A, of course, would be selling higher. The point we make is that the market price in general reflects already any superiority that one enterprise has demonstrated over another. The investor who prefers Bond A because he expects its related stock to rise a great deal faster than Stock B, is exercis- ing independent judgment in a field where certainty is lacking and where mistakes are necessarily frequent. For this reason we doubt that a suc- cessful policy of buying privileged issues from the investment approach can be based primarily upon the purchaser’s view regarding the future expansion of the profits of the enterprise. (In stating this point we are merely repeating a principle previously laid down in the field of fixed- value investment.) Where the speculative approach is followed, i.e., where the issue is bought primarily as a desirable method of acquiring an interest in the stock, it would be quite logical, of course, to assign dominant weight to the buyer’s judgment as to the future of the company. Three Important Elements. 1. Extent of the Privilege. In examining the terms of a profit-sharing privilege, three component elements are seen to enter. These are: a. The extent of the profit-sharing or speculative interest per dollar of investment. b. The closeness of the privilege to a realizable profit at the time of purchase. c. The duration of the privilege. The amount of speculative interest attaching to a convertible or warrant-bearing senior security is equal to the current market value of the number of shares of stock covered by the privilege. Other things being equal, the larger the amount of the speculative interest per dollar of investment the more attractive the privilege. Examples: Rand Kardex 51/2s, previously described, carried warrants to buy 221/2 shares of Class A stock initial
at the time of purchase. c. The duration of the privilege. The amount of speculative interest attaching to a convertible or warrant-bearing senior security is equal to the current market value of the number of shares of stock covered by the privilege. Other things being equal, the larger the amount of the speculative interest per dollar of investment the more attractive the privilege. Examples: Rand Kardex 51/2s, previously described, carried warrants to buy 221/2 shares of Class A stock initially at 40. Current price of Class A stock was 42. The “speculative interest” amounted to 221/2 X 42, or $945 per $1,000 bond. Reliable Stores Corporation 6s, offered in 1927, carried warrants to buy only 5 shares of common stock initially at 10. Current price of the common was 12. Hence the “speculative interest” amounted to 5 X 12, or only $60 per $1,000 bond. Intercontinental Rubber Products Co. 7s offered an extraordinary example of a large speculative interest attaching to a bond. As a result of peculiar provisions surrounding their issuance in 1922, each $1,000 note was convertible into 100 shares of stock and also carried the right to pur- chase 400 additional shares at 10. When the stock sold at 10 in 1925, the speculative interest per $1,000 note amounted to 500 X 10, or $5,000. If the notes were then selling, say, at 120, the speculative interest would have equalled 417% of the bond investment—or 70 times as great as in the case of the Reliable Stores offering. The practical importance of the amount of speculative interest can be illustrated by the following comparison, covering the three examples above given. Item Reliable Stores 6s Rand Kardex 51/2s Intercontinental Rubber 7s Number of shares covered by each $1,000 bond 5 221/2 500 Base price $10.00 $40.00 $10.00 Increase in value of bond when stock advances: 25% above base price 12.50 225.00 1,250.00 50% above base price 25.00 450.00 2,500.00 100% above base price 50.00 900.00 5,000.00 In the case of c
portance of the amount of speculative interest can be illustrated by the following comparison, covering the three examples above given. Item Reliable Stores 6s Rand Kardex 51/2s Intercontinental Rubber 7s Number of shares covered by each $1,000 bond 5 221/2 500 Base price $10.00 $40.00 $10.00 Increase in value of bond when stock advances: 25% above base price 12.50 225.00 1,250.00 50% above base price 25.00 450.00 2,500.00 100% above base price 50.00 900.00 5,000.00 In the case of convertible bonds the speculative interest always amounts to 100% of the bond at par when the stock sells at the conver- sion price. Hence in these issues our first and second component elements express the same fact. If a bond selling at par is convertible into stock at 50, and if the stock sells at 30, then the speculative interest amounts to 60% of the commitment, which is the same thing as saying that the current price of the stock is 60% of that needed before conver- sion would be profitable. Stock-purchase-warrant issues disclose no such fixed relationship between the amount of the speculative interest and the proximity of this interest to a realizable profit. In the case of the Reliable Stores 6s, the speculative interest was very small, but it showed an actual profit at the time of issuance, since the stock was selling above the subscription price. Significance of Call on Large Number of Shares at Low Price. It may be said parenthetically that a speculative interest in a large number of shares selling at a low price is technically more attractive than one in a smaller number of shares selling at a high price. This is because low-priced shares are apt to fluctuate over a wider range percentagewise than higher priced stocks. Hence if a bond is both well secured and convertible into many shares at a low price, it will have an excellent chance for very large profit without being subject to the offsetting risk of greater loss through a spec- ulative dip in the price of the
umber of shares selling at a low price is technically more attractive than one in a smaller number of shares selling at a high price. This is because low-priced shares are apt to fluctuate over a wider range percentagewise than higher priced stocks. Hence if a bond is both well secured and convertible into many shares at a low price, it will have an excellent chance for very large profit without being subject to the offsetting risk of greater loss through a spec- ulative dip in the price of the stock. For example, as a matter of form of privilege, the Ohio Copper Com- pany 7s, due 1931, convertible into 1,000 shares of stock selling at $1, had better possibilities than the Atchison, Topeka and Santa Fe Convertible 41/2 s, due 1948, convertible into 6 shares of common, selling at 1662/3, although in each case the amount of speculative interest equalled $1,000 per bond. As it turned out, Ohio Copper stock advanced from less than $1 a share in 1928 to 47/8 in 1929, making the bond worth close to 500% of par. It would have required a rise in the price of Atchison from 166 to 800 to yield the same profit on the convertible 41/2 s, but the highest price reached in 1929 was under 300. In the case of participating issues, the extent of the profit-sharing inter- est would ordinarily be considered in terms of the amount of extra income that may conceivably be obtained as a result of the privilege. A limited extra payment (e.g., Bayuk Cigars, Inc., 7% Preferred, which may receive not more than 1% additional) is of course less attractive than an unlimited participation (e.g., White Rock Mineral Springs Company 5% Second Preferred, which received a total of 261/4% in 1930). 2 and 3. Closeness and Duration of the Privilege. The implications of the second and third factors in valuing a privilege are readily apparent. A privilege having a long period to run is in that respect more desirable than one expiring in a short time. The nearer the current price of the stock to the level
more than 1% additional) is of course less attractive than an unlimited participation (e.g., White Rock Mineral Springs Company 5% Second Preferred, which received a total of 261/4% in 1930). 2 and 3. Closeness and Duration of the Privilege. The implications of the second and third factors in valuing a privilege are readily apparent. A privilege having a long period to run is in that respect more desirable than one expiring in a short time. The nearer the current price of the stock to the level at which conversion or subscription becomes profitable the more attractive does the privilege become. In the case of a participa- tion feature, it is similarly desirable that the current dividends or earn- ings on the common stock should be close to the figure at which the extra distribution on the senior issue commences. By “conversion price” is meant the price of the common stock equiv- alent to a price of 100 for the convertible issue. If a preferred stock is con- vertible into 12/3 as many shares of common, the conversion price of the common is therefore 60. The term “conversion parity,” or “conversion level,” may be used to designate that price of the common which is equiv- alent to a given quotation for the convertible issue, or vice versa. It can be found by multiplying the price of the convertible issue by the conversion price of the common. If the preferred stock just mentioned is selling at 90, the conversion parity of the common becomes 60 X 90% = 54. This means that to a buyer of the preferred at 90 an advance in the common above 54 will create a realizable profit. Conversely, if the common sold at 66, one might say that the conversion parity of the preferred is 110. The “closeness” of the privilege may be stated arithmetically as the ratio between the market price and the conversion parity of the common stock. In the foregoing example, if the common is selling at 54 and the preferred at 110 (equivalent to 66 for the common), the “index of close- ness” becomes 5
yer of the preferred at 90 an advance in the common above 54 will create a realizable profit. Conversely, if the common sold at 66, one might say that the conversion parity of the preferred is 110. The “closeness” of the privilege may be stated arithmetically as the ratio between the market price and the conversion parity of the common stock. In the foregoing example, if the common is selling at 54 and the preferred at 110 (equivalent to 66 for the common), the “index of close- ness” becomes 54 --- 66, or 0.82. COMPARATIVE MERITS OF THE THREE TYPES OF PRIVILEGES From the theoretical standpoint, a participating feature—unlimited in time and possible amount—is the most desirable type of profit-sharing privilege. This arrangement enables the investor to derive the specific benefit of participation in profits (viz., increased income) without mod- ifying his original position as a senior-security holder. These benefits may be received over a long period of years. By contrast, a conversion privi- lege can result in higher income only through actual exchange into the stock and consequent surrender of the senior position. Its real advantage consists, therefore, only of the opportunity to make a profit through the sale of the convertible issue at the right time. Similarly the benefits from a subscription privilege may conservatively be realized only through sale of the warrants (or by the subscription to and prompt sale of the stock). If the common stock is purchased and held for permanent income, the operation involves the risking of additional money on a basis entirely different from the original purchase of the senior issue. Example of Advantage of Unlimited Participation Privilege. An excellent practical example of the theoretical advantages attaching to a well-entrenched participating security is afforded by Westinghouse Electric and Manufacturing Company Preferred. This issue is entitled to cumulative prior dividends of $3.50 per annum (7% on $50 par) and in additi
permanent income, the operation involves the risking of additional money on a basis entirely different from the original purchase of the senior issue. Example of Advantage of Unlimited Participation Privilege. An excellent practical example of the theoretical advantages attaching to a well-entrenched participating security is afforded by Westinghouse Electric and Manufacturing Company Preferred. This issue is entitled to cumulative prior dividends of $3.50 per annum (7% on $50 par) and in addition participates equally per share with the common in any dividends paid on the latter in excess of $3.50. As far back as 1917 Westinghouse Preferred could have been bought at 521/2, representing an attractive straight investment with additional possibilities through its participating feature. In the ensuing 15 years to 1932 a total of about $7 per share was disbursed in extra dividends above the basic 7%. In the meantime an opportunity arose to sell out at a large profit (the high price being 284 in 1929), which corresponded to the enhancement possibilities of a convert- ible or subscription-warrant issue. If the stock was not sold, the profit was naturally lost in the ensuing market decline. But the investor’s original position remained unimpaired, for at the low point of 1932 the issue was still paying the 7% dividend and selling at 52 1/2—although the common had passed its dividend and had fallen to 15 5/8. In this instance the investor was able to participate in the surplus prof- its of the common stock in good years while maintaining his preferred position, so that, when the bad years came, he lost only his temporary profit. Had the issue been convertible instead of participating, the investor could have received the higher dividends only through converting and would later have found the dividend omitted on his common shares and their value fallen far below his original investment. Participating Issues at Disadvantage, Marketwise. Although from the standpoint of long-p
its of the common stock in good years while maintaining his preferred position, so that, when the bad years came, he lost only his temporary profit. Had the issue been convertible instead of participating, the investor could have received the higher dividends only through converting and would later have found the dividend omitted on his common shares and their value fallen far below his original investment. Participating Issues at Disadvantage, Marketwise. Although from the standpoint of long-pull-investment holding, participating issues are theoretically the most desirable, they may behave somewhat less sat- isfactorily in a major market upswing than do convertible or subscrip- tion-warrant issues. During such a period a participating senior security may regularly sell below its proper comparative price. In the case of West- inghouse Preferred, for example, its price during 1929 was usually from 5 to 10 points lower than that of the common, although its intrinsic value per share could not be less than that of the junior stock.2 The reason for this phenomenon is as follows: The price of the com- mon stock is made largely by speculators interested chiefly in quick prof- its, to secure which they need an active market. The preferred stock, being closely held, is relatively inactive. Consequently the speculators are will- ing to pay several points more for the inferior common issue simply because it can be bought and sold more readily and because other spec- ulators are likely to be willing to pay more for it also. The same anomaly arises in the case of closely held common stocks with voting power, compared with the more active nonvoting issue of the same company. American Tobacco B and Liggett and Myers Tobacco B (both nonvoting) have for years sold higher than the voting stock. A sim- ilar situation formerly existed in the two common issues of Bethlehem 2 A much greater price discrepancy of this kind existed in the case of White Rock Mineral Springs Participating P
to be willing to pay more for it also. The same anomaly arises in the case of closely held common stocks with voting power, compared with the more active nonvoting issue of the same company. American Tobacco B and Liggett and Myers Tobacco B (both nonvoting) have for years sold higher than the voting stock. A sim- ilar situation formerly existed in the two common issues of Bethlehem 2 A much greater price discrepancy of this kind existed in the case of White Rock Mineral Springs Participating Preferred and common during 1929 and 1930. Because of this market situation, holders of nearly all the participating preferred shares accepted an offer to exchange into common stock, although this meant no gain in income and the loss of their senior position. Steel, Pan American Petroleum and others.3 The paradoxical principle holds true for the securities market generally that in the absence of a spe- cial demand relative scarcity is likely to make for a lower rather than a higher price. In cases such as Westinghouse and American Tobacco the proper corporate policy would be to extend to the holder of the intrinsically more valuable issue the privilege of exchanging it for the more active but intrin- sically inferior issue. The White Rock company actually took this step. Although the holders of the participating preferred might make a mis- take in accepting such an offer, they cannot object to its being made to them, and the common stockholders may gain but cannot lose through its acceptance. Relative Price Behavior of Convertible and Warrant-bearing Issues. From the standpoint of price behavior under favorable market conditions the best results are obtained by holders of senior securities with detachable stock-purchase warrants. To illustrate this point we shall compare certain price relationships shown in 1929 between four privileged issues and the corresponding common stocks. The issues are as follows: 1. Mohawk Hudson Power Corporation 7% Second Preferred, carry- ing war
eptance. Relative Price Behavior of Convertible and Warrant-bearing Issues. From the standpoint of price behavior under favorable market conditions the best results are obtained by holders of senior securities with detachable stock-purchase warrants. To illustrate this point we shall compare certain price relationships shown in 1929 between four privileged issues and the corresponding common stocks. The issues are as follows: 1. Mohawk Hudson Power Corporation 7% Second Preferred, carry- ing warrants to buy 2 shares of common at 50 for each share of preferred. 2. White Sewing Machine Corporation 6% Debentures, due 1936, car- rying warrants to buy 21/2 shares of common stock for each $100 bond. 3. Central States Electric Corporation 6% Preferred, convertible into common stock at $118 per share. 4. Independent Oil and Gas Company Debentures 6s, due 1939, convertible into common stock at $32 per share. The following table shows in striking fashion that in speculative mar- kets issues with purchase warrants have a tendency to sell at large premi- ums in relation to the common-stock price and that these premiums are much greater than in the case of similarly situated convertible issues. 3 The persistently wide spread between the market prices for R. J. Reynolds Tobacco Com- pany common and Class B stocks rests on the special circumstance that officers and employ- ees of the company who own the common stock enjoy certain profit-sharing benefits not accorded to holders of the Class B stock. The New York Stock Exchange will no longer list nonvoting common stocks, nor are these permitted to be issued in reorganizations effected under Chap. X of the 1938 Bankruptcy Act. Senior issue Market price of common Conversion or subscrip- tion price of common Price of senior issue Realizable value of senior issue based on privilege (conversion or subscrip- tion parity) Amount by which senior issue sold above parity, (“pre- mium”), points Mohawk Hudson 521/2 50 163*
B stock. The New York Stock Exchange will no longer list nonvoting common stocks, nor are these permitted to be issued in reorganizations effected under Chap. X of the 1938 Bankruptcy Act. Senior issue Market price of common Conversion or subscrip- tion price of common Price of senior issue Realizable value of senior issue based on privilege (conversion or subscrip- tion parity) Amount by which senior issue sold above parity, (“pre- mium”), points Mohawk Hudson 521/2 50 163* 105 58 2d Pfd White Sewing 39 40 1231/2† 971/2 26 Machine 6s Central States 116 118 97 98 -1 Electric Pfd Independent Oil & 31 32 105 97 8 Gas 6s * Consisting of 107 for the preferred stock, ex-warrants, plus 56 for the warrants. † Consisting of 981/2 for the bonds, ex-warrants, plus 25 for the warrants. Advantage of Separability of Speculative Component. This advantage of subscription-warrant issues is due largely to the fact that their speculative component (i.e., the subscription warrant itself) can be entirely separated from their investment component (i.e., the bond or preferred stock ex-warrants). Speculators are always looking for a chance to make large profits on a small cash commitment. This is a distinguish- ing characteristic of stock option warrants, as will be shown in detail in our later discussion of these instruments. In an advancing market, there- fore, speculators bid for the warrants attached to these privileged issues, and hence they sell separately at a substantial price even though they may have no immediate exercisable value. These speculators greatly prefer buying the option warrants to buying a corresponding convertible bond, because the latter requires a much larger cash investment per share of common stock involved.4 It follows, therefore, that the separate market 4 Note that the Independent Oil and Gas bonds represented a commitment of $33.60 per share of common, whereas the White Sewing Machine warrants involved a commitment
tely at a substantial price even though they may have no immediate exercisable value. These speculators greatly prefer buying the option warrants to buying a corresponding convertible bond, because the latter requires a much larger cash investment per share of common stock involved.4 It follows, therefore, that the separate market 4 Note that the Independent Oil and Gas bonds represented a commitment of $33.60 per share of common, whereas the White Sewing Machine warrants involved a commitment of only $10 per share of common. But the former meant ownership of either a fixed claim or a share of stock, whereas the latter meant only the right to buy a share of stock at a price above the market. values of the bond plus the option warrant (which combine to make the price of the bond “with warrants”) may considerably exceed the single quotation for a closely similar convertible issue. Second Advantage of Warrant-bearing Issues. Subscription-war- rant issues have a second point of superiority, in respect to callable pro- visions. A right reserved by the corporation to redeem an issue prior to maturity must in general be considered as a disadvantage to the holder; for presumably it will be exercised only when it is to the benefit of the issuer to do so, which means usually that the security would otherwise sell for more than the call price.5 A callable provision, unless at a very high premium, might entirely vitiate the value of a participating privi- lege. For with such a provision there would be danger of redemption as soon as the company grew prosperous enough to place the issue in line for extra distributions.6 In some cases participating issues that are callable are made convertible as well, in order to give them a chance to benefit from any large advance in the market price of the common that may have taken place up to the time of call. (See for examples: National Distillers Products Corporation $2.50 Cumulative Participating Convertible Pre- ferred;7 Kelsey-Hayes
on there would be danger of redemption as soon as the company grew prosperous enough to place the issue in line for extra distributions.6 In some cases participating issues that are callable are made convertible as well, in order to give them a chance to benefit from any large advance in the market price of the common that may have taken place up to the time of call. (See for examples: National Distillers Products Corporation $2.50 Cumulative Participating Convertible Pre- ferred;7 Kelsey-Hayes Wheel Company $1.50 Participating Convertible Class A stock.) Participating bonds are generally limited in their right to participate in surplus earnings and are commonly callable. (See White Sewing Machine Corporation Participating Debenture 6s, due 1940; 5 The callable feature may be—and recently has been—an unfavorable element of great importance even in “straight” nonconvertible bonds. In a few cases a callable feature works out to the advantage of the holder, by facilitating new financing which involves the redemption of the old issue at a price above the previous market. But the same result could be obtained, if there were no right to call, by an offer to “buy in” the security. This was done in the case of United States Steel Corporation 5s, due 1951, which were not callable but were bought in at 110. 6 Dewing cites the case of Union Pacific Railroad—Oregon Short Line Participating 4s, issued in 1903, which were secured by the pledge of Northern Securities Company stock. The bondholders had the right to participate in any dividends in excess of 4% declared on the deposited collateral. The bonds were called at 1021/2 just at the time when participating distributions seemed likely to occur. See Arthur S. Dewing, A Study of Corporation Securities, p. 328, New York, 1934. 7 Coincident with the rise of the common stock from 167/8 to 1247/8 in 1933, all the National Distillers Preferred Stock was converted in that year. Nearly all the conversions were precipi- tated by a cha
dholders had the right to participate in any dividends in excess of 4% declared on the deposited collateral. The bonds were called at 1021/2 just at the time when participating distributions seemed likely to occur. See Arthur S. Dewing, A Study of Corporation Securities, p. 328, New York, 1934. 7 Coincident with the rise of the common stock from 167/8 to 1247/8 in 1933, all the National Distillers Preferred Stock was converted in that year. Nearly all the conversions were precipi- tated by a change in the conversion rate after June 30, 1933. The small balance was con- verted as a result of the calling of issue at 40 and dividend in August. United Steel Works Corporation Participating 61/2s, Series A, due 1947; neither of which is convertible.) Sometimes participating issues are pro- tected against loss of the privilege through redemption by setting the call price at a very high figure. Something of this sort was apparently attempted in the case of San Francisco Toll-Bridge Company Participat- ing 7s, due 1942, which were callable at 120 through November 1, 1933, and at lower prices thereafter. Celluloid Corporation Participating Sec- ond Preferred is callable at 150, whereas Celanese Corporation Partici- pating First Preferred is noncallable. Another device to prevent vitiating the participating privilege through redemption is to make the issue callable at a price that may be directly dependent upon the value of the participating privilege. For example, Siemens and Halske Participating Debentures, due in 2930, are callable after April 1, 1942, at the average market price for the issue during the six months preceding notice of redemption but at not less than the original issue price (which was over 230% of the par value). The Kreuger and Toll 5% Participating Debentures had similar provisions. Even in the case of a convertible issue a callable feature is technically a serious drawback because it may operate to reduce the duration of the privilege. Conceivably a con