Let us consider in more detail the organization and financing of Petroleum Corporation of America, mentioned in the last chapter. This was a large investment company formed for the purpose of specializing in securities of enterprises in the oil industry. The public was offered 3,250,000 shares of capital stock at $34 per share. The company received therefore a net amount of $31 per share, or $100,750,000 in cash. It issued to unnamed recipients—presumably promoters, investment bankers and the management—warrants, good for five years, to buy 1,625,000 shares of additional stock, also at $34 per share.
This example is representative of the investment trust financing of the period. Moreover, as we shall see, the technique on this score that developed in boom years was carried over through the ensuing depression, and it threatened to be accepted as the standard practice for stock financing of all kinds of enterprises. But there is good reason to ask the real menaing of a set-up of this kind, first, with respect to what the buyer of the stock gets for his money, and second, with respect to the position occupied by the investment banking houses floating these issues.
Cost of Management; Three Items. A new investment trust—such as Petroleum Corporation in January 1929—starts with two assets: cash and management. Buyers of the stock at $34 per share were asked to pay for the management in three ways, viz.:
- By the difference between what the stock cost them and the amount received by the corporation.
It is true that this difference of $3 per share was paid not to the management but to those underwriting and selling the shares. But from the standpoint of the stock buyer the only justification for paying more for the stock than the initial cash behind it would lie in his belief that the management was worth the difference.
- By the value of the option warrants issued to the organizing interests.
These warrants in essence entitled the owners to receive one-third of whatever appreciation might take place in the value of the enterprise over the next five years. (From the 1929 view-point a five-year period gave ample opportunity to participate in the future success of the business.) This block of warrants had a real value, and that value in turn was taken out of the initial value of the common stock.
The price relationships usually obtaining between stock and warrants suggest that the 1,625,000 warrants would take about one-sixth of the value away from the common stock. On this basis, one-sixth of the $100,750,000 cash originally received by the company would be applicable to the warrants, and five-sixths to the stock.
- By the salaries that the officers were to receive, and also by the extra taxes incurred through the use of the corporate form.
Summarizing the foregoing analysis, we find that buyers of Petroleum Corporation shares were paying the following price for the managerial skill to be applied to the investment of their money:
| 1. Cost of financing ($3 per share) | $9,750,000 |
| 2. Value of warrants (1/6th of remaining cash) | about 16,790,000 |
| 3. Future deductions from managerial salaries, etc | ? |
| Total | $26,540,000 + |
The three items together may be said to absorb between 25 and 30% of the amount contributed by the public to the enterprise. By this we mean not merely a deduction of that percentage of future profits but an actual sacrifice of invested principal in return for management.
What Was Received for the Price Paid? Carrying the study a step farther, let us ask what kind of managerial skill this enterprise was to enjoy? The board of directors consisted of many men prominent in finance, and their judgment on investments was considered well worth having. But two serious limitations on the value of this judgment must here be noted. The first is that the directors were not obligated to devote themselves exclusively or even preponderantly to this enterprise. They were permitted, and seemingly intended, to multiply these activities indefinitely. Common sense would suggest that the value of their expert judgment to Petroleum Corporation would be greatly diminished by the fact that so many other claims were being made upon it at the same time.
A more obvious limitation appears from the Corporation’s projected activities. It proposed to devote itself to investments in a single field—petroleum. The scope for judgment and analysis was thereby greatly circumscribed. As it turned out, the funds were largely concentrated, first in two related companies—Prairie Pipe Line Company and Prairie Oil and Gas Company—and then in a single successor enterprise (Consolidated Oil Corporation). Thus Petroleum Corporation took on the complexion of a holding company, in which the exercise of managerial skill appears to be reduced to a minimum once the original acquisitions are made.
We are forced to conclude that financial schemes of the kind illustrated by Petroleum Corporation of America are unsatisfactory from the standpoint of the stock buyer. This is true not only because the total cost to him for management is excessive in relatoin to the value of the services rendered but also because the cost is not clearly disclosed, being concealed in good measure by the use of the warrant artifice. (The foregoing reasoning does not rest in any way upon the fact that Petroleum Corporations’s investments proved unprofitable.)
Position of Investment Banking Firms in This Connection. The second line of inquiry suggested by this example is also of major importance. What is the position occupied by the investment banking firms floating an issue such as Petroleum Corporation of America, and how does this compare with the practice of former years? Prior to the late 1920’s, the sale of stock to the public by reputable houses of issue was governed by the following three important principles:
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The enterprise must be well established and offer a record and financial exhibit adequate to justify the purchase of the shares at the issue price.
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The investment banker must act primarily as the representative of the buyers of the stock, and he must deal at arm’s-length with the company’s management. His duty includes protecting his clients against the payment of excessive compensation to the officers or any other policies inimical to the stockholder’s interest.
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The compensation taken by the investment banker must be reasonable. It represents a fee paid by the corporation for the service of raising capital.
These rules of conduct afforded a clear line of demarcation between responsible and disreputable stock financing. It was an established Wall Street maxim that capital for a new enterprise must be raised from private sources. These private interests would be in a position to make their own investigation, work out their own deal and keep in close touch with the enterprise, all of which safeguards (in addition to the chance to make a large profit) were considered necessary to justify a commitment in any new venture. Hence the public sale of securities in a new enterprise was confined almost exclusively to “blue sky” promoters and small houses of questionable standing. The great majority of such flotations were either downright swindles or closely equivalent thereto by reason of the unconscionable financing charges taken out of the price paid by the public.
Investment-trust financing, by its very nature, was compelled to contravene these three established criteria of reputable stock flotations. The investment trusts were new enterprises; their management and their bankers were generally identical; the compensation for financing and management had to be determined solely by the recipients, without accepted standards of reasonableness to control them. In the absence of such standards, and in the absence also of the invaluable arm’s-length bargaining between corporation and banker, it was scarcely to be hoped that the interests of the security buyer would be adequately protected. Allowance must be made besides for the generally distorted and egotistical views prevalent in the financial world during 1928 and 1929.
Developments since 1929. For a time it appeared that the demoralizing influence of investment-trust financing was likely to spread to the entire field of common-stock flotations and that even the leading banking houses were prepared to sell shares of new or virtually new commercial enterprises, without past records and on the basis entirely of their expected future earnings. (There were definite signs of this tendency in the beer-and liquor-stock floations of 1933.) Fortunately, a reversal of sentiment has since taken place, and we find that the relatively few common-stock issues sponsored by the first-line houses are now similar in character and arrangements to those of former days.
However, there has been a fair amount of activity in the common-stock flotation field since 1933, carried on by houses of secondary size or standing. Most of these issues represent shares of new enterprises, which in turn tend to fall in whatever industrial group is easiest to exploit at the time. Thus in 1933 we had many gold-, liquor- and beer-stock flotations, and in 1928—1929 there was a deluge of airplane issues. The formation of new investment companies, on the other hand, appears to be a perennial industry. In surveying such common-stock flotations, the starting point must be the realization that the investment banker behind them is not acting primarily in behalf of his clients who buy the issue. For on the one side the new corporation is not an independent entity, which can negotiate at arm’s-length with various banker representing clients with money to invest, and on the other side, the banker is himself in part a promoter, in part a proprietor of the new business. In an important sense, he is raising funds from the public for himself.
New Role of Such Investment Bankers. More exactly stated, the investment banker who floats such issues is operating in a double guise. He makes a deal on his own behalf with the originators of the enterpise, and then he makes a separate deal with the public to raise from them the funds he has promised the business. He demands—and no doubt is entitled to—a liberal rewards for his pains. But the very size of his compensation introduces a significant change in his relationship to the public. For it makes a very real difference whether a stock buyer can consider the investment banker as essentially his agent and representative or must view the issuing house as a promoter-proprietor-manager of a business, endeavoring to raise funds to carry it on.
When investment banking becomes identified with the latter approach, the interests of the general public are certain to suffer. The Securities Act of 1933 aims to safeguard the security buyer by requiring full disclosure of the pertinent facts and by extending the previously existing liability for concealment or misrepresentation. Although full disclosure is undoubtedly desirable, it may not be of much practical help except to the skilled and shrewd investor or to the trained analyst. It is to be feared that the typical stock buyer will neither read the long prospectus carefully nor understand the implications of all it contains. Modern financing methods are not far different from a magician’s bag of tricks; they can be executed in full view of the public without its being very much the wiser. The use of stock options as part of the underwriter-promoter’s compensation is one of the newer and more deceptive tricks of the trade.
Two examples of new enterprise financing, in 1936 and 1939, will be discussed in some detail, with the object of illustrating both the character of these flotations and the technique of analysis required to appraise them.
Example A: American Bantam Car Corporation, July 1936. This offering consisted of 100,000 shares of 6% Cumulative Convertible Preference stock, sold to the public at $10 per share, its par value. Each share was convertible into 3 shares fo common stock. The “underwriters” received a gross commission of $2 per share, or 20% of the selling price; however, this compensation was for selling effort only, without any guarantee to take or place the shares.
The new company had acquired the plant of the American Austin Car company, which had started out in 1929 with $3,692,000 in cash capital and had ended in bankruptcy. The organizers of the Bantam enterprise bought in the Austin assets, subject to various liabilities, for only $5,000. They then turned over their purchase, plus $500 in cash, to the new company for 300,000 shares of its common stock. In other words, the entire common issue cost the promoters $5,500 cash plus their time and effort.
The prospectus stated—what was an obvious fact—that the preference stock was “offered as speculation.” That speculation could work out successfully only if the conversion privilege proved valuable, since the mere 6% return on a preferred stock was scarcely an adequate reward for the risk involved. (The character of the risk was shown clearly enough in the enormous losses of the predecessor company.) But note that before the conversion privilege could be worth anything, the common stock would have to sell for more than $3 1/3 per share‚ and in that case the $5,500 investment of the organizers would be worth over $1,000,000. In other words, before the public could make any profit, the organizers would have to multiply their stake 180 times.
Sequel. By June 30, 1939, the company had accumulated a deficit of $750,000; it was compelled to borrow money from the R.F.C., and the preferred-stock holder no longer had any equity in current assets. The price of the preference stock declined to 3, but at the same time the common was quoted at ¾ bid. This meant (if the quoted price could be trusted) that, although the public had lost 70% of its investment, the organizers’ $5,500 contribution had still a nominal market value of $225,000.
Example B: Aeronautical Corporation of America, December 1939. This company offered to the public 60,000 shares of new common stock at $6.25 per share. The “underwriters” who made no firm commitment to take any shares, received on the sale of each share the following three kinds of compensation: (1) 90 cents in cash; (2) 1/20 of a share of stock, ostensibly worth 31 cents, donated by the principal stockholders; (3) a warrant to buy ½ share of stock at prices varying between $6.24 and $8,00 per share. If the common stock was fairly worth the $6.25 offering price, these warrants were undoubtedly worth at least $1 per share called for. This would mean an aggregate commision for selling effort of $2.34 per share, or more than one-third the amount paid over by the public.
The company had been in business since 1928 and had been manufacturing its light Aeronca planes since 1931. Its business had grown steadily from $124,000 sales in 1934 to about $850,000 sales in 1939. However, the enterprise had been definitely unprofitable to the end of 1938, showing an aggregate deficit at that time of over $500,000 (including development expense written off). In 9½ months to October 15, 1939, it had earned $50,000. Prior to this offering of new shares to the public there were outstanding 66,000 shares of stock, which had a net asset value of only $1.28 per share. In addition to the warrants for 30,000 shares to be given the underwriters, there were like warrants for 15,000 shares in the hands of the officers.
There seemed strong reason to believe that the company occupied a favorable position in a growing industry. But analysis would show that the participation of the public in any future increase in earnings was seriously diluted in three different ways: by the cash selling expense subtracted from the price to be paid for the new stock, by the small tangible assets contributed by the original owners for their stock interest and by the warrants which would siphon off part of any increased value. To show the effect of this dilution, let us assume that the company proves so successful that its fair value is twice its tangible assets after completion of the financing—say, about $1,000,000 as compared with $484,000 of tangible assets. What could then be the value of the stock for which the public paid $6.25? If there were no warrants outstanding, this value would be about $8 per share on 126,000 shares. But allowing for a value of say $2.00 per share for the warrants, the stock itself would be worth only $7.25 per share. Hence even a very substantial degree of success on the part of this enterprise would add a mere 16% to the value of the public’s purchase. Should things go the other way, a very large part of the investment would soon be dissipated.
Should the Public Finance New Ventures? Fairly complete observation fo new-enterprise financing registered with the S.E.C. since 1933 has given us a pessimistic opinion as to its soundness and its economic value to the nation. The venturing of capital into new businesses is essential to American progress, but no substantial contribution to the upbuilding of the country has ever been made by new ventures publicly financed. Wall Street has always realized that the capital for such undertakings should properly be supplied on a private and personal basis—by the organizers themselves or people close to them. Hence the sale of shares in new businesses has never been a truly reputable pursuit, and the leading banking houses will not engage in it. The less fastidious channels through which such financing is done exact so high an over-all selling cost—to the public—that the chance of success of the new enterprise, small enough at best, is thereby greatly diminished.
It is our considered view that the nations’s interest would be served by amending the Securities Act so as to prohibit the public offering of securities of new and definitely unseasoned ventures. It would not be easy to define precisely the criteria of “seasoning,”—e.g., size, number of years‘ operation without loss—and it may be necessary to vest some discretion on this score with the S.E.C. We think, however, that borderline and difficult cases will be relatively few in number (although our second example above belongs, perhaps, in this category). We should be glad to see the powers and duties of the S.E.C. diminished in many details of minor significance; but on this point of protecting a public incapable of protecting itself, or view leans strongly towards more drastic legislation.
Blue-sky Promotions. In the “good old days” fraudulent stock promoters relied so largely upon high pressure salesmanship that they rarely bothered to give their proposition any semblance of serious merit. They could sell shares in a mine that was not even a “hole in the ground” or in an invention the chief recommendation for which was the enormous profit made by Henry Ford’s early partners. The victim was in fact buying “blue sky” and nothing else. Any one with the slightest business sense could have detected the complete worthlessness of these ventures almost at a glance; in fact, the glossy paper used for the prospectus was in itself sufficient to identify the proposition as fraudulent.
The tightening of federal and state regulations against these swindles has led to a different type of security promotion. Instead of offering something entirely worthless, the promoter selects a real enterprise that he can sell at much more than its fair value. By this means the law can be obeyed and the public exploited just the same. Oil and mining ventures lend themselves best to such stock flotations, because it is easy to instill in the uninitiated an exaggerated notion of their true worth. The S.E.C. has been concerning itself more and more seriously with endeavors to defeat this type of semifraud. In theory a promoter may offer something worth $1 per share at $5, provided he discloses all the facts and adds no false representations. The Commission is not authorized to pass upon the soundness of new securities or the fairness of their price (except in the case of public-utility issues which come under the terms of the Public Utility Holding Company Act of 1935). Actually, it appears to be doing its best, by various pressures, to discourage and even prevent the more grossly inequitable offerings. But it is essential that the public recognize that the Commission’s powers in this respect are severely limited and that only a sceptical analysis by the intending buyer can assure him against exploitation.
Promotional activities are attracted especially to any new industry that is in the public eye. Profits made by those first in the field, or even currently by the enterprise floated, can be given a fictitious guise of permanence and of future enhancement. Hence gross overvaluations can be made plausible enough to sell. In the liquor flotations of 1933 the degree of overvaluation depended entirely upon the conscience of the sponsors. Accordingly, the list of stock offerings showed all gradations from the thoroughly legitimate down to the almost completely fraudulent. A somewhat similar picture is presented by the aircraft flotations of 1938—1939. The public would do well to remember that whenever it becomes easy to raise capital for a particular industry, both the chances of unfair deals are magnified and the danger of overdevelopment of the industry itself becomes very real.
Repercussions of Unsound Investment Banking. The relaxation fo investment bankers’ standards in the late 1920’s, and their use of ingenious means to enlarge their compensation, had unwholesome repercussions in the field of corporate management. Operating officials felt themselves entitled not only to handsome salaries but also to a substantial participation in the profits of the enterprise. In this respect the investment-trust arrangements, devised by the banking houses for their own benefit, set a stimulating example to the world of “big business.”
Whether or not it is proper for executives of a large and prosperous concern to receive annual compensation running into hundreds of thousands or even millions of dollars is perhaps an open question. Its answer will depend upon the extent to which the corporation’s success is due to their unique or surpassing ability, and this must be very difficult to determine with assurance. But it may not be denied that devious and questionable means were frequently employed to secure these large bonuses to the management without full disclosure of their extent to the stockholders. Stock-option warrants (or long-term subscription rights) to buy shares at low prices, proved an excellent instrument for this purpose—as we have already pointed out in our discussion of stockholder-management relationships. In this field complete and continued publicity is not only theoretically desirable but of practical utility as well. The legislation of 1933—1934 marks an undeniable forward step in this regard, since the major facts of managerial compensation must now be disclosed in registration statements and in annual supplements thereto (Form 10-K). With publicity given to this compensation, we believe that the self-interest of stockholders may be relied on fairly well to prevent it from passing all reasonable limits.