stock in order to induce exchanges, so dominates the investment characteristics of the new preferred stock as to make that stock in substance not a senior security entitled to the exemption provided by Section 18(e) of the Act but a right to purchase within the meaning of the prohibition of Section 18(d). The real consideration for exchanging the old preferred stock is not the priorities of the new security but its right to purchase common stock, and consequently the new security must be viewed as a right to purchase in applying the standards of the statute. We are of the opinion that under the circumstances presented, particularly the difficulties that would be imposed on investors, both present as well as prospective to whom the safeguards of the statute extend, in evaluating this security were its issuance permitted, and the fact that we are not able to find on the basis of the record before us that the exchange offer falls within the range of fairness, we cannot grant an exemption under the standards of Section 6(c). The speculative nature of the new preferred stock, the difficulty of its evaluation, and our consequent inability to make the necessary findings are demonstrated by the record, particularly the testimony of the two expert witnesses who testified in support of the plan. Before considering that testimony we examine the assets and income of Alleghany as they bear upon the exchange offer. Alleghany's total net assets and net assets per share of old preferred stock and common stock in the years 1946-1954 are shown in the following table: 1 For the years 1946 to 1953, inclusive, the figures presented are based on indicated market quotations of assets, except for certain unlisted securities and joint venture investments carried at cost. For 1954, the figures presented are based on market quotations for all investments. ? Deficit. The steady increase, except for 1953, shown in the above table in the asset coverage for the old preferred stock is attributable in part to increases in value of Alleghany's assets and in part to the retirement through repurchase or exchange of a large number of shares of old preferred stock and prior preferred stock at substantial discounts from their liquidation values. Substantial changes have taken place in the composition of Alleghany's assets since 1946, when virtually all of its investments, exclusive of U.S. Government obligations, were in securities of carriers and its holdings of C & O common stock were its most substantial investment. As shown on the following table, at December 31, 1955, Alleghany's assets aggregated $102,421,760, with its principal investments being in the common stock of Investors Diversified Services, Inc. (“IDS”), a registered investment company controlling or managing an important group of investment companies, and in direct holdings of Central common stock as well as in a half interest in a joint venture holding such stock : 1 The joint venture held 330,000 shares of Central common stock and had approximately $2.200.000 invested in stock of Delhi-Taylor Oil Corporation and Lionel Corporation. 2 In 1956 Alleghany acquired an additional 118,900 shares of Central common stock. At the same date Alleghany's outstanding liabilities and securities senior to the preferred stock involved in the exchange offer aggregated approximately $23,000,000. The following table shows Alleghany's annual gross and net income, exclusive of security transactions, its profits or losses from security transactions, and the net income per share, exclusive of security transactions for the period 1946 to 1954. In the period covered by the table, Alleghany had sufficient income only in 1948 and 1949 to cover the $5.50 per share current dividend preference of the old preferred stock, although as previously pointed out no dividends have been paid on that stock since 1931.16 A statement of income for Alleghany for the years 1954 and 1955 is attached as Appendix A. It shows total income from dividends and interest of $1,676,115 in 1954 and $2,511379 in 1955, which after payment of substantial amounts of expenses, including over $800,000 of interest on debentures and bank loans, resulted in a net loss of $105,247 in 1954 and net income of $316,721 in 1955, exclusive of profits from security transactions of $4,278,748 in 1954 and $1.989,172 in 1955. Alleghany's investments in the common stocks of Missouri Pacific Railroad Company and IDS yield no dividends. As of the end of 1955, Alleghany anticipated income in the immediate future only on the notes receivable it held and from its investments in Central common stock, on which dividends of 50¢ per share were paid in 1954 and which was placed on a $2 annual dividend basis in 1955. The annual dividend requirement on Alleghany's outstanding prior preferred stock is $101,048 and on the 1,323,440 shares of new preferred stock issuable under the exchange offer $794,064, or an aggregate of $895,112. The record indicates that in formulating the exchange offer Alleghany, relying on the prospect that the Central common stock would be placed on a $2 annual dividend basis, anticipated that its income would be sufficient to meet the dividend requirements on the new preferred stock. It appears that payment of dividends on this stock, as well as on the common stock, was dependent upon the ability of Central to continue its present $2 dividend rate and some improvement in net portfolio income or upon the availability of profits from security transactions. In any attempted evaluation of the new preferred stock, consideration would have to be given to the many variables which, in addition to changes in the market prices of the securities in Alleghany's portfolio, might affect the net asset value of the Alleghany common stock. On May 25, 1955, the date as of which the conversion ratio under the exchange offer was fixed, the Alleghany common stock had a net asset value of $8.79 per share. If effect were given to the issuance of the new preferred stock, such value would increase to $12.55. If the conversion of all the new preferred stock into common stock, the early occurrence of which the record indicates is not likely, were assumed as of that date, the net asset value would have been $8.73 per share. These calculations, how 16 Until 1950, Alleghany was barred by virtue of an existing capital deficit from paying any dividends. Beginning in that year, it paid dividend arrearages on a formerly outstanding prior preferred stock, and those arrears were eliminated in 1953 when most of the balance of the issue was exchanged for the presently outstanding prior preferred stock. ever, do not make allowance for the changes in asset value which would result from (1) the conversion into common stock of the 25,262 outstanding shares of prior preferred stock, each share of which has an $80 stated value and is convertible into 16 shares of common stock, or at an effective price of $5 per share; (2) the exercise of an option held by Robert R. Young, chairman of Alleghany's board of directors, to purchase 100,000 shares of common stock at $3.0625 per share until May 1, 1961; and (3) the exercise of the outstanding perpetual warrants to purchase approximately 2,000,000 shares of common stock at $3.75 per share. If conversion of these three items were assumed as of May 25, 1955, the asset value would have been reduced to $7.09 per share, and if it were further assumed that all of the shares of new preferred stock issued under the exchange offer were converted into common stock, the asset value of the common stock would have been $7.83. Furthermore, while the record indicates that the likelihood of conversion of the perpetual warrants is remote, it suggests that a somewhat greater likelihood exists for near-term conversion of the prior preferred stock, which sells at little or no premium and in which arbitrage activity may therefore cause conversions. If the common stock were placed on a favorable dividend basis, conversion of the prior preferred stock would be increased. It also appears highly likely that the option held by Young would be exercised before it expires in 1961. If conversion of the prior preferred and the exercise of Young's option were assumed as of May 25, 1955, the asset value of the common stock would have been $8.38 before giving effect to the issuance of the new preferred stock, $11.77 after giving effect to the issuance of that stock, and $8.55 upon the further assumption that all the new preferred stock was converted into common stock. On the basis of the various conversion hypotheses set forth above, but excluding any assumed exercise of the perpetual warrants, the 47 shares of common stock obtainable on conversion of the new preferred stock received under the exchange offer would have a net asset value ranging from approximately $217 to $413, depending on the extent of conversions assumed. One of the expert witnesses who testified in support of the exchange offer was Winthrop Lenz, a partner in the securities firm of Merrill Lynch, Pierce, Fenner & Beane ("Merrill Lynch") which was furnished the plan as originally drafted by Alleghany so that that firm could determine whether it would underwrite the plan or agree to act as dealer-manager in effecting the exchange. After the plan was considered by Lenz and certain of his associates, Merrill Lynch advised Alleghany that it was prepared to act as dealer-manager provided the plan were modified, as it subsequently was, to include the 15-year non-callable feature of the new preferred stock and to increase the number of shares of common stock into which the new preferred stock would be convertible by providing that such number be computed on the basis of the closing market price of the common stock rather than, as the plan had originally provided, at such market price plus $1." Lenz testified that the exchange plan would have to offer enough to the holders of the old preferred stock to persuade them to surrender their claim for dividend arrears "for a conversion privilege which is a very intangible thing and which can shrink and expand very rapidly" as the price of the common stock changes. Lenz observed that preferred stockholders were being asked to give up a claim on redemption of $237 in exchange for new preferred stock having a par value of $100 with all the remaining value attaching to a highly volatile conversion privilege. Since under the plan a one-point decline in the common stock would be reflected in a 47 point decline in the preferred stock, Lenz stated that he and his associates felt that to induce the preferred stockholders to give up a considerable amount of security and assume the inherent risks involved in the conversion privilege it was necessary to offer a reasonable amount in excess of the total claim of $237 or somewhere between $250 and $260, which he characterized as a “maximum kind of premium." Lenz and his associates were of the view that under the exchange plan as it was amended the 10 shares of new preferred stock issuable for a share of old preferred stock would have a market value of $250 to $260 as of the date the conversion ratio was fixed. They believed the conversion privilege alone would result in a market value of approximately $237, and that the non-callable pro 17 Lenz testified that in considering the plan Merrill Lynch wished to be sure that its customers, for whom it was record holder of over 25,000 shares of common stock and over 200.000 perpetual warrants, were not adversely affected by the offer and that it was also fair to the preferred stockholders. 18 vision would add to the market value of the new preferred stock about 50 cents On the basis of the conversion ratio of 47 shares, the non-callable feature at In the period after the conversion ratio was fixed the price of the old pre- preferred stock after the conversion ratio was fixed was due to a rise in the 18 Lenz and his associates compared the new preferred stock with Alleghany's outstand- 19 The expert who testified in addition to Lenz stated that while the 15-year non-callable 20 The following table covers the 20 trading days from May 27, 1955, when Alleghany announced the • Prices are for old preferred stock through June 6, 1955, and for 10 shares of new preferred stock After allowance for price of $3.75 per share payable on conversion. market price of the common stock attributable to the exchange offer rather than to independent factors such as an increase in the value of Alleghany's portfolio, it would be evidence of the offer's unfairness. 23 While Lenz considered that the rise in the market price of the Alleghany common stock reflected increases in its underlying asset value," he thought that not all of the benefits realizable by the common stock from the plan were reflected in its market price in advance of the plan's consummation.22 Lenz also pointed out that since a petition for reconsideration was pending before the ICC, the market price of the common stock during the period after the ICC's initial approval of the plan on May 26, 1955 and before the temporary restraining order issued on June 23, 1955 probably did not give full effect to the increase in asset value which would inure to the common stock as a result of the plan. In Lenz's opinion, this increase and a corresponding increase in the price of the new preferred stock would occur after final consummation of the plan. As previously pointed out, on May 25, 1955, the date as of which the conversion ratio under the exchange offer was fixed, the Alleghany common stock had a net asset value of $8.79 per share, and if effect were given to the issuance of the new preferred stock, such value would increase to $12.55 by virtue of the elimination of the prior claim representing the dividend arrearages on the old preferred stocks. Lenz expressed the view that Alleghany's common stock would continue to sell at a premium over its asset value, as it had at times in the past, so long as that asset value was increasing, and that Alleghany's common stock might be expected to increase to approximately the $12.55 figure after final consummation. On that basis the common stock into which each share of old preferred stock would be ultimately convertible would be in excess of $400, an amount which is considerably above the $270 figure that Lenz recognized as being high in terms of fairness to the existing common stockholders. In our opinion this would appear to produce a grossly unfair result. Arthur M. Leinbach, a railroad security analyst for Kidder, Peabody & Co., the securities firm which submitted the successful offer to act as dealer manager for the exchange plan, also testified as an expert witness and expressed the opinion that the exchange offer was fair both to the preferred and common stockholders. Originally, in his consideration of the plan in January and February, 1955, he also anticipated that the price of the common stock would increase after consummation of the plan to some premium over the increased asset value resulting from the elimination of dividend arrears under the exchange offer, and that this increase would be reflected in an increase in the market price of the new preferred stock. However, when he testified he explained that he had changed this view and no longer anticipated that the Alleghany common stock would sell at a premium over its asset value, but that he instead anticipated that it would, like other investment companies, sell at some discount from asset value, probably between 25% and 40%. He was of the opinion that the market price of the common stock prior to the effective date of the exchange offer largely reflected the benefits anticipated from the increase in asset value as a result of the exchange Thus, in the 20 trading days from May 25, 1955. Alleghany's common stock increased from 8 to as much as 10%, and the underlying asset value increased by $2.13 per share of common stock, primarily as a result of rises in the prices of Central common stock from 40% to 444 and of IDS stock from 65 to 82. Lenz did not express any opinion regarding the effect of changing the date as of which the conversion ratio was to be fixed from a date 5 days after an order of approval by the ICC, as originally proposed, to a date preceding the announcement of the ICC's approval. Since trading had proceeded on the assumption that the conversion ratio would be fixed after the ICC had approved the plan, it is likely that the market value of the common stock on May 25, 1955 did not fully reflect the benefits anticipated from the plan, particularly the increase in asset value because of the elimination of arrears on the old preferred stock. In any event, the full extent of this benefit would not be definitely known until the extent of acceptances was announced. Lenz did not believe that the possibility of ultimate conversion of the new preferred stock, and the consequent diluting effect on asset value, would hold down the market price of the common stock, since such conversions were not a likely prospect for 15 years. In our opinion, this illustrates the potentially deceptive effect on investors of the right to purchase common stock which the new preferred stock represents. |