Security Analysis : Sixth Edition, Foreword by Warren Buffett: Additional Aspects of Security Analysis. Discrepencies Between Price and Value

measure by the use of the warrant artifice. 2 (The foregoing reasoning does not rest in any way upon the fact that Petroleum Corporation’s investments proved unprofitable. 3 )
    2 In a series of “Notes” on the history of United Corporation financing by Sanford L. Schamus, in
Columbia Law Review
of May, June and November, 1937, the proposal was advanced that prospectuses issued under S.E.C. legislation should carry a tabulation showing the effect of the exercise of warrants on earnings and asset values. See November 1937 issue, pp. 1173–1174.
    3 A review of the operations of Petroleum Corporation, published by the S.E.C. in May 1939, criticizes severely a number of deals in which the management was interested on the other side. After 1933 a unique turn was given to the status of Petroleum Corporation through acquisition of a large interest (39.8%) therein by Consolidated Oil. The two companies thus became the largest stockholders of each other, an extraordinary and highly objectionable situation. See Part 3, Chap. II (2d sec.), of the
Report of the S.E.C. on Investment Trusts and Investment Companies
.
    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 howdoes 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:
    1. 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.
    2. 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 stockholders’ interest.
    3. 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. 4 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.
    4 An apparent exception might be made sometimes in a case such as Chile Copper Company where the demonstrated presence of huge bodies of ore was regarded as justifying public financing to bring the mine into production. The sale of stock of the Lincoln Motor Company in 1920 was one of the few real exceptions to the rule as here stated. In this instance an unusually high personal reputation was behind the enterprise, but it resulted in disastrous failure.
    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 bargainingbetween 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