Opinion ID: 376668
Heading Depth: 3
Heading Rank: 2

Heading: AFDC as Portrayed in the Prospectus.

Text: 30 Appellant's principal claim on appeal is that Detroit Edison violated Section 11 because it failed to expressly disclose the non-cash nature of AFDC, and in fact, created the impression that it was synonymous with true (i. e., cash) income. This erroneous impression was allegedly imparted through semantic artifice, compounded on one occasion by disregard of applicable accounting principles. We find these claims to be without merit. 31
32 Appellant first points to the note defining AFDC, and particularly to the sentence reading, the allowance for funds used during construction amounted to 11%, 15%, 13%, 30%, 44% and 46% of net income available for Common Stock for the years 1967, 1968, 1969, 1970 and 1971 and for the 12 months ended June 30, 1972, respectively. Although the preceding sentence stated that AFDC was non-operating income, and that it was in fact a cost item, it is contended that this passage implies that AFDC funds constituted cash revenues available for distribution to shareholders. Plainly, however, such an interpretation is unreasonable when the highlighted sentence is read in context. Fairly construed, the note simply demonstrates that as measured relative to AFDC net income steadily declined as construction projects and the costs of capital escalated. Rather than enticing potential investors, this disclosure, properly interpreted, was more likely to have a discouraging effect. 33
34 Appellant also calls attention to the following statement in the portion of the prospectus dealing with dividends: . . . AFDC allowance for funds used during construction, as a percentage of net income available for common stock, increased from 11% during the fiscal year ended December 31, 1967 to 46% for the twelve months ended June 30, 1972; accordingly, a major portion of the Company's current annual dividend of $1.40 per share of Common Stock is being paid from sources other than operating income. This passage is alleged to suggest that AFDC income was a major source of dividend funds, thereby reinforcing the view that it was a cash-like asset. 35 While the quoted passage is not entirely free from ambiguity and could usefully have been expanded to indicate that the other sources included earnings from investments, public offerings and the like but not AFDC, it would not mislead the reasonable investor. Fairly understood, the thrust of the passage was to alert readers that as operating revenues were increasingly being diverted to construction, dividends were increasingly being paid from other sources. The statement at issue does not compel the conclusion that AFDC was being drawn upon to pay dividends; on the contrary, AFDC was merely being used as a measuring rod to indicate the relative decline of operating income as an element of dividend payments. Furthermore, Detroit Edison explicitly indicated that current income was insufficient to cover both dividends and construction costs, and that the shortfall was therefore derived from non-operating revenues such as the proceeds of stock and bond issues. The investor was warned by footnote (a) to the Statement of Changes in Financial Condition that Net Income included AFDC. Armed with this information and the Consolidated Statement of Income he could determine that dividends were greater than net income less its AFDC component and that they therefore were being paid from other non-operating sources, not including AFDC. 36
37 Appellant cites as improper the inclusion of the AFDC sum in the $446 million of internally generated funds which Detroit Edison asserted would constitute 25% of the total funding of the utility's construction program for the next two years. Set forth on page three of the prospectus, this estimate was intended to underscore the fact that substantial external financing was necessary. 38 Since AFDC income is merely a balancing entry, an offset to expenses not chargeable to the present period, it does seem that the inclusion of it in an amount representing currently available cash funds was erroneous. However, such a misstep does not render the entire prospectus misleading. First, the entry did not on its face indicate that AFDC was included in the sum of money which was expected to come from the utility's own coffers, and therefore did not compound any possible misperception on the part of potential investors that AFDC was a cash item. 39 Second, appellant has not advanced any persuasive evidence to indicate that this error was material. Although a revised computation would indicate that Detroit Edison would require approximately 82% rather than 75% of its construction funds from external sources, and although in absolute terms this represented a substantial amount of money, there is nothing in the record to indicate that this additional increment would make it more difficult for Detroit Edison to obtain the necessary financing. The testimony of the utility's investment bankers, the only direct evidence on point, was to the contrary. 40 Moreover, the thrust of the passage was that the utility was in the midst of a massive construction program and that an extremely large proportion of the funds required for this expansion was coming from external sources. That statement is not made materially misleading because in fact a slightly higher percentage of funds than indicated would have to be raised in the capital markets. 41
42 Finally, appellant charges that the inclusion of AFDC in the net income figure in the Consolidated Statement of Changes in Financial Position buttressed the misimpression that AFDC was interchangeable with cash and constituted a violation of applicable accounting principles. Again, these objections do not withstand analysis. 43 The net income entry bears a footnote which states that AFDC is included in the computation, and further refers the reader to the definition of the accounting device previously set forth in the income statement. The reader was apprised that the net income figure contained certain cost elements within it by the fact that the same footnote was appended to an expense entry denominated as Plant and Equipment Expenditures. 44 Appellant contends that the AFDC portion of the net income figure should have been broken out and deducted from this total. Such an approach, however, would have required, in order that AFDC be effectively capitalized, that an identical entry be made on the debit side of the balance sheet and subtracted from current expenditures. This offsetting entry would have been improper since AFDC, comprised in part of an equity component, could not be deemed an ordinary expense, and could not legitimately have been characterized as a sum spent on plant and equipment. To avoid that distortion, prevailing accounting wisdom directed that AFDC be treated precisely in the manner it was in the Consolidated Statement of Changes in Financial Position, as undifferentiated items of both income and expense, each balancing the other. 45 Moreover, it is undisputed that the inclusion of AFDC as an element of income did not distort the bottom line of the statement; the ultimate net profit figure was not affected, and indeed the Consolidated Statement of Changes in Financial Position showed a decrease in working capital. It may be argued, of course, that notwithstanding this bottom line accuracy, the portrayal of AFDC as a component of net income was misleading because it artificially inflated the apparent cash flow into the company, a signal consideration in the eyes of some potential investors. It postulates the existence of investors who are at once savvy enough to appreciate concepts such as cash flow and yet unable to comprehend the definition of AFDC fairly and accurately set forth earlier in the prospectus. In determining the adequacy of disclosure, we are required to view the prospectus from the standpoint of the reasonable, not schizophrenic, investor. 46 Little need be said of appellant's contention that in adding the AFDC total to the Company's net income, Detroit Edison violated Opinion No. 19 of the Accounting Principles Board. That directive required the deduction of expense items applicable to current operations from overall revenues in determining the amount of cash or working capital generated internally by an enterprise during a reporting period. Since AFDC is not a current expense, but an expense which will be attributed to a later period, it does not seem that Opinion No. 19 condemned the inclusion of AFDC under the net income heading. Moreover, whatever its currency among accounting scholars, Opinion No. 19 had not been expressly incorporated into the Uniform System of Accounts. To the extent that the recommendations set forth therein were embraced by the FPC through its issuance of Accounting Release No. 10, it must be noted that that decree by its own terms was applicable only to annual reports to be submitted to the FPC on its own Form 1 and not to registration statements or prospectuses. 10 Neither the SEC nor the FPC, each of which reviewed the prospectus, objected to AFDC's inclusion amongst net income in the Consolidated Statement of Financial Changes. 47