Court Opinion

ID: 9466610
Source: CourtListenerOpinion
Date Created: 2023-08-05 01:21:00.914025+00
Date Added: 2024-06-11T17:39:49.882355
License: Public Domain

IRVING R. KAUFMAN, Chief Judge
(dissenting):
I respectfully dissent. In my view, Detroit Edison’s failure to disclose clearly the non-cash nature of the “allowance for funds used during construction” (AFDC) reported as “other income” on its income statement materially misstated the company’s ability to generate funds from current operations, and therefore violated section 11 of the Securities Act of 1933, 15 U.S.C. § 77k.
The procession of esoteric and sophisticated accounting principles here at issue requires an exposition of the facts which the majority chooses to ignore. Before exploring the defects in Detroit Edison’s prospectus, however, the significance of an accurate portrayal of the company’s ability to generate cash from its current operations must be made clear. As the majority notes, the allure of an investment in the common stock of a public utility lies not in the remote possibility of sudden growth or appreciation in the stock’s market value. Rather, investors are attracted to utility stocks by the prospect of a steady, hopefully high level of dividends. Since dividends constitute the principal return on investment for a utility’s common shareholders, an informed appraisal of the company’s ability to pay dividends is not only material, but essential to an intelligent investment decision. Such an appraisal, however, requires detailed information on the company’s ability to generate cash, both from internal and external sources.
In assessing a firm’s ability to generate cash, an investor must go beyond a simple examination of the company’s income statement. Since most firms employ the accrual basis of accounting in determining net income, revenues and expenses recognized on the income statement do not necessarily represent cash received or disbursed during the period. Just as a firm may recognize revenues or expenses in connection with transactions that do not produce cash, it may receive or disburse cash in transactions not reflected on its income statement. Thus, issuance of capital stock or bonds will produce cash, and the payment of dividends or construction costs will expend cash, but none of these transactions will ordinarily affect a company’s reported net income. Where, as here,1 a company has undertaken *212a massive construction program, it may report a relatively high net income, and still require extensive outside financing to meet its increasing cash needs. When such companies turn to the securities markets to raise the cash needed to finance their capital expansion, it is incumbent upon them to supply potential investors with accurate information on the sources and amounts of cash already available to the company. Otherwise, it is impossible to appraise accurately the risk associated with the investment being solicited. For example, the risk associated with offers to invest in two utilities, both paying the same level of dividends per share, will differ markedly if one company is able to generate internally 70% of the cash required to pay its dividends and construction costs, while the other can generate only 30% from internal sources.
In the instant case, Detroit Edison’s prospectus contained an income statement that reported net income for the fiscal year ending June 30, 1972 of $85.6 million. Of this sum, $31.5 million was attributable to AFDC, reported on the income statement as “other income.” The amount reported as AFDC consisted of (1) the interest expense paid by Detroit Edison on its long-term borrowings for capital expansion, and (2) an imputed rate of return on the company’s own' capital used for construction projects. Although AFDC was composed of expense items that normally would be charged against a firm’s income, the Federal Power Commission’s Uniform System of Accounts required public utilities to segregate their current expenses (e. g., advertising) from capital expenses (e. g., the cost of borrowed funds used to expand capital plant), and to capitalize the latter expenses for future depreciation. 18 C.F.R., Part 101, Electric Plant Instructions § 3(17) (1972). In this manner, Detroit Edison was able to assign its cost of capital expansion to the period in which the newly created assets would be consumed. Its future customers would thus pay their fair share of services rendered to them through rate adjustments designed to compensate the utility for its increased depreciation expense as the assets were consumed.
To account for AFDC, Detroit Edison established a depreciable fund on its balance sheet by debiting an asset account, and crediting an income account. In keeping with the requirements of the Uniform System of Accounts, the credit to income was made to an account labelled “other income,” and reported as such in the company’s income statement on page 7 of the prospectus. 18 C.F.R., Part 101, Income Accounts § 419.1 (1972). Although this credit to “other income” acted to increase Detroit Edison’s reported net income, it did not reflect cash or working capital generated by the company during the reporting period. Ordinarily, this fact would have been disclosed in Detroit Edison’s statement of changes in financial position (“funds statement”), presented on page 23 of the prospectus, which serves to report the flow of funds in and out of a company, that is, the actual receipt and disbursement of cash and cash-equivalents. In accordance with Opinion 19 of the Accounting Principles Board (APB), all profit-oriented businesses are required to present a funds statement whenever a balance sheet and income statement are issued. “The Statement should begin with income or loss before extraordinary items, if any, and add back (or deduct) items recognized in determining that income or loss which did not use (or provide) working capital or cash during the period. Items added or deducted in accordance with this procedure are not sources or uses of working capital or cash, and the related captions should make this clear . .” APB Opinion 19, H10 (Mar. 1971).
Since AFDC was recognized in computing Detroit Edison’s income, but did not produce cash during the period, APB Opinion 19 mandated its subtraction from net income on the company’s statement of *213changes in financial position.2 Even before Opinion 19 was released by the APB, Arthur Litke, Chief Accountant of the Federal Power Commission, anticipated the need to disclose accurately the non-cash nature of AFDC income by issuing Accounting Release (AR) No. 10. In reporting AFDC on the funds statement, AR 10 expressly required separate delineation of AFDC from net income as a “non-cash credit to income,” and a corresponding offset to construction and plant expenditures as an application of funds that did not consume cash.3
Detroit Edison nonetheless failed to break out the AFDC component of either its net income or construction expenditures in the funds statement presented in its prospectus. Instead, the section of the statement devoted to operating sources of cash simply reports net income of $85.6 million, to which $61.5 million in depreciation, $13.4 million in deferred income taxes, and $8.9 million in investment tax credits are all added back as expenses that did not use cash. Since the statement reports no additions to income that did not produce cash, such as AFDC, the “total resources from operations” is depicted as the sum of the above figures, $169.4 million. If, as APB Opinion 19 and AR 10 required, AFDC had been subtracted from net income on the *214funds statement as an income item that did not produce cash, the potential investor would have learned that “total resources from operations” amounted only to $138 million instead of the $169.4 million figure reported by the company.4
In an apparent effort to correct this misleading figure, a footnote was added to the line for net income on the funds statement, stating that net income included amounts reported as AFDC, and referring the reader to a purported definition of AFDC contained in footnote (b) to .the income statement. This footnote, which describes AFDC as an “item of non-operating income” consisting of “the net cost . of borrowed funds used for construction purposes and a reasonable rate upon other funds when so used,” which “amounted to . 46% of the net income available for Common Stock . . . ,” apparently satisfies the majority that a full and adequate disclosure of AFDC’s non-cash nature was made. How this patent non sequitur serves to clarify rather than obfuscate is difficult to perceive. At most, this note simply identifies AFDC as “non-operating” income, much like the interest received on a company’s marketable securities. In no sense does it inform the reader that AFDC is a non-cash source of income. Obviously cognizant of this omission, the SEC staff cautioned Detroit Edison to disclose the fact that 46% of current dividends were being paid from “non-cash earnings” rather than “non-operating income.” Indeed, both Detroit Edison’s Chief Accountant and the Price Waterhouse partner who certified the financial statements presented in the prospectus admitted that neither the funds statement nor the footnote to the income statement disclosed the non-cash nature of AFDC income.
The prospectus, moreover, compounded the confusion by indicating elsewhere that AFDC was a source of cash available either for plant construction or payment of dividends. For example, on page 3 of the prospectus the company estimated that 25% of its $446 million construction program would be financed from internally generated funds, a percentage that both the appellee and my brothers concede could be derived only by inclusion of AFDC as one source of “internally generated funds.”5 The statement of retained earnings, presented on page 22 of the prospectus, also supported the impression that AFDC income was available for distribution to shareholders by neglecting to break out the AFDC component of net income. The statement simply reported net income of $85.6 million, from which $66.7 million in current dividends were paid to shareholders. Of course, the careful reader of financial statements would know that net income does not necessarily translate into cash received during the current period. Thus, to analyze properly Detroit Edison’s ability to pay dividends from internally generated funds, such *215an investor would be required to turn to the funds statement to determine what elements of reported net income did not produce cash in the current period. But, as I have noted, the funds statement offered the reader no additional assistance since it too failed to subtract AFDC from net income. The inescapable — but inaccurate — implication of both statements taken together is that Detroit Edison’s net income provided more than enough cash to pay its current dividends.6 Moreover, when these two statements are read in the context of other references to AFDC contained in the prospectus, the potential investor is led to believe that Detroit Edison’s current operations produced sufficient cash to pay both its dividends and to fund 25% of its capital expansion. In truth, however, if Detroit Edison were to have financed 25% of its construction program from internally generated funds, it would have had sufficient cash remaining in fiscal 1972 to pay only 25% of dividends declared. The difference, of course, would have to be raised from additional outside financing.
It may well be, as the majority implies, that utility specialists and expert accountants were well aware of the non-cash nature of AFDC. It may even be presumed that the success or failure of Detroit Edison’s offering would rest largely upon these experts’ careful analyses of the prospectus, and not the untutored scrutiny of the appellant or other hapless investors. But I fail to see how any of this bears on the issue before us, namely, whether there is a substantial likelihood that a reasonable investor would consider the non-cash nature of AFDC income important in reaching an investment decision. See TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449, 96 S.Ct. 2126, 2132, 48 L.Ed.2d 757 (1976). Because the failure to disclose the non-cash nature of Detroit Edison’s AFDC income significantly overstated the amount of cash generated internally, and thus obscured the sources from which the company proposed to fund its cash requirements, the prospectus was materially misleading. The facts and figures presented in Detroit Edison’s prospectus, as Learned Hand once remarked in another context, “merely dance before my eyes in a meaningless procession: cross-reference to cross-reference, exception upon exception — couched in abstract terms that offer no handle to seize hold of.” L. Hand, The Spirit of Liberty 213 (I. Dilliard ed. 1960). In reaching this conclusion, I by no means suggest that corporate management must address investors “as if they were children in kindergarten.” Richland v. Crandall, 262 F.Supp. 538, 554 (S.D.N.Y. 1967). Rather, by insisting upon full and fair disclosure of any deviation from generally accepted accounting principles, I would place the risk of ambiguity upon those who create it.

. In 1972, Detroit Edison had embarked on a five year program to expand and renovate its existing plant. The company estimated its total construction costs during the period would *212exceed $2.4 billion, of which it hoped to generate approximately $800 million from internal sources. Accordingly, it planned to raise $1.7 billion from external financing.

. The majority asserts that APB Opinion 19 was inapplicable to Detroit Edison’s prospectus because the Opinion’s “recommendations” were not “expressly incorporated into the Uniform System of Accounts” and, in any event, because Opinion 19 “required the deduction [only] of expense items applicable to current operations,” not future expenses such as AFDC. My brothers’ arguments notwithstanding, the fact that Detroit Edison was subject to the jurisdiction of the Federal Power Commission by no means exempts it from the requirements of federal securities laws. See 15 U.S.C. § 77c. Accordingly, the disclosures in its prospectus should have been made in conformity with generally accepted accounting principles as authoritatively prescribed by the Accounting Principles Board and its successor, the Financial Accounting Standards Board. SEC Accounting Series Release No. 150 (Dec. 20, 1973). This, however, Detroit Edison failed to do.
Opinion 19 sets forth two alternative procedures for reporting changes in financial position on the funds statement. One method permits a firm “to begin with total revenue that provided working capital or cash during the period and deduct operating costs and expenses that required the outlay of working capital or cash during the peñod.” Opinion 19, H 10. The preferred method, however, is to begin with net income before extraordinary items, then add back or deduct “items recognized in determining that income or loss which did not use (or provide) working capital or cash during the period.” Id. Had Detroit Edison begun its funds statement with “total revenue that provided working capital or cash during the period,” the majority would be correct in asserting that it was not obligated to deduct future expenses, such as AFDC, from the revenue figure. But Detroit Edison elected to begin its funds statement in the prospectus with net income for the period. Accordingly, it should have deducted items recognized in computing that income, such as AFDC, which did not provide working capital or cash during the period.

. Though accounting releases promulgated by the FPC’s Chief Accountant are not technically a part of the Uniform System of Accounts, the Commission delegated “final authority” to the Chief Accountant to develop and interpret the System of Accounts. 18 C.F.R. §§ 3.4(e)(3) and 3.5(b)(1) (1972). Accordingly, there is simply no justification for the majority’s selective application of the express regulations of the Uniform System of Accounts, and their authoritative interpretation in releases issued by the Chief Accountant. When faced with the propriety of Detroit Edison’s use of AFDC income accounting, my brothers assert that the format and substance of the company’s income statement in its public disclosures to investors were mandated by the Uniform System of Accounts. But when the issue is whether Detroit Edison complied with AR 10 in preparing its funds statement, the majority tells us that the directive was applicable only to annual reports submitted to the Federal Power Commission, “and not to registration statements or prospectuses.” 'This assertion aside, both Arthur Litke, the FPC’s Chief Accountant, and John Johnson, Detroit Edison’s Chief Accountant, stated that the company’s reports to shareholders should conform with the requirements of AR 10. In a letter dated March 12, 1971, Litke advised the company that “[t]he accounting treatment required by AR-10 should not result in any confusion between the F.P.C. Form No. 1 and your Annual Report to Shareholders, because the statement to shareholders should conform in all material respects to the statement required in F.P.C. Form No. 1.” Similarly, Johnson testified at his deposition that the disclosures in the funds statement provided to shareholders should have been the same as those made in the reports to the Federal Power Commission.

. In upholding the adequacy of Detroit Edison’s presentation of AFDC income in its funds statement, my brothers claim that deduction of AFDC from net income as an item that did not produce cash would have necessitated an identical, but improper, entry “on the debit side of the balance sheet.” As the Federal Power Commission’s Chief Accountant clearly demonstrated in AR 10, proper presentation of AFDC as an offset to net income in the Source of Funds section of the funds statement simply necessitated the creation of a contra account to construction and plant expenditures in the statement’s Application of Funds section.

. The majority discounts the presence of this admitted error because it can find nothing in the record to indicate that the contribution of only 18% of construction costs from internal funds, rather than 25%, would hinder the company’s access to outside financing. Regardless of whether this is the case, the question before us is what would»be considered material by the offerees of Detroit Edison’s stock sale, not its potential lenders. No one can assert with confidence that an investor considering purchase of Detroit Edison’s common stock would not view the company’s significantly lower contribution to capital expansion from internally generated funds as an important factor in reaching a decision not to invest. Moreover, the inclusion of AFDC within the percentage reported as “internally generated funds” reinforces the misleading impression created by the funds statement that AFDC income provided cash available to the company during the current period.

. The majority contends that the misleading impression created by the funds statement and statement of retained earnings is alleviated by the footnote to the funds statement indicating that net income included sums reported as AFDC, and referring the reader to the income statement. Upon returning to the income statement, my brothers argue, the curious reader could have deducted the amount reported as AFDC from the net income figure, turned to the statement of retained earnings, and noticed that the amount currently paid in dividends exceeded the amount of net income less AFDC. All this assumes, of course, that the curious reader skilled in such gymnastics would be able to detect that AFDC was a non-cash item of income which should be deducted from net income to discern the company’s true ability to pay dividends from internally generated cash. Clearly, the majority asks too much. As the appellee’s own experts testified, the prospectus nowhere discloses the non-cash nature of AFDC income.