21 Securities Regulation, Disclosure and Third Avenue

OCTOBER 2006

The principal Federal laws covering securities regulation are the Securities Act of 1933, as amended (“the 1933 Act”) and the Securities and Exchange Act of 1934, as amended (“the 1934 Act”). The 1933 Act and the 1934 Act have three principal regulatory purposes:

  1. Insure the maintenance of free, fair and orderly trading markets.
  2. Provide disclosure to Outside, Passive, Minority Investors (OPMIs).
  3. Provide oversight of Managements, Directors, Insiders, Control Persons and Professionals.

Disclosure has two principal purposes:

  1. Aid and abet the maintenance of free, fair and orderly markets. This function is directed exclusively toward meeting the perceived needs of short-term traders who believe they are vitally affected by near-term fluctuations in market prices.
  2. Provide information to long-term buy-and-hold investors such as Third Avenue Value Fund (TAVF, “The Fund”).

For short-term traders, what the numbers are, especially earnings per share (EPS) as reported become of paramount importance. A consequence of catering to short-term traders has been that Generally Accepted Accounting Principles (GAAP) has come to be dominated by rigid rules, rather than principles. As a result, GAAP has been made as complicated as the Internal Revenue Code. Such complications are unnecessary for GAAP, whose principal purpose has to be to give OPMIs objective benchmarks, not “truth” or “economic reality”, something rigid rules can never do.  The Internal Revenue Code, in contrast, has to be complicated because its purpose is to calculate one number – a taxpayer’s periodic tax bill.

For buy-and-hold investors (and control persons), the GAAP factor of paramount importance is what the numbers mean, rather than what the numbers are. Here there is rarely a Primacy of the Income Account, i.e., emphasis on EPS. Rather, there is a balanced approach where each element of the accounting cycle – balance sheet, income account, cash reconciliation – is weighted by the user of the financial information. In some cases, there might be a Primacy of the Income Account (e.g., strict going concerns); in some cases there might be a Primacy of NAV (e.g., investment companies); while in most cases there is a Primacy of a Balanced Approach (e.g., everything in the accounting cycle becomes useful for an analysis).

In the current regulatory scheme, there seems to be much too much emphasis on controlling disclosure to meet the perceived needs of short-run traders. There is no question that capital markets are most efficient where the trading markets are free, fair and orderly. However, fulfilling the stated information needs of short-run speculators really does not contribute to the maintenance of free, fair and orderly markets. Rather, the best protection for all participants in OPMI markets is self-protection. Increasingly, disclosure ought to recognize the needs or desires of buy-and-hold investors who are reasonably diligent, reasonably intelligent and reasonably well trained. The best hypothetical standard for disclosure, to my mind, ought to be what is required for making sound judgments by those who are long-term unsecured creditors, holding privately-placed debt instruments; and not the average investor who thinks he, she, or it, are vitally affected by day-to-day, or hour-to-hour, price fluctuations. This is because, at bottom, the average investor cannot be protected unless he, or she, or it, protect themselves. The present emphasis on serving short-run interests seems to be ruining U.S. capital markets for publicly-traded equities.

It ought to be noted, however, that it is hard for TAVF management to complain about the disclosure system. Over the last 40 years, the Securities and Exchange Commission (SEC) has done a magnificent job in improving disclosure for buy-and-hold investors such as TAVF. Disclosure has never been better for the Fund.

One of TAVF’s best tools for appraising management is examining the GAAP choices they opt to make when given a choice, e.g., in Exploration and Producing oil companies (E&P), compare the choice between successful efforts accounting and full cost accounting. E&P managements’ choices tell TAVF management a lot about how conservative or promotional an E&P management might be. This is an argument against rules and for principles.

The accounting principles that ought to govern GAAP should, in my opinion, encompass the following:

  1. Financial statements are prepared under the assumption that the users are well trained, diligent and intelligent.
  2. The Company is a stand-alone, never to be substantively consolidated with stockholders, management, or creditors.
  3. There exists a modifying convention of conservatism.
  4. There is no Primacy of the Income Account. Rather, emphasis has to be placed on a balanced approach without any preconceived notions that the income account is more important than the balance sheet, the cash reconciliation, or footnote disclosures – and vice versa.
  5. The goal of GAAP, with the possible exception of mark-to-market investment companies, has to be to provide the user of financial statements with objective benchmarks, not truth. The user’s task is to convert objective benchmarks into the user’s version of truth.
  6. The financial statements, including footnotes, should strive to disclose all material facts that might have negative connotations.

There are certain areas where market participants ought to protect themselves, provided they are given, through regulation, the tools with which to protect themselves. Disclosure is one such area. There are other areas, admittedly, where the only meaningful protection for individuals resides in regulation providing strong, stringent, rules. Such an area, for example, is in the regulation of prescription drugs to assure safety and efficacy. Individuals are in no position to self-protect themselves when it comes to prescription medicines.

In the investing arena, there are federal laws which provide a substantial amount of substantive protection to market participants unwilling, or unable, to self-protect. These laws are embodied in the Investment Advisers Act of 1940, as amended; and, more particularly, the Investment Company Act of 1940, as amended. TAVF is regulated under the Investment Company Act of 1940, as amended, as are all U.S.-based mutual funds.

Third Avenue is harmed by non-productive regulation as embodied both in GAAP, as currently constituted, and the Sarbanes-Oxley Act of 2002 (SOX). Also, frivolous stockholder lawsuits are a problem, especially the class of lawsuits labeled “fraud on the market”. As things exist now, no foreign issuer is likely to access U.S. capital markets unless they absolutely need U.S. capital. TAVF invests heavily in foreign securities. Further, many small companies, now publicly traded, are thinking about “going dark”, i.e., no longer being subject to regulation by the SEC. Needless to say this environment is not conducive to the well-being of the U.S. economy, which for many years, at least since 1933, has benefited from having the deepest, most efficient, best informed capital markets ever known to mankind.

In retaining strong, efficient capital markets, it remains important that trading markets continue to be free, fair and orderly. It is hard for me, however, to see how requiring traders to self-protect after being given adequate disclosure detracts from efficient markets. If anything, the emphasis on the phony economics embedded in relying on short-run EPS as reported introduces material market inefficiencies. The goal of Federal securities regulation is Investor Protection. I submit that most useful Investor Protection lies in self-protection, and not in precise numbers derived from rigid rules, especially quarterly EPS as reported.

On November 1, 2006, I briefly addressed the Third Avenue Management Value Conference in New York. In those remarks, I compared what TAVF is doing with the bulk of its equity investments to Private Equity Limited Partnerships. My comments, modestly edited, were as follows:

Private Equity Limited Partnerships, such as KKR, Blackstone, Thomas Lee and Carlyle Group are all the rage today. These are entities which acquire control, or elements of control, over a variety of properties or corporations.

A huge amount of Third Avenue’s portfolios is in the common stocks of companies performing the same function as Private Equity LPs. These Third Avenue common stock investments include the following: Brookfield Asset Management, Capital Southwest, Cheung Kong Holdings, Forest City Enterprises, Guoco Group, Henderson Land Development, Hutchison Whampoa, Investor AB, Jardine Matheson, RHJ International, Wharf Holdings and Wheelock & Co.

Permit me to compare the differences between Third Avenue’s private equity common stock investments with those of the typical Private Equity LP.

  1. Third Avenue buys into its private equity investments at prices that represent very substantial discounts from readily ascertainable NAVs. Private Equity LPs obtain control by paying premiums over OPMI market prices. Private Equity LPs most often negotiate deals. Third Avenue pays prices in the open market which are way, way below prices that are paid typically in negotiated deals. However, frequently in the case of Management Buy Outs (MBOs), deals are not negotiated at arm’s-length because management becomes part of the buying group. Private equity buyers often can get some very attractive deals in MBOs.
  2. The various Third Avenue investments are in companies that are extremely well-financed. Controlled entities of Private Equity LPs tend to be leveraged to the hilt.
  3. The Third Avenue Investments tend to be managed primarily for long-term growth. Private Equity LP controlled entities tend to be managed with the objective of extracting from the operating entities as much cash as possible as soon as possible.
  4. Limited Partners (LPs) of Private Equity LP tend to pay much higher promotes to General Partners (GPs) than do Fund shareholders. The Third Avenue expense ratio is 1.1% of Assets Under Management (AUM). Typical LP fees are 2% of AUM plus 20% of gains after, say, a 6% bogey.
  5. There is no meaningful lock-up for Third Avenue Funds. Any shareholder can redeem daily, subject only to a small redemption charge for short-run holders. The typical LP can’t redeem any investment for at least a year.
  6. In terms of corporate governance, Third Avenue shareholders have manifestly more rights and protections than do LPs.
  7. Lead Investors in Private Equity LPs get to do “due diligence” on the LP and also negotiate many terms of the arrangements between the GPs and the LPs. Third Avenue Funds relies on the public record, and also interviews with managements and others. Third Avenue owns common stocks. It does not negotiate terms.

My family and I have invested a substantial part of our net worths in Third Avenue. We have almost no investments in Private Equity LPs.

I like it that way.

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