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the management ranks is an important factor for most small com-panies. At issue here is whether managers have access and expo-sure to the top people within the corporation and whether the toppeople  within  the  corporation  are  willing  to  devote  time  andenergy  to  training  and  understanding  their  middle  managementranks.
Some candid conversations with midlevel employees can givea good indication of how the company stacks up in this regard.Why do people work there? What do they like about the job? Whatdo they dislike? What would cause them to move on? And, impor-tantly,  how  do  they  actually  spend  their  time  while  at  work?These simple questions can give a true sense of how the rank-and-file employees feel about upper management.
CONCLUSION
Your  intuitive  feelings  about  the  research  process  can  hold  thekey to uncovering quality management teams. Reflect on the feel-ings  that  arise  in  reaction  to  your  various  conversations  withmanagement.  Did  the  key  people  convey  a  sense  of  energy  andexcitement, and did they answer your questions directly or werethey evasive? Did they volunteer information or was it difficult toobtain even the most basic facts? Would you want to hire or workwith  the  key  management  team?  In  many  ways,  when  you  buystock in the company, you are buying a share in the managementteam, and you should feel comfortable owning that share of themanagement.  The  intuitive  reaction  occurs  normally  in  people.Rather than suppressing these intuitive reactions, allow them tomove into the front of your thought process and consider them auseful resource.
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CHAPTER 6
CorporateGovernance
This chapter will attempt to answer the following questions:
• How  can  a  micro  cap  investor  find  and  use  principal  agent
information?
• What  information  resources  are  available  to  micro  cap
investors?
In evaluating a company, an enormous amount of information canbe gathered simply by examining the parties with whom the com-pany is associated. The outside institutions a company selects canbe very helpful in determining the general quality of the company.In general, there should be a meaningful fit between the outsideresources  and  the  company  itself.  These  outside  resources  arenonmanagement members of the board of directors. Directorshipsheld  by  existing  management  in  other  companies,  foundations,government  boards,  or  nonprofit  organizations;  the  company’scommercial  banker;  the  company’s  investment  banking  affilia-tions;  the  company’s  independent  outside  auditors;  and  the  lawfirms  that  represent  the  company  can  all  give  important  indica-tions about the company and its spheres of influence. These keyconstituencies can also tell an awful lot about management’s gen-eral attitude and inclination toward shareholders.
In today’s highly charged atmosphere of business governance,
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the  independent  outside  members  of  the  board  of  directorsshould be scrutinized. Does the board appear to be a collection offriends of the CEO, or do they appear to be a group of indepen-dent people who could be an asset to the company in providingcertain  expertise  and  guidance  in  the  overall  management  of the  business?  Remember,  the  independent  outside  trustees  arecharged with the fiduciary responsibility of supervising manage-ment in the context of the best interests of the shareholders. Theboard  of  directors  should  be  evaluated  carefully  to  determinewhether  each  member  is  truly  independent  and  looking  out  forthe best interests of the shareholders.
It can also be very telling to examine the directorships held bymembers of the existing management team and inside managersat the company. Because of the fiduciary obligation of any direc-tor, there is the potential of personal liability being associated asan  independent  outside  director.  So  the  fact  that  an  executivewould accept a directorship in another company should reflect agreat deal about that individual. It is not unusual to find indica-tions of very strong competence in connection with managementpeople  who  may  serve  on  outside  boards.  There  are  instanceswhen outside directorships will lead inside management to otherhighly placed executives who can be a resource to that manage-ment as well as an invaluable contact. However, you may also findthat key executives are busy raising money for charitable organi-zations  or  spending  large  amounts  of  time  on  the  local  schoolboard, and those commitments need to be weighed against theirfocus on managing the activities of the company. A sure indica-tion  of  this  type  of  distraction  is  the  executive  who  may  list  alarge  number  of  public  and  private  board  directorships.  Con-versely,  another  caution  flag  can  be  the  management  team  thatappears  to  have  little  or  no  outside  engagements  with  otherboards,  either  public  or  private.  This  can  be  the  sign  of  an  in-wardly focused management team that lacks a grasp of the keyissues of corporate governance. This is not to say that any of thisis either good or bad—just that it is another factor that should beevaluated when reviewing a company as a potential investment.
The  company’s  banking  relationships  should  also  show  thecorrect fit with the company. Federal filings and annual reportsdo not always disclose which banks a company has financial rela-tionships  with.  Normally,  most  companies  are  forthcoming  in
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telling you which banking institutions they deal with. A companyshould deal with a bank that is large enough to handle the finan-cial needs of the corporation, but the relationship with the bankalso  should  be  of  the  correct  size  and  scale  to  be  meaningful and not one where the company is a very small client of a verylarge bank. In today’s current financial environment, banking re-lationships are far more fluid and flexible than they have been his-torically. Nevertheless, a strong banking relationship is a criticalaspect for most micro cap companies and should be consideredin that regard.
The company’s investment banker should follow a similar par-adigm  to  that  of  the  company’s  commercial  banker.  A  qualityinvestment banking relationship can help the company to accesscapital  markets  in  a  timely  and  efficient  way.  In  addition,  theinvestment banking relationship may provide the opportunity forthe  company  to  obtain  sell-side  research  coverage  that  can  becritical  in  helping  to  maximize  shareholder  value  in  small  andmicro cap companies. Beyond that, the investment banker can actas  an  intermediary  in  the  case  of  a  potential  acquisition  or  apotential  merger  with  another  company  that  may  help  enhanceshareholder  value.  Again,  it  is  the  fit  of  the  relationship  thatshould  be  examined  with  most  care.  When  discussing  strategywith a management team, it is fair to ask the nature of their invest-ment  banking  relationships.  Are  there  investment  bankers  onretainer or who are paid a regular fee? It’s also fair to ask whattheir  investment  bankers  have  done  for  them  in  the  past  fewyears. The answer to that question should give you a pretty clearindication  of  the  strength  of  the  company’s  investment  bankingrelationship.
THE COMPANY’S SOCIAL RELATIONSHIPS
Like people, companies form and maintain certain social relation-ships. In some companies there is a single family that dominatesthe  management  ranks.  If  this  is  the  case,  it  normally  creates a  pattern  of  corporate  governance  that  revolves  around  familyties.  This  may  not  be  bad;  however,  it  can  stifle  new  ideas  and discourage  bright  and  aggressive  but  unconnected  people  from
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joining the firm. In a powerful, well-connected family, nepotismamong the ranks in the firm can be a great asset. However, as wewill  see,  in  some  instances  it  can  literally  be  a  disaster  for  thecompany.
Another typical pattern is that of school-based relationships.In  many  instances,  graduates  of  large,  top-tier  private  businessschools  such  as  Harvard,  Stanford,  Yale,  and  MIT  will  typicallyhave a bias toward recruiting and hiring key management peoplewho have also attended these schools. If a firm seems to be dom-inated by graduates of a single school, it can be a red flag for eval-uating the management culture. Sometimes it indicates that themanagement team is not interested in ideas or concepts that gobeyond the bounds of what they believe was taught in their affili-ated business school.
The same social and school patterns can also be detected withregard to other major cultural beliefs within management. Certainmanagement  teams  may  seem  to  be  focused  on  religion,  ethnicbackground, political affiliations, or gender. It’s not uncommon tosee top management teams within companies that are dominatedby a particular ethnic background, for example, Italian-Americanor African-American teams. It is also not unusual to see manage-ment  teams  that  are  dominated  by  a  single  religious  affiliation,such as a predominately Jewish management team. Some compa-nies have strong ties to either the Republican or the DemocraticParty,  and  some  management  teams  have  a  high  percentage  ofmale  or  female  members.  These  biases  can  be  the  result  of  theenvironment in which the business itself operates and should beconsidered in that context. So it is worth asking this question: Dothe  similar  backgrounds  work  better  together  and  relate  moreeasily to those within the company and within the industry?
INFORMATION RESOURCES
The following is a checklist of potential information resources touse when researching a micro cap investment.
• The company• Federal regulatory filings made by the company
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• Competitors of the company• Customers of the company• Suppliers to the company• Industry trade associations• Sell-side research analysts• Buy-side research analysts• Newspapers, magazines, and other publications• Internet searches• Briefs and related legal documents filed in public lawsuits
The Company
For practical purposes, anyone within the company at any levelcan give you a starting point for a research discussion. It is idealto eventually meet the key senior management officers within thecompany.  The  investor  relations  officer  can  frequently  be  themost helpful individual with regard to gaining access to key man-agement personnel.
Former employees are always a wealth of information about acompany. They might also be upset and angry with management,and this should be considered when you are listening to what for-mer employees have to say about a company. Most often, formeremployees are overlooked, yet they are more likely to talk openlyabout a company than current employees. It is normally possibleto  find  a  company’s  former  employees  through  an  industry  ortrade  association  Internet  web  site.  In  addition,  the  previousyear’s annual reports and federal filings will show changes in offi-cers and directors. It is fair to ask the company about these peo-ple  and  how  you  can  contact  them.  When  dealing  with  formeremployees, it is important to be honest with them and tell themthat you are considering making an investment in the company,that  you  have  no  connection  with  the  company  or  the  manage-ment  of  the  company,  and  that  everything  that  you  discuss  will be off the record and private.
In addition, through networking within the industry, you maybe able to find someone who was offered a senior-level job at thecompany but turned down the offer. This contact can be invalu-able  because  the  person  can  often  lend  an  insider’s  view  of  thecompany’s position and strategy within the industry, even thoughthe contact is, in fact, an outsider. The job rejecter’s reasons for
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not joining the firm may not be relevant; however, as an industryparticipant his or her insights into the firm can be very useful.
Competitors
Normally,  the  easiest  place  to  find  a  company’s  competitors  iswithin  industry  directories  and  on  industry  web  sites.  Competi-tors can often provide the most valuable insights into a company.Interestingly enough, sales and marketing people tend to be themost useful resources among competitors. They typically knowthe marketplace very well and understand the dynamics of what’sdriving business within the markets they deal with. In addition,the generally open and gregarious nature of the salespeople oftenmakes  them  easy  to  approach  and  talk  to  about  competitors.Industry trade shows tend to be a rich resource for finding andmaking contacts among competitors within a given industry.
Customers
Customers are usually the most thoughtful and objective sourceof  information  about  a  company.  In  many  instances,  they  cancrystallize a large amount of information in a few sentences sim-ply  by  answering  the  question  of  why  they  are  doing  businesswith  that  particular  company.  If  the  customers  are  unhappy  orangry about how they are treated, that clearly tells you one thing.Conversely, if the customers are happy or generally pleased, thattells you another. Unfortunately, most of the time it is difficult toget a highly positive or negative response from a customer; how-ever, it is possible to pick up a sense of their general feeling aboutthe relationship.
Suppliers
Vendors and suppliers who sell products and services to the com-pany are often especially knowledgeable about the company andthe industry. In fact, when talking off the record, vendors and sup-pliers  to  an  industry  can  often  provide  very  useful  insights  intonot  just  the  company  but  the  industry  itself.  Again,  as  in  deal-ing with any related party, keeping information confidential and
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being honest about your assessments certainly help in developingthese types of relationships.
Trade Associations
Trade associations can also be a valuable resource when research-ing a company. Of course, trade associations typically will not saynegative  things  about  their  members;  however,  they  may  saytelling things about companies that are not members of their tradeassociations. In addition, trade associations often have unique andaggregated data about a whole industry that is sometimes pack-aged and available for free or for a small cost on their web sites. Itmay be possible to arrange an introduction from the company tothe trade association. This will help to open the door to the tradeassociation and get a more meaningful response than you other-wise would obtain by contacting the trade association directly.
Industry Professionals
Industry professionals are also good contacts and can be usefulresources.  They  are  capable  of  making  perceptive  judgmentsabout the company and the industry because of their special skillsand because they see a lot of other companies that might be com-parable to the company being researched.
Legal Documents
We live in a highly litigious society. The by-product of all the com-mercial  litigation  that  goes  on  in  the  public  arena  is  a  massiveamount of legal filings, which can be a useful source of informa-tion about a specific company or an industry in general. They canbe difficult and laborious to read; however, such legal communi-cations  can  yield  a  large  amount  of  information.  Informationabout the lawsuits themselves can often be discovered by readingthe publicly filed disclosure documents of the company and thenreferencing them back to the state and federal courts that are thevenues for the company. Pleadings and responses, as well as judi-cial opinions, can often be found as a matter of public record onthe web sites of various courts.
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PUBLIC COMPANY FEDERAL FILINGS
Material information must be made publicly available by compa-nies so that all shareholders and potential shareholders can haveequal and immediate access to material facts. Professional invest-ment managers cannot by law have significant information madeavailable  to  them  that  is  not  also  made  available  to  the  generalpublic.  This  concept  of  limited  but  equal  access  to  public  com-pany information is usually termed “full and timely accurate pub-lic disclosure of material information.” This basic principle can bethe cornerstone of the information advantage discussed earlier inthis book.
The  officers  of  a  company  and  the  board  of  directors  arerequired to review all information that is relevant to the company.Then they must decide what is material information and thereforemust be made public. As has been in the news over the last fewyears, there’s a great debate about what rises to the level of mate-rial information in choosing from the various methods of accuratepresentation  of  financial  and  corporate  information.  Of  course,the  courts  have  become  the  final  word  on  what  is  material  andwhether insiders have made the required disclosures.
Public companies are allowed to maintain confidential infor-mation from their shareholders because of the need to protect pro-prietary information and proprietary technology. Public disclosureof certain information could hurt a company’s competitive advan-tage  or  position  and,  in  conjunction,  hurt  the  earnings  power  ofthe  company.  Members  of  the  public,  shareholders,  and  invest-ment  managers  often  believe  that  their  questions  deserve  ananswer;  however,  company  officers  often  tell  only  a  minimalamount of information in order to satisfy disclosure requirements.There  is  adequate  justification  for  company  management  towithhold  key  information,  and  the  law  recognizes  that  ability.However, if a company is not disclosing material facts as it goesalong,  shareholders  have  a  legal  remedy  through  suing  the  offi-cers  and  directors  for  damages  after  the  facts  become  public.These  suits  are  seen  more  and  more  frequently  as  shareholderrights litigation becomes a growing area within the legal commu-nity. As a result, the important question is whether the withhold-ing  of  such  material  information  was  in  the  best  interest  of  the
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company or whether it was instead to try to hide problems withinthe  company.  At  times,  as  we  have  seen,  this  nondisclosure  ofmaterial  information  actually  rises  to  the  level  of  fraud  andbecomes a criminal act.
The issue of access to information is somewhat problematicin the micro cap sector. As a matter of business practice, there aremany micro cap companies that make it very difficult for the pub-lic  at  large  to  obtain  any  significant  material  information  aboutthe company. Sometimes it is worth discussing with managementthe lack of information flow, but at other times it is more produc-tive to move on to companies that welcome the interest of poten-tial outside shareholders rather than fearing it.
Many companies provide a broad range of information that isreadily available, both to shareholders and to the nonsharehold-ing public. While other sources are very important, the companyitself should not be overlooked as a significant potential source ofmeaningful  information.  Of  course,  companies  will  send  basicfinancial  information  such  as  annual  and  quarterly  reports  andnews releases as well as reprints of articles and speeches made bymanagement  to  just  about  anyone  who  requests  them  from  thecompany. Often, all this material is presented on the company’spublic  web  site  and  is  easily  downloadable  from  that  web  site.The company may be willing to send basic product literature andmight also have public relations newsletters and regular market-ing and sales material. You can usually be added to the distribu-tion  list,  either  via  e-mail  or  regular  mail,  simply  by  asking  thecorporate investment relations officer. However, the most usefulbasic  company  information  is  often  found  at  the  Securities  andExchange  Commission,  and  a  simple  Internet-based  search  willgive an investor access to all recent filings and other useful publicdisclosures made by the company. Getting this information is rel-atively simple and inexpensive, and it can be done very quickly togain a basic perspective on the company.
SEC REPORTS
Public  companies  are  required  to  file  a  number  of  documentseach  year  with  the  Securities  and  Exchange  Commission  in 
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Washington, D.C. These filings are required by statute to promotefull  and  fair  disclosure  about  company-level  information.  As  abasic reference source, the following reports are worth reviewingto provide a meaningful overview of a company and its operations.
Annual Report Form 10-K
This  filing  discloses  a  good  deal  of  information  over  and  abovewhat can be found in the written annual report of the companythat is distributed to shareholders. It is really the foundation ofthe SEC’s full and fair disclosure requirement and is normally thebest single source of information available on a company and itsoperations. The SEC annual report 10-K should be available for allreporting companies. (This chapter discusses reporting and non-reporting companies in more detail later.) The information in the10-K  is  required  by  federal  regulations  and  is  contained  in  twoparts of the report. Part 1 must include the following 10 items:
1. An  identification  of  the  company’s  principal  business  andproducts  or  services,  the  principal  markets  and  methods  ofdistribution, and the material competitive factors surroundingthe  industry  is  required.  This  would  include  any  backlog  ofwork and expectations of the availability of critical raw mate-rials as well as any important patents, licenses, or franchisesthe company may hold or grant. It also must describe the esti-mated cost of research and development, the number of peo-ple  that  the  company  employs,  the  effects  of  any  new  orpending environmental and regulatory issues, and any mater-ial litigation that the company may be involved in. If there ismore  than  one  principal  business  of  the  company,  the  com-pany must describe for the last five fiscal years the revenueand net income for each principal business if it accounted formore than 10 percent of sales or 10 percent of pretax income.2. A description of the company operations for each of the lastfive fiscal years and any additional years to assist in keepingthe summary clear and accurate, as well as per-share earningsand dividends for those prior five years are required to be dis-closed. Any change in accounting principles or practices mustbe disclosed, as well as the date of the accounting change andthe reasons for the accounting change, along with its impact
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on operating earnings and a description of that impact fromthe company’s independent accounting firm.
3. The third section concerns properties, plant, and equipment.A listing of the location of the principal facilities of the com-pany and any additional properties, leases, or significant cap-ital assets are required to be described in this section of thereport.
4. A list of all parent and subsidiary companies, and for each onenamed,  the  percentage  of  voting  securities  owned  by  thecompany that forms the basis for control must be describedeither in a narrative form or, for a larger, more complex orga-nization, in the form of an organizational chart.
5. A  description  of  material  legal  proceedings,  including  anypending  litigation  or  any  disputes  that  may  result  or  areexpected to result in material litigation, are required to be dis-closed in this section.
6. Any  increase  or  decrease  in  any  outstanding  securities,including information for each class of securities, is requiredto be disclosed in this section. The section will also accountfor reacquired securities and newly issued securities or secu-rities that have been exchanged for property services or othersecurities, and the resulting valuation at the time of exchange.In addition, new securities that have resulted from a modifi-cation of outstanding securities such as a share split or distri-bution of securities owned by the corporation to shareholdersmust also be disclosed in this section.
7. A list of the holders of record for each class of equity securi-ties as of the end of the fiscal year is required to be disclosedin this section.
8. A list of all corporate executive officers and the nature of fam-ily relationships between them and the positions and officesheld must be disclosed in this section.
9. A  statement  of  any  arrangement  and/or  insurance  underwhich any director or officer is indemnified or insured againstany liability must be disclosed in this section, as well as thecapacities and duties of each officer and director.
10. A list of all the financial statements as prepared by the com-pany  and  reviewed  by  the  company’s  independent  auditors,
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including  all  footnotes  to  the  financial  statements,  must  beexhibited as Section 10 of Part 1 of Form 10-K.
Part 2 of Form 10-K requires that five additional items be dis-closed.  Firms  often  meet  this  filing  requirement  by  issuing  aproxy statement for the annual meeting because these items areusually subject to periodic votes by shareholders or by the boardof directors of the corporation.
1. This  section  identifies  any  owners  of  10  percent  or  more  ofany class of securities and contains a listing of securities heldby each of the officers and directors according to the amountand percentage of securities by class.
2. A listing of the names, offices, and terms of office for each ofthe directors and officers of the company must be included inthis section. In addition, the biographical and business back-ground of each officer and director must be included in thissection.
3. A listing of the directors and the three highest-paid officers ofthe  company,  along  with  the  aggregate  total  fees  and  remu-neration  paid  to  all  officers  and  directors,  must  be  listed  inthis section of the report.
4. Options  granted  to  management  and  officers  to  purchasesecurities must be disclosed. This has been a topic of muchdebate in the past few years. The granting of options to offi-cers and directors must be listed since the beginning of eachfiscal  year,  along  with  a  chart  or  table  disclosing  all  theoptions  granted  to  all  officers  and  directors  and  the  vestingprice of those options.
5. In this section, a statement of material changes or significanttransactions that may involve assets, pension, retirement, sav-ings, or other similar arrangements, as well as loans to offi-cers and directors, must be disclosed, along with the businessinterests of the related officer or director who will be benefit-ing from the transaction. Disclosure of certain material trans-actions can be very important for the analysis of conflicts ofinterest between the company and its management and out-side directors.
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Quarterly Report Form 10-Q
This report is required to be filed within 45 days of the end of eachof the company’s first three fiscal quarters. It is intended to be aquarterly  update  of  the  information  contained  in  the  annualreport  form  10-K.  However,  the  information  contained  in  Form 10-Q is slightly less detailed in its requirements than that in Form10-K. The important difference is that the quarterly financial dataare not required to be audited by the company’s outside auditors.However,  the  regulations  do  require  that  management  still  pro-vide  a  fair  and  accurate  statement  of  results  and  also  alert  thereader to any significant special items that may affect the quarteror the ongoing business operations.
Material Current Events Form 8-K
This form is not filed on a regular basis, as Form 10-K and Form10-Q are. However, this form is filed whenever a key event occursat the corporate level. It often discloses material items not foundin any other corporate filing. These data are especially importantto small and micro cap companies because they may not be dis-closed in any other venue outside of Form 8-K. There are 14 spe-cific items that must be disclosed in Form 8-K:
1. Any change in control of the company
2. Material legal proceedings against the company
3. The  acquisition  or  disposition  of  a  significant  amount  ofassets other than those that would occur in the normal courseof business
4. The  material  withdrawal  or  substitution  of  any  assets  thatmay  be  securing  any  class  of  registered  securities  such  asmortgage bonds
5. Changes in securities involving a material change to the rightsof  shareholders  of  any  class  of  registered  securities  for  anyreason
6. An