When Isn’t a $68M Civil Action Material?

Tom Konrad CFA

David and Goliath (Photo credit: Wikipedia)

Last week, I investigated the Goliath vs. David civil action in which Norfolk Southern Corp. (NYSE:NSC) and Wheeling & Lake Erie Railroad (WLE) are attempting to prevent Power REIT (NYSE:PW) from foreclosing on the lease of the 112 miles of track owned by Power REIT and operated by WLE under a sublease with NSC.

As in Biblical times, Power REIT, in its role as David, looks likely to surprise the market with a legal victory.  I calculated that any victory could lead to payments ranging from $16 million to $70 million dollars or more, or $10 to $43 a share, which is truly enormous for a stock trading at $8 a share.  At the time, I had not seen NSC’s sublease agreement with WLE, but have since found it in an attachment to NSC’s and WLE’s legal complaint.  The lease led me to revise my estimate of NSC’s potential  liability to approximately $68 million, and WLE’s to $15.9 million (see below.)

As counter-intuitive as it sounds, even a legal defeat would still bring significant benefits to PW shareholders, leading to a win-win situation for PW shareholders.

But the case should also interest Norfolk Southern shareholders, because it raises significant questions about corporate disclosure.

Goliath Not Paying Attention

Even for a $18.5 billion Goliath like Norfolk Southern, the potential award amounts to real money.  With 316 million shares outstanding, $68 million is 21 cents a share.  That would be far from crippling for a company with $708 million in cash on its books and $402 million in income last quarter, but it’s certainly material.

That’s why I was shocked to find that the company’s 2011 annual report did not mention the action.   When I attempted to contact the parties, I was told by an NSC spokesman that ”We don’t generally comment on matters of litigation.”  WLE’s Director of Law & Government Relations referred me to their attorneys in the matter, who also said it is their policy not to comment on pending litigation.  I also contacted two of NSC’s leading stock analysts, only to find they were not familiar with the case.

I did get an email response from Michael Hostutler, NSC’s director of investor relations, who told me that the case “is not material to Norfolk Southern,” which is why it’s not in the annual report.  When I asked him on what basis the case was immaterial, he did not respond.

The omission of the case from NSC’s annual report is inconsistent with NSC’s apparent disclosure policy.

This policy seems to be to include legal proceedings in its annual report even when they are immaterial.  The report discusses two ”penalties in excess of $100,000″ and a class action against NSC and other class 1 railroads regarding fuel surcharges, despite the fact that the the report characterizes all three as  not having material effects on NSC’s “financial position, results of operations, or liquidity.”

Surely an action in which the potential award is in the millions of dollars bears mentioning if the policy is to discus any award in excess of $100 thousand.

The Nature of the Liability

Paragraph 2 of NSC’s 1990 sublease agreement with WLE states,

The Sublessee [WLE] hereby expressly assumes during the term of the Agreement all of the duties, obligations, liabilities and commitments of NW [NSC] as lessee under the Lease except the balance in the account due Lessor [PW] because of dispositions of property under Section 9 or the Lease, hereafter the “Settlement Account,” on the Closing Date… The balance of the Settlement Account on the Closing Date is $7,466,951.42, for which NW will remain solely responsible.

If NSC’s potential liability were limited to $7,466,951.42, I would agree that this would not have a material impact on the company.  That amount is likely already carried on NSC’s books as a long term liability.  Even if the court decides that it is due immediately, the small size of the settlement account relative to NSC’s cash flow should render it immaterial.

However, PW’s counterclaim in the case seeks payment not only of the settlement account, but of back interest at the Applicable Federal Rate (AFR.)  Because NSC’s portion of the settlement account began accruing in 1967, and more than two decades have passed since then, my estimate of the total interest on that $7,466,951.22 is approximately $60.6 million, for a total of $68 million.  (WLE’s portion would be approximately $8.4 million principal and $5.9 million interest, for a total of $15.9 million.)  Note that my interest calculations are approximate, since the AFR changes monthly, and I only put in one interest rate each year in my spreadsheet.  Further, I don’t have data for the AFR before 1990, so I approximated with the long term treasury rate less one percent.  You can access my spreadsheet to test your own assumptions here.

The approximately $60.6 million in back interest is almost certainly not already on NSC’s books, and so it would be a new liability.  If the court were to award back interest on the settlement account, it would reduce NSC’s earnings by about 19 cents a share in the quarter which it was awarded, most likely sometime in 2013.

Conclusion: Class Action Lawsuits May Follow Stinging Pebbles

Goliath probably thought David’s sling was immaterial, but in the end it proved decisive.  While there is no chance that a relative pebble like an award of even $68 million will take down Norfolk Southern, it would have a material impact on NSC’s books.  If it did, the shareholder lawsuits that follow losses stemming from undisclosed risks would then sting a lot more than pebbles.

It’s admirable that NSC management discusses legal actions involving awards over $100 thousand.  My guess as to why they are not talking about this one is that top NSC management is simply unaware of the potential award of back interest on the settlement account.  My guess is that this lack of awareness arose because WLE is taking the lead in the case, not because of some cover-up on the part of NSC’s management.  But if this slipped by them, their inattention a little worrying in and of itself.

It will be interesting to see what legal disclosures appear in NSC’s 2012 Annual Report, now that my articles and questions to Mr. Hostutler should have brought this pebble to their attention.

Disclosure: Long PW

This article was first published on the author’s Forbes.com blog, Green Stocks on December 4th.

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