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Forum activities relating to Farmer Bros. Co. were suspended in 2007, following the second year of new management.

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Status Report and Situation Analysis

January 5, 2004


The public shareholders of Farmer Bros. Co. may be justifiably encouraged by some very meaningful changes during the past year, but much more change will be needed before shareholders can benefit from the reasonable value of their investments.


What’s been accomplished

Responding to shareholder proposals, information demands and litigation, management has implemented or committed to the following changes:

·        Communications:  An investor relations firm was hired and, breaking a fifty year tradition, management has been issuing public statements and responding to press inquiries.

·        Independent board:  The board was restructured, two years ahead of regulatory deadlines, to require a majority of independent directors and establish committees for key responsibilities.

·        Strategic options:  The board engaged an investment banking firm and has publicly committed itself to considering strategic options in the best interests of shareholders, specifically including the possible alternatives of “potential acquisitions, additional share repurchases and extraordinary dividends.”

·        Stock split:  The board stated its intent to implement a 10-for-1 stock split, if and as permitted by shareholder approval of the required increase in authorized shares.[1]

·        End of family dispute:  The potentially destabilizing 23% stock positions of dissident Crowe family members were acquired by the corporation at a 20% discount to current market prices, reducing both directly held and Farmer-controlled trust positions so that the relative voting positions of Farmer family interests and public shareholders (now without the unpredictable Crowe votes) will remain roughly equal.

These changes are a significant, nonreversible departure from management’s past practices and policies.  For the first time in fifty years, management has not only responded to its shareholders but has also taken steps to conduct Farmer Bros. more like a publicly traded company.  This is real progress.  Unfortunately, though, it is not enough.


What remains to be done

The recent responses of the company’s board of directors to asserted shareholder interests appear to be more defensive than accommodating.  Their concessions, though meaningful, must be viewed in the context of board actions such as the proposal of a reincorporation plan which are clearly intended to entrench and otherwise benefit management at the expense of public shareholders.  These conditions must be satisfactorily addressed to provide shareholders with the fair value of their investment in Farmer Bros.:

·        Proposal for reincorporation:  Management’s proposed plan for reincorporation appears to be designed to entrench management control and insulate them from any oversight or legal liability for their conduct.[2]  Particularly for Farmer Bros., this is clearly undesirable and the implementation of such a plan would seriously impair shareholder value.  Stopping the plan will depend on timely SEC action to enforce its laws under the Investment Company Act of 1940 (“ICA”).[3]

·        Fund management:  The management of the company’s investment funds, which continue to constitute more than half the corporate assets and account for more than half the company’s income, does not meet the standards of other funds or of federal regulations.  To assure investors that these funds will be properly managed, the company should conform with accepted practices for the engagement of professionally qualified advisers and for financial reporting.[4]

·        Use of corporate funds for ESOP:  The board recently acted to give the ESOP another $31 million of corporate funds to buy control of more voting stock, adding to the $24 million given in 2003 after shareholders challenged management’s conduct.  In the latest transaction, management also gave their ESOP a 20% discount to the stock’s current trading price, costing the company approximately $8 million.  The use of corporate funds to give the ESOP an  18% block of voting stock clearly benefits management at the expense of public shareholders, and management evidently knew that the transactions would violate securities laws applicable to investment companies.[5]  Shareholder interests, and possibly also the interests of employees whose pensions have been burdened with more than $60 million debt and a non-diversified stock investment, require a reversal of these transactions.

·        Tax benefits:  By failing to register as an “investment company” as permitted under the ICA, Farmer Bros. has been paying corporate income taxes on investment earnings which otherwise could have been distributed pre-tax to shareholders.  Though the specific amounts of taxes attributable to investment earnings cannot be determined from the company’s financial statements, an indication of the amount involved can be found by observing what was reported just for interest income, excluding the more complicated earnings from dividends and net gains on derivatives or other positions.  The amount of interest income reported for the five years from 1999 to 2003 was $36.1 million.  Applying the stated 35% statutory federal tax rate suggests a $12.6 million cost associated with only the interest income, and only for that five year period, resulting from management’s failure to register as an investment company.  Shareholder interests require action to stop these unjustified tax payments, and to recover what has been unnecessarily paid during the past decade.

·        Director responsibility to public shareholders:  The company’s existing board of directors does not appear to be responsive to the interests of public shareholders.  Correction of this condition will require either a change in the composition of the board or the enlightenment of its existing members.

These conditions, with the uncertainties of correcting them, are reflected in the heavily discounted $315 trading range of a stock that many of its shareholders believe should be valued well in excess of $400 per share.


Prospects for value enhancement

The value of your investment in Farmer Bros., more than for most companies, will depend on how its corporate governance is defined.

Currently, in the absence of more effective oversight, investors cannot confidently rely upon the company’s management to use corporate resources for the benefit of public shareholders.  The necessary improvement in management oversight can come from three possible sources:

·        Shareholder litigation:  Shareholders can initiate legal actions such as the class action recently commenced by Professor Rosenthal to protect investor rights.  Claims against directors, for example, could seek recovery from them of the $60 million given to the ESOP, the $8 million discount on the pricing of stock to the ESOP, and the income taxes that would not have been paid by an ICA registered investment company during the past decade, as well as other costs or value impairment for which they may be held responsible.  Perhaps more importantly, though, shareholder litigation could result in a settlement or court order to establish more effective governance conditions.  In any event, demonstrating that shareholders are able and willing to hold directors accountable should encourage more enlightened board responses to investor interests.

·        SEC enforcement:  The SEC could take action to enforce ICA and other securities laws that would prevent management’s proceeding with their proposed reincorporation plan.  Based on management’s report of the SEC’s existing concern about Farmer Bros. being an unregistered investment company, it should be possible for the SEC to quickly consider the regulatory implications of the voting now scheduled for January 21st.  The recent federal court decision that nobody other than the SEC can enforce the relevant regulations may also encourage their timely enforcement action.

·        Shareholder representation:  If either shareholder or SEC actions succeed in limiting the obstructions of entrenchment bylaws and ESOP purchases of voting stock, the rights of Farmer Bros. shareholders to vote and obtain information should be sufficient to stimulate responsive, dutiful oversight by the independent directors who will in the future constitute a majority of the company’s board.

In summary, the value of your Farmer Bros. shares will depend on what the SEC and shareholders themselves do to protect investor rights.

The company’s management is not likely to revert to its past practices, but the recent board actions do not encourage reliance on management’s understanding of its duties to public investors.  Effectively, in its use of corporate funds and proposal of a reincorporation plan, management has asserted its intent to pursue its own interests over those of the company’s non-management shareholders.  And, finally, unconstrained by oversight, management is openly disregarding acknowledged shareholder and SEC concerns about compliance with laws intended to protect investors.  This must be taken as a challenge.


GL – 1/5/04


[1] The company reported in its December 24, 2003 press release that the board had approved the stock split, but that its implementation would be subject to shareholder approval of a proposed plan for reincorporation in Delaware which provides for the required increase in authorized shares.  It is assumed, however, that the board’s determination of the benefits of a stock split would be equally applicable if the company continues to be incorporated in California.

[2] This view is clearly stated in the expert opinion of Professor Lucian A. Bebchuk submitted in support of the shareholder action against directors.

[3] A shareholder action was initiated for injunctive relief, but the court ruled that shareholders did not have a private right of action to enforce the relevant provisions of the ICA, and that only the SEC could do so.

[4] Management has been asked, repeatedly since mid-2002, to address the issue of compliance with federal laws applicable to companies which meet the ICA definition of an “investment company.”  Last month, the company’s apparent violations of securities laws applicable to investment companies were addressed in shareholder litigation, and management admitted in their latest revision of a preliminary proxy statement that the SEC itself is concerned that Farmer Bros. appears to be an unregistered investment company.

[5] In an August 26, 2002 letter to the SEC, the company’s legal counsel acknowledged that these transactions with the ESOP would violate federal securities laws applicable to investment companies.



The Forum is open to all Farmer Bros. shareholders, whether institutional or individual, and to professionals concerned with their investment decisions.  Its purpose is to provide shareholders with access to information and a free exchange of views on issues relating to their evaluations of alternatives.  As stated in the Forum's Conditions of Participation, participants are expected to make independent use of information obtained through the Forum, subject to the privacy rights of other participants.  It is a Forum rule that participants will not be identified or quoted without their explicit permission.

There is no charge for participation.  Franklin Mutual Advisers, LLC, the manager of funds owning approximately 12.6% of Farmer Bros. shares, provided initial sponsorship for the Forum and arranged for it to be chaired by Gary Lutin.  Continuing support and guidance of the Forum is provided by an Advisory Panel of actively interested shareholders.

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