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Test Item 2. Lawsuits is one of the Five-Minute Tests described in Chapter 4 of It's Earnings That Count. The recommendation is to examine the footnotes in the SEC filings "for evidence of lawsuits that could mortally wound the company".

This is a critical test for some businesses, especially where competitive advantage relies on patent protection or where product liability is at stake. For other businesses, the test may give you additional, helpful information about management.

There are some limitations in relying on SEC filings to learn about lawsuits. First, the timing of reports about litigation are at the discretion of the reporting company. Second, you hear just one side of the story -- the firm's interpretation. Third, the depth of information revealed is also at the discretion of the reporting company.

Here's a suggestion for magnifying the power of the test with very little additional time and effort: use the PACER system to search the U.S. court system for cases where your target company is a participant.

Here's a description of PACER...

Public Access to Court Electronic Records (PACER) is an electronic public access service that allows users to obtain case and docket information from Federal Appellate, District and Bankruptcy courts, and from the U.S. Party/Case Index. Currently most courts are available on the Internet...Electronic access is available for most courts by registering with the PACER Service Center, the judiciary's centralized registration, billing, and technical support center.

In order to access PACER, you have to register to obtain a login and password. Registration is free. You must supply a credit card number at the PACER secure Web site in order to register. Once you have your PACER account, you now have access to search most court records in the US through the U.S. Party/Case Index.

There is a cost to read the court documents. PACER charges $.08 per page. They bill on a quarterly basis, but will not bill unless cumulative charges are over $10. You can do a brief search for many, many companies and just read the initial document summary -- usually just one or two pages -- and still not go over this limit.

Here's an example of how PACER helped me with one of the companies I own: Faro Technologies (NasdaqNM:FARO)...

** If you read Faro's 2004 10K, here is what it says about Legal Proceedings: "The Company is not a party to any material pending legal proceedings other than ordinary routine litigation incidental to the Company's business. The Company is subject to various claims and contingencies related to lawsuits arising out of the normal course of business. The Company believes that the ultimate outcome of any pending legal proceeding, even if the outcome were unfavorable to the Company, is not likely to have a materially adverse effect on the Company's business, financial condition or results of operations."

** If you did a search for Faro on PACER last year, however, you would have found Faro was involved in a patent infringement lawsuit filed in 2003 by its major competitor. You could also have read the court documents if you wanted to dig deeper. You would have learned that the case could have some impact on Faro, because of the impending length of the case and consequent litigation costs, and possible adverse rulings.

** It turns out that in July 2005 Faro received an adverse ruling in this case, and subsequently put more strongly worded warnings in its 10-Qs about the impact of this case. This tells you something about the case and something about management.

** Search of the case index for Faro not only turned up the current lawsuit, but also previous lawsuits. I learned much about Faro just by reading a few court documents from these previous suits.

In short, using PACER is a fast, easy way to get up-to-date, impartial information about legal proceedings for a company you are interested in, without relying on the company itself. I highly recommend it to augment your initial review of the SEC filings.

-Ears






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