UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2007 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ..............to .............. Commission File Number: 814-61 CAPITAL SOUTHWEST CORPORATION (Exact name of registrant as specified in its charter) Texas 75-1072796 (State or other jurisdiction of incorporation (I.R.S. Employer or organization) Identification No.) 12900 Preston Road, Suite 700, Dallas, Texas 75230 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (972) 233-8242 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check One): Large accelerated filer ____ Accelerated filer X Non-accelerated filer ____ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes No X Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 3,889,151 shares of Common Stock, $1 Par Value as of January 9, 2008 TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Page No. ----------------------------- -------- ITEM 1. Consolidated Financial Statements (1) Consolidated Statements of Financial Condition September 30, 2007 (Unaudited) and March 31, 2007........3 Consolidated Statements of Operations (Unaudited) For the three and six months ended September 30, 2007 and September 30, 2006.......................................4 Consolidated Statements of Changes in Net Assets For the six months ended September 30, 2007 (Unaudited) and year ended March 31, 2007............................5 Consolidated Statements of Cash Flows (Unaudited) For the three and six months ended September 30, 2007 and September 30, 2006.......................................6 Portfolio of Investments September 30, 2007.......................................7 Notes to Consolidated Financial Statements.......................12 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................18 ITEM 3. Quantitative and Qualitative Disclosure About Market Risk.........................................20 ITEM 4. Controls and Procedures.................................20 PART II. OTHER INFORMATION ITEM 1 Legal Proceedings........................................21 ITEM 1A. Risk Factors...............................................21 ITEM 4. Submission of Matters to a Vote of Security Holders.....21 ITEM 6. Exhibits and Reports on Form 8-K........................22 Signatures ...................................................................23 (1) As described in Note 2, the financial statements for fiscal year 2007 have been restated. PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Financial Condition ---------------------------------------------- Assets September 30, 2007 March 31, 2007 ------------- ------------- (Unaudited) as restated Investments at market or fair value Companies more than 25% owned (Cost: September 30, 2007 - $28,758,246 March 31, 2007 - $28,632,356) $ 389,987,981 $ 526,993,983 Companies 5% to 25% owned (Cost: September 30, 2007 - $19,962,243, March 31, 2007 - $18,798,896) 82,329,351 76,398,002 Companies less than 5% owned (Cost: September 30, 2007 - $31,982,402, March 31, 2007 - $24,211,045) 96,917,751 77,763,048 ------------- ------------- Total investments (Cost: September 30, 2007- $80,702,891, March 31, 2007 - $71,642,297) 569,235,083 681,155,033 Cash and cash equivalents 31,871,482 38,844,203 Receivables 102,956 337,892 Other assets 9,379,527 9,170,185 ------------- ------------- Totals $ 610,589,048 $ 729,507,313 ============= ============= Liabilities and Shareholders' Equity Other liabilities $ 1,341,573 $ 1,457,847 Deferred income taxes 2,374,777 2,317,777 ------------- ------------- Total liabilities 3,716,350 3,775,624 ------------- ------------- Shareholders' equity Common stock, $1 par value: authorized, 5,000,000 shares; issued, 4,326,516 shares at September 30, 2007 and 4,323,416 shares at March 31, 2007 4,326,516 4,323,416 Additional capital 116,689,936 116,373,960 Undistributed net investment income 6,728,945 5,655,020 Undistributed net realized loss on investments (2,371,590) (3,100,142) Unrealized appreciation of investments 488,532,193 609,512,737 Treasury stock - at cost (437,365 shares) (7,033,302) (7,033,302) ------------- ------------- Net assets at market or fair value, equivalent to $156.04 per share at September 30, 2007 on the 3,889,151 shares outstanding and $186.75 per share at March 31, 2007 on the 3,886,051 shares outstanding 606,872,698 725,731,689 ------------- ------------- Totals $ 610,589,048 $ 729,507,313 ============= ============= (See Notes to Consolidated Financial Statements) 3 CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Operations ------------------------------------- (Unaudited) Three Months Ended Six Months Ended September 30 September 30 ------------------------------ ------------------------------ 2007 2006 2007 2006 ------------- ------------- ------------- ------------- as restated as restated Investment income: Interest $ 679,442 $ 933,678 $ 1,244,129 $ 1,139,530 Dividends 801,467 757,935 1,164,894 1,540,501 Management and directors' fees 226,200 179,950 451,400 378,400 ------------- ------------- ------------- ------------- 1,707,109 1,871,563 2,860,423 3,058,431 ------------- ------------- ------------- ------------- Operating expenses: Salaries 291,085 320,334 565,221 663,799 Net pension benefit (127,434) (43,284) (163,671) (72,471) Other operating expenses 288,194 230,737 553,158 451,965 ------------- ------------- ------------- ------------- 451,845 507,787 954,708 1,043,293 ------------- ------------- ------------- ------------- Income before interest expense and income taxes 1,255,264 1,363,776 1,905,715 2,015,138 Interest expense -- 178,222 -- 325,204 ------------- ------------- ------------- ------------- Income before income taxes 1,255,264 1,185,554 1,905,715 1,689,934 Income tax expense 44,400 15,200 54,160 28,024 ------------- ------------- ------------- ------------- Net investment income $ 1,210,864 $ 1,170,354 $ 1,851,555 $ 1,661,910 ============= ============= ============= ============= Proceeds from disposition of investments $ 402,777 $ 10,045,064 $ 728,552 $ 10,442,080 Cost of investments sold -- 826,317 -- 826,317 ------------- ------------- ------------- ------------- Net realized gain on investments 402,777 9,218,747 728,552 9,615,763 ------------- ------------- ------------- ------------- Net decrease in unrealized appreciation of investments (138,128,989) (2,931,221) (120,980,544) (8,148,701) ------------- ------------- ------------- ------------- Net realized and unrealized gain (loss) on investments $(137,726,212) $ 6,287,526 $(120,251,992) $ 1,467,062 ============= ============= ============= ============= Increase (decrease) in net assets from operations $(136,515,348) $ 7,457,880 $(118,400,437) $ 3,128,972 ============= ============= ============= ============= (See Notes to Consolidated Financial Statements) 4 CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Changes in Net Assets ------------------------------------------------ Six Months Ended Year Ended September 30, 2007 March 31, 2007 ------------- ------------- (Unaudited) as restated Operations Net investment income $ 1,851,555 $ 4,233,340 Net realized gain on investments 728,552 14,966,296 Net increase (decrease) in unrealized appreciation of investments (120,980,544) 147,681,609 ------------- ------------- Increase (decrease) in net assets from operations (118,400,437) 166,881,245 Distributions from: Undistributed net investment income (777,630) (2,323,150) Capital share transactions Exercise of employee stock options 231,390 1,794,850 Adjustment to initially apply FASB No. 158, net of tax -- 1,173,751 Stock option expense 87,686 169,003 ------------- ------------- Increase (decrease) in net assets (118,858,991) 167,695,699 Net assets, beginning of period as restated 725,731,689 558,035,990 ------------- ------------- Net assets, end of period $ 606,872,698 $ 725,731,689 ============= ============= (See Notes to Consolidated Financial Statements) 5 CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows ------------------------------------- (Unaudited) Three Months Ended Six Months Ended September 30 September 30 ------------ ------------ 2007 2006 2007 2006 ------------- ------------- ------------- ------------- as restated as restated Cash flows from operating activities Increase (decrease) in net assets from operations $(136,515,348) $ 7,457,880 $(118,400,437) $ 3,128,972 Adjustments to reconcile increase in net assets from operations to net cash provided by operating activities: Proceeds from disposition of investments 402,777 10,045,064 728,552 10,442,080 Purchases of securities (1,163,347) (370,230) (9,215,094) (370,230) Maturities of securities 150,000 482,491 154,500 884,936 Depreciation and amortization 6,272 4,022 10,681 7,887 Net pension benefit (127,434) (43,284) (163,671) (72,471) Realized gain on investments (402,777) (9,218,747) (728,552) (9,615,763) Net decrease in unrealized appreciation of investments 138,128,989 2,931,221 120,980,544 8,148,701 Stock option expense 44,100 77,711 87,686 81,831 Increase (decrease) in receivables 50,016 (31,415) 234,936 (47,285) (Increase) decrease in other assets (23,679) 1,955 (30,408) (17,988) Increase (decrease) in other liabilities 43,779 21,727 (75,384) (84,856) Decrease in accrued pension cost (30,266) (36,568) (66,834) (71,035) Increase in deferred income taxes 44,400 15,200 57,000 25,400 ------------- ------------- ------------- ------------- Net cash provided by (used in) operating activities 607,482 11,337,027 (6,426,481) 12,440,179 ------------- ------------- ------------- ------------- Cash flows from financing activities Decrease in notes payable to bank -- (150,000,000) -- -- Distributions from undistributed net investment income -- -- (777,630) (772,050) Proceeds from exercise of employee stock options -- -- 231,390 1,097,500 ------------- ------------- ------------- ------------- Net cash provided by (used in) financing activities -- (150,000,000) (546,240) 325,450 ------------- ------------- ------------- ------------- Net increase (decrease) in cash and cash equivalents 607,482 (138,662,973) (6,972,721) 12,765,629 Cash and cash equivalents at beginning of period 31,264,000 162,932,468 38,844,203 11,503,866 ------------- ------------- ------------- ------------- Cash and cash equivalents at end of period $ 31,871,482 $ 24,269,495 $ 31,871,482 $ 24,269,495 ============= ============= ============= ============= Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ -- $ 201,441 $ -- $ 325,204 Income taxes $ -- $ -- $ -- $ 20,000 (See Notes to Consolidated Financial Statements) 6 Portfolio of Investments - September 30, 2007 Company Investment (a) Cost Value (b) ------------------------------------------------------------------------------------------------------------------------------------ +AT&T INC. ++20,770 shares common stock (acquired 3-9-99) $ 12 $ 878,779 San Antonio, Texas Global leader in local, long distance, Internet and transaction-based voice and data services. +ALAMO GROUP INC. 2,830,300 shares common stock 2,190,937 48,115,000 Sequin, Texas (acquired 4-1-73 thru 5-25-07) Tractor-mounted mowing and mobile excavation equipment for governmental, industrial and agricultural markets; street-sweeping equipment for municipalities. ALL COMPONENTS, INC. 8.25% subordinated note due 2012 (acquired 6-27-07) 6,000,000 6,000,000 Addison, Texas 150,000 shares Series A convertible preferred stock, Electronics contract manu- convertible into 600,000 shares of common stock facturing; distribution at $0.25 per share (acquired 9-16-94) 150,000 6,600,000 and production of memory Warrant to purchase 350,000 shares of common stock and other components for at $11.00 per share, expiring 2017 (acquired 6-27-07) - - computer manufacturers, --------- --------- retailers and value-added 6,150,000 12,600,000 resellers. +ALLTEL CORPORATION ++8,880 shares common stock (acquired 7-1-98) 88,699 618,758 Little Rock, Arkansas Owner and operator of the nation's largest wireless network. +ATLANTIC CAPITAL BANCSHARES, INC. 300,000 shares common stock (acquired 4-10-07) 3,000,000 3,000,000 Atlanta, Georgia Holding company of Atlantic Capital Bank a full service commercial bank. BALCO, INC. 445,000 shares common stock and 60,920 shares Wichita, Kansas Class B non-voting common stock 624,920 4,500,000 Specialty architectural (acquired 10-25-83 and 5-30-02) products used in the construction and remodeling of commercial and insti- tutional buildings. BOXX TECHNOLOGIES, INC. 3,125,354 shares Series B convertible preferred Austin, Texas stock, convertible into 3,125,354 shares of Workstations for computer common stock at $0.50 per share graphics imaging and design. (acquired 8-20-99 thru 8-8-01) 1,500,000 2 CMI HOLDING COMPANY, INC. 10% convertible subordinate note, due 2009 (acquired 7-2-07) 1,913,347 1,913,347 Richardson, Texas 2,327,658 shares Series A convertible preferred stock, Owns Chase Medical, which convertible into 2,327,658 shares of common stock develops and sells devices at $1.72 per share (acquired 8-21-02 and 6-4-03) 4,000,000 2,000,000 used in cardiac surgery to Warrants to purchase 109,012 shares of common stock relieve congestive heart at $1.72 per share, expiring 2012 (acquired 4-16-04) - - failure; develops and Warrants to purchase 431,982 shares of Series A-1 supports cardiac imaging convertible preferred stock at $1.72 per share systems. expiring 2012 (acquired 7-2-07) - - --------- --------- 5,913,347 3,913,347 7 Company Investment (a) Cost Value (b) ------------------------------------------------------------------------------------------------------------------------------------ +COMCAST CORPORATION ++64,656 shares common stock (acquired 11-18-02) $ 21 $ 1,562,089 Philadelphia, Pennsylvania Leading provider of cable, entertainment and communi- cations products and services. DENNIS TOOL COMPANY 20,725 shares 5% convertible preferred stock, Houston, Texas convertible into 20,725 shares of common stock Polycrystalline diamond at $48.25 per share (acquired 8-10-98) 999,981 999,981 compacts (PDCs) used in oil 140,137 shares common stock (acquired 3-7-94 and 8-10-98) 2,329,963 2,000,000 field drill bits and in --------- --------- mining and industrial 3,329,944 2,999,981 applications. +DISCOVERY HOLDING COMPANY ++70,501 shares Series A common stock (acquired 7-21-05) 20,262 2,031,134 Englewood, Colorado Provider of creative content, media management and network services worldwide. +EMBARQ CORPORATION ++4,500 shares common stock (acquired 5-17-06) 46,532 250,200 Overland Park, Kansas Local exchange carrier that provides voice and data services, including high-speed Internet. +ENCORE WIRE CORPORATION 4,086,750 shares common stock (acquired 7-16-92 thru 10-7-98) 5,800,000 75,605,000 McKinney, Texas Electric wire and cable for residential and commercial use. EXTREME INTERNATIONAL, INC. 39,359.18 shares Series C convertible preferred Sugar Land, Texas stock, convertible into 157,436.72 shares of common Owns Bill Young Productions, stock at $25.00 per share (acquired 9-30-03) 2,625,000 8,391,000 Texas Video and Post, and 3,750 shares 8% Series A convertible preferred stock, Extreme Communications, convertible into 15,000 shares of common stock at which produce radio and $25.00 per share (acquired 9-30-03) 375,000 800,000 television commercials and Warrants to purchase 13,035 shares of common stock corporate communications at $25.00 per share, expiring 2008 (acquired 8-11-98 videos. thru 9-30-03) - 375,000 --------- --------- 3,000,000 9,566,000 +FMC CORPORATION ++6,430 shares common stock (acquired 6-6-86) 66,726 668,977 Philadelphia, Pennsylvania Chemicals for agricultural, industrial and consumer markets. +FMC TECHNOLOGIES, INC. ++11,057 shares common stock (acquired 1-2-02) 57,051 1,275,093 Houston, Texas Equipment and systems for the energy, food processing and air transportation industries. +HEELYS, INC. 9,317,310 shares common stock (acquired 5-26-00) 102,490 55,904,000 Carrollton, Texas Heelys stealth skate shoes, equipment and apparel sold through sporting goods chains, department stores and footwear retailers. 8 Company Investment (a) Cost Value (b) ------------------------------------------------------------------------------------------------------------------------------------ HIC-STAR CORPORATION 10% subordinated note due 2007 (acquired 10-19-04 and Dallas, Texas 1-13-05) $ 352,646 $ - Holding company previously 12% subordinated notes due 2008 (acquired 3-25-05 thru engaged in mortgage banking 2-27-06) 717,523 1 operations, which have now Warrants to purchase 463,162 shares of Series A common been sold. stock at $1.00 per share, expiring 2014 (acquired 3-31-04 thru 1-13-05) - - --------- --------- 1,070,169 1 +HOLOGIC, INC. ++316,410 shares common stock (acquired 8-27-99) 220,000 19,282,025 Bedford, Massachusetts Medical instruments including bone densi- tometers, mammography devices and digital radiography systems. +KIMBERLY-CLARK CORPORATION ++77,180 shares common stock (acquired 12-18-97) 2,358,518 5,422,667 Dallas, Texas Manufacturer of tissue, personal care and health care products. +LIBERTY GLOBAL, INC. ++42,463 shares Series A common stock (acquired 6-15-05) 106,553 1,741,832 Englewood, Colorado ++42,463 shares Series C common stock (acquired 9-6-05) 100,870 1,639,496 Owns interests in broadband, --------- --------- distribution and content 207,423 3,381,328 companies. +LIBERTY MEDIA CORPORATION ++35,250 shares of Liberty Capital Series A common stock Englewood, Colorado (acquired 5-9-06) 51,829 4,400,258 Holding company owning ++176,252 shares of Liberty Interactive Series A common stock interests in electronic (acquired 5-9-06) 66,424 3,384,038 retailing, media, communi- --------- --------- cations and entertainment 118,253 7,784,296 businesses. LIFEMARK GROUP 1,449,026 shares common stock (acquired 7-16-69) 4,510,400 44,000,000 Hayward, California Cemeteries, mausoleums and mortuaries located in northern California. MEDIA RECOVERY, INC. 800,000 shares Series A convertible preferred stock, Graham, Texas convertible into 800,000 shares of common stock at Computer datacenter and $1.00 per share (acquired 11-4-97) 800,000 6,000,000 office automation supplies 4,000,000 shares common stock (acquired 11-4-97) 4,615,000 30,000,000 and accessories; impact, --------- --------- tilt monitoring and 5,415,000 36,000,000 temperature sensing devices to detect mishandled shipments; dunnage for protecting shipments. PALLETONE, INC. 12.3% senior subordinated notes due 2012 (acquired 9-25-06) 1,553,150 2,000,000 Bartow, Florida 150,000 shares common stock (acquired 10-18-01) 150,000 750,000 Manufacturer of wooden Warrant to purchase 15,294 shares of common stock at pallets and pressure-treated $1.00 per share, expiring 2011 (acquired 2-17-06) 45,746 61,000 lumber. --------- --------- 1,748,896 2,811,000 +PALM HARBOR HOMES, INC. 7,855,121 shares common stock (acquired 1-3-85 thru 7-31-95) 10,931,955 62,841,000 Dallas, Texas Integrated manufacturing, retailing, financing and insuring of manufactured housing and modular homes. 9 Company Investment (a) Cost Value (b) ------------------------------------------------------------------------------------------------------------------------------------ +PETSMART, INC. ++300,000 shares common stock (acquired 6-1-95) $ 1,318,771 $ 9,567,000 Phoenix, Arizona Retail chain of more than 928 stores selling pet foods, supplies and services. THE RECTORSEAL CORPORATION 27,907 shares common stock (acquired 1-5-73 and 3-31-73) 52,600 108,850,000 Houston, Texas Specialty chemicals for plumbing, HVAC, electrical, construction, industrial, oil field and automotive applications; smoke contain- ment systems for building fires; also owns 20% of The Whitmore Manufacturing Company. +SPRINT NEXTEL CORPORATION ++90,000 shares common stock (acquired 6-20-84) 457,113 1,710,000 Reston, Virginia Diversified telecom- munications company. TCI HOLDINGS, INC. 21 shares 12% Series C cumulative compounding preferred Denver, Colorado stock (acquired 1-30-90) - 677,250 Cable television systems and microwave relay systems. +TEXAS CAPITAL BANCSHARES, INC. ++489,656 shares common stock (acquired 5-1-00) 3,550,006 10,630,432 Dallas, Texas Regional bank holding company with banking operations in six Texas cities. VIA HOLDINGS, INC. 9,118 shares Series B preferred stock (acquired 9-19-05) 4,559,000 2 Sparks, Nevada Designer, manufacturer and distributor of high-quality office seating. WELLOGIX, INC. 4,540,883 shares Series A-1 convertible participating Houston, Texas preferred stock, convertible into 4,540,883 shares Developer and supporter of of common stock at $1.1011 per share (acquired software used by the oil and 8-19-05 thru 6-15-07) 5,000,000 2 gas industry to control drilling and maintenance expenses. THE WHITMORE MANUFACTURING COMPANY 80 shares common stock (acquired 8-31-79) 1,600,000 26,600,000 Rockwall, Texas Specialized mining, railroad and industrial lubricants; coatings for automobiles and primary metals; fluid contamination control devices. +WINDSTREAM CORPORATION ++9,181 shares common stock (acquired 7-17-06) 19,656 129,636 Little Rock, Arkansas Provider of voice, broadband and entertainment services. 10 Company Investment (a) Cost Value (b) ------------------------------------------------------------------------------------------------------------------------------------ MISCELLANEOUS - BankCap Partners Fund I, L.P. - 6.0% limited partnership interest (acquired 7-14-06 thru 4-3-07) $ 2,371,476 $ 2,371,476 - Diamond State Ventures, L.P. - 1.9% limited partnership interest (acquired 10-12-99 thru 8-26-05) 146,000 146,000 - First Capital Group of Texas III, L.P. - 3.3% limited partnership interest (acquired 12-26-00 thru 8-12-05) 964,604 964,604 - Humac Company - 1,041,000 shares common stock (acquired 1-31-75 and 12-31-75) - 178,000 - PharmaFab, Inc. - contingent payment agreement (acquired 2-15-07) 2 2 - STARTech Seed Fund I - 12.1% limited partnership interest (acquired 4-17-98 thru 1-5-00) 178,066 1 - STARTech Seed Fund II - 3.2% limited partnership interest (acquired 4-28-00 thru 2-23-05) 950,000 1 - Sterling Group Partners I, L.P. - 1.7% limited partnership interest (acquired 4-20-01 thru 1-24-05) 1,064,042 2,400,000 ------------------------------------------------------------------------------------------------------------------------------------ TOTAL INVESTMENTS $ 80,702,891 $569,235,083 ============= ============ ------------------------------------------------------------------------------------------------------------------------------------ +Publicly-owned company ++ Unrestricted securities as defined in Note (a) Notes to Portfolio of Investments --------------------------------- (a) Unrestricted securities (indicated by ++) are freely marketable securities having readily available market quotations. All other securities are restricted securities which are subject to one or more restrictions on resale and are not freely marketable. At September 30, 2007, restricted securities represented approximately 88.5% of the value of the consolidated investment portfolio. (b) Under the valuation policy of the Company, unrestricted securities are valued at the closing sale price for listed securities and at the lower of the closing bid price or the last sale price for Nasdaq securities on the valuation date. Restricted securities, including securities of publicly-owned companies which are subject to restrictions on resale, are valued at fair value as determined by the Board of Directors. Fair value is considered to be the amount which the Company may reasonably expect to receive for portfolio securities if such securities were sold on the valuation date. Valuations as of any particular date, however, are not necessarily indicative of amounts which may ultimately be realized as a result of future sales or other dispositions of securities. Among the factors considered by the Board of Directors in determining the fair value of restricted securities are the financial condition and operating results of the issuer, the long-term potential of the business of the issuer, the market for and recent sales prices of the issuer's securities, the values of similar securities issued by companies in similar businesses, the proportion of the issuer's securities owned by the Company, the nature and duration of resale restrictions and the nature of any rights enabling the Company to require the issuer to register restricted securities under applicable securities laws. In determining the fair value of restricted securities, the Board of Directors considers the inherent value of such securities without regard to the restrictive feature and adjusts for any diminution in value resulting from restrictions on resale. 11 CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------------------------------ (Unaudited) 1. Basis of Presentation Principles of Consolidation. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for investment companies. Under rules and regulations applicable to investment companies, we are precluded from consolidating any entity other than another investment company. An exception to this general principle occurs if the investment company has an investment in an operating company that provides services to the investment company. Our consolidated financial statements include our management company. The financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and the instructions to Form 10-Q and Article 6 of Regulation S-X. The financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Form 10-K/A for the year ended March 31, 2007. Certain information and footnotes normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted, although we believe that the disclosures are adequate for a fair presentation. The information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the results of operations for the interim periods. 2. Restatement of Consolidated Financial Statements Capital Southwest Corporation (the "Company") has filed an amendment to its Annual Report on Form 10-K for the year ended March 31, 2007, to amend and restate its consolidated financial statements and selected per share data and ratios for each of the fiscals years ended March 31, 2007, 2006 and 2005 and our selected per share data and ratios for the years ended March 31, 2004 and 2003. In addition, we have filed an amendment to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2007. After reviewing the accounting treatment for deferred taxes on unrealized appreciation of investments, the Company has determined its long-standing policy of recording deferred taxes on unrealized appreciation of investments was not in conformity with generally accepted accounting principles and its previously issued financial statements required restatement. The effect of the restatement on the consolidated statement of financial condition as of March 31, 2007; the consolidated statement of operations and consolidated statement of cash flows for the three months and six months ended September 30, 2006; the consolidated statement of changes in net assets for the six months ended September 30, 2006 and year ended March 31, 2007 is as follows and shown in tables below: (A) A Regulated Investment Company (RIC) is required to record deferred taxes when it is probable the RIC will not qualify under Subchapter M of the Internal Revenue Code for a period longer that one year. Historically, management believed it was probable the Company would not maintain its qualifying status as a RIC in future years and recorded a deferred tax liability on the unrealized appreciation of investments. However, upon further analysis, the Company determined it was only reasonably possible, but not probable, the Company would not maintain its qualifying status as a RIC. Thus the deferred tax liability consistently recorded and disclosed should not have been recognized. (B) The Company historically has accrued income taxes payable on its investment gains as they have been incurred, as it has been the Company's practice to retain its investment gains. However, RICs are required to accrue federal income taxes on investment gains that are retained only on the last day of the tax year. The Company incorrectly recorded the tax impact of its investment gains in periods other than the last day of its tax year, December 31. Therefore, the income taxes payable recorded at times other than the tax year end should not have been recognized. (C) The Company incorrectly classified its' return of capital contributions cumulatively as "undistributed net realized gains on investments." RICs are required to classify return of capital contributions as "additional capital" in the period in which tax basis amounts become permanent; and reflect undistributed amounts remaining since its' previous tax year end adjusted for temporary tax basis differences as "undistributed net realized gains on investments." 12 Notes to Consolidated Financial Statements (continued) The restatement will eliminate the accrual for deferred taxes on unrealized appreciation of investments, and income taxes payable and related tax carryforwards on realized gains, increasing the net asset value per share and net assets from operations for the periods restated; and reclassify return of capital contributions to "additional capital." As of March 31, 2007 ---------------------------- Previously Reported (3) As Restated (2) Consolidated Statement of Financial Condition ------------ ------------ ------------------------------------------------------ Total assets 729,507,313 729,507,313 ============ ============ Income taxes payable 231,274 -- (B) Deferred income tax 213,474,680 2,317,777 (A)(B) ------------ ------------ Total liabilities 215,163,801 3,775,624 ------------ ------------ Additional capital 11,221,601 116,373,960 (C) Undistributed net realized gains (losses) 102,766,040 (3,100,142) (B)(C) Net unrealized appreciation of investments 397,410,737 609,512,737 (A) Net assets at market or fair value 514,343,512 725,731,689 ------------ ------------ Total liabilities and shareholders equity 729,507,313 729,507,313 ============ ============ Six Months Ended September 30, 2006 ---------------------------- Previously Consolidated Statement of Operations Reported (1) As Restated (2) ------------------------------------------------------ ------------ ------------ Net investment income 1,661,910 1,661,910 ============ ============ Net realized gain on investments 6,243,744 9,615,763 (B) Net decrease in unrealized appreciation of investments (5,142,701) (8,148,701) (A) ------------ ------------ Net realized and unrealized gain on investments 1,101,043 1,467,062 ------------ ------------ Increase in net assets from operations 2,762,953 3,128,972 ============ ============ Three Months Ended September 30, 2006 ---------------------------- Previously Consolidated Statement of Operations Reported (1) As Restated (2) ------------------------------------------------------ ------------ ------------ Net investment income 1,170,354 1,170,354 ============ ============ Net realized gain on investments 5,985,684 9,218,747 (B) Net decrease in unrealized appreciation of investments (2,120,220) (2,931,221) (A) ------------ ------------ Net realized and unrealized gain on investments 3,865,463 6,287,526 ------------ ------------ Increase in net assets from operations 5,035,817 7,457,880 ============ ============ 13 Notes to Consolidated Financial Statements (continued) Year Ended March 31, 2007 ---------------------------- Previously Consolidated Statement of Changes in Net Assets Reported (3) As Restated (2) ------------------------------------------------------ ------------ ------------ Net investment income 4,233,340 4,233,340 Net realized gain on investments 16,334,000 14,966,296 (B) Net increase on unrealized appreciation before distributions 96,343,609 147,681,609 (A) ------------ ------------ Increase in net assets from operations before distributions 116,910,949 166,881,245 Undistributed net investment income (2,323,150) (2,323,150) Net realized gains deemed distributed to shareholders -- (11,417,283) (C) Allocated increase in share value for deemed distribution -- 11,417,283 (C) Employee stock options exercised 1,794,850 1,794,850 Stock option expense 1,173,751 1,173,751 Adjustment to initially apply FASB Statement No. 158, net of tax 169,003 169,003 ------------ ------------ Increase in net assets 117,725,403 167,695,699 Net assets, beginning of year 396,618,109 558,035,990 ------------ ------------ Net assets, end of year 514,343,512 725,731,689 ============ ============ Net asset value, per share $ 132.36 $ 186.75 ============ ============ Six Months Ended September 30, 2006 ---------------------------- Previously Consolidated Statement of Changes in Net Assets Reported (1) As Restated (2) ------------------------------------------------------ ------------ ------------ Net investment income 1,661,910 1,661,910 Net realized gain on investments 6,243,744 9,615,763 (B) Net decrease on unrealized appreciation before distributions (5,142,701) (8,148,701) (A) ------------ ------------ Increase in net assets from operations before distributions 2,762,953 3,128,972 Undistributed net investment income (772,050) (772,050) Employee stock options exercised 1,097,500 1,097,500 Stock option expense 81,831 81,831 ------------ ------------ Increase in net assets 3,170,234 3,536,253 Net assets, beginning of year 396,618,109 558,035,990 ------------ ------------ Net assets, end of year 399,788,343 561,572,243 ============ ============ Net asset value, per share $ 103.15 $ 144.89 ============ ============ 14 Notes to Consolidated Financial Statements (continued) Six Months Ended September 30, 2006 ---------------------------- Previously Consolidated Statement of CashFlow Reported (1) As Restated (2) ------------------------------------------------------ ------------ ------------ Net cash provided by operating activities 12,440,179 12,440,179 Net cash provided by financing activities 325,450 325,450 ------------ ------------ Net increase in cash and cash equivalents 12,765,629 12,765,629 ============ ============ Three Months Ended September 30, 2006 ---------------------------- Previously Consolidated Statement of CashFlow Reported (1) As Restated (2) ------------------------------------------------------ ------------ ------------ Net cash provided by operating activities 11,337,027 11,337,027 Net cash used in financing activities (150,000,000) (150,000,000) ------------ ------------ Net decrease in cash and cash equivalents (138,662,973) (138,662,973) ============ ============ (1) As presented in the Company's original Form 10-Q for the quarter ended September 30, 2006 (2) Adjusted to reflect the restatement described above. (3) As presented in the Company's original Form 10-K for the fiscal year ended March 31, 2007 (A),(B) and (C) are described in detail above. 3. Stock-Based Compensation In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R), which revised SFAS 123. SFAS 123R also supersedes APB 25 and amends SFAS No. 95, Statement of Cash Flows. SFAS 123R eliminates the alternative to account for employee stock options under APB 25 and requires the fair value of all share-based payments to employees, including the fair value of grants of employee stock options, be recognized in the income statement, generally over the vesting period. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin ("SAB") No. 107, which provides additional implementation guidance for SFAS 123R. Among other things, SAB 107 provides guidance on share-based payment valuations, income statement classification and presentation, capitalization of costs and related income tax accounting. Effective April 1, 2006, we adopted SFAS 123R using the modified prospective transition method. We recognize compensation cost over the straight-line method for all share-based payments granted on or after that date and for all awards granted to employees prior to April 1, 2006 that remain unvested on that date. The fair value of stock options are determined on the date of grant using the Black-Scholes pricing model and are expensed over the vesting period of the related stock options. Accordingly, for the quarter and six months ended September 30, 2007, we recognized compensation expense of $44,100 and $87,686, respectively. As of September 30, 2007, the total remaining unrecognized compensation cost related to non-vested stock options was $1,971,812, which will be amortized over the weighted-average service period of approximately 6.4 years. 4. Employee Stock Option Plan On July 19, 1999, shareholders approved the 1999 Stock Option ("Plan"), which provides for the granting of stock options to employees and officers and authorizes the issuance of common stock upon exercise of such options for up to 140,000 shares. All options are granted at or above market price, generally expire ten years from the date of grant and are generally exercisable on or after the first anniversary of the date of grant in five to ten annual installments. At September 30, 2007, there were 37,500 shares available for grant under the Plan. The per share weighted-average fair value of the stock options granted on May 15, 2006 was $31.276 per option 15 15 Notes to Consolidated Financial Statements (continued) using the Black-Scholes pricing model with the following assumptions: expected dividend yield of .64%, risk-free interest rate of 5.08%, expected volatility of 21.1%, and expected life of 7 years. The per share weighted-average fair value of the stock options granted on July 17, 2006 was $33.045 per option using the Black-Scholes pricing model with the following assumptions: expected dividend yield of .61%, risk-free interest rate of 5.04%, expected volatility of 21.2%, and expected life of 7 years. The per share weighted-average fair value of the stock options granted on July 16, 2007 was $41.777 per option using the Black-Scholes pricing model with the following assuptions: expected dividend yield of .39%, risk-free interest rate of 4.95%, expected volatility of 19.9%, and expected life of 5 years. The following summarizes activity in the stock option plan since March 31, 2007: Number Weighted-Average of shares Exercise Price Balance at March 31, 2007 52,500 $ 86.184 Granted 25,000 152.980 Exercised (3,100) 74.642 Canceled (4,000) 93.490 --------- --------- Balance at September 30, 2007 70,400 109.998 ========= ======== At September 30, 2007, the range of exercise prices and weighted-average remaining contractual life of outstanding options was $65.00 to $152.98 and 6.41 years, respectively. The total intrinsic value of options exercised during the six months ended September 30, 2007 was $75,129 with the exercise prices ranging from $65.00 to $93.49 per share. A total of 3,100 new shares were issued for the $231,390 cash received from option exercises for the six months ended September 30, 2007. At September 30, 2007, the number of options exercisable was 9,930 and the weighted-average exercise price of those options was $79.01. 5. Summary of Per Share Information Three Months Ended Six Months Ended September 30 September 30 --------------------- --------------------- 2007 2006 2007 2006 ---------- ---------- ---------- ---------- as restated as restated Investment income $ .44 $ .48 $ .74 $ .79 Operating expenses (.12) (.13) (.25) (.27) Interest expense -- (.04) -- (.08) Income taxes (.01) (.01) (.01) (.01) ---------- ---------- ---------- ---------- Net investment income .31 .30 .48 .43 Distributions from undistributed net investment income -- -- (.20) (.20) Net realized gain on investments .10 2.38 .19 2.48 Net decrease in unrealized appreciation of investments after (35.52) (.76) (31.11) (2.10) Exercise of employee stock options * -- -- (.09) (.29) Stock option expense .01 .02 .02 .02 ---------- ---------- ---------- ---------- Increase (decrease) in net asset value (35.10) 1.94 (30.71) .33 Net asset value: Beginning of period 191.13 142.95 186.75 144.56 ---------- ---------- ---------- ---------- End of period $ 156.04 $ 144.89 $ 156.04 $ 144.89 ========== ========== ========== ========== Shares outstanding at end of period (000s omitted) 3,889 3,875 3,889 3,875 * Net decrease is due to the exercise of employee stock options at prices less than beginning of period net asset value. 16 Notes to Consolidated Financial Statements (continued) 6. Subsequent Events In July 2007, William R. Thomas, retired from role as President and Chief Executive Officer, but has continued in capacity as Chairman of the Board. Gary L Martin was named President and Chief Executive Officer. In August 2007, Susan K. Hodgson resigned from her position as Secretary-Treasurer and Chief Financial Officer. Tracy L. Morris was hired in September 2007, as Controller and Chief Financial Officer. As described in Part II. Item 1. Legal Proceedings; on August 27, 2007 a lawsuit was filed against, Capital Southwest Corporation, Capital Southwest Venture Corporation, Heelys, Inc., and its Chief Executive Officer, Chief Financial Officer and directors who signed its registration statement with the SEC in connection with its December 7, 2006 initial public offering ("IPO") and its underwriters for the IPO. Four similar suits were filed in September and October 2007. On November 15, 2007, the Company received a Staff Determination Letter from NASDAQ, stating that we were delinquent in our SEC filings for the quarter ended September 30, 2007 and in violation of NASDAQ rules. The letter instructed us to file for an appeal for the determination or trading of the Company's stock would be suspended. On November 20, 2007, the Company requested a written hearing with NASDAQ. The hearing date is set for January 10, 2008. 7. Recent Accounting Pronouncements The State of Texas recently passed House Bill 3 (HB3), which revises the existing franchise tax system to create a new tax on virtually all Texas businesses. Starting in the fiscal year 2007, HB3 changes the franchise tax base, lowers the tax rate and extends coverage to active businesses receiving state law liability protection. We have been subject to an immaterial amount of Texas franchise taxes and expect the HB3 to have some affect, but have not determined the extent of this impact. In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, "Accounting Changes and Error Corrections--a replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS 154"). This Statement replaces APB Opinion No. 20, "Accounting Changes," and FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements." SFAS 154 requires retrospective application to prior periods' financial statements for changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The impact of this standard, if any, will depend upon accounting changes or errors that may occur in future periods. The Company adopted SFAS 154 effective December 31, 2005. Prior to the quarter ended September 30, 2007, SFAS 154 did not have any impact on the company's financial statements. In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, "Fair Value Measurements" (SFAS 157). The standard defines fair value, outlines a framework for measuring fair value, and details the required disclosures about fair value measurements. The standard is effective for years beginning after November 15, 2007; therefore, we will adopt SFAS 157 effective April 1, 2008. We are evaluating the impact of SFAS 157. In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for us beginning April 1, 2008. The impact, if any, from the adoption of SFAS 159 has not been determined. 17 Notes to Consolidated Financial Statements (continued) In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for us beginning April 1, 2008. The impact, if any, from the adoption of SFAS 159 has not been determined. Net asset value at September 30, 2007 was $606,872,698, equivalent to $156.04 per share. Assuming reinvestment of all dividends and tax credits on retained long-term capital gains, less deferred taxes on unrealized appreciation on investments in prior periods, the September 30, 2007 net asset value reflects an increase of 10.6% during the past twelve months. September 30, September 30, 2007 2006 ---- ---- Net assets $606,872,698 $561,572,243 Shares outstanding 3,889,151 3,875,751 Net assets per share $156.04 $144.89 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Results of Operations The composite measure of our financial performance in the Consolidated Statements of Operations is captioned "Increase (decrease) in net assets from operations" and consists of three elements. The first is "Net investment income", which is the difference between our income from interest, dividends and fees and our combined operating and interest expenses, net of applicable income taxes. The second element is "Net realized gain on investments", which is the difference between the proceeds received from disposition of portfolio securities and their stated cost. The third element is the "Net increase (decrease) in unrealized appreciation of investments", which is the net change in the market or fair value of our investment portfolio, compared with stated cost. It should be noted that the "Net realized gain on investments" and "Net increase (decrease) in unrealized appreciation of investments" are directly related in that when an appreciated portfolio security is sold to realize a gain, a corresponding decrease in net unrealized appreciation occurs by transferring the gain associated with the transaction from being "unrealized" to being "realized". Conversely, when a loss is realized on a depreciated portfolio security, an increase in net unrealized appreciation occurs. Net Investment Income Interest income of $1,244,129 in the six months ended September 30, 2007 increased from $1,139,530 in the year-ago period due to an increase in excess cash and interest rates. During the six months ended September 30, 2007 and 2006, we recorded dividend income from the following sources: Six Months Ended September 30 ------------ 2007 2006 ---- ---- Alamo Group Inc. $ 339,096 $ 338,556 Dennis Tool Company 37,499 49,999 Encore Wire Corporation 163,470 Kimberly-Clark Corporation 81,811 75,636 Lifemark Group 150,000 300,000 PalletOne, Inc. 0 89,842 PETsMart, Inc. 18,000 18,000 The RectorSeal Corporation 240,000 480,000 TCI Holdings, Inc. 40,635 40,635 The Whitmore Manufacturing Company 60,000 120,000 Other 34,383 27,833 ------------- ------------- $1,164,894 $1,540,501 ============= ============= 18 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Net Increase (Decrease) in Unrealized Appreciation of Investments Set forth in the following table are the significant increases and decreases in unrealized appreciation by portfolio company: Three Months Ended Six Months Ended September 30 September 30 ------------ ------------ 2007 2006 2007 2006 ---- ---- ---- ---- Encore Wire Corporation $ -- $ -- $ 6,130,000 $ 8,174,000 Heelys, Inc. (130,442,000) 30,000,000 (139,760,000) 30,000,000 Media Recovery, Inc. (9,000,000) -- (9,000,000) -- Palm Harbor Homes, Inc. (7,855,000) (15,710,000) (7,855,000) (23,565,000) The RectorSeal Corporation -- -- 10,850,000 -- During the six months ended September 30, 2007, the value of our investment in Encore Wire Corporation was increased by $6,130,000 due to the company's ability to cope with an increasingly volatile wire and cable market. The value of our investment in The RectorSeal Corporation was increased by $10,850,000 due to increased sales and earnings at the company derived largely from growing demand for the smoke containment systems manufactured by its Smoke Guard subsidiary. Offsetting the gains at Encore and RectorSeal during the six months ended September 30, 2007, was a $139,760,000 decline in the value of Heelys, Inc., which experienced significantly slower growth and an extreme decline in market price during the past quarter; a $7,855,000 decline in the value of Palm Harbor Homes, Inc. due to the deterioration of the manufactured housing market; and a $9,000,000 decline in the value of Media Recovery, Inc. due to reduced sales and earnings at the company. Portfolio Investments During the quarter ended September 30, 2007, we made additional investments of $1,050,000 in an existing portfolio company. We have agreed, subject to certain conditions, to invest up to $4,846,947 in four portfolio companies. Financial Liquidity and Capital Resources At September 30, 2007, we had cash and cash equivalents of approximately $31.9 million. Pursuant to Small Business Administration (SBA) regulations, cash and cash equivalents of $3.8 million held by Capital Southwest Venture Corporation (CSVC) may not be transferred or advanced to us without the consent of the SBA. Under current SBA regulations and subject to SBA's approval of its credit application, CSVC would be entitled to borrow up to $16.4 million. With the exception of a capital gain distribution made in the form of a distribution of the stock of a portfolio company in the fiscal year ended March 31, 1996, we have elected to retain all gains realized during the past 39 years. Retention of future gains is viewed as an important source of funds to sustain our investment activity. Approximately $65.2 million of our investment portfolio is represented by unrestricted publicly-traded securities, and represent a source of liquidity. Funds to be used by us for operating or investment purposes may be transferred in the form of dividends, management fees or loans from Lifemark Group, The RectorSeal Corporation and The Whitmore Manufacturing Company, wholly-owned portfolio companies, to the extent of their available cash reserves and borrowing capacities. 19 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Management believes that our cash and cash equivalents and cash available from other sources described above are adequate to meet our expected requirements. Consistent with our long-term strategy, the disposition of investments from time to time may also be an important source of funds for future investment activities. Item 3. Quantitative and Qualitative Disclosure About Market Risk We are subject to financial market risks, including changes in marketable equity security prices. We do not use derivative financial instruments to mitigate any of these risks. Our investment performance is a function of our portfolio companies' profitability, which may be affected by economic cycles, competitive forces, foreign currency fluctuations and production costs including labor rates, raw material prices and certain commodity prices. Most of the companies in our investment portfolio do not hedge their exposure to raw material and commodity price fluctuations. However, the portfolio company with the greatest exposure to foreign currency fluctuations generally hedges its exposure. All of these factors may have an adverse effect on the value of our investments on our net asset value. Our investment in portfolio securities includes fixed-rate debt securities which totaled $9,913,348 at September 30, 2007, equivalent to 1.7% of the value of our total investments. Generally these debt securities are below investment grade and have relatively high fixed rates of interest; therefore, minor changes in market yields of publicly-traded debt securities have little or no effect on the values of debt securities in our portfolio and no effect on interest income. Our investments in debt securities are generally held to maturity and their fair values are determined on the basis of the terms of the debt security and the financial condition of the issuer. A portion of our investment portfolio consists of debt and equity securities of private companies. We anticipate little or no effect on the values of these investments from modest changes in public market equity valuations. Should significant changes in market valuations of comparable publicly-owned companies occur, there may be a corresponding effect on valuations of private companies, which would affect the value and the amount and timing of proceeds eventually realized from these investments. A portion of our investment portfolio also consists of restricted common stocks of publicly-owned companies. The fair values of these restricted securities are influenced by the nature of applicable resale restrictions, the underlying earnings and financial condition of the issuers of such restricted securities and the market valuations of comparable publicly-owned companies. A portion of our investment portfolio also consists of unrestricted, freely marketable common stocks of publicly-owned companies. These freely marketable investments, which are valued at the public market price, are directly exposed to equity price risks, in that a change in an issuer's public market equity price would result in an identical change in the fair value of our investment in such security. Item 4. Controls and Procedures An evaluation was performed under the supervision and with the participation of our Management, including the President and Controller, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934). Based on that evaluation, the President and Controller concluded that our disclosure controls and procedures were not effective due to a material weakness in the Company's internal control over financial reporting ("ICFR") disclosed in "Item 9A. Controls and Procedures" of the Company's Annual Report on Form 10-K/A, for the fiscal year ended March 31, 2007. The following material weakness is the basis for our conclusion: 20 Item 4. Controls and Procedures (continued) o We did not maintain an adequate process to assess and determine the probability of the Company maintaining its qualifying status as a RIC subject to subchapter M of the IRC over the next twelve months at any given quarter. To address this material weakness, Management will add a formal evaluation to consider whether it is probable the company will not qualify as a RIC subject to Subchapter M of the IRC over the next 12 months at any given quarter. Additionally, the Company will review its investment gains quarterly and calculate the tax impact on those gains it will retain, however, they will only record the tax liability at the last day of the tax year. Management will also determine, based on materiality, any footnote disclosure that may be required during the interim periods. Furthermore, Management will review and assess temporary and permanent differences for reclassification to "additional capital" at each tax year end. When considered necessary by Management, an independent attorney or accountant with requisite knowledge of investment company taxation will be consulted in order to provide necessary guidance. Accordingly, Management believes that the financial statements included in this report fairly represent in all material respects the Company's financial position, results of operations and cash flows for the periods presented. There were no changes in the Company's internal control over financial reporting that have materially affected, or are reasonably likely to materially affect our ICFR during the fiscal quarter ended September 30, 2007. PART II. OTHER INFORMATION Item 1. Legal Proceedings We are currently the subject of certain legal actions. In our judgment, none of the lawsuits currently pending against us, either individually or in the aggregate, is likely to have a material adverse effect on our business, results of operations, or financial position. We, Capital Southwest Corporation and Capital Southwest Venture Corporation, have been named in a lawsuit filed on August 27, 2007 in the United States District Court of the Northern District of Texas, Dallas Division, against Heelys, Inc and its Chief Executive Officer, Chief Financial Officer and the directors who signed its registration statement with the Securities and Exchange Commission in connection with its December 7, 2006 initial public offering ("IPO"), and its underwriters for the IPO. The complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933 and the plaintiffs are seeking compensatory damages in an unspecified amount, as well as reasonable costs and expenses incurred in the action, including counsel fees and expert fees. Four similar suits were also filed in September and October 2007 in the United States District Court of the Northern District of Texas making substantially similar allegations under Sections 11, 12 and 15 of the Securities Act of 1933, and seeking substantially similar damages. These lawsuits have been transferred to a single judge, and we expect that all the cases will be consolidated into a single action, with a consolidated complaint filed shortly thereafter. We believe that the plaintiffs' claims are without merit, we deny the allegations in the complaints, and we intend to vigorously defend the lawsuits. Item 1A. Risk Factors There have been no material changes to our risk factors as disclosed in Item 1A, "Risk Factors", in our Annual Report on Form 10-K/A for the fiscal year ended March 31, 2007. 21 Item 4. Submission of Matters to a Vote of Security Holders Our Annual Meeting of Stockholders was held on July 16, 2007, with the following results of elections and approval: Votes Cast ----------------------------------------- Against/ Abstentions/ For Withheld Non-Votes --- -------- --------- a. The following Directors were elected to serve until the next Annual Meeting of Stockholders: Donald W. Burton 3,390,519 25,241 473,391 Graeme W. Henderson 3,388,577 27,183 473,391 Samuel B. Ligon 3,390,069 25,691 473,391 Gary L. Martin 3,386,898 28,862 473,391 William R. Thomas 3,384,051 31,709 473,391 John H. Wilson 3,335,121 80,639 473,391 Votes Cast ----------------------------------------- Against/ Abstentions/ For Withheld Non-Votes --- -------- --------- b. Grant Thornton LLP was approved as our independent registered accounting firm for the 2008 fiscal year. 3,412,395 516 476,240 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 31.1- Certification of President required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), filed herewith. Exhibit 31.2- Certification of Controller required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act, filed herewith. Exhibit 32.1- Certification of President required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code, furnished herewith. Exhibit 32.2- Certification of Controller required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code, furnished herewith. (b) Reports on Form 8-K We filed the following Current Reports on Forms 8-K with the SEC during the quarter ended September 30, 2007: Current report on Form 8-K filed with the SEC on July 18, 2007 relating to the resignation of Susan K. Hodgson as Secretary-Treasurer (Chief Financial Officer), effective August 6, 2007; and naming Jeffrey G. Peterson as Secretary of the Corporation. Current report on Form 8-K filed with the SEC on September 24, 2007 relating to the arrival of Tracy Morris as Controller serving as the Chief Financial Officer of the Corporation. 22 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CAPITAL SOUTHWEST CORPORATION Date: January 9, 2008 By: /s/ Gary L. Martin -------------------- ---------------------------------- Gary L. Martin, President (chief executive officer) Date: January 9, 2008 By: /s/ Tracy L. Morris -------------------- ---------------------------------- Tracy L. Morris, Controller (chief financial/accounting)