(ORATION TINANCE : - GREENE' 8>UU GfoUege nf Agriculture 3tt (Gonwll UniuerattB Jtlfara, H. % ICtbrarg Cornell University Library HG 4026.G83 Corporation finance; a study of the princ 3 1924 013 778 448 ™ The original of this book is in the Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924013778448 Corporation- Finance A Study of the Principles and Methods of the Management of the Finances of Corporations in the United States; with Special Reference to the Valuation of Corporation Securities by THOMAS L. GREENE VICE-PRESIDENT, THE AUDIT COMPANY OF NEW YORK FORMERLY AUDITOR, MANHATTAN TRUST COMPANY THIRD EDITION t < f I ' T, £.« : rr U I G. P. PUTNAM'S SONS NEW YORK AND LONDON Cbe "Knickerbocker press a. Copyright, 1897 BY G. P. PUTNAM'S SONS Entered at Stationers' Hall, London (B-ZS. -\ ■\ ' 1 S ■ '"'. '\ "■ M ',- v / *7 tCbe ftnicbetbocltec prcee, new Cock CONTENTS. CHAPTER PAGE I. — Bonds and Stocks i II. — Forms of Corporate Enterprise . 16 III. — Railway Bonds 33 IV. — Subsidiary Companies and their Se- curities 63 V. — Corporation Accounting ... 80 VI. — The Examination of Railway Re- ports 102 VII. — Public Policy towards Corporation Profits 131 VIII. — Corporation Reorganizations and Receiverships 146 PREFACE. BEFORE there can be any intelligent discussion of the problems which arise in the management of corporations, it is necessary that there shall be a wider knowledge of the objects sought in corporation finan- ciering, and of the practical reasons which have led to the policy pursued in the United States, together with its results. Some suggestions have been made which may, I trust, prove of service to the large class of business men and lawyers who are not infrequently called upon to deal with the incorporation or with the administra- tion of an industrial undertaking ; in the description of the methods of practical finance the attempt has like- wise been made to supplement the text-books already in the hands of educators and students. Experience has developed and brought into promi- nence business rules and facts which will be useful to an investor in estimating the value of the bonds or shares of corporations in which he may be interested, and it has been the aim to present these rules and practices in such a manner as, while technical in its precision, shall also be available for the purposes of the general reader. T. I* G. New York City, March, 1897. CORPORATION FINANCE CHAPTER I BONDS AND STOCKS THE business man or firm must borrow money. With, the few exceptions, where firms have com- mand of practically unlimited sums of their own, business success is possible only through the aid of the money-lender. I^et us suppose for illustration that a firm employs a capital of $1,000,000 in its business, one half of which it borrows from the banks on its commer- cial paper at six per cent, interest. We will suppose also that the firm " turns its capital over " six times a year, which is only another way of saying that its vol- ume of annual sales is six times the capital. Assuming that our firm is enabled to earn two per cent, net upon its sales, the resulting profits, $120,000, amount to twelve per cent, upon the capital employed. As under our assumption the firm is paying six per cent, on the amount borrowed, or $30,000 yearly, it follows that the actual earnings upon the firm's own capital are $90,000, or eighteen per cent., a handsome return made possible only through the borrowing of money which can be used to extend the volume of trade and to earn some- 2 Corporation Finance thing for the firm over and above the percentum of interest paid. The actual profits earned under this system vary in different trades, though usually the vol- ume of business is in inverse proportion to the percent- age of profit on the annual sales. Whatever sum we select or whatever earnings we assume, the principle underlying the illustration is the same. Of course a part of the capital of such firm or corporation in busi- ness must be invested in credits granted to customers and in some form of merchandise in stock. The practical working out of this fact that borrowing money is now essential to business success, is beneficial to the customer of the firm, to the consumer, and to the people at large. Competition is even more severe be- tween trading firms than in the cases of large manufac- turing corporations ; profits tend everywhere to a mini- mum, so that in the end the percentage of earnings on sales declines toward the level of existence. Slowly, therefore, the possibilities of profit, under this system of doubling or trebling the volume of business through the borrowing of capital, are, through the pressure of competition, taken from the firm and given to the pub- lic in the shape of lower prices or superior service. This is the universal law of trade. If we suppose, under our former illustration, that in time the volume of sales reaches eight times the capital employed and that the percentage of profit declines from two per cent, to one per cent., making a return of $80,000 annually, from which as before interest on borrowed capital, amounting to $30,000, is to be deducted, we see that our supposed firm has toiled steadily to increase its trade, has taken large commercial risks in the way of bad debts, declines in the prices of commodities, etc., and has, after all, made but ten per cent, upon its own Bonds and Stocks 3 capital invested and hazarded in its business ; a return too small to compensate for the labor and the danger of loss. Clearly, however, the addition of borrowed capital and the increased volume of trade thereby- secured give advantages of profit, in which both firm and customer are entitled to share. Concurrently with the growth of firms and corpora- tions which do a large business under these conditions, there has come a large increase in the amount of money waiting to be loaned, and a large advance in the meth- ods by which the surplus capital of the world is col- lected for loaning. Banks, insurance companies, trust companies, and savings banks, in short, firms and cor- porations, both large and small, formed for every con- ceivable financial purpose and of every conceivable kind, now stand ready to lend to the deserving bor- rower. The more depressed the times, the more easily and cheaply can the safe borrower secure needed money. But the greater part of these increasing sums of money is for loan only upon some sort of security. The lenders who are willing to take some risk are few; those who wish to be certain of the return of their money are many. To secure this safety, the owners of this surplus capital are willing to lend it at a low rate of interest. The unwillingness of the average investor, individual or institutional, to put his money at any business hazard, is one of the main causes for the continued fall in the average rate of interest. Capital competes with capital for safe investment. The demand for security in loans gives the business firm or corporation its opportunity. If perfectly sound in condition and management, it can borrow its outside capital at a low rate, and so increase its own profits. The machinery for gathering money and loaning it has 4 Corporation Finance been so perfected, and the knowledge of the conditions of safety in business has become so extended, that the proportion of borrowings to a firm's entire capital has been much increased. Formerly it was with hesitancy that a bank would lend a firm one quarter of its required capital ; now, there is a temptation for a writer to say that a quarter of the firm's own money, with three quarters of borrowings, would be nearer the usual proportion. To borrow one half of one's neces- sary capital, in money or goods, is common. The comparative ease of obtaining credit, the fall in the average rate of profit made possible by this increase in capital, and the resulting heavy increase in the output and in the volume of trading throughout the world, made necessary in order to earn a fair return under the diminishing ratio of profit, are the forces under which we are witnessing prosperity and depression in almost regular cycles. To take advantage of these trade forces, and at the same time to check the excesses due to them, constitute the great industrial problem of our time. These conditions of safe lending and mercantile borrowing have drawn a sharp line of distinction in industrial finance. The lenders of money to firms or corporations are creditors, the stockholders are part- ners in the enterprise. As creditors are willing to furnish capital up to the line of safety, it has become a common saying that the bonds of a corporation ought to cover the minimum value of the property or fran- chise, leaving the fluctuating or uncertain part of the enterprise to be represented by the shares. This is a good rule, but one which differs in its application to different cases. L,oans upon real estate in cities can be made with safety up to a larger percentage of the Bonds and Stocks 5 appraised value than in towns or upon farms. So too with, corporations or with firms of long standing, whose style of management is well known, the stability of whose trade or traffic has been tested by experience, and where the limits of the expected fluctuations in volume of commerce can be reasonably predicted ; such companies or firms can borrow capital up to a high percentage of their supposed worth. The practi- cal test of this limit of borrowing is found by a con- sensus of opinion in answer to this question : To what amount can commercial paper or bonds be floated at par and at about the ruling rate of interest for such borrowings ? Even if the firm or company be in ex- ceptionally good credit and able to borrow up to a large percentage of the real capitalization (including in this term the guaranties and other fixed charges not covered by bonds) yet the managers should for their own future safety conservatively limit their borrowings to the minimum value of their property as the same might be estimated in a time of possible adversity. It is not good financiering to sell evidences of in- debtedness at a heavy discount, even though the stated rate of interest be below the usual percentage. It is better, if possible, to arrange the rate of interest so that the bonds or notes will fetch par. It occa- sionally happens that for sentimental reasons, or per- haps to differentiate a later issue from former ones, a company will knowingly offend against this rule, and put out bonds — perhaps under a blanket mortgage — bearing a low rate of interest for less than their par value. Since the par value of these bonds must be paid at maturity, the shareholders, if they wish to pro- tect themselves against the discount, may ask that this discount be prorated over the number of years to the ) Corporation Finance uaturity of the mortgage and a proportion be deducted rom the net earnings each year. The tendency to elieve the present by a sacrifice of the future is nat- ural, but cannot be defended on abstract grounds. For :xample, a company which might float a five per cent. >ond at par chooses to issue a four per cent, bond at let us say) 80. Of course, to raise a certain amount >f money it must then increase the issue by twenty- five )er cent. If a million of dollars is needed, the com- )any must put out $1,250,000 of bonds at 80 to obtain he required sum ; the interest to be paid annually neanwhile being the same as though five per cent. >onds had been issued at par. Manifestly, though, such an issue requires the payment of $250,000 extra jrincipal at maturity, an amount which might be pro- ated over the number of years till maturity and leducted each year from income. That would at least ierve to remind shareholders of the real expense of such a method of financiering, even when thought to )e made necessary by circumstances. The course of he Louisville and Nashville, since 1894, in this very natter deserves commendation. One of the reasons for such issues at a discount is that investors like to buy a )ond selling a little less than par, because it offers a setter chance for an increase in value than a bond sell- ng at a premium. If it requires a rate of interest far ibove the ruling market rate to enable the issue to fetch jar, it is a proof that the amount of principal asked for s too large for the business to support. To issue bonds or commercial paper at too high a rate of interest or at too great a discount from the face ralue, except for special reasons, is a violation of the Drinciple upon which modern industrial debt financier- ing is based. As we have seen, this principle is that Bonds and Stocks 7 as large a part of the required capital must be borrowed at as low a rate of interest as will enable the partners in the enterprise to use those borrowings in their busi- ness with safety and at a profit to themselves. If the partners or shareholders of a new enterprise are not willing to contribute the necessary money beyond this secure proportion, there is something doubtful about the outcome. What has been said about firms applies with changed circumstances and names to corporations. They, too, must borrow, though their borrowings may take the form of a mortgage rather than that of com- mercial paper. We occasionally read of a surface rail- way or other company which has no bonds upon its property, but only shares. If the enterprise is at the beginning so doubtftd that borrowed money would en- danger success, the promoters do well to take all the risk, providing they have faith in the outcome. But in the case of a corporation starting with something assured, or where experience has demonstrated that there is a margin of safety, to avoid borrowing may not be good financiering. A street electric railway paying six per cent, on its stock could sell bonds up to half of its capital on a basis, we will say, of five per cent, interest. By issuing such bonds it could, on the same earnings, pay seven per cent, instead of six per cent, on its capital stock. Every profitable corporation, if it so decides, may rightly take all the advantage possible of these principles in the management of its finances. The shareholders in a corporation are the partners ; they take the risks of the business, and are not only entitled to all profits but may rightly increase those profits by every legitimate means. It is also a business question whether the share capital should be subdivided 8 Corporation Finance into classes with a preference of one class over another. In the cases of certain trading or manufacturing com- panies no bonds are issued, the capital being divided into one or more classes of preferred shares together with common stock. The corporation of H. B. Claflin Company in New York City is an instance in point. This company was formed in 1890 to take over the dry- goods jobbing business of H. B. Claflin & Co. It has a capital of $9,000,000, divided into first preferred stock, bearing cumulative dividends of five per cent., second preferred stock, bearing cumulative dividends of six per cent., and common shares covering nearly one half of the capitalization. In such cases the higher shares should have the preference not only in divid- ends, but in claims upon the assets ; in return for which privilege they are limited to a certain- but com- paratively small rate of dividend annually. Such shares usually carry a cumulative claim as against the other classes, which means that a dividend passed at any one quarter or year must be made up from future earnings before the lower shares receive any return. Under such circumstances these preference stocks really take the place of bonds, and are to be so considered in theory. Their advantage over bonds lies in this, that in years of extreme depression or of great trade losses, suspens- ion of preference payments does not involve fore- closure and loss to the common stock, because time is allowed in which to make up such losses. In the cases of corporations formed to take over trading or manu- facturing concerns in whose business violent fluctu- ations are possible, the issue of preference stocks instead of bonds is to be commended ; but with com- panies whose business may reasonably be called stable, bonds are in better favor. In both instances much de- Bonds and Slocks 9 pends upon the management, but the average investor seems to think himself more secure where annual pay- ments of interest are obligatory ; he believes that a lit- tle pressure upon the management has often a goodeffect. In the United States the majority of preference shares in the hands of the public represent equitable claims upon future or present prosperity. They were generally issued by the railways as evidences of debt which the exigencies of the times required should be deferred ; perhaps some peculiar obligation not then easily paid ; but more probably, such preferred shares were given to old bondholders who were compelled by insolvency to yield something of the principal and interest of their then debt. In 1888 the Chesapeake and Ohio Railway was reorganized without foreclosure, the bondholders consenting to readjust their claims. The " B " bonds of the old company (bearing six per cent.), dated 1878, were exchanged for two thirds of their face value into new five per cent, bonds, and for one third into first preferred stock. The company becoming more pros- perous, this first preferred stock was, in 1893, ex- changed two thirds into " blanket " four and a half per cent, bonds, and one third into common stock. This process relieved the needs of the company at the time, while afterwards the holders of old " B " bonds received more than the value of their original investment. The I^ake Superior and Mississippi Railroad was sold under foreclosure in 1877 to the holders of its first mortgage bonds, who exchanged their bonds into preferred shares at the rate of $1200 of such shares for each bond of $1000. The new company, the St. Paul and Duluth, thereupon issued a new first mortgage, bearing five per cent. In time a second mortgage was put upon the property for extensions and improve- io Corporation Finance ments. Under this policy the necessities of the situ- ation were met, and after 1883 the course of the old first mortgage holders was justified by the receipt of regu- lar dividends upon the preferred shares ; without such concession the loss to such holders would have no doubt been almost total. Though no stronger for these reasons legally, prefer- ence stocks issued to represent deferred claims embody an ethically good claim upon the general or future prosperity. At other times companies having only common shares may like to exchange a part in certain propor- tions for preferred. In such cases the motive is often sentimental ; the company may be earning a small sum over fixed charges (bond interest, rentals, and taxes), a sum too small for division among a large number of common shares, but enough to pay, perhaps, four per cent, on a small preferred capital. It is considered better to pay that four per cent, if the capital is arranged so as to allow of it, because such payment, or, in fact, any honest payment of dividends, improves the credit of the company in the eyes of the public. Senti- ment is an important factor in corporation financiering, one of which the good manager will make legitimate use. It is, however, an abuse of sentiment where divid- ends not fairly earned are paid in order that the credit of the corporation may have a fictitious support. The declaration of dividends on the preference bonds of the Philadelphia and Reading in 1893, followed a month later by the bankruptcy of the company and the placing of the property in the hands of receivers, is open to the above criticism. An exception to this statement should be made in cases where a succession of prosperous years is followed by a period of losses ; if recovery Bonds and Stocks 1 1 seems fairly in sight, it is proper to continue such divid- end payments for a while rather than destroy the con- tinuity of such returns to shareholders. An instance is that of the Chicago, Burlington, and Quincy, a company which suffered severe losses, in 1888, through a strike among its enginemen. Though confessedly not having earned it, the company paid the dividend, and was under the circumstances justified in so doing. The statements made regarding the stocks and bonds of railway companies are true also as to the bonds and stocks of other corporations, though changes must be made to meet the circumstances of each case. In instances where large corporations have been formed for the prosecution of enterprises which demand large plants and extensive organizations for the carry- ing on of the business, the same remarks may be made without much modification. Such extensive companies formed, say, for the manufacture of certain particular articles in much demand, require the expenditure of large sums of money for special machinery and for the erection of buildings specially designed for the purpose of the business. This plant and machinery may be almost valueless for any other purpose than for this particular manufacture. Bonds issued by such a com- pany are, like railway mortgages, really dependent upon the success of the corporation and its business, since usually the amount of such bonds is largely in excess of the value of the land and machinery if sold for any other than the original purpose of manu- facturing. The difference between the valuation of the plant at forced sale and the amount for which it is bonded, represents the good- will of the business, whether it is so stated in the company's accounts or not. It does not alter the case to say that the amount of the 12 Corporation Finance bonded indebtedness (or preferred stock) has really- been expended by the company upon its property. The lien is not so much upon the property itself as upon the business success of the company. Yet that success may be so reasonably sure that it may properly form the basis for borrowing at a low rate of interest. Those who have knowledge of the particular line of manu- facturing which the new company is to pursue, may be clear in their judgment that the success of the com- pany will be beyond a peradventure. Yet for the in- vestor or for the banks or for the capitalist generally, nothing can take the place of experience as the basis of a judgment as to corporation values. When a com- pany has been running long enough to enable the or- dinary lender of money to form such a judgment, he is usually willing to grant the company a larger pro- portion of credit than was at first obtainable. The fact, however, that at first only a comparatively small proportion of the required capital could be bor- rowed at ordinary rates of interest may have led the promoters of such enterprises to try to borrow a still larger sum, with the result that the extra risk as esti- mated by the banking houses is paid for during the whole life of the bonds by an unusually high rate of in- terest, or, which is the same thing, by a heavy discount from the par value of the bonds issued. An instance of such a discount is afforded by a prominent railroad company. This company issued, in 1884, ten-forty ad- justment bonds, bearing six per cent. These bonds were so named because they could be called in by the company at no and cancelled ten years from date, be- coming due in forty years. These bonds, after first being offered to the shareholders, were sold at 57^ with a bonus of stock at 22^. In other words, for $ 800 in cash Bonds and Stocks 13 the purchaser received one $1000 adjustment bond and $1000 in stock at par. Thus the bonds practically cost the purchaser $575 each. The then managers, rep- resenting foreign stockholders, finding the company pressed for ready money to take up called loans (tem- porarily, as it turned out), thought themselves com- pelled to offer such severe terms ; the situation hav- ing become acute through mistakes in financial policy in previous years. The credit of the company having meanwhile greatly improved, these bonds were paid in 10 years. The conversion of the Atchison incomes into " A " and " B " bonds in 1892 is an illustration of the mortgaging of future prosperity to relieve present needs for money. Such extra interest or discount is a meas- ure of the badness of the financiering or of the pressure of necessity, and in times of depression may even cause such a financial pressure of annual charges as in effect to be a reason for bankruptcy. When we hear it stated, as we sometimes do, that a particular business cannot bear the high rates of interest which it is directly or indirectly paying, we may rightly assume, in the absence of some other oppressing cause, that the reason for the present distress goes back to the time when the promoters of the enterprise or the organizers of the newly incorporated company formed to take over an old business, were unwilling to accept the estimate of experienced money-lenders upon the success of the company. Either by advancing their own money or by inducing others to become partners in the enter- prise, they ought to have obtained share capital enough so as to have started the enterprise conservatively ; one important element of this conservatism being that only so much money should be borrowed as could be obtained on favorable terms. 14 Corporation Finance In the cases of comparatively small corporations formed for trading purposes or to prosecute a business comparatively small in volume, care must be exercised by both organizers and lenders of money. The bonds of such corporations are not eagerly sought for from the nature of the case. Sometimes, as has been already remarked, the financiering of such corporations is accomplished by the issuing of preferred stocks instead of bonds. So far as the general public is concerned, the borrowing of money on the part of such small com- panies does not differ greatly from the procedure observed in the borrowing of money on commercial paper by partners. But few of the bonds of these small companies reach the public ; the principal source of supply for borrowings being the banks. The banks in lending money to these small corporations require statements from them the same as in the cases of firms ; but because of the difference in responsibility between partners and corporations, lending institutions, in addi- tion to the claim upon the assets of the company, usu- ally demand the personal endorsement of the officers, thus in effect securing from such small companies the personal liability of the managers precisely as though the business were the property of an individual or a firm. Municipal bonds form an exception to the rules of borrowing according to the probability of successful business. A municipality is any territorial subdivision of a country, city, county, village, or township, which may wish to borrow money for any improvement allowed by law. The security for such borrowings does not rest primarily upon business profits but upon the property embraced, though in the long run property valuations in any city or county must depend upon the prosperity Bonds and Stocks 1 5 of the community. Usually the power to bond the town is limited by law to an amount covering so small a percentage of the town values that the question of the security of such bonds, from the point of view of the sufficiency of the property pledged, does not often arise. On this account municipal bonds, when they are good, are very good indeed, and command high prices at the hands of a special class of investors, such as sav- ings banks and insurance companies. The dangers of municipal bonds arise from another quarter. The ques- tions of legality of issue are so complex, and, as even after able legal opinions, unexpected difficulties may be encountered, their purchase becomes a matter of some risk, including perhaps a long-contested lawsuit, in cases where counties and towns may for any reason desire to repudiate their obligations. For these reasons, cities enjoying good credit can sell their bonds at the lowest rate of interest known in financial circles ; while as for the bonds of other less known municipal divis- ions, only such institutions as have unlimited resources for investigation and for the enforcement of the pay- ment, if found necessary, become the purchasers. In general, municipal bonds are not favorite forms of in- vestment with the average capitalist. CHAPTER II FORMS OP CORPORATE ENTERPRISE WHEN a firm, established long enough to give its returns some stability, desires to sell its busi- ness, it soon finds that the easiest way to accomplish this result is by incorporation. When the company is decided upon or formed, the bonds or shares become available for public sale or subscription in any desired amounts. In this way a large business with its plant can be sold by piecemeal, as it were, at a total valu- ation which could not be obtained in any other way. The larger the business the more difficult is it to find partnership purchasers. The usual course in such matters is to consult some banking or promoting house which can be induced to finance the project (i. e., to furnish any money required during the transfer), and which has facilities for dis- posing of the new bonds or shares to its customers and the public. It is a tendency of the times to give the sale of public securities into the hands of those whose profession is that of judging of the values of the securi- ties to be offered. The majority of the investors have their own concerns to look after, and in any case are not good judges of bonds or shares or of the prospects of success of special enterprises. Such persons in the end take the advice of trusted banking houses. Since the reputation of such houses is very important to id Forms of Corporate Enterprise i 7 them, they take pains not to recommend purchases which may involve their customers in losses. Con- versely their recommendation is much sought after for new enterprises, and to pay their charges is the cheap- est way in the long run to ' ' float ' ' a public corpora- tion. These remarks, of course, do not apply to cases where all of the new capital is retained by the old partners. Where such houses are consulted by the would-be incorporators there is usually a difference as to the value to be put upon the enterprise ; the owners are perhaps over-sanguine ; the banking house, if conserv- ative, goes through the submitted facts and figures in cold blood. It knows, too, approximately, what the public will be willing to pay. The capitalization is then fixed at a sum which it is supposed will allow of a small distribution of profits even in poor years. There is first the division of the capital into bonds (or preferred stock) and common shares. In order that money may be borrowed at the lowest rate of interest, and thus every possible profit be reserved for the com- mon stock, it is necessary that bonds should be issued only to the minimum value of the property. When preferred stock has a preference not only as to divid- ends but also as to assets in cases of failure, it takes the place of bonds and should be regarded in the light of a debt. What this minimum value is, is not an easy question to determine. Sometimes it is taken to include the values of the buildings, machinery (or other contents), and the raw material on hand or in process of manufacture. Whether this is safe depends in part upon the nature of the business. Sometimes real-estate experts are asked to appraise the plant as a basis for bonds : but here care should be taken as to 1 8 Corporation Finance the instructions given to such appraisers. If they are required to give an opinion on the value of the ground, buildings, etc., for the use of that particular business, they may honestly put their appraisal at figures far above anything which could be obtained at forced sale in case of insolvency, and security in such an event is the very thing sought for by the bondholder. In the same way and under similar instructions an extrava- gant valuation may be put upon the machinery, which may not be new, and indeed may already be in process of supersedure as to kind in other and competing estab- lishments. The raw or half- worked up material should be also computed at prices which allow for possible fluctuations because of changes in fashions or by reason of any circumstances which may affect the particular business under consideration. Yet bonds aggregating a larger sum than the valuation of the plant at forced sale may be legitimate and safe because of the stable nature of the manufacturing or trading to be taken over by the new company. But in such cases it should be distinctly understood that a part of such bonded debt rests for security upon success rather than upon real-estate values, i. e., upon the " good- will." The amount of common stock to be issued does not occasion so much trouble. Allowing for the ups and downs of business, the common capital should fairly represent the fluctuating possibilities of the new con- cern. To estimate this future properly, the number of common shares should be conservatively small ; but the difficulty here, as everywhere else in corporation finan- ciering, is the dislike of the public to the payment by a corporation of dividends higher than the normal rate of interest. It is better financiering to pay good returns in good years, thus allowing for a decline in periods of Forms of Corporate Enterprise 1 9 depression, than to capitalize the company up to the highest point with the possible result of making the whole common issue of little or no value in poor years — and worthless shares are always a menace to honest business. In asking for subscriptions to bonds or shares in a new corporation formed to take over a manufacturing or trading business, it is usual to employ reputable public accountants who are required to make a report stating what the profits have been for a number of years. These accountants' certificates have had great weight with purchasers, but recent events have limited their importance. Too much meaning was found in such certificates by small capitalists ; they were con- strued practically to guarantee the whole corporation and its future. As a matter of fact, those certificates were valuable as giving an expert statement of the books of the old partnership as they stood ; but they were not intended to explain or to sit in judgment upon the commercial facts which lay behind those books. Being employed by the old partnership or by the pro- moting house, such accountants may have examined only such accounts as they were requested to, made statements in the form desired, or omitted items which they were not paid to investigate. A firm of account- ants might certify that the average annual profits for three years were a given sum, and stop their report at that point. If the partners had a year previously formed the resolution to incorporate, they might easily swell their revenues greatly during the last year. The discrepancy would be detected if the earnings were given for each year separately, but not if an average alone were stated. Again, the form of such a certificate might be that the accounts and bills receivable ex- 20 Corporation Finance ceeded those payable by a given sum which might be added to the assets to be covered by the proposed share capital ; and such a statement, while true, might be misleading. The accounts receivable might be such as were always outstanding, for which working capital should be provided in the plan of capitalization. If so, and every business needs more or less of such working sums of money, simply to offset them by bills payable — meaning money borrowed from the banks — is, under the circumstances, manifestly improper. Borrowed money is a debt, and the plan of incorporation under discussion assumes that the bonds or preferred stock covers the whole of that debt. This particular error in incorporating is sometimes ventured upon in order to give to the old partners all the money subscribed by the public for the bonds and common stock, but it con- ceals the real status of the finances and leaves un- guarded a possible danger. Moreover, bills payable must be met in full while the running accounts of cus- tomers may not be worth their face, leaving a deficiency not covered by such a plan of incorporation. The rise and fall of the Thurber-Whyland Company in New York City furnishes an example. It may be that the certificate unintentionally mis- leads in another way. The books may be exact in giving the earnings and expenses for the previous year, and yet the resulting profits may not be a proper basis for corporate capitalization ; for the reason that selling prices may have been exceptionally high or the cost of raw material or of some important item of ex- pense exceptionally low, so that the year's profits may be too good for an estimate of the future. The case of the Allsopp Brewery in England is an illustration. For these reasons, the course for those proposing to Forms of Corporate Enterprise 2 1 incorporate themselves, or to promote such incorpora- tion, or to purchase the bonds and shares in the new company, is to supplement the information furnished by the accountant with other expert knowledge regarding the circumstances and conditions under which the par- ticular business has been and is likely to be carried on. A matter which should be considered is that of man- agement. Practiced experience, as well as the best economic theory, lays emphasis upon the importance of an aDle manager. Nothing can take his place ; and his rewards in the shape of salary or returns upon his shares, must be commensurate with his importance. In building up a business the personal element is a great factor. In railways there has been developed in the process of time a body of specialists who are trained in their work of superintending and managing railroad operations, and from whom men may always be had by any company to take control. This same thing will in time be true of all corporation work which concerns the production or distribution of staple goods or neces- saries, and, indeed, this is true already of certain lines of work ; but it is a point to be considered by all in- terested in new corporations whether expert manage- ment can be had, particularly if those who brought the old firm up to its place of importance are soon to drop out of control through age or lack of interest. When our important corporations have passed their experi- mental stage, proper management will be largely a question of proper payment. Aside from the advantages which the corporate form offers for the gathering of capital in small sums for some great enterprise, for the massing of men and machinery at some proper spot, and for the conduct of 22 Corporation Finance a large business at a small expense per unit of output, there are benefits to other and smaller concerns by the transfer into corporations. It often happens that part- nerships are turned into companies without intention to become public concerns. Perhaps a number of per- sons acquire an interest in a business established and built up by a father and uncle, a business which it is intended to keep in the family. But the multiplication of owners occasions much difficulty, while another death or two may put the whole enterprise in peril, perhaps require a selling out to other parties in order to determine the value which would then require to be divided. These perils lying in the path of firms hav- ing many partners, some minors, some women, are well understood. Some of them may be guarded against by such devices as insuring the lives of the managing part- ners ; but many of such instances are best solved by organizing a corporation to carry on the business ; in this way the proportion of each partner or heir can be set aside in shares, which can be transferred or sold in any proportion or at any price without affecting the business itself. Nor will death destroy the living of the remaining owners ; for corporations do not die with the death of shareholders. One of the arguments against trading coporations is that the new company may lose the advantage of the zeal and ability of the manager who has brought the business up to its present state of profitableness, but who having now no such interest in the result will drop out altogether, or will not give it the old and close attention. In scattered instances this may be a good objection, for we should not omit the personal equation from our calculations. To supply a class of managing specialists in trading or manufacturing is a work of time ; but if a particular Forms of Corporate Enterprise 23 line of trading or manufacturing is large enough to demand expert management and to give remunerative employment to those who will study the business, such a class will surely arise to meet that demand. The only danger is that until a good manager is born and made, the business may suffer to a certain extent. It is proper to take the contingency into account in esti- mating on the probable future values of the bonds and shares of a corporation if offered for public subscription or sale. In some cases the contingency may be provided for by arranging to have the old managers retain a large interest for a certain number of years, or in any way which will make future success an advantage to the old partners. But to partners who form a company for family reasons, these possible objections do not apply. The status of such companies is directly affected by the fact that no bonds or shares are to be sold to the public ; therefore the public are concerned with the success or failure of such a family company only so far as that company may wish to borrow money from the banks or ask for credit on goods purchased. In such cases equity requires a complete exhibit of their affairs to those who have a right to that information. For the public at large, and for the information of the state which granted the charter of incorporation, a statement of the assets and liabilities in brief form is properly demanded. The profits of a family company is not a matter with which the state need concern itself. The limits of liability under a corporate form are well under- stood, and if liability is limited, so also is the credit ; no undue advantage is taken of anybody by incorpora- tion. Bank officers when asked for loans will either accept the signature of the company through its proper 24 Corporation Finance representative, or will demand the personal endorse- ment of some individuals ; the matter of credit in family corporations regulates itself. A defect in our general laws touching corporations is often the neglect to distinguish between those com- panies which are public in their nature and those which are private. A company whose bonds or shares are held by the public and which depends upon public sup- port for its financiering, ought to be compelled (if it does not agree of its own motion) to give out its busi- ness accounts in such detail that the holders of its bonds or preferred or common stocks can form a clear idea of the profitableness, of the financial standing, and of the managerial success of their company. But private or family companies are under no obligations to the pub- lic as to their affairs except as already noted, and should not be required to make returns in detail. The distinc- tion between public and private corporations would at times be difficult to draw ; no rule could be made which would not sometimes err. Perhaps a limit to the num- ber of stockholders would furnish a practical test under which such a distinction could be made. It is sometimes thought that the legal restrictions imposed upon corporations and the state oversight to which they are subjected, are such drawbacks to the corporate form as to balance the advantages already referred to. Such restriction and such oversight will probably never be withdrawn ; indeed, the tendency of the times — as evidenced as much in economic discus- sion as in actual legislation — is toward further restraint. The matter of stock or bond watering often has busi- ness effects which a prolonged strike or some other commercial event can alone make clear ; the whole discussion as to " monopoly," though somewhat crude Forms of Corporate Enterprise 25 as yet, may, as regards future legislation, turn in the end upon the question whether the profits arising from combination or from huge corporations have been equi- tably divided between the three parties in interest : the company itself, the consuming public, and the em- ployees. To answer such a question, the widest in- formation will be necessary. Corporations, therefore, should not look forward to any general reduction in the amount of state regulation. But while this seems to be true generally, it by no means follows that corporations will find that form of doing business less favorable than before. If we keep in mind the fact that a corporation — a public company — implies a well-established business on a scale so great as to require large capital and a large and well equipped plant, it will be seen that the best success cannot come from the partnership form. If we accept a large out- put or traffic and a correspondingly low cost per unit of production as the criterion of a well-managed com- pany, we necessarily imply a large business enjoying good credit and with years of experience behind it, things which are not so hopefully to be expected from a firm. Such a company must, in the nature of the case, have an element in its business which, from want of a better word, may be called monopolistic ; if that advantage is used for the public good there should be no complaint ; it is an advantage in the hands of a skil- ful manager for which the company may well pay by giving publicity to its affairs. Nor should it be forgot- ten that in such cases publicity does not have the draw- backs urged by small trading companies — that it invites competition. If our supposed company is well man- aged and is doing business at a low ratio of profit, publication of its affairs rather repels competition 26 Corporation Finance by showing the hopelessness of success to a new company. Precisely because a large volume of transporting or manufacturing is essential to the stability and long- continued success of an ideal corporation, so such cor- porations tend gradually to absorb the production of such articles as can be carried or manufactured in large quantities, and, of course, consumed by the pub- lic in like amounts. Generally such articles are the nceessaries of life, or if not strictly speaking neces- saries, then those with which the consuming public are especially concerned. From this point of view also we must expect in the future additional legislation. The best defence of corporations against unduly severe laws is full publicity. The history of a company, its early losses and struggles, the prices of the commodity when the business was begun compared with prices now, the cost of production per pound or gallon or barrel, show- ing the reduction, and in view of such facts the moderate profits of to-day — statements such as these will prove to be the best defence against drastic legislation before the bar of public opinion. But a company relying upon such a defence must be sure that its course as regards prices and policy is one which cannot be fairly attacked. For these reasons, while the restrictions imposed by the state are sometimes onerous and often foolish, yet the advantages of the corporate form for the prosecu- tion of a large and stable business must outweigh the disadvantages. Probably the question of taxation is a serious one for most corporations. Their form and their business seem to invite taxation. It may be that for a time corporations will be obliged to carry more than their proportionate share of the common burden in this respect. In the end this question will run into Forms of Corporate Enterprise 27 the more general one of the rightful profits to be made; but meanwhile taxes are things for which incorpora- tions must be prepared. Corporations formed to carry on a business semi- public in its nature, like that of supplying water and gas to the citizens of cities and towns, do not need extended discussion. So far as the arrangement of their finances is concerned, it should not depart greatly from the principles already laid down for the formation of manufacturing companies. Into the matter of gov- ernmental ownership it is not purposed to enter here ; but regarded from the financial point of view the amount of bonded indebtedness should not exceed the safe value of the property conservatively estimated. Gas and water companies do not indeed often offend in these particulars, since in successful cases the shares have so increased in value as to leave no doubt of the conservatism of the original financial plan. The investor should look into the probability of losses by reason of a change in policy on the part of the com- munity, or because of the beginning of the enterprise on a scale of expenditure not warranted by the prob- abilities. Yet water and gas are modern necessaries of life, and the supplying of these necessaries, when done by private companies under a conservative plan, is a proper and safe business for the investment of money. Another form of industrial enterprise destined to assume an important position in investment finance, is that of supplying street transportation to the inhabit- ants of cities and towns. The rapid growth in the use of electrical power has carried the matter of surface railways in and between cities and villages to a posi- tion of great importance. As forming the basis for the 28 Corporation Finance. investment of capital there can be nothing better than the street traffic of our cities. Experience has demon- strated that such traffic is even more constant and stable than that of steam railroads, and is capable of yet greater development, as surface car lines are ex- tended to meet the demands of a spreading population and as travel increases in proportion as the facilities of easy and rapid transit are increased. But while the safety of street travel as a basis for the investment of capital cannot be disputed, there may remain questions about the values of the bonds and shares of individual street railway companies for whose settlement further time is required. Some six or eight years ago the motive power of street lines was the horse; but electricity, it was soon found, upset all the old calculations of receipts and expenses. The capitalization of the company was increased by the cost of the new power but so was the volume of travel, so that great profits were shown to have been earned. The demand for electric equipment led to its manu- facture in such quantities and under such uniformity of detail that the prices of new motors and the like fell to one half the old figures. Study and experience found ways of keeping rolling stock and motors in repair at a cost formerly believed impossible ; and meanwhile the traffic receipts continued to increase steadily and regularly as the public came to realize the improvements in street conveyance and to take increasing advantage of them. In the cases of companies freshly established and operating in large cities, it may be assumed, for the pur- poses of a rough calculation, that the roadbed will re- Forms of Corporate Enterprise 29 quire a complete renewal in ten or twelve years, the overhead construction (if the trolley is used) within fif- teen years, the electric station and buildings in from twenty-five to fifty years, the car bodies in twelve or fifteen years, and the motor trucks in ten or twelve years, with the steam machinery in fifteen years. These averages of life should, of course, be extended in cases where circumstances would make such a test too severe, as, for instance, in interurban lines using the turnpikes. When, however, fair averages can be ob- tained and the cost of such renewals estimated, it will be possible for those interested in a new road to make a hypothetical calculation of the average annual earn- ings for the future, leaving the expected increase in traffic as an offset to any possible error in the calcu- lation. We are now accumulating a mass of experiences and figures about street railway companies which will place the bonds and shares of those companies on as sure a basis as those of steam railroads and as fully entitled to the good opinion of the investing public. Meanwhile, an approximate result can be obtained by any one who will take the time and trouble to make a thorough analysis of the condition and circumstances in any particular case. A matter to be considered also is the life of the char- ters of the street companies and the rights to the use of the highway. Generally speaking, the American public are not disposed to be unfair, and a practical seizure of street railway property by a forfeiture of the charter or by a refusal to renew the same without com- pensation is not to be expected. On the other hand, it is often a matter of importance how far the company 30 Corporation Finance is protected against competition perhaps on adjoining streets. It is well also to examine the provisions of the charter to see whether they contain requirements which may prove onerous in the future. Throughout this book the form of corporation dis- cussed is that of the company whose capitalization rests directly upon the property, and whose shares are owned by individuals. There is, however, a company of an- other sort formed under the laws of certain States, par- ticularly New Jersey, which permit corporations to hold the shares of other corporations. In such instances the company does not itself hold property or manage a busi- ness, but issues its bonds or shares upon the bonds or shares of other and operating companies held in its treasury; it is, in short, a corporation of corporations. In certain lines of business such financing companies are the logical result of the movement toward consolid- ation, of which the simple company was the first out- come. In some cases no other method of concentration seems possible. Perhaps the production of some article requires that the various processes shall be conducted in as many different States whose laws demand that the business within that State shall be conducted by a com- pany incorporated by that State. If all these sub- sidiary companies are to work in harmony there must be some method of uniform management, brought about most easily by a common ownership of the differ- ent shares. Economically speaking, such financing companies are to be judged by their results, precisely as in the case of simple corporations. Companies are sometimes formed to hold the shares of other companies, principally to prevent competition and to stop the reduction in prices that perhaps previ- ously to such common ownership was bringing disaster Forms of Corporate Enterprise % i upon all concerned. Financial insolvency is a thing to be dreaded for its own sake ; and when it would ap- parently lead to no better conditions than before, it con- fers no benefit upon the community. Such companies are, as before, judged by their ultimate results, society at large being adverse to such combinations only as they may prevent genuine progress through the forma- tion of still larger single companies able to reduce costs to themselves and prices to the consumer. Such com- binations are sometimes made through Trust agree- ments, which purport to give to the old proprietors in lieu of their old title, a trustee's certificate stating that they are entitled to such a proportion in the equity of all the combined businesses as their original property bore to the whole, these various values being previ- ously fixed by negotiations^ between those concerned. The public at large are hostile to such Trusts, believing them to be secret agreements in restraint of trade and against the interests of the community. Moreover, they appear to be unnecessary, since all the essential advantages of a Trust can be secured under the form of a lawful corporation either simple or compound. Where the properties sought to be combined have been owned by firms or individuals, it has often been found expedient to transfer the title of such properties, perhaps lying in different States, directly to the com- bining company in return for the issue of bonds and shares of the new company in agreed proportions. In such cases the possible advantages are that it may give to the new company the knowledge and skill possessed in different degrees and about different parts of the pro- cess by the old proprietors, for common use ; that it may prevent frauds in weight and quality which the previous extreme competition may have brought about ; 32 Corporation Finance and that it may allow a concentration of buying and selling at the least expense and with better results. If a reasonable share of these advantages is given to the public in one form or another, the new company has a strong argument for its existence. As to the finances of such huge corporations, or of companies holding the shares of other companies, they do not differ in principle from the rules already quoted regarding simple corporations. The bonds issued (in- cluding the underlying liens, if any) should not exceed in amount the minimum worth of the property, and the shares should fairly represent the fluctuating values remaining. The bonds and shares of such great com- bining corporations, generally speaking, are not quoted on the exchanges at as high a range as those of rail- ways. This may be due partly to the fact that the business of the company may be, from the nature of the case, highly speculative in character, and therefore uncertain as to results in any particular year ; or its affairs may be in the hands of men perhaps experienced in that particular line of business, but who have not yet acquired a reputation with the investing public ; or perhaps there may be on its board of directors or among its officers no one in whom capitalists have confidence as experienced in financial management, for the depart- ment of the finances in corporation affairs requires special care and ability just as does the manufacturing or trading. Time will be required to bring about a settled public opinion as to the degree of value which can safely be put upon the businesses of huge industrial combinations or corporations. CHAPTER III RAILWAY BONDS WHEN the owner of a dwelling-house executes a mortgage upon his property up to a certain percentage of its assumed value, the transaction, so far as the financiering is concerned, is not different in theory from similar transactions when entered into on a larger scale by corporations. The lender of the money first inquires into the safety of his loan. He does not wish to become in effect a partner with the mortgageor by making himself dependent even to a small extent upon the success of the borrower in busi- ness. He loans the borrower a sum of money equal to one half or two thirds of the appraised value of the dwelling-house, considering this proportion of that value as secure even under a forced sale. Practically, therefore, the mortgageor, as in the case of corporations, borrows money at a comparatively low rate of interest upon the minimum value of his property. If the sum asked for is in excess of these percentages of the value the loan is refused, or if accepted is taken at a corre- spondingly high rate of interest, thus violating the principle of debt financiering already discussed. Mortgages upon dwelling-houses differ, however, in some important points from the debts due by corpora- tions. The lender of money upon ordinary real estate does not rely for security upon the success of the bor- 3 33 34 Corporation Finance rower in business, — that has already been stated ; but neither does the lender rely upon the profitableness of the profession or trade in which the mortgageor is engaged. The reliance is rather upon the business success of all citizens, with allowances, of course, for advances or reductions in values of real estate which may come from the shiftings of population or the caprices of fashion. If the mortgageor should be unable to pay the interest on his mortgage when due, and the property should be offered for sale under foreclosure proceedings, any man in any line of business may become the purchaser. In short, the property and its value is not dependent upon any one man or any one trade, but upon the prosperity of the whole community. This is not generally the case with large corpora- tions. The railway lines in the United States, for example, vary in capitalization from $15,000 to $200,000 per mile, with an average of about $50,000. They are bonded for an average of $32,000 per mile. Railway lines are expensive to construct. A roadbed must be built up and made fit to bear the running of trains ; the erection of costly bridges and other works must be undertaken ; rails and ties must be bought, so that the railroad properties as they exist to-day could not be duplicated for the amount of their bonded debt ; yet if the trains were to stop running, the rails and ties would be worthless except for old iron and wood, while the right of way could be sold to the neighboring fanners only at a low valuation per acre. The whole property of a railroad company, considered simply as real estate and old material, is worth but a small fraction of the amount for which it is mortgaged. The creditors of the company depend for the security of their money not upon the property considered as such, but upon the Railway Bonds 35 business for which the company was organized ; that is, upon the transportation of passengers and goods. If that transportation yields a profit, the bonds are safe, other- wise not. The bondholders cannot, as in the case of a dwelling-house, hope to sell the property to any com- panies except those engaged in transportation. The American law and the wording of American railway mortgages state the lien to be upon the property ; but, commercially speaking, this is not correct ; the mort- gage is really upon the company's revenues. But rail- way trains must continue to be run. Not only is there a public duty involved which forbids the State to allow the stoppage of railway working except in extreme cases, but, since the value of the bonds depends upon income, the operations which produce that income must be continued even though the result be in part unfavorable ; otherwise the loss would be total. But since railways must be worked, the expenses of work- ing must be paid. Sufficient material and supplies must be bought, the claims of employees for wages must be met, and everything reasonably necessary for the proper Operation of the railway must be paid from current revenues. It is seen, therefore, that the lien of a railway bond is finally shifted from the real estate to the gross earnings and then to the net earnings of the company. The statement that the real lien of a railway bond is upon the commercial success of the company as a carrier of traffic explains some of the anomalies of corporation practice. The railway mortgage repeats in the strong- est legal phrases the supposed fact that, if interest or principal is not paid when due, or if any other pro- vision is not complied with, then the mortgage shall be foreclosed and the property sold to the highest bidder. 36 Corporation Finance This is a legal fiction. Although the terms are the same in railway mortgages as in those on dwelling- houses, the commercial facts just mentioned forbid compliance with them. In the great majority of cases the selling of a railway at forced sale, even to another company, is out of the question except as the result of reorganization. Partly to give the appearance of living up to the terms of the mortgage and partly to prevent those terms from being literally carried out, the courts appoint receivers for railway properties in bankruptcy or about to become so. Out of this contradiction between the too strong language of our railway mort- gages and the commercial facts which control, has arisen the American custom of appointing railway receivers, a custom which is in the course of evolution, both as to the law and as to the practice under that law. The English "debenture" expresses the real situation more clearly than the American bond. The former by its language limits its lien to the earning capacity of the company, though the real liens are the same in both cases. Probably the American custom of putting into the railway mortgage terms which are stronger than the commercial facts warrant was due to the feeling, at one time prevalent, that the granting by the company of a number of legal rights (such as fore- closure) supposed to be absolute, added to the value of the security. Something of this feeling remains with us yet, for in the United States the debenture bond, except when issued by companies of unusual credit, like the New York Central, is not classed as high as bonds drawn in the American fashion. The principal use of the right of foreclosure in rail- way bonds is to convey title to a reorganization com- mittee in case of insolvency. The courts are always Railway Bonds 37 careful to insist upon the carrying out of the forms aqd remedies provided for in the mortgage, when cases of this sort are brought before them. Yet so well under- stood is the real situation that the same courts will ask the creditors of a bankrupt company to be speedy in coming to some agreement in order that the receivers may be discharged ; implying that the receivers are operating the property in order to keep the road run- ning and to prevent disintegration of the system as a temporary expedient, until some readjustment of the obligations can be made ; and such indeed is the actual practice. The Richmond and West Point Terminal Railway and Warehouse Company, a financing corporat- ion formed to control other companies, became bankrupt in 1892. An elaborate plan of reorganization embrac- ing the subsidiary companies was promulgated in 1894 under the name of the Southern Railway Company. To bring the different properties under one company, foreclosure proceedings were begun and carried out against the Richmond and Danville Railroad Company, under its consolidated mortgage of 1886, and against the East Tennessee, Virginia and Georgia Railway Com- pany, under its equipment and improvement mortgage of 1888 and its general mortgage of 1890. Those and other properties embraced under the West Point Com- pany were, under these foreclosures, bid in by the Southern Railway Company, subject to underlying liens. Exchange of bonds and shares of these fore- closed companies for those of the new company were proceeded with according to the plan of reorganization, the suits for foreclosure being carried out without oppo- sition to transfer the title. But since railways fill so large a part in our modern industrial life and since we can safely say that there 38 Corporation Finance must be carriers of traffic so long as civilization en- dures, it is apparent that that traffic can be made the security for the borrowing of money as safely and legitimately as can a dwelling-house ; provided always that those rules of financiering are observed which require only that the minimum value of the property be represented by such funded debts. The investor, therefore, need not fear to put his money into railway bonds or debentures because of the commercial condi- tions under which railways are operated ; but those commercial conditions require that he should, if he seek safety for his investment, consider the bearing of these facts upon the particular road in which he is interested. If the earning capacity of that company becomes for any reason impaired, the strong legal lan- guage of the mortgage will not save the holder of the company's bonds from loss. In the end he must accept as a basis for revaluation of his securities the earning power of the company as a carrier of traffic. When money is loaned upon a dwelling-house the mortgage is made to cover the real estate as security, the bond which usually accompanies the mortgage being a contract under which the mortgagor pledges all his property for the repayment of the loan. The terms have a slightly different meaning, however, when applied to corporations. The mortgage is the indenture issued by the company to trustees who may be trust companies or individuals. The preference for trust companies as trustees under these mortgages arises from the fact that their existence is continuous, that they have all the machinery for properly execut- ing large transactions, and because their names are known to all investors. The mortgage made to trustees contains the terms Railway Bonds 39 under which the money is borrowed. Under this mort- gage and governed by its terms the Company issues bonds of the denomination stated in the instrument, usually $1000, which bonds may be registered with the interest payable by check, or may be coupon bonds accompanied with sheets of coupons that when cut off on the respective interest dates are payable to bearer as drafts upon the company and so easily collectible. The one form of bond or the other is preferred accord- ing as the holder wishes to make a permanent invest- ment secured against theft or destruction, though the sale of a registered bond is a matter requiring some little time and trouble — or prefers a form which, in the language of Wall Street, is a "good delivery" for instant sale at any time. The railway mortgage usually begins by giving the name of the company with the particulars of its incor- poration ; then follows an exhaustive list of the prop- erty to be mortgaged. If there are prior liens upon the property or on any part of it, these exceptions are stated. Then the amount for which the mortgage is to be issued is stated, and the purposes for which the money is to be used should be given in detajt,\ Then may be stated the procedure under which the trustee is allowed to certify bonds for sale to the public. The object of appointing a trustee is to see tha|; the legal formalities embodied in the mortgage; are strictly car- ' ried out, and that there is no over-issue. The mort- gage often contains a provision exempting the trustee from all liability under any circumstande/3. Sometime^, the bonds are to be certified by the trustee, froln/^ime to time merely on the resolution of the Board 1 of Direct- ors ; but the more modern mortgages deny this power of issue until certain forms are observed. For instance, 40 Corporation Finance in the case of bonds on a road under construction it is often provided that no new bond shall be issued until a certificate is filed with the trustee, signed by the president and chief engineer, certifying that the stated number of miles of road have been completed and turned over to the operating department. In cases where there are existing underlying liens it is sometimes provided in the mortgage that these underlying bonds shall be paid off as they mature and not extended ; this is done in order to insure to the issuing bonds a first lien at the maturity of the under- lying mortgages. In late mortgages, some sections relating to reorganization in case of insolvency have been inserted. The sections referring to the foreclosure of the mortgage are usually very carefully considered. A common arrangement is that in case of non-payment of interest, when such a default continues for six months, at the request of a certain small proportion of the bondholders, the trustee may begin foreclosure pro- ceedings or enter upon the possession of the property ; or in case of a demand by a considerable percentage of the bondholders, shall do so. In that way practical control of the foreclosure proceedings is given to a cer- tain proportion of the holders of the bonds outstanding. A few of the, older mortgages give this power of control- ling foreclosures to a small proportion (the old general mortgage of the Philadelphia and Reading granted the privilege to , ten per cent, of the outstanding bonds), but the later mortgages require a larger percentage. .Another interesting feature in modern mortgages, inserted because of certain experience in that direction, allows the trustees under certain circumstances to with- draw the proceedings for foreclosure, if such have been begun, where a more favorable outcome would be had Railway Bonds 41 by compromise, or where a technical default should not allow the company to pay off an established and secure mortgage not yet due, for the sake of refunding the loan, in that compulsory fashion, at a lower rate of interest. It is also well to give to the majority of the bonds outstanding — say three fourths — the power to direct a trustee to buy in the property at foreclosure in accordance with any plan or reorganization which may be adopted, and also under certain circumstances to authorize the creation of new mortgages prior to the one under consideration. These latter features are in the mortgage of the Southern Railway Company. Since the provisions of the mortgage govern the whole transaction, and since a mistake here may have disas- trous consequences, it is the usual custom to employ good corporation lawyers, so that the terms of the mortgage may be formulated in strict accordance with the equities of the case. On the one side the stock- holders, as well as the company itself, desire that the conditions of the mortgage shall be as little onerous as possible; on the other hand, the lenders wish the mort- gage drawn so as to give them the best security. Just where the line of compromise shall fall depends to a certain extent upon the reputation of the company and its general credit. On the other hand, where pro- visions of the mortgage are too loosely drawn, they may defeat their own purpose in not allowing money to be borrowed by the corporation at the most favor- able rates and under the most favorable conditions. Mortgages are divided into classes and called by various names according as their claim upon the prop- erty is direct or indirect. Prior lien bonds need no particular discussion. Our present railway systems have been formed in most cases out of a number of 42 Corporation Finance existing roads. In a great many instances these older and smaller companies have issued bonds which are necessarily the first mortgage upon their respective portions. These senior bonds, as they are sometimes called, may be liens upon old roads which are now parts of the new main line and worth many times the original mortgage. Such underlying bonds, having been issued years ago, often bear six per cent, or seven per cent, interest, and being considered thoroughly secure, sell on the exchanges at such prices as yield the investor but a small return. Upon the system as a whole there may be a first mortgage, so called because it is the first mortgage of the consolidated company, although the prior lien bonds just mentioned of course take precedence of it. After the first mortgage other bonds may come. A form of bond which was at one time popular but afterwards fell into partial disrepute, is the income or preference bond. The bond is so called because it attempts to combine the lien of a mort- gage with contingency of interest. The mortgage in due form declares the principal to be a claim upon the property, but follows this statement with another, that no interest shall, be paid unless it has been earned. In most cases the question whether there shall be any net earnings applicable to this interest in any given year is left absolutely to the discretion of the Board of Direct- ors. A fatal objection to the income or preference bond is that it is an attempt to combine two contra- dictory commercial principles. As we have already seen, the lender of money to a corporation does not wish to participate either in the profits or the losses arising from the success or failure of the company, but simply intends to loan his money on what he thinks is sufficient security, so that he may receive the interest Railway Bonds 43 on the same and the principal when due. To the stockholders who manage the company are left the profits or losses over and above this charge upon the minimum value of the property, whichever these may be. It will be noticed that security for both interest and principal is the essence of the creditor's position, while contingency depending upon success is the essence of the stockholder's position. We might, therefore, expect that a so-called bond which attempts to combine security with contingency would prove dis- appointing to all concerned, and so it has turned out. In some cases income bonds have been given to old security holders in part payment for sacrifices which they were asked to make because of former insolvency. In such cases it would have been better had these old holders accepted their changed position from creditors to partners and received preferred stock for their de- ferred claims. The income bonds of the Atchison, Topeka and Santa Fe, issued after the reorganization of 1889, and the preference bonds of the Philadelphia and Reading, issued after the reorganization of 1886, are instances of snch bonds. A practical objection often raised to income bonds by British and German holders of such bonds, is that the Board of Directors represent- ing the shareholders may in years of good earnings put into the property the surplus revenues which might have gone toward paying interest on the income bonds, and continue such a policy until such time as the earn- ings of the company justify paying interest to the income holders and at the same time a dividend on stock. Against such appropriation of the earnings, when equitably due to them, the income holders have usually no remedy. Sometimes the power of voting has been given to such bonds in order to guard against 44 Corporation Finance such a possible abuse ; but preferred stock is a bettei thing to issue and to hold under these circumstances than the miscalled income bond. In our corporation history there have been instances of preference bonds, like those of the Philadelphia and Reading, with the definition of net earnings applicable to their payment drawn in the mortgage of 1888 in such severe terms that there seemed no loophole of escape. Nevertheless charges have in such cases been ingeniously put ahead of such bonds. It may happen, too, that the very severity of the language which is in- tended to compel the payment to the preferred holder of all earnings over and above certain specified and fixed charges, by defeating other borrowings or by depriving the company of improvement moneys, may so embarrass the managers of the company as to cause the preference bonds themselves to fall in value. Another form of corporation borrowing of which we have seen instances in late years, is that of collateral bonds or trust notes. Collateral bonds are obligations issued by a company with a lien upon the real estate junior to that of other mortgages. To give these col- lateral bonds value in the eyes of investors they are made a first lien upon various bonds and stocks, usu- ally of auxiliary companies, which are taken from the treasury of the system and deposited with some trust company as trustee under the terms of the collateral mortgage. As the name implies, such a mortgage is really a borrowing upon the collateral owned by the company, and differs from the borrowing of money from the banks through the hypothecation of the securities in the company's treasury, only by arranging for a loan for a term of years and at a fixed rate under certain specified conditions Railway Bonds 45 A large system which has been formed by the con- solidation from time to time with it of various other and smaller corporations usually finds that it has collected in its treasury a considerable number of bonds or shares which represent to it its investments for control. These bonds or shares are those of railroad companies whose corporate existence may still be kept up, but which form nevertheless an integral part of the present system ; or they may be the bonds or shares of ter- minal companies, or warehouse or elevator companies, or of some water transportation company which pro- vides by river or lake an important connection with the present company ; or, of companies which furnish much traffic to the railroads, and whose securities were bought in order that that traffic may be held for the system beyond a doubt. In all these cases it is assumed that the continuance of the control of the parent company over the various enterprises whose bonds and shares it holds is necessary to the preserva- tion of the system and to the securing to the system of the traffic represented. To pledge these various shares and bonds for a new loan is regarded as legitimate financiering because it grants to the holders of the col- Lateral bonds a claim upon the assets of the company, a claim which often in effect, though not in name, is equal to that of regular mortgage bonds. An illustration of such mortgages by a strong com- pany is that of the four per cent, extension bonds of the Chicago and Northwestern Railway Company, issued in 1886, upon the bonds of the branch road, the Fre- mont, Elkhorn, and Missouri Valley, deposited with the trustee as collateral. In like manner the Illinois Cen- tral Railroad Company in 1888 issued collateral bonds based upon the deposit with the trustee of various 46 Corporation Finance bonds of subsidiary roads important to the system. The uncertainty of the value of a claim upon collateral in cases of insolvency is illustrated by the history of the collateral trust bonds of the Oregon Short Ivine and Utah Northern Company. This company, under the control of the Union Pacific, purchased more than half the stock of the Oregon Railway and Navigation Com- pany (a connecting road), and, depositing the same with the trustee, issued thereon its collateral trust bonds. Pending the reorganization of the Union Pacific and because of a decline in the earnings of the Oregon Railway and Navigation Company, the value of these collateral trust bonds became but nominal. In 1883 the Wabash, St. I/rais, and Pacific issued $6,000,000 of collateral trust bonds bearing six per cent, interest and sold them to the public at 90. Under the reor- ganization of this company into the Wabash Railroad Company (dating from July, 1889) these collateral trust bonds were exchanged into debenture " B " bonds of the new company, the latter being quoted at less than one third of the price at which the collateral trust bonds were originally issued and sold. The difficulty which experience has found with col- lateral bonds lies in the fluctuating value of the securi- ties pledged under them. The collateral bond held by the public is a mortgage upon certain other mortgages, and if foreclosed by reason of insolvency the purchasers legally come into possession, not of the real estate of the company, but of certain other bonds, which in turn may have to be foreclosed separately, necessitating a large number of distinct actions. The loss is the same whether these separate transactions are actually carried out or an equivalent reduction made in the quoted values of the bonds. Not only is the expense of the Railway Bonds 47 transaction and the ultimate outcome made doubtful by these facts, but in securing the absolute property delays which may occur under these circumstances may cause further losses ; for it is plain that the value of the sub- sidiary properties whose bonds and shares are pledged as collateral may depend, in cases where the mortgag- ing company becomes bankrupt, largely upon the quickness with which they may be seized upon and handled with vigor by their new owners. In a devel- oping country new discoveries in mining may be made, or new centres for trade distribution or manufacturing may be formed, which may change the value to the system of a branch line or auxiliary company so materi- ally and so rapidly, that holders of a funded obligation resting for security upon these subsidiary properties may find their real security slipping away from them while they are yet helpless. For these reasons a collat- eral bond usually ranks in quotations below that of other mortgages of the same company covering specific portions of its property. But while these remarks are true in many cases there are instances, like those of the Chicago and Northwest- ern and Illinois Central, to which they do not practi- cally apply. There are railways which have been in operation for many years and whose traffic not only as to volume but as to source has become well established. Fluctuations in the value of the properties directly owned by such companies are so little likely to occur that collateral bonds issued upon the stocks and bonds of such subsidiary properties are a comparatively safe investment. There is no hard and fast rule for judging of the lien in these cases. Each company and each collateral mortgage must be valued by the merits in each particular case. The general reputation and 4& Corporation Finance credit of the mortgaging company should also be taken into consideration. The objections raised to collateral bonds before spoken of have led to variations in the form intended to meet these difficulties. Such a variation is that of collateral trust notes. I/ike collateral bonds these notes are an obligation of the issuing company and are made a first lien upon certain shares and bonds of properties important to the system, which are given to some trust company to be held as collateral for the notes. With this difference, however, that the mortgage gives the control of the hypothecated bonds and shares to a par- ticular trust company or to a committee of financiers, who have the power to dispose of these hypothecated bonds and shares under circumstances which are care- fully stated in the mortgage. Sometimes authority is given to this committee to sell these hypothecated securities at certain stipulated prices or at their discre- tion, the proceeds of the sale being used to redeem the collateral notes ; or else the committee are empowered to make such sales either of all or of part of the securi- ties as they may deem best, in case of a forfeiture of interest payments by the obligating company. These provisions, with others of the same tenor, are inserted in the collateral trust mortgage in order to do away with the objections of investors and by making the transaction more nearly like the ordinary borrowings of money at the banks, to command a higher price for these notes than would otherwise be obtainable. Exam- ples may be found in the issues of collateral trust notes by the Union Pacific and Northern Pacific Companies in 1891 and 1893. Railway systems which have attained their present magnitude either through the consolidation of parts of Railway Bonds 49 their road at different times or through the amalgama- tion at one time of a number of smaller companies, often find themselves obliged to provide new capital in order to arrange for improvements necessary for hand- ling a larger amount of business, improvements which are required in order to introduce the very economies in operating for which the combination may have been formed. In a developing country like the United States the demand for railway capital, except in periods of depression, is continuous. As traffic grows so must facilities increase. And since it has heretofore been our experience that an increase in the number of pas- sengers and tons of freight is accompanied by a de- crease in the amount received per passenger or per ton, an American road should be considered well managed if the net earnings, legitimately arrived at, increase a little faster than the fixed charges. Such a result, if fairly obtained, proves that the additional capital spent upon the property from year to year has been product- ive. Acknowledging that systems require the expend- iture of money, it often becomes a problem upon what special security this money should be raised. One method is that of issuing "blanket" mortgages, as they are called, a Wall Street term which means merely that the system which already has prior mortgages upon different parts of it, now issues bonds which cover the system as a whole, subject, of course, to the under- lying encumbrances upon the property. In the minds of financial men some of these blanket mortgages do not hold a first-class position ; the feeling against them may be summed up thus : blanket bonds are not first mortgages — a fact which everyone must admit. Yet if it is true that systems must grow, just as parts of the same system increased while inde- 50 Corporation Finance pendent, there is much to be said in justification of obtaining capital by bonding the system as a whole. The majority of the things needed by the system are such as are chargeable upon the separate parts only proportionately. Equipment which is bought for the benefit of the system should not be paid for by the fur- ther issue of divisional bonds, even where such addi- tional issues are provided for in the divisional mortgage. So, too, bonds sold for the acquisition of freight yards are intended to facilitate the handling of traffic over the whole system. In the approaching days when the use of air-brakes for freight trains and of one pattern of freight-car coupler will increase the number of trains which may be moved rapidly and safely over any par- ticular piece of road, the capacity of the terminals rather than that of the track will even more than at present prove the standard by which the limit to the volume of traffic will be measured. It would be unjust under these present or supposed future circumstances to charge the cost of such terminals to that part of the whole system upon which they may happen to be located. There is no way of meeting these demands so equitably as by the issue of system bonds for system improvements. Blanket mortgages have been issued by the Chicago, Milwaukee, and St. Paul and the I/mis- ville, and Nashville Railway Companies, among others. If these blanket mortgages are carefully drawn with provisions compelling the retirement of the prior liens as such mature, they will in time become first mort- gages themselves. Some modern blanket mortgages also contain sections limiting the amount of bonds which may be issued for improvement in any one year, the intention being to prevent the forcing upon the market of such an issue of bonds as to cause a decline Railway Bonds 5 1 in price, and also to check a yearly issue in excess of reasonable requirements. An example of such a guarded mortgage covering an issue of blanket or sys- tem bonds is that of the Cleveland, Cincinnati, Chi- cago, and St. I/Ouis general mortgage of 1893. If corporations become insolvent it is expected that such blanket or general bonds will be the first to be seriously affected. The Wabash, St. I,ouis, and Pacific Company in 1880 issued and sold $16,000,000 of its six per cent. " general " or system bonds at 95. Be- coming bankrupt, a new corporation, the Wabash Rail- road Company, was formed in 1889. The general bonds of the old company were converted into deben- ture "B" bonds of the new company, these being quoted at less than one third of the price at which the generals were originally sold. There is no doubt that blanket mortgages may lend themselves to over-colored notions of future possible traffic sometimes held by optimistic managers. The ease with which such bonds may be issued to the large amounts for which the mortgages are made sometimes proves too tempting to railway officers who, through good motives or bad, venture upon extravagant calcu- lations of the growth in business for the future. In such cases blanket bonds are not regarded much more highly than would be the same amount of preferred stock. While this, however, is a danger, it is not a good argument against system bonds when legitimately issued. Blanket bonds should be judged, therefore, by that principle in general debt financiering which requires the amount of borrowed money to be well within the minimum value of the property. When this requirement is kept in view, and when the company has been operating its lines of railway long enough to 52 Corporation Finance allow a fair estimate as to the stability of the traffic, the issue of blanket or system bonds is proper and safe. One form of railway mortgages differing somewhat from those which have just been considered, is that of terminal bonds. Mortgages upon terminal properties which are indispensable to the successful operation of railways are generally well regarded by investors. Proper terminals are more and more essential to our railways as the commercial development of the country proceeds. Passenger stations in important cities, with the land necessary for approaching tracks, are neces- sary if a company is to continue in business and not to yield its traffic to some rival ; and mortgages upon such properties are well thought of. Mortgages upon some railway terminals at Chicago and New York are exam- ples. There are other terminal bonds, however, which cover cases not precisely similar to the one just men- tioned. Terminal properties which are used or may be used by two, three, or more railroads sometimes depend for their immediate value upon the question whether their facilities are, or in the near future can be, fully utilized ; or whether one or more of the occupying companies may not transfer their favors to some other terminal property more accessible to their lines. These inquiries embrace also another set of facts ; whether the properties covered by the mortgage under consid- eration are the best that can be had and whether they are therefore from that point of view also sure of con- tinued occupancy. The case of the Chicago and North- ern Pacific Company is an illustration. This company acquired lands, tracks, and other terminal properties in the city of Chicago, and in 1890 authorized an issue of $30,000,000 five per cent, bonds. It was admitted that the properties covered by the mortgage were of great Railway Bonds 53 value of themselves, but because of lack of tenants fully to utilize their facilities, on the appointment of receivers for the Northern Pacific and Wisconsin Central Com- panies in 1893 (companies which had practically guar- anteed bond interest), the Chicago and Northern Pacific was likewise placed in the hands of receivers, its bonds falling in price to one half their former quotations. In other cases railway companies have themselves issued terminal bonds which they make a first lien on certain specific terminal properties of their own. In such instances the value of the grounds and buildings in cities must be judged according to the hints already given. If such bonds, however, cover terminals in towns or villages remote from cities or away from places which from the traffic point of view may be called strategic, the question may arise whether the land thus set apart for country terminals has any special value for railroad purposes. If the company could easily put down elsewhere tracks and buildings suitable for their purpose, then their so-called terminal bonds are dependent for their value not so much on the property mortgaged as upon the general success of the company as a carrier of traffic. Some of the older of our railway mortgages provide for a sinking fund. The sections relating to such funds usually provide that a certain sum shall be set apart annually and paid to the mortgage trustees. These sums are to be invested in the company's bonds of the issue to be thus retired, either by purchase in the open market or more commonly at a price fixed in the mort- gage, the particular bonds required being drawn by lot and the result advertised in the daily papers. The bonds thus chosen cease drawing public interest. It is usually also provided in such cases that the bonds pur- 54 Corporation Finance chased by lot shall not be cancelled but remain alive (that is, remain in all their original force against the company) in the hands of the mortgage trustee, the interest on them being added to the sinking fund and used in the purchase of further outstanding bonds. By this method it is not difficult to calculate the exact annual payments by the company which will be neces- sary in order that the mortgage trustee at the maturity of the mortgage may have on hand the amount of money required to pay all interest and principal and thus cancel the whole issue. It is sometimes provided that the money contributed by the company to form a sinking fund may be used to purchase other bonds of the same system in case the bonds in question cannot be had at a named price ; or perhaps the whole matter is left to the discretion of the trustee or of the company's directors. It usually hap- pens that the quotations of such sinking-fund bonds are higher than the purchase price named in the sinking- fund sections of the mortgage, and hence the invest- ment of the fund in other securities is necessary. The course followed in such cases is to buy such other bonds, perhaps of subsidiary roads, as will indeed make up the par value required at maturity, but whose value depends upon the fact that they are obligations of the selfsame system. Such bonds — or indeed any bonds other than the issues originally intended to be extinguished by the sinking fund — could not be sold to the public without increasing the interest charges pay- able to the public by the amount of the interest on the old bonds. In this way the owners of the old bonds indeed receive their principal and interest, but the fixed charges of the system are not in any wise reduced by the transaction. Sometimes it is thought desirable for Railway Bonds 55 the company to take over into the treasury all these securities held in the funds, the maturing issues being meanwhile met by sales of other bonds of the same company which bear a lower rate of interest or are part of a larger mortgage and already sure of a market. In such cases the labor of keeping up the sinking fund is thrown away, because usually the exchange of the new bond for the old could have been easily accomplished without that machinery. When railway companies are in good credit, or when the mortgage containing sinking-fund clauses covers property conceded to be worth more than the bonds, the establishment of such funds is a financial mistake. If the bonds are to be compulsorily retired so many each year by lot at say 1 10 per cent, of their par value, that fact immediately decreases their value as invest- ments. No investor likes to buy bonds which, how- ever good or whatever the premium he may have paid for them, he may have to give up a short time after purchasing. If a bond is really good, the longer the time it has to run the better the bond-buyers like it. Another practical objection is that no one wishes to be on the lookout for advertisements which he may or may not chance to see, but which are legal notices binding on the bondholder that interest on the bonds named by their numbers ceases on a certain date. On the other hand, the companies would rightly object to a sinking-fund system which should require them to contribute certain sums yearly to be used in buying that particular issue of bonds in the open mar- ket. Such a provision would soon create an artificial scarcity in those bonds so that the price quotations would be above the normal. To purchase at a high 56 Corporation Finance premium bonds which at maturity the company could pay at par would be poor financiering, and a use of the current revenues of the company to which the share- holders could properly object. The form of sinking fund which allows of the investment of the funds in securities other than those intended to be retired, is of little practical value to the bondholders in question. Their mortgage is upon a certain piece of property, and that is still their main hope. It usually happens that the securities purchased by such a fund are those of the same system, and thus at maturity it is often found that to pay off one obligation there is nothing in the fund but another obligation of the same company ; and if the first is not itself good, the other is not likely to be worth much. Investments of sinking funds in bonds of other enterprises are not favored for obvious reasons, while purchases of such undoubted securities as govern- ment bonds at high premiums would cost the company and the bond- and shareholders more than the accruing benefits. For these reasons, sinking-fund requirements have been left out of most of our modern railway mort- gages. As to companies in poor credit, whose bonds rule very low in price, there is not much to be said. Corporation financiering requires that debts shall be only of such a proportion to the real value as will bring the highest returns to the company with the lowest rate of interest. Sinking funds do not need discussion where different conditions prevail. As such funds can be accumulated from but one source — the revenues of the company, and as under our present supposition, those reserves are not enough to sustain the bond credit, it is practically useless to rely upon them for the formation of any such thing as a sinking fund. Com- panies in distress will always use current revenues to Railway Bonds 57 pay pressing needs regardless of sinking-fund clauses in their mortgages. Since under practical conditions sinking funds in the mortgages of railways having good credit are not favored, we may next inquire as to the public aspect of the matter. In national finance it is now understood that sinking funds for the payment of government bonds can be established only from governmental rev- enues ; in short, from taxes. If, therefore, it be the opinion that the government should not remain always in debt, but arrange to pay off its borrowings by de- grees, the funds must be supplied from taxes. The government is not in business and has no business rev- enues. But corporations which, so far as we now see, must continue to earn money through their services to the public indefinitely, occupy a different place. The rules covering public debt financiering do not now apply. Rather do we see the opposite, where borrow- ing is not only a necessity, but often the only road to success. The revenues of such corporations do not come from taxes, but from moneys given to them in return for services rendered in a business way to those concerned. Such services must in some form be con- tinuous, and the benefits paid for continuously on a business basis. Moreover, through competition or in other ways, the profits of such companies tend toward smaller margins, these being usually only enough to pay a fair return to the capital invested. Since the only way to pay off debts is from revenue, it follows that the retirement of bonds at maturity by cash pay- ment (except, of course, through the sale of other bonds) could be effected only by increasing the revenues through advancement of the prices charged to passen- gers and shippers, or by the shareholders (or perhaps 58 Corporation Finance the bondholders themselves) foregoing their returns for years. As a practical matter either way is unadvisable or impossible. Unlike taxes, rates or prices could not be advanced so largely as to pay off bonded debts. Railway charges, for example, could not be increased to that extent in the face of an adverse public opinion. On the other hand, to stop dividends for such a pur- chase would prove equally unpopular, and would also result in a decay of public progress in our industries ; for no one would undertake a new enterprise if he were not permitted to reap the annual fruits of his ability and labor. For these reasons the payment of corporation debts from corporation revenues is, generally speaking, im- possible in practice. Hence it is assumed — by large railway systems, for illustration — that when an existing mortgage matures the company will be able to borrow new money to pay off the old, and perhaps at a lower rate of interest. Sinking funds for such a purpose are unnecessary, though, as a matter of formal obligation, they may be kept up by companies in good credit, like the Chicago, Burlington, and Quincy or Chicago and Northwestern. But reference has been made to corpo- rations which it is assumed will go on doing a stable business indefinitely. Other companies may be subject to extreme fluctuations in profits, or, like mining cor- porations, may have a certain number of years to run when their business opportunities will be exhausted. In such cases sinking funds fulfil a proper purpose — that of guarding the interests of the mortgagees, and should be insisted upon ; such funds may be established either by way of deposit with trustees of moneys to purchase bonds or be held in trust, or by writing off the values of the plant before paying dividends and holding Railway Bonds 59 such moneys in a sort of depreciation account, or by a combination of both methods. There is no real con- fusion between indefinite and short-lived companies, for by a commercial law the short-lived corporation may retain a rate of profit on its transactions high enough, if well managed, for all sinking-fund purposes, and higher than anything which the stable corporation may hope to gain. A business which bears no evidence of stability and endurance, or whose life, if it is to be short, cannot be calculated and provided for, should not become incorporated. The partnership form is best adapted to enterprises which are largely speculative in character. In order to draw capital from all sources, corporation mortgages are made to trustees who certify to certain bonds of small denominations. In this way the bor- rowings of corporations, amounting in some cases to more than a hundred million dollars at a time, are divided into small sums within the reach of the humble investor. Of late years the trust companies in the Eastern cities have been selected as trustees instead of individuals whenever the law of the State where the property was situated allowed of such selection. Trust companies have manifold advantages over individuals in such a relationship ; they do not die ; the large amount of financial business which they daily transact provides them with the machinery for such purposes ; while their well-known names stand as evidence to the purchasing public that at least the necessary formal- ities have been complied with. Beyond that responsi- bility the trustees of corporation mortgages usually assume none. In recent years the trust companies have shown a tendency, when acting as mortgage trustees, to recog- 60 Corporation Finance nize a greater moral responsibility than they at first were willing to bear. Trust companies did not, of course, intend to appear as in any way guaranteeing the bonds to which they certified, though that seems often to have been the erroneous opinion of the un- thinking ; but trustees now acknowledge themselves bound within the limits of the mortgage to use their influence to protect the interests of the bondholders. A trust company which should now allow the issue of unsecured bonds because of some glaring defect in the language of the mortgage, would no longer be morally excused by financial opinion, though perhaps held technically innocent. One way in which this sentiment attributing some sort of ethical responsibility to trustees of corporation mortgages manifests itself is through slight alterations in the wording of the mortgage itself. The old lan- guage was that the trustee was to be held harmless under all circumstances. Now the trustee is often found willing to assume responsibility at least for gross negligence or for the negligence of servants or clerks not carefully selected. If to some such phrases be added a more careful drawing of the mortgage as to its provisions against unauthorized issues of bonds, a bet- ter compliance with the ethics of the situation would be had ; for it is undeniable that a part of the public com- plaint against the fraudulent issue of bonds should be directed against the inadequate safeguards imposed in the mortgage rather than against the trustee. As an example of what is meant may be taken a mortgage which we will say may be issued for the purpose of improving a railroad, though the proceeds of the bond when sold may be devoted toward an entirely different object, one, we will say, tainted with Railway Bonds 6 1 fraud. Such a fraudulent misuse of company borrow- ings would be checked at the outset if the mortgage had contained sections limiting the amount of money which should be expended in any one year, and pro- viding that the trustees should not certify to any of the bonds until a certificate had been filed with the trust company, signed by the chief engineer, stating that a certain amount of work had been done or a certain number of miles of new road or new track con- structed. This statement of the chief engineer could have been accompanied by an affidavit, signed by the president and treasurer of the company, to the effect that the allegations of the chief engineer were true. Provisions of this character, varied according to the circumstances of each case, but to the same intent, should be inserted in every mortgage which contem- plates the spending of new money for corporation uses. Restrictions such as these would protect the trustee ; while at the same time rendering the officers clearly responsible to the public and to the law for any lapse of corporation duty as to any issue of bonds whenever a fraudulent or unauthorized use of the money was thus guarded against. The two ideas of better care on the part of the trustees of corporation mortgages, and of better definition of the terms and conditions under which the money is to be borrowed and used, go to- gether. Both are essential unless we are willing to entrust the whole matter to the good faith and to the interpretation put upon responsibility by those con- cerned. The necessity of granting to the directors chosen by the stockholders to manage the property, at least a proper amount of liberty in that management is obvious ; but that concerns the shareholders, not the creditors. Good corporation financiering requires that 62 Corporation Finance money be borrowed on the best possible terms. Since bondholders do not wish to concern themselves with questions of success or failure in management, they are best pleased with investments which are surrounded with all possible money safeguards. Cheap borrowing demands that the prejudices of capitalists be, within all reasonable limits, regarded. The listing of bonds and shares on the exchanges is of benefit to both corporations and investors. A wider market is thus made for those who wish to buy or to sell. One of the advantages of corporation securities, and one which gives to them a higher range of values than they otherwise would obtain, is the ease and rapidity with which sales can be made. Real estate, for instance, with all its good points, has the drawback that it cannot be quickly turned into cash at need. In like manner a mortgage on country property cannot be used at the banks as collateral for loans, nor can a mortgage on good city property always be easily dis- posed of. Bonds and shares of corporations which can be listed on the exchanges have at once a standing (not value) which gives them a market at some price always. Corporations which issue bonds and shares intended for public purchase, should list such issues whenever possible. CHAPTER IV. SUBSIDIARY COMPANIES AND THEIR SECURITIES. OUR American systems of railways are matters of growth. They usually consist of a number of smaller roads once independent which have been joined together by purchase or by consolidation. Where these lines are continuous their status does not need discus- sion. The original bonds of such lines are recognized as having a prior lien which cannot be disputed, and as such they command very high quotations on the stock exchanges ; but in addition to old roads which now form a part of the existing main line, nearly all our systems have branch roads, which at greater or less length reach from the main line into some agricultural section or to mines or to cities. In this way facilities of transportation are afforded to the sections thus reached, while the main-line traffic is increased. It is only lately that the importance of well-located branch lines to s Ange- les, California, and Kansas City, Missouri, and that the remainder of the through charge was divided between the other carrying companies mile for mile. These other lines between the points named consisted of the Atlantic and Pacific from Barstow, California, to Albu- querque, New Mexico, about 747 miles, and the Atchi- son main line thence to Kansas City, about 920 miles. To secure the connecting line, the Atlantic and Pacific, the Atchison Company, jointly with another company, had guaranteed interest on the Atlantic bonds ; a necessary measure, for under the mile-for-mile con- Subsidiary Companies : their Securities yi tract and because of light local traffic and heavy operat- ing expenses, this connecting line up to the date of the receivership had shown large deficits under fixed charges which were made good by the guarantors. When reorganization became necessary in 1895, the bondholders of the Atlantic and Pacific were unwilling to accept the deficits under the bookkeeping as prov- ing the small value of their property, claiming that the commercial and fair worth had never been properly de- termined by the Atchison system when solvent. In such cases the only sure ground for determining the values of auxiliary properties or for refusing acquies- cence in a new lease or in a reorganization plan, is the real commercial earning power or importance of the property in dispute. If such power has never been ascertained in the manner already indicated, the holders of bonds need not consent to a reduction until such appraisement has been made by competent author- ities. There is every chance for fierce disputes at just this point ; for in cases of bankruptcy the owners of roads on the main lines naturally look upon their lien as paramount to obligations of any kind due to sub- sidiary companies ; and technically they are of course right. But the question at once arises : whence comes the traffic which, moving over the main lines, yields the earnings on which the senior mortgage has the first claim ? If from the stations on the main lines — if it is strictly " local " — the branch holders may be told to " take their road." But if, as often happens, the figures prove that an important part of this traffic is interchanged with branch roads, as in the case of the Union Pacific before mentioned, then those branch lines are entitled to an equitable share in the prosper- ity of the system whatever that may be ; a share to be 72 Corporation Finance decided by the proportion which branch-line earnings properly determined bear to the whole. For these reasons the question of the real value of branch lines and branch-line bonds, when not settled until insolvency or termination of a lease, gives rise to endless contro- versies. And yet the obligations of subsidiary com- panies when based upon values which by custom have come to have a substantial basis, are safe investments ; though those values ought to be established through accurate statistics from the very beginning. It thus appears that branch lines are necessary to the development of the railway systems of our newer States and equally a necessity to the growth in wealth of the sections of the country traversed by them. It also appears that certain of these branches may have shown a yearly deficit under their own fixed charges, although the indirect benefits to the main lines may have been greater than the deficits paid from the com- pany's treasury. In such case, however the accounts may be kept, the total result is a gain to the system. The question now arises, how should these deficits be treated in the company's books ? In some instances railways have preferred that the gross earnings should at first be reported as favorably to the main lines aa possible in order that these might make a better show- ing. Sometimes controlling companies in making up their accounts for the year omitted those branch-line losses from their income statements, charging them instead as "loans" to subsidiary companies or as " investments " in branch-line bonds and stocks. It would not be equitable to condemn every instance of this kind. If a reasonable expectation existed that the increase of traffic upon a new branch would in a year or two be such that the owning company would be Subsidiary Companies : their Securities J$ reimbursed for such branch-line advances, the policy of carrying such deficits as loans for a short time might properly be followed. Instances may be found in the history of the Louisville and Nashville Railroad where some branch lines wisely projected but which did not yield in the first year or two direct income sufficient to pay the accruing bond interest, soon developed traffic enough to pay back to the parent company the full amount of all fixed charges from the beginning. But railway managers are perforce optimistic, and share owners are naturally desirous of the best possible returns from their holdings ; so managers were led to continue the practice once begun of charging branch- line losses to capital instead of deducting them from income. So dividends, or perhaps bond interests, were paid year by year on alleged earnings of the main line, when in fact such earnings were annually overstated. The Louisville and Nashville Railroad just mentioned is an instance of this latter policy also ; for in 1894 it began for the first time to deduct from its profit-and- loss statements the losses on one of its main branches which it had for years beeen carrying as "assets" in an optimistic hope that the amounts " advanced" to the branch would be made up from increased earn- ings. In that same year, 1894, the New York, Lake Erie, and Western began also for the first time to de- duct the losses of its auxiliary companies from its main- line income account. The policy of carrying branch- line deficits as assets in the general balance-sheet was carried out systematically by the Richmond and West Point Terminal Railway and Warehouse Company. Those who wish to follow the matter further will find abundant illustration in the records and reports of that company and of the railways embraced in its 74 Corporation Finance control. In this way ' ' investments ' ' in branch-line roads or other subsidiary property were increased on one side of the ledger, to be balanced by an equal increase of funded, floating, or current debts on the other. It was inevitable under such a system of accounting and of dividend paying that the real weak- ness of a system should be revealed at the first touch of adversity. It usually happens that the limit of credit to such a company comes at the very time when good credit is essential in order to tide affairs over a tempo- rary decline in profits. No more money can be bor- rowed, for the borrowing powers have been exhausted in order to collect funds for past payments to bond- or stockholders ; a receivership then becomes unavoidable and the true state of things becomes publicly known. A few systems, some only when really insolvent and some while solvent, have adopted the policy of charg- ing off against surplus income the losses of auxiliary companies which had been accumulating perhaps for many years. Such housecleaning should be general. A healthy financial opinion regarding the wisdom of conservatism in estimating profits, is not the least of the good effects of business depression. Among sys- tems which have pursued a rash course so long that the holdings of shares are endangered, it is useless to hold the accounting department responsible. As re- marked, the process of debiting or crediting items to certain accounts on certain ledgers, is simple ; the real difficulty lies in putting a correct opinion upon the items themselves and in formulating a clear mercantile theory about them and that which they represent. In a large number of cases the parent company, in order to create a market for branch-line bonds or to buy the control of certain independent roads, has guar- Subsidiary Companies : their Securities 75 anteed the payment of interest on these bonds as well as payment of the principal at maturity. In our corpo- ration history there have been instances of the repudia- tion of such guaranties, and the question of their com- mercial value is raised in the reorganization of nearly every large system. The forms of words which contain this guaranty are many. "For value received" is perhaps the most common, the usual meaning of that phrase being that the traffic connection gives to the guaranteeing company an equivalent for its obligation. In certain cases the language means merely that the parent company agrees that the interest shall be paid to the bondholders ; it then sometimes happens that the obligating company purchases the coupons without cancelling them. By this method the lien of interest would not be discharged but kept alive ; and at the maturity of the mortgage these purchased coupons are legally entitled to rank with the bonds in claiming part of the property. An instance may be found in the his- tory of the consolidation of the former roads into the Pittsburgh, Cincinnati, Chicago, and St. I,ouis Railway Company in 1890. The practical effect of such purchas- ing is to weaken the value of the bonds to that extent. The guaranteeing company, however, cannot " pur- chase ' ' coupons, but must pay and cancel them unless there is express authority for the former course. Other forms of guaranty recite certain specific con- siderations or refer back to certain conditions not given in the endorsement on the bond but contained in the resolutions of the Board of Directors and not easily accessible to the public. If the matter is of importance, it is advisable for all holders of guaranteed bonds to consider the form of guaranty carefully and to obtain and read the proceedings of the different boards of 76 Corporation Finance directors or officers or committees which have dealt with the subject. In this way a clear idea may be obtained of the nature of the obligation and of the con- sideration which has been given for that obligation. The courts have always upheld and enforced the guaranties of railway companies whenever that was legally possible ; still, if a company resolves to repudi- ate its obligations, it will often find a legal reason for so doing. The laws governing such transaction in the several States are sometimes conflicting, and the ques- tion of the applicability of this or that statute or section of the constitution to a particular case is often so much in doubt that the question of lack of power to make such a contract or to enter into such a guaranty is easily raised if a company needs to do so ; and it is often hard to settle. The innocent holder of repudiated bonds is entitled to the benefit of every doubt and usu- ally gets that benefit ; but, as before stated, if a com- pany decides to dishonor its promises, the legal points it may raise are many, and the result not always clear. The repudiation by the Evansville and Terre Haute Company in 1894 of its guaranty on Evansville and Richmond bonds is in point. In estimating the value of guaranteed bonds, therefore, the holder must take into consideration the general reputation for good faith and solvency which the company bears in the opinion of the financial public. There have been instances in our corporation experi- ence in which companies have justified their repudiation of guaranties by a general argument. That argument usually runs thus : " A company has guaranteed the almost perpetual payment of certain interest. At the time such an agreement was made the circumstances justified the bargain ; the branch taken over was worth Subsidiary Companies : their Securities fj to the main company all that was annually to be paid for it. But in a few years business changed greatly ; another road was built into the branch's territory, or the mine or manufacturing, for which the branch was projected, gave out. In fine, the yearly result to the guaranteeing company is now a heavy deficit under the agreed rental. Should the company be kept to the letter of its contract no matter what happens, or should the branch share in the common loss ? The equity of a continuing contract is a thing yet commercially unde- termined. In business affairs most continuing contracts which involve loss upon either party are settled either by a compromise or by the insolvency of the losing party. In trade the instances are very few indeed where such losses are paid regularly year by year indefinitely. It is true that for obvious reasons the courts always insist upon the letter of a contract because the sacredness of contracts is vital to business ; yet the statement that no machinery exists for determining such questions does not alter the fact that the common- sense of mankind is against the enforcement of such unfair contracts running indefinitely. The principle is the same as that which allows a debtor to escape his debts under certain conditions, because it would be hopeless and cruel to keep a man in jail or even in debt for his whole life. That no such rule exists for corpo- rations merely shows that corporation law has not got that far ; meanwhile suffering companies try to reach precisely that end through legal quibbles and consider themselves commercially entitled to carry their purpose out if possible. ' ' Arguments like these have convinced a few thinkers, and in consequence propositions are sometimes heard that continuing guaranties should be made adjustable 78 Corporation Finance as to percentage of returns every ten or twenty years. The lease of the Central Pacific to the Southern Pacific was so drawn. The argument of a defaulting corporation is, however, usually weakened by the facts of the case. A company wishes at the time to build a new line or buy control of one already existing. The situation is carefully considered by the officers and directors and the degree of necessity decided upon. That company must pay for that line, and must agree with the money-lenders or the owners as to terms. If it could borrow money on its guaranty at five per cent., let us say, but could not induce the capitalists to build the line and take' their chances without a guaranty at less that ten per cent., let us suppose, then clearly enough the five per cent, saved annually by guarantee- ing the bonds is a part of the consideration though it may not be mentioned in the documents ; the saving is of the nature of an insurance given by managers who ought to know what they are doing. If now the expect- ations of these managers be not realized, it is not sim- ple equity to demand a readjustment. If that had been the idea originally, the investors would have demanded much higher returns at the start. Readjustments have never been in commercial favor even when provided for in contracts. The statistics are in the hands of one of the parties, the other being able to get but slight knowledge of the real facts. For these reasons capital- ists have been unwilling to accept adjustable guaran- ties, considering them not so much inequitable as uncertain and indefinite. It follows from what has been said that guaranteed bonds are often safe but sometimes not. It is a mistake for investors to buy bonds merely because they are guaranteed, and oftentimes a mistake in financiering Subsidiary Companies : their Securities Jg for companies to issue them expecting them to find favor on that ground alone. The terms and conditions under which the guaranty was given, the form in which the obligation is set forth, the good faith of the guar- anteeing company, are all to be carefully considered. In some cases the replies to these questions will be so satisfactory that no further investigation need be made, especially if we believe the revenues of the company to be equal to the fixed charges and something more ; for the ability of a company to earn its interest is as im- portant as its intention to pay if earned. In a large number of cases it is well for the investor to look a little further and for the company to ask him to do so. The question in such an investigation is: Does the guaranty represent the commercial situation ? Does the branch line really earn the interest on its bonds ? Is it as it stands worth to the guaranteeing company all that it costs that company annually in interest and expenses ? If so, the bonds are, for the time at least, secure. This question is in a great many cases very hard to determine. The same neglect which has been discussed in previous pages of this chapter regarding branch lines whose bonds are not guaranteed, follows these guaranteed roads also. Many companies have not kept these accounts so as to show whence their revenues are really derived ; such companies ought to suffer in credit for their carelessness. The financial position of branch-line bonds, whether dependent upon the traffic of the roads covered or upon the guaranty of the main line, should be clearly defined. An opinion as to the value of such branch-line bonds, guaranteed or not, is then possible. The more favorable that opinion, the better is it for the company which is responsible for them. CHAPTER V CORPORATION ACCOUNTING EVOLUTION in accounting is to be expected the same as in the methods of conducting business. As the transactions become numerous and increase in complexity, a corresponding change in the style of keep- ing the books is demanded. The principles of book- keeping are simple, and the various kinds of entries are easy of general comprehension. The practical difficulty lies in making the books set forth the real facts ; for it is in judging of the true meaning of those facts that the statistician's art consists, the process of recording the figures, once the facts are agreed upon, being compara- tively easy. Moreover, truth is many-sided ; a business optimist will see things favorably and make up his fig- ures accordingly, while an ultra-conservative merchant will seek to have the position of his affairs set forth in the most unfavorable light. There is the more excuse for optimism in corporation matters, for corporations live on, and having more extended credit, often live down losses which would wreck partnerships ; thus it sometimes happens that for his own reputation's sake and because of that good credit, the manager of a large corporation will give to his statements the brightest colors that the circumstances permit. For these reasons criticisms upon corporation reports are so often unfavorable ; not because of malice on the part of 80 Corporation Accounting 81 the critic, so much as of abounding optimism on the part of the usual corporation manager. The excuse for such optimism should fairly be taken into account : that there is no hard-and-fast line between fact and credit ; that many a railway (for illustration) is helped over a bad place by its credit, and helped safely, whereas if the exact truth were known, that credit might be destroyed and with it perhaps the whole capitalization. A little unwilling forbearance on the part of creditors may bring everything around right and cause no loss. Every corporation must adopt such forms of accounts as suit its particular business. They should embrace such a number of separate books as will enable the management to know exactly what is being done in every department and in every detail and at what cost. The collection of statistics costs money, but modern experience is showing that only by accurate statistical knowledge can modern business be successfully carried on. There are good systems containing elaborate pro- visions for ascertaining the various costs in manufactur- ing. A corporation should be more, rather than less, exact than a firm. The sources of profit down to the minutest detail should be carefully inquired into ; in no other way can the manager know which class of work to encourage, or which to study with a view of improving the process of production. In large companies the main account is that of the general balance-sheet, in which are regularly stated the other accounts such as surplus income or profit and loss. Thus the balance-sheet reflects merely the changes in the general condition during the year, not the amount of profit. This table or statement is the one upon which the lender of money or the investor 6 82 Corporation Finance should bestow his careful scrutiny, because on the interpretation of the items depends one's judgment as to the solvency of the company. The income table is simply an account of the earnings and expenses in totals, together with the proper deductions from the net revenue for the year. Accompanying the income account should be tables explaining in full detail the items there given in gross. There may be a difference of opinion between the managment and the bond- or shareholders as to the proper disposal of certain items of expenditure made during the year. There may be a legitimate question whether such items are properly chargeable to income or not ; such questions are not only theoretical but very practical, because on their answer often depends whether a dividend is paid or not. For such reasons the report which every corporation ought to make to its shareholders and the public (if the public holds the shares) should contain statements in sufficient detail of every transaction during the year, whether included in the income account or not, in order that every one may form his own judgment on the wis- dom of the management and the safety of his invest- ment. In cases where the charging of items of expenditure to the income account may be a doubtful policy, or where, from the nature of the case, it is difficult to decide such questions, since the answer may depend upon one's opinions as to the business prospects for the future, the profit and loss account offers an easy com- promise. To this profit and loss account may be cred- ited annually all the surplus earnings of the corporation over and above fixed charges and dividends, or fixed charges only, leaving dividends for the profit and loss table. Against these surpluses may be charged from Corporation Accounting 83 time to time the cost of unproductive improvements ; the deficits of subsidiary companies, which for the time must be met from the revenues of the owning corpora- tion ; sums which have been included in the earnings of previous years and which have now proved uncollect- ible, and in general all items which, in the judgment of the management, should not be deducted from the income of the year, but which good financiering re- quires should be treated in the accounts in some way as debits, even if temporarily, in order that no inflation in the assets may occur. Such a profit and loss account, if carefully and fully kept, will prove a better test of the earning capacity of the company than the income account, which shows the profits in any one year, for the reason that the former table gives an average of results extending over a number of years. The annual reports of the Denver and Rio Grande Railway are worthy of study in this particular. One of the perplexing things in the financial man- agement of a large manufacturing or trading company, is the treatment of the expenditures for the care of the plant. A depreciation account in some shape must be kept by every company or firm in business. The real estate may decline in value, and in any case, in any progressing concern, money will be required to be spent each year to adjust the buildings more perfectly to the requirements of the business, and yet these ad- justments may not add anything to the salable value of the property, and should not, therefore, be added in the accounts to the company's investment in real estate. In like manner, machinery will wear out, and is always subject to the danger of new inventions, which may render the old machinery practically worth- less. It is not easy to foresee when a new outfit will 84 Corporation Finance be in part or in whole required, though experience soon places a limit to the number of years in which a given set of machinery may be useful. The proper course in these cases is always the conservative one. The corporation should estimate the probabilities of depreciation always against itself, and set aside yearly such sums from its profits as will suffice to renew so much of the plant as may be expected to wear out or to become useless in a given time. Unless this depreci- ation fund is carefully thought out and its separation from profits rigidly insisted upon, the shareholders of the corporation and perhaps the bondholders may in the course of years find that their securities cover a property of little or no business value. If certain sums are not set aside to meet this depreciation, and if for this reason dividends are paid larger than would other- wise be the case, to the extent to which this is carried the returns received by the shareholders are not dividends but their capital returned to them in piece- meal. These depreciation sums should be real and not merely bookkeeping liabilities of the company to itself. Modern corporation accounting requires that in the- ory a sharp line of distinction should be drawn between outlays which may be considered a part of the regular working expenses, and those which are chargeable to an increased investment in the business. In theory the former should be deducted from the gross earnings before the net revenue is determined, while the latter may be met by an increased issue of bonds or shares. There is no doubt of the correctness Of this principle in general, but in its practical application it is subject to great modification. English shareholders in American corporations usually insist upon such a system of ac- counting as divides the expenditures strictly according Corporation Accounting 85 to this rule ; and such indeed is the general practice in Great Britain. By charging to capital every item small and large which could by any possibility be construed to be a betterment, the British railways have increased their capitalization until they are dependent for a con- tinuance of interest payments on good traffics year by year. Thus far no harm has come to these railways from this policy, because the fluctuations in the vol- ume of their traffics have been comparatively slight. But in the United States more caution must be observed in this matter. From the very nature of the case, business of all kinds in a developing country must be more subject to changes in profitableness than in older countries. The very character of the American people, energetic and progressive, makes business all the more liable to such fluctuations. Bad years follow good years in every line of American industry, although differences are less violent in those trades which are the longest established and among those companies which have been in operation long enough to render their business comparatively stable. The principle, therefore, of charging all so-called betterments to cap- ital and meeting the cost from the sale of bonds or shares, requires modification according to the circum- stances of each particular company. The more fluctu- ating the volume of business has been or is likely to be, the more important is it that in one form or another a part of the profits in prosperous years should be with- held from the shareholders and put into the property or set aside for its renewal. To those who wish a working principle to distinguish the proper items to be charged to capital account in the actual management of Ameri- can corporations, railway and other, the following definition is suggested : No additions to the property 86 Corporation Finance either to the real estate or to the machinery (if a manu- facturing company), or to the roadbed and track (if a railway company), should be considered betterments and charged to capital, unless they increase the pro- ductivity or earning capacity of the plant. Under this rule the purchase of additional equipment for a railway would be an expenditure which could conservatively be met by the issue of bonds or equipment notes, because such purchases would enable a larger volume of traffic to be handled ; on the other hand, the replacement of a wooden bridge by an iron one would not be a proper charge to capital, under our definition, unless it was one of a series of expenditures deliberately resolved upon in order that heavier trains could be run and a larger volume of traffic handled, thus increasing the revenues of the company — an increase which our theory demands should be clearly seen to be possible after the various amounts of capital set aside for this purpose had been spent. The same rule might be applied to corporations other than railways ; the safe course is to charge against revenues (possibly through the profit- and-loss account) the cost of all additions to the prop- erty which do not increase the output or decrease the cost of production. Yet any rule or any principle in so delicate a matter can properly be applied in each case only after a careful study of all the circumstances, including the business of past years and the prospect for the future. With railroad laws in nearly every State permitting unrestricted building, American rail- roads are constantly liable to attack by competing lines projected for legitimate or speculative purposes. In England companies are not chartered unless a public necessity for the proposed line is shown. In the United States the only safe course for the old roads is to make Corporation Accounting 87 themselves strong by using a part of their earnings for betterments, thus keeping down the capital accounts. The Pennsylvania Railroad has pursued this policy for forty years, having in that time, according to its re- ports, paid eighty millions of dollars for betterments out of profits. The foreign shareholders have fre- quently complained of this policy, though experience has shown it to be an essential element in the present strength of that company. On railways the working officers prefer to have included in the operating expenses only such sums as may rightly be grouped under that title. This is a proper request on the part of the superintendents, because they naturally wish that their administration of the affairs of the company should be shown to be conservative and careful. There is another reason also for keeping operating expenses distinct, in that it enables the managers to compare the same items of expenses year by year. If these items are varied by the inclusion or exclusion at times of sums whose proper accountings may be in doubt, the comparison of costs from year to year is vitiated and a valuable test of the efficiency of the operating officers is lost. To meet this requirement certain corporations deduct the costs of such betterments as one item from the net rev- enue often in the income statement. The objection to this course lies in the fact that the sums thus expended are lost sight of; and to the extent to which those items are hidden, the real amount of money spent upon the plant is understated. This is not a mere book- keeping objection. The railways have found that the real cost of their property is a factor in dealing with legislatures. Laws may be passed in order to reduce freight rates and passenger fares to a point which shall 88 Corporation Finance yield the companies a return " on cost." The same point may arise at any moment with companies other than railways. Every corporation should therefore so keep its accounts as to show the amounts expended to improve the plant year after year from earnings. A common custom is to apply the annual surplus directly to the construction charges for the year, bonds being issued for the amount of the capital account after thus deducting the surplus. That custom practically adds the surpluses spent for betterments to the capitaliza- tion ; yet it is a question whether it would not be better to open a comprehensive proflt-and-loss account, in which the cost of betterments, as well as other indirect but necessary expenditures, could be included. Corporations small in capitalization but public in their nature and in their stock holdings, often conduct businesses which do not require an elaborate system of accounting. Such companies are often managed by men who are themselves large owners in the property and at the same time skilled in that particular trade. Such men, for their own use or for that of the few other shareholders, need only the simplest statements of the business. It is customary in these small companies to unite the general balance-sheet with the income ac- count, and in their cases this custom leaves no diffi- culty. On the one side are stated the items of cost of property, the valuation of the tools and machinery, the cash in the bank, perhaps the amount of interest charges and dividends paid during the year, and the working expenses. On the other side of the account, the revenues of the year, the bonded debt, and the current debt. Such simple statements are well enough for those who understand the business thoroughly, while the changes in the items from year to year allow Corporation Accounting 89 of the working out of the various principles which have just been discussed but about which no such sharp distinction need be drawn as in the case of large manufacturing companies. The original cost of the property can be written off from time to time by adding to the cash on hand a yearly sum before dividing profits ; a method of keeping a depreciation account which meets the peculiar requirements of such com- panies as have only a limited existence, such, for instance, as those which operate a mine where the amount of coal or ore can be estimated within reason- able limits. This sum of money in the bank is then applicable to the extinguishment of the bonded or share capital at the proper time, or may be used for heavy improvements to the property if such should be decided upon. Small corporations which have been formed for family reasons, and whose shares are held by the former partners and not sold to the public, require no special discussion. Their affairs are man- aged very much the same as under the former partner- ship. The formation and increasing numbers of corpora- tions whose shares are held by the public and whose business is trading, have led to a more rigid system of estimating mercantile credits and of inspecting the items upon which that credit is based. The evolution of corporation (or partnership) credit is one which must work for the good of all concerned. Such companies yield increasing opportunities for the investment of small sums, and while thus gathering together the little rivulets of capital, their managers should themselves be under a moral responsibility to take all the more care of other people's money. It is well therefore that the affairs of trading companies should be subjected to go Corporation Finance such analyses as will indicate their solvency. Prepar- ing statements that will stand examination is one of the best tests to which corporation managers submit as tending to bring the real position clearly before their own eyes and making them conservative in conducting the business and in estimating profits for the share- holders. Following this thought further, below will be found the statement of a non-existing trading com- pany, whose assets and liabilities may be commented upon without reserve. The figures chosen for the pur- pose are intentionally doubtful and do not, of course, reflect the real position of our small corporations. They have been compiled in this form arbitrarily and for the sake of comment. "The Blank Trading Company" we will suppose was incorporated for the purpose of importing and sell- ing fancy goods. The statement below is assumed to have been made December 31st and the inventory to have been taken on the same day. The head office is in New York City, with branches in Boston and Chi- cago. The president of the company is interested in a retail store in Chicago, to whom the company sells goods. The statement of assets and liabilities of the company is as follows: THE BLANK TRADING CO. ASSETS A. Cash on hand $ 600 B. Cash in Consolidated and other banks 4 000 C. Bills receivable (due from customers) 7 000 D. " " (due from branches) 10 000 E. Accounts receivable (due from customers) 63 000 G. Merchandise (valued at cost) 170 000 H. Real estate 27 000 J. Machinery and fixtures 800 K. Merchandise in bonded warehouses 37 600 $320 000 Corporation Accounting 91 INABILITIES P. Capital stock \f^^ *f °°° r ' (.common 50000 Q. Bills payable for merchandise 47 000 R " ' " to banks 15000 S. " " for commercial notes sold 10 000 T. Open accounts 109 000 V. Deposits of employees 4 500 X. Profit and loss 34 500 $320 000 Some additional facts are assumed. A portion of the merchandise in warehouses is subject to " trust re- ceipts." There is a contingent liability (not shown in the statement) of $20,000 for endorsed bills receivable outstanding. About $12,000 of accounts and bills receivable is acknowledged to be past due. Sales the preceding year amounted to $350,000. Expenses of conducting the business were $60,000, and dividends of eight per cent, upon preferred and twelve per cent, upon common shares, calling for $10,000, were paid during the year. First as to the items of the statement. Item A, cash on hand, needs no particular comment. It represents actual money in the hands of the company. In a few instances where deliberate fraud was intended this item has been manipulated. Sometimes the words " and cash items ' ' have been added so that uncollectible bills or things of that character could, by a stretch of language, be included. In one instance, where a pay- ment was soon to be made to creditors, a sum of money was borrowed from the bank and called " on hand," though the bank by understanding did not allow the cash to go from its possession, retaining it at interest over statement day. But such cases are rare. " Cash " has a recognized meaning, and is correctly accounted 92 Corporation Finance for by the vast majority of companies and firms. Item B, cash in bank, also means what it says, being funds of the company on deposit and subject to cheque ; as our company is a reputable one, there is nothing to cause doubt as to these items of cash, A and B. Item C, customers' bills receivable is a small one. If it were necessary to examine into it closely, one ought to know something about the customers whose bills are held and the character of the obligation. Business methods have changed in recent years. It was at one time the general custom to settle all accounts by giving bills. Now, with the exception of a few trades, it is customary to keep running accounts, so that the jobber does not have his customers' due bills as evidences of money owing to him as much as formerly. Of course, an obligation signed by two known firms, though one be small, is better than single-name paper ; but' such paper is no longer obtainable in quantities. In the present case the item is considered a good asset. Item D, covering bills receivable due from branches, must be thrown out. Since the branches are parts of the main house their obligations are also obligations of the main house, and cannot in any way be called assets. The confusion sometimes brought into the matter of the relations between parent houses and their branches, or between the home office of a corporation and its sub- sidiary offices, is cleared up when we remember that for the general purpose of estimating upon the financial value of shares and bonds, the branches and the head office constitute but one concern. If juggling with figures or technical book keeping operations is indulged in, it is usually done to conceal annual losses or de- preciation or else to make the reported condition seem better than the reality. In small trading companies Corporation Accounting 93 the matter is usually more simple. Instances have been known where the head office, ignoring the real position of its branches, has asked for bills payable to cover only the book keeping debts due to the parent company. These bills in the names of the branch were endorsed by the manager and discounted at the bank, the proceeds, of course, making a surprisingly excellent showing in the annual statement. The indorsed bills were not included among the liabilities because not considered ' ' direct ' ' obligations. Of course, the ex- hibit thus made was not a correct statement of the company's real condition. Many trading firms and corporations habitually exclude from their public an- nouncement all indirect obligations of endorsement on the ground that they become a proper charge only when not paid by the maker. This is true so far as the sheet itself is concerned, but the share- or bond- holder who wishes to learn all the facts should know by a separate statement how large these indirect endorsed obligations are. If out of proportion, it then becomes important to inquire why they exist, and how far the makers are financially responsible. The matter of indirect debts which may become direct, is one which should have careful consideration in all corporation management. A manager willing to take advantage of book keeping technicalities may not speak of con- tracts which he has made for the purchase of supplies or machinery because dated ahead, and therefore not yet direct obligations ; but all such prospective debts must be known if a clear view of the future is desired. The Blank Trading Company acknowledge that they have a contingent liability amounting to $20,000. Item E, accounts of customers, is a most important one in a trading company's statement, and one equally 94 Corporation Finance hard to value. Book accounts and merchandise are the main assets of firms and corporations doing a trad- ing business. If, upon investigation, it is found that these two items can be considered really good assets, the company is justified in expecting credit. The first question to ask concerning accounts receivable is : Are they in proportion to the amount of business done and not in excess of the proportion of the same item among other houses in the same trade ? In some trades these book accounts run fairly uniform throughout the year. In others they vary so as to show large amounts at one season with small sums at another ; in the latter case one may judge of the item partly by the date of the statement. In the particular line of trade which has been chosen for our illustration the amount of accounts receivable on the last day of the calendar year ought to be quite small, increasing in amount from the first of the year until the conditions are reversed by spring or early summer. Perhaps ten per cent, of the gross aggregate sales would be a fair proportion to expect for this item in the statement under our assumed condi- tions. It will be noticed that this item is, therefore, about twice what it ought to be. This fact of itself furnishes a reason for further investigation. It is, of course, possible, that these accounts are all good — possible, but not probable. One might inquire how much of these book accounts is over-due and is carried along by the company. If the proportion of over-due accounts in this item is at all heavy, it is an indication either that goods have been too freely sold to irresponsible parties on credit, or else that some misfortune, such as the loss of a staple crop, has fallen upon a certain section of the community in which a large quantity of The Blank Trading Company's goods Corporation Accounting 95 have been sold ; a possibility always to be borne in mind when inquiring whether the credit risks are scat- tered or practically confined to one or two sections of the country ; to be sure not to be caught by any tech- nical differences, one should ask how many of these accounts have been extended when due, which, of course, is another way of carrying them. If the com- pany will make up a statement of the customers who are indebted, one may obtain their rating from a mer- cantile agency and see what the proportion is between their capitals as thus reported and the obligations in question. If a large part of these obligations figure out to be more than twenty-five per cent, of the capital of these customers, one may distrust the value of their accounts. In the present case, it is slated that the president of the company is interested in a retail store to whom the company sells goods. Technically we may expect that the company would not consider the account of this retail store as over-due, and yet it is possible that the swelling of this item beyond the limits customary in that particular line of trade may be owing to the credits granted to this particular store. Perhaps it is found that suspicions are in part confirmed, and that the excess of book accounts over the normal amount is really dead-wood carried by the. company. One, therefore, in his estimate of values, may put down this item at about $30,000. Item G, merchandise. It is so easy to accumulate old and unsalable merchandise that nothing but eternal vigilance can keep a firm free from that error. It is very difficult for the ordinary investigator to make up his mind regarding this item in the company's state- ments ; so much depends upon the business instinct with which the goods are selected and the judgment g6 Corporation Finance with which the future of the particular trade is fore- casted. Another matter that one should know is, on what basis the value of the goods has been arrived at. In our table it is stated that the merchandise is ' ' val- ued at cost," meaning cost to The Blank Trading Company. In these figures, therefore, is included the manufacturer's profit, which again is affected by the credit of the purchasing company. The open accounts due by this corporation are fairly heavy, and one may reasonably conclude that the merchandise has not been reduced in cost by any discounts for cash. In short, it is proper to refuse to accept this item at its face value in estimation on the solvency of the company. In judging of a firm's or corporation's solvency the character of the goods dealt in must always be borne in mind. The difference between staple and fancy goods is one which not only distinguishes one trade from an- other but is an important distinction many times to be drawn between a certain set of articles and another in the same store. Groceries may be accepted at almost full value even under the hammer, while silks and rib- bons are dependent upon the caprices of fashion from one season to another. In like manner hardware can be taken at a close estimate nearer to its inventory value than can boots and shoes. Wool is a more stable article than woollens ; and so we might go through the list. In the present instance it is proper to say that fancy goods are of uncertain value, yet one may assume that The Blank Trading Company deals in the more stable kinds. Nevertheless, it is clear that one cannot assume the full value for the stock of merchandise in question if sold at auction. Balancing all these proba- bilities, the value of this item may be fixed at $100,000. The proper valuation to be put upon book accounts Corporation Accounting 97 and merchandise in cases of insolvency are constant subjects of study among those whose business it is to loan money to firms or companies either by direct dis- count or through purchase of commercial paper. Below is a table of liquidating values for five trades, compiled by a banker of experience : Trades Accounts Receivable Merchandise percentage good percentage good Hardware 72 80 Dry Goods 67 70 Boots and Shoes 80 65 Furniture 70 68 Groceries 40 95 The experience of different bankers and of different trading firms and companies may be more favorable or unfavorable than this table indicates regarding the realizable value of book accounts and stocks of mer- chandise. It should, therefore, be modified in accord- ance with the business reputation of the men in charge, or of the traders in the particular section to whom the goods have been sold on credit. Item H, real estate, $27,000. This value seems a little high for the comparatively small amount of busi- ness done, and should have further investigation. Some small companies, sometimes through carelessness rather than actual error, add the cost of improvements made from year to year to the value of their real estate until this item comes to stand on their books at an amount much in excess of its actual selling worth. In the present instance, it is assumed that this has been the practice, and that the actual value of the property by appraisal is $15,000. Item J, machinery and fixtures, is a small one in 98 Corporation Finance any case and need not be commented upon. If it were an important item, one should inquire as to the de- preciation. Item K, merchandise in bonded warehouses, $37,600, is subject to the same criticism as regards its real value as that already passed upon the merchandise in stock ; that is, for the purpose of questioning the solvency of the company or of putting a value upon its preferred or common shares the figures named in the statement are too high. In addition to this, it is noted in the business statement that a part of this bonded merchandise is subject to trust receipts. It is a common practice for firms doing an importing business to have the foreign goods consigned to a New York City banking house, upon whom also the foreign bills are drawn payable in a certain number of days, varying according to the customs of the different coun- tries. It frequently happens that these goods reach their destination before the bills drawn against them are due. In order that the merchandise may be sold by the importing firm soon after arrival, an arrange- ment to this effect is made through trust receipts. One form of such receipts gives the importing house possession of the goods, but without title, the house or corporation guaranteeing to hand the proceeds of the sale over to the banking house. Another form permits the putting of the goods in store under warehouse receipts. These forms are varied according to the cir- cumstances of the case and the credit and standing of the importing company; but in whatever way the busi- ness is transacted, the meaning is that the merchandise affected is not the property of the importing house, and cannot, therefore, be included in its list of assets. In the present case, something must be deducted from Corporation Accounting 99 this face value on this account also. It will be dealing generously with this item if it is put down at $20,000. By adding up the assets as re-valued, we find the total to be $177,400. A glance at the table of liabil- ities shows a total of $320, 000. If from this one deducts for his own purpose capital stock and the profit and loss — the latter item being simply to balance accounts, — he finds the actual debts for money to amount to $185,000, or about $8000 more than the assets as valued in our examination. This means, in effect, that if the company should be wound up, the holders of both pre- ferred and common stock would lose their whole invest- ment and very likely some of the creditors also would not be paid in full. Although according to the state- ments this trading company paid dividends last year amounting to eight per cent, upon the preferred and twelve per cent, upon the common shares, yet it is clear that no dividends ought to have been distributed until a fund had been accumulated which would bal- ance the possible bad debts and depreciation of mer- chandise of which we have spoken. The sales are stated to have amounted the preceding year to $350,000. This, it will be noted, is only 3^ times the capital. There has been some gross misman- agement of the business because modern conditions demand that the capital should be turned over many more times than this during the year. This impression is confirmed when we look at the amount of business expenses, $60,000. Taking the expenses and dividends together, it will be noticed that it required twenty per cent, profits on the small amount of sales to meet them. Few business houses in these days of sharp competition can be assured of the continuance of so large an aver- age gross profit as that at wholesale. There is clearly ioo Corporation Finance something the matter with the affairs of the company. It is possible that some of the excess in accounts receiv- able already spoken of represents bad debts contracted by the company in order to cover so large an amount of business expenses. To secure so large a percentage of profit they have been willing to sell goods to retail houses with indifferent credit. If these bad debts had been charged off there would have been no dividends and it might have been found that expenses had not been earned. Although the valuation put on the assets shows that at forced sale they would only realize enough to pay the creditors, it does not follow that the affairs of the company cannot be retrieved. There is a foundation here for better business. If energy and ability can be secured, in the management, the amount of sales can be doubled and expenses reduced so as to show a great change in the proportion to the volume of trade. If for a while the profits thus realized could be applied to the reduction of the uncertain items among the assets, it is possible that in a few years the aspect of things could be so completely changed as to show that the company was again in a sound condition. Complete change in the modern methods of supply- ing mercantile credits makes it necessary for the lender of money whether on commercial paper or in the form of bonds or of preferred shares, to rely upon the general solvency of the firm or corporation. This of itself makes needful a more or less thorough investigation into the whole affairs of the borrowing houses. Very likely in this matter as in other lines of business there will arise banks and banking houses which will make a specialty of such loans. The same set of facts puts a new responsibility upon Corporation Accounting ioi the firms and companies which ask for credit. These requests for loans involve two things : first, that the borrowers are honest and mean to pay — which, in the majority of cases, is taken for granted, — and second, that there is a reasonable hope of their ability to pay. This latter point does not concern the honesty of the managers, but depends for its answer upon a wide esti- mate of business facts. It is, therefore, no reflection upon a borrowing firm or company to have the investor or lender ask for such a statement of their affairs as shall enable him to form a business judgment upon their condition. The asking for investment money on mercantile loans from banker or investor implies, there- fore, that such a statement shall be forthcoming. The habit of making such statements for more or less public examination will cause the managers to give even closer attention to the meaning of various items which they are carrying upon their books. In this way conservatism is increased by the conditions of doing business, which now demand, on the one side, large loans of capital, and, on the other, business ability and honesty without sentimentalism. CHAPTER VI THE EXAMINATION OF RAILWAY REPORTS THE bonds and shares of the railways of the United States form the most available investments or instruments of speculation for the people. The general knowledge about railways is greater and the industry itself more firmly established than is the case with other large enterprises. The securities of these rail- ways are the ones most prominently dealt in upon our exchanges, thus giving to holders the important advan- tages of easy and quick purchases or sales. For these reasons it is advisable that the items which are con- tained in the usual annual reports should be analyzed at length and in detail, in order that any purchaser or holder may be able to form for himself a general idea of the meaning of railway statistics and of the import- ance of the differences appearing in those reports from year to year. The Great Eastern Railway is a supposititious road in the United States east of the Missouri River. Having no actual existence, its supposed records can, without invidious comparisons, be made the text of an examin- ation into the meaning of railway statistics, and the relation of one item to another in such tables as are usually printed in railway annual reports. Although paying four per cent, dividends, it is assumed that the stock of the Great Eastern Railway 102 The Examination of Railway Reports 103 is not quoted at very high prices on the exchanges. A company which is really earning four per cent., and which seems likely to continue earning and paying that dividend, usually finds its stock well thought of in financial circles. Contrary to this rule, a holder of Great Eastern shares sees his stock declining under daily sales presumably by " insiders." Naturally his attention is aroused ; he asks himself why the prices of his shares should fall ; in search of information which should satisfy his questionings, he first takes up the annual report of his railway and looks over the figures given therein. On the first pages he finds an income account for the last fiscal year, containing nothing which on the face of it could be construed unfavorably. The statement of the result of the year is as follows : GREAT EASTERN RAILWAY : INCOME ACCOUNT TO JUNE 30 Gross earnings : passenger $1,080 000 freight 5. 6o ° °°° mail and express 120 000 Total 6,800000 Operating expenses (62 per cent.) 4, 200 000 Net earnings 2,600 000 Add interest on bonds owned 250 000 Gross income 2,850 000 Fixed charges : taxes $100000 bond interest 1)3°° 000 1,400 000 Net income i,45° °°° Dividends at four per cent 1,200 000 Surplus for the year, carried to profit and loss 250 000 104 Corporation Finance On succeeding pages of the annual report are given the results for the year of the Rich Valley Railroad, a branch or feeding line, owned by the Great Eastern Company, but operated independently : Gross earnings $1,500 ooo Operating expenses 1,400 000 Net earnings 100 000 Guaranteed bond interest paid 700 000 Deficit for the year 600 000 There is nothing which necessarily shows bad man- agement in the fact that a "feeder" is not self-sup- porting. The Rich Valley, as its name implies, may be a short line running through a rich agricultural and manufacturing district, the greater part of whose traffic is carried by the parent road to the great mar- kets. Were it not for this branch the traffic would seek a rival road. Hence in this case the profits result- ing from the carriage of this extra business are worth to the Great Eastern Railway, it is assumed, a great deal more than the $600,000 which it loses through its guaranty of Rich Valley bonds. The policy of build- ing or purchasing branch lines which are run at a loss may, of course, be carried to such an extreme as to involve the guaranteeing company ; particularly when the real effect of such annual losses is concealed by the method of book-keeping adopted in this case. Clearly the Great Eastern Company must pay this deficit of $600,000 ; but from what fund ? Since the gross and net earnings of the main line receive all the benefit of the traffic turned over to it by the branch, and since, as we have assumed, this benefit is great, it follows that the cost of procuring that extra traffic is a proper The Examination of Railway Reports 105 charge against the income helped thereby. In other words, the annual loss of $600,000 on the branch line, unless clearly but a temporary deficit, ought to be deducted from the gross income of the Great Eastern Railway before a dividend is declared. If this is not done — and a glance back at the income account pre- sented shows no mention of the item, — the real earning power of the company is to that extent overstated and the dividend unjustifiable. How, then, is the deficit of the Rich Valley branch carried ? To answer this question the general balance- sheets for two years must be examined. These gen- eral balances show on the one side the assets of the company and on the other the liabilities. The different amounts are stated at their face and not at their intrin- sic values. Ordinarily it is useless labor to go through a company's general balances for the sake of getting at the actual worth of the properties. Hence, for the information of ordinary shareholders, the most import- ant object in having general balance accounts is the opportunity afforded for annual comparison. If we note the changes in the items from one year to another, we can often get valuable hints about the real pros- perity of the company, because the facts thus revealed may not be mentioned in the text of the annual report. First, then, should be stated the balance-sheet for two years : io6 Corporation Finance GREAT EASTERN RAILWAY GENERAL BALANCE-SHEET, JUNE 30, PREVIOUS YEAR Assets Liabilities $45,000 000 $30,000 000 Cost of equipment 10,000 000 Funded debt (5 %), 25,000 000 Stocks owned, Interest accrued. . 500 000 Rich Valley Co. 1,000 000 Due connecting Five per cent. 600 000 bonds of Rich Due for wages 500 000 Valley branch Supply accounts 5,000 000 payable Claim vouchers 100 000 Advances to Rich. Valley 400 coo 100 000 Due from connect- Profit and loss. . . . 5,500 000 250 000 Materials on hand, 200 000 Accounts receiv- 100 000 Suspense accounts 100 000 Cash on hand 250 000 • $ 62, 300 000 $ 62, 300 000 GREAT EASTERN RAILWAY GENERAL BALANCE-SHEET JUNE 30, PRESENT FISCAL YEAR (Corresponding to the income account given above.) $48,000 000 $30,000 000 Cost of equipment 11,000 coo Funded debt (5 50. 27,000 000 Stocks owned, Interest accrued. . 700 000 Rich Valley Due connecting 1,000 000 1,000 000 5,000 000 Due for wages 700 000 Advances to Rich Accounts payable, Bills payable 300 coo Valley 1,000 000 1,000 000 Due from connect- Supply accounts 200 000 300 000 Materials on hand 150 000 Claim vouchers Accounts receiv- 200 000 300 000 Profit and loss 5,750 000 Suspense accounts Cash and cash 200 000 $66,950 000 4, = $66,950 000 The Examination of Railway Reports 107 A brief explanation of the items first may be desir- able. The costs of road and equipment are approxi- mate statements of the amount of money spent for these objects, though they contain items which are only in- directly a charge against cost. For example, in those balance-sheets will be noticed an increase of bonds from $25,000,000 to $27,000,000 during the year. If these bonds were sold at a discount, say twenty per cent., the amount so deducted from their face value, $400,000, would not represent money put into the road directly or physically, though the whole increase, $2,000,000, it will be noticed, is added to cost of road in another way, i. e., in its lack of credit. Sometimes this item of bond discount does not arise from lack of credit but from an attempt to issue bonds at a rate of interest so low, com- pared with the ruling rate in the money market, that par cannot be obtained for the bonds. In such cases, since the income account presumably is benefited by the small annual interest charges, that same income account should be debited each year with a proportion of the loss by the discount. The item profit and loss has misled many. If the assets foot up more than the liabilities (and every road tries to have it so, even as a matter of book-keeping, for appearance's sake), the item appears on the liability of the account. It will thus be seen to be what it really is, merely the balance between the assets and liabilities in the general balance- sheet representing the supposed excess of property over the capitalization and debts. It is not money in hand : it usually covers former annual surpluses which may long ago have been spent for equipment or on road, or invested in the materials carried in the storehouses and not yet put into the property. If a road has cash or salable securities in unusual measure, these will 108 Corporation Finance be found on the opposite side of the accounts as assets. Another item is the interest accrued but not due. Such accrued interest should always be put down as a liability in balance-sheets, otherwise an unreal pros- perity would be shown at one time or an unreal depres- sion at another, according as the bond interest becomes payable. In all railway tables there are found items of current accounts with connecting roads both debit and credit, cost of materials and supplies purchased but not yet used or charged to the respective operating departments, and the like, being things for which working capital must be provided. Two further items in our statements merit notice. Supply bills payable is one. Every report should be examined to see whether this liability is included. It is the custom for all large companies to buy their fuel, rails, ties, etc., on time. Hence every company on any particular date has a large amount of obligations out, which are not yet due and for which no notes have been issued. Tech- nically these may not be considered in the balance- sheets until due, but since they are sure to become due shortly, there can be no true statement of the com- pany's condition made without including them. Some- times when engines and cars have just been purchased, these unrecorded obligations may be very heavy. Again, when in straits for money, railway companies do not hesitate to pigeon-hole the bills for supplies sent them until the accumulated debts become large ; and, if not stated in the balance-sheets, an untrue appear- ance of ease in money matters is given. Audited vouchers often form a growing obligation when traffic is depressed. Claims for losses of goods and rebates (not always unfair) are common ; in spite The Examination of Railway Reports 109 of care, overcharges in the freight bills rendered con- signees will be made through the errors of clerks ; wrecks may destroy much property for which the com- pany is responsible ; cattle may be hurt by trains ; and, worst of all, accidents may kill or maim passengers. The claims thus presented to the company are often very large in amount. After investigation a certain portion are pronounced true claims and marked for payment. Such items are called " audited claims or vouchers" and should find a place in every balance- sheet. The still larger amounts of claims for losses, overcharges, or rebates not yet passed upon cannot well be stated in the balance-sheet, because their amount is uncertain, yet when " cut rates " are freely given the aggregate of claims and rebates which must presum- ably one day be paid may be so great that the amount, if known, would make a serious impression. Yet, on the other hand, where the sum of such unaudited claims stays approximately the same from year to year, no real harm is done by not attempting to include them in the company's tables. Among the assets the items " accounts receivable " and ' ' suspense accounts ' ' require little explanation. These are claims carried by the company against other roads or against merchants. They may be good or they may not. Every company should have a separate table of " Profit and i/oss," to which all such doubtful credits should be charged. It may be technically cor- rect book-keeping to keep uncollectible accounts stand- ing among the assets of the general balance-sheet, but no matter how the rules of book-keeping treatises may read, the object of all corporation accounting is to represent the commercial facts. Companies which hesitate to deduct losses (branch- no Corporation Finance line losses included) from their income account and yet shrink from actually calling such losses ' ' assets ' ' should charge such deferred claims to " Profit and i/oss," crediting that account with the annual surpluses from operation. The difference would then show the real earnings. If at any time such old claims should be- come collectible, the same account could be credited with the sums thus recovered. The array of figures in our general balance-sheets looks a little bewildering ; so to make the matter clearer, we will tabulate the changes during the year : EXPENDITURES : FOR WHAT PURPOSE INCURRED Increase in cost of road $3,000 000 " " cost of equipment 1,000000 " " advances to Rich Valley 600000 " " accounts receivable 200 000 " " suspense accounts 100 000 $4,900 000 RESOURCES : WHENCE DERIVED Decrease in amounts due from connecting roads. .. 50 coo " " material on hand 50000 " " cash and cash items 150 000 Increase in funded debt 2,000 000 " " interest due 200 000 " " amounts due connecting roads 400000 " " wages due 200 000 " " unadjusted accounts 300 000 " " bills payable 1,000000 " " supply accounts due 200 000 " " vouchers audited 100 000 " " profit and loss 250000 $4,900 000 The Examination of Railway Reports 1 1 1 This summary of changes in the position of the company during the year is worth study. The words "expenditures" and "resources" are used in their book-keeping sense : a decrease in the amount due from other roads and an increase in the amount due to other roads being both alike resources for our present purpose. The statement shows an increase in invest- ment in road and equipment amounting to 14,000,000, of which more hereafter. The deficit of the Rich Val- ley branch is seen to have been carried in the accounts also as an increase in value of plant, offset on the other side of the account by money newly borrowed. We are assuming that this is not a correct principle and that the value of the property has not been advanced a penny through the Rich Valley, since all the profit for the branch for the year has already been included in Great Eastern earnings. This system of disposing of branch-line losses in the accounts is resorted to mainly to allow of borrowing money to meet the deficiency. Carrying subsidiary losses as assets and borrowing money or issuing bonds therefor, has been a common practice. The combination of many small roads into a large system permits such accounting, either through mistakes, optimism, or for purposes of deception, with- out danger of detection by superficial examination. Sometimes this way of concealing deficits is practised for a year or two during hard times, the officers intend- ing to apply the surplus revenues of succeeding pros- perous years toward wiping out all these imaginary assets and the debts contracted to pay for them. Such a policy should be leniently judged, if honestly held. Of course it is also proper to treat in this way a genu- ine loan when repayment is reasonably certain. The balance-sheets further show that the only bonds owned 112 Corporation Finance by the Great Eastern Railway are those of the Rich Valley branch. A glance at the income account shows $250,000 received from this source. It thus appears that in order to show that dividends had been earned, the directors of the Great Eastern Company did not charge up the losses of the Rich Valley branch as they should have done, but did take credit to them- selves for $250,000 unearned interest on their own guaranteed bonds. We now begin to grow suspicious and scrutinize the items more closely. The bonded debt and the bills payable amount to $28,000,000, for which interest at but five per cent, on the total (and money is not always borrowed " in the street " at as low a rate as that) would amount to $1,400,000 per year, whereas but $1,300,000 is allowed in the income account. This may be an accurate statement for that particular table, since the bonds may not have been issued for the whole year and hence a year's interest may not yet be due ; still our comparison shows that at least $100,000 must be added in our calculations to the requirements for another year. The expeditures in the table show $3,000,000 spent upon the property and $1,000,000 upon equipment during the year ; the other items make up a total ex- penditure of $4,900,000. Eet us now see how this sum was obtained. Allowing for the discount, $2,000,000 was raised from the sale of bonds and $1,000,000 was borrowed on call (z. e. , can be demanded by the lender at any time), or for a definite (though short) period. The remaining $1,900,000 was gathered by piecemeal. Debts due the company were more closely collected, and on debts due by the company, it will be seen, pay- ments were deferred. Wages are running farther in The Examination of Railway Reports 113 arrears and $200,000 more of bond interest was not paid. There is a new item "unadjusted accounts," which in this table undoubtedly is simply another name for more floating debt. Money due for supplies and for acknowledged claims has been held back. There has been further economy in the already too small stock of materials on hand. Cash is dwindling ; let the reader note the significant change in the word- ing of this item. A year ago it was ' ' cash, ' ' now it is "cash and cash items." While "cash" has a definite meaning in "Wall Street, the phrase "cash items" may cover a lot of rubbish which cannot be turned into cash at all — notes of bankrupts, disputed balances, and the like. It is not a harsh judgment which in this case assumes the amount of actual money on hand to be very small. Then the two offsets, ac- counts receivable and suspense accounts, down in the table as an increase of assets to the amount of $300,000, may fairly be rejected as assets altogether. A com- pany in the position of the Great Eastern would not allow such accounts to be so much increased ; for being in stress for money it presumably would have collected them if they had been good. The table of changes certainly wears a very unfavor- able aspect ; yet one purpose of the managers has been accomplished, to cover up among a number of items a part of the money they have spent. Reliance is put on the fact that stockholders will not figure through the accounts. Now as to the $4,000,000 increase in cost of road and equipment. Every report should contain a table giv- ing in detail the items charged to construction or cap- ital account. There is such a field for deception or for equally ruinous bad judgment in construction statistics H4 Corporation Finance that the utmost publicity should be insisted upon. The following construction account is divided (arbitrarily as to these figures) into columns of proper and improper charges to capital. CONSTRUCTION ACCOUNT CHARGED 10 CAPITAI, Properly. Improperly. Road, for new rails $400 000 for damages from wrecks by ac- cidents for renewals of ties for double track goo 000 for new bridges 200 000 for real estate bought 750 000 for new stations 250 000 Total charged to road, $3,000 000. Equipment, for 15 replaced engines... for 15 new engines 150 000 for 500 replaced freight cars for 500 new freight 250 000 for 25 replaced passenger coaches for 25 new passenger coaches 100 000 Total equipment, $1,000 000. $3,000 000 $350 000 150 000 150 000 250 000 $1,000 000 Every active concern must in some shape keep a depreciation account, to which shall be charged certain sums for renewal of machinery, etc., before profits are divided. If this is not done, the company will at the end find itself without plant and without money. In The Examination of Railway Reports 115 railway matters this is best accomplished simply by replacing cars and locomotives as they become worn out, and charging directly to operating expenses the cost of such new cars as do not add to the number of cars in use. In this way the quantity and quality of equipment or buildings or track are kept up at the expense of the annual earnings. In the construction account just given, $1,000,000 is improperly charged to capital and paid for by bonds, because the items cover depreciation and should have been included in the operating expenses. The test to be applied for the ascertainment of wrong charges to capital on equip- ment account is that of comparison. Every railway report gives, or should give, a list of the number of engines, passenger and freight cars in service at the close of the fiscal year. It is an easy matter to calcu- late the increases from year to year. For the reason that variations may at times occur, it is better to take a period of years. If the increases in the lists for, say, five years, multiplied by a fair valuation for each class, equal approximately the sums of the amounts charged to capital for new equipment during that period, then no wrong charges on this account have been made. In the case before us, we will compare the lists on two successive years. STATEMENT OF EQUIPMENT Preceding year. Present year. Increa fo. of locomotives 185 200 15 " " passenger cars " " freight cars 375 29,500 400 30,000 25 500 This statement of equipment explains why, in the table of construction just given, $500,000 charged for 1 1 6 Corporation Finance replaced engines and cars is marked as improperly debited to that account. The actual increase in the list during the year is but half that carried in the com- pany's balance-sheet as cost of plant. Other items included in the construction table as improperly charged, are payments for train accidents and for replaced ties. These, of course, should go into operat- ing expenses. Payments for wrecks may, however, be concealed under " double-track" or similar items if a company is determined to deceive. As to ties, it is fair to assume that these last about seven years, de- pending, of course, on the climate and the kind of wood used. If we estimate 2800 ties to the mile of single track as about the average requirement, we have as an estimate of yearly renewals 400 ties per mile. Here, again, a number of years should be taken to obtain a fair average ; but, in the long run, if a road's renewals of ties fall on the average much below 400 ties per mile per year, inquiry should be made as to the reason. As to rails : the life of a steel rail is not yet definitely ascertained ; perhaps twenty or twenty-five years may be taken in order not to be unfair to the company under examination. Estimating the weight of steel rails at seventy pounds per yard, the required weight per mile of single track is one hundred and ten tons. This would assume an average renewal of five or six tons per mile per year. A calculation spread over a number of years would show how far short of such an average a particular company had fallen. If its rails are new, or nearly so, such a calculation would be of value only as approximating the amount which will be required for that purpose in the future. By our analysis of the Great Eastern's construction The Examination of Railway Reports 117 account we have ascertained the amount which should have been charged to operating expenses, to have been $1 ,000,000.. This added to the $600,000 loss on the branch line, makes $1,600,000 which should have been deducted from income. As the sum applicable to divid- ends in the income account was $1,500,000, we reach the conclusion that the dividend was not really earned and should not have been declared. It will be remembered that the road was operated for sixty-two per cent. The percentage of expenses to earnings is of little use except as a guide for further examination. Of itself it is only the percentage re- lation between two sets of independent figures. If a railway earns one dollar and spends fifty cents, it is operated for fifty per cent. ; but if from any cause — water competition, let us say — it can get but seventy- five cents for the same unit of service, and if its ex- penses per unit stay at fifty cents, then it is operated for 66^ per cent. Usually the volume of units of traffic increases as the charge per unit falls, so that the road makes as much gross profit from the larger as from the smaller receipts per unit ; but manifestly we must go into details of the operating expenses if we would form a judgment upon the management. Here are four statistical tables of the Great Eastern Railway : OPERATING EXPENSES Maintenance of way and structures $ 4 2 ° °°° Maintenance of equipment : Passenger cars fioo coo Freight cars 300 000 Engines 60 000 460 000 Conducting transportation 2,320 000 General expenses 1,°°° °°° $4,200 000 I iS Corporation Finance STATISTICS OP OPERATIONS MIXES OF RAILWAY OPERATED 8oO Passenger-train mileage 1,800 ooo Freight-train mileage 3,200 000 Switching, etc., mileage 1,000 000 Total engine mileage 6,000 000 Number of passengers 800 000 " " " 1 mile 36,000000 Tons of freight 3,000 000 " " " 1 mile 700,000000 Rate of fare per mile, in cents .03 Rate of freight per ton per mile, in cents .008 Mileage of passenger and baggage cars 9,000 000 Mileage of freight cars 96,000 000 GENERAL ITEMS Maintenance of way per mile $525 Average number of passengers to each train mile 20 Average number of tons to each freight train mile 220 Average number of passenger cars to each train 5 Number of freight cars to each train 30 Average mileage of each freight car per day 10 Average earnings per mile : each passenger train Jjo.60 each freight train 1.75 Cost of motive power per engine mile : Repair of engines Jo.oi fuel 05 Engineers and firemen .07 Oil and waste 01 $0.14 Railway reports do not always give just these statist- ics, but usually the information we need can be ob- tained by a little figuring. The cost of maintenance of way per mile is easily ascertained by dividing the average number of miles operated into the total pay- The Examination of Railway Reports 1 1 9 ments for that account. The average number of pas- sengers or of tons of freight to each train is found by dividing the train mileage into the number of miles travelled by passengers or the tons one mile, respect- ively. The results are, therefore, somewhat in the ab- stract, but they afford the best comparison regarding the economy of the train service, one of the most im- portant things to be considered in judging railway properties. It is necessary to know the number of miles run annually by cars, freight cars especially, in order that we may check the construction account and judge of the general efficiency of the company's manage- ment. The amount allowed for maintenance of way is too small for the volume of traffic and number of trains. The sum varies from $2000 per mile in the case of our principal roads, downwards. Generally this item is best judged by comparing the amounts spent per year for a number of years with those spent by neighboring companies similarly situated. On many railroads the average annual cost of necessary repairs and renewals is $500 on each passenger coach, $40 each for freight cars, and $1000 each for engines. Multiplying these averages into the list of equipment given above, we find that there should be an addition of over a million dol- lars to the sum allowed in the operating expenses for repairs and replacement of equipment. This, of course, would increase the total expenses by that amount and correspondingly decrease the net income. As we know that the Great Eastern Railway (or any railway) can- not long be run without making the repairs and renew- als its neighbors find necessary, we are forced to the conclusion that if money enough to care rightly for the property has been expended and charged to current 1 20 Corporation Finance working expenses, the fixed charges might not have been earned. Bankruptcy, therefore, awaits the com- pany, unless heroic measures are taken to remedy defects in management and save the property. The decline in the market prices of the stock was more than warranted. Our inquiring stockholder would do well to dispose of his holdings at once at whatever price he can get ; unless his ownership is so large and his knowledge of railway operation so good as to enable him to ascertain and himself apply the proper remedy. We have not yet exhausted comment on these tables. The cost of fuel (five cents per engine mile) is not high ; and if we add two or three cents to the cost of repairs for locomotives, the cost of motive power, per mile run, is low, — a point much in the company's favor. The rate received per ton per mile is not high, and perhaps a careful examination of the commercial condi- tions of the country through which the road runs would show where improvement is possible. The passenger department is grossly mismanaged. So many trains are run that the average number of passengers is only twenty per train mile. The average for the whole United States is about forty-five, and to carry less than thirty-five passengers per average mile is hardly profit- able. Trains should at once be withdrawn until only the reasonable demands of the public are met. Since only half the present number of passenger cars is really needed, it was a gross abuse of power for the manage- ment to purchase more coaches, as the construction account shows they did. There is no particular fault to be found with the lading of the average freight train or with the earnings per freight train mile ; they are up to the average, if not beyond it. But to what use The Examination of Railway Reports 121 so many freight cars can be put is a mystery. It ap- pears that the average mileage of the freight cars is but ten miles per day ; it should be at least three times that number to be profitable. The daily mileage of each freight car on the average is found by dividing the total freight-car mileage by the number of cars. Nine or ten thousand miles per year is the expected work of each freight car on the average on a successful road. Very likely more than half of the large number of cars owned (large in proportion to traffic carried) are standing idle on side tracks. The construction account showed 1000 cars bought at an expense of $500,000. Not a single car should have been added to the list, since under good management one third the number already owned should carry the stated volume of business. The extra number of cars should be reduced or loaned out to other roads, to be paid for at the standard rate for use of foreign cars, about three fourths of a cent per mile run. It sometimes happens that an unscrupulous company will charge renewals of equipment to capital and conceal the fact by adding the new cars to the old list of a year ago, even though it may not have in service the number of locomotives and cars certified to in the report ; such unjustifiable additions are called " vacant numbers." Vacant num- bers sometimes arise from the destruction of worthless cars which should be replaced from operating expenses but temporarily are not, because of hard times. This is a legitimate economy if so stated in the report ; though it is better to charge against income the estimated cost of filling the vacant numbers. If the mileage of freight cars is stated in the report, these juggles with equipment, when at all serious, can be detected. If the company is really short of cars the 122 Corporation Finance cost of hiring equipment (itemized in the detailed table of operating expenses) will be a large and increasing sum. If more cars are, for the purposes of deception, kept in the lists than are actually running, either be- cause old cars have been broken up and not replaced or are allowed to stand in the yards though worthless, the fact will be revealed by dividing the number of cars into the total mileage. If this total mileage includes foreign cars, such foreign mileage must be deducted and the mileage of home cars on foreign roads added. If, as in the Great Eastern case, the whole freight equipment ran an average of but 3200 miles during the year, when the average should have been 9000 miles or more, there is serious mismanagement or fraud. There has therefore been gross mismanagement or fraud also in locking up capital by the purchase of unnecessary equipment, which when bought must be kept in repair though perhaps falling to pieces through lack of use. In view of these latter criticisms it is probable that all the items in the construction account should receive careful investigation. The amount allotted to general expenses on a road carrying a fair amount of traffic should be not much over ten per cent, of the total ex- penses. Judged by this test the Great Eastern man- agers may be wasting about $500,000 a year. In short, the directors of this company are either ' ' work- ing ' ' the road for their own benefit, or are culpably negligent of their duties as trustees for the stockholders. It is often of importance to find out whether a com- pany has much ready cash or is likely to be obliged to borrow for interest or dividends. An estimate upon this point is possible. Taking the balance-sheet given for the last fiscal year of the Great Eastern Railway on a former page, we find the cash items as follows : The Examination of Railway Reports 123 Quick assets. Due from connect- ing roads $200 000 Accounts receiv- able 300 000 Suspense accounts 200 000 Cash and cash items 100 000 f8oo 000 Excess of debts 2,700 000 Quick liabilities. Due connecting roads $1,000 000 Due for wages 700 000 Unadjusted accts. . 300 000 Bills payable 1,000 000 Supply accts 300 000 Vouchers 200 000 $3,500 000 Very likely the true state is a little worse than this, for while "unadjusted" or "suspense" debts must usually be paid in full at some time, accounts receiv- able or in suspense often cover items carried along in this way from year to year, and in part at least worth- less or unavailable. The real cash resources as indi- cated in the above statement may be fairly set down as not more than half the sum stated, or $400,000. The item of accrued interest ought also to be included in the pressing debts, if the actual day of payment is near at hand — as, for example, July 1st, when the fiscal year closes June 30th. Materials and supplies, prop- erly carried in the balance-sheet as assets since the company's working capital is invested therein, are not available for the payment of current debt and are there- fore excluded from our table. A glance at the balance- sheet shows that the only treasury assets which can be sold are the bonds of the Rich Valley branch, amount- ing to $5,000,000. It is doubtful under our showing whether these bonds could be sold at a heavy sacrifice, if at all ; for an investigation would reveal the fact that the bonds were really dependent for their value upon the success of the system, since the branch line itself 124 Corporation Finance is not earning the interest. A proper inquiry at this point would be whether the Rich Valley is commer- cially entitled to a larger proportion of the combined earnings ; if so, its bonds would be enhanced in value, though the enhancement would be at the expense of the earnings of the main line. Of course, the selling of Rich Valley bonds in the Great Eastern treasury would only exchange one form of debt for another, and would not therefore relieve the real situation. The company's affairs require thorough overhauling. Yet the fact that a company in tempo- rary difficulties has in its treasury bonds available for sale, is often important. The obligation is changed from a floating to a funded debt, and therefore relieves the company from the fear of a receivership. Yet such a change really avails nothing in the long run unless the business or the management changes with it in such a way as to insure a greater success. The affairs of the company look desperate ; it is doubtful whether such an entanglement could be straightened out with- out a receivership for a few years, long enough to enable the pressing debts to be liquidated without too much sacrifice of the company's assets. Nevertheless, we see that in spite of gross mismanagement there is a good traffic, which in capable hands could be made to earn a fair revenue. We will, therefore, assume that indignant shareholders turn out the board of directors and discharge the officers, substituting capable and honest men. I,et us suppose new directors and officers in charge. Of course the payment of dividends is sus- pended and all energies are devoted to saving the prop- erty from foreclosure. In such large affairs, all that is wrong cannot be righted at once. Corporate salvation is a work of time. In the present case we will assume The Examination of Railway Reports 125 that money could be borrowed to meet pressing needs, that two or three years' hard work has had its results, and that the income of the road is now meeting in full all proper operating expenses and fixed charges. Under these conditions the income account would be as follows : Gross earnings : passenger $2,000 000 freight 7,000 ooo mail, express, and miscellaneous. 600 000 Total earnings 9,600000 Operating expenses (70 per cent.) 6, 745 000 Total income 2,855 coo Fixed charges : taxes $150 000 bond interest 1,500 000 1,650 000 Net income 1,205 °°° Deduct loss on Rich Valley bonds outstanding $ 350 000 Deduct amounts set aside to pay interest and principal of old floating debts. . . 350 000 700 000 Surplus for year, devoted to improvements and betterments $505 000 This is very satisfactory. Passenger earnings have increased by the judicious issue of commutation and excursion tickets, though the fare received on the average has fallen from three cents to two cents per mile. In the intervening years the new officers have increased the volume of traffic. Taxes and bond inter- est have increased, and the losses on the Rich Valley branch are now properly charged. Evidently also the new management has adopted the policy of paying off old debts by degrees, $350,000 being set aside for that purpose. There still remains a surplus of $500,000, which is to be spent for improvements on the property. 126 Corporation Finance Altogether there is a fair prospect of resuming divid- ends, so that those who purchased the stock when at its lowest point will very likely make large profits. For the sake of contrast, the details of the operating expenses are given : Maintenance of way $1,000 ooo Maintenance of equipment : 400 passenger cars at $500. . . $200 000 15,000 freight cars at $50 , 750 000 200 engines at #1000 200 000 1,1.50 000 Conducting transportation 4>095 000 General expenses 500 000 $6,745 000 STATISTICS Miles of railway operated, 800. Passenger-train mileage 2,500 000 Freight-train " 3,600000 Switching " 1,200000 7,300 000 No. of passengers, one mile 100,000 000 Tons of freight, one mile 900,000 000 Rate of fare in cents per mile .02 " "freight " " " .008 Mileage of passenger and baggage cars 12,000 000 " " freight cars 150,000000 No. of passengers to each train 40 No. of tons of freight to each train 250 A generous amount is allowed for maintenance ; when the plant is once in excellent condition, it can be maintained at a less cost than that here given. The expense for trains earning revenue (this phrase ex- cludes switching mileage and the like) is about $1 per train mile. In actual operation, this expense runs from eighty cents upwards per mile run, varying according The Examination of Railway Reports 127 to conditions, particularly the relative cheapness or dearness of coal, which forms a large item in all rail- road expenses. As we have assumed that the Great Eastern Railway obtains its fuel cheaply, the assumed cost per train mile is fair, indicating reasonably high expenses for improving the property if the management is good, or a waste of money if the management is bad. Under the old state of affairs on this railway, the expense per train mile was about eighty cents. Our examination of details showed that this old appearance of cheapness was deceptive. Whether the new cost of about $1 per train mile is due to a generous care of the property or to greater waste, can be told only by fur- ther scrutiny into the accounts. The table of statistics enables us to judge of the new management, and by contrast with the old figures shows important differences. The number of locomo- tives and passenger cars is the same as before. These have been presumably kept in good condition, the amounts allowed in the new operating estimates being fairly large. Freight cars have been reduced one half, partly by sale and partly by the breaking up of old and small cars which were uneconomical to use. The new management had to do the best they could with the property as they found it when coming into power. The number of passengers per train has doubled, show- ing more careful study of that part of the corporation problem. Nothing has been added to capital account, but the policy has been inaugurated of setting aside certain sums for the payment of outstanding unfunded debts. The old traffic of the company was large enough to furnish a good basis for the present better condition ; the question was one of management ex- clusively. 128 Corporation Finance The management of American railways is better than it used to be — better as to operation and more e^act as to the accounts. Nevertheless, while some railways furnish model specimens of book-keeping in their re- ports, others, weighed down in some cases by tradi- tional policy in their accounting, publish statements of their finances which are misleading. For example, the practice of carrying branch-line losses as assets, wrong as the policy seems when stated in those words, never- theless can in some cases be justified from a book- keeper's standpoint. Yet it is clear that a railway company might continue to call such deficiencies " in- vestments in subsidiary roads, ' ' and continue to issue bonds to cover the actual cash required, until at last a poor year might not yield earnings enough to pay interest on the overloaded debt. If, at the same time, owing to the state of the money market and the spread- ing knowledge of the road's real condition, no one would lend it any more money, a crisis would be im- pending, with a certain loss to the holder of the com- pany's bonds and perhaps an assessment on the stock. It has been assumed that the Rich Valley, though not itself earning interest, was valuable to the Great East- ern because of the interchanged traffic. In some cases these branch lines may not be worth much to the parent road, and may, indeed, have been " unloaded " on the old road by unscrupulous insiders. In judging of such cases, the ordinary stockholder must rely upon the character of the men in control. Full knowledge of such details is not usually possible to him. But while every particular concerning a road cannot be and need not be known, it has been the purpose of this chapter to show that any one with a fair know- ledge of railroad operations can find out for himself the The Examination of Railway Reports 1 29 broad facts concerning any company, provided suffi- cient details are given in the annual reports, and pro- vided he will take the trouble to examine them closely. It is. a mistake to suppose that nothing can be ascer- tained from the annual reports of railways ; the main facts can be. It is often thought that the figures can be manipulated, and so made worse than useless ; this is true, but only to a certain degree. The items in a railway report are interdependent in a way often un- suspected. For example, if bonds have been issued or bills payable contracted, some item or items on the other side of the balance-sheet must be increased also. The inquirer should then proceed to look into such items of assets with a view to finding out whether such increases are legitimate, and if so, whether they com- mend themselves to his judgment. Charges to capital should be scrutinized carefully, with a glance at the items allowed for maintaining roadbed, track, and equipment to see whether these have been neglected. Comparison should always be taken with a road simi- larly situated, and more than one year's work should be tabulated. The lading of the trains can easily be ascertained, while a little study will show that the number of tons carried one mile, the rate per ton mile, the number of train miles run, the cost of the same, and the net earn- ings of the company, are all related to each other. In order that the general facts regarding a railway's operation and financial management may be open to investigation, public opinion should require that the annual reports of all railways should contain state- ments in detail of every item of income and expense, including statistics of trains. By following and com- paring these statistics from y**ar to year and studying 130 Corporation Finance them in connection with the statements of similar rail- roads, an investor or stockholder, after the manner herein set forth, can form a fair judgment as to the main facts which affect the value of the company's bonds or stock. CHAPTER VII PUBLIC POLICY TOWARD CORPORATION PROFITS IF we assume that advancement in material civiliza- tion is made possible chiefly through a cheapening of the cost of production for staple articles, and if we believe that true progress can be made only as both labor and capital receive their due rewards, we state the conditions of an industrial problem which point directly toward more effective organization. Cheaper cost, higher wages, and better profits form a union of blessings which can be realized, if realized at all, in no other way than through combinations of capital, larger in the aggregate, though divided into small owner- ships, together with the best mechanical resources, a massing of employees, and an efficient oversight of the whole. Following industrial precedents, we may ex- pect that time will be required before the greater part of our commerce in staples will be carried on by such large organizations, yet the evolution, though slow, is unmistakably in that direction. Such organizations, so far as we can now see, can be best arranged through corporations. Just as the State may pass laws regulating the business and credit of part- nerships, so it may give charters to companies and enact statutes defining their rights and responsibilities, limited liability is the essence of the corporation idea ; 131 132 Corporation Finance combining the possibility of gathering large amounts of capital in the forms of bonds and shares, with easy and legal ways of dividing that capital into proportions, minute yet distinct. The corporation, assured of a continued existence though its officers or shareholders may die, offers on the one side a well-understood chance to investors with risks small as compared to a partnership, and on the other an unequalled oppor- tunity to men of first-rate administrative ability. The relation of such trade bodies to the State and to the public may give rise to problems with which suc- ceeding generations must deal. In the development of large corporations three parties should be benefited : the capitalist, the consumer, and the laboring man. But before the political or social economist may prop- erly discuss the rights of the latter two as to their fair share of the larger profits which the corporate form renders attainable, there must be an acknowledgment of the fairness of good returns to the capitalist. With- out a prospect of profit no capital could be obtained for investment in land, buildings, or machinery, and with- out this first venture of capital, few laborers could find employment. This is particularly true at the forma- tion of the corporation, and for a reasonable number of years thereafter. With the question of the fairness of large corporation profits long continued, we are not now concerned. So far as experience goes, we may believe that commercial forces, in the majority of cases, are effective for a reduction of the profits of long-estab- lished corporations to a normal basis. It often happens that this privilege of making money is granted by public opinion to firms and individuals, but denied to incorporated companies. It is forgotten that a corporation, particularly at the beginning, is a Public Policy 133 business enterprise as purely as a partnership. Pur- chasers of its bonds or shares weigh the chances of success, and usually demand concessions in some way commensurate with the supposed risks, before buying. In the case of a partnership, this practical demand for a profit in proportion to the danger of loss and the resulting uncertainty, is admitted to be equitable. It is no less so where the same business is undertaken by a company. The owner of a dwelling-house which has doubled in value collects his rent on the advanced val- uation ; and no objection is made. If the house should be owned by a stock company, the doubling of the annual returns on the shares would in the minds of many be an economic offense. At the beginning the enterprise of building a costly line of elevated railway in New York City was thought to be a doubtful one. The original projector was able to secure capital enough to build an experimental piece of road, but not to demonstrate the success of the plan commercially and financially. The capitalists, who secured control and proceeded with the work of extending the lines, believed in the enterprise and backed their belief with their 'money ; yet many people thought failure would be the result. When afterwards success was seen to be assured, the payment of good returns in some form on the sums originally invested was believed by the capitalists who hazarded their money to be their com- mercial right. Public opinion seems, indeed, to be confused between the question of the fairness of corporation dividends in ordinary cases, and the larger and more difficult ques- tion of the equity of high profits when earned by huge corporations long established and monopolistic in their nature. Yet even in these latter cases, few such coin- 134 Corporation Finance parries are monopolies at the start ; they usually begin business under doubts as to their financial success, just as other companies do ; their development into grasp- ing concerns belongs rather to the second stage of the corporation problem at which the United States (speak- ing broadly) has hardly yet arrived. If, then, corporations are primarily business enter- prises under a new form, and if they are in consequence entitled to business profits the same as partnerships, it becomes proper to consider the tests to which the fair- ness of such business profits may be rightly subjected. The prevailing ideas on this subject as regards corpo- rations are clearly inequitable, and this injustice is in great part responsible for stock-watering and other ills with which corporation finance is afflicted. Public opinion still insists that the rates of dividends paid by corporations shall be measured, as to their fairness, by the ruling rate of interest on borrowed money. It is constantly said that five or six per cent, annual returns on the share capital of a company is all that should be paid, since about that percentage is the normal yield on bonds or commercial paper or paid on notes dis- counted at the banks. It is overlooked that the standard thus set is the rate on money loaned on good collateral, and considered secure both as to interest and principal. The comparison may be proper as between the prevailing rate of interest and that paid by the company on its bonds ; but manifestly the returns on that part of the capital hazarded by the shareholders should not be so judged. If that rule were really car- ried out, if public opinion had been able to limit returns even in hazardous enterprises to a bare inter- est rate, the community would be the worst sufferer from the lack of facilities in transportation, in manu- Public Policy 135 facturing, and in trading which it now enjoys. The only result of this ill-defined but commercially errone- ous opinion about the rate of dividends has been to complicate the whole subject of corporation investment and regulation with a series of false issues. We are treated to long discussions and severe statutes upon the subject of " water " in the stocks and bonds of rail- ways and other corporations ; while the real point has usually been the commercial justice of returns larger than the rate of interest on borrowed money when paid to shareholders in companies formed and managed sim- ply as business enterprises. The experience of all civilized countries has shown the uselessness of all direct attempts to limit profits by legislation. Such attempts merely compel concealment in some way, or dull the edge of enterprise. For exam- ple, the charter of the Boston and Worcester Railroad (now a part of the Boston and Albany), granted by Massachusetts in 1831, has this section : " Toll is granted as may be agreed upon by the directors provided that if, at the expiration of ten years, the net income from tolls and other profits shall have amounted to more than ten per cent, per annum upon the cost of the road, the legislature may take measures to reduce the tolls in such a manner as to take ofF the surplus." It is agreed that the railroad in question has paid much more than the ten per cent, yearly allowed, dur- ing the last sixty years. There is no known instance of such a limitation of dividends being practically en- forced where commercial profits justified a higher rate. The only legislation which, under present conditions, has much chance of practical effect, is that of which some London (England) gas charters furnish an illus- 136 Corporation Finance tration. By Act of Parliament certain of these gas companies must sell the gas at ^s. gd. per 1000 feet. For every penny taken off this price to consumers the company is allowed to increase the dividend one fourth of one per cent. ; for every increase in the price, there must be a corresponding dividend reduction. Of course such legislation is crude, for there can be no arithmetical ratio between the prices of the goods sold and the annual dividends on the shares ; but it embodies a principle, which indeed usually works itself out in rough fashion, that there must be a division of the benefits of the corporate form between the parties con- cerned. It would be inequitable if a corporation should keep all the profits for its shareholders ; and equally unjust if it could so keep none of them. It is not necessary to prove that values have increased in the United States ; figures, such as those of the cen- sus, showing such increases between 1880 and 1890, are available for those wishing to follow the subject far- ther. It is also a matter of common knowledge that, while certain individuals and firms have failed, others have amassed large fortunes. A number of firms have taken the corporate form and have offered their shares to the public. In no one of these cases of incor- poration of old partnerships was the original amount invested in the business by the partners stated ; the public, it is held, has no right to that information. The prospectuses of the Proctor & Gamble Co., The H. B. Claflin Co., or of the larger corporations, like the American Sugar Refining Co. , may be searched in vain for such information. The present status of the new company and its probable future, based upon the profits for several years past, are, however, always set forth in the prospectus, and these facts and estimates Public Policy 137 really form the basis upon which the amount of capital- ization the new company can bear is arrived at. What percentage upon the original investment the yearly profits to the old partners have been, is not thought to have any bearing upon the value of the business at the time of incorporation. The capitalization is fixed at such an amount as will in the judgment of the promoters allow the shares to be sold to the public at about their par value. If the profits are legitimate, the business stable, and the financial condition honestly set forth, the arrangement is proper. If the enterprise had been started originally as a corporation, it is to be feared that the large profits annually earned would have been considered as commercial wrongs to the community. But whether these profits are fairly earned or not, is a question which cannot be determined by the percent- age of such profits to the original investment. Their fairness is not alone to be judged by the rate of returns, nor by the fact that those returns are divided among partners or paid to shareholders by an incorporated company. Conceding that in fairness the value and profits of a corporation should vary with the degree of success, and be allowed to grow with the growth of business gen- erally, the question arises : How should that increase be registered ? Real estate finds purchasers at prices which show the successive changes in values. The property of large companies cannot be so treated. A merchant takes an inventory on a certain day, and so can close his books for the year with exactness. Not so a railway, for example, whose balance-sheet must continue on the same nominal basis of values from year to year in order to preserve the continuity of the com- pany. Such corporations can show the daily or yearly 138 Corporation Finance fluctuations in the value of their assets, and in the value of their stocks and bonds based upon those assets, only by changes in the market prices. This occasions no trouble in the case of industrial corporations whose stock is in few hands ; but in the case of companies whose shares are owned largely by persons exercising no direct control over its affairs — by investors, in short — other questions arise ; when increased profits are to be divided higher dividends must be paid or additional stock issued. Usually the stock is ' ' watered ' ' to make the capitalization conform in a rough way to the value of the property as determined by its probable earning capacity. During the flush times following the resump- tion of specie payments in 1879, the railways, particu- larly those west of Chicago, felt the full effects of the improved conditions and good crops. They made money rapidly. The Chicago, Rock Island, and Pacific Railway Company, for illustration, paid 9% per cent, dividends on its then capital stock in the fiscal year ending March 31, 1879, and ten per cent, in 1880. Finding its profits still increasing, the company, in June, 1880, doubled its capital stock, giving to the holders two shares for one. The prognostications of its officers were for the moment justified, for the com- pany on its doubled shares paid 6^ per cent, in divi- dends in 1881, and seven per cent, in 1882. Stock-watering in this, its innocent form, is not an attempt to cover up extortion, so much as to solve a commercial question. It is not a cause of an increase in profits, but rather an effect of such increase, whose fairness toward customers should be judged in other ways and by other means. The prejudice in the public mind against the distribution of dividends by corporations at a percentage higher than the usual Public Policy 1 39 interest upon loans, makes the public itself in a meas- ure responsible for such shares of unpaid stocks as are issued to conceal the fact that the earnings are larger than the usual borrowing rate. The remedy for stock-watering, therefore, even in its innocent form, is not additional law but a change in public opinion, which shall allow the payment of ten, twelve, or fifteen per cent., if legitimately earned, to the shareholders of corporations organized for business purposes. It would certainly be a gain in honesty if the capital of a company could openly be stated at a sum no larger than the amount actually invested. This would be the result much oftener than now if such returns as are above suggested could, without protest — because of that fact, — be paid if earned. But tbis is not all. The community by its feeling against high corporation dividends deprives itself of a certain natural protection against unfair earnings ; because if such were openly paid competition would be oftener at- tracted. The tendency of an open return would be toward a lower return. In the case of the Chicago, Rock Island, and Pacific Company just mentioned, the extreme profitableness of traffic-carrying in the years following 1880 was found not to be lasting. After 1 pay- ing seven per cent, in dividends upon the doubled stock yearly, from 1882 to 1887, the company distributed but four per cent, in the years from 1889 to 1893^, thus 1 bringing the real returns to about the same rate' as , ruled before the watering. Had the original capital not been doubled this latter return would, not seem ^o small. What the community has lost in freights and ' ' facilities, through the efforts of the managers, to pay ( dividends on doubled capital at a rate which should nominally be as high as the usual interest on borrowed money, can only be a matter of conjecture. 140 Corporation Finance The tendency of corporation managers, under the pressure of public protest against high dividends, to water the capital has been much accelerated by the financial law that stock-watering actually increases market values. If a company is paying ten per cent, annually in dividends, its shares will be quoted, let us say, at 175. If now the company doubles the number of its shares and continues to pay five per cent., its new stock will be quoted at about par. The original holder, while receiving the same aggregate dividends as before, finds his principal increased in value. The same law holds good when shares are below par. If a company's stock is quoted at sixty, and a stock divid- end of fifty per cent, be declared, the quotations will not fall to forty as they ought. This fact, probably explainable on the previously mentioned theory that share values are in part based on the interest rate, has always been a strong incentive to stock-watering. Another objection to stock-watering isthat while it provides a method by which capitalization and profits may correspondingly increase, it affords no means of registering a decline in those profits, for shares once issued cannot readily be found and called in. In spec- ulative America fluctuations in business profits are to /be expected, and one of the embarrassing things in Wall Street is the presence there of shares having little 1 or too intrinsic value but which may be used by unscru- pulous and sometimes almost penniless adventurers to obtain possession of a railway or other company. The temptation in such cases is great for the men thus 1 placed in control to recoup themselves in some way for the cost of purchasing that control. Iyow-priced stocks cannot, of course, be avoided, but their number might be largely decreased if we could remove from the Public Policy 141 exchanges those shares which represent "water" principally, and which have fallen below the expect- ations of optimistic stock-waterers. The well-known early history of the Erie Railway furnishes a good illustration. Yet here, as before, we must first remove the cause of the trouble ; namely, the public feeling against good corporation profits based upon the origi- nal investment. The argument of the stock-waterer always is, that in no other way can he secure profits commensurate with his risks, even if fairly earned ; and it is an argument which has its force. While the amount of capitalization has little effect upon the rates charged by the railways — for it is in reference to railways that the question has been most discussed — the indirect results of excessive capitaliza- tion are evil. If a company's capital stock has been doubled and the shares now receive (let us say) five per cent., these shares are sold to innocent holders on the basis of a five per cent, return. If, for any reason, the dividend should be reduced to four per cent, there are immediate protests from the then share- holders, for the reason that the apparent returns are below the nominal rates of interest. But if, on the other hand, the company had been allowed to continue payments of ten per cent, upon the original number of shares, that percentage of payment for good commercial reasons could be reduced to eight per cent, without so much complaint — the reduction in the actual earnings of the company being the same in both cases. It is because of this that, when a decline in profit comes, stock-watering has a direct effect. The managers knowing that a reduction in the dividend rate from four to five per cent, will be very unpopular, strive in every way legitimately and illegitimately to continue 14 2 Corporation Finance the old payments. They will withdraw trains, will discharge employees, will buy less supplies, and in every way will endeavor to increase their net earnings up to the former amount, with the result that the public are deprived of facilities to which they are en- titled and which they might otherwise obtain ; while at the same time the industrial depression is aggra- vated by the larger number of men thrown out of work directly through the action of the company in their discharge and indirectly in the refusal to purchase the usual amount of material and supplies. Here, again, the condemnation goes farther than complaints against the existing management and touches the source of the trouble, viz., the attempts of the company, per- haps years before, to placate public opinion while at the same time paying the high dividends to which its shareholders considered themselves entitled. There is reason for thinking that the former lack of train service on the New York City Elevated and the de- ficiency in other facilities (such as the proper lighting of the cars), of which loud and frequent complaints were made, can be traced back to the time when the owners, finding their projected profits more than five or six per cent, on the original cost, issued the watered stock of the Manhattan Company to correspond with the expected increase in dividends. Had public opin- ion allowed the payment of ten or twelve or fifteen per cent, on the original capitalization, it is possible that better service would have afterwards been given, even though the dividends had then been reduced to eight per cent. Public opinion against high corporation returns is thus responsible indirectly for the later pub- lic complaints of overcrowding and other ills. What has been considered may be called the inno- Public Policy 143 cent form of stock-watering. But all stock-watering is not innocent. An unreal prosperity may be brought about through an illegitimate curtailing of expenses and in other ways, so that an extra issue of stock may falsely be made to seem justifiable on grounds of large but fair profits. Or honest prosperity may come up quickly, to fall away as quickly. In either case, whether through fraud or error, the increase of capital stock may be commercially unwarranted and a source of loss to innocent investors. Again, parties in control of a railroad or other large corporation owning compara- tively few shares, may decide suddenly to distribute new shares free ; and, by taking advantage of their ex- clusive information, may, if unrestrained, make large sums of money for themselves. Or, further, a com- pany's directors, to perpetuate their control, may issue new shares to themselves at merely the cost and trouble of buying old shares on a margin. This may result in giving over to men not equitably the real owners, the management of an important property. Such control is not likely to be exercised for the public good, but rather for speculative purposes. Such stock-watering as this is an abuse of the principles of good corporation finance, against which it is the right of the State to protect itself by all legitimate means. Yet, until high returns are freely allowed, the distinction between the right and the wrong of the practice is one always to be borne in mind. The laws of New York State regard- ing railways try to meet this difficulty. Its statutes provide that no increase of capital stock shall be valid unless approved by a two-thirds vote of the share- holders at a meeting called for that purpose after twenty days' notice to each stockholder, and unless also approved by the Board of Railroad Commissioners. 144 Corporation Finance A further amendment, passed in 1890, adds that no stock shall be issued except for money, labor, or prop- erty. In passing upon applications for increase, the Board since 1883 has wisely interpreted the statute as not condemning such issues where cause is shown. The Board consents to an increase when the new stock is to be sold and the proceeds spent upon the property ; but if the stock is to be distributed free, then the total capitalization (bonds and stock) must not exceed the cost of the property. It is the custom to include in the term cost, all improvements paid for out of revenue. Practically, therefore, when such an unpaid issue seems expedient for sound commercial reasons, but little stands in the way of the Board's approval ; for ex- penditures on the property above cost of mere mainten- ance from year to year can usually be shown by all prosperous roads ; yet it would be better to increase dividends than to increase the capitalization. On the other hand, the New York statutes have apparently stopped, or at least rendered very difficult, the fraud- ulent cases of stock issue just referred to. The neces- sary vote of so large a proportion of stockholders after a three-weeks notice of the reason for calling them together, renders the action of a. minority -holding Board of Directors practically impossible should such a board attempt to give money or control to themselves by a sudden issue. The real owners must first approve of the plan. Then the public stockholders' meeting and the public argument before, and investigation by, the Board of Railroad Commissioners take so much time that all concerned have an opportunity in which to arrange their holdings for the change. There is, of course, the further objection to any issue of share capital without full payment, however justified by Public Policy 145 trade circumstances, that it really gives to a holder at once and at a particular time that increase in value which may have been accruing for years. But by such laws as these of New York, the State, until public opinion as to corporation profits changes, has gone as far as it rightfully can to protect all interests. No statute can give exact justice, to every complainant. To stop all free issues of stock, even the innocent, would, in the present state of opinion upon the unfairness of high corporate dividends, put a check upon corporate enterprise which would work injury to the public as a whole. The State selfishly wishes its capitalists to realize enough returns from incorporated capital so that as many railroads as are needed may be built, the public thus getting facilities in transportation not otherwise attainable. The State of Massachusetts in 1894 enacted amendments to its railroad laws, which forbid the free issue of stock under any circumstances ; issues of shares are lawful only after approval by the Board of Railroad Commissioners and for the purposes certified to, and must be sold to shareholders at auction at not less than par, or at the market value if more than par. Such absolute prohibition of stock-watering is economically justifiable only where no limit is put upon corporation dividends either in public opinion or indirectly through legislation intended arbitrarily to reduce charges. CHAPTER VIII CORPORATION REORGANIZATIONS AND RECEIVER- SHIPS A I/THOUGH as has already been stated, the corpo- ration form is best adapted for those businesses which meet a public demand, whose volume of trading or traffic or manufacture is apparently steady, and whose profits under good management may be ex- pected to be reasonably uniform, and although under such conditions insolvency should be rare, yet incorpo- rated companies at times become bankrupt — that is, are unable to pay their floating or funded debts. If such corporate insolvencies in any line of business con- stitute a larger percentage than is shown by the gen- eral average throughout the United States, a percentage larger either in the proportion of bankrupts to the whole or in the proportion of assets to liabilities, then it is important for the welfare both of investors and of the public that careful investigation should be made to ascertain the causes of such undue percentages. Perhaps the reasons for such large proportion of bankrupts may lie in the fact that the earnings of the company from some cause have been reduced so fast that the expenses could not correspondingly be cut down ; or it may be that the capitalization of the company was in the first place arranged on a false basis; or perhaps the failure may have come from Reorganizations and Receiverships 147 a combination of these causes. Sometimes, also, wide- spread commercial disasters, such as the failures of crops over a large section of the country, may account for the temporary embarrassment ; although even in such a case the possibility, in a concern whose finances have been conservatively managed, ought long ago to have been taken into account. But from whatever cause arising or whatever the per- centage may be of those companies which have failed to have achieved success, the fact of the inability of any company to pay its debts brings up at once a large number of financial problems of extreme difficulty and delicacy. The affairs of the simple trading company, when forced to succumb, may prove comparatively easy of adjustment ; but not so with large companies. Our great railway systems, for example, have grown to their present size by degrees through the construction or absorption into the system of lines or branches once independent, or which may yet be nominally considered so. The credit of such a huge railway system is also a matter of growth; but a good credit once attained does not yield easily to the first rumor of disaster. The managers, properly careful for the interest of the share- holders, put the best face upon the declining revenues in the hope that the deficit may be but temporary — and indeed by helping to tide over a period of embarrass- ment through the means of old-established credit, the managers of such a system have in many instances really saved the property for the shareholders. In other cases, however, where the evil was too deep- seated to be removed or where the embarrassment con- tinued so long that it could be no longer ignored, the confession of insolvency has found the affairs of the company in a most unfortunate shape. 148 Corporation Finance The receivers, upon appointment, have been ordered by the court to pay off those back debts which properly should have been discharged at the time of their incur- ring from current revenues, but which were allowed to accumulate in order to enable the managers to maintain the appearance of solvency. As these claims are made a first lien upon the property either with or without the issue of receivers' certificates, usually the property must remain in receivers' hands at least as long as it may be necessary to accumulate from the revenues sums sufficient to provide for these prior claims. If, after a time, it is found that the payment of these claims from revenues is impossible, or where receivers' certificates have been issued for this very purpose and are now outstanding, then these sums must be taken into account by the reorganizes of the company as so much which must be raised by the owners of the prop- erty before it can be turned over to them. In addition to the sums of money thus directly re- quired, it is almost always found that other cash amounts are also necessary. Since a railway system does not plunge at once into insolvency, it usually finds itself tending in that direction for a longer or shorter time previous to the final confession, and it commonly hap- pens during these months or years when the stress of the circumstances began to bear hard upon them, that the managers have omitted to do many things which the business of the company really required. In the case of railways the roadbed may have been long neg- lected without absolutely going below the standard of safety. Repairs to wooden bridges or trestles have been delayed and renewals of rails and ties have been put off, so that the real requirements of the property are not revealed until a receivership makes conceal- Reorganizations and Receiverships 1 49 ment no longer advisable. When that receivership comes and before reorganization plans can be drawn up, the amount of money necessary to be spent in order to make good all depreciation and to render the plant capable of the most economic working must be de- finitely known. This is the time, too, for an outlook into the future when the possible changes in transport- ation rates or in the services demanded should be met by some arrangement for granting to the reorganized company certain sums of money year by year for this future use. Altogether the cash requirements for the present and for the future constitute sums which must be raised in reorganization either by assessments upon the shares and bonds or — what amounts to the same thing — by some arrangement which will allow of a prior mortgage upon the property sufficient to accom- plish these results. Usually, also, it is necessary that the accounts of the defaulting company should be gone over carefully in order that the real earnings of the property, unadulterated through bookkeeping assets or suspense accounts or padding of any kind, should be ascertained. With these figures before them and with the outlook for business in general and in the section of the country immediately concerned in particular, the banking firm or committee are able to determine within reasonable limits what the earning power of the company after reorganization will be. Here, then, are the elements of the problem at the beginning. A certain amount of cash must be raised to pay off debts and to make good the deficiencies in the depreciation account ; allowance must be made for the cash requirements of the future ; and finally all the fixed charges of the reorganized company must be brought so far below the assumed 15° Corporation Finance earnings as to give to the new bonded capital a good standing and credit at once upon all the exchanges. It having been determined to what extent the present bond- and shareholders must suffer loss in order to bring the capital of the new company within the earn- ing limits at the time of reorganization, the next prob- lem is the division of this loss among the old security holders. This is a task demanding the widest know- ledge combined with the best financial judgment. Under our assumption the railway system, now insolv- ent, is composed of many different parts, each having upon it bonds varying in value, in interest charges, and in length of time to maturity, whose liens upon the various properties may also be so interlaced as to make their disentanglement a very difficult thing indeed. Very likely there are prior hen mortgages upon the older parts of the road on which the interest charges have unquestionably been earned. Where such is clearly the case, such bonds should not be asked to surrender any part of their principal or interest. A fundamental axiom in corporation financiering is that bonds which are unquestionably good should unquestionably be paid. Nothing tends to throw discredit upon corpora- tion securities so much as a lack of discrimination in cases of insolvency between bonds which are good and those which are not. Perhaps there is also a first mortgage upon the entire system whose interest has been earned ; if so, the loss should fall upon the junior securities ; or perhaps one of the difficulties of reorganization begins at this point. It may be that the main line has earned the interest on these first-mortgage bonds, to judge from the state- ments prepared in the auditor's office ; but it is im- portant to inquire whence comes the traffic whose Reorganizations and Receiverships 151 carriage has yielded this profit ? There may be branch lines which give to the system so much of its volume of business that without them interest on the first-mort- gage bonds would not have been earned ; it may be that valuable terminals in the large cities are occupied by the company subject to mortgages of their own ; or, again, perhaps contracts of various kinds have been entered into with connecting roads which on their face are unprofitable, and yet if those contracts were an- nulled the resulting indirect loss to the company might seriously imperil the interest on the first mortgage which we are considering. Manifestly, in the face of such complications, it will not do to say that interest on these first-mortgage bonds has been earned and should be paid, while at the same time no allowance is made for interest upon the terminal bonds or branch-line obligations or contracts with connecting lines. If it is a question of division of the losses between them, the exact proportion which each should suffer can only be determined after a careful search into the whole mat- ter and after a full investigation into the claims of each one of these from a transportation point of view. It is, in a majority of cases, useless for the holders of bonds having a lien upon a specific piece of road to think of foreclosing their mortgage and taking the property covered by it out of the system to make it independent. An exception, of course, must be made in the cases of property such as a terminal in a large city, which may be essential to the business of the de- faulting company and yet which may be so situated as to be easily turned over to and used by some other company. In such cases, of course, there is no alter- native but to keep such terminals in the system by paying interest upon the bonds ; usually the courts are 152 Corporation Finance quick to recognize the exigencies of the situation and to authorize the receivers to pay such interest even at the expense of the remaining parts of the trust estate. Usually, however, a piece of property, even though covered by a separate mortgage, finds its chief value as a component part of the system as a whole. The reason for the amalgamation of separate railways into one system is that the business as a whole may be administered to the best advantage of all. Under these conditions the individuality of any one part of the system is in time lost and cannot be easily regained even under a separate ownership through foreclosure of that particular mortgage. There is something, therefore, beyond mere words in the disinclination so often stated by the courts to allow any ' ' disintegration of the system," and there is likewise good reason for the further order that at any sale for the purposes of re- organization the whole shall be offered as one parcel. This is the true policy, not only from the point of view of the investor which we have just been considering, but also from that of the public whose facilities for quick and cheap transportation would be seriously inter- fered with, were an old system allowed to be broken into its separate parts by reason of differences of opin- ion between the bondholders as to the values of their respective mortgages. The same reasoning with modi- fications suited to the circumstances applies to corpora- tions other than railways which have been conducting large business operations. Stockholders to whom belong all the profits of the enterprise should under ordinary circumstances be will- ing to bear the losses. It is upon this principle that the cash requirements of an insolvent company, which have just been referred to, are usually made up by an Reorganizations and Receiverships 153 assessment upon the shares. But this principle is it- self limited by expediency. If, under the influence of impending trouble and actual insolvency, the quota- tions for the shares on the exchanges have fallen to very low figures, a large assessment levied upon each share might indeed, if carried out, result in the wiping out of such stock under a reorganization, but would not bring into the treasury of the new company any cash ; the old shareholders would prefer to lose their holdings rather than to pay the assessment demanded, unless they were convinced that the prices of the new shares upon the exchanges after reorganization would at least be higher than the amount of the assessment. If the shares alone are asked to furnish the money for the cash requirements and at the same time to stand the brunt of the reorganization generally, the new stock to be given in exchange for the assessment might be of little value. From the nature of the case the equities of a reorganization cannot be proved like a mathematical problem, but are matters of individual judgment ; hence able lawyers employed by aggrieved shareholders are often able to bring forward facts and arguments to such an extent as to make doubtful or delay the carrying out of any plan of reorganization to which their clients are unanimously opposed. More than that, the mortgages, under whose terms the bond- holders must act in foreclosing, often contain sections whose exact meaning perhaps is doubtful, or whose provisions cannot be quickly carried out, offering chances for long legal delays. It is sometimes possible for the shareholders to oppose the foreclosure of a mortgage so skilfully as to make the carrying out a matter of years. For all these reasons it is customary in drawing up plans of reorganization to consult the 1 54 Corporation Finance so-called "rights" of the stockholder to as great a degree as is consistent with justice to all concerned. The practical effect of this small deference to the shareholder is to put a part of the losses under reorgan- ization upon the junior securities ; that is, upon those mortgages which of course come ahead of the stock, but whose lien upon the property is subsequent to the older bonds. Perhaps the cash requirements already spoken of may be arranged for by an assessment of several dollars upon each share of stock and also upon the junior bonds. Sometimes when the future looks hopeful, the holders of the senior bonds may be asked to forego their interest for a while or to refund their coupons into a separate loan for which they may re- ceive other securities under the plan. In the history of American railway reorganizations, it has been a common thing to find certain bonds or shares given to the old holders, to represent the cash assessments which they were asked to pay, or the losses in principal or interest to which they were asked to submit. Such a course is justified by business conditions in the United States. In America values are largely determined by reference to the future. Quotations of the corporation stocks or bonds upon the exchanges are governed by two considerations — the present earnings and the expectation for the future. Such a method of estimating values is to be expected in a large country not yet fully developed, whose agri- cultural and mineral possibilities are great, and which on the average is increasing in wealth and in the volume of business year by year. The very pace by which industry usually advances leaves the way open for temporary depreciations, and these for a time may curtail business to such an extent as to leave a railway Reorganizations and Receiverships 155 or other corporation unable to meet its obligations. If, under these circumstances reorganization becomes necessary, it is not forgotten that the future may have in store for the company greater earnings than are now annually being obtained. Hence it is in accordance with business facts that the holders of bonds or shares which, under the stress of present necessity, must sac- rifice something, should ask that some evidence of their former claims against the company be granted them. They ask for this evidence so that if the com- pany in future years should earn as much as in times of former prosperity or indeed anything at all beyond the present standard, these old postponed claims may then become alive again and be worth something to their holders. Nearly all railway reorganizations re- cognize the justice of this position, and the plans are arranged accordingly. Another reason why the method of giving some evi- dences of indebtedness in exchange for assessments or bond losses is popular, lies in the fact that investment sentiment seems better satisfied where paper of some kind is given to bondholders in return for their sacri- fices, than where such sacrifices are demanded without it. This is true even in cases where the intrinsic values of the two pieces of paper are no larger than that of one alone would be. But even where intrinsically the same, it is a common experience that the quotations for the two are larger than would be that for one alone. The great majority of mankind are optimists and deal with corporations' shares and securities optimistically. The natural hopes of investors, therefore, serve to give to an income bond or a share of stock dependent upon future earnings, a quotable value which through senti- ment may be considerably higher than that justified by the present position of the company. 156 Corporation Finance For these reasons it may be possible in an easily ar- ranged plan of reorganization to give to the holder of a discredited bond a new bond for a part of his claims, and in addition an income bond or shares of preferred stock, in such proportion that by selling both new issues the old bondholder may be able to get back his entire investment and really lose nothing. Such a proced- ure, however, is oftentimes possible only when the capitalization of the new company is largely increased. If regard is had to the present time only and to the demands of the present holders of the bonds of the defaulting company, such a reorganization will be con- sidered a success ; and it is not to be denied that the wish to satisfy present demands is legitimate so far as it may be proper. But if we regard the day of reckon- ing, such a reorganization may not be defensible. The new capitalization may indeed be made to mature long years hence, but when that maturity arrives and the increased principal must be met, the wrongfulness of a plan which increases the capitalization, even though without an increase of obligatory charges at the mo- ment, becomes apparent. And if, meanwhile other disasters should overtake the corporation, the old in- judicious arrangement of increased capitalization will make it all the more difficult to secure to the company such new money or such concessions as it may need. When the holders of discredited bonds are asked to surrender a part of their principal and to accept a smaller rate of interest, an income bond to represent the losses may be offered to them. To satisfy the con- ditions of the problem, this bond must be of such a character as to be quoted in the Street at such a figure as will reimburse the old holders for their sacrifices ; at the same time, of course, the object of the reorgani« Reorganizations and Receiverships. 157 zation must be kept in view — that is, to reduce the fixed charges. To satisfy both these conditions, the income bond must be made contingent upon earnings on the one hand, and on the other must have also such obliga- tory features as will commend it to investors. Al- though these two features are contradictory, such a bond has, in a number of cases, been arranged for in American reorganizations. Experience has shown what, indeed, might have been expected, that such a form of corporation capital works out no better in prac- tice than in theory. On the one side, the holders of such income or preference bonds are continually claim- ing that certain profits earned by the railway company should be paid over to them. On the other hand, the principal being an obligation, these income or preference bonds often stand in the way of proper management of the finances of the company. As every growing system has increasing needs, the managers find easy opportuni- ties where the expenditure of a few thousands of dollars would bring a large return in the way of increased traffic or profit ; yet they are debarred from borrowing money because the income mortgages deny them that privilege. The result of this curious position is that the company does not progress as it ought, the acuteness of the managers being meanwhile exercised to devise means whereby the too stringent terms of the in- come mortgage may be made practically of no effect. For illustration, a company may need larger terminals, and these terminals may be the means of increasing the profits which should go toward paying something upon the income bonds. Being, however, unable in its own name to borrow the money to pay for these terminals (because the new mortgage cannot be put ahead of the income bonds), the company may arrange to have them 158 Corporation Finance held in another name, meanwhile entering into a con- tract with the terminal company to pay over to the latter certain sums for the use of the supposed ter- minals. Such a terminal charge per passenger and per ton is agreed upon as will be enough to meet the interest on the new terminal bonds ; such terminal charges being meanwhile added to the working ex- penses of the system. In this way practically the interest on the terminal bonds is paid for by the parent company, although the terms of the income or preferred mortgage would forbid such a thing if attempted directly. All these considerations being taken into account, the quotations for these income bonds often rule so low upon the stock exchanges as to make a large issue necessary if the original losses of the bond- holders under reorganization are to be thus made up. As a consequence, the capitalization of the new com- pany is much larger than that of the old. Preferred stocks given in exchange for the sacrifices of the old bondholders are much better than income bonds from the point of view of good corporation finan- ciering. Preferred shares may thus properly represent deferred claims. There is no peremptory obligation resting upon the company to pay an annual dividend upon these shares, particularly if they are made non- cumulative. To make dividends on preferred shares cumulative is not good policy except in extreme cases, because it lays the shares open in modified degree to the reasoning which has just been applied to the income bonds. Preferred shares, too, have voting power, and their holders, even though small in num- ber, are thus put in the way of defending their own interests in the Board of Directors or before it. More- over, while an excessive capitalization represented by Reorganizations and Receiverships. 159 shares is an evil and gives rise to some objectionable con- ditions in our corporation finance, yet it is by no means so dangerous as excessive capital represented by bonds. Altogether, therefore, preferred shares represent de- ferred claims under reorganization much better than can income or preference bonds, and in all cases of reorganization should be issued for such purposes where the laws of the state will allow of such issue. The issue of preferred shares in exchange for assess- ments paid by the common-stock holders is often made expedient by the sentimental wish of the assessed shareholder to have some special piece of paper to represent his payments. Legally the owner of a single bond is entitled to all the rights and advantages which the terms of the mort- gage may give. It is becoming more common, however, to limit the rights of a small minority by modifying somewhat the extreme language of the mortgage. Rail- way mortgages now usually provide that the trustees shall take legal proceedings, shall declare the principal due and shall proceed to foreclose, only when a certain percentage of the bondholders request it so to act. Cus- tom yet gives to one half of the bonds outstanding, or sometimes to a smaller percentage, the right to demand the satisfaction of their mortgage through the trustee. But the legal right of foreclosure is one thing and the commercial expediency is often quite another. A sys- tem with a number of different classes of bonds upon it being in difficulties, the holders of some of the junior issues may be unwilling to agree to any plan of reor- ganization whatever, or may find fault with the pro- portion of new securities to be given them under the advertised plan. In either case one half or more of the bondholders have the power to compel the trustees to 160 Corporation Finance begin foreclosure proceedings. If these proceedings are carried through, these same bondholders must be prepared to bid in the property in order to secure their debt. This, in turn, involves ' ' financing ' ' the new company. They must often be prepared to furnish money enough at the sale to pay all the floating and current indebtedness, and if they would make a success of their new company, they must also be ready to furnish the capital which under our assumed con- ditions the system needs in order to be put in good condition and ready for economical working. These two requirements may call for so much money that the bondholders may well hesitate before they enter upon such an undertaking. Holders of corporation securi- ties are scattered throughout the country, and perhaps many of the bonds are held in Europe. A scattered majority stands rather helpless before such a problem ; the trustee will not act unless expenses are guaranteed to it, while no banking house will undertake the forma- tion of a new company unless it sees clearly that the conditions favor success, and unless, too, it has the support of a majority of the mortgage issues. It is customary now for committees to be formed to protect the interests of the various securities involved in the insolvency. If such committee succeed in getting the greater part of the securities deposited with it, it be- comes a factor in the reorganization ; yet even when this is the case, such committee may not be willing to furnish the large sums necessary to finance the new company in a manner favorable to the particular bonds held by them. It will thus be seen that it is better for the bond- holders of a bankrupt railway system to accept a plan of reorganization, if found equitable, rather than to Reorganizations and Receiverships 1 6 1 attempt to buy in the property for themselves. If the proposed plan of rehabilitation is believed by a majority of all bondholders to be unfair, it will usually fall to the ground through lack of support ; that is, a plan, to be carried out successfully, must have the active as- sistance of a majority of the bondholders given to it through a deposit of bonds of those holders who assent to the plan. No matter how strong the language of the mortgage, the bonds issued under it are worth only what the commercial conditions of the company allow ; hence it is better for the holders of defaulted bonds to accept a plan when found upon examination to be equitable, than to insist upon their legal rights ; for their bonds are worth only what their proportion of the total value of the company's property comes to ; they could not get any more than that proportion even though they insisted upon the full terms of the mort- gage. Corporation reorganizations resolve themselves into commercial problems rather than legal. As business conditions change rapidly in a develop- ing country, it frequently happens that a company when insolvent and about to be reorganized wishes to get rid of certain branches, guaranties, leases, or other contracts which in the course of time may have proven themselves very unprofitable. So long as the corpora- tion is solvent, the question of the justice of living up to its contracts does not arise. When, however, it con- fesses that it is unable to pay its debts, then its financial rehabilitation becomes a question of commercial value, and in this light it is deemed proper for a reorganization committee to plan for a cutting off of those branches, leases, or other contracts which are recognized as bur- densome upon the company. Sometimes a company is rehabilitated without a sale of its property at foreclos- 1 62 Corporation Finance ure. In such happy cases it has been found possible to make such an arrangement among all the bond- and stockholders as enables the old company to rearrange its mortgages and shares and go on with its business under the existing charter. In cases, however, where unprofitable branch lines have had to be supported or onerous contracts carried out, the determination to relieve the company from these burdens proves a stumbling-block to the easy form of rehabilitation just referred to ; for whenever a company is rehabilitated by a change in its financial arrangements and proceeds with its business under its old charter, all the contracts, guaranties, and leases which it may once have entered into are kept alive and become claims against the com- pany. The only method of getting rid of such burden- some guaranties or leases is through the foreclosure of some one of the mortgages and a sale of the property and franchises to another company. If there is a char- ter in existence whose privileges are such as to meet the conditions of the insolvent company, then the prop- erty may be sold and conveyed to a company organized under it. If this is not possible, then a new charter must be obtained in the state or states concerned. It is at this point that new difficulties arise. In many cases the charters under which the insolvent systems are now operating were granted many years ago and contain privileges which could not now be obtained from any legislature or from congress. It may be that the state which originally gave the fran- chise has, since granting that charter, enacted new laws which forbid perhaps the very things that the old charter permits. Under these circumstances the fore- closure of one of the mortgages on the system and the sale of the property to a company formed under a new Reorganizations and Receiverships 163 charter might involve the surrender of so much of the old commercial rights as would render the success of the enterprise doubtful. Here, again, it may be expedi- ent for the holders of a senior or a junior mortgage to make some concessions which will allow of a restora- tion of the plant into the hands of the original com- pany, rather than to insist upon the carrying out of the provisions of the mortgage, which, though legally clear, are impossible of fulfilment except at the ex- pense of the holders of the bonds themselves. When systems having old and valuable state or federal char- ters have also burdensome leases or contracts, the adjustment becomes one of great difficulty. If the present charter be retained, the onerous contract is still in force even though temporarily disowned by the receivers ; if it is sought to throw off these contracts by a sale to a company newly organized under present laws, an equally large or even larger loss may be entailed. If neither party will yield something under these conditions, the property may stay in the hands of receivers much longer than would be otherwise neces- sary, and longer too than the courts prefer to keep the control in their possession. If at last neither will yield, it becomes a choice of evils. It may be that during the period of embarrassment the general business of the company has suffered to such an extent that the senior bonds are affected. It then becomes a question whether these senior bonds will foreclose their mortgage and let the property go for what it will bring ; in such cases the breaking up of large and important systems is a thing to be lamented in the interest of the public no less than that of the creditors themselves. Before insolvent companies undergo reorganization there is usually a period of receivership. The practice 164 Corporation Finance of operating insolvent railways through court officers appointed for the purpose is not yet definitely settled either as to the methods of working or as to the legal doctrines involved, the whole matter being yet in a state of evolution. It is the boast of our law that it changes to meet the changing demands of commerce as business becomes more complex and the rules govern- ing it necessarily more involved ; so as regards railway receiverships our present situation is the result of a compromise between the terms of railway mortgages and the commercial conditions under which railway operations are carried on. The original idea of appointing a receiver to take charge of the property of a firm or individual was that the business might be wound up with as little delay as possible and the assets sold and distributed to the cred- itors in some equitable proportion. As corporations became more common, taking the place of firms and individuals, the same idea was applied to them when insolvent. They were placed in the hands of receivers in order that their affairs might be closed up with the least possible delay by dividing the assets among the creditors in the proportion to which it was shown they were entitled. It was inevitable that the question of the proper method of treating insolvency among rail- way companies should arise. From small beginnings the number of miles of railway in the United States increased rapidly until now, judged by the magnitude of the property invested and the amount of business done, the railways form perhaps our largest industry, certainly one of the most complex. Through one cause or another it was inevitable that bankruptcy should increase among these rail carriers as their mile- age increased ; and in such cases also it was natural, Reorganizations and Receiverships 165 as in the cases of firms or small corporations, that receivers should be appointed pending a settlement of the insolvent debtor's affairs. But here a new quest- ion arose. A trading firm or corporation unable to pay its debts could be wound up and its assets dis- tributed to its creditors without loss to the community. Other traders could take their places and business would go on as before ; but it was otherwise with the railways. It was quickly seen that great states and sections of states depended upon the continued opera- tion of these railways for the transaction of their every- day business, for supplies of clothing and manufactured goods, and even for meat and bread. Whatever the outcome, the trains must be kept running. Since, in the course of time, local railways have grown into sys- tems, it was found that the interests involved in these systems were so enormous that their combined assets could not be easily sold as one parcel to any one person or company, or sold separately without breaking up the systems. Hence, until the serious questions of reorganization or sale were settled, the receivers of these systems must continue to run the trains in the interest of the public. As these necessary adjustments were often found very complicated, requiring a long time for negotiations and final agreement, the receivers appointed by the courts were placed for the time being in the position of railway managers. They were con- fronted with technical problems of much practical im- portance. They were required to become familiar with disputed questions concerning reasonable rates and their ramifications. The conflicting claims of cities and towns as to charges which should be relatively fair to each were pressed upon their attention. In short, it was required that receivers should be able to form- 1 66 Corporation Finance ulate for the operation of the properties in their charge a policy which should be equitable to the capitalists whose money was invested in the road, to all the sec- tions served by the railway, and to the general travel- ling and shipping public. Needless to say, the success of such a task required men of administrative ability, with the further result that the courts through their appointed officers were obliged to decide upon the details of administration. It was the practice at first for receivers to be asked for solely by certain creditors of the company in order that their property might be held together and protected against the seizure of certain parts of the system by other creditors which might destroy the value of the property as a whole. Usually the corpor- ation appeared before the court in opposition to the motion, so that, if receivers were appointed at all, the court acted upon information brought to its knowledge after a severe legal struggle. The idea that the corpor- ation itself could ask for an appointment of a receiver for its own property originated with the late Jay Gould, whose contention in the Wabash cases in this respect was afterwards affirmed by the Supreme Court of the United States, which held that a company could itself ask for the protection of the court if such was for the best interest of all concerned. Under this doctrine few of our large railway systems are now placed in any but "friendly" hands. In such cases the matter is all planned out beforehand and the men chosen. Any creditor of the company, friendly to the administration, may allege that the corporation owes him money that it cannot pay, and as every going concern has plenty of creditors in the ordinary course of business, such a convenient creditor is usually not hard to find. To this Reorganizations and Receiverships 167 complaint, usually prepared in secret, some one of the company's officers arranges a reply confessing the truth of the charge. All parties concerned, each with the respective documents, and without notice to the other creditors or to the public, apply to the judge, perhaps at night, who forthwith grants the application and ap- points the receivers already arranged for. That this procedure opens the door to the possibility of great abuse of corporate interests needs no argument. That on the whole the plan has worked fairly well is ow- ing to the high character of our judiciary and also of the officers in charge of our great corporations. Yet it is not reassuring to holders of stocks, bonds, or float- ing debt to know that a conspiracy between any small creditor and any one of the principal officers of a cor- poration may throw the control of the whole property of the company into the hands of the court. Unques- tionably, the appointment of former officers of the com- pany as receivers leads to the charge at times that those who had wrecked the company are still left in power. Moreover, the door is open to abuses, such as the diffi- culty easily thrown in the way of a thorough investiga- tion into the company's condition, which it may be the wish of the old managers to thwart, but which may be necessary before an equitable plan of reorganization can be evolved. Yet the affairs of our large corpora- tions have become so complicated that only those long familiar with them are capable of administering them without losses both to owners of the road and to ship- pers. This business fact has so far controlled the action of the courts in the appointing of old officers of the insolvent corporation as receivers, though usually other men not previously connected with the company, but representing important interests as well as the seg- 1 68 Corporation Finance tions through which the road runs, are chosen to serve with them. Laws have been introduced in various states to check the abuses to which the methods of receiverships have given rise, but while these statutes have done good as to certain matters of detail, the com- mercial facts of which we have spoken have been strong enough thus far to prevent any material modification of the policy. The immediate cause of a railway receivership is usually the floating debt. Strictly speaking, the ex- pression " floating debt" means the money borrowed by a company on collateral and made payable on demand or within a short time. The term, however, is sometimes used to cover other debts of the corpora- tion, such as for supplies which have been bought but not paid for. A railway which is fairly prosperous can arrange to pay its bond interest in a period of depres- sion without showing signs of distress. Every large business concern, such as a manufactory, must arrange for a depreciation of plant and machinery before setting aside earnings applicable to interest or dividends. The reason for this is that, were a contrary course to be pur- sued, the stock- or bondholders would very shortly find themselves in possession of a worthless property. In factories the expected losses from depreciation are usu- ally arranged for by setting aside a certain sum of money from the earnings yearly, but the practice of railways is different. It is the custom with them to renew or replace roadbed, track, and equipment from year to year as fast as these deteroriate or become worn out, charging the cost directly to working expenses. By these means the whole plant is kept up to its stand- ard at the expense of the earnings, the effect being the same as though specific sums had been set aside from Reorganizations and Receiverships 169 income each year. This method of arranging for de- preciation allows the railways to vary the amount of replacement from year to year according as the seasons are prosperous or the reverse. In a good year more may be spent upon the roadbed and the track and for the purchase of new equipment to replace the old at the cost of working expenses, than perhaps was pro- portionately required. Then, in poor years, not so much of this sort of work may be done, allowing a larger proportion of gross income to be payable to bond- and stockholders. This saving in the working expenses by a stoppage of repairs to the plant is usually the first resort of the railway manager when pressed for im- mediate money to pay bond interest. Then there are always demands for new capital for improvements necessary to be made by every railway as its traffic increases. Ordinarily bonds are sold to meet these capital charges. If, because of a lack of confidence on the part of the investing public, or a lack of credit as regards this particular company, such bonds cannot be sold, except perhaps at a great sacrifice, then the management proceed to borrow the necessary money for these capital improvements and perhaps for the then due bond interest. Usually the company must hypothecate with the bankers from whom the money is borrowed bonds either of the company itself or such as are held in its treasury and controlling- subsidiary lines important to the integrity of the system, so that the banker's loan may be fully secured. If matters go from bad to worse, if it appear to the lender that the situation of the company is becoming more and more critical, so that he is beginning to doubt the real value of the collaterals held by him, he then calls for his money, if it is loaned on demand, or gives notice that 170 Corporation Finance he will ask for it when the same shortly matures. If the company cannot arrange to borrow the amount from some one else, and if it is confronted with the sale of all its securities at bankrupt prices, the managers may resolve to confess their own insolvency before a public confession is made by the sale of the securities held by the banker. Perhaps, just at this moment, a large amount of interest is due to bondholders. In such a case the railway managers may choose to default on the bond interest and take the money for payment to the floating-debt holders, in order to save for the company the collateral which the bankers may hold, and which may be essential to the control of parts of the system, but which would very likely go for a song if pressed for immediate sale. While, therefore, floating debts do not differ from other obligations of the company except in form, they have come to be recognized in Wall Street as a source of great danger in any period of business depression or lack of credit. If this money borrowed on demand or on short notice can be funded into bonds having years to run, the com- pany cannot suffer through a demand upon it for the principal, but it is safe so long as the interest is promptly paid. This reasoning has led railway com- panies at times to adopt the plan of selling long-time bonds in order to pay off the floating debt, even though the price received should be far below par. But such a course compels the company to pay a very high rate of interest during the whole life of the bonds and is con- sidered such bad financiering that such sales are taken in Wall Street as an acknowledgment that the company is hard pressed — with results to the credit of the cor- poration almost as bad as though the distress had been openly acknowledged. Under these circumstances, Reorganizations and Receiverships 171 " friendly " receivers are often asked for so that inter- est may be withheld from the bondholders and used to take up the obligations of the company immediately pressing, particularly in cases where a failure to meet those obligations would entail severe losses upon the system for all time. The court appointing receivers thus asked for usu- ally stipulates that debts incurred in the operation of a road for several months shall be paid by the receivers. At first blush it would appear that such an order entails hardship upon the creditors of the company, yet upon examination it will be found to be equitable. Trans- portation is conducted as a cash business. Travellers and shippers are required to pay their money down before taking their journey or receiving their property. Since a railway must be run in the interest of the gen- eral public, and since this involves the theory that its working expenses must be paid, it is clear that the expenses of to-day are properly chargeable to the gross receipts of to-day paid in cash by the patrons of the road. But, as we have seen, in periods of distress, the managers in order to postpone a confession of bank- ruptcy in the hopes that the temporary trouble may be tided over, begin to put off payments for wages or for coal, rails, ties, and supplies of all descriptions which they may continue to buy, because necessary for the continued operation of the trains. In this way, at the date of appointment of receivers, every bankrupt road has large arrears of wages and accounts to be made up. As these current obligations are really chargeable to the receipts of the several months past, and as these receipts have been taken to pay bond interest or for other purposes in the interest of the bondholders, it is proper that the prior claims for current expenses should 1 72 Corporation Finance be made up from the first receipts of the road under the receivership. If there is any complaint to be made on the part of the bondholders, it is that the knowledge of these facts has not been brought to their attention ; but usually in such a matter the managers of the road act in good faith, in the hopes that better times may enable them to pay up the back debts and save the indirect losses to the bondholders, which a public con- fession of the real situation would at that time have caused. The heavy expenses confronting, the receivers at the time of their appointment are met partly from defaulted bond interest and perhaps from receivers' certificates. At first these certificates, generally made a first lien on the property, were authorized very sparingly by the courts and only in cases shown beyond dispute to be necessary. Gradually such issues were extended, until the present practice is for authorization of certificates for any purpose which the court may be led to believe is for the ultimate benefit of the road. In this way an- other mortgage is put ahead of the regular mortgage whose bonds, held by the public, have been supposed and declared to be a prior lien upon the road. The force of circumstances often thus impairs the rights of existing mortgages though these be drawn in strong legal language. The right to issue receivers' certifi- cates has been, and may be, greatly abused. In one case the expense of operating greatly exceeded the re- ceipts. The property and franchises should have been sold at once so that the first-mortgage bondholders might at least have received the value of the rails and equipment ; but the court allowed the receivers to go on running the road until the certificates issued to make up the losses amounted to more than the value Reorganizations and Receiverships. 1 73 of the property, the bondholders not getting a cent. Receivers' certificates should be authorized only when a careful judgment tempered by conservatism justi- fies their issue. As just said, the directors, at the first appearance of a decline in profits, economize in de- preciation expenses, hoping for better times. If the decline continues and a receivership ensues, the pass- ing of the property into the hands of the court is an acknowledgment of facts regarding impairment of income which are true though not before generally known. Hence the issue of receivers' certificates commercially represents the impairment of income just referred to, but which at the time was not enforced against the bondholders. Railway mortgages are not sacred because of the strong legal terms in which they are drawn, but are dependent upon success in the busi- ness of transportation, differing in this respect from real-estate mortgages which rely more upon the pros- perity of the whole community. The legal doctrine of certificates is in a state of evolution, with a tendency to approximate its working to the business circum- stances. Our practice of railway receiverships is thus a development of our own circumstances and a sort of compromise between the too strong language of our mortgages and the actual conditions of the business of transportation. A receiver may decline to pay the rentals due to leased lines or the interest owing on guaranteed bonds if these lines are at the time of the receivership unpro- fitable, no matter how necessary to the parent company these branches may once have been. But the old con- tracts are still legally in force against the company, and can be thrown off only by a sale of the franchise and property to a new corporation. Such a sale sometimes 1 74 Corporation Finance would involve a forfeiture of valuable charter rights besides a long legal struggle ; and in such reorganiza- tions committees usually try to formulate some plan which shall bring the fixed charges below the mini- mum profits by allotting the necessary losses among all classes of securities in proportion to their respective values to the system as a whole — a process which does not regard the hens of the mortgages so much as the worth of the lines they cover. But with plans of reor- ganization, the receiver properly should have nothing to do. The legal doctrine and the practice regarding receiv- erships and receivership problems have, in the United States, been developed thus far largely in the affairs of railways. Railways so clearly have public duties to perform that it was inevitable that questions regarding their continued operation should require settlement. This point once settled, matters of detail about the proper working would naturally come up for adjust- ment in the order of their commercial evolution. For these reasons we find the custom regarding rail- way receiverships much in advance of those concerning other corporations. But though these latter lag be- hind, there are not wanting signs that some of the problems of this character which we are trying to solve in transportation, are in the future to demand consider- ation in manufacturing. When factories were numer- ous but small and easily managed by an individual or by a firm composed of but few persons, it was not a matter of great public moment whether one or two firms failed. The demand could be easily supplied by the manufacturers still in business and perhaps the factory itself, belonging to the insolvent partners, would be re-opened and run by another firm. The Reorganizations and Receiverships. 1 75 case is altered already, if we have in mind the large corporations formed to do certain manufacturing on an extensive scale, and the point is likely to demand more attention in the future, when, in the probable evolution of things, the greater part of our manufactured output may be produced by a comparatively few companies having large capital, extensive plants, and the best of appliances — for to such a state of production are we slowly tending. Already cases of the insolvency of large manufactur- ing companies have been before the courts. In appoint- ing receivers, it is now customary in such instances to allow these officers of the courts to continue the busi- ness. I/ike railways, these large corporations cannot very well stop working. Not only are large bodies of laboring men dependent for bread upon this continued operation, but concerns throughout the country would be embarrassed if their orders, perhaps half executed, should not be completed at the appointed time. Under our assumptions, it might not be possible for the customers of the corporation to obtain the required articles from any other source of supply, and certainly not in time to go ahead with their own plans, — plans which if not carried out might cause financial embar- rassment to them also and to others. In short, the larger the company, the more complete the producing organization, the more important to the community is its continued operation. We have heard complaints from solvent companies or firms that the competition of factories in the hands of receivers was unfair to them, exactly as in the case of railways ; but the growing interdependence of trade and commerce leaves no other alternative. This being so, the discussion just had on the com- 1 76 Corporation Finance mercial facts underlying railway receiverships has a bearing upon the immediate and future problems of manufacturing or trading corporations. This is all the more true because these latter are now issuing mort- gages after the manner of transportation companies. In the present customs about railway receiverships and their rapid evolution under the stress of actual condi- tions, and in the philosophy which seems to underlie those customs, we may catch glimpses of the probable experience awaiting the community if large business corporations are to do the most of our manufacturing, and if the managers of those companies should repeat the financial blunders or frauds which appear in our past railway history, or if commercial disaster should compel a readjustment of capital. INDEX. Accountants, public, 19 ; judg- ing of business, 20 Accounting with branch lines, 69 ; losses of branch lines, 72- 74 ; charging off old deficits, 74 ; difficulty in setting forth facts, 80 ; excuse for optimism, 80 ; truth might destroy credit and chance for recovery, 80 ; general balance - sheets, 8 1 ; should show full details, 81, 82 ; profit and loss account, 82 ; treatment of depreciation, 83, 84 ; charging to income or capital, 82—84 ! betterments on British railways, 85 ; better- ments on American railways, 85, 86 ; operating expenses, 87 ; importance of knowing cost of plant, 88 ; for small companies, 88 Accounting for mercantile cor- porations, 89 ; cash, mean- ing oi, 91 ; customers' bills receivaole, 32; indirect obliga- tions, 93 ; customers' accounts, 94 ; merchandise, 95 ; charac- ter of goods dealt in, 96 ; table of liquidation values, 97 ; real estate, 97 ; machinery and fix- tures, 97; merchandise in bond , 98 ; proportion of profits to sales, 99 ; estimate of liabilities and assets revalued, 99, 100 ; statements of condition, 100, 101 Accounting of railways, 102 ; in- come account, 103; general bal- ance-sheet, 106, 137 ; capital losses through lack of credit, 107; explanation of assets, 107; explanation of liabilities, 108 ; bills payable for supplies, 108, 169 ; accrued interest, 108 ; audited vouchers, 108 ; rebates and cut-rates, 109 ; profit and loss, 109 ; details of general balance-sheet, 107-109 ; tabu- lated changes in general bal- ance-sheets, no; expenditures and resources in yearly state- ments, in ; losses of subsidi- ary companies as assets, in; expenditures for capital, how gathered, 112, 113 ; increase in costofroadandequipment, 113- 115 ; statement of equipment, 115: life of rails, 116; percent- age of operating expenses to earnings, 117; examples of operating expenses, 117, 118; maintenance of way, 119, 169 ; maintenance of equipment, 119, 169 ; average number of passengers to train, 120 ; cost of fuel, 120; cost of motive power, 120 ; freight train lad- ing, 120 ; freight cars and freight car mileage, 121, 122 ; general expenses, 122 ; table of quick assets and liabilities, 123 ; bonds in treasury, 123, 124; saving a railway, 124; income account under change 177 i;8 Index Accounting of railways. — Con. of management, 125 ; operat- ing expenses under change of management, 126 ; average cost of a train mile, 127 ; re- ports may give investor the broad facts, 129 ; floating debts, 168, 169, 171 ; see also Great Eastern Railway Alsopp Brewery, 20 American Sugar Refining Com- pany, 136 Atchison, Topeka and Santa Fe, 13, 66, 70 Atlantic and Pacific, 70, 71 B Blank Trading Company, 90 ; estimate of financial position, 99 Bonds, should fetch par, 5 ; if issued at a discount, 5 ; good effect of issue to reasonable amount, 7 ; of manufacturing companies, ir ; experience necessary to establish values, 12; risk paid for by high in- terest, 12 ; municipal, 14 ; of railways dependent on success of company, 34 ; of railway, a lien really upon net earnings, 35 ; debentures, 36 ; foreclos- ure of mortgage to convey title in reorganization, 36 ; prior lien, 41, 42 ; first mortgage, 42, 150 ; income or preference, 42-44, 156-158 ; the position of holders of, 43 ; collateral trust, 44, 45 ; collateral trust notes, 48 ; "blanket" or sys- tem, 49 ; terminal, 52 ; funded debts of railways generally can- not be paid off, 58 ; listing on the exchanges, 62 ; of branch lines, 68-72, 151, 163; of sub- sidiary companies, guaranteed, 75, 76, 163; argument for re- pudiation of guaranties, 76, 77 ; adjustable branch line guaranties, 78; argument against adjustable guaranties, 78 ; guaranteeing, questions to be asked about, 79 ; prior lien, 150 ; foreclosing on specific piece of road, 151 ; terminal, 151 ; junior mortgages some- times assessed under reorgani- zations, 154 ; given for assess- ments, 156 ; under reorganiza- tion, 159-161, 172 ; selling of, to provide for floating debts, 170 Borrowing money, necessary for business man or firm, 1 ; ex- ample of result, 1 ; beneficial to all concerned, 2 ; effect upon prices and profits, 2 ; methods of collecting capital, 3 ; such funds not to be put at hazard, 3 ; should be only to minimum value of property, 4, 5 ; if at too high a cost, 7 ; necessity of a sufficiency of capital, 13 ; by small corpora- tions from banks, 14, 23 ; mini- mum value of industrial com- pany, 17 ; by railways in times of stress, 170 ; see also Bonds, Capital, Mortgages Boston and Albany Railroad, 135 Branch lines, their advantages to parent company, 63, 64 ; divis- ion of earnings with parent company, 65 ; allowances of constructive mileage, 66-68 ; commercial value of, 68, 69 ; how determined in reorganiza- tion, 71; under reorganization, 70 ; their deficits, how carried in accounts, 72-74 ; under re- organizations, 163 ; receivers of parent company may decline to pay rentals of, 173 Capitalization, see Bonds, Ac- counting, Corporations Index 179 Central Pacific, 78 Chesapeake and Ohio, 9 Chicago, Burlington and Quincy, 58,67 Chicago, Milwaukee and St. Paul, 50 Chicago, Rock Island and Paci- fic, 138, 139 Chicago and Northwestern, 45, 47, 58 Chicago and Northern Pacific, 52 Claflin, H. B., Co., 8, 136 Cleveland, Cincinnati, Chicago and St. Louis, 5 1 Companies, gas, 27 ; water, 27 ; Companies, street railway, their traffic stable, 27 ; electricity changes old conditions, 28 ; in- crease of travel, 28 ; reduction in cost of equipment and re- pairs, 28 ; when freshly estab- lished, 28 ; charters, 29 Corporations, distinction between public and private, 24 ; state regulation of, 24 ; widest infor- mation required concerning, 25 , publicity, a safeguard against restrictions, 25, 26 ; taxation of, 26 ; owning shares of other corporations, 30 ; formed to own competing plants, 31 ; trusts, 31 ; possible advantages of combination, 31; their finances, 32 ; mining and other short -iived companies, 58 ; accounting of, 80 ; evolu- tion toward, 131 ; limited lia- bility, the essence of , 131; three parties in interest, 132 ; profits granted to firms often denied to, 132-135 ; grasping monop- olies not now concern us, 134 ; usual test of profits of, by pre- vailing rate of interest, 134 ; uselessness of attempts to limit profits, 135 ; British gas «om- panies, charters of, 136 ; divi- dends of British gas companies, how related to prices of gas, 136 ; registering an increase in value of plant, 137, 138 ; water in stocks or bonds, 135, 138 ; stock - watering, remedy for, 139 ; gain in honesty if actual capital could be stated, 139 ; stock-wateringincreasesquoted values of shares, 140 ; low- priced shares not desirable, "140 ; amount of capital little effect upon rates, 141 ; reduc- tion of dividend easier on non- watered stock, 141 ; effects of stock-watering on service, 141, 142 ; paying high dividends on elevated railroad, 142 ; illegiti- mate stock -watering, 143 ; laws of New York about increasing capitalization, 144 ; laws of Massachusetts about increas- ing capitalization, 145 ; absol- ute prohibition of stock-water- ing, 145 ; may become bank- rupt, 146 ; good credit not affected easily, 147 ; may owe large sums on insolvency, 148, 173; not broken up because of insolvency, 163, 164 ; receivers of, practice of, 165; "friendly" receivers for, 166, 167 ; floating debts, 168, 169, 171 ; payment of floating debts required in insolvency, 169, 171 ; old con- tracts in force in insolvency until reorganization, 173; valu- able charters in insolvency, 174 ; continuing operation un- der receivers, 175 , industrial, under receiverships, 175, 176 ; mercantile, accounting of, see Accounting ; railway, account- ing of, see Accounting Companies, see Corporations, In- corporation D Denver and Rio Grande, 83 Dividends, improve corporate credit, 10 ; sometimes paid i8o Index Dividends. — Con. when not earned, n ; see also Corporations E Elevated Railroad in New York, 133, 142 Erie Railroad, 73, 141 Evansville and Richmond, 76 Great Eastern Railway, 102 ; in- come account, 103 ; Rich Val- ley branch, 104 ; deficits of branch, 104 ; general balance- sheets, 106 ; general balance- sheets analyzed, no; construct- ion account, 114 ; statement of equipment, 115 ; statements of operating expenses, 117, 118 ; table of quick assets and quick liabilities, 123 ; income account under new manage- ment, 125 ; operating expenses under new management, 126 Incorporation of firms, 16; bank- ing houses in connection there- with, 17 ; advantages of, for family concern, 22 ; not for un- stable businesses, 59; profits set down in prospectus, 136; origi- nal cost of plant not statec"., 136 Illinois Central, 45, 47, 67 Louisville and Nashville, 6, 50, 73 M Management, importance of, in corporate affairs, 21 ; of Ameri- can railways, 128 Mortgages on dwelling houses, 33 ; not dependent on business success of borrower, 33 ; rail- way, wording about lien not to be construed too literally, 35 ; railway, description of, 39-41 ; more careful drawing discussed, 60, 61 ; foreclosure under re- organization, 159, 160; affected by commercial conditions, 161 ; development of receiverships under, 173 ; see also Bonds, Corporations, Reorganizations N New York Central and Hudson River, 36 Northern Pacific, 48, 53, 65 O Oregon Railway and Navigation, 46 Oregon Short Line, 46, 66, 67 Pennsylvania Railroad, 87 Philadelphia and Reading, 10, 44 Pittsburgh, Cincinnati, Chicago and St. Louis, 75 Proctor & Gamble Co., 136 R Receivers, to operate railway pending plan of reorganiza- tion, 37 ; must pay certain debts, 148, 171 ; authorized to pay certain interest, 152 ; legal practice of, not settled, 164 ; original theory of appointment, 164; of railways, problems con- fronting, 165, 166, 174; of trad- ing firms, 165, 175; "friendly," Index 181 166, 167 ; certificates of, 172, 173; may decline to pay under old contracts, 173 ; practice under, a compromise, 173 ; probabilities regarding, as to industrial companies, 174 ; see also Reorganizations Reorganizations, affecting branch lines, 70—72 ; large amounts of money must often be raised in, 148, 149 ; earning power of company must be ascertained, 149 ; division of losses among security-holders, 150 ; good bonds should be undisturbed, 150; various mortgages under, 150, 151 ; courts do not favor disintegration of systems, 152 ; losses of shareholders, 152 ; assessments, 153; so-called "rights " of shareholders, 153, 154 ; position of junior secur- ities, 154 ; bonds or shares given for assessments, 154 ; equity of giving evidence of future claims for assessments , or bond losses, 155, 156 ; work of committees, 149, 160, 161 ; increasing capitalization under, 156; increased capitalization represented by bonds or stock, 159; not hindered by language of mortgages, 161 ; as com- mercial problems, 161-163 Richmond and West Point Com- pany, 37, 73 S Shareholders are partners in the enterprise, 7 ; position of, un- der reorganization, 152-154 Sinking funds, 53-58 Southern Railway, 37, 41 Stock, common, when exchanged into preferred, 10 ; amount to be issued at incorporation, 18 Stock, preferred, should have preference upon assets, 8 ; when more advisable than bonds, 8 ; often represents old debts scaled down , g ; ethical claims when so issued, 10 ; given for assessments, 156 ; under reor- ganizations, 156, 158; cumulat- ive dividends under reorganiz- ation, 158 Stock watering, see Corporations St. Paul and Duluth, 9 Trustees under mortgages usually trust companies, 38 ; their re. sponsibility, 59 U Union Pacific, 48, 66, 68, 7r W Wabash Railroad, 46, 51 Wisconsin Central, 53 By CHARLES A. CONANT A History of Modern Banks of Issue With an Account of the Economic Crises of the Nine- teenth Century, and the Crisis of 1907 Fourth Edition. Revised and Enlarged. Svo. Net, $3.50 " No better volume can be recommended to the general reader •rho wishes to familiarize himself not only with the theory of bank- ing, but with the history and actual experience of this great agency of industrial progress." — Chicago Evening Post. " We can only express our hearty appreciation of the book as a whole. It is extremely interesting. It cannot but be useful, and to us it is very cheering. Mr. Conant's book, from beginning to end, is a proof that sound currency is evolved necessarily from the pro- gress of an industrial and commercial people." — N. Y. Times. Wall Street and the Country A Study of Recent Financial Tendencies. 8°. Net, $1.25. (By mail, $1.35.) " The author shows a comprehensive grasp of economic and financial problems, and the capacity for a clearness of statement. . . . 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"It is difficult to exaggerate the wealth of thought and the keenness of analysis contained in these chapters. Each one is crammed full of matter, presented in an at- tractive manner, illustrated by references to history and to contemporary business methods, and often summed up in some phrase or some statement of likeness or unlikeness that is pregnant with suggestiveness." — Prof. Richmond Mayo-Smith, in Political Science Quarterly. G. P. Putnam's Sons New York London . ':' « ■