^tatE Q[iiUege of Agriculture At Olotnell Unittecaity irtliaca, £?. ^. ICtbratg Cornell University Library HG4011.L7 Corporation finance; an exposition of the 3 1924 013 991 413 Cornell University Library The original of tliis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924013991413 Modern Business A SERIES OF EIGHTEEN TEXTS, ESPECIALLY PREPARED FOR THE ALE5CANDER HAMILTON INSTITUTE COURSE IN ACCOUNTS, FINANCE AND MANAGEMENT EDITED BY JOSEPH FRENCH JOHNSON DEAN, NEW YOSX UNnrEESITY SCHOOL OZ COUMEECE, ACCOUNTS AND 7INANCE Titles Authors ECONOMICS OF BUSINESS .... Edwaed Sherwood Meade University of Pennsylvania ORGANIZATION AND MANAGEMENT Lee Galloway New York University SELLING R. S. Butler University of Wisconsin CREDITS Lee Galloway New York University TRAFFIC Philip B. Kennedy New York University ADVERTISING Lee Galloway New York University BUSINESS CORRESPONDENCE . . . G. B. Hotchkiss New York University ACCOUNTING PRACTICE ..... Leo Greendlinger New York University CORPORATION FINANCE William H. Lough New York University MONEY AND BANKING Earl Dean Howard Northwestern University BANKING PRACTICE H. M. Jefferson New York University FOREIGN EXCHANGE Franklin Escher New York University I Thomas Conway INVESTMENT AND SPECULATION A ^^^^^"'^ Atwood"'""' I New York University INSURANCE Edward R. Hardy New York University REAL ESTATE Walter Lindner New York University AUDITING Seymour Walton Northwestern University COST ACCOUNTS Stephen W. Gilman University of Wisconsin COMMERCIAL LAW Charles W. Gerstenberg New York University ALEXANDER HAMILTON INSTITUTE NEW YORK Corporation Finance AN EXPOSITION OF THE PRINCIPLES AND METHODS GOVERNING THE PRO- MOTION. ORGANIZATION AND MANAGE- MENT OF MODERN CORPORATIONS ■ <■'"■■■ ''/ '' BY ' ''.,V-' WILLIAM H. LOUGH '' "" SECRETARY, ALEXANDER HAMILTON INSTITUTE; PROFESSOR OF FINANCE IN NEW YORK UNIVERSITY SCHOOL OF COMMERCE, ACCOUNTS AND FINANCE (fim'^^ Modern Business Volume VI ALEXANDER HAMILTON INSTITUTE NEW YORK COPTBIOBT, 1909, BT ALEXANDER HAMILTON INSTITUTE «rV COPTBIQHT, 1911, BY ALEXANDER HAMILTON INSTITUTE COPTBIGHT, 1912, BT ALEXANDER HAMILTON INSTITUTE CopTBipnT, 1913, BT ALEXANDER HAMILTON INSTITUTE TABLE OF CONTENTS INTRODUCTION, CHAPTER I. THE CORPORATE FORM. iECTION PAGE 1. "Non-Stock" Corporations i. . 1 2. " Stock " Corporations 2 3. Definitions 2 4. The Fiction of " Corporate Entity." 3 5. Corporations in Ancient Nations 4 6. Popularity in Modern Times 5 7. Adaptability to Raising Large Amounts of Capital . . 5 8. Permanence 8 9. Centralization of Control 9 10. Transferability of Ownership 10 11. Limited Liability 11 12. Disadvantages of the Corporate Form 13 CHAPTER II. LEGAL STATUS OF THE CORPORATION. 13. Defining and Controlling Instruments 17 14. Common Law of Corporations , 17 15. The State Constitution 18 16. Method of Creating the Corporation 19 1 7. Essential Features of the Charter 20 18. A Sample Charter 22 19. The Corporate Name 24 20. The Corporate Purposes 24 21. Other Important Features of the Charter 28 22. The By-Laws .28 23. Essential Features of the By-Laws ....<>. 33 vli vm CONTENTS CHAPTER III. INTERIOR ORGANIZATION. SECTIOH PAGE 24. Rights of Stockholders 37 25. The Proxy and its Uses 38 26. The Right to Dividends 40 27. The Right to Information 41 28. Liabilities of Stockholders 42 29. Rights of Creditors 44 30. " Dummy " Directors 44 31. Powers and Liabilities of Directors 45 32. The Efficiency of Corporate Organization 47 CHAPTER IV. WHERE AND HOW TO INCORPORATE. 33. A Corporation May be Chartered in Any State and Do Business in Other States 49 34. The Regulation of " Foreign " Corporations . . . .51 35. Choosing the State of Incorporation 52 36. Comparative Charges in Several States 53 37. Liberality of Corporation Laws in Several States . . 55 38. Permanence of the Laws 56 39. Reputation of Various States 57 40. Comparative Summary of the Advantages and Disadvan- tages of the Important States of Incorporation . . 58 41. Agreements Prior to Incorporation 63 42. The Wide Range of Choice in Incorporation .... 64 CHAPTER V. CORPORATE STOCK. 43. Stock Certificates Not FuUy Negotiable 65 44. Par vs. Market Value of Stock 68 45. Nature of Preferred Stock 71 46. Uses of Preferred Stock 73 47. Cumulative Voting 175 48. Voting Trusts . . ., 1717 CONTENTS ix CHAPTER VI. TYPES OP BUSINESS CORPORATIONS. SECTION PAGS 49. Further Classification of Corporations 79 50. The " Parent " Company 81 51. Nature of a Holding Company 81 52. The Holding Company as a Means of Organizing " Trusts " 83 53. Complexity of Holding Companies 86 54. Organization of the Standard Oil Company .... 87 CHAPTER VII. THE SOURCES OF CORPORATE FUNDS. 55. Summary of Preceding Chapters 91 56. Four Sources of Corporate Funds 91 57. The Investing Public as a Source of Funds .... 93 58. Difference Between Investment and Speculation . . 94 59. The Speculative Public as a Source of Funds ... 95 60. Desirability of Borrowing Funds 96 61. Distribution of Security Issues 102 CHAPTER VIII. SHORT TIME LOANS. 62. Trade Credit as a Source of Funds .105 63. What Reliance Should be Placed on Bank Loans .^ . .107 64. Notes Sold to the Public as a Source of Funds . . .114 CHAPTER IX. THE CORPORATE MORTGAGE. 65. What Determines the Value of Fixed Assets.^ . . .119 66. Nature of a Mortgage Bond . . 121 67. Essential Features of a Deed of Trust 122 68. Classification of Mortgage Deeds of Trust . . . .125 X CONTENTS CHAPTER X. TYPES OF CORPORATION BO^rt)S. SECTION PAGE 69- Classification of Bonds 127 70. Mortgage Bonds 129 71. Sinking Fund Bonds 130 72. Collateral Trust Bonds 133 73. Equipment Trust Bonds 135 CHAPTER XI. TYPES OF CORPORATION BONDS (continued). 74. Debenture Bonds 141 73. Income Bonds 144 76. Other Types of Bonds 147 77. Purposes, Manner of Payment, and Conditions of Re- demption of Bonds 149 78. Convertible Bonds 151 CHAPTER XII. CORPORATE PROMOTION — THE NEW ENTERPRISE. 79- The Function of a Promoter 154 80. "Discovery" of a Proposition 156 81. " Assembling " a Proposition 157 82. Financing a Proposition — The Initial Development . 158 83. Foresight in Providing Funds 160 84. Advantages of a Wide Distribution of Stock . . . . l6l 85. " Starting Right " in the Sale of Stock l6l 86. A Concrete Illustration .162 CHAPTER XIII. THE PROMOTER AND THE CORPORATION. 87. Professional Promoters I67 88. Lawyers and Bankers as Promoters I69 89- Eiigineering Firms as Promoters I69 90. Secret Profits are Illegal 171 91. Misleading Statements Constitute Fraud 174 CONTENTS xi SECTION PAGE 92. Contracts on Behalf of the Corporation and Their Ac- ceptance 175 93. The Promoter's Pay 175 94. The Promoter's Risks and Labors . . . . . , .178 95. Is the Promoter Over-Paid? 178 CHAPTER XIV. CORPORATE PROMOTION — FORMING CONSOLIDATIONS. 96. The Importance of Small Industrial Combinations . .180 97. Difficulties in the Promoter's Task 181 98. "Discovery" of a Small Consolidation 182 99- Basis of Consolidation .183 100. The Necessity for Cash 190 101. One Method of Raising Cash I91 102. Problems in Forming a Large Consolidation . . . .194 103. Basis of Consolidation 195 104. The Interborough-Metropolitan Consolidation . . .196 CHAPTER XV. THE UNITED STATES STEEL CORPORATION. 105. Preparing the Ground 199 106. The Steel Consolidations Preceding the Formation of the United States Steel Corporation 200 107. A Condition of Unstable Equilibrium 201 108. Method of Promotion 205 109- Prospectus of the Corporation 206 110. Profits of the Promoters 209 111. Capitalization at the Beginning 209 112. Additions to the Steel Corporation 211 113. Financial Changes . 213 114. Basis of Capitalization 215 115. Operating Policy of the Corporation 218 116. Securities of the Corporation and Their Standing . .219 CHAPTER XVI. SELLING SECURITIES — THE PROSPECTUS AND THE BANKING HOUSE. 117. The Four Methods of Selling Securities 223 118. General Characteristics of a Good Prospectus . . . 224 xii CONTENTS SECTION PACE 119. A Typical Speculative Prospectus 226 120. A Typical Investment Prospectus 228 121. The Ideal Prospectus 2S0 122. Selling Through Banking Houses 231 123. Requirements of Reputable Banking Houses .... 232 124. Their Methods of Selling Securities 235 CHAPTER XVII. SELLING SECURITIES — THE WALL STREET MARKET. 125. The Principal Stock Exchanges of the United States . 239 126. Listing Securities 240 127. The Curb Market 242 128. Stock Exchange Methods 243 129. Importance of Speculative Dealings 245 130. Buying on Margin 246 131. SelUng Short 247 132. Stock Exchange Houses vs. Bucket Shops .... 248 133. The Classes of Wall Street Speculators 250 134. A Summary View of the Stock Market 251 135. Stimulating Speculative Interest 251 136. Syndicate Operations 253 137. Stock Market Manipulation 254 CHAPTER XVIII. SELLING SECURITIES — THE UNDERWRITING SYNDICATE. 138. Origin of Underwriting 256 139. Advantages of Underwriting to the Corporation . . . 257 140. Advantages to the Buyers of Securities 258 141. When is Underwriting Advisable? 259 142. Why Underwriting Syndicates are Formed .... 262 143. Three Types of Syndicates 263 144. A Fourth Type — Pooling the Sale of the Security . . 268 145. A Fifth Type — Distributing the Security . . . .265 146. The Large Underwriting Houses 267 CONTENTS xiii CHAPTER XIX. MANAGEMENT OF THE UNDERWRITING SYNDICATE. SECTIOM PACE 147. Informal Agreements 269 148. A Formal Syndicate Agreement 269 149. Characteristics of Syndicate Agreements 277 150. Functions of Underwriting Syndicates 278 151. Underwriting Speculative Securities 279 152. An Example of Speculative Underwriting .... 280 CHAPTER XX. INVESTMENT OF CAPITAL FUNDS. 153. Importance of Wise Investment 284 154. The Installment Method of Getting Cash as Needed . 284 155. Disadvantages of this Method 286 156. Other Possible Methods 287 157. How Much Shall be Invested in Fixed Capital ? . . . 288 158. Forms of Working Capital 289 159. How Much Working Capital Shall be Carried? . . . 290 160. The Practice of Large Corporations 291 161. Factors that Aifect Working Capital 293 162. The Working Capital of the Pennsylvania Railroad . . 294 163. General Conclusions as to Working Capital .... 295 CHAPTER XXI. DISPOSITION OF GROSS EARNINGS. 164. Determination of Income 297 165. Honesty in Stating Gross Earnings 298 166. What Are Operating Expenses? 298 167. Necessity for Depreciation Reserves 299 168. Income From Other Sources and Deductions . . . 302 169- How Much Shall be Paid Out in Dividends ? . . . .303 170. Variability of Profits 304 171. Regularity of Dividends Desirable 308 172. Prudence in Paying Dividends ., 309 xiv CONTENTS CHAPTER XXII. BETTERMENT EXPENSES. SECTION PAGE 173. Two Classes of Betterments .311 174. Sources of Funds for Betterments . . . . . . .312 175. Appropriations from Earnings 313 176. Objections to This Me'-hod 314 177. The Attitude of Stockholders 314 178. The Case of the Lehigh Valley Railroad 316 179. Policy of the Union Bag and Paper Company . . . 320 180. Borrowing Funds for Betterments 321 181. Policy of the Pennsylvania Railroad 322 182. General Conclusions as to the Financing of Betterments 323 CHAPTER XXIII CREATION AND USE OF A SURPLUS. 183. Definition 325 184. Four Sources of Surplus 326 185. The Fifth Source — Saving 327 186. Policy of the " Trusts " 329 187. How Should Surplus be Invested 330 188. The Surplus as a " Rainy Day Fund " 330 189. Putting the Surplus Back Into the Property ,., . . 333 CHAPTER XXIV. DISTRIBUTION OF THE SURPLUS. 190. Effect of a Surplus on Assets and Dividends . . . 3S5 191. Distribution Through Stock Watering 337 192. Distribution Through Subscription Privileges . . . 339 193. An- Opportunity Thus Given for Cheap Investment . 340 194. Cashing the Privilege — The Subsequent Sale . . .341 195. " " " — Short Selling 342 196. " " " — Sale of Old Stock . . .343 197. " " " — Sale of " Rights " . . . .343 198. Theoretical Value of a Right 345 199- Privileged Subscriptions as a Method of Stock Watering 347 CONTENTS XV CHAPTER XXV. MANIPULATION BY CORPORATION OFFICERS. SECTION PAGE 200. Ought We to Study Manipulation? 349 201. The Corporate Form Favors Manipulation .... 349 202. Is Manipulation a Necessary Evil.'' 350 203. Scope of the Chapters on Manipulation 351 204. Exorbitant Salaries 352 205. Fraudulent Contracts 353 206. New Companies for Profitable Business 355 207. Misuse of " Inside " Information 358 208. Is Manipulation by Officers Common? . . < . . 360 CHAPTER XXVI. MANIPULATION BY DIRECTORS. 209. Usual Methods 36l 210. Fraudulent Contracts 362 211. Attitude of the Courts . 365 212. New Companies for Profitable Business 366 213. Juggling Accounts 367 214. An Accountant's Observations 370 215. Remedies for This Kind of Manipulation .... 371 21 6. Inflicting Loss on the Corporation 373 217. The Danger in Losing Control of a Corporation . . .375 CHAPTER XXVII. MANIPULATION BY AND FOR STOCKHOLDERS. 218. Cheating Creditors 379 219. The Chicago and Alton Deal 380 220. Manipulation Through Subsidiary Companies . ^ . 382 221. Central of Georgia Income Account 383 222. Squeezing the Minority Stockholders 385 223. A Complicated Real Estate Proposition 387 224. Robbing a Partnership to Pay a Corporation . . . 389 225. Remedies for Manipulation 392 xvi CONTENTS CHAPTER XXVIII. INSOLVENCY AND RECEIVERSHIPS. SECTION PAGB 226. Two Types of Insolvency 394 227. Causes of True Insolvency ... 395 228. One Cause of Legal Insolvency — " Lack of Capital " . 397 229. The Case of the Detroit, Toledo & Iromton Railway Com- pany 398 230. Additional Causes of Legal Insolvency 400 281. Two Methods of Handling Insolvency — Bankruptcy and Dissolution 401 232. A Third Method — Appointment of a Receiver . . . 403 233. Duties of a Receiver 404 234. Receiver's Powers 406 CHAPTER XXIX. PRINCIPLES OF REORGANIZATION. 235. Reasons for Reorganization 408 236. The Formation of Committees 410 237. Why Not Foreclose? 412 238. Problems Confronting the Reorganization Committee . 413 239. Necessity for Cash 416 240. Raising Cash by Assessments 417 241. J Reducing Fixed Charges. 420 242. Capitalization of the Reorganized Corporation . . . 422 243. Summary of the Chapter 424 CHAPTER XXX. THREE TYPICAL REORGANIZATIONS. 244. Growth of the Santa Fe System 425 245. First Reorganization of the Santa Fe and Its Results . 429 246. Second Reorganization and Its Results 431 247. Growth of the Rock Island System 434 248. Rock Island Reorganization 437 249. Westinghouse Reorganization 440 Quiz Questions 445 INTRODUCTION Twenty years ago a knowledge of corporation finance was not essential to the average business man. Only the larger concerns, roughly speaking, were organized in the corporate form. We have only to look around us to see that the situation to-day in this respect is en- tirely different. The corporate form, though not yet universal, is far ahead of partnerships and of individual proprietorships in popularity and in influence on busi- ness methods. As its advantages become better known we may expect to see it adopted even by small and back- ward concerns. This tendency is bringing to the front numerous problems of corporation law and management with which every man in business should be famihar. From this point of view the present volume is written. It is intended primarily for the information and guidance of business men of all stations and degrees. Most of what is said here wUl be found applicable both to large and to small corporations. The facts and illustrations, however, are largely drawn from the experience of the big industrial and railroad combina- tions. The chief reason for directing attention to the big corporations is that their methods are well developed and are worthy of study and imitation by the managers of smaller corporations. Most of us have a great deal to learn from the men who control the financial affairs of such companies as the United States Steel Corpora- tion, the Union Pacific Railroad Company, and the Pennsylvania Railroad Company, to mention three of our greatest and best managed corporations. INTRODUCTION While the first object of the volume is to serve business men, the author trusts that it will prove useful also to at least four other groups: (a) To stock and bond brokers and their employes, many of whom, the writer has observed, have only a fragmentary knowledge gained from experience, not a comprehensive knowledge, of financial operations. (b) To lawyers, all of whom should have a clear understanding of the financial as well as the legal phases of corporate organization and management. (c) To bankers, who are constantly dealing with aU kinds of business corporations. (d) To accountants, to whom a comprehension of corporation methods and problems is almost as essential as a knowledge of strictly accounting principles. This fist might be indefinitely extended. It is not too much to say that everyone directly or indirectly connected with modern business ought to possess for his own protection and advancement a correct understand- ing of the principles of corporation finance. The thirty chapters in the volume may be conveniently classified into seven groups : Chapters I-VI present the elements of corporation law. They may be omitted by lawyers, but are essential to aU other readers. Chapters VII-XI describe all the methods and in- struments that are used in this country in raising funds for corporations. Chapters XII-XV explain how corporations are promoted, and give in illustration a brief account of the United States Steel Corporation. Chapters XVI-XIX discuss the four methods of selling the securities of a corporation. INTRODUCTION Chapters ■ XX-XXIV deal with the problems of honest financial management of a corporation. Chapters XXV-XXVII discuss the schemes and tricks of dishonest manipulators. Chapters XXVIII-XXX are concerned with the causes of insolvency and the problems of reorganization. The reader should bear in mind that all these questions are treated from the standpoint of corporation officials, not from the standpoint of stockholders or of prospective investors. Additional light may be obtained from the volume on Investment and Speculation^ in which the interests of buyers of securities are kept to the front, and from the volumes on Accounting and on Commerciai ^^^- W. H. Lough. New York University School of Commerce J Accounts and Finance. CHAPTER I THE CORPORATE FORM 1. "Non-stock" corporations. — Everybody knows in a vague way that a corporation is an association of in- dividuals formed to carry on an enterprise. Compara- tively few people, however, understand just what the corporation is in the eyes of the law or the extent and the limitations of its activities. Obviously, the first step in the study of corporation finance should be an examina- tion of the powers and possibilities of this peculiar and wonderfully effective form of organization. Corporations fall into two distinct groups. There are, first, corporations without capital stock, or "non- stock" corporations; to this class belong almost all churches, hospitals, chartered clubs, universities and other strictly social and charitable organizations. The prime characteristic of such corporations is that the members share equally in all the privileges of member- ship without regard to the amount of money that each may have contributed. There is no arrangement for transacting a money-making business and distributing profits or losses. In fact, non-stock corporations exist either for the common benefit of all the members or for the purpose of serving the public at large. Many in- teresting questions as to the rights and powers of such corporations might be discussed; but the discussion would be out of place in this volume. 2. "Stock" corporations. — We are here concerned only with the second class, namely, "stock" corporations; VI— ] 1 2 CORPORATION FINANCE to this class belong all business corporations. Two ap- parent exceptions, mutual insurance societies and stock exchanges, both of which are ordinarily "non-stock" corporations, may be noted; both organizations in their fundamental character, however, are simply clubs which, like many other clubs, oiFer to their members certain Taluable privileges. "Stock" corporations, on the other hand, are formed with the object of carrying on busi- ness ventures; they have a capital stock divided into transferable shares; they are intended to make profits which are to be distributed to their members, or stock- holders, in proportion to the number of shares each one possesses; each stockholder secures his shares by pur- chase for vahiable consideration from the corporation or by transfcj from some previous stockholder; each stockholder is a > owner of the corporation and its assets to the extent of the number of shares that he holds. 3. Definitions. — The most famous definition of a corporation, and a definition that in its main features is as sound to-day as it ever was, is that given in the Dart- mouth College case in 1819 by Chief Justice Marshall of the United States Supreme Court, who referred to a corporation as "an artificial being, invisible, intangible, and existing only in contemplation of law." Blackstone, author of England's greatest legal text -book, gives a definition that is almost as well-known as Chief Justice Marshall's in the following words: "A corporation is an artificial person created for preserving in perpetual succession certain rights, which being conferred on natural persons only, would fail in the process of time." You will note that this definition emphasizes the most striking distinctive feature of the corporation, namely, its artificial personal ity. The corporation is an entity or being in itself, apart from the persons who organize THE CORPORATE FORM 3 and own it. Let us review some of the results of this legal fiction that the creation of a corporation brings into the world a new person, — artificially created, to be sure, but yet endowed with many of the powers of an ordinary human being. In the first place, as the corporation has an existence apart from the lives of any or all its owners, it is not broken up by the death or withdrawal of any owner. In the second place, the corporation has the right to buy and sell and contract debts in its own name and for itself; it may even owe money or lend money to some or all of its owners. In the third place, it may sue and be sued in the courts, without thereby involving any of its owners. In the fourth place, it may enter into all kinds of legal contracts, just as an individual might do. 4. The -fiction of "corporate entity" — Here, then, is the first and most fundamental fact about the corpora- tion for the student to grasp and keep always clearly in view, that it is a separate, distinct artificial person. It is true that within the last few years the courts of the United States have shown a strong tendency to go be- hind this artificial personality and to throw responsibility on the owners and managers of a corporation, especially in case of fraud. Clark, the author of a standard legal work, says: That a corporation is a legal entity, separate and distinct from the members who compose it, is a mere legal fiction, in- troduced for the convenience of the corporation in transacting business, and of those who do business with it ; and, when urged to an intent and purpose not within its reason and policy, the fiction will be disregarded, and the fact that the corporation is really a collection of individuals will be recognized, even at law. Courts of equity, in every instance, look behind the corporate 4 CORPORATION FINANCE entity and recognize the individual members and will do so when- ever justice requires. Yet the fact remains that the corporation's existence, property, contracts and debts all adhere to the corpora- tion itself and not to the individuals who together own the corporation. It is true, also, that this artificial per- son, the corporation, has neither mind nor body and can- not therefore think or act. The law, however, easily gets over this difiiculty by treating the managers and officers of the corporation as agents empowered to carry on its operations. 5. Corporations in ancient nations. — This fiction of artificial personality seems to be at first sight an un- necessary and even absurd idea, and the results that fol- low from the adoption of this fiction appear more like the spinning of legal cobwebs than the working out of common-sense principles. But a little further study reveals that the corporate form substantially as it exists to-day has been used by many ancient and modern nations. It seems, therefore, that there must be some good reason or reasons for its widespread use. The archaeologists tell us that as far back as the prosperous days of Babylon the inhabitants of that ill-fated country in their commercial transactions used corporations some- what as we use them now. The Romans also developed and made great use of the corporate form of organizing enterprises. Indeed, it is asserted by Blackstone, and was at one time universally believed, that our modern corporations are descendants in a direct line of the ancient Roman corporations. Although this theory is no longer fully accepted, it remains true that the Roman law with regard to corporations has had considerable influence in the development of our modern corporation law, Without going further into this historical survey. THE CORPORATE FORM 5 which is a little outside the scope of this book, we may- lay down this generalization, that in almost every great active cormnercial nation the corporate form of organ- ization has sooner or later come into existence. It must, then, we may be sure, have some clear and important business advantages. 6. Popularity in modern times. — This conclusion is confirmed when we reflect that along with the marvelous business development of the last century there has been apparent a more than proportional increase in the num- ber and importance of corporations. At first only large enterprises, such as railroads, steamship companies and great manufacturing establishments were so organ- ized. Later the smaller factories and wholesale estab- lishments followed the lead of the larger concerns. Finally within the last few years we have witnessed both in Europe and particularly in this country the extension of the movement to small manufacturing and retail establishments. The drift in this direction is so apparent that it need not be dwelt upon at any length. Every reader of this book may look around and see with- in his own circle numerous concerns in corporate form which were conducted a few years ago by individuals or partnerships. Unless this tendency receives some unexpected check it will not be many years before the corporate form wiU be adopted by almost every business, large and small, in the United States. 7. Adaptability to raising large amounts of capital. — Evidently there must be great advantages in the corpo- rate form ; otherwise the landslide toward it would long ago have been stopped. It will be worth while to review briefly some of these advantages. Originally, as has been said, corporations were con- fined almost altogether to large enterprises and were used 6 CORPORATION FINANCE principally because of the facilities which they afforded for raising and handling large amounts of capital. In this respect they are obviously far superior both to in- dividuals and to partnerships. Not even the richest individual — ^not John D. Rockefeller nor Andrew Car- negie nor Lord Rothschild — would be able out of his own resources to build and operate one of the great railroad systems of the United States. Even if one of these men were able individually to take care of an enterprise of this size, he would not care to do it. Men of great wealth do not consider it advisable to put all their money into one business. They scatter their investments, so that if one proves a failure profits on the others may more than counterbalance the loss. Nor would a partnership, great and wealthy as some partnerships have been, be an efficient method of bring- ing together the vast amounts of capital that are re- quired for every great enterprise. It would be an extraordinary coincidence if several men of immense wealth, who might conceivably construct and own in partnership a big railroad or a big industrial trust, were able to harmonize inevitable differences of opinion and to co-operate efficiently in a partnership arrangement. It is probably safe to say that in the whole commercial history of the world we could not find a single mstance of, say, a billion or even half a billion — perhaps even a hundred million — dollars of capital raised and man- aged under a partnership agreement. It is well to remember in this connection that even the greatest in- dividual fortunes are mere dots compared to the total wealth of a vast country like the United States. Furthermore, of these individual fortunes only a small part ordinarily is free at any one time to be used or in- vested as the owner wills. THE CORPORATE FORM 7 The corporate form, on the other hand, has infinite possibilities so far as the raising and managing of capi- tal is concerned. Any number of people, large or small, may contribute funds. The American Tele- phone and Telegraph Company, for example, has over 25,000 stockholders, the Pennsylvania Railroad Company over 60,000, and the United States Steel Corporation not far from 110,000. A large num- ber of owners of a corporation does not tend to break up and render inefficient the management, for the control of whatever capital the owners contribute is kept in the hands of the officers of the corporation. Thus the corporation, without losing in efficiency, may reach out into the highways and by-ways of the land, draw its capital from a thousand or from a hundred thousand individuals and heap up vast aggregations of capital that could not possibly be obtained in any other manner. For this reason it is inevitable that the corporate form should be used in the financing of practically every large enterprise. This advantage of corporations, that they are able to collect and to make use of the small contributions of many individuals, though most prominent in great undertakings, is by no means to be overlooked in the case of smaller enterprises. Frequently an inventor or a retail dealer or any small business man who needs a few hundred or a few thousand dollars, could not ob- tain it from his own immediate relatives and friends. The same man, perhaps, may easily raise the capital he requires by organizing a corporation and selling small interests to a considerable number of people. Many a business man has thus obtained necessary capital which he has made the foundation of a fortune. 8. Permanence. — The second important advantage 8 CORPORATION FINANCE of the corporate form is permanence. When an in- dividual owner of a business dies, his business dies with him. It may, to be sure, be carried on by his family or bought by strangers; on the other hand, it may be that no practicable method of disposing of it except at an enormous sacrifice will be found. This is largely _a matter of chance, because no organization for carrying on the business is in existence. A partnership is almost equally subject to chance. When a partner dies, the firm is thereby automatically dissolved. The surviving partner or partners may, of course, form a new firm and take over the interest of the deceased partner. In so doing, however, disputes are Uable to occur, especially in those hnes of business where the earnings are irreg- ular and the value of the assets is not clearly defined. If the surviving partners are unable to continue the business properly or are disposed to drive a hard bargain, the estate of the deceased partner may be deprived of a large part of its rightful interest in the business. Here, again, there is no permanent machinery for managing the business. The partnership, hke the in- dividual business, is subject to all the uncertainties and calamities that beset the lives of individual human beings. The corporation, on the other hand, exists until it becomes bankrupt, is allowed to lapse or is voluntarily dissolved. The death of any man, even if he owns 99 per cent of the stock of the corporation, does not aiFect the corporation itself. It is an "artificial being," a creature of the law not subject to the infirmities of human existence. It is so organized that if one officer dies or withdraws, a successor may be quickly chosen. As the corporation exists apart from the persons who own it and as control is vested in its officers, the death or withdrawal of an owner does not at aU disturb its THE CORPORATE FORM 9 machinery, and the death or withdrawal of an officer means simply that someone else must be found and ap- pointed to the position. 9. Centralization of control. — This brings us to the 'third important advantage of the corporate form, namely, its centralization of power and responsibility. In this particular feature it cannot be, of course, supe- rior to individual ownership, but it is far ahead of the partnership. As the law does not recognize in the part- nership anything but a group or association of individ- uals, it follows that each partner is empowered to conduct the business, to buy and sell the partnership assets, to make binding contracts and incur debts. Ordinarily, to be sure, the partners mutually agree to a fixed division of duties and powers, but this division is not supposed to be known or to be binding on outsiders. Each partner, so far as his dealings with outsiders are con- cerned, is the whole partnership. Obviously, therefore, no partnership should ever be formed except between persons who have entire confidence in each other; and even then a partnership often proves an unsafe and inefficient method of conducting business. Except by mutual agreement binding only on themselves, to repeat, there is no clear-cut division of powers and responsi- bilities. Under the corporate form, on the other hand, busi- ness can be transacted only by the duly appointed officers; no owner, unless he is also an officer — even though he hold almost all the stock — ^has any authority to transact business for the corporation. Each of the officers of the corporation, as is explained in the chapter on "Interior Organization," has his sphere of duties care- fully defined, both within the corporation and outside. Persons not connected with the corporation are expected 10 CORPORATION FINANCE to have their dealings only with the duly authorized officers, and if they do not exercise reasonable care in this respect may find whatever agreements or contracts they make invahd. This will be more clearly understood by the reader after a study of the chapters on agency in the volume on Commercial Law. Furthermore, the relations of the corporate officers to each other are clearly defined and the gradations of authority are so marked that each one may understand clearly just how far he is empowered to act on his own judgment and what questions he should refer to his official superiors. The great advantage of this care in organization and in delegation of power is so obvious that it need not be dwelt upon at any length. A well-managed corporation carries on its affairs with the precision and smoothness of a well-disciplined army. 10. Transferability of ownership. — A fourth advan- tage of the corporate form is the ease with which its ownership may be transferred. An individual owner who desires to sell his property must find a purchaser for all of it at one and the same time. A partner who de- sires to sell his interest in the firm must either make some satisfactory arrangement with the other partners, which may be a difficult matter, or must find a purchaser who offers satisfactory terms and is personally acceptable to the other partners, and that is likely to prove still more difficult. Altogether the problem of withdrawing funds that have been invested in an individually-owned prop- erty or in a partnership is almost always hard and frequently insoluble. Under the corporate form the problem is much simpler. The ownership of a corpo- ration is represented by shares, any or all of which may be transferred from hand to hand without interfering in the least with the stability of the corporation. An owner THE CORPORATE FORM 11 of several shares need not, therefore, find any one person to take all his property off his hands ; he may sell a few shares to one man, one or two to another, and so on, and thus dispose of his property piecemeal. Furthermore, as the corporation is managed directly by the officers, not by the owners, no consideration ordinarily need be given to the question as to whether or not a prospective buyer is a good business man or is acceptable to the other persons interested in the corporation. Women, old men, administrators and trustees of estates, institutions of all kinds — all are possible purchasers of corporate securities. Thus the owner of corporate shares finds his market much broader and his facilities for selKng much better than does the owner of a partnership interest. The se- curities of large corporations are constantly dealt in on the stock exchanges of large cities, and thus a continuous and easily accessible market is afforded to every owner. 11. Limited liability. — The fifth and last important advantage of the corporate form is the fact that the liability and possible loss of each owner is limited. Gen- erally speaking, the owner of any corporation security is safe in reflecting that though the security may become worthless and he may lose all that he paid for it, he cannot possibly lose more than that amount. The reader may perhaps think that to the owner of the stock of a failed corporation this statement affords but cold com- fort; but compare his situation with that of a partner in a bankrupt firm. The partner may not only lose all that he invested in the firm, but in addition is personally liable for all the unpaid debts of the firm. As has been explained above, it is possible that these debts may have been foolishly or even fraudulently contracted by some other partner ; yet that fact would not relieve any other partner from his personal liability. No doubt most 13 CORPORATION FINANCE readers of this paragraph will call to mind instances in their own experience of individual owners or of partners in disastrous enterprises who have lost everything they owned, including even their homes and most of their personal property, by the failure of such enterprises. If a corporation fails, on the other hand, and its debts prove greater than its assets, the creditors have no claim on the property of the stockholders outside the failed business. An important exception to this principle of limited liability exists in the case of stockholders of national banks. They are individually liable in case of failure not only for their investment but for an additional sum equal to the par value of their holdings of bank stock. A similar rule applies in Minnesota to stockholders of most corporations and there are one or two other exceptions which are referred to in Chapter IV. Even in such cases, however, though the liability of stock- holders is somewhat greater than with the ordinary cor- poration, it is still strictly limited. No doubt this principle of limited liability has been one of the main advantages of corporations that has led to their formation in a great many cases, and especially has encouraged in recent years the widespread move- ment to change partnerships into corporations. No business man, especially one who has considerable per- sonal property and perhaps is advanced in years, likes to reflect that at any moment, through the fraud or mis- management of some subordinate or partner, or through some unavoidable natural calamity, he may be compelled to give up his home and personal property in order to satisfy the demands of business creditors. The corpo- rate form of business relieves him of this haimting spectre. THE CORPORATE FORM 13 The prominent advantages of the corporate form, which have brought about its great extension in recent years, may then be summed up as follows : ( 1 ) Flexibility. The owners of a corporation may be few or numerous. This makes the corporate form especially well adapted to collecting large amounts of capital by means of small contributions from a great many people. (2) Peemanence. The life of a corporation is not dependent on the life or on the caprice of any individual. (3) Centralization of control. Under the cor- porate form the officers of the corporation within care- fully defined hmits exercise complete control. (4) Transferability of ownership. Corporate shares may be readily sold either in a block or piecemeal and have a wide market. (5) Limited liability. The corporation alone, with certain minor exceptions, is liable for its own debts and the shareholders cannot lose more than their orig- inal investment. 12. Disadvantages of the corporate form. — In view of these advantages it may be asked why aU kinds of busi- ness without exception are not organized under the cor- porate form. The answer is that certain minor disad- vantages, which in some instances are sufficient to offset the advantages named, are inseparable from corpora- tions. These disadvantages may be briefly summed up as follows: (1) Increased expense. All states impose certain incorporation fees, license and franchise taxes on corpo- rations, which taxes are in addition to the ordinary state and local taxes on property. These taxes are, however, uniformly small. The United States Government also imposes a tax on corporate income. In addition, 14 CORPORATION FINANCE legal assistance is almost always necessary in forming corporations, and there may be an additional charge on this account of from $25 up. These corporate expenses are, of course, too slight to be worth much consideration, except in the case of very small enterprises, where they may sometimes be of sufficient importance to prevent the adoption of the corporate form. (2) Limited POWERS. As the corporation derives aU its powers from the state in which it is incorporated, and as all its powers should be distinctly stated in its articles of incorporation (see Chapter II), it may be somewhat hampered at times by lack of authority to carry on oper- ations that would be profitable. This, however, is a superficial objection that may be readily dismissed; for a good corporation lawyer will always find it possible to include in the statement of the powers of the corporation authority for every act that would be necessary in prac- tice. If not, it is always easy to form a new corporation for whatever specific action is desired. This point also is further discussed in Chapter II. (3) Limited credit. A lender of money would, of course, prefer, other things being equal, to lend to an individual or a partnership, rather than to a corporation, because the liability of the owners of the property in the former case is unlimited, and in the latter case, as has been explained, is limited. Thus a partnership which is converted into a corporation will sometimes be em- barrassed more or less by reluctance of its creditors to continue extending credit as freely as before the con- version. This objection, which is of importance usually only in the case of a small and closely held business, may be overcome, if desired, by the ofiicers or certain stock- holders personally endorsing the corporation's notes and biUs payable. By so doing they, of course, lose the THE CORPORATE FORM 15 advantage of limited liability, but they retain all the other advantages of the corporate form. There are some business activities, however, in which the personal element is so prominent as to make unlimited liability desirable. A firm of accountants, for instance, could not be changed to a corporation without forfeiting to some extent the confidence of the business public, for every public accountant is and ought to be personally Hable to the fullest extent for the honesty and accuracy of his work. The same thing may be said of bankers and engineers, and to some extent of business advisers and systematizers ; for such activities the corporate form, on account of its limited liability feature, is ill-adapted. (4) Governmental, control. Some concerns are strongly averse, for good reasons, to any publicity what- ever as to their operations and financial results. They may perhaps be making so much money that they desire to keep it secret in order to avoid attracting competitors ; or their real business may be quite different from their ostensible business, and they would not desire to attract attention to this fact by the inclusion of unusual powers in articles of incorporation. For fear of governmental supervision, therefore, they retain the partnership, even with all its disadvantages. The reader will readily see that this hst of disadvan- tages of the corporate form does not include anything of great importance to most legitimate kinds of business. Certainly the disadvantages are of little weight in most cases in comparison with the obvious and substantial gains that may be had by adopting the corporate form. We are justified in concluding, therefore, that the tendency toward the corporate form of conducting busi- ness, which has been referred, to above, will not dimin- ish, but rather will increase in the coming years. The 16 CORPORATION FINANCE corporation is the efficient twentieth century means of conducting business. In city and in country, from the captains of finance to the smallest units in the army of business, in transportation, in manufacturing, in trad- ing, even in farming, the corporation has come to be recognized as the best form yet discovered for organizing the production of wealth. To confess oneself ignorant of the nature, the func- tions, the abuses and the possibilities of this mighty in- strument is indeed a confession of business inefficiency and narrowness. The pages that follow are to be de- voted to a discussion of the formation and management of corporations which, it is hoped, will place this truly important and somewhat difficult subject in a clear light before our readers. CHAPTER II LEGAL STATUS OF THE CORPORATION 13. Defining and controlling instruments. — The cor- poration, we have said, is a "creature of the law," and this statement is to be taken Uterally. This artificial creature has no existence, no powers, no privileges, no duties, ex- cept those which are conferred upon it either by express statement or by implication. The artificial creature, in other words, does not have what we may call the natural rights of an individual to live unmolested and to pursue whatever objects he pleases, so long as the rights of oth- ers are not interfered with, but only artificial rights. In order to determine in any particular case, therefore, what a corporation may or may not do and what its standing is, we must look to the particular instruments which give it being and control its actions. These instruments in every state in the Union are three in number: (1) The Constitution of the State. (2) The General Corporation Act. (3) The Charter of each particular corporation. Supplementing the charter, practically all corporations have a set of by-laws for their own guidance. In order to understand the legal status of a corporation we must consider briefly each of these instruments. 14. Common law of corporations. — It must be borne in mind, in connection with what follows in this chapter, that corporations of one kind or another have been in existence for a very long time, and that the courts of England and of the United States have given a large VI— 2 IT 18 CORPORATION FINANCE number of decisions dealing with the duties and powers of corporations. These decisions form the great body of common law with reference to corporations; and this common law, for which search must be made through the precedents of many years, governs where it is not super- seded. Corporations as forms of business organization, however — and especially as forms of organization for relatively small enterprises — are comparatively modern. From the very beginning the English Parliament and the state legislatures of this country have found it ex- pedient to enact statutes in order to define clearly the powers and duties of corporations. These statutes in every state are now so explicit and comprehensive as to govern the great mass of corporate activities. They form the body of statutory law with reference to corpo- rations. The reader wiU find in the volume on Com- MEB.CIAL Law a full exposition of the relations between common and statutory law and of the manner in which statutes of the legislature are interpreted by the courts. For our purpose it is enough to say that the statute law supersedes the common law wherever the two disagree and that statute law with regard to corporations is so voluminous that we need rarely go back of it to the common law. 15. The state constitution. — The fundamental law in each state of the Union is the constitution of the state, and no provision which conflicts with any clause in the state constitution will be legal. This is a point, not merely of theoretical, but also at times of distinct practi- cal importance. For instance, the Constitution of the State of Pennsylvania prescribes that all Pennsylvania corporations shall elect their officers by what is known as "cumulative voting" — a method that is described at some length in Chapter V. In one case, with which LEGAL STATUS OF THE CORPORATION 19 the writer happens to be famUiar, certain stockholders of a small Pennsylvania corporation planned to pass a rule against cumulative voting and by means of that rule to elect all members of the board of directors. Great was their chagrin and surprise when they discovered that no Pennsylvania corporation is competent to enforce such a rule as they proposed. It frequently happens that some of the ordinary statute provisions of a state are found, when tested in the courts, to be in conflict with some provision of the state constitution and there- fore null and void. The reader, then, should not forget that behind every enactment of the legislature looms the constitution of the state, a fundamental factor that should not be left out of his reckoning. 16. Method of creating the corporation. — The direct legislative authority to create a corporation may be given in one of two ways, by special enactment of the legisla- ture for the benefit of this particular corporation, or by a general act which governs the creation of all corpora- tions. Formerly the first named method was universal. It proved itself, however, both inconvenient and unfair. Authority to incorporate was granted arbitrarily by the legislature for certain enterprises and denied to others equally deserving. It was necessary to have a "pull" in order to get the desired enactment. Favoritism and corruption, coupled with unwise conservatism, were the natural results of this method. It has therefore fallen into disuse and is definitely prohibited by the constitu- tions of many states of the Union. One rather conspic- uous exception to the general rule that corporations are no longer formed and managed under the provision of special enactments is the Bay State Gas Company, a corporation organized by Mr. J. Edward Addicks, and later controlled, it is understood, by Mr. Thomas W. 20 CORPORATION FINANCE Lawson. This company was given large powers and privileges by a special act of the Legislature of Dela- ware during the time when Mr. Addicks was reputed to be the political boss of the State. The present-day method of creating the corporation is by complying with the provisions of a general corpo- ration act — in some states called an "enabling act." Such an act usually prescribes the general purposes for which corporations may be lawfully formed, the chief powers which they may possess — such as power to hold property in the parent and in other states, power to hold its own stock, po^ver to hold stock of other corporations (not conferred by all states), power to borrow money, power to do business in other states, and so on — the num- ber of incorporators and stockholders, the manner and lawful purposes of issue of capital stock, the rights of the stockholders, the minimum numbers of directors and of officers, the character and amount of taxes, the nature of reports required, the exact form to be followed in incor- porating, and so on. Under such a general act any citizens of the state — sometimes of other states — who meet the requirements of the law may form a corporation. Thus the favoritism and corruption in- cident to the old method of special enactment" are eliminated. The universal establishment of these general corporation acts is one of the most important reforms in business methods of the second half of the nineteenth century. Though many of these acts — as is pointed out in Chapter IV — are far from perfect, we all have reason to be profoundly thankful that they exist at all. 17. Essential features of the charter. — We come now to the immediate instrument of incorporation, the LEGAL STATUS OF THE CORPORATION 21 charter — sometimes called the certificate of incorpora- tion or the articles of incorporation. Where the charter is obtained under a general corporation act, it is drawn by the incorporators or their attorney and presented to the proper state official, usually the secretary of state. If the charter as drawn is approved, the secretary of state signifies his acceptance thereof, and the corporation comes into being. There is no favoritism in this pro- cedure, as there is in the granting of charters by special acts; the secretary of state has no authority to refuse any charter which is properly drawn and which complies with the provisions of the state law. A charter need not be a very lengthy instrument, al- though large companies sometimes find it desirable to prevent future misunderstanding by inserting into the charter a great many details not absolutely essential. In practically all states every charter must contain, among other things, the following information: (1) The name of the corporation. (2) The purpose or purposes for which it is formed. (3) The amoimt of capital stock, and if there is a division into classes of stock, the rights of each class. (4) The number of shares of stock. (5) The location of the principal business ofiice. (6) The period of existence of the corporation, which is usually unlimited or perpetual. (7) The names and usually the post-ofiice addresses of the incorporators. If the reader desires a more detailed statement of the requirements in any particular state, he cannot do better than to go direct to the statutes of that state. It would lead us too far afield if we were to enter here on any comprehensive legal study of charter forms and provi- 22 CORPORATION FINANCE sions. A few remarks, however, as to the essential fea- tures of a charter and the presentation of the sample form following will not be out of place and will help to make clear some points of corporation practice that might otherwise be obscure. 18. A sample charter. — The following is a very brief and simple charter, which conforms to the laws of the State of New Jersey. The form in other states would be slightly diiferent. The writer is indebted to Mr. Thomas Conyngton for permission to copy this form from his manual "The Modern Corporation." CERTIFICATE OF INCORPORATION OF THE CARHART DRUG COMPANY. We, the undersigned, for the purpose of forming a corpora! tion under and by virtue of the provisions of an act of the Legislature of the State of New Jersey, entitled " An Act con- cerning corporations (Revision of 1896)," and the several sup- plements thereto and acts amendatory thereof, do hereby sever- ally subscribe for and agree to take the number of shares of stock of the said corporation hereinafter placed opposite our respective names, do further certify and set forth as follows : First — The name of said corporation shall be "CARHART DRUG COMPANY." Second — The location of its principal office in the State of New Jersey shall be at No. 15 Exchange Place, Jersey City. The name of the agent who shall be therein and in charge thereof, upon whom process against this Corporation may be served, is the Corporation Trust Company of New Jersey. Third — The objects for which this corporation is formed are: (a) To manufacture, prepare, compound, mix, com- bine, buy, sell and generally deal in all manner of LEGAL STATUS OF THE CORPORATION 23 chemicals, chemical products, drugs and pharmaceu- tical compounds and preparations, and to patent, register or otherwise protect the same. (b) To obtain, purchase or otherwise acquire formulae, patents and secret processes for the manufacture and preparation of chemicals, drugs and the compounds and preparations thereof, and to operate under, sell, assign, grant licenses in respect of, or otherwise turn the same to account. (c) To enter into, carry out or otherwise turn to ac- count contracts of every kind; to have and maintain offices within and without the State ; to acquire, hold, mortgage, lease and convey or otherwise use or dis- pose of real and personal property in any part of the world ; and in general to carry on such operations and enterprises and to do all such things in connection therewith as may be permitted by the laws of New Jersey and be necessary or convenient in the conduct of the Company's business. Fourth — The total authorized stock of the corporation shall be twenty-five thousand dollars ($25,000), divided into two hun- dred and fifty (250) shares of the par value of one hundred dollars ($100) each, and the amount of capital stock with which said corporation will begin business is five thousand dollars ($5,000). Fifth — The names and post-office addresses of the incor- porators and the number of shares subscribed for by each are as follows : Names Addresses Shares Wilhs J. Carhart. . .15 Exchange Place, Jersey City, N. J. 40 Sheldon McCammis. « " " " " "" 5 John B. Whelan . . . « " " " " " " 5 Sixth — The period of existence of said corporation shall be unlimited. In Witness Whereof, we have hereunto set our hands and 24 CORPORATION FINANCE seals this 21st day of July, A. D. nineteen hundred and eight. Willis J. Carhart. (L. S.) Sheldon McCammis. (L. S.) ' John B. Whelan. (L. S.) In the presence of Harmon Watson. Thomas O'Connell. (Execution in due form.) 19. The corporate name. — The name of a corporation is part of its property and sometimes — especially after the corporation has been long enough established to have acquired good will — is highly valuable property. For that reason, a new corporation is not allowed to assume a name already taken by a previously existing corpora- tion nor even a name so similar as to cause confusion. If the older corporation, however, in such a case were Aot incorporated or licensed in the same state as the new company, the state authorities would have no right to reject the new company's charter on account of the sim- ilarity in name. Under such circumstances the only remedy of the older company would be to bring suit in the courts. Some states lay down certain arbitrary rules, such as that the prefix "The" must be used, or that the word "incorporated" or "limited" must follow the corporate name. Alabama, Colorado, Kentucky, Con- necticut, Delaware, Kansas, Missouri, North Carolina and Virginia require the word "company" to be a part of the corporate name. As a matter of business, it is usually very desirable for a new corporation to adopt some distinctive, self-explanatory, short name, and to avoid so far as possible hackneyed words and phrases. 20. TTie corporate purposes. — There is no more im- portant section of the charter than that in which the LEGAL STATUS OF THE CORPORATION 25 corporate purpose or purposes are stated. For most corporations, the activities of which are to be confined to some one line of business, a brief and simple statement is all that is necessary. The incorporators and their attorney should bear in mind in this connection, however, that it costs nothing at the beginning to insert a very full and comprehensive description of all the possible activities of the corporation and that the absence of the right word or phrase may at some future time cause serious inconvenience. The corporation is not obliged to carry out all of the purposes named in the charter; on the other hand, it has no authority to do anything which is not so named or clearly imphed. The courts, to be sure, are generally liberal in their interpretation of the implied powers of corporations; but it is better to keep out of the courts and to take a little care at the beginning so as to avert any future disputes as to whether proposed activities are beyond the purposes and powers of the corporation or not. To illustrate the care with which the purposes of a large company are stated in order to comprehend and give legal authority for any possible future activity, the charter of the United States Steel Corporation, which was drawn by one of the great corporation lawyers of the country, the late James B. Dill, of New Jersey, may be cited. The section of the charter, in which the purposes of this great corporation are stated, is too long to be quoted in full. Nine paragraphs are devoted to describing all the manufacturing, landowning, mining, trading, contracting, inventing and patenting, security- buying, selling and holding activities which could be thought of by all the eminent lawyers and business men who helped Judge Dill to draw the charter. Then follow the two paragraphs quoted below, in which, as 26 CORPORATION FINANCE the reader will observe, the incorporators aim to provide for any other possible activity not already distinctly set forth. Note particularly the itahcized clauses. A state- ment somewhat similar to these two paragraphs might be included to advantage in the charters of many much smaller corporations, and perhaps would dispose of otherwise troublesome questions of authority. The business or purpose of the Company is from time to time to do any one or more of the acts and things herein set forth; and it may conduct its business in other States and in the Terri- tories and in foreign countries, and may have one office or more than one office, and keep the books of the company outside the State of New Jersey, except as otherwise may be provided by law ; and may hold, purchase, mortgage and convey real and personal property either in or out of the State of New Jersey. Without in any particular limiting any of the objects and powers of the corporation, it is hereby expressly -declared and provided that the corporation shall have power to issue bonds and other obligations in payment for property purchased or ac- quired by it, or for any other object in or about its business; to mortgage, or pledge any stocks, bonds, or other obliga- tions, or any property which may be acquired by it, to secure any bonds or other obligations by it issued or incurred ; to guar- antee any dividends or bonds or contracts or other obligations ; to make and perform contracts of any kind and description ; and in carrying on its business, or for the purpose of attaining or furthering any of its objects, to do any and all other acts, and things, and to exercise any and all other powers which a co- partnership or natural person could do and exercise, and which now or hereafter may he authorized by law. A further illustration of the importance of a clear and full statement in the charter of the purposes for which a corporation is organized is contained in a decision of the New Jersey Court of Errors and Appeals handed down March 5, 1909. The case involved the right of a rail- LEGAL STATUS OF THE CORPORATION 27 road company to acquire and hold the stock of certain trolley companies near Atlantic City. The court de- nied this right and said, among other things: The power to purchase, hold, etc., stock and bonds of other corporations conferred by Section 61 of the general corporation act is to be exercised subject to the limitations imposed by Sec- tion 2 of the same act ; that is to say, the power exists as a pri- mary power only when the purpose to exercise it as such is expressed in the certificate of incorporation ; and otherwise it exists as an incidental power only so far as necessary or con- venient to the attainment of the objects that are set forth in the charter or certificate of incorporation. It is only by reference to the certificate of incorporation that the Attorney General and other officials interested on behalf of the people can readily determine what powers have been granted and whether the company is usurping franchises not granted by the state. It is by reference to the articles of association that investors can conveniently ascertain the character of the contract into which they are entering and the property rights they are acquiring in purchasing stock of the company. It must not be forgotten that stock ownership by one com- pany in another is only a mode by which the former company engages in the business of the latter. But since the second com- pany (if Section 51 were unqualified in its effect) might like- wise hold stock in any other corporation or corporations, and these might do the same ad infinitum, stock ownership in any company under such a system would not evidence a participation in any definite kind of business, but in eff^ect a participation in a "blind pool" subject to the uncontrolled will of the majority. There would be an end at once of all practical force to the doc- trine that incorporation evidences a contract between the state and the corporation or between the corporators and stockholders themselves. Evidently the eminent lawyers who drew up the charter, or certificate of incorporation, of the railroad 28 CORPORATION FINANCE company in this instance were either careless or lacking in foresight. Otherwise, they would have avoided this adverse decision very easily by including among the powers granted by the charter the right to acquire and hold stock. 21. Other important features of the charter. — The amount of capital and the number of shares of a new corporation which are desirable depend on principles of capitalization that are discussed in Chapter VII and which need not be considered at this stage. Most, though not all, of the state laws require that the principal office of the corporation shaU be within the state where the charter is secured. Partly for this reason, other things being equal, it is better to secure a charter from that state in which most of the business of a corpo- ration is carried on ; but this is by no means an invariable rule, as will be pointed out in Chapter IV. It is also usual, although not universal, to provide that one .or more of the incorporators shall be citizens of the state which grants the charter. The minimum number of in- corporators in most states is three. The number of directors of a new corporation is an important point to consider when the charter is obtained. Sometimes the number is stated not in the charter, but in the by-laws and may readily be amended from time to time; but where the number is fixed by the charter it cannot be easily changed. A small board obviously is apt to be more efficient than a large board. This is another question which will come up for fuller discussion in a subsequent chapter. 22. The by-laws. — The by-laws are simply a collec- tion of permanent rules for transacting business adopted by the stockholders or directors. It is not absolutely necessary, though almost always very desirable, that a LEGAL STATUS OF THE CORPORATION 29 corporation should have by-laws. The by-laws usually contain provisions as to: (1) Issue and transfer of stock. (2) Meetings of stockholders and directors. (3) Election of directors and officers. (4) Powers and duties of directors and officers. (5) General directions as to the management of the corporate property. As in the case of the charter, we will run over briefly some of the important features of corporate by-laws. First, the reader should study with care the following set of by-laws, which is used by a New York corporation, but could be adapted with slight changes to any small company. This set is taken from Mr. Conyngton's ex- cellent manual, "The Modern Corporation," BY-LAWS OF THE STANDARD BLEACHING COMPANY, NEW YORK CITY Article I. — Stock. 1. Certificates of Stock shall be issued in numerical order from the stock certificate book, be signed by the President and Treas- urer and sealed by the Secretary with the corporate seal. A record of each certificate issued shall be kept on the stub thereof. 2. Transfers of Stock shall be made only upon the books of the Company and before a new certificate is issued the old cer- tificate must be surrendered for cancellation. The stock books of the Company shall be closed for transfers twenty days before general elections and ten days before dividend days. 3. The Treasury Stock of the Company shall consist of such issued and outstanding stock of the Company as may be do- nated to the Company or otherwise acquired, and shall be held subject to disposal by the Board of Directors. Such stock 30 CORPORATION FINANCE shall neither vote nor participate in dividends while held by the Company. Article II. — Stockholders. 1. The Annual Meeting of the stockholders of this Company shall be held in the principal office of the Company in New York City at 12 M. on the second Monday in January of each year, if not a legal holiday, but if a legal holiday then on the day following. 2. Special Meetings of the stockholders may be called at the principal office of the Company at any time by resolution of the Board of Directors, or upon written request of stockholders holding one-third of the outstanding stock. 3. Notice of Meetings, written or printed, for every regular or special meeting of the stockholders, shall be prepared and mailed to the last known post-office address of each stockholder not less than ten days before any such meeting, and if for a special meeting, such notice shall state the object or objects thereof. No failure or irregularity of notice of any regular meeting shall invalidate such meeting or any proceeding thereat. 4. A Quorum at any meeting of the stockholders shall con- sist of a majority of the voting stock of the Company, repre- sented in person or by proxy. A majority of such quorum shall decide any question that may come before the meeting. 5. The election of Directors shall be held at the annual meet- ing of stockholders and shall, after the first election, be con- ducted by two inspectors of election appointed by the Presi- dent for that purpose. The election shall be by ballot, and each stockholder of record shall be entitled to cast one vote for each share of stock held by him. 6. The Order of Business at the annual meeting, and, as far as possible, at all other meetings of the stockholders, shall be : 1. Calling of Roll. 2. Proof of due notice of Meeting. 3. Reading and disposal of any unapproved Minutes. 4. Annual Reports of Officers and Committees. LEGAL STATUS OF THE CORPORATION 31 5. Election of Directors. 6. Unfinished Business. 7. New Business. 8. Adjournment. Article III. — Directors. 1. The Business and Property of the Company shall be man- aged by a Board of seven Directors, who shall be stockholders and who shall be elected annually by ballot by the stockholders for the term of one year, and shall serve until .the election and acceptance of their duly qualified successors. Any vacancies may be filled by the Board for the unexpired term. Directors shall receive no compensation for their services. 2. The Regular Meetings of the Board of Directors shall be held in the principal office of the Company in New York City at 3 P. M. on the third Tuesday of each month, if not a legal holiday, but if a legal holiday, then on the day following. 3. Special Meetings of the Board of Directors to be held in the principal office of the Company in New York City may be called at any time by the President, or by any three members of the Board, or may be held at any time and place, without notice, by unanimous written consent of all the members, or with the presence of all members at such meetings. 4. Notices of both regular and special meetings shall be mailed by the Secretary to each member of the Board not less than five days before any such meeting, and notices of special meetings shall state the purposes thereof. No failure or irregu- larity of notice of any regular meeting shall invalidate such meeting or any proceeding thereat. 5. A Quorum at any meeting shall consist of a majority of the entire membership of the Board. A majority of such quorum shall decide any question that may come before the meeting. 6. Officers of the Company shall be elected by ballot by the Board of Directors at their first meeting after the election of directors each year. If any office becomes vacant during the year, the Board of Directors shall fill the same for the unex- 32 CORPORATION FINANCE pired term. The Board of Directors shall fix the compensa- tion of the officers and agents of the Company. 7. The order of business at any regular or special meeting of the Board of Directors shall be : 1. Reading and disposal of any unapproved Minutes. 2. Reports of Officers and Committees. 3. Unfinished Business. 4. New Business. 5. Adjournment. Article IV. — Officers. 1. The Officers of the Company shall be a President, a Vice- President, a Secretary and a Treasurer, who shall be elected for one year and shall hold office until their successors are elected and qualify. The positions of Secretary and Treasurer may be united in one person. 2. The President shall preside at all meetings, shall have gen- eral supervision of the aff'airs of the Company, shall sign or countersign all certificates, contracts and other instruments of the Company as authorized by the Board of Directors ; shall make reports to the directors and stockholders and perform all such other duties as are incident to his office or are properly re- quired of him by the Board of Directors. In the absence or disability of the President, the Vice-President shall exercise all his functions. 3. The Secretary shall issue notices for all meetings, shall keep their minutes, shall have charge of the seal and the cor- porate books, shall sign with the President such instruments as require such signature, and shall make such reports and per- form such otEer dtitieft-aa_are incident to his office, or are prop- erly required of him by the Board of" Directors, 4. The Treasurer shall have the custody of all moneys and securities of the Company and shall keep regular books of ac- count and balance the same each month. He shall sign or coun- tersign such instruments as require his signature, shall perform all duties incident to his office or that are properly required of him by the Board, and shall give bond for the faithful perform- LEGAL STATUS OF THE CORPORATION 33 ance of his duties in such sum and with such sureties as may be required by the Board of Directors. Article V. — Dividends and Finance. 1. Dividends shall be declared only from the surplus profits at such times as the Board of Directors shall direct, and no divi- dend shall be declared that will impair the capital of the Com- pany. 2. The moneys of the Company shall be deposited in the name of the Company in such bank or trust company as the Board of Directors shall designate, and shall be drawn out only by check signed by the Treasurer and countersigned by the President. Article VI.— Seal. 1. The Corporate Seal of the Company shall consist of two concentric circles, between which is the name of the Company, and in the centre shall be inscribed "Incorporated 1905, New York," and such seal, as impressed on the margin hereof, is hereby adopted as the Corporate Seal of the Company. Article VII. — Amendments. 1. These By-Laws may be amended, repealed or altered, in whole or in part, by a majority vote of the entire outstanding stock of the Company, at any regular meeting of the stock- holders, or at any special meeting where such action has been announced in the call and notice of such meeting. 2. The Board of Directors may adopt additional by-laws in harmony therewith, but shall not alter nor repeal any by-laws adopted by the stockholders of the Company. 23. Essential features of the by-laws. — The sections with regard to stock are usually of a formal character and state simply that the ownership of stock shall be evidenced by the issue of certificates to each stockholder, and that transfers of ownership shall be made only upon the books of the company. The reader should thor- oughly understand this provision, which is practically universal. Frequently the engraved certificate of stock VI— 3 34 CORPORATION FINANCE in the possession of a stockholder, which usually reads "This is to certify that John Doe is the owner of . . shares of the capital stock of the John Doe Company, transferable only on the books of the company, etc.," (see page 70) is incorrectly called and mistaken for stock itself. As a matter of fact, stock is an intangible thing; it is merely a right to a share in the company's assets and earnings. A certificate is only a convenient method of proving that a certain person is the owner of stock. A certificate may be lost or stolen or given away* or sold and yet the ownership of the stock wiU remain unchanged. Only by transfer on the books of the com- pany will a change in ownership be consummated. The usual method of transferring stock is to sign a blank form on the back of each certificate (see page 70) which authorizes the secretary of the corporation or some other agent of the owner to make the transfer. The by-laws almost always specify the time and place of an annual meeting of stockholders for the transaction of important business. Special meetings may be called from time to time on request of a certain number of stockholders or in whatever manner the by-laws may lay down. The important point is that to make a special meeting legal every stockholder must have proper notice in writing mailed to his last-known address. Meetings of the directors also are usually required at stated inter- vals and it is set forth in the by-laws that the directors are to elect the officers of the company and otherwise to manage its affairs. The essential officers of a corporation are the presi- dent, the secretary and the treasurer. The duties of each officer should be and usually are clearly specified in the by-laws. Ordinarily the president, briefly stated, is the chief executive officer; the secretary keeps the LEGAL STATUS OF THE CORPORATION 35 records of the corporation; the treasurer handles the corporate funds. The reader should clearly understand, however, that this definition of duties is not necessarily or universally followed. The by-laws may make the president the custodian of funds and the treasurer the chief executive officer, or may distribute the duties in any other manner. The law recognizes, however, that an outsider has the right to assvime that the man who is given the title of president, treasurer or secretary is given the powers and duties that customarily belong to that position. The by-laws usually declare that dividends shall be paid only out of surplus, not out of the capital of the corporation, although this is simply a formal statement of a principle which could not legally be violated in any case so long as the corporation has creditors. A corporate seal is usually adopted and briefly described in the by-laws. The procedure and necessary percent- age of favorable votes in order to amend the by-laws are usually stated. The board of directors or the stockholders may some- times adopt new rules of action which will be binding until rescinded, without the formality of amending the by-laws, simply by passing a formal resolution. No resolution, it need scarcely be said, will be legally bind- ing if it is contrary to any by-law provision. Resolu- tions are frequently used,- however, to supplement and further elucidate the by-laws and to lay down a general permanent pohcy. • We have now covered very briefly the main points that the. reader should bear in mind as to the legal status of the corporation and as to the instruments that confer and define that status. All this is rather dry and more or less technical matter; yet it must not be slurred 36 CORPORATION FINANCE over by anyone who desires to acquire that knowledge of the corporate form and understanding of its uses and misuses that is essential to every person successfully concerned with modern business. We cannot aiFord to forget that the corporation is created and maintained under certain specific provisions of the law to which all its actions must conform. CHAPTER III INTERIOR ORGANIZATION 24. Bights of stockholders. — In this chapter we sli^iJ treat as briefly as the subject will permit the relations to each other of the various groups of individuals who are interested in a corporation. Those groups are: I. Stockholders. II. Creditors. III. Directors. IV. Ofiicers. Every corporation must be so organized that the duties, the liabilities and the rights of each of these groups are clearly known and may be enforced. The nature of stock — the fact that it is an intangible share in the corporation's assets and earnings — ^has al- ready been discussed. Each owner of stock becomes to the extent of his holdings an owner of the corporation. His rights fundamentally are the same as the rights of other owners of private property, but the full exercise of these rights is under the corporate form much abridged and modified. To illustrate, the private owner of a piece of property has the right to sell or destroy or give away or use for his personal enjoyment the prop- erty and its earnings. A stockholder, however, cannot sell or destroy or otherwise tamper with his proportion of the corporation's assets, because under the corporate form he has committed those assets to the care of other people. 37 38 CORPORATION FINANCE The rights of stockholders as a body are : (1) To elect directors. (2) To amend the charter or by-laws. (3) To sanction or veto the selling or mortgaging of the permanent assets of the corporation. (4) To dissolve the company. The first two rights have been touched upon in the preceding chapter and need not be further considered. The third right is not universal in all states and under . all charters, but is generally conceded. In some states the courts assume that the stockholders, having chosen directors, freely turn over to them the sole and complete management of the business without any reservations whatsoever. Even in such states, however, the directors, in order to avoid any charge of fraud that might be brought against them, generally prefer on such impor- tant actions as the sale of permanent assets to have the officially expressed concurrence of the stockholders. A clause is sometimes placed either in the charter or in the by-laws requiring unanimous consent or the consent of a very large percentage of the stockholders in order to validate a sale or mortgage of permanent assets. The right of dissolution is very seldom exercised inasmuch as an unsuccessful corporation may be very easily aban- doned and its charter allowed to lapse by non-payment of taxes. 25. The proxy and its uses. — The rights of each in- dividual stockholder are four in number, as follows: (1) To receive notice of and to participate in all stockholders' meetings. (2) To share in the assets of the corporation in pro- portion to his stockholdings in case of dissolution. (3) To share in dividends declared by the directors in proportion to his stockholdings. INTERIOR ORGANIZATION 39 (4) To inspect the accounts of the corporation. The first right has already been mentioned. It should be further observed, however, that a stockholder's right to participate in meetings is not confined to personal attendance at the meetings. If he does not go himself he may confer the right to represent him upon some other person. The instrument which confers this right is known as a "proxy" and generally reads somewhat as follows : KNOW ALL MEN BY THESE PRESENTS, that I, the undersigned, do hereby constitute and appoint John Doe my true and legal attorney to represent me at all meetings of the stockholders of the Blank Company and for me and in my name and stead to vote throughout upon the stock standing in my name on the books of said company at the times of said meetings, and I hereby grant my said attorney all the powers that I should possess if personally present. This is a form well adapted to conferring a simple, un- limited right to represent the stockholder who gives it. The proxy may be much more formal and may contain any limitations that the giver chooses to impose; for in- stance, it may be good only for one meeting or up to a certain time or for a certain purpose, such as giving an afiirmative vote on a proposition that is to come before the meeting. The use of proxies in this country is widespread and is an important feature of corporation management. In England stockholders are more likely to appear in person at the annual meetings. By means of proxies American corporation officials are accustomed to hold meetings with no one but themselves actually attending, but with a constructive attendance through their proxies of more than a majority of the outstanding stock. The 40 CORPORATION FINANCE Union Pacific Railroad, for instance, which is incorpo- rated in Utah and must hold its annual meetings in that state, whereas its principal office is in New York City, every year sends its secretary and a few minor officials from New York to Salt Lake City, each official carrying a satchel full of proxies. The annual meeting is then held and the election of directors carried out with all the formality that would characterize a fully attended meet- ing. Any lone stockholder who appears in person will find that his presence adds nothing to the effectiveness of the proceedings and does not change their character in the least. Of course, in smaller companies the stock- holders are more likely to be present in person, although even there representation by proxy is the established custom. One point about a proxy that should be impressed on the mind of every stockholder is that it is never under any circumstances irrevocable. The courts will not rec- ognize an irrevocable proxy as a valid agreement. No matter what the wording of the original proxy may be, no matter if it clearly and emphatically states that it is irrevocable, a stockholder may, as a matter of fact and of law, revoke it at his will. The second right, as has already been intimated, is of small practical importance. 26. The right to dividends. — The third right — to share in dividends — is so often misunderstood by stock- holders that its limitations need to be carefully noted. In the first place, notice that nothing is said as to earn- ings. A corporation may be getting enormous yearly profits and yet an individual stockholder may not draw any dividends whatever; nor can the stockholder get at these earnings until dividends are declared. In the second place, it will be pointed out in connection with the INTERIOR ORGANIZATION 41 powers of directors that directors alone have the right to declare dividends and cannot be compelled by any legal action whatever to grant dividends to the stock- holders until they see fit. A case in point, which at- tracted some attention several years ago, was that of the Midvale Steel Company, a fairly large and now pros- perous company, located in a suburb of Philadelphia. The management of the company for the ten years 1887 to 1897 devoted all of its earnings to improvement of the plant, in spite of protests and strenuous efforts on the part of minority stockholders to force the declaration of dividends. The courts will not interfere with the policy of the board of directors in this regard unless fraud or mismanagement can be proved. 27. The right to information. — The fourth right — to inspect the corporate books and accounts— was originally universally admitted and was of considerable impor- tance. Each stockholder could go into the company's office whenever he chose and demand that he be given access to all the books and accounts. Early in the his- tory of business corporations, however, it became evident that the manager of a rival business could buy a single share of stock and thereby obtain trade information that could be used to the detriment of the corporation. Thus the anomaly was presented of a stockholder of a -corpo- ration being able to work against the corporation's in- terests. The courts, recognizing the situation, have greatly modified and almost nullified this original right. No stockholder can now on legal grounds demand that he be furnished with information as to the customers of the corporation, the persons from whom supplies are bought and their prices, the corporation's contracts, and other points of similar nature. In most states he gets all the information that rightfully belongs to him if he 42 CORPORATION FINANCE obtains simply a summary of the profit and loss account for the preceding year and of the balance sheet at the end of the corporation's fiscal year. Indeed, he cannot in all states secure even this meagre and apparently in- nocuous information. The movement in favor of pubUcity of corporate ac- counts, however, is now so general and strong, and the force of public opinion behind it is so great, that almost all the important corporations voluntarily give to their stockholders and to the public fairly complete annual reports. Railroads particularly under the Interstate Commerce Act, as amended in 1906, are compelled to render to the Interstate Commerce Commission and through the Commission to the pubHc and to their stock- holders, a very complete and detailed smnmary of their operations each year. One striking exception among the large corporations to this general tendency toward increased publicity is the Standard Oil Company, whose management has never yet given out anything more than a bare statement of the amount of the capitaUzation and of the dividends declared. Publicity of accounts is not to be confused with the right of the individual stock- holder to have access to the corporation's books, for even the greatest degree of publicity extends only to general financial results of the corporation's activities, not to the corporation's individual purchases, sales and contracts. The right to actual inspection of the books, with few unimportant exceptions, is entirely a theoretical, not a practically important, attribute of stockholders. 28. Liabilities of stockholders. — The next topic to consider is that of liabilities of stockholders, which may be grouped under the following four heads : ( 1 ) Their liability to the corporation or to unsatisfied INTERIOR ORGANIZATION 43 creditors of the corporation for unpaid installments on part-paid stock. (2) Their liability to unsatisfied creditors of the corporation in case dividends have been paid out of capital assets. (3) In New York State, their Uability to employees and servants for wages due by the corporation. (4) In the state of Minnesota, their liability (except manufacturing corporations) to corporate creditors up to an amount equal to the face value of their stock- holdings. In national banks the same rule holds good. (5) In California the unlimited liability of each stockholder for his proportion of unpaid obligations in- curred while he remained a stockholder of record. This liability continues even though he sells his stock. With further reference to the liability first stated in the preceding paragraph, it should be observed that cor- porations frequently do not need at the beginning of their existence all the capital assets that will later be necessary. They therefore ask their stockholders to pay only a certain percentage of their stock subscriptions at the beginning and either set certain dates for the re- maining payments or leave the dates to be fixed later by the directors of the company. In the latter case it sometimes happens that the corporation becomes so pros- perous that the unpaid installments are not called for and in the course of years stockholders may almost forget that they are still unpaid. Then if the corpora- tion later gets into financial difficulties, the owners of stock at the time may suddenly find themselves con- fronted by a demand for the immediate payment of un- paid installments. It is a very unpleasant and not especially uncommon situation. Buyers of stock should 44. CORPORATION FINANCE therefore be very certain that their certificates are marked "full paid and non-assessable," or else make sure that they can meet whatever installments are un- paid, when called for, without great inconvenience to themselves. The payment of dividends out of capital instead of out of earnings is a practice which we shall have occasion to refer to later in this volume. All that need be said about it here is that it might obviously be used as a means of diverting to stockholders assets pledged to creditors of the corporation and for that reason is not permis- sible. 29. Rights of creditors. — The creditors of a corpora- tion are of two distinct kinds, secured and unsecured. The secured creditors are those who have had set aside for them under some form of agreement certain parts of the property of the corporation which are to be devoted, in case the corporation fails at the specified time to meet its debt, to paying the creditor in full. The exact procedure will be discussed at some length in connection with corporate notes and bonds. The unsecured creditors hold simply a claim against the general unattached assets of the corporation. Whether the creditors be secured or unsecured, they have no part in the organization or management of the corporation so long as the debts to them are fully and promptly met. Only in case of insolvency or bank- ruptcy may they step in and exercise any rights which may have been conditionally granted to them. We wiU therefore defer a study of their place in the corporate organization until we come to the subjects of insolvency, bankruptcy and reorganization. 30. "Dummy" directors. — The statutes of nearly all the states require that the directors of a corporation INTERIOR ORGANIZATION 45 shall also be stockholders. In most states the owner- ship of a single share is sufficient to meet this re- quirement. As an example of the striking diiFerence at times between what the law intends and what it ac- complishes, this requirement deserves special mention. Obviously it is intended to prevent any one man from "packing" the board of directors; in practice it serves to facilitate the creation of and control over "dummy" directors. A dummy director is one who serves the interest of some other person and who votes as he is told. Some- times he is an actual stockholder or is given stock out- right in order to qualify him for his position, and the man who controls him depends on influences outside the corporation to retain his control. When any doubt exists as to that point, however, the "dummy" director usually receives a certificate of stock duly transferred to him on the books of the company — which thus qualifies him to act as director — but is required to endorse the certificate back to the real owner. Thus the owner of the stock always has a string tied to the "dummy" director. If his orders are not followed to his satisfaction, all that he needs to do is to send in the certificate, have the stock transferred back to himself and thereby disqualify the "dummy." Thus a major- ity stockholder may elect a whole board of directors who are absolutely subservient to his orders and repre- sent only his interests. He may not himself be a member of the board at all, and yet may dictate its every action. 31. Powers and liabilities of directors. — In theory, however, even if not in practice, a board of directors is supposed to represent all the stockholders equally. Partly for that reason the board, as has already been 46 CORPORATION FINANCE indicated, is given complete control over the corpora- tion's assets and oiScers. Very seldom, indeed, will the courts restrain the directors from taking any action short of selling or mortgaging the corporation's perma- nent assets, unless fraud or wrongdoing is conclusively shown. Their powers are usually more or less modified, however, by the corporation's by-laws, and, like other officers, they are not at liberty to transgress or omit any of the duties specifically set forth in the by-laws. As a general thing they have power among other things to fill vacancies in their own number until the next annual meeting of the stockholders for the election of directors, to appoint and remove officers of the corpo- ration, and under limitations to modify or enact by-laws. Any or all of these powers the board of directors may delegate, if they see fit, to a standing conmiittee chosen from their number. Where the board of direct- ors is so large as to be unwieldy and difficult to assemble at regular intervals, such delegation of powers is cus- tomary. The board of directors of the United States Steel Corporation, for example, which consists of twenty-four members, delegates a large part of its func- tions to a standing committee of eight members known as the finance committee. The finance committee holds frequent meetings and conferences with the chairman of the board of directors, and between meetings of the full board has complete authority to settle most ques- tions. It also handles with full authority such financial questions as in most corporations would be referred to the board of directors. The committee with these func- tions in most corporations is called the executive com- mittee. The usual duties of corporation officers have already been treated in the preceding chapter. One officer not INTERIOR ORGANIZATION 47 mentioned there, who is in several large corporations of much importance, is the chairman of the board of directors. In the United States Steel Corporation, the New York Central Railroad Company, the National City Bank of New York, and other companies of like magnitude, the chairman of the board of directors is a prominent paid oflficer to whom the presi- dent of the corporation reports. It would not be far from wrong to say that the chairman represents the board of directors and the standing committees of the board in the intervals between meetings. To him, in other words, are delegated ad interim the full powers of the board. Personal liabilities of directors may arise in four ways : (1) By reason of neglect or wrongdoing on their part that results in loss to the company. (2) By issuing stock as full paid that is not actually full paid. (3) By paying dividends out of capital. (4) By doing other acts specifically forbidden by the statutes of the state in which the company is incorpo- rated. These acts, it should be observed, in the eyes of the law are wrong and fraudulent. So long as the direct- ors keep within the law, no liability will attach to them in their capacity of directors. 32. The efficiency of corporate organization. — The reader may now see more clearly perhaps why "central- ization of control" was named in the first chapter as one of the important advantages of corporations. He may carry away a more vivid idea of the whole arrangement if he compares the corporation to a double pyramid, as shown in this diagram: CORPORATION FINANCE Clerks and Laborers The base of one pyramid represents the body of stock- holders or owners of the corporation who delegate their rights as owners to the directors, who in turn transfer all active authority to the president or other chief execu- tive officer, who is at the apex of that pyramid. The other pyramid represents the subordinate officials and employees of the corporation. The chief executive officer is also the apex of this pyramid and transmits his orders through the various grades of subordinates to the clerks and laborers at the base of the pyramid. Thus responsibility and authority conferred by the stockholders and exercised over the employees are both centered in this chief executive officer. It is an organ- ization almost ideally adapted, so far as efficiency and economy go, to the conditions of present-day industry. CHAPTER IV WHERE AND HOW TO INCORPORATE 33. A corporation may he chartered in any state and do business in other states. — The reader is probably well aware that a corporation need not necessarily take out a charter in the state in which it transacts its principal business. In fact, the great majority of the large in- dustrial and railroad companies are incorporated in one state and carry on their operations in several states; in many cases none of their permanent assets worth men- tioning are located in the state of incorporation. This anomalous condition is made possible by the peculiar character of our American political system. Each state has the right to create corporations and by custom such corporations are recognized and allowed the usual rights and privileges in all other states. It should be noted at this point that such rights and privileges are granted as a matter of custom and of policy, or of "comity," to use the legal term, and not — as is some- times stated even in legal text-books — under that clause of the Constitution, of the United States which says that "the citizens of each state shall be entitled to all privileges and immunities of citizens in the several states." A corporation is not a citizen, but an artificial person created by law, which is an entirely different thing. In an early case before the Supreme Court of the United States, The Bank of Augusta vs. Earle, the right of a corporation to make a contract outside the VI— 4 4-9 50 CORPORATION FINANCE state of its incorporation was brought into question. The decision of the Court upheld this right as a legal presumption, but stated that the right might be with- drawn by any state legislature. The opinion written by Chief Justice Taney is so important and informing that some of the salient paragraphs are quoted below: It is very true that a corporation can have no legal existence out of the boundaries of the sovereignty by which it is created. It exists only in contemplation of law, and by force of law ; and where that law ceases to operate, and is no longer obligatory, the corporation can have no existence. It must dwell in the place of its creation and cannot migrate to another sovereignty. But although it must live and have its being in that state alone, yet it does not by any means follow that its existence there will not be recognized in other places ; and its residence in one state creates no insuperable objection to its power of contracting in another. It is indeed a mere artificial being, invisible and in- tangible; yet it is a person, for certain purposes in contempla- tion of law, and has been recognized as such by the decisions of this court. . . . Now, natural persons, through the in- tervention of agents, are continually making contracts in coun- tries in which they do not reside ; and where they are not per- sonally present when the contract is made ; and nobody has ever doubted the validity of these agreements. And what greater objection can there be to the capacity of an artificial person, by its agents, to make a contract within the scope of its limited powers, in a sovereignty in which it does not reside; provided such contracts are permitted to be made by them by the laws of the place.'' The corporation must no doubt show that the law of its crea- tion gave it authority to make such contracts, through such agents. Yet, as in the case of a natural person, it is not neces- sary that it should actually exist in the sovereignty in which the contract is made. It is sufficient that Its existence as an artificial person, in the state of its creation, is acknowledged and recog- nized by the law of the nation where the dealing takes place ; WHERE AND HOW TO INCORPORATE . 51 and that It is permitted by the laws of that place to exercise there the powers with which it is endowed. It is nothing more than the admission of the existence of an artificial person created by the law of another state, and clothed with the power of making certain contracts. It is but the usual comity of recognizing the law of another state. We think it is well settled, that by the law of comity among nations, a corporation created by one sovereignty is permitted to make contracts in another, and to sue in its courts ; and that the same law of comity prevails among the several sovereignties of this Union. The public and well-known and long-continued usages of trade ; the general acquiescence of the states ; the par- ticular legislation of some of them, as well as the legislation of Congress ; all concur in proving the truth of this proposition. 34. The regulation of "foreign" corporations. — In the state in which its charter is granted a corporation is called "domestic"; in other states it is a "foreign" cor- poration. This word "foreign" must not be taken to refer to corporations of other countries than the United States ; such corporations are known as "alien." Every state in the Union regulates to a greater or less degree the business carried on within its borders by foreign corporations. In some states it is necessary to procure a license, which may be obtained by" deposit- ing with some official a certified copy of the corpora- tion's charter and naming some agent on whom legal papers may be served. In other states it is merely required that the foreign corporation shall maintain an office and have an agent within the state. Some states restrict the power of foreign corporations to hold real estate. These regulations are not intended to apply to corporations which merely solicit orders or execute contracts incidental to their main business, but to those which are permanently established. 52 CORPORATION FINANCE 35. Choosing the state of incorporation. — Unless there is some reason to the contrary, it is generally much better for a corporation to get its charter in the state in which its principal business is located. This remark applies particularly to small companies operating wholly within one state. There are several reasons therefor. One is the fact that a foreign corporation must usually pay incorporation and annual franchise taxes in the state of incorporation and in addition a license fee or some other kind of a tax in the state in which it does business. Another reason is that the courts of each state are inclined to treat domestic corpora- tions with greater consideration than foreign corpora- tions. A third reason is that there is a popular prej- udice, more or less well-founded, against those companies which go to other states for their charter. Creditors and prospective buyers of the corporation's securities are apt to ask embarrassing questions as to why the corporation cannot or does not comply with the legal requirements of its own state. A fourth reason is the inconvenience caused by the necessity of filing reports and generally of maintaining a separate office in the state of- incorporation. If the managers of a small local concern, therefore, are considering where to in- corporate, the answer will almost always be, "Get your charter in the state where you expect to do most of your business." The answer to a similar question is not so easy, how- ever, where the prospective corporation will be large, or where its business will be widely scattered through many states, or where its managers have in view some purpose or purposes not favored by the laws of the state in which its principal office is to be located. Neither is the answer so easy even for small local con- WHERE AND HOW TO INCORPORATE 53 cerns in those ultra-conservative states in which the corporation laws are unduly burdensome or corporation taxes unduly expensive. Under all these circumstances, persons who are about to form a new corporation, or who are thinking of giving up their charter in one state, will naturally look about and compare the ad- vantages obtainable under the laws of the various states. There are great variations among the states in regard to taxes, liberality of corporation laws and treatment of foreign corporations, and the problem of weighing all these factors and picking out the most economical and advantageous corporate home is often very difficult. The advice of a thoroughly competent corporation lawyer in all such cases is absolutely essential. Never- theless, for his own protection, both in forming and in dealing with corporations, every business man should have a pretty accurate idea of the requirements and privileges in all the important states. 36. Comparative charges in several states. — The first and most obvious factor to consider in selecting the state of incorporation is the cost. This cost consists of organization fees, annual taxes and counsel fees. The following tables copied from a convenient manual by Thomas Conyngton, of the New York Bar, entitled "Corporate Organization," will give the reader an idea of how these expenses run in the five states which are most commonly used for incorporation by companies that expect to do business in other states: COMPARATIVE TABLE OF ORGANIZATION EXPENSES. (Including all Filing and Incidental Fees.) Capital Stock of Company. New Jersey. New York. Delaware. Maine. South Dakota. $1,000 $35.00 $16.00 $25.00 $27.00 $13.00 5,000 35.00 17.50 25.00 27.00 13.00 10,000 35.00 20.00 25.00 27.00 13.00 64. CORPORATION FINANCE Capital Stock of Company. 25,000 New Jersey 35.00 New . York. 27.50 Delaware. 25.00 Maine. 67.00 South Dakota. 13.00 50,000 35.00 40.00 25.00 67.00 18.00 100,000 35.00 65.00 25.00 67.00 18.00 500,000 110.00 265.00 65.00 67.00 23.00 1,000,000 310.00 515.00 115.00 117.00 28.00 5,000,000 10,000,000 1,010.00 2,010.00 2,515.00 5,015.00 365.00 615.00 517.00 1,017.00 43.00 43.00 COMPARATIVE TABLE OF ANNUAL FRANCHISE TAXES. $1,000 5,000 $1.00 5.00 $1.50 7.50 $5.00 5.00 $5.00 5.00 None 10,000 10.00 15.00 5.00 5.00 u 25,000 25.00 37.50 5.00 5.00 u ■ 50,000 50.00 75.00 10.00 5.00 C( 100,000 100.00 150.00 10.00 10.00 « 500,000 500.00 750.00 25.00 50.00 M a; ST *-< ^1 "^ Si A o - o : w I ti 00,000or STOCK r^WYDRKSaXiNG ISLAND RRCQ (THt STEINW^V TUNHClJ COnffOP*Tt PtMrtCHIBE eiPiOtC j*nu*(r^ IV >■ X RAPro TRANSIT SUBWW z IMTEB-MtT.CO OV*Nei33.»l2.eO0 OF STCCK I^^^ERBORouGH rapid tfiansitco OPtRATCS 78 1QMiLC^''tr^£[ IS FOR aoVEABSwiT aiOt* Lt*tt 13 Fl NEWYDRKirQUEENSCOUrnVFKCO (7^j7HiLC%OF TMACk) tS.CCM.SOO OF BTOCI NSOL.'^ '«46 z; Cny ISLANDHRCO, 3TOCK isoooo BONDSlvMTcie;,, 276-731- PELHAM PAPKRYCO. ( ISMlLEOl"' TR/NCK I STOCK *SOOOQ BONDS IVK-fG** 27750. INTERBOROUGH PTETHOPOLITAN CO. STOCK Dins coHpAW lenosto 51* c .ooqo BONDS Col, trust .«^?t i9a« 7o,e>o«.ooo ■ NOTES COL TRUST e-/* lOio is.oooqoo THIS COMPAMV OtWNB THE TOL LOWINa *S*WUNT9 OF CTOCIC iNTCBBonouGH n T.co tJ3.91v.Boo MCTROPOLlTAM gTREtT RV CO 4*.a&9.eOO METROPOLITAN S CCLIR ITI CS CO e9>392,OCH3 FOR THESE"5TOCKt.TWt INTER METCa txcHANSt ITB 0«N StCUWlTIES !»» FOLl.O«V« - '■QR CAr" 9HAHC 1 ( R.T.CO. «30OCON0S&ct99 COMMON STOCK , FOB EACM SHARE IM MEIT. =.T.RY CO., lioo PnCFERHED STOCK a, »5B.COMMOM STOCK.., FOR KACM SHARE IN MET. SECCO (75*/* PAID UP ) # 9A.BO COHHON STOCK R^K COACH CO. *I.SSaoOO STOCK OVXNCD rrV.TRANSPORTATlON CO wrn^pouTAN sEcuRrnEsco A HOLDir-iGCJ5 OPERATES NO ROAD 5TOCK(7S%Fwioj #30.000,000. THE LONG ISLAND RH.CO. HrtSflN INTEREST IN THESE COS EQUALTOTHATOFniE INTERBOROUGH R. T CO, N.Y &.L-ONG ISLAND TRACTiaWOO (.40. MILES OFTRAC-. ) onr.»c - STOCK PRtFEfiBEo Sbso'Soo i'l" S O LONG ISLAND EJ-ECTRICRYCO (at 7 MILES OF track) ov^fjLD I STOCK t *oo.ooo. * £90 00c BOIMDS B^'flBo «ooooo soo 00. MIT aiC CO OWNS #BOQ.JOO OF STO ■42 "iP ST, inANHATTAJTvTLLE.;^ S.NICHOLAS i«^/E.FlR CO. ( ZAM Mint, or TRACIt } " TOTAL PLEDGE! BONDS I'^'MTG «?* .910 ♦iSOftCOQ IMCOMC 6> I 913 1.000 OOQ$I.*«0 MORTGA&ES loo.ooQ all NOTES FWYA8LE 738s..*oo. < STOCK 200Q000 1 KINGSBRIDGE R.R.CO. NOTES PAYABLE « a.-t3J.ea2 |E.i£*a.7i STOCK e,»oo ALL ItT ^tC CO OrtNS Jtt970 000 OF STOCK THIRD AVE. R.R.CO. 3TOCK $15 995.600 BONDS ly MTG5t*i9S7«5.oo. |VCON4-^Cooo 3T.6fc NOTESo«NEt> ev itaoxc DRY DOCKEAST BROADWAY fit] BATTERY R.RCO. (l7a7MILE9 OF TRACK ) | TDTAL fxtasn GEJH'l MT<3 9JH9SB ♦ qcqooo CTFSorlNDEB55t' SErtTL)*l,10«000 rJOTES PAYABLE ti,95»2oF fioae^fcs STOCK 120Q00O LiaftToo UNION RV. CO. r 6iB MILtft 3F TftACKl BONDS WM.TG.sy* le^a tcoooooo. *' io»eo NOTES PAYABLE 4S4C 077 *< 71S.O«-l STOCK a, 000. 000 AtL BRONX TRACTION CO. YONKER5 R.R. CO. ( 34.46 MiLESOFTOACk) \ TOTBi.' p BONDS If Ktss^ 1946 «i. 000.000 NOTES PAYABLE |49B< 1 NOTES PftYABLE STOCK as « 3 00.003 BSa,*fis *332 ecS SOUTHERN BOULEVARD RRCQ BOTND3(c1) ('■'MTG.5'>i»^B 825^*000 NOTES PAYABLE lajioei-risso WESTCHESl ER ELECTRIC RRCC [37SO«V.L^OT TBACt.) BONDS iVMTb s-'-.^s ifccooo* NOTE PAYABLE \,9f>7 -fS ii.3o7s STOCK SCQ OOO ALI. JE^lOr-lE PftRK RY. CO. STOCK $BQooo.BOND5a?t*ioc(Ooo ALL feTOCK^t' SOe.OOofjJi'rKeD PEOPLES TFIACTION CO *ANCH1»E0 in THt BPOM7C »LL ^tOO.OOO STOCK OlVNIO NYWES-rcHESTEB&..OONN.TfW«mONCO BOriDSJa Eoqoco-iSBD -> cm»& bRokx franchici Ji.ooaooo STOCK Owned "WAUACOP.TLfiNDT ST FERRIES RYCO. ELECTRIC STORAGE BATTERV CO. COMMON STOCKjIfe 098 226 PREFCRREOtgKeOO A'..LTMt ♦l.eOQOOO STOCK OV*NEO 28 8*29^'ST. CROSS TOWN HY. CO. (5 7MILesTRflCR.)B0ND5 3ji(99*(tt)«lOOO.OOO ALHiSOQOOO ATOCK OyVMEO FULTON ST. R.R.CO. flMILE TBACK )aOND54?t 1896^8011000 .SUED ft^OOOOOo) OWMCO CITV KY. CO. ALL STOCK 16S1 ( 157 MILES OFTBinCKiN BROMX) STOCKiSO.OOO.OOO Def(CIT^Snfc7(M3Sg2.4i4 POPfT GEORGE STOCK. 9 S. OOQOOO 6TOCK OrtNCD 8J1««/E.RTICQ ( f MIUE.B TRACK^ .0»*ON STOCK 4t FIJI ED CHARGES BROADWAY a^7"^AVE.R.RC0 ( 20 MILE* OF TRACK ) STOCK»B loqooo-SvsTEM o^^at^^^o^. BONDS i*-'MT'G.6*4i.B»yiooo-MsoYaacwi«m EVMT.Gbj* I'ji^ 4 900.0CO CONSOLS B-* 19- 3 «76rvo.o LtAOtD fCO COnPOCAT Lire SECOND AVE.R R.CO. (30-.6MlLC»OFTFr^ :d 1 LH_K 5 ! ata.ooo- MIT otc ct £*«18ilS-TOOO BOND5GEN CONST s>«..w»4i.3eoe^o. | OEB, K-ii looa e- o tt'CONer-.a-o R*.|,o.o LEASED FOR SOBTEAOa ft'-.OO OOO NYS.. HARLEM R.R.CO. Ate BTOCK (♦l,OOQOOo]o«N[0 IN SYSTEM TI-ERTY FOURTH 3TCROSST0WN RYCO. ( »S MILES OF track) - !•«»"--■ 1 * ■ ooqooo BONDS BlV I99fe(e LEASED FOR CORPORATE LlFt lOy-ON STOCK ftriKEDCMAHGtS TWENTY-THIRD ST. RY. (3 ©MILES OF TRACK.) STOCK isooooo-eTOTtM ovvms ♦ j.*o» OC&. PT^ ISO OOP- ALL • isooopoo. LEASED FOR SOO YEA»« - 7^ STOCK S.. riKLlIJCriAk IrtTEB-MCT. CO Ol/VNO ^.««ODa.6CO CTOCK WETIiOPOUTAN STREET RAnjWfflYCQ t 5*.9»1ILtSOF TRACK) STOCK %3Z.OOOOQO GENL.COL.THU6T 5^ (»97 REFUNDING 4% E002 riETCRQSSTOWNlVei*. I9ZO LEX AVE.B^Pflvr B5fc 1993 COX. ai9'--A\/E_ W B7* 1993 90 FERBV Bit 1919 BWAv Surface iv b:* i»e4 isoaooo REALESTATe MTG'5. «90,ooo eiwAY SURFACE 2'-° BJb i.ocqooo METCHOS5TO\VN£"-P51fc . 30Q000 44l,OtHOOO 300c 000 42 ST acGRAND-ST.FERRYRRCQ f «.»« MILES OF track) BTOCK, eT+aoOO-EVSTCMOrtUSt-*-*: BOND51VM.TG.e?t.i9o9 »2J«oc n -s R-r CO owMS all bonds L_ l&t t)IPIRCOt97^-l/B»4 ON STOCK S. Fl KED CHARSES ELE^CKERSr &cFULtONniTlRYR.R.CO. STOCK 4900.000 -ai-sTcM cwns iioooa EOiNDS 4»t loso f Tooooo 1_£A5ED FOR 99»ycARe-l57t OH STOCK i; Fixio CHARGES CENTRAL CROSSTOVVN R.R.CO. ( SSfeMILES OF TRACK) STOCK ffcooooo- SYSTEM OWNS 4B02 60O BONDS l^'c7 1052 (b) NOTES gy- g BSqooo. LEASE EXPIRES i9aa 1«>ONBTOCK EIGHTH AVE. R.R.CO. iiaOMlLESOF track) 1000000 - METSECCOOWH64CC SCRIP •>»7SQOOO NINTH AVE.R.Pi.CO. STOCK $000,000 EASED FOR 980VEAR& e%ONSTOCKgc FDtFOCMARSES CHRISTOPHER S*.10'-^ ST. R.R.CO. STOCK4fc&0000(_^ MILES OF TWACK)p0NO6J%19retZlO. OOP LEAeCe FOB CORPOflATr Vire-9?*.ON STOCK CENTRAl- PARKNAcERrVERR.RCO. (s0.77MILEQ0F TRACK ) STOCK #1600000- »»-8TEM OWNS 1336.900 LtABCU FQ R BODY C:"H-. il SIXTH >:;:/£ RR CO. ^.Ml LES OF TRACK 1 STOCK S e. 000.000. 1 Chart of Interborough-Metropolitan System, Compiled for New York Public Service Commission. TYPES OF BUSINESS CORPORATION 87 New York. The Interborough-Metropolitan Company controls all the street car, elevated and subway railway lines in the principal boroughs of New York City. It was formed, as shown in the chart, by an exchange of its securities for the securities of two formerly competing companies, the Metropolitan Securities Company and the Interborough Rapid Transit Company. The relations of these two companies to each other, to their direct sub- sidiaries, and to the subsidiaries of their subsidiaries, are as clearly as possible presented in the chart. 54. Organization of the Standard Oil Company. — To illustrate further the extent, as well as the complexity, of the organization of a great holding company, there is presented below the most complete list ever published of the subsidiaries formerly controlled by the Standard Oil Company. The reader will find this list of value, not only for the present purpose, but for future refer- ence. The Standard Oil Company of New Jersey was the "parent" of something over half of the subsidiaries shown in this list ; it was a true holding company, in the sense in which that term has been defined in this chapter, so far as the other subsidiaries named were concerned. I. COMPANIES WHOSE STOCK WAS OWNED DIRECTLY BY THE STANDARD OIL COMPANY Total Per Cent Capital Owned by Name. Stock. Standard. Anglo-American Oil Co., Ltd $5,000,000 100 Atlantic Refining Co 5,000,000 100 Bedford Petroleum Co 350,000 99.3 Borne-Scrymser Co 200,000 99.9 Buckeye Pipe Line Co 10,000,000 100 Carter Oil Co 2,000,000 100 Chesebrough Mfg. Co 600,000 55.5 Continental Oil Co 300,000 100 Colonial Oil Co 250,000 99.7 Crescent Pipe Line Co 3,000,000 100 88 CORPORATION FINANCE Total Per Cent Capital Ownedby Name. Stock. Standard. Clarksburg Light & Heat Co 100,000 51 Deutsch-Amerikanische Petroleum Gesellschaft 2,250,000 100 Deutsch-Amerikanische Petroleum Gesellschaft (share warrants) 5,250,000 99.9 Empire Refining Co 100,000 78.5 Empreza Industrial de Petrolio 500,000 70 Eureka Pipe Line Co 5,000,000 100 Forest Oil Co ? ? Gilbert & Barker Mfg. Co 40,000 100 Galena-Signal Oil Co. pfd 2,000,000 74.4, Galena-Signal Oil Co. com 8,000,000 70 Hazelwood Oil Co ? ? Hope Natural Gas Co 500,000 100 Indiana Pipe Line Co 1,000,000 100 Interstate Cooperage Co 300,000 100 Lawrence Natural Gas Co 450,000 100 Mahoning Gas Fuel Co 150,000 99.9 Marion Oil Co 100,000 SO Mountain State Gas Co 500,000 100 National Transit Co 25,455,200 99.9 New York Transit Co 5,000,000 100 Northern Pipe Line Co 4,000,000 100 Northwestern Ohio Natural Gas Co 2,775,250 59.4 Ohio Oil Co 10,000,000 99.9 People's Natural Gas Co 1,000,000 100 Pennsylvania Lubricating Co 50,000 60 Pittsburg Natural Gas Co 310,000 100 Romano-Americana 2,500,000 100 Reserve Gas Co 2,225,000 50 Raffinerie Franfaise 80,000 100 River Gas Co 190,000 , 52.6 Solar Refining Co 500,000 99.8 Southern Pipe Line Co 10,000,000 100 South Penn Oil Co 2,500,000 100 South West Pennslvania Pipe Lines 3,500,000 100 Standard Oil Co., California 17,000,000 99.9 Standard Oil Co., Indiana 1,000,000 99.9 Standard Oil Co., Iowa 1,000,000 100 Standard Oil Co., Kansas 1,000,000 99.9 Standard Oil Co., Kentucky 1,000,000 99.9 Standard Oil Co., Nebraska 600,000 99.9 Standard Oil Co., New York 15,000,000 100 Standard Oil Co., Ohio 3,500,000 99.9 Swan & Finch Co 100,000 100 TYPES OF BUSINESS CORPORATION 89 Total Per Cent Capital Owned by Nam.». Stock. Standard. Underhay Oil Co 25,000 98.8 Union Tank Line Co 3,500,000 99.9 Vacuum Oil Co ■ 2,500,000 100 Waters-Pierce Oil Co 400,000 68.6 West India Oil Refining Co 300,000 50 West Virginia Oil Co 200,000 50.6 West India OU Co 100,000 99.3 Washington Oil Co 100,000 71.4 II. COMPANIES WHOSE STOCK WAS OWNED PRIMARILY BY SUBSIDIARY COMPANIES Amerikanische Petroleum Anlagen $187,500 100 Automaat Co 10,000 100 EschweUer Petroleum Import 7,500 25 Ghent Petroleum Co 200,000 60 HoUandsche Petroleum Vereeniging 12,000 100 Mannheim Bremer Petroleum Actien Gesellschaf t . . . 750,000 100 Petrolifere Ghent 20,000 74.5 Petrolifere Nationale 10,000 100 Petroleum Raff, vorm August Korff 375,000 54.6 Societe Anonyme H. Reith Co 412,500 61 Rheinische Petrol. Actien Gesellschaf t 250 100 Actien Gesellschaf t Atlantic 287,500 60 American Petroleum Co 3,140,000 61.3 Street Tank Wagon Business-Duren 4,250 71 Gibraltar Petroleum Co 25,000 100 Imperial Oil Co., Ltd 4,000,000 83.1 Det Danske Petroleums Aktieselskab 756,000 51.3 Tidewater Oil Co 20,000,000 31.1 Tank Storage and Carriage Co., Ltd. pfd 300,000 100 Tank Storage and Carriage Co., Ltd., ordinary 42,195 100 Societa Italo- Americana pel Petrolio 1,000,000 60 Aktieselskabet Ostlandske Petrol. Cie 162,000 9.2 Krooks Petrol, and Olje Aktiebolag 270,000 10 Skanska Petroleums Aktiebolaget 135,000 60 Svenska Petroleums Aktiebolaget 27,000 75 Sydvenska Petroleums Aktiebolaget 98,550 24.7 Kestkustens Petroleums Aktiebolag 177,500 15.3 Koenigsberger Handels Compagnie 575,000 49.8 Petroleum Import Compagnie 80,000 100 Schweizerische Petroleum Handels Gesellschaf t 60,000 60 Societe Anonyme Petrolea 80,000 66.5 Wachs. & Flossner Petrol. Gesellschaft 25,000 100 90 CORPORATION FINANCE Name. Westphalische Petroleum Gesellschaft S. T. Baker Oil Co Galena Oil Co. — Soci^t6 Anonyme Fran^aise... Queen City Oil Co., Ltd Connecting Gas Co Cumberland Pipe Line Co East Ohio Gas Co Franklin Pipe Line Co New Domain Oil and Gas Co Prairie Oil and Gas Co St. Paul Petroleum Tanks (Lim.) Societa Meridionale pel Commercio del Petrolio. Societa per gli Olii Minerali Soci6t6 Tunsienne des Petroles International Oil Co., Ltd Vacuum Oil Co., Proprietary Limited Vacuum Oil Co., Reszvenytarsasag Vacuum Oil Co., Limited Vacuum Oil Co. — Socitt6 Anonyme Francjaise . . Deutsch — Vacuum Oil Co Vacuum Oil Co. — Societa Anonyme Italiana .... Vacuum Oil Co. — Aktiebolag Taylorstown Natural Gas Co Total $229,963,195 Standard Oil Co. of New Jersey 98,338,300 Grand total $328,301,495 Total Per Cent Capital Ownedby Stock. Standard, 25,000 100 50,000 100 40,000 100 200,000 87.4 825,000 49.9 1,000,000 99.9 6,000,000 100 50,000 39 1,000,000 99.9 10,000,000 100 250,000 55 120,000 156,000 52.1 80,000 65 2,750,000 99.4 500,000 100 2,100,000 100 275,000 99.9 400,000 100 625,000 100 100,000 100 27,000 96.6 10,000 70 CHAPTER VII SOURCES OF CORPORATE FUNDS 55. Summary of preceding chapters. — The first six chapters of this book cover those fundamental features of corporation law which are essential to an understand- ing of the financial organization and management of corporations. We have taken up in turn among other topics : the advantages of corporations over other forms of conducting business ; the legal powers of the corpora- tion; the charter; the by-laws; the duties, rights and privileges of stockholders; of directors; of officers; the process of incorporation ; the factors to consider in select- ing the state of incorporation; the relative advantages and disadvantages of several states; the characteristics of common and preferred stock; the uses of cumulative voting and of voting trusts ; the nature of a close corpo- ration; of an ordinary operating company; of a parent company; of a holding company. AU of this matter, although essential, is intended merely as an introduction to what follows. Our real subject is not the legal, but the financial, side of corporation practice, and this sub- ject we are now ready to take up. It must not be for- gotten at any stage of this study, however, that all finan- cial measures must comply with and be in harmony with the legal principles that have been discussed. 56. Four sources of corporate funds. — In financing a corporation the managers may go for funds to six dif- ferent sources, as follows: 91 92 CORPORATION FINANCE (a) Active interests in the business : (b) Profits of the business (c) Trade creditors \ (d) Banks (e) The investing public ; (f) The speculative public. There is no need of discussing in detail methods of raising funds from people who are actively engaged in the management of the corporation. Each one presum- ably will be fully informed as to the records and pros- pects of the company and will regulate his investments accordingly. In the case of close corporations the proc- ess of raising funds is simply to allow each person in- terested to invest as much as he can and will on terms that are settled by direct bargaining. Profits that are not paid out from a surplus may be one of the most important sources of funds. The Carnegie Steel Company, as we shall see later, is a con- spicuous example. This particular topic is fully dis- cussed in later chapters and need only be mentioned here. It may not be plain at first sight that the trade cred- itors of a concern are in reality furnishing part of the funds necessary to the business; but a moment's reflec- tion makes it evident that a company which continually carries, say, $10,000 of accounts payable, thereby makes that amount available for its business. If the trade cred- itors should demand cash for every purchase, the concern would have to raise the $10,000 from some other source. In some lines of business, especially retail, a very small investment is sufficient to carry on comparatively large operations simply because long-time payments are per- missible. Usually, however, the merchant or manufac- turer who buys on credit also sells on credit, in which SOURCES OF CORPORATE FUNDS 93 case the funds derived from trade creditors are promptly placed at the disposal of trade debtors. Of course, it is possible also that a business may draw its funds from the advance payments of the people who buy its products; but this is so unusual a case that it is hardly worth mentioning. Banks are institutions whose primary function is to furnish funds for commercial enterprises. Without go- ing into the theory of banking, it may be pointed out that banks are dealers in credit. They buy the credit of other people in the form of notes and similar obliga- tions and they„sell their own credit principally in the form of deposits. Any reader to whom this statement is not altogether clear may turn to the volume on Money AND Banking for further enhghtenment. In order to make its credit good a bank must always be ready to re- deem prOTnptlyjei£ry_ehe.ck that may Jbe presented to it for paj^ment. Therefore, a well-managed bank wiU "never tie up its assets in permanent investments, but will keep them always "liquid." For that reason the corpo- ration manager can look to banks only for short-time loans, usually not longer than ninety days. We will dis- cuss the requirements of banks in detail in the next chap- ter. It is enough for the present to say that fundssg; cured from banks ^ill almost always be short-time loans in stricUyTInu^damounts backed by unquestionable '^eciirT^r "BTTT^ investing public as a source of funds. — The fifth source of funds is the investing public. This phrase covers, not only individuals, but institutions. The most important classes of investors are; (a) professional and salaried people who have no busmess_oftheii^osKn. in which to place the ir savings; (b) women and minors who have"TnKeiited money; (c) estat es heI3r m_trust; 94. CORPORATION FINANCE (d) savings institutions; (e) insurance companies. Business men are not investors in securities of other cor- porations than those in which they are directly interested to any great extent, for the obvious reason that they are apt either to put their savings into their own concerns or to seek larger returns than are offered by strictly investment securities. One of the great problems of raising funds for many kinds of business is to arouse interest and inspire confi- dence in this investing public. They may be appealed to by advertisements and circular letters — a plan which is seldom successful; or they may be reached — usually with much better results — through bond and broke rage houses whose business ^t is to retajTinvestinenrsec urities to their clien^^ This is another topic that wiU come up for later discussion. 58. Difference between investment and speculation. — This is a good place to define the words "investment" and "speculation." The former word, as it is used in a some- what technical sense by the leading financial papers, re- fers to a security or other property which is practically certain, so far as human minds can foresee, not to de- preciate in value. No security in which the element of risk is prominent can properly be called an investment. If the probabilities are strong, but not conclusive, that the security or property will not depreciate in value, then the terms semi-investment or semi-speculative may be applied. To illustrate, a United States Government bond is certainly an investment, and so is a first mortgage bond on any of the standard railroads. Most of the in- dustrial bonds, however, even where the earnings are large and the prospects apparently good, would be classed as semi-investments, because there is always dan- ger that competition or some new invention will cut into SOURCES OF CORPORATE FUNDS 95 the business. In the same way high-grade preferred stocks of successful railroads and industrial companies would be called either semi-investment or semi-specula- tive issues. For our purposes in this book these finer distinctions are not necessary and would perhaps be con- fusing. We shall, therefore, use the word "investment" in a more popular sense to include both the true invest- ment and the semi-investment or semi-speculative se- curities. We may define it, in its objective sense, as any security or other property the principal of which seems safe and returns on which (interest, dividends or rent) seem certain. The great majority of corporate stocks would be classed as speculative ; for no matter how promising they may be conservative brokers would not in most cases be willing to call them safe. Calling a security "specula- tive," the reader should understand, is not necessarily condemning it or objecting to its sale. As a matter of fact, few corporations comparatively have anything but speculative securities to offer. Moreover, it is only by more or less speculative purchases that returns on capital above 5, 6 or 7 per cent may be obtained. Nearly all investment securities have been at one time specu- lative in character. When the terms "highly specu- lative" or "purely speculative" are used, however, it is generally safe to assume that the writer intends to convey the idea that the security in question has a very remote chance of ever getting into the investment class. 59. The speculative public as a source of funds. — The speculative public may be roughly subdivided into three groups: (a) ill-informed people who do not know the difference between an investment and a speculation and who are continually placing their hard-earned money in the hands of unscrupulous promoters in the blind faith 96 CORPORATION FINANCE that they are making an investment; (b) intelligent business and professional men who buy and hold for a rise speculative securities and property in the full knowl- edge that they are taking chances; (c) speculators who buy securities and property "on margin" in the hope of making a quick and large. profit. Group (a) may be reached by means of circular letters and advertising; group (b) , generally by personal solicitation or through the stock-market; group (c) , usually through the stock- market. A detailed discussion of the methods of reach- ing and interesting possible buyers of corporate securi- ties must be deferred. For the present our attention should be confined to the securities themselves. Corporate funds fall into two classes: borrowed funds and owned funds. The borrowed funds are se- cured through accounts and bills payable, through bank loans or through bonds and mortgages. The owned funds are secured through issues of stock. 60. Desirability of borrowing funds. — ^Why should a corporation borrow funds at all? The reader will per- haps answer, as many people do, that it borrows from necessity; that as soon as possible it ought to pay off its debts, just as a man gets rid of the mortgage on his house as soon as he can. The fact is, however, that for a cor- poration to be out of debt is no credit to it, but rather a sign that it is either in a dangerous position or not intelligently managed. Only one method of raising funds is cheaper than borrowing, and that method is stealing. Therefore, a corporation should borrow as much as it can within the limits of safety. To illustrate the desirability of borrowing part of the funds of a corporation : Suppose a manufacturing com- pany needs $100,000 to carry on its business and pro- duces an average net income of $6,000. If it raises the SOURCES OF CORPORATE FUNDS 97 whole $100,000 by stock issues, it will only pay 6 per cent dividends — ^not enough to compensate for the risks and uncertainties of the business. Now suppose that the company is dissolved and the same business is carried on under a new company which sells $50,000 of 5 per cent, bonds, gets additional and larger credits to the ex- tent of $10,000 and borrows $5,000 from banks at an average rate of 5 per cent. Then, only $35,000 stock need be issued, the income of which, after deducting in- terest charges of $2,750, will be $3,250, or 9.3 per cent, a satisfactory return. Thomas L. Greene, author of "Corporation Finance," points out that a few years ago three-quarters of owned to one-quarter of borrowed funds was thought about right, whereas now the proportion in well-managed cor- porations is nearer one-quarter owned to three-quarters borrowed. The result has been to reduce the average rate of returns on capital and thereby to reduce cost of production and prices. In order to make profits at all under present conditions mercantile and manufacturing concerns must borrow heavily. Of course, there are hm- its to the safety and advantages of borrowing. On the following pages are given five recent balance sheets (Herring-Hall-Marvin Safe Company, Ameri- can Thread Company, Bethlehem Steel Company, A. Booth & Company, and United States Leather Com- pany) selected practically at random, which will perhaps make these statements somewhat more vivid and con- crete. Assuming that the balance sheet of the first- named concern is based on the actual value of the prop- erty (which is, to be sure, a pure assumption) we arrive at the real amount of funds utilized in the business by deducting from the total assets the item of "Patents, trade-marks, etc., $92,000," leaving approximately VI— 7 98 CORPORATION FINANCE HERRING-HALL-MARVIN SAFE CO. Assets: Real estate and buildings Machinery, Sec 298,864 Stocks on hand at cost 207,076 Work in process & materials 320,988 Bills & accts. rec. & cash 372,830 Insurance, &c., paid in adv 8,095 Stock of other companies 1,000 Patents, trade-marks, &c 92,000 Total $1,612,506 Liabilities : Capital stock $700,000 Debentures maturing to 1915 410,000 Bills payable 170,354 Accounts payable 93,561 Reserves for completion of contracts 64,208 Contingent liability reserves 16,000 Surplus of year's operation 59,383 Total $1,513,506 AMERICAN THREAD CO. Assets : Land, water, & steam povper, mills, machinery, plant & effects $12,694,896 Stocks-in-trade at net cost 4,960,971 Accounts receivable, net 1,016,445 Cash at bankers & in hand 341,483 Sundry investments 229,840 Advance payments 38,293 Total $19,281,937 Liabilities : Com. stock ($3.50 paid up) $4,200,000 5% Pfd. stock (fully paid) 4,890,475 4% 1st mtge. bonds 6,000,000 English Sew. Cot. Co. Ltd 351,164 Accounts payable 770,410 Bond int. accrued 60,000 SOURCES OF CORPORATE FUNDS 99 Depreciation fund 2,076,987 Div. on com., payable July 588,000 Profit fit loss 344,891 Total $19,281,927 BETHLEHEM STEEL CO. Assets: Property account $37,857,260 1st mtge. bonds reed, in part payment for property 518,848 Inventories 6,795,542 Notes and accts. receivable 2,513,186 Cash on hand & in bank 4,230,418 Deferred charges -. 943,324 Total .• $52,858,578 Liabilities: Capital stock $29,770,000 Bonds of Bethlehem Steel Co 16,159,000 Notes & accts. payable, &c 5,735,154 Bond interest accrued 103,145 Reserved for depreciation 400,000 Reserved for relining furnaces, &c 97,885 Surplus 593,421 Total $52,858,578 A. BOOTH & CO. Assets ! Cash $510,777 Merchandise 937,976 Accounts receivable 1,556,689 Bills receivable 980,560 Unexpired insurance, R. R. mileage, etc 119,448 Treasury preferred stock 20,800 Treasury common stock 170,650 Plants, steamboats, real estate, etc 5,510,927 Total $9,757,827 100 CORPORATION FINANCE Liabilities: Common stock $3,000,000 Preferred stock 2,500,000 Surplus 1,532,700 Undivided profits 203,138 Accounts payable 931,989 Bills payable 1,601,000 Total $9,757,827 UNITED STATES LEATHER CO. Assets: Cash $3,505,159 Due by customers 10,761,665 Bills receivable 1,377,339 Doubtful debts. vSl 8,833 Other debtors 1,070,603 Hides & leather 15,269,784 Bark at tanneries 1,677,963 Sundries, pers. property, &c 654,637 Advance to other companies 1,930,931 Drawbacks 464,492 Railroad mortgage 100,000 Tannery plants, etc 6,847,706 Stock of other cos 56,760,181 Bonds of other cos 6,879,888 Real estate interests 490,235 Treasury stock Good-will, &c 63,833,300 Unexpired insurance 106,293 Total $169,637,987 Liabilities : Common stock $63,883,300 Preferred stock 63,283,300 Bonds less in treas 5,080,000 Accrued interest, etc 67 960 Current accounts 609 585 Foreign exch. not due 2,073,904 Bills payable 13,080,000 Miscellaneous 639 739 Surplus 32,913,309 Total $169,637,987 SOURCES OF CORPORATE FUNDS 101 $1,420,000. The borrowings, including bonds, bills pay- able and accounts payable, are approximately $670,000, or something over 47 per cent of funds. To arrive at the actual funds utilized in the property of the American Thread Company we should deduct from the $19,281,000 assets the depreciation fund of $2,076,000. Of the total funds, approximately $17,- 200,000, about $7,750,000 is borrowed (including bonds, debts to stock- and bond-holders and to Enghsh Sewing Cotton Co., and accounts payable) . The percentage of borrowing is 45. Deducting reserves for depreciation we find funds of the Bethlehem Steel Company to be approximately $52,- 500,000. Borrowings are about $22,000,000 or 42 per cent. In the case of A. Booth & Company there are funds of about $9,750,000 and borrowings of $2,500,000, or 25.6 per cent. As the firm failed in September, 1908, this low percentage of borrowings tends to confirm what has already been said, to the eif ect that abnormally small borrowings indicate either a weak or a mismanaged com- pany. In estimating funds in the United States Leather Company, we should, of course, deduct "good-will." It is not improper also to deduct stocks and bonds of other companies, all of which were obtained in exchange for preferred and common stock. This leaves actual funds of approximately $42,700,000, against borrowings of $20,800,000, about 49 per cent. It goes without saying that this analysis of the five balance sheets is superficial and that the results are merely suggestive. To ascertain the exact proportion of borrowed to owned funds in each case we should have first to learn the exact, not the nominal, value of the 102 CORPORATION FINANCE assets, which is an impracticable task. As it is reason- ably certain that the cost in every case is less than the book value of the assets, the true percentages of bor- rowed to owned funds are in all probability greater than the figures given. Four out of these five corporations no doubt borrow more than half the funds they use. Other well-managed companies follow the same prin- ciple. 61. Distribution of security issues. — The next ques- tion to consider is: What issues of securities or credit instruments should a corporation put out and what pro- portion of its total funds should be obtained by each of these issues? In order to raise funds from each of the four sources outside the business itself named above the corporation manager will offer: SOURCES SECURITIES (a) To trade creditors Bills and notes payable (b) To banks Notes payable and en- dorsed notes receivable (c) To the investing pub- Mortgage bonds and per- He haps preferred stock (d) To the speculative pubhc. Stock. The amount of each security offered will depend in part on the assets and in part on the earnings of the corpo- ration. Corporate assets in nearly every line of business fall naturally into six groups, as follows: (a) Fixed investments essential to the business, such as real estate, buildings and machinery and, in the case of holding companies, securities of subsidiary corpo- rations. SOURCES OF CORPORATE FUNDS 103 (b) Property that could be sold without breaking up the business, though the sale would probably be at a heavy sacrifice, such as, outlying real estate, securities of other companies control of which is not essential to the integrity of the corporation, raw materials, and goods in process. (c) Finished products on hand. (d) Accounts receivable. (e) Cash. (f ) Intangible assets, such as good- will, trade marks, etc. To the first five groups roughly correspond obliga- tions for borrowed money, as follows: (a) Mortgages and mortgage bonds obtainable as a rule on good terms up to 60 to 75 per cent of the ap- praised value of real estate; 50 per cent of buildings; 25 to 40 per cent of machinery ; 50 to 90 per cent of se- curities. (b) and (c) Income, profit-sharing and car-trust bonds, on a great variety of terms, preferred stock in some cases and to some extent short-term notes and bank loans. (d) and (e) Accounts payable and bank loans. Group (f) and the differences between the other as- sets and their corresponding Uabilities are usually rep- resented by stock issues and by surpluses. The reader will understand, no doubt, that this classification is merely approximate and is not always followed in prac- tice; yet an analysis of balance sheets will reveal, on the whole, a close adherence by corporation managers to the principles just stated. In all industries, more or less, and especially in rail- roads and stable manufacturing concerns, the creditors of the corporation, as we shall see later, pay more at- 104 CORPORATION FINANCE tention to the income account than to the balance sheet. The gross earnings of any corporation are necessarily devoted to the following purposes: (1) Operation; (2) maintenance; (3) fixed interest charges and rentals ; (4) floating interest charges; (5) betterment and sur- plus; (6) dividends. The stability and amount of the earnings will, of course, greatly aff"ect — in fact, determine largely — the value of a corporation's assets, and in that way will aif ect the amount and kind of securities that it may wisely issue. CHAPTER VIII SHORT-TIME LOANS 62. Trade credit as a source of funds. — The preceding chapter named, without describing, the three forms in which corporations incur short-term or medium-term ob- ligations, namely, trade credit, bank loans and notes sold to the public. We will now take up each of these forms in turn and see what we can discover as to the principles that should govern their use. Readers of this volume who are themselves engaged in an unincorporated busi- ness will perhaps read what is said as to the first two forms named with a more lively interest if they reflect that the principles laid down apply to partnerships or to individual proprietorships as well as to corporations. The funds raised from the trade creditors of a cor- poration are secured simply by buying goods on credit. It is not customary in most lines of business to demand cash immediately on delivery of goods, except from concerns that are considered untrustworthy. Thirty days is usually allowed before trade creditors begin to press for payment and a company whose business is worth having can often considerably lengthen the av- erage time of settlement, if that policy proves desirable. In some lines — especially when the sales are in large lots — sixty to ninety days, or even six months, is the usual allowance. For sixty days or over the debtor company generally gives a formal promissory note or else accepts a time draft which amounts to about the same thing. 105 106 CORPORATION FINANCE As was indicated in Chapter VII, it is good business policy for a company to take as much trade credit as it can get on advantageous terms and with safety. These two quahfications are worth elaborating. A company does not obtain trade credit on advantageous terms: (a) when by so doing it acquires a reputation for "slow pay" which makes dealers unwilling to quote to the company their lowest prices; (b) when by so doing it loses the benefit of cash discounts larger than the pre- vailing discount on bank loans, — provided in this case that the company is not already borrowing as much as it should from banks. A company cannot accept trade credit with safety when by so doing its short-time lia- bilities are brought up nearly equal to its quick assets. Notice that the relation is not between total liabilities and total assets, but between quick liabilities and quick assets. A concern must have cash funds at hand to meet its accounts and bills payable when due and no other assets, no matter how valuable, will serve the pur- pose. A failure to realize just that simple fact haiS been responsible for many an unnecessary bankruptcy. Taking the five balance sheets previously referred to (see pages 98-100) , we find: (1) That on the date of the balance sheet the quick liabilities of the Herring-Hall-Marvin Safe Company were about 70 per cent of quick assets and about 29 per cent of all the current assets, including stocks, work in process and materials. (2) That the corresponding percentages for the American Thread Company were 58 per cent and 18 per cent. (Current liabilities, including debt to English Sewing Cotton Company, in proportion to current as- sets, including stocks, investments and advance pay- ments.) SHORT-TIME LOANS lOT ( 3 ) That the corresponding percentages for the Beth- lehem Steel Company were 85 per cent and 44 per cent. ( 4 ) That the corresponding percentages for A. Booth and Company were 83 per cent and 64 per cent. (5) That the corresponding percentages for the United States Leather Company were 100 per cent and 82 per cent. We may infer from these five representative balance sheets that a conservative company will not, as a rule, allow its accomits, bills and notes payable to run much over 75 to 80 per cent of its quick assets. This per- centage is, in fact, not far from normal. It would be foolish to try to lay down any absolute rule where so much depends on the custom of each line of business, on the seasons, on the nature of the company's assets, on the ease with which bank credit may be secured, and on the general commercial outlook. Enough has been said to indicate that trade credit, though a necessity to nearly every successful corporation, may become too extensive. Further discussion of this important phase of corporation finance must be deferred until we begin a study of the financial management of corporations. 63. What reliance should be placed on bank loans? — Bank loans are not usually to be had except on first- class security and for short periods. Perhaps the best method of considering the advantages and disadvan- tages of bank loans will be to run over hastily the de- tailed statements which many conservative banks now require applicants for loans to file with them. A blank form for such statements, adopted by the New York State Bankers' Association, and widely used, is pre- sented on pages 108-109. Let us see how critically a banker will examine one of these statements when pre- sented by a corporation with which he is not thoroughly 108 CORPORATION FINANCE w <1 3 ■P., U) •O h ■M ".S ■S°2 ■H n p CD " 3 . go •0 o ^ I. 3 o 3jH "So r°So a... a a J, S o 0) tdDfl Or-, a r^ O ■ ^h5 h: : : : ojoj o FSiH (U rKrH " " • • -o la • p, OS 0} o ; 3 :§:::: : ■ :S s a 1 PI '3 ■ • • 03 M o ■ ■ ■ ei 03 P5 : €6- • "5 k (U . n bli fl . a . « M a a s ■ S -a.a 3 o TlJ 0) . "^ - rR «r o - el rt • mD « t^ . 13 o 02 < : ^4 :gs|'^s2 : o o ■ J-^S&SSi • TlJ <0 . » lOHizioo : -2 a 2 • o o 5 k: s : : : : t» fH .1^ '. .g •* fl <» ■' H . . . . ia^sSI : .= » 3 £ »H a > »£ t^ os = a •5 Receivabl contingen iny of tne assets use o ! to :S : « n " i,a9.-3 : o^ a^ ^ " a.. 1 3 • ■ ■ • :J n oB 2 : . . : H • . . . 3 ° sg : 3< I ! ! ! S « Sk : > ; ; ; 1 ' T,TA Pledg on dBE PAID iOT tl ame B ^ •• s a ig o H « ooS . w ^2; Oo2 O^oa o p^ * iffl fip 50 " SHORT-TIME LOANS 109 a a . a Mm g a Eh b O ft ^ o M E-i . ■;= S« £ g . o W « a § ■s •" B S m M a o 03 w k5 o M r^ M d "^ H S « o K O 1 g H pq fe fe S o O O O S M H H « H S Eh B &< Hi l> ^« es •• ja m ^ s °^ 02 o mm A4 >> 1 OS w bo 1 H O 1 CO o s 03 a ID 03 d S| o ;>> 5 1 03 o M P llO CORPORATION FINANCE familiar. What is said on this point is largely based on an article by Mr. William Post, Cashier of the Central National Bank of Philadelphia, in The Journal of Accountancy, Volume 1, page 181. Take first the item, "notes receivable." In most lines of business notes are little given except by weak concerns, and a large amount of "notes receivable" out- standing, therefore, may indicate that a corporation has been in the habit of granting unsafe credits. Some of the principal lines in which note giving is still common are harvesting machines, plumbers' supplies and electric trolley supplies. Where notes are received to any considerable extent they are generally discounted at once by well-managed corporations. Corporations which show a large figure under this heading of "notes receivable," therefore, would be regarded by the banker with distrust. "Notes and accounts receivable of officers," except in insignificant amounts, would naturally arouse suspi- cion. Ordinarily officers of corporations are expected to keep their personal obligations and the company funds entirely separate. The valuation of merchandise should be made by means of an expert's inventory. In connection with these items a careful banker will take into consideration the possibility of extensive fluctuations in value, partic- ularly in the case of staple articles such as pig iron, cotton, wool and metal. The other assets specified are not of immediate in- terest to the banker, because they will not ordinarily be sold to meet short-time obligations. They may be con- sidered, however, as a final protection to the banker in case the concern should go into bankruptcy. Mr. Post suggests, "that in estimating the value of SHORT-TIME LOANS 111 plants, a sharp distinction should be made between buildings used for manufacturing and for merchandis- ing purposes. A business structure, conveniently located for trade, is a good asset. It is not adapted specially to any one purpose. Even if the business which now occupies it should be withdrawn, it could be sold and applied to some other use. Its value can be easily appraised. The banker is justified, therefore, in placing a high net value upon such property when weU located. With the manufacturing plant, however, the situation is entirely different. The whole building is often specialized to some particular use: if the busi- ness fails it is very difficult to apply the premises to other purposes," Machinery is even less salable, as a rule, than a manufacturing building. In general, a concern that is not making a success of its undertaking will very seldom find buyers, except at a very heavy sacrifice, for its fixed assets. Turning to the liabihties, we have already laid down the rule that "notes payable" given for merchandise, except in the few hnes of business specified above, are not required from first-class concerns, "The second and third items," says Mr. Post, "are distinguished in order to show how much paper a concern may have with its own banks and how much it may have negotiated through a note broker. It is quite important to the banker to know how much paper a borrower has sold, as the saying is, 'on the street,' If he finds that the borrower is choking his bank account and at the same time putting a large amount of paper out into the open market, the banker is likely to arrive at the conclusion that the borrower is not keeping available any partic- ular resource or channel which he could utilize in case of a stringency in the money market. It is a fiixed rule 112 CORPORATION FINANCE of financial management that a concern should not borrow largely at its bank and at the same time sell large amounts of its paper in the market. If the bank line is full, paper should not be upon the street ; if made largely for the street, then the bank should be kept open." "Accounts payable" is to be considered, of course, irt contrast to "accounts receivable" and the propor- tions already mentioned in this chapter should be ob- served. Ordinarily only close corporations would have any deposits made with them by individuals. Where there are such deposits they would be regarded as a possible source of danger, since the persons who make them are apt to be in close touch with the management and to be informed of any impending trouble in time to protect themselves — possibly at the expense of the other creditors. Bond and mortgage debts should, of course, be pro- portioned to the fixed assets of the corporation. The mortgage should be very carefully examined in order to make sure that it does not cover more than the fixed assets. Sometimes a real estate mortgage will contain a clause making it a first lien also on the chattels or quick assets of the corporation. Chattel mortgages are unusual and do not often exist unless a corporation is already in serious straits. A large amount of contingent liabilities would be regarded as a weakness. Especially is this true of the item "other contingent liability," which refers to en- dorsement of outside paper and to miscellaneous obliga- tions. Generally speaking, a corporation is not expected to assign its accounts receivable. There may be well- SHORT-TIME LOANS 113 grounded exceptions to this rule but the exceptions require explanation. The item "other assets used as collateral" would be filled out normally only by commission houses among which the custom is to put up bills of lading or ware- house receipts as collateral for loans. In the United States a manufacturing company is not expected to pledge any specific asset except its fixed capital. In Canada and in Europe manufacturers obtain funds from banks upon pledge of raw material and finished products. The banker wants to be sure that a corporation is carrying sufficient insurance; otherwise a fire or some other accident may make the assets almost valueless. The items under the head "business and results" are important, inasmuch as they teU the banker to what extent the company may meet its obhgations out of income. An expert in any particular business can tell very often by an inspection of these items whether the company is weU-managed or not, for he will know how large should be the percentages of gross profits and of net profits to sales. It is very difficult for an out- sider to form any sound judgment on this point. "Dividends paid" wiU indicate how conservative the corporation is in providing against possible futiu-e losses. The item of "bad debts" obviously shows how carefully the corporation looks after its credits. The succeeding items are intended to answer ques- tions with regard to the balance sheet or profit and loss statement. The banker will, of course, observe very carefully what assets are covered by outstanding mortgages and bonds. He wants to know what bank accounts are kept other than those named in the balance sheet, because some concerns may keep additional secret bank accounts with the idea of inducing the bankers VI— 8 114 CORPORATION FINANCE to favor them with loans, A knowledge of the average terms on which goods are bought and sold enables the banker to form an idea as to how pressing the corpora- tion's accounts payable and as to how "quick" its ac- counts receivable are. By learning the time of year when accounts receivable, stocks of merchandise and liabilities are at their maxima and minima, the banker may better judge as to whether the balance sheet repre- sents the normal condition of the corporation or not. It goes without saying that to have the statement based on an actual inventory and to have it audited, be- fore presentation, by a certified public accountant, wiU add greatly to its value in the eyes of any banker. We have gone over this blank form at some length for two purposes: First, because it illustrates how a corporation's statement may be analyzed and how much information may be extracted from it; second, because it shows how strict and careful conservative bankers are in granting loans. The writer does not mean to say that every concern which borrows nioney from a bank presents such a detailed statement and has it so closely analyzed as what has been said may indicate. It is true, however, that the custom of demanding and of thoroughly inspecting such statements is growing. It is also true that a conservative corporation will not desire bank loans unless it can present a statement that would meet with the approval of any careful banker. 64. Notes sold to the public as a source of funds. — Promissory notes of a corporation may be given in order to raise funds from (a) concerns which supply mer- chandise, (b) banks or (c) the public. We have already seen how and to what extent they may be issued in the first two cases ; we have now to consider the third case. SHORT-TIME LOANS 115 The form of the note is substantially the same in all three uses. It is a simple promise to pay and must con- tain the features that are essential to all valid negotiable notes, which are: (a) two parties to the contract, (b) transferability, (c) a definite sum of money, (d) definite day of payment, and (e) proper signature. It is worth noting here that as a general rule the power to bind a corporation in this manner does not belong to an officer unless it is expressly conferred on him. Never- theless, the note of a corporation signed and in the hands of an innocent holder for value is usually binding, even if the signer acted beyond his powers. Technical ob- jections to a note, based on its improper execution or on unauthorized uses of the money borrowed, are not usually upheld. It is worth noting also that the cor- poration signature should be used. Notes signed by officers in their own names, even if their corporate titles are given, or notes containing such words as "jointly and severally promise to pay" may be held as personal obligations. The usual, although not a necessary, distinction be- tween notes given in the ordinary course of trade or to banks and notes sold to the public is in the length of time of the debt. In the first-named cases they do not usually run over six months. Notes sold to the public are more likely to run from one to ten years. Two or three years is about the average period, intermediate between sixty-days to six months notes, on the one hand, and ten to one-hundred-year bonds, on the other hand. They are issued in denominations varying from $100 to as high as $100,000. The chief objection to these instruments is that they do not appeal to any large dependable body of pur- chasers. The commercial banks do not care for them 116 CORPORATION FINANCE because they are not "quick" enough. Comparatively- few individual investors will buy them because they are to be cancelled within a comparatively short period, and the average individual investor does not choose to watch his investments closely and renew them fre- quently. His idea, on the contrary, is to get hold of a safe security that yields a steady return and to keep it indefinitely. The market for medium-term notes, therefore, is restricted, generally speaking, to persons of large means who are in fairly close touch with the financial world and who happen to have idle funds on hand. Such persons are most easily reached through the big financial houses and these houses almost invari- ably absorb note issues of any size and distribute them to their clients. On account of the limitations of the market it is always difficult to tell in advance whether an issue of medium-term notes will be taken up by the public or not. It is still more difficult — in fact, impossible — to tell at the time of issue whether the notes can be readily renewed when the time of payment arrives. No con- servative corporation manager will put out such notes unless he has first provided for their payment when due. This he may do in two ways : either by saving the necessary amount out of the corporation's income or by securing through bond issues the funds with which to pay off" the notes. The first course involves cutting down the borrowings of the corporation which, as has been pointed out, is likely to be undesirable. Ordinarily the second course would be inadvisable, for if bonds are to be put out at all they might as well be issued in the first place. This suggests the usual reason for the issue of notes SHORT-TIME LOANS 117 to the public, namely, as a temporary expedient when a bond issue is for the time being deferred. Some- times a railroad is building a new branch or a manu- facturing company is putting up a new building on which an issue of bonds is to be based. In the mean- time medium-term notes may be issued to secure funds for construction. Again, a company in need of funds may find the general financial situation unfavorable to a bond issue and may put out notes with the intention of selling bonds before the notes come due. ■ The prac- tice, though often justifiable, is always more or less risky. In April, 1907, for instance, the Erie Railroad issued, for that reason, $5,500,000 of one year notes. In April, 1908, the conditions being still unfavorable, the railroad authorized an issue of $15,000,000 three year notes, of which $5,500,000 were exchanged at par for the first issue. In July, 1907, the Bethlehem Steel Company issued $1,187,000 of 6 per cent serial three, four, and five year notes, apparently for the same reason. In October, 1906, the American Locomotive Company issued $5,000,000 of one to five year notes for the purpose of paying floating indebtedness and of providing working capital. It is expected that these notes will be redeemed out of income. These examples will indicate roughly when and how medium-term notes are issued. Although notes for the public are generally simply unsecured promises to pay, they may, especially for the longer terms, be based on certain definite property. A corporation's holdings of securities of other companies are frequently put up under mortgage as collateral security. It is difficult to draw a line between long- time collateral trust notes and short-time collateral 118 CORPORATION FINANCE trust bonds; in fact, notes and bonds merge into each other and the distinction between them is in some cases merely nominal. In this chapter we have been dealing with the current obligations of corporations. The main point with re- gard to them to bear in mind is that they ought to be offset, if they are to be made good, by a more than equal amount of current assets, and no other kind of assets will serve the purpose. To issue notes and put the funds .thus secured into fixed or semi-fixed assets without having on hand a large surplus of current assets is unsound and dangerous financing. CHAPTER IX THE CORPORATE MORTGAGE 65. What determines the value of fixed assets? — Now we take up the long-time obligations — especially mortgages and mortgage bonds — of corporations. Evi- dently they must be based on permanent, or fixed assets, and in amount will correspond roughly to the value of such assets. Here we meet with the difficult and important question, What determines the value of fixed assets? Most people would be inclined to say that the cost of the assets must determine their value. A moment's reflec- tion, however, shows this statement to be untrue. Suppose, for instance, that a man has put up a plant at an expense of $100,000 for refining copper, and after- wards discovers that there is no copper within hauling distance. The plant would not be worth the expense of demolishing it. On the other hand, suppose that he does put his plant in a rich copper country and secures such favorable contracts with the mine owners that he makes profits of $100,000 a year and may expect to con- tinue such profits for an indefinite period. His plant, in that ease, could be sold for perhaps a million dollars. Evidently cost of construction would have very little to do with the value of such assets. The second opinion is that the value of fixed assets is determined by the expense of duplicating them. It is claimed, for instance, that to arrive at a fair valuation of the railroad property of the United States, all we 119 120 CORPORATION FINANCE need to do is to figure how much it would cost to re- produce this property under present conditions. The illustration already used, however, would apply in criticism of this second opinion as well. Thej^ird_opimonJ^s tha^^ is determined by their earning power as in the above illustration. It takes no argument to show that this is actually the case in ordinary business practice. If you were going to buy anything in the nature of a fixed asset, from a university education to a steel mill, your first question as a business man would be. How much will this asset earn for me? Similarly, an investor in buying the securities of a corporation will inquire as to the value of the corporation's fixed assets, and will naturally estimate their value on the basis of earnings — not the present earnings altogether, but probable future earnings as well. Bear in mind that this principle that earnings de- termine value is applicable only to fixed assets. The selling value, of floating assets, such as raw material, tools, finished goods on hand, is another matter. That will be determined, normally, as the science of economics explains, by cost of production. The difference arises from the fact that fixed assets — land, buildings, machinery — are not intended for sale, but for use. They generally have little or no value except for the purpose for which they were intended; and their value for their purpose can be determined only by their earning power. We have already intimated without going into details that the amount of investors' securities which may be issued by any corporation depends both on the value of its fixed assets and on the amount of its income available for interest charges. There is no contradic- THE CORPORATE MORTGAGE 121 tion between these two considerations. At bottom the important factor on which to base bond issues of a going concern is the amount and stability of income. We shall elaborate and emphasize this point a little later. 66. Nature of a mortgage bond. — The simplest method and the method most common among small cor- porations of borrowing long-time funds is by direct mortgage on the corporation's real property. An ordinary mortgage conveys "aU right, title and interest" in a given piece of property to the mortgagee, with the proviso that the transfer is to become null and void in case principal and interest are paid as promised. Al- though the old common-law phrases, which would cause the whole property mortgaged to pass to the mortgagee in case of default, are generally retained in the mort- gage indenture, yet the mortgage is universally re- garded at law as in effect a lien. A simple corporate mortgage is in no important respect diiFerent from a mortgage by an individual or firm. Where large sums of money are to be raised by a mortgage, however, the procedure is not quite so simple. In such a case it is customary to offer mortgage bonds in convenient denominations to the public. As the property mortgaged is for all practical purposes in- divisible and as there are a large number of secured bondholders, it is impracticable to give a separate mortgage with each bond. It becomes necessary, therefore, to give the mortgage to some individual or concern, acting as trustee for the bondholders, in which case the mortgage indenture becomes a deed of trust. Each bond is a simple promise to pay, its phrasing being more formal, however, than that of a note. It is executed under corporate seal and contains a reference ito the indenture between the corporation and the 122 CORPORATION FINANCE trustee. A study of the sample mortgage bond printed on page 123, will serve better than a long description to show the reader exactly what is contained in a bond. The varieties of mortgage bonds will be considered later. For the present let us take up the terms of the deed of trust between the corporation and the trustee. 67. Essential features of a deed of trust. — Experience has demonstrated the necessity of making this deed very exact and comprehensive. The indenture of a large railroad mortgage may contain as many as 50,000 to 100,000 words. If printed and bound it would make a good-sized book. Of course, the ordinary in- dustrial corporation would not find so lengthy and involved a description of the property and the terms of the mortgage necessary. To the lay reader even a comparatively simple indenture is apt to seem a mass of cumbersome and more or less nonsensical legal phrase- ology; but it must be borne in mind that every such deed is closely scanned by a large number of able and experienced lawyers, who will demand that no possible loophole for evasion or misinterpretation shall be left open. The rights and obligations of each of the three parties to the agreement, the corporation, the bond- holder and the trustee, must be fully and explicitly set forth and the mortgaged property must be described so exactly that no conflict with other mortgages or obliga- tions can possibly arise. The instruments have now come to follow certain models and are almost always arranged about as follows: First, of course, come the date and the names of the parties to the indenture. Next follows the preamble, in which is a full statement of the legal status of the corporation, including the state in which it is incorpo- rated, the amount of its capital stock and bonds, the § o^ 1-H >^ ^ < p^ S o o i-H o o Q <1 f^ o o rt ^ pc; 1— 1 H .5-p-a la 0.0) S -, S'-a >> "■^ >.SjJ.ti-S^-.^ a* ti-B „.S g>i^ o >i««'M 3 Mrt .C.S "^ o « millKlilCslJ "^pi.:SJ's|^:iJ-"3SgS i ^ S g.H5 s a.SS 3 t-^ S^iS» 0S2J«-OJ^pPiJ__Eud«"tiSo §+j "■ >i.a s^ ti „-5 *^ g ' i.^ ** E3^ Q-9 Moi "^=3 *3 CQ ^•« «^^ fl^ a*^^ S-^^a £ ^'Saeiiaigspu:-?^^^? SSIS-t! o ■W -r -— 0) t- ■= d *r d'S <»-a d_ II t H» SJ8 £|2 ^ iS-f 5 on a ><», o o II f II a :• & 3 S ^ " o S3 •« M .S 'H — " fe -d MO >,c c « C U U C3 -a > ifi ice o OJ =0 8)°^. a^l tH .t) H .S •a Q M ° ° *i f^^ a '"' o „ u J, <^ 5 w ^ h m OhJ3 'a JJ UJ3 U u o g(u„c8c60j-.=H.S5;ii£ ■Co gT3 -S "^.rr" C ^ "H CO 'So 2 ? CB C3 a =« *4jj= " fc. H, CO 5 3 j= a.i2 "e-a f^S SDo'*;'g'^£ -s . S a J4 Si*- i! -a J! u iJ 2 *' a ° 0) o B B -B 3 cs 3 ^ O ..a » OJ -a opqfL, g J: +j — «> U C8 5 S c3 B O " >« S (U t; o f" s. "^•"3 o «73 .a a " *"? tH "co 0) ■B ^ ca »H >■ •*-' -^ U QJ 4j . .1= „ ti_ ^, G^ ca "d oj a ^^^ O 2h ^ CD ' — ' ^ o'^S U 41^ B CD m B'-i "S B^jf OS D coOt-l fj •i-H ca .2 g .S ■sag^iS "'3 b'" •e o-B ° W 2 « •2 a -y js-d rt,S CO H « . SE I £ " ►< S ■^ °'^ ^- H ca -^ rH fd -H-oP ■& f^ t-i o ^ p. » . . H +■< o 'O ||£ d -co" e!^ g S3 r'S 1. *^ rf c 3 I— I o o 4J O a 'E a ° *4H I 1 ^ U CB " S U " B . ^ 53 ca !>■ o m ^ SI'S I a o s V 0*.oS.2 ■ — iMO o en « X bU pB c ^ 43 .5 A 138 CORPORATION FINANCE the whole of which remains as such security/ until the last note is paid. These deferred payments extend over a period ranging from four to ten years, and during such periods and until the final payment is made and all the provisions of the Car Trust Con- tract have been fully complied with, the conditional purchaser uses the Rolling Stock as lessee only, and subject to the legal rights of the lessor, in whom the title to the property remains fixed and inalienable and unaffected by any liens or indebtedness of any kind of the lessee. The lessee is also bound by the contract to keep the Rolling Stock in proper repair, to replace it if destroyed, and to hold it at all times subject to the inspection (it being readily identified, not only by the road numbers, but by the ownership plates invariably attached to each locomotive or car) of the lessor, by whom and for whose benefit it is fully insured. In case of default of any of the payments, or of non-per- formance of the other provisions of the contract, the lessor has the legal right, not only fully recognized and confirmed by the United States Courts, but also protected by direct legislation in many of the States, to take immediate possession of the Roll- ing Stock wherever it may be, or however in use, to sell it at public or private sale, and to apply the proceeds to the payment of any indebtedness arising under the contract, whether matured or not, and in cases where a Receiver is appointed, the rule of the Courts if to order him to pay the Car Trust notes as they ma- ture, rather than lose the use of the Rolling Stock and the benefit of the payment already made on it. The securities arising under these Car Trusts are assigned to a Trust Company, and are held by it in trust, as security for certain Bonds of The Railroad Equipment Company issued against the same. The holder of these Bonds has therefore as his security: The direct obligation of the Railroad Equipment Company. The direct obligations maturing at specified dates, generally monthly or quarterly, of the Corporation, the lessee of the Roll- ing Stock. TYPES OF CORPORATION BONDS 139 The absolute ownership of such RoUing Stock which is kept in repair, insured, and replaced if destroyed, and the first cost of which, already reduced by the cash payment at the outset, is being steadily still further reduced by the periodical payment made by the lessee.' The security behind bonds of this character is excel- lent. In the first place, no railroad has ever yet de- faulted on an equipment trust bond issue, because to do so would mean a loss of its equipment. All through the railroad receiverships of the 90's the receivers paid the interest and principal on these bonds regularly. In the second place, the railroad merely leases the equipment until the last payment is made and in case of default, therefore, no legal process is necessary in order to enable the trustee to take physical possession of the property. The leases usually provide that the equipment is to be kept in good repair. In effect this form of security is a kind of chattel mortgage. From the railroad corporation standpoint it is open to the usual objection against chattel mort- gages, namely, that it pledges a semi-fixed asset under a short term obhgation which must be met at all hazards. It may well happen that the railroad, in order to meet this obligation, will have to part with funds necessary in order to meet other fixed charges. The best managed railroad corporations use these instruments with great caution. One reason for their existence is that many existing first and second mortgages on railroad prop- erty have what is called an "after-acquired property" clause, which makes the mortgage extend over aU the property that the railroad owns at the time of making the mortgage and all that it acquires thereafter. Under this clause a straight mortgage on equipment would not 140 CORPORATION FINANCE be a first lien. The lease is the method by which this difficulty is overcome. The market for equipment trust bonds is narrow, partly because the public does not thoroughly under- stand them and partly because the issues are relatively small. They are largely bought by banks, insurance companies and other financial institutions desiring to in- vest their reserve funds to the best advantage. The average jdeld on equipment trust bonds is considerably better than on ordinary mortgage bonds and their safety is almost perfect. The principle of the equipment trust bonds is not applied to any considerable extent in industrial corpo- rations and with very few exceptions it would be highly inadvisable for such corporations to buy equipment in this manner. CHAPTER XI TYPES OF CORPORATION BONDS (CONTINUED) 74. Debenture bonds. — There are two diiFerent uses of the word debenture which are somewhat confusing. In law any instrument which formally acknowledges a debt and promises payment, including any written bond secured or unsecured, is a debenture. In finance, how- ever, the term has come to be restricted to a bond which is not secured by a lien upon any specific property. In other words, it is for all practical purposes, siniply an unsecured promissory note running for a number of years. Being unsecured, the debenture bond, in case of insolvency, is legally on the same level as the general floating indebtedness of the insolvent corporation. The debenture is much used in the financing of Eng- lish corporations. Indeed, our American mortgage bond, in the case of railroads at least, is there almost un- known. It is used so largely because the English invest- ors realize clearly that the earnings of the railroad after all are their actual security. As has already been pointed out, the holders of a railroad mortgage in case of fore- closure seldom take the physical property which legally belongs to them, because to separate any portion of a railroad's property from the rest is to diminish and per- haps destroy its value. Logically, therefore, the Eng- lish custom is right and the American custom is wrong. In practice, however, it is probable that the American railroad managers have borrowed more funds on better terms than have the Enghsh railroad managers. An 141 142 CORPORATION FINANCE English railroad corporation has only one kind of a bond — ^the simple debenture — to offer; an American railroad corporation may offer, as we have seen, an indefinite variety of mortgage bonds, each bond being secured by a lien on some part or section of the railroad property. The American junior bond, for that reason, looks better to the average investor than the English junior bond, and is more readily salable. Notice that this statement says "looks better," not "is better." If all American railroad mortgage bonds were to be ex- changed for simple debentures arranged in the order of their priority, investors would be as well off as they are now. Under the present system, however, the existing de- benture bonds are for the most part far inferior in se- curity and investment standing to mortgage bonds. Indeed, it would hardly be correct to call any of the present railroad debenture bonds, with a few notable exceptions, investments at all in the technical sense of that word, as previously defined. If debenture bonds are so far inferior to mortgage bonds and therefore so much less attractive to investors, why issue them at all? There are several possible reasons. In the first place, a company may have reached its limit, so far as mortgage borrowings are concerned; it may have nothing of any great value left on which first and second mortgages have not already been placed. Third mortgages are so unpopular with investors that a simple debenture may be more easily sold. Sometimes debenture bonds are created when a bank- rupt railroad company is reorganized. The reorgan- izers may desire to lighten the load of mortgages that previously weighed down the company and perhaps caused its bankruptcy. In the general scaling down of TYPES OF CORPORATION BONDS 143 the mortgage securities — a subject which we shall con- sider in detail when we take up reorganization — the junior mortgage issues are often replaced by debentures. This is the origin of most of our present railroad de- bentures. A third possible reason may be that a conservative corporation is anxious to reserve some of its resources for future mortgage issues. Suppose a railroad, for instance, already has a first mortgage on all its property and desires to borrow a comparatively small additional sum. If it places a second mortgage on its property it will have used up much of its remaining borrowing capacity. If it issues simple debentures, however, it wiU still have a second mortgage to fall back upon. Usually debenture bonds issued under such circumstances are accompanied by an agreement between the corporation and the bondholders to the effect that if any new issue of mortgage bonds is subsequently put out the debenture bondholders shall be secured by the same mortgage as the new bondholders. A fourth reason that has at times led to the issue of debenture bonds is that they are intended to be sold to Exiropean investors, among whom, as has already been stated, such bonds are highly regarded. In the reor- ganization of the Wabash Railroad Company in 1887, for instance, certain issues which are actually secured as to principal by a third mortgage were nevertheless given the name of "debenture bonds, Series A," because they were intended for English investors. In this country the most successful railroad debenture bond issues are those of the New England railroads, for the obvious reason that the earnings of these roads are not only large, but particularly stable. The Boston and Maine R. R. Co. has outstanding four mortgage bond 144 CORPORATION FINANCE issues and seven debenture issues. All of the de- benture bond issues commanded good prices and were considered sound investments. The earnings of this company have averaged six or seven times interest charges. Similarly the New York, New Haven and Hartford R. R. Co. has six issues of debenture bonds outstanding in addition to numerous issues of mortgage bonds of subsidiary companies. The net earnings of this company have been more than three and one-half times the interest charges. The practice of issuing de- benture bonds seems to be gradually gaining favor among American railroads, and a number of lines have adopted the policy of replacing mortgage issues when they mature by simple debenture issues. The debenture bond is not much used by industrial corporations, how- ever. These corporations do not usually have the con- fidence of investors and the stability of earning power which are necessary to make debenture bond issues suc- cessful. 75. Income bonds. — The income bond is a hybrid, partaking of the nature of both bonds and stock. As the name implies, the payment of interest charges can be demanded only when there is sufficient income for that purpose ; if the interest charges are not earned they need not be paid. The principal, however, is usually secured by a mortgage. If there is no such mortgage, as happens in one or two cases, the word bond is a mis- nomer. For all practical purposes such an "income bond," so-called, is preferred stock without voting power. Income bonds are usually the product of reorganiza- tion and are designed to take the place of junior mort- gage bond issues which it is thought necessary to scale. Their advantage lies in the fact that they do not impose any fixed interest charges on the corporation. How- TYPES OF CORPORATION BONDS 145 ever, there is a great disadvantage in the fact that the principal is secured by mortgage and that therefore new mortgage bond issues in the future are hard to float. Another disadvantage is that there is apt to be dispute between the corporation and the bondholders as to whether the interest charges are actually earned or not. This objection can be obviated in part by inserting in the bond such a detailed statement of the method by which net income is to be determined as is given in the sample income bond shown on pages 146 and 147. The new system of railroad accounting under the Interstate Com- merce Commission will probably aid in the settlement of this question in connection with railroad companies. For an example of the difficulties inherent in income bonds see the case of the Central of Georgia Railway Company cited in Chapter XXVII. 76. Other types of bonds. — The name of "participat- ing bonds," is almost self-explanatory. A bond of this class usually gets a fixed rate of interest and in addition a share of whatever profits are earned by its underlying security. The best known issue of this kind was the Oregon Short Line participating 4's issued in 1903 and retired the next year, which were secured by all the stock of the Northern Securities Company, amounting to $82,- 491,000 in the Oregon Short Line treasury. These bonds were to receive not only the regular 4 per cent, but whatever dividends over 4 per cent were declared on the collateral stock. Profit-sharing bonds, which are infrequently issued, usually entitle the bondholder to get back his principal with the agreed interest and also to share in whatever increase in the value of the underlying assets may take place before the retirement of the bonds. Joint bonds are direct obligations of two or more cor- VI— 10 14.6 CORPORATION FINANCE o M m o H < H H ; o ^ CO 4-' 9 o 4-> J3 "3 E o B I* 0) O § go aj m ^H t3 ^ * .2 S. 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I 00 CO O '§5 a .S ftp o 00 u ^ ft ■M '^ a1 J3 60 ii .3 ■< ca ft TYPES OF CORPORATION BONDS 147 6„^gSOa|^«i3=^.|gl3-gS„„^S »S „ -3 ^.a'S 1 S «o i xl ^^ c-t ^1 - g g-^J " s £| 2 .• 8atfg°S|>^i|-Sg^cS^|S^"«^-S £fe.i I ■y H £• u :5*^ So o^ SB'O g j,-S So-S «o^^ °oi^ ■S«3--s-2i;u-s-wfe"an,rt£3SSu>^.a u:3 S' T3 ^?ooC c3^HP-prtO*t^eO'+-'cfl ■'GO. mS* ^au«„'S'2§o.S-^S„io='|^£g££^g ^-o I " ^ g -S' § s 's -p - " 1 - ^ H g a § s g -g . -^ " ^ c o •H^^>>S^ ft >-5 .a 13 CO *^ .U 3 Pi M o u ^ :S o -"^ ^ 5i 'O _M- >2 .2 fi< ft ^ a 3 ^ -a 4) ■3 a rj M OJ ._ o O 0) O jj V a 3 .- to (>. -a ^ c s -^ TO g g a C -M 3 1-5 3 B !>. T3 E 11 ft 3 a «^ o >» o ,, ft i! ft .4_) B 'O « c H § M S .5 o 4-) B a> O S .^ o a s _•» s 0) t^ B a o fS 13 CO CO CO •>-< "d _ B 'O cj B J3 cS ft S ft H C3 ,B -P, ■■ S 8 ^ £ T3 aj O ^ bo B .a ''' .4_) O o-a ft 0) ■d tB CO U be V a c « 3 -a o ^ to 'k^ cS B -a B ft B o ^* 3 ■« ^ B to ft B ■■n & B 3 B •S £ a I '^ 00 'O ■-I c . c3 > a ■- s tB Pi zz^ B (B ft H £ 5 a "S a a 3 o ^ a > ^ !« .. 4J +J 4J U a to -d B 3 a 3 ^ Pi -B « H *j W Q 5 -s s 3 ■d a CO CO 3 O !3 ^ 3 .- ^ a " s ■3 '^ -d * 7?. K^ a S ■f ft CO 3 V5 4-1 £ 1 1 § ^d CO a 1 ■d B Si * TYPES OF CORPORATION BONDS 149 porations which join in issuing them. A well-known example is the Northern Pacific-Great Northern issue of joint collateral trust 4's. Somewhat the same effect is gained when a holding company guarantees a subsidiary company bond issue. A corporate security which should be mentioned here, although it is not, strictly speaking, a bond, is a receivers' certificate. This represents money expended by the re- ceivers of an insolvent corporation under authority of the court, as shown in the sample given on page 148. They constitute a claim on the property of the corpora- tion superior to all other claims whatsoever. They go ahead of the first mortgage bonds. They do not, of course, usually exist in large quantities and a reorgan- ized corporation will endeavor to refund and pay them off as quickly as possible. It is well to bear in mind, however, that in the case of an insolvent corporation this kind of a security may be used as a last resort when funds could hardly be secured in any other manner. 77. Purposes, manner of payment, and conditions of redemption of bonds. — The descriptive words applied to bonds indicating their purposes are almost all self-ex- planatory. "Unifying," "refunding," "adjustment" and "consolidated" imply that the previous bond issues are to be retired or rearranged in some way. "Con- struction," "improvement" and "extension" show that the funds secured from the bond issue are to be expended in some kind of development. "Purchase-money" bonds are sold before the property on which they are based is actually bought. Usually the funds secured by the sale of the bonds are turned over to a trustee to be held until certain specific property is purchased. Then the funds are paid out by the trustee and he receives in return a first mortgage on the property. 150 CORPORATION FINANCE A registered bond is issued to an individual in the same manner as a certificate of stock and ownership can be transferred only on the books of the company. In- terest is paid by checks which are sent out to the reg- istered owner. Coupon bonds are usually payable to bearer and interest payments are represented by coupons attached to the bond, as indicated in the bond forms given on pages 123 and 137. When the interest date ap- proaches, the coupon is detached from the bond and de- posited in a bank just as a check on the corporation would be deposited. In fact, the coupons are practi- cally simply post-dated checks. Sometimes coupon bonds are registered as to principal, in which case trans- fer of ownership is not made simply by delivery, but must pass through the books of the company. The in- terest coupons, however, are payable to bearer. Fre- quently an issue of bonds may be either coupon or reg- istered at the option of the buyers. There are obvious advantages in each form. The coupon form is very convenient, inasmuch as it may readily be sold or hypothecated. The registered form makes up in safety what it lacks in convenience. If it is lost or stolen it can be negotiated only by a forgery of the signature of the person in whose name it stands, in which case the transfer would not be valid. When a coupon bond is lost or stolen and is once sold to an in- nocent purchaser for value, the original owner must stand the loss. A gold bond is one which specifies that payment of principal and interest shall be made in gold coin. If there is no such provision it is understood that legal tender will be acceptable. There have been times in the history of the United States, notably during the periods of greenback inflation and of free silver agita- TYPES OF CORPORATION BONDS 151 tion, when this gold coin provision was regarded as highly important. At present not a great deal of at- tention is given to it. Redeemable bonds are those which may be redeemed at the option of the corporation before date of maturity. Sometimes the selection of the particular bonds to be redeemed is made by lot and the terms of redemption are made attractive with a view to appealing to investors with a speculative twist of mind. The wisdom of issuing redeemable bonds is questionable. It introduces an ele- ment of chance which makes it very difficult to figure mathematically their exact value and which probably tends to depress their market price. Serial bonds are redeemable in series extending over a term of years. 78. Convertible bonds. — This is a type of security that was revived a number of years ago, and has since be- come increasingly popular. It may be changed or con- verted under certain conditions into some other kind of security — usually into stock. The privilege of con- version may belong to any kind of a bond, mortgage, debenture, collateral trust or income. The usual ar- rangement is to permit a mortgage bond to be ex- changed for preferred stock of the issuing corporation at a prescribed rate of exchange and within a certain definite period. For instance, the Union Pacific Railroad issued in 1901, $100,000,000, of 4 per cent bonds which were con- vertible into common stock at par. As Union Pacific common sold in 1907 and 1908, at an average price much higher than par, practically all of this issue was con- verted long before the expiration of the time limit set. The advantage of this scheme is that it gives bonds a speculative, in addition to their investment, value. The 153 CORPORATION FINANCE buyer figures that he gets as safe an investment security as he would have if there were no such privilege and in addition he may share, if he chooses, in any great upward movement of the stock. The privilege of convertibility enables the company to borrow at a lower rate of in- terest. A further advantage, from the corporation's standpoint, is that the company if successful may expect to be relieved by the process of conversion of the pay- ment of interest on the bonds. Thus room will be made for additional future issues of bonds, if such issues are regarded as necessary. From the investor's point of view the advantages of convertible bonds are summed up in a circular by Mr. Henry Hall issued in March, 1909. Notice that this circular recommends the bonds to the semi-investing rather than to the strictly investing pubHc. Convertible bonds belong to the sounder class of speculative investments, combining a reasonable degree of safety and cer- tainty of interest return, with possibilities of substantial en- hancement in value. Investors make from 25 to 50 per cent profit, sometimes more, on convertible bonds when properly bought. Convertible bonds were first issued in this country forty and fifty years ago, when the financing of even the most promising of American railroads and at a high rate of interest was a. diffi- cult matter, and when it was occasionally necessary to offer special inducements to ensure the success of a new loan. Most of the financing of St. Paul, for instance, for twenty years or more after 1860, was accomplished through the issue of this class of bonds. It is said that as late as 1896, there were yet outstanding twelve separate convertible issues of the St. Paul. From 1880 to 1900, few or no issues of convertibles were made; but the requirements of the railroads then became so imperative and the multiplicity of competing issues became so great, that in 1900 and 1901 the convertible idea was once more resorted to. TYPES OF CORPORATION BONDS 153 In a general way, convertible bonds tend always to follow the price of the stock for which they are exchanged. This tend- ency is clearly exhibited by the quotations in this circular. Their fluctuations in price are therefore more hvely than those of staid first mortgage and other strong issues. An ordinary bond of good standing seldom moves more than 5 to 10 points from year to year, while convertibles are apt to fluctuate from 10 to 30 points in a single twelve months. The Erie 4!S, Series A, fell from 109% in one year to 4)6% in the next and then rose to 801/2. Convertible bonds are always a direct obligation of the com- pany. Some of these issues are secured by mortgage. Others are not, but this latter fact does not necessarily impair their value. It merely suggests a careful scrutiny of general condi- tions and the business of the company before buying them. Of course there are corresponding disadvantages. The stockholder may well say that if the company is going to be successful it would be far better to let the bonds stand and thus save more of the income for the stockholders. On the other hand, if the company is not successful, the bonds will not be converted into stock. The stockholder sees loss for himself in either alterna- tive. This would perhaps be an unanswerable argu- ment, if it were not for the fact that the bonds are almost always offered at less than market prices to stockholders, so that the holders of convertible bonds and the holders of stock are likely to be the same persons ; or at least the stockholder gets a valuable privilege in the form of a right to subscribe to the bond issues. CHAPTER XII CORPORATE PROMOTION— THE NEW ENTERPRISE 79. The function of a promoter. — ^A promoter is a man who organizes a new business and sets it going. The business need not necessarily take the form of a corporation. It may be handled as a partnership or a joint stock company. As new enterprises at the present time, if of any magnitude, are almost always conducted by corporations, however, it will be convenient and not far f lom the truth to apeak as if the work of a promoter were confined to organizing and financing corporations. The promoter is necessary because the great mass of the funds used in large corporate enterprises is passive ; that is to say, the owners of investment funds are not primarily engaged in buying and handling business en- terprises. They wait until a good proposition is pre- sented to them. The function of the promoter, there- fore, is to bring his proposition to the attention of the owners of funds in such a manner as to arouse their in- terest and confidence and induce them to buy the securities of his new corporation. The word promotion has a tinge of discredit attached to it, partly because the promoter, from the very nature of his work, is apt to be over-sanguine and a little care- less as to exact accuracy, and partly because the high- sounding word promotion is used by many swindlers who prey upon ignorant and foolish speculators. One of these last mentioned gentry describes his operations in the following words: 154. CORPORATE PROMOTION 155 To-day the promoter — ^the 20th Century genii — takes an existent business enterprise, and, for every five dollars it annually earns, gives it immediately ninety-five dollars. He takes an Opportunity — an intangible, impalpable thing — and from it creates an actuality, a vigorous growing enterprise that showers wealth and happiness on thousands. He takes appar- ently irreconcilable interests, waves his promotion wand above them, and presto ! they become associated by the bands of com- mon interest ; loyal to a single standard. Over business men he throws a mantle that protects their private means against bank- ruptcy, litigation or ruin. He carries a veritable Aladdin's Lamp — the Lamp of Knowledge, the Lamp of Power, through which he conjures opportunities into actualities, small businesses into large. His powers, legitimately employed, upbuild indus- try. Literally, in service to humanity, he stands with powers as beneficent as those exhibited by the Good Genii of our child- hood tales. The end of this quotation, when apphed to men whose sole object is to draw into their own pockets as much as they can of the savings of their credulous victims, is sufficiently absurd. But when it is restricted to the true promoter, a man whose judgment and business instincts are sound and whose persuasive powers are used to se- cure funds for a legitimate business enterprise, the state- ments are not at all exaggerated. The promoter does, in fact, perform highly important tasks and often richly deserves the great rewards which fall to his share. Many of the great business men of America are pro- moters — though, as noted in the next chapter, such men do not usually spend all, or even most, of their energies in promotion. To this class belonged the men who be- tween 1900 and 1907 formed great industrial "trusts," including H. H. Rogers, John W. Gates, D. G. Reid, W. H. Moore. Closely allied with them were finan- 156 CORPORATION FINANCE ciers like J. P. Morgan, E. H. Harriman, George F. Baker and James Stillman. 80. "Discovery" of a proposition. — A promoter in handling an enterprise has three separate tasks before him. First, he must "discover" his proposition; second, he must "assemble" it; third, he must "finance" it. The discovery of a proposition does not mean simply to find it, but includes a thorough investigation into all the surrounding conditions, and the solution in advance of all the difficult problems that are likely to arise in its development. Let us suppose, for instance, that a new invention which looks good on the surface is brought to the attention of a promoter. If he understands his busi- ness he will first of all examine critically every factor that points toward the invention's success or failure. He will find out whether it is patented and just what features the patent covers. If it is not patented, he will make sure, through a competent patent attorney, that the device is actually new and patentable. If he is prudent he will probably instruct the attorney to find out whether any similar invention is used in foreign countries or not. Next, he will consider whether other devices are in use which perhaps accomplish the same purpose as well or nearly as well as the invention. After making sure that the invention is what it purports to be, he will consider the possible markets for the article. The invention may be a new machine that could be used in only a few concerns, and perhaps these concerns would prefer to retain their present machines rather than expend any great amount of money for something new. In this connection the promoter will have to find out whether any incidental expenses are necessary in connection with the use of the invention. Generally speaking, the slighter the change from current methods. CORPORATE PROMOTION 157 the more readily the invention may be marketed. The amount of advertising and selling expense called for must also be taken into account. Next, the promoter takes up the cost of manufactur- ing. He finds out whether new and specially con- structed machinery is necessary in manufacturing the invention, and whether any especial skill on the part of laborers is required. He considers the amount of ex- periment that will be necessary in order to perfect the invention and in addition figures a large amount of ex- tra cost for unforeseen contingencies. These are only a few of the factors that the promoter would investigate before taking any further action. Their mmaber is sufficient to indicate, however, that any promoter who has a reputation to make or preserve, can- not afford to jump hastily at whatever proposition is presented to him. The process of discovery may take a long time, perhaps months or even years. The case just cited is comparatively simple. Where a promoter is dealing with such an enterprise as a new railroad or a new mine or with a consolidation of manu- facturing plants, he is confronted by a far more com- plicated situation. If the investigation is thorough and searching, the promoter will be able to give a well- grounded and satisfactory answer to every question that prospective buyers may raise. 81. "Assembling" a proposition. — By assembhng a proposition is meant the process of getting temporary control into the hands of the promoter. If he is dealing with an invention, he assembles the proposition by get- ting an option on the invention or by making an agree- ment with the inventor on a royalty basis. In the case of a consolidation of plants or railroads into a new cor- poration, assembling is frequently much more compli- 158 CORPORATION FINANCE cated and difficult. In such a case the promoter may have to get options or arrange the terms of purchase with every plant and perhaps with all the different classes of security-holders involved. Unless a promoter has these agreements or options in his own hands, it is as a rule foolish for him to go ahead with any further efforts. He might complete his arrangements for put- ting the new corporation on its feet and then find that in the meantime the original owners of the property had sold to other parties or had taken steps that would di- minish the value of the property. Or he might find that after forming the corporation and hringing the owners of the funds and the owners of the property together, they would mutually agree to dispense with his services and would leave him, so far as his compensation is con- cerned, out in the cold. 82. Financing a proposition — The initial develop- ment. — Now we come to the most difficult part of the promoter's work, his financing of the new corporation. No hard and fast rules can be laid down to cover the promoter's procediu'e. There are some general prin- ciples, however, which apply to all enterprises and which should always be kept in mind. First, it is advisable in practically every case to de- velop the proposition as far as possible with the pro- moter's own resources and those of his immediate friends before it is presented to outsiders. In making this statement it is assumed, of course, that the promoter really has faith in his proposition and is willing to take whatever risk is involved in developing it; otherwise the promoter will naturally spend as little as possible of his own money. In the case of an invention, for instance, which the promoter is trying to finance, it is far better to have the invention actually manufactured and a few CORPORATE PROMOTION 159 of the articles on exhibition before any attempt is made to interest outside capital. If this is impossible, a work- ing model at least should be on hand. The average capi- talist is not likely to part with his money unless he sees before him something mere tangible and impressive than a verbal description of what the inventor expects his as yet unborn machine to accomplish. If a promoter is financing, let us say, a copper mine, he should do his utmost to have the ore bodies opened up and mining operations started, even if only on a small scale, before he starts to float his corporation. Where the promoter is consolidating several existing plants he already has some of his exhibits at hand in the form of the going plants and companies that are to be consoK- dated. Nevertheless, the combination itself is in re- ality a new enterprise and the promoter should spare no pains to secure some practical demonstration of its prof- it-making possibilities. Sometimes he may point to the success of previous combinations created under closely similar conditions. If he does not have examples, at least he can get exact figures as to the selling, admin- istrative and operating expenses under the present ar- rangement which would be saved if the combination were effected. In general the promoter must bear in mind that an enterprise which exists only on paper does not make anything like as powerful an appeal to the buyer of securities as an enterprise which has something tangible to show. It may be that the standing and prospects of the enterprise are in reality very little changed simply by producing some tangible results. Nevertheless, the confidence of people with funds is much increased and this, after all, is the promoter's main object. 160 CORPORATION FINANCE 83. Foresight in providing funds. — Second, the pro- moter should take care not to get his enterprise into such a condition that funds must be secured immedi- ately on whatever terms are demanded. This is a situ- ation that is quite apt to confront one who goes ahead with construction and development too rapidly. In his eagerness to make a favorable showing he may perhaps run short of funds, find the obligations of his corpora- tion pressing and be compelled to make some very dis- advantageous deals or see his corporation go into bank- ruptcy. Many a meritorious enterprise has suffered this fate. To prevent such a catastrophe the promoter should see that his corporation is capitalized for a larger amount than he expects to need; thus there will always be unused securities which may be offered for sale without involv- ing tedious and unnecessary formahties. It may be well to have this stock actually issued and transferred to the treasurer of the company in the manner which has been previously described. Furthermore, the promoter should endeavor to raise in advance of any expensive construction or develop- ment all the funds that will be required for that purpose. The corporation which has a factory half -built, or min- ing machinery partially installed, or merchandise busi- ness half -stocked, is in an extremely precarious condi- tion. Without additional funds it can go neither backward nor forward. It has no valuable assets or established trade on which to borrow funds, it has no trade credit, it has no record of sales and profits to pre- sent to prospective buyers or securities. It is therefore unable to secure any funds except from some individual or small group who may come to its rescue. The pro- moter may feel reasonably confident that their assistance CORPORATE PROMOTION 161 will be purchased only with the sacrifice of his own control and probably of most of his profits. 84. Advantages of a wide distribution of stock. — Third, it is usually far better both for himself and for the corporation that the promoter sell his securities to a large number of small buyers rather than to a small nimiber of large buyers. In the former case the stock- holders are scattered and their holdings are too small to induce them to take any active interest in the business. Consequently the promoter, even if he fails to retain a majority of the voting stock, is left in absolute control. In the second case, the promoter is watched and perhaps hampered by the large stocldiolders ; even if he holds a majority of the voting stock, he will probably not desire to arouse their objections and will therefore feel obliged to consult them or their representatives. Such an arrangement the promoter who has faith in his own abilities and ideas does not desire. He usually feels that he understands the proposition better than anyone else and that to him should be left the con- duct of the business until it is well started toward success. From the standpoint of the corporation, a large number of small stockholders is almost always desirable. The wider the distribution of the stock, the more friends the corporation has and the easier, probably, will be the selling of additional securities. Besides, the large capitalists who might be interested in the enterprise, should generally be kept in reserve for such emergencies as have been described. If the corporation does get into difficulties, in spite of all the care that its promoter may take, it can then turn as a last resort to these capitalists instead of drifting helplessly into insolvency. 85. "Starting right" in the sale of stock. — Fourth, if VI— 11 ' 162 CORPORATION FINANCE the promoter is handling a legitimate small enterprise, he should look for his funds to the people of the locality where the enterprise is started. If the enterprise is too large for them, at least he should accomphsh his pre- liminary financing — that is, the raising of sufficient funds to get the enterprise started, although not enough to carry it on to success — among the local people. Con- servative bankers and business men always recognize the superior opportunities for getting exact information of local investors and have considerable confidence in their judgment. It is a great advantage to a promoter in presenting his enterprise to the pubhc to be able to say that a large part of the funds have been subscribed by persons who are on the ground and in close touch with what is actually being accomplished. The same ob- servations apply to people with technical training if the enterprise has many difficult technical features. The promoter of a corporation to manufacture a new elec- trical engine, for instance, ought to have the support of experts in that field — ^manifested not only in words, but by money — ^before he starts his campaign for sub- scriptions among outsiders. 86.-4 concrete illustration. — The practical applica- tion of the principles here laid down in the promotion and financing of interurban electric railroads has been well described in a lecture before the students of New York University School of Commerce, Accounts and Finance by Dr. Thomas Conway, Jr., of the University of Pennsylvania. Dr. Conway said: The proposition having been discovered and thoroughly in- vestigated, and the necessary options, for example the rights of way, etc., together with the necessary franchises, having been obtained, the promoter arranges to present the proposition to those who will furnish the money necessary. He accom- CORPORATE PROMOTION 163 panies his statement of anticipated earnings, with a map of the territory, showing population adjacent and tributary to his proposed lines, and he submits also engineers' estimates of cost of construction and cost of operation, based on the amount of traffic to be expected from the given population and its ratio of increase, and the grades and curves which will be encountered. He is now ready to arrange for the financing of his proposition. His first step is to organize a corporation, usually under the laws of a state in which his road expects to operate. This cor- poration will be organized with a minimum capital permitted by laws of the state in order to save initial taxes payable to the state. It will be organized with a minimum amount of cash payment and, if possible, requirements for actual contributions, will be satisfied by turning in options to the company. The charter of the company contains the authorization of the amount of capital which will be required to finance the enterprise. This capital consists of bonds, preferred and common stock. It is important that the amount of bonds per mile of road should be kept down to the lowest practicable figure as a large bonded debt immediately arouses a suspicion and suggests the advisa- bility of a more skeptical and scrutinizing investigation of the promoter's representations. The amount usually fixed upon as conservative is $20,000 per mile. This may be exceeded in cases of especially expensive construction where interest on an excessive amount may be ofi'set by lower cost of maintenance. The preferred stock issue is usually for subscription in the immediate locality where interest in the new proposition must be aroused. It is advantageous to secure the largest possible amount in this manner, since it gets down the amount of bonds to be sold and makes their sale correspondingly easy. Two courses of action are now open to the promoter. He may either, after securing the proper introductions, address himself to a private banker in some financial center and ofi'er to him the en- tire bond issue, or he may arrange for the financing of his enter- prise in his own locality, approaching the city banker only after he has a record of earnings upon which to base his argument. The investor to whom these securities must be sold, will not 164 CORPORATION FINANCE buy the bonds of an enterprise which has no recognized status, so long as it remains in formation and in chaotic condition. It is in his eyes a speculation and as such he is reluctant to put his money into its securities. If the bonds are, therefore, sold in the city, to the city banker, he must borrow the money to build the road, and must hold the bonds until at least a year's operation of the new property has been completed. The city banker will demand hard terms as a condition of advancing this money, if indeed one can be found with sufficient confidence in the new enterprise to risk his capital in its inauguration. It is better, therefore, if possible, that the promoter should arrange for a preliminary financing of his scheme among local interests. This he does in the first place by securing subscrip- tions to preferred stock as already indicated. He also obtains a guarantee of purchase of the bonds of his corporation from local interests, bankers, institutions and capitalists, with whom he is acquainted, the condition of the guarantee being, that if the bonds are not sold within a definite time, say three years, above the price named in the contract of guarantee, the guar- antors will take them at that price. The city banker would usu- ally require that local interests guarantee at least a portion of the bonds, and it is therefore just as well for a promoter if he can accomplish this to secure guarantee of the entire issue. In order to make the stock of his company fully paid a device fre- quently resorted to is that of a construction company organized by the promoter and his friends and associates, who receive all the stock except what preferred stock may be prescribed for bonds of the new company in exchange for an agreement to construct and equip its lines in accordance with the plans and specifications of the engineers, which are made part of the agreement. At the time this contract is executed, all the common stock and sometimes such a portion of the preferred as may not have been provided for is turned over to the construc- tion company, together with a small amount of the bonds. The remainder of the bonds are issued to a trust company, which acts as trustee for the holders, in installments correspond- ing to the completion of sections of the lines as certified to by CORPORATE PROMOTION 165 the engineers representing the trust company. The promoter or his representative, acting for thef construction company, which has now come into possession of all the securities of the new corporation, arranges with some trust company or bank to advance sufficient funds to build and complete the line. The security offered is the bond issue of the railroad company sup- plemented by the guarantees above mentioned and by a certain amount of the stock. The common stock of the railroad com- pany, it should be mentioned, is divided up among the guaran- tors of the bonds. The trust company advances the funds, the banker finally sells the bonds, and what remains constitutes the promoter's profit. The amount of common stock, which must be given to each one of those interests, and that can be re- tained by the promoter, varies with circumstances. In return for making the loan, the trust company usually exacts a com- mission of say 2% per cent to 6 per cent, besides the regular interest of 6 per cent or in some cases as high as 8 per cent, the loans running for two years. This money is advanced on serial notes of the construction company, corresponding to the comple- tion of different sections of the road, and secured by the bonds which are issued to the construction company by their trustee as fast as the road is completed. For example, we will suppose that the total amount of bonds is $1,000,000, and that these should be issued in ten installments to the construction company. The first installment of $100,000 is issued at the time the contract with the railroad company is executed. The construction company takes this note together with the guarantee of the purchase of these bonds, and $100,000 of bonds, and borrows from the trust company $100,000. With this $100,000 it pays for the completion of five miles of road. When it is certified to the trustee of the bonds that this mileage has been completed, another $100,000 of bonds is issued, an- other note negotiated and in this way by serial installments and notes, the trust company in time advances all the funds neces- sary to build the line. Prior to the completion of the lines some portion of the interest may be earned by the sections which may be put into operation. It is customary, however, to pro- 166 CORPORATION FINANCE vide in tlie original capital issue sufficient funds for the payment of one or two years' interest. If the calculations of the promoter have been correct, after the company has completed its first full year of operations, little difficulty will be experienced in arranging for an advan- tageous sale of the bonds to the city banker. Some stock may be demanded along with these bonds, but the amount will be small compared with what would have been asked if the banker had been obliged to advance the money for construction. In agreeing to take the bonds of an interurban electric railway the banker is running little risk, and is often able to dispose of all the bonds as soon as he has completed his payments for them. These bonds, until the notes which have been secured have been paid, remain in the custody of the trust company which ad- vances the money to the construction company as fast as the bonds are delivered to the banker. He makes payment for them, and with these funds the notes of the construction comj)any are satisfied and all the bonds have been taken up and paid for; the indebtedness of the construction company is discharged, and there remains in its hands a certain amount of cash and securi- ties which are distributed to its stockholders. The construc- tion company's work having been accomplished, it is then dis- solved. CHAPTER XIII THE PROMOTER AND THE CORPORATION 87. Professional promoters. — It is time to say some- thing about the promoter, his personaUty, his duties, his legal responsibilities, the services that he performs and the pay that he receives. Readers who are unfamiliar with the world of finance may have assumed from what has been said that a certain class or group of men make it their sole business to promote enterprises and that no one else ventures into this field. This would be an en- tirely erroneous impression. Anyone who is pushing a money-making scheme is a promoter for the time being, or at least he is performing some of the functions of a promoter. On the other hand, as not everyone by any means is well fitted by temperament, training or practice to make a success of the difficult work of pro- motion, comparatively few men are concerned with such work to any great extent. We may classify the men who spend a considerable amount of their time and energy in promotion into four groups. Let it be clearly understood, however, that this classification does not pretend to be com- plete. First come the professional promoters, the men who really do make it their main, and almost their sole, busi- ness to hunt for enterprises that promise profits and to finance those enterprises. This type is common in fic- tion, but rare in real life. So far as the writer recalls, he has met only one man who could be put in this class, 167 168 CORPORATION FINANCE a tall, lank, fervent individual with a persuasive air. At the time the writer knew him he was engaged in selling the stock of a Mexican rubber plantation com- pany; he was also interested with others in the de- velopment of a tract of real estate near New York City; and he was investigating the possibilities of a copper mine in North Carolina. No doubt other plans were gei-minating in his mind. He was of the enthusiastic, visionary type, utterly incompetent to manage an enter- prise, but skillful in appealing to the aspirations and emotions of others. On the whole, he was fairly suc- cessful ; that is to say, he was making enough money on one enterprise to pay his losses on the others and to get a decent living in the bargain. He was unquestionably honest in his convictions ; indeed, it was easy for him to be honest, for he possessed a mind that readily believed whatever he wished to believe. Probably he was used as a tool in many cases, although he never suspected it, by shrewder and less scrupulous men. It might be said that Mr. John W. Gates, Judge W- H. Moore, Mr. Daniel G. Reid, and the others named in Chapter XII, are professional promoters. It would be more nearly correct, however, in the writer's opinion to classify these men as primarily brokers, or lawyers, or bankers, who have won a few great successes in the field of promotion. The man who does nothing but "promote" is not apt to achieve marked successes, one reason being that the really great opportunities ai-e nob usually stumbled upon by chance or disclosed to those who seek after them, but are revealed only to those who have an intimate acquaintance with the details of the business to be promoted. The only exception to this statement worth noting is when one who has already achieved success as a promoter is called in by men who PROMOTER AND CORPORATION 169 thoroughly understand the business to be promoted and who place their knowledge at his disposal. 88. Lawyers and hankers as promoters. — The second class consists of lawyers and bankers in small commu- nities. Such men have exceptional opportunities to in- form themselves as to local conditions; they frequently take hold of some local enterprise, such as a steam or street railway, secure the assistance of experts for inves- tigation and carry through the proposition to success. Still more frequently, however, so far as the writer has observed, such men underestimate the difficulties of the problem ; they take it up with enthusiasm but are forced either to drop it or to call in men of wider experi- ence. The men to whom they generally turn constitute the third class of promoters, namely the larger bankers and brokers. The amount of promotion work performed by such men is limited and they usually confine their active participation— except for advice — to the financ- ing of such enterprises as they take up. Mr. J. Pier- pont Morgan stands out as the most prominent example of this class. 89. Engineering firms as promoters. — The fourth class — and this is a recent important development — consists of engineering firms engaged in construction work of various kinds. Certain large engineering con- cerns have established a wide reputation for success in operating street railroads, water works, electric lighting plants, and so on. These firms naturally have built up a large and well-equipped staff of experts in those fields. As the staff is expensive, it becomes a pressing problem to keep them profitably employed all the time. In the effort to solve this problem such firms have drifted into the custom of taking up new enterprises of merit 170 CORPORATION FINANCE and performing the work of promotion themselves. Their prime object in so doing is to employ their own engineering talents and the abilities of their staff to the best advantage. Incidentally, of course, they have no objection to securing some of the other returns that naturally follow from successful promotion. These engineering promoters have three great ad- vantages which have told heavily in their favor: (1) They are able to carry on a thorough investiga- tion of any project that is presented to them without much extra expense ; and as they are constantly engaged in such investigations, they have developed a body of experts who are able to give the best possible judgment as to the outlook for success in each instance. Conse- quently, they seldom go wrong. (2) They are almost invariably big enough and have resources enough to finance the projects which they undertake themselves, if necessary. However, as they are primarily engineers, not financiers, they nearly al- ways prefer to secure the greater part of the funds from other persons. This they accomplish by calling to their assistance some large banking and brokerage house, which will undertake to sell the securities of the corporations organized by the engineering firms. The alliance thus formed is of great advantage to the bank- ing house, inasmuch as it may accept with confidence the results of the investigation carried on by the engi- neering firm's experts. (3) The engineering firm, having a reputation to acquire and sustain, does not desert the new enterprise as soon as financed, as most promoters do, but sticks with it until it is a thoroughly established success. The en- gineering firm must have on its staff experts, not only in planning and building the street railroad or power PROMOTER AND CORPORATION 171 plant or whatever the new project may be, but also in operating the enterprise. It is in position, therefore, not merely to put the new corporation on its feet, but to give it a good running start toward success. Further- more, if the corporation later gets into difficulties, the engineering firm may be relied upon to come to its as- sistance. With these advantages there is no telling how far the tendency toward promotion by engineering firms will go. It would not surprise the writer to see almost all business of this kind except the largest projects turned over by common consent within the next few years to the well-established engineering firms. No doubt, as soon as this tendency becomes well known, cheap imitators of the reliable engineering concerns will come into the field. This difficulty, however, can be overcome, and in the end we shall perhaps find the business of promotion cleaner, more reputable and con- ducted with greater ability than under present condi- tions. 90. Secret pro/its are illegal. — No matter who the promoter of any particular enterprise may be, it is al- ways necessary for him to raise funds from outsiders for his new corporation; and in the process of raising funds he must make representations as to the standing and prospects of the corporation. He also frequently enters into contracts on behalf of the corporation to be. His activities in both directions frequently raise knotty legal questions, which it is important for us to notice. At law a promoter is in an anomalous situation, so far as his relation to his corporation is concerned. He is not, strictly speaking, an agent, because an agent must have a principal and the company promoted can- not be a principal because it is not yet in existence; 172 CORPORATION FINANCE yet the courts have held that his activities in many respects are analogous to those of an agent. In addi- tion, a promoter is in a sense a trustee of the interests of the corporation that he is organizing. He is under obligations to do his best for the corporation and to act always in good faith for its benefit. Furthermore, he must disclose all the pertinent facts in connection with the contracts and bargains that he makes for the cor- poration to its officers and stockholders when formed. Generally speaking, secret profits and fraud on the part of the promoter are not merely immoral, but are regarded by the courts as illegal as well. Where such transactions are discovered the corporation may bring suit and recover damages. The four cases given in abstract below illustrate different phases of this prin- ciple. 1. B agreed to sell land to X and Y, promoters of a corporation, for $12,000. He then associated him- self with them and the three agreed to form a corpo- ration which should buy the land for $40,000, out of which B was to receive the $12,000 he had originally de- manded and in addition one-third of the profits of pro- motion. The company was formed, the purchase price of $40,000 paid and the stock of the company sold to outsiders. Subsequently the facts were discovered and the company filed a bill against the administrator of B's estate for the funds which B had received over and above $12,000, the ground of action being that B, as a promoter, was not entitled to make a profit by a sale of his land to the company at a fictitious value. The Supreme Court of Pennsylvania ordered a refund to the company of the amount received above $12,000. 2. B and C with the object of incorporating a mining company purchased oil lands for $10,000, and united PROMOTER AND CORPORATION 173 in organizing a company to buy the lands for $81,000. It was represented to prospective shareholders that B and C had purchased in the interest of the company and that the price paid by the company was the same as that paid by B and C to the original owners. The cor- poration sued B and C to recover the difference between the price paid in the first instance, and the figure at which the property was turned over to the corporation, and the suit was successful. 3. In a recent New York case it was shown that a promoter joined with the owner of a tract of land in procuring options of doubtful validity on adjoining tracts. The promoter then organized a corporation to purchase the land at an advanced price under an agree- ment with the owner that the profits thus secured were to be shared equally. The promoter bought the land for $66,223, though the deed to him recited $80,000 as the purchase price, and conveyed the land to the cor- poration for $80,000 and 400 shares of stock. He sold the stock to other stockholders and kept for himself the $13,777 profit. All of the money paid to the original owners of the land belonged to the corporation. It was held that the corporation was entitled to the $13,777 profits. 4. The promoters of a plantation company purchased land in Cuba for $40,000 and secured an option on addi- tional land so drawn that it appeared they paid $20,000 for the option, making the total purchase price appear to be $60,000. In fact, nothing had been paid. They organized a corporation and represented to their associ- ates that the plantation cost $60,000. They assigned their option to the corporation, taking $2,000 in stock as their share. Their associates retained the balance of the stock. It was held that the promoters were under a fidu- 174 CORPORATION FINANCE ciary relation to the corporation and that the corporation was entitled as against them to the cancellation of the stock so issued to them. It should be understood that there would be neither legal nor moral objection to a promoter's sale of prop- erty to his corporation at a higher price than he paid for it. The only obligation resting on him is that he should not conceal his profits. In practice it is very difficult to prevent concealment and the promoter may readily find methods of making sworn statements as to his profits that will be true, so far as they go, but will not be the whole truth. A scheme much used in buying property that is later to be sold to the pro- moter's corporation is to have it passed from the original owners first to another corporation owned by the pro- moter or to a friend of the promoter; then this corpo- ration or friend will sell to the promoter at a price far in advance of what was paid to the original owner and the promoter will be able to assert that he turns it over to the corporation he organizes at cost to himself or at a very small profit. Sometimes the property may be made to pass through two or three intermediate hands in order to make detection more difficult. 91. Misleading statements constitute fraud. — An- other feature of the promoter's work which should be considered relates to his statements with regard to the en- terprise whether made verbally, in correspondence or in prospectuses. These statements are subject to the general principles of the law relating to fraud. The promoter is bound not merely to make his statements accurate, but not to omit any facts of vital importance. Of course, the same difficulties that are found in all applications of the law relating to fraud are evident here. The promoter may state what he considers to PROMOTER AND CORPORATION 175 be the facts and may omit features that he considers non-essential and it would be impossible to prove that his motives and intent were not of the best. We shall see in dealing with prospectuses how easy it is to give a misleading impression without actually making any misstatements. 92. Contracts on behalf of the corporation and their acceptance. — Difficulties sometimes arise in connection with the contracts which a promoter makes on behalf of his proposed corporation. As the promoter is not an agent, he has no right, strictly speaking, to act in behalf of the corporation. Courts of equity, however, have modified this strict rule to such an extent that the corporation accepts the contract by accepting its bene- fits. Acceptance need not be expressed in words; it may be reasonably inferred from the acts of the corpo- rations. 93. The promoter's pay. — The most vital questions that arise between the promoter and his corporation are: How shall the promoter be paid for his services? How large shall his profits be? The promoter usually feels that he is entitled to all he can get. The corpo- ration's stockholders, on the other hand, are apt to be dissatisfied even with a compensation that the promoter considers exceptionally small. The following extract from the Report of the Industrial Commission ^ states the essential facts. ' There are various ways for the promoter to receive his pay. In certain instances, as, for example, the United States Rubber Company, the promoter received for his work 5 per cent of the total stock issued, but had to pay out of this the charges of lawyers, accountants, appraisers, and bankers. A more usual form of remuneration is to give the promo- 1 Second volume on " Trusts and Industrial Combinations," page VIII. 176 CORPORATION FINANCE ter a certain amount of stock with which to buy the plants re- quired and to pay expenses, permitting him to retain the surplus for his profits. In the case of the Rubber Goods Manufactur- ing Company the syndicate subscribers furnishing cash received for each $100 paid in $100 in preferred stock and $90 in com- mon stock. The promoters had to purchase the plants and were given the entire issue of preferred and common stock. If they could buy the plants for the proceeds of 100 per cent of preferred stock and 90 per cent of common, they made the 10 per cent of common stock for their profit; if they had to pay more than that sum their profits were correspondingly lessened; if they could buy for less, naturally they made more than the 10 per cent of the common stock. They were under the express limitation that no preferred stock was to be issued in excess of tangible assets, and no common stock in excess of an amount determined by the earning capacity of the plants, as shown by previous experience, capitalized on a 7 per cent basis. In the case of the American Smelting and Refining Company, syndicate subscribers for each $100 paid in cash received $100 in preferred stock and $70 in common stock. The promoters received the remaining $30 in common stock, out of which they had to pay the entire expenses of organization. They retained the remainder for their profits. Speaking generally, Mr. Chap- man states that when a financiering syndicate receives for its subscriptions par in preferred stock and something less than par in common stock, the usual custom is for the promoters to receive the remainder of the common stock as pay for their serv- ices and for covering the costs of organization. In most oases their profits will depend upon the rigidity with which they can hold down their expense accounts, and^ in many cases, wtere the purchase of plants is entirely in their hands, upon the skill which they can show in making purchases. Usually, of course, a care- ful appraisement has been made of plants beforehand, so that the basis of the stock issue is well known to all parties inter- ested in the deal. A certain speculative chance is also often given to the promoters through the fact that it is within their PROMOTER AND CORPORATION 177 discretion to buy for cash or stocks as they can best make agree- ments with the vendors. In that case they can sometimes make much better bargains for themselves by paying cash, or, on the other hand, by persuading the vendors to take securities, thus lessening the amount of cash that needs to be paid out. It is regularly the case that the promoter receives his pay in common stock. Within the last two or three years there seems to have been a more conservative tendency shown by the bankers and others interested in financing the industrial combinations. The man who advances money to buy the various plants is, in many in- stances, taking a considerable risk and expects often to secure high pay therefor. The extent of his pay is dependent never- theless largely upon his judgment as to the future course of de- velopment of the business of the combination in question. He practically buys securities of manufacturing establishments. If they earn high dividends his earnings will be great, provided he retains the securities ; if he sells them his profits will be de- termined by the market rate of the securities, that being de- pendent again in the long run upon the earning capacity of the establishments. The more usual terms probably, under which within the last two or three years the financial agreements have been made, are that for each $100 cash paid in the subscribing member of the financial syndicate receives par in preferred stock with a bonus in common stock equal to the preferred less the amount reserved for the pay of the promoter. This resei-ve has sometimes been as high as 50 per cent of the common stock, sometimes 30 per cent, and sometimes only 10 per cent. Instead of the plans mentioned above numerous others are of course found, especially where it is more desirable to issue bonds or where for some reason it seems desirable to make special terms, owing to the peculiar situation of some of the members entering into the combination. Promoters sometimes receive specified sums of money for their services ; bankers practically always have to take for their services a percentage of the stock or the surplus left over. VI— 12 178 CORPORATION FINANCE 94. The promoter's risks and labors. — Enough has been said to indicate that the promoter's labors and risks are heavy. If he does his work thoroughly he will probably spend a long time in careful investigation of the enterprise and in examination of all the possible causes of failure before he binds himself in any manner. If he is a man of sound judgment, as he must be in order to be successful, he will probably find serious if not fatal flaws in most of the enterprises that come to his atten- tion. A professional promoter must expect, therefore, to spend a large amount of time and money in studies and investigations that bring him no return. Unless this part of his work is thoroughly done his efforts are foredoomed to failure. In the process of assembling his proposition, the promoter must always take considerable personal risks. He buys options, enters into contracts, and perhaps spends money for further experiment, all of which will be absolutely lost unless his promotion proves successful. In financing the enterprise, the promoter puts in jeopardy not only the time and money previously ex- pended, but his business reputation as well. One notoriously unsuccessful promotion will probably end a promoter's activities, at least if he is engaged in an entirely legitimate line of business. 95. Is the promoter overpaid? — It is obvious also that the promoter must possess a rare and highly valu- able combination of talents. He must be keen, shrewd, a good bargainer, farsighted, prudent, enthusiastic, persuasive, and, above all, he must inspire confidence. With this necessarj'^ combination of talents, labors and risks, it is not surprising that the promoter should sub- sequently claim and exact large profits. It is no doubt PROMOTER AND CORPORATION 179 true that a considerable number of men who have wor success in this field have made millions and tens of millions of dollars in a very short time. To the on- looker it sometimes appears that these millions almost came dishonestly, that it is hardly possible that they are legitimate earnings. The average on-looker, how- ever, has no conception of the amount or importance of the preliminary work which the promoter performs. Neither has he any conception of the large number of failures in this field. Probably the losses of promoters, who have spent their own time and both their own and their friends' money without benefit to themselves, would almost equal or perhaps exceed the total profits of successful promotions. We must not forget to consider also the great im- portance to business and industry of their achievements. They are the men who have found and developed the inventions, the improvements and the better organiza- tion of industry which underlie our modern prosperity. Frequently the inventor complains that he has made less out of his invention than did the business promoter; the manufacturer complains that with all his years of eiFort he has made less out of his factory than did the promoter who takes it into a big consolidation ; the mine owner complains that he has made less out of his land and ore than did the promoter who obtained the funds for its developments. All of these complaints are natural enough; yet they all alike fail to take into ac- count the obvious fact that the promoter's efforts have not done them harm, but good. He has performed for each of them a great service ; and even if he retains the larger part of the profits, they have no just ground for complaint. CHAPTER XIV CORPORATE PROMOTION— FORMING CONSOLIDATIONS 96. The importance of small industrial combinations. — Of late years the most conspicuous and perhaps the most important field for promoters has been the con- solidation of manufacturing and railroad companies. The tendency toward consolidation has been even more widespread in the last few years than has appeared to the casual observer. Popular attention has been directed almost exclusively to what is called the trust movement, that is, the combinations of big companies with a view to controlling prices. Of still greater importance, however, to the average business man has been the tendency to consolidate small local plants, not for the sake of achieving even a partial monopoly, but for the sake of the economies that result from manufacture on a larger scale than is possible by a small partnership or corporation. Among the most important economies that may be thus affected are: first, the elimination of wasteful competition in selling and advertising; second, the opportunity to use expen- sive and highly specialized machinery more constantly and thereby prevent the loss that results from allowing such machinery to lie idle; third, a position of greater advantage to business managers in their dealings with labor unions; fourth, bringing to bear the best brains and experience to be found in any of the plants con- solidated on the problems of each plant. No statistics have been or could be collected to show 180 FORMING CONSOLIDATIONS 181 exactly the extent of this movement. It is certain, however, that the great mass of the manufacturing capital of the United States is now employed by such consolidations and that the position of the small isolated manufacturer is daily becoming more precarious. In- deed, this result is inevitable, for the consolidation can usually effect the economies mentioned above without equally great disadvantages. The consolidation, there- fore, although it may have no monopoly and no control over prices, either of raw materials or of finished products, easily undersells its small competitors. It is not worth while to rail against such a movement; busi- ness men will do better to recognize its inherent strength and get into line. 97. Difficulties in the promoter's task. — The forma- tion of a consolidation through the medium of a holding company, which is the usual form, is by no means an easy task. It brings into play all the shrewdness, persuasiveness and business judgment that a promoter may possess. Usually managers and owners of the vari- ous plants to be taken into the proposed consolidation are so mutually jealous and antagonistic that it is next to impossible for any one of them to effect a friendly combination with all his competitors. Once in a while a successful manufacturer may buy outright the securi- ties, or perhaps the physical assets, of competing plants ; but this is an exception. Usually the promoter of a consolidation must come from the outside. He will probably be better off if he has had no connection with the business and therefore has no grudges and no prej- udices to overcome. Sometimes the outside promoter is a banker friendly with all the interests to be combined; sometimes he is a well-known promoter who has made a name for fair dealing and success; sometimes he is a 182 CORPORATION FINANCE security holder in one or more of the concerns to be con- sohdated, who has taken no active part in their manage- ment. He will of necessity have constantly at his command the expert knowledge of men directly con- cerned with the business. For the sake of simplicity we wiU first consider the process of consolidating two or more small independent partnerships or corporations into a somewhat larger combination of some local importance ; and after that we will consider the still more complicated problems that arise in the process of forming a big "trust "^ — using that word in the popular sense — a combination of previous consolidations. 98. "Discovery" of a small consolidation. — In organ- izing a small consolidation the promoter's first step, as has already been indicated, must be a thorough inves- tigation of all the concerns which are to be included. Usually the promoter will not have the time or the facilities to undertake such an investigation personally or by means of his own assistants. But he should certainly be unwilling to accept the unsupported state- ments of the manufacturers; he will, therefore, use the services of competent engineers, of expert public accountants and perhaps of lawyers. The accountants' examination should produce the most important and significant results, and on these results the terms of the consolidation will probably be based. The accountant's work in this connection should be even more extensive and searching than in the case of a regular audit. This is particularly true because the managers in the case of an audit presumably desire a correct report; in the case of this special investigation their interests lead them to favor over-valuation of assets, fictitious accounts receivable and a padded in- FORMING CONSOLIDATIONS 183 come statement. The accountant must get an accurate physical inventory of the property, if possible ; he must verify the accounts and bills receivable as vi^ell as the accounts and bills payable; he should look into all in- direct and contingent liabilities with great care ; he must see that sales do not include goods sent out "on con- signment" and "on approval" and that profits are not swelled by sales of what are in reality capital, not current, assets. 99. Basis of consolidation. — The promoter's next step, if he is acting not simply on his own account, but as a sort of arbitrator for the various manufacturers, each one of whom is willing to go into the consolidation on reasonable terms, is to draw up a tentative "basis of consolidation." In an article in The Journal of Accountancy for November, 1908, Mr. F. H. Mc- Pherson, F. C. A., gives in illustration the following informal memorandum of agreement which was used as a basis in a certain consolidation of small companies with which he was concerned. The agreement is typical and is well worth careful reading. It is given in fuU below: Basis of Consolidation: A corporation to be formed under the laws of the State of Michigan, with a paid-up capital of ten million dollars, to be apportioned into 6 per cent preferred stock and common stock, as the parties interested may hereafter determine. This corporation to purchase all the assets, property, good- will, etc., of all the four companies and to pay therefor in pre- ferred and common stock and by an assumption of the indebted- ness of each company. The amount of preferred and common stock, to be paid to each company, to be determined by the value of the net tangible assets and the valuation placed upon the earning power of each company. 184 CORPORATION FINANCE In placing a value upon the tangible assets, same to be reached as follows : (1) The land, buildings, machinery, tools, and patterns, to be determined by appraisers, to be chosen by a majority of a committee made up of one appointed by each of the com- panies ; on failure of this committee to agree on appraisers the selection to be left to the committee who present these suggestions. (2) Inventories of raw materials, work in progress and manu- factured stock to be taken, and valuations placed thereon by the individual companies, and this to be done under the supervision of a disinterested party, to be named by the committee. The inventories are to be made as of the same date, and to be taken at substantially the same time. When completed the inventories are to be passed and agreed upon by a committee consisting of a representative of each of the companies and one to be named by the committee. The decision of these five to be binding. (3) In reaching the value of the earning power of the several companies, consideration is to be given to the following de- tails : (a) That profits are incidental to the business and have not been anticipated. (b) To the charging to operating expenses of items, excep- tional or unusual, and which have had the effect of reduc- ing profits below normal. (c) The effect upon the earnings of the money paid out as interest upon borrowed capital, in case it be found that the borrowings (loans) made by the several companies are disproportionate to each other. (d) That all charges to operating expenses are proper charges against the business and that they are made for and during the proper period. (e) That proper and reasonable allowances have been made for repairs and renewals and that these have been charged against earnings. FORMING CONSOLIDATIONS 185 (f ) That charges against earnings for depreciation are ad- justed upon an equitable basis. (g) Such other matters as appear from an examination of the accounts and which would prejudicially affect the earnings of any of the companies, either advantageously or disadvantageously. (h) The value of the earning power to be determined by a consideration of the business done by each of the several companies for the three years, 1903, 1904 and 1905. (i) Accountants to be selected by the committee and ques- tions which may arise as to treatment of various matters and about which there is difference of opinion, to be de- termined by the committee. ( j ) All costs and expenses incurred in making appraisals, ex- amination of accounts, or of performing the other duties in connection with the formation of the proposed new company to be charged to and borne by the new com- pany ; should the new company not be formed, then such costs, expenses, and disbursements to be borne by the four individual companies in proportion to the number of men employed by each. It will be noted that the agreement just cited does not specify just when preferred and when common stock shall be paid by the holding company for the securities of the subsidiary companies. One very common arrangement is set forth in the following extracts from another actual agreement where several fair-sized man- ufacturing corporations and partnerships were to be consohdated. This agreement provided: Each vendor executing this agreement also executes and de- livers a schedule of the entire property, which it sells to said purchaser, setting forth briefly the various classes of property, with the sufficient description of the .several items of real estate, plant and movables to identify the same, which schedule sets forth the value of the entire property so sold, the tangible and 186 CORPORATION FINANCE intangible property in separate items, the tangible property being valued as prescribed by subdivisions a and b in the Method of Appraisal hereinafter set forth, and the value of its intangi- ble property ascertained and certified by one or more responsible public accountants, as prescribed by subdivision c of said Method of Appraisal, together with a statement of any addi- tional facts, and of the valuations based thereon, which, in the vendor's judgment, may aid the Appraisal Committee in exer- cising the discretion conferred upon it by subdivision b of said Method of Appraisal. The valuations of the tangible and in- tangible properties so made by each vendor shall be considered as prima facie evidence of the true value of said vendor's prop- erty for the purposes of sale, but shall in no case be controlling upon the Appraisal or Executive Committee hereinafter ap- pointed, such valuations or prices being subject in all cases lo any investigation and modification which the said committee or committees may deem that justice requires; the total of such valuations as verified or modified according to the, terms of this agreement, to be the purchase price which said vendor is to re- ceive for its entire property so sold. PURCHASE PKICE The purchase price to be paid to such vendor for the property sold by it to the purchaser shall be the total value of its tangible and intangible property and shall be paid in stock of the pur- chaser at par, as follows : — 1. Tangible property paid for in preferred, etc. Each vendor whose net earnings for the six months ending July 1st, 1898, amount to 4 per cent — that is, at the rate of 8 per cent per annum — on the value of its land and plant, ascertained as above, shall receive preferred stock for the full value of all its tangible property. Any vendor whose net earnings for the said period of six months shall amount to less than at the rate of 8 per cent per annum on the value of its land and plant, shall receive pre- ferred stock to the amount of twenty-five times its net earn- FORMING CONSOLIDATIONS 187 ings for said six months; and the balance of the value of said tangible property it shall receive in common stock. Each vendor has upon its schedule set forth a statement of its net earnings for said period, which is subject to modification by said committee under the above rules applicable thereto. 2. Intangible property paid for in common stock. The entire value of the intangible property, ascertained as per this agreement, shall be paid by the purchaser in its com- mon stock at par. Simultaneous with the sale and transfer of its properties each vendor shall receive from the purchaser in stock, or if permanent certificates are not ready, then scrip for the same, one-half of the purchase price to which it claims to be entitled by its schedule, less an amount of preferred stock equal to 125 per cent of its mortgage indebtedness, if any, and the re- mainder of said stock shall be withheld by the purchaser until the exact amount of the purchase price shall have been finally determined as herein provided, whereupon the vendor shall be- come entitled to the remainder of the purchase price, but the purchaser may out of such remaining stock retain an amount thereof sufficient to secure it against any defective title and against any indebtedness which is not otherwise sufficiently pro- vided for. APPKAISAL, ETC. Each vendor expressly covenants and agrees that the prop- erty set forth by it in its schedule has been fairly and honestly valued in accordance with the following rules and methods, which shall be the rules and methods to govern the Appraisal and Ex- ecutive Committees in their verification or modification of the same. METHOD OI" APPRAISAL. ( 1 ) Tangible Property, (si) Land: Land shall be separately appraised at its actual value without reference to plants thereon, and consideration shall be 188 CORPORATION FINANCE given to special adaptability or want of adaptability to the busi- ness. Plants shall be appraised apart from the bare land at their value to-day to a going concern for the purpose for which used, based upon present cost of construction at the same places re- spectively. No vendor shall set forth in its schedule any unim- proved land or other property belonging to it which is neither a part of the plant of such vendor nor essential in the operation of the same, nor shall the same be purchased by the second party. (b) Materials, Supplies and Manufactured Product. These shall be appraised at what it would cost to replace the same at the place and date of the transfer of the same to the purchaser. (2), Intangible Property. (c) Intangible property shall be appraised by multiplying by ten the average yearly earnings during the past five and one- half years, which shall be ascertained as follows : — In order to arrive at the earnings of the property sold by each vendor and to determine on a uniform basis fair for all, the earning power of the property so sold, each vendor shall add to its net profits such of the following items as have been thereto- fore deducted by said vendor in ascertaining its net profits dur- ing said period. 1. Interest on indebtedness. 2. Insurance of any description. 3. Arbitrary items of depreciation or wear and tear not paid out or actually incurred as a debt, and all items of new con- struction. 4. Also salaries and compensation paid to officers, directors, partners, trustees, superintendents of departments or works, gen- eral managers, auditors, cashiers and chief accountants, but all wages, salaries and compensation paid to laborers, servants, fore- men, clerks and employees in subordinate positions shall remain charged against earnings. 5. The accountants must ascertain the amounts expended by each of said vendors for repairs, renewals and maintenance of plant which have been deducted from earnings during said period FORMING CONSOLIDATIONS 189 of five and one-half years, and the said amounts so ascertained are set forth on the schedules of said vendors. In order to place said vendors on a uniform basis as to the amounts expended, or which ought to have been expended, for repairs, renewals and maintenance of plant and charged against or deducted from the earnings during said five and one-half years or other period, each vendor shall add to said earnings any amount actually expended by it for repairs, renewals and main- tenance of plant which it has heretofore charged against and deducted from said earnings, and there shall then be charged against and deducted from said earnings of each vendor ascer- tained as aforesaid, annually a sum equal to 3 per cent of the schedule value of the plant of said vendor completed prior to the last date of the five and one-half years or other period ap- plicable to said vendor. In the case of those vendors, if any, which shall not have kept a separate repair account the amounts expended by them for repairs, as required by this subdivision shall be ascertained as nearly as possible by the accountants and the committee of ap- praisal from the books of such vendors and from the condition of their plants and otherwise, and in default of information to the contrary it shall be assumed that they have expended in re- pairs a sum equal to 3 per cent of the value of their respective plants. Having by the foregoing methods, ascertained the earnings, there shall thereupon be deducted from the average annual earn- ings of each vendor for said period, a sum equal to 5 per cent (5%) of the value of the land and plant sold and completed prior to the last date of the five and one-half years or other period applicable to such vendor, and the balance of said aver- age annual earnings so ascertained shall be deemed for the pur- poses of this agreement the net profits of the respective vendors to be severally multiplied by ten as aforesaid. Provided, however, that in case it shall be found that the aforesaid multiplier of ten will produce a grand aggregate of common stock greater in amount than the grand aggregate of preferred stock, the Executive Committee shall choose such 190 CORPORATION FINANCE lower multiplier as will limit the grand aggregate of preferred stock. Provided, further, that in the event that the grand aggregate of the average annual net earnings of the vendors, ascertained as aforesaid, shall be found to exceed 12 per cent of the total value of the tangible property, then said Executive Com- mittee in its discretion may choose such multiplier as will fix the volume of common stock as closely as may be at an amount upon which such past net earnings would show 6 per cent applicable to dividends upon such common stock after providing for the dividend on the preferred stock. And thereupon such newly chosen multiplier (whatever the same may be) shall be the multiplier to be used in the case of each vendor. The agreement that has just been cited in part de- serves careful study. As the extracts given are self- explanatory, however, it wiU be left to the reader to work out for himself the exact methods employed by the pro- moters, and accepted by the owners of the plants in determining values. The substance of the plan, it will be seen, is that tangible property is to be represented by preferred stock in the consolidation and additional earning power by common stock. This puts the consol- idation, so far as capitaUzation is concerned, on a con- servative basis. The same plan, slightly modified, is widely used. 100. The necessity for cash. — Having investigated and assembled his proposed consolidation, the promoter must next arrange for its financing. It may be said at this point that the basis of consolidation in itself finances the new consolidation, inasmuch as it provides for the exchange of the consolidated company's securities for the subsidiary companies' securities. This financing is not sufficient, however, to provide for the needs of the FORMING CONSOLIDATIONS 191 new corporation. Working capital, to a considerable amount, must certainly be obtained or the new corpora- tion will plunge at once into bankruptcy. Further- more, a consolidation almost always implies changes in methods of operation. New officers must be appointed, old ones dismissed. Some of the plants perhaps will be dismantled or put on part time; other plants will be remodeled and refitted with expensive modern machin- ery. Frequently the whole arrangement of the plants and processes of manufacture will be reformed in order to introduce the methods that belong to large scale production. All of these changes may be necessary in order to obtain the economies that belong to combina- tions. They may and probably will prove wise and in the end highly profitable. At the moment of forming the consolidation, however, they call for large amounts of new capital funds and bring to the front some of the most difficult problems of financing which a promoter has to face. 101. One method of raising cash. — Following the basic principles outlined in Chapter XII, the promoter of a small consolidation will endeavor to raise whatever cash is necessary first of all from local bankers and financiers. If he succeeds in obtaining the co-opera- tion of these men, he is much more likely to find his proposition regarded favorably by larger banking in- terests. Two courses are now open to him: either he may issue bonds of the new company, which will not be first mortgage, but which he may name "first and refunding" or "first general" or "first consolidated" ; or he may try to sell stock in addition to that which has been given to the owners of the consolidated plants. Either course has its disadvantages. The bond issue probably cannot be sold on advantageous terms because 192 CORPORATION FINANCE the consolidation must necessarily be an experiment at the beginning and even its best securities will have a speculative character. Furthermore, in many cases the promoter will find the property of the subsidiary com- panies already mortgaged so that the bonds of the con- solidated company, whatever title he may pick out for them, will be in reality junior liens. The sale of stock is undesirable because the stock issue in all probability is already large; it has to be large in order to make the terms offered to the owners of the subsidiary plants sufficiently attractive. If still more stock is issued to be sold to the public, it will be very difficult to pay dividends even on the preferred, not to speak of the common. This result, the promoter certainly does not desire. He has promised usually heavy cumulative dividends at once on the preferred stock and has held out hopes of early dividends on the common, and his reputation is staked on the fulfillment of these predic- tions. Moreover, he is himself usually a large holder of the common stock. On balancing these considerations, the promoter usually finds himself strongly inclined to favor the sale of bonds if they can be sold at any reasonable price. His sanguine temperament — for that kind of tempera- ment naturally belongs to a promoter — leads him to minimize the danger of increasing the new corporation's fixed charges and to exaggerate the probable profits. He therefore turns to local bankers for assistance in borrowing the necessary funds. Frequently, as the first step, he has the corporation put out a bond issue under a mortgage of the limited open-end type. The pro- vision may be, and often is, that of the total issue one- half shall be off'ered for sale in the first year, one-fourth in the second, and one-fourth in the third year ; of course, FORMING CONSOLIDATIONS 193 the length of time over which the S3,le is spread and the corporation's allotment each year may vary indefinitely, depending on the urgency of the company's need for cash. He then obtains a guarantee from local finan- ciers, including perhaps some of the banks, to take the xmsold bonds at the end of each period from the corpora- tion at a low price which is specified. By this guarantee the corporation is protected from an absolute failure to secure cash. The guarantors must, of course, be paid, usually by a considerable commission on all the bonds that are sold. This kind of an arrangement, which we wiU consider at greater length later, is known as under- writing. The promoter may now take his bond-issue — or part of it, if he has been able to get the sale of only a part guaranteed — ^to a friendly bank and secure a short- time loan, using the bonds as collateral security. He has thus provided for the immediate cash necessities of the new company at the beginning of its existence. As fast as he can sell the bonds, he pays off the bank loans and thus puts the corporation in a stronger financial position. If the issue is entirely successful, the corpo- ration will soon have plenty of cash, obtained by this bond issue, and will be able to carry out the improve- ments in operation which are expected to make the consolidation a profitable venture. The essential feature of this plan, it will be noted, is the distribution of the risk among several different parties. The bank is well protected in accepting the bonds as collateral by the guarantee of responsible parties to buy the bonds at the end of a certain period, if no purchaser willing to pay a higher price is pre- viously found. The guarantors usually take little risk, for the price of the bonds to them is made low enough to VI— 13 194 CORPORATION FINANCE be attractive. The corporation obtains at once what- ever cash is necessary and its only risk is that it may have to sell its bonds to the guarantors at a low price. Naturally the promoter in the period left to him before the guarantors' option becomes effective does his best to sell the bonds at a good price. The methods which he uses and the agencies through which he works are fully treated in 'later chapters. 102. Problems in forming a large consolidation. — There is no difference in principle between the pro- moter's functions in forming a small and his functions in forming a large consolidation. He is doing things on a bigger scale, however, and finds necessary several important variations in his methods. In the first place, such a consolidation is ahnost always too large to be handled by any one man. In order to reach all the parties concerned and to inspire confidence, it is generally desirable for several promoters to work together, each performing a portion of the labor. When the United States Steel Corporation was formed, as described in the following chapter, almost all of the prominent, successful promoters of the country were concerned in one way or another. Apart from the necessity of dividing the work to be performed, it is very desirable to promote harmony and secure the best solu- tions of the difficult and complicated problems involved in such a consolidation by getting the ideas of a con- siderable number of able and experienced men. In the second place, the promoter or group of pro- moters is dealing with such a large number of security owners of subsidiary companies that lengthy consulta- tion with these owners and bargain-making is out of the question. Usually the heavy stockholders in the subsidiary companies are consulted and frequently they FORMING CONSOLIDATIONS 195 have some part in the scheme of promotion. The great mass of stockholders, however, are simply notified, when the proper time comes, of what is proposed and are in- vited to accept the offer which the promoters lay before them. 103. Basis of consolidation. — The amount and char- acter of the security issues of the proposed consolidation, and the terms upon which these securities will be exchanged for the securities of the subsidiary companies, are fixed by the promoters in advance. This does not mean that the terms are unfair to the subsidiary com- panies' stockholders. On the contrary, they are usually extremely liberal. It must be remembered that it is very desirable for the holding company to have all the stock — certainly all the voting stock — of each sub- sidiary. The less subsidiary company stock there is left outstanding, the less is the chance of complaint and annoying legal processes on the part of the dissenting stockholders against the actions of the holding company. The promoters, therefore, try to oflTer such terms that all, or almost all, the stock of subsidiary companies will be exchanged for stock of the consolidation. The usual arrangement is to divide the capital stock of the consolidation into preferred and common, the amount of the preferred being equivalent to the total- market value of all the subsidiary company stock. Practically any amount of common stock may be issued; the promoter usually puts out as much as he thinks can possibly obtain dividends within a reasonable number of years. The stockholders of the subsidiary companies are then oiFered somewhat more than the market value of their stock payable in cash, or consid- erably more than its market value payable in preferred stock. If they take preferred stock, they will ordinarily 196 CORPORATION FINANCE receive in addition a substantial bonus of common stock. The first proposition is intended to catch the ultra-con- servative; the second proposition is intended to be even more attractive. The stockholder is to receive in place of his present holding, h'aving a fluctuating and uncer- tain dividend, a more than equal amount of stock preferred as to dividends, and in addition a considerable amount of the new common stock. Very few stock- holders are hkely to refuse so attractive an offer. The apphcation of these principles is well illustrated in the promotion of the biggest and one of the most successful consolidations that has yet been formed, the United States Steel Corporation. So important is this great company, not only in connection with our present study of corporation finance, but in its infiu- ence on industry in this country, that it has been thought best to devote a separate chapter to a review of its origin, its promotion, its financial history and its prospects. 104. The Interborough-Metropolitan Consolidation. — Another typical consolidation which was formed under very different conditions is the Interborough-Metropol- itan Company, the hplding company for the transporta- tion companies of New York City. A chart showing the compUcated internal organization of the company has been presented in Chapter VI. The terms of the consolidation are clearly set forth in the following ex- tract from a lecture by Albert W.* Atwood, Financial Editor of the New York Press and Lecturer on Invest- ments in New York University. 1. Companies Taken Over. Metropolitan Street Railway $ 52,000,000 stock Metropolitan Securities Co. 30,000,000 " Interborough Rapid Transit Co. 35,000,000 " $117,000,000 FORMING CONSOLIDATIONS 19T 2. jCapitalization of Inter-Met. Bonds $ 70,000,000 Preferred Stock 55,000,000 Common Stock 100,000,000 Total $225,000,000 Deduct 117,000,000 Excess $108,000,000 3. Basis of Exchange. Interborough — one share received $200 bond and $99 conmion stock in the Inter-Met. Metropolitan Street - — one share received $100 pre- ferred and $55 common in the Inter-Met. Metropolitan Securities ■ — one share, $75 paid up, re-- ceived $93.50 common in the Inter-Met. The Interborough-Metropolitan took over practically all the capital stock of the subsidiary companies. In 1902 the Metro- politan Street Railway, which had been the company which con- trolled and operated the surface lines, ran short of money and a scheme was devised to keep it going by leasing it to the New York City Railway (which had a comparatively small amount of stock) the stock of which was in turn all taken over by the Met- ropolitan Street Railway shareholders. By getting a large ma- jority of the stocks of the Metropolitan Street Railway and the Metropolitan Securities Company the Inter-Metropolitan got control of the entire surface system and by securing the stock of the Interborough Rapid Transit it got control of the subway and elevated lines. The total of securities taken over was about $117,000,000 and the new company issued $225,000,000 of securities. The excess capitalization was $108,000,000, which in view of the fact that many believed the surface lines were already waterlogged, was a remarkable piece of finance. Three reasons are advanced for the excess capitalization : 1. The promoters say they honestly believed that within two or three years the common stock would be earning 2 per cent. 2. The merger was formed at the height of the business and 198 CORPORATION FINANCE financial boom of 1906 and at that time the later financial and business reaction was not generally foreseen. 3. The holders of the securities of the old companies had to have an inducement to exchange their securities for the new ones. In other words, they had to be hypnotized into believing that they were getting something for nothing. Much was made of the growth of the passenger traffic in New York and the official prospectuses declared the common stock of the new combine would certainly be able to pay dividends in time owing to the growth of population. These two illustrations will serve to indicate the gen- eral practice in exchanging a consolidated company's securities for those of the subsidiary companies. It may be observed that the steel consohdation was far more conservative than was the Interborough-Metro- politan consolidation. The second-named company was in a dangerous situation from the very beginning, for it was compelled to pay regular interest on its large bond issue or go into receivers' hands. The steel corporation gave only a small amount of bonds — ^rela- tive to its total capitalization — and consequently was not in serious danger of insolvency. Even if it had failed to pay interest on its preferred stock it would not have been forced into a perilous position. The Interborough- Metropolitan financing was on its face so unsound as to arouse the suspicion that this particular consolidation was never intended to succeed. CHAPTER XV THE UNITED STATES STEEL CORPORATION 105. Preparing the ground. — 1890 to 1900 is an im- portant decade in the history of the steel business of the United States. Between 1890 and 1893 production was vastly increased, while the demand for iron and steel products practically stood still. As a result, prices were declining and a majority of the steel producers were in a precarious situation even before the severe crisis of 1893 began its work of destruction. The crisis hit the steel makers especially hard, and wiped out many of the small concerns. In the five years of depression that followed, individuals and partnerships as factors in steel production almost disappeared; their places were taken by comparatively large and strong corporations. These corporations not only managed to live, but even to thrive in a way, because they were able to buy new plants and enlarge old ones at bargain prices. By the year 1898 in all branches of the steel industry, including bar iron, rolled iron, steel rails, sheet steel, tin plate, wire, and other more highly finished products, a considerable number of fairly efficient and well-managed corpora- tions, which had grown in strength during the depres- sion, were prepared to handle the flood of new business that was expected to come with the revival of good times. The flood came and with it such a rise in prices and a deluge of profits as would have seemed inconceivable two or three years before. Steel, in Andrew Carnegie's picturesque phrase, is either "a prince or a pauper." 199 200 CORPORATION FINANCE The reason is that, as large amounts of fixed capital must be invested, the supply of steel products cannot easily be increased or decreased ; whereas, as steel is not a prime necessity, the demand fluctuates violently. In other words, since supply and demand do not move up and down together, prices and profits jump from one extreme to the other with extraordinary rapidity. 106. The steel consolidations preceding the forma- tion of the United States Steel Corporation. — In 1898, then, American steel makers had reached a higher level of prosperity than ever before and were moving rapidly upward ; the business was carried on by a comparatively few fairly strong corporations in each hne; at the same time, public interest in the advantages of industrial com- binations and in their supposed opportunities for great profits was keen and the public appetite for the securi- ties of such combinations, or "trusts," had been excited. Placing these three factors together, we see why the three years following, 1898-1901, were marked by a remarkable series of steel consolidations. We cannot take time here to tell the stories, interesting though they would be, of these consolidations. For our purpose it will be enough to name the important steel companies in existence in 1900. 1. The Federal Steel Company was formed in Sep- tember, 1898, by combining the Ilhnois Steel Company, the Minnesota Iron Company, and the Elgin, Joliet and Eastern Railroad. Its authorized capital was $200,- 000,000, of which, however, only $99,700,000 was ever issued. 2. The American Steel & Wire Company was organ- ized by John W. Gates in March, 1898. It was big enough to control virtually the entire production of wire goods. Its capital was $90,000,000. THE UNITED STATES STEEL CORPORATION 201 3. The National Tube Company, formed in Feb- ruary, 1899, included over a dozen companies. It was the largest concern of its kind in the world and at the time the third largest concern in the iron and steel busi- ness, being surpassed only by Carnegie and Krupps, of Germany. 4. The National Steel Company, the American Steel Hoop Company, the American Sheet Steel Company and the American Tin Plate Company were organized in the period from December, 1898, to March, 1900, by Judge W. H. Moore, his brother, James H. Moore, Daniel G. Reid, William B. Leeds, and others who were later given the titles "Moore Party" and "Rock Island Crowd." Of these concerns the largest was the Tin Plate Company, which was a consolidation of forty companies, embracing about 95 per cent of the total output of tin plate in the United States. 5. The biggest and most powerful company of all. The Carnegie Company, was not a consolidation, but a growth. This great concern had been built up by the consistent policy, extending over many years, of putting most of its earnings into improvements instead of into dividends. The organizing genius of Carnegie, Frick, Phipps,and their co-workers, had made ils body of work- ingmen the most efficient and its enormous plant the most economical in the world. Through its control of the H. C. Frick Coke Company, the Oliver Mining Company, the Pittsburg Steamship Company and the Pittsburg, Bessemer & Lake Erie Railroad, together with its fifty-year contract with the Rockefeller iron, mining and transportation companies, its supply of raw materials at low cost was assured for many years to come. 107. A condition of unstable equilibrium.. — In one of 202 CORPORATION FINANCE the most brilliant chapters in his well-known volume on "Trust Finance" Professor E. S. Meade has well de- scribed the conditions in the steel business in 1900. In- dustrially the situation might be said to be one of un- stable equilibrium. It might have been expected that all of these consolidations would have been content to enjoy the prosperity, which was being showered upon steel makers, and would have desisted from intense com- petition with each other. Ordinarily competitive strife awakens in periods when business is stagnant and miUs idle, while harmony is readily secured so long as orders are outrunning production. This would, in fact, have been the happy situation in the steel trade if it had not been for the appearance of a powerful new factor, the tendency toward integration. "Integration" is the economist's technical word for the control by one concern of the whole process of production from the raw material to the finished product. Ordinarily the manufacture of any finished article, say a tin can, is carried on through several stages, and at each stage passes from one group of producers to another group. In making the tin can iron ore must be mined ; the miner sells his ore to a manu- facturer who transforms it first into iron and next into steel; this manufacturer sells his product to a manufac- turer of sheet steel, who in turn passes it on to the manu- facturer of tin plate ; finally the can manufacturer buys the tin plate and forms it into tin cans. At each stage of such a process there is a sale of the partly finished product and a profit is taken that enters into the final cost of production. Under the policy of integration, according to which all these stages are combined under the control of one great manufacturing concern, a two- fold advantage is gained; first, the intermediate profits are all secured; second, a permanent, dependable supply THE UNITED STATES STEEL CORPORATION 203 of raw materials at lowest costs is assured. This second advantage is even more important than the one first named. The Carnegie Company in 1900 up to a certain point was an integrated company; that is, it controlled great quantities of ore and coal, owned its own steamships and railroads for the transportation of these raw materials to its Pittsburg plants, and at the Pittsburg plants turned out steel rails and a large variety of half -finished products. It was partly for this reason that the com-, pany had become so strong and prosperous. Neverthe- less, it was by no means wholly independent, for its chief customers were the other steel companies in the Pitts- burg district which purchased its steel billets, ingots, bars, plates and slabs. The Federal Steel Company, also, was "integrated" up to a certain point, but like the Carnegie Steel Company was by no means independent of its large customers. A large part of its business consisted in furnishing wire rods to the American Steel and Wire Company and steel billets to the National Tube and the American Bridge Companies. The Na- tional Steel Company, a much smaller concern, furnished part-finished products to the other Moore companies, the American Tin Plate, American Sheet Steel, and Ameri- can Steel Hoop. The group of producers of finished steel products were by no means satisfied with their position. They desired to secure the advantages of integration for them- selves ; particularly they were anxious to free themselves from the domination of the concerns on which they were dependent for raw materials. Therefore, all of these companies in 1898, 1899 and 1900 were planning to pur- chase ore and coal lands, to get control of transportation companies and to construct furnaces and mills for the 204. CORPORATION FINANCE manufacture of part-finished steel products. The American Steel and Wire Company bought two thou- sand acres of Connellsville coal land and large ore prop- erties. It already had partially under its control a fleet of twelve ore steamers. It now announced its intention to build large steel plants at Milwaukee and Pittsburg. The National Steel Company purchased iron mines and coal land and started to increase its furnace capacity. The National Tube Company began work on a large steel plant at Wheeling, West Virginia. The completion of these projects meant heavy loss to the Carnegie Company and the Federal Steel Company. They were forced to fight back. The Federal Steel Company threatened to build wire mills unless the American Steel and Wire Company should abandon its proposed Milwaukee plant, and the threat for the time being proved eff'ective. The Carnegie Company an- nounced that it would construct a large tube miU at Conneaut, Ohio, and let it be understood that it would not hesitate to enter into active competition with all the producers of finished goods. There was no doubt in the minds of those who knew Andrew Carnegie but that these plans would actually be carried out. They recalled that "the wild Scotchman" had been successful in even more daring schemes. The situation was full of dangers. The prosperity of the steel makers could not continue through the bitter competitive war that seemed to be in prospect. The officials of the Carnegie Company apparently were not seriously worried, for they felt confident of the ability of their organization to finance and make highly profit- able in the end whatever new construction might become necessary. The officials of the other great companies, however, were not so complacent. AU of the large con- THE UNITED STATES STEEL CORPORATION 205 solidations were capitalized, as we shall see, up to the limit of their earning power, and their stock had been sold on the promise of large and regular dividends. Moreover, large amounts of the stock were still owned by the original promoters and underwriters. The man- agers, therefore, were far from eager to enter into a regime of severe competition. Under these conditions the suggestion that an immense holding company, the greatest trust in the world, be formed was favorably received. It furnished the only possible peaceful so- lution of the pending problems. The strongest finan- cial houses, as well as the largest steel companies, were committed in advance to this plan, because it was the only means of protecting them from severe loss. 108. Method of promotion. — The promotion of the United States Steel Corporation was not, for the reasons that have been given, an especially difficult task. The chief obstacle was overcome when men of sufiicient breadth, imagination and ability to form a clear con- ception of what was to be done had been found. So stupendous an undertaking could only be carried out by the giants of the financial, the industrial and the legal worlds. Fortunately for the project, the right men were at hand and were interested in its success; above all, the active support of Mr. J. P. Morgan, the most forceful personality in Wall Street, did more than anything else to make the plan practicable and ultimately successful. The details of the promotion of the United States Steel Corporation have never been disclosed. Long in- vestigation was not as necessary as in most promotions for the reason that the promoters were familiar at first hand with the concerns to be consolidated. The plan at first, it is known, was to combine only the great com- 206 CORPORATION FINANCE panics; the Carnegie Steel Company, Federal Steel Company, National Tube Company and the American Steel and Wire Company. The potential competition, however, of the four Moore companies looked so threat- ening that they also were brought into the combination. Certain other large companies, such as the Jones and Laughhn Steel Company, of Pittsburg, were ap- proached, but no terms were agreed upon. The United States Steel Corporation filed its certifi- cate of incorporation in New Jersey on February 23, 1901, showing a capitalization of $3,000. Under its amended certificate of April 1, 1901, however, its capi- talization was changed to $1,100,000,000, one-half common and one-half preferred. The charter, it may be noted, gives discretion to the board of directors to in- crease its capital stock. 109. Prospectus of the corporation. — In the light of the later history of the company and as an example of scientific prospectus-making, some extracts from the prospectus issued by the firm of J. P. Morgan and Company are given below. The reader should note how carefully each positive statement is qualified and how much more is implied as to prospective profits than is actually said. Yet the prospectus cannot be called misleading. If it is read as carefully as it was written, it will be found not only to contain technically accurate statements, but to give a correct impression as weU. The difficulty comes in the fact that comparatively few persons are capable of giving it a careful reading. The prospectus also contains a sufficient account for our pur- pose of the basis of consolidation. A syndicate, comprising leading financial interests through- out the United States and Europe, of which the undersigned arc THE UNITED STATES STEEL CORPORATION 207 managers, has been formed by subscribers to the amount of $200,000,000 (including among such subscribers the under- signed and many large stockholders of the several companies), to carry out the arrangement hereinafter stated, and to provide the sum in cash and the financial support required for that pur- pose. Such syndicate, through the undersigned, has made a contract with the United States Steel Corporation under which the latter is to issue and deliver its preferred stock, and its common stock, and its 5 per cent gold bonds in consideration for stocks of the above-named companies and bonds and stock of the Carnegie Company and the sum of $25,000,000 in cash. The syndicate has already arranged for the acquisition of substantially all the bonds and stock of the Carnegie Company, including Mr. Carnegie's holdings. The bonds of the United States Steel Corporation are to be used only to acquire bonds and 60 per cent of the stock of the Carnegie Company. The syndicate offers for each $100 par value of stock of the class mentioned below, the amount set opposite thereto in pre- ferred stock or common stock of the United States Steel Cor- poration at par: Name of company and class of stock. Amount of new stock to be delivered in par VALUE. Preferred Common Stock Stock Federal Steel Company : Preferred stock ,. . $110.00 Common stock 4.00 $107.50 American Steel and Wire Company of New Jersey: Preferred stock . 117.50 Common stock 102.50 National Tube Company : Preferred stock 125.00 Common stock . ., 8.80 125.00 208 CORPORATION FINANCE National Steel Company: Preferred stock . . . .' 125.00 Common stock 125.00 American Tin Plate Company: Preferred stock 125.00 Common stock 20.00 125.00 American Steel Hoop Company : Preferred stock 100.00 Common stock 100.00 American Sheet Steel Company: Preferred stock 100.00 Common stock 100.00 With reference to the last four companies, the aggregate amount of stocks so to be offered was arranged with the princi- pal stockholders of those companies, who have requested the dis- tribution of such amount among the four companies, to be made in the percentages above stated. Statements furnished to us by officers of the several companies above named and of the Carnegie Company show that the aggre- gate of the net earnings of all the companies for the calendar year 1900 was amply sufficient to pay dividends on both classes of the new stocks, besides making provisions for sinking funds and maintenance of properties. It is expected that by the con- summation of the proposed arrangement the necessity of large deductions heretofore made on account of expenditures for im- provements will be avoided, the amount of earnings applicable to dividends will be substantially increased, and greater stability of investment will be assured, without necessarily increasing the prices of manufactured products. All shares of the United States Steel Corporation deliverable to or for account of the syndicate, which shall not be required for the acquisition of the stock of the Carnegie Company or for delivery to depositors under terms of this circular, are to be retained by and to belong to the syndicate. It is proper to state that J. P. Morgan & Co. are to receive no compensation for their services as syndicate managers be- THE UNITED STATES STEEL CORPORATION 209 yond a share in any sum which ultimately may be realized by the syndicate. J. P. Morgan & Co., Syndicate Managers. 110. Profits of the promoters. — The sum which ulti- mately was realized by the syndicate was never made public, but it is easy to figure that it must have been in neighborhood of $240,000,000, face value, of common stock, against which should be off -set $25,000,000 cash furnished by the syndicate and the expenses of promo- tion. Assuming that the common stock was sold by the syndicate members at an average price of thirty, which is probably lower than the actual average, we have gross profits of $72,000,000. Deducting the $25,000,000 and assuming expenses to have been $1,000,000, we have left net promoters' and underwriters' profits of $46,000,000 — a huge sum and yet not too great, considering the risk and the financial power and ability required in the unprecedented undertaking. The provision of cash by the syndicate was a somewhat unusual method of meeting this part of the financial problem involved in promoting a consolidation. 111. Capitalization at the beginning. — It is worth noting that the $160,000,000 Carnegie stock obtained in exchange $98,000,000 preferred stock, $90,000,000 common stock and $144,000,000 bonds of the Steel Cor- poration. In addition $160,000,000 Carnegie bonds ob- tained an equal amount of United States Steel collateral bonds. Thus the par value of the stocks and bonds given to Carnegie Company security holders was nearly one-half billion dollars, more than one-third the total capitalization of the corporation. The aggregate capi- talization of the other seven original companies was $457,000,000 and the par value of Steel stock given in VI— 14 glO CORPORATION FINANCE exchange was $532,000,000, an increase of $75,000,000. The terms of exchange were so hberal that 98 per cent of the stock of the original eight companies was acquired. Shortly afterwards two other companies were taken in, namely: 1. The American Bridge Company which had been formed in April, 1900. This company had absorbed twenty-six separate concerns and embraced over nine- tenths of the bridge-building interests of the United States. 2. The Lake Superior Consolidated Iron Mines Com- pany, which owned and operated valuable mines in the Mesaba range of the Lake Superior iron region. Practically all the securities of the Lake Superior Company were acquired and 85 per cent of the stock of the American Bridge Company. The capitalization of the United States Steel Corpo- ration at the end of the first year was as follows : Capital Stock, Preferred $ 510,281,100.00 " " Common 508,302,500.00 Capital Stock of Subsidiary Cos., outstand- ing 215,914.38 U. S. Steel Bonds 303,757,000.00 Other bonds , 56,997,326.00 $1,379,553,840.38 The figures following will give some idea of the enormous extent of the steel corporation's property at the beginning: 213 different plants and transportation companies; 41 mines; nearly 1,000 miles of railroad; a lake fleet of 112 vessels which constituted one-third total tonnage of Northern Lakes; controlled 78 blast fur- naces, one-third of the number in United States ; owned THE UNITED STATES STEEL CORPORATION 211 57,000 acres of coking coal land; leased 50,000 acres Pocahontas Coal land, W. Va.; owned considerable areas of steam and gas coal in Illinois. The most im- portant assets of all were the ore deposits in the Lake Superior region, which were estimated by Mr. Schwab at 750,000,000 tons. 112. Additions. — The principal additions to the steel corporation have been: 1— Shelby Tube Co. . 1901 2— Union Steel Co 1902 3 — Holdings of Chemung Iron Co., Duluth 1903 4 — Properties of Clairton Steel Co 1904 5 — Lease of Hill holdings in Lake Superior Region .... 1906 6 — Tennessee Coal, Iron and Railroad Company 1907 The Shelby Steel Tube Company was a small and greatly over-capitalized concern which was, however, the largest maker of seamless tubing in the world. The Union Steel Company was a consolidation of seven coke-mining, sheet steel, tin plate and steel com- panies in and near Sharon, Penna. The Chemung Iron Company was a Detroit concern which owned a large and important block of Mesaba ore deposits. The Clairton Steel Company was a Pittsburg concern which owned a large plant, 2,600 acres of coking coal land, 20,000 acres of mineral lands in the Marquette Range and considerable railroad and limestone proper- ties. On April 15, 1907, the notable lease of the Hill ore lands was ratified. The lease provides that a royalty of $1.65 per gross ton for ore of a fixed grade was to be paid in 1907 and the royalty increased 3 4-10 cents per ton each succeeding year. The minimum to be mined 212 CORPORATION FINANCE and shipped was 750,000 tons in 1907 and was to in- crease 750,000 tons per year until it reached 8,250,000 tons. The option was reserved, however, to the Steel Corporation to end the lease in 1915, and in 1912 the ap- proaching termination of the lease was announced. In November, 1907, the corporation acquired about $30,000,000, or practically all, of the outstanding com- mon stock of the Tennessee Coal, Iron and Railroad Company. The stock was paid for at the rate of $11,- 904.76 par value of the 10-60 year sinking fund 5 per cent bonds of the steel corporation for $10,000 par of Tennessee common. Many readers no doubt will recall the circumstances surrounding this deal. It was made possible by the ability of the Steel Corporation to put up ready cash in the critical time of the October, 1907, crisis. The cash was used to buy in the Steel Corpora- tion's own bonds with which to pay for Tennessee stock. The operation thus had a double effect of supplying cash to persons who needed it badly, and of supplying a security, which was acceptable as collateral, in place of the unavailable Tennessee stock. The Tennessee Company owned 16 blast furnaces, 450,000 acres of coal, ore and limestone and timber lands, large developed coal mines and a big steel rail mill at Ensley, Ala. Besides these large purchases the steel corporation has also increased its holdings by building out of its earnings an entirely new plant. At Gary, Indiana, there has been erected a large modern steel rail mill at a cost of $75,000,000. The mill began operations in 1909. The Gary tract covers about 9,000 acres, of which 1,163 acres are devoted to the plant. The cost was nearly $80,000,000. This new plant was called for by the great increase in the western demand for steel. THE UNITED STATES STEEL CORPORATION 213 113. Financial changes.— The chief event in the financial history of the Steel Corporation is its much discussed preferred stock conversion of 1902. In April of that year the management issued a circular to stock- holders saying that $50,000,000 new capital was needed, one-half for redemption of temporary loans incurred by constituent companies and one-half for improvements. The plan proposed was to create a new issue of $250,- 000,000 5 per cent bonds, of which $200,000,000 was to be exchanged, dollar for dollar, for an equal amount of preferred stock and $50,000,000 was to be sold for cash. Each preferred stockholder was offered the right to sub- scribe to the extent of one-half his holdings, paying 40 per cent in stock and 10 per cent in cash, or to the extent of 40 per cent of his holdings, paying in stock alone. The argument urged for this plan was that the $50,000,- 000 would be raised and yet an annual saving in the company's charges of $1,500,000 would be effected. To this plan 99 8-10 per cent of the stock voted at the annual meeting assented. The plan was objectionable, however, to certain stock- holders for the obvious reason that a new issue was cre- ated superior to their own security without any corre- sponding enhancement in the value of the corporation's assets. The plan was further objectionable in that the issue was to be underwritten by a syndicate which in- cluded some of the corporation's directors. The syndi- cate agreed to take enough of the bonds to bring the total sale up to $100,000,000.^ In return they were to have the privilege of subscribing to any or all of the bonds not taken by the stockholders and they were to get a 4 per cent commission on all the bonds sold to the stock- holders or otheiTvise. It was objected that under this 1 See a copy of the agreement in Chapter XIX. 214 CORPORATION FINANCE agreement the syndicate took a very slight risk inasmuch as it was practically certain that at least $100,000,000 worth of bonds would be sold, and got an excessive com- mission. The objections on this score were never satis- factorily answered. The opponents of the conversion plan secured a tem- porary injunction and brought suit to restrain the di- rectors from carrying out the plan. The decisions of the court, however, were in favor of the Steel Corpora- tion management, on the ground that no fraud was shown and that the great majority of the stockholders had approved the issue. The danger of disaster to the corporation, on account of its great increase in bonded obligations, is somewhat lessened by the fact that the interest on these sinking fund 5's must lapse for two years before foreclosure proceedings can be commenced. This provision is a safeguard to the corporation, though, of course, it would not be of great value in a period of prolonged depression like that from 1893 to 1897. The slump in the steel business in 1903 made it neces- sary for the corporation to economize. Several mills were dismantled and some of the sub-executive offices were abolished. It became desirable to change somewhat the financial organization of the corporation. In March, 1903, the original Carnegie Company of Pennsylvania, the National Steel Company and the American Steel Hoop Company were combined under the name of the Carnegie Steel Company of New Jersey and later in the year the American Sheet Steel Company and the American Tin Plate Company were combined as the American Sheet and Tin Plate Company. Early the next year the corporation's search for wider markets led to the formation of the United States Steel Products Export Company, which is the selling agency for all THE UNITED STATES STEEL CORPORATION 215 the foreign business of the corporation. The direct con- trol of this company is in the Federal Steel Company. 114. Basis of capitalization. — Is the steel corpora- tion over-capitalized? It is not worth while to rehash the wordy debate on this question, which has lasted for several years, but a few facts ought to be noted. The aggregate capitalization of the first ten companies to enter the corporation was approximately $710,000,000. In exchange for this amount of stock the corporation issued $868,000,000 stock and $144,000,000 bonds, an increase of $302,000,000. In addition the promoters of the steel corporation received for their services some- thing over $240,000,000 in stock. Even though we should estimate that all the subsidiary companies' stock represented tangible assets, therefore, we should still have to conclude that $542,000,000 of United States Steel capitalization was water at the start. But what are the facts as to the capitalization of the original companies? Daniel G. Reid, president of the American Tin Plate Company, testified before the In- dustrial Commission that of the $46,000,000 capitaliza- tion of that company, $18,000,000 (preferred stock) was supposed to represent the value of the property and $28,000,000 (common stock) represented hopes for the future and the pay of the promoter. It is well known that in the capitalization of the National Steel, Ameri- can Steel Hoop and American Sheet Steel companies, all of which were promoted by the same interests as the American Tin Plate Company, the same principle was followed. Similarly, Mr. John W. Gates testified that of the $80,000,000 capitalization of the American Steel and Wire Company, $20,000,000 to $30,000,000 was water. Of the $100,000,000 capitalization of the Federal Steel ai6 CORPORATION FINANCE Company, about $45,000,000 represented tangible assets and $10,000,000 cash assets, while the rest was water. These statements are enough to indicate that of the $710,000,000 capitalization of the original companies, a large share stood for nothing more tangible than good will and "prospects." The suits to prevent the carrying out of the preferred stock conversion plan of 1903 brought out some inter- esting statements. One affidavit, by an engineer who was represented as an expert, said that the plants and properties of the corporation could be duplicated for about $200,000,000 and that the total assets, including good will and organization, were not worth $500,000,- 000, Another affidavit stated that the plants of the Carnegie Company, represented 44 per cent of the pro- ductive capacity of the steel corporation and that these plants had been valued on March 12, 1900, by the part- ners of the Carnegie Company in a legal proceeding at $75,000,000. On the other hand, Mr. Charles M. Schwab, then president of the steel corporation, sub- mitted the following valuation: 1 — Iron-ore Properties $ 700,000,000 2— Plants, Mills, Fixtures, Equipments 300,000,000 3— Coal and coke fields, 87,589 acres 100,000,000 4 — Transportation properties . . 80,000,000 5 — Blast Furnaces 48,000,000 6 — Natural Gas Fields 20,000,000 7 — Lime Stone Properties 4,000,000 8 — Cash and cash assets . ., 214,278,000 $1,466,278,000 There is not such a great difference between these two estimates as at first appears. More than one-half the assets, as given by Mr. Schwab, consist of ore and THE UNITED STATES STEEL CORPORATION 217 coal land in which he included unmined ore at a high value. Beyond question, such an estimate is uncertain and speculative. Technical progress may introduce new methods of treating ore which will greatly reduce the value of this large buried mass. Besides, Mr. Schwab had already counted the value of this ore once when he based his estimate of the value of the plants on their low cost of production and, as a factor in that low cost, counted in the cheapness with which they could secure raw materials. In what has been said it has been assumed that the proper way to value a property is to arrive at the prob- able cost of replacing it. But there is another method of valuation which is more popular among business men, and, to the writer's mind, more scientific. This method is to capitalize earning power. The profits of the eight original sub-compan-es of the Steel Corporation in 1900 were $96,000,000. The record of the Steel Corporation in the first seven years of its history was as follows: Net Earnings 1902 $133,308,000 1903 109,171,000 1904 73,176,000 1905 119,787,000 1906 156,624,000 1907 160,965,000 1908 91,267,000 Average $120,614,000 Now if we assume that 10 per cent is a fair rate on money invested in the steel business and capitalize prof- its on that basis, we get a result not a great deal below the present capitalization. 218 CORPORATION FINANCE Our general conclusion on this point must be some- thing like this: If the properties of the Steel Corpo- ration were sold under the hammer, they probably would not fetch one-half or one-third the amount at which the corporation is capitalized. Even if we take into con- sideration good will, organization, financial connections, and so on, we could hardly say that the assets equal or nearly equal the capitalization. But, if we base our valuation on earnings, not assets, we can safely say that the over-capitalization is not very great. The Steel Corporation is earning immense sums be- cause it is well managed ; because it has prestige ; because in some lines it has almost a complete monoply. These things are not tangible assets, but they are sources of income; and income, according to ordinary business us- age may properly be capitalized. Even from the ultra-conservative standpoint, it may be said that the Steel Corporation is rapidly "squeezing out the water" for it has made it its pohcy to provide from its gross income for depreciation and for improve- ments. The figures following show that about $300,- 000,000 have thus been added to the tangible assets of the corporation since its formation. Sinking Funds, subsidiary companies $ 9,367,412 Sinking Funds, U. S. Steel Bonds 25,624,410 New Construction 176,137,166 Increase in surplus 82,223,107 $293,352,095 115. Operating policy. — A careful study of the op- erating policy of the Steel Corporation belongs else- where. Our attention may be turned, however, to a few conspicuous facts. THE UNITED STATES STEEL CORPORATION 219 The corporation's relations with its employes have so far been exceptionally harmonious. There has been no strike or serious trouble of any kind. At the end of 1902 the corporation started its famous profit-sharing plan under which a large amount of preferred stock has been sold to employees. The workers are divided into six classes, according to salary, and each class is allowed to buy a certain proportion of stock each year at a fixed price. The prices named have always been somewhat below the market prices. The corporation gives a bonus of $5 for each share which is held for five years. The result has been to give a considerable number of the 210,000 employees a lively interest in the success of the corporation, and to bind them more closely to the man- agement. The scheme has proved practicable and has been probably of great benefit in maintaining industrial ft peace. The corporation is, of course, simply a holding com- pany and has only a general oversight over the sub- companies. Each subsidiary company manages its own internal affairs and buys and sells from and even com- petes with other sub-companies. Cross shipments, how- ever, are avoided and raw materials are furnished by common agencies. The idea is to stimulate each com- pany by internal competition and otherwise to the highest pitch of efficiency. The operating ratio or per cent of manufacturing costs to gross business has been very steady with a slight tendency downward since 1902. The ratio has not moved up very high in periods of de- pression, which is considered an indication of econom- ical management. 116. Steel securities. — The securities of the United States Steel Corporation now outstanding are: 220 CORPORATION FINANCE 1— Underlying bonds $ 160,877,877 2— Coll. Tr. Gold 5's, 1901 270,277,000 3— " « Skg. Fd. 5's, 1903 189,346,500 Total Bonds $ 620,501,377 4— Preferred Stock 360,281,100 5— Common Stock 508,302,500 Total Securities $1,489,084,977 The underlying bond issues are too numerous and too small in volume to be worth discussing here. Most of them are secured by direct first mortgages and are very closely held. The collateral trust gold 5's of 1901, due April 1, 1951, are secured by the deposit of all the securities owned by the corporation. A sinking fund of $3,040,- 000 per year is used to purchase bonds obtainable at 115 or less, and since April 1, 1911, has been applied to the redemption of the bonds drawn by lot. Almost all these bonds are held, it is understood, by Andrew Car- negie and are not on the market. A more interesting issue to us is the collateral trust sinking fund 10-60 year gold 5's of 1903. The autho- rized issue was $250,000,000, of which $200,000,000 was reserved for exchange with preferred stock under the conversion plan. As a claim on the assets, these bonds rank next to the 5's of 1901. They are further pro- tected by a sinking fund of $1,010,000 per annum to be used until 1913 for the purchase of bonds at 110 or less and after 1913 for the redemption of bonds, drawn by lot, at 110. This last named feature introduces a speculative element into the security which is supposed to enhance its value. If the estimates already quoted of the asset value of the property of the corporation are THE UNITED STATES STEEL CORPORATION 221 correct, these bonds have behind them chiefly the earning power of the corporation. The preferred stock issue is 7 per cent cumulative. Dividends have not been missed since the formation of the corporation. The common stock drew 4 per cent in the first two years; % per cent in 1903; nothing from that date till 1906; ll/^ per cent in 1906; 2 per cent until 1909, when 4 per cent was paid, and 5 per cent since 1909. Steel has been a prince now for several years. Is it likely to become so much of a pauper that dividends or even interest will be threatened? There can be no doubt but that the corporation is still in danger; a bad slump or even insolvency is conceivable. On the other hand, there are at least two good reasons for believing that the danger is rapidly lessening and in a few years will be a thing of the past. One of these reasons is that the physical condition of its properties is excellent, according to all reports, and is being constantly improved. We have already alluded to the large appropriations for depreciation and for bet- terments. It is estimated that following the completion of the Gary plant, the capacity of the corporation was increased about 75 per cent ; yet the interest charges are practically the same as they were at the beginning. In addition, new ore deposits, it is said, of a value of $400,- 000,000 have been located on the lands of the Steel corporation. The second reason is that the demand for steel in this country is apparently insatiable. Steel rail production to-day is nearly three times that of 1881 ; yet this particular kind of product which was of great im- portance in 1881 is now only a fraction of the entire steel trade. The demand for structural shapes and for machinery, already enormous, is just beginning to grow. CORPORATION FINANCE To get an idea of what may be expected in the next ten or twenty years, let us observe the per capita increase in the production of pig iron in the last three decades as shown below: 1880 171 pounds 1890 329 " 1900 399 " 1905 619 " 1910 669 " If the steel business, then, grows, as the biggest and most farsighted men in that line expect, and if the pres- ent policy of improving and enlarging the proper- ties continues, as there is no reason to doubt, we may safely conclude that the earnings of the Steel Corpora- tion will become very much larger than they are now. Of course, those earnings will not grow continuously. The steel business is speculative and erratic in its very nature and always will be, so long as periods of depres- sion and of prosperity alternate. Yet the enterprise and efficiency of the United States Steel managers seem to be almost a guarantee that at the worst steel earnings wiU never sink so low that interest charges cannot be met; it is reasonable to expect that they will never sink so low that preferred dividends cannot be met ; and it is even reasonable to hope that the common dividends will always be maintained at or above their present level. CHAPTER XVI SELLING SECURITIES— THE PROSPECTUS 117. The four methods of selling securities. — ^When- ever new securities — whether of an established company, of a new concern or of a reorganization — are issued, these are four possible ipethods of disposing of them. The first method is by an inside distribution of the se- curities to people already interested in the business. This method we have already considered. In the case of a close corporation the distribution of the securities is ob- viously a simple matter of bargain-making among the few people involved. In the case of a consolidation the distribution to insiders is carried on by exchanging the new securities for old securities as already explained. The second method is to work through the Wall Street, or some similar, market, which is considered in the chapter following. The third method is to sell them to the public through established bond or brokerage houses. This method will be discussed both in this chapter and under the head of underwriting. The fourth method is by direct appeal to the public through newspaper and magazine advertising, through circular and individual letters and through salesmen. In a great many corporations the promoter finds the first three methods unavailable and is forced to resort to this fourth method. This is particularly true of speculative enterprises. The principles that should be followed in the presen- CORPORATION FINAJSCE tation and selling of corporate securities direct to the public are not different from the principles that should be followed in selling other articles. These principles are treated in the treatise on Selling and Buying and need not be reviewed here. Something should be said, however, about the document in which the leading facts with regard to the securities are stated and the pros- pects of the company discussed, namely, the prospectus. 118. General characteristics of a good prospectus. — The promoter's prospectus should be, and with success- ful flotations usually is a work of art. A good prospec- tus will appeal to a large number of people, will arouse their interest, will hold their attention from beginning to end, and will engender confidence. A poor prospec- tus will nulhfy whatever success the promoter may have had in stimulating curiosity on the part of the prospec- tive buyers of his securities. It goes without saying that it should be well written and attractively printed. In this respect the same rules that apply to other selling literature should be followed. Naturally the prospectus will emphasize the strong features and minimize the weak spots of the business. The promoter must take care, however, in so doing that he does not misstate or conceal any material fact. Otherwise he may be held Uable for fraud, or at least anyone who subscribes to the corporation's securities on the strength of the prospectus may have good legal grounds for withdrawing from his contract. The skill- ful prospectus writer, who is presenting to the public securities which he knows to be highly speculative in character, must find some means of reconciling these apparently inconsistent requirements. He must pre- sent all the important facts and yet he must make his prospectus strong, attractive and convincing. Any SELLING SECURITIES— THE PROSPECTUS well-trained writer should be able to do the trick if he studies his proposition carefully. Obviously in any prospectus the strikingly attractive features of the enterprise will be made prominent and much will be said about them. Perhaps the statements M ith regard to them A^ill be printed in bold face or other prominent type, so as to catch the eye of the reader at once. Statements as to the more doubtful and risky features of the enterprise will be tucked away in some obscure corner. Thus the law will be satisfied and at the same time it will take a very careful, intelligent read- ing to ascertain from the prospectus the real facts of the case. Another means of avoiding legal objections is to make sweeping general statements without making the writer or any other definite person responsible for them. Such phrases as "competent judges have reported," or "after expert examination we believe," or "witnesses who have seen the property are thoroughly convinced," are very common introductions in prospectuses. The statements in themselves may be untrue; yet by using such phrases the writer may succeed in divesting himself of any personal responsibility. Most prospectuses, as any reader of them will testify, are so vague, that what the writer implies assumes a much more prominent place in the average reader's mind than what he actuallj^ says. In a recent mining pros- pectus, for instance, we have the following typical sentence: "We have every reason to believe that the corporation will have assets at the end of the year that will astonish each and every holder of the stock, and it is our belief that claims, titles and rights cannot be bought outright for $1,000,000 or more." Notice that this sentence does not contain any single statement of VI— 15 226 CORPORATION FINANCE fact to which the prospectus-writer could be bound down. Another hoary trick that is worked over and over again in the prospectuses of new companies, is to call attention to the immense profits of other companies working in the same field. It is very seldom indeed that a copper-mining prospectus is issued that does not call attention in big type to the profits made by the holders of the original stock of Calumet and Hecla, the Copper Queen, Anaconda, and other classic examples. The reader is expected to infer that the new corporation will have a similar history. 119. A typical speculative prospectus. — The pros- pectus of a company designed to own and publish a magazine is given in part below. The reader will find in these few paragraphs illustrations of all the principles mentioned above. In this case, although the magazine is stated to have been in existence for twenty-eight years, not one word is said as to its record; instead, all the emphasis is given to "prospects," "purpose" and "possibilities." I It is a medium that can treat any subject with justice to it- self and its readers ; therefore, its pulling power for subscrip- tions, you will agree, covers possibly a greater field for circula- tion, than any magazine that you can recall. Its field of expan- sion is simply unlimited. J'rom an advertising standpoint, I might say, after years of experience, I do not know of a publication that has such pros- pects for money making as The Blank Company. Being a practical publisher, it is my purpose to put The Blank Company in the place it should enjoy, and in order to do this, I have deemed it wise to share its future with a number of my friends, and am, therefore, organizing a company capitalized at $60,000 for the immediate expansion of The Blank Company. The stock is secured by the property, the name and the good will, which, if put up at auction, would be considered a bargain, SELLING SECURITIES— THE PROSPECTUS 227 if purchased at many times the amount of the company's cap- italization. If you have looked into the magazine field, you will know that although some of the larger magazines are capitalized for over a half-million dollars, they are all making phenomenal money for their early investors. The general magazine field I consider pretty well covered, but a magazine of the unique name that The Blank Company possesses, can be expanded and developed and larger profits made from it than any other publication enjoys. To illustrate the earning power of magazines, permit me to say that one magazine was sold some time ago to a well-known newspaper publisher for nearly $700,000, in spite of the fact that at that time it had a circulation of only 250,000 and a shrinking in its advertising patronage. Another well-known magazine, whose circulation had dropped down below 50,000 and had practically no advertising, declined an offer of $10,000 for its name and good will. I will recall that if you had been able to buy a thousand dollars worth of Munsey's stock, on the ground floor basis (that you are now offered in The Blank Company) for your invest- ment the thousand dollars in Munsey's now would be paying you $10,000 to $12,000 a year in dividends. If you could have invested only $100 in Munsey's, your hold- ings would now be worth from ten to twelve thousand dollars and would be paying you $1,000 to $1,200 a year in dividends; a larger investment would have made you wealthy. An English author, who ten years ago obtained $2,000 worth of McClure's Magazine stock in exchange for a manuscript, sold his holdings recently for $20,000, having received in dividends during that time the round sum of $14,000. For his $2,000 worth of manuscript he received in a decade $34,000 in cash, a profit of 1,700 per cent. Everybody's, The Ladies' Home Journal and many other magazines, represent wonderful money-making investments. The same opportunity is knocking at your door at this mo- ment. The Blank Company, with its twenty-eight years of continuous existence, with an unlimited advertising field and with 228 CORPORATION FINANCE a subscription list that can be increased beyond that of any other publication in existence, offers you a rare opportunity in asso- ciating yourself with an enterprise which will make money for its stockholders very rapidly. If you want to go in with me in developing and expanding The Blank Company, I will offer you some of its stock at its par value, $10 per share. This opportunity, however, will only remain open for a short while. Stock can be purchased on a basis of 3 per cent for cash with subscription, or 10 per cent down and 10 per cent per month. 120. A typical investment prospectus. — In the above remarks we have had in mind principally the pros- pectuses of highly speculative companies. We need not pass judgment here on the legitimacy of the methods that are used by such companies to obtain subscriptions for their stock. It is certainly improper to delude subscribers. On the other hand, it is unquestionably proper to present a new enterprise in a favorable light. Just where the dividing line between an honestly favor- able and a dishonestly deceptive 'presentation comes is a question which every promoter must settle with his own conscience. The prospectuses of well-known, entirely legitimate investment securities often go to the other extreme. They present merely a dry, formal statement of the facts with sometimes a tabulation of the assets and earnings of the company or bald figures of some other kind. For instance, several of the leading banks of the world — including Baring Brothers and Company of London, Comptoir National d'Escompte de Paris, Credit Lyonnais of Paris, Deutsche Bank of Berlin, J. P. Morgan and Company, the First National Bank and the National City Bank of New York — co-operated in issuing on March 1, 1909, a $50,000,000 5 per cent SELLING SECURITIES— THE PROSPECTUS 229 internal gold loan of the Argentine Government. Much might have been said as to the wealth, high stand- ing and prospects of the Argentine Republic and as to the small amount of the loan in comparison with the great resources back of it. The bonds were sold at the price of 99 per cent of the face value, thus yielding to the purchaser something over 5 per cent, a high rate on the loans of a government of good standing. We can imagine, taking the examples that have been given above as a basis, how a promoter used to getting up prospectuses for speculative concerns would have reveled in the opportunities that this issue would have afforded him, how he would have enlarged on the Argentine Republic's reputation and prosperity, how many word pictures he would have drawn to illustrate his statements. The prospectus issued by the great banks that have been named, however, compressed a description of the bonds, a statement of the terms on which they would be issued, and the argument on behalf of the bonds into the four bi'ief, cold paragraphs that follow: Provision is made for a sinking fund of 1 per cent. By the operation of this sinking fund the loan will be paid off in thirty-six years at the latest. The contract with the Argentine Government provides that said fund is to be applied half yearly to the purchase or tender of bonds at or under par or by draw- ings at par should the bonds be at over par. The first operation of the sinking fund will take place in the month of December, 1909. Drawn bonds will be payable on March 1st or Septem- ber 1st following the date of the drawing. The Government undertakes not to increase the sinking fund or to redeem the whole of the loan before March 1st, 1914. We reserve to ourselves the absolute right in our discretion to close the application list at any time without notice and to 230 CORPORATION FINANCE reject any or all applications and also to allot smaller amounts than applied for. All applications should be made on forms which may be ob- tained at our offices, and must be accompanied by a deposit of $50 per bond. If no allotment is made, the deposit will be returned in full, and if only a portion of the amount applied for be allotted, the balance of the deposit will be appropriated towards the amount due on March 10th, 1909. If any further balance remains, such balance will be returned. In case of failure to pay the balance of the subscription when due, all right in any previous payment will vest in us absolutely without accountability there- for. Although such a presentation is unattractive, it is frequently eiFective. The coldness and dryness carry with them the sense of conservative safety. For that reason, a statement of this kind is sometimes put for- ward as a prospectus of what is in reahty a highly speculative company; and this trick when skillfully executed has been known to succeed. 121. The ideal prospectus. — Even in the most formal prospectus, however, it is usually well to use untechnical expressions and to present facts in such a manner that they will be not merely significant, but interesting. Some such tendency is coming into evidence, even in the presentations of strictly investment securities. The number of people who are possible investors in such securities is constantly increasing and the amount of such securities is also increasing. In order to create a market for these immense issues among people who are not familiar with the technical jargon of the financial world, it is necessary to change somewhat the old- fashioned formal method of presentation. This change is undoubtedly for the better. As the intelhgent in- SELLING SECURITIES— THE PROSPECTUS 231 terest of the public in financial affairs grows, we may expect to see the typical prospectus of a speculative corporation and the presentation of a strictly investment security approaching each other more closely in tone and in form. Although in this country the prospectus, as has been indicated, is so frequently used to present speculative and even swindling schemes in a false light that pros- pectus-writing has come to be regarded almost as a dishonorable method of securing money for an enter- prise, and although this opinion is not without basis, yet it must be borne in mind, on the other hand, that there are such things as a legitimate direct appeal to the public for funds and an honest prospectus. In England this method of raising funds is much more generally used for reputable enterprises than in this country. To take one instance, it is said that the English Eastman Kodak Company was floated with- out any assistance whatever from bankers or under- writers. About $5,000,000 of stock was sold to the public through direct newspaper advertising, circulariz- ing and the issue of an attractive prospectus. That the method in this instance has been entirely successful is shown by the fact that the company's stock is now selling at the rate of about $675 a share. It is to be regretted that the number of similar instances in this country is so small. 122. Selling through banking houses. — The securities of almost all large legitimate corporations are sold through banks and brokerage houses. The advantage of this method to the investor is that he is protected more or less by the investigation and experienced judgment of his banker. The disadvantages are three: first, on ac- count of his leaving the investigation to the banker he CORPORATION FINANCE does not acquire that first-hand knowledge of the enter- prise in which he invests that it would be desirable for him to obtain; second, that he is thus left practically at the mercy of his banker ; third, that the broker's com- mission, which is often not inconsiderable, intervenes between the buyer of the security and the selhng corpo- ration. The advantage to the corporation of selling through a bank or brokerage house is that the corporation officials may feel certain that the issue will be success- fully disposed of in this way, especially if it is "under- written," as explained in Chapter XVIII. With a corporation of any size, the bond or brokerage house will probably be one of the large concerns that carry on their work in the Wall Street district of New York, the State Street district of Boston, the La Salle Street district of Chicago, or the corresponding financial center of some other large city. 123. Requirements of reputable hankirig houses. — The good Wall Street houses will not undertake to float issues of small size — certainly none less than $100,000 and preferably not that small — for two reasons; first, because there is not enough profit in selling small issues to pay for the expenses ; second, because a small issue of stocks or bonds never becomes well-known to the public and is therefore not readily marketable. As to the kinds of enterprises that will be taken up, the better houses pre- fer in the order named, steam railroads, electric rail- roads and industrials. Most of them will not touch mines, oil companies, or any other highly speculative enterprise. The only practicable means for getting funds for such an enterprise from the public ordinarily is by direct solicitation. There are not many high-class Wall Street houses SELLING SECURITIES— THE PROSPECTUS 233 engaged in selling securities and there are a considerable number of imitation banking houses whose main object is to get their hands on the money of "suckers." The working plan of such swindlers is to receive persons who come to them with securities to sell, no matter how worthless the securities may be, with open arms, wax enthusiastic over the market for the securities, make numerous high-sounding promises as to the sales which they will be able to make, and in conclusion demand from the victimHas his "guarantee of good faith" a sum of money for expenses. Of course this money is not honestly spent. The high-grade banking houses, on the contrary, will receive any new proposition that is pre- sented to them, especially if it comes from a stranger, with skepticism ; and, if they show any interest at all, it is to be expected that they will make a long and thorough investigation, before committing themselves in any manner. It is poor policy to approach one of these houses without having a business introduction of some kind. Generally speaking, it is well to present the proposition in writing in the first place, giving a clear and complete statement with all the supporting evidence that can be added. A Wall Street banker of the class that the writer has in mind is not likely to be carried off his feet by persuasive personal eloquence and is more likely to yield to cold figures than to impassioned appeals. It takes a man who has spent a lifetime in the Street to tell absolutely what are the sound, reliable houses and what are the more or less shady concerns. There are Wall Street firms which, to the writer's knowledge, are regarded by Wall Street bankers as worse than banditti, which nevertheless have kept in existence and have apparently been prosperous for many years. Such 234 CORPORATION FINANCE firms may maintain expensive suites of offices, may have pious-looking personages at their head and may give an appearance of permanence and honesty. The only sure sign of their general unreliability, that the writer can give, is that they are out looking for business, that they make an effort to secure for themselves the flota- tion of securities of small corporations and that they are wiUing to pretend to sell such securities without having first made an adequate investigation. Even this symp- tom, however is not always present, for the heads of such concerns are shrewd and experienced enough to make a pretense at times of conducting an investigation before they accept the proposition that has been presented to them. The first step in the investigation of an enterprise by a reputable house will be to get the complete record of all the men who have any connection with it. If there is a flaw in the reputation of any of them, the whole proposition will probably be dropped. Next, the prospects of the enterprise itself will be looked into. Every large house engaged in selling securities keeps on its own staff capable men who are qualified to form an expert judgment as to the merits of the common forms of business enterprises, such as street railroads, manufacturing plants, and so on. In addition, unless the house is absolutely satisfied, it will probably obtain reports based on searching examinations by three classes of professional experts, namely, engineers, lawyers and accountants. If all of these are favorable, from begin- ning to end, the proposition will perhaps be accepted. The three essential factors in making a proposition acceptable are: (1) Good reputation of the men connected with the enterprise. SELLING SECURITIES— THE PROSPECTUS 235 (2) Absence of risky factors in the general nature of the business or in the general situation. For instance, a street railway company would not be taken up if the people of the locality in which it had been located were for some reason bitterly hostile to public service corpo- rations. In the same way, as has been said, the good banking houses wiU not deal in the securities of unde- veloped mines, no matter how promising. (3) Practical certainty of profits sufficient to meet all fixed charges. This almost goes without saying; yet it is worth noting, because many people seem to im- agine that if a new corporation promises to hav-e consid- erable profits its securities are safe investments. It is necessary that these profits should not only be large in the aggregate, but should be steady enough and certain enough to guarantee that the corporation will never be compelled to pass any of its interest payments or other fixed charges. 124. Their methods of selling securities. — The good Wall Street houses are so exceedingly careful in their investigations because they sell most of the securities they handle, not to the public at large through adver- tising and through wide distribution of prospectuses, but to a comparatively small number of their clients. These .clients include not only individuals, some of whom have regular sums to invest every year, but also such institutions as insurance companies, saving banks and trust companies. It is necessary in order to hold this clientele that the house should establish and maintain a reputation for the strictest integrity and conservatism. So long as this reputation is maintained there is seldom any difficulty in selling whatever securities the house may accept. The following extract from an article in 236 CORPORATION FINANCE the "Bond Buyers' Dictionary" gives further details as to the methods of such houses. It is through the retail bond dealers that the great investing public of the country is reached. The other day a retired mer- chant died in Pittsburg whose wealth was estimated by bankers to exceed $50,000,000. Of the several million persons who read of his death in the newspapers the following morning only a few had ever heard his name before. There are thousands of similar capitalists in the United States, each possessing a for- tune greater than was owned by any single individual in the country fifty years ago, whose names are entirely unknown to the average newspaper reader. There are several hundred thousand others who possess independent fortunes. It is with these individual investors that the retail bond merchant deals. All have a large list of wealthy customers, to which they are continually adding. The customers of some are mostly in New York or Pennsylvania, of others in New England, of others in Canada, of others in the West or the South. Some have wealthy foreign customers. The number of regular customers may range from 5,000 to as high as 25,000. There is one retail bond house in WaU Street, which has been in business for seventy-five years, that has a list which could not be purchased for several million dol- lars. It includes 22,000 names, and these customers purchase, on an average, nearly $5,000 of bonds a year apiece, or a total of more than $100,000,000 a year. This house would not hesitate to purchase a block of $5,000,000 or $10,000,000 or even $20,- 000,000, of municipal, county, or railroad bonds, knowing that it would be able to dispose of the entire block in the course of a few months in small lots to its regular customers. Practically every large retail bond house in Wall Street now employs salesmen, who travel over the country selling bonds, very much as drummers sell tea or coffee. Some of the largest houses employ as many as forty salesmen ; altogether, more than 300 are employed in Wall Street. Each has his own territory and possesses his own customers. Many make salaries of from SELLING SECURITIES— THE PROSPECTUS 237 $lO,000 to $15,000 a year, and some even more. All are, to some extent, experts on values. In addition to employing sales- men the retail bond houses advertise extensively. The reputation of a bond house, and the following which it possesses among investors, is its principal stock in trade. The majority of the customers of a bond house purchase securities from it, not because of personal and expert knowledge of the se- curity and safety of the bonds, but because of the reputation of the house. The average investor whether he invests $5,000 or $500,000 a year, after a superficial examination, purchases securities almost entirely on the recommendation of his bond dealer. The enormous profits the bond dealers make is the price they charge for lending this credit to corporations and municipalities. Practically every one of the leading Wall Street bond houses may boast that no investor has necessarily ever lost a single dollar through the purchase of bonds on their recommendation. With such a record, is it any wonder that, when such a bond house offers a block of bonds for sale, accom- panied by a recommendation, that the entire issue is often over- subscribed within twenty-four hours of the opening of the books ? The profit of the banking house may take one of two forms, either a commission on the sales or the difference between the price at which it buys the securities and the price at which it sells them. Commission is more com- mon and is regarded as more profitable. The amount of commission depends altogether on the size and repu- tation of the issue, and no definite statement on this point can well be made. The question frequently comes before such a house. Do you absolutely guarantee the securities that you offer to be safe investments? Invariably the answer is: No, we give you freely the benefit of our experience and of our best judgment, but whatever risk is involved is yours, not ours; we guarantee nothing. Nevertheless, 238 CORPORATION FINANCE it is a well-known fact that almost all houses of the best character will protect their customers in case of loss or risk. In the first place, the house does not lose interest in the security as soon as the issue has been sold. It watches the future career of the issuing corporation with the closest attention and frequently exerts strong influence toward a conservative management of the cor- poration. If in spite of all its care and its efforts, the security depreciates in value, as wiU happen once in a long time, the house will probably offer to buy it back from its customers at the selling price. This is not laid down as an infallible rule, but as a custom. Of course, the house does not feel bound to follow that course un- less it has very strongly recommended the security in the first place. Its motive in making the offer is simply to maintain its hard-won reputation for fair dealing. CHAPTER XVII SELLING SECURITIES— THE WALL STREET MARKET 125. The principal stock exchanges of the United States. — The stock exchange offers the best market for a great many corporate securities. Some readers are perhaps already familiar with the organization of that market and its manner of conducting business and will find much of the information given in this chapter already familiar. In spite of the importance of the Wall Street stock exchange, however, and in spite of the glib manner in which almost every one talks about it and against it,~ surprisingly few people have a correct understanding of its operations. What is said about the New York Stock Exchange and Wall Street in this chapter applies in general, with slight modifications, to a considerable number of smaller stock exchanges in the larger cities of the United States. Chief among these exchanges are: (1) The Boston Stock Exchange, on which local securities are bought and sold and which is the chief market for the stocks of copper-mining companies. (2) The Philadelphia Stock Exchange, on which local securities and the securities of the Lehigh Valley, the Pennsylvania and the Reading Railroads are bought and sold. (3) The Pittsburg Stock Exchange, the principal business of which is the handling of securities of the local steel companies, and of the United States Steel Corporation. 240 CORPORATION FINAJNCH; (4) There are stock exchanges also in Baltimore, St. I^ouis, Chicago and San Francisco, all of which are comparatively small and the operations of which are confined to local securities. ( 5 ) In this group should be included the Consolidated Stock Exchange of New York, or the "Little Ex- change," as it is frequently termed, whose members buy and sell the same stocks that are traded in on the New York Stock Exchange, or "Big Exchange." The transactions on the Consolidated are on a much smaller scale than on the "Big Exchange"; stocks are custom- arily bought and sold in ten share lots or multiples of ten, instead of in one hundred share lots or multiples of one hundred, as on the New York Stock Exchange. The reader will see from this .brief summary that large dealings in securities of corporations of national importance are confined almost wholly to the floor of the New York Stock Exchange. With some excep- tions the stock of any corporation will be bought and sold on one exchange and one only ; the chief exceptions, to most of which allusion has already been made, are: Amalgamated Copper Company stock, which is handled both in New York and in Boston; Pennsylvania Rail- road Company, Lehigh Valley Railroad Company, and Reading Railroad Company, both in New York and in Philadelphia; United States Steel securities, in New York, Boston, Chicago and Pittsburg. 126. Listing securities. — In the first paragraph it was stated that the stock exchanges off'er an excellent market for the sale of securities of certain corporations only. This limitation must be stated, because each of the exchanges confines its members, so far as trades on the floor are concerned, to a comparatively small number of THE WALL STREET MARKET 241 approved securities. On the New York Stock Ex- change all new securities offered for approval are in- vestigated before being "hsted." The Exchange has strict rules governing the admission of securities to the "listed" class. There is a committee of five to whom are referred all applications for including securities among those listed. Accompanying the application, there must be filed a complete description of the prop- erty of the corporation, a full and true balance sheet, an income account, and information on certain other points. In the case of bonds a full statement of the terms under which the bonds are issued, a certified copy of the mortgage, and proof that the mortgage has been properly recorded, must be submitted. The exchange strongly recommends — a recommendation that has all the f orce^jof ajxjQrder — thafcorporatioris whose securi- ties are listed shall furnish to their stockholders com- plete annual reports at least fifteen days prior to annual meetings. Many industrial corporations which are unwilling to comply with the requirements as to publicity, were for- merly admitted to the "unlisted" class. This means that their securities were bought and sold on the floor of the exchange in the same manner as the listed securities, and so far as the general public was concerned there was no apparent difference between the two classes. There was, in fact, however, a very important difference, for the corporations whose securities were unlisted were not required to give complete reports as to their opera- tions to the stock exchange committee or to their stockholders. Although the public did not appreciate the fact that such a distinction existed, men in the finan- cial district were fully alive to its importance. Listed se- VI— 16 242 CORPORATION FINANCE curities almost without exception were much more highly regarded by bankers and were more acceptable as collateral for bank loans. For this reason, most corporations preferred to meet all the requirements and have their securities listed. About 85 per cent of the securities handled on the New York Exchange entered the listed department, and the unlisted group — partly on account of the force of the growing demand for publicity — rapidly declined in numbers and in importance. Among the last converts from the unlisted to the listed class were two industrial companies of great size and importance, the American Sugar Refining Company and the American Smelting and Refining Company. This entrance into the listed department was rightly interpreted as a final proof that the day of corporate secrecy, so far as stockholders are concerned, had gone by, and shortly thereafter the use- less "unlisted" class was abandoned. 127. The Curb Market. — There are a considerable number of large corporations that are unwilling or unable to furnish even the very moderate amount of information that is necessary in order to have their se- curities entered on the Stock Exchange list. There are other securities that are very highly speculative in their nature, or that are issued by corporations which are not honestly and efficiently managed — "cats and dogs" such securities are called in Wall Street slang — ^which are bought and sold in considerable quantities in the Wall Street district. As such securities would not be admissible under the rules of any reputable exchange, an outside unorganized market has come into existence. This is known as the Curb Market, for the reason that the meetings of the brokers who participate in it are held in the open air in one of the streets in the Wall Street THE WALL STREET MARKET 243 district near the street curb. There are no written rules and no fixed organization for the Curb Market. Any- one may go among the throng of brokers standing on the street and buy or sell securities if he can find anyone else to trade with him. As a matter of fact, however, a stranger would not be able to transact any business, for no one would be sure that he would live up to what- ever obligations he might contract. In practice, in or- der to do business on the "Curb," a broker must either have high standing and reputation on his own account or must be a representative of an established brokerage firm. Among the well-known and important corpora- tions whose securities are bought and sold in the Curb Market we may mention the former subsidiaries of the Standard Oil and American Tobacco companies and a number of industrials, the stocks of which are also traded in on local exchanges outside New York, such as the Baldwin Locomotive Company, the J. I. Case Com- pany, Cluett-Peabody Company, Goodrich Company and Studebaker Company. Most of the other active stocks on the Curb Market are of mining companies. The Curb Market is also the center of transactions in "rights" (which are described in Chapter XXIV) and in contracts for purchase and delivery of stock and bonds that are not yet issued. Such stocks and bonds are traded in "w. i.," to use the Wall Street abbrevia- tion, which stands for "when issued." 128. Stock Exchange methods. — The scene on the floor of any of the regular stock exchanges and on the street where the curb brokers congregate always seems to an uninitiated observer strange and confusing. On the larger exchanges he sees a number of posts set up at regular intervals, each post bearing the initials of several of the corporations whose securities are listed on 244 CORPORATION FINANi^E that particular exchange. Around each post, if it is a busy day, are a large number of brokers, each armed with a pencil and a memorandum pad, and many of them engaged in making frantic signs to other brokers. The signs, which are unintelligible to the outsider, in- dicate offers to buy at a certain price or acceptances. A broker who has the stock or bonds of any corpora- tion to sell goes to the post to which that corporation is assigned, offers his stock and receives bids. Any reader who has never visited an exchange must not get the idea that this proceeding is as simple and unexciting as it seems when described in cold print. If the market is at all active, the seller may have to fight his way to the center of a struggling group, yell out his offer at the top of his voice, and accept one or more of the bids that may be yelled back at him in the twinkKng of an eye. The noise that comes from the floor of a crowded stock exchange during an active business day resembles nothing so much as the roaring of wild beasts. It has often been remarked, as an indication of the good faith and high standards of honor that must pre- vail as a rule among stock-exchange brokers, that in the midst of all this confusion and outcry a hasty sign from the purchaser and a nod from the seller of a block of securities may close a deal involving thousands of dollars. Each broker makes his own memorandum of the transaction and at the close of the day the houses which they represent compare notes and through the stock exchange clearing house settle their balances. It is very seldom that a serious error or even a misunder- standing occurs. Differences of opinion as to prices and quantities of securities are, of course, inevitable once in a while, but are usually adjusted in the friendliest manner. THE WALL STREET MARKET 245 The volume of business transacted in this manner on the leading stock exchanges is enormous. Million share days on the New York Stock Exchange, though somewhat above the average, are not at all uncommon. In other words, $100,000,000 worth of business is trans- acted. Of course it goes without saying that such quantities of shares are not bought outright, taken out of the market and placed in a vault. On the contrary, the great mass of the business of buying and selling is speculative. What is actually bought and sold is the right to receive or the right to deHver certain quantities of shares at the end of the day at the price fixed in the deals between brokers. In most cases no actual delivery is made. Through the stock exchange clearing house the transactions in the same stock offset each other and only the balances are delivered by those who sold to those who buy. Many floor traders seldom see any stock certificates because they make it a rule to sell during the day as much as they buy. They make both sales and purchases with the view to "scalping" small profits, Yg and 14= psr cents. 129. Importance of speculative dealings. — Nothing need be said here as to the ethics of speculation, a subject which is adequately treated in another volume. It may be well to remark, however, that aU these speculative transactions on the stock exchange, particularly the small transactions, perform at least one very useful service, namely, they tend to steady security prices. Obviously, if a stock starts to move up or down and a group of floor traders are at hand all trying to sell at each slight advance with a view to getting their small speculative profits, the price will probably not soar very rapidly. The same remark in substance will apply to all speculative dealings. 246 CORPORATION FINANCE Enough has been said about the stock exchanges and stock and bond brokers to give some idea perhaps of their methods of operation. It is no part of the business of stockbrokers to buy and sell to any large extent on their own account, although many of them, to be sure, do not by any means abstain from so doing. Their main function, however, is to serve as agents for other persons who may desire to buy or sell securities. Some of these persons are true investors who are either parting with some of their stockholdings for cash or are buying securities outright with a view to holding them for the sake of dividends and of future increases in their value. Such persons, however, are in the minority ; most of the buying and selling of stocks on the stock exchanges is speculative. Of this speculative business a small pro- portion is carried on by the outright purchase of stocks or bonds, which the purchaser hopes will rise in value within a short time so that he may sell at a substantial profit; or by the outright sale of securities which the seller hopes to be able to buy back within a short time at a substantial reduction. The great mass of specula- tive business, however, and for that matter of all the business transacted in Wall Street, consists of buying and selling "on margin." 130. Buying on margin. — By marginal transactions are meant those in which most of the necessary funds are borrowed and only a small percentage or "margin" is required of the person for whom the securities are bought or sold. The procedure in making a marginal speculative purchase is somewhat as foUows: The speculator desires to own, we will say, one hiuidred shares of a stock which is selling at or near a par of $100 ; the least margin that will be accepted by reputable THE WALL STREET MARKET 24.7 brokers in such a case will be $10 per share. The specu- lator, therefore, assuming that he does not already have an account with his broker, gives him a check for $1,000 and an order to buy the one hundred shares. A repre- sentative of the brokerage firm buys the one hundred shares on the floor of the exchange in the manner already described. At the end of the day he must be prepared to pay for the shares, which means an outlay of approxi- mately $10,000 (100 shares at $100 each). In order to raise this amount the broker arranges with his bank to accept the shares, after they are bought, as collateral for a loan, which on standard stocks will be about 80 per cent of the market value, or on this block, $8,000. There still remains a difference of $1,000 which the broker must supply out of his own funds. If the stock shortly after this transaction advances, we will say ten points, the fortunate speculator will perhaps give an order to sell, and the broker will secure approximately $11,000 for the block. With this he repays the bank loan of $8,000, reimburses himself for his loan of $1,000 and after deducting interest on the $9,000 supplied by the bank and by himself and deducting his brokerage charges, he turns the rest over to the speculator. On the other hand, if the stock goes down seven or eight points the speculator is called upon to put up additional margin or, failing that, the broker sells the stock, repays the bank loan, reimburses himself, deducts interest and brokerage charges as before, and returns to the specu- lator anything that may happen to be left of his $1,000. 131. Selling short. — If the speculator chooses to sell on margin, or "sell short" in the Wall Street phrase, he deposits his $1,000 as before and orders the broker to sell. The broker's representative executes the sale on 248 f CORPORATION FINANCE the floor of the exchange and of course is called upon to make delivery at the end of the day. As neither the speculator nor the broker owns the stock that has been sold, it is necessary for the broker to borrow the stock from some owner. This he does in the "loan corner^" as it is called, of the stock exchange, where stocks are loaned to "shorts" on payment of the market price. In form this loan is a sale of stock ; it is provided, however, that on return of the stock the p-mount paid for the stock wiU be given back. This borrowed stock the broker uses to make delivery of the block that he has sold. If within a short time the stock goes down, the fortunate speculator orders his broker to buy a block at the lower price ; the broker uses the block that he buys to repay the lender of the stock with which delivery was originally made. He turns over to the speculator his $1,000 margin plus the diiference between the price at which the block of stock was sold and the price at which it was bought and minus brokerage charges. The bro- kerage house, when it borrowed stock with which to make delivery, paid to the lender the market value of the stock and is allowed interest on this sum ; the speculator, therefore, in his "short" operations is relieved of interest charges. On the other hand, if the stock goes up several points in this case, the broker will call for more margin ; failing that, he will buy a block of stock with which to repay the stock he has borrowed, will deduct from the speculator's margin the difference between the price at which the stock was sold and the price at which it was bought, together with brokerage charges, and will then return to the speculator anything that may be left of his $1,000. 132. Stock exchange houses vs. bucket shops. — The following quotation from a circular letter issued by a THE WALL STREET MARKET 249 large brokerage house gives an accurate statement of the terms upon which reputable brokers handle marginal transactions : We execute commission orders for the outright purchase, in any amount, of listed stocks. Our charge is that fixed for all members of the New York Stock Exchange, % of 1 per cent of the par value, or 12% cents a share, except that we make a minimum charge of $1 for any one transaction. Our requirement for doing business upon margin is 10 per cent upon the par value of the active Stock Exchange issues quoted at 50 or below ; 15 per cent for those quoted between 50 and 100 ; and 20 per cent for those quoted above 100. We reserve the right, when opening a margin account, to refuse to purchase those securities which either have not a ready market or are not available for collateral purposes. Those who desire to sell active stocks short, may do so upon a maintained margin of 15 per cent, in the case of stocks selling at par or below, and upon a margin of 20 per cent in the case of those selling above par, we, of course, to reserve the right to discriminate against any partic- ular securities. We do not buy or sell less than 100 shares of stock or $10,000 of bonds, upon margin, so that $1,000 is the least amount with which such an account can be opened. Our in- terest charges depend upon the cost of our own funds and are figured at the end of each month, so we cannot say in advance just what rate will be charged, but we will be glad to take this question up in detail at any time. In opening margin accounts we require either a bank refer- ence or an introduction from some of our friends. We never open margin accounts for women or in the name of a woman, nor do we open margin accounts for bank officials or bank employees. Just a word should be said here about bucket shops and swindling brokerage concerns of all kinds. The characteristic of all such concerns is that whatever 250 CORPORATION FINANCE money is turned over to them for buying and selling stocks never gets out of their own pockets. Whatever may be said as to the ethics of true stock exchange speculation, and as to its moral and economic effects, it is certainly true that Wall Street ought not to be blamed for the existence of the methods of the bucket shops. Wall Street brokers are, as a rule, entirely honorable in their dealings with customers. They make it their business to execute whatever orders are given to them by their customers under conditions which are fully and clearly set forth. If the customer misunder- stands those conditions or misjudges the market, it is his own fault, not the broker's. A legitimate broker will make every effort to guide his customer aright and protect him from loss, for the broker's reputation and success depend directly on the success of his customers. The bucket shop, on the other hand, obviously prospers from the losses of its customers. 133. The classes of Wall Street speculators. — The Wall Street speculative contingent may roughly be di- vided into three classes: first. Wall Street men, bank- ers, brokers or corporation officials, who buy and sell securities on a large scale and who make it their business to keep in constant touch with all that goes on in the stock market; second, substantial men of property and business standing whose first interests are not in the Wall Street game, but who take a "flier" once in a while in some security or group of securities of which they have special knowledge; third, the hangers-on, the true lambs, a class made up largely of professional men, broken-down business men and women, who are suffer- ing under the delusion that they can make money in Wall Street without having a special knowledge either of Wall Street methods or of the conditions in some par- THE WALL STREET MARKET 251 ticular line of industry. This third class is by no means so large as the moralists, the muck-rakers and the comic papers represent; yet it is true that its representatives are only too painfully in evidence. It is true also that the members of this class inevitably lose in the long run, and that too often they are infected with a poison that ruins them both financially and morally. It is more than doubtful, however, if Wall Street ought to be held responsible for the losses of such people. For the most part they are weak and foolish and it may safely be said that if they had not fallen victims to the Wall Street craze they would have found some other means of losing their money. 134. A summary view of the stock market. — What precedes is intended to present to the reader a bird's- eye view of the Wall Street market, or the stock ex- change market, for securities. To recapitulate: only a comparatively few large corporations have their secur- ities listed on any of the stock exchanges ; those corpora- tions whose securities are listed have a well-advertised, continuous and easily accessible market for their secur- ities; this market is utilized both by investors and by speculators, but, so far as stocks are concerned, the specu- lative element is of chief importance; most of the speculation is carried on by means of marginal purchases and sales; the speculators may be classified under the three heads. Wall , Street operators, business men and "lambs." With these leading facts before us, we are now ready to discuss briefly the process of selling a new security through the stock exchange markets. 135. Stimulating speculative interest. — If the new security is a small issue put out by one of the less im- portant companies, the process of selling it through a stock exchange will not be much diiferent from that 252 CORPORATION FINANCE which has been described in previous chapters. The new security will be advertised, inquiries will be invited, an alluring prospectus will be issued, the new security- will be listed and the corporation managers will then sit back and wait for orders to reach them. Let us suppose, however, that a new stock of a large issue is to be put out by one of the well-known com- panies. In that case, the corporation managers, or the syndicate which is underwriting and handhng the sale of that stock, will not only take all the means mentioned in the preceding paragraph to insure the success of the sale, but will go further. They will take measures to create a speculative interest in the stock and to "make a market" at a good price. In addition to their advertisements and prospectuses, they will probably set to work other forces stiU better fitted to secure buying orders from marginal specula- tors. Now the average speculator is not much attracted by brass band announcements or even by newspaper stories, no matter how well written and convincing they may seem. But he rises to a tip like a hungry fish to the bait. He reasons that what is known to everybody will bring Httle profit to himself, but that information which comes to him confidentially by word of mouth gives him an exceptional opportunity. Therefore, Wall Street, from morning to night in an active market, himis with tips, rumors and gossip. The tips that are thus circulated are not all valueless by any means, although it must be admitted that a speculator who follows them too closely will probably be a heavy loser in the end. The first move, then, of the managers of a large new stock issue will probably be to see to it that rumors as to the extent and high quality of the issue, and above all, as to the "interests" that will support its market price, begin THE WALL STREET MARKET 253 to circulate. Thus the appetite of speculators will be stimulated and large buying orders from them will prob- ably await the first appearance of the stock on the market. The next step will be to range the brokers in favor of the new issue, so that whatever advice they give to their customers will tend to favor its purchase. The most di- rect method of securing the brokers' favorable attention is by seeing to it that the new stock is acceptable as col- lateral for bank loans. Partly for this reason it is very important that among the persons interested from the beginning in the new issue should be representatives of large banking interests. If the broker feels sure that the stock will be acceptable as collateral, he knows that he will be able to carry large amounts of it for his cus- tomers on easy terms. 136. Syndicate operations. — The next step is to se- cure an agreement among the syndicate members and perhaps with large banking and brokerage interests out- side the syndicate that the price of that particular se- curity will be held at a given figure. Thus when the Interborough-Metropolitan Company, the great $240,- 000,000 merger of the transportation lines of New York City, was formed, the members of the syndicate were said to have agreed that the price of the common stock should not be allowed to fall below fifty. In order to maintain the price at this point they were compelled after the stock had been issued to purchase large blocks and take them off the market. In this particular case the syndicate, for reasons which need not be here dis- cussed, went to pieces after about a year, and the price of the common stock suddenly broke very sharply. During the year, however, the agreement was lived up to. Where such an agreement is made and maintained, 254 CORPORATION FINANCE the eiFect is to steady the price of the stock, or at least to hold it above the figure agreed upon, and thereby to attract both speculators and investors. 137. Stock market manipulation. — The fourth step in making a market for a new issue is to manipulate the price in such a manner as to gain the good will of specu- lators and brokers and arouse expectations of large profits. Manipulating a stock is a process that requires great skill, judgment and cool nerve. Several men in the Wall Street district have become famous for their abilities along this line; foremost among them is the well-known and successful operator, the late James R. Keene. To Mr. Keene was entrusted most of the large speculative stock fiotations of recent years. He was almost uniformly successful. One method by which a manipulator may fix a quota- tion for his security is by "wash sales," by which is meant selling with one hand and buying with the other. Brokers on the New York Stock Exchange, according to the rules of the exchange, are not allowed to be parties knowingly to such a process. They are not sup- posed to know, however, and as a matter of fact, cannot know, whether or not a selling order given to them is matched by a buying order simultaneously given to an- other broker. By means of such matched orders a ma- nipulator may raise or depress the price of a stock al- most at will with no further expense than brokerage commissions — provided, of course, that his plans are not interfered with by large buying or selling orders from other parties. It is customary for a stock market ma- nipulator in this manner to fix or attempt to fix the price of a security at the beginning and then gradually raise its price and thus stimulate speculative interest in the security. THE WALL STREET MARKET 265 As the security advances in price and stockholders begin to send in their orders to buy, the manipulator, if his plans work out successfully, gradually feeds out small amounts of the stock that he has on hand. This process must be very gradual and carried on in such a manner that it cannot easily be observed; otherwise, the stock-market price will be depressed, stockholders will take warning and will begin to seU and the market will be spoiled. Furthermore, it is not well to allow the price to go up too rapidly or too steadily; otherwise the ma- nipulation will be too apparent and furthermore no op- portunity will be given to prospective buyers to purchase at slight recessions from previous prices. The price of a skillfully manipulated stock will move upward and downward by jerks, the tendency on the whole being up- ward. If the manipulation is secret and skillful, not even the most expert observer can be certain whether the price is subject to manipulation or not. It will be impossible here to enter into a study of all the intricacies of manipulation and of the schemes which have been successfully worked in the past. The object of this chapter is attained if the reader sees that the se- curities, stocks especially, of large corporations may be sold through the stock market at much higher prices than would be possible if the same stocks were sold direct to investors. A further study of this interesting branch of our subject will be found in the volume on Invest- ment AND Speculation, CHAPTER XVIII SELLING SECURITIES— THE UNDERWRITING SYNDICATE 138. Origin of underwriting. — One means of float- ing an issue of securities, we have seen, is to dispose of them through the agency of banking and brokerage houses. In such cases the financial houses may not merely undertake to sell the securities, but may make themselves responsible for the success of the sale. One method of so doing is by agreeing to take for them- selves, if no other purchasers are found within a specified period, all of the unsold portion of the issue at a certain agreed price. Thus the issuing corporation is relieved of part of its risk and the buyers of the securities are made to feel that well-informed financiers have faith in their value. This process — modified more or less, as described later in this chapter — is known as under- writing. The origin of underwriting is to be found in the famous London institution called Lloyd's. Lloyd's Coffee House was the place where the export and import merchants of London assembled in the 17th century to transact their business with shippers. As aU such trade at that time was peculiarly subject to mishaps of all kinds, the practice grew up of dividing the risk on cargoes and shipments among a large number of mer- chants; each party to the agreement wrote his name under the contract and from this custom arose the name "underwriting." We are to discuss in this chapter the 256 THE UNDERWRITING SYNDICATE 257 same principle as it is now applied to new issues of se- curities. The essential part of the arrangement is the insuring of someone against loss or failure. A secon- dary feature is the division of the risk among a con- siderable number of people, so that no one of the in- surers is liable to suffer great loss. 139. Advantages of underwriting to the corporation. — There are several reasons why banking and brokerage houses may properly carry on this business of financial underwriting and why the business is usually profitable both to themselves and to the corporation which issues the underwritten securities. In the first place, the bankers are presumably experts in the valuation of se- curities. Their judgment as to the price which should be set on a new security or as to the terms of exchange, if the new security results from a conversion of an old security, is a valuable, authoritative judgment. In the second place, the bankers are also experts in selling se- curities and each house involved in the underwriting usually has an established clientele to whom it may readily dispose of almost any securities that it recom- mends. The corporation, on the other hand, has no facilities whatever for selling stocks and bonds; its ac- tivities are in the field of transportation, or industry, or trade, not in finance. Two further reasons are even more potent in inducing corporation managers to have new security issues under- written. First, even though the corporation can obtain expert financial advice and is reasonably sure to make a success ultimately of the sale of any securities it puts out, yet the time that will elapse before the sale is com- pleted and the money received is always uncertain. Now the corporation ordinarily would not be trying to sell new securities if it did not need money at once or in VI— IT 258 CORPORATION FINANCE the near future. It is disastrous to the success of many industrial or commercial operations to hold them in abeyance until the tedious process of selling a large block of bonds or stocks is completed; yet it is dangerous to go ahead so long as the sale is incomplete. This delay can be avoided by having the security underwritten, for the underwriters will pay the corporation within a definite period. The second reason tha,t appeals strongly to corporation managers is that the credit of a corporation is seriously affected by any apparent in- ability to market its securities. One failure — or even a success that is too hard-won — would hamper the corpo- ration greatly both in getting loans and in making future sales of stock. 140. Advantage to the buyers of securities. — There are telling advantages to the buyers of securities also in having them underwritten. As was pointed out in Chapter XVI, reputable banking houses never sell se- curities until after they have been satisfied by a search- ing investigation that the securities are all that they are represented to be. Though this does not mean a guar- antee on the part of the banking house, it does mean that the buyer has the advantage of their expert, and presumably impartial, examination of every question, legal, financial, accounting, engineering or commercial, that pertains to the new security. This investigation is expensive; no ordinary investor could afford it on his own account. He is, therefore, willing to pay a little higher price for a security if this service has been per- formed. Another advantage to the buyer is that he may be sure that the whole security issue has been sold by the cor- poration. A half -sold issue is a sign of weakness and a hindrance to the completion of the corporation's plans THE UNDERWRITING SYNDICATE 259 so serious as to reduce the value usually of the portion that has been sold. Suppose, for instance, that an in- dustrial company desires to build a new plant at a cost of $10,000,000 and sells only $8,000,000 worth of the securities which are intended to finance the project. What can the company do? It can neither complete the plant nor return the $8,000,000. In all probability the money will be used unprofitably and the stocks or bonds sold by the company will be poorly secured. This danger is avoided when the whole block of securities is taken at one time by underwriters. A third advantage to the buyer is that any reputable banking house will watch closely any security that it has underwritten, and will come to the assistance of the security-holders in case the corporation later gets into difficulties. As will be brought out in our study of re- organization, the committees formed to assist in devising plans to reorganize insolvent corporations almost always contain representatives of banking houses who are there to look after the interests of their clients. For these reasons underwriting certainly adds to the value of securities. The underwriters naturally are not impelled by charitable motives ; they expect a reasonable compensation for their risk and trouble, and frequently the compensation runs well up into millions of dollars. Barring collusion and graft, which have been only too apparent in isolated cases, it may be laid down as a general rule, however, that the underwriters give more than value received. There is no question in the writer's mind but that our corporation financing is cleaner and more efficient because underwriting is the general prac- tice. It is hard to over-estimate the value of examina- tion and supervision by fair-minded financial experts. 141. When is underwriting advisable? — It must not 260 CORPORATION FINANCE be inferred that every new stock or bond issue ought to be underwritten. Small issues, say $500,000 or less, can usually be sold to a comparatively small number of investors by direct solicitation on the part of the corpo- ration. Then again, well-established, successful corpo- rations frequently sell new stock or bond issues to their stockholders at bargain prices. Ordinarily there is no risk in such a sale aad consequently no necessity for underwriting. An interesting concrete case, in which there is doubt as to whether new issues of bonds should be underwritten or not, was brought to public attention in March, 1909. At the annual meeting of the stockholders of the Penn- sylvania Railroad Company Mr. Moorfield Storey, a Boston lawyer, submitted the following resolution : Whereas, The Pennsylvania Railroad Company is to-day the first railroad corporation in the world, and its securities are en- titled to rank with the best that can be offered, and, therefore, to command the highest price in the markets, both of this and foreign countries ; and. Whereas, There is now abundant capital in the hands of capitalists and combinations of capitalists the world over, who are seeking opportunities for buying such securities, and it is desirable that the directors of this company should take ad- vantage of the opportunity which these conditions afford to obtain the highest price possible -for such securities as the com- pany now proposes to sell ; and. Whereas, The sale of railroad securities to the highest bidder after open competition will do much to remove the public be- lief that such securities are issued for excessive amounts, and thus tend to prevent legislation adverse to these corporations, which is now threatened. Resolved, That the stockholders of the Pennsylvania Rail- road Company desire to have the proposed issue of securities so offered as to be open to competitive bidding by responsible THE UNDERWRITING SYNDICATE 261 banking houses, and that the issue of securities should be ad- vertised in advance, it being required that such bids shall be accompanied by certified check for such amount as may be necessary to insure good faith. This reasoning sounds plausible at the first hearing, but is far from convincing. It fails to take unto ac- count the risks involved in the proposed plan and the advantage to the railroad of having the right kind of banking connections in periods of financial stress. In the course of an able discussion of this proposal the New York Evening Post said: Those who hold different views appeal to the Pennsylvania's own experience in 1903. Early in that year, when the stock was selling around 157, the shareholders were offered $75,000,- 000 new stock at 120. Before the time for closing the sub- scription list expired, the price of the old stock had fallen almost to 120, and the management was confronted with the diffi- culty that beset the Steel Corporation the same year, when bonds which had been offered to the shareholders at par were selling in the open market at .65. Needless to say, the Steel bonds were finally sold to a syndicate and not to the shareholders. When Pennsylvania dropped to around 120, in the spring of 1903, a banking syndicate was hastily formed to underwrite the new issue for which a commission of 2% per cent was allowed. Before the whole operation was concluded the old stock had touched 110%. Under favorable conditions a road in such high credit as the Pennsylvania, the St. Paul, the Great North- ern, the Union Pacific, the Illinois Central, or the North- western could get a better price for an issue of bonds by shopping among the international banking houses than by con- fining negotiations to one banking firm. But all of the roads named have at one time or another been forced to borrow when the prices of investment securities were falling or when money market conditions were unfavorable. A railroad which has established permanent banking connec- 262 CORPORATION FINANCE tions has a guarantee that money can be raised in troublesome times, when necessary, as well as when investors are clamoring for securities. When acting in such capacity bankers are sup- posed to advise a railroad what kind of securities will find the readiest market, exactly when the securities should be issued, a very important point, and what price the public should be asked to pay for the issue. It is also the business of railway bankers to protect the market for a new issue until the securities reach the hands of investors. 142. Why underwriting syndicates are formed. — It would naturally be expected that each of the large financial houses engaged in the underwriting business would handle on its own responsibility whatever busi- ness comes its way, and that rivalry would prevent their co-operating to any considerable extent. The fact is, however, that these houses have long since learned that it is inadvisable for any one of them, no matter how powerful, to guarantee the success of a large security issue. It is true that the banker's judgment and ex- perience should enable him to avoid heavy risks; yet a certain amount of risk is inevitable. A banker does not know what may happen in the financial world, does not know when the bankruptcy of some big concern or un- expected political events may create a sudden panic. If he is caught at such a time with his funds tied up in a large issue of new and unsalable securities, he may be forced into bankruptcy and is almost certain to suffer severe loss. It is not considered conservative banking, therefore, for any one house or even any two or three houses to underwrite a large issue. Many banking houses follow a definite policy in this respect and refuse absolutely to underwrite more than a certain sum, say $100,000 or $500,000 or $1,000,000, depending on the size of the house, even when the risk seems particularly small. THE UNDERWRITING SYNDICATE 263 Another reason for co-operation among bankets is that each house desires to offer a variety of securities to its chentele. If it speciahzes too much or offers only a few securities, it cannot expect to attract and hold reg- ular customers. A third reason for co-operation is in order that a broad geographical distribution may be obtained and the sale of the security issue be made correspondingly easy. A Pittsburg steel company, we will say, is putting out a large new bond issue and gets a New York banking house to underwrite the issue. New York and Pitts- burg investors may be loaded with similar bonds already; under such circumstances the New York banking house will certainly invite houses in Boston and Chicago and other centers, which are not yet saturated with such bonds, to participate in the underwriting. For these reasons the banks and brokerage houses that handle this business on a large scale always band them- selves together in the case of an issue of considerable size into an underwriting syndicate. By means of the syndicate the risk, the trouble and the profits are divided among §everal houses. The syndicate so formed may belong to any one of five types. 143. Five types of syndicates. — Originally the nor- mal arrangement was to have the syndicate as a whole guarantee the price of the issue, and let the corporation attend to the selling. Under this plan, to give an ex- ample, a corporation putting out a $5,000,000 bond is- sue would offer the bonds to the public at a fixed price, say 95, and the syndicate would agree to accept any of the bonds not bought by the public at a lower price, say 90. This is underwriting in the original sense of the word; it is a species of insurance. Under such a plan the syndicate would have two sources of profit; first, a 264 CORPORATION FINANCE commission on the portion sold to the public, or a fixed bonus; and, second, the diiference between the whole- sale price to them and the retail price at which they would ultimately dispose of the bonds. The ordinary commission would range between 2 and 5 per cent. This type is seldom used nowadays, principally for the reason already given that the corporation is not well equipped to attend to the sale of securities. A second type, also rather unusual, is a syndicate formed to take an "underwriter's option." Under this plan the syndicate takes the block of bonds or stock at a fixed price, payable only as resold. As fast as the syndicate disposes of the bonds it turns over the proceeds to the corporation, after deducting whatever it receives above the fixed price. The corporation pays somewhat less for this service than for other kinds of underwriting, because the syndicate takes no risk; on the other hand, as the corporation cannot be certain when it will get its money, the type is not much favored by conservative corporation managers. The third type of syndicate comes into existence when a large banking house has bought for itself a big secur- ity issue and wishes to distribute the risk. In such a case the original underwriter frequently calls upon other banking houses and upon individuals to take portions of the issue at prices low enough to be attractive. The agreement with the parties who are called in may be ex- ecuted in anticipation of a contract that is about to be made between the original underwriter and the corpora- tion. Full details as to an excellent example of this type of underwriting syndicate will be found in the agreement made in order to guarantee the conversion of the United States Steel Corporation preferred stock, which is given in full on pages 270-277. THE UNDERWRITING SYNDICATE 265 144. A fourth type — pooling the sale of the security. — The fourth type of syndicate acts as a unit in making a contract for the purchase of an issue and pools the sale of the stock or bonds. The chief difference between the third and fourth types lies simply in the fact that the syndicate members deal directly with the corporation, not with a banking house. They thus secure for them- selves all the profits of the underwriters. Such a syndi- cate is always managed by some one house or individual having complete authority. Its organization and man- agement are further discussed below. On the whole, this is probably the best known and most common form of large syndicates. To illustrate the workings of this type we will sup- pose that a syndicate has been formed, under the leader- ship of Speyer & Company, to underwrite a $25,000,000 bond issue at 90 ; to the public the price of the issue, we will say, is 95. One concern may agree to take $1,000,- 000, or one-twenty-fifth of whatever amount the public fails to buy; another concern may take $2,500,000, or one-tenth of whatever is left unsold, and so on. All the bonds are left, in this form of syndicate, with Speyer & Company, who offer the bonds to the public and sell all that they can. If the whole issue is taken by the public, each party to the syndicate receives his profits, after deducting expenses, without further trouble. If the public does not take the whole issue, each member must take his agreed proportion at the syndicate price, 90. In good times the risk in such a transaction is slight; if the public is indisposed to buy bonds, however, or if any serious mistake in their valuation has been made, the syndicate members may lose heavily. 145. A fifth type — distributing the security. — The pooling arrangement above described, although it se- 266 CORPORATION FINANCE cures centralized and efficient management, is apt to prove unsatisfactory in that it does not bring into play the whole selling machinery of the various syndicate members. For this reason it has become more and more customary of late years to distribute the security issue among the members of the syndicate. This is the fifth type of an underwriting syndicate. Strictly speaking, of course, the distribution of securities is not an under- writing in any sense, but a sale. It is a sale at a special price, however, made under certain restrictions and de- signed to serve exactly the same purpose as true under- writing ; the term therefore is freely applied to it in the Street. Chief among the restrictions on the sale is an agreement, either tacit or written, that the securities shall not be resold to the public at less than a certain fixed price. Frequently it is also agreed that some one or two of the syndicate members shall be given the first oppor- tunity to advertise a sale of the securities, and that the other members are to keep out of the open market for a limited period. Such an agreement would not bar any of the syndicate members from selling the securities to their regular clients. Among the members of a syndicate of this type there are frequently several individuals and institutions who are buying the securities, not for resale, but for invest- ment; they are simply getting in on the ground floor, making their investment at the special syndicate price. Readers will perhaps recall that this practice was brought to public attention and much discussed during the great insurance investigation of 1904. Mr. George W. Perkins, later of the firm of J. P. Morgan and Com- pany, and Mr. James H. Hyde, among others, alleged that their participation as individuals in syndicates, which was disclosed during the investigation, was for the THE UNDERWRITING SYNDICATE 267 purpose of buying bonds at especially low prices for the insurance companies which they represented. One ob- jection to allowing investors to participate in syndicates of this type is that they may decide later to sell the securities allotted to them before the banking members of the syndicate are through selling, and may thereby break the price. With the view to avoiding such a re- sult syndicate managers are exceedingly careful in choosing members who buy for investment, not for re- sale. 146. The large underwriting houses. — The Wall Street Journal, in a recent article dealing with the prac- tice of the big corporations in disposing of bond issues to underwriting syndicates of the third, fourth and fifth types, says: One method is to sell the bonds in a block to one of the great underwriters. Pennsylvania, Baltimore and Ohio, Union Pacific, and many others, sell direct to Kuhn, Loeb & Com- pany, get the money, and thereafter take only an indirect in- terest in the bonds. Rock Island sells to Speyer & Company, 'Frisco to Blair & Company and others, New York Central, Lake Shore, Southern Railway, Erie and others to J. P. Mor- gan & Company. The price at which these railroads sell their bonds to the underwriters is not generally known. It is taken to be a private matter, but it often leaks out. Another method, not uncommon, is to sell the bonds to the big retail bond houses who distribute them to a wide and wealthy public through advertising and through correspond- ence. Each of these houses has its clientele. Some are strong in New York, others in Canada, others in the South, etc. They are more or less specialists, and get to be known for a particular grade of bonds or stocks. These two methods, of course, overlap greatly. Harvey Fisk & Sons, for instance, known for years as a big retail bond house of wide clientele, frequently underwrite whole issues of 268 CORPORATION FINANCE securities, as in the case of the Electrical Securities collaterals, recently brought out. Similarly, Fisk & Robinson took the whole issue of the new Buffalo & Susquehanna Railway 4I/2S. J. P. Morgan & Company, Kuhn, Loeb & Company and Speyer & Company generally participate to a greater or less extent in any extensive new bond issue, because their clientele demands it, even though these firms may not be the original underwriters. Summing up what has b&n said with regard to the various types of underwriting syndicates, it is evident that the tendency is growing for the corporation to sell its new security issues at fixed prices to the large bank- ing houses and then wash its hands of the business of selling the securities. Experience has demonstrated that this is the best method for the corporation. Bank- ing houses also prefer this method to the original under- writing, which consisted simply in guaranteeing the price, for two reasons: first, because they can thus con- trol the price and time of sale and bring to bear their skill in selling ; second, because the underwriters, having full control of the securities, can post them as collateral and secure bank loans, thereby reducing their direct cash obligations. In making this last statement the writer has in mind the distinction between "banking houses" and "banks" which may not be familiar to all readers. "Banking houses," so-called, seldom carry deposits to any great extent from other people, and do not make a business of loaning money. Their chief interests lie in buying and selling securities. "Banks," on the other hand, draw their profits mainly from receiving deposits and making loans. CHAPTER XIX THE MANAGEMENT OF THE UNDERWRITING SYNDICATE 147. Informal agreements. — As there are only a few large banking houses and institutions, even in the whole country, which ordinarily take part in large underwrit- ing syndicates and as these houses are thoroughly fa- miliar with each others' policies and resources, the agree- ments among them are frequently quite informal. In one large transaction recently, as was later brought out on the witness stand, J. P. Morgan and Company formed an underwriting syndicate simply by allotting a certain proportion of the security issue to each of several large firms and institutions. The members of the syndi- cate were not consulted at all or even advised in writing, but were merely called on the telephone and notified of their participation. The informality was possible in this case because the syndicate was expected to make good profits and J. P. Morgan and Company well knew that everyone concerned would gladly take as large an allotment as the syndicate managers would grant. 148. A formal syndicate agreement. — Ordinarily, however, a formal syndicate agreement is drawn up and signed. As these agreements are not generally made public, their exact terms seldom become known. The most elaborate and perhaps the most important agree- ment of this nature that has been given out, was produced on the witness stand in the famous suit to prevent the conversion of United States Steel preferred stock into bonds, referred to in Chapter XV. The agreement is 269 270 • CORPORATION FINANCE of such interest and importance that it is given in full below : U. S. STEEL CORPORATION PREFERRED STOCK RE- TIREMENT SYNDICATE AGREEMENT. An agreement made the 12th day of March, 1902, by and between J. P. Morgaii & Co., co-partners, as Bankers, of the City of New York, parties of the first part, and the sub- scribers hereto (hereinafter called severally, parties of the sec- ond part). Whereas, The United States Steel Corporation (herein- after called the "Steel Company") proposes to make with J. P. Morgan & Co., a certain contract or contracts whereunder in behalf and on account of the Steel Company they are to offer to all of the preferred stockholders of the Steel Company, severally and ratably, the preferential opportunity of subscrib- ing for and of taking at par the "Ten-Sixty Year" Five Per Cent Sinking Fund Gold Bonds of the Steel Company in even amounts approximately equal to 40 per cent of their several holdings of preferred stock, such subscriptions to be payable in such preferred stock at par, provided that every such subscrip- tion stockholder at the time of such original subscription pay- able in preferred stock shall have the right of his option then to make an additional subscription payable in cash for such bonds to an amount equal to 25 per cent of his stock subscription; such bonds to be authorized now for the principal sum of $250,000,000 and Whereas, in and by such contracts J. P. Morgan & Co. are to guarantee to the Steel Company, that subscriptions for such bonds will be made for the aggregate sum of at least $100,000,000, payable in preferred stock to the extent of four- fifths of said sum, and in cash for the remaining one-fifth thereof; such contracts to provide for the payment or allow- ance to J. P. Morgan & Co., of a commission of 4 per cent upon the aggregate par amount of all such bonds, which shall be sold and delivered under their said offer, or to them, they SYNDICATE MANAGEMENT 271 having the prior right to take all of such bonds which shall be offered for subscription, and which shall not be taken by the preferred stockholders under such offer; and Whereas, upon the terms of this agreement, and for the purposes above mentioned all of the parties hereto now desire to form a syndicate to provide and to furnish to J. P. Morgan & Co. for delivery to the Steel Company the preferred stock, and the cash required under their said guaranty, and to receive from J. P. Morgan & Co., four-fifths of the net commissions by them received . under the said contract or contracts with the Steel Company, which contracts J. P. Morgan & Co. are au- thorized from time to time to make, modify and perform, as in the exercise of their unlimited discretion from time to time they may deem proper, do agree, as follows, viz. : First. On signing this agreement each subscriber has delivered to J. P. Morgan & Co. certificates for preferred stock of the Steel Company in the amount indicated in his stock sub- scription hereto, which preferred stock, to such extent as may be required to meet the requirements of their said guaranty, is to be delivered to the Steel Company at par in exchange for the Ten-Sixty Year Five Per Cent Gold Bonds of the Steel Company for an equal amount at par, to be received therefor by any subscriber, and any such preferred stock not so delivered to the Steel Company is to be returned to the subscribers rata- bly according to their several subscriptions. Second. Each subscriber further agrees to pay J. P. Morgan & Co. in cash the sum specified in his cash subscription hereto, for which cash J. P. Morgan & Co. shall receive from the Steel Company bonds as aforesaid at par equal to the amount of such cash payment by such subscribers. Third. The several deliveries and undertakings of the several subscribers under this agreement shall be made and per- formed by the subscribers respectively when and as requested by J. P. Morgan & Co. or by the subscribers, of any of said Five Per Cent Sinking Fund Gold Bonds of the Steel Company. Fourth. The several subscribers shall be called upon to 272 CORPORATION FINANCE make payments of cash in respect of their several subscriptions only ratably according to the several amounts thereof ; but each subscriber shall be so responsible to the full extent of the sev- eral undertakings regardless of performance or non-perform- ance by any other subscriber. In the same proportion except as otherwise provided the several subscribers shall be responsible for loss resulting to the Syndicate under this agreement. Noth- ing herein contained shall constitute the parties hereto partners, or shall render any of the subscribers liable to contribute more than his several proportionate amount as herein provided. Fifth. In the case of the failure of any subscriber to perform any of his undertakings hereunder as and when called for by them, J. P. Morgan & Co. in behalf of themselves and the syndicate shall have, and at their sole and exclusive option they may exercise, the right to exclude such subscriber from all interest in the Syndicate, and in their discretion, without any proceedings, either at law or in equity, they may dispose of such subscriber's participation hereunder of any interest or right of such subscriber hereunder or under any of said proposed contracts, but nevertheless, each subscriber in default shall be responsible to J. P. Morgan & Co. for the benefit of themselves and the other subscribers hereto for all damages caused by any failure on his part. At any public sale under this article of any interest or right of any subscriber J. P. Morgan & Co. or any party thereto may become purchaser for their ' or for his own benefit, without accountability ; bulf notwithstanding any sale, whether public or private, the de- faulting subscriber shall be responsible to J. P. Morgan & Co. and to the Syndicate for all damages caused by such failure on his part. Sixth. J. P. Morgan & Co. shall have full power in their liscretion from time to time, to agree with the Steel Company upon the terms and provisions of any contracts such as are above referred to ; and also, from time to time, to enter into any agreements with the Steel Company modifying the said contracts as they may deem expedient. They may deliver to the Steel Company a copy of this agreement, having annexed SYNDICATE MANAGEMENT 273 thereto a list of the subscribers ; and thereupon to the extent of their several subscriptions, the subscribers, severally and respectively, but not jointly, and no one for any other, shall become responsible for the performance of such contracts with the Steel Company in discharge of the obligations thereunder of J. P. Morgan & Co. Any and all contracts with the Steel Company made by J. P. Morgan & Co. shall be open to in- spection by any subscriber at the office of J. P. Morgan & Co. Seventh. J. P. Morgan & Co. shall be the sole and final judges as to whether at any time it is to the interest of the Syndicate to proceed further under this agreement or under said proposed contracts ; and wherever they may deem ex- pedient, they may abandon the objects contemplated, in this agreement and said proposed contracts and all further proceed- ings thereunder. In such event all the cash or stock and bonds by them received and then held for account of the Syndicate, and the proceeds of such stock and bonds shall remain charged with the payment of all expenses and liability by them incurred hereunder* and shall be applied : — First to the payment of any and all expenses and obligations incurred by J. P. Morgan & Co. under any provisions of this agreement. Secondly, in repayment to the subscribers (so far as the same may be sufficient for that purpose) of all amounts of preferred stock or of cash by them respectively delivered here- under to J. P. Morgan & Co., such repayment to be made to the subscribers ratably. Eighth. J. P. Morgan & Co. shall be sole managers of the Syndicate, and in behalf of the Syndicate they may make any and all arrangements, and may perform any and all acts, even though not herein provided for, in their opinion necessary or expedient to carry out the purposes of this agreement, or to promote or to protect what they deem to be the best interests of the Syndicate. The enumeration of specific powers in this or in any other article of this agreement shall not be construed as in any way VI— 18 g74 CORPORATION FINANCE abridging the general powers of this article intended to be con- ferred upon or reserved to J. P. Morgan & Co. Ninth. From time to time before October 1, 1903, J. P. Morgan & Co. in behalf of the Syndicate, may make sales of all or any part of the bonds received by them for account of the Syndicate. Any such sales may be made by J. P. Morgan & Co. either publicly or privately, by themselves, or in such man- ner as they may deem proper, and shall be upon such terms and for such price or prices as they may deem expedient. Each subscriber hereby assents to, and agrees to be bound by any such action. No subscriber shall be entitled to receive any of said bonds before October 1, 1903. In the meantime, in their discretion, J. P. Morgan & Co. either themselves may retain all or any part of such bonds, or they may deliver to any subscriber his proportionate part thereof, upon his agreement to hold the same subject to sale by J. P. Morgan & Co. and to return the same upon call of J. P. Morgan & Co. at any time before Octo- ber 1, 1903. Should any subscriber desire to withdraw from sale the por- tion of bonds to which he may be entitled hereunder, J. P. Morgan & Co., in their discretion may deliver to any sub- scriber his portion of such bonds upon his agreement to hold the same for himself without sale until October 1, 1903, or until the complete sale by J. P. Morgan & Co. at an earlier date of all bonds held by or for the Syndicate. Tenth. Until October 1, 1903, or until the final distribu- tion hereunder, J. P. Morgan & Co. in such manner, at such prices, on such terms, and in such amounts as they may deem expedient, shall have power for account of the Syndicate, to make purchases of the 5 per cent gold bonds and of the pre- ferred stock of the Steel Company, and they may resell any such bonds and stocks which they may have purchased and in their discretion they may make any further undertakings of any kind with any persons concerning any such bonds and stocks. They may apply towards any such purchases any SYNDICATE MANAGEMENT 275 sums realized from any sales of bonds and stocks of the Steel Company under any provisions of this agreement ; and they may make advances, or may procure loans, and may secure the same to such amounts and in such manner as from time to time they may deem expedient for any of the purposes of this agree- ment. Eleventh. J. P. Morgan & Co. shall issue to the sub- scribers suitable receipts in respect of payments made here- under, and they may issue to the respective subscribers certifi- cates of interest of such tenor and form as they may deem suitable. Such certificates of interest and rights and obliga- tions hereunder of the respective subscribers may be made trans- ferable in such manner and on such terms and conditions as J. P. Morgan & Co. may prescribe. Tw^ELFTH. J. P. Morgan & Co. shall have authority from time to time and at any time to incur such expenses as they may deem proper in carrying out, or endeavoring to carry out, this agreement or said proposed contracts, or in doing any act or thing which they may deem to be in the interest of the Syndicate, and all such expenses shall constitute and be a prior charge in their favor upon any and all moneys, stocks and bonds by them received or held hereunder. Any and all moneys by them received hereunder shall hold by them as bankers in general account. They also shall have power and authority, in their sole and absolute direction, finally to fix and pay all compensations or depositaries, brokers, agents and counsel, or others, and in the expense account may be included brokers' commissions as usually paid. Thirteenth. After the complete performance of the en- tire obligation of the Syndicate hereunder, but not before the first day of October, l903, unless otherwise determined by J. P. Morgan & Co., in the exercise of their unrestricted dis- cretion, payment may be made to the Syndicate by J. P. Morgan & Co. for the purpose of this agreement, out of any moneys for such purposes received or retained by J. P. Morgan & Co. Fourteenth. J. P. Morgan & Co. shall not be liable under any of the provisions of this agreement nor for any 276 CORPORATION FINANCE matter therewith connected except for good faith in perform- ing or in refraining from performing or carrying out, the obli- gations by them herein expressly assumed; the implication of any obligation not herein expressly assumed by them being hereby expressly denied and waived. It is understood that, in the same manner as other subscribers, J. P. Morgan & Co. may become subscribers hereto, that as such subscribers they shall be liable for all subscriptions by them made, and that in all respects they shall be entitled to the same rights and benefits as any other subscriber. Any sub- scriber hereto may, on his own account, make any agreement with any other subscriber or with the Steel Company. Fifteenth. This agreement shall bind, and is for the benefit of the parties hereto and their administrators and execu- tors, severally and respectively, but no assignment hereunder shall be valid unless assented to in writing by J. P. Morgan & Co. All rights and powers J. P. Morgan & Co. hereunder shall vest in said co-partnership firm, as from time to time consti- tuted, without further act or assignment. Sixteenth. Nothing herein contained shall be construed as creating any trust or obligation whatsoever in favor of any person or corporation other than the subscribers, nor any obligation in favor of the subscribers excepting only as herein is expressly provided. Seventeenth. Each subscriber shall set opposite his subscription hereunder an address, to which notices, calls or other communications may be sent, and any notice, call or other communication addressed to any subscriber at the address so given, and either at such address or mailed, shall be deemed ac- tually given to such subscriber, and shall be sufiicient for all the purposes hereof. If any subscriber shall fail so to furnish an address to J. P. Morgan & Co., he shall not be entitled to any no- tice of calls or offers, or any other notice hereunder, and he shall be deemed to assent to any action of J. P. Morgan & Co. Eighteenth. In consideration of the irrevocable rights in them vested hereunder, and the promises of the several SYNDICATE MANAGEMENT 277 subscribers, J. P. Morgan & Co. have become parties to, and in good faith will endeavor to consummate the purposes of this agreement; and, after receipt thereof from the Steel Com- pany, they will, as herein provided, deliver to the Syndicate the said Five Per Cent Gold Bonds, or the proceeds thereof, and the said cash compensation. In wi-bness whereof, the parties of the first part have hereunto affixed their signatures, and the parties of the second part at various dates have affixed their subscriptions hereto, it being understood that for convenience this agreement may be subscribed in several parts and copies with the same force and effect as if all the subscriptions were on one part or copy thereof. SUBSCRIPTION FOR FIVE PER CENT GOLD BONDS. Name Address Preferred Stock Cash 149. Characteristics of syndicate agreements. — The most prominent feature of this agreement, as the reader has no doubt observed, is the absolute and unrestricted authority retained by the managers of the syndicate. Such phrases as "J. P. Morgan & Company shall have full power in their discretion," "J. P. Morgan & Com- pany shall be the sole and final judges," "J. P. Morgan & Company shall have authority from time to time aind at any time," "J. P. Morgan & Company, in the exer- cise of their unrestricted discretion," and so on, abound. In this respect the agreement is typical of all underwrit- ing syndicates. Indeed, it is easy to see that without such unrestricted authority the syndicate managers could not carry on their operations with the necessary promptness and secrecy. The real check to any abuse of this power is to be found in the necessity resting on each banking firm to preserve its reputation for integ- rity absolutely unstained. For the same reason this agreement, like most other 278 CORPORATION FINANCE such agreements, is marked by open dealing, so far as the essential things are concerned. At the very begin' ning of the agreement J. P. Morgan and Companj state the commission which they are to receive. There is nothing on their part concealed from the othei syndicate members; they state clearly what their profits and what the profits of each member are to be. The same rule holds true even in cases where tl^e original underwriter is to make an extra profit over and above what goes to the other syndicate members. Secret prof- its are not permissible under the code of ethics that governs underwriting transactions. Sometimes it happens that one of the underwriting firms finds its allotments too large for some reason, in which case it will probably form a sub-syndicate. The members of the sub-syndicate are usually individuals or smaller banking firms. They are not brought into con- tact at all with the original syndicate and have no part in its workings, but are responsible solely to the othet members of the sub-syndicate. 150. Functions of underwriting syndicates. — Under- writing syndicates may handle the securities of (a) Established corporations. (b) Reorganized corporations. (c) New corporations. The first case is the one that has been kept in view so far in this discussion and need not be further considered. The second case presents some points of difference which will be referred to in the chapters dealing with reor- ganization. In both cases the syndicate is handling in- vestment securities and its sole problem is to market those securities to the best advantage. The third case is closely allied with promotion; the syndicate methods in this case require some further consideration. SYNDICATE MANAGEMENT 279 151. Underwriting speculative securities. — The se- curities of a new corporation, no matter how brilliant its prospects may be, are almost always speculative ; the only exception is when a new corporation is formed to take over a business already established, and this excep- tion we need not consider here. The first distinction, then, between a syndicate formed to underwrite the se- curities of a new corporation and other syndicates is that it is handling stocks and bonds of doubtful value which it cannot recommend unreservedly. A second distinction is that the syndicate must be prepared to put up more cash or furnish more credit in proportion to the size of the security issues than would ordinarily be necessary. This follows from the fact that conservative banks are not willing to lend much money on speculative stocks and bonds. A third distinction is that the syndicate must be pre- pared to carry the proposition through to the end; in no other way except at an enormous sacrifice can the money needs of the new corporation be met. A fourth distinction lies in the fact that for their own protection the syndicate members must build up and maintain the credit of the new corporation. Evidently there are several difficult and dangerous problems here to be solved. It is essential to their so- lution that the syndicate should absolutely control the new corporation. Without control measures may be taken that will impair the credit of the corporation and bring heavy losses upon the syndicate. Even with full control such enterprises are usually deemed too risky to be participated in by banking houses of the best class. At least if such houses do enter the syndicate they accept only small allotments, knowing full well the danger of becoming more deeply involved as the enterprise pro- 280 CORPORATION FINANCE ceeds. No one can tell in advance what the cash re quirements of a new corporation may be. Each enterprise of this nature has its own variation? of the difficulties and dangers that have been cited and requires a solution that will exactly fit its own peculi- arities. Perhaps the best way of explaining the usual solution will be to present the facts of a particular in- stance with which the writer happens to be familiar. 152. An example of speculative underwriting. — In the spring of 1902 the promoter of a smelting and re- fining company in Mexico succeeded in convincing a number of Philadelphia financiers that his proposition was worth looking into. They made a thorough investi- gation, satisfied themselves that the proposed plant would certainly prove profitable, and undertook to finance its construction. Engineers' estimates called for an expenditure of something over $2,000,000 and a period of three years before the plant would begin to earn expenses. As a matter of fact, the expenditure was approximately $3,000,000 and the construction work was not completed until early in 1907. A syndicate of Philadelphia and Baltimore capital- ists and banking houses was formed to underwrite the enterprise. Next an entirely different syndicate of banking houses was organized, which agreed to take the notes when issued up to a certain amount of syndicate No. I, the notes to be secured by the stock of a corpora- tion organized to construct the plant. The corporation was capitahzed at $2,000,000, half preferred and half common stock. All its stock was sold to syndicate No. I, for $1,000,000. Syndicate No. I then posted the stock and gave notes to syndicate No. II, which loaned the $1,000,000. Thus syndicate No. I was not called xipon for cash, except for expenses, and the construction SYNDICATE MANAGEMENT 281 company was supplied with $1,000,000 with which to begin operations. Next, after expending the $1,000,000, the construction company issued $500,000 of its own notes, which being its only obligations were accepted by Philadelphia banks. The discount on this and the other sales, for the sake of simplicity, we will eliminate. Up to this point one-half the necessary fvmds had been secured and at the end of two years the work of construction had been more than half completed. Now a new corporation was formed which was to operate the plant. The reader will observe that the first corporation existed simply to carry on con- struction. The operating corporation at once took over the stock of the construction company, title to which up to this time had remained with syndicate No. I. Then the operating corporation put out a first-mortgage bond issue, based on all its property then owned and thereafter to be constructed, and sold during the next two years $1,500,000 of bonds. In this way the whole $3,000,000 necessary to built the plant was raised by borrowing and the members of syndicate No. I furnished nothing to the enterprise but their credit. The diagram on page 282 will perhaps assist the reader in arriving at a clear understanding of the whole series of transactions. The plant at the date of writing has been running a little over two years. Earnings have been more than sufficient to meet all interest charges and other expenses, and it is expected that large profits will be earned in the future. Although the enterprise is not yet beyond the speculative stage, its chief difficulties have been over- come and its prospects appear bright. The first use to which surplus earnings will be devoted, according to the present plans, will be the paying off of the $1,000,000 of notes issued by syndicate No. I, and of the $500,000 S83 CORPORATION FINANCE ° OS "3 l« u ? ^ ^ U 5« ? XOe zgS S§z ' byog o " g 4 „ 3 a< i.'0.o« UL CTOCK OT OMWTINO UaUHl ICED FORAUStOCKOF s 8 SYNDICATE MANAGEMENT 283 notes of the construction company. As soon as these obligations are met the construction company may be dissolved and the operating company will begin to pay, it is expected, big dividends. It may seem strange that a new plant could thus be constructed wholly with borrowed funds; yet there is nothing especially unusual about the operation. The secret of the success of the syndicate in this instance lay in the fact that they were themselves strong financially and could borrow the. first $1,000,000 readily. This left a margin of safety to those who loaned funds directly to the two corporations. Furthermore, the syndicate members were shrewd and prudent enough not to use up all the available credit of their corporations at the beginning. On the contrary, the essential feature of their plan of operation was to leave the best lien till the last. Thus they were able to borrow $1,500,000 on first mortgage bonds at a time when most corporations under ordinary management would have been compelled to call on their stockholders for funds. Much more complicated instances might have been cited. The principles followed in all those that have proved successful, however, have been the same, namely : utilize the credit of the backers of the corporation at the beginning and save the best security that the corporation can oif er till the end. Working in this way, the under- writing syndicates of new corporations frequently bor- row large sums on advantageous terms. CHAPTER XX INVESTMENT OF CAPITAL FUNDS 153. The importance of wise investment. — The next question that confronts the promoter or manager of a new corporation after he has succeeded by one means or another in raising the necessary funds is, How shall those funds be invested? This seems a very easy prob- lem at first sight; and indeed the simple process of in- vesting is easy enough. To invest capital funds- wisely and to the best advantage for the future of the corpora- tion, however, is a task that requires careful thought and foresight. A great many mistakes are made just at this point. The causes of failure of a great many failed corporations may be traced back unquestionably to errors in the original investment. Of course, each corporation has its own peculiar con- ditions to meet and no general principles can be laid down that will take the place of keen observation and careful reflection over all factors in the particular situa- tion that each manager faces. Nevertheless, there are some principles with regard to investment of capital funds so universal and some fatal errors so common that a short study of the problem is evidently worth while. Even if the result of this study is only a series of gener- alities, still experience shows that these generalities are worth making and worth keeping constantly in view. 154. The installment method of getting cash as needed. — In the first place, a new corporation as a rule does not require all of the capital fimds that wiU be nec- 284. INVESTMENT OF CAPITAL FUNDS 285 essary for its development at the outset. On the other side, as was emphasized in connection with the subject of promotion, the corporation managers should have in sight from the very beginning all the capital funds that they are likely to need; for an effort to raise additional capital for an enterprise that is only half or two-thirds completed, and not on a paying basis, is painful and fre- quently unavailing. The manager or promoter of the corporation, then, looks for some method of reconciUng these conflicting requirements. The simplest and best method, from the corporation's standpoint, is to obtain subscriptions before the new concern is started for more than enough stocks and bonds to carry it through to success, but to have the cash for these securities payable in installments. This method is common and works very well with enterprises, the total capital cost of which can be accurately estimated in ad- vance — such enterprises, for instance, as the erection of an office building or the construction of a railroad. In such cases the installments may be certain definite per- centages due at days fixed in advance, say 10 per cent when the corporation is organized, 25 per cent at the expiration of three months, 25 per cent at the end of six months, 20 per cent at the end of nine months, and the remaining 20 per cent at the end of a year. In this way the sale of securities is facilitated, because buyers prefer usually to pay in installments, and the corporation gets its funds as needed. The case is quite different, however, when the total amount of capital funds needed cannot be foretold. A corporation may be formed, for instance, to open up a mine or construct a tunnel or start a maga^ne. No- body can foresee absolutely what obstacles the under- ground work of the mine or tunnel will encounter, or 286 CORPORATION FINANCE how quickly the magazine will "take" with the reading pubhe. The promoter of such an enterprise, if he is honest with himself, will recognize that the corporation perhaps may need less and probably will need a great deal more capital funds than he anticipates. In order to meet this situation he will, if he can, induce people to subscribe capital funds to an amount greater than will probably be needed, issue part-paid stock when install- ments to a certain amount, say 50 per cent, have been paid and make the rest of the installments payable at the option of the corporation. Thus the corporation can get all the funds it needs and at the same time does not have to carry large suras for which it has no partic- ular use. This is the ideal arrangement for such a corporation. 155. Disadvantages of this method. — Unfortunately this plan does not appeal to the average stockholder. He does not like the idea of being liable at all times for the unpaid installments, particularly as the calls for additional payments in many such enterprises are apt to come during periods of financial distress at the very time when it will be extremely disagreeable for him to meet them. Moreover, in large corporations such an arrangement gives to the managers of the corporation an opportunity for manipulation that they are not al- ways virtuous enough to resist. Take the case, for ex- ample, of a well-known street railway company, which may be recognized by some of our readers, but whose name it would be improper to give in this connection: This company has a very large amount of part-paid stock outstanding, the remaining installments being due and payabje at the option of the board of directors. It is strongly suspected that the board on several occasions have agreed among themselves in advance to issue a call INVESTMENT OF CAPITAL FUNDS 287 for an installment and have thus given themselyes plenty of time to accumulate cash. Then the call has been issued and the installment made payable at a very early date, so as to make it difficult for most of the stock- holders to meet the call. The result naturally has been in each instance that considerable amounts of the part- paid stock were thrown on the market and bought up at bargain prices by the directors and their friends. With the funds received from the installment the corporation has been in position to put its property in good condition and show excellent earnings for a year or two, thus al- lowing the directors to sell stock at high prices. After it was distributed the directors have issued another call and have repeated the milking process. Experiences like this have made buyers of securities very cautious in the purchase of part-paid stock. Generally speaking, it is a difficult thing to sell any stock that is not labeled "full paid and non-assessable." 156. Other possible methods. — It follows that the managers of a corporation, the needs of which for capi- tal funds cannot be estimated in advance, are driven to take one of two courses : either they must sell at the be- ginning a far greater amount of securities than wiU probably prove necessary, and put their idle funds to some use outside the original purpose of the corporation, or else they must trust to luck that they will be able to sell more securities when additional capital funds are needed. Neither one of these alternatives is free from serious objections. Here, then, is the first great problem in connection with the investment of capital funds, that of getting the funds when and if they prove to be needed. If that problem is not solved in just the right manner, either the corporation will have more funds on hand than it 288 CORPORATION FINANCE needs and its rate of profits on stock will thereby be diminished, or else it will not have enough funds and its development will thereby be cheeked. 157. How much shall he invested in fixed capital? — The next question to consider is, What proportion of the capital funds shall be put into "fixed" and what into "working" capital? The distinctions between fixed, semi-fixed, current and quick assets were discussed in Chapter VII. The fixed and semi-fixed assets to- gether — those assets, in other words, which cannot be readily converted into cash — constitute the corporation's fixed capital. Working capital is somewhat different. It consists, not of the current assets, but of the difference between current assets and current obligations. In other words, it consists of that amount of current assets which is not furnished by trade and other short-time creditors and by temporary bank loans. The amount of fixed capital required by any corpora- tion depends, of course, on the nature of its operations. Industrial and mining corporations must have machin- ery; railroad companies must have track and rolling stock; trading companies must have office furniture be- fore they can start business. The necessary total of fixed capital is not always so great as it appears to an outsider, for the reason that in most enterprises land, buildings and even machinery can be rented to better advantage than they can be bought. Accountants rec- ognize this fact and are in the habit, in estimating the true cost of production in a manufacturing establish- ment, of charging an estimated rent for the land and buildings even though they be owned in fee by the corporation. It is well for corporation managers to consider this possibility, especially in starting a new INVESTMENT OF CAPITAL FUNDS 289 enterprise, and where pbssible avoid the investment of large sums in fixed assets until after the success of the enterprise is assured. One of the characteristics of fixed capital is that, al- though it may be essential and valuable to the corpora- tion which owns it, it is likely to have very little value if put on the market for sale. Its value remains, in other words, only so long as the concern is "going." Therefore, the smaller the proportion of a corporation's capital invested in fixed assets, the better off it is in case of failure or bankruptcy. 158. Forms of working capital. — ^Working capital may take any or all of four forms : (1) Cash, either on hand or in banks. (2) Bills and accounts receivable. (3) Raw materials and finished products in stock. (4) Securities of other corporations held, not for control, but for temporary investment. As an illustration take the following table, which shows the current assets and current liabilities of the United States Rubber Company for two recent fiscal years, as shown on the published balance sheets, and the working capital, or excess current assets over cur- rent liabilities: CURRENT ASSETB. Inventories $18,404,726 $13,533,169 Cash 2,061,401 2,723,380 Bills receivable 3,681,126 994,250 Accounts receivable 8,687,631 8,494,234 Totals $32,834,884 $25,745,033 VI— 19 290 CORPORATION FINANCE CURKENT LIABILITIES. Loans and notes payable $ 6,821,077 $ 2,44>0,077 Accounts payable 737,384 362,634 Due General Rubber Co 7,269,441 7,164,111 Reserve for discount ..... 872,989 874,735 Totals $15,700,891 $10,841,557 Working capital $17,133,993 $14,903,476 159. How much working capital shall he carried? — The amount of actual cash needed by a corporation varies with the size of its pay-roll and other current demands for cash, with the amount and character of its accounts payable considered in connection with its ac- counts receivable, with the discounts that it may obtain on purchases by making cash payments, and with its facilities for securing temporary loans. The force of these considerations must be estimated by the corpora- tion managers. Obviously there is a waste in carrying unnecessarily large bank balances; if any interest is received on such balances, it will not usually run higher than 3 per cent. On the other hand, every corporation naturally desires to stand well with banks and will carry large enough balances to make its deposits worth having. Otherwise, the corporation in times of difficulty may turn to banks in vain for temporary assistance. The amount of accounts receivable cannot be de- termined by the financial management of a corporation, but depends on the volume of sales, on the custom of the trade as regards payment and on the efficiency of the credit department in granting credits and in making collections. The amount of finished products and raw materials on hand is directly determined, of course, by the operat- ing department of each company. Nevertheless, the executive heads of the company should and usually do INVESTMENT OF CAPITAL FUNDS 291 exercise some discretion in this regard, particularly with a view to reducing the amount of working capital thus invested to a minimum. A great many manufacturing corporations, on account of improper purchasing and accounting methods, are wasteful in this regard. Care- ful perpetual inventories of goods in stock will often make it possible to buy and sell more closely without interfering in the least with the operating efficiency of the business. Although this is a topic which belongs rather to organization and accounting than to finance, its importance to a corporation's financial management should not be overlooked. 160. The practice of large corporations. — The fol- lowing compilation made by the Wall Street Journal is of particular interest in that it shows the practice with regard to working capital of the largest and best-man- aged corporations. A study of reports of the leading industrial companies shows that the United States Steel Corporation takes the lead in work- ing capital, with the Standard Oil Co. second, the International Harvester Co. third and the General Electric Co. fourth. Including sinking and reserve fund assets invested in securi- ties, amounting to $32,442,400, the working capital of the U. S. Steel Corporation is $261,789,885. The International Harvester Co., aside from the Standard Oil Co., probably has a larger working capital to gross business than any other corporation of consequence. Its working capi- tal as of December 31, 1907, aggregated $77,087,811, while its gross business amounted to only $78,206,890. The General Electric Co. also shows up well from the stand- point of working capital, reporting $61,235,724 on January 31 last, compared with its gross business of $70,977,168. The following table gives the working capital of several of the prominent industrial companies, together with gross busi- ness and capitalization : 292 CORPORATION FINANCE Gross Working Capital Business. Capital. Stock. United States Steel Corp'n.. $757,014,767 *$261,789,885 $868,583,600 Inter. Harvester Company . . . 78,206,890 77,087,811 120,000,000 General Electric Company . . . 70,977,168 61,235,724 65,167,400 West. Elec. Mfg. Company . . . 33,026,240 19,061,807 24,969,000 Lackawanna Steel Company . . . 33,011,410 13,881,340 34,721,400 Republic I. & St'l Company . . . 31,229,423 6,720,000 47,607,900 Bethlehem Steel Company . . . 15,000,000 7,434,573 29,770,000 Am. Steel Foun. Company . . . 19,463,521 4,834,843 17,184,000 Midvale Steel Company 1,804,929 750,000 Allis - Chalmers Company 12,522,074 35,790,000 Cambria Steel Company 14,597,865 45,000,000 Total $730,970,851 $1,389,570,450 The above figures show that the twelve companies in question are well fortified with working capital. The aggregate working capital stands at $730,970,851, as compared with total stock capitahzation of $1,389,570,450. The figures given above indicate that the companies in ques- tion are in a strong position to weather any depression that may reasonably be expected. * Includes sinking and reserve fund assets amounting to $32,442,401. INVESTMENT OF CAPITAL FUNDS 293 To invest working capital to any considerable amount in the securities of other corporations is not a very com- mon or commendable practice. It is justifiable only in those companies that have great fluctuations in demands for cash and that cannot secure fair interest on bank balances. The buying and selling of securities is no part of the business of any corporations except the few which are distinctly organized for that purpose. Prof- its that are derived from this source are justly regarded as speculative and highly uncertain. 161. Factors that affect working capital. — Consider- ing the situation as a whole the proportion of working to fixed capital in any business may be said to depend upon five factors, as follows: (1) Volume of business. (2) The regularity of supply of whatever raw ma- terials are used and the savings which may be effected by buying raw materials in large quantities. If it is necessary for the corporation to pick up large batches of raw materials at irregular periods in order to get ad- vantageous terms, of course the working capital must be correspondingly increased, for two reasons : first, be- cause larger amounts of raw materials must be carried in stock than would otherwise be necessary; second, be- cause larger bank balances must be maintained in order to meet these irregular demands. (3) Regularity of the demand for the product of the corporation. The same considerations apply here as were named in connection with the preceding factor. (4) Customs of payment in the business. Some manufacturing corporations normally buy on 90 days' time and sell on 30 days' time. This arrangement makes it possible to meet the accounts payable out of accounts 294. CORPORATION FINANCE receivable and lessens the necessary amount of working capital. (5) The length of time required to turn out the finished product. It takes three or four years normally to build a big steam vessel. During that period the ship-building corporation will necessarily pay out large sums for lumber and materials and a big working capi- tal, therefore, will be necessary. The same remark ap- plies to all concerns in which the period of manufacture is lengthy. There is one great industry of the United States which can usually get along with a very small proportion of working capital, namely, railroad operation. The prime reason is that the railroads are manufacturing a commodity, that is, transportation, which is continually in demand and which is paid for ordinarily as soon as it is produced. There are no outlays to speak of for cur- rent raw materials ; the only raw materials that railroads use are for fixed assets and may be regarded as part of the cost of securing fixed capital. 162. The working capital of the Pennsylvania Rail- road. — Even among railroads there may be exceptional circumstances which make necessary large working capitals. The Pennsylvania Railroad, for example, in the early part of 1909 was completing its immense ter- minal improvements in and near New York City. In a sense it was engaged in the contracting business on a great scale, for it was building tracks, tunnels and sta- tions. Therefore, it needed temporarily as much work- ing capital as a manufacturing corporation should have. Making a strict classification of current assets and liabilities, the Pennsylvania Railroad's cash position at the end of 1908 compared with its position twelve months before as follows: INVESTMENT OF CAPITAL FUNDS 295 CURRENT ASSETS. 1908 1907 Changes Cash $56,025,898 $37,385,673 Inc. $18,640,225 Bills & accts. recv 14,294,080 18,069,840 Dec. 3,775,860 Cash assets $70,319,978 $55,455,613 Inc. $14,864,365 CURRENT LIABILITIES. Payrolls & vouch $14,227,369 $20,226,164 Dec. $ 5,998,795 Int. accrued, etc 3,231,248 2,875,982 Inc. 355,266 Miscellaneous 4,211,496 3,966,996 Inc. 244,500 Current liabilities $31,670,113 $27,069,142 Dec. $ 5,399,029 Excess cur. assets 48,649,865 28,386,471 Inc. 20,163,394 This makes the company's net free capital, subject to the company's need of money to carry on its everyday business of transportation, more than $48,000,000 and $20,000,000 in excess of what it had been the year before. The other assets, not to be classed as quick items but more or less subject to liquidation in time, and deferred and contingent liabilities, compare as follows: DEFERRED AND CONTINGENT ASSETS. 1908 1907 Changes Due on N. & W. & C. & O. stocks $15,492,685 $15,492,685 Loans for cons., &c 12,403,834 18,412,493 Dec. $ 6,008,659 Due from controlled com- panies 3,159,784 462,218 Inc. 2,697,566 Materials on hand 10,449,483 15,929,925 Dec. 5,480,442 Sink, fund assets 8,148,208 7,772,627 Inc. 375,581 Total $49,653,994 $58,069,948 Dec. $ 8,415,954 DEFERRED AND CONTINGENT LIABILITIES. Car trusts chgd out .... $ 2,043,803 $ 1,424,871 Inc. $ 618,929 Taxes chgd out 2,731,109 3,023,197 Dec. 292,088 Due Penna. Co 2,290,897 Dec. 2,290,897 Extr. exp. fund 2,500,000 Dec. 2,500,000 Sinking fund liab 10,339,057 9,815,956 Inc. 523,101 Total $15,113,966 $19,054,921 Dec. $ 3,940,955 Excess def. & con. assets $34,540,028 $39,015,027 Dec. $ 4,474,999 296 CORPORATION FINANCE 163. General conclusions as to working capital.— Many other industries, partieulariy those manufacturing staple articles of trade, require a comparatively small proportion of working capital. On the other hand, there are hues of business, such, for instance, as publishing, in which only a little fixed capital (office furniture, plates, etc., chiefly) is needed. This is true more or less of all trading corporations. As was intimated at the beginning of this chapter, the principles herein laid down are of a very broad and general nature and can be successfully applied only by keen intelligence. Perhaps the chief practical con- clusion is that the most careful thought must be given to securing a proper proportion of working capital. No matter how valuable the fixed assets of a corporation may be, if it does not have all the funds necessary to transact current business and to meet current obligations, it will inevitably prove a failure. Right here is where most of the mistakes and failures of the early stages of corporate management occur. Managers trust that the current sales will take care of current expenses; when the inevitable hitch occurs they have no other resources to use and the corporation suddenly plunges into the quicksands of financial trouble and discredit. This problem of providing sufficient working capital will crop out again when we come to consider the causes of corporate insolvency. CHAPTER XXI DISPOSITION OF GROSS EARNINGS 164. Determination of income. — The ordinary form of income statement of a corporation is somewhat as follows : (a (b (c (d (e (f (g (h (i (J (k (1 (m Gross earnings from operation or manufacture. Deduct operating or manufacturing ex- penses. Net earnings from operation or manufacture. Add income from other sources. Total income. Deduct taxes. Balance applicable to fixed charges. Deduct interest. Deduct rentals. Deduct sinking fund and other charges. Balance applicable to dividends and surplus. Deduct dividends. Surplus from the year's operations. It goes without saying that each corporation has its own methods of stating accounts and that there are many variations from this standard form. The essen- tial items, however, are those stated above. It would be well for the reader to study with some care the income accounts of large corporations which are made public from time to time and which are printed in the financial columns of all metropolitan newspapers. If any of the items given above are not altogether clear, the reader 297). 298 CORPORATION FINANCE should turn to the volume on Theory and Practice of Accounting and go over the explanation there given of the income statement. The relations between accounting and finance are so close that a fair understanding of the basic principles of accounting is necessary in order to deal intelligently with the problems of financial management. In what is said below in reference to each of the items in the income account it will be assumed that the reader is familiar with accounting terms and with the elements of accounting practice. 165. Honesty in stating gross earnings. — Perhaps the only comment needful on the first item "gross earnings" is that it should be honestly stated. This remark is trite enough, and yet not uncalled for. A great many corporation managers are in the habit of including in their gross earnings sales that have been made to parties of doubtful credit which are represented merely by accounts receivable that are probably bad. In the case of holding companies it is not so uncommon as it should be to include in the gross earnings sales made from one company to another in the combination. Of course this is simply a juggling with figures. A still more flagrant instance of dishonesty was disclosed by Mr. Stephen Little, an accountant of wide reputa- tion, who in 1894 was called upon to investigate the condition of the insolvent Atchison, Topeka and Santa Fe Railroad Company. Mr. Little found that the. railroad had paid out millions of dollars in rebates to shippers which had not been deducted from its state- ment of gross earnings. 166. What are operating expenses? — Operating ex- penses are also often grossly misstated, although in this instance the fault is apt to be due, not so much to the DISPOSITION OF GROSS EARNINGS 299 dishonesty of the corporation managers, as to their ignorance of correct accounting principles. The oper- ating expenses ought always to include not only the actual expenditures for raw materials, labor and current repairs, but also a liberal allowance for anticipated re- pairs and renewals and for depreciation. Repairs in the early years of a corporation's activities are seldom as great a burden as in later years. Ac- countants figure that most manufacturing machines will show a rising percentage of necessary repairs each year for the first five to ten years of their existence and after that a fairly steady ratio will be maintained. Now it is evident that unless some allowance is made during the first few years for the rise in this item during the fol- lowing years, a misleading statement of operating ex- penses will be presented. Corporations differ greatly in their handling of charges for renewals of machinery and equipment. Many of them figure that the new machines they buy are additions to their capital and therefore should not be charged against the income account at all. If the new machine, however, replaces to any extent an old machine, this reasoning is obviously incorrect. Only the difference between the value of the old and the value of the new machine could properly be charged to capital account. Conservative corporations in this country, railroads particularly, are in the habit of charging the whole cost of their new equipment, as a rule, as a part of operating expenses. The English railroad practice, on the other hand, is to charge the whole expense to capital and to raise new capital funds to meet it. We shall have occasion to consider this point further in con- nection with "betterment expenses." 167. Necessity for depreciation reserves. — The sub- 300 CORPORATION FINANCE ject of depreciation is too large and important to receive full consideration in this place; a more extended treatment will be found in the volumes on accounting. As the desirabihty of allowing properly for deprecia- tion ought to be indelibly impressed on the mind of every person interested in corporation management, however, some brief remarks on the subject, even at the risk of reiteration, are worth making here. There are three general causes of depreciation, as follows : (a) Failure to keep property in first-class working condition. (b) The gradual breaking down of property in spite of all that may be done to keep it in good condition. (c) Most important of all, obsolescence or the im- pairment of value because of new inventions and processes. It is difficult for anyone not directly familiar with modern manufacturing enterprises to conceive of the rapidity with which changes in mechanical methods follow each other. Each important change is apt to make necessary a general revision of all the machinery and processes of manufacture. In the intense com- petition between industries, no concern that allows itself to f aE behind in the race to install the latest and most economical devices will long be able to survive. Ameri- can manufacturers have long been famous for the vigor and fearlessness with which they adopt new machinery and processes, even though the change may make almost worthless the expensive equipment that had previously been installed. The Carnegie Steel Company, it is said, time after time, has relentlessly sent to the scrap heap costly machines and even whole plants that were found to be inferior to new inventions. DISPOSITION OF GROSS EARNINGS 301 This policy certainly pays in the long run, as the striking success of the Carnegie Steel Company shows. Where products are being turned out in great quantities, a very slight saving in the cost of producing each unit may prove to be the margin between bankruptcy and prosperity. Yet, though the policy is to be praised and followed, it must not be forgotten that it involves large losses for the time being whenever old machines are superseded by new. These losses ought to be foreseen and provided against when the first steps of an enter- prise are taken. The only possible means of so do- ing is to charge as part of the operating expenses every year a liberal sum for depreciation — a sum that will take care, not merely of decay due to old age and lack of repair, but of obsolescence as well. Anything like a scientific treatment of depreciation has unfortunately been conspicuously absent from the accounts of most American corporations. Manufac- turers have been too willing to make rough guesses where fairly exact scientific deductions might have been drawn. Electric and steam railroads have uniformly declined to make any allowance whatever for deprecia- tion on the ground that the value of their franchises is steadily rising and that this is sufficient to offset what- ever depreciation of their property is going on. There is a certain amount of truth, to be sure, in this assertion ; yet it reveals a woefully careless habit of thought. Such slap-dash methods fortimately are now being eradicated, so far as interstate steam and electric lines are concerned, through the control over their accounts now exercised by the Interstate Commerce Commission. Recent rulings of the Commission have very properly made it obligatory on railroads to form as accurate estimates as they can of the annual depreciation of their CORPORATION FINANCE property and to set aside every year as part of operating expenses an adequate depreciation charge. To avoid any possible misunderstanding by those who may not be f amihar with accounts, it may be well to state at this point that depreciation reserves, so called, are not sums set apart and invested outside of the prop- erty, but are merely the total charges against gross earnings over a series of years on account of deprecia- tion. The depreciation reserves are not separable from other capital funds invested in the business except as a matter of accounting. 168. Income from other sources and deductions. — We have now reached in our income statement the item "net earnings derived from operation." To these earnings should be added "income from other sources." In order to make the income account a clear and ac- curate statement of results of the year's operations, it is very important that this "income from other sources" should be stated separately and not confused with "net earnings from operation"; otherwise the cor- poration managers will be claiming credit for returns that are quite distinct from the company's own opera- tion. Income from other sources includes dividends on the stocks of subsidiary and other companies, inter- est on the bonds of such companies, interest on bank deposits, rentals of property owned by the corpora- tion and not used in its own operations, and other items of that nature. Such returns are frequently temporary or irregular, in which case, in order to make the situation clear, they ought to be specifically named in the income statement. We now deduct taxes which, it will be noted in our model income statement, should not be included under fixed charges. There is some difference of opinion on DISPOSITION OF GROSS EARNINGS 303 this point. It is not a matter of sufficient importance, however, to be worth arguing over. The view here taken is that taxes are variable in amount, and are not, therefore, on the same basis as the regularly recurring fixed charges. As to the nature of interest and rentals, little need here be said. Sinking funds have been sufficiently treated for our purpose in another place. The deduction of fixed charges leaves as a balance the income applicable to dividends and surplus. Pre- ferred dividends, as have previously been explained, are classified as cumulative and non-cumulative. Cimiula- tive dividends, to the corporation managers, are often extremely disagreeable things. They are not so bad as interest charges, for they may be deferred as often as necessary. On the other hand, the fact that they are cumulative makes them pile up at an alarming rate, and in the course of a very few years, if they are not paid, they become a charge ahead of the common stock that makes common stock dividends seem an unattain- able vision. For the best interests of common stock- holders, therefore, it is usually very desirable to pay cimiulative preferred dividends regularly. If a shrink- age in profits makes a temporary lapse necessary, the lost ground should be regained at the first opportunity. 169. How much shall he paid out in dividends. — The next question to consider in disposing of the earnings of a corporation is. How much shall be paid out in non- cumulative and in common dividends. Mr. Thomas F. Woodlock has well said that the payment of dividends is the only absolutely non-productive expenditure that an honest corporation makes. This may sound like a meaningless paradox, but it is literally true. So far as the corporation itself is concerned, whatever is paid out 304. CORPORATION FINANCE in dividends is a total loss. On the other hand, it is also true that the only reason for the corporation's ex- istence is that it may pay dividends to the stockholders. There is a conflict of interest here evidently and often a strong conflict of opinion between the managers of a corporation and the stockholders as to whether dividends should be paid or not. In the next chapter some striking examples will be cited. Assuming that a corporation has a balance for the year applicable to dividends and surplus, and that all persons concerned are agreed that some dividends should be paid, the question takes the form, How large an amount shall be thus distributed to stockholders? The first and most natural answer to this question is that all the profits of each year belong to the stockholders and should be paid out in dividends; and this answer is deemed entirely satisfactory by many intelligent people. The English corporations almost invariably follow this practice, and some important American corporations as well. The New York Central Railroad Companj', for instance, has for many years paid out in dividends each year almost all the net earnings of the year. There are two distinct disadvantages in this practice: First, it does not permit the corporation to create a surplus of any considerable size; second, it makes the dividend rate irregular. The first disadvantage will be more fully discussed in Chapter XXIII. The second disadvantage is of great importance and calls for some explanation. 170. Variahility of profits. — In all lines of business the profits necessarily vary from year to year. This is true because all the factors which enter into and de- termine profits are variable. These factors are: DISPOSITION OF GROSS EARNINGS 305 (a) Volume of sales. (b) Prices obtained. (c) Prices of raw materials. (d) Wages. In no line of business is the volume of sales the same from year to year and in no line even where the general trend is upward, can the volume be expected to increase steadily and regularly. Some fair degree of regularity, to be sure, can be attained in the cases of large public service corporations, such as waterworks, street railways and steam railroads, that deal with great masses of people. Even here there are sometimes surprising fluc- tuations. In most lines of industry, prices are very unstable and show big variations from year to year. In general it may be said that those industries have the most regular prices and volume of sales which are con- cerned with the necessities of life; and the farther you get away from those necessities, the more violent are the fluctuations in those two items. To make these statements more definite let us examine the records of some of the leading industrial, street rail- road and steam railroad companies during the year of depression, 1908. The following gives the percentage of production of the leading industrial companies, com- pared with normal: United States Steel Corporation 60 Republic Iron «,nd Steel 90 Lukens Iron & Steel 60 Corn Products Refining 75 Standard Oil 95 General Electric 60 Westinghouse 60 Pennsylvania Steel 60 Maryland Steel 60 VI— 20 306 CORPORATION FINANCE Jones & Laughlin ^^ Amalgamated Copper 100 National Lead 95 American Smelting & Refining 80 Sloss-Sheffield Steel & Iron 80 International Paper TO United States Rubber T5 Allis-Chalmers 65 American Can 75 American Car & Foundry 35 Pressed Steel Car 20 Railway Steel Spring 75 American Locomotive 40 Bethlehem Steel Corporation 50 International Harvester 100 United States Realty & Improvement 100 Orders for new railway equipment in 1908 were less than 40 per cent of those received during 1907 and hardly 20 per cent of orders booked in the big rush of business in 1905. The course of new business during the preceding four years may be gathered from the fol- lowing comparison: Year Loco. Orders Fgt. Car Orders 1908 1,182 62,700 1907 3,282 151,700 1906 5,642 310,315 1905 6,265 341,315 In striking contrast is the record of the following railroad and street railway companies. Notice partic- ularly the small fluctuations in the street traffic in large cities. The decrease in street railway gross earnings was less than 1 per cent and in steam railroad gross earnings about 19 per cent. DISPOSITION OF GROSS EARNINGS 307 ELECTRIC STREET RAILWAYS. Company and Period 1908 1907 Decrease. Boston, May-July $ 3,696,000 $ 3,623,000 $ 27,000 Mass. Elec, Apr.-June 1,995,842 1,924,333 *71,S09 Chicago Rwys., Mch.-May 2,625,533 2,574,324 *S1,209 Twin City, Apr.-June 1,474,389 1,492,671 18,282 United St. Louis, Mch.-May... 2,645,364 2,735,406 90,042 Detroit United, Mch.-May 1,675,042 1,675,743 701 Total $14,012,170 $14,025,477 $13,307 * Increase. STEAM RAILROADS. Company and Period 1908 1907 Decrease. Lake Shore, April-June $ 9,182,851 $11,160,400 $ 1,977,549 New Haven, April-June 10,913,741 12,670,010 1,756,269 Pennsylvania, Jan.-Mch 31,375,489 37,203,589 5,828,100 Louis. & Nash., Feb.-Apr. . . . 10,073,802 12,012,701 1,938,839 Missouri Pac, Feb.-Apr 9,467,500 11,927,824 2,460,324 Boston & Maine, Apr.-June.. 8,836,556 10,499,302 1,662,746 Total $79,849,999 $95,473,826 $15,623,827 The explanation of the different manner in which the street railways and steam railroads have fared is largely to be found in the different character of their traffic. Street railway gross is 95 per cent derived from pas- senger receipts, while from 65 to 70 per cent of railroad gross is realized from freight; and in periods of uni- versal curtailment freight earnings quickly feel the depression. Even with an absolutely invariable volume of sales and level of prices any industry would still be subject to great variations in profits by reason of changes in raw material prices and in wages. This statement is obvious enough without any elaboration. It should be remarked that the amount of wages paid out is not de- pendent altogether on the nominal rate of wages, but also to a great extent on the efficiency of labor. When times are good and sales in all lines are heavy, it becomes 308 CORPORATION FINANCE necessary to employ workingmen of an inferior grade, who in bad times are always "out of a job." Taking on such men means a great reduction in the average efficiency of labor and in economy of production. 171. Regularity of dividends desirable. — ^We are safe in saying, then, that great fluctuations in profits are inevitable in most lines of business and cannot be altogether avoided, even by the large public service corporations which furnish the necessities of life. It follows that if all the earnings each year are paid out in dividends, the rate of dividends will fluctuate — in many cases fluctuate violently. The reader may per- haps ask at this point, Why not let them fluctuate? Let the stockholders in a corporation take their profits as they are earned, just as the owner of an individual busi- ness or partner in a firm would do. The answer to this question is that stock, and espe- cially the stock of large corporations, is widely held by people of all classes who are not in touch with business affairs and not prepared to take care of haphazard re- turns that drop into their laps from time to time, but who desire above all things a steady, regular and de- pendable income. Such people do not want lean years and fat years; they want a series of moderately good years. They belong, not to the speculative, but to the investment class. On account of the demand that such people create for regular dividend-paying securities, the market prices of such securities are far higher than they would otherwise be. For example, take two stocks, one of which pays over a series of five years, 4 per cent, 7 per cent, 6 per cent, 3 per cent and 5 per cent, averaging 5 per cent for the period, and compare it with another stock which has regularly paid 5 per cent each year; you will always find a marked difi'er- DISPOSITION OF GROSS EARNINGS 309 ence in market price in favor of the second stock. The principal reason for this difference is that so many people prefer a regular dividend payer. It is for the best interests of all a corporation's stock- holders to pay regularly a steady rate of dividend, inasmuch as the market price is thereby enhanced. The corporation manager, then, is confronted with the prob- lem of reconciling this demand with the irregularity of the corporate profits. The only safe method of accom- phshing this result is to pay out in dividends no more than the minimum earnings of the corporation in its worst years. Thus the dividends may always be kept at a fixed rate and whatever is earned above the dividend requirements will go into the company's surplus. 172. Prudence in paying dividends. — This may seem an unnecessarily harsh rule, for it keeps the rate of dividends low and thereby unnecessarily, it may seem, cuts down the stockholders' income. In the long run, however, it works no injustice. As we shall see in suc- ceeding chapters, whatever surplus is saved out of in- come, goes to increase the company's earning power and eventually its regular dividend rate. Looking back over the ground covered in this chapter, we see that great care, prudence and foresight on the part of a corporation directorate in the distribution of gross earnings is necessary in order to give perma- nence and long-continued success to the corporation. The board of directors must see to it that the gross earn- ing of each year are not overstated and that operating expenses are not understated. In connection with the latter item they must take care that sufficient reserve has been set aside to provide for accrued repairs and for depreciation. They must, of course, meet all the fixed charges of the corporation out of income under penalty 310 CORPORATION I'lNANCE of seeing the company forced into bankruptcy. They must pay cumulative preferred dividends so far as practicable, although in this regard some discretion is permitted to them. Finally they must resist unwise pressure from stockholders for larger dividends than the condition of the company in the long run will warrant. If they do not resist these demands, the com- pany will- be compelled probably sooner or later to reduce its dividend rate, thus removing its stocks from the class of desirable investments and lowering their market prices. The ideal corporation director wiU stand like Horatius at the bridge, defending the wealth and profits of the corporation from the onslaughts of hungry stockholders who do not possess either foresight or intimate knowledge of the business. A corporation which has such a directorate is peculi- arly fortunate and, whatever its line of business, may reasonably expect to attain a lasting success. A cor- poration which does not have such a board will perhaps prosper for a season and apparently enrich its officers and stockholders. In the end, however, it wiU prove to be but a mushroom growth. All the while its vitality is dwindling, its substance is being eaten out and sooner or later, to the surprise of unwary investors, it suddenly crumbles away. CHAPTER XXII BETTERMENT EXPENSES 173. Two classes of betterments. — All improvements and all expansions of property may be grouped under the general name "betterments." The question as to whether betterments should be made or not is primarily something for the operating officials of the company to decide. They should understand thoroughly the condi- tion of the property, the cost of the proposed better- ments and the prospects for additional business, and from the study of these factors should be able to draw pretty definite conclusions as to their advisability. All betterments may be roughly divided into two groups : (a) Those which are practically certain to bring about an immediate increase in revenue. (b) Those which are expected to prove profitable in the long run, but which may or may not bring immediate returns. As an example of the first class, we may suppose that a manufacturing company is about to put in a new and expensive engine; in such a case the proper officials should be able to calculate in advance almost exactly the annual saving that will be made possible by this partic- ular improvement. As an example of the second class, we may suppose that the same company is considering the advisability of building a Young Men's Christian Association reading room and gymnasium for the benefit of their employes. 311 312 CORPORATION FINANCE Their motives, we may presume, are not in the least philanthropic; they expect the investment to yield big returns in the form of a better satisfied and more intelli- gent force of workingmen. The extent of the returns, however, cannot be calculated exactly and in any case will not be immediate. The dividing line between the two classes is not al- ways very clear and there may often be more difficulty than in the two examples just cited in assigning a pro- posed betterment to its proper class. The classification, however, consciously or unconsciously, is almost always made by intelligent corporate officials and directors. 174. Sources of funds for betterments. — Once a betterment expense has been agreed to, the next ques- tion is how to raise the necessary funds. This is a purely financial question, which deserves even fuller consideration than is possible within our space limits. At bottom the problem of raising capital funds for betterments is of the same general character as the prob- lem of raising the initial capital funds when a corpora- tion starts business. There are, however, as we shaU see, some important variations in the problem. The sources of capital funds, whether at the begin- ning or during the corporation's existence, are the same as have already been given, namely: (a) The active managers of the corporation. (b) Surplus earnings. (c) Trade creditors. (d) Banks. (e) The investing public. (f ) The speculative public. For our present purpose we may eliminate sources (a), (c) and (d). There is nothing to be said with regard to them that has not already been said in Chapter BETTERMENT EXPENSES 313 VII. There remain: source (b) , from which the funds may be obtained by one of two methods, either direct appropriations from surplus, or abnormally high oper- ating expenditures; source (e), which may be reached either by the issue of medium-term notes or by the issue of bonds; and source (f) from which funds may be ob- tained by the sale of new stock. 175. Appropriations from earnings. — The safest and surest known method for providing for betterments and building up any concern is by making appropriations out of earnings. Expansion that is financed in this manner will be very slow, to be sure, unless the profits of the concern are inordinately large. This very slow- ness, however, is in some respects an advantage. It necessitates a gradual growth, a kind of evolution of the business, and thus automatically provides against waste and recklessness. It is practically certain that any concern which is built up altogether or in large part by means of appropriations from each year's sur- plus will be conducting its business along conservative lines. That it is not impossible by this method to con- struct in time an immense and profitable concern is proved by the history of two of our great industrials, the Carnegie Steel Company and the Baldwin Locomotive Works. The Carnegie Company had its inception in 1871 in an insignificant steel-making plant which was bought with the few thousand dollars that Andrew Carnegie and his associates were able with great difficulty at that time to command. It has since expanded until it is to-day worth, as a going concern, perhaps a half -billion dollars ; and all that expansion has been the result of profits slowly turned back into the business. In this respect the history of the Baldwin Locomotive Works is closely similar. S14 CORPORATION FINANCE 176. Objections to this method. — Yet in spite of these great successes we must not overlook the two obvious disadvantages of this method of obtaining funds for betterments. The first and most vital objection is that the slowness of the process may occasion the loss of valuable opportunities. While an old, conservative company is thus gradually acquiring the funds neces- sary for the expansion of its business, it may well be that a somewhat more daring concern may borrow the funds necessary for expansion and thus capture the op- portunity that was at first open to both of them. Conservatism undoubtedly is a business virtue; yet for the best results it needs to be mixed with a strong dash of speculative fervor. The second objection is that the ordinary stockholder in any concern desires to enjoy the profits of a business as they are earned and objects strongly to having those profits diverted to betterment expenses. It is true that an increase in the corpora- tion's assets is an increase in his assets, for he is part owner of the corporation. It is true, also, that an in- crease in assets will be to some extent reflected in a rise in the market value of his stock, so that he may sell out if he chooses and put his money into a more liberal cor- poration. This last, however, is not a wholly satisfac- tory argument to the stockholder, for market values are based more largely on earnings and dividends than they are on underlying assets. This is a truth that will be found fully illustrated in the volume on Investment AND Speculation. Thus the body of stockholders is apt to oppose strenuously a reduction in their dividends in order to provide for betterments. It seems to them as if they were being compelled to make a sacrifice for the benefit of future stockholders. 177. The attitude of stockholders, — An example BETTERMENT EXPENSES 815 that was conspicuous a few years ago was the deter- mined struggle on the part of minority stockholders in the Wells-Fargo Express Company for larger divi- dends. This company was controlled by the Harriman party, and Mr. E. H. Harriman, following his usual policy, was, as it seemed, too much inclined to sacrifice dividends to financial strength. The minority stock- holders stated that the Wells-Fargo Company had been piling up an enormous surplus, which was not needed or used in the business, but was invested in the securi- ties of other companies. The majority stockholders — that is the Harriman party — rejoined that the security holdings of the Wells-Fargo Company were for the sake of control and for the prevention of ruinous competition; in other words, that earnings had been consistently devoted to betterments. The undeniable facts are that the company was highly prosperous, was paying relatively small dividends and was more or less harassed by a body of dissatisfied stockholders. The objections by the stockholders in such cases may be induced by any or all of three motives : (1) They may simply be anxious for present divi- dends, even though they be paid at the risk of reducing the corporation's future earnings and prosperity. Human nature is so constituted that to almost all of us $1 this year looks better than $2 five years from now. (2) Some of the stockholders may have speculative tendencies which lead them to desire a good market price and a quick sale for their stock — perhaps with the idea that after a while the dividends will be cut and they will be able to repurchase stock at much lower prices. This motive will always be strong when many of the stockholders belong to the speculating, rather than to the investing class. Here is one of the best reasons 316 CORPORATION FINANCE why a conservative corporation manager will desire to put his stocks on an investment basis from the very beginning, if possible. (3) The stockholders in a corporation which has a large funded debt may reason that whatever sums are diverted from dividends to betterments go to increase the security and the value of the corporation's bonds rather than of its stock. We shall have occasion to deal with this motive and its results when we take up in Chapter XXVII the methods of manipulation for the benefit of the body of stockholders. It is enough to say here that this motive, although narrowly selfish, is stiU entirely legitimate and often has great weight. Wherever these motives are at work — and some or all of them are likely to be strong in almost any body of stockholders — objections to heavy betterment expendi- tures out of earnings will be in evidence. In the Wells-Fargo case the protesting stockholders, however disagreeable they might make themselves, did not have much influence with the management, because they were distinctly in the minority. It often happens, however, that the active managers of a corporation are more prudent or more farsighted than the majority of their stockholders and for the good of the corporation desire to pursue a policy of small dividends and large betterment expenses which would not be supported if it were clearly presented to the stockholders. In order to attain their object the corporation officers must keep the stockholders more or less in the dark; and this they do by the very simple process of charging expenditures for betterments under operating expenses. 178. The case of the Lehigh Valley Railroad. — The history of the Lehigh Valley Railroad so well illustrates the workings and the results of this species of well-inten- BETTERMENT EXPENSES 317 tioned deceit that it is worth a rapid review. In the year 1897 new interests, which were represented in the active management by President Walters, came into control of this company. The five years following, 1898 to 1902 inclusive, were a period of remarkable development and prosperity for almost all the railroads and industrial corporations of the United States, and the Lehigh Valley was no exception. Gross earnings from operation increased 25 per cent; the revenue tonnage increased 150 per cent; at the same time the average freight rate per ton per mile showed a slight gain. On the other hand, the outlay per train mile for moving this tonnage decreased. Thus earnings were apparently going up while running expenses rela- tively were decreasing, and a largely increased net income would naturally have been expected to follow. The facts were, however, that the gross income (not gross earnings) decreased from $6,800,000 in 1898 to $4,800,000 in 1901 and $4,650,000 in 1902, when the anthracite coal strike was in progress. An inquiring stockholder, who might have chanced to consider with care these strange and anomalous figures, would perhaps have turned to the balance sheet of the company in the expectation of finding therein revealed some noteworthy addition to assets purchased out of earnings. But our inquiring friend would have been disappointed. He would have found the compara- tive figures of the important assets of the road as follows : ASSETS 1898 1902 Cost of Road $18,639,291.95 $18,639,291.96 Cost of Equipment 19,018,419.98 19,018,419.98 Securities owned 32,949,322.14 39,300,209.80 318 CORPORATION FINANCE The only change here is an increase in the securities owned, which is not sufficient in amount to account for all that apparently should have been saved out of earn- ings. The book values of road and equipment, it will be noticed, have not been changed. The true explanation could have been found only by analysis of the operating expenses of the railroad. In the first place, the proportion of total operating ex- penses to gross earnings from operations — or operating ratio, as it is called — had risen from 70 per cent in 1898 to 81 per cent in 1902. As a normal railroad operating ratio would be 60 to 65 per cent, it is evident that this extraordinarily high ratio of the Lehigh Valley in 1902 indicated one of two things: either bad management or inflated operating expenses. We may get some hght as to which was responsible in the present case by a slight further analysis of operating expenses. In 1895 22 5-10 per cent of the total operating expense went to maintenance of way ; in 1902 over 40 per cent. In 1895 the average train-load was 384 tons ; in 1902, 467 tons. Evidently large sums had been devoted during the interim to betterments which greatly increased the economy and efficiency of the road's management. We are now informed that during the five years, 1898 to 1902, all new equipment, all side-tracking and other expansions of track, all contruction of bridges and buildings, all reballasting of track and similar items had been charged to operating expenses. Professor Edward Sherwood Meade, to whose searching analysis we are indebted for much of the information here presented, estimates that in these five years the Lehigh Valley under Mr. Walters' management, spent almost $13,000,000 on betterment expenses which ordinarily would have been provided for by new issues of stock or BETTERMENT EXPENSES 319 bonds ; in other words, the $13,000,000 under a different management would have been distributed to stock- holders. In 1902 a new management came into power, and the report for the fiscal year 1903 shows some radical changes in accounting methods. Net income, for in- stance, which had been $4,650,000 the preceding year, suddenly jumped to $8,300,000. The new manage- ment, after appropriating $1,250,000 for betterments and after paying all fixed charges, was still able to show over $2,000,000 available for dividends ; this, in the face of a deficit after allowing for fixed charges the pre- ceding year of over $1,200,000. In 1904 the stock was given a dividend of 1 per cent. In 1905 it was put on a 4 per cent basis. Between 1901 and 1908 the gross earnings of the Lehigh Valley were increased about 33 per cent. Its net earnings were considerably more than doubled, and yet its fixed charges were increased scarcely at all. The figures below tell the whole story of this remarkable growth more plainly than it could be put in words. 1908 1901 Increase Miles operated .... 1,447 1,382 65 Gross earnings . . . . $35,510,154 $26,683,533 $8,826,621 Gross, per mile . . . 24,500 19,300 5,200 Net earnings 12,183,582 5,765,113 6,418,469 Net, per mile 8,420 4,170 4,250 Chgs, less other inc. 4,813,008 4,364,800 448,208 Charges, per mile . 3,320 3,150 170 Surplus 7,370,574 1,400,313 5,970,261 Surplus, per mile . . 5,100 1,013 4,087 Now, what is the meaning of these facts and figures? In the first place, it is plain that the road was in poor 320 CORPORATION FINANCE condition prior to Mr. Walters' administration and that he left it in such excellent condition that its net earnings afterward showed a phenomenal increase. There can be no question but that the millions which Mr. Walters poured into the property were wisely spent and have since been efficiently administered. To an investor or corporation manager this review should be an inspiring story of honest profits ably secured. Nevertheless, it must be admitted that Mr. Walters' policy, so far as the stockholders were concerned, was one of evasion and deceit. True it is that whatever he did was intended for their own best interests; yet it is also true that they would not always have approved of his actions if they had known exactly what was going on. We do not need to enter into the ethics of the case. It is plain, however, that the stockholders, from any or all of the motives we have previously mentioned, might with justice have objected to Mr. Walters' course. As a matter of fact, they did finally become alive to the situation and helped in bringing a new management into power. 179. Policy of the Union Bag and Paper Company. — Another illustration of large operating expenses being used to beguile stockholders into putting a large portion of earnings into betterments is to be found in the recent history of one of the smaller trusts, the Union Bag and Paper Company. In a review of this com- pany's condition, recently issued, we find the following remarks : Benefit is now being derived from the liberality with which out- lays for repair work, maintenance and improvements have been made. Since the formation of the company nine years ago, about $3,000,000 have been expended in construction, purchase of woodlands, etc., in addition to requirements for ordinary re- BETTERMENT EXPENSES 321 pairs and maintenance, which have been charged directly to operating expenses, and also in addition to the amounts ex- pended in 1906 for the property of the Gres Falls Company and that of the Allen Bros. Company. All told over $6,000,000 have been expended, since the company's incorporation, for ad- ditional property and new construction, and the company has increased its capital obligations only to the extent of $2,439,- 000. While the company's physical and producing capacity has been undergoing improvement, its financial position has also been bettered, net working capital having been increased in the past four years by approximately $1,058,000 or about 100 per cent. 180. Borrowing funds for betterments. — The third means of raising funds for betterments is through issues of medium-term notes. It is not necessary to consider this method with great care, inasmuch as it has already been discussed in Chapter VIII. The examples given there were sufficient to show the dangers of this method. Obviously it cannot properly be utilized except to pro- vide for betterments which are practically certain to yield large and immediate profits; otherwise the corpo- ration will be incurring obligations that must be met out of income and that will perhaps become exceedingly dangerous. A much better method, generally speaking, of secur- ing the funds for permanent betterments is by means of long-term bonds. As has been previously explained, large well-established corporations do not usually expect to pay off these bonds when they fall due, but plan to refund them by new issues. In other words, what they actually do is to incur a permanent fixed charge. Now if a betterment is of such a character that it is practically certain to produce profits year after year larger than the fixed charges assumed in order to make the better- VI— 31 CORPORATION FINANCE ment, it is no doubt good policy to raise the necessary funds by the issue of long-time obligations. 181. Policy of the Pennsylvania Railroad. — The set- tled policy of the Pennsylvania Railroad is the best known and most consistent illustration of the working of this principle. This company, it is understood, separates all its betterment expenses into the two classes previously named : First, those which will in all human probability result in a permanent saving or profit more than equal to interest on the funds thus invested ; second, those which will probably prove profitable, but which may or may not yield profits in the immediate future. To the first group the Pennsylvania management assigns such betterments as shortening and straighten- ing a line, cutting down grades, providing new equip- ment where an increase in traflfic is certain, and so on; to the second class they assign such betterments as a large part of the tunnel construction in and around New York City, providing new equipment for a hoped-for in- crease in traffic, operating passenger stations, and so on. The Pennsylvania Railroad's custom is to pay for all betterments of the first class by bond issues and for all betterments of the second class by appropriations from surplus. Thus the stockholders secure at the same time the maximum of returns and the maximum of safety. It is the ideal policy as regards betterments and will no doubt be more generally adopted in the future by railroad and industrial corporations. To illustrate its workings in the concrete case of the tunnel into New York City and accompanying improve- ments, the following figures are presented. Up to the end of 1908 the total cost of the tunnel extension, as shown by the annual reports, was $77,528,664, of which only 60 per cent had been capitalized. The total cost BETTERMENT EXPENSES 323 is covered by the following charges on the books and appropriations of surplus profits: Cost on Books, December 31, 1908 Charged to surplus income of 1908 Charged to profit and loss account in 1907 Charged to profit and loss account in 1906 Charged to profit and loss account in 1905 Charged to profit and loss account in 1903 $46,528,664 1,000,000 7,000,000 13,000,000 5,000,000 5,000,000 Total cost of tunnel extension at end of 1908 . . $77,528,664 The cost on the books given above is the figure at which the Pennsylvania Railroad carried the work then accomplished as an asset. But in 1908 the Pennsylvania Railroad proper required the lines west of Pittsburg to assume a part of the burden and accord- ingly the Pennsylvania Company turned over $10,000,- 000 in securities, deducting the value thereof from its profit and loss surplus. Assimiing that the income derived from these securities will defray the interest charges on $10,000,000 of the capital invested in the tunnel, the Pennsylvania Railroad will have to look to the operation of that property to yield fixed charges upon capital borrowings for that purpose of only about $36,500,000. 182. General conclusions as to the financing of better- ments. — The only remaining method to consider of se- curing funds for betterments is by means of stock issues. The comparative merits of increasing capitalization by means of stock, as compared with bond, issues are too obvious to need much discussion. A bond issue is a cheaper means of getting the necessary funds, for bonds can always be sold to better advantage than stock which yields the same return; on the other hand, bond issues S24 CORPORATION FINANCE are objectionable insofar as they tend to increase the fixed charges and thereby imperil the safety of the com- pany. New stock issues are safe enough, but of course tend to reduce the rate of distribution on the stock al- ready outstanding. We may, perhaps, lay down this general rule, that betterments of the second class — fol- lowing the classification we have given — ought to be financed either out of surplus or by means of new stock issues ; betterments of the first class ought to be financed by bond issues, or in rare cases by issues of medium-term notes. In what is said with regard to the financing of better- ments, as in all other general questions of corporation policy, we must be content with broad conclusions. Corporation managers who differ from the general principles here laid down are not necessarily to be con- demned offhand. They may have good reasons which do not appear on the surface. Every business man must base his actions, not so much on general principles, as on the important concrete factors that confront him. At the same time it is also true that a clear understand- ing of these principles and of the practice of large cor- porations will aid the corporation manager in handhng more intelligently and more successfully whatever peculiar and difficult problems arise before him. CHAPTER XXIII CREATION AND USE OF A SURPLUS 183. Definition. — One of the most talked about topics in the field of Corporation Finance is the "surplus," its formation and its management. Yet in spite of all the discussion, there is still a great deal of confusion even in the minds of lawyers and men familiar with financial affairs as to what a surplus is and what it is good for. The main principles that govern the manage- ment of surplus are not different from those which should control the management of other capital funds, and are simple enough to seem obvious when they are once clearly stated. That they are not always clearly comprehended, however, is proved by the loose writing and thinking with regard to the subject that is so often manifest. A brief satisfactory definition of surplus is that it is the difference between the assets and the obligations of a corporation, including under "obligations" all the outstanding stock of the corporation, as well as its re- serves and debts. Suppose, for instance, that we have a corporation with assets of all kinds, having a total book valuation of $1,000,000, and having on the other side of the account debts represented by accounts pay- able, bank loans, notes and bonds of $500,000, deprecia- tion and other reserves of $50,000 and outstanding cap- ital stock amounting to $250,000; it is evident that the corporation must have secured $200,000 of its assets from some other source within the business; and that 325 CORPORATION FINANCE source we call surplus. The surplus account, as is ex- plained in the volume on Accounting Theory and Practice, appears on the liability side of the balance sheet, because it is an amount for which the corporation must render an account. 184. Four sources of surplus. — In our discussion of the corporation's surplus we will consider : (a) How it is obtained. (b) What is done with it. (c) Its uses and management. One possible, though very unusual, means by which a corporation obtains a surplus is by inheritance. Take, for instance, a corporation which is a consolidation of two companies, each having a surplus of its own. The consolidation may conceivably simply guarantee the bonds and other outstanding debts of the subsidiary companies, may issue dollar for dollar in stock for the stock of the subsidiary companies and may transfer the former surpluses bodily to its own accounts. As we have seen in our study of the formation of consolida- tions, however (Chapter XIV), the new corporation will usually issue securities far in excess of the market value of the assets of the old companies. The con- solidation, therefore, will not only not start out with a surplus usually, but will be compelled greatly to over- value its assets in order to make a balance sheet possible. We may dismiss this first possible source of surplus, then, with the statement that it is too uncommon to be worth much discussion. The second source of surplus, which also is rather unusual, is the selling of the corporate stock or bonds above par. Evidently the corporation in such a case receives a sum of money greater in amount than the obligations which it incurs. Now this extra sum may CREATION AND USE OF SURPLUS 327 be handled by an accountant in three or four diif erent ways. One way is to include it in the corporation's sur- plus account. The propriety of this method may be disputed, but this is an accounting rather than a finan- cial question. A surplus may originate, in the third place, in whole or in part from the sale of a corporation's fixed or semi- fixed assets. Thus if a manufacturing company owns a plant which has become obsolete and worthless for manufacturing purposes, and the value of which has been fully covered by a depreciation reserve — ^in other words, written oif the books — and afterwards sells this plant, the sum resulting would go into the surplus ac- count. Of course, the reader will understand that if the value of the plant in such a case had not been written off the books, but was still included in the corporation's bal- ance sheet, the only effect of its sale would be a transfer of the amount received from the property account to cash or notes receivable or whatever was taken in pay- ment for the plant. A similar source of surplus is a revaluation of the fixed assets of a corporation when the revaluation shows an increase in their value. This increase would nat- urally be represented on the liability side of the balance sheet by a corresponding gain in the surplus. Gen- erally speaking — and it must be remembered that there are some exceptions to this rule — an upward revaluation of assets is not in accordance with correct accounting or financial principles. Therefore, this fourth source of surplus is not commonly found. 185. The fifth source — saving. — This brings us to the fifth and most common source of surplus, namely, saving from income. The uses to which income should be put have been discussed at some length in Chapter 328 CORPORATION FINANCE XXI ; and the final uses, after the fixed charges and re- serves had been provided for, were found to be divi- dends and surplus. It will do no harm to reiterate the important principle there laid down that the dividends of practically every corporation should be maintained at a fixed rate and should move only to increase. Fluc- tuating dividends destroy the confidence of the invest- ing public and greatly reduce the credit of the corpora- tion below what it might possess. The proper policy, with few exceptions, is to ascertain the minimum net earnings of a company in the years of greatest deprecia- tion and rigidly hold the dividends at or below that minimum. The rest of the net earnings will be trans- ferred to the company's surplus account. That this method of forming a surplus may build it up with great rapidity is shown by the record of that great industrial concern, the Standard Oil Company. The annual net profits, the sums appropriated to surplus and to dividends, and the totals of each item for seven years are as follows : Tear Profits Dividends Surphui after divs. 1908 $ 80,000,000* $ 39,335,320 $ 40,664,680* 1907 85,000,000* 39,335,320 45,664,690* 1906 83,122,251 39,335,320 43,786,931 1905 57,459,356 39,335,320 18,124,036 1904 61,670,110 35,188,266 26,481,844 1903 81,336,994 42,877,478 38,459,516 1902 64,613,363 43,851,956 26,761,307 Total $513,202,074 $279,258,980 $233,943,094 *Approxim'ated; not reported after 1906. It is evident that in the case of any company which follows the principle just laid down, the proportion of dividends paid will vary with the fluctuations in earn- CREATION AND USE QF SURPLUS 329 ings. The greater those fluctuations the more rapid will be the increase in surplus. The converse proposition is that a stable rate of earnings makes unnecessary the creation of a big surplus. 186. Policy of the "trusts" — Professor Edward S. Meade's well-known volume on "Trust Finance" gives the result of a careful study of the dividend and surplus policy at the beginning and during the existence of all our important industrial combinations or "trusts." The prime object of the managers of almost all these com- binations at the beginning, Professor Meade points out, was to pay dividends and thereby encourage the sale of stock. They were therefore averse, as a rule, to ap- propriating any considerable amounts to the surplus ac- count. They even, in some cases, incurred a deficit iji order to pay dividends. Professor Meade computes that twenty-six important consolidations, which he has studied with especial care, earned in the four years 1898-1901, $150,201,390. He says: This amount, although large in the aggregate, represents but little more than 3 per cent per annum. It would appear, as already stated, that every consideration of prudence would incline the directors of these companies to reserve practically all their profits in order to strengthen the financial position of their companies. So far from following the path of prudence, however, 61.9 per cent — almost two-thirds of these profits — were paid out in dividends, leaving 38.1 per cent for the sur- plus reserve. The inadequacy of this reserve may be better understood when it is compared with the outstanding capital whose permanent value it was intended to secure. A reserve of only 4.2 per cent is the net result of the operations of three years. The industrial trusts are excellent examples of cor- porations which for reasons of their own were reluctant 330 CORPORATION FINANCE to keep dividends down to a conservative basis and to create large surpluses. The results of their imprudence are familiar to most of us — perhaps entirely too familiar to some. The common and preferred stock of most of these companies received dividends for a few years, but at the first hint of trade and financial depression, earn- ings feU off, dividends were stopped and the market prices of the stocks dropped with a thud. We have here presented an impressive lesson that ought to be mastered by every corporation director and stockholder — ^the les- son that in times of plenty provision should be made, through creation of an adequate surplus account out of income, for the seasons of famine that are sure to come. 187. How should surplus he invested. — ^We have next to consider what form the surplus of a corporation should take, or, in other words, how it should be invested. Its possible forms or uses are as numerous as the uses to which the original capital funds of a corporation may be put, and may be classified under the following heads : (a) Cash. (b) Securities. (c) Decrease of current liabilities. (d) Sinking fund. (e) Increase in stock of raw materials or finished products on hand. (f) Betterments. (g) Extensions and additions to fixed assets. It goes without saying that the surplus should be used to strengthen the weak spots, whatever they may be, in the corporation's capital equipment. We can be some- what more specific, however. 188. The surplus as a "rainy day fund." — There are two distinct and opposed opinions as to the true function CREATION AND USE OF SURPLUS 331 of a surplus : one, that it should be merged with the rest of the corporation's capital funds; the other, that it should be set aside as an insurance against future losses. Let us first consider the justification and the results of this second opinion. Its advocates base their case on the assertion that the original investment of capital funds should be sufficient to carry on properly all the business of the company; if these funds are not sufficient, then they should be increased by borrowing or by bringing in new stockholders, not by saving out of profits. The arguments in favor of providing funds for betterment by borrowing, rather than by saving, have already been given and have been found to have considerable weight. The advocates of this opinion are convinced of the ad- visabiHty of maintaining dividends at a stable rate and conceive it to be the true function of a surplus account to equalize the dividends over a series of years. In other words, the surplus account should be, in their view, as it has well been called, simply a "rainy day fund," to be drawn upon for dividends whenever the necessity arises. It follows, if this opinion is correct, that the surplus ought to take the form of cash or something that may readily be turned into cash, for example, securities. Otherwise, it will not be readily available for dividends in periods of financial stress when it is most likely to be needed. It is true, to be sure, that a surplus may be in- vested in permanent assets and yet be treated as a "rainy day fund," for these assets may be made the basis of temporary loans to the corporation. The objection here is that it is uncertain whether such loans can be obtained when they are most needed and, moreover, it is unsafe to base temporary loans on a corporation's fixed assets. On the whole, then, we may say, that if the surplus ac- CORPORATION FINANCE count is to be regarded simply as a kind of reservoir in which future dividends for lean years are to be stored, that reservoir should be filled with cash or easily market- able securities. The chief exponents of this policy are the great English and German shipping companies, particularly the Cunard Company and the Hamburg-American Line. The former company is said to have nearly one- third of its total assets invested in securities which have no direct connection with its shipping business. If the company runs into a period of intense competition dur- ing which it cannot earn dividends, or should it sustain severe losses, enough securities would be sold to maintain the regular dividend rate. There are obvious advan- tages in this course; on the other hand, there are disad- vantages equally obvious and for most corporations of controlling importance. The first disadvantage is that to build up a cash sur- plus is almost a waste of that much capital. It is a waste because capital in that form earns next to nothing. If it is kept as a permanent cash balance it may, to be sure, draw interest at 2 or 3 per cent, or in exceptional cases, even 3% per cent ; but this is a totally inadequate return on an industrial investment. If the surplus is in the form of marketable securities the case is almost as bad; for the only securities that are marketable in times of stringency are high-grade bonds which do not yield above taxes more than 3I/2 per cent or 4 per cent at the outside. As the second disadvantage, it must be borne in mind in this connection that funds so invested, though safe enough from the corporation's standpoint, do not give the corporation stockholder safety sufficient to compensate for the small yield. What is meant by this statement is that the surplus, however invested, is CREATION AND USE OF SURPLUS part of the corporation's capital and would be swallowed up by the corporation's creditors in case of bankruptcy. Thus the surplus goes to protect the creditor rather than the stockholder. The stockholder would be much better off, so far as safety is concerned, if his portion of the surplus were turned over to him individually and he would himself buy good securities with the proceeds. 189. Putting the surplus back into the property. — Having these disadvantages in view, corporation man- agers in this country have almost universally put the surplus of their corporations back into the property. Sometimes it is used to increase the cash balance where more cash is really needed in the business, or to buy securities of companies which it is desirable to control. In both these cases, however, the object is not to separate the surplus from the business, as it is when the rainy day fund is formed, but to make it productive in the business. Sometimes it goes into betterments, as explained in the previous chapter, or into extensions or into some other of the seven forms mentioned above. Just which form shall be chosen by the corporation management depends on considerations which have already been discussed in the chapter on "Investment of Capital Funds." As a normal return on capital invested in commercial enter- prises in this country would run from 6 per cent on up, it is evident that as a rule the investment of surplus in the business in which it was produced is the best and most profitable policy. Perhaps the stockholder may object at this point that the surplus is taken from the profits which ought to be. turned over to him. The objection is superficial and fails to take into account the various methods by which a surplus may be, and in the end, must be, distributed to the corporation stockholders. Some of these methods 334. CORPORATION FINANCE are not well understood; indeed it is doubtful whether half the stockholders in business corporations realize how or when their surplus is distributed to them. This is the interesting topic which will be the subject of our next chapter. CHAPTER XXIV DISTRIBUTION OF THE SURPLUS 190. Effect of a surplus on assets and dividends. — Ordinarily, as stated in the preceding chapter, a sur- plus is formed out of savings from income and is in- vested in the capital assets of the corporation. Thus it becomes merged at once with the capital funds. The average stockholder feels that it is lost to him. He sees, to be sure, that the assets of the corporation are increased by the formation of a surplus, and he will admit prob- ably, if you press him, that theoretically this increase in assets is a good thing for the corporation and for every stockholder and tends to increase the value of his stock. The admission, however, is apt to be grudgingly made and probably does not disturb the stockholder's convic- tion that whatever sums are devoted to surplus are taken out of the pockets of the owners of the corporation. He sees how these sums are taken away from him, but does not see clearly in what form they come back to him. The object of this chapter is to explain the methods by which the surplus may be and generally is returned. It has already been mentioned — and, for that matter, is self-evident — that surplus wisely invested in capital assets increases the earning power of the corporation and therefore its ability to pay large dividends. Moreover, the surplus when properly invested so as to extend the sales of the corporation or its ownings of raw materials, or its control over competitive plants, tends strongly to make earnings more stable and therefore to make prac- 335 336 CORPORATION FINANCE ticable a distribution in dividends of a larger proportion of earnings. This is a point not often alluded to and worth a word of explanation. It is evident that gen- erally speaking the larger the business a concern does, the more stable and dependable will be its earnings — for slight local fluctuations up and down will almost always balance each other. If a big jobbing corporation loses trade for local reasons in one section of the country, it may reasonably hope that gains in other sections will at least counterbalance the loss. It is also true that con- trol, even partial control, over the prices of raw materi- als or of unfinished products tends to make earnings more stable. It may well happen for these reasons that a relatively small surplus will have a more than propor- tionate influence on a corporation dividend rate — not so much, to reiterate, because it increases earnings, as be- cause it makes them more uniform. Frequently — and this is especially true of a close cor- poration — no individual stockholder would be able to save and invest to such good advantage as the corpora- tion can do for him. Take once more the famous ex- ample of the Carnegie Steel Company. Does anyone suppose that any single stockholder in that company would have become as wealthy if the earnings had reg- ularly been paid out to the stockholders in dividends instead of being put back year after year into the prop- erty? The stockholders did not receive very large div- idends for many years, and some perhaps were inchned to complain that they were not getting the returns on their investment that were justly due them. In this case the stockholders were never given any considerable proportion of earnings, nor was the vast surplus of the company distributed, except to a hmited extent, until the sale of the Carnegie Steel Company in 1901 to the DISTRIBUTION OF THE SURPLUS United States Steel Corporation. Then the extraor- dinary strength and riches of the company were suddenly revealed. Almost a half -billion dollars in cash or salable securities were showered upon the fortunate stockholders of the company. Pittsburg, like a night-blooming cereus, suddenly blossomed with millionaires. 191. Distribution through stock watering. — This chapter is not to deal, however, with the distribution of surplus through its effect on dividends or through the final sale of the company's assets, but rather with the more direct and usual methods. First among these methods to be mentioned is the declaration of an extra stock dividend. In the year 1880 the Chicago, Rock Island and Pacific Railroad Company was a highly suc- cessful corporation with large earning power, due in part to the fact that for many years a considerable pro- portion of the earnings had been put back into the prop- erty. The directors of the corporation thought it wise to increase their dividend payments, and yet on account of the popular prejudice against large railroad earnings did not wish to increase the dividend rate. They there- fore adopted the plan of consolidating with themselves a small subsidiary railroad, the stock of which they al- ready owned; they paid for that stock and for the stock of the Chicago, Rock Island and Pacific Railroad Com- pany by an immense issue of stock of an entirely new corporation, the Chicago, Rock Island and Pacific Railway Company. This stock of the new corpora- tion was distributed to the old stockholders in the pro- portion of two new shares to one old share. Then on all the stock outstanding they declared and main- tained a dividend rate nearly equal to what had pre- viously been paid. In eiFect this process was a capital- ization of a surplus of the corporation and a distribution VI— 32 338 CORPORATION FINANCE of the surplus to stockholders. A more recent instance of somewhat the same kind is the well-known Chicago and Alton deal, which is discussed in Chapter XXVII. The essential feature of such a transaction is the cap- itahzation of surplus and distribution of this extra capitalization to stockholders. The reader may inquire as to the advantage of this course. Surely, he will say, two shares of a total capital stock of $2,000,000 are worth no more than one share of a total capital stock of $1,000,000. The two shares in the first instance repre- sent no larger proportion of assets and earnings than , the one share in the second instance. This reasoning is plausible and time so far as it goes ; yet the fact remains that the stockholders gain something by a stock dividend. In the first place, the dividend rate is kept down by this means, and in the case of public service corporations public hostility is to some extent avoided. In other words, the stock is watered, and the dividend rate main- tained. The American Telephone and Telegraph Com- pany is one of the many examples of companies which have thus greatly increased their capitalization from time to time, apparently with this object in view. A discus- sion of the ethics of such a transaction would be interest- ing, but is outside the scope of this volume. In the second place, it is well known to corporation managers and to all who have studied the stock market with any care that two shares of stock, each paying 4 per cent per annum, will have a combined market price higher than one share of stock paying 8 per cent per annum. This seems a curious anomaly, but is readily explained. There are more people able and willing to buy low-priced than there are to buy high-priced se- curities. Therefore, the market for the two shares in this illustration is wider than the market for the one DISTRIBUTION OF THE SURPLUS 339 share; that is to say, the demand for the two shares is somewhat greater and therefore their combined price will be higher. This same principle leads the promoters of mining and oil and other highly speculative companies to fix the par value of their shares at a low figure, $10 or $1 or 10 cents, or even as low as 1 cent. Applying the principle to stock dividends we see that there may be a real gain to a stockholder in an increase in the number of shares he holds, even though there is no change in the amount of dividends he receives. 192. Distribution through subscription privileges. — We are ready now to discuss the most conmion and im- portant method of distributing a surplus, namely, the granting of subscription privileges for new issues of stock. In most states, as the reader is already aware, stock cannot be regarded as fully paid if it is sold for less than its par value. No state, however, makes it obligatory under any circumstances to sell stock at more than its par value ; yet the stocks of successful corpora- tions which are able to maintain stable dividend rates of more than 6 or 7 per cent per annum, almost always have market values higher than par. Here is an oppor- tunity for the corporation directors, if they see fit, to give the stockholders a valuable privilege — ^the privilege, namely, of buying new stock issues at less than the market prices. The relative advantages of providing funds for im- provements and extensions of property by bond issues, by stock issues and by appropriations from earnings, have been discussed in Chapter XXII. It was there laid down as a general principle that provision of per- manent capital funds by means of stock issues is not ad- visable unless all the new stock is taken by the old stock- 340 CORPORATION FINANCE holders. This condition will be fulfilled, however, when the old stockholders are given the valuable privilege of buying the new stock at less than its market value, and under such circumstances the raising of additional capi- tal funds by stock issues is a very common and on the whole commendable method. We have now to consider exactly how surplus may be distributed by means of these "privileged subscriptions" and how each stock- holder may best secure his share of the advantages that should accure to him. 193. An opportunity thus given for cheap investment. — The privilege of buying a certain amount of stock below the market price enables the stockholder, if he chooses, to make a new investment on exceptionally favorable terms. For instance, in 1902 the Illinois Central Railroad Company put out a new stock issue and gave to its stockholders of record the privilege of buy- ing the new stock at par in any amount up to 20 per cent of their stockholdings. Thus if a man had 100 shares of old stock, he was given an oportunity to buy 20 shares of the new stock at par. The average price of Illinois Central stock during the six months follow- ing the date of the new issue was 156^, thus showing a large paper profit to those who bought the new stock. As this stock was then paying an 8 per cent dividend, those who bought and held it for investment were get- ting much more than the usual market return on their investment. A great many stocldiolders, however, do not care to increase their capital investment, but prefer to take their profits at once. In such a case they have a choice among four different methods of securing the profits, as follows: (a) A stockholder may buy outright the proportion DISTRIBUTION OF THE SURPLUS 341 of new stock allotted to him as a speculation, and a little later at some favorable opportunity may sell it. (b) He may sell "short" after the issue of new stock is announced and deliver when he gets his quota of new stock. (c) Instead of selling "short" he may sell outright an amount of his old holdings just equal to the amount of new stock that he has a right to buy. (d) He may sell his privilege or "right" to subscribe to the new stock. It will be well to compare briefly the advantages of these four methods. 194. Cashing the privilege. — The subsequent sale. — The first-named method is the simplest, but not gener- ally the best. The chief difficulty is that the stock- holder must pay cash for his quota of the new stock: and that means that he must either borrow the money or must lose the interest on some of his own funds. Frequently the subscriptions to the new stock are pay- able in installments. There may be a period of several months or a year between the date of the first installment and the final issue of the stock. For many stockholders it may prove decidedly inconvenient either to use their own funds or to borrow money. Another disadvantage lies in the well-known fact that the market price of any stock after a privileged subscription has been allotted to it almost always tends downward. One reason ob- viously is that the new issue increases by so much the total amount of stock outstanding; the second reason is that after a "right" has once been granted, investors figure that there will be no additional rights for a number of years; a third reason is that the chief men interested in a corporation that is about to put out a new issue and the underwriters of a new issue will usu- 343 CORPORATION FINANCE ally "bull" the previously outstanding stock in advance, in order to create a good demand for the new issue. Now a stockholder who follows the first of the four methods and does not sell his stock until after he has paid for and received it, will probably sell on a falling market and will not reap as much profit as one who follows either of the other three methods. On the other hand, it must be said for this first method, that it is ab- solutely safe — a statement which cannot be applied to the method next to be considered." 195. Cashing the privilege. — "Short selling." — The mechanism of "short selling" has already been treated in Chapter XVII. In the case inmiediately before us a stockholder who had the right to subscribe to twenty shares of a new issue might deposit a margin of 10 or 15 per cent with his broker and instruct him to sell short. The broker borrows the twenty shares in order to make delivery and keeps on borrowing until the stockholder is able to get his twenty new shares from the corporation and turn them over to the broker to repay the borrowed stock. Under this arrangement the stockholder will be more likely than under the first method to get the top market price, because he will sell immediately after a "right" is announced — sometimes, if he has inside in- formation, even before, such announcement is made. This method further makes it unnecessary for the stock- holder to Iborrow any money. He simply turns over his rights to his broker who uses, in order to pay for the new stock, the money that he has received from the "short" sale. All this sounds very easy and simple and, as a matter of fact, it usually works out all right. The difficulty comes in the fact that any man who sells short runs the risk of being caught in a bull movement of that stock DISTRIBUTION OF THE SURPLUS 343 or even in a "corner." ^ The reader may perhaps sug- gest that in such a case he may easily make dehvery from his old stock and thus obviate any serious loss. The answer here, however, is that probably he has sold short the amount of his old stock as well as of his quota of new stock, or has in some other way tied up the old stock; otherwise, he would probably follow the third, rather than the second, method. Successful corners are not very common in WaU Street or any other market. When they do come, however, they bring disaster and ruin in their train. 196. Cashing the privilege. — Sale of old stock. — The third method is not open to either of the objections that have been specified. The stockholder is much more likely to get the best market price than under the first method; he is not involved in the dangers that attach to the second. He picks his own time to sell and from the proceeds of the sale has funds enough to buy the same amount of new stock with large profits in addition. The sale of part or all of the stockholder's shares will not impair in any way his right to subscribe to the new stock, inasmuch as this right is always granted to stock- holders of record on a given day ; it makes no difference whether the stockholder of record increases or decreases his holdings after that day. The only fault to be found with this method is that it is not practicable for all stock- holders. A great many of them, in all probability, will have their holdings posted as collateral for loans, or for some other reason wiU not care to part with stock even temporarily. 197. Cashing the privilege. — Sale of rights. — The fourth method, the sale of "rights," is the next best plan 1 The meaning of the term " corner " is explained in the volume on In- vestment AND Speculation. 344) CORPORATION FINANCE ordinarily and is much used by those who do hot care either to increase their holdings or to decrease them even temporarily. It is customary when any of the large corporations give their stockholders a "subscription privilege" to a new stock issue, to send out to each holder of record a formal statement of the number of new shares to which he has a right to subscribe. Such doc- uments may be endorsed and transferred in the same way as stock certificates and are bought and sold on many of the stock exchanges and on the New York Curb Market. These documents are themselves known as "rights," just as certificates of stock are loosely called "stock." As was stated in Chapter XVII, there are confusing differences of terminology between the New York and some of the other stock exchanges, particularly Phila- delphia. In New York a "right" is the privilege to subscribe to a certain amount, usually a fractional part of a share of new stock. A stockholder, therefore, has as many "rights" as he has shares. In Philadelphia, on the other hand, a "right" means the privilege of buying one of the new shares of stock. To illustrate, suppose that the Lehigh Valley Railroad Company, whose se- curities are listed on both exchanges, should issue new stock to old stockholders at less than the market price and should give the subscription privilege at the rate of one new share to every five old shares. In that case the holder of five shares would have one "right" to dispose of on the Philadelphia or five "rights" on the New York Exchange. Of course the Philadelphia "right" would be worth five times as much as the New York "right." The difference is merely in terminology. It may be thought that the third and fourth methods DISTRIBUTION OF THE SURPLUS 345 would yield practically the same returns, but this is an error. The third method is almost always more prof- itable, the reason being that there is a much broader demand for stock than there is for "rights" to subscribe to stock. As was explained in Chapter XVII, there is a large body of purchasers not directly concerned with the stock market, who are constantly taking the standard stocks out of that market and holding them for perma- nent investment. This demand does not exist in the case of "rights," because few people, outside of those whose business it is to know such things, understand how the value of a "right" is figured or even what it is. It would often be greatly to the advantage of these per- manent investors if they did buy "rights" instead of stock. As the matter now stands, however, almost the only buyers are stock brokers and their immediate fol- lowers who buy as a quick speculation in the hope of making a quick profit. As they are willing to buy only in case they think they are getting a bargain, it follows that the price of rights is usually less than it should be theoretically. 198. Theoretical value of a right. — Let us see how the value of a right should in theory be ascertained. The reader may perhaps have jumped at the conclusion that the value would be the difference between the market price of the old stock and the price at which the new stock is sold to stockholders. This is incorrect, however, because it fails to take into consideration the change in the value of each share brought about by an increase in the amount of stock outstanding. The new stock, it must be remembered, is issued at less than the market price, and does, not, therefore, bring to the com- pany's treasury its proportionate amount of assets. For this reason it is inevitable that the market price of 34.6 CORPORATION FINANCE each share after the new stock has been issued should be less than it was before. To illustrate these abstract and rather vague state- ments, take the case previously cited, that of the Ilhnois Central Railroad, which in August, 1902, increased its stock 20 per cent and gave to each five shares of old stock the privilege of subscribing to one new share at par. The market price of the old stock at the time the rights were granted was about 170, giving a premium, or excess above par, of $70 per share. Now there is to be added for each share of the old stock, $20 in assets, because each old share has the right to subscribe to one- fifth of a new share at par. At the same time there is to be added $20 to the capital stock for each $100 previ- ously outstanding. The market value of each share, therefore, after the new stock has been issued, will be 170 -f- 20 ■ = 158 2/6, which in theory would be the 100 + 20 •" market price of each share after the new stock issue. As a matter of fact, the average price of Illinois Central shares during the six months following August, 1902, was 152 3-5. The value of the "right" belonging to each share of old stock would, of course, be in this case one-fifth of the difference between par and the market price of each share of new stock, or 1-5 of 58 1-3, ap- proximately 11 2-3. The following formula, commonly used on the New York Stock Exchange, gives directly the theoretical value of a right. Let P represent the premium on the old shares and R represent the percentage of increase. Then the value of a right will be found by the formula "p V "R — — — . Applying this formula to the Illinois Central 1 + R . ,- , 70 X .2 14 ,, ^„ . example, we would have -, , o ^ fir ~ 11-66. As 1 ~\~ .^ 1.^ DISTRIBUTION OF THE SURPLUS 347 has been stated these theoretical prices for "rights" are seldom obtained because speculative purchasers of rights are not willing to go that high. Moreover, there are some assumptions underlying these mathematical form- ulae which may or may not be true. It is assumed, for instance, that the stock market price of the old stock is a normal price uninfluenced by speculative factors. It is assumed, also, that the company's use of the funds which come to it from the sale of new stock will be neither more nor less remunerative than the use of the capital funds previously in its possession. It is assumed, moreover, that the market price after the new stock has been issued will be uninfluenced by speculative factors. There is a risk in all these assumptions, as the profes- sional stock market trader well knows, and he is therefore unwilling to pay the full theoretical price for the rights. Summing up, then, we may conclude that of the four methods of securing profits from privileged subscrip- tions, which have been described, the third method is, on the whole, hkely to yield the largest returns. The second method comes next in that respect, but has the disadvantage of being dangerous. The fourth method comes next, and the first method is, on the whole, least desirable. It will not do to accept these conclusions as being true at all times and under all circumstances. They are merely generalizations based on experience. 199. Privilege subscriptions as a method of stock watering. — So far as distribution of surplus is con- cerned, giving "rights" to privileged subscriptions to new issues of stock produces the same effect, though not to an equal degree, as a stock dividend. The assets of the company in proportion to the number of shares are diminished, and the stockholder gets the benefit. If the old rate of dividends is maintained on all the stock 348 CORPORATION FINANCE outstanding after the new issue, each stockholder may be truthfully said to have come into possession of some of the company's surplus. The privileged subscription is a device for increasing capitalization without propor- tionately increasing assets. In that sense it is "stock watering." The meaning of the ternas "stock watering" and "overcapitahzation" have been sufficiently discussed and need not be given further attention. It is enough to reiterate that whatever may be said for or against the practice in connection with public service corporations, it is in private corporations, when properly used, a simple and legitimate means of making a corporation's capital- ization correspond to its earning powers ; and is in addi- tion, as outlined in this chapter, a legitimate means of transferring to the stockholder a part of the surplus which his company has created for him. CHAPTER XXV MANIPULATION BY CORPORATION OFFICERS 200. Ought we to study manipulation? — So far we have been dealing with and endeavoring to formulate the principles of honest and efficient corporate manage- ment ; the rest of this book will deal with dishonesty, in- eflSciency and failure. Sometimes any study of rascal- ity is condemned offhand on the ground that it may suggest swindling practices to persons who otherwise would not have thought of them. Perhaps there is something to be said in favor of this view ; if any readers of this volume feel themselves morally weak it may be well for them to omit the next three chapters. On the other side of the argument, we may say that a thorough knowledge of fraudulent methods does not by any means encourage fraud, for it reveals that almost all such methods, however cunning they may appear, are un- sound and dangerous. Furthermore — and this is the important point — ^honest men ought certainly to acquire as clear an insight as they can into the methods of swindlers in order that they may be on their guard and may protect themselves and those who are dependent upon them. 201. The corporate form favors manipulation. — The corporation, as practically every business man now ap- preciates, is for most concerns the most convenient, use- ful and efficient form of organization that has yet been devised. It is likewise true that the corporation so far has proved itself a most efficient form in the hands of 34-9 350 CORPORATION FINANCE rascals for transferring other peoples' rightful property into their own pockets. In an address on "Abuse of Corporate Privileges" printed in the American Law Review Mr. Seymour D. Thompson has described from the lawyer's point of view the present conditions. He says: Our corporate life is honeycombed with corruption. A cor- poration is formed; its business is put into the hands of cer- tain managers holding some of its stock and expert in the man- agement of its business. Debts are created and the managers become the creditors. The result is that rings are organized within rings, wheels within wheels, combinations within cofli- binations. The managers, in the character of creditors, seize upon and foreclose the property of the corporation, and by well-known processes squeeze the other stockholders out and be- come themselves proprietors with larger holdings than they had before. This sweating process, dignified by the name of fore- closing and reorganizing, has come to be a regular industry in our courts of justice. Courts of justice have neither the time nor the means to take upon themselves the management of all the corporations in the country ; and therefore the outraged and complaining stockholders are told that they cannot come into court until they have exhausted all the remedies within the corporation. 202. Is manipulation a necessary evil? — Now this de- plorable condition, which is one of the chief evils of the American business world, is not, fortunately, a necessary evil. We may well doubt, indeed, whether the lawyers with their quibbles and conservatism will do much to remedy conditions. But we may expect much from the growing interest of the public in corporate affairs. The evil exists chiefly because the corporate form of organ- ization is still a thing in which most people have had little experience and the workings of which they do not MANIPULATION BY CORPORATION OFFICERS 351 clearly understand. The true remedy, then, for the evils of corporate manipulation, is publicity and educa- tion. These three chapters following, which constitute the first attempt, so far as the author knows, to classify and describe the methods commonly used for defrauding some of the owners of a corporation for the benefit of others, will fulfill their chief purpose if they have some slight influence in checking this evil. Perhaps the words "fraud" and "swindling" in the preceding paragraphs should not have been used; they do not convey exactly the conception which is in the author's mind in writing these chapters. We are not to be concerned here with ordinary clear cases of fraud ; a study of such cases belongs to law rather than to finance. Moreover, a clear-cut instance of fraud is not usually a very dangerous thing, because the victim may seek and obtain redress in the courts. The chief danger comes not from crude and obviously illegal larceny, but from acts that cannot be proven fraudulent and that belong in the shadowy borderland, bounded by shrewd dealing on the one side and on the other by plain swin- dling. Some of the practices to be described are allow- able, although most of them are discredited under the rules of the business game as those rules are generally interpreted. 203. Scope of the chapters on manipulation. — It should be made plain also at the beginning that in these chapters not much will be said about "malefactors of great wealth" or about large "predatory corporations," although some of these corporations furnish shining examples which cannot be, overlooked. We shall deal rather with everyday small business corporations and with those kinds of manipulation that may be found in every section of the country. The "sharks" of Wall 352 CORPORATION FINANCE Street do not by any means have a monopoly, as some of the cases to be cited will show, on dubious finance. As a basis of classification we will take up methods of manipulation under the four heads: (a) Manipulation by officials. (b) Manipulation by directors. (c) Manipulation for stockholders as a body. (d) Manipulation for controlling stockholders. Of course, this classification is not exact. We shall find constant overlapping, for the obvious reason that any man or group who desire to manipulate will prob- ably try to make their control as complete as possible, and will work through stockholders' meetings, directors' meetings, and officers' administration. Nevertheless, this classification will be found convenient and for the present purpose sufficiently accurate. 204. Easorbitant salaries. — The most obvious and common method by which a corporation official may milk a corporation of its profits is by paying himself an exorbitant salary. This is a practice so frequent and so easy that it would be superfluous to cite examples. A corporation official cannot, to be sure, absolutely fix his own salary, for that power is reserved to the directors. If the official, however, is a powerful stockholder, or if two or three officials can get hold of a majority of the stock, or if an official can bring outside pressure to bear upon the board of directors, he may cause a salary to be allotted to him far in excess of what he is actually worth to the company. It is not at all unusual for minority stockholders in small corporations to be de- prived of profits because the president, or other official, who owns the controlling stock raises his own salary as fast as profits go up. It would be very difficult^ — prac- tically impossible — in such a case to prove fraud. No MANIPULATION BY CORPORATION OFFICERS 353 court would undertake to say that a salary was fraudu- lent, or that directors were acting beyond their powers in agreeing to it, unless the salary were beyond all reason. 205. Fraudulent contracts. — Another favorite method of manipulation by officers is the use, or rather abuse, of their power to purchase and to make contracts on behalf of the corporation. The evil of purchasing of- ficers being in league with the firms from which they buy supplies and getting a rake-off on the corporation's purchases, has been so much exploited as to make un- necessary any further illustration. There is no question but that something of the kind does go on in many of the larger corporations. Yet the purchasing agent is generally a subordinate official whose policy is closely scrutinized by his superiors and who is subject to instant dismissal if any strong tendency on his part toward "grafting" is discovered. His delinquencies are not so interesting to us in this study as those of his superiors. Let us examine briefly a few instances in which high cor- porate officials have misused their power to bind the corporation. In the Illinois courts some years ago suit was brought by H. P. Killjoy, a stockholder, against the Mandarin Brewing Association. He alleged, and seems to have proved to the satisfaction of the court, that in 1896 three brothers purchased a majority of the stock and obtained control of this brewing corporation. They elected themselves to the directorate and to most of the corporation offices. One of the brothers owned a piece of real estate which the corporation purchased at an amount alleged to have been far in excess of its true value. The brothers, as directors, paid themselves large salaries as officers and no dividends were forthcoming VI— 23 354. CORPORATION FINANCE to the stockholders. The stockholders were kept in ignorance of the purchase of the real estate and of the size of the salaries. Although the court was so far convinced of the truth of these allegations that a re- ceiver was appointed for the company, no criminal or civil action was taken against the three brothers. The facts cited in a recent case in the Massachusetts courts are of interest in this connection. Samuelson, defendant in the case, was treasurer of the Easton Ferry Company. He sold bonds of the company and neglected to account for them. He charged the com- pany for bank discounts larger than the bank charged, claiming that this extra discount was for his own personal indorsement, which appeared on the notes. He purchased coal in his own name at a low price and, as treasurer, bought the same coal for the company from himself at a high price. In this case the court ruled that Samuelson should be charged with the market value of the bonds that he had sold and should refund the difference between the market price of the coal and the price at which he had purchased it from himself for the company. Here again there was no hint of criminal liability or punishment. Take another case, this time from the ISTew York courts. Two officers of a paper company obtained an option to purchase a manufacturing plant for $75,000. The same plant was sold to the corporation, of which one of the defendants was president, for $100,000. The deed was taken directly from the owner of the plant to the corporation reciting a consideration of $1. The majority of the stockholders had no knowledge of the option price of $75,000 until later. On learning the facts they elected new officers who, on behalf of the company, brought suit against the defendants for the MANIPULATION BY CORPORATION OFFICERS 355 difference between the true purchase price and the price charged to the corporation. The suit was unsuccess- ful. As this is not a legal treatise, a discussion of the exact legal reasons for the decisions of the court in each of the three cases cited is not necessary here. The important feature common to the three cases and common to practically all similar cases is that in the present state of the law an oiScial may make contracts and purchases directly advantageous to himself and disadvantageous to the corporation without fear of punishment — pro- vided, of course, that he and his lawyers make no legal blunders. Assuming that he avoids this pitfall, the worst that can happen to him through the operation of the law is a restitution of his ill-gotten gains, which is, of course, no punishment at all. His true punishment comes simply in the fact that sooner or later his dis- honesty will be discovered and his reputation among honorable business men will be indelibly smirched. 206. New companies for profitable business. — A third method by which corporation officials often transfer an undue portion of corporate profits to themselves is by the formation of new companies for profitable busi- ness. Every corporation, whether it be railroad, in- dustrial, trading or financial, will find some features of its operations more profitable than others. The ordinary stockholder may not know anything about the actual operation of the business or about the oppor- tunities for large profits; obviously the officers who do understand the situation are under a strong temptation to use their knowledge for their own, instead of for the corporation's, benefit. The writer, for instance, knows of a company of con- siderable size, which is in the business of buying and sell- 356 CORPORATION FINANCE ing domestic rugs and carpets. The concern began to" deal in a small way in oriental rugs and Smith and Jones, the president and office manager, respectively, dis- covered at once that in their town this business was extraordinarily profitable. Instead of taking hold of the business and developing it for the established corpo- ration of which they were officers, Jones resigned his position, organized a new company, in which Smith was secretly a large stockholder, and quickly secured all the oriental rug trade of their city for the new cor- poration. The stockholders of the first corporation retain Smith as their president to this day and regard him highly for his business ability. At the same time. Smith is growing rich from the profits of the new cor- poration. The stockholders, even if they knew all the facts, would not be justified in saying that they had been defrauded. All that they have lost, in fact, is an op- portunity. The ethics of the proposition is too big a question to be here discussed. Whether the action of the officials in this case be regarded as right or wrong, it is certainly true that its effect was to transfer possible profits from the corporation to the officers. Take another instance, which has been related to the writer by a public accountant. The Automatic Door Fastening Company is a corporation with a large capitalization. It controls a patent device that can be cheaply manufactured and readily sold at a good price. The officers easily sold the stock to a number of small investors who were impressed with the high value of the patent and the large profits which would certainly be forthcoming as soon as it was put on the market. The corporation secured the necessary amount of capital funds, and manufactured the device; at this point the MANIPULATION BY CORPORATION OFFICERS 357 stockholders learned that a subsidiary corporation, owned by the officers, had been formed in each section of the country where sales were expected to be large and that every subsidiary corporation had a hard and fast contract with the parent company by which the sub- sidiary company got the device at a price that barely covered the cost of manufacture and was given exclusive selling rights in its own section. Practically all the projfits evidently were thereby transferred from the corporation to the subsidiary companies. There is nothing new in such an arrangement. Thirty-five years ago when the numerous short-distance railroads of the United States were first being consoli- dated into systems, railroad officials discovered that the most profitable traffic was that which moved over long distances. It was not long after this discovery before twenty-five or thirty "despatch lines" and "fast freight lines" were in existence, each of which handled the through long-distance traffic over two or more railroads under contracts by which much the greater portion of the large profits went to the despatch line companies. It is almost needless to add that the chief stockholders of these new companies were railroad officials. The same principle was applied by Commodore Vanderbilt when the New York Central System was formed by holding in his own hands the stock of com- panies which owned the important terminals of the railroad. These terminals were then leased to the New York Central on terms that were not generally exorbi- tant, but that nevertheless yielded a large return to the Commodore. Although the Vanderbilt family for many years have not held a majority or anything like a majority of the New York Central stock, yet they 358 CORPORATION FINANCE have been able to dominate the management of that road and to secure for themselves large profits through their ownership of these terminal companies. 207. Misuse of inside information. — The fourth method of milking a corporation for the benefit of its oflicers is by making use of "inside" information. This is, on the whole, the safest and least disreputable method. Indeed the line between the proper and im- proper use of the information that necessarily comes into the officers' possession is so indistinct that no one has yet been able to trace it. We are all agreed, no doubt, that it is quite improper for the president of a corporation to make a business of speculating in the stock of his company, especially if he "sells short" and thereby puts himself under temptation to mismanage the company. On the other hand, probably few people would raise any objection to an officer's investing in some shares of his company's stock, if he has good reason to believe that the stock is selling below its true value; nor does there seem to be any valid objection to his selling this same stock, if later he discovers that speculative forces have raised it far above its true value. Now just where shall the line between what is proper and improper in this regard be drawn? No one can say. It is as shadowy as the line between specula- tive and investment buying. Whatever doubt there may be as to whether the use of inside information by a corporation officer to guide his buying and selling of stock is improper or not, there can certainly be no question but that the use of such in- formation by an officer in order to enrich himself directly at the expense of the corporation is wholly un- justifiable. The three cases cited below are fair examples of what is sometimes done : MANIPULATION BY CORPORATION OFFICERS 359 (a) An officer of an oil refining company in Pennsyl- vania, who had no authority to sell stock for the corporation, received a buying order addressed to him- self as an official of the corporation for 5,000 shares at 20 cents a share. He filled the order by transferring 5,000 shares from himself to the purchaser and then took for himself 5,000 shares of treasury stock at the special price of 2 cents a share. In this case, the facts being fully proved, the court ordered a refund of the difference between the two prices to the corporation. (b) The XYZ Manufacturing Company, with capi- tal stock of $500,000, one-half paid in, went into receivers' hands. The company had notes for $20,000 outstanding, bearing 10 per cent interest and secured by a mortgage on its property. The president, know- ing the condition of the company, just before the failure, secured the notes in exchange for $30,000 face value of his stock in the company. Ten thousand dollars was paid on the notes when they fell due, but the other stockholders objected to paying the remainder. The president transferred his claim for the remaining $10,000 to an outsider and the court enforced payment of the claim. (c) Robinson, the treasurer of a railroad company, which was in poor condition, bought up outstanding notes of the company at a large discount with his own money and as treasurer saw to it that the notes were paid when due at their full face value. The court held that the treasurer had done nothing illegal. He was at liberty to buy the notes for himself, as he was under no obligation to buy them for the road. He could meet them when due with the road's money, as that money was there to pay any or all of the road's debts and not any special debt. 360 CORPORATION FINANCE The striking feature of these three cases, as in several of the other cases cited, is that although the officials were obviously unfaithful to their trust and were not acting in good faith as agents for the corporation, never- theless they were able to escape legal punishment. 208 Is manipulation by officers common? — The four methods that have been given and illustrated, by which corporations are frequently deprived of part of their just profits by their own officers are: (a) Exorbitant salaries. (b) Collusion or fraud in marketing, purchases and contracts. (c) Formation of new companies for especially profitable business. (d) Misuse of confidential information which comes to officers by virtue of their position. It would certainly be a gross exaggeration to say that all or a majority of the corporation officers of the United States are guilty of any of these practices. On the contrary, it is probably true that their dealings with or for the corporation which they serve are in most cases absolutely honorable. Yet it must be regretfully ad- mitted that these four methods of milking a corporation are only too well-known and too skillfully practiced. As an accountant of wide experience says, in speaking of corporate manipulation by officers, "That this is con- stantly being done is obvious from the fact that so many men, drawing salaries with large corporations of $10,000 to $15,000 a year, become millionaires in a very short period. It is a mere matter of arithmetic to demonstrate that this is not done out of the money that they save." CHAPTER XXVI MANIPULATION BY DIRECTORS 209. Usual methods. — As has already been stated, it is difficult to draw the line between manipulation by officers and manipulation by directors, for in most cases more or less collusion between the two is essential to the success of any of their fraudulent schemes. It is possible, however, to draw a distinction between those forms of manipulation which are primarily intended for the benefit of officers and those forms which are primarily for the benefit of directors; with the latter class of manipulative methods we have now to deal. The method that was given the first place in our con- sideration of manipulation by officers, namely, exorbi- tant salaries, is not worth attention here. Directors, to be sure, are frequently allowed fees for attending meetings, and sometimes these fees seem to be somewhat excessive. They are frequently prescribed, however, in the by-laws, in which case, of course, the stockholders as a body would have no ground for complaint against the directors as a body. In any case, the fees are not large enough to make it worth while for the directors to attempt to defraud the stockholders and enrich them- selves by this particular method. Without much question the courts would set aside directors' fees for attending meetings much higher than $10 to $25 for each meeting and would look with suspicion on an especially large number of meetings. 361 362 CORPORATION FINANCE Eliminating this possible method of manipulation, then, as of small consequence, we may set down four important and not uncommon means of transferring an undue proportion of a company's assets and profits to the pockets of its directors. These four methods are : (a) Fraudulent purchases and contracts. (b) Formation of new companies for especially profitable business. (c) Deceiving the body of stockholders by means of juggled accounts. (d) Forcing the corporation unnecessarily into bank- ruptcy or into receivers' hands. The reader will observe that the first two methods have been discussed in the preceding chapter. There are, however, some variations that should be mentioned between the apphcation of these methods by officers and by directors. 210. Fraudulent contracts. — The number of cases of fraudulent purchases and contracts by directors that have been brought before the courts are so numerous that it is difficult to make a selection. The following instances are typical: (a) In an Alabama case the facts brought out were as follows: The promoters of a large electric manu- facturing company obtained as a profit in its formation approximately $2,000,000 of stock and were thereby able to exercise considerable influence on the board of directors. The directors, in spite of the demands of several stockholders, neglected to seek to recover from the promoters any portion of their excessive profit. Suit was brought by a stockholder to compel the directors to act and they replied that they deemed the proposed attempt to recover inexpedient. It is intimated in the court's decision that they were improperly influenced MANIPULATION BY DIRECTORS 363 by the promoters and the court ordered them to make the attempt. (b) Three directors of a corporation formed to build a summer resort hotel caused the corporation to pur- chase the land on which the hotel was to be located from themselves at a 200 per cent profit to themselves. The land was purchased subject to a heavy mortgage. When only $25,000 had been subscribed toward the $90,000 required to erect the hotel, the directors made a contract to start construction of the building. Their object in so doing was to enhance the value of other land in that vicinity which they owned. The corpora- tion became insolvent and the directors, on foreclosing their mortgage on the land, virtually became the owners of the land and of as much of the hotel building as had been erected. The court in this case held that the direc- tors were liable to the stockholders for the depreciation in the market value of the stock. (c) Two of three directors of a South Dakota corporation, for the purpose of securing control of the corporation for themselves, caused the issue and im- mediate sale to one of their friends of a large amount of new stock sufficient to give the two directors and their friend together a majority. The court held that as the friend knew all the facts, the sale of the stock conferred no rights upon the purchaser. It may be inferred from this decision that if the purchaser had been an innocent party, the transaction would have been vahd. (d) In a somewhat similar instance in New York a full board of directors authorized the issue of sixty- seven shares of stock to increase its capital. The presi- dent of the company reported at a subsequent meeting that he had received no subscriptions, and four of the 364 CORPORATION FINANCE seven directors thereupon took the stock without knowl- edge of the holder of the majority of stock previously issued, who was also a director. In this case the court allowed the purchasers to hold and vote the stock, but enjoined them from using it to the injury of the pre- vious majority holder. (e) A railroad company was organized in Minnesota to build a local road in that state. Capital stock of $2,000,000 and bonds to the extent of $1,500,000 were authorized. A director and owner of a majority of the outstanding shares drew up a contract with the XYZ Construction Company under which the company was to build the road and receive 331 shares of its capital stock together with first mortgage bonds to the amount of $20,000 per mile. The XYZ Construction Company then made a contract on its own account with the firm of A & B, under which the firm was to pay $5,446 for each $20,000 block of bonds and in addition was to furnish the material necessary to build the road. The director above referred to was interested with A & B and was to receive for himself an agreed share of the railroad bonds. The actual cost of construction was to be about $14,000 a mile. The contract came before the board of directors and two directors, whom we will call Smith and Jones, voted for the contract with the understanding that they also were to become interested with A & B and to receive a portion of the profits. Afterwards they offered to contribute one-fourth of the cash required for actual construction of the road in order to become partners with A & B. Their offer was refused. They then brought suit, exposed the whole transaction and asked to have the contracts declared void for fraud. The court held that there was no fraud on the face of the transaction but that MANIPULATION BY DIRECTORS 365 fraud could plainly be inferred, inasmuch as the cor- poration was made to pay more than was necessary for contruction. They held, however, that the two direc- tors, Smith and Jones, having knowledge of the trans- action, did not come into court with "clean hands" and could not cry fraud because they lost what they bad attempted to gain. The contract, therefore, was noi set aside. 211. Attitude of the courts. — These illustrations, taken almost at random, indicate what opportunities for fraudulent manipulation are open to corporate directors and how slight is the danger of legal punishment. As may be observed over and over again, the courts assume that a corporation is honestly managed in accordance with the wishes of the stockholders unless the contrary is absolutely proved. Stockholders who object to the contracts and purchases made by their directors are apt to be told that their true remedy is to elect a new board. Obviously this principle of the law, however far from applicable it may be in particular cases, works out, on the whole, for the good of the greatest number. Most corporations are honestly managed. Directors are rightly believed generally to have a far more extensive knowledge of the affairs of the corporation and of the contracts and purchases that should be made than the body of stocldiolders have. The courts, therefore, ordinarily do not desire to set aside contracts made by the directors or even by investigation to cast doubt upon those contracts. The attitude of the courts, it must be admitted, is correct. On the other hand, as the in- stances given above plainly indicate, it is also true that this attitude gives directors almost unlimited op- portunities for fraudulent manipulation. The only 366 CORPORATION FINANCE practicable remedy in the long run is for the stockholders to be exceedingly careful to elect men of proved probity to their directorate. 212. New companies for profitable business. — The second method of manipulation by directors that has been named is the formation of new companies for profitable business. A few typical illustrations will best explain the working of this method. (a) The directors of a New York building and loan association, the charter of which required the funds to be invested in first mortgages, nevertheless bought some second mortgages. The association became insolvent and receivers were appointed. Some of the directors then organized a realty company which took from the receivers the land and buildings owned by the associa- tion at 50 cents on the dollar and made part payment with additional second mortgages. The directors thus secured for themselves at small cost most of the valuable assets of the association. The court discharged the re- ceiver and appointed another receiver to conserve the remaining assets. (b) The Strong Lumber Company and the Hoffman Manufacturing Company elected three men, consti- tuting a majority of both boards, directors of both com- panies. The Hoifman Manufacturing Company, which had the better credit, accepted time drafts drawn upon them by the Strong Lumber Company, although no consideration had been given. To secure themselves from personal liability the three men as directors of the Strong Company placed a mortgage on the property of that company and issued bonds which were turned over to the Hoffman Company. When the facts were presented, the court entered a decree setting aside the mortgage. MANIPULATION BY DIRECTORS 367 (c) The directors of a railroad company in Nevada were members of a syndicate which intended to build a connecting road. The road was built and paid for by the syndicate and was mortgaged heavily. The syndicate received all the bonds and stock and then transferred 51 per cent of the stock to the railroad com- pany, of which they were directors, in consideration of this company's guaranteeing the bonds. The guar- antee of the bonds allowed the syndicate to sell them at a good price. The court held that allegations of fraud were not sustained and that the whole transaction was legitimate. In the last two cases the profit to the directors evi- dently came in the form of increased credit for companies in which they were interested. It seems clear in both cases that there was no corresponding advantage to the corporation ; otherwise the corporation in each case would have made the arrangement on its own accoimt. The reader will observe, no doubt, that directors have opportunities of the same kind as those which fall to officers, when it is discovered that some particular feature of a company's business is especially profitable. Either the directors or the officers, or both together, may organize a new company of their own to handle that business and thus may divert profits to themselves. 213. Juggling accounts. — The third means open to directors, who wish to manipulate! corporate affairs for their own interests, is to tamper with the corporation's books and thus give the stockholders a wrong impression as to the company's condition. The methods that may be used to accomplish this object are so numerous and so complicated that it would be impracticable to enumerate all of them here. Indeed, this section of our subject belongs to accounting rather than to finance. 368 CORPORATION FINANCE A few typical instances, however, which have been supplied by some of the most experienced and best known public accountants in the United States to the writer, may be enumerated. The reader will find further light on this important subject in the volume on Auditing. (a) The directors of a holding company, which owned the entire stock of four separate manufacturing companies, desired to present a favorable report of the year's operations to their stockholders. In order to do so they took into account dividends paid by three of the companies and ignored altogether a very heavy loss incurred by the fourth company. Their excuse for so doing — ^which excuse, however, carries very little weight — ^was that the holding company as a stockholder in the other companies was entitled to the benefit of all the dividends declared, but could not be called upon to make up any loss that might be sustained; this excuse obviously overlooks the fact that the loss incurred by the fourth company constituted a diminution of the assets of the holding company. A firm of certified public accountants was called upon to sign the mislead- ing report prepared by the directors. The accountants were given access to the books of the holding company but were refused the books of the subsidiary companies. The firm lost the audit, which went to more pliable accountants (not holding the degree of certified public accountant), and the original report was presented to the stockholders. Presumably the directors seized the opportunity to sell their stock in the holding company at a high price. At any rate, the holding company went into bankruptcy not long afterwards. (b) A railroad company, when the time for the annual report and audit approached, deliberately withheld the MANIPULATION BY DIRECTORS 369 intertraffic claims of other companies, amounting to a considerable sum, by simply pigeon-holing the docu- ments and not recording them as a part of their current obligations. This action was taken, it is stated, by order of the executive committee of the board of directors, who were about to ask authority for a new stock issue and who desired to bring out the issue shortly after the annual report appeared. The certified public account- ants, who had charge of the annual audit, in this case discovered the deception through a general analytical study of the year's operations whereby it was seen that while such intertraffic claims ought to exist, they were not in evidence. (c) An industrial company was enabled to maintain a market value for its stock through the payment of unearned dividends out of capital. The deficit was not shown on the books and was not known to the stock- holders until after an audit by public accountants. Its existence, however, should have been known to the directors and in all probability was known during the period in which unearned dividends were declared. In this case judgment was obtained in the courts against the directors and restitution of the unearned dividends was obtained. (d) In a case brought in the federal courts stock- holders asked for the cancellation of stock alleged to have been fraudulently and secretly issued by the board of directors. It was stated that a person, to whom the certificate was issued without consideration to the com- pany, executed to one of the directors a power of attorney authorizing him to vote the stock and delivered the certificate signed in blank. Thus, although no transfer appeared on the books of the corporation, the stock was actually owned and voted by one of the VI— 24, 370 CORPORATION FINANCE directors. As the stock of this corporation was widely scattered and as the reports to stockholders were frag- mentary and misleading, the whole transaction would have passed unnoticed if it had not been accidentally revealed to one of the stockholders. The court in this case merely cancelled the certificate in question and neither civil nor criminal liability was found to attach to the directors. 214. An accountant's observations. — A certified pub- lic accountant, whose experience in handling such cases has been exceptionally large, has been kind enough to sum up for the writer the results of his observations in the following note: The methods employed for the purpose of giving a wrong impression to the stockholders or the public as to the company's condition as shown by the published balance sheet are almost in- numerable, but I will cite a few. Where the accounts are subject to audit and it is desired to make a good appearance at the date of the balance sheet, the practice of borrowing a large sum of money from brokers or bankers for a few days is often resorted to. By this means at the date of the balance sheet the company has apparently a large amount of available funds, though in point of fact the loan is repaid a few days later. In the same way, where such a corporation as a loan and investment company finds itself hold- ing securities of a speculative character, such as mining stock, it is quite customary to make a sale of these securities to brokers a few days before the date of the balance sheet, with the under- standing that the company is to repurchase them at the same price less commission for the accommodation a few days later. Ill this way the company avoids showing on its published bal- ance sheet any investments that are not of a gilt-edged charac- ter, and in both the instances quoted above it is very hard for the auditor to find any grounds for refusal to give an unquali- MANIPULATION BY DIRECTORS 371 fied certificate to the balance sheet ; the condition is as stated by the accounts at the particular date at which they are drawn up. Again, where it is desired to conceal from stockholders the fact that the company is making large profits or, on the other hand, incurring heavy losses, the valuation placed upon invest- ments in stocks and bonds of other corporations or the valua- tion placed upon merchandise on hand is often juggled, the officers of the company constituting themselves the arbiters as to what is really the actual value of such assets. Another window-dressing plan often employed is to treat the balances due on current account from the branch houses of the corporation as though they were accounts receivable due from ordinary customers. Goods on consignment are often similarly treated as though they were accounts receivable and included in the balance sheet at sale price under this caption in- stead of at cost price. 215. Remedies for this kind of manipulation. — What little has been said here with regard to juggling accounts by directors is sufficient to drive home at least one truth, namely, that the only safety for stockholders lies in insisting upon frequent and thorough examina- tions by certified public accountants of the highest standing. The chief asset of a public accountant is his unquestioned reputation for penetration and integrity. The loss of that reputation means the loss of his profes- sional standing and of his clientele. He has, therefore, the strongest motive to lay bare the true condition of any corporation which he is called upon to examine and to state the exact facts to the stockholders. The stock- holders may safely place confidence in him — unless, to be sure, he happens to be one of those black sheep, a few of whom find temporary employment in all professions. In England it is customary for the stockholders them- selves to elect a public accountant to serve as the annual 373 CORPORATION FINANCE auditor of their company. It will be a fortunate day for American stockholders when this practice becomes prevalent also in this country. We may lay it down as a general principle that officers and directors who are worthy of their trust will not object to having their operations scrutinized at least once a year by an impar- tial and absolutely independent expert. Another tendency which works indirectly toward the same result is the growing demand on the part of the people of the United States for publicity in corporation affairs. The demand for publicity is especially effec- tive in the case of railroads and other public service corporations, most of which are now required to render complete annual reports either to the Interstate Com- merce Commission or to some corresponding state authority. The primary purpose of this requirement is to obtain information that will aid legislatures and com- missions in deciding upon reasonable rates and prices. It is doubtful, in the opinion of the writer, whether this result will be achieved. There can be no question, how- ever, but that the interests of stockholders of sucb companies have been greatly advanced by a general adoption of this requirement. It is now possible for an investor to obtain such a complete and authoritative knowledge of the interior affairs of the principal American railroads as to make possible an intelligent judgment of the honesty and efficiency of the manage- ment. Seeing the advantages that are thus gained, the stockholders of other large corporations are insisting more and more forcibly on a similar publicity and in- vestors are refusing to buy the securities of companies which do not present satisfactory annual reports. That this attitude has for some years been making itself felt MANIPULATION BY DIRECTORS S73 appears from the numerous conversions, referred to in Chapter XVII, of securities quoted on the New York Stock Exchange from the unlisted to the listed group. 216. Inflicting loss on the corporation. — The fourth important method of manipulation by directors is through forcing heavy losses and frequently even bank- ruptcy on their companies. Here again a few examples selected from a mass of cases which the writer has exam- ined will best illustrate the principal variations of this method. (a) The G. and R. Railroad Company, a Kentucky corporation, constructed a road from Graceton to Rawlings for which it was heavily indebted. Robinson, a director, with the assistance of other directors, used the profits of the road to make improvements and thus made impossible the payment of interest on the outstand- ing bonds. The company was thus forced into bank- ruptcy and at the bankrupt sale all the property and rights were sold to Robinson. Robinson and others then formed a new corporation to hold the road. Five years later the stockholders of the bankrupt corporation brought suit against the heirs of Robinson to have the court adjudge the road as held in trust for the G. and R. Railroad Company. The court found that Robinson had violated his duties of trust by willfully mismanag- ing the road and misappropriating the earnings and, therefore, returned the property to the original stock- holders, compensation being allowed to Robinson's heirs for the amount actually paid by Robinson for the road. Evidently Robinson's actions in this instance, although finally declared unlawful, would have passed unchallenged but for the enterprise and persistency of one or two of the stockholders. (b) In a recent case in the federal courts, certain 374 CORPORATION FINANCE trustees of a building and loan association sold a valu- able piece of real estate to a trust company, in which some of the trustees were also interested, in exchange for securities of doubtful value. A mortgage on the real estate was taken from the trust company as a guarantee that the securities would realize the price agreed upon for the property, but by agreement the mortgage was not recorded. Later the trust company desired to sell the property and the trustees passed a resolution authorizing the cancellation of the mortgage, and it was cancelled without the knowledge or consent of the stockholders. Shortly afterwards the trust com- pany became insolvent, the securities held by the build- ing and loan association were found to be worthless and next to nothing was obtained for the property that had been sold. This may be taken as a typical instance of loss willfully inflicted on a corporation by its own directors. (c) A corporation was indebted to its directors and they caused mortgage bonds to be issued to them for the indebtedness. The bonds were immediately as- signed to a rival corporation. Before anything further had been done the stockholders learned of this trans- action and brought a suit for damages. The court held that the directors would be personally liable for what- ever consequences of their acts might affect injuriously the interests of non-consenting stockholders. (d) A stockholder of a Montana mining corporation in an action alleged that officers and directors in pur- suance of a plan to depreciate the company's stock, in order to render practically worthless stock held by the plaintiff and others similarly situated, refused to sell treasury stock of the corporation in order to procure funds with which to prosecute assessment work on the MANIPULATION BY DIRECTORS 375 company's mining claims essential to compliance with the state and federal laws. Further the directors sys- tematically depreciated the value of the treasury stock by words and actions, refused to accept money oiFered therefor, removed the books of the company from the state, declined to give the plaintiff" any information re- garding the company's aff'airs and in general so con- ducted its business as to destroy the value of its shares. Their object in so doing was to make it necessary for the company to give up its mining claim in order that they might re-locate the property in their own names. In this case the court decided that fraud had been sufficiently shown and placed a receiver in charge of the property. The decision, however, would not have been, reached except for certain imprudent remarks on the part of some of the directors. 217. The danger in losing control of a corporation. — The most interesting instance that has come to the writer's notice is given by a certified public accountant in one of the Western States, who vouches for its being a typical and actual case of manipulation by directors. He writes as follows: A owned a majority of the capital stock outstanding in a manufacturing concern. Besides himself he had two dummies for the two other members of the board of directors. B de- sired to buy an interest in the concern and bought less than half of A's stock (leaving A still in control), with the understanding that B was to become a member of the board of directors, and that A and B should select another person whom they might interest at some future date when selling more stock. There- fore, they mutually decided to place a dummy temporarily on the board. B is a crook, as develops afterwards. C (the agreed-upon dummy) proves to be a bigger crook than B, thus giving B a majority in the board of directors. After this ar- rangement has been carried through, B and C trump up some 376 CORPORATION FINANCE imaginary charges against the methods of management of A, and thus the majority of the board depose A as president and manager of the concern. A opposes the action and the case is brought into the court. B and C being the majority of the board of directors, the court upholds their action and gives an injunction against A not to interfere with B and C. B and C then buy some worthless vacant property for a few dollars, which they appraise at an excessive value and sell to the company, taking stock in payment at the increased values. This stock is then divided between B and C, thus leaving A in the minority as a stockholder. The factory then burns down and a low settlement is made with the insurance companies, be- cause suspicion was directed toward B for having set fire to the property. Their assets having thus been reduced, and wishing to make an excellent impression upon the court, and further wishing to hide their fraudulent action in placing the excessive value on the vacant, valueless property, they decrease the capi- tal stock to about 10 per cent of the original capital stock. Each stockholder obtains his proportionate share of the new stock. In this manner B and C beat A from a half interest to a sixth interest. They then incorporate a new company called The Investment Company, of which B and C are the only stockholders and in which B and C put up $5,000, which they loan out on improved realty to the manufacturing company, obtaining therefor a note secured by a mortgage. They then proceed to incorporate another company, which succeeds the old manufacturing company. They value the as- sets of the old company at about one-third of what they stand on the books. The new company purchases the assets at the re- duced value, giving the stockholders of the old company stock in the new concern in proportion of one to three, thus reducing the holdings of A from a half to an eighth interest in the same assets of which he was originally the owner. The new company then contracts with D, who Is another crook, to build it a factory. The contract made with him is at a figure which is about $5,000 higher than the ordinary contractor would have built it for. MANIPULATION BY DIRECTORS 377 In addition to this B and C give him a large block of stock as a part consideration for the building of the plant. This $5,000 in excess of the real cost of the factory is paid to D every other day in cash and the books indicate that such cash was for his pay-roll. But circumstantial evidence points to the fact that these payments are bogus transactions on the books and that in fact the money goes into the bank account of the Investment Company. Then the Investment Company begins to play treasurer for the new company, because it has no funds. Thus it loans the $5,000 back to the manufacturing company. The new manu- facturing company needing more funds, the Investment Com- pany sells the $5,000 note above mentioned to the manufactur- ing company, permitting the manufacturing company to credit the Investment Company for this $5,000 on its books. The manufacturing company then puts up the $5,000 note as col- lateral for a loan of $3,000 at the Bank. The result is that the Investment Company secures a credit in its favor for $5,000 for an actual value of but $3,000. After this transaction the Investment Company shows signs of anxiety for the money it has advanced, $5,000 in cash and $5,000 in notes. It there- fore secures its claims by a mortgage from the manufacturing company on its new plant for $10,000. The plant is completed, the stock bonus issued to the contrac- tor, and this stock transferred to the Investment Company. Circumstantial evidence shows that no consideration was paid by the Investment Company to the contractor for this stock. As the case stands at present, the Investment Company is trying to foreclose its mortgage and if successful, will entirely defeat the interest of A, who in less than eight months was beaten out of a more than half interest in a successfully-run factory. I was employed in this case by order of the court upon the complaint of A that B and C were wasting the assets of the company. I cannot see how under the laws of the state A has any redress whatever, except to show fraud in the first issue of additional stock and in the subsequent decreasing of the capital 378 CORPORATION FINANCE stock. But from the point of view of law it will be exceedingly difficult to bring in this evidence. However, there is a ray of hope in the horizon; namely, that the state statutes forbid the directors to put a mortgage on a mining or manufacturing plant without calling a special stockholders' meeting and obtain- ing the consent of two-thirds of the stock. These directors had two-thirds of the stock and could have easily complied with the requirement, but their attorney evidently overlooked this point and we believe that we can have this mortgage set aside and a receiver appointed. In this case the receiver could start suit against B and C and then bring out these fraudulent transac- tions. The cases that have been cited seem scarcely to call for comment. They all — and especially the last case — however, give point to one precept, which controlling stockholders would do well to keep before them, namely, DO NOT PART WITH CONTROL. A swindling or hostile board of directors can do more in one session to wreck a corporation and bring loss to its honest stockholders than a capable board can accomplish in years toward repairing the damage. CHAPTER XXVII MANIPULATION BY AND FOR STOCKHOLDERS 218. Cheating creditors. — The subject matter of this chapter is concerned with manipulation directed, toward one of two objects; either toward depriving creditors of some of their just rights for the benefit of the body of stockholders; or toward increasing the profits of controlling stockholders at the expense of minority interests. In the first case the stockholders may be either acting as a body, or manipulation carried on primarily for the benefit of the majority stockholders may be of such a character that the minority can success- fully obtain a share in its advantages. Generally speaking, manipulation by and for stockholders as a body is confined to small close corporations. We shall find, however, one or two notable exceptions to this rule. We are all of us familiar, some of us perhaps to our loss, with the old trick of an individual or partnership buying a stock of goods on credit, disposing of it quickly and secretly, concealing the returns and shortly afterward going into bankruptcy. The trick may be worked by corporations as well as by partnerships or by individuals. Indeed, the corporation affords an addi- tional advantage to the swindlers in that its bankruptcy need not affect them in the least. Credit-men under- stand the game in all its variations thoroughly and are especially cautious in granting credit to small close cca*- porations, no matter how imposing may be their title and their capitalization. This scheme, of course, is 379 380 CORPORATION FINANCE simply a plain case of fraud and has no especial interest for "us in this study. A slightly different method of reaching much the same result is to have a corporation pile up a large debt on the strength of its assets and then to allow the assets to depreciate. Stockholders of a corporation whose outstanding bonded debt is high are always under temptation to encourage this policy. By so doing they may secure large dividends for themselves over a series of years and at the end leave assets of small value to satisfy the bondholders. As we have already found in our study of corporate mortgages (Chapter IX) properly drawn instruments of this character provide that the property mortgaged shall be maintained in at least as good condition as at the time that the mortgage is drawn, on penalty of having the corporation put into the hands of receivers. If the trustee under the mort- gage performs his duties properly he wiU see to it that this provision is enforced. If the stockholders and directors acting for the stockholders really desire to evade the provision, it may require the closest atten- tion and rigorous action on the part of the trustee to forestall them. 219. The Chicago and Alton deal. — The well-known instance of the Chicago and Alton Railroad deal illustrates another variation of the same principle. The facts with regard to the Chicago and Alton manipula- tion which were fully brought out in an investigation by the Interstate Commerce Commission in 1907, may be briefly summarized as follows: A close syndicate in 1898 bought about 80 per cent of the outstanding com- mon stock of the Chicago and Alton Railroad Company. The company had been managed with great conserva- tism for several years and had saved from its earnings MANIPULATION BY STOCKHOLDERS 381 and put back into the property a surplus of $12,500,000. Now a surplus is legally, of course, the property of the stockholders of a corporation. It is so unusual, how- ever for stockholders to distribute this surplus directly to themselves that bondholders naturally look upon it as in part a protection to themselves and buy bonds with that understanding. Ordinarily, as has been explained, the surplus is invested in the form of perma- nent assets of the corporation, and the value of these assets is a strong factor in influencing the bond buyer. The syndicate of common stockholders in this case, determined to secure for themselves, and incidentally the other stockholders, the accumulated surplus of the com- pany. They therefore issued new bonds to the extent of $32,000,000, which were sold at 65 and the proceeds, about $21,000,000, turned into the company's treasury. They then declared an extra cash dividend of 30 per cent and thus transferred a large share of the cash ob- tained by the bond issue into their own pockets. The action was much discussed at the time, was condemned by some and defended by others, but did not arouse much public interest until the investigation by the Inter- state Commerce Commission in 1907 brought it into prominence. Then, probably to the surprise of the members of the syndicate, the verdict was practically unanimous against them. They were tried before the bar of public opinion and were found guilty of misuse of corporate funds which had been entrusted to their care. There can be no question but that this imanimity on the part of the public is highly significant. It means that between 1898 and 1907 a notable gain in the public's knowledge of corporation finance and in the public's conception of what is and what is not justifiable had- taken place. The gentlemen who composed the 382 CORPORATION FINANCE syndicate ought not to be too severely criticised, for they merely acted in accordance with the custom of the period. We may well hope and believe that manipula- tion of this kind and of the other kinds that have been enumerated will become less and less frequent as our conceptions of the trusteeship implied in almost all corporate activities become clearer. 220. Manipulation through subsidiary companies. — Another method that is very commonly used when stockholders plan to get the better of the creditors of their corporation, is the device of interposing one or more corporations between the creditors and the assets on which they think they have a claim. A case in point which was recently settled out of court, and in which the names of the parties concerned, therefore, cannot here be given, is that of an amusement company operat- ing a large park in one of the cities of the United States. The operation of the park was extremely costly and, as the price of admission was only ten cents, the returns were not sufficient to pay expenses. There were, how- ever, a large number of shows and amusement enter- prises in the park which were highly profitable. The stockholders of the corporation as individuals were interested in these sideshows and secured large profits. The corporation which owned the park, on the strength of its apparent prosperity, was able to borrow large amounts of money. When the time for settlement came the creditors learned the true state of affairs and were informed that their claims were practically worthless. Fortunately in this case they were able to bring such pressure to bear on the stockholders that their claims were settled. It is quite evident, however, that as a method of getting loans and avoiding re-payment the scheme is workable. MANIPULATION BY STOCKHOLDERS 383 Here is another instance which shows that eminent and entirely respectable railroad directors are not above working the same trick for the benefit of their road. The N. E. Railway owned a majority of the stock of a small rail and boat line which had income bonds outstanding. The large company, being in control, was able to apportion traffic and earnings as it pleased and gave less than its share to the small line. Three of the boats owned by the small company were being paid for on the installment plan and one of these payments was allowed to lapse, thereby forfeiting the interest of the small company in the boats. The large railroad company then bought the boats from the vendors, being allowed the amount which had already been paid by the small company. Then a consolidation of the large and the small companies was determined upon and, as the earnings of the small company had been practically stopped, its shareholders received only one share in the new consolidated company for every ten shares in their possession. The income bondholders received no interest after the large company came into control and when the consolidation took place were compelled to consent to a great reduction of their claims. The case was threshed out in the courts and it was decided that all the steps taken were legal, except the voluntary passing of the payment on the boats. 221. Central of Georgia income account. — Another case in point, that several years ago attracted a great deal of attention in the financial world, was set forth in the suit of the income bondholders of the Central of Georgia Railroad Company for the payment of interest in full on the bonds. The reader will recall that in describing the nature of income bonds it was stated that they are falling into disuse on account of the in- 384 CORPORATION FINANCE evitable disputes that arise as to what are and what are not profits. The bonds in question were issued in 1895 at the time of the reorganization of the old Central Railroad and Banking Company of Georgia. This case well illustrates the subject now under dis- cussion, inasmuch as it discloses one method of manipula- tion in favor of stockholders at the expense of creditors. The principal fact alleged by counsel for the income bondholders, and practically admitted by the railway company, was that a subsidiary corporation, the Ocean Steamship Company, almost all of the stock of which is owned by the Central of Georgia Railway Company, had been making large profits and that these profits had been appropriated by the railway company. Evi- dence disclosed that the Ocean Steamship Company kept no separate bank account but deposited all its funds to the credit of the Central of Georgia Railway Com- pany. There were, however, separate books of account for the two companies and it was claimed at the suit, on behalf of the railway company, that the earnings of the steamship company were simply loaned to the parent corporation. These earnings, the reader should under- stand, were not used in order to declare dividends on the stock of the Ocean Steamship Company held in the treasury of the railway company, but were turned over bodily under the fiction of a "loan"; therefore the earnings of the steamship company did not appear at all in the income account of the railway company, and the railway company thereby avoided showing sufficient profits to pay interest to the income bondholders. The counsel for the railway company urged, according to the brief of petitioners' counsel, "that the net earnings of the steamship company should not be included in the income account of the railway company and that unless MANIPULATION BY STOCKHOLDERS 385 a dividend is declared by the steamship company no part of the net earnings of the steamship company belong to the railway company or are pledged to the bond- holders, and that the question of declaration of a dividend is a matter of discretion lodged with the board of directors of the steamship company, with which a court of equity should not interfere. In other words, the railway company interposes the doctrine of 'corpo- rate entity' and desires to have what it regards as the 'sacredness' of the doctrine taken cognizance of by a court of equity." The decision of the court in this case, which was ren- dered after long and hard-fought litigation, was in favor of the complaining bondholders. It would cer- tainly seem clear to a layman that the subsidiary cor- poration was here used as a device to prevent the in- come bondholders from securing profits justly due. These cases are sufficient to show what risks creditors may unwittingly take on themselves and how careful they should be in fixing the terms of their mortgage. Especially is this true in dealing with corporations which carry on several activities and which may through separate companies readily divert their earnings from the rightful creditors to the stockholders. 222. Squeezing the minority stockholders. — We are ready now to take up the second group of manipulative methods to be discussed in this chapter, namely those methods which are designed to enrich controlling stock- -„,:;™,. :. :.e ^:::ssnse of minority interests. Let us „.^^^ ,„„„ following instance, taken from a Missouri court decision, of willful mismanagement : The Olympic Theatre Company was organized in May, 1903, with a capitalization of $50,000. E. S. James, Sr., obtained 240 shares, par value $100, and VI— 35 386 CORPORATION FINANCE J. S. Mcintosh, 150 shares; the other 110 shares were never issued. Three days after the organization the company obtained a hundred-year lease of a lot in St, Louis. Under the terms of the lease the company was to pay the owner a rent of $2,500 for the first two years and thereafter at the rate of 6 per cent of the appraised value of the lot. The company had the right to pur- chase at the appraised value at the end of five years. The lease was to become^ void by non-performance of any of its conditions and, in the event of its being voided, the owners of the lot were to get full title to whatever buildings the theatre company might erect on the lot. The company erected a building and conducted a theatre. In 1905 Mcintosh sold his stock to Robert Henry, and Henry became a director and treasurer of the company. E. S. James gave ten shares of stock to his son, E. S. James, Jr., and made him the third director. In 1907 James, Sr., transferred ten shares to another son, Alfred James, and ten shares to a clerk, L. R. Osgood. In the same year the new board of directors elected were James, Sr., James, Jr., and Osgood, thus forcing Henry out. In 1908, as the company was not strong enough financially to buy the lot, the stockholders gave the directors the right to dispose of the company's option to any stockholder. The directors immediately sold the option for $50 to James, Sr., who there- upon resigned as president and director and had his son Alfred elected in his place. James, Sr., then used his option to buy the lot for $50,000 and made an agree- ment with the company fixing its appraised value at $65,000 and its annual rental at $3,500. Alfred James then resigned his offices and his father was re-elected president and director. The board failed to pay the MANIPULATION BY STOCKHOLDERS 387 rent when due and James, Sr., as owner of the lot under the terms of the lease to the company, declared the lease void and was placed In possession of the lot and the building erected thereon. Henry, the minority stock- holder, brought suit and it was finally decided that suffi- cient evidence of fraud had been produced to warrant the court in reinstating the lessee in possession of the theatre under the terms of the lease. It may be inferred from the decision that two factors which decided the court in favor of the plaintiff were, first, that the James family were evidently acting as a unit, and, second, that the books of the corporation had been destroyed. These were tactical errors which might readily have been avoided ; if they had not been present, it is safe to say that the whole series of transactions would have been found legal. A more simple and common case is stated in a recent decision of one of the federal circuit courts. The officers and owners of a majority of the stock of a wire company voted as stockholders to lease the property of the com- pany at a low rental to another corporation, all of whose stock was held by these same majority stockholders. No fraud was shown and the petition of the minority stock- holders to set aside the lease was not granted. In another federal court case it was shown that the majority stockholder of a gas company absolutely dominated the board of directors and induced the board to purchase worthless bonds of another corporation in which he was interested, by which he was able to make a large individual profit. Here again the minority stockholders, in spite of their unremitting efforts, were unable to prove fraud. 223. A complicated real estate propositiofi,. — Here is an instance furnished by a prominent accountant 388 CORPORATION FINANCE and which is stated to be typical of the operations of a certain group of companies. The Suburban Development Company is a close corporation which speculates in acreage and sells city lots on a commission basis. The company sells a piece of property belonging to an outsider, Smith, to the Redbank Realty Company. This last named company is in reality a subsidiary corporation, all of whose stock is owned by the Suburban Development Company. The Suburban Development Company collects a commission from Smith for selling his property. The company now organizes a third corporation, the Long View Land Company, which buys the property at a handsome advance and assumes the mortgage which was on the property when Smith owned it. The Long View Land Company, in addition to assuming the mortgage, issues all its stock to the Suburban Development Company for the balance of its purchase price. The Long View Land Company now makes a contract with the Suburban Development Company whereby the last-named corporation sells the lots on a commission of 20 per cent. The Long View Land Company is also charged an exorbitant amount for office rent and pays large salaries to its officers, who are the stockholders in the Suburban Development Com- pany. The Suburban Development Company now pushes the sales of the lots owned by the Long View Land Com- pany. When no outsiders can be induced to buy, other subsidiary corporations are formed which buy lots at high prices from the Long View Land Company. Thus this company is given a fictitious appearance of great prosperity and a surplus is created on the books. With such a showing it is easy to find purchasers of the MANIPULATION BY STOCKHOLDERS 389 stock of the Long View Land Company, which is in the treasury of the Suburban Development Company. After all but the controlling shares are sold, the sub- sidiary companies which have bought lots from the Long View Land Company go into bankruptcy, the lots are returned and the paper profits of the Long View Land Company suddenly vanish into thin air. The object of this complicated series of transactions, as the reader will see, is simply to sell the minority stock of the Long View Land Company. The majority shares must be retained in the hands of the manipulators in order to avoid investigation and litigation. The com- pany advertised and kept before the public in all these transactions is, of course, the Long View Land Com- pany. All the time, however, the stockholders of the controlling corporation are calmly pocketing all the real profits. The above illustrations are typical. It would seem impossible to enimierate all the possible variations in method. The feature common to them all, however, is the transfer of property from one corporation to another corporation owned by the majority stockholders of cor- poration number one. This is what the minority stock- holder must always fear and, so far as possible, provide against. There is no other way of preventing such manipulation except by associating only with honest majority stockholders in companies where the fullest publicity obtains. 224. Robbing a partnership to pay a corporation. — One more instance should be added to the list already given, for it shows very clearly what may be accom- plished in the way of defrauding helpless and ignorant minority owners. James Ehrenbahn, a partner in the firm of L. A. 390 CORPORATION FINANCE Ehrenbahn and Company, manufacturers of agricul- tural implements, died in the year 1896. He had an undivided one-fourth interest in the firm and in addi- tion had loaned the firm $3,000. He also had a one-third interest in a credit against the firm of $12,000, the other two-thirds belonging to his brother, L. A. Ehrenbahn. The firm held property whose book value was approximately $260,000. Immediately after the death of James Ehrenbahn the surviving partners caused to be written off to profit and loss accounts and bills receivable alleged to be uncollectible amounting to $110,000, leaving a net book value of the property of the firm of approximately $150,000. L. A. Ehrenbahn was acting not only for himself but also for the estate of his brother, of which he had been appointed adminis- trator. The surviving partners made no attempt to close the affairs of the firm, but continued in business and made large profits, of which they rendered no ac- counting. In continuing the business they used up money and property belonging to the estate of James Ehrenbahn. About October 1, 1898, the surviving partners agreed to form a corporation, lease to it the plant and real estate of the co-partnership and sell to it on credit, the terms being indefinite, the personal property, accounts and bills receivable in the hands of the surviving partners. The corporation took over the inventory of finished products at an appraised value to be paid for out of money received from the sale of implements on hand. The organization of the corporation was in 1898 and its operations began the same year, but no stock was issued until 1903. A peculiarity of the business thus transferred was that large amounts of agricultural implements were MANIPULATION BY STOCKHOLDERS 391 sold "on consignment" to agents who had the privilege of either returning the goods or of paying for them. The corporation now began to deal with these agents, sent them new stocks of goods and allowed them without protest to return the goods which had been sent them on consignment by the partnership; thus the accounts and bills receivable of the partnership were rendered worthless and their place was taken by accounts re- ceivable of the corporation. Furthermore, the corpora- tion used no dihgence in collecting the accounts re- ceivable of the partnership that were left outstanding. In March, 1903, L. A. Ehrenbahn for himself, and assuming to act as administrator of his brother's estate, delivered a new lease to the corporation of the land and buildings belonging to the partnership at the excessively low rate of $1,000 a year. In the same year the partner- ship made a final sale to the corporation of the personal property for $20,000, although this same property had been valued in 1898 at $50,000. Between 1898 and 1903 the corporation paid nothing for the property or for its use. Beginning in 1904 the corporation paid annual 10 per cent dividends on a capitalization of $100,000. The record does not show what dividends were paid between 1898 and 1904. When the case came into court on complaint of the heirs of James Ehrenbahn decision in substance was that the corpora- tion should be compelled to pay a price to be fixed after investigation by a master for the personal property and real estate. It was adjudged, however, in the case of accoimts and bills receivable, that no legal liabihty lay against the corporation. There can be no question, judging from the facts as presented to the court, that large sums had been de- liberately withheld from the partnership and transferred 392 CORPORATION FINANCE to the corporation by the manipulation of the accounts and bills receivable. Yet this manipulation could be carried on so easily by the corporation that it was im- possible to prove fraud or bad faith. 225. Remedies for manipulation. — The examples that have been cited in these three chapters on corporate manipulation seem to the writer not only interesting but highly instructive. It is an unpleasant duty to record instance after instance of cunning rascality, especially when the record to be truthful must set forth at least temporary successes on the part of the rascals. As was said at the beginning, the swindling operations are for the most part in a field which the law does not reach and their perpetrators are seldom given the legal punishment to which they are justly entitled. For- tunately the punishment of social opprobrium and loss of business standing is generally visited upon them. The purpose of these chapters will have been secured if they serve to warn owners of corporate securities of the facilities which the corporate form affords for graft and dishonesty. The writer desires to reiterate that instances of the kind that have been narrated are rare compared to the vast amount of entirely honorable and legitimate business transacted under the corporate forrri of business organization. Nevertheless they are fre- quent enough to demand attention and, so far as pos- sible, prevention. One preventive is for security-holders to insist on complete and absolute publicity as to the affairs of their organizations. Another preventive is for them to attend stockholders' meetings and take an active interest in all that goes on in the corporation. A third preventive is to see to it that under the cumu- MANIPULATION BY STOCKHOLDERS 393 iative system of voting every stockholder gets a chance to be represented. A fourth preventive is to insert explicit provisions in the corporate by-laws as to salaries of officers, amount of indebtedness to be incurred, amount of surplus to be set aside each year, and so on. The best preventive of all, however — ^without which all the other measures will prove of small avail — is for the security-holder to investigate with the greatest care the reputations of all the officers and directors of the corporation. CHAPTER XXVIII INSOLVENCY AND RECEIVERSHIPS 226. Two types of insolvency. — The causes of in- solvency have perhaps been sufficiently indicated in connection with the subject of management of capital funds and of earnings. At any rate, they may be inferred to be the reverse of the principles of sound corporate finance, which were there laid down. It will do no harm, however, to recapitulate briefly the principal causes. A great many business men, even the managers of large corporations, are evidently not fully alive to the dangers which threaten any corporation. It is well to distinguish between two types of in- solvency. The distinction for our purpose is important, although in law and in ordinary business language it has not been clearly kept in view. We may call one type "true" and the other "legal" insolvency. True insol- vency exists where the value of an individual's, firm's or corporation's assets is less than its total debts. This, by the way, is substantially the definition given in the National Bankruptcy Act, but it is declared by eminent legal authorities to be a definition without precedent in the law. Such insolvency may or may not lead to failure. Certainly if failure is not to follow there must be an improvement in the condition of the business. It frequently happens, however, where debts are not immediately payable, that a concern insolvent in this sense will manage to pull out of its difficulties and meet its obligations when they finally mature. 394 INSOLVENCY AND RECEIVERSHIPS 395 Legal insolvency exists when a concern's cash assets are insufficient to meet its liabilities as they fall due. It may weU be, and frequently is, true in such a case that the total assets would far overbalance the total obliga- tions. As obligations are almost uniformly payable in cash and cash only, however, it really makes no differ- ence how great the value of the firm's unsalable assets may be. Legal insolvency almost of necessity leads immediately to suspension or, in the case of small concerns, to bankruptcy. The only escape would be a compromise of some kind accepted by creditors. 227. Causes of true insolvency. — True insolvency may exist from the very beginning of corporate existence, although not usually without bad faith on the part of the incorporators. It is possible, however, that the value of a corporation's assets at the beginning may be honestly over-estimated, that the corporation may borrow an undue amount of money secured by such assets, and that the money thus obtained may be fool- ishly expended. In such a case, unless a marked rise in the value of the assets takes place, the corporation may be said never to have been truly solvent. It is only a question of time until the inevitable failure arrives. A second cause of true insolvency may be a great and perhaps unavoidable decline in the value of a corpora- tion's assets. If, for instance, a cyclone demolishes the property of a corporation that does not carry insurance against such a calamity, insolvency will necessarily be the result. The fall in the value of the assets may be due simply to ordinary causes, which are not offset by a depreciation reserve. Any one of a hundred other events, which will occur to every reader, may reduce the value of assets below obligations. It may be stated, however, that a conservatively managed corporation is 396 CORPORATION FINANCE not likely to suiFer in this way. The principles of in- surance and of depreciation are now so widely applied that a high degree of protection is afforded. The third cause of true insolvency, especially with trading companies, is bad management in buying and selling goods. The lack of a proper system of cost ac- counting may lead corporation managers to a long- continued course of selling below cost. The fact that such a course has been followed may not become entirely apparent for a number of years; then it is found that the corporation has been gradually consuming its capi- tal funds in order to pay running expenses. The complexity of modern business is such that fre- quently an accurate and searching analysis carried on at considerable expense is necessary in order to deter- mine whether a business is being carried on at a profit or not. Many a concern has seen its sales growing, its gross profits swelling and apparently its surplus increasing, while at the same time, owing to lack of care to maintain its fixed assets in good condition and to keep up its established trade, it has in reality been moving rapidly into insolvency. An anecdote is told of a large wholesale dealer in men's clothing who was selling quantities of goods at prices which expert accountants found to be considerably below cost, including in cost all the selling and administrative expenses. The ac- countant approached the manager of the company and asked him how he could afford to carry on his business. "Ah," was the naive reply, "you see our transactions are on so much larger a scale than those of any of our competitors." It seems needless to add that this par- ticular concern did not long keep out of the bankruptcy court. The fourth cause of true insolvency is actual fraud INSOLVENCY AND RECEIVERSHIPS 397 or theft, a cause which need not be here discussed. 228. One cause of legal insolvency — "lack of capital." — ^As to the causes of legal insolvency, we have a val- uable mass of information collected by the two great mercantile agencies, Bradstreet's and Dun's. The Bradstreet Company summarize their judgments as to the prime causes of all the business failures that oc- curred in the United States during the four years pre- ceding the crisis of 1907, in the following table : Causes of Failure. Incompetence . . . . Inexperience Lack of capital . . . Unwise credits . . . Failures of others Extravagance Neglect Competition Specific conditions, Speculation Fraud Percentages. 1907 22.6 4.9 37.1 2.3 1.4 .9 S.5 1.2 16.3 .7 10.1 1906 22.3 4.9 3S.9 2.6 2.0 1.0 2.2 1.0 17.3 .8 10.0 1905 24.4 4.8 33.4 3.S S.'Z 1.1 2.9 1.5 16.3 .7 9.2 1904 23.1 5.1 32.2 3.4 2.5 .8 3.1 1.3 19.1 .8 8.6 The reader will notice that "lack of capital" heads the list and that personal incompetence comes second. Un- fortunately no distinction is made between lack of per- manent capital and lack of working capital. It seems safe to say, however, that lack of permanent capital does not usually in itself lead to insolvency; most businesses may be automatically adjusted to any reasonable amount of capital. The difficulty comes rather in the form in which the capital funds are invested, particularly in sacrificing quick in order to build up fixed assets. To make this statement concrete let us examine the Wall Street Journal's analysis of two typical instances of financial difficulty. In February, 1909, the Ameri- can Ice Company was reported to be facing insolvency 398 CORPORATION FINANCE and reorganization and the Journal commented as fol- lows: The annual report just submitted shows that the floating debt, about $650,000 a year ago, has now reached the threaten- ing proportions of something like $1,250,000. Herein lies the whole trouble with the American Ice Company. The concern transacted a gross business during the year ended October 31, of $8,120,000, and it is clear that to maintain this volume of business ample liquid capital is essential. The report evidences the need of working funds in other ways; it shows that $72,- 728 was expended for interest on its floating debt. Where the company will raise money is a problem. It is known that institutions friendly to the company which have helped it out of difficulties in the past, have withdrawn further support. The company has little credit of its own to borrow on. The treasury contains several hundred thousand dollars worth, par value, of securities of subsidiary concerns, but these are hardly sufficient for collateral for a loan as large as Amer- ican Ice requires. Evidently the company was in danger of legal, not true, insolvency. After the above paragraphs were written the ice company denied its allegations and as- serted that it was not in serious need of financial assist- ance. Nevertheless the quotation indicates clearly enough where a trained financial writer looks for symp- toms and causes of weakness. 229. The case of the Detroit, Toledo and Ironton Railway Company. — The paragraphs that follow con- stitute an attempt to explain the failure of the Detroit, Toledo and Ironton Railway Company. The company in question, a reorganization of the old Detroit Southern, began business in the early part of 1905. When the management of the property again passed into the hands of the court this year, its new career had lasted about two and a INSOLVENCY AND RECEIVERSHIPS 399 half years, during no part of which had it succeeded in earning the fixed charges which the capitalization of the reorganization plan had fastened upon it. In the first full fiscal year of its operation as an extended system, the deficit after payment of interest charges and taxes amounted to $270,000 ; in the second fiscal year which ended June 30th last, the deficit reached the sum of $371,000. After that, presumably, the company ran still further behind. As to the question of working capital, the Detroit, Toledo & Ironton's balance sheet of June 30, 1905, practically the be- ginning of its career, shows current assets of $l,218,524i and current liabilities of $390,194, making an apparent working balance of $828,330. Among these current assets was an item, " due from reorganization committee, $1,050,000." A year later this item had disappeared into equipment account, and the inference is that it never was a part of true working capital. In that case, the new company began without any working cap- ital, but with an actual funded debt of about $200,000. If President Zimmerman's theory that the receivership is pri- marily attributable to the clause of the Hepburn law which for- bade the company to proceed with its Kentucky coal mining project is true, the Detroit, Toledo & Ironton as it exists was not a success to begin with. That is, it did not have and could not obtain a current revenue sufficient to carry its own obliga- tions, aside from the cost of the Ohio River Bridge and Ken- tucky extension, and could only become a self-sustaining prop- erty by tapping an entirely new and rather distant source of traffic. Such a development naturally could not take place except through the investment of much additional capital and the completion of works bound to take a year or two in con- struction. Meanwhile the company was exposed in a perilous financial condition to the usual danger of adverse general con- ditions, which did not fail to arrive. The two causes assigned in this case are : First, lack of earning power in the assets sufficient to meet fixed charges, which is a condition of true insolvency; 400 CORPORATION FINANCE and, second, lack of current assets, or of working capital. 230. Additional causes of legal insolvency. — ^We have found in our study of financial management that it is not usually advisable for a concern to allow its ac- counts payable to exceed 70 to 80 per cent of its ac- covmts receivable; that its bank loans should be repre- sented for the most part by cash in the bank; and that its finished products on hand should not be offset by any corresponding liability. If these relations are not main- tained, the company is apt to sink first into an unprof- itable and next into a highly dangerous situation. The concern begins to lose profits, if its working capital is insufficient to permit taking full advantage of all con- siderable discounts for the prompt payment of bills. This point has already been discussed in connection with financial management. It is obvious that as working capital decreases the corporation manager is driven to depend more and more upon his current sales and ac- counts receivable for funds with which to pay his bills. If for any reason his sales fall off sharply or his debtors fail to pay promptly, he will be unable to meet his own obligations promptly. Unless he can secure extensions or arrange for loans from some other source failure is inevitable. Let us give attention again — for this is an important point — ^to the fact that a concern may fail in this manner although its assets may be thoroughly sound and far in excess of obligations, its business large and growing, and its profits great. Carelessness or lack of apprecia- tion of the necessity of keeping up working capital may thus be the sole cause of legal insolvency. As to the statement that the trouble with many concerns is "lack of capital," our analysis has indicated that the proper INSOLVENCY AND RECEIVERSHIPS 401 wording of this phrase in most cases would be "lack of working capital." A slightly different cause of legal insolvency arises when a corporation, in order to pay dividends, unduly increases its quick obligations. It may well be in such a case that the dividends have been earned and are prop- erly due to the stockholders. If the profits that are to be used for dividends, however, have been put back into the property or into any sort of a permanent invest- ment, the payment of the dividends will involve borrow- ing money. Among conservative financiers this is universally regarded as a dangerous practice. Divi- dends ought to be provided for in advance by so large an accumulation of cash that their payment wiU not unduly reduce, even temporarily, the corporation's working capital. A third frequent cause of legal insolvency is inability to renew medium term notes or refund long-time obliga- tions when due. This situation may not be the fault, so much as the misfortune, of the corporation. The ob- ligation may fall due during the height of a crisis when borrowing of money on any terms is next to impossible. It may have been entirely proper to issue the obligations in the first place', the assets may be far more than suffi- cient in value to cover them; and yet the actual cash to meet them may not be forthcoming. We shall have oc- casion in the following pages to discuss a recent case of failure and reorganization which falls within this class. 231. Two methods of handling insolvency — Bank- ruptcy and dissolution. — There is so much confusion — not only in the public mind, but even among lawyers — as to the exact nature of the remedy that should be ap- plied when a corporation gets into financial difficulties, that it seems proper to preface our study of corporate VI— 26 403 CORPORATION FINANCE reorganization by a brief survey of the legal aspects of insolvency, receivership and bankruptcy. Much of what is said in this chapter will apply to individual pro- prietorships and to partnerships, as well as to corpora- tions. Additional information on the topics here briefly treated will be found in the volume on Commerciax Law. The reader is probably already aware that the con- stitution of the United States confers upon Congress the sole authority to estabhsh a uniform law as to bank- ruptcy procedure for the whole country, and that the latest expression of this authority is found in the Na- tional Bankruptcy Act of 1898. Bankruptcy may be either voluntary or involuntary. It may be asked for by an insolvent individual or partnership in order to obtain a discharge from his or its debts; or it may be asked for by creditors whose claims are unsatisfied in order to obtain an equitable division of the property of the bankrupt. The Bankruptcy Act provides that a corporation cannot become a voluntary bankrupt, but that corporations engaged principally in manufactur- ing, trading, printing, publishing, mining or mercan- tile pursuits, owing debts to the amount of $1,000 or over, may be adjudged involuntary bankrupts. The converse of this statement is that all other corporations, including those engaged in banking and transportation, are incapable of becoming bankrupts. As a matter of fact, it is seldom to the interest either of stockholders or of creditors to force a corporation into bankruptcy. Indeed, the chief reason that may lead to such drastic action is the desire of unsecured creditors to prevent secret deals and transfers of the corporation's assets and to expose any past irregularities in the conduct of the corporation. Bankruptcy is especially valuable at INSOLVENCY AND RECEIVERSHIPS 403 times as a means of making invalid liens or judgments that have been secured by favored creditors within four months of the period of bankruptcy. A second method of handling the affairs of an in- solvent corporation is by a dissolution of the corporation and a distribution of its assets to creditors and share- holders. This method is even more infrequent than bankruptcy and is plainly out of place except for cor- porations, the organization and good will of which are not worth saving. 232. A third method — Appointment of a receiver. — A third method is the use of what is known in law as a "bill in chancery." The objects sought to be obtained by this method are, first, to come to an equitable settlement between the corporation and its creditors, and, second, to preserve the corporation's organization and continue its business. The "bill in chancery" is, in lay language, simply a petition presented to a court of equity asking the court for protection and supervision of the corpora- tion's property and business until a settlement of the conflicting claims may be secured. If the petition is granted, the court at once appoints an officer responsible solely to the court known as a "receiver," whose busi- ness it is to conduct the corporation's affairs until he is discharged. The petition may be presented by any one of four parties: (a) the corporation itself; (b) the stockholders; (c) secured creditors; or (d) unsecured creditors. A petition of this character presented by a corpora- tion in its own name is unusual and instances of its being granted by the court are still rarer. It is also somewhat unusual to find petitions by stockholders presented and granted. A complaining stockholder is usually told by the court that his proper course, if he is dissatisfied with 404 CORPORATION FINANCE the management of the corporation, is to elect new di- rectors. Moreover, a complaint by a stockholder that his corporation is insolvent and should be placed in a receiver's hands is seldom necessary, for in such a case creditors will be more than likely to take the initiative. Where the corporation itself is willing that a receiver should be appointed the petition is usually presented by friendly unsecured creditors. This is, in fact, the usual method of securing what is known as a "friendly re- ceivership." It is doubtful, however, in many states, whether an unsecured creditor can successfully apply for a receivership in the face of opposition on the part of a corporation. Secured creditors have a far stronger case and a petition on their part based on the proved insolvency or mismanagement of the corporation is not generally denied. Unlike petitions in bankruptcy, bills in chancery may be presented either in the federal courts or in any of the state courts which have jurisdiction. Here is a frequent cause of much confusion and frequently of conflict be- tween courts. The legal questions involved are entirely too complicated and technical to be discussed in this chapter. All that need be said is that where large in- ter-state corporations are involved the tendency is grow- ing to apply to the federal courts for relief. One reason is that the judges of these courts are especially familiar with cases of this kind; another reason of still greater importance is that federal judges in different parts of the country work together more harmoniously than do the judges of diff'erent states. 233. Duties of a receiver. — If the corporation is car- rying on simply a trading business and goes into bank- ruptcy, the activities of the receiver in bankruptcy will be comparatively simple. He will dispose of the assets INSOLVENCY AND RECEIVERSHIPS 405 as rapidly as he can and will use the funds thus obtained, so far as they will go, to settle with creditors. There may be a considerable waste in this process, for the established trade and business connections of the failed company will go for nothing. Yet, on the whole, it is the quickest and most certain method of satisfying the obligations of the company, and it is usually followed. Unless the corporation's borrowings have been far in excess of the value of its tangible assets, the obligations will be met and the loss will all be borne by the stock- holders. In an ordinary bankruptcy the stockholders' interests are very little considered. Where the failed corporation is a large manufactur- ing or railroad company with a great amount of fixed capital and a receiver is appointed by a court of equity, his duties are entirely different. He has as his object in this, as in the former case, the payment of corporate obligations. It is very seldom, however, that this ob- ject, when the corporation has large fixed assets, can be attained by the sale of these assets. Ordinarily there is no one to buy them except at a tremendous sacrifice. It would evidently be quite impossible to find cash buyers for the milhons of dollars of property of any of the great industrial combinations or of any of the great railroads. Therefore, the receiver is permitted in such a case to go on with the business. No profitable ac- tivities of the concern are allowed to cease. It goes on manufacturing or transporting, or whatever its business may be, under the receiver's administration, just as it did under the administration of its own officers. As the holders of claims against the failed corporation cannot hope for inmiediate payment in cash, a settlement with them must be made in some other manner — usually through a reorganization, a subject to which con- 406 CORPORATION FINANCE siderable attention is given in the following chapters. 234. Receiver's powers. — The receiver is a very powerful official. So long as no actual fraud or obvious mismanagement on his part is proven, he is at liberty to make such disposition of the assets and earnings under his charge as he sees fit. He may use his power altogether for the benefit of the creditors, or he may use it in part also for the benefit of the stockholders. If he has the latter object in view, he will naturally do what he can to delay a settlement until a favorable period ar- rives and will thus preserve as much of the property as possible for the stockholders. In view of his power it is always very important to the stockholders — and frequently more equitable to every one concerned — to have a receiver of their own choosing appointed. In recent years it has become cus- tomary for corporations which are getting into diffi- culties to secure from the court the appointment of what are generally known as "friendly" receivers. Fre- quently the friendly receivers are officers of the corpo- ration. In order to get this result there must be collusion between one or more of the creditors and the corporate officials. The creditor or creditors and the of- ficials go secretly — often at dead of night — to some judge who has jurisdiction; the creditor complains that his debt is unpaid and the officials confess insolvency; then the creditor asks for the appointment of some man previously agreed upon to act as receiver, and the judge then and there duly appoints him. Of course, the judge must be fully aware of this scheme and must approve it. On account of the conflicting jurisdictions of our state and federal courts, however, it is usually a very easy matter to find one among the several judges with the proper authority who will do what is wanted. INSOLVENCY AND RECEIVERSHIPS 407 It will not do to say ofF-hand that in every case the appointment of friendly receivers is absolutely wrong, or that the judge who makes the appointment is corrupt. As has been intimated, insolvency sometimes results from causes beyond the control of corporate officials and hasty action on the part of receivers would cause heavy unnecessary loss. We cannot absolutely con- demn, therefore, either the officials who request the ac- tion or the judge who complies with the request. Nev- ertheless, the transaction, being secret and more or less irregular, seldom reflects credit on any one concerned. Since the receiver, however he may be appointed, is a court officer, his expenses are court expenses and until paid constitute a lien on the corporate assets that goes ahead of all other claims. This fact has already been referred to in the discussion of receivers' certificates. Receivers' certificates may be issued in order to secure funds for practically any purpose that the receiver deems proper. The funds may be used to purchase new supplies or equipment or to improve and extend the property. If the development of a corporation has been greatly hampered by lack of funds a receivership may thus prove a very desirable thing, for the receiver has an opportunity to put the company into prime condi- tion. Receiverships have been known in this way to prove the salvation of an insolvent concern. The receiver usually charges and gets a very large fee for his services. There has been much complaint and agitation at times on this account, especially in connection with bank receiverships. The size of re- ceiver's fees during the panic year, 1907, in New York City became almost a public scandal. This, however, brings up questions which do not properly fall within the scope of corporation finance. CHAPTER XXIX PRINCIPLES OF REORGANIZATION 235. Reasons for reorganization. — There are two general classes of reorganization: first, those that are necessary as the result of insolvency; second, those that prove desirable in order to readjust the securities and the means of control of a company. The principles of reorganization also are somewhat differently applied in railroads and in manufacturing concerns. In order to bring out these distinctions we shall take up in the following chapter three typical reorganizations : First, of an insolvent railroad; second, of a solvent railroad; and, third, of an insolvent industrial. In this chapter our attention will be confined to the general principles which apply in all kinds of reorganizations. The reasons for reorganization in lieu of a simple sale of property have already been aUuded to. In order to make them plain, however, we should give them some further conlsideration. The complexity of the financial organization of a large corporation is one factor to take into account. In the case of a railroad the parent com- pany will probably own the securities of a number of subsidiary companies. Each one of these subsidiary companies will have one or more mortgages on its hne. The stock and perhaps some of the bonds of the sub- sidiary companies will be owned by the parent company and will perhaps be posted as security for a collateral trust bond issue. The parent company will perhaps own a main line and several branch lines, and will have 408 PRINCIPLES OF REORGANIZATION 409 outstanding mortgage bonds based on each of the branch lines, mortgage bonds based on the terminals and real estate holdings, and very likely, in addition, a general mortgage bond issue to cover whatever property is left. Then there will probably be preferred and common stock and short-time claims, including accounts payable, accrued wages and bank loans. Such a group of cor- porate relationships and obligations may be taken as typical. It is, in fact, not half so complex as the finan- cial organization of many large railroad and industrial companies. In contrast to this complicated financial scheme we find the railroad property to be practically, for operat- ing purposes, an indivisible unit. The word "indi- visible," as here used, does not mean, of course, that the property is actually physically merged into one. It would be possible for the branch line bondholders to mark out and segregate their property and take it for themselves ; for the terminal bondholders to do the same ; for the main line bondholders to do the same; and so on. It is indivisible, however, in the sense that a division of the property would destroy most, if not all, of its value. This statement applies only to a well-constructed, uni- fied railroad system. If any part of the system is su- perfluous, it may be lopped off and taken by its own bondholders. This, for instance, was the case with the St. Louis and San Francisco Railroad, which was owned by the Atchison, Topeka and Santa Fe, up to the bankruptcy of the latter road in 1893, and was then taken over by the St. Louis and San Francisco bond- holders. The same thing was true of the Oregon Short Line, which was temporarily cut off from the Union Pacific System in the bankruptcy of 1893. I Assuming that a failed corporation possesses prop- 4.10 CORPORATION FINANCE erty which is commercially indivisible, the question that arises in case of bankruptcy is, What arrangement can be made to prevent the property from being split up into segments by the conflicting claims of the various security-holders ? How can it be held together, put back on its feet and restored to its rightful position as a valuable profit-making business? Every bondholder, as well as every stockholder, is keenly interested in find- ing the right answer. The value of any bond, as has already been shown, depends in large part on the earn- ing power and prosperity of the issuing corporation. 236. The formation of committees. — In the process of getting an answer the first step is to ascertain as nearly as possible the exact status of each of the cor- poration's obligations. Usually this task is left to the receivers or to such persons as are selected to act as a reorganization committee. Each class of bondholders chooses representatives whose duty it is to represent the interests of that particular class. These representatives are usually called a committee and are selected in va- rious ways. Sometimes a meeting of the bondholders of one class is called and the members of the committee are elected. Sometimes banking houses which have under- written one or more of the bond issues come forward and offer to serve on reorganization committees. Gen- erally these members of the committee ai-e self -chosen, and are of such character and standing that they readily secure the support of their fellow bondholders. Shortly after the breakdown of a big corporation it is quite customary for one of the heavy bondholders of each class to send a circular letter to the other bondholders of that class stating that they should be represented in the pending negotiations and asking that they place their interests in his hands. Usually he states in the PRINCIPLES OF REORGANIZATION 411 circular that his only interest in the matter is to secure the rights of the persons to whom he appeals and that he will act in good faith with that sole object in view. The bondholders signify their consent by depositing their bonds with some stipulated trust company. If a majority of the bonds of a given class are deposited, the self-appointed representative or committee is authorized to act on their behalf. We should bear in mind, how- ever, that the committee's authority is only that of a representative. It cannot bind the bondholders to any terms whatever. Whether the bondholders accept the plan which their committee approves or not will depend largely on their estimate of the character and intelli- gence of the members of the committee. Within a few days after an important insolvency is announced, there will usually come into existence a number of diiferent duly authorized committees, one representing the general mortgage bondholders, one the bondholders of each of the subsidiary companies, one the debenture bondholders, if there is such an issue, and so on. Ordinarily it is not necessary for the bona fide first mortgage bondholders to organize. They are so well protected that they can afiford to sit quiet while the other claimants fight it out. Usually also the stock- holders do not organize. They have practically no voice in the reorganization, anyway, if the receivership is unfriendly ; if it is friendly their interests are already protected. Sometimes, however, the stockholders as a body, or the preferred and conmion stockholders, each acting as a class, will appoint committees of their own when burdensome assessments seem imminent. Once the committees are appointed the "jockeying for position" and the arguments pro and con as to the strength of each of the competing claims on the corpora- 4-13 CORPORATION FINANCE tion's assets begin. If many different claims are in- volved, it will probably be necessary for the committee of each class of security-holders to appoint a single rep- resentative and have these representatives form a general reorganization committee. It is the duty of this committee to discuss terms of reorganization and finally to agree upon a plan which may be submitted to the security-holders. 237. Why not foreclose. — The reader may well in- quire at this point why the bondholders as a whole or some class of bondholders do not foreclose and sell under their mortgage and thus get enough cash to meet their own claims, or failing that, bid in the property for them- selves. It may correctly be suggested in this connec- tion that for the purpose of buying the property when it is sold, each bond would be accepted at its par value. This question has already been answered in part by the statement in the last chapter to the eiFect that it would be next to impossible to sell a large corporation to an outsider for cash, because the amount involved is too large. Besides, an outsider who wished to get con- trol of the property could accomplish his purpose much more economically by buying the securities of the failed corporation at the low prices at which they naturally sell during the period of reorganization. In answering the second part of the question we must consider that the bondholders whose securities are close to the property would not have anything to gain by a sale. Their principal and interest, presumably, are well protected and they could not by any process of juggling get more than principal and interest. With the junior mortgage bondholders the situation is somewhat differ- ent. They might at times, if the reorganization scheme appears unfavorable to them, have something to gain PRINCIPLES OF REORGANIZATION 4-13 by compelling foreclosure, and bidding in the property. In this case, however, they might be forced to settle all the claims that rank ahead of their own in cash, which would ordinarily be too large an undertaking. How- ever, the possibility of such action on their part is always recognized by the reorganization committee and their claims are in consequence treated with greater respect than they would otherwise command. The result is that foreclosure proceedings are usually only a form. After reorganization plans have been completed fore- closure is simply a method of transferring the property of the old corporation to a new corporation. 238. Problems confronting the reorganization com- mittee. — The reorganization committee, then, once formed has a reasonably free hand. At the same time it must act with due circumspection in order not to arouse the hostility of any powerful body of security- holders. It must treat everybody with apparent jus- tice; it must reconcile conflicting claims and interests. The success of whatever plan of reorganization it adopts will depend upon the extent to which the plan is ac- cepted by security-holders. As noted above, the first and perhaps most important duty of the committee, therefore, is to form some working estimate of the rela- tive values of the different classes of securities. First, they must consider whether there has been an impairment of assets and earnings sufficient to affect the first mortgage bonds. Usually this question may be answered in the negative. If an affirmative answer has to be given, any attempt at reorganization might as well be given up, for nothing can be done except to allow the first-mortgage bondholders to take whatever ; property is left. Assuming that the first mortgage bondholders are still in an entirely safe position, the re- 414 CORPORATION FINANCE organization committee next considers the situation of the bondholders secured by mortgages on outlying or small sections of property. Mortgages of this nature on railroads are usually divisional, terminal, branch line or real estate; with industrial corporations there may be mortgages on unessential plaints or property. For in- stance, a consolidation may originally have taken in twenty plants, and may have found ten of the plants so uneconomical that it has transferred almost all their business to the other ten; or a merchandising cor- poration may have gone into general trucking; or a paper mill may own a great expanse of forest land, not all of which is essential to its business. In such cases the outlying mortgage bondholders may be allowed to take their property, and their claims may then be elim- inated from further consideration. It may well be, on the other hand, that the separate pieces of property so mortgaged are highly essential, in which case the bond- holders would be able to insist on a settlement of their claims in full. Thus a railroad could not well get along without its terminals or without equipment, and the re- organization committee would have to allow full value to all bonds based upon such property. A manufac- turing corporation may derive its chief projfits indirectly from its control of the sources of raw materials, in which case the reorganization committee would arrange to pay bonds based on such property in full, even if the prop- perty taken in itself were not of great value. Disputes are bound to arise in connection with many of these claims on specific pieces of property. A railroad branch line, for instance, may earn very little revenue for itself, according to the railroad's method of figuring, and may have absolutely no value PRINCIPLES OF REORGANIZATION 415 except as an adjunct to the failed railroad. Yet it may turn over to that railroad a large and highly profitable traffic. The bondholders will naturally point to this traffic as justification for a demand that their claims be paid in full. The other interests involved will point to the isolated position of the branch line apart from the railroad as sufficient ground for attaching very little value to the branch line bonds. Usually a compromise is necessary. Both parties have much to lose and noth- ing to gain by a permanent separation of main and branch lines. Each side will probably "bluiF" so far as it dares, and each will finally concede something. The reorganization committee next takes up the claims of the general mortgage bondholders and en- deavors to ascertain how much assets and earnings are left for them after satisfying prior claims. This may or may not be a particularly difficult task; that all de- pends on the nature and complexity of underlying mortgages. The value of the general mortgage bonds will depend to a great extent on the wording of the mortgage. It may cover only such property as was in existence when the mortgage was drawn or may contain an "after-acquired property" clause. Next in order of consideration are the debenture bonds. As these bonds are chiefly claims on earnings, not on assets, the reorganization committee in estimating their value will try to find out how much of the corporation's income is left for them after paying prior interest charges. Finally, the reorganization committee will consider what must be done for the preferred and common stock- holders. Sometimes in heavily over-capitalized concerns the common stock will be wiped out absolutely. It is 416 CORPORATION FINANCE more usual, however, to try to preserve something for the stockholders, with the proviso, usually, that the stock- holders pay certain cash assessments. 239. Necessity for cash. — Another factor in reorgan- ization not previously mentioned is the current or floating deht of the corporation. This debt may take the form either of loans and medium-term notes having specific security or of unsecured obligations, such as accounts payable. Whether secured or unsecured, this floating debt must be paid in cash; otherwise the creditors of this class will certainly attach the assets of the corporation and eiFectually prevent the success of reorganization. The only path of escape from the floating debt would be through foreclosure and sale of the property, and this path does not lead to reorganiza- tion. The reorganization committee, therefore, must by some means raise cash sufficient to meet all this floating debt in order that the reorganized company may begin business. Furthermore, there must be enough cash left over to provide the reorganized company with a fair working capital ; otherwise it will i begin at once to get into new difficulties, as is well illustrated by the career of the Detroit, Toledo and Irbnton Railroad reviewed in the last chapter. The committee also, if it desires to have the reorganized company prosper, must see to it that its fixed charges are not larger than its minimum net earnings. We have thus, four main objects of every reorganization: (a), to pay the float- ing debt; (b) , to provide working capital; (c) , to bring the property up to at least normal efficiency; (d), to reduce fixed charges below minimum earnings. The first three of these objects require cash in large amounts; especially is this true since a company which is approaching insolvency almost always lets its ac- J-HlINCirLES OF REORGANIZATION 4.17 counts payable accumulate, its working capital decline, and its property become impaired. Of course, this may not be the situation at all if the corporation has simply met with some temporary reverse, which brought it into a condition of legal insolvency. In such a case the problems of reorganization are comparatively simple. As a general thing, however, the reorganization com- mittee will find it necessary to raise cash from every available source. As sufficient cash makes the attain- ment of the first three objects named above easy, we may say that the reorganization committee will consider two things of prime importance: first, to raise cash; second, to reduce fixed charges. 240. Raising cash by assessments. — There are three possible methods of securing cash: first, by the sale of some of the corporate property; second, by the issue of new securities; third, by assessments on the security- holders. The first method is almost never practicable. If the corporation possesses outlying property non- essential to its business, it is more than likely that this property has been heavily mortgaged and must be turned over to the mortgagees. The second method, as a general thing, is equally impracticable. Obviously a corporation is not likely to fail unless it has already exhausted its borrowing power, and the sale of the stock of an insolvent corporation is out of the question. These considerations again do not necessarily apply when the corporation is not a true insolvent but has merely suflFered a temporary setback. Even in true insolvency cash is sometimes raised through consider- able issues of receivers' certificates, which in reorgan- ization are funded along with the first mortgage bonds into a new first mortgage issue. At times this may be entirely proper and expedient. The efficiency of the V1--27 418 CORPORATION FINAJNCJK corporation's assets may have become impaired and a little cash raised by receivers' certificates may put them into such a condition as to enhance its earning power vastly more than the amount of the extra fixed charges thus imposed. The third method — assessment on the security-holders — is almost universal. Naturally the first and heaviest assessments fall on the common and prefejjed stock- holders. The possibility of raising cash by this method is limited by the stockholders' estimate of the value of the stock of the reorganized company. They are given the choice either of paying the assessment or of for- feiting their equity in the corporation's assets. If the assessment is made too high evidently the stockholder will choose to forfeit whatever rights remain to him, rather than to pay what is asked. The reorganization committee will therefore endeavor to keep the assess- ment down to what it considers a reasonably low figure. Under these conditions the average stockholder almost always finds it worth while to pay his assessment and retain an interest in the company. If he cannot raise the necessary cash he will sell his stock in the open market for whatever it will fetch to someone who has both the courage and the means to meet the assessment. It is almost always true that the stock of a failed com- pany sells at an abnormally low figure. It is frequently true that a short time after reorganization, the stock of the reorganized company sells at a price considerably above the price of the old stock during the receivership plus the assessment. In other words, experience has demonstrated that the stockholder will do better if he sticks with the company than if he forfeits or sells his shares. By paying the assessment he reduces his losses. PRINCIPLES OF REORGANIZATION 419 Sometimes, although rarely, it becomes necessary to assess the junior bondholders also. It seems strange that a creditor of the corporation should ever be forced to pay an assessment in order to remain a creditor, yet the logic of the situation compels the bondholders, when they are thus assessed, to accept it with as good grace as they can muster. The bondholders will not and cannot equitably be compelled to pay unless the burden is too heavy for the stockholders to carry alone. If the amount of cash needed is so large that most of the stockholders would rather lose their equity in the property than furnish their proportion of the cash, the bondholders find themselves in an unpleasant dilemma. Either they must take some of the burden off the stock- holders' shoulders, or they must take the whole burden themselves and eliminate the stockholders altogether. Almost always they prefer the former alternative. When the Atchison, Topeka and Santa Fe Railroad, for instance, was reorganized in 1894, the cash require- ments were so large that each stockholder would have been compelled to pay in the neighborhood of $14 per share, and it was more than doubtful if the stock of the reorganized company was worth this amount. The re- organization committee, therefore, imposed $4 of the assessment on the junior bondholders. Usually the cash needed by the company is not required at once, and the terms of payment of the assessments may therefore be made fairly easy, thus reserving some of the cash resources of the corporation. Another means of providing funds for future use is to base the bond issues of the reorganized company on a limited open-end mortgage, so that the company need not be hampered for many years to come by a dearth of funds. 420 CORPORATION FINANCE 241. Reducing fixed charges. — Having provided the reorganized company with sufficient cash, the reorgan- ization committee now takes up its final and most difficult problem, reduction of fixed charges. The fixed charges that may be affected are of three kinds: guarantees, rentals and interest. A company may be dissolved in reorganization, in which case it is, of course, released from its previous contracts and the reorganized com- pany may or may not renew them. If guarantees of interest and dividends on subsidiary company securi- ties have proved burdensome and unprofitable, the reorganization committee has an opportunity to dis- pense with them. It does not follow that the com- mittee will always take this action. The guarantee may be necessary in order to hold control of the sub- sidiary companies. Frequently, however, the holders of the guaranteed stock and bonds will submit to a re- duction of the guarantee rather than take back their property. Much the same thing may be said of rentals. The owners of a leased property would ordinarily have great difficulty in leasing it to any other corporation and could not very well operate it themselves. Especially is this true when the leased property has been constructed in the interest of the failed corporation. The owners, therefore, have practically no choice in the matter. They must submit to any reasonable reduction that the reorganization committee demands. Far more important usually in its effect on fixed charges is the substitution for the interest-bearing securi- ties of the old corporation of dividend^paying securities of the new corporation. Sometimes, also, old securities which bear interest at a high rate are converted into new securities bearing interest at a low rate. The result of PRINCIPLES OF REORGANIZATION 421 this readjustment, if the reorganization is to prove suc- cessful, must be to bring the total fixed charges below the net earnings of the corporation even in the worst years. Ordinarily the reorganization committee will first make a conservative estimate of the lowest earnings likely to occur in the future and will eut down interest charges accordingly. Of course this reduction is not proportionate on all the bond issues, but is adjusted in accordance with the relative strength of the various claims against the corporation, as already indicated. One of the great advantages of reorganization is the possibility which it affords of unifying and simpli- fying the complicated and sometimes conflicting obliga- tions that have been imposed at various times. The reorganization committee will usually arrange for a few comprehensive, well-defined mortgages in place of the numerous mortgages previously existing and will increase the amount authorized under each mortgage. This principle, however, cannot be extended too far. The committee cannot, for instance, without getting into legal difficulties, absorb any of the old bond issues, interest on which has unquestionably been earned ' for several years previous. The old first mortgage issue and the first mortgage bonds on highly important specific pieces of property will therefore generally be left untouched. On top of them, however, the com- mittee may impose a new general mortgage bond issue of large size sufficient to refund all the existing issues that are to be absorbed, to refund the old first mortgage bonds when they finally fall due and to pro- vide for necessary improvements and extensions. This general mortgage issue will be designed evidently to become in time a first lien on all the corporation prop- erty. For these new general mortgage bonds the old 422 CORPORATION FINANCE junior bonds will be exchanged on such terms as may be finally agreed to. 242. Capitalization of the reorganized corporation. — Assuming that the reorganization committee has succeeded in determining the relative values of the various issues of mortgage bonds, it may now proceed to a corresponding allotment of the new general mortgage bonds. Suppose, for instance, that there had been outstanding $1,000,000 second mortgage bonds, $500,000 branch line bonds and $1,500,000 debenture bonds, and that the new general mortgage issue avail- able for exchange is fixed on the basis of the lowest earnings at $2,000,000; suppose also that the reorgan- ization committee estimates the first-named issue on the basis of lowest earnings to be worth 80 per cent of its par value, the second-named issue, 60 per cent, and the third-named issue, 60 per cent: It would then offer to the bondholders of the first class $800 in new general mortgage bonds for each $1,000 of the old bonds, and to the bondholders of the second and third classes, $600 in the new bonds for $1,000 of the old bonds. As the values of the old issues and the amount of the new issue are figured on the same basis, lowest net earnings, they must, of course, exactly correspond. Not every case is so simple by any means, as our illustration. The same principle, however, would always be applied. It is felt to be equitable, as well as necessary in order to satisfy the bondholders, that they should be com- pensated for the reduction of their interest-bearing principal. This is accomplished by giving them at least enough dividend-paying principal to bring the par value of their holdings in the reorganized company up to an equality at least — sometimes considerably more than an equality — with the par value of their old secur- PRINCIPLES OF REORGANIZATION 423 ities. Formerly it was customary to give them the diflference between the par value of their old bonds and the par value of their allotment of new interest-bearing bonds in the form of income bonds. Income bonds have already been described and characterized. They are a fallacy and a delusion and at the present time are practically unused. Their place in reorganization has now been taken by preferred stock. The debenture bondholder in our illustration who got $600 in new bonds for $1,000 in old bonds would under the present practice probably get also at least $400 in preferred stock. He thus has a chance to share in the future prosperity of the company. He may well hope and even expect that in the end he will more than recover his losses. The same principle is applied to all the other bondholders, so far as practicable, and even to the preferred and common stockholders. It follows that one usual and almost necessary result of a reorganization is a great increase in capitalization. The reorganization committee en- deavors to remedy the failures and disappointments of the past and present by drawing heavy drafts on the future. It is only fair to say that in this country these drafts have usually sooner or later been honored. The final problem which the reorganization conmiittee must settle is whether to revive the old company and the old charter or to take out a new charter and organize a new company. The first course involves a maintenance of all the previously existing contracts and obligations of the company not provided for in the reorganization scheme. Its advantage, of course, lies in the retention of the charter which may perhaps confer valuable privileges. The question is at bottom legal rather than financial. In truth, it is a matter usually of no very great consequence. 434 CORPORATION FINANCE To insure stability of financial management, until after the reorganized company is well started, it is not uncommon to place the new stock in the hands of a vot- ing trust for a period of years. The nature and operations of such a trust have already been described. 243. Summary of the chapter. — Briefly the principles and the results of reorganization may be summed up as follows : (a) The reorganization must remove the immediate causes of bankruptcy by providing cash and at the same time reducing fixed charges. (b) The reduction of securities bearing fixed charges may well be and usually is accomplished by a great increase of dividend-paying securities. (c) In determining who shall stand the losses caused by the company's insolvency, the reorganization com- mittee will first rank the securities in the order of their safety and will then impose the losses in inverse order. (d) In so doing the directors must of necessity con- sider primarily the ability of the security-holders to make trouble for or to wreck the reorganized company if their demands are not satisfied. (e) In raising necessary cash they will naturally im- pose the first and heaviest assessments on stockholders, but they must bear in mind that if they go beyond certain limits the stockholders will forfeit their shares rather than pay the assessments. The working out of these principles will be further discussed in connection with the illustrations cited in the following chapter. CHAPTER XXX THREE TYPICAL REORGANIZATIONS 244. Growth of the Santa Fe System. — The prin- ciples of reorganization laid down in the preceding chapter will be much better understood if we consider their apphcation in a few typical instances. For this purpose we will take, first, the forced reorganization of the insolvent Atchison, Topeka and Santa Fe Railroad Company in 1894; second, the voluntary reorganization of the prosperous Chicago, Rock Island and Pacific Railway Company in 1902; third, the forced reorganiza- tion of the Westinghouse Electric Manufacturing Company in 1908. It is necessary to go back several years in order to get a typical case of a large railroad receivership and re- organization, for American railroads in the last fif- teen years have enjoyed extraordinary, and up to 1907 almost uninterrupted, prosperity. It is true that a considerable number of railroad systems, including the Seaboard Air Line, the Chicago Great Western, the Detroit, Toledo and Ironton, the Chicago, Cincinnati and Louisville, the International and Great Northern, the Western Maryland and the Macon and Birmingham went into the hands of receivers as the result of the fi- nancial panic of October, 1907. None of these roads, however, is of first-rate importance and their problems did not prove as intricate and difficult as the problems of the numerous railroad reorganizations following the great crisis of 1893. We shall find it therefore more 425 426 CORPORATION FINANCE instructive — even if not of so great current interest- - to study one of the 1893 reorganizations rather than one of later date/ Like most of our great railroad systems, the Atchi- son, Topeka and Santa Fe has grown by leaps, so to speak. It was chartered in Kansas in the year 1863, and contruction on the first section of the road was begun in 1869. The main line from Kansas City to Colorado, thence' in a southerly direction to Albuquer- que, New Mexico, and thence southwest to a con- nection with the Southern Pacific Railroad at Deming, Arizona, was not completed until 1881. In 1882 the Atchison exchanged its stock for the stock of the Sonora Railroad, and thus secured an entrance to Guaymas, Mexico. The company by using a section of the track of the Southern Pacific had a through route from Kansas City to the Pacific Coast. To appreciate the importance of reaching the Pacific Ocean it must be borne in mind that traffic from any of the Pacific Coast ports may move readily and cheaply by water to any other of these ports. The Santa Fe was therefore in a position to take through business by its part-water- and-part-rail route from any port on the Pacific Coast to the East. This route, though important, could not, however, bring to the Santa Fe a large proportion of the traffic to and from the Pacific Coast in the face of the existing competition of the all-rail routes, particularly of the Santa Fe's chief competitor, the Southern Pacific. President Strong of the Santa Fe therefore entered into 1 Acknowledgment should be made here, In connection with the following reviews of the Santa Fe and Rock Island reorganizations, of the informa- tion obtained from Mr. Stuart Daggett's " Railroad Re-Organization." Most of what follows as to these two companies is based on Mr. Daggett's re- searches. He is one of the first to bring to bear on financial problems the thorough, scientific methods of university scholarship. TYPICAL REORGANIZATIONS 427 an alliance with the St. Louis and San Francisco Rail- road, which owned the charter of a company known as the Atlantic and Pacific Railroad Company. By the terms of this alliance the two roads jointly financed the operations of the Atlantic and Pacific and by means of purchase and of new construction endeavored to secure a through rail route to San Francisco. In 1885 — one of the great railroad building years of the United States — the Atchison, by construction, purchase and lease combined, managed to reach Los Angeles. The main line of the road still had its eastern terminal, however, at Kansas City and the system did not reach the Gulf of Mexico, or in fact any of the rapidly developing agricultural country south of Kansas. To remedy this defect a road, known as the Gulf, Colorado and Santa Fe, had been constructed, partly in the interest of the Santa Fe, from Galveston to a point about two hundred miles north, and another line known as the Southern Kansas Railroad was built south from Arkansas City to connect with the track of the Gulf, Colorado and Santa Fe. In 1886 the stock of the last- named road was bought by the Atchison and the bonds, to the extent of about $17,000 per mile, were assumed. In 1887 the Atchison purchased the Chicago and St. Louis Railroad between Chicago and Streator, Illinois, and other subsidiary companies constructed new track up to Streator. By 1888 it had thus obtained its Chicago entrance. In the meantime between '86 and '89 it had built a large number of branch lines in all directions largely for the purpose of forestalling competition. "The method of financing these competitive extensions varied," says Mr. Daggett. "Sometimes the parent company guaranteed the principal and interest of the 438 CORPORATION FINANCE branch line bonds; sometimes it took these into its treasury and issued collateral bonds against them; sometimes, perhaps more frequently still, it leased new roads for a rental equivalent to the annual interest on their bonds. If the branches could have earned their fixed charges, the burden of the Atchison would have been nominal, but as in large part they could not, it was real and serious." The results of the rapid expansion of the Santa Fe from 1884 to 1888 are well summarized by Mr. Daggett in the following table: 188i 1888 Mileage 2,799 7,010 Bonds $48,258,500 $163,694,000 Stock (Atchison) 60,673,150 75,000,000 Gross earnings 16,699,662 28,265,339 Operating expenses 9,410,424 21,958,195 Net earnings from operation 7,289,237 6,307,145 Net profits excluding divi- dends 5,147,883 def, 2,933,197 Net profits, including pay- ments for dividends and interest on floating debt . def. 5,557,323 It should be noted that while the bond indebtedness (including the assumed bonds of subsidiary companies) had considerably more than tripled, gross earnings had increased only about 70 per cent and net earnings from operation had declined. Evidently, unless this tendency should be speedily reversed, the company was doomed to insolvency. In addition the floating debt had in- creased from approximately $3,300,000 in 1884 to over $8,000,000 in 1888, and the road had consequently been forced to authorize, in October, 1888, $10,000,000 of three-year notes. TYPICAL REORGANIZATIONS 429 245. First reorganization of the Santa Fe and its results. — The situation was so obviously dangerous that a committee of the directors was appointed in 1889 to bring about a friendly reorganization and thereby to avert bankruptcy. About one-third of the $163,000,000 of bonds were direct obligations secured by mortgages on the Atchi- son's own property, while the other two-thirds con- sisted of obhgations of thirty-two subsidiary companies. From what has been said in the preceding chapter, it will be seen that the entanglements and conflicts of these various issues were almost beyond unraveling. The directors first aimed at simplification and with that object in view suggested that two large issues be put forth, one of 4 per cent general mortgage bonds, to the amount of $150,000,000, and one of 5 per cent income bonds to a total of $80,000,000. Some $14,000,000 were to be sold in order to raise necessary cash and the remainder of the two bond issues was to be exchanged for the numerous existing issues. Income bonds were much used in reorganization at that period and were not received with the distrust which they now excite. The proposal to the original bondholders that they should exchange their mortgage bonds in part for income bonds was not, of course, altogether palatable; yet it must be remembered that the bonds which were to be thus exchanged had always been regarded as more or less speculative in character and had for that reason been sold, for the most part, well below par, and, further- more, that the branch line bondholders would have lost rather than gained by a forced bankruptcy and fore- closure sale. Moreover, the basis of the exchange was such as to compensate them in part for their loss of fixed interest payments by a larger principal. In other 430 CORPORATION FINANCE words, as usually happens in reorganizations, the com- pany proposed to cut down its current fixed charges and held out in place thereof hopes of high optional pay- ments in the future. The reorganization plan was accepted and put into effect. After this reorganization, the Atchison policy of rapid expansion was apparently renewed with fresh vigor. In 1890, by an exchange of securities, the St. Louis and San Francisco Railroad was brought into the Atchison system. This acquisition of 1,300 miles at one stroke did not prove nearly as profitable as was anticipated. In the same year the Colorado Midland, 346 miles long, was purchased. When the $10,000,000 note issue of 1888 fell due in 1891, the directors found themselves unable to meet the payment out of earnings and therefore arranged for a two-year extension. In 1892 the need of addi- tional funds for improvements and extensions, which, as the reader may have noted, had not been at all provided for in the reorganization of 1889, made necessary a new issue of second mortgage bonds. As the terms of issue of the $80,000,000 income bonds forbade any prior lien (ex- cept the first mortgage) being placed upon the property, it was necessary before placing a second mortgage to arrange for the protection of the income bondholders. This was accomplished by making the second mortgage cover an issue of $100,000,000 4 per cent bonds, $80,000,000 of which were to be exchanged doUar-for- doUar for the income bonds, and $20,000,000 to be sold for cash. Thus in 1893, by a coincidence, which may be called unfortunate, but which with wise manage- ment would never have occurred, the Atchison had to face largely increased fixed charges and the payment of the $10,000,000 note issue, both coming at the same time TYPICAL REORGANIZATIONS 431 with the panic and the traffic losses of that disastrous year. In January, 1894, the inevitable insolvency arrived. 246. Second reorganization and its results. — Several bondholders' committees, according to the custom in re- organization, were quickly formed. Among others the English holders of second-mortgage bonds sent over a strong committee which put forward what was known as the English plan of reorganization. This plan involved foreclosure either by the first or second mortgage bondholders. In either case the first mortgage issue would be left undisturbed and overdue interest would be paid either in cash or in new securities. A new income mortgage bond issue was to be exchanged for the second mortgage bonds and was also to provide compensation for an assessment of $12 per share on the stockholders. By paying this assessment the stock- holders would retain their stock interest in the road, as well as receive income bonds. The income bonds were to have voting power. The substance of the plan, it is evident, was to reverse the former conversion of in- come bonds into second mortgage bonds. In the re- conversion the English bondholders were to secure an increase in principal and the important privilege of voting. The plan was not acceptable to the stock- holders, however, who felt that part of the load thus imposed upon them ought rightfully to be borne by the second mortgage bondholders. Before the argument had been carried far a new factor was introduced into the situation, namely, the publica- tion of the report of Mr. Stephen Little, an expert ac- countant who had thoroughly investigated the Atchison books. Mr. Little found that by means of peculiar fic- titious accounts — ^most important of which was an ac- 4.3a CORPORATION FINANCE count that carried rebates by the company as an asset — the recorded earnings of the railroad had been deUber- ately inflated. The annual net earnings, according to the company's reports, had been as follows : 1891 $ 7,631,598 1892 10,953,896 1893 12,126,866 According to Mr. Little they should have been: 1891 $ 5,204,880 1892 7,S53,173 1893 8,085,608 1894 5,956,615 This startling announcement completely changed the plans which had been formulated. It was evident that a far more radical reduction of fixed charges would be essential. A new committee proposed the second and final re- organization plan in March, 1895. The pxirposes of this plan were stated to be: (a) To reduce fixed charges to a safe limit; (b) To provide for future capital requirements; (c) To liquidate the floating debt ; (d) To reinstate existing securities upon equitable terms in the order of their priority; (e) To consolidate and unify the system. The committee proposed foreclosure under the first mortgage and the formation of a new railway company which was to issue (a) Common stock $102,000,000 (b) 5 per cent non-cumulative preferred stock $111,486,000 TYPICAL REORGANIZATIONS 433 (c) General 4 per cent bonds $96,990,582 (d) Adjustment ' 4 per cent bonds $51,728,310 Old common stockholders were to receive share for share new common stock provided they paid an assess- ment of $10 per share and for this $10 were to receive $10 in new preferred stock. An underwriting syndicate guaranteed to take the place of defaulting stockholders. The old general mortgage bondholders were given 75 per cent of their holdings in new general mortgage bonds and 40 per cent in adjustment bonds. The second-mortgage bondholders were to be assessed $4 for every $100 of their holdings and were to receive 113 per cent in new preferred stock. It was provided that ad- ditional bonds under the general mortgage might be is- sued at the rate of $3,000,000 per year up to a limit of $30,000,000 and that thereafter additional adjustment bonds might be issued at the rate of $2,000,000 per year up to a Hmit of $20,000,000. The St. Louis and San Francisco Railroad and some other smaller subsidiary lines were not included in the reorganization plan, but were turned over to their own bondholders. It will be seen that this plan accomplished the five purposes named by the committee. It brought about a very radical reduction of fixed charges affecting even the first mortgage bondholders. It gave room for ad- ditional issues of bonds under certain restrictions to provide for future improvements and extensions. It brought in about $14,000,000 cash to meet current ob- ligations. It retained the relative claims of the various security-holders to the road's assets and earnings. Fi- nally, by lopping off nonessential lines, it helped to con- solidate and unify the system. 1 The so called adjustment bonds were in reality income bonds. VI— 28 434. CORPORATION FINANCE • The principal opposition to the plan came from some of the minority stockholders who believed that the former management had proved untrue to their interests and that this management had not been entirely eliminated. This opposition, however, was unable to muster enough votes to defeat the reorganization plan. The high credit and prosperity of the Atchison in the last few years indicates that the reorganization was car- ried through on sound lines. There has never been a question raised since the reorganization but that the com- pany could easily meet all its obligations. The road has been greatly improved and strengthened physically and earnings have grown far more rapidly than expenses. The changes in the decade following 1897 are shown in the following tabulation : 1897 1907 Mileage 6,479 9,273 Gross earnings $30,621,230 $93,683,407 Net earnings 7,754,041 32,163,692 Annual surplus 1,452,446 21,168,724 Naturally the market price of the Atchison securi- ties has steadily risen. Nobody suffered in the end from the reorganization. On the contrary, all the security- holders who retained their interests have seen them steadily appreciate in value. The Atchison reorgan- ization of 1895 may weU be taken as a fair type of a highly successful readjustment of charges. 247. Growth of the Rock Island System. — ^We will consider now an entirely different kind of reorganization — one in which not necessity but desire for quick specu- lative profits was the controlling factor. In order to understand the situation it will be well to review hastily the history of the Rock Island Railroad. The line was completed between Chicago and Rock Island in 1854, TYPICAL REORGANIZATIONS 435 and from Rock Island to Council Bluffs in 1869. The company was prosperous almost from the beginning. Its road ran through a well-settled and fertile territory where traffic was large and certain and construction was cheap. Capitalization was very moderate, especially as compared with many other western railroads whose con- struction was paid for not in cash but in extravagant allotments of stocks and bonds to the contractors. In 1880 the road was earning so much and paying such large dividends that it seemed desirable to water the stock. This was accomphshed by an exchange of the stock of the Chicago, Rock Island and Pacific Railroad Company for the stock of a new Chicago, Rock Island and Pacific Railway Company in the ratio of about two to one. The new Railway Company also took in some other properties previously controlled by the Railroad Company, and was, therefore, in form, though not in fact, a consolidation. The new railway company did not continue to be as prosperous as it was in the beginning. The middle '80s were hard years for western railroads, for all of them were forced into competitive railroad building, which for the time being was largely unprofitable. The Rock Is- land dividends and the market prices of the road's se- curities suffered severely. Nevertheless, the road's man- agement was conservative and able and the company not only survived, but even paid dividends through the try- ing depression of 1893-1897. After 1897 the road shared in the renewed prosperity of the United States and began in its conservative way to plan for further expansion and development. In 1901, however, the conservatism of the company suddenly disappeared as if the earth had swallowed it. Directors and officers who had served for years and dec- 436 CORPORATION FINANCE ades were removed, and new men — younger men of an entirely diiferent type — ^were put into their place. With the older men there vanished also the former ideals and purposes of the company and a very diiferent path toward success and prosperity was entered. The reason for these changes is to be found in the fact that during 1900 and 1901 a small coterie of speculative promoters known as "the Moore crowd," of whom we have heard in connection with the formation of the United States Steel Corporation, had quietly bought a majority of the common stock in the Wall Street market. The process of buying had been carried on so patiently and warily that it was hardly suspected and the price of the stock was very little increased. The financial world first got an inkling of the situation when in April, 1901, Mr. WilHam H. Moore and Mr. D. G. Reid were elected to the directorate. The principal men in the new party, which now rap- idly assumed full control of Rock Island affairs, were Mr. W- H. Moore, his brother Mr. J. H. Moore, Mr. D. G. Reid and Mr. WilUam B. Leeds. No one of these men had had any experience in railroad man- agerial positions and none of them had ever been prom- inently identified before with railroad operations. All of them, however, were bold and successful speculative promoters and all of them were well versed in the ways and wiles of the speculative security market. Their successes had been gained in the promotion of the com- panies which were taken into the United States Steel Corporation. Their interest in railroad affairs, there- fore, it was easy to see, was entirely financial. They did not take, and as a matter of fact never have taken, any active part in the operating management of their road. All their energies have been given to maintain- TYPICAL REORGANIZATIONS 437 ing its financial status and at the same time directing for their own benefit its financial operations. In the two annual meetings of June, 1901, and June, 1902, the stockholders increased their capital stock from $50,000,000, at which it had been placed in 1880, to $75,000,000. Also the stock of some smaller roads, in- cluding the important Choctaw, Oklahoma and Gulf, was bought by the Rock Island, payment being made partly in cash and partly in Rock Island secu- rities. 248. Rock Island reorganization. — The "Moore crowd" now brought forward the scheme of reorganiza- tion which they had devised primarily, it appears, with a view to selling a large part of their stock without los- ing control. The plan involved two holding companies and a double exchange of securities. It is perhaps the most complex and ingenious scheme on a large scale for attaining the purpose just named that has yet been suc- cessfully put through. The operating company under this scheme remained the same as it had been since 1880, the Chicago, Rock Island and Pacific Railway Company. The first hold- ing company (whose prime object, apparently, was to meet any legal objection that might afterwards arise to the consolidation of competing railway companies) was the Chicago, Rock Island and Pacific Railroad Com- pany, incorporated in Iowa. The second holding com- pany was the Rock Island Company, incorporated in New Jersey. The outstanding bonds and other secu- rities of the old "railway" company were left undis- turbed. The new "railroad" company issued stock to the amount of $75,000,000. The Rock Island Company issued $96,000,000 common and $54,000,000 preferred stock. The last-named company then delivered $127,- 438 CORPORATION FINANCE 500,000 of its preferred and common stock to the Chi- cago, Rock Island and Pacific Railroad Company of Iowa in exchange for all the $125,000,000 common stock of the Iowa company. After this transaction the last- named company had in its treasury most of the common and preferred stock of the Rock Island Company; it also had the right to issue $75,000,000 bonds. It now of- fered for each share of the railway company's stock, one share of its own 4 per cent bonds, one share of Rock Island Company common stock and $70 of Rock Island Company preferred stock. These bonds were to be col- lateral trust secured by the deposit of all the "railway" company shares obtained by the "railroad" company. Thus the "railway" stockholders would, in case of de- fault, get back exactly the stock which they had ex- changed. The "railway" stockholders readily accepted this prop- osition, which was equivalent to giving a large stock div- idend, and figured that even if they retained in their own hands all the securities which they received in exchange they could not lose and might benefit by the exchange. If they did not care to retain all the securities they re- ceived, they could easily dispose of their Rock Island common and preferred shares and thus get a large im- mediate cash payment. We shall understand better why the "Moore crowd" desired this reorganization if we examine the charter provisions of the Rock Island Company. One of the important clauses reads as follows: There shall be five classes of directors. The first class shall contain a majority of the whole number of the directors as fixed at any tifne by the by-laws. The holders of the preferred stock shall have the right to the exclusion of the holders of the com- mon stock to chose directors of the first class. TYPICAL REORGANIZATIONS 439 Thus a majority of the Rock Island Company preferred stock could elect a majority of the board of directors of that company and this board, through the company's holdings of "railroad" stock could completely control all the affairs of the Chicago, Rock Island and Pacific Railway Company, the operating company. Now the outstanding preferred stock of the Rock Island Com- pany is only a little over $45,000,000; therefore the ownership of approximately $22,500,000 par value of this preferred stock would be sufficient to give complete control over the whole Chicago, Rock Island and Pa- cific Railway Company, having a total capitalization of about $225,000,000. Indeed, if this $22,500,000 pre- ferred stock were carried on a margin of $20 a share, $5,400,000 cash would suffice to secure control. The advantage of this reorganization to the "Moore crowd" may readily be seen if we compare the price they paid for control in the "railway" company with what is necessary for control in the Rock Island Company. Assuming that they bought all their stock outright and paid in the neighborhood of 140, which was not far from the average market price while they were buying control of the "railway" company, their investment would have been $52,500,140. In exchange for this under the re- organization scheme they obtained stock and bonds which at the market prices of the early part of 1903 were worth : Rock Island Company common $18,375,049 Rock Island Company preferred 21,918,808 Chicago, Rock Island & Pacific Railroad Co. 4% bonds 32,765,712 Total $73,069,569 440 CORPORATION FINANCE As the preferred stock was all that was necessary for control they were left free to sell their bonds and com- mon stock, and it will be observed that this sale would have brought to them just about as much cash as they had originally paid for control of the Chicago Rock Island and Pacific Railway Company. In other words, control of the Rock Island Company, carrying with it control of both subsidiary companies, cost them in cash next to nothing. In addition, the Rock Island Company later obtained control of another great railroad system, the St. Louis and San Francisco. The Rock Island directors ac- complished this by offering to exchange for each share of common stock of the St. Louis and San Francisco $60 par value in the common stock of the Rock Island Company and $60 par value in a new issue of 5 per cent gold bonds, the bonds being secured by deposit of the "Frisco" common stock as collateral. It will be ob- served that this great addition to the Rock Island system did not disturb in any way the controlling force of a majority of the relatively small issue of Rock Island Company preferred stock. Thus by reorganization and purchase the "Moore crowd" with a very small expendi- ture of cash, have under their control a system with an aggregate mileage of 14,270 miles. 249. W estinghouse reorganization. — This reorgani- zation of 1908, although not essentially different in principle from the Santa Fe reorganization, introduces some new features that are worthy of attention. Owing to space limits it is necessary to confine our attention to these peculiar features. This is a typical instance of a company which was strong in equipment and ability and which was doing a TYPICAL REORGANIZATIONS 441 large and profitable business and yet suddenly found itself technically insolvent. Its difficulties resulted from a lack of sufficient working capital. The com- pany's assets were too largely fixed, and quick assets were relatively too small, considering the amount and character of the company's business. In prosperous times the company was able to prosper with the rest of the country. In the period of strain, however, it was very quickly stripped of cash and, being unable to ob- tain capital, necessarily went to the wall. It naturally followed that the most active and influ- ential body of creditors in planning the reorganization were merchandise creditors ; next to them came the bank creditors ; the bond and note holders were little consulted and their claims were not disturbed. The problem before the reorganizers of this company diff'ered from that which confronts most reorganizers in that the company needed simply to be tided over a bad period. No one apparently felt any question as to the renewed prosperity of the company as soon as normal business conditions should be restored. The permanent fixed charges were met even during the period of re- organization. All that was necessary, therefore, was to take care of the floating debt. The main elements in the floating debt were notes payable to banks, $7,919,000, and merchandise debts, $4,762,000. After much discussion and consideration of two or three plans, the merchandise creditors, through their committee, finally agreed to accept new common stock of the company at par in full settlement of their claims on certain conditions specified below: (a) Such of the bank debt as would not accept new common stock to be provided for partly by convertible bonds of an issue already authorized previous to the 442 CORPORATION FINANCE bankruptcy and partly by 5 per cent notes running for an average period of 5 years. (b) The existing issues of convertible bonds, deben- ture certificates and collateral notes not to be disturbed. (c) The preferred and common stockholders each to pay a 25 per cent assessment in cash. It will be observed that none of the sacrifices under this plan were to be made by the bond and note holders. Indeed, it would have been impossible to impose sacri- fices upon these classes or to refuse or modify their claims, for in that case they would certainly have been prompt to bring foreclosure proceedings, buy the prop- erty at a forced sale and thus reduce the unsecured claims and wipe out the stockholders. The bond and note holders, in other words, were in an impregnable position because the company, even in the worst times, was more than earning the permanent fixed charges. The bank creditors came next Jn order of preference, and their only loss, therefore, was an extension of time of payment of their obligations. The unsecured credit- ors, knowing the weakness of their position, were willing to accept stock in payment. Under the circumstances it was both expedient and just that the stockholders should be called on for a particularly heavy assessment. It was expedient because the prospects of the company were excellent and the stock, even through the reorgan- ization, sold at fairly good prices. The stockholders, therefore, could weU afford to pay this assessment rather than forfeit the stock. It was just that they should pay because the difficulties of the company could have been prevented if less had been paid out in dividends and more cash had been reserved for an emergency. Such protests as were made by the stockholders for these TYPICAL REORGANIZATIONS 443 reasons proved unavailing and the plan as outlined above has been carried into effect. The company operating under this plan has re- established itself as a firm and prosperous corpora- tion. There was no reason to fear the result. The plan provided for all the floating debt incurred before the reorganization, it enlarged only very slightly the fixed charges of the company, and it introduced new and conservative elements into the management of the company. The cash working capital on hand after re- organization was sufficient for the needs of the next two years, even if business had been very poor indeed. In addition it was at once clearly stated on good authority that dividends on the new common stock of the company would not be paid for at least two years, thus giving time for the accumulation of a substantial surplus. These drastic measures proved effective in strengthen- ing the .company's financial position and enabling it to go forward steadily, almost as if no setback had oc-. curred. QUIZ QUESTIONS {The numbers refer to the numbered sections in the text. ) CHAPTER I 1. What are "non-stock" corporations? 2. What are "stock" corporations? For what pur- pose are they usually organized? 3. What is the most striking distinctive feature of the corporation compared to other forms of business association? 4. In what sense is "corporate entity" a fiction? 5. In what nations have corporations been prominent features of business life? 6. Show briefly how the use of corporations has spread in recent years. 7. State how and why the corporate form is well adapted to raising large amounts of capital. 8. In what sense is a corporation more permanent than a partnership or than individual proprietorship? How is this attribute an advantage? 9. Show how and why the corporate form better lends itself to an efficient, centralized control of a bus- iness than the partnership form. 10. Can an interest in a corporation be more readily transferred from one person to another than an interest in a partnership? Why? 445 446 CORPORATION FINANCE 11. What is the principle of hmited liabihty of cor- porate stockholders? Is the principle universally ap- plicable? Name the principal advantages of the corporate form of organization. 12. Name the principal disadvantages of the cor- porate form. Mention two kinds of enterprises in which these disadvantages outweigh the advantages. CHAPTER II 13. What are the legal instruments that define and control a corporation's activities? 14. How far is the common law applicable to cor- porations? 15. Is it important to consider the provisions of the constitution of the state in which a corporation is formed? Why? 16. Discuss the relative advantages of two methods of securing authority to incorporate. 17. What is a charter? What is a certificate of incorporation? What are articles of incorporation? What information should a charter ordinarily contain? 18. Draw up a charter for a company (imaginary or otherwise) following the model given in the text. 19. Can a new corporation assume a name which has already been adopted by a corporation chartered in some other state? Do any of the states prescribe any part of the names of corporations organized under their laws? 20. Why is it important to state the purposes for which a company is formed fully and carefully in the charter? Why did the New Jersey Court of Errors QUIZ QUESTIONS 447 and Appeals hand down a decision adverse to the rail- road company in the instance cited in the text? 21. What is the minimum number of incorporators in most states? of directors? 22. What topics are usually considered in the by- laws of a corporation? Draw up a brief set of by-laws for a company (imaginary or otherwise) following the model given in the text. 23. What are the usual by-law provisions as to stock, meetings, officers, dividend payments and by-law amend- ments? How may new rules of action be adopted without the formality of amending the by-laws? CHAPTER III 24. What are the four fundamental rights of the body of stockholders of a corporation? May a board of directors ordinarily sell the assets of their corpora- tion without the consent of the stockholders? 25. Name the four fundamental rights of each in- dividual stockholder. What is a proxy? Write a proxy conferring the right to vote in favor of a pro- posed amendment at a special meeting called for the purpose of considering the amendment. When is a proxy irrevocable? 26. Can stockholders force a board of directors to declare a dividend, provided the company is admitted to have earned large profits? What is meant by the "right to dividends"? 27. Does a stockholder have a legal right to inspect the books of his company? How does the movement in favor of publicity of accounts work in favor of stockholders? 4*48 CORPORATION FINANCE 28. What are the two chief universal liabilities of stockholders? 29. What are the two classes of creditors? Has either class a right to interfere in the internal manage- ment of the debtor corporation? 30. What are "dummy" directors? How are they sometimes kept under control? 31. What in general are the powers of a board of directors? May those powers be delegated? Under what circumstances do directors become liable for loss suffered by their corporation? 32. Why is it stated in the text that the corporate form is "almost ideally adapted, so far as efficiency and economy go, to the conditions of present-day industry" ? CHAPTER IV 33. By virtue of what legal principle do corpora- tions chartered in one state of the Union extend their operations to other states? Give the gist of the de- cision of the Supreme Court in the case of The Bank of Augusta vs. Earle. 34. May a state regulate in any manner corporations doing business within its borders, but chartered in an- other state? If so, how? 35. Give three reasons in favor of securing a charter from the state in which a corporation has its principal office. Why are not these reasons decisive in all cases? 36. From the tables given in the text estimate the organization fees and the annual franchise taxes of a corporation with $50,000 capital stock in New Jersey, New York, Delaware, Maine and South Dakota. What QUIZ QUESTIONS 449 other expenses will probably be incurred in starting a new company? 37. Name four states which have liberal incorpo- ration laws? 38. Why is it desirable to secure a charter in a state which has an estabhshed and weU-adjudicated corpora- tion law? 39. Name three states which bear poor reputations as states of incorporation. Name three states which bear good reputations. 40. if you were about to incorporate a manufactur- ing company, located in Massachusetts, designed both to operate a plant and to buy up the stock of several competing companies, the capitalization to be $2,000, 000, in what state would yOu take out a charter? What other states would you be inclined to consider favorably? Base your answer on the data given in the text and state your reasons fully. An excellent method of get- ting familiar with the main features of the various state laws is to make up a number of similar hypo- thetical cases and consider each one carefully. 41. What is a "subscription contract" and when is it used? 42. What is meant by the statement that a capable lawyer can generally fit out any corporation with the exact powers and privileges that wiU prove most ad- v^antageous. CHAPTER V 43. In your opinion should stock certificates be made fully negotiable? Give your reasons in full. 44. What is the "par value" of a share of stock? The VI— 39 450 CORPORATION FINANCE "market value"? Is there any good reason toi the custom of giving shares a nominal value in money? 45. Define fully "preferred stock," showing wherein the preference may consist. 46. Name and discuss four uses of preferred stock. What is "voting stock"? 47. What is the object of "cumulative voting"? How is that object attained? 48. What is a "voting trust"? What is the usual plan of organization? What is the usual object in establishing a voting trust? CHAPTER VI 49. Define "quasi-public corporations," "private cor- porations," "close corporations." 50. What is a "parent company"? What is the difference between a "parent company" and a "holding company"? 51. Why does a holding company usually aim to se- cure more than a bare majority of the stock of its subsid- iary companies? What is the distinction between the ordinary balance-sheet of a holding company and its "consolidated" or "general" balance sheet? ' 52. Under what plan were the early "trusts" or- ganized? Why do most "trusts," so-called, now take the form of holding companies? 58. Taking the chart of organization of the Inter- borough-Metropolitan Company, show what relation of ownership and control exists between the New York City Railway Company and the Interborough-Metro- politan Company. ' 54. How many companies are directly controlled by QUIZ QUESTIONS 451 the Standard Oil Company of New Jersey? How many indirectly? CHAPTER VII 55. Enumerate from memory the principal topics covered in the first six chapters of this book. 56. What are the six sources of corporate funds? In what sense may profits be called a possible source of funds? In what sense do trade creditors supply cor- porate funds ? Can a corporation manager or promoter ordinarily sell the stock or bonds of his company to a bank? If not, why not? 57. What are the important classes of investors? 58. How would you distinguish between an "invest- ment" and a "speculative" security? 59. What are the important classes of buyers of speculative securities? 60. Why is it desirable that a corporation should borrow a considerable proportion of its funds? What proportion of the funds used by the five companies named in the text are borrowed? 61. What kinds of securities ordinarily will a cor- poration offer in order to secure funds from (a) trade creditors, (b) banks, (c) the investing public, and (d) the speculative public? Name and describe the six im- portant groups of corporate assets. What securities may be issued corresponding to each group? In deter- mining what securities a corporation shall issue are the earnings of the corporation, as well as its assets, taken into consideration? If so, how? 45a CORPORATION FINANCE CHAPTER VIII 62. How are corporate funds secured from trade creditors? What two qualifications limit the general statement that a corporation should buy as much as it can on credit? What is a conservative percentage of accounts, bills and notes payable to quick assets? 63. What are the main points that will be considered by a careful banker in determining how much credit he is willing. to extend to a corporation? 64. What are the essential features of a vaUd nego- tiable promissory note? What is the chief objection to using short or medium term notes sold to the public as a means of securing corporate funds? Under what circumstances is it good financial policy for a corpo- ration to issue such notes? In general should the short- time obligations of a corporation ever be based on the corporation's permanent assets? CHAPTER IX 65. What three opinions are prevalent as to the chief factor that determines the value of fixed assets? 66. What are the characteristic features of a mort- gage? What is a mortgage bond? What is a mortgage deed of trust? 67. What are the essential and usual provisions of a corporate deed of trust? 68. Define "closed," "open-end" and "limited open- end" mortgage deeds of trust? Which of the three types is generally the best? Why? QUIZ QUESTIONS 453 CHAPTER X 69. Give from memory the principal descriptive words applied to corporate bonds indicating (a) their security, (b) their purposes, (c) their manner of pay- ment and (d) their conditions of redemption. 70. What is a junior mortgage bond? How is the fact that it is a junior bond sometimes disguised? 71. What are sinking fund bonds? What are the principal objections to their use? 72. What are collateral trust bonds? Why may they sometimes be sold more readily than the securities on which they are directly based? How may they be used to finance the process of buying control of subsidiary corporations? 73. What is an equipment trust bond? Why are they so highly regarded by investors? CHAPTER XI 74. Compare English with American practice with reference to the use of debenture bonds. What reasons lead to the issue of debenture bonds from time to time by some corporations in this country? 75. What are income bonds? What is the chief ob- jection to their use? 76. Define "participating," "profit sharing" and "joint" bonds and "receiver's certificates." 77. What are registered bonds? Coupon bonds? What are the advantages and' disadvantages of each form? What are redeemable bonds? 78. 'What are convertible bonds? What are their advantages and disadvantages to the corporation? 454 CORPORATION FINANCE CHAPTER XII 79. What is a promoter? Does he have a legitimate and useful function or not? Give your reasons. 80. What is meant by the promoter's "discovery" of a proposition? Illustrate in detail with reference to some hypothetical case, such as a new gold mine in Alaska or a proposed creamery in a small country town. 81. What is meant by "assembling" a proposition? Illustrate in detail with reference to the same hypo- thetical case used in the previous question. 82. What are the first steps in financing a proposi- tion? What is the advantage of carrying the develop- ment of the proposition as far as practicable before asking outsiders to supply funds? 83. Why should a promoter usually endeavor to raise more money in advance of complete development of a proposition than he expects wiU be needed? 84. Why is it usually better for a promoter to sell to a large number of small buyers than to a small number of large buyers? 85. To whom should a promoter go first, generally speaking, for funds? Why? 86. Show how the principles of promotion laid down are apphed in the illustration given in the text. CHAPTER XIII 87. Why are professional promoters usually unsuc- cessful in the long run? 88. Why do lawyers and bankers in small communi- ties do a considerable amount of promotion work? To QUIZ QUESTIONS 45S what extent do the large metropolitan bankers and promoters enter the field of promotion? 89. What are the advantages of engineering firms as promoters? 90. Is a promoter in any sense an agent of his cor- poration? A promoter buys a manufacturing plant for $10,000 and sells it to a corporation which he promotes for $20,000, representing this latter sum to be the price he paid for the plant: is he legally entitled to his $10,000 profits? If not, what course may he pursue in order to evade the law? 91. Why is it diflicult to enforce the principle that misleading statements by a promoter are fraudulent? 92. A promoter makes a contract on behalf of his corporation which is not yet formed: how may the cor- poration become bovmd by this contract without for- mally ratifying it? 93. How did the promoters of the Rubber Goods Manufacturing Company receive their pay? Of the American Smelting and Refining Company? In gen- eral what two plans of determining a promoter's profits are most commonly used? 94. What are the chief risks and tasks that a pro- moter must generally assume? 95. Do you think that promoters in general are or are not overpaid? Give your reasons. CHAPTER XIV 96. Why is there a strong tendency toward consol- idation among small as well as among large industrial establishments? 97. What are the principal diflSculties that are apt 456 CORPORATION FINANCE to confront a promoter who undertakes to consolidate several existing concerns? 98. Describe briefly the process of "discovering" a consolidation. 99. What is the usual method of "assembling" a con- solidation? What is a "basis of consolidation"? What are the characteristic features of the two agreements cited in the text? 100. Why is it important for the promoter of a con- solidation to consider with especial care the means of providing his new corporation at the outset with suffi- cient cash? 101. Why does the promoter of a consolidation gen- erally try to raise cash by means of a bond issue? How may he manage to dispose of bonds issued by a new corporation with small or uncertain assets? 102. How does the problem of forming a large con- solidation differ from the problem of forming a small consolidation? 103. What is the usual basis of consolidation or ex- change and how is it determined? 104. What was the basis of exchange in the forma- tion of the Interborough-Metropolitan Company? In what respects was it faulty? CHAPTER XV 105. What were the conditions under which the steel business of the United States was conducted in the decade, 1890-1900? 106. What were the chief steel companies in the field in 1901 and why had most of them been formed in the three years, 1898-1901? QUIZ QUESTIONS 457 107. What is meant by "integration" of an industry? How did this factor operate to bring about the forma- tion of a great steel combination? 108. Why was not the promotion of the United States Steel Corporation an especially diflScult task? Why were the four Moore companies included in the com- bination? What was the original capitalization of the United States Steel Corporation? 109. Was the prospectus issued by the promoting syndicate misleading? How much cash did the syn- dicate furnish? 110. What were the approximate profits of the pro- moting syndicate? 111. What percentage of the stock of the underlying companies was secured by the Steel Corporation? Give from memory a list of some of the important assets of the corporation. 112. What have been the principal additions to the Steel Corporation? Give briefly the terms of the Hill ore lease and of the Tennessee Coal, Iron and Railroad Company deal. What is the approximate cost of the steel rail mill at Gary, Indiana? 113. Describe briefly the preferred stock conversion plan of 1902. What objections were raised to the plan? What important changes in the interior financial or- ganization of the corporation have been made? 114. Give briefly the argimient tending to show that the Steel Corporation is greatly over-capitalized. Give briefly the argument on the other side of the question. 115. What in general is the policy of the Steel Cor- poration toward its employes? Do the subsidiary com- panies of the corporation compete with each other? 116. What are the principal outstanding securities of the Steel Corporation? What reasons may be given 458 CORPORATION FINANCE for expecting that these securities over a period of years will rise in value? CHAPTER XVI 117. Name the four methods of selling corporate securities. 118. What are the characteristics of a good prospec- tus? Why are statements in speculative prospectuses usually vague? 119. Show that the characteristic features of specula- tive prospectuses are present in the example cited in the text. 120. What are the characteristics of strictly invest- ment prospectuses? Is it safe to assume that these characteristics are never apparent except when the se- curity offered is of the highest grade? 121. What would be the characteristics of an ideal prospectus ? 122. What are the advantages and disadvantages to a corporation of selling its securities through large bond and banking houses? 123. What are the characteristics of large, high-class banking houses in contrast to disreputable concerns and what are the essential factors that make a proposition acceptable to them? 124. What are the usual banking house methods oi selling securities? Do such houses guarantee the safety of the securities they sell? QUIZ QUESTIONS 4t59 CHAPTER XVII 125. Name the principal stock exchanges of the. United States. 126. What percentage of the securities handled on the New York Stock Exchange are "listed"? What are the requirements for listing? 127. What is the "curb" market and what classes of securities are bought. and sold in this market? 128. Describe briefly the method of handling trans- actions on the floor of a stock exchange. 129. What is the relative importance of speculative as compared with investment business, and what func- tion is performed by the speculative business? 130. Describe the process of buying securities "on margin." 131. Describe the process of selling securities "short." 132. What are the characteristics of stock exchange houses in contrast to "bucket shops"? 133. Into what three classes may WaU Street specu- lators be divided? 134. Give from memory a brief review of the char- acteristics of the Wall Street security market. 135. What measures may be taken to stimulate speculative interest in a security that is about to be issued? 136. With what object is a syndicate frequently formed to assist in the flotation of a security? 137. By the use of what methods may the price of a stock market security be manipulated and kept imder contfol? 460 CORPORATION FINANCE CHAPTER XVIII 138. What is underwriting? How did the practice and the word originate? 139. What are the chief advantages to the corpora- tion in having its new issues underwritten? 140. What are the advantages to the buyers of se- curities? 141. When is underwriting inadvisable? What is your opinion as to the merits of the Pennsylvania Rail- road controversy referred to in the text? Give your reasons. 142. Why do the underwriting houses in ahnost every case band themselves together into syndicates? 143. Describe three types of syndicates. 144. Describe the type of syndicate in which the sale of the security is pooled. 145. Describe the type of syndicate in which the un- derwritten issue is distributed among the members of the syndicate. 146. Name some of the principal underwriting houses. What is the distinction between a bank and a banking house? CHAPTER XIX 147. Why are underwriting syndicate agreements frequently quite informal? 148. Make an abstract showing the principal points covered in the agreement of the syndicate formed to underwrite the preferred stock conversion of the United States Steel Corporation. 149. Mention two general characteristics of under- writing agreements. QUIZ QUESTIONS , 461 150. With what three classes of corporations do un- derwriting syndicates deal? 131. What are the peculiar problems and difficulties involved in underwriting the security issues of new or speculative corporations? 152. Review from memory the example of specula- tive underwriting given in the text and make sure that you understand thoroughly all the operations involved. What conditions made possible the construction of a new plant in this case wholly with borrowed funds? What principles followed in this case are applicable in all cases where it is desired that an undeveloped corpo- ration should borrow as much as possible? CHAPTER XX 153. What mistake is frequently made in the invest- ment of the original capital funds of a corporation? 154. What are the advantages of the installment method of getting funds for a corporation only as the funds are needed? 155. What are the disadvantages of this method? 156. What are the other possible methods of getting cash as needed, when the total amount necessary cannot be accurately foreseen? 157. What considerations determine how large an amount must be invested by a corporation in fixed cap- ital? What is working capital? 158. What are the four forms which working capital may take? 159. What factors determine how large an amount of working capital should be carried by a corporation? 160. Of the companies named in the text which one 462 CORPORATION FINANCE has the largest percentage of working capital to gross business? Can you suggest any reason? 161. What are the five factors that immediately affect working capital and determine its amount? Why do railroads require only a small proportion of working capital? 162. About how much working capital did the Penn- sylvania Railroad Company carry in 1908? Why was this amount greater than that carried by most railroad companies? 163. Why is it of the utmost importance that a cor- poration should be supplied with the proper amount of working capital? CHAPTER XXI 164. Draw up from memory a model corporate in- come statement, arranging the items in their proper order. 165. By what common methods may a company's statement of gross earnings be padded? 166. What expenditures and what reserves should always be included under the head of operating ex- penses? 167. What are the causes of depreciation? What is a depreciation reserve? What method of allowing for depreciation has been in common use among steam and electric railroad companies? Is a depreciation reserve usually set aside as a separate sum to be invested outside the corporate business? 168. Why should "income from other sources" be stated separately? Why should cumulative preferred dividends be paid regularly, if practicable? QUIZ QUESTIONS 463 169. Should a corporation ordinarily pay out all its profits in the form of dividends to its stockholders? If not, why not? 170. What four factors determine the amount of profits? What industries are apt to have the most regular profits? Why are the profits of railroad equip- ment companies so variaHe? 171. Why is it desirable that a corporation should establish and maintain from year to year a regular dividend rate? How may regularity of dividends be secured in spite of irregularity of profits? 172. Why is great prudence and foresight on the part of the directors in declaring dividends essential to the best interests of a corporation? CHAPTER XXII 173. What are the two important classes of better- ments? 174. What are the three important sources of funds for betterments? 175. What are the advantages of providing for bet- terments by appropriations from earnings? 176. What are the two objections to this method? 177. What three motives may lead stockholders to oppose a policy of providing for betterments by appro- priations from earnings? How do corporation officers sometimes manage to follow this pohcy without the consent of even a majority of stockholders? 178. Review briefly from memory the case of the Lehigh Valley Railroad Company and show how Presi- dent Walters for some years pursued the pohcy referred to above. 464 CORPORATION FINANCE 179. Show how the Union Bag and Paper Company is now profiting by reason of having previously pursued this policy. 180. When and how may funds for betterments safely be borrowed? 181. What policy as to provision for betterment ex- penditures is followed by the Pennsylvania Railroad? 182. What are the comparative merits of bond and of stock issues as means of raising funds for better- ments? CHAPTER XXIII 183. Define "surplus." 184. Give and discuss briefly foiu* sources of surplus. 185. What is the fifth source of surplus? Can a surplus be built up to any considerable amount by this method? 186. What was the policy of most of the industrial trusts as to surplus in the first few years of their exist- ence? What were the results of their policy? 187. How may a surplus be invested? What general principle should be followed? 188. What is meant by using the surplus as a "rainy day fund"? What companies follow this practice? What is the argument in its favor? What are its dis- advantages? 189. What is the usual practice in this country with reference to the use of a surplus? CHAPTER XXIV 190. What should be the effect on dividends of putting a surplus back into the property of a corpora- QUIZ QUESTIONS 465 tion? Is the effect ever to increase dividends in a pro- portion greater than the proportion of surplus so in- vested to the original corporate capital? If so, when? 191. How may stock- watering be a method of dis- tributing a surplus to stockholders? Give an illustra- tion. Why is it that a stock paying a regular dividend of 4 per cent often sells for more than half as much as a stock paying an equally regular and certain dividend of 8 per cent? 192. What are subscription privileges? How may they be used as a method of distributing surplus? 193. How does a subscription privilege give an op- portunity for cheap investment? What four methods may be used by stockholders in order to secure quick cash profits? 194. What is the method known as the "subsequent sale"? What are the objections to its use? 195. What is the "short selling" method? What is the objection to its use? 196. What is the method known as "sale of old stock"? Why cannot it always be used. 197. What is the method known as "sale of rights"? What is meant by a "right" in New York? What does the same word mean in Philadelphia? What is the objection to the use of this method? 198. What factors determine the theoretical value of a right? What is the formula commonly used on the New York Stock Exchange? Why is the market value of a right usually less than its theoretical value? 199. Is the granting of privileged subscriptions a method of stock watering? Are they objectionable on that account? VI— 30 466 CORPORATION FINANCE CHAPTER XXV 200. What good reason can you give for taking up the study of corporate manipulation? 201. Is it true that the corporate form favors manipulation? Why? 202. Is any force at work in the financial and in- dustrial world which has a strong tendency to check manipulation? 203. What four classes or bodies of persons may endeavor to manipulate a corporation for their own benefit? ' 204. How may high salaries be used as a method of manipulation? 205. How may the power to bind a corporation by purchases and contracts become a means of manipula- tion? Is it usually possible to find a legal remedy or punishment? 206. How may the power to form new companies to handle especially profitable business be used as a method of manipulation? How was this principle apphed by Commodore Vanderbilt? 207. How may a corporate officer manipulate a cor- poration by reason of having "inside" information? 208. Is there reason to think that the use of these four methods of manipulation is not uncommon? CHAPTER XXVI 209. Why do not directors who wish to manipulate a corporation in their own interest enrich themselves by voting exorbitaht fees to themselves? What four methods do such directors commonly use? QUIZ QUESTIONS 467 210. How may directors misuse their power to make contracts on behalf of their corporation? Illustrate by reference to the case of the Minnesota railroad company cited in the text. 211. Why do not the courts interfere in such cases? 212. How may directors manipulate by forming new companies or transferring credit or assets of their company to some other company? Give an illustration. 213. State a few methods of juggling the accounts of corporations which are not infrequent. How may directors profit by juggling the accounts of their cor- poration? 214. What is meant by "window-dressing"? How may it be used by directors as a method of manipula- tion? 215. What remedies for this kind of manipulation may be suggested? 216. How may directors secure gain for themselves by inflicting loss or even bankruptcy on their corpora- tion? Give two illustrations. 217. Review the essential features of the case cited in the text. How might the manipulation of the cor- poration in this case have been prevented? CHAPTER XXVII 218. How may stockholders fraudulently secure profit for themselves at the expense of the creditors of the corporation? 219. What are the essential facts in the well-known ease of Chicago and Alton Railroad Company? 220. How may subsidiary companies be used as a 468 CORPORATION FINANCE means of manipulating a corporation and defrauding creditors? Illustrate. 221. Review the main facts in the Central of Georgia Railway case cited in the text. 222. Show how the minority stockholders in a cor- poration may be "squeezed" by wilful mismanagenient on the part of the majority stockholders and illustrate by reference to the case of the Olympic Theatre Com- pany cited in the text. 223. Review from memory the series of transactions in the real estate proposition cited in the text and show exactly how the minority stockholders ia the Long View Land Company were defrauded. . 224. Review from memory the series of operations carried on by L. A. Ehrenbahn cited in the text and show how they all worked in favor of the manipulation of his deceased brother's estate in his own interest. 225. Mention four measures preventive of manipula- tion that should be taken by honest stockholders. CHAPTER XXVIII 226. Distinguish between "true" and "legal" in- solvency. 227. Mention four possible causes of true insolvency. 228. What are the chief causes, according to Brad- street's table, of legal insolvency? What is the real meaning of the phrase "lack of capital" when used in this connection? 229. What were the two causes, according to the Wall Street Journal^ of the failure of the Detroit, Toledo and Ironton Railway Company in 1909? QUIZ QUESTIONS 469 230. Mention three immediate causes of legal in- solvency in addition to "lack of capital." 231. What is bankruptcy? Can a corporation be- come a voluntary bankrupt? Can all corporations be- come involuntary bankrupts? Is dissolution of the cor- poration a common method of handling insolvency? If not, why not? 232. What is a "bill in chancery"? By whom may it be presented? How may a friendly receiver for a corporation be obtained? What courts have jurisdic- tion in cases of corporate insolvency and receiverships? 233. What, briefly stated, are the duties of the re- ceiver of a failed corporation? 234. From what source does he obtain his authority? How are his powers limited? May he incur debts bind- ing on the insolvent corporation? Does he receive a fee? CHAPTER XXIX 235. Why is it usually necessary and desirable to re- organize large insolvent corporations rather than to sell their property and distribute the assets among the creditors? 236. Why is the formation of committees usually the first step in reorganization? How are these committees appointed? How much authority do they possess? How may a general reorganization committee be formed. 237. Why are bondholders usually ready to agree to a reorganization rather than foreclose and force a sale and distribution of assets? 238. What are the main problems and difficulties that confront a general reorganization committee? How 470 CORPORATION FINANCE are the relative standing and value of the various issues of mortgage bonds and other claims on the corporation determined? What concession is usually made to the stockholders of the corporation? 239. Name the four main objects of every reorgani- zation. Why is it necessary usually to raise considerable amounts of cash? 240. What are the three possible methods of raising cash? Why do almost all reorganizations of insolvent corporations involve assessments on security holders? How large may the assessments on stockholders be made? Under what circumstances may bondholders be induced to pay assessments? 241. What three classes of fixed charges are usually reduced in reorganization? What threat may be used to force an acceptance of a reasonable reduction ? What principle is usually followed in determining the maxi- mum total amount of fixed charges to be imposed upon the reorganized company? 242. How are bondholders usually compensated for the reduction in their yearly interest? What is the effect on the total capitalization of the company? What factors determine whether or not the reorganized com- pany shall operate under the charter of the old com- pany? Why is a voting trust frequently formed at the time of organization? 243. Summarize briefly from memory the principles of reorganization laid down in this chapter. CHAPTER XXX 244. Sketch from memory the growth of the Santa Fe System. What were the effects on the company's QUIZ QUESTIONS 471 financial strength of the rapid expansion in the years 1884-1888? 245. What were the main results of the reorganiza- tion of 1889 ? What were some of the events that led up to the failure of the company in 1893? 246. What was the substance of the so-caUed English plan of reorganization? Why was it not adopted? What were the main features of the plan that was finally adopted? What have been the results of this reor- ganization? 247. Sketch from memory the growth of the Rock Island System. 248. Outline the plan of reorganization brought for- ward in 1902. What was the prime object of this re- organization? Was that object attained? Show how control of the Rock Island System may have been se- cured by the Moore crowd without any permanent out- lay? 249. Why did the Westinghouse Company fail? What was the main problem that confronted the reor- ganization committees? What were the main features of the plan adopted? INDEX Accountant's work in consolidation, 183-183. Adaptability of corporate form, S-8. Addicks, J. Ed., 19. "Alien" corporations, SI. American Bridge Co., 203, 210. American Ice Co., 397-398. American Law Review, 3S0. American Locomotive Co., 117. American Sheet Steel Co., 203, 308, 215. American Steel and Wire Co., 200, 203, 204, 306, 307, 315. American Steel Heop Co., 203, 208, 215. American Telephone and Telegraph Co. Number of stockholders, 7. Watered stock, 338. American Tin Plate Co., 203, 308, 215. American Thread Co., 98, 101, 106. Appointment of receiver, 403-404. Argentine Republic bonds, 23. Arizona, corporate laws of, 54, 57, 58. Atchison, Topeka and Santa F6 R. R. Co., 298, 409. First reorganization, 429-431. Growth, 426-428. Second reorganization, 431-434. Atlantic and Pacific R. R. Co., 427. Atwood, Albert W., 196. B Bad management, 396. Balance sheets, 82-83. Baldwin Locomotive Works, 313. Baltimore and Ohio R. R. Co., 129. Bank of Augusta vs. Earle, 49-51. Bank Loans, 108-109. Bankruptcy and insolvency, 401- 403. Banks, function of, 93. Bay State Gas Co., 19. Bethlehem Steel Corporation, 99, 101, 107, 117. Betterment expenses, 311, 324. Borrowing funds for, 321-322. Classes of, 311-312. Conclusions as to, 323-324. Lehigh Valley R. R. policy, 316- 330. Pennsylvania R. R. policy, 332- 323. Sources of funds for, 312-313. Stockholders' attitude toward, 314-316. • Union Bag and Paper Co. policy, 320-321. Bill in Chancery, 403. Blackstone, 2, 4. Bonds, see " Corporate Bonds." Booth, A. & Co., 99, 101, 107. Boston and Maine R. R. Co., 143- 144. Bucket shops, 348-350. By-laws, 28-36. California, corporate laws of, 57. Capital, lack of, 397-398. Capitalization, Factors affecting, 102-104. In reorganization, 422-424. Of U. S. Steel Corporation, 215. Carnegie, Andrew, 199, 201. 473 474) INDEX Carnegie Steel Co., 92, 201, 203, 204, 206, 209, 216, 300, 301, 313, 336. Central of Georgia R. R. Co., 383- 38S. (Centralization of corporate man- agement, 9-10. Charter, Essential features of, 20-22. Important feature of, 28. Where to obtain, S2. Chicago and Alton R. R; Co., 380- 382. Chicago, Burlington & Quincy R. R. Co., 134. Chicago, Rock Island & Pacific R. R. Co., 337, 435, 437, 438, 439. Chicago, Rock Island & Pacific Railway Co., 337, 435, 437, 439, 440. Choctaw, Oklahoma and Gulf R. R., 437. Classification of corporations. Close, 80. Holding companies, 81-87. Large, 80. Non-stock, 79. Open, 80. Parent companies, 80-81. Small, 80. Stock, 79. Colorado Midland R. R., 430. Commission on Uniform State Laws, 65-66. Common law of corporations, 17-18. Connecticut, corporation laws of, S7, 58-59. Contracts, Manipulation by directors, 362- 365. Manipulation by officers, 353-355. Conway, Jr. Dr. Thomas, 162. Conyngton, Thomas, 22, 29, S3. Corporate bonds. Collateral trust, 133-135. Convertible, 161-153. Debenture, 141-144. Equipment trust, 135-140, Gold, 150. Income, 144-147. Joint, 145, 149. Names of, 130. Manner of payment of, 128, 149. Mortgage, 121-122, 129. Participating, 145. Payment of, 149, 151. Profit-sharing, 145. Purposes of, 128, 149-151. Receivers' certificates, 149. Redeemable, 151. Redemption of, 128, 141-151. Registered, 151. Security of, 127-128. Sinking fund, 130-133. Serial, 151. Corporate entity, 3. Corporate form, abuse of, 350. Corporate funds. Borrowing, 96-102. Security issues, 102-104. Sources of, 91-96. Corporate mortgage. Closed, 125-126. Deed of trust, 122-125. Limited open-end, 125-126. Open-end, 125-126. Trustee under, 380. Corporate name, 24. Corporate purposes, 24-28. Corporate organization, 53. Efficiency of, 47-48. Flexibility of, 64. " Corporation Finance," 97. Corporation laws. Comparative summary, 58-62. Liberality of, 55-56. Permanence of, 56-57. Reputation of, 57-58. Corporations in ancient nations, 4. Corporations, Definitions of, 2. Right to do business in foreign states, 49-51.. Statements to banks, 108-109. Cunard Co., 333. Curb market, 242-243. INDEX m5 Daggett, Stuart, 426^27. Dartmouth College case, 2. Deed of trust, 123. Delaware, corporate laws of, S3, 54, 56, 67, 59. Detroit, Toledo and Ironton Rail- way Co., 398-400. Deductions from income, 303. Defining and controlling instru- ments, 17. Depreciation reserves, 299-302. Dill, James, B., 25. Directors, " Dummy," 44-45. Liabilities of, 45-47. Manipulation by, 361-378. District of Columbia, corporation laws of, 54, 57, 59-60. Dissolution, 403. Disadvantages of corporate form 13-16. Dividends, Cumulative, 72. Fluctuations in, 308. Non-cumulative, 72. Paying, 303-304, 309-310. Reductions in, 314. Regularity of, 308-309. "Domestic" corporations, 51. "Dummy" directors, 44-45. Federal Steel Co., 200, 203, 204, 206, 207, 215. Fixed assets, 327. Value of, 119-121. Foreign corporations, 51. Fraud, 396-397. Frick, H. C. Coke Co., 201. G Gates, John W., 215. General Electric Co., 291-292. Government control of corporations, 15-16. Greene, Thomas L., 97. Gross earnings. Determination of, 297-298. Statement of, 298. Gulf, Colorado & Santa F^ R. R., 427. H Hall, Henry, 152. Harriman, E. H., 315. Hamburg-American Line, 332. Herring-Hall-Marvin Safe Co., 97- 98, 106. Hyde, James H., 266. E Eastman Kodak Co., 231. Efficiency of corporate organization, 47-48. Electric railroads, 307. Equipment companies, 306. Equipment trust bonds, 137. Erie Railroad Co., 117. Essential features of by-laws, 33- 36. Essential features of charter, 20-22. Expenses of incorporation, 13-14. Illinois Central R. R. Co., 340, 346. Illinois, corporation laws of, 57. Important feature of charter, 28. Incorporation, Agreements prior to, 63-64. Expenses of, 53-55. Where to incorporate, 52-53. Wide range of choice in, 64. Income, 302-303. Income bonds, 144-147. Influence of corporations, 16. Individuals interested in corpora- tion, 37. Inheritance of surplus, 326. 476 INDEX Inside information, 358-360. Insolvency, Causes of legal, 397-398, 400-401. Causes of true, 395-397. Detroit, Toledo & Ironton, 398- 400. Methods of handling, 401^04. Installment method of getting cash, 284-287. Integration, 202. Interborough-Metropolitan Co., 86- 87, 253. International Harvester Co., 291. Interstate Commerce Commission, 301, 372, 380. Inventions, 300. Investment, Amount in fixed capital, 288-289. Amount in working capital, 290- 291, 293-294. Definition of, 94-95. Importance of, 284. Of surplus, 330, 340. Practice of large corporations, 291-293. Jones and Laughlin Steel Co., 206. Journal of Accountancy, 66, 110, 183. Lack of capital, 397-398. Lawson, Thomas W., 20. Leeds, Wm. B., 436. Lehigh Valley R. R. Co., 316-320, 344. Liabilities, Of directors, 45^7. Of stockholders, 42-44. Of stockholders of National Banks, 12. Limited credit of corporations, 14- 15. Limited liability of corporations, 11- 13. Limited powers of corporations, 14. Little, Stephen, 298, 431. M Maine, corporation laws of, 53, 54, 56, 57, 60. Manipulation by directors. Accountant's statement, 370-371. Attitude of courts, 365-366. Contracts, 362-365. Juggling accounts, 367-370. I^oss of control dangerous, 375- 378. Loss to corporation, 373-375. Methods of, 362. New companies, 366-367. Remedies, 371-373. Manipulation by officers. Contracts, 353-355. Corporate form favors, 349-350. Methods of, 352. Misuse of inside information, 358-360. Necessary evil, 350-351. New companies, 365-358. Ought we to study, 349. Remedy, 351. Salaries, 352-353. Manipulation by and for stockhold- ers, Central of Georgia R. R. incon-j account, 383-385. Chicago and Alton deal, 380-382. Creditors, causing loss to, 379-380. Ocean Steamship Co., 384. Remedies, 392-393. Squeezing minority stockholders, 385-387. Subsidiary companies, 382-383. Marshall, Chief Justice, 2. Massachusetts, corporation laws of, 57, 60-61. McPherson, F. H., 183. Meade, Edward S., 84, 132, 202, 318, 329. Meetings of stockholders, 34. Method of creating corporation, 19- 20. Method of getting qash, 287-288. Midvale Steel Co., 41. INDEX 477 Minnesota, corporation laws of, 57. Moore Companies, 203, 206. " Moore Crowd," 436, 437, 438, 439. Morgan, J. P., 205. Morgan, J. P. & Co., 269, 277. Mortgage bond, nature of, 121-122. N National Steel Co., 201, 203, 204, 207, 215. National Tube Co., 201, 203, 204, 206, 207. Nevada, corporation laws of, 61. New Jersey, Corporation laws of, 53, 54, 56, 57, 61-62, 84-85. Incorporation of U. S. Steel Cor- poration, 206. New Jersey Court decision, 26-27. New York, corporation laws of, 53, 54, 56, 57, 58, 62. New York Central R. R. Co., 304, 357. New York Curb Market, 344. New York Evening Post, 261-263. New York, New Haven &■ Hartford R. R. Co., 144. New York Stock Exchange, 346. "Non-stock" corporations, 1. Northern Pacific-Great Northern, 134, 149. o Obligations, quick, 401. Ocean Steamship Co., 384. Officers of Corporation, 34-35. Oliver Mining Co., 201. Operating expenses, 298-299. Oregon Short Line, 145, 409. Over-estimation of assets, 395. Ownership of stock, 33-34. Pennsylvania, Corporation laws of, 57. Cumulative voting required, 18-19, 77. Pennsylvania R. R. Co., 260-261. Annual report of, 322-323. Number of stockholders, 7. Policy of, 322. Perkins, George W., 266. Permanence of corporations, 8-9. Personality of corporations, 3-4, 8, 17. Petition for receiver, 403. Philadelphia Stock Exchange, 239. Pittsburg, Bessemer and Lake Erie R. R., 201. Pittsburg Steamship Co., 201. Pooling, 83. Popularity of corporate form, 6. Post, William, 110. Powers of directors, 45-47. Prices of raw materials, 305. Production percentages of indus- trial companies, 305-306. Profits, variability of, 304-308. Promoters, Bankers as, 169. Contracts by, 175. Definition, 154. Difficulties of, 181-182. Engineering firms as, 169-171. Function of, 154^156. Lawyers as, 169. Misleading statements by, 174- 175. Pay of, 175-177, 178-179. Professional, 167-169. Risks and labors of, 178, 179. Secret profits of, 171-179. Promotion, Assembling a proposition, 157- 158. Basis of consolidation, 183-190, 195-196. Discovery of a proposition, 156- 157. Discovery of small consolidation, 182-183. Distribution of stock, 161. Financing a proposition, 158-159. Illustration from Electric R. R, Co., 162-166. 478 INDEX Methods of raising cash, 191-193. Necessity for cash, 190-191. Of industrial combinations, 180- 181. Of Interborough Metropolitan consolidation, 196-198. Providing funds, 160-161. Sale of stock, 161-163. Prospectus, Characteristics of, 224-226. Ideal, 330-231. Investment, 228-230. Speculative, 226-228. Proxy, 38-40. Purposes of U. S. Steel Corporation, 25. Q Quick Obligations, 401. R Railroad reorganization, 426. Railroads reorganized in 1907, 425. Receivers' certificates, 148, 149. Receiver, Duties of, 404-406. Powers of, 406-407. Regulation of " foreign " corpora- tions, 51. Reid, Daniel G., 215, 436. Reorganization, Assessments for cash, 417-419. Atchison, Topeka & Santa F6 R. R. Co., 425-434. Capitalization in, 423-424. Cash requirements, 416-417. Committees, 410-412. Fixed charges reduced, 420-423. Foreclosure, 412-413. Problems of, 413-416. Reasons for, 408-410. Rock Island Co., 437-440. Summary, 424. Westinghouse Co., 440-443. Report of Industrial Commission, 175-177. Revaluation of fixed assets, 327. "Right," 341, 343, 343, 344, 345- 347. Rights of creditors, 44. Rights of stockholders, 37-38. Rock Island Co., 437-438, 439, 440. Rock Island System, Growth, 434-437. Reorganization, 437-440. Roosevelt, Theodore, 57. S St. Louis & San Franciscc R. R. Co., 409, 437, 430, 433, 440. Salaries, manipulation of, by offi- cers, 353-353. Sale of old stock, 345. Sale of rights, 343-345. Sample by-laws, 39-33. Sample charter, 33-34. Saving from income, 327-328. Schwab, Charles M., 316, 317. Securities, Banking house methods of selling, 331-333. Buying on margin, 346-247. Listing,- 340-242. Methods of selling, 223-224, 335- 238. Requirements of banking houses, 332-235. Selling short, 347-248. Selling above par to obtain sur- plus, 326. Short selling, 343-343. South Dakota, corporation laws of, 53, 54, 5". Southern Kansas R. R. Co., 437. Southern Pacific R. R. Co., 436. Speculation, Definition of, 96-97. Importance of, 245-246. Speyer & Co., 265. Standard Oil Co., 291. Lack of publicity of accounts, 42. Organization of, 87-92. Surplus of, 328-329. INDEX 479 State constitution, 18-19. Stimulation of speculative interest, 251,253. Stock, Buying, 340-341. Certificates of, 65-68. Common, 71. Form of certificate of, 70. Nature of, 33-34. Par vs. market value of, 68-71. Preferred, " cumulative," 72. Preferred, nature of, 71-73. Preferred, "non-cumulative," 72. Preferred, uses of, 73-75. Watering, 347, 349. Stock corporations, 2. Stock Exchange, 239-240. Methods of, 243-245. Volume of business, 245. Stockholders, Attitude towards betterment ex- penses, 314-316. Liability of, 42-44. Meetings of, 34. Surplus belongs to, 333-334. Stock market manipulation, 254-255. Stock market, 251. Subscription contract, 63. Subscription privilege, 339. Surplus, Advantages of cash, 331-332. Cunard Co. policy, 332. Definition of, 325-326. Disadvantages of keeping in cash, 332-333. Distribution of, 380-381. Distribution through stock-water- ing, 337-339. Distribution through subscription privileges, 339-340. Sale of old stock, 343. Sale of rights, 343-344. "Short selling," 342-343. Subsequent sale, 341-342. Efl'ect on assets, 335-337. Effect on dividends, 335-337. Fixed assets as a form of, 327. Functions of, 331. Hamburg-American Co. policy, 332. Investment of, 330. Obtained by inheritance, 336. Policy of trusts, 329-330. Rainy day fund theory, 330-333. Revaluation of assets as a source of, 327. Saving from income as a source of, 327-329. Sources of, 326-329. Uses of, 333-334. Syndicate operations, 253-254. Taney, Chief Justice, 50. Taxes, 302-303. Thompson, Seymour D., 350. Transfer of stock, 34. Transferability of corporate owner- ship, 10-11. " Trust Finance," 84, 132, 202, 329. Trusts, 83. Surplus of, 329-330. U Underwriting, Advantages to buyers, 258-259. Advantages to corporation, 257- 259. Origin of, 256-257. When advisable, 259-262. Underwriting houses, 267-268. Underwriting syndicates. Characteristics of, 277-278. Distributing securities through, 265-267. Example of speculative dealing by, 280-282. Formal agreement of, 269-277. Functions of, 278. Handling speculative issues, 279- 280. Informal agreements of, 269. Pool sale through, 265. Types of, 263-264. Why formed, 262-263. 480 INDEX Union Bag and Paper Co., 320-321. Union Pacific R. R. Co., 40, 129, 151, 409. U. S. Leather Co., 100, 101, 107. U. S. Steel Corporation, 291, 337, 436. Additional companies, 211-212. Basis of capitalization, 215-218. Capitalization at beginning, 209- 211. Conditions before formation. 201- 205. Cost of charter, 54. Earlier steel consolidations, 200- 201. Financial changes in, 213-215. Formation of, 194. Method of promotion, 206-209. Number of stockholders, 7. Operating policy, 218-219. Profits of promoters, 209. Prospectus of, 206-209. Record of earnings, 217. Securities of, 219-222. Standing committees of, 46. Syndicate agreement, 270-277. Value of assets, 395-396. Vanderbilt, Commodore, 357. Volume of sales, 305. Voting, cumulative, 75-77. Voting trusts, 77-78. W Wabash R. R. Co., 143. Wages, 305. Wall Street, 343. Wall Street Journal, 267, 291, 397. Wall Street speculators, classes. 250-251. Wells Fargo Express Co., 315-316. Westinghouse Electric & Manufac- turing Co., 440-443. Western Union Tel. Co., 129. West Virginia, corporation laws of, 54, 57. Woodlock, Thomas F., 303. Working capital, 400-401. Forms of, 289-290. Importance of, 284-296. Practice of Pennsylvania R. R Co., 294-295.