OlorneU Mmocratty library 3tl)aca. Ncm ^atk Zcr\jijayy>Mru>JI\J^^ ,K/y\ Date Due i , t^\m i . Q 0^ JUl^ ^ t)^S'4 7 a imR ^ 1948 J T i^ -ftrn ■^t36iK im^ 09 J^ 't \^ panies,^ the. second predominates with financially weak companies. With local public utilities this influence of a company's financial position on its rate policy is sometimes an important factor. Conservatively capitalized, prosperous electric light companies, for example, have not infrequently reduced their rates below the maximia fixed by the regulating com- missions, simply in order to build up business and to estab- lish a good-will on the part of the public. But with the in- terstate railroads it is doubtful whether the principle has been to any considerable degree operative. Railroads are only to a limited extent monopolies ; often they have been highly competitive. Competition has usually prevented a weak 1 Not always, however ; the controlling interests in a financially sound company sometimes adopt the short-sighted policy in order to sell out at top prices. Xg] THE EFFECT OF CAPITALIZATION jg or bankrupt road from raising its rates. Some authorities have presented evidence tending to show that rates on over- capitalized railroads have been even lower than on the more conservatively financed lines/ The Alton, for example, underwent an upward revision of its capitalization at the beginning of the present century ; but in spite of this increase, transportation rates declined materially. A similar situa- tion prevailed on the Rock Island. One of the most exces- sively capitalized roads in the country is the Chicago Great Western Railway ; yet its charges have been among the very lowest. The grossly overcapitalized Erie has charged lower average freight rates per ton-miile than the undercapitalized Lackawanna. Other similar instances might be cited. Whether these cases really indicate an inverse correlation between capitalization and rates, or whether they are purely a matter of chance, could be proved, if at all, only by more careful statistical studies than have yet been made. Prob- ably the latter explanation is correct; for it so happens that most of the overcapitalized railways that have been cited as charging low rates are located in unusually competi- tive territory. In theory, however, an actual relation of cause and effect is not out of the question. The very reasons that may induce an overcapitalized monopolistic railway to raise its rates may cause an overcapitalized competitive rail- way to lower them. In both cases the short-sighted desire to secure maximum immediate returns prevails. But in the one case this object would be attained by charging all that the present traffic will bear, while in the other case it would be attained by lowering rates so as to undercut com- petitors. ^ " Windom Committee,'' Report, op. cit., pt. ii, p. 142 ; U. S. Industrial Commission, Report, vol. xix, p. 413; F. A. Delano, Commercial and Financial Chronicle, vol. civ (1917), p. 318; Carl Snyder, American Railways as Investments (New York, 1907), pp. 64-5; Frederick Strauss, The Relation Between Capital and Rates — an Address delivered at the University Club, New York City, March 7, 1912 (Buffalo, etc., 1912). 20 RAILROAD CAPITALIZATION [20 Our conclusions, then, as to the effect of capitalization on rates, when these rates are fixed by the railways themselves, is that some rela;tionj may exist, but that this relation is much less direct and of much less significance than is generally assumed in popular discussions. B. INFLUENCE OF CAPITALIZATION ON RATES UNDER GOVERNMENT CONTROL In these days of strict government regulation, it is far more important to study the factors that influence our courts and comimissions in their rate decisions than to discuss the raite-making policy of the railway management. For the gov- ernment, not the railway, has the last word. General rate levels are now limited, not to what the traffic will bear, but rather to what the Interstate Commerce Commission or the United States Supreme Court will bear. If regulating commissions were to allow railway com- panies to charge such rates as would earn interest and dividends on all outstanding securities, the relation between capitalization and rates would be obvious. But as a mat- ter of fact, no such simple relation prevails; the connection is more indirect. In order to understand this connection, we moist have in mind the gaiei-a,l principles which guide ai commission or a court in a rate case. The starting point in the tiieory of rate regulation is the principle of common law, now supported by state and federal statute^, that public service enterprises must charge " reason^ able " rates. Until very recently, no test of reasonable- ness has been set by statute. But in the United States a standard has been developed by the courts, under their authority to review all rate regulations to determine whether they violate the constitutional guaranties against confiscation of property. According to these court deci- sions, a company must ordinarily be allowed to charge suf- ficient rates to earn a " reasonable return " on the " fair 21 ] THE EFFECT OF CAPITALIZATION 21 value of the property being used by it for the convenience of the public." This so-called " valuation basis " of rate mak- ing has now been formally accepted by Congress, which hasi provided in the present Transportation Act that the Inter- state Commerce Commission shall fix such rates as will per- mit each group of carriers to earn a " fair return on the aggregate value " of -their railway property.^ In determining the influence of capitalization in a rate case, we m,ust pay regard to both of the above-mentioned factors: "reasonable" (or "fair") return, and "fain value." Does the amount of outstanding securities havei any effect on the rate of return that a commission or a court would consider " reasonable? " Does it affect the estimate of the "fair value" of the property? Each of these questioms must be answered before we can settle the relatioin between capitalization and rates. Let us consider these two points separately, first analyzing the fair vcdtte, and later discussing the rate of return on that value. I. Capitalization and "Fair Value " As every student of public utility problems knows, the courts. have never set any definite standard of " fair value " for rate making. Usually they have accepted a valuation based on a compromise of different possible tests. What these tests may be is indicated in the leading case of Smyth V. Ames.' The famous dictum in that case reads as fol- lows : 1 The Act provides that, for a period of two years beginning March I, 1920, the Commission shall fix a " fair " return equivalent to a rate of SH' per cent of the aggregate property value but may, in its discretion, allow an additional half per cent to make provision for improvements. At the end of the two-year period, the rate of return is to be fixed by the Commission from time to time at such a point as the prevailing conditions may jtistify. « 169 U. S. 466, S4S (1898). 22 RAILROAD CAPITALIZATION [22 We hold, however, that the basis of all calculations as to the reasonableness of rates .... must be the fair value of the property being used by it for the convenience of the public. And in order to ascertain that value, the original cost of construction, the amount expended in permanent improve- ments, the amount and market value of its bonds and stock, the present as compared with the original cost of construc- tion, the probable earning capacity of the property under particular rates prescribed by statute, and the sum required to meet operating expenses, are all matters for consideration, and are to be given such weight as may be just and right in each case. On the basis of this dictum there are two distinct grounds on which the amount of capitalization might be given weight m estimating " fair value : " First, it might be taken as evidence of " the original cost of construction " and of the " aimount expended in permanent dmiprovements ; " second, it might be held to constitute in itself a vested right, to be honored at its face value. This second interpretation might follow from the fact that the dictum refers to the " amount and market value of its bonds and stocks " as separate items to be considered, distinct from the item of original cost. Let us discuss first the use of capitalization as evidence of the actual cost of the property. Capitalization as evidence of the actual investment. In the determination, of " fair value " for rate-making purposes, courts have held that one of the most important elements to be considered is the original cost of the property. In- deed, the recent tendtocy, on the part of some commissions at leasit, has been to make it the controlling test — ^a tendency to which some authorities think that the courts will soon ac- cede. Unfortunately, however, the railways of this country failed to keep accurate records of their capital costs until fequired to do so under the amerdmetit of 1906 to the In- terstate Commerce Act. So far from making correct en- 23] THE EFFECT OF CAPITALIZATION 23 tries of capital expenditures, many of the railways, prior to that date and to some extent even thereafter, de- liberately made excessive charges to the capital accoimt in order to conceal from the public and from the regulating commissions the true relation between profits and investment. The practice of stock watering went hand in hand with a practice of inflating the property accounts, which were writ- ten up so as to balance whatever amounts of securities the controlling interests might deem fit to issue. In spite of its notorious inaccuracy, this nominal capita- lization, to which the book values were made to correspond, has been the only record of actual costs possessed by the com- missions and courts. Indeed, not only hasi capitalization been the only record of actual cost, but also, in the case of most railways, it has been the only test of any sort on which " fair value " might be based; for physical valixations have not yet been completed. Faced with the necessity of deciding whether railroads should be allowed to raise their rates, and lacking any other information as to the fair value of the property, the Inter- state Commerce Commission, in all its general rate cases, has been obliged to take account of capitalization as an evidence of the property value. To be sure, it has placed little confi- dence in the figures so obtained, and has therefore attempted to discount them as far as possible. But in the absence of other data, it has been compelled to base its decisions largely on these faulty statements.^ Recognition of the unsatisfac- ^ The above statement was written before the recent rate decision, dated July 29, 1920, granting to all carriers a heavy increase in freight and passenger rates. This new decision goes farther than any previous case in accepting capitalization or book value as the controlling factor in the determination of fair value. As compared to a book value of ^,040,572,611, the "fair value" was found by the commissioni to be $18,900,000,000. A review of earlier decisions by the Interstate Com- mission with reference to capitalization as an element in " fair value " will be found in Appendix A, infra. 24 RAILROAD CAPITALIZATION [24 tory character of such evidence is what led the commission to urge upon Congress the necessity of a physical valuation. When this valuation has been completed, the commission may be expected to disregard entirely the outstanding se- curities in its estimate of the property value. Whether the physical valuation', when completed, will show that the railways have been making excessive profits in the past is of course a matter for conjecture. Railway men', however, confidently assert that total net capitalization of American railways will be found to be under rather than over the total "physical value" as based on replacement cost. It must be admitted that preliminary reports on the valuation of several of the railways tend to bear out this contention.^ But this of course raises the whole question whether public utilities should be valued for rate-making purposes on the basis of their present high replacement cost, or om the basis of their much lower original cost. In the latter case, the outstanding capitalization is almost certainly excessive. The present treatise will not discuss this per- plexing question of rate making. Although no one can deny that in the past, overcapitaliza- tion has been used deliberately as a mfeans of deceiving the government and the public as to the actual dost of the pro- perty, one need not conclude that it may always be so used. It is entirely conceivable that the railways might be permitted to water their stock without limit, while being compelled to state correctly on their balance sheets the actual property investments. In tha.t case, an excessive stock issue would be, ofifset on the balance sheet by a cor- responding' entry to " Stock Discount." Under such a pro- cedure, the property account would state correctly the actual ^ For detailed statistics on this point, see the testimony of Thomas W. Hulme before the Interstate Commerce Commission, Washington, May 26th and 27th, 1920, separately printed by the Secretary, Presi- dents' Conference Committee, Philadelphia, June 4, 1920. 25] THE EFFECT OF CAPITALIZATION 25 cost, with the result that courts and commissions would not be deceived if they desired to base rates on the actual invest- ment. Precisely that practice has prevailed in England. British railways have been permitted to issue large amiounts of watered stock, but in their reports to the Board of Tradd they have been obliged to state frankly the amount of water. Not so, however, with American iiailways. They have balanced their excessive stock issues, not by charges to Stock Discount, but rather by an: overvaluation of their property. It is this deliberate deception that has made stock watering as practised in America so much more vicious than stock watering in England.^ Capitalization as a separate factor in " faiir value." For anyone who is not versed in the legal profundities of rail- way counsel, it may be difficult to see how nominal capitali- zation can be claimed as an element in fair value except in so far as it may indicate the actual investment. Yet railway spokesmen have repeatedly argued that the amoun/t of out- standing securities should be given weight in determining fair value, entirely irrespective of the actual cost. The basis of this plea is the " innocent investor " argumemt. Even if securities are fictitious, they have been bought in good faith by investors who supposed that they represented real pro- perty. These investors, it is held, should not be " penal- ized " for the sins of bygone financiers. During the recent general rate cases, — the "Five Per Cent," and the " Fifteen Per Cent " cases, — ^the financial and railway interests set going a wave of propaganda urging' thiis claim for the prdteotion of existing securities. The nature of their argument is indicated in an address before the Investmetit Bankers Association of America by itsi president, Mr. A. B. Leach. Mr. Leach's remarks are re- ported as follows : 1 But even the British practice has not escaped criticism ; see pp. 60-61, infra. 26 RAILROAD CAPITALIZATION [26 A very strong and able committee of our members attended a session of the Interstate Commerce Commission when the earlier railroad rate question was under consideration. They presented, with all due emphasis, that the investors' position in relation to the rate question is that the railroads should be granted the increase asked for, whatever may have been the error or failures or mistakes of mind or purpose in issuing some of these securities, the fact remains that the railroads have be- come very important, if not the most important industry in the country, and the investments in railroad securities form a very large percentage of the security for the savings of our people, in more than one way.^ One would not be justified, however, in assuming that commissions actually itake account of outstanding securities simply because investors plead for such consideration. Railway interests, in rate cases, have continually entered pleas whiich comimissioins have continually denied. We must turn, therefore, to the decisions of courts and commissions to see whether, these pleas have won recognition. On this point the theory of the law is sufficiently clear. The United States Supreme Court has held that public utilities are entitled to a return on the " fair value " of the property, not on; the securities issued against that property.* To be sure, the above-quoted dictum' in Smyth v. Ames states that in the determlination of the fair value of a com- pany's property, " the amount and market value of its bonds and stocks " are among the elements to be considered. But 1 Proceedings of the Association of Investment Bankers of America, Denver, September, 1913, pp. 15-16. 2 This statement applies to securities that have not been issued under the specific authorization of a public service commission. Whether or not securities, when officially approved by a commission, will create a legal claim in rate decisions has not as yet been settled in court. The public utility laws contain a disclaimer of any obligation or guaranty on the part of the state with respect to authorized securities ; but some authorities are doubtful as to the complete efficacy of this disclaimer. 27] THE EFFECT OF CAPITALIZATION 27 later decisions have been unanimous in holding that this statement did not imply the right to earn profits on fictitiousi securities. Indeed, quite the contrary view was expressed in the Smyth case itself, as well as in subsequent decisions. So generally recognized is this point of view today, that we need spend no time here in following the court decisions. However, further citations are given in Appendix A of this study. Public service commissions, no less than courts, have been almost unanimous in asserting that capitalization is not of itself an element in " fair value." Some years ago, to be sure, the Interstate Commerce Commission, in the Spokane Rate Case,^ appeared to be taking a contrary position;, acknowledging the claim of outsitanding securities, even when watened. But this position' seems latter to have been entirely reversed.^ Few authorities today would question the statement that in the theory of the law, at least, a capitalization in excess of actual assets should have no consideration in fixing the " fair value" of the property. But it is often maintained by persons familiar with the procedure of rate cases that, despite all theory, courts and commissions do give weight to the claim for a return on excessive security issues. The " innocent investor " plea is thought to have some influence. It is extremely difficult,, if not impossible, definitely to prove or to disprove this opinion by reference to the published reports of rate cases. For in fixing a valuation, commis- sions do not state what, if any, allowance has been made for watered securities. If such allowance is niade, it does not so appear in the report, but is probably covered up by an excessive estimate of the value of intangibles, such as " over- 1 IS I. C. C. Rep. 376, 410 (1909). * See Appendix A for a discussion of the position of the Interstate Commerce Commission and of various state commissions. -^ 28 RAILROAD CAPITALIZATION [28 head charges," or "going value." Only those who have taken part in the proceedings can really know whether or not capitalization has influenced the decision. It is therefore very significant to find testimony from be- hind the scenes to the effect that outstanding securities are in fact taken into account. Members of the Interstate Com- merce Commission and of various state commissions have expressed this view. In an address before the National Association of Railway Commissioners, Interstate Com- merce Commissioner Clements remarked : It is often said that capitalization has nothing to do with the question of reasonable rates. Perhaps legally and tech- nically speaking that is true, but as a matter of fact it is never left out of view.^ On another occasion, Mr. Clark, Chairman of the Interstate Commerce Commission, expressed a similar view.^ At the conference of the National Association of Rail- way Commissioners for 191 3, there was presented a sympo- sium of opinions, from various commissioners on questions of security regulation.' Of the six commissioners who ex- pressed an opinion on the influence of capitalization in valua- tion cases, five believed that such influence existed, and only one, Mr. Roemer of the Wisconsin Commissioni, seemed to take the opposite view. Such testimony from men who have themselves taken part in regulating rates can hardly be gainsaid. One is forced to conclude that excessive capitalization, all legal theory to the contrary, has caused courts and commissions ^ Proceedings, 24th Convention, 1912, p. 219. * U. S. Congress, House of Rep., Committee on Interstate and For- eign Commerce, Hearings, February 9 to March 17, 1914, op. cit., pp. 57-8/. ^Proceedings, 2Sn allowance.^ Still another divergence between, rate-value and capitaliza- tion-value was indicated by the New York Court of Appeals, in a review of a rate decision by the Public Service Commis- sion for the First District.^ The case involved the treat- ment of " going-value " in the Wisconsin sense of the ac- crued deficit from early operation. The commission, in op- posing the allowance of this item in rate-value, argued that such deficits are not properly subjects of capitalization. To this contention the court replied as follows : It may be, as is urged, that a well-conducted enterprise will charge the cost of developing the business to operating ex- penses and that it would open the door to an overissue of se- curities to permit the capitalization of early losses. In answer, it is sufficient to say that we are dealing, not with proper methods of bookkeeping, not with the proper capitalization upon which to issue securities, but solely with the fair return which the company is entitled to receive from the public. Treating a reasonably necessary and proper outlay in build- ing up a business as an investment for the purpose of deter- mining the fair rate of return to be charged is far from hold- iQn this point see D. & H. Co., i P. S. C. R. (2nd Dist. N. Y.) 392 (1908), decision reversed in People ex rel., the D. & H. Co. v. Stevens, 197 N. Y. I. 'Kings County Lighting Co. v. Willcox, 210 N. Y. 479 (1914)- 72 RAILROAD CAPITALIZATION [72 ing that it should be treated as capital against which securities might be issued.^ Accrued deficits, according to this decision, may properly be added to rate value, but perhaps not properly added to capitalization. The court did not state the grounds on which it made this distinction, but one may surmise that it had in mind the prudence of valuing and capitalizing corporate assets at a minimum. Summing up these various opinions of courts and commis- sions, one finds sanction for each of the following distinc- tions between the basis of capitalization and the basis of rate- making value : ( I ) the use of original investment or actual cost in the former case and replacement cost in the latter; (2) the acceptance of earning capacity as a factor in the one case but not in the other; (3) the addition of the value of non-public-service property for securities but not for rates ; (4) the allowance of accrued deficits from early operation as an item in rate-making value but the rejection of this item in fixing the proper capitalization. Doubtless Other distinc- tions have been made which have not come to the writer's attention.'' What, now, is to be said for the use of the same standard of value in security cases as in rate cases, and why have commissions so generally adopted different bases? The chief reason for accepting the same basis has already been suggested: It is that the par value of securities is ac- •/6i(f., pp. 488-9. 'The tendency of nearly all commissions is to be much more liberal in fixing the limit for security issues than in setting a value for rate making. For example, most commissions have on occasion permitted the capi- talization of replacements, and some of them have authorized the issu- ance of securities below par. But action of this sort has been a con- cession to the necessities of the case, taken by commissions with the full recognition of the fact that it violates the accepted principles of sound capitalization. On this point, see pp. 93-95, infra. 73] THE BASIS OF CAPITALIZATION 73 cepted by the unwary as an indication of the actual value, and therefore that any excess of capitalization over value for rate making might deceive investors as to the return that they would be permitted to earn. Of course, such a danger would not be present if the amount of securities were less than the valuation for rate making ; and precisely that situation might be expected in most cases at the present time, where securities are based on original cost, while rates are based on cost of replacement. But original cost is not in all cases less than replacement cost; and in the future, un- der a period of falling prices, the tendency may be quite the reverse. In spite of this cogent reason in favor of the same standard for securities as for rates, the argument against it is even stronger, as long as rates are to be based en cost of replacement. One objection alone would be conclusive against basing securities on the latter standard ; namely, the practical difficulty of reducing outstanding capitalization in order to make it correspond to a fall in the value of the property. Once the securities are issued, they cannot be recalled except at great inconvenience tO' the holders. Moreover, legal difficulties might prevent a scaling-down. On that account, it is essential that the basis for security issues be stable, not subject to fluctuations with changing physical valuations of the property. But even if the practical objections to the use of replacement cost could be overcome, the wisdom of applying^ that stand- ard to security issues would be very doubtful. On many accounts it is important that the par value oi the securities should represent the actual investmient, even though some other test of " fair value " for rate making be accepted. This point is discussed in the following section. 74 RAILROAD CAPITALIZATION [74 (2) Original Investment According to this basis, every dollar in par value of stocks and bonds must represent a dollar contributed to the en- terprise by the investors. No securities may be issued to cover unearned increment, and none may be issued against surplus from reinvested earnings. On the whole, one miay say that those commissions which do not permit the use of stock dividends accept original investment as the proper basis of capitalization; for ob- viously, if some other standard, such as replacement cost or market value, were adopted, it would be necessary to authorize stock dividends whenever the valuation should exceed the amount of outstanding securities.^ In Massa- chusetts, New Hampshire, South Carolina, and the District of Columbia, stock dividends are illegal,^ while in other states their use is much restricted by commission nilings. For many years the policy of Massachusetts has been to limiit stock and bond issues of public utilities to the original investment.^ Every application by companies for permis- sion to capitalize their surplus has been denied by the regu- lating commissions. This drastic restriction of security issues is in large measure the outcome of principles of rate regulation that have been accepted in Massachusetts — ^at least in the case of gas and electric companies. The Board of 'This statement is subject to qualification. For instance, in reorgan- ization cases and in consolidation cases the new capitalization may be made to correspond to replacement cost or to any other basis with- out resort to the use of a stock dividend in the technical sense of the term. The practice of commissions in reorganization cases is noted below, pp. 88-89. 'Mary L. Barron, "State Regulation of the Securities of Railroads and Pubhc iServic'e Companies," Annals of the American Academy of Political and Social Science, vol. Ixxvi (1918), p. 181. 'This policy, however, is not in every respect consistently followed; exceptions are noted at a later point in this chapter, pp. 89-90. 75] THE BASIS OF CAPITALIZATION 75 Gas and Electric Light CornmissioHers of that state has always denied the right of utilities to earn on their surplus such high rates of profit as are allowed on the capital con- tributed by the investors. Quite naturally, therefore, it has refused to permit the issuance of securities^ against sur- plus ; for such perraission would appear to concede the right of stockholders to earn the normal rate of return on the entire property.^ In the matter of security issues, New Hampshire has fol- lowed the Massachusetts, precedent by forbidding stock dividaids.^ But unlike Massachusetts, the New Hamp- shire Public Service Commission has not accepted original investment as the controlling basis in a rate case.* Here, then, is another illustration, of the tendency of commissions 'Cases illustrating the position of the Massachusetts Board of Gas and Electric Light Commissioners in the matter of surplus are: (a) With respect to rate making, Springfield Gas Co., 9 Ann. Rep. 6 (1893) ; East Boston Gas Co., ibid., p. 9.; Worcester Gas Lt. Co., 10 Ann. Rep. 31 (1894); Haverhill Cas Co., 16 Ann. Rep. 9 (1900); Haverhill Gas Co., 28 Ann. Rep. 41 (1912). Cf. also an article by Morris Schaff, Chairman of the Mass. Board of Gas and Electric Light Commissioners, on "Capitalization of Earnings of Public Service Companies,'' Annals Amer. Acad. Pol. &■ Soc. Science, vol. liii (May, 1914), pp. 178-181. (b) With respect to security issues, Edison Elec. Ilium. Co. of Fall River, 11 Ann. Rep. 20 (1895); Maiden & Melrose Gas Lt. Co., ibid., p. 29; Haverhill Gas Securities Co., 15 Ann. Rep. 6 (1899) and 16 Ann. Rep. II (1900) ; Haverhill Gas Co., 27 Ann. Rep. 79 (1911) ; Fall River Gas Works Co., 28 Ann. Rep. 98, reversed by court in 214 Mass. 529. 'See, for example, Grafton County Elec. Lt. & P. Co., s N. H. P. S. C. R. 160. In this case, the commission went so far as to refuse to permit a merger on the ground that it would result in an increase of capitalization and would therefore violate the spirit of the law for- bidding stock dividends. This decision, however, was overruled by the court (Grafton County Elec. Lt. & P. Co. v. IState, 77 N. H. S39, 94 Atl. 193, P. U. R. 1915 C (1064). 'In rate cases this commission has refused to accept exclusively any one basis of valuation, but has assumed to consider all relevant factors. See the Index-Digests in vols, iv and vi of its Reports. 76 RAILROAD CAPITALIZATION [76. to distinguish between the " fair value" for rate making and the basis of capitalization. Let us now consider the mierits of original investment as the standard in security cases. Of course, its advantages- would be clear enough if rate-making value were to be determined by the same method. But, with the important exception of Massachusetts, public service commissions have followed the rulings of courts in refusing to accept that basis in rate cases. On what grounds, then, may it be used as the basis of capitalization? To this question the answer is two-fold. In the first place, the original investment basis has the practical merit of being stable, whereas most other bases are fluctuating. We have already noted this point as a fatal objection to the use of replacement cost. In the second place, there is a decided advantage in making the par value of the securities stand as a public record of the actual contribution of investors. Even though this contribution may not be used at the pre- sent time as the criterion of " fair value " in rate regulation, it should nevertheless be given all possible publicity. Finality in the principles of valuation has been by no means attained ; and it is quite possible that publicity of the actual investment, if it should reveal excessive rates of profit, might lead to a radical revision of the present methods of valuation. But even assuming reproduction cost to be the permanent method of valuation in rate cases, it is highly important that investors should know^ the actual rates of profit on the original investment. Those who support the use of replacement cost as the basis of valuation say that the possibilty of gain through unearned increment in the values of land and other fixed capital will serve as an induce- ment to investors in lieu of a higher rate of return on the original contribution. But this view presupposes not merely the possibility of unearned increment but also the- yy-^ THE BASIS OF CAPITALIZATION "jy recognition^ of that possibility by investors. The best way to advertise the opportunity for future profits is to make known the actual gains in the past; and for that purpose a capitalization restricted to the original investment would be most effective. fjj Actual Cost This standard resembles the previous one in using original rather than present cost but differs from it in taking the cost of the entire property — ^not merely that part of the cost that was defrayed from the proceeds of security issues. In a word, the difference is this: that actual cost equals original investment plus surplus from reinvested earnings. Of the many disputable points of rate regulation, few have given the courts and commissions more concern than the treatment of corporate surplus in fixing a " fair value." Is a public service company entitled to a return on the earnings that have been reinvested in the property, or should it be restricted to a fair return on the original contribu- tion? To this question commissions have given different answers, although courts have almost invariably held that a return may be earned on surplus. We are not here con- cerned, however, with the merits of this controversy. That is a problem in rate making and not a question of capitaliza- tion. For us the problem is simiply this : Assuming that a company is entitled to a return on surplus from reinvested earnings, should it also be permitted to capitalize this sur- plus by issuing certificates against it ? As we have already noted, public service commissions have to face this problem in connection with applications for permission.' to issue stock dividends. Such issues are justified by applicants on the ground that they represent actual capital secured by the reinvestment of earnings which might have been distributed among stockholders in the form 78 RAILROAD CAPITALIZATION [78 of a cash dividend. On this point the laws and practices of the different states vary. We have already observed that Massachusetts and New HanHpshire strictly forbidl stock dividends. On !the other hand, the commissions of New Jersey,' Vermont,^ Michigan,^ Ohio,^ Illinois,^ Indiana * and California^ have authorized companies to issue stock dividends in order to capitalize a bona-fide surplus fromi reinvested earnings. Where this practice has been permit- ted, the actual cost basis of capitalizaition is generally the accepted principle.* Even some commissions ithat do not directly permit the use of stock dividends have allowed the same end to be attained by indirect means. In this matter the precedent has been set by New York. Up to 1910, the law of that state provided that a public service corporation might issue securities only for one of the following purposes: (i) the acquisition of property; (2) the construction, completion, extension or im- provemient of its facilities; (3) the improvement or main- tenance of its service; and (4) the discharge or lawful re- ' P. U. R. 1917 E 720, 1918 B 240 and 1046. See also a statement by the New Jersey commission of general principles governing its action in security cases, 3 Ann. Rep. N. J. P. U. C. 161 (1Q12). 'P. U. R. 1916 C 606, 607. ' P. U. R. 1915 A 205. «P. U. R. 191S A 540. ' P. U. R. 191S C 324, 1916 D 276. 'It would not be correct, however, to say that all commissions which permit stock dividends accept the actual cost basis of capitalization. For example, the Maryland Public Service Commission is authorized by law to permit stock dividends when necessary to make the total capitaliza- tion equal " fair value,'' i. e., rate-making value. The California com- mission on one occasion refused to permit the issuance of a stock dividend on the ground that capitalization would thereby be raised above the rate-making value. Both of these cases have been noted above, under the heading, Rate-making Value. But these are excep- tional cases. 79] THE BASIS OF CAPITALIZATION 79 funding of its obligations.^ These four conditions, which were copied almost verbatimi by other states,^ did not seem to authorize security issues for the purpose of capitalizing reinvested earnings — at least, soi it was held by the New York Commission for the Second District.* But in 191 o the law was amended and a fifth clause added, which pro- vides that securities may be issued " for the reimbursement of moneys actually expended from' income or from any other moneys in the treasury of the corporation . . . within five years next prior to the filing of an application with the proper commission."* This new clause, which was soon copied by other states,^ entitles a comipany that has rein- vested earnings in its property to capitalize the resulting surplus by issuing new securities. Whether or not the amendment directly permits stock dividends is a point on which commissions have differed. The California Rail- road Commiission seems to have answered in the affirmative.* On the other hand, the New York Public Service Commis- ■L, 1907, ch. 429, sees. SS and 69. 'Several states still retain these four conditions without the amend- ment presently to be noted. According to my latest information, these states are Georgia, Kansas, Massachusetts, Michigan, Nebraska, and New Hampshire. *Re Erie R. R. Co., i P. S. C. R. (N. Y. 2nd Dist.) 115 (igo8); Re Babylon Elec. Lt. Co., ibid., p. 132. On the other hand, the Georgia Railroad Commission, acting on the advice of counsel, held that it was empowered to permit stock dividends under a law similar to that of New York (38 Ann. Rep. Ga. R. C. 31, 93 [1910]). Perhaps, how- ever, the Georgia commission may have based its decision on a clause in the statute, not present in the New York law, stating as a fifth condition that securities may be issued " for lawful corporate purposes falling within the spirit of this provision." *L. 1910, ch. 480, sees. 55 and 69. * Arizona, California, Illinois, Indiana, Maine, Missouri, Ohio, Wis- consin (Barron, op. cit., p. 179). « P. U. R. 191S C 324, 1916 D 276. go RAILROAD CAPITALIZATION [8o sion for the Second District does not interpret the amend- ment of 1 910 as sanctioning stock dividends. It holdsi that, under the fifth clause, securities may be issued only for cash, and that this cash nmis't be used to " reimburse the treasury " for funds that it has already paid out on capital account/ But whichever way the law is interpreted, the practical result may be the same. For a company, under the New York ruling, may simiply issue stock for cash, and may immediately afterwards pay out that cash in dividends. As the New York commission seemis to have recognized,^ the outcome in this case would be precisely the same as if the company had issued a stock dividend.'' At the present time, actual cost is by far the most w'idely accepted basis of capitalization among state commissions. ^Re Central Hudson Gas & Elec. Co., 3 ?• S. C. R. (2nd. Dist. N. Y.) 386 (1912). 'Ibid. 'To the above statement, which the writer published in substantially the same form in a recent article (Pol. Sci. Quart, vol. xxxv [1920], p. 43), exception is taken by Mr. Ledyard P. Hale, Counsel for the New York Public Service Commission, Second District. In a per- sonal letter Mr. Hale writes : " There is a substantial difference between a stock dividend and the temporary use for capitalization expenditures of a surplus which might be paid out in dividends when so used but which in fact is not paid out then but later. As administered by the commission, the Amendment of 1910 simply puts ordinary small ex- penditures for capital purposes within the business judgment and dis- cretion of directors and avoids applying to the commission every time such a small matter is contemplated." The present writer is quite ready to accept Mr. Hale's statement that, in actual experience, the law has not yet been used as a means of capitalizing large surpluses and to concede that therefore the law has not yet proved to be a means of evading the prohibition of stock dividends. But the possibility of evasion remains. Is it not probable that the failure of companies hitherto to capitalize anything more than " ordinary small expenditures " has been due to their failure to earn any large surpluses during recent years? And will not the situation be different in the future in the event of a return of prosperity to the public service industries? Si] THE BASIS OF CAPITALIZATION 8l What accounts for its general acceptance? Comipared to raite-nmking value — as that value is usually determined — it has the marked advantage of being stable. But, as we have already observed, this merit is also possessed by the original investment basis. Why, then, should actual cost be pre- ferred to the latter standard ? In other words, why should surplus be capitalized? To this question an obvious reply would be that, since surplus, under the rulings of the courts, must be counted as part of the property on which investors may claim a return, there is no need to distinguish it from any other part of the investment by leaving it uncapitalized. But that statemienit may be seriously questioned. At least two reasons may be giveni for making the distinctioni between' surplus and original capital. In the first place, it is sound financial policy to maintain a surplus as a reserve to equalize dividends over good and bad years and to mieet emergency demands.^ In the second place, it is important to keep a record of the amount of capital contributed by investors as distinct from the amount contributed in earnings by the rate-paying public. What the public wants to know, and what the investors need to know, is the exact relatioui be- tween the net earnings of a public utility and the contribu- tion of the security holders. This relation can be most clearly seen if the outstanding securities represent, dollar for dollar, the original investment. We have already dis- cussed this point in the previous section. In view of these serious objections to the capitalization ' However, it would not always be necessary to devote the entire sur- plus to that purpose; a sufficient part might be set aside as a reserve, and the remainder capitalized. Indeed, this compromise measure has been approved by the New Jersey Board of Public Utility Commis- sioners in a recent security case, in which it allowed a company to issue stock dividends, but required it to leave uncapitalized fifteen per cent of the cost of the property (Toms River Elec. Co., 5 Ann. Rep. N. J. P. U. C.682 [1918]). 82 RAILROAD CAPITALIZATION [82 of surplus, why do most states permit the practice ? Prob- ably this liberality is due not so much to theoretical prin- ciples as to practical considerations of finance. Many public utilities would be unwilling to reinvest earnings in improve- ments if they were not given the opportunity to capitalize that reinvestment by issuing stock dividends. Therefore in order to induce companies to make improvements out of earnings, commissions have adopted the liberal policy with respect to securities. Whether or not the advantages to be secured by this concession outweigh the disadvantages o£ concealing the original investment — and hence, the actual rate of profits — ^is a question which the writer does not at- tempt to answer. But he would call attention to the fact that the Railroad Securities Commission, in its now famous report to the President, expressed the view that all stock and scrip dividends should be prohibited. " It is far better," said the report, " to let the increased value be shown by a higher rate of dividend on the existing shares of stock, instead of by an addition to their nominal amiount." ^ (4) and (5) Market Valine and Earning Capacity According to the market value basis, securities should be issued in such amounts as to make the total par values ap- proximately equal to the market values. All stocks and all bonds must be worth par, or else those which are quoted be- low par must be offset by those which are quoted at a pre- mium. Writers on corporation finance have often failed to distin- guish between the market-value basis and a kindred but by no means identical basis, usually termed " earning capacity " or "earning power." As the term is currently used, it means simply the expected net earnings capitalized at some hypothetical rate of interest — say four or five per cent. The ^Report of the Railroad Securities Commission, p. 27. 83] THE BASIS OF CAPITALIZATION 83 figure arrived at by this mathematical process is supposed to indicate the proper limit of security issues. Obviously, a capitalization arrived at in this manner may have some rela- ton to the market values of the securities, for these values depend to a very large extent upon the net earnings. But, although the two bases are related, they may differ widely in amount. Everything depends on the rates of capitaliza- tion. If " earning power " happens to be computed at the same rale at which the market capitalizes the earnings, it will be identical with market value — otherwise not. For the most part, commissions have sanctioned neither market value nor earning capacity as the test of proper capitalization. But to this rule there have been exceptions. The public utilities statutes of New York and of Missouri recognize " earning power at reasonable rates " as one of the elements to be considered in determining the " fair struc- tural value " for capitalization in reorganization cases.'' A more tmqualified endorsement of the eaming-power theory was given ir some early decisions of the New York Public Service Commission for the Second District. In an opinion on the application of the Westchester Street Railroad Com- pany ^ for permission to issue capital stock. Chairman Stevens discussed at length the proper basis of capitalization. After remarking that value, in the strict economic sense of the word, mean® nothing but exchange value, he concluded : t In cases where the sole attraction of a property which gives it exchange value, or in other words creates a desire for its ownership, is pecuniary gain, the measure of the desire and hence of the ratio of exchange is clearly the amount of gain which it is believed can be realized. The fundamental con- sideration indicates that the net earnings rule of valuation, ^ This point is discussed further on pp. 88-89, infra. 2 3 P. S. C. R. (2nd Dist N. Y.) 286 (1912) ; decision reversed, 158 App. Div. (N, Y.) 251, modified, 210 N. Y. 456, 211 N. Y. 533. §4 RAILROAD CAPITALIZATION [84 when properly and carefully applied with due regard to all the features of the individual case, is probably the one having the surest support of basic principles.^ In the case at hand, the company had failed to earn even operating expenses, but the commission allowed a capitaliza- tion of about $4CX),ooo, perhaps as a generous estimate of the earning possibilities for the future. That figure was be- low the estimated replacement cost depreciated — $445,694; so thait, in this particular instance, earning' power was the conservative rather than the liberal basis. This ruling of the New York commission, however, was not unanimous. In an able dissenting opinion Commissioner Sague said : I disagree with the theory as developed in this case, and believe that too much stress is placed upon the element of earn- ing power, and too little on the other items which determine value . . . the duty of the commission is to approve of an amount of capital which can be used in making up an honest balance sheet which can be applied later, either by the com- mission or the public, as a basis for determining whether a corporation is giving its customers fair treatment . . . the most important basis for capitalization would appear to be the money which has been skilfully and economically invested in the property.^ A similar majority decision and a similar dissenting opinion from Commissioner Sague were rendered on the application of the Canadian American Power Corporation* for permission to capitalize a profitable contract for the purchase of electricity. The Illinois Public Service Commission has also given weight to earning power in certain security cases. In several '/Wrf., 327. 'Ibid., 342. »4 P. S. C R. (2nd Dist. N. Y.) 40 (1914I. 85] THE BASIS OF CAPITALIZATION 85 instances the commission has penmitted a company to pur- chase property, and to capitalize that purchase, at an amount in excess of the fair value for rate-making purposes/ Thisi distinction was justified, in one case, in the following words : , This commission, among others, has heretofore recognized the difference between the value of a utility when used as a basis for fixing schedules of rates and when it is made the ob- ject of purchase and sale between a willing buyer and seller. The allowance of the higher value in the latter case may easily be justified upon the grounds that a prospective purchaser may be satisfied with a smaller return upon his money than he may believe the commission would allow him in a possible future rate-making inquiry . . ," Much the same position was taken by the New Hampshire Supreme Court in overruling a decision of the New Hamp^ shire Public Service Commission, which had refused to al- low a desired increase of securities upon consolidation.* The decision turned partly on the question whether such an increase violated the law forbidding stock dividends and partly on the more general question of the propriety of the proposed capitalization. On both points the commission had decided against the company; but on both points this decisioti was overruled by the court. According to the court, the value of the property for the purpose of issuing securities should be based on the answer to the quesition, " What would a single individual, with abundant ineans, desirous of engaging in the business, but perhaps cautious in making investments, pay for such properties in the situa- tion found upon' the data of the capitalizaition!?"* Here the ^Re 111. Termin. R. Co., P. U. R. 1917 B 494; cf. also 4 HI- P- U. C. 850, 855, 8S9 (1917). • P. U. R. 1917 B 509-10. 3 Grafton Coiaity Elec. L. & P. Co. v. State, 78 N. H. 330, 100 Atl. 668, P. U. R. 1917 E 345; cf. also P. U. R. 1915 C 1064. *P. U. R, 1917 E 348. 86 RAILROAD CAPITALIZATION [86 court apparently accepts "reasonable market value" £is the basis for security issues. The principal argument usually advanced in support of both the market-value and the eaming-capocity bases of capitalization rests on the appeal to so-called sound economic theory. Capitalization, it is said, should represent the value of the property. But value, in its strict economic sense, means simply market value. Therefore the popular notion that capitalization should be equal to cost, — whether original cost or replacement cost, — ^rests on an econotmiic fallacy. The proper standard is either market value or earniitig power, which is [the basis of market value. If the above appeal to " sound economics " could be ac- cepted as having any claim whatever tO' validity, it would apply only to the strict market-value basis of capitalization and not to the eaming-power basis. For current economic theory recognizes no capitalization of earnings at any other rate than the actual market rate. The idea of finding value by capitalizing net earnings at an assumed rate is quite foreign to economic theory. But irrespective of this point, the argument rests on an invalid assumption; it assumes that capitalization should really be based on value, and that the only problem is to de- termine what that value is. As a matter of fact, the very opposite is more nearly true. Capitalization might better represent almost any other significant fact than value. For the value may be found simply by reference to current price quotations. Why, then, attempt to indicate it in the par values? The same remark is in point with respect to the eaming-power basis. As Cole puts it. What is the advantage of capitalizing on the basis of earn- ing edacity? . . . The mere schoolboy, if you tell him the earnings of a company, and the rate of interest, can tell you its capitalized value. In other words, to register on the books 87] THE BASIS OF CAPITALIZATION 87 a capitalization based on earning capacity is not only to register an unnecessary figure, but to bury the actual cost of the assets.^ The real grounds, however, upon which the eaming-power basis is favored by most financiers are quite different from the theoretical reasons stated above. Securities may be made more marketable if the capitalization is in more or less direct relation to the net earnings. A small issue of stock, paying high rates of dividends, cannot be sold on such favorable terms as can a larger issue that pays the same cmuount of dividends but at lower nominal rates. Investors feel that a stock paying only four per cent is safer than a stock paying eight of ten per cent, and therefore they will pay more in proportion for the former. The eammg-power basis of capitalization allows financiers to take advantage of this preference for low-dividend-pay- ing stocks. By making a very liberal and optimistic esti- mate of the future earnings and by capitalizing this estimate at a high amount, — that is, at a low rate, — they are able to raise market values above the prices that would prevail under a more conservative capitalization. But when the eaming-capacity basis is interpreted and justified in this way, it loses all pretense of representing the value of the property. Capitalization, instead of corres- ponding to the assets, is really determined at whatever amount will give to the securities their highest market values. The principle was aptly stated by Frederick Strauss when he remarked that " capital seeks that form of expres- sion in the way of stock and bond issues that has the greatest market value." ^ Since this principle is at the root of all those evils of stock watering that we desire to prevent, it 'William Morse Cole, Accounts, Their Construction and Interpreta- tion, rev. ed. (Boston, 1915), p. 208. 'Public Service Magazine, vol. xiv (1913), p. 99. gg RAILROAD CAPITALIZATION [88 will hardly be accepted in defense of earning power as the proper basis of capitalization. Conflicting Practices of Commissions Assuming the validity of the principle that nominal capitalization should correspond to actual assets, which of the five proposed bases of valuation should be chosen? In principle, at least, the choice should rest with that basis which will be tniost useful as a public record. Judged by this test, market value, earning capacity, and perhaps even rate-making value would have to be ruled out — market value because it is easily noted fromi the stock quotations; earning capacity because it can be computed by anyone who knows the net earnings and the assumed raite of capitaliza- tion; rate-making value because it is given so much pub- licity in rate decisions that some different statistical fact might better be represented in the nominal capitalization. The choice, then, would seem to lie between original invest- ment and actual cost, with the balance in favor of the former. This, we say, would be the logical choice. But in prac- tice, public service commissions have followed no such line of reasoning. They have used first one basis, then another, then a combination of several — depending on the circum- stances of the particular case. In reorganization cases, especially, one finds the greatest lack of uniformity. For this indefiniteness the state laws are largely responsible. Illinois, for instance, makes the vague requirement that the capitalization of reorganized companies must not exceed the " fair value." ^ Wisconsin places the limit at the "true value." ^ Still more confus- ing is the New York law,^' copied almost verbatim by Mis- souri. It reads as follows 1 Stats. (1913-16), ch. ma par. 8686 (37). 2, Stats. (1919), ch. 8s, sec. 1753 (11). • Public Service Commissions Law, sees. SSa and 69a. 89] THE BASIS OF CAPITALIZATION 89 Upon all such reorg^zations the amount of capitalization . . . shall be such as is authorized by the commission which, in making its determination, shall not exceed the fair value of the property involved, taking into consideration its original cost of construction, duplication cost, present condition, earn- ing power at reasonable rates and all other relevant matters and any additional sum or sums as shall be actually paid in cash, provided, however, that the commission may make due allowance for discount of bonds. This long enumeratioiii of elements to be considered in determining capitalization has the effect of preventing any approach to a definite standard. By proper jugglery of the various factors almosit any capitalization may be justified as conforming to " fair value." That such is the outcome in practice is indicated by the recent decisions of the Mis- souri Public Service Commission, which has been called upon to approve two very important reorganizations under the requirements of a statute similar to that of New York.^ One looks in vain in these decisions for any scientific basis upon which the various amounts allowed were held to indicate " fair value." Another striking exampile of the conflict beitween different principles of capitalization is to be found in the practice of Massachusetts. The commissions of that state are on re- cord as supporting the original-investment basis of capitaliza- tion. According to the Public Service Commission, " the general purpose of the so called ' anti-stock-watering laws ' is to linnit capitalization to honest and reasonable invest- ment, dollar for dollar."'' At another time it said, "our whole anti-stock-watering public utility code rests on the ^Rt St. (Louis & S. F. R. Co., December 22, iprs, P. U. R. 1916 F 49; Re Dunham [reorganization of Kansas City street railways], December 28, 1915, P. U. R. 1916 E 544. •Bay State Rate Case, 4 Mass. P. S. C. 33 (1916). go RAILROAD CAPITALIZATION [90 assumption that rates are to be mainly determined by figur- ing a fair leturn on capital [i. e., capitalization] and that therefore capital should accurately represent investment, no less no more." ^ Yet, in two important respects (this rule is violated. In the first place, it is violated by the law that the capitalization of reorganized street-i"ailway companies shall not exceed the " fair cost of replacement." ^ In the second place, it is violated by the requirement that stock must be sold at a price not materially below its market value, even when that price is above par.^ Attention! has already been called to the conflicting prac- tices of the New York commissions. At least four out of the five proposed bases of capitalization have been applied by them at various times. Original investment seems to bei the standard implied in the law forbidding the issuance of stock dividends. But the commissions, by allowing the in- direct capitalization of surplus under the law permitting the reimbursement of the treasury for capital expenditures, have to that extent supported the actual cost basis. Earning power was the test favored by Mr. Stevens of the Ccwni- mission for the Second District and applied in two or three important decisions; but rate-making value has on several occasions been favored by the Commission for the First District. This confusion of principles may or may not be justified. Perhaps it can be shown that no' one basis of capi.talization' is applicable in all cases. But if that is true, — if it is really out of the question to fix a single definite standard, — ^the whole attempt to make capitalization correspond to assets is of doubtful value. For the purpose of any such attempt is simply to give full publicity to the amount of the assets. 'Middlesex & Boston Rate Case, 2 Mass. P. S. C. gp (1914), p. iii. 'R. L., ch. 112, pt. iii, sec. 145 (h). ^ On this point see p. 95, infra. gi] THE BASIS OF CAPITALIZATION 91 If this purpose is to be attained, the basis for determining the amount must be well known to those who may rely on it. At present, the confusing variety of standards pre- vents any such knowledge. Only by referring to the re- ports of the public service commdssions — and frequently not even then — can one tell what the nominal capitalization really means. But if anyone is willing to go to that trouble, he will find little use in par values; for he will be able to analyze directly the property accounts of the company with- out concerning himself about the nominal liabilities. Practical Difficulties of Eq^ializing Capitaiisation ami Investment Even if public service commissiions were ready to ac- cept a definite basis of valuation for capitalization purposes, they would still face the almost impossible task of regulat- ing securities on that basis. Indeed, one may say without exaggeration that only in exceptional cases have comimis- sions been able to enforce an equality between capitalization and assets, no matter by what s:tandards the assets may be measured. Two obstacles have prevented success : first, the difficulty of scaling down capitalization already excessive; second, the impossibiHty of marketing new securities always at par. • The first difficulty is due to the tardiness of the states in assuming control over public utility finance. Except in Massachusetts, security regulation was instituted only after years of almost unrestricted stock watering. The harm had already been done; it could not soon be undone. Drastic measures to enforce the reduction of excessive capitalization have been considered unwise as being not only unfair to pres- ent investors but also inexpedient because of the resulting injury to public utility credit pending the readjustment. Most public service commissions have therefore not insisted 92 RAILROAD CAPITALIZATION [92 upon a scaling down of existing capitalization as a condition of the issuance of new securities. They have attempted simply to prevent further overissues in the future^ This rule of letting existing securities alone has not been followed, however, in Massachusetts or in Texas. In both of these states the policy has been to require that existing capitalization shall not exceed the fair value of the prop- erty. Massachusetts has been able, usually though not always, ito enforce this rule, since overcapitalization had never become very extensive there. Texas, on the other hand, has been much less successful. In 1893 i* passed a law forbidding the issuance of bonds in excess of the "reasonable value" of the railway property; but it pro- vided that, in exceptional cases, the face value of stocks and bonds combined might exceed the physical value of the property by not more than fifty per cent. Even with this modification^ the law discouraged new investments in Texas railways to such an extent that the legislature has been subsequently obliged to make it much less rigid. An act of 1 901 provided that under certain conditionsi roads might issue securities to build extensionsi without regard to the capitalization of the existing property. Another act, in 1903, authorized the Railroad Commission to make similar allowance in the construction of double track and all neces- sary appurtenances. But even with these modifications, the Texas statute is still sharply criticized by railway officials as unduly restrictive. Yet, with all the criticism that has been made of the Texas policy of scaling down existing capitalization, the law has not yet succeeded in making the outstanding securi- ties correspond to the physical values. In 1916, according to the Texas Railroad Commission, the average value per 1 See pp.. 147-50, infra. 93] THE BASIS OF CAPITALIZATION 93 mile of line on those roads that had beeni appraised was $26,779, whereas the average amount of stocks and bonds on that saimie mileage was $31,174, leaving an excess of about 16 per cent over the assets. From these experiences one is forced to conclude that the process of squeezing the water out of ithe present capitaliza- tion of railways will be a hopelessly slow one unless more radical measures are adopted by the federal government than have ever been attempted by our state governments. The only feasible means of equating capitalization and assets will be to require a complete reorganization of our railroad corporations. On many accounts, this may be the very best thing to do. It would fit in well with the plan for consoHdation of railways into a few great systems and with the proposal to require federal incorporation of in- terstate carriers. In the final chapter of this treatise, we shall discuss the wisdom of some such plan. But whatever one may think of the proposal, one must admit that no less thoroughgoing measure — no more gradual scaling down of outstanding securities — is likely to bring about a correspond- ence between capitalization and assets during any period of time for which it is worth while to plan. While the first practical difficulty which public service commissions have to face — ^the difficulty of scaling down existing capitalization — might thus be met by wholesale reor- ganization, not even this drastic device would solve the second problem — that of keeping new security issues equal to new investments. The difficulty is that stocks and bondsi cannot regularly be sold at par. They cannot be sold at par for the reason that it is often necessary to issue securi- ties of the same classi, bearing the same rate of interest and dividends, at different times and under different conditions of the market. Even though the original issue were to be sold at its full face value, subsequent issues might not be saleable at half that price. g^ RAILROAD CAPITALIZATION [94 Public service commissions have tried in various ways to meet this difficulty. In some states, commiissions require companies that are unable to sell their stock for par to issue bonds or notes. Even the bonds, to be surd, may have to be sold at a discount ; but the discount may be amortized by charges against income. This recourse to bonds as a means of avoiding the sale of stock below par cannot be too strongly condemned. In the first place, so long as the bond discount remains unamortized, the purpose of preventing overcapitalization is not attained. In the second place, the prevention of overcapitalization is not worth the cure of overbonding. Most authorities agree that an excess of total par values is less serious than an overweight of debt.'- Our public service laws, by stressing the former at the ex- pense of the latter, are committing an error of the gravest character. In other states, the commissions have frankly vi(jlated the orthodox principles of capitalization, by permitting the! sale of stock below par.'' A few of the eastern states have done this to a limited extent,* but in several western states, in California and Arizona, for example, the sale at a dis- count is the rule rather than the exception. ^ See Report of Railroad Securities Commission, p. 25. 2 Heilman, op. cit., pp. 899-903; Barron, Annals, Amer. Acad. Pol. & Soc. Science, vol. Ixxvi (March, 1918), pp. 185-7. * For example, Maine requires that companies newly organized must sell their stocks at par, although old companies may be allowed to issue them at a discount. (See i Me. P. U. C. 51 [1915] and Applic. of Black Stream Elec. Co., P. U. R. 1915 C 361). New York forbids by law the sale of stock below par; but the Public Service Com- mission for the 2d District has at least on one occasion sanctioned an evasion of this law by permitting the Erie Railroad to issue bonds at 85 which were convertible into stock at the rate of $200 in stock for every $100 in bonds {Re Erie R. R. Co., P. U. R. 1916 D 113). The Wisconsin law prohibits the issuance of stock below par, but the Secretary of the Wisconsin Commission, Mr. H. L. Geisse, recently advocated a modification permitting sale at a discount {Electric Rail- way Journal, vol. xlvii [1916], pp. 602-3). 95] THE BASIS OF CAPITALIZATION 95 The fact that commissions have been obliged constantly to violate the accepted principle of equality between capitali- zation and assets is convincing evidence that the principle itself is unworkable. Indeed, so far as the writer can see, there is only one feasible way by which public service com- miissions might prevent capitalization from exceeding the investment; that is by keeping it ordinarily far below the investment. If railroads were as a general rule under- capitalized^ they might never find it necessary to overstep the limit of fair value. Precisely this method of procedure has been' adopted in Massachusetts ; and it is by means of this expedient that Mas- sachusetts, alone of all the states, is able to claim that the capitalization of its public utilities (at least of its gas and electric companies) does not exceed their reasonable cost. For years this state has required public service corporations to sell their stocks at heavy premiums, whenever the market prices would jusitify those premiums. By this means, and by the consistent refusal of the regulating commissions to allow the capitalization of surplus, the market values of gas and electric stocks have for the most part been kept so high that the necessity of sale at a discount has been avoided. This resort to undercapitalization as an alternative to overcapitalization has much to be said in its favor. Some persons, indeed, go so far as to hold that undercapitalization, so far from being an evil, is a positive good. To err on the safe side, they say, is an advantage. This view is very similar to the position' taken by some accountants, that an undervaluation of assets for the property account should be encouraged.'^ But whatever one may think of the wisdom of undercapitalization' with respect to industrial companies, ^ This position, however, is not accepted by the best American au- thorities; see, for instance, H. R. Hatfield, Modern Accounting (New York, 1913), pp. 83-S. ^6 RAILROAD CAPITALIZATION [96 one must admit that the practice, as applied to public service companies, has serious objections. The first and minor objection is that it would necessitate the sale of Sitock at premiums — ^that is, at prices above par. Now the experience of the stock market proves that investors are reluctant to pay high premiums for stocks. They fed that the par value indicates, to some extent, the normal value and that therefore a higher price is excessive. As a result, stock cannot be sold at a high premium unless the dividend rate is sufficient to yield a higher return on the investment than would have been necessary if the stock were selling around par. Of course, this higher yield is a tax on the rate-pay- ing public. Much more serious, however, is the second objection — > that undercapitalization causes the public to underestimate the actual investment and therefore to exaggerate the rate of profits. Needless to say, such a misapprehension would be almost sure to do harm. It would probably lead to government action to reduce profits below a reasonable re- turn — 2u result not only unfair to investors but also disas- trous to railway cnedit. One of the miost critical ques- tions that will arise when the government establishes a really efifective control over the profits of public service corporations is whether the public, when it knows the actual rate of pro^ fits in these enterprises, will be sufficiently liberal in its judgment of what constitutes a reasonable rate of return. There is danger that no adequate allowance will be made for the risks of the business. Some writers, indeed, aware of the popular tendency to begrudge more than a " savings- bank " rate of interest, have gone so far as to defend, or at least to condone, stock watering as a necessary safeguard against this prejudice. Of course, such a defense will not be accepted by anyone who really believes in democracy. The public has the right to know the facts even though it may gy-j THE BASIS OF CAPITALIZATION 97 sometimes misuse those facts. But it also follows that the public should not be misled by an understatement of the investment any more than by an overstatement. Attempt toi Equalise Capitalization and Assets Unnecessary The conclusion to which the above discussion has led — that the principle of correspondence between capitalization and assets cannot be realized in practice — would be a gloomy one were it not for the fact that it is as unnecessary as it is impracticable. If the amount of the a«sets is known and given full publicity, what need is there of attempting to set up an equivalent face value in bonds and stocks? The balarice sheets, if correctly kept, will show the actual invest- ment. All that is required is that the property accounts be kept on a strict cost basis. The trouble in the past has been that accurate records have not been kept. Companies have not only, watered their securities, but they have also concealed the presence! of that water by a corresponding overvaluation of the assets. For this reason it has been quite impossible to find the actual investment by consulting the balance sheets. But this dif- ficulty need not prevail in the future, for commissions are requiring, with increasing strictness, thait property accounts should show the actual costs. Only one serious objection can be urged against this proposal to disregard par values. So deeply set is the notion that par values represent actual property, that people might continue to attribute a significance to nominal capitalization even after the true investment had been made public. This danger, as we saw in the previous chapter, is a real one. But there is one possible way to overcome it — namely, to issue capital stock without par value. In the following chapter, we shall discuss at length this much debated expedi- ent. q8 railroad capitalization [98 Summary According to the generally accepted theory, 1100111131 capital- ization should correspond to the cost or to the value of the property. The standard for determining that cost or value has been much in dispute. No less than five possible bases have been given weight in the decisions of public service com- missions. They are (i) rate-making value, (2) original investment, (3) actual cost including surplus derived from reinvested earnings, (4) market value, and (5) earning power. The two bases that have been most generally favored by commissions are original investment and actual cost. Usually, oine of these two has been used even when some other standard of value has been accepted for rate-making purposes. But the practice of commdssions has been far from consistent ; and no one basis has been adopted to the exclusion' of all others. No matter what basis the commissions have accepted as the test of proper capitalization, they have never been able to apply it rigorously in actual practice. The history of security regulation from its commencement in the nineties down to the present time testifies without exception in any state that the attempt to secure even an approximate balance between par values and actual investment is foredoomed to failure. It has resulted in the curbing of investment, as in Texas; in dangerous recourse to bonds because of inability to issue stock at par, as in New York; in the violation of the principle by undercapitalization, as in Massachusetts; or in the almost complete abandonment of the principle by overcapitalization, as in California and in other western states. Nowhere has it succeeded; nowhere can a public service commission point to the capitalization of companies under its jurisdiction as an indication of the actual invest- ment in the property. ggj THE BASIS OF CAPITALIZATION 99 In view of these facts, the attempt to use nominal capital- ization as a record of the investment should be frankly- abandoned. In that case, either of two proposals might be accepted: first, to allow the par values to remain but to recognize them merely as a convenient fiction; second, to issue capital stock without par, thus removing nominal capi- talization as a source of deception. Having noted a seriousi objection to the first plan, we turn, in the following chapter, to the alternative measure. CHAPTER IV Shares of Stock Without Par Value ^ 1 Favoring the Removal of Par Values : Proceedings of the New York Bar Association, vol. xv (1892), p. 137 et seq., and vol. xxxii (1909), pp. 270-82; Testimony of F. L. Stetson before the United States Industrial Commission, Report, vol. i (1900), p. 976; Edward M. Shep- ard, Annual Address before the Bar Association of New Hampshire, Proceedings, vol. ii, Old Series (igo6), pp. 273-97; E. M. Shepard, "Corporate Capitalization and Public Morals," Address before the Illi- nois Bar Association, Proceedings, 1907, pt. ii, pp. 29-60; Frederick EHiright, " Par Value of Stock," Yale Law Journal, vol. xvi {1907), pp. 247-52 ; Chairman Frank W. Steviens, Decision In re N. Y. C. & H. R. R. and iR. & E. 'Rapid Ry. Co., i P. S. C. R. (2d Dist. N. Y.) 294 315 (1908); Report of the Railroad Securities Commission (1911), pp. 25-26; 'R S. Lovett, Statement before the Railroad Securities Commis- sion, December 21, 1910 (New York, 191 1?), pp. 16-18; R. S. Lovett, Testimony before the " Newlands Committee " {Hearings before the Joint Committee on Interstate and Foreign Commerce Pursuant to Public J. Res. 25 . . . [Washington, 1916-18]), pp. 686, 707; Victor Morawetz, "Shares Without Nominal or Par Value," Harvard Law Review, vol. xxvi (1913), pp. 729-31; National Association of Railway Commissioners, Proceedings, 1913, pp. 197-98, and 1916, p. 241 et seq. ; Frank White, White on Corporations, 8th ed. (New York, 1915), pp. 7i^-73) Hastings 'Lyon, Corporation Finance (Boston, 1916), pt. i, pp. 104-S. Opposing the Removal : Arthur K. Kuhn, A Comparative Study of the Law of Corporations (New York, 1912), p. 115; William Z. Ripley, Railroads: Finance and Orgamization (New York, 1915), pp. 91-4; William Morse Cole, Accounts, Their Construction and Interpretation, rev. ed. (Boston, 1915), p. 207; Milton B. Ignatius, The Financing of Public Service Corporations (New York, 1918), pp. 78-83 (Doubts value of the removal as applied to public utilities subject to financial control by commission). Descriptive : John Adams, Jr., " Stocks and their Features — a Division and Qassification,'' Annals, Amer..Acad, Pol. and Soc. Science, vol. xxxv (1910), pp. 526-7; Halford Erickson, Regulation of Public Utilities: 100 [100 lOiJ SHARES OF STOCK WITHOUT PAR VALUE loi To those who accept the position, maintained in the pre- vious chapter, that the attempt to secure equality between nominal capitalization and actual assets is neither feasible nor necessary, it will probably appear desirable to take the logical step of abandoning all pretense at such equality. Already the means of securing this object has been sug- gested, namely, the issuance of shares of stock without par values. But since this proposed measure has been criticized no less than favored, we shall devote a chapter to the dis- cussion of its merits. History of the Proposal ^ Credit for originating this device for meeting the evils of watered stock is accorded to a committee of the New York Bar Association, which in 1892 proposed an amend- ment to the New York corporation laws by which private corporations should be permitted to issue shares of com- mon stock without nominal value.^ But the general prin- ciple of recognizing shares simply as participation certifi- Three Discussions (Madison, Wis., ign), pp. 61-2; Franklin Escher, "Without Par Value," Harper's Weekly, vol. Ivi, May 11, 1912, p. 22; Thomas Mulvey, Company Capitalization Control (Ottawa, Ont., 1913), pp. xcvi-cv; Thomas Mulvey, "Blue .Sky Law," Canadian Law Times, vol. xxxvi (1916), p. 43; Edward S. Mead, Corporation Finance, rev. ed. (New York, 1915), pp. 45-6; Charles W. Gerstenberg, Materials of Corporation Finance, 3d ed. (New York, 191S), pp. 43, 47; W. F. Moody, Jr., "The Value of Par Value," Moody's Magazine, vol. xix (1916), pp. 129-30; Albert W. Atwood, "New Devices of Finance," McClure's Magazine, vol. xlvii, July, 1916, pp. 64-5 ; Robert J. Bennett, Corporation Accounting (New York, 1917), PP. 89-91; Roy B. Kester, Accounting: Theory and Practice, vol. ii (New York, 1918), pp. 9-10, 20; F. H. Hurdman, "Capital Stock of No Par Value," Journal of Accountancy, vol. xxviii (1919), pp. 246-57; Arthur S. Dewing, The Financial Policy of Corporations (New York, 1920), pt. i, pp. 13-15. 'C/. White on Corporations, 8th ed., pp. 371-73. 'New York Bar Association, Proceedings, vol. xv (January, 1892), p. 137. I02 RAILROAD CAPITALIZATION [io2 cates was by no means new. The Bar Association com- mittee referred to its use in German corporation finance, while a later writer noted that its " general adoption in practice . . . would bring us back to the joint-stock type of the Sixteenth, Seventeenth and Eighteenth centuries." ^ A few years after this committee had made its original report, one of its members, Mr. F. L. Stetsoni, repeated the proposal in testifying before the United States Industrial Commission.^ Again in 1909 the same committee, in a report to the Bar Association, renewed its recommenda- tions ^ and submitted a draft bill for consideration by the New York Legislature. In 1912, just twenty years after the first favorable report by the committee of the Bar Association, New York State took the lead by adopting the measure as a part of its cor- poration law. By this ax:t business corporatioois are per- mitted to issue shares without par value, other than pre- ferred shares with a preference as to principal.* The example of New York was soon followed by other states. According to a recent count, nine others have al- ready amended their corporation laws to permit the issu- ance of no-par shares: Maryland (1916), California (1917), Delaware (1917), Maine (1917), Virginia (1918), Illinois (1919), Pennsylvania (19 19), New Hampshire {1919), and Ohio (1919).^ It seems entirely probable 1 Arthur K. Kuhn, A Comparative Study of the Law of Corporations, p. IIS. * Report, vol. i (1900), p. 976. * Proceedings, vol. xxxii (Jan. 1909), pp 270-82. *L. 1912, ch. 351, amended by L. 1917, ch. 500. *F. H. Hurdman, "Capital Stock of No Par Value," Journal of Accountancy, vol. xxviii (1919), p. 253. Mr. Hurdman's timely article makes it unnecessary to present in this chapter an analysis of the pro^ visions of the different statutes. I03] SHARES OF STOCK WITHOUT PAR VALUE 103 that within the next few years similar legislation will be generally adopted throughout the United States. Up to the present time, however, most of the states that have provided for shares without par value have refused to extend the privilege to certain important classes of corpora^ tions. New York has set the example here by excepting from the provisions of the act not only banking companies but also public service corporations.^ These latter companies were excluded because they are under the special super- vision of the public service commissions; their securities can be issued only after being approved by the proper com- mission. Security regulation, it was believed, would pre- vent stock watering on the part of public utilities and would therefore make unnecessary the resort to no-par shares as a cure for overcapiitalization. Whether or not such a belief is justified is a question that we shall discuss presently. But here we must note that the New York precedent of requiring the retention of par values for public utility securities has not been universally accepted. Even before the passage of the New York act, Mr. Stevens of the New York Public Service Commission! for the Second District raised the question whether the removal of par values from public utility stocks would not be a wise action.^ Two years later, in 1910, the Railroad Securities Comanissian gave its unqualified support to a proposal to permit interstate railways to issue shares of stock without par value.' Subsequently, members of the ^ But the provision excluding public utilities has been circumvented, to some degree, by the holding company device. At least two public utility holding companies have issued common stock without par value under the New York law: the Interboro Consolidated Corporation and the Western Power Corporation. (See p. 105, note 3, infra.) 'i?e N. Y. C & H. R. R. and R. & E. 'Rapid iRy. Co., i P. S. C. R. (2nd Dist. N. Y.) 294, 315 (1908). ^Report, p. 25. 104 RAILROAD CAPITALIZATION [104 Wisconsin Railroad Commission^ and of the California Railroad Commission'' have endorsed the proposal as ap- plied to all public utilities. Influenced, no doubt, by these favorable opinions, several states have permitted public service corporations as well as business corporations to issue shares without par value. The recent amendments to the corporation laws of Delaware, Maryland, Pennsylvania, and Virginia, providing for the issue of stock without par value, contain no clause exclud- ing public utilities from the provisions of the acts. In the cases of Delaware * and Maryland,* however, there is some * Mr. Roemer, Chairman of the Wisconsin Railroad Commission, in an address before the Southern Gas Convention, Mobile, Ala., April 23, 1914, cited by Fred 'L. Holmes, Regulation of Railroads and Public Utilities in Wisconsin (New York, 191S), p. 240. On the other hand. Commissioner Erickson of the same commission expressed himself as undecided as to the wisdom of permitting no-par ishares : Regulation of Public Utilities: Three Discussions (Madison, Wis., 1911), pp. 61-2. 'Commissioner Edgerton in decision re Pacific Gas & Elec. Co., P. U. R. 1915 C 325, and the late Commissioner Eshleman in address before the National Association of Railway Commissioners, Proceedings of Twenty Fifth Convention (1913), pp. 197-98. •In Delaware there is a law (Rev. Code 1915, ch. 65, sec. 102) which requires that railroad companies incorporated and operating in that state must indicate in their Articles of Association the amount of capital stock, "which shall not be less than five thousand dpUars for every mile of road proposed to be constructed." A ;similar provision applies to electric railways, except that the amount is here two thousand instead of five thousand. I am informed by the Secretary of State of Delaware that his office regards this law as preventing the issuance of stock of no par value by companies of the above-mentioned class. He writes : " If you should have no capital stock [with a par value] of a corporation incorporated under the provisions of section 102 of the General Corporation Laws, there would be no way whereby this office could know that the fourth paragraph of this section would be com- plied with." * In Maryland the right of railroad corporations to issue shares with- out par value is made doubtful by a provision of the Maryland statutes (Annotated Code, Article 23, sec. 264) stating that the capital stock of I05] SHARES OP STOCK WITHOUT PAR VALUE 105 doubt whether railroad corporations may issue no-par shares in view of the fact that the older statutes applying specifically to that class of corporations may perhaps be held to require the use of stock having a par value. The law of California specifically provides that all public service corporations may issue stock without par, but only with the approval of the Railroad Commission. Illinois and New Hampshire exclude railroads but do not exclude other public utilities. Ohio and Maine follow the New York precedent by excepting all public service corporations. During the first few years after the passage of the New York act of 1912, only a few corporations took advantage of the privilege of issuing stock without nominal value. There was a natural hesitation lest the new device might not prove popular with the investing public. But experi- ence soon proved such fears to be groundless; investors have accepted no-par shares quite as readily as any others. Judging from the newspaper prospectuses of recent months, one may conclude that the use of common shares without par value has now become the rule rather than the exception for newly incorporated companies.^ Even sev- eral of the large older corporations have exchanged their former shares for the newer type.* Only a few public ser- vice companies, however, have as yet followed the example of the industrials.^ This is doubtless to be explained by a railroad corporation shall be divided into shares of fifty dollars each. I am informed by Mr. James Piper of the Baltimore law firm of Piper, Yellot, Hall & iCarey that the courts have not yet rendered a decision as to whether or not this clause applying to railways is superseded by the subsequent act permitting corporations in general to issue no-par shares. '£. g., Cuba Cane Sugar Corp., Kennecott Copper Corp., Submarine Boat Corp., Allied Packers, Inc., United Retail Stores Corp. (preferred stock also without par), Atlantic Lobos Oil Co., Shaffer Oil & Re- fining Co. •JB. g., B. F. Goodrich Co. and General Motors Corp. *E. g., Penn Central Light & Power Co., incorporated in Pennsyl- Io6 RAILROAD CAPITALIZATION [io6 the fact that it was not until the year 1916 that any state permitted such action on the part of utility corporations and that, since then, the financing oif public service enter- prises has been at a very lowr ebb. . Advantages The main object of the reform that we have been dis- cussing is to remove the fictitious element in corporation finance. The par value of a share of stock can have no significance except in so far as it represents actual assets. In the theory of the law, that is just what it is supposed to represent; in practice, it represents nothing of the kind. This divergence between theory and practice is due in part to the lax corporation laws of several states ; but it is also due to another cause which cannot be removed ; namely, to the impossibility of issuing stock always at par regardless of the conditions of the market. Since, therefore, par value cannot serve its intended pur- pose of indicating the actual capital, it may better 'be re- moved instead of being allowed to remain as a source of vania (common and preference shares without par value). At least two public utility holding companies, incorporated in New York, have issued common shares without par value : the Western Power Corp. (of Cali- fornia) and the Interboro Consolidated Corp., a company holding the securities of the New York City railway companies (see p. 103, note I, supra). A number of volimtary associations, organized under the Massachusetts law to hold the securities of public utility companies, have issued participation shares without par value: e. g., Boston & Worcester Electric Companies, Boston Suburban Electric Companies, and Central Massachusetts Light and Power Co. In the first two cases, both the preferred and the common shares are without par value, while in the last, the preferred shares retain the par value. The Chicago Elevated Railways, a voluntary association organized under the laws of Massachusetts, has issued preferred and common shares which are " expressed as of a par value of $100," but which are carried on the books at no valuation (see p. 119, note i, infra). The Chicago Rail- ways Co., an Illinois corporation, has issued capital stock of the merely nominal amount of $100,000; this stock is held in trust, and against it are issued 265,100 " participation certificates " without par value. I07] SHARES OF STOCK WITHOUT PAR VALUE 107 deceit to unwary investors. The removal may be expected to have the wholesome effect of forcing the attention of investors upon the value of the property 'behind their secur- ities rather than on the nominal amount of those securities. This result, if it can be achieved, will mark a great advance in corporation finance; for too often have investors been deceived by their assumption that a large nominal capital- ization means an equally large investment. To eliminate this danger of deception would be to remiove one of the serious evils of stock watering. To be sure, it must be admitted that the mere use of shares without par value will not alone cure the evils of stock watering; for the removal of par Value does not re- move all the sources of deception to which the unwary in- vestor is subject. 'On this point a word of caution has already been uttered ; ^ and it will be repeated in a later section of the present chapter in order to emphasize the need for further safeguards. But the truth of this admis- sion does not weaken the force of the fact that one source of deception may be removed ; and that consideration alone justifies the reform. The opinion has sometimes been advanced that the use of shares without par value, while suitable for business cor- porations, should not be extended to railroads or to other public service corporations whose securities are subject to control by a government commission. This view accounts for the failure of New York and other states to include public utilities among those corporations that may issue stock of no par value. Regulation of securities is thought to be an alternative to the removal of par value; the one measure aims to prevent stock watering by making the par value equal the investment, while the other would secure the same end by abolishing the par value entirely.^ 1 P. 57, supra. 'Cf. Ignatius, Financing of Public Service Corporations (1918), p. 83, I08 RAILROAD CAPITALIZATION [loS If commission regulation could in fact secure an approx- imate balance between nominal capitalization and actual in- vestment, one might concede the wisdom of retaining the par value of public utility stocks. But, as we have already noted in the previous chapter, no such results have been secured, nor is there any likelihood of success in the future. In a large number of cases, par values will either under- state or exaggerate the actual contribution made by the in- vestors. Therefore as long as par values are retained, they will remain a source of misinformation. Of course, one may freely admit that careful control of securities by a commission will greatly reduce the danger of deceit occasioned by fictitious par values. Not only will the more extreme forms of stock inflation be prevented, but, what is even more important, the investing public will be informed as to the actual capital in the enterprise, so that it may discount any excessive stock issues. Yet, with all these cautions, the danger of misunderstanding is merely minimized but not removed so long as the par value re- mains. The " magic of par value " is too potent to be en- tirely eliminated by a program of publicity.^ But there is even a stronger reason for removing the par value of public utility stocks. Unless it is removed, com- missions will still feel under obligation to strive for an ap- proximate equality between capitalization and investment. Of course they will not succeed, — they never have succeeded, — but instead of abandoning all efifort to secure an equality, they will make the attempt to come as near to a balance as is at all practicable. They will permit the issue of stock below par — but only as a last resort, rather than as a reg- ular and proper procedure. This, at least, has been the tendency of state commissions up to the present time ; and it is almost sure to continue to be the policy in the future, owing to the popular hostility to stock watering. 1 See pp. S9-6i, supra. ioq] shares of stock without par value 109 This half-way measure — this particd abandonment of the attempt to make capitalization correspond to assets — is in many ways more dangerous than would be the complete recognition of par values as a mere fiction. In the first place, it serves to strengthen rather than to weaken the illusion on the part of investors that par value represents the actual investment. In the second place, it causes com- missions to approve the resort to excessive bond issues as a means of avoiding the necessity of selling stock below par. This second tendency was noted in the last chapter as a serious objection to security regulation as now practised by state commissions ; but it is almost inevitable as long as commissions are under pressure to prevent the sale of stock at a discount. The only adequate means of removing this pressure is to remove the par value, so that stock may be issued at whatever prices are justified by market conditions. One special advantage of shares without par value de- serves particular eaniphasis at .the present time ; namely, their convenience in cases of reorganization and consolidation. Few will deny that any program of railway reform has little chance of solving the present difficulties of our inter- state transportation systems that does not involve, first, a reorganization of unwieldy financial structures and, second, a consolidation of certain independent roads into larger groups. Heretofore, however, both of these financial operations have usually resulted in an increase rather than a decrease of nominal liabilities. It is true that, in re- cent years, when reorganizations and consolidations have been subject to the approval of state public service con> missions, the tendency to inflation has been partly elim- inated. But even in these cases, commissions have usually found it impossible to enforce a rigid scaling-down of capi- talization to the point of equality with the assets. The ob- stacle has been the relucta:nce of security holders to accept 1 1 o RAILROAD CAPITALIZA TION [no new securities of a lower par value than that of the stocks and bonds which they are asked to surrender. To be sure, the commissions might have insisted on such an exchange; but in the case of consolidations, that requirement might have caused the stockholders to abandon their plan for a merger, while in the case of reorganizations, it would have led the security holders to decline either to pay assessimients or to subscribe for new securities. The use of shares without par value, however, will make it much easier to consolidate or to reorganize on a sound financial basis. Because of the removal of par values, there will not be the same need for a stringent reduction in the number of shares ; the holders of one share of old stock may be given with less reluctance one share of new stock, since the new stock indicates nothing as to the amount of investment represented by each share. The special convenience of shares without par value in the above cases was noted by the Railroad Securities Com- mission. Its statement on this point is worth quoting in full : Where two roads have consolidated whose shares have dif- ferent market values, it has been the custom to equalize the difference by the issue of extra shares of the consolidated company to the owners of the higher priced stock. This practice has always tended to produce increase of capital is- sues, and may readily cause the new stock to be issued for a consideration less than its par value. The only alternative was to scale down some of the old stocks; and this often in- volved serious difficulties, both of business policy and of law. By the simple expedient of omitting the dollar mark from the new shares, the number can be adjusted to the demands of financial convenience, without danger of misrepresentation or suspicion of unfairness to anyone.^ In the case of reorganizations, the advantage of shares with- ■ At this point the opinion of the .Securities Commission seems over- optimistic. Even virhen the par value is removed, there is some danger Ill] SHARES OF STOCK WITHO UT PAR VAL UE m out par value is even more obvious. It is here that the neces- sity and justice of getting money from stockholders is great- est. It is here that the impossibility of getting them to pay par for new shares is most conspicuous. We believe that in such cases the public interest would be subserved and the speedy rehabilitation of the roads promoted, by requiring the conver- sion of the common stock and encouraging the conversion of the preferred stock into shares without par value; the cer- tificates simply indicating the proportionate or preferential claims of the holders upon assets and upon such profit as migKt from time to time be earned.^ Alleged Objections Having noted the advantages to be gained by authorizing railroads to issue shares without par value, we must now discuss the supposed objections. At least six criticisms have been made, each of which we shall consider in turn. I. That the removal of par value will encourage inflation by making easy the issue of an excessive number of shares. This point was discussed by the Railroad Securities Com- mission. It remarked : The danger of inflation deserves more serious consideration. We believe, however, that it is more apparent than real, be- cause shareholders will be jealous of permitting other share- holders to acquire shares in the association except at full market value, and will not permit the issue of such shares to themselves at prices so low as seriously to impair the market or other value of their holdings. Shares either with or with- out par value, and whether sold at par or above par or be- that an increased number of shares may give a false impression of an increase in value. On this point see pp. 126-27, infra. However, it can hardly be doubted that the use of no-par shares will reduce, even though it does not remove, the danger. ^Report, p. 26. 112 RAILROAD CAPITALIZATION [112 low it, should, except in casas of consolidation and reorgan- ization, be offered in the first instance to existing shareholders pro rata.^ But the above comments of the Securities Commission leave some important points unanswered. In the first place, it is not clear what is meant by inflation in the case of no-par stock. If each share represents, not a fixed amount, but merely a fractional interest in the total capital, what- ever that capital may be, is any significance to be placed on the number of shares into which the total stock is divided ? And if the number of shares does indeed have a signifi- cance, — if the possibility of inflation still exists after the par value is removed, — ^is the Securities Commission correct in assuming that the self-interest of the shareholders will prevent such inflation? An answer to the first question has already been suggested in an earlier chapter.* There we saw that the danger of inflation persists in spite of the removal of par value. Further discussion of this point is deferred to a later section of the present chapter. As to the second question, it must be admitted that the reply of the Securities Commission is not entirely convincing. In the past, when stock had a par value, the self-interest of shareholders did not suffice to prevent inflation. Why, then, should it suffice with the par value removed? One must concede, then, that the danger of inflation re- mains in spite of the use of no-par shares. Indeed, one might argue that, in the absence of all restrictions on the issuance price, the danger may even be increased. That fact, however, does not condemn the removal of par value from the shares of public utilities and railroads. For, since ^Report, p. 26. 2 P. 57, supra. 113] SHARES OP STOCK WITHOUT PAR VALUE 113 the issue of shares is to be subject to control by commis- sion, the danger of inflation is equally well guarded against, whether the par value is removed or not. 2. That the removal of par value will encourage the flo- tation of shares of low market value — a result condttcive to overspeculation. This point is somewhat similar to the previous one. Ripley gives it as one reason for his oppo- sition to the use of no-par stock. " The abolition of par value," he says, " permitting carriers to issue capital stock for relatively small sums in cash, cannot but encourage speculative interest in railways — an element of danger much to be deplored." ^ This view accepts a prevalent assumption that a low market value gives shares a speculative character. But to what extent is this assumption justified? To be sure, it must be admitted that, in the experience of the stock- market, low-priced shares have generally been of a specu- lative nature. But the relation is not to any considerable extent one of cause and effect. What gives these shares their speculative character is the low value, not so much of each separate share, but of the total stock issue as com- pared with the value of the entire property represented by both bonds and stocks. In other words, it is primarily the narrow equity of the stock issue as a whole which makes the shares subject to such wide market fluctua- tions. The extreme width of the fluctuations is due, first, to the fact that a slight change in the earning power of the property will cause a great change ini the balance of the earnings available for the stock, and, second, to the fact that a controlling interest in the enterprise may be bought with a relatively small outlay of capital. Both of theses factorsi tend to make the stock a gamble rather than an investment. ^Railroads: Pmanee and Organisation (New York, 1915), p 94. 1 1 4 RAILROAD CAPITAUZA TION [114 The fact that low market values per share have been a symptom rather than a cause of speculation is well exem- plified in the case of the Rock Island financial manoeuvres, so well described by Ripley.^ It was the narrowing of the controlling interest to an investment of only about fifty million dollars and the complete wiping out of the equity of the holding company's stocks which made the securities a football for speculation. Would anyone anticipate similar results if Pennsylvatiia capital stock, or Northwestern pre- ferred or common were to be divided into one-dollar shares, leaving the total investment unchanged ? Does any- one suppose that Liberty bonds are much more speculative because they are issued in fifty-dollar denominations in- stead of merely in thousand-dollar denominations — or, on the other hand, that mining stocks would become steady in- vestments if they were only marketed in hundred-dollar shares instead of in one-dollar shares? One must admit that there is a certain minimum of truth in the assumption that the low price of a share tends in itself to make it speculative. It arises from the fact that people of small means can afford to speculate more freely in low-priced stock. But if public policy requires the curb- ing of this small-scale gambling, much more effective means may be found than the retention of a par value. For ex- ample, a minimum tax might be placed on the transfer of all shares of stock in whatever amounts, so that the small transaction would be discouraged by the disproportionately high tax. Or, again, the law might fix a minimum price below which shares without par value might not be issued. Indeed, that very thing is done by New York State, which re- quires that shares without par value must represent a cap- ital of at least five dollars or some multiple thereof per share. Instead of five dollars, the minimum might be set 1 Op. cit., pp. 524-32. 115] SHARES OF STOCK WITHOUT PAR VALUE 115 at fifty or one hundred dollars, or at any other desired amount. 3. That the removal of par value will release stockhold- ers from their liability to creditors for the full payment of their subscriptions. Under the limited-liability laws, stock- holders in corporations are liable for the corporate debts only to the amount of their stock subscription as measured by the par value of the shareholdings. If a creditor finds that stock has been issued without a corresponding payment to the company in cash or property, he may sue the stock- holders for unpaid claims up to the amount still due on the stock subscription. Now, some writers fear that the aboli- tion of par value will take from creditors this safeguard. For in that case there can be no liability to make good the difference between the nominal value of the stock and the amount actually paid in on that stock. ^ This objection, however, can readily be met. The recent state laws permitting the issuance of shares without par value have met it in two ways. The first way, adopted by New York, California, and Maine, is to forbid the issuance of part-paid shares and to make the corporate directors personally liable for violation of this provisioni.^ The sec- ond way, adopted by Delaware, is to permit the issuance of part-paid shares, but to make shareholders liable to the 'Ripley makes this critidsm (Railroads: Finance and Organization, P-94)- 'For instance, the Maine law (L. 1917, ch. 144) reads: "No corpor- ation formed pursuant to section one hundred and fifteen hereof shall begin to carry on business or shall incur any debts until the amount of capital stated in its certificate of incorporation shall have been fully paid in money or in property taken at its actual value. In case the amount of capital stated in its certificate of incorporation shall be in- creased as hereinafter provided, such corporation shall not increase the amount of its indebtedness then existing until it shall have received in money or property the amount of such increase of its stated capital." Il6 RAILROAD CAPITALIZATION [ii6 corporation's creditors for all amounts due on their sub- scriptions/ This second expedient retains the same safe- guards that are present under the old system, with a simple modification to the effect that stockholders are liable for whatever amount they have agreed to pay rather than for an amount equal to the par value of their shares. So far from taking away any protection from creditors, this new measure may even increase the protection. Up to the present time, as every student of corporation finance knows, the laws making shareholders liable for full pay- ment on their stock have proved but a very meager safe- guard to creditors. A part of the difficulty has been due to the unwillingness of courts to hold shareholders responsible for full payment in cases where it was impossible for the issuing company to market its stock at par.^ But where the liability is fixed, not by a par value, but by the amount subscribed for each particular issue, the reasonableness of the liability for any unpaid balance is so clear that a much more rigid enforcement of the law may be expected. 4. That the removal of par value will make it easier for promoters to retain an excessive amount of the stock as a reward for their services. In the past, one of the great evils connected with the promotion of American railroad corporations has been the exorbitant profits that promoters have made by taking an excessive amount of stock in pay- ment for their activities. Of course, the disproportionate interest that the promoter secures lessens by so much the 'The Delaware Law (L. 1917, ch. 113, sec. 10) reads. "... in the case of stock without par value, this liability [for the unpaid balance on subscriptions to stock] shall be limited to the unpaid balance of the consideration for which such stock was issued by the corporation, which said sum or proportion thereof may be recovered as provided for in section 49 of this Chapter ..." 2 Cf. Handley v. Stutz, 139 U. S. 417 (1891). 117] SHARES OF STOCK WITHOUT PAR VALUE 117 value of the holdings of bona Me investors; it exacts a tribute which must be paid either by the other stockholders in the form of lower dividends or by the public in the form of higher transportation rates. It is feared by some that this evil, bad enough under the old order of things, may become even more serious if the par value is removed from the stock. The dollar sign, it is thought, does serve to sortie extent to restrain the promoter from taking an excessive amount of stock. It serves to impress upon the other shareholders the size of the slice which the promoter proposes to cut for himself. " Ten thousand shares " of stock as a reward to the promoter might not sound as ex- orbitant as a " million dollars of stock ". ^ The force of this objection, however, may be seriously doubted. Indeed, it is at least open to argument that the removal of par value will decrease rather than increase the difficulty referred to. As long as par values remain, it is possible for promoters, simply by inflating the nominal capitalization, to conceal the fact that they have cut away a large slice of the stock. Investors are given one hundred dollars or more of stock for every hundred dollars that they contribute; they are quite unaware that they are pay- ing partly for genuine stock and partly for water. Sup- pose, now, that the par values are removed. Is there not some reason to suppose that investors will be more rather than less critical of the disposition of the stock by pro- moters, now that the deceptive nominal valuesi are not pres- ' This point has been called to my attention by a friendly critic, who writes as follows : " The dollar sign does afford some small protection to the ihvestor as against the promoter who allots a disproportionate amount of shares to himself, or to others, for services rendered. It makes comparisons easier. If I pay $100,000 for a thousand shares, the issuing of another thousand in exchange for property worth only $50,000 is a rather more obvious discrimination than if I pay $100,000 for, say, a one-thousandth interest in a company which gives a similar fractional interest for property of whatever value." 1 18 RAILROAD CAPITALIZA TION [ i ig ent? At least, it seems reasonably clear that promoters will not find it easier to withdraw excessive profits when the par value is eliminated than when the par value was retained- 5. That par values are necessary, or at least desirable, as a convenient device for accounting. This view has been expressed by several authorities in accounting. William Morse Cole, for example, objects to the removal of par values on the ground that " it neglects a point most im- portant for the accountant — namely, that some sort of capi- talization is necessary for any scientific bookkeeping.'"' Unfortunately, Cole does not state the grounds for this opinion. Ripley, who takes a similar view, is more specific. After noting other objections to the use of stock without par value, he writes : And what is of great importance for the future under the growing tendency to ascertain the physical valuation of the property, all standards by which to readily measure the reason- ableness of the general scale of charges disappear. Thd scientific accountant must have some absolute basis for his bookkeeping. Without some such starting point the relation between a fair return upon the investment and a surplus arising either from issue of shares at a premium or inordinately high rates becomes difficult to state.^ Ripley's argument seems to be that vnthout par value it is difficult to set up accurate accounts on the liabilities side of the balance sheet and to distinguish clearly between share capital on the one hand and surplus on the other. As a matter of fact, however, is not the situation quite the contrary? The distinction between capital and surplus is ^Accounts, Their Construction and Interpretation, rev. and enl. ed. (Boston, 1915), p. 207. * Railroads: Finance and Organization, p. 94. Iig] SHARES OF STOCK WITHOUT PAR VALUE ng even more clearly and simply shown without the fiction of par values. In that case, the proper accounting procedure is simply this : Stock is credited to the Capital Stock Ac- count, not at its face value, but at the price for which it has actually been sold.^ Where the shares have a par value, a different rule of accounting applies. Here, stock is cred- ited to the Capital Stock Account at par, regardless of the issuing price; any excess or deficit in the actual proceeds is carried to a Premium and Discount Account. Under the former procedure, the total contribution by stockholders is shown in a single account ; under the latter, it can be arrived at only by a process of addition or subtraction. The above points may be made clearer by an example. Suppose that a company has issued one thousand shares of stock at $150 per share and suppose that the company has a surplus from reinvested earnings of $50,000. Now if the stock has a par value of $100 per share, the facts will be shown by the following entries in the accounts : Assets Liabilities Property $2O0,(XX) Capital Stock $100,000 .Stock Premium 50,000 Surplus from Earnings 50,000 $200,000 $200,000 'Although the above accounting procedure seems to have been adopted by most corporations that have issued shares of stock without par value, it has not been universally adopted. For example, the Kennecott Copper Corporation enters its capital stock on the books at a valuation of five dollars per share in spite of the fact that much of its stock was issued at a. price of fifty dollars per share. The reason for this re- tention by the Kennecott Corporation of a nominal value for book- keeping purposes is doubtless to be found in the peculiar provisions of the New York corporation law, discussed below, pp. 121-24. Still another method of accounting has been adopted by the Chicago Elevated Railways, a voluntary association. This company carries its participa- tion shares (preferred and common) on the balance sheet at no valu- ation. It then sets up a single proprietorship account. I20 RAILROAD CAPITALIZAIiON [120 If, on the other hand, the stock is without par value, then the same factsi will be shown oni the balance sheet asi follows : Assets Liabilities Property $200,000 Capital Stock $150,000 Surplus 50,000 $200,000 $200,000 The second statement makes even more clear than the first the distinction ibetween the original investment (Cap- ital Stock) and the surplus. It does this by eliminating the stock premium (or discount) account. The removal of this account, so far from being a loss, is a great gain. Of what possible use is it to enter into a separate account an amount by which the proceeds of stock exceed or fall short of a fixed nominal sum (the par value) ? Moreover, the pres- ence of a stock premium has sometimes led to the payment of unearned dividends, because the premium has been treated like income frolmi earnings, tO' be paid out ini dividends in- stead of being kept intact as part of the corporate capital.^ We conclude, then,_ that accounting has much to gain and little to lose by the removal of a necessarily fictitious par value. 'C/. Mead, Corporation Finance (1915), p. 206. It is true that some authorities have defended the practice of paying out premiums in dividends. Ignatius seems to think that this may be proper. He says : " . . if the reason for the collection of premiums is that of equalizing the interests of the new stockholders with those of the old, should not the additional payment by the new stockholders be carried to the same account which registers the value-over-par interest of the old, to wit, the Corporate .Surplus or Deficit account?" {Financing of Public Service Corporations, p. 75). But the objection to that practice is that shareholders may be deceived as to the actual earnings of the company ; they may fail to see that the proceeds from premiums are an extra- ordinary source of profit and therefore not to be counted upon as a regular annual source of income. Receipts from premiums and receipts from earnings should therefore be kept quite distinct — the former being treated as an increase in capital and the other as income. 12 1 ] SHARES OF STOCK WITHOUT PAR VALUE 121 6. That the removal of par value will open the way to the impairment of capital. One of the evils against which corporation laws have attempted to guard is the impairment of capital by the payment of unearned dividends. Where the amount of capital is presumed to be determined by the par value of the stock, the law forbids the disbursement of this capital in the form of dividends. If, now, the par value is to be removed, it is thought that the distin'c-i tion between capital and divisible surplus may be harder to maintain — that unscrupulous directors may be able to en- croach upon the capital without fear of legal redress. But if the new laws permitting the issue of shares with- out par value are drawn so as to make clear the distinction between capital and surplus, and if they provide a definite penalty against encroachment on capital, there is no reason to anticipate any more difficulty with the new kind of stock than with the old. Indeed, as has already been pointed out, the distinction between capital and surplus is even more easy to maintain when the par value is removed than when it is retained. All proceeds from the sale of stock are to be considered capital ; all reinvested earnings are to be credited to surplus. It must be admitted, however, that some of the present laws permitting the issuance of shares without par value are very defective at just this point. The New York stat- ute, for instance, may be criticized here. According to this law, any corporation, in order to issue common stock with- out par value, must state in its certificate of incorporation the amount of capital with which the corporajtion will carry on business, which amount shall be not less than the amount of the preferred stock (if any) authorized to be issued with a preference as to principal, and in addition thereto a sum equivalent to five dollars or to some multiple of five dollars for every share authorized to be issued, other than 122 RAILROAD CAPITALIZATION [122 preferred stock; but in no event shall the amount of such capital be less than five hundred dollars.^ The law further provides that No such corporation shall declare any dividend which shall reduce the amount of its capital below the amount stated in the certificate as the amount of capital with which the corpora- tion will carry on business.^ Now let us note the implications of these provisions. Instead of defining the capital of the corporation as the entire amount of the proceeds realized by the sale of stock, and instead of requiring that no part of these proceeds may be paid out in dividends, the law simply states a " minimum capital " of five dollars (or some multiple) per share of common stock, which must be on hand before the commencement of business, and which may not be disbursed in dividends. But suppose that a corporation states its minimum capital at five dollars per share in its certificate of incorporation, and then issues its stock at fifty dollars per share.* Does the law regfard that extra forty-five dol- lars per share as capital? And would the law prevent the distribution of those forty-five dollars per share as a cash dividend? Apparently not. If this interpretation of the law is correct, it indicates a very serious defect. For the corporation is then free to treat a large part of the proceeds from the sale of stock either as surplus or as capital, whichever it desires. It is hardly necessary to point out the dangers of such a situa- tion. Creditors who have relied on a fifty-dollar equity 'L. 1912, ch. 351, sec. 19. 'Ibid., sec. 20. •That is precisely the case with the Kennecott Copper Corporation, which carries its common shares at a valuation of five dollars per share although a considerable portion of the stock was issued on the basis of fifty dollars per share. See p. 119, note i, supra. 123] SHARES OF STOCK WITHOUT PAR VALUE 12-^ behind every share of common stock may awaken to the fact that all but five dollars per share has been distributed among stockholders; shareholders may suddenly learn that they have been receiving dividends, not out of income, but out of the very capital that they contributed. So great is the danger from this defective law, that if it could not be removed, it would be enough to condemn the entire plan of issuing shares without par value. But as a matter of fact the trouble can easily be remedied. The defect of the New York law is that it does not go far enotigh in removing par values ; it still retains par value to the extent that it fixes the stated capital at a certain amount per share. It is a compromise between the old principle and the new; and like so many compromises, it is worse than either of the two extremes. Unfortunately, several other states have followed the example of New York in providing that the minimum capital which must not be impaired by dividends is to be a certain fixed sum per share. The laws of Maine and Ohio are in this respect almost identical with that of New York, while California has adopted a similar provision with re- spect to business coi-porations although not with respect to public utilities. In other states, however, a different prin- ciple prevails : the entire proceeds of the sale of stock are counted as constituting the capital. The laws of Pennsyl- vania ^ and Maryland " seem specifically to indicate this ; ' L. 1919, no. 363, sec. 3 : " For the purposes of this act, the " stated -capital' of a corporation issuing shares without nominal or par value shall be the capital with which the corporation will begin business, as stated in the certificate of incorporation or reorganization . . . plus any net additions thereto, or minus any net deductions therefrom: Pro- vided, That ' stated capital ' shall not include any net profits or surplus earnings so long and during such period as the same may be paid out in the form of dividends under the provisions of section eight of this act ... " Ibid., sec. 8: "No corporation having shares without nominal or par 124 RAILROAD CAPITALIZATION [124 while in Delaware, Illinois,^ and Virginia one is left to infer the same in the absence of provisions to the contrary. Limitations of the Measure as a Remedy for the Evils of Stock Watering Although most of the objections urged against the use of shares without par value are unwarranted, many of the claims in its favor are equally unfounded. Frequently it has been advocated as in itself oflfering a cure for the evil of overcapitalization. Business men. have favored it, not as a mere aid to the government in its control over public utility securities, but as an all-sufficient substitute for such control. Judge Lovett, for instance, in a statement before the Railroad Securities Commission, held that the issuance of shares, as shares, without attributing to them a value, which of necessity varies and is more or less mislead- ing, rationally solves all the problems about ' watered ' stock, value, issued under the provisions of this act, shall declare or pay any dividend out of capital or out of anything except net profits or surplus earnings." ' L. 1916, ch. 596, sec. 9 : " For the purpose of any rule of law or of any statutory provision (except as in this section otherwise provided) relating to the amount of such stock issued, the amount of such stock issued shall be taken to be the amount of cash or the value of the ser- vices or property (determined by the board of directors as required by law) for which such stock has been issued." 'The Illinois law, to be sure, requires that a company, in order to carry on business, must have a capital equal to at least five dollars per share of stock of no par value. There seems to be nothing in the law, however, to. indicate that this five dollars is anything but the minimum — nothing, that is, to indicate that if a corporation issued its shares for more than five dollars per share, it would be permitted to pay out in dividends all except five dollars per share. To that extent, I take it, it differs from the New York law, which, by forbidding a corporation to pay any dividends that would reduce the capital below the minimum stated in its certificate of incorporation, would seem by implication to permit the disbursement in dividends of any sums received from the sale of stock in excess of the minimum five dollars. 125] SHARES OP STOCK WITHOUT PAR VALUE 125 and dispenses absolutely with the necessity for any legislation upon that subject.'^ Similar views were expressed by the Committee of the New York Bar Association.* Even Commissioner Erickson of Wisconsin seemed to think that this position might possibly be tenable.^ Other writers, however, have strongly denied this con- tention. Kuhn, who refers to the use of shares without face value in the i6th to i8th centuries, says: Historical experience teaches that the aliquot shares attained values as fictitious as those often found at the present time, producing all of the evils attending overcapitalization.* He therefore concludes that abolition of par value will accomplish no good and will do away with a convenient mathematical device. Ignatius, while not denying that the removal of par values may be useful in the case of private business corporations, warns against expecting too much from it. He says : Removing the par value is not enough; standing by itself that change does not interpose any obstacle to the practices which have been the means of working overcapitalization heretofore. Take, for instance, the device of issuing shares in exchange for property or service accepted at an overvalua- tion ; if the shares have a par value, the acceptor of the shares may reap a profit by reselling to those who will assume that the actual price paid for them upon issue equaled that paid for other shares of the same issue. If on the other hand the shares have no par value, the acceptor of the shares in exchange for property or services has precisely the same opportunity for ^Statement before the Railroad Securities Commission, op. cit., p. 17. * Proceedings, vol. xv (1892), p. 138. 'Regulation of Public Utilities: Three Discussions, p. 62. *A Comparative Study of the Law of Corporations, p. 115. 126 RAILROAD CAPITALIZATION [126 profit by reselling to those who will likewise assume that those shares had been issued for consideration equaling that paid for other shares of that issue, since all shares of the one is- sue are required to be offered for sale upon like consideration.* It is not necessary to accept Kuhn's view of the useless- ness of the proposal, or to admit Ignatius's doubt as to its advisability under commission regulation of securities, to see a large measure of truth in these remarks. After all, the abandonment of par value merely gets rid of one of the deceptive figures in corporation accounting. It does not substitute the correct data. A share, it indicates, is simply a fraction of a given total investment. But how large is this total investment? That remains to be shown. Noth- ing less than government supervision can insure a correct statement of the actual investment. It cannot be too strongly emphasized that the use of shares without par value will not of itself remove the danger of stock inflation. This point has been already discussed in an earlier chapter.^ How is it possible, one asks, to inflate shares without par value, when each share is now supposed to represent, not a definite amount of investment, but merely a certain fractional interest in the total property? The answer is that shares, even shares of no par value, will not be regarded by inves- tors as representing mere fractional claims. People do not think in those terms. They think of a share as representing an amount not a fraction. That amount is determined m their minds largely by the market quotations and by the established dividend. If, then, the number of shares is doubled without any increase in earning power, — say, by the issue of a stock dividend of cme hundred per cent, — in- vestors will probably fail to see that each share now repre- •^ Financing of Public Service Corporations (1918), pp. 81-82. 2 P. 57, supra. 127] SHARES OF STOCK WITHOUT PAR VALUE 127 sents an earning power of only half its former amount. The market values of the new shares will therefore be in- flated. By taking advantage of this failure of investors to discount the increase, unscrupulous financiers will be able to profit in the future, as they have profited in the past, by issuing shares in excessive amounts. We conclude, then, that only when accompanied by more positive forms of regulation does the device of shares without par value promise much relief from the evils of overcapitalization. Its role is the modest though significant one of removing a fictitious statement in order to leave a clean sheet for the correct information. The more am- bitious part claimed for it of solving in itself the problem of stock watering, it is wholly unfitted to play. Proper Scope of Application — Should it include Preferred Stock? If we accept the general principle of the proposal to issue shares without nominal value, two questions arise as to the proper extent of its application in railroad law. First, should it apply to preferred stocks as well as to common? Second, should it be compulsory or simply optional ? On the first point the present laws differ. Delaware, Ohio, and Virginia exclude all preferred stock from the provisions of their acts ; New York and Maine exclude pre- ferred stock with a preference as to principal; Maryland excludes stock preferred as to dividends and subject to re- demption as well as stock preferred as to principal. Illi- nois, Pennsylvania and New Hampshire, on the other hand, make no restrictions as to the class of stock which may be issued without par value. California, in its law applying to industrial companies, follows the New York precedent by excluding stock preferred as to principal, but in the similar statute applying to public utilities, it provides that a com- J 28 RAILROAD CAPITALIZATION [128 pany not only may but mttst issue all classes of stock with- out par value provided it issues any class without par. At least two reasons may be given for retaining the par value on preferred shares, even when it is removed from the common. First, this distinction between the two classes of stocks conforms to a custom, not infrequently observed in corporation finance, of issuing bonds and preferred stock in amounts equal to the value of the tangible assets, and of issuing the common stock as a capitalization of intangible assets, such as " good-will " or " franchise value ". By requiring this additional stock to be issued without nominal value, the law attempts to compromise between the exi- gencies that may be thought to require stock watering and the traditional principles that demand an equality between par value and assets. Second, the distinction is defended on the assumption' that, when stocks are preferred not cmly as to dividend but also as to assets in the event of disso- lution, the par value is necessary in order to define the amount of this prior claim. The first point rests on a principle of capitalization that is neither practicable nor desirable. It is not practicable because the difficulties, already noted, of securing an equal- ity between par values and assets would remain the same even though common stock were not to be counted as a part of the total capitalization. It is not desirable because the issue of bonds and preferred stock up to the amount of the actual investment would often exceed the limits of safety for these classes of securities. The second argument has some force but is by no means a determining consideration. Even without the device of par values, stipulation can be made as to the claim of pre- ferred shares in the event of dissolution. To be sure, the presence of a par value gives more publicity to the amount of the claim ; but that point is of no great importance. 129] SHARES OF STOCK WITHOUT PAR VALUE 129 Although the positive objections to the removal of the par value from preferred stocks are not convincing, one must concede that the reasons, in its favor have less force than with commoni stocks. For with the former class of security, the fixed rate of dividends prevents the nomiinal value from influencing appreciably the market valuation. If the dividend charges are kept within safe limits, in- vestors are not liable to be misled seriously by fictitious par values. The great danger of deception is in connection with the common stock. On the whole, however, it is prob- ably wiser to go the whole length by removing the par value from all classes of stock. Should it be made Compulsory? As proposed by the Railroad Securities Commission, and as provided in all the present state laws, the issuance of no-par shares is made entirely optional with the companies. Should this continue to be the case with respect to the fed- eral railroads, or should the change be made compulsory for all of them ? The defense of a purely optional law is that the right to issue shares of no par value is offered as a means of avoid- ing the necessity of issuing stock below par. Corporations may be given their choice of two practices : They may either issue no-par stock at such prices as the market justifies, or else they may retain the par value, but subject to the strict requirement that all such stock must be issued at not less than par. If they choose the latter plan, they may then be held to rigid accountability for observing the statutory re- quirements as to the issuance price of the stock. But while an optional provision may be conceded to be better than no provision at all, there can be little doubt that a compulsory measure will be much more satisfactory. The advantage to be gained by the more thoroughgoing measure I^o RAILROAD CAPITALIZATION [130 is the advantage of uniformity. If some railroad companies are permitted to issue no-par stock, while other companies retain the old form of shares, confusion will result. The success of the new system depends on the degree to which investors are educated to an appreciation of the fact that their shares represent, not a fixed amount of investment, but simply a right to a certain portion of the corporate in- come. This educational process will go on. much faster if the removal of the par value is made general for all rail- road corporations. Needless to say, it would go on still faster if it could be made universal for all corporations of every character. The latter goal, however, is not apt to be reached under the divergent laws of many states — not at least for many years. But the general adoption of the plan by all interstate railways may be secured under a law re- quiring federal incorporation. Summary The proposal to remove the par values from issues of stock is a recognition of the hopelessness of the attempt to maintain an equality between nominal capitalization and actual investment. Several objections have been urged against the plan, but they are based, for the most part, on a mistaken or exaggerated notion of the usefulness of par values. On the other hand, the proponents of this plan have often claimed for it too much. They have asserted that its adop- tion would make all further measures of protection against stock manipulation unnecessary. This view cannot be sus- tained. The abolition of par value simply removes one source of misinformation. It does not remove all sources; still less does it provide the necessary valuation that must take the place of the nominal capitalization. These objects can be secured only by positive measures of financial control. 13 1 ] SHARES OF STOCK WITHOUT PAR VALUE 131 Nevertheless, the removal of par values is good as far as it goes. As applied to the railroads, the measure should be thoroughgoing; it should be compulsory rather than op- tional, and it should apply to stocks of all classes, common and preferred. CHAPTER V Federal Regulation of Railroad Securities In the preceding chapter, much emphasis was laid on the fact that the use of shares of stock without par value is not alone sufficient to meet the evils of overcapitalization, and that, in addition, there must be an effective control of security issues by the governm'ent. It remains, then, to coinsider in this final chapter some of the problems of government con- trol. Fortunately, one question that heretofore has occasioned much controversy has recently been settled : the question of state versus federal jurisdiction. Under the Transportation Act of 1920, the security issues of interstate carriers are brought under the exclusive control of the Interstate Com- merce Commission. State commissions are deprived of all authority, except for their right to a hearing before the In- terstate Commerce Commission in cases involving the inter- ests of the states that they represent. So generally recog- nized is the wisdom of this change of jurisdiction, involving the centralization of power in the hands of one body, that we need take no time to recount the obvious advantages to be obtained. Provisions of the Transportation Act With Respect to Control of Security Issues Ri^^lation of security issues is provided for in section 439 of the new Transportation Act (section 20a of the amended Interstate Commerce Act). In its general char- 132 [132 1^3] FEDERAL REGULATION OF SECURITIES 133 aoter, the measure is similar to those which have been in force for several years in the various states/ No carrier may issue securities without first making application to the commission and securing its consent. Exception is made of " notes to be issued by the carrier maturing not inbre than two years after the date thereof and aggregating (together with all other then outstanding notes of a maturity of two years or less) not more than 5 per centum of the par value of the securities of the carrier then; outstanding."^ But the federal law gives the commission wider discretion in approving or disapproving an issue than do the laws of most states. With a few exceptions, the newer state laws enumerate certain definite purposes for which securities may properly be issued;* the duties of the regulating cotnlmis- sions are imore or less restrioted to seeing that the proposed is^es fall within the specified purposes.* On the other hand, the federal statute makes no specification of pur- poses. It provides simply that the Interstate Commerce Commission shall approve a security issue when^ it finds that the isstie (a) is for some lawful object within its corporate purposes, and compatible with the public interest, which is necessary or appropriate for or consistent with the proper performance ' The most complete analysis of the dififerent state laws is by Barron : "State Regulation of the Securities of ^Railroads and Public Service Companies," Annals, Amer. Acad. Polit. and Soc. Science, vol. Ixxvi (March, 1918), pp. 167-go. 2 Interstate Commerce Act, sec. 20a (9) . s New York and other states enumerate five purposes : see pp. 78-80, supra. ■•But on this point commissions differ greatly in their interpretation of their powers; some, like the Wisconsin commission, interpret their powers very narrowly, while others, like the two New York com- missions, assume a wide discretion. Cf. Ignatius, Financing of Public Service Corporations, pp. 290-94. 134 RAILROAD CAPITALIZATION [134 by the carrier of service to the public as a common carrier, and which will not impair its ability to perform that service, and (b) is reasonably necessary and appropriate for such purpose. Another clause goes even further in conferring discre- tionary powers by authorizing the comlmission to prescribe the terms of an issue: The Commission shall have power by its order to grant or deny the application as made, or to grant it in part and deny it in part, or to grant it with such modifications and upon such terms and conditions as the Commission may deem necessary or appropriate in the premises, and may from time to time, for good cause shown, make such supplemental orders in the premises as it may deem necessary or appropriate, and may by any such supplemental order modify the provisions of any previous order as to the particular purposes, uses, and extent to which, or the conditions under which, any securities so theretofore authorized or the proceeds thereof may be ap- plied, subject always to the requirements of the foregoing paragraph. Nothing is said in the act as to the prices at which se- curities may be issued. There is no prohibition of the sale of stock below par or even of the issuance of a scrip or stock dividend. In only one case is a definite statutory limit placed upon the amount of securities that may be issued; namely, in consolidations. Here the law reads that " the bonds at par of the corporation which is to become the owner of the consolidated proper'ties;, together with the outstanding capital stock at par of such corporation', shall, not exceed the value of the consolidated properties as de- termined by the Commissdoni." ^ No similar provision is 'Transportation Act, 1920, sec. 407, Interstate Commerce Act, sec. 5(6) (b). 135] FEDERAL REGULATION OF SECURITIES made with respect to reorganizations, although such pro- visions are now commonly included in the state laws. It is evident from the foregoing notes on the Transporta- tion Act that Congress wished to place upon the Interstate Commerce Commission the burden of determining the prin- ciples of capitalization to which all railroads must hence- forth conform. This is a heavy task. Fortunately, how- ever, it is a task that has already been faced by the regulat- ing commissions of more than twenty states; and their pioneer experience will serve to guide the action of the federal authorities. Space does not permit of a discussion of all the prin- ciples that have been developed by state commissions in their control over security issues. Indeed, such a discussion has really been made unnecessary by the able situdies of Barron, Bullock, Heilman, Ignatius, Ripley, and others.^ The re- mainder of this chapter, therefore, will be confined to a study of three problems that seeim) particularly to warrant further consideration. The first topic is the control of the issuance price of shares of stock without par value; the second is the limitation of bonds and other evidences of indebtedness ; the third is the treatment of security issues already outstand- ing. (i) Control of the Issuance Price of Shares of Stock Without Par Value Up to the present time, one of the chief objects of security regulation has been to prevent the pracltice of stock watering — that is, to prevent the issuance of shares for less than their full par value. Now, however, it is proposed to issue stock which has no par value. This raises a new problem. What is now to determine the prices at which shares may be is- •See the references to these authors in the Bibliography at the end of this work. 136 RAILROAD CAPITALIZATION [136 sued? And should the government set a price limit, or should it leave this entirely to the discretion of the issuing company? To these questions, many of the advocates of shares without par value would have a ready reply. They would insist that the removal of par values makes unnecessairy any governmental control of the issuance price. This conclu- sion, they would say, follows from the very nature of the new kind of shares. Each share represents, not a fixed amount, but a fractional interest in the whole property. Hence, the determination of the number of shares to be issued, and of the issuance price, becomes merely a question of dividing (the shares, into such sizes as are most con- venient to the investors. In this problem the goverrument has no direct concern — no more than it has in the question whether or not a railway company should issue bonds in orue- hundred-dollar denominations or simply in thousand- dollar denominations. In fact, the two problems are pre- cisely the same in principle. A similar line oi reasoning. would apply to the question of the propriety of a stock dividend. With par value removed, a stock dividend is supposed to mean nothing but the divi- sion of shares into smaller, more convenient claims. It does not necessarily indicate an increase in the value of the property, and therefore it need not be made contingent on such an increase. Already, however, we have seen the weakness of this argu- ment.^ It assunnes that the removal of par values will cause stockholders to think of their shares as representing nothing but fractional i'niterests in the total earnings and assets of the company. But this assumption is not justified. Investors will continue to think of their shares as worth a certain relatively fixed amwunt, an amount determined in their 1 Pp. 126-27, supra. 137] FEDERAL REGULATION OF SECURITIES 137 minds by the price that they paid for their holdings, by the dividend record, and by the recent market quotations. Under these circumstances, if the number of shares is in- creased without a corresponding increase in earning power, the investors will be influenced by their current notions as to the value of each share, and they will therefore not fully discount the reduction in the equity behind each share that is occasioned by the new issue. The result will be in- flation of market values, a result which, as we saw in an earlier chapter, is responsible for most of the harm done by stock watering.^ The danger to which we have referred, however, applies only to increases of stock issue and not to original issues made at the inception of an enterprise. In the latter case there is no established market value by which investors may be deluded. Here, then, it will be safe for the government to allow the corporation to set its own issuance price, sub- ject, however, to the very important condition that stock must be offered on equal terms to everyone.^ But with subsequent issues of stock a different rule should prevail. The government should require that the shares be sold at their full market value, or not far below it. The object of this requirement is to prevent the increase in the number of shares from being disproportionate to the increase in the earning capacity of the property. In this way the danger of inflation to which we have referred will be removed. This rule, that shares of stock of public service corpora- tions must be sold at their market value, has been applied iQiap. ii, pp. SO-S7- 'This proviso is especially necessary with respect to payment of stock to promoters. The government must set a value upon the pro- moter's service and must see that the amount of stock going to the promoter does not exceed his just claims for services rendered. 128 RAILROAD CAPITALIZATION [138 by some governmaits even where the shares are given a par value. In England the principle has been widely ac- cepted for local public utility companies, sale at auction being a customary requirement. According to trustwor- thy reports, the British experience has proved highly suc- cessful.^ In America, a similar policy has been followed by Massachusetts.^ Here, however, the plan has met with some difficulties. During a period of falling security prices it has been impossible to obtain a ready market for shares of stock when ofifered at public auction or when offered to stockholders at the prevaiHng market prices of the old shares. On that account, the Massachusetts law was modified in 1908 so as to permit railway companies to issue shares at a price to be determined by the stockholders but subject toi approval by the Railroad Commission, which must see that the price is not " so low as to be inconsistent ■Robert H. Whitten, Regulation of Public Service Companies in Great Britain (New York, 1914), ch. iii. In England the requirement that all shares of stock be sold at public auction is an integral part of the method of rate control to which local public utilities are subject. The British method, unlike the usual American method, is to base the rate of return directly on the securities rather than on the valuation of the entire property. Thus, a company may be allowed to charge rates sufficient to pay a ten-per-cent dividend on its outstanding stock. But in order to give the public the benefit of the very lowest possible rate of return on the invested capital, companies are required to sell their stocks (except the original issues) at the full market price. In this way, if a share of stock paying ten-per-cent dividends would sell for 200, the public would enjoy the use of capital at the rate of only five per cent. There is much to be said for this plan of rate regulation. Its adoption for our own railways ha« been advocated in a number of able articles by John Bauer ; see, especially, " The Control of Return on Public Utility Investments," Political Science Quarterly, vol. xxxi (1916), pp. 260-88. See also Whitten, op., cit., ch. xiv. ' See Ripley, Railroads: Finance and Organisation, pp. 297-301 ; Charles J. Bullock, "Control of the Capitalization of Public Service Corporations in Massachusetts," American Economic Association Pub- lications, series no. 3, vol. x (igog), pp. 384-414. 139] FEDERAL REGULATION OF SECURITIES 139 with the public interest." The commission has interpreted the above-quoted clause as requiring an issuance price " not materially lower than a price which would assure a ready market for the issue." In view ai the Massachusetts experience, it may be found advisable for the federal government to adopt a similar compromise measure permitting the issue of stock at a few points below the prevailing market prices of the old shares. Such a concession, while not ideal, would cer- tainly create no serious danger of inflation. If it seems wise to fix the issuance price of stock at not far below its market value, what shall we say of stock dividends? Of course, to permit stock dividends is just the reverse of requiring the sale of stock at its market value. Yet one cannot deny that a stock dividend may sometimes have a legitimate object. This object is to divide the stock into smaller shares when the value of each old share has become inconveniently large. Not only the stockholders but also the public may derive benefit from such a division ; for the divided shares can be issued at higher relative prices, and consequently the cost of raising capital can be reduced. Where a case of this kind arises, permission to issue the stock dividend should probably be granted. The danger, of course, is that the increased nuimber of shares will cause an inflation in values. But this danger can^ probably be minimized, although perhaps not entirely removed, by giv- ing full publicity to the fact that the new stock does not represent any increase in actual capital. (2) Restriction of Indebtedness Several times in the course of this study the fact has been emphasized that overindebtedness is a menace to corporate credit of far more serious character than is an overissue of common stock. With respect to railways today, that re- I40 RAILROAD CAPITALIZATION [140 mark is especially in point. The increasing tendency of railway companies to finance their capital requirements by the sale of bonds or notes rather than by the issuance of stock has occasioned alarm among all persons familiar with the problem. To reimiedy this dangerous situation by bringing about a safer balance should be one of Ithe chief aims of government control. How, then, is this end to be attained? The first pre- requisite is a more liberal policy of rate regulation. As a lesult of the higher operating costs, railroads, within recent years, have suffered so severe a fall iti their net earnings that they have been unable to market their stocks; they have been forced to resort almost entirely to bond issues or to note issues. But the allowance of increased rates, necessary as it is for the purpose in question, is not enough. It will help to give railways the power to keep their debts within safe limits, but it may not give them the will to do so. Adversity, in the past, has not been the only cause of over- indebtedness ; prosperity also has led to much the same result with certain railways. Some of the most reckless and fatal cases of overbonding have occurred during a period of prosperity, when speculative managements have capital- ized the high earnings by inflating the funded debt as well as by watering the stock. In this way the controlling in- terests have been able to profit by trading on a narrower equity.^ Two examples in recent railway history are 1 Our American system of rate making has the unfortunate ten- dency to encourage this " trading on a narrow equity ; " for it allows a given rate of return on the entire " fair value " of the property irre- spective of the nature of the outstanding securities. For example, if the rate of return on the property value is fixed by the government at eight per cent, it will be to the interest of the stockholders to raise the largest possible amount of capital by the issuance of bonds bearing a rate of interest lower than eight per cent. The stockholders wilt gain the difference between the rate of interest on the bonds and the 141 ] FEDERAL REGULATION OF SECURITIES 141 Rock Island and Alton. In both of these instances the funded debt was increased, not to secure necessary funds for improvements, but simply to enrich the controlling stock- holders.^ These lessons' of experience should not be for- gotten; They prove conclusively that a mere return of " good times " will not guarantee a return of good credit ; there must be safeguards against the abuse of prosperity. These safeguards must be secured by regulation. Two very different problems are involved in the reg- ulation of bond and note issues by the govemmenit. The one concerns the control of proposed new issues; the other concerns the treatment of issues already outstanding. In the present section we shall discuss simply the first question, leaving the matter of existing capitalization for later study. In deciding upon a proper method of control, the federal government will naturally turn for precedents to the various states. A canvass of the states on this point discloses two divergent policies: The one policy is to set a definite statutory limit to the amount of debt that a railway company may incur ; the other policy is to give to the regulating com- mission authority to fix such a limit as may be deemed ap- propriate in each individual case. Most of the states that adopt the first policy set the limit at a certain ratio of bonds to stock, the proportion' of bonds varying from two-thirds of the capital stock, as in Iowa, Nebraska, and Utah, to twice the stock, as in Delaware, Massachusetts, and Pennsylvania.^ In imlany states the limit is fixed at equal portions of stocks and bonds, or of stocks) and total indebtedness. eight-per-cent return on the property. This defect of our system of rate regulation is not present in the English system, noted above (p. 138, note l), by which the rate of return is fixed directly on the securities rather than on the valuation of the property as a ■whole. 1 iSee pp. SS-S6, supra. ' For the different state laws see Barron, op. cit., pp. 176-78. 142 RAILROAD CAPITALIZATION [142 Among those states that do not fix a statutory limit, different practices prevail. The laws of several states grant to the regulating commissions specific authority to limit the proportion of bond issues. The statutes of Wisconsin and Indiana direct the commissions to fix a " reasonable pro- portion " of bonds to stocks, while the California law gives the Railroad Commission authority to permit bond issues equal to, in excess of, or below the amount of capital stock. Ill other states the laws make no reference to the restriction of indebtedness, but, nevertheless, the commissions of some of these states have interpreted their general authority to approve or disapprove security issues as giving them the power to restrict the ratio of bonds to stock. ^ Those commissions that assume discretionary authority have generally adopted the principle that bond issues should not be permitted to exceed such limits as will give reason- able assurance that interest and discount can be met out of current earnings.^ Sometimes, in order to have some defi- nite standard, commissions have fixed a proportion of bonds to stock, or of total debt to value of the property, which should ordinarily set the limit to the amount O'f borrowing.* ■ Such was formerly the position of the two public service com- missions of New York State; but several recent court decisions have thrown doubt on their authority to limit bond issues, provided that these issues are for lawful purposes : See Re Dry Dock, East B'way and Battery R. R. Co., 7 P- S. C. R. (ist Dist. N. Y.) 59 (1916), and Re Hudson River & Eastern Traction Co., 3 P. S. C. R, (and Dist. N. Y.) 172 (1911). On the other hand, the New Jersey commission, under a law similar to that of New York, has been upheld by the court in its assumption of control over the relative amounts of bonds and stocks: 3 Ann. Rep. N. J. P. U. C. 16 (1912) and 4 ibid., 3 (1913). ' See, for instance, N. J. P. U. C, Conference Order No. 7 and Conference Ruling No. 13, and Cal. R. C Rep., year ending June 30, 1913, PP- I74-7S- 'The California commission has fixed 80% of the property value as the usual Hmit {op. cit., p. 175) ; the Indiana commission will not 143] FEDERAL REGULATION OF SECURITIES 143 But such rules are not rigidly followed ; they are generally waived when a cSSmpany is otherwise unable to raise neces- sary funds. Of the two above-mentioned policiesi prevailing in dif- ferent states which should be adopted by the federal govern- ment — the one which provides a definite statutory limit, or the one which gives full discretion to the regulating com- mission? Or is some compromise measure desirable? The present Transporation Act, to be sure, seems to accept the principle of giving discretionary powers to the Inter- sltate Commerce Commission. But this act is only an ex- periment ; if a change is desirable, it can be made. Each of the two policies has its own merits, and also its own shortcomings. A statutory limit has the distinct advantage of setting something definite on which a rail- way management may base its financial plans and on which a commission may form its decisions. The benefit of a definite guide of this kind is not to be appraised too lightly. Railway managements know what to count on ; they are able to make their financial arrangements with definite knowledge of the amounts which they must raise by the sale of stock or by the reinvestment of earnings. In other words, they do not need to speculate on the uncertain outcome of ai commission ruling, and, therefore, they are not tempted to gamble upon the prospects of a lenient decision forced from the commission under the plea of dire necessity. Not only the company but also the regulating commis- siion is in a stronger position when it is acting under a defi- nite statutory rule. In the absence of such a rule, its position at law is somewhat precarious. Even where the law follows the example of Wisconsin and Indiana by allow the bonds to exceed the total investment, except possibly in emergency (P. U. R. 1918 E 311); the Maine commission sets the ratio of bonds to stock at two to one (P. U. R. 1917 B 898). 14^ RAILROAD CAPITALIZATION [144 granting specific power to the public service commission to fix a " reasonable proportion " of bonds to stocks, it is un- certain to what extent the courts will uphold the commis- sion in the use of its discretion. In their solicitude for the freedom of action of the private owners and in their caution against the delegation of legislative powers, the courts may possibly put serious limits on the authority of a commission to restrict bond isssues. May they not hold that any in- crease in bonds must be permitted unless it is clearly and convincingly imreasonable? For example, would they up- hold a commission if it should adopt the conservative policy of limiting bonded debt to half the value of the property? It is doubtful. On the other hand, the principle of statutory limit has also its serious defects. Its very merit of definiteness is also its weakness. For it fails to take account of the peculiar circumistances that make each case properly a matter for separate consideration. For example, it makes no provision for emergency cases where companies lack the credit to sell stock and where they must issue more bonds or notes in order to raise necessary capital. Special treat- ment may be called for in such cases. If the federal govemiment were faced with the simple dilemma of choosing between a rigid statutory rule and the grant of full discretion to the Interstate Commerce Com- mission, it would probably do wisely to accept the second alternative. But is it necessary to adopt either extreme? Is there no compromise measure that will combine most of the merits of a rigid debt limit with the advantages of a flexible system? Probably there is. What is needed is a normal debt limit, to be set by statute, but subject to modifi- cation in cases of necessity. Such a measure would be analogous to the provisions of our present national bank- ing law, which fixes a minimum ratio of cash reserves to I4S] FEDERAL REGULATION OF SECURITIES 145 deposits, but which gives to the Federal Reserve Board the power to waive the reserve requirements in cases of emergency. Without attempting to formulate the details of this com- promise measure, let us consider the general features of such a plan. First, there must be a normal debt limit. We have already noted that many of the states set this limit at a certain ratio of stocks to bonds. But a more un- satisfactory standard could hardly be suggested. No pru- dent investor with the slightest knowledge of corporation finance would accept the ratio of outstanding bonds to stock as even a rough measure of the solvency of a corpora- tion. Any number of circumstances may destroy the significance of such a measure : The stock may be watered, on the one hand, or may have been issued at a premium, on the other; the bonds may bear a high or a low rate of in- terest; the cottiipany may have heavy fixed charges not represented by the outstaniding bond issues, such as interest on floating debt, rentals of equipment or of track, amortiza- tion charges ; the net earnings may be unusually low, or un- usually high, as compared with the investment. Some other test, then, should be substituted for the above-mentioned one in fixing a proper debt limit. Prob- ably the most satisfactory one is the proportion of fixed charges to net earnings. For example, the law might pro- vide that railroads must not incur any debt, or assume any other obligations, which would raise their total fixed charges to more than a certain percentage of the average net earn- ings during the preceding five-year period. Such a standard would be far superior to the current one based on the ratio of bonds to. stocks. While by no means perfect, it would at least afiford a rough test of safety and that is all that can be expected of any hard and fast rule.^ 'Possibly a better limit tlian the above would be a certain ratio of 146 RAILROAD CAPITALIZATION [146 So much, then, for the statutory limit. But that limit should be subject to relaxation in cjises of necessity. Just as the Federal Reserve Board may waive the reserve re- quirements of the federal reserve banks or of the member banks, so should the Interstate Commerce Commission have the power to make special concessions to railway companies with respect to their debt limits. Whether or not the law should attach certain penalties, conditions, and restrictions to the grant of such concessions, or whether that matter should be left entirely to the judgment and discretion of the Interstate Commerce Commission, is a problem of detail that need not be discussed here. (^) Scaling Down of Existing Capitalization Governmental regulation of railway finance labors under the very serious handicap that it has begun late in the game. It has come only after years of financial abuse ; it takes ef- fect when many railways are seriously overcapitalized and when the majority of railways are overindebted. Until this situation is remedied, until the weaker roads are com- pelled to readjust their outstanding obligations so as to make their capital charges commensurate with their earn- ings, it will avail little to attempt to regulate future security issues. One cannot build solidly except on a solid base. What, then, is to be done at this late hour ? Should there be a drastic and immediate scaling down of excessive capi- talization, or should the readjustment be moderate and gradual ? In either case, how is the end to be attained ? Fortunately, one of the problems that have hithertoi caused much difficulty in financial reorganizations need give but little concern in the present instance; namely, the total expenses (operating expenses, taxes, and fixed charges) to gross earnings. Cf. Lawrence Chamberlain, The Principles of Bond In- vestment, 3d ed. (New York, 1913), pp. 276-78. 147] FEDERAL REGULATION OF SECURITIES 147 problem of reducing the total capitalization of a company so as to make it correspond to the assets. That difficulty is disposed of by the conversion of all outstanding shares of stock into shares without par value. The removal of the par values will minimize the necessity of any reduction in the number of shares held by present stockholders. But a far more difficult and important problem remains in the necessity of cutting down the fixed charges of over- indebted railway companies. For it cannot be too fre- quently emphasized that overindebtedness, rather than over- capitalization in the ordinary sense of the term, is the in- cubus on American railways today. If constitutional difficulties were not in the wa:y, a strong case could be made for a federal statute requiring all over- indebted companies to reorganize at once on a sound financial basis. Such a law would seem harsh to existing investors ; yet it might be justified in the public interest. And even the investors might ultimately gain rather than lose, as they would be required merely to exchange bonds and notes for stock without yielding their right to whatever earnings the valuation of the property may entitle them to receive. But we hardly need argue the merits and demerits of such a law ; for it would almost certainly be held unconstitutional. There is, to be sure, a possibility that a reorganization of the kind mentioned might be upheld in court if it were made an incidental feature of an act requiring the consolidation of all interstate carriers into a few large companies under federal charter. But even that procedure would be of doubtful constitutionality. These same constitutional difficulties have been met by the various state commissions in their attempts to regulate public utility securities. With two or three exceptions, therefore, the state commissions have not attempted to scale down capitalization already outstanding but have con- 148 RAILROAD CAPITALIZATION [148 fined themselves to the supervision of new security issues.^ Gradually, it is hoped, this moderate policy will bring the companies to a healthy financial condition — in some cases through the reinvestment of earnings or the increment of property values, in other cases through bankruptcy, receiver- ship, and reorganization. Whatever one may think of the ultimate possibilities of this Fabian method, one must admit that it is woefully slow. As to a gradual readjustment through the invest- ment of earnings, that is the very thing that a financially weak company cannot do. It has no' surplus to invest. Only strong companies, like the Pennsylvania Railroad, can be counted on to turn back large earnings into their property. As to bankruptcy and reorganization, that may be deferred indefinitely. By skimping imaintenance charges and by making no extensions and improvements, an overbonded company may keep up a miserable existence for years with- out becoiming formally bankrupt. Meanwhile, of course, the public suffers from poor service. Not all states, however, have been content to leave exist- ing security issues alone. Massachusetts and Texas are notable exceptions. These states have adopted the policy of refusing to sanction new security issues whenever the proposed issue would bring the total capitalization out of proportion to the property values. Under this rule, an overcapitalized company is compelled to scale down its out- standing securities before it may make any further issues. In the execution of this general policy, the methods of Massachusetts and of Texas differ materially. The prac- tice of Massachusetts is determined by precedents set by ^ See Heilman, " The Development by Comimssions of the Prin- ciples of Public Utility Capitalization," Journal of Political Economy, vol. xxiii (1915), pp. 888-92; Ignatius, Financing of Public Service Corporations, pp. 294-96. 149] FEDERAL REGULATION OF SECURITIES 149 the regulating commissions ; that of Texas is determined by statute. Consequently, the rule has been applied less rigidly in the former state than in the latter. With what success have these efforts met? Are the re- sults sufficiently satisfactory to warrant imitation by the federal government ? Judging from the experience of Mas- sachusetts, one might conclude that the experiment is suc- cessful, at least with respect to gas and electric companies. For Massachusetts is probably the only state in which the local imblic utilities are, for the most part, conservatively capitalized. Yet Massachusetts really furnishes no ade- quate test. In that state, regulation began before oVercapiital- ization had become prevalent. Therefore, the problem of scaling down existing security issues has not been a seriousi one. The case of Texas, however, is quite different. When Texas first undertook the regulation of railroad securities, overcapitalization had already been carrifed to absurd extremes. The famous Stock and Bond law of 1893 was a, belated attempt to cure the evil. According to that law, railroad companies are forbidden toi issue bonds in excess of the " reasonable value " of their property as determined by the Railroad Commission, except that in emergenciesi railroads may be allowed to issue stocks and bonds which, together, will not exceed the property value by more than fifty per cent. Most writers agree that the results of this law of 1893 have not been satisfactory.^ To be sure, the statute has led to a material reduction in capitalization; but it has also* acted as a serious check to the raising of new capital. 1 For discussions of security regulation in Texas see Ripley, i?o»7- roads: Finance and Organisation, pp. 301-6, and articles listedi in die Bibliography, infra, under the names, R. C. IHiff, Lewis H. Haney, E. T. Miller, Charles iS. Potts, Railway and Engineering Review, Edward P. Ripley, and R. A. Thompson. I50 RAILROAD CAPITALIZATION [150 Rather than submit to a reduction of their outstanding se- curity issues, railway companies have simply avoided making new issues. Recognition of the unfortunate tendency cA the Stock and Bond law to check investment has caused the Texas legislature to modify the provisions considerably. It is now provided that a railway may issue new securities for extensions and for doublentracking, regardless of the amount of capitalization already outstanding. No doubt these modifications have helped to remove the check to the rais- ing of new capital, but they have done so simply by a sur- render of the very principle on which the original act was based. "^ It must be admitted, then, that the experience of Texas in its attempt to scale down redundant security issues is not such as to invite imitation by the federal government. But are we to conclude that the task of readjusting existing capital burdens is hopeless, and that the wiser course is to follow the precedent set by the other states in taking account only of future security issues ? This conclusion does not follow. The fatal defect of the Texas plan is that it applies the pres- sure in the wrong place. The only punishment meted out to companies for failure to scale down excessive capitaliza- tion is refusal to permit them to issue further securities. But this is a punishment that hurts the public more than the company. What is needed is some form of governmental action that will induce financially weak companies to reor- ganize, but which will not give them the alternative of re- maining unregenerate simply by declining to apply for permission: to issue new securites. How is this end to be accomplished ? The means to this end are to be found in a wise exercise of the powers of government over railway rates and railway ''■ See pp. 92-93, supra. I5i] FEDERAL REGULATION OF SECURITIES 151 service. These powers may be exercised in such a way as to compel or induce cxverbonded, miscapitalized companies to submit to reorganization. Compulsion may be used by a policy of severity toward the companies that fail to re- organize; persuasion, by a policy of liberality toward those companies that make the necessary capital readjustments. There are numerous measures by which this policy of discrimination can be enforced. Rate control furnishes one possibility. It is a well recognized fact that the govern- ment enjoys a considerable latitude in its power to fix rates. The courts, to be sure, will protect a railway in its right to a " reasonable return on the fair value of the prop- erty." But the rate of return that the courts uphold as " reasonable " is the minimum rate — a rate usually consider- ably below that which is required in order to maintain the credit of the railway company. Suppose, now, that Con- gress were to fix a minimum rate, just high enough to satisfy the courts in their protection of property rights, which every railway is to be permitted to earn. Suppose further, that it sets a higher rate of return, which may be earned only by those railways that conform to certain standards of proper capitalization — standards based, per- haps, on the relation of fixed charges and preferred divi- dends to the valuation of the property. The application of this differential rate will hasten the reorganization of finan- cially top-heavy railways, either through voluntary action on the part of security holders or through bankruptcy and foreclosure proceedings. The use of the rate-making power may be supplemented by other forms of pressure. Service requirements may be enforced without leniency. Weak railways are frequently able to postpone bankruptcy only by allowing their service to deteriorate. If required to improve their service, to establish grade crossings, to replace woruKXit rails, and to 152 RAILROAD CAPITALIZATION [152 purchase new equipment, they would be forced quickly into a receivership. Now the government, within limits, has the power to enforce reasonable service standards. Especially where the safety of the traveling public is at stake, its authority has been upheld in court. Let the government enforce these standards rigorously, and let the railways take the consequences if their financial structure makes it impossible for them to fulfill their obligations as public servants. It must be admitted that the policy suggested above — the policy of forcing hopelessly overcapitalized railway com- panies tO' submit at the earliest possible moment to a thoroughgoing readjustment — breaks violently with the tendency of the past and with notions current at the pres- ent time. Hitherto, it seems generally to have been as- sumed that leniency rather than rigor is properly to be shown to financially weak railway companies. Instead of hastening a receivership and reorganization, the efifort has been to avoid it. This has been notably the case with the New England railways; forbearance has marked the treat- ment of these mismanaged companies. Laws have been passed validating previous illegal acts and permitting new corporate action otherwise forbidden by statute. Every- thing has been done that could well be done to forestall the threatened bankruptcy. This past practice oif tempering the wind tO' the shorn lamb may or may not have been wise. Certainly bankruptcy and receivership are unfortunate occurrences, unfortunate both to the public and to the private investors. But one must admit that the situation today is unusual. We have come to a crisis in our railway afifairs. Railway credit must be revived, and revived at once. At a time like this, stronger medicine is required than may have seemed neces- sary in the past. Measures that once might have seemed 153] FEDERAL REGULATION OF SECURITIES 153 too radical are now the only alternatives to the more radical step of government ownership and operation. So far we have emphasized the wisdom of reversing the present policy of leniency toward miscapitalized railways. Equally essential, however, is the adoption of a liberal policy toward those companies that are willing to cooperate with the government in putting themselves on a sound financial footing. To state the case more concretely, the holders of junior bonds or notes in an overindebted rail- way should be induced to exchange their loans for shares of stock, not mierely by the threat of loss in case the ex-. change is not made, but also by the prospect of a liberal return if the conversion is accepted. After all, no policy of governmental control of securities can do much to restore railway credit unless it is accom^ panied by a policy of rate control that will make the stock holdings of properly Unatvced railways an attractive" form of investment. To that end, a dividend rate should be al- lowed that is sufficiently above the current yield of bonds to compensate for the extra risk. If the public is unwilling to grant that extra rate, if it begrudges more than a " savings- bank rate " of interest, it would better proceed withoult de- lay to adopt a program of government ownership ; for under these conditions, private ownership is bound to fail. Summcwy The Transportation Act of 1920, in its provisions for federal control of railway securities, follows the main out- lines of the .more recent public utilities laws of the various states. It differs, however, from most of these laws in giving to the regulating commission the widest discretionary powers instead of making specific rules on which decisions must be based. Amojigi the many problems that will arise under the new 154 RAILROAD CAPITALIZATION [154 plan of financial regulation, three are of special importance : (i) the control of the issuance price of stock where the shares are without par value; (2) the restriction of indebt-, edness; (3) the treatment of security issues already out- standing. The first problem' raises the question whether or not the removal of the par value from shares of stock makes it un- necessary for the government toi control the issuance price. To this question the proper answer seemis to be that the( price of an initial issue of shares may safely be left to the discretion of the directors, but that subseqfient issues should be required to be sold at not far below the full market vahie. This latter requirement is for the purpose of preventing the speculative inflaticfti that often results from the issuance of shares to stockholders at an unduly low price. The second problem concerns the limit that should be placed on the power of a railway corporation to incur debts. On this point two distinct policies have prevailed in dif- ferent states : The one policy is to fix a statutory limit, usually a certain ratio of bonds to stock ; the other policy is to give the regulating commission authority to set such limits as it may deem appropriate to the particular circumstances. This chapter proposes a compromise. Let a definite normal debt limit be fixed by statute, but let the Interstate Commerce Commission have the authority to set aside this limit when- ever circumstances require. The statutory limit, however, should not be the one now prevailing in the different states. Instead of setting a proportion of bonds to stock, the law should fix a normal ratio of fixed charges to net earnings. The latter ratio is much superior to the former as a test of the solvency of a railway corporation. The third problem — treatment of existing security issues — ^is the most puzzling of all. Both constitutional and practical difficulties are present. Under ordinary circum- 155] FEDERAL REGULATION OF SECURITIES 155 stances, therefore, one might be inclined to leave outstand- ing securities alone. Indeed, most of the states have done just that. But railway credit, today, is in such a critical condition that a more radical policy is called for. There must be a speedy reorganization of grossly overbonded rail- ways in order to leave a clean sheet for sound financial prac- tices in the future. The government, therefore, should use all legitimate means in its power to hasten such reor- ganizations. This end may be accomplished by adopting a policy of severity toward recalcitraJit companies and a policy of liberality toward those companies that conform to the standards of sound capitalization. APPENDIX A Court and Commission Decisions on the Relation of Capitalization to " Fair Value " There is no present occasion to cite at length the decisions on Ithis subject, in view of the excellenitj digests that are already available.^ It is sufficient to summarize the situation, and to present some points of interpretation which may] not have been fully discussed elsewhere. /. The Courts In a legal discussion of the relation of capitalization to fair rates, the famous dictum in Smyth v. Ames'* is the starting point. This dictum, which has already been quoted,* mentions "the amount and market value of its stocks and bonds " as one of the elements to be considered in determining the " fair value " of a public service com'- pany. Does this mean that the amount of the securities must be considered, even if it is known to exceed the actual cost of the property? That question is answered in the Smyth decision as follows : * If a railroad corporation has bonded its property for an amount that exceeds its fair value, or if its capitalization is 1 Whitten, Valuation of Public Service Corporation, vol. i, Index *, V. "Capitalization," vol. ii, pp. 874-92; Beale & Wyman, Railroad Rate Regulation, 2nd ed., 1915, pp. 220-229. '169U.S. 466 (1898). 2 Pp. 21-22, supra. *Ibid., p. 544. 156 [156 157] APPENDIX A 157 largely fictitious, it may not impose upon the public the burden of such increased rates as may be required for the purpose of realizing profits upon such excessive valuation or fictitious capitalization; and the apparent value of the property and franchises used by the corporation, as represented by its stocks, bonds, and obligations, is not alone to be considered when de- termining the rates that may be reasonably charged. . . . It must be conceded that even this statement is not quite as clear-cut a disavowal of the right to earn a retum oni watered securities as might be desired: it still leaves the feeling that perhaps such securities are entitled to a little consideration, although not to very much. But the course of subsequent court decisions, including that of the Supreme Court itself in Knoxville v. Knoxville Water Co.,^ leaves little doubt in the matter. In the Knoxville case the court said : Counsel for the Company urge rather faintly, that the capitalization of the Company ought to have some influence in the case in determining the valuation of the property. It is a sufficient answer to this contention that the capitalization is shown to be considerably in excess of any valuation testified to by any witness, or which can be arrived at by any process of reasoning. Other courts, both state and federal, have uniformly fol- lowed these precedents, denying the right to a return on excessive securities. Whitten, Beale, and Wyman cite numerous examples. //. The State Public Service Commissions The various state public utility commissions are almost iinanimous an declaring that capitalization, when deter- mined without governmental approval, shall not be made a ^212 17. S. I, II (1909)- 158 APPENDIX A [158 basis of valuation. Only one partial exception has come to the writer's attention; namely, that of the Maryland Public Service Commission, which considers itself bound by ai peculiar clause in the public service law of the state to pro- tect " as far as possible " the value of the bonds issued prior to the act/ With respect to stock issues, the Mary- land commission follows the practice of other states in assuming to disregard par values. In order to conform to the letter of the Smyth v. Ames decision, which requires that the amount and market value of the stocks and bonds be considered, the customary pro- cedure of the commissions has been to take evidence on the capitalization and on the return on securities. But if capita- lization is found to be excessive, the statement is usually made that the commission has " considered " the amount of the stocks and bonds, and has determined that it shovdd be disregarded, or given little weight, in fixing a rate.* 'Bachrach v. Consolidated Gas, Electric Light and Power Co. of Baltimore, Ann. Rep. Md. P. S. C, 1913, p. 39. 'Whitten, vol. ii, p. 874-92, cites decisions of various public service commissions with respect to capitalization as a factor in " fair value." More recent cases are: City of Lincoln v. Lincoln Water & Et. Co. (111. P. U. C), P. U. R. 1917 B i; i?e Richmond Lt., Heat & P. Co. (Ind. P. S. C), P. U. R. 1917 B 300; 2?ff Kansas City Elec. Lt. Co. (Mo. P. S. C), P. U. R. 1917 C 728; Re Newton Gas & Elec. Co. (N. J. P. U. C), P. U. R. 1916 A 514; Moretz v. Edison Elec. Ilium. Co. of B'klyn, 7 P. S. C. R. (ist Dist. N. Y.) 175; Ben Avon Borough v. Ohio Valley Water Co. (Pa. P. S. C), P. U. R. 1917 C 390; Re Port- land Ry., Lt. & P. Co. (Ore. P. S. C), P. U. R. 1918 B 266. In a re- view of the above-cited New York case, Dr. John Bauer, referring to the question whether capitalization should be considered in fixing ' a " fair value," remarks : " The point involved, so far as the writer knows, was never before so definitely set forth and argued by a com- pany; and the commission's view may therefore serve as a leading and commendable precedent" {American Economic Review, vol vii [1917], pp. 438-42)- 159] APPENDIX A 159 ///. The Interstate Commerce Commission Of particular significance is tlie attitude of the Interstate Commerce Commission. One of the well-known rate deci- sions of this body is sometimes quoted as giving recognition to capitalization even when it is clearly shown to be fictitious. This was the Spokane case of 1909.^ in which complainants against the railways made the plea that thirty million dol- lars of the capitalization of the Great Northern represented no investment in the property and hence should not be con- sidered in determining a fair rate of return. To this con- tention, Commissioner Prouty, in the ruling decision, re- plied as follows : ^ But we very much doubt whether in determining what rate of dividend the stock of a railway company may earn we can properly deduct in every instance watered stock. It is im- possible to distinguish the spurious from the genuine. Those who received their stock without consideration have usually parted with it and that very stock, if it could be identified, is owned by its present possessor for a valuable consideration. The whole stock has gone upon the market, has assumed a market value, has become the subject of investment by in- nocent stockholders. We may undoubtedly and we should have in mind the manner in which this stock was issued and the consideration which was paid for it, but we do not think that we should, for example, treat the outstanding stock of the Great Northern as $120,000,000 and not $150,000,000. These transactions ought to have been prevented to begin with. Great sums might have been properly saved the public by suitable supervision at the outset, but the evil has been done, and for the most part cannot be safely undone. If this gov- ernment in the past has permitted the " capitalization " of earnings and securities and the " conferring of benefits " it ought not to-day to penalize the innocent holders of the values thus created. » IS I. C. C. Rep. 376- 'Ibid., p. 410. l6o APPENDIX A [l6o The above quotation, however, is purely in the nature of a dictum, as the commission decided to require the re- duction in rates without reference to this particular point at issue. The same question was discussed in the ruling opinion by Commissioner Prouty in the Eastern Rate Case of 1911.^ Referring there to the Smyth v. Ames dictum that the amount and market value of the securities should be considered, Mr. Prouty remarked that, although counsel did not mention these matters, the commission regarded them as entitled to consideration:. But in the further dis- cussion of this point, he seems to indicate that it is market value rather than par value which may constitute a claim for protection. In this case, as> in the Spokane cases, the question of capitalization had no effect on the actual deci- sion; for it was held that in any event, no justification could be found for the proposed increase in rates. These two opinions of Mr. Prouty, in so far as they may be interpreted as indicating a recognition, of watered securi- ties in the determination of a fair return, have found no acceptance in the later decisions of the comtmlission. In the Western Rate Advance Case of 1911,^ which was decided on the same date as the above-mentioned Eastern case, Commissioner Lane remarked in the ruling opinion that "this commission cannot accept capitalization as represent- ing either investment or value." In Railroad Commission of Texas v. Atcheson, Topeka, & Santa Fe Railway Co., et al.,^ decided in the same year. Commissioner Harlan saidj The capitalized value per mile of road is not to be regarded, however, as having any signiiicance in this controversy, nor do we attach any weight to the book value appearing on the ac- counts of the Company. ' 20 I. C. C Rep. 243. '20 I. C. C. Rep. 307, 320. •20 I. C. C. Rep. 463, 474. l6ij APPENDIX A l6l In an express rate decision of 1912/ Commissioner Lane made the following statement: There is no sacredness in the stated amount of the capital stock of any company. When the courts speak of a return upon the capital of a public utility they mean a return upon the investment. The investor in a railroad, an express com- pany, or a telegraph company should be compensated for the sacrifice that he has made and not paid a premium because of the manner in which he chooses to state his financial condition or his expectations. In the more recent rate-advance cases, the commission's treatment of capitalization has been clear and consistent. The amounts of outstanding securities have been considered simply as evidence of the actual investment in the physical property. For instance, in the Five Per Cent Case of 1914/ the commission based its conclusion that the returns were inadequate on the showing that the ratio of net operating income to book values had declined since 1900. The validity of the book values themselves, as indication of true value, was expressly denied. But it was believed that the com- parative statements would give at least a rough indication of relative investments during the period in question. The same use of capitalization as an indication of real values has been followed in the other cases, but always with the attempt to distinguish the fictitious from the genuine.* '24 I. C C Rep. 421. '31 I. C. C Rep. 351, Reopened, 32 Ibid., 325. 'Western Rate Advance Case, 35 I. C. C. Rep. 497 (1915) ; Anthracite Coal Rate Case, 35 I. C. C. Rep. 220 (1915) ; Fifteen' Per Cent Case, 45 I. C. C. Rep. 57 (1917). APPENDIX B Protection of Credit as a Factor in Commission Rate Decisions In Chapter I the point was made that commissions some- times allow more than a " fair " rate of return in order to bolster the credit of weak public service corporations. Ta the extent that this is true, overcapitalization may result in the allowance of excessive charges. We shall here consider, first, the position of the Interstate Commerce Commission and, second, the attitude of various state commissions. The courts may be left out of account, as they generally assume no authority beyond the guaranty of " fair " returns. /. The Interstate Co^mmerce C cymtmssion In all the general rate-advance cases before this commis- sion, the carriers have urged a declining railway credit as the chief reason for raising rates. As Commissioner Lane put it, in the Western Rate Advance decision of 1911,^ the main contention of the carriers was that " we need the money." In so far as this need for higher rates in order to maintain credit may be due to unavoidably rising costs of capital, or to higher operating expenses, the commission has always recognized the plea as valid. But where the weakness of credit is attributable to overcapitalization, or to other causes for which the railways themselves are re- sponsible, the argument has not been accepted so readily. In the Eastern Rate Advance Case of 191 1,* it was urged '20 I. C. C. Rep. 307. '20 I. C. C. Rep. 243. 162 [162 163] APPENDIX B 163 by the carriers that their rates were insufficient to maintain their credit. This fact was denied in the decision, but even if it were admitted, the commissioni did not consider itself at liberty to allow higher rates on that account. In the majority opinion, Commissioner Prouty remarked •} A fundamental economic fallacy underlies the proposition that we should permit rates otherwise unreasonable for the purpose of bolstering up the credit of our railways. It would be much better for the government to guarantee these bonds than to permit the people and the industries of this country to bear the burden of unreasonable transportation charges. A similar view was expressed in the first decision on the Five Per Cerut Case of 1914.^ In this case the carriers held that rates were insufficient either to yield a " fair return " on the property or to attract capital. The commission stated that it was deluged with letters fromi all over the country pleading the need for higher rates in. order to raise credit to stimulate business. But it held that, even if it had the will, it did not possess the power to raise rates for this purpose. As to the necessities of the weak railways, it said:' No one could reasonably contend that the public should pay higher transportation rates because once prosperous pro- perties — like the New Haven, the Chicago & Eastern Illinois, the Alton, and the Frisco, or the Cincinnati, Hamilton & Dayton — ^may now be in need of additional funds as a con- sequence of mismanagement. The commission, however, did concede the need for in- creased revenues, although not on the grounds mentioned ^Ibid., p. 253. »3i I. C. C. Rep. 331. *Ibid., p. 3S8. 1 64 APPENDIX B [164 above. At the first hearings, the five-per-cent increase was permitted anly within the Central Freight Association and not for the entire Official Classification Territory. But the case was later reopened/ and a more general increase was al- lowed on the ground that the earnings of recent months had declined. While the new decision makes no overt admis- sion that the commission had changed its position with re- spect to the quesition of credit, Commissioner Clements, in his dissenting opinion, complained that in fact this plea of the carriers was heeded. After referring tO' the weight that the majority seemed to place on the book values, which were obviously untrustworthy, he said : ^ If, now, to strengthen and maintain the credit of the car- riers, regardless of the causes of its exhaustion or impairment, and without the application of the usual tests of reasonable- ness, these increases are justified, then, it seems to me that we are only at the beginning of what I fear will be a train of de- moralizing results, disappointing and embarrassing to all con- cerned. It is by no means certain that it would not, in the long run, be cheaper to the public to guarantee the bonds of the weak roads unable to meet their obligations, rather than to try to take care of them by increased rates, which inure to the strong roads as well as to the weak. This view of Mr. Clements, that the commission was in- fluenced by the argument of the need to strengthen credit, seelms to find support in the Fifteen Per Cent Case of 191 7.* It will be recalled that in tMs case the railways urged the existence of a dire emergency due to the war. Rising costs, it was claimed, were threatening earnings at the very time when the railways must go into the market for large funds in order to provide facilities required by the war. In its >32 I. C. C. Rep. 32s (1914). 2 Ibid., p. 340. •45 I- C. C. Rep. 303. 165] ' APPENDIX B 165 decision, the commission admitted a need for higher earn- ings and allowed certain increases, although it did not find that any such emergency existed as would justify the immediate general increase desired by the carriers. Certainly, in this case, the mainconsiderationwasthatof the expediency of the increase rather than the question of fairness to investors. It is of course quite possible that in this case the commissioni may have considered the two questions to be identical, or at least indistinguishable. But the fact that attention was directed primarily to need rather than tO' justice is signifi- cant. This position was taken even more unequivocally in the concurring opinion of Commissioner Harlan.^ Up to the present, then, the position of the Interstate Com- merce Commission with respect to^ credit requirements as a separate factor in rate making must be considered somewhat uncertaiti. Formally it is still on record as denying the( claim ; practically it seems recently to have given it recogni- tion.^ II. State Public Service Commissions The Massachusetts Public Service Commission has taken a position similar to that of the Interstate Commerce Com- mission, denying its own authority to sanction " unreason- able " rates in order to support railway credit. In its an- nual report for 1916 it made the follO'Wing remarks under the heading, " the Question of Credit : " * Beyond question the great need at the present time of most ^Ibid., p. 326. 2 The Transportation Act of 1920 provides that the Interstate Com- merce Commission, in determining a " fair return " on the property- value, ■' shall give due consideration, among other things, to the trans- portation needs of the country and the necessity (under honest, efficient and economical management of existing transportation facilities) of enlarging such facilities in order to provide the people of the United States with adequate transportation" (Sec. 422). '4 Ann. Rep. Mass. P. S. C. xxv. l66 APPENDIX B [1 66 of the steam railroads and street railways operating within the Commonwealth is new capital. ... In view of this situation, many have felt that the Commission, in dealing with questions of rates or service, ought to be guided chiefly by its concepts of what will do the most at the moment to promote the sale of the companies' securities. While this feeling is not unnatural, it is the product of a one-sided point of view, and disregards the fact that the Com- mission exercises no arbitrary power nor unfettered discre- tion, but is the administrator of a definite code of laws by which its action must be governed. . . . It is quite possible that in certain cases an increase in rates, though inherently unjust and unreasonable, may be expedient as the lesser of two evils, but this is a broad question of policy, which the legislature must decide in any given case, and which has not been left to the discretion of this Com- mission. Not all commissions, however, have accepted this view of their duties in rate making. The Maryland Public Ser- vice Commission seems to have taken a different positionj in the case of Bachrach v. Consolidated Gas, Electric light & Power Co. of Baltimore.^ This company had been heavily overcapitalized as a result of consolidation; capitalization was $43,518,088, of which $29,358,cx30 consisted of bonds and other debt, while replacement cost depreciated was esti- mated at perhaps $26,417,414, including five million dollars for value of easements. Referring to the question of a proper rate of return, the commission expressed itself as follows : Whatever is done now must bear fruit in the future. The citizens of Baltimore are dependent upon the Defendant Com- pany for two of the prime necessities of modern life, and its extension to meet the growing demand for its products is one ^ Report for year 1913, p. 39. 167] APPENDIX B 167 of the conditions upon which the growth of the city and the multiplication and development of its industries depends. That the sins of over-capitalization impose a burden upon the people is undeniably true, and they cannot be too strongly condemned. But the burden would not be lightened, but made heavier, if conditions should be imposed upon the present management of the Company, which is not responsible for the things that we complain of, which would seriously impair its ability to meet the just demands of the community for service.^ The rates which the commission finally fixed were esti- mated to be sufficient to yield a return of over $500,000 after payment of interest charges. In arriving at this " reason- able return " the commission considered itself under obliga- tion to protect the interest of the bonds pursuant to a peculiar statute of the state mentiooied in Appendix A. But, in addition, it allowed an estimated surplus sufficient to pay preferred dividends and to leave a small balance, in order to support the company's credit. The California Railroad Commission, according to the testimony of one of its former members, has sometimes been compelled to allow higher rates in order to support the credit of a weak company. In a report before the National As- sociation of Railway Commissioners in 1913, the late Com- missioner Eshleman of California made a statement to this effect and gave it as evidence of the need for security regula- tion.'' Since our entry into the war, the need to support the credit of public utilities has been more generally recognized by the various state commissions. Thus, the Indiana com- mission recently remarked that while a company must bear its part of the war burden, it must nevertheless be kept in ai ^Ihid., p. 34- ^Proceedings of the Twenty-fifth ConventioM of the National As- sociation of Railway Commissioners, 1913, p. 195. 1 68 APPENDIX B [1 68 state of financial solvency.^ The California connmiissicm said that " in determining the rate of return . . . careful consideration must be given, among other matters, to the ability of the utility to secure additional funds necessary for extensions, betterments, and improvements."^ The New York Commission for the Second District* permitted a company to earn rates sufficient for an extension of credit under the rules imposed by the War Finance Corporation. The commissions of Pennsylvania,* Maine,' and Oregon* are on record as giving consideration tO' financial needs. The New Jersey Commission' has gone so far in its ef- fort to support public utility credit as to allow the Public Service Electric Company toi increase rates during the war so as to pay eight-per-cent dividends after all fixed charges, although no appraisal of the plant had been made. In its decision, it said : We have not dealt with the value of the property in this proceeding. In the existing emergency, the determining con- sideration must be to keep the property in uninterrupted and effective operation. This involves the payment of fixed ren- tals and charges without regard to the value of property, since failure to ratify such contractual rents and charges would jeopardize uninterrupted operation. 1 Re Fisher, P. U. R. 1918 F 662. ^Re San Joaquin Lt. & P. Corp., P. U. R. 1918 F 662. »i?e Empire Gas & Elec. Co., P. U. R. 1918 D 912. ^Re Springfield Consol. Water Co., P. U. R. 1918 E 358. *Re Lewiston, Augusta & Waterville St Ry., P. U. R. 1918 E 681. •Littlepage v. Hosier Valley Teleg. Co., P. U. R. 1918 E 425. 'i?e Public Service Electric Co., P. U. R. 1918 B 857. APPENDIX C The Alton Controversy Perhaps no other recent instance of stock watering has received so much attentioni, or hasi been the subject of such division of opinion, as the Alton recapitalization^ accom- plished under the leadership of Mr. Harriman. Condem- ned by one writer as combining " practically all oif the pos- sible abuses or frauds " of railway finance/ it has been de- fended by another as a perfectly innocent and proper pro- cedure/ while a third holds that " actual damage was done to the company's credit, but no harm was done, or could possibly have been done, to the travelling public." * In 1907 the case was investigated by the Interstate Commerce Commission, which reported in terms of sharpest condemn nation.* More recently, the matter has again been brought to public attention by the controversy between Professor Ripley, who supports the Interstate Commerce Commission in its criticism', and Mr. George Kennan, who stoutly de- fends Mr. Harriman's acts as above reproach.^ The points 1 Ripley, Railroads: Finance, and Organization, p. 262. 'Kennan, see references below. * Railway Age Gazette, editorial comment, "'Cost of Service' and the Alton Case," vol. xlviii (1910), p. 222. *i2 I. C. C. Rep. 29s (1907). 'Ripley, op. cit., pp. 262-7; Kennan, "The Chicago and Alton Case: A Misunderstood Transaction," North American Review, vol. cciii (1916), pp. 3S-S4; Ripley, "Federal Financial Regulation," ibid., pp. 538-52 ; Kennan, " Misrepresentation in Railroad Affairs," ibid., pp. 871-82. Both of Mr. Kennan's articles have appeared, in revised and amplified form, in separate monographs bearing the above titles (The Country Life Press, Garden City, N. Y., 1916). 169] 169 170 APPENDIX C [170 at issue in this controversy touch so closely upon the principles developed in the early chapters of this treatise, that it will be worth while to review them in detail. First, however, let us note briefly the conceded facts of the case. The Facts of the Case At the end of the last century, the Alton was a conser- vatively capitalized railway with a low indebtedness, mak- ing excellent earnings atid paying from seven to eight per- cent dividends. But its management imder President Blackstone was not suflficiently progressive. It had failed to keep pace with the modem development of transportation facilities and had not even provided adequate allowances for maintenance and depreciation. This fact, together with a reduction in freight rates under increasingly keen competi- tion, had been responsible for a decline in net earnings during the 90's, with a consequent reduction in dividends from 8 per cent to yy^ per cent and then to 7 per cent. In 1899, Mr. Harriman and his associates secured con- trol through the purchase of nearly all the common and preferred stocks at 175 and 200, respectively. Their an-, nounced policy was to make such improvements as would put the road in first-class condition, and to develop the line as a connecting link in the larger Harriman system. To a measurable extent, both of these policies were carried out. But the financial transactions involved in the program for development were made the occasion for an increase in capitalization far beyond the amount required in order to secure the necessary funds. This inflation was ac- complished by the following series of step's. First Step, 1899. Sale of thirty-two million dollars, face value, of three-per-cent bonds to stockholders — the syndi- cate — at sixty-five. These bonds were later resold by the syndicate at a very material profit. The average price ob- 171J APPENDIX C 171 tained has never been nxade public, although the Interstate Commerce Commission reported that ten million dollars of the bonds were bought at ninety-six by New York life- insurance companies. According to an estimate of the com- mission, the average price was ninety, which would give ai profit of eight millions ; but this figure has been challenged by Mr. Harriman's protagonists. Second step^ 1900. Payment of a thirty-per-cent extra cash dividend on both classes of stock, amounting to $6,669,000. The funds for the dividend were secured from the proceeds of the above-mentioned bond issue. This left only $13,410,000 from' the issue of thirty-two millions of bonds available for refunding and improvements. In order to prevent the resulting excess of nineteen mil- lions in capital liabilities from creating a deficit on the balance sheet, the assets of the company were written up by $12,444,177.66, with a corresponding credit to "Construc- tion Expenditures Uncapitalized." Against the latter ac- count were charged the thirty-five-per-cent discount on the bonds and the cash dividend. This left a debit balance which was transferred to Profit and Loss. The syndicate justified this procedure on the ground that a surplus of over twelve millions had been accumulated by the reinvestment of earnings, but that this surplus had not, heretofore, ap- peared on the books, owing to the practice of charging im- provements to Operation instead of to Capital. Under that interpretation, the bonds that were issued in excess of the additions to property would amount simply to a capitaliza- tion of the surplus. Third step, ipoo. Formation of the Chicago and Alton; Railway, as a holding company to take over the stock of the operating railroad. The reason given by the syndicate for the formation of this new company was that the charter of the old company would not permit the merger of some newly 172 APPENDIX C [172 acquired lines. Exchange of securities was made on the following terms: For $3,472,200 par value of the old pre- ferred, the holding company paid ten million dollars in cash; for $18,322,400 par value of the old common, the holding comlpany issued $19,489,000 of its own preferred stock and $19,542,800 common stock. In order to raise the ten millions of cash in payment for the preferred stock of the railroad, and also to secure an additional three millions for the purchase of a branch line owned by the Harriman syndicate, the railway company sold to its stockholders (composed almost entirely of the members of the syndicate) twenty-two million dollars, face value, of 3j^-per-cent collateral trust bonds, at 60, netting the company about thirteen million dollars. As in the casd of the earlier bond issue, these securities were issued much be- low the market price, which ranged f rcan' 78 tO' 86j^ for two or three years after the issue. Another source of profit to the stockholders was thus tapped. Fourth and last step, ipo6. The holding company and the operating company were consolidated to form the new Chicago and Alton Railroad. In this case there was no material increase of capitalization, the exchange of stocks being on the basis of par for par, except for the issuance of $879,300 " prior lien and participating " stock to take up the small outside holdings of the original railroad stocks on the basis of three new shares to one of old preferred, and two to one of common. This step has not been the subject of special criticism. The total effect of these various financial transactions may be seen in the following table, which compares the liabili- ties of the old railroad in 1898 with those of the consoli- dated company in 1906. 173] APPENDIX C 173 Per cent LiabUitie_s Year 1898 Year 1906 Increase Inc. Common Stock $18,751,100 $19,542,800 $ 791,700 4 Pfd. & Prior L. iStocks . . 3,479,500 20,423,300 16,943,800 480 Total iShare Capital . . . $22,230,600 $39,966,100 $i7,73S,Soo 80% Fimded Debt Outstdg. . . 8,650,850 64,350,000 55,699,150 644 Guaranteed Stocks 2,129,000 3,693,200 1,564,200 73 Other Liabilities 940.957 . 5,865,056 4,924,099 525 Total Indebtedness .... $11,720,807 $73,908,256 $62,187,449 530% Total Liabilities $33,951,407 $II3,874,3S6 $79,922,949 235% Against this increase in total capitalization of about eighty million dollars was an additional investment in the property, according to the company's own books, of only eighteen million dollars. Changes in Control of the Railway Since the time of this financial reorganization, there has been frequent shift in the controlling interests of the railroad. In 1904, the company came under the joint control of the Union Pacific and the Rock Island railroads, the former having purchased a majority of the Alton preferred stock, and the latter owning some of the preferred and nearly all of the common.^ This arrangement lasted only until 1907, when the "Clover Leaf" (Toledo, St. Louis & Western Railway), a Hawley property, secured control through the purchase of the Rock Island's interest. The Union Pacific still retained, and continues to retain, its holdings of about ten million dollars of the preferred, but it did not remain in ''■ The Interstate Commerce Commission states that the Rock Island, between 1903 and 1907, purchased $4,880,000 of the preferred and $14,420,000 of the common at a total cost of $9,709,876.49. In 1907 it sold all of this common and $4,100,000 of the preferred to the "Clover Leaf" line in exchange for $4,110,000 series "A" bonds of the latter roa,^ (for the preferred stock) and $5,047,000 series "B" bonds (for the common stock). 36 L C. C. Rep. 43 (i9i5)- 174 APPENDIX C [174 control after 1907; so that Mr. Harriman's connections were severed at that time. More recently, since both the Alton and the Clover Leaf roads have got into financial dif- ficulties, the Union Pacific interests have again assumed direction. Rise and Fall of the Income So much for the financial circumstances and the changes in control. Now^ for the effects on the well-being of the railroad. Under the Harriman management, the physical condition of the road was materially improved. Gross earn- ings per mile increased 56 per cent from 1899 to 1907; net earnings per mile increased 55 per cent. This rise took place in spite of material, reductions in rates. In 1907, the income after payment of the heavy fixed charges was suf- ficent to pay the 4-per-cent preferred dividend, with a surplus of about 5 per cent on- the common stock. When Mr. Har- riman severed his connections with the road, in that same year, he seemed to have left it in a condition of prosperity. Current issues of railway and financial journals, comment- ing on the remarkable growth of traffic, cited the case as another instance of the effects of Mr. Harriman's goldeni touch. But beginning with the year 1908, the Alton record has been almost steadily downward. To be sure, gross earnings have continued to increase with the exception of a few off- years. Net earnings per mile, however, reached a limit in 1909 which was never exceeded or even again attained until 19 1 7, under the extraordinary war conditions. At the same time that income was falling off, fixed charges were steadily rising. In 1912, there was a deficit after payment of interest, and this has continued during every subsequent year. Were it not for the financial support of the Union Pacific, which has advanced the necessary funds, the Alton would in all probability have become a bankrupt road. 175] APPENDIX C 175 Professor Ripley's Criticisms Professor Ripley places the responsibility for the recent misfortunes of the Alton squarely upon the Harjriman reorganization. By that act, he says, the road was over- loaded with a burden of fixed charges in excess of earnings. As a result, it has been unable to secure money for neces- sary improvements, its service has deteriorated, and it faces the " need of high rates for service in order to sup- port the fraudulent capitalization." Mr. Ripley lays great emphasis on the alleged attempt on the part of the promoters to conceal the fictitious nature of the increased capitalization by devious accounting methods — by writing up the assets and charging the 30-per-cent cash dividend and the bond discount to the resulting surplus, and by using the holding-coimlpany device in order to conceal the financial position of the operating company. Mr. Kennan's Reply In his reply, Mr. Kennan admits the facts of the fictitious increase in capitalization, but insists that the transactions were entirely legitimate, that they were not concealed, and that they resulted in no injury to the company. The chief points in his attack on Mr. Ripley's argument may be stated and examined in turn. I. That the syndicate did, not make exorbitant profits. Professor Ripley's estimate of $23,600,000 profits is grossly exaggerated. While it is impossible to tell the exact amount of the gain, the prices at which the syndicate sold their se- curities would give them " a net profit of probably eight per cent and possibly twelve or fifteen per cent upon the cash outlay." (p. 41) ^ Ans. The estimate of profits is wholly speculative. The actual figures have never been divulged, and the quoted * Page references are to North American Review, vol. cciii (1916). 1^6 APPENDIX C [176 market prices of some of the securities in question are only nominal. To be on the safe side, Mr. Kennan's estimate is not challenged. 2. That the creation of the surplus was entirely legal and proper. Legal authority supports the right of com- panies to charge to capital bona-fide improvements that have previously been charged to operating expenses, (pp. 43-4)- Ans. In a revised edition of his article, Mr. Kennan him- self admits by implication that the surplus was not justified. He there says : The only reasonable objections to such a course are stated, very fairly, by Professor Mead and President Fink. The former is of opinion that capitalization of sums previously spent for betterments is justifiable only when the betterments have actually increased earnings, which in the Chicago and Alton case they had not done. " Its earnings for many years," Professor Mead says, " had been stationary, and its property had not been kept up to standard." If the company had main- tained a proper depreciation account, there would have been no such surplus. For these reasons he disapproves of the capitalization of past betterments and the issue of bonds to pay a dividend thereon; but he admits that, in the absence of state legislation expressly forbidding it, " the legality of the proceeding is not to be questioned." This judgment, how- ever, does not change the facts that the money was expended, and the cost might properly have been charged, at the time, to capital account. The proceeding involves a question of financial expediency, but not, in any sense, of illegality.^ In the present discussion, the question of legality is of little concern: we are here studying the principles, not the existing laws, of capitalization. But it may be noted in passing that even the legality may be questioned if it is true, as the above quotation indicates, that " if the company had '^ The Chicago and Alton Case (Garden City, N. Y., 1916), pp. 23-4. 177] APPENDIX C 177 maintained a proper depreciation account, there would have been no such surplus." Much more imiportant, however, is the undeniable fact that the procedure was financially inex- pedient and therefore contrary to public policy. 3. That the payment of the thirty-per-cent cash dividend and the sale of bonds to reimburse the treasury for the pay- ment were legal and proper. They amounted simply to the capitalization, of the above-mentioned surplus, (pp. 43-4). Ans. Assuming the validity of the surplus, — a. very ques- tionable assumption, — the issuance of bonds against it was probably legal under the state laws as they then stood. But that it was in violation of the public interest is entirely clear. Any increase in debt weakens the corporate credit by reducing the margin of safety. It is therefore justi- fied only as a means of securing capital that cannot be se- cured on equally good terms by the sale of stock. In the case at hand no such necessity prevailed, for no capital whatever was raised. The same remark applies to the is^ suance of bonds by the holding company in place of the preferred stock of the operating company. The added burden of fixed charges brought no compensating advantage to the railway. From the public standpoint it was therefore unjustifiable. During recent years, railway officials have constantly urged the necessity of higher earnings in order to enable the roads to secure capital by the sale of stock instead of bonds. What,' then, shall we say of a railroad that makes its very prosperity the excuse for assuming heavy and wholly unnecessary increases in bonded debt ? 4. That the sale of bonds at 65 was reasonable under the circumstances. While it is true that the Harriman syndi- cate made a large profit by reselling at a higher price, the excessive amount of the profit could not have been antici- pated. It was due partly to the passage of a New York 178 APPENDIX C [178 law making the bonds a legal invesitment for savings batiks, and partly to the unexpectedly favorable conditions of the market. A few years later, in 1907, the prices of these bonds had fallen almost to the issuance price, although they were " just as good then as they ever had been." (pp. 44-6). Ans. This argument might have more weight were it not for the fact that the syndicate repeated the trick soon after- wards by causing the holding company to issue its 3 J4 -per- cent collateral trust bonds ait 60. The market prices of these bonds ranged from 78 to 86J/2 for two or three yearsi after the issue. 5. The alleged overcapitalization. Those who make that charge do so on the assumption that capitalization should represent the actual cost. But there is good authority for the position that capitalization should be based, not otx cost, but on earning power. The latter is the more defensible standard, (p. 46."^ ). Ans. The earning-power basis is discussed at length in Chapter III of this study.'' It rests on the false notion that capitalization should represent value, but it cannot be sustained even on that theory, except in so' far as it happens to coincide with market value. The extended defense of the principle presented in Mr. Kennan's revised edition^ illustrates both of these fallacies: First, it assumes that capitalization should be based on value and hence that the only quesition is to find out what that value is; second, it assumes that a fair measure of value is the probable earn- ings capitalised at hypothetical rates of interest. In" defense of this latter view, Mr. Kennan makes the following quo- tation from' a well-known economist: 1 More fully developed in the revised article printed in monograph form : The Chicago and Alton Case, pp. 28-32. 2 Supra, pp. 82-88. 3 Op, cit. 179] APPENDIX C lyg As an investment, land is valued, as is any other form of income-producing property, by capitalizing its annual return at the current rate of interest.^ Now this assertion is perfectly sound; but one notes that the author was careful to state that the capitalization is " at the current rate of interest " — current, that is, for similar investmefnts at that particular time. Mr. Kerman, however, in his computation of earning power, uses rates very different from the current ones. He calculates on the basis of the 3 and 3^-per-cent nominal rate of interest on the bonds, the 4-per-cent dividend on the preferred stock, and a four-per-cent rate on the common.'' No one of these rates was as high as the market rate ; that is to say, every one of these securities was selling well below par. There- fore, one cannot accept a capitalization based on those rates as representing in any way "the value of the prop- erty." ' 6. That, accepting earning power as the proper standard, the Alton capitalization was not excessive. Mr. Harriman estimated that, as a result of certain improvements of the physical property, net earnings would rise to four milliow dollars per year, sufficient to pay interest on the bonds and dividends on both classes of stock. The actual results more than justified this estimate. In 1907, net earnings were 'H. R. Scager, Principles of Economics (New York, 1913), p. 239. 'Op. cit, p. 34. 'If the present discussion were an attempt to determine whether, and to what extent, Mr. Harriman and his associates were guilty of a breach of business ethics, it would be necessary to add to the above criticism this statement: that in spite of the scientific absurdity of the earning-power theory of capitalization, it is a principle that has been accepted by many persons of high standing and honorable reputation. The real defense would therefore be, not that Mr. Harriman's methods were valid, but that they conformed to the standards of the time. But the matter of personal blame does not concern the present discussion. l8o APPENDIX C [l8o $4,415,974 — enough to cover all prior charges plus five per cent on the common stock (pp. 47-8) . Ans. Even on the basis of earning power, the capitaliza- tion was excessive. The apparent large earnings during the last year of the Harriman control were not a fair test. This point is discussed in the section following. 7- That the later misfortunes of the Alton road were in no sense caused by Mr. Harriman 's management ; for they did not take place until Mr. Harriman had left control. They were due to a number of circumstances — to poor business conditions, to the unexpected rise in operating ex- penses, to the decline in rates, and to the inefficient financial management by the " Clover Leaf " interests. " Mr. Har- riman left the road on a dividend paying basis in 1907 and two years later he died." (pp. 49, 873). Ans. It is true that the trouble did nat appear until after Mr. Harriman's withdrawal from control. But that does not absolve his syndicate from responsibility. Anyone who will consult the successive operating reports of the railway during the period in question will note that the factors in the railway's financial misfortunes are two : first, an extra- ordinary upward trend in the fixed charges from the begin- ning of the Harriman administration down to the present time; second, a decline in net earnings after 1909. Either of these two trends alone would have meant an injury to the railway credit ; but the serious condition — the failure to earn' interest charges — was due to the combination of the two. The changes in earnings and fixed charges may be noted in the table below, which gives the figures on a per-mile basis. l8i] APPENDIX C i8i Chicago & Alton Railroad. Income and Charges Per Mile of Line OpiatATED, BY Three Year Averages i 1897-9 1905-7 1912-14 Blackstone Harriman Clover Leaf Period Period Period Gross Oper. Revenue $8,266 $12,680 $14246 Maintenance 1,506 3,035 5,219 Other Expenses & Taxes 3,750 5,529 6,898 Oper. Expenses & Taxes 5,256 8,564 12,117 N«t Earnings 3,010 4,1 16 2,129 Other Income 296 45 85 Total Net Income 3,306 4,161 2,214 Fixed Charges 1,267 2,603 3i8i6 Dividends 1,865 847 o Surplus 174 711 * 1,602 ♦Deficit Mileage 844 915-970-970 IQ26-1026-1033 1 The figures for the three different periods are not strictly com- parable owing to changes in the accounting methods; but for practical purposes the discrepancies are not serious. Prior to 1899, the company deducted certain expenses before stating the gross operating revenues ; but in 1899 and thereafter these charges were added to operating ex- penses instead of being deducted before stating the gross. In its oper- ating report for 1899, the company computed the i8g8 earnings on the new basis as well as on the old. I have therefore used the new basis for i8g8 and have also estimated the 1897 earnings on the new basis, by adding to the reported gross earnings and to the operating expenses the amount ($460,970) by which the 1898 earnings as computed by the new method exceeded the earnings as computed by the old method. By the ?ame method, I have estimated the maintenance charges for 1897 at $90,408 in excess of the reported figure. " Fixed charges " include interest on debt, discount charges, dividends on guaranteed securities, rentals of leased lines. For the first period, the figures have been computed from the annual reports of the company; for the two later periods, they have been taken from Moody's Analyses of Railroad Investments, with a modi- fication by which taxes are included in operating expenses rather than in fixed charges. 1 82 APPENDIX C [182 (a) The increase in fixed charges. For this extraordin- ary increase the Harriman reorganization is admittedly in large measure responsible. Even the rise that took place after 1907 must be attributed in part to this circumstance; for the recapitalization placed such a burden of debt upon the company ithat it was unable to secure the necessary funds except by borrowing on unfavorable terms. (b) The decline in the net earnings. This was due chiefly to the increased operating expenses. Other factors mentioned by Mr. Kennan were also in part responsible. But is it really true, as Mr. Kennan suggests, that when Mr. Harriman left the road, the earnings were sufficient to justify the inflated capitalization? According to the opera- ting statement, they were indeed sufficient to pay four or five per cent on the common stock. But aside from the fact that the two years which gave this favorable showing vyere unusually good years for the road (1905 the St. Louis Fair, 1907 the high business prosperity), one ma:y question whether the anaount of the net earnings was not deceptive. For the experience of later years shows that during the Harriman period, nmintenance charges were inadequate. Let us look further into the matter. The reader will note from the above table that the chief reason for the decline in net earnings during the " Clover Leaf " period has been' the extraordinary rise in mainten- ance charges. During the first three years of its control, the new management had allowed the charges to drop off ; but beginning with 191 1 it raised them above any previous amiO'unts. Under the Harriman control, the average main- tenance charges per mile, from 1900 to 1907, were $2,595 ; under the Clover Leaf, the average from 1908 to 191 7 was $4,422, an increase of $1,827 cur seventy per cent. This rise is all the more extraordinary in view of the fact that even in the Harriman period, maintenance charges had 183] APPENDIX C 183 risen to over twice the figure under the Blackstone adminis- tration. In 1899, for example, the maintenance charges were only $1,481 as compared with $3,120 in 1907. It is evident from these facts that the Alton railway was left by the Blackstone administration in a much worse physical condition than was at first supposed. Even the increased maintenance during the Harriman period did not suffice to make good the deferred charges of prior years. This view is confirmied in the annual report of the President for 1913, which states that the property was still in poor physical condition as a result of the previous insufficient provisions for upkeep.^ We are compelled, therefore, to conclude that, if the Alton earnings during the last years O'f Mr. Harriman's control had been made ito bear their fair share of the main- tenance charees, they would not have yielded the amounts required to support the high capitalization.'' When, in ad- dition, one recalls that no attempt was made to amortize the heavy bond discounts, and that consequently this burden has been deferred to the time when the bonds mature, it is evident that the apparent prosperity of the Alton in 1907 was an illusion. 8. That the transactions, so far from being concealed, were given complete publicity. They were without ex- ception announced in the current financial publications. Therefore, by no chance could investors have been de- ceived, (pp. 51-2; 877-9). Ans. It is probably true that Mr. Harriman met all formal requirements of publicity. Each step in the reorganization' was published at the time. The Interstate Commerce re- port, on which Mr. Ripley based his statement to the con- ^ Report, p. 6. 2 This statement is not meant to imply that Mt. Harriman designedly skimped the maintenance charges in order to conceal the true condition. It is quite possible that the inadequacy of the charges did not become apparent tmtil later. 1 84 APPENDIX C [184 trary, did an injustice to Mr. Harriman by failing to make this fact clear. But it is also necessary to remark that the public notices of the transactions, though they may have conformed to the customary requirements, were wholly insufficient tO' pro- tect investors against the deceptive appearances of the transactions. The various steps in the financing were so complicated, and the accounting methods so involved, that the successive public announcements were sure to confuse the ordinary investor. Take, for example, the procedure of setting up a surplus against which to charge the discount on the bonds and the extra cash dividend. It is true that an experienced analyst or accountant, by comparing the balance sheets and earnings statements for succeeding years, and by consulting the notices of the financial transactions in the current financial journals, could arrive at the true position of the assets and liabilities. But most investors are not experienced in analysing reports and cannot take the time to make critical examinations. These people would almost surely be deceived by the appearance of a great increase in the investment. 9. That Professor Ripley's accusation that Mr. Harriman prejudiced the interests o^f shippers " by creating the need for high rates for service in order to support the fraudulent capitalization " is doubly misleading: It indicates, first, that rates are dependent on capitalization, and second, that Mr. Harriman raised rates to bolster up fictitious se- curities. The former is an economic fallacy; the latter is simply a misstatement of facts, for rates actually declined after the reorganization. Ans. (a) The relation of capitalization to rates has been discussed in Chapter I of this study. There it is shown that the connection, is by no means fanciful, but that the more serious charge against overcapitalization is that it injures railway service. l85] APPENDIX C 185 (b) I|t is apparently true that rates fell instead of rising. That was due largely to competition, and perhaps partly to state regulation. If Professor Ripley understood the contrary, he was misinformed. But if one takes his words literally, they are perfectly true. The Alton reorganization, by in- juring the coanpany's credit, has certainly " created the need for high rates of service in order to support the fraudulent capitalization." To be sure, this need has not yet been satisfied. But are not railway spokesmen constantly telling us that in the future, the salvation of the transportation service of the country depends on securing some method of rate control which will enable the weak roads to earn suf- ficient profits ? And has not the Alton became one of those weak roads that demand special tenderness ? ID. " The most surprising of all Professor Ripley's mis- statements is that which charges Mr. Harriman with ' crip- pling ' the Alton road * physically.' " As a matter of fact, so far from crippling it, he built it up. When he bought it, it was a run-down, old-fashioned railway ; when he left it, it was a first-class, modern system. Ans. No one can deny that Mr. Harriman made con^ spicuous improvements. It is true that a large amount of deferred maintenance had not been made good when he left control. Nevertheless, the physical condition was imimensely improved. But this accomplishment, however creditable, does not belie the charge that great harm was done by the financial reorganization. These two preformances were entirely separate, and the latter was not a necessary means of accom- plishing the fortaer. Mr. Harriman's management there- fore did two things — it improved the road physically, and it injured its credit. The laitter circumstance made it imt- possible for the new administration to maintain the very standards of physical efficiency that Mr. Harriman had him- self inaugurated. APPENDIX D Bibliography on the Regulation of the Security Issues of Railroads and Other Utilities Consideratioo of space has required the restriction of this list to references that touch directly on the subject of security regulation; hence the omission of many of the other references that have ap- peared in the footnotes of this study. The preparation of this biblio- graphy has been much facilitated by the typewritten List of Refer- ences on Regulation of the Issuance of Railroad Stocks and Bonds, prepared by the Bureau of Railway Economics in Washington, and dated January 12, 1919. The last-named list contains about fifty references that are not mentioned below, either because they did not seem of sufficient importance, or because they do not bear directly on the subject, or else because they were not accessible to the present writer. Andrews, Edward L., " The President's Proposal for a Federal Railway System." Albany Law Journal, vol. Ixix (1907), pp. 266-71. Atwood, Albert W., " Protecting the Stockholder. Part IV : By Law." Harper's Weekly, vol. Iviii, Feb. 28, 1914, pp. 28-31. Ayres, Arthur U., "Governmental Regulation of Security Issues." Political Science Quarterly, vol. xxviii (1913), pp. 586-92. Barron, Mary L., " State Regulation of the Securities of Railroads and Public Service Companies." Annals of the American Academy of Political and Social Science, vol. Ixxvi (March, 1918), pp. 167-go. Bauer, John, " The Control of Return on Public UtiUty Investments." Political Science Quarterly, vol. xxxi (1916), pp. 260-88. , " The Brooklyn Edison Case Decided." American Economic Re- view, vol. vii (1917), pp. 438-42. Capitalization not a factor in value for rate making. Beale, Joseph H. & Wyroan, Bruce, Railroad Rate Regulation, 2d ed. by Bruce Wyman. New York, 1915. Ch. vi, " Basis of Capital Charges," Topic B, " Outstanding Capitalization." Birdseye, Cumming & Gilbert, editors. Annotated Consolidated Laws of the State of New York, 2d ed. New York, 1918. Abstracts of court and commission decisions on the Public Service Commissions iLaw of New York, relative to control of capitalization, vol. vi, pp. 6914-21, 6939-44, 7104-05. 186 [i86 187] APPENDIX D 187 Bullock, Charles J., "Control of the Capitalization of Public Service Corporations in Massachusetts." American Economic Association Publications, series no. 3, vol. x (1909), pp. 384-414. Discussion, pp. 415-30. Calkins, Grosvenor, "Massachusetts Anti- Stock- Watering Law." Quar- terly Jiournal of Economics, vol. xxii (1908), pp. 640-45. Chamber of Commerce of the United States of America, Referendum No. 21 on the Report of the Railroad Committee on Questions of Railroad Regulation. Washington, D. C, September 12, 1917. Clements, Judson C, " Public Control of Railway Capitalization." Railway Age Gazette, vol. lix (1915), pp. 1227-8. Cleveland, Frederick A. & Powell, F. W., Railroad Finance. New York, 1912. Commercial and Financial Chronicle, " Financial Government by Com- mission," vol. Ixxxvii (1908), pp. 1391-2. , Editorial on decision of New York Court of Appeals in the Delaware and Hudson case, vol. Ixxxix (1909), pp. 1504-5. Dawes, Rufus C, " Regulation of UtiUty Corporations : Criticism of Commission Control in Limiting Capitalization and Stock Issue on Public Service Properties." Public Service, vol. ix (1910), pp. 78-80. Duff, R. C, The Attitude of the Texas Banker to Texas Railroads. 'Houston, igii. Reprinted from Texas Bankers' Journal, April, 1911. Dunn, Samuel O., The American Transportation Question. New York, 1912. Pp. 258-67, " Regulation of Finances." , Regulation of Railways. New York, 1918. Ch. viii, " Regulation of Securities." Electric Railway Journal, " New York Public Service Commission's Report to Legislature," vol. xxxiii (1909), pp. 133-7. , "Attitude of Massachusetts Commission on Questions Affecting Capitalization," vol. xxxiii (1909), p. 339. , "Consolidated Stock Not Limited by Fair Value," vol. xlviii (1916), pp. 965-7. Discusses a decision of the Illinois Public Service Commission. Electrical World, " Issuance of Stock for Purposes of Consolidation," vol. Ixviii (1916), pp. 266-8. Discusses a decision of the Illinois PubHc Service Commission. Erickson, Halfredi Regulation of Public Utilities: Three Discussions. Madison, Wis., 1911. Pt. iii, "Government Regulation of Security Issues." , " Should Government Regulate Security Issues of Public Utilities ? " Public Service, vol. xiii (1912), pp. 115-21. Escher, Franklin, "The Hadley Report's Bearing on Railroad Invest- ments," Harper's Weekly, vol. Ivi, Jan. 6, 1912, pp. 28-9. 1 88 APPENDIX D [1 88 , "The Problem of the Railways. V. Proposed Federal Control of Railway Security Issues." Harper's Weekly, vol. Ivi, Sept. 28, 1912, p. 22. Eshleman, John M., "Should the Public Utilities Commission Have Power to Control tiie Issuance of Securities ? " Annals of the American Academy of Political and Social Science, vol. liii (May, 1914), pp. 148-61. Farwell, F. C, " Why Railroad Financing in Iowa is Difficult." Elec- tric Railway Journal, vol. xxxix (1912), pp. 696-7. Fink, Henry, Federal Regulation of Railroad Securities and Valuation of Railroad Properties. Letter to the Railroad Securities Com- mission in Reply to Request for Information and Opinions, New York, December 31, 1910. Roanoke, Va., i9ii( ?). Gardiner, W. H., Jr., The London Sliding Scale as a Method for the Government Regulation of Public Service Corporations. Read be- fore the National Electric Light Association at its Twenty-First Convention, held at Atlantic City, New Jersey, June 5, 6, 7 and 8, igo6. New York, 1906. Appendix A, " The Public Regulation of Gas Companies in Great Britain and Ireland, with Special Refer- ence to the ' Sliding Scale,' " by Nathan' Matthews. Appendix B, "An Act to Consolidate and Convert the iCapital of the Gas Light and Coke Company of London, England." Geisse, H. L., "Attitude of Wisconsin Commission on Security Issues." Electric Railway Journal, vol. xlvii (1916), pp. 602-3. Gerstenberg, Charles W., Materials of Corporation Finance. 3rd ed. New York, 1915. Many valuable reprints on security regulation and capitalization. Gray, John H., "Competition and Capitalization, as Controlled by the Massachusetts Gas Commission." Quarterly Journal of Economics, vol. XV (1901), pp. 254-76. Haines, Henry S., Problems in Railway Regulation. New York, 191 1. Ch. viii, " Problems in Finance." Haney, Lewis H., ed., Some Corporation and Taxation Problems of the State. Bulletin of the University of Texas, no. 236, Austin, 1912. "Railway Capitalization," by Judge N. A. Stedman, pp. 83-92. "Railway Capitalization in Texas," by R. F. Higgins, pp. 93-110. "Railway Capitalization and the Valuations of the Texas Commission," by Judge W. D. Williams, pp. 111-120. Heilman, Ralph E., " Two Rate Decisions of Importance." Quarterly Journal of Economics, vol. xxix (1915), pp. 840-8. Discusses the Middlesex and Boston Rate Case. , " The Development by Commissions of the Principles of Public Utility Capitalization." Journal of Political Economy, vol. xxiii (191S), PP- 888-909. iSg] APPENDIX D 189 , "Commission Control of Refunding Utility Securities." Utilities Magazine, voL i, March, 1916, pp. 26-30. , " The Control of Interstate Utility Capitalization by State Com- missions." Journal of Political Economy, vol. xxiv ( 1916) , pp. 474-88. — — , "Capitalization of Public Utility Consolidations." American Economic Review, vol. vii (1917), pp. 187-94. Higgins, R. R, see Haney, Lewis H., ed. 'Hines, Walker D., Statement of Walker D. Hines before Railroad Securities Commission at New York, December zz, igio. New York, 1910 (?). Holmes, Fred L., Regulation of Railroads and Public Utilities in Wis- consin. New York, 1915. Ch. xvi, "Regulation of Stocks and Bonds." Ignatius, .Milton B., The Financing of Public Service Corporations. New York, 1918. Johnson, Emory R., "Regulation of Railroad Securities." Investment Weekly, vol. xix (1917), pp. 14-15. Journal of Commerce (New York). Editorials on federal regulation of railway securities. Nov. 5, 1913, p. 8; May 9, 1914, p. 4; May 21, 1914, p. 4; June 22, 1914, p. 4; June 30, 1914, p. 4; July 24, 1914, p. 4; Nov. 5, 191S, p. 4. Knox, Philander C, " The People, the Railroads, and the National Au- thority." Albany Law Journal, vol. Ixx (igo8), pp. 144-49 (147-48). La FoUette, Robert M., "Let Us Reason Together." Editorial, La Follette's Weekly, vol. vi, no. S (January 31, 1914), pp. 1-3. Opposes security regulation. Lane, Franklin K., " Railroad Capitalization and Federal Regulation.'' American Review of Reviews, vol. xxxvii (igo8), pp. 711-14. Lawton, W. H., "Government Regulation of Securities." Journal of Accountancy, vol. xii (1911), pp. 357-60. Literary Digest, " Fatherly Guidance for Railroad Financiers," vol. xlviii (1910), pp. 49-50. Lovett, Robert S., Statement of R. S. Lovett before the Railroad Se- curities Commission. ■ (,As rearranged and amplified.) . . . December 21, 1910. New York, 191 1 (?). Lyon, Hastings, Corporation Finance. Boston, 1916. Massachusetts, Report of the Commission on Commerce and Industry, March, 1908. Boston, 1908. Pp. 57-69, " Massachusetts Statute Regulating the Issue of New Stock by the Public-iService Cor- porations." , Report of the Special Commission to Investigate Voluntary As- sociations, Boston, January 4, 1913. House no. 1788. , Information Relative to Voluntary Associations Owning or Con- trolling Public Service Corporations. Public Document, no. loi. Boston, 1913. I go APPENDIX D [190 , Report of Tax Commission on Voluntary Associations, Boston, January 17, 1912. House no. 1646. Matthews, Nathan, see Gardiner, W. H., Jr. Mead, Edward S., Corporation Finance. Rev. ed. New York, 1915. Ch. vi, " State Supervision of Securities." , " The Public Service Commission and the Investor." Lippin- cotfs Monthly Magazine, vol. xc (1912), pp. 764-8. Miller, E. T., " The Texas Stock and Bond Law and Its Administra- tion," Quarterly Journal of Economics, vol. xxii (1907), pp. 109-19. Moody's Magazine, " Government Regulation of Bond and Stock Issue," vol. xi (1911), pp. 53-4. Morris, Ray, Railroad Administration. New York, 1920. On security regulation, see pp. 215-23. Mulvey, Thomas, Under Secretary of State of the Dominion of Canada, Company Capitalization Control. Report on Existing Legislation in Canada and Elsewhere. Ottawa, 1913. , "Certified Securities." American Economic Review, vol. iv (1914), pp. 588-601. , "Blue Sky Law." Canadian Law Times, vol. xxxvi (1916), pp. 37-45. National Association of Railway Commissioners, Proceedings, 1889-1918. Most of the recent numbers contain discussions of security regula- tion. See, esp.. Proceedings of 25th Annual Convention (1913), and of 28th Annual Convention (1916). National Civic Federation, Commission Regulation of Public Utilities; a Compilation and Analysis of Laws of Forty-Three States and of the Federal Government, for the Regulation by Central Commissions of Railroads and Other Public Utilities. New York, 1913. Pp. 849- go6, " Stock and Bond Issues." — I — , Draft Bill for the Regulation of Public Utilities With Documents Relating Thereto. Authorized to be Published by the National Civic Federation, October 23, 1914. New York, 1914. " Newlands Committee," Hearings. See United States Congress, Joint Committee on Interstate and Foreign Commerce. Potts, Charles iS., Railroad Transportation in Texas. Bulletin of the University of Texas, no. 119, March i, 1909. Ch. ix, "Control of Capitalization — the Stock and Bond Law." , " Texas Stock and Bond Law." Annals of the American Academy of Political and Social Science, vol. liii (May, 1914), pp. 162-71. Public Service, "Ohio Utility Commission is Criticized by Financiers," vol. xiii (1912), p. 70. Railway Age Gazette [Nearly every volume of recent years contains dis- cussions of railroad security regulation.] , " Many Railway Presidents Favor Federal Supervision of Securi- ties," vol. Ivi (1914). P- 39- I9l] APPENDIX D 191 , "Regulation of Railway Securities,'' vol. Ivi (1914), pp. 61-2. Railway and Engineering Review, " The Effect of regulation in Texas," vol. Hi (1912), pp. 493-95. Railway World, "To .Regulate the Issuance of Railway Securities," vol. Iviii (1914), pp. 345-47- Ramstedt, A. P., Extracts of letter of A. P. Ramstedt, Chairman of the Public Utilities Commission of Idaho, on the subject of Railway Regulation, addressed to Senator Newlands. Railway Age Gazette, vol. Ixi (1916), p. 1 134. Rea, Samuel, Reprint of Letter to Railroad Securities Commission, February 6, 1911. Philadelphia(?), 1911. Reynolds, C. A., "Overcapitalization of Public Utilities." Case and Comment, vol. xxi (1915), pp. 875-77. Ripley, Edward P., Address before the Texas Welfare Commission, Austin, May 21, 1912. Subject, "Railroads and Railroad Securities in Texas." Ripley, William Z., Railroads: Rates and Regulation. New York, 1913. Review of the Report of the Railroad Securities Commission, pp. 573-78. Substantially a reprint of an article in the American Economic Review, mentioned below. , Railroads: Finance and Organization. New York, 1915. Ch. ix, "State Regulation of Security Issues." , " The Capitalization of Public Service Corporations." Quarterly Journal of Economics, vol. xv (1901), pp. 106-37. Reprinted in Trusts, Pools and Corporations, ist ed. (Boston, 1905), ch. vii. , " Railroad Valuation." Political Science Quarterly, vol. xxii (1907). pp. 577-610. , " Report of the Railroad Securities Commission." American Economic Review, vol. ii (1912), pp. 181-85. , " One Law Instead of Forty-Eight." New York Times Annalist, vol. iii (1914), pp. 588-89. , " Public Regulation of Railroad Issues." American Economic Re- view, vol. iv (1914), pp 541-64. Substantially reprinted as ch. ix in Railroads: Finance and Organization. Sinsheimer, Paul, " Financial Aspects of Valuation." Utilities Magazine, vol. i, Nov., 191S, pp. 165-69. Smalley, Harrison S., " The Regulation of Railway Capitalization." Edi- torial Review, vol. iv (1911), pp. 275-86. Spencer, Arthur M., " The Prevention of Stock-Watering by Public Service Corporations." Journal of Political Economy, vol. xiv (1906), pp. 542-52. Stedman, Judge N. A., see Haney, Lewis H., ed.. 192 APPENDIX D [192 Stiles, fMeredith, N., " Problems of the Railroad iSecurities Commis- sion.'' Moody's Magazine, vol. xi (191 1), pp. 167-72. Stoddard, W. L., " Possible Railway Securities Legislation." Railway Age Gazette, vol. lix (1915), p. 946. , " The Securities Bill Side-Tracked." Railway Age Gazette, vol. Ix (I9i6),p. 154. Taft, William Howard, President, Presidential Message of January 7, 1910, Cong. Rec, vol. xlv, p. 461 et seq. Recommends federal control of railroad securities. Thelen, Max, " The Newlands Railroad Investigation." Utilities Maga- zine, vol. ii, Jan., 1917, pp. 1-9. Reprinted in the Hearings of the " Newlands Committee," pp. 1069-78. , " Federal Incorporation of Railroads." Utilities. Magazine, vol. ii, March, 1917, pp. i-ii. Reprinted in the Hearings of the "New- lands Committee," pp. 1085-94. , " Desirable Scope and Method of Federal Regulation of Railroad Securities." Annals of the American Academy of Political and Social Science, vol. Ixxvi (March, 1918), pp. 191-201. Thompson, R. A., " Regulation of the Issuance of Texas Railroad Se- curities by the State Government." Address before the Texas Academy of Science at Austin, October 24, 1902. Transactions of the Academy for 1902, pp. 1-17. , "Methods Used by the Railroad Commission of Texas under the Stock and Bond Law, in Valuing Railroad Properties." Trans- actions of the American Society of Civil Engineers, vol. lii (1904), pp. 328-45. Discussion, pp. 346-64. Trumbull, Frank, Statement of Mr. Prank Trumbull, Chairman of the Board of Directors of the Chesapeake and Ohio Railway Company, before the Federal Railroad Securities Commission at New York, December iz, 1910. (.Revised.) New York( ?), 1910. United States. 'Congress. House. Committee on Interstate and For- eign iCommerce. Hearings . . on H. R. 6268 to Limit the Issue of Stocks and Bonds. [.May 12, 1908]. Washington, 1908. Hearings before the Committee . . . on Bills Affecting Interstate Commerce. [Jan. i8-March 25, 1910]. Washington, 1910. On security regulation, pp. 611-42; 669-75; 803-22; 1142-52; 1171-77; 1279-84. Hearings on the Bill H. R. 12811. Investigation and Report of Property Values, Together with the Status and Cpntrol of Stocks and Bonds of Carriers Subject to the Act to Regulate Commerce. February 15 and 16, 1912. [The "Physical Valuation Bill"]. Washington, 1912. .... Amendment of Act to Regulate Commerce. House Rep. 637, 63d Cong., 2nd Sess. Washington, 1914. 193] APPENDIX D 193 Proposed Amendments to Section 20 of the Act to Regulate Com- merce . . . House !Rep. 681, 63d Cong., 2d Sess. Washington, 1914. " Regulation of the Issuance of Stocks and Bonds by Common Car- riers." Hearings before the Committee . . February p to March 17, 1914. Washington, 1914. Return of Railroads to Private Ownership. Hearings ... 3 vols. Washington, 1919. lOn security regulation see Index, vol. iii, s. v. " Capitalization " and " Securities." United States. Congress. Joint Committee on Interstate and For- eign Commerce. [The " Newlands Committee"]. Hearings . . . Pursuant to Public J. Res, 25, a Joint Resolution Creating a Joint Sub-Committee . . . to Investigate the Conditions Relating to Inter- state and Foreign Commerce, and th'^ Necessity of Further Legis- lation Relating Thereto ... 3 vols. Washington, 1916-18. Contains several discussions of security regulation. United States. Congress. iSenate. Committee on Interstate Commerce. Valuation of the Several Classes of Property of Common Carriers. Report of the Committee . . . with Hearings. Sen. Rep. 1290, 62d Cong., 3d Sess. Washington, 1913. Security regulation discussed. Government Control and Operation of Railroads. Hearings before the Committee . . Pursuant to S. Res. 171 . . Parts i to 7. Washington, 1918. On security regulation see Index, s. v. " Capitalization " and " .Securities." Extension of Tenure of Government Control of Railroads. Hear- ings ... 3 vols. Washington, 1919. On security regulation see Indexes, vols, i and iii, s. v. " Capitalization," " Securities," and " Stocks and Bonds." United States. Railroad Securities Commission, Report of the Railroad Securities Commission to the President and Letter of the President Transmitting the Report to Congress. 626. Cong., 2d Sess. House Doc. no. 256. Washington, 191 1. , Indexes to Evidence. Printed in small number at Government Printing Office. The evidence itself, amounting to about S,ooo typewritten pages, was not printed; but copies were supplied to each member of the Commission and to the Interstate Commerce Commission. , References to State Laws in Regard to Securities of Railroad Corporations, Compiled January, 191 1. Washington, 191 1. Wang, Ching Chun, Legislative Regulation of Railway Finance in England. University of Illinois Studies in the Social Sciences, vol. vii, nos. 1-2. Urbana, 1918. Warren, Bentley, "Regulation in Massachusetts. Discussion of the Report of the Railroad Securities Commission." Aera, vol. i (1913), pp. 672-77. 194 APPENDIX D [194 Whitten, Robert H., Regulation of Public Service Companies in Great Britain; with Supplementary Chapters on the Boston Sliding Scale and Toronto Auction Sale and Maximum Dividend Plans. New York, 1914. Reprint of lAppendix G of the Annual Report of the New York Public Service Commission for the First District, De- cember 31, 1913. , Valuation of Public Service Corporations; Legal and Economic Phases of Valuation for Rate Making and Public Purchase. 2 vols. New York, 1914. On problems of security issues see Index, s. v. " Capitalization." Wickersham, George W., Federal Control of Stock and Bond Issues by Interstate Carriers. An Address before the Illinois State Bar As- sociation, Chicago, Illinois, June 24, 1910. Washington, 1910. Re- printed in The Changing Order; Essays on Government, Monopoly, and Education, Written during a Period of Readjustment. New York, 1914. Williams, Judge W. D., see Haney, Lewis H., ed. Williams, William H., Letter to the Railroad Securities Commission in Reply to Their Request for Information and Opinions upon Questions pertaining to the Issuance of Stocks and Bonds of American Rail- ways. New York, 191 1. Wyman, Bruce, see also Beale & Wyman. , Wyman on Public Service Corporations. Full title: The Special Law Governing Public Service. Corporations, and all Others En- gaged in Public Employment. 2 vols. New York, 191 1. Vol. ii, ch. xxxii, topic B, " Outstanding Capitalization." INDEX A Accounts, manipulation of, 22-24, S7-6i; Alton case, 17s, 183/. Actual cost, capitalization as evi- dence of, 22-25 ; as basis of capitalization, 77-82, 98 Adams, C F., Jr., evils of stock watering, 15 n. 3 Adams, J., Jr., shares without par, 100 n. Adamson, Representative, railway securities bill, 30 n. i Allied Packers, Inc., shares with- out par, IDS n. i Alton (see Chicago & Alton) Anthracite Coal 'Rate Case (I. C. C), 161 n. 3 Arizona statutes, on purposes of issue, 79 n. 5 ; stock below par, 94 Assets, capitalization and (see Capitalization) Atlantic Lobos Oil Co., shares without par, 105 n. i Atwood, A. W., shares without par, 100 n. Auction, sale of stock at, 138 B Babylon Electric Light Co., Re (N. Y. P. S. C. 2nd Dist.), 79 n. 3 Bachrach v. Consolidated Gas, etc. (Md. P. S. 0, 158 n. I, 166 Balance rSheet (see also Accounts), entry of no-par shares, 118-20, 122 n. 3 ; Alton finance, 171, 183/. Barron, M. L., 11 ; stock dividends, 74 n. 2; purposes of issue, 79 n. ? : stock below par, 94 n. 2 ; state laws on security regulation, 133 n. I ; principles of security regulation, 13S ; ratio of stocks to bonds, 141 Basis of Capitalization (see Con- tents of Ch. Ill), bibliography, IPS] 64; the problem, 64-67; rate- making value as, 67-73, 88; ori- ginal investment as, 74-77, 88 98; actual cost as, 77-82, ^, 98 market value as, 82-88, 178/. earning capacity as, 82-88, 178/. conflicting practices of commis- sions, 88-91 ; summary, 98/. Bauer, J., 12; control of rates by security issues, 138 n. i ; capi- talization and fair value, 158 n. 2 Bay State Rate Case (Mass. P. S. C.), 89 n. 2 Beale & Wyman, rate of return, 31 11. 3 ; capitalization and fair value, 156 n. i, 157 Ben Avon Borough v. Ohio Val- ley Co. (Pa. P. S. C), 158 n. 2 Bennett, R. J., shares without par, loi Bibliographies, relation of capi- talization to rates, 14; basis of capitalization, 64; shares with- out par, 100/. ; security regula- tion, 186-94 Black Stream Electric iCo., Appl. of (Me. P. U. C), 94 n. 3 Blackstone management of Alton, 170, 183 Bonds and other evidences of debt, excess more dangerous than watered stock, 45-^; overissues furthered by forbidding sale of stock below par, 94, 109; income bonds, 48/. ; ratio to stock, 139- 46; sale at discount by Alton, 170/., 17s, 177 Bonus stock, criticized and de- fended, S3 n. I Book values (see also Capitaliza- tion), relation to capitalization, 22-2S, S9-6i Borrowing (see Bonds and other evidences of debt) 195 196 INDEX [196 Boston & Maine (,see also New England railways), inferior ser- vice, 39 & n. I Boston Suburban Electric Com- panies, shares without par, 105 n. 3 Boston & Worcester Electric Com- panies, shares without par, 105 n. 3 Bronx Gas & Electric Co., Re N. Y. P. S. C. 1st Dist), 69 n. 2 Bullock, C. J., security regulation, 135; control of stock issues in Massachusetts, 138 n. 2 California iRailroad Commission, basis of capitalization, 69/. ; stock dividends allowed, 78 n. 6, 79; stocks below par, 94, 98; shares without par, 104; ratio of bonds to stocks, 142 & n. 3 ; capitaliza- tion and rates, 167/. California statute^, on purposes of issue, 79 n. S ; shares without par, IQ2, lOS, IIS, 123. 127; ratio of bonds to stocks, 142 Canadian American Power Co., Re (N. Y. P. S. C. 2nd Dist.), 84 Capital account, treatment of shares without par, 118-24; Alton finance, 171-73, 176 Capital, impairment of, 58; alleged danger of removing par values, 121-24 Capital stock (see iStocks, also Shares without par value) Capitalization (see also Basis of capitalization, and iStock water- ing) and assets, relation between on American railroads, 24 & n. i, 92/. ; reasons for equalizing, 90/. ; difficulties of equaUzing, 91-99; equalization unneces- sary, 97 of consolidations, no; federal law, 134/. of good will, 128 and rates, relation between (see Contents of Ch. I), biblio- graphy, 14; discussion, 9, 14- 38 ; conclusions, 37/. ; Alton as example, 184/. of reorganizations 47, 49, 83, 88/., 90, 109-11, 134/. scaling down excessive out- standing, 91-93, 146-53 and service, relation between, 13/-. 38-43; Alton as example, 184/. of surplus, laws and decisions on, 74/., 77-82; arguments pro and con, 81/. ; Alton, 176/. and value for rate making, re- lation between, 21-31, 156-61 ; conclusions, 29-31 Central Hudson Gas & Electric Co., Re (N. Y. P. S. C 2nd Dist), 80 n. I Central Massachusetts Light & Power Co., shares without par, lOS, n. 3 Certificates of participation, with- out par value, loif., 106 n. Chamberlain, L., relation of fixed charges to earnings, 14S n. Charges, fixed, relation to earn- ings, 145 n. Charges, transportation, effect of captitalization on (see Capitali- zation and rates) Chesapeake & Potomac Telephone ■Co., Re (Md. P. S. C), 68 n. 3 Chicago & Alton, relation of capi- talization to rates, 19, 38; recapi- talization as example of finan- cial abuses, App. C, 33, 36, SS & n. 2, 141 Chicago & Eastern Illinois, pay- ment of excessive dividends to Frisco, 51; financial manipula- tion, 163 Chicago Elevated Railways, shares without par, 105 n. 3; entry of no-par shares on books, 119 n. Chicago Great Western, relation of capitalization to rates, 19; poor service, 38 ; cost of rehabil- itation, 39 Chicago, Milwaukee & Puget Sound, fictitious stock issue and falsified accounts, 59 Chicago Railways Co., shares without par, 105 n. 3 Chicago, 'Rock Island & Pacific, relation of capitalization to rates, 19; evil effects of overcapitali- zation, 33, 38, 41, 55/.; mani- pulation of accounts, 58; specu- lative stocks, 114; excessive debt, 141 ; control of Alton, 173 & n. 1 I9/J INDEX 197 Cincinnati, Hamilton & Dayton, manipulation of accounts and payment of dividends out of capital, 58; financial weakness, 163 City of Lincoln v. Lincoln Water & Light Co. (111. P. U. C), 158 n. 2 Clark, Commissioner, relation of capitalization to rates, 28 Clark, W. H. & Jenks, basis of capitalization, 64 n. i Clements, Commissioner, relation of capitalization to rates, 28; plea for higher rates to support credit, 164 Cleveland & Powell, basis of capi- talization, 64 n. I Clews., H., criticism, of stock water- ing, IS n. 3; relation of capitali- zation to rates, 17 n. 2 " Clover Leaf Line " (^see Toledo, St. Louis & Western) Cole, W. M., basis of capitaliza- tion, 64 n. I, 86/.; criticism of shares without par, 100 n., 118 Commissions, public service (see also Security regulation, Inter- state Commerce Commission, New York Public Service Com- mission, etc.), rate regulation, 20-22, 31/., 65/.; capitalization as factor in rate-making value, 21-31, App. A ; capitalization and rate of return, 31-38; plea for higher rates to support credit, 33-35, App. B; guaranty of se- curities not created by approval, 26 n. 2; causes of railway fail- ures, 42/.; restriction of indebt- edness, 139-46 Common Stocks, evils of over- issue, 50-57 Competition, effect of capitaliza- tion on amount of, 17 n. 2; eflfect of capitalization of rates under, 18/.; as cause of railway fail- ures, 41 Concealment of investment by stock watering, 22-25, S7-6i Congress (see United States Congress) Consolidations, capitalization of, 109/-, 134/- ; of interstate rail- ways, 147 Constitution, guaranties of prop- erty rights, 20/., 147/. Convertible stock, issue allowed by New York commission, 94 n. 3 Conyngton, T., basis of capitali- zation, 64 n. I Cost, actual (see Actual Cost, also Original investment) Courts (see also United iStates Supreme Court, New York Court of Appeals, etc.), control over rates, 20-23, 26/., 29; capi- talization as factor in fair value, 21-23, 26, 29, 156/.; rate of re- turn, 31, 32 n. I, 5.1; basis of capitalization, 71/., 75 n. i & 2, 76, 83 n. 3, 85/. ; capitalization of outside property, 71 n. i ; treat- ment of surplus for rate making, 77; ratio of bonds to stocks, 144; scaling down excessive capitali- zation, 151/. Credit, effect of capitalization on, Ch. II ; Alton case, 185 ; pro- tection of as factor in rate mak- ing, 33-35, 44, App. B; effect of weak credit on railway ser- vice, 38-43; means of reestab- lishing railway credit, 152/. Cuba Cane Sugar Corp., shares without par, 105 n. i D Daggett, S., railway reorganiza- tions, 39, 47 n. I ; causes of railway failures, 41 n. 3, 42 n. i ; preferred stocks and income bonds in reorganizations, 49 & n. I ; falsified accounts of Erie, SI n. I, s8 n. i Debt, funded (see Bonds and other evidences of debt) Decej^tion, chief evil of over- capitalization, 23-25, 52-57, 96/., 106-09 Delano, F. A., capitalization and rates, 19 n. i Delaware & Hudson iCo., Re (N. Y. P. S. C. 2ndDist.), 71 n. i Delaware, Lackawanna & Western, relation of capitalization to rates, 19 Delaware statutes, ratio of bonds to stocks, 141 ; shares without par, 102, 104 & n. 3, 115/., ii6 n. I, 124, 127 198 INDEX [198 Dewing, A. S., shares without par, loi n. Dillon, S., defense of stock water- ing, 15 n. 3 Discount, sale of bonds, at, by Alton, 170/., 17s, 177 District of Columbia statutes, stock dividends forbidden, 74 Dividends {see also Stock divi- dends), tendency to become quasi-fixed charge, 50-52; es- ces-sive, a result of overcapitali- zation, 48-57; common stock, 50-52; preferred stock, 48/.; payment out of capital, 58, 121- 24; payment out of surplus, 120 & n. I, 171, 175 Dry Docks, East B'way & Battery ■R. R. Co., Re (N. Y. P. S. C. 1st Dist.), 142 n. I Duff, R. C, Texas' Stock and Bond Law, 149 n. Dunham, Re (Mo. P. S. C), 70 n. 2, 89 n. I Dunn, S. O., effect of overcapi- talization on service, 13 n. i Dwight, F., shares without par, 100 n. Earning capacity, as basis of capi- talization, 82-98, 178/. Earnings, exaggeration of by rail- way managements, 58/., 182/. East Boston Gas Co. case (Mass. Gas Commiss.), 75 n. i Eastern Rate Advance Case of 191 1 (I. C. C), 160, 162/. Edgerton, iCommissioner, shares without par, 104 n. 2 Edison Electric Illuminating Co. of Fall 'River, case (Mass. Gas. Commiss.), 75 n. i Elliott, President of New Haven, plea for higher rates, 34 Empire Gas & Electric Co., Re (N. Y. P. ,S. C. 2nd Dist.), 168 n. 3 England, regulation of rates and securities {see Great Britain) Equity, trading on, 140; encour- aged by American method of rate control, 140 n. Erickson, Commissioner, shares without par, 100 n. i, 104 n. i, 125 Erie Railroad Company, Re (N. Y. P. S. C. 2nd Dist.), 94 n. 3 Erie, relation of capitalization to rates, 19; payment of unearned dividends, 51 ; falsification of earnings, 58; convertible bonds, 94 n- 3 Escher, F., shares without par, 100 n. Eshleman, Commissioner, shares without par, 104 n. 2; capitali- zation and rates, 14 n. i, 167 " Expedient rate " versus " fair rate," 31-36, App. B. Express rate decision of 1912 (I. C. C), iSi F Failures, causes of railway, 41-43 " Fair rate " of return, versus " expedient rate," 31-36, App. B. Fair value for rate making, capi- talization as factor in, 21-31, App. A Fall River Gas Works Co. case (Mass. Gas Commiss. and Mass. Sup. Ct), 75 n. I I Falsification of accounts, a means of inflating market values, 57-59 Fankhauser, W. C, causes of rail- way failures, 42 n. i Federal regulation of securities, lof., Ch. V; provisions of Transportation Act of 1920, 132-35 Fifteen Per Cent Rate Case (I. C C), 25, 161 n. 3, 164/. Fink, President, capitalization of Alton surplus, 176 Fisher, Re (Mo. P. S. C), 168 n. i Five Per Cent Rate Case (I. C. C), 25, i6i, 163/. Franchise value, capitalization of, 128 Frisco {see St. Louis & San Francisco) Funded Debt {see Bonds and other evidences of debt) G Geisse, H. L., stock below par, 94 n. 3 General Motors Corp., shares with- out par, IDS n. 2 Georgia Railroad Commission, stock dividends, 79 n. 3 199] INDEX 199 Georgia statutes, on purposes of issue, 79 n. 2; stock dividends, 79 n. 3 Germany, certificates without par value in, 102 Gerstenberg, C. W., shares with- out par, 100 n. Going value, a. cloak for watered stock, 28; Wisconsin use, 71 Good will, capitalization of, 128 Goodrich, 'Co., B. F., shares with- out par, 105 n. 2 Gould roads, financial breakdown, 41 Government regulation {see Com- missions, public service, and Security regulation) Grafton County Electric Light & Power Co. case (N. H. P. S. C), 75 n. 2 Grafton Coimty Electric Light & Power Co. v. State (N. H. Sup. Ct), 75 n. 2, 85 & n. 3 Great Britain, stock watering in, 25, 60/. ; sale of stock at auction, 138 & n. I ; rate control in, con- trasted with American methods, 140 n. I Great Northern, watered stock, IS9/. Guaranty of security issues, not intended under regulation, 2(5 n. 2 Hadley, A. T., capitalization and rates, 14 n. i, 17 & n. i & 2 Hale, L. P., purposes of issue in N. Y., 80 n. 3 Handley v. iStutz (U. ,S. Sup. Ct.), 116 n. 2 Harlan, Commissioner, capitaliza- tion and fair value, 160; on plea for higher rates to support credit, 165 Harriman, E. H., reorganization of Alton by, App. C Hatfield, H. R., 12; fictitious ac- counting, 59 n. 3; undervalu- ation of assets, 95 n. Haverhill Gas Co. case (Mass. Gas Commiss.), 75 n, i Heilman, R. E., 11 ; object of se- curity regulation, 64 &n. 2; stock below par, 94 n. 2; principles of security regulation, 13S; treat- ment of outstanding capitaliza- tion, 148 n. Holding companies, public utility, issue of no-par shares by, 105, n. 3; Alton, 171/., 175 Holmes, F. L., shares without par, 104 n. I Hudson, J. F., evils of stock watering, 14 n. i Hudson River & Eastern Traction Co., Re (N. Y. P. S. C. 2nd iDist), 142 n. I Hulme, T. W., capitalization and valuation of American railways, 24 n. Hurdman, F. H., shares without par, 100 n., 102 n. 5 Ignatius, M. B., 11; capitaHzation and rates, 14 n. i ; shares with- out par, 100 n., 107 n. 2, 125/.; dividends out of premium- surplus, 120 n. ; powers of com- missions, 133 n. 4; principles of security regulation, 135; treat- ment of outstanding capitaliza- tion, 148 n. Illinois Public Utilities Commis- sion, basis of capitalization, 84/. ; stock dividends allowed, 78 Illinois statutes, on purposes of issue, 79 n. 5; shares without par, 102, IDS, 124 & n. i, 127 Illinois Terminal Railroad Co., Re (111. P. U. C), 8s & n. I Impairment of capital, 58; with no-par shares, 121-24 Income accounts versus capital ac- counts, 120 n. Income bonds, 48/. Indebtedness {see Bonds and other evidences of debt) Indiana Public Service Commis- sion, stock dividends allowed, 78; ratio of bonds to stock, 142 n. 3 ; higher rates allowed to sup- port credit, 167/. Indiana statutes, on purposes of issue, 79 n. 5; ratio of bonds to stocks, 142 & n. 3 Inflation {see also Stock water- ing), of market value, 57-61, 111-13 126/., 136/., 139 " Innocent investor " plea, 25 2CX) INDEX [200 Intangibles, value of, a cloak for stock watering, 27/. Interboro Consolidated Corp., shares without par, 103 n. i, 105 n.. 3 Interstate Commerce iCommission, 21; accounting regulations, 22/.; capitalization and fair value, 14 n. I, 23-28, 159-61 ; railways in receiverships, 42; protection of credit in rate cases, 35, 162-65; criticism of railway accounts, 58; exclusive control of secur- ity issues, 132-35; the Alton case, App. C Interstate Consolidated Street Railway Co., Petit, of (Mass. R. C), 165 Investment {see Original invest- ment, also Actual cost) Investors, plea for higher rates to protect, 25/., 27; deception of by overcapitalization, 51-57; decep- tion of by false accounts, S7-61 ; injured by Alton reorganization, 169, 183/. Iowa statutes, ratio of bonds to stocks, 141 Issuance price, governmental con- trol of, 95-97, 134-39 Jenks & Clark, basis of capitali- zation, 64 n. I Johnson & Van Metre, basis of capitalization, 64 n. i Journal of Accountancy, capitali- zation and rates, 14 n. I K Kansas City Electric Light Co., Re (Mo. P. S. C), 158 n. 2 Kansas City street railway reor- ganization, 89 n. I Kansas statutes, on purposes of issue, 79 n. 2 Kendrick, J. W., financial break- down of Missouri, Kansas & Texas, 41 Kennan, G., Alton reorganization, App. C Kennecott Copper Corp., shares without par, 105 n. I ; entry of no-par shares on books, 119 n. 122 n. 3 Kester, R. B., 12; shares without par, 100 n. Kings County Lighting Co. v. Willcox (N. Y. Ct. App.), 71 n. 2 Knoxville v. Knoxville Water Co. (U. S. Sup. Ct.), 157 Kuhn, A. K., shares without par, 100 n., 102, 125/. L Lackawanna {see Delaware, Lackawanna & Westerij) Lane, F. K., opposes security regu- lation, 31 ; capitalization as fac- tor in rate making, 160, 161, 162 Laws {see Statutes, state, also Federal regulation of securities) Lawson, W. R., stock watering by British railways, 61 n. i Leach, A. B., plea for innocent purchaser of watered securities, 25/. Legislation on security issues {see Statutes, state, also Federal regulation of securities) Lewiston, Augusta & Waterville iStreet Railway, Re (Me. P. U. C), 168 n. S Liability of holders of shares with- out par, 115/. Lincoln, City of v. Lincoln Water & Light Co. (111. P. U. C), 158 n. 2 Littlepage v. Mosier Valley Tele- graph Co<.i (lOre. P. U. C), 168 n. 6 Lough, W. H., basis of capitali- zation, 64 n. I Louisville & Nashville, improper accounting, 58 Lovett, R. S., capitalization and rates, 15/. ; shares without par, 100 n., 124 Lyon, W. H., 12; bonus shares, 53 n. I ; basis of capitalization, 64 n. I ; shares without par, 100 n. M McDermott, E. R., stock watering by British railways, 61 n. I Maine Public Service Commission, stock below par, 94 n. 3; ratio of bonds to stocks, 143- n. ; need for higher rates to uphold credit, 168 20l] INDEX 20I Maine statutes, on purposes of issue, 79 n. 5; shares without par, 102, IDS, 115 n. 2, 123, 127 Maintenance, deferred, 39, 148, 182/. Maires v. Flatbush Gas Co. (N. Y. P. S. C. 1st Dist), 69 n. 3 Maiden & Melrose Gas Light Co. case (Mass. Gas Com.), 75 n. i Maltbie, Commissioner, basis of capitalization, 6g Manhattan & Queens Traction Corp. Re (N. Y. P. S. C. ist Dist.), 69 n. 2 Manipulation of accounts, 22-24, 57J61; Alton case, 175, 183/. Market value, as basis of capitali- zation, 82-88, 178/. Maryland Public Service Commis- sion, basis of capitalization, 67f. ; stock dividends, 78, n. 6; capi- talization and rates, 158; on need for higher rates to uphold credit, 166/. Maryland statutes, shares with- out par, 102, 104 & n. 4, 123 & n. 2, 127 ; protection of outstand- ing bonds, 158 Massachusetts regulating commis- sions, on pka for higher rates to uphold credit, 35, 165/. ; break- down of New England rail- ways, 39/. ; basis of capitaliza- tion, 74/.; capitalization of sur- plus, forbidden, 75 & n. i ; con- flicting principles of security regulation, 8^/. ; early control of issues, 91 ; sale of stock at premiums, ps, 138/.; treatment of outstanding capitalization, 92, 148/. Massachusetts statutes, stock divi- dends forbidden, 74, 78; pur- poses of issue, 79 n. 2; sale of stock at premium, 90, 98, 138; capitalization of reorganizations, go; ratio of bonds to stocks, 141 Mead, E. S., capitalization and rates, 14 n. i, 17 n. i & 2; shares without par, 100 n. ; basis of capi- talization, 64 n, I ; payment of dividends out of premium-sur- plus, 120 n. ; capitalization of Alton surplus, 176 Mergers (see Consolidations) Meyer, Commissioner, publicity versus regulation of securities, 31 Michigan Public Service iCommis- sion, stock dividends allowed, 78 Michigan statutes, on purposes of issue, 79 n. 2 Middlesex & Boston Rate Case (Mass. P. S. C), 90 n. I Miller, E. T., Texas Stock and Bond Law, 149 n. Missouri, Kansas & Texas, finan- cial breakdown, 41 Missouri Pacific, reorganization, 39 ; financial breakdown, 41 ; payment of unearned dividends, SI ; improper accounting, 58/. Missouri Public .Service Commis- sion, basis of capitalization, 70/. ; reorganizations, 89 Missouri statutes, on purposes of issue, 79 n. 5; capitalization of reorganizations, 83, 88/. Mitchell, iS. Z., opposes security regulation, 30, n. i Monkswell, Lord, stock watering by British railways, 61 n. I Monopoly, effect of capitalization on rates charged under, 17/. Moody, W. F., Jr., shares with- out par, 100 n. Morawetz, V., shares without par, 100 n. Moretz v. Edison Electric Illumin- ating Co. of Brooklyn (N. Y. P. S. C. 1st Dist), 158 n. 2 Mulvey, T., shares without par, 100 n. N National Association of Railway Commissioners, discussion on se- curity regulation, 14 n. i, 28; shares without par, 100 n. Nebraska statutes, on purposes of issue, 79 n. 2; ratio of bonds to stocks, 141 New England railways (see also Boston & Maine, and New York, New Haven & Hartford), break- down of service, 39/., 152 New Hampshire Public Service Commission, stock dividends, 75 & n. 2; basis of capitalization, 75 & n. 2 & 3, 85 202 INDEX [202 New Hampshire statutes, stock dividends forbidden, 74/., 78; purposes of issue, 79 n. 2 ; shares without par, 102, 105, 127 New Hampshire Supreme Court, basis of capitalization, 75 n. 2, 85 New Haven Railroad (^see New York, New Haven & Hartford) New Jersey Board of Public Util- ity Commissioners, stock divi- dends allowed, 78 & n. i, 81 n. I ; ratio of bonds to stocks, 142 n. I & 2; allowance of higher rates to uphold credit, 168 " Newlands Committee" Hearings, causes of railway failures, 43 n. i Newton iGas & Electric Co., Re (N.J. P. U. C), 158 n. 2 New York Bar Association, com- mittee, recommends law permit- ting issuance of shares without par, 100 n., loi/., 125 New York .Central & H. R. R. R. & [Rochester & Eastern Rapid iRy. Co., Re (N. Y. P. S. C 2nd iDist.), 100 n., 103 n. 2 New York Court of Appeals, basis of capitalization, 71/. New York, New Haven & Hart- ford, financial breakdown, 34, 39 & n, 2; payment of unearned dividends, 51; plea for higher rates, 163 New York & North Shore Trac- tion Co., Re (N. Y. P. ,S. C. ist iDist), 69 n. 3 New York Public Service Com- mission, First District, New York City street railway reor- ganizations, 40; basis of capi- talization, 68, 71/., 90; discre- tionary powers, 133 n. 4; ratio of bonds to stock, 142 n. i New York Public .Service iCom- mission. Second District, basis of capitalization, 70/., 83/., go; purposes of issue, 78-80, stock below par, 94 n. 3; shares with- out par, 103 ; allowance of higher rates to uphold credit, 168 New York statutes on purposes of issue, 78-80, 133 n. 3; stock divi- dends forbidden, 78-80; capitali- zation of reorganiziations, 83, 88/.; stock below par, 94 n. 3; ratio of bonds to stock, 142 n. i ; shares without par, 102/., 114, IIS, 119 n. 1, 121-24, 127 New York street railway system, poor service and overcapitaliza- tion, 40 No-par share (see Shares without par value) Notes, short term, not subject to approval of Interstate Commerce Commission, 133 O Ohio Public Service Commission, stock dividends allowed, 78 Ohio statutes, on purposes of issue, 79 n. 5 ; shares without par, 102, lOS, 123, 127 Oregon Public Service Commis- sion, capitalization and fair value, 158 n. 2; allowance of higher rates to support credit, 168 Original investment as basis of capitalization, 74-77, 98 Overcapitalization (,see Capitali- zation, also Stock watering) Pacific Gas & Electric Co., ap- plication to issue stock divi- dend, 70 Pacific Gas & Electric Co., Re (Cal. 'R. C), 104 n. 2 Par value (see also Capitalization and Shares without par value), source of deceit to investors, 52/. ; influence on market values, 50-57 ; shares without, Ch. IV, 135-39; stock issuance below, 72 n. 2, 93-95, 135 ; issuance above, 135-37 Participation certificates without par value, loif., 106 n. Penn Central Light & Power Co., shares without par, 105 n. 3 Pennsylvania Public Service Com- mission, allowance of higher rates to support credit, 168 Pennsylvania Railroad, reinvest- ment of earnings, 148 Pennsylvania statutes, ratio of bonds to stocks, 141 ; shares without par, 102, 104, 123 & n. i, 127 203J INDEX 203 Peoole ex. rel. the D. & H. Co. v. Stevens (iN. Y. 'Ct. App.) , 71 n. i Pare Marquette, payment of un- earned dividends, 51, 58; im- proper accounting, 58 Physical value of American rail- ways, 24 & n. I, 92/. Piper, J., shares without par, 104 n. 4 Portland Railway, Light & Power Co., Re (Ore. P. S. C), 158 n. 2 Potts, iC. ,S., Texas Stock & Bond Law, 149 n. Powell, F. W. & 'Cleveland, basis of capitalization, 64 Preferred stocks, effect of over- issue on railway credit, 48/. ; use of by railways and utilities, 49; without par value, 102, 127-29, 131 Premiums, sale of shares at, 95-7, 118/. Price of issuance, control of, 95- 97, 134-39 Profits, concealment of by stock watering, 23, 55, 96/. Promoters, false statements by, 57 ; profits to, in case of stock with- out par value, 1 16-18, 137 n. 2 Prouty, Commissioner, capitaliza- tion as factor in rate cases, 159/-; on plea for higher rates to support credit, 163 Public Service Commission {see Commissions, public service) Public^ Service Electric Co., per- mission to raise rates to support credit, 168 & n. 7 Public utilities, local, effect of capitalization on rates, 18 Public Utilities Reports, Anno- tated, II Publicity versus regulation of se- curities, 10, 30/., S9-61 Puget Sound extension, finance, 59 Purposes of issue, state laws on, 78-80; federal law, 133/. Railroad Commission of Texas v. Atcheson, etc. (L C. C), 160 Railroad Securities Commission, United States, recommends pub- licity rather than security regu- lation, 30; distinction between stocks and bonds, 46, 64 & n. 3; opposes stock dividends, 82; warns against overissue of bonds, 47 n. 2, 94 n. I ; recommends shares without par, 100 n., 103, 110-12, 129 Railway Age Gazette, breakdown of four railways, 41 ; Alton case, 169 & n. 3 Rate-making value, as basis of capitalization, 67-73, go Rate regulation, capitalization as factor in, 20-38, App. A & B; as cause of railway failures, 41/. ; British and American methods compared, 138 n. i, 140 n. I ; need of liberal policy to permit financing by stock issues, 140/. ; use of to compel reor- ganization of weak roads, 151 Rate of return, effect of capitali- zation on, 31-38 ; " fair rate " versus " expedient rate," 31-36, App. B Rates, effect of capitalization on {see Capitalization and rates) " Reasonable rates," 20-35 Receiverships, miles of road in, 42 Regulation (see Rate regulation, also Security regulation) Reorganizations, as alternatives to rate increases, 38; funds for re- habilitation, 39; as means of equating capitalization and as- sets, 93; reduction of debt through, 47; use of preferred stocks and income bonds in, 49, capitalization of, 83, 88-90, 134/. ; advantage of shares with- out par value in, 109-11 Replacement cost, as basis of rate- making value, 24; as basis of capitalization, 66/., 69, 76, go Richmond Light, Heat & Power Co., Re (Ind. P. S. C), 158 n. 2 Ripley, E. P., Texas Stock & Bond law, 149 n. Ripley, W. Z., 11; evils of over- capitalization, 13 n. I ; New York street railway finance, 40; basis of capitalization, 64 n. I ; Rock Island finance, 114; shares without par, 100 n., 113, 115 n. i, 118; principles of security regu- lation, 13s ; control of issuance 204 INDEX [204 price in Massachusetts, 138 n. 2 ; security regulation in Texas, 149 n. ; Alton case, App. C Rock Island {see Chicago, Rock Island & Pacific) Roemer, Commissioner, capitali- zation and rates, 28 ; shares with- out par, 104 n. i Sague, Commissioner, basis of capitalization, 84 St. Louis & San Francisco, over- capitalization, 33; rehabilitation expenses, 39; financial break- down, 41 ; payment of dividends prior to receivership, 48; receipt of excessive dividends from C & E. I., SI ; reorganization, 89 n. I ; need for higher taxes to support credit, 163 St. Louis & iS. F. R. R. Co., Re (,Mo. P. S. C), 7on. 2, 89n. i San Joaquin Light & Power Corp., Re (Cal. iR. C), 168 n. 2 Scaling down of excessive capitali- zation, 91-93, 146-S3 SchafI, Commissioner, security reg- ulation in- Massachusetts, 75 n. i Seager, H. R., measure of value, 179 & n. I Secrecy, an accompaniment of stock watering, 22-25, 57-61 Securities (see Stocks, also Bonds and other evidences of debt) Securities Commission {see Rail- road Securities Commission) Security regulation, bibliogrgaphy, 186-94; publicity versus regula- tion, 10, 30/., 59-61 ; basis of capitalization, Ch. Ill; control of issuance prices, 95-97, 134-39; no-par shares not a substitute for, 127 Selig:man, E. R. A., 12 Service, effect of capitalization on, 14, 38-43; need of stricter stand- ards of, 151/. Shaffer Oil & Refining Co., shares without par, 105 n. i Shares without par value {see Contents of iCh. IV), biblio- graphy, 100 n. ; as a solution of evils of stock watering, 10, 65 ; historical development, 100-06 ; advantages, 106-11; alleged ob- jections, 1 1 1-24; treatment on balance sheet, 118-24; not a sub- stitute for security regulation, 57, 107, 124-27 ; inclusion of pre- ferred stock, 127-29; optional or compulsory, 129/. ; control of issuance price, 135-39 ; summary, 130/. Shepard, E. M., shares without par, 100 n. Smyth V. Ames (U. S. Sup. Ct.), 21/., 26/., 156-58, 160 Snyder, Carl, capitalization and rates, 19 n. i South Carolina, stock dividends forbidden, 74 Speculation, possibilities of with no-par shares, 1 13-15 Spokane Rate Case (I. C. C), 27, 159 Springfield Consolidated Water Co., Re (Pa. P. S. C), 168 n. 4 Springfield Gas Co. case (Mass. 'Gas Commiss.), 75 n. I State versus federal regulation of securities, 9, 11, 132 Statutes, state {see also Federal regulation of securities) pur- poses of issue, 68, 78-80, stock dividends, 74/., 78; basis of capitalization, 74 & n. 2 & 3, 89/. ; capitalization of reorganizations, 88/. ; outstanding capitalization, ga/. ; stocks below par, 94 & n. 3; shares without par, 102-05, 107, 1 14-16, 121-24, 127-29, 132-35 Stetson, F. L., shares without par, 100 n., IQ2 Stevens, Commissioner, basis of capitalization, 83/., 90; shares without par, 100 n., 103 Stock dividends, objections to, 54/., 57, 126; state laws and commis- sion decisions on, 67/., 74, 75 & n. I, 77-82, 85; defense of, 81/., 139; not forbidden by_ federal law, 134; use in connection with no-par shares, 136, 139 Stock watering, proposed reme- dies, 10; early criticisms of, 14- 15; defense of, 15-16, 53 n. i, 96/. ; a method of concealing in- vestment, 22-25, 48-63; less seri- ous than overbonding, 45-48, 94; 205] INDEX 205 Alton as example, 55/. and App. C; Rock Island as example, 55/. Stocks (see also Capitalization and Shares without par value), con- trol of issuance price, 90, 93-9S, 138; stocks versus bonds, 46-48; ratio of to bonds, 141-46; com- mon stocks, effect of overissue on credit, 49-57 ; preferred stocks, effect of overissue on credit, 48/. Strauss, F., capitalization and rates, 19 n. i ; basis of capi- talization, 87 Street railways, plea for higher rates, 35 n. ; overcapitalization of, in New York City, 40 Submarine Boat Corp., shares without par, 105 n. i Surplus, capitalization of {see also Stock dividends), laws and de- cisions regarding, 74 f., 77-82; arguments pro and con, 81/. ; Alton case, 176/. Texas Railroad Commission, capi- talization of Texas railways, 92/.; scaling down of outstand- ing issues, 98, 148-50 Texas Stock and Bond Law, 92/., 148-50 Thelan, Commissioner, causes of railway failures, 43 n. i Third Avenue Railway, overcapi- talization, 40 & n. 2; reorgani- zation, 68/. Thom, A. P., causes of railway failures, 43 n. i Thompson, iR. A., Texas Stock & Bond Law, 149 n. Toledo, St. Louis & Western ["Clover Leaf"], control of Alton, 173 & n. I, 174, 180, 182 Toms River Electric Co., Re (N. J. P. U. C), 81 n. I Transportation Act of 1920, on se- curity regulation, 9, 132-35, 143, 153/-; on rate of return, 211 & n. I ; on protection of credit as factor in rate making, 165 n. 2 Trolley lines, plea for higher rates, 35 n. ; financial breakdown in New "S:ork, 40 U Undercapitalization, 57; evils of, 95-97 Undervaluation of assets, 95 & n. i Union Pacific, control of Alton by, 56, 173/- United Retail Stores Corp., shares without par, 105 n. i United States Congress, debates on stock watering, 9; reports of committees on security regula- tion, 192/. United States Industrial Commis- sion, Report, relation of capitali- zation to rates, 14 n. i, 19 n. i; basis of capitalization, 64 n. i United iStates Railroad (Securities Commission (see Railroad Se- curities Commission) United States Supreme Court, capitalization as factor in rate making, 26/., 256/. Utah statutes, ratio of bonds to stocks, 141 Valuation for rate making, rela- tion of capitalization to, 21-31, App. A; Texas railways, 92/. Van Metre, T. W., 12, 64 n. i Vermont Public Service Commis- sion, stock dividends permitted, Virginia statutes, shares without par, 102, 104, 124, 127 Voluntary associations, issue of shares without par, 105 n. 3 W Wabash Railway, financial break- down, 41 Wang, C. C, British railway finance, 61 n. i War, leniency of commissions dur- ing, 35, 167/. Washington statutes, ratio of bonds to Stocks, 59 Watered stocks (see Stock water- ing) Westchester Street Railroad Co., Re (N. Y. P. S. C. 2nd Dist.), 64 n. I, 83 206 INDEX [206 Western Power Corp. (of Calif.), shares without par, 103 n. i, IDS n. 3 Western (Rate Advance Case of 191 1, capitalization as factor in rate making, 160, 161 n. 3, 162 Whiter R, shares without par, 100 n., loi n. I Whitridge, Receiver, stock water- ing as cause of breakdown of New York street railways, 40 Whitten, !R. H., rate of return, 31 n. 3 & 4; capitalization and fair value, 156 n. i, 157, 158 n. 2; financial control in Great Britain, 61 n. i, 138 n. i " Windom Committee," relation of capitalization to rates, 14, 17, 19 n. I Wisconsin Railroad Commission, stocks below par, 94 n. 3; shares without par, 104; discretionary powers of commission, 133 n. 4; going-value, 71 Wisconsin statutes, on purposes of issue, 79 n. s ; reorganization, 88; stocks below par, 94 n. 3; ratio of bonds to stocks, 142 Wood, W. A., basis of capitaliza- tion, 64 Worcester, E. P., capitalization and rates, 15 Worcester Gas Light Co. case (Mass. Gas Commiss.), 75 n. i Wyman, B., rate of return, 31 n. 3; capitalization and fair value, 156 n. I, 157 Young, A. A., 12; evils of stock watering, 52 n. i VITA The author was bom in Evanston, Illinois, December 5, 1891. His elementary and secondary training was re- ceived in the Evanston public schools and at the Evanston Academy. In 191 3 he received the degree of A. B. from Northwestern University. During the following year he was in the statistical service of a firm of New York bankers. In 1914 he began graduate studies at Columbia University, with major work in economics and minor work in history, sociology, and statistics. In the field of econ^ omics he attended lecture courses by Professors Chaddock, Mitchell, Ripley, Seager, and Seligman. The present thesis was developed in the seminar of Professor Seligman.. Ini 1918-19 he served, first, in the Statistical Department of the Council of National Defense and, later, in the Economics Division of the Governmietit Inquiry in New York. He became instructor in economiics at Columbia University in the autumn of 1919. 207 *-' %>*^'^.'^' . i -t-H ,' '<-.-, i,, -£lf t ,.J --'-t f S-#t( f ■. v.'/?:. if*'*-'",' HRniiiiiriifnnnsi Him>u«()(!i»«