llHIHIiIlK Mill IW, I Dsz \ / \ THE / NtJMBER_ rai3elerjg itt^urai|i^e €fmpmv ACTtJARIAJ> DEPARTMENT s.s-'g.A: " Kf- D 1. 1 Rate PimnwAay.n "PPCeTTlb^r "^^ 192.0 Gl TmS BOOK IS NOT TO BB TAKEN PHOM THE LIBl^ARr WITHOCT THE OONSIBJT OF THE LTBRARIAS ' 3IHIf=!E 40769 4-13-23 «K — >rv- V.1 F nancial policy of corporations. 3 1924 024 928 099 Date Due SEP '^JVC PRINTED IN -^4496- ^ & NO. 23233 The original of tiiis book is in the Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://archive.org/details/cu31924024928099 The Financial Policy OF Corporations By ARTHUR STONE DEWING Assistant Professor of Economics, Harvard University; author of "Corporate Promotions and Reorganizations," "History of the National Cordage Company," etc. IN FIVE VOLUMES VOLUME I CORPORATE SECURITIES NEW YORK THE RONALD PRESS COMPANY 1920 Copyright, 1919, by The Ronald Press Company Copyright, rg2o, by The Ronald Press Company All Rights Reserved A *fl:.u.^5. TO William Z. Ripley PREFACE This book is a study of the financial structure and the financial problems of large business corporations. The cor- poration has been gradually called upon to assume the opera- tion of those business enterprises which require considerable capital and skill of management but which are not compre- hensive enough for governmental operation. To this concep- tual creature of the law modern society has delegated some of the most important functions of its economic life. And to en- able its many members to co-operate with each other and derive the benefits of each other's capital, the fascinating realm of corporation finance has been gradually built up. The problems connected with this highly artificial realm of corporation finance are intimately connected with great and far-reaching economic and social questions. In the ease with which they effect the transfer of property, corporation securities are a substantial bulwark of an economic democ- racy; in the ease with which they perpetuate the form without the substance of property ownership, they jeopardize the very existence of an economic democracy. It is such contradic- tions as this that give to the financial problems of corporations an importance far beyond mere descriptive economics. It is perhaps not too much to hope that this study will be of value to two groups of persons. There are many business men and bankers who are concerned with finance as a means to a purely practical end — namely that of administering their particular businesses wisely and with broad judgment. If this study helps them to accomplish this practical purpose and to see their daily problems in a wider perspective, it will have served a good end. It is my hope, too, that this study will help to strengthen college teaching in contemporary economic problems. Ameri- vi PREFACE can students are turning, in increasing numbers, to contempor- ary social and economic courses of study. Those educated in the older humanitarian moulds of thought may regret this change in the students' point of view. Nevertheless, it is present. It cannot be stifled, nor circumvented by the substi- tution of the study of other peoples and other times. The alert undergraduate of vigorous, virile personality, the best foundation for the making of American men, wants to know how banks are organized, how railways are run, and how the average man one meets on the street is getting a living. These may be very prosaic questions, but they are very vital ones. And the college undergraduate demands — I know this from an intimate teaching acquaintance with many young men in two of our universities — that his college course shall give him a direct and sympathetic appreciation of the foundation upon which rest those great social and economic questions which present themselves in any direction he turns — the news- paper, the periodical, politics, even the banter of the dilet- tante in social reform. I have a strong belief that there is no opposition between the theory and the practice of sound finance. As in all other spheres of social activity, good practice is based on sound theory and sound theory has its constant pragmatic justifica- tion in successful practice. In their mutual desire to strengthen our economic fabric the practical business man turns more and more to the economist, and the economist feels an increas- ing sympathy and a greater respect for the constructive genius of modern business activity. A small, temporary imprint of Volumes I and II was first printed in 19 19 and these volumes are now reprinted with unimportant changes. The last volumes were finished in 1920. Arthur S. Dewing. Cambridge, Massachusetts. October 15, 1920. INTRODUCTION Finance is the science of money. As the value of money Hes in the value of other things for which it is exchanged, any transaction in which goods or services are given for money, might be called a financial operation. The term "finance," however, broad as would be its most general definition, is or- dinarily narrowed to embrace only a study of the principles and the methods of obtaining control of money from those who have saved it, and of administering it by those into whose control it passes. The term is employed usually in connection with relatively large transactions, in which there may have been difficulty in bringing together the requisite amount of money, or in which a number of different parties are concerned. Regarded, indeed, as a science or a body of scientifically related facts, finance has come to refer to large capitalistic undertakings whether conducted by a government or its political subdivision, or by an individual or group of in- dividuals. The science of finance may be conveniently divided into public finance and private finance. The former deals with the methods of securing money for the conduct of government and the administration of the public funds; the latter with the methods of securing money for private, usually gainful, enterprises and the administration of this money by individ- uals, corporations, and voluntary associations. The two fields are distinct. In the former, money is spent so that it may yield, ostensibly, the greatest value for the members of the community; while in the latter the money is spent so that it will yield, ostensibly too, the greatest ultimate profit to those who contributed it. The point of view is different throughout, although there is this in common, that in each case the ulti- mate economic sanction is the largest value with the least viii INTRODUCTION waste, and the ultimate ethical sanction is justice to all con- cerned. Private finance in its turn may be further subdivided into various departments, such as personal finance, partnership finance, and corporation finance. From another point of view it may be subdivided according to the kind of industry for which the money is gathered— banking finance, railroad finance, public utility finance, industrial finance, or mining finance. The present book is concerned wholly with private finance, and especially with those financial operations carried on by the modern economic unit known as the business cor- poration. The primary purpose of the present work is to describe the financial processes of corporations. Without attempting to formulate a legal or historical definition, a corporation may be described as an organization sanctioned by government to carry on some specific and clearly defined undertaking. The corporation is considered as separate from its members; it is capable of expressing purposes and ideals of its own, of own- ing property, of contracting debts, of suing and being sued — all in its own name without in any way involving its incorpora- tors, officers, directors, or shareholders. In these respects corporations are to be distinguished from partnerships and purely voluntary associations involving the individual respon- sibility of their members. Speaking in general terms, corporations may be divided according to their main purpose into those existing for an altruistic or ideal purpose, such as churches, colleges, and scientific societies; and those existing for an economic pur- pose, the business corporations, such as railroads, banks, and gas works. The term "corporation finance" includes, specifi- cally, the financial transactions of the latter group. Corporation finance deals with both fact and policy. It is concerned with fact, in so far as it describes the prevailing INTRODUCTION ix customs and methods which are employed in the financial ad- ministration of the modem corporation; it deals with policy, in so far as it succeeds in formulating principles or rules of expediency which may serve as guides to sound financial pro- cedure. The two should be distinguished. For example, that short-term notes have been issued extensively by rail- roads since 1910 as a means of securing money from in- vestors, is a plain fact about which there can be no dispute. That such a course has been inexpedient and should not be con- tinued, is a judgment of policy over which there may be a dispute. One is a clear statement of empirical fact, and the other a statement of financial policy. Both kinds of state- ment find places in a science of finance. Yet care must be ex- ercised to distinguish between them, for the former is ob- jectively true, while the latter is significant only as the product of mature generalizations, based on grounds of economic ex- pediency. As in all other branches of the social sciences, what purports on its face to be an inductive principle, turns out on analysis to represent merely a summary statement of a limited, though extensive, area of experience. The assumption that business corporations as a class are organized and conducted primarily for profit, does not ob- scure the still more important fact that in receiving a profit, all private corporations must serve a public end. The rail- roads were built originally by money collected from men who hoped to obtain large profit through their operation. Never- theless the railroad has wrought a veritable social and eco- nomic revolution, welding into a coherent industrial unity the peoples of widely separated geographical regions. Built by private means, and administered by private agencies, the rail- roads, the electric light companies, the gas works, were con- ceived primarily to yield a profit; yet this profit was possible only so long as they served real human need. This is the presupposition of the social justice of private property. X INTRODUCTION Empirical facts and theoretical psychology both substan- tiate the belief that individtial initiative, personal ambition, and even the primitive passion of conquest, are forces which are necessary to produce the greatest efficiency of economic production with the least waste of social capital. The diffi- culty about the modern practice of this theory lies in the in- adequacy of the quantity of capital that can be devoted by a single individual or group of individuals to a single enterprise. Yet economic progress, since the industrial revolution, has de- pended more and more on increasing the quantity of capital at the command of a single enterprise. The capitalization of the Pennsylvania railway system is close to a billion dollars; that of the New York Central system is the same — an amount of capital inconceivable for a private enterprise to command a century or even half a century ago. The all-important eco- nomic problem of the last hundred years has been to secure the initiative and coherence, the force of individual ambition with its attendant responsibility, that goes with the private conduct of enterprise, and at the same time secure to the private managers the necessary capital to carry on vast and expensive undertakings. In brief, it has been the problem of retaining the force and responsibility of private business without the limitations of private capital. The problem has been solved by the corporation.^ The officers and directors of the corporation retain the responsi- bility of private effort, the stockholders furnish the capital in unlimited amounts. Although merely an immaterial form, it has nevertheless wielded an economic and social influence greater than any other purely conceptual entity of the last century. The contribution of the corporation to the evolu- *The books and monographs on the development and economic significance of toe corporation have been legion. See particularly for legal aspects Baldwin, S. E in Two Centuries' Growth of American Law (Yale Bicentennial Series [igoi], and for brief account of early American corporations, Davis, J. S., Charters for Ameri- can Business Corporations in the Eighteenth Century. 15 Jour. Am. Stat. Assn 426 (1916). INTRODUCTION xi tion of the form of modern industry has been no less potent than that of machinery to its technique. Aside from the form of the corporation itself, as a con- ceptual entity, three wide-spread influences have tended to ac- centuate the importance of corporation finance. These are the broader distribution of wealth among small capitalists, the increasing public responsibilities which private corporations assume as they increase in size and influence, and lastly the widening breach between the persons who save capital, that is to say, the capitalistic forces of society, and the managers of business enterprise, that is to say, the entrepreneurs. The extent to which the Fourth Liberty Loan was sub- scribed throughout the country was a revelation to most econo- mists of the potential saving power of the workers, the small farmers, the shopkeepers, in fact the great body of American men and women whose individual margin between receipts and expenditures is ordinarily small. True, the Great War has very much increased the margin of the ordinary worker, farmer, and small entrepreneur, nevertheless the latent power of saving has been present to a far larger and wider extent than anybody realized, even the observant student of con- temporary economic conditions. Much of this vast fund of the small savers has been finding its way into the economic current through the instrumentality of co-operative banks, savings banks, and life insurance companies, so that the ulti- mate origin of the savings has not been at first sight clear. Statistics show, however, that the real owners of the railroads of this country are the life insurance companies and the small national, state, and savings banks; and the real owners of these institutions are the thrifty wage earners, shopkeepers, farmers, and country merchants. The means of the economic development in this country have come, as in England, France, and Holland, from the wide-spread thrifty, industrial, middle class. The United xii INTRODUCTION States Steel Corporation has over a hundred thousand indi- vidual stockholders, the Pennsylvania Railroad and the Amer- ican Telephone and Telegraph have fifty thousand each; be- yond this number there are the millions of creditors of the life insurance companies and savings banks whose contribu- tions have made possible the enormous bonded issues of those corporations. Sporadic cases exist of large capitahsts. The large merchants and large banks use their own resources. But the resources of even such concerns are insignificant com- pared with the aggregate of the small savers of the country to whom the accumulation of capital is merely incidental to the every-day planning of life. This fact explains why there is no capitalist class, for the great industries of this country are owned by the people. It explains, also, why our unstable economic life produces so little of individual permanency — and yet so great permanency of our fundamental economic institutions. All this is possible because wealth has assumed the form of corporation securities instead of titles to land. Another cause for the increasing importance of corpora- tion finance lies in the influence wielded by the great private corporations in our economic and social organization. Soon after the United States entered the Great War it was realized that one of the essential elements to our success was an effi- cient transportation system. Because of the narrow vision and still narrower understanding of men who composed the Interstate Commerce Commission, the railroads had not been allowed to increase their rates in proportion to the costs of operation. Consequently, their earnings had declined and with their earnings their credit. As a result, the railroads had been unable to improve their plants in proportion to the demands of our widening economic activities, so that when the crucial test of the war came, the railroads were — quite as disastrously as the various departments of the government — unprepared for the test. INTRODUCTION xiii The railroads are by no means the only great corporations essential to our national life. When the Westinghouse Elec- tric and Manufacturing Company failed in 1907, creditors, co-operating with the receivers who acted under instructions from the court, sought every means to rehabilitate the cor- poration. The business interests of the country required the active existence of this concern, because it was then the second largest manufacturer of electric equipment in the country. The ideas of eminent domain, of the inviolability of franchise contracts, of regulated monopoly as applied to public service enterprises — all testify to the important place which these enterprises occupy in our modern life. The telephone system, the gas works, the electric light and power company, and the street railroad, are all private corporations of varying size whose activities are indissolubly bound up with the industrial hfe of their communities. These two aspects — the widening ownership of the cor- poration and the widening public concern in its success — have developed together. The success or failure of a business con- ducted by a single individual or a group of individuals is not of wide pubhc interest. Thousands of small businesses fail every year without the fact being noted except in the tables of the credit statistician. The big businesses, with their le- gions of stockholders, are big because of wide-spread owner- ship, and of the public concern which such business activity entails. It is this interaction between increasing size with its increasing number of stock- and bondholders and an increasing public importance, which is one of the most significant ele- ments in contemporary economic history. And these changes have been concurrent with a growing divergence between the owners and the operators of these large corporate enterprises. The economist has long since distinguished between the parts which management and capital play in industry, though he has failed to recognize the fact that xiv INTRODUCTION this separation has applied in practice only to large businesses. In small industries the separation is difficult and inexpedient: the farmer is both owner and operator of his farm ; the phar- macist owns and operates his comer drug store; the local country butcher owns his shop, slaughters his cattle, and sells his meat. But as enterprises increase in size and scope, the operators find themselves able to employ profitably more cap- ital than they individually can command. Then they are ^'backed" by others — first wealthy friends, then the local com- munity, then the great army of small savers who live on less than they produce. In the same way, the first bankers in the rich Italian cities of the Po Valley seven centuries ago were business men who participated in the maritime ventures of others, and somewhat later the first English banks were the goldsmith companies which owned and loaned their gold. As wealth increased on the one hand and business specializa- tion on the other, men who had little if any capital, but marked ability, were led to assume the management of enterprises built with capital furnished by others. Under the simpler economic conditions of earlier times, when the owner and the manager were one, finance was com- paratively simple. But now with a constantly increasing diversification in the elements of a business, the financial methods of the proprietor-manager have given place to others which are increasingly complex. The field of corporation finance has been progressively widened, following the changes in the form under which in- dustries are conducted. From 1830 to 1890 railroads and banks were the only great industries requiring the use of large amounts of capital and hence requiring, of necessity, the cor- porate form of organization. Therefore, the financial terms, methods, and policies connected with the new form became established in railroad finance before they were carried over into othefSndustries. Just prior to the panic in 1893, however, INTRODUCTION xv manufacturers conceived the idea of organizing their com- petitive businesses into large units for which new capital could be secured from public subscribers. Family businesses and partnerships of several generations were changed into corpora- tions, and these in turn merged into great industrial consolida- tions. And concurrently the financial practices were trans- formed to agree more nearly with the established practices of railroad finance. It is this entire body of precedents, prac- tices, policies — based on accident, on law, and on past expe- diency, and applying to all kinds of corporations — which forms the substance of corporation finance. This work is divided into five volumes. The first deals with the form of securities likely to be issued by a corporation. The second traces the embryonic development of a corporate enterprise through the period of organization, or promotion. A third discusses various problems arising from the financial administration. A fourth section describes the methods which may be pursued in obtaining the money necessary to expand a corporation and the forms which this expansion may take. And the fifth and last section is concerned with the failures of business enterprises and the various means to be employed to rehabilitate a bankrupt corporation. The volumes are inter- related ; no single phase of corporation finance is complete in itself. CONTENTS Volume I — Corporate Securities Chapter Page I Capitalization and Common Stocks 3 Elemental conceptions of capital, 3; Economic capital, S ; Capitalization, 5 ; Capital stock, 6 ; Two types of cap- ital stock, 7; Certificates of association, 9; Massachusetts trusts, II ; Certificates of part ownership, 13; Stock with- out par value, 13; Assessment, 16. 11 The General Form of Bonds 17 General definitions, 17; Part of an issue, 18; The promise to pay, 20; The denomination, 20; The time of payment, 21; The rate of interest, 22; The place of pay- ment, 23; The security, 24; Open and closed mortgage bonds, 24; The maturity of bonds, 27; Redemption of bonds, 31; Convertibility of bonds, 33; Lack of voting power, 34; Conditions of enforcement, 35; Investment status of bonds, 36. III Bonds Secured by Pledge of Specific Property . . 40 The classification of bonds, 40; First mortgage bonds, 41 ; The after-acquired property clause, 44 ; Divisional bonds, 45; Special direct lien bonds, 46; Second and later mortgage bonds, 48; General and consolidated mortgage bonds, 50; Refunding mortgage bonds, 50; Collateral trust bonds, 54; Short-term notes, 64. IV Bonds Secured by Credit 67 Nature of straight credit bonds, 67; Receivers' certifi- cates, 68 ; Assumed bonds, 69 ; Guaranteed bonds, 71 ; Joint bonds, 74; Debentures, 77; Income bonds, 82; Par- ticipating bonds, 87; Convertible bonds, 87. V Equipment Obligations 89 General definition of equipment obligations, 89 ; History of their issue, 90; Extent of present use, 92; Chief rea- sons for issue, 94; Economy, 94; Avoid after-acquired property clause, 98 ; Subordinate reasons, 98 ; The Phila- delphia plan of issue, 99; Equipment bonds, loi ; Security pledged, 103; Treatment in reorganization, 109; Invest- ment strength, 112. xvii xviii CONTENTS Chapter Page VI Preferred Stocks ^^3 Status of preferred stocks, 1 13; General description, 114; Conditions of issue, 115; Lien on assets, 116; Re- demption, 119; Preferred stock dividend rate, 121 ; Cumu- lative, 124; Participating, 127; Protection of position, 128; Protection from note issues, 130; Protection from bond issues, 133; Protection from further issues, 134; Management rights, 134. VII Convertible Issues ^37 General description, 137; Historical uses, 137; Conver- sion security of bonds, 138; Conversion security of pre- ferred stocks, 140 ; Conversion ratios, 141 ; Difficult ratios, 143; Convertible short-term notes, 143; Double conver- sions, 144; Periods of conversion, 14s ; Main purpose of all convertible issues, 147. Volume II — Promotion I The Promoter 3 Stages in promotion, 3; The promoter, 4; Promoter and inventor, 5 ; Tlie promotion of an invention, 6 ; The work of a promoter in the public service field, 9; The promoter of a new factory in an established industry, 13 ; The pro- moters of industrial combinations, 14; Value of the pro- moter, 17; The promoter's profits, 19; The legal status of the promoter, 20. II The Banker's Contribution to Promotion 21 The position of the investment banker, 21 ; Contrast be- tween investment banker and institutional banker, 21 ; Con- trast between investment banker and stock-broker, 25; True functions of investment banker, 26; The distributive function, 28 ; The selective function, 29 ; Aids to the invest- ment banker's selection, 30 ; Social and economic service of selection, 34; The administrative functions, 35. Ill The General Principles Underlying the Financial Plan . . 38 The nature of the financial plan, 38; Fundamental con- siderations, 40 ; The cost of the property, 41 ; Future earn- ing capacity, 41; Conditions of the investment market, 46; The balance of control, 47. CONTENTS xix Chapter Page IV The Financial Plan of a New Manufacturing En- terprise 48 Invested capital as a basis for estimated earnings in manufacturing promotions, 48; Value of earnings of other similar businesses, 49; "Dead reckoning" from probable demand, 50; The value of past earnings in the cases of industrial consolidations and reorganizations, 52; The in- fluence of investors' prejudices, 56; Financial plan for highly speculative business, 57; Financial plan for indus- trial consolidation, 58; General summary of principles, S9- V The Financial Plan of the New Public Utility . , 61 Connection between rates and earnings of a local utility, 61 ; Tests of earning capacity of a new utility, 64; Popula- tion, 64 ; Wealth, 65 ; Past and future of locality, 67 ; Actual and potential- competition, 68 ; Comparative earn- ings, 69; Estimation of earnings of a reorganized utility, 69; Money investment required, ']2,; Form of the financial plan, 75 ; Financial plan of an hydro-electric enterprise, 80 ; Human factors in promotion, 85. VI The Financial Plan of a Railroad Promotion ... 88 Kinds of contemporary railway promotion, 88; Early railroad promotion, 89 ; The construction company, 91 ; The financial plan of the new railroad, 97; Illustrative example of small contemporary railroad promotion, 99; Promotion of an interurban railway, loi. VII Underwriting Syndicates 104 General definition of a syndicate, 104; Types of under- writing syndicates, 105 ; The guaranteeing syndicate for sale of a large, well-known corporation's securities, 107; Ordinary underwriting syndicates and the function of the manager, no. VIII Marketing of Investment Securities 129 Kinds of investment banking houses, 129; The whole- sale investment banker, 129; The typical large distributing house, 131 ; The small dealer, 137 ; The procedure of sell- ing, 138 ; The various services rendered by the bond house, 140; The fallacy of direct selling, 146; The profits of se- curity selling, 148. XX CONTENTS Chapter Page IX The Marketing of Low-Grade Securities 152 Risk incident to all promotion, 152; Four methods used to sell low-grade securities, 154; Appeal to avarice, 157; Appeal to speculative instinct, 159; Appeal to vanity, 164; The "sucker lists," 166. Volume III — The Administraticn of Income I The Significance of Accounting Theory in Finance 3 The basis of business policy is the science of account- ancy, 3 ; Accountancy based on a correspondence between economic and money values, 4; Balance sheet and income account contrasted, 5 ; Net profits deduced by two sepa- rate sets of adjustments, 7. II Theory of Compensation for Wasting Assets ... 9 Classifications of adjustments, 9; Repairs, 11; Deprecia- tion, 14; Obsolescence, 21; The important principle of all reserves, 25; Certain objectionable accounting practices, 26. III The Cost of Borrowed Capital 29 The problem of the use of capital, 29; Classification of payments for borrowed capital, 30 ; Cash discounts, 31 ; Interest on merchandise loans, 31 ; Interest on funded debt, 32; Rentals and royalties, 34; The amortization of bond discount, 37; Summary statement, 40. IV Management of Surplus 42 Sources of the surplus, 42 ; Paid-in surplus, 43 ; Surplus through the sale of stock at a premium, 44; Surplus through sale of capital assets at an advance over book values, 45; Surplus through reorganization, 49; Accumu- lated surplus from earnings, and its investment, 50. V Special Reserves for Business Contingencies ... 54 The necessity of special reserves, 54; Classification of these special reserves, 56 ; Reserves for taxes, 57 ; Reserves for property destruction, 60; Reserves for public, unre- munerative improvements, 65 ; Reserves for business uncer- tainties, 69. CONTENTS XXI Chapter Page VI The Principles Governing the Distribution of Profits to Stockholders 72 The distribution of surplus to the stockholders a matter of policy, 72 ; Considerations determining dividend policy, 76 ; Reinvestment of surplus in the business, ^^ ; Confidence in accounting methods, 80; Regularity in dividend pay- ments, 82 ; Importance of dividend regularity, 84 ; Dividend regularity involves the prediction of earnings, 86; Extra dividend, 97; Bond and scrip dividends, 98; Stock divi- dends, loi ; Property dividends, iii; Taxation of stock dividends, 112. VII The Practical Expediency of Dividend Disbursements 114 Principles of dividend distribution applied to concrete cases, 114; The small manufacturing business, 114; The small public utility, 118; The small railroad, 121 ; The local bank, 123; Effect of widespread ownership of common stock, 123; Principles illustrated by resolution of Union Pacific Railroad directors, 124. VIII Treatment of Sinking Fund Reserves 125 Reasons for the existence of a sinking fund, 125 ; Occur- rence of sinking fund, 126; Methods of operating the sink- ing fund, 130; Fixed reserves, 131; Varying, clearly de- fined reserves, 132 ; Reserves depending on the fluctuations of business, 133; Optional sinking funds, 136; Investment of sinking funds, 137 ; Serial bonds, 141 ; The sinking fund and permanent debt, 143 IX The Voting Trust 146 Origin of the voting trust, 146; Purposes of the voting trust, 148; Chief use at time of reorganization, 150; Re- striction of trustees' powers, 152; Termination, 154; Le- gality and value, 155. Volume IV — Expansion I Underyling Motives and Principles 3 Problem defined, 3 ; Two fundamental problems involved, 4; Motives leading to expansion, 4; Ambition, 4; Creative impulse, 5; Profits, 6; Speculation, 6; Procedure of the present study, 7. xxii CONTENTS Chapter Page II The Law of Balanced Return . 9 Statement of the Problem, 9; Law of diminishing re- turns, 10 ; The scope of the law, 12 ; Application of dimin- ishing returns to manufacturing, 13; Quantity factors in production, 14; Illustrations from shoe industry, 16; Tentative conclusions, 19; The law of balanced return expounded, 21 ; Illustrations of the operation of the law, 25. III Industrial Combinations 33 The problem of industrial incorporations, 33 ; Historical survey of industrial consolidations, 34; Reasons for cessa- tion of industrial consolidation, 38; The failure of the industrial consolidation, 41 ; The present-day problem, 52 ; Importance of extremes of ability, S3; Four modern suc- cessful types of consolidation, 54; Automatic industries likely to succeed in large-scale production, 54; Integrated industries, 54; Chain stores, 57; Export companies, 64. IV The Expansion and Consolidation of Railroads . 69 Methods of treating subjects, 69; Analysis of forms, 71; The lease, 74; Traffic leases, 76; Gross earnings leases, 76; Net earnings leases, 77 ; Fixed rental leases, 79 ; Stock con- trol by purchases, 83 ; Stock control by exchange, 85 ; Stock control by collateral trust bond, 86; Outright purchase, 92; Historical period of railway consolidation, 94; First period of end-to-end consolidations, 96; Second period, 100; Third period, 106. V The Public Utility Holding Company 109 Means of control over many small companies, 109 ; Early history, no; Four advantages, 113; Superior technical effi- ciency, 114; Economy in purchase of equipment, 118; Ad- vantage in business dealings with public, 118; Advantages in financing, 122; Financial structure of the public utility holding company, 128; Special types of holding com- pany, 134. VI The Community of Interests 137 Problem of business organization a balance between unity and diversity, 137; A balance involving advantages of each, 139 ; Trade associations, 145 ; District associations, 146 ; Manufacturers' associations, 151 ; Community of in- terests, 154; Community of interests in production and dis- tribution, 155; Community of interests in stock owner- ship, 157. CONTENTS xxui Chapter Page VII The Sources of Capital and Short-Term Borrowings i68 Problem of new capital, 168; The investment of earn- ings, 168; Growtli of short-term corporate borrowings, 172; Evils of short-term notes, 174; Distinction between self-liquidating and fixed property, 176. VIII Expansion Through the Sale of Securities to Bankers 180 Problems to be considered, iSo; Advantages of issues of bonds rather than stock, 181 ; Advantages of stock issues, 184; Advantages of sales through bankers, 188; Assur- ance of sales, 188; Widening of market for securities, igo; Relative economy, 193 ; Exchange, 195 ; Growing use of stocks rather than bonds, 196; Pretended safeguards from point of view of investor, ig8. IX Privileged Subscriptions 202 Conditions of privileged subscription, 202; Terms of offer, 203 ; Value of the right, 210 ; Effect of the privileged subscription on the market price of the stock, 213 ; Methods of taking advantage of privileged subscription, 214; The profits from privileged subscription, 217; Underwriting privileged subscription, 218. Appendix ... 221 Volume V — Failure and Reorganization I The Problem of Reorganization .... ... 3 The problem stated, 3 ; The importance of reorganization, 5 ; Motive, 5 ; Difficulty of definition, 7 ; Two stages in reorganization, 8. II Causes of Failure 10 Distinction between the fundamental and the superficial causes of failure, 10; Four fundamental causes of failure, II; Competition, 11; Unprofitable expansion, 14; Cessation of public demand, 21 ; Excess payments of capital charges, 22; Superficial signs of failure, 26. Ill The Procedure of Reorganization 29 Motives governing the procedure of corporate reorgan- ization, 29; Events immediately preceding failure, 33; Formation of committees, 33 ; Classifications of reorganiza- tions according to legal procedure, 37; The appointment of a receiver, 40; Investigations succeeding receivership. xxiv CONTENTS Chapter Page 48; The formation of the reorganization plan, 52; Execu- tion of the plan, 55 ; Adjustment of opposing interests, 60. IV The Reorganization of Railroads 66 Importance of railway reorganization, 66; Summary of the intents of railway reorganization, 67; Five periods in the history of railway reorganization practice, 70; Earliest period of railway failures, 72; Second period comprising reorganizations following the panics of 1857 and 1873, 73; Third period of the later eighties, 77; Fourth period fol- lowing the panic of 1893, 80; Contemporary theory and practice of railway reorganization, 86; A classification of railroad reorganizations, 90. V Money Requirements at Time of Railroad Reor- ganization 96 Divisions of the subject, 96; The treatment of floating debt holders, 97; The issue of receivers' certificates, I02; The uses of new money, 105 ; The sale of treasury assets, 108; Assessment of stockholders, 109; Expediency of meeting assessment, 120; Reorganization underwriting syn- dicates, 122. VI The Reduction in Fixed Charges in Contemporary Railroad Reorganizations 129 Reorganization plans all modifications of the first type, 129; Classes of securities to be dealt with, 130; Treatment of the underlying bonds, 131 ; Treatment of first general mortgage bonds, 140; Treatment of junior bonds, 149; Reorganization of Class II, 151 ; Reorganization of Class III, 153; Cancellation of burdensome leases, 155; Voluntary reorganization, 159; Effect on total capitaliza- tion, 160. VII Industrial Reorganization Plans 162 Causal characteristics of industrial reorganizations, 162; Chief ends of an industrial reorganization, 166; Simple means of obtaining money, 167; Assessment on security holders, 169; Assessment on outside creditors, 172; Changes in capitalization, 174; Reorganizations to e>ctinguish ac- cumulated preferred stock dividends, 176; Reorganizations to relieve a burden of floating debt, 181 ; Reorganizations to reduce fixed charges, 183; Voluntary industrial reor- ganizations, 185. General Index 107 The Financial Policy OF Corporations VOLUME I CORPORATE SECURITIES CHAPTER I CAPITALIZATION AND COMMON STOCKS Elemental conceptions of capital, 3 ; Economic capital, 5 ; Capitali- zation, 5; Capital stock, 6; Two types of capital stock, 7; Certifi- cates of association, 9; Massachusetts trusts, 11; Certificates of part ownership, 13; Stock without par value, 13; Assessment, 16. The securities which a corporation may issue consist of two general types: stocks and bonds. Their characteristics, rules, etc., will be discussed in detail in the succeeding chap- ters of this voliune. Here it is advisable to consider first the general subject of capital and capitalization. The elemental conception of finance, is capital. The word "capital" has been used, unfortunately, in such a variety of senses that it is now meaningless outside of its context. As a conception of economic theory it has been defined, inter- preted, and reinterpreted according to the training or whim of the economist. As a conception of accounting, it has been variously conceived as an asset or a liability, as property or merely an equity. In our common speech it has come to imply a variety of meanings all vaguely in accord with the va- riety of views current in the business world. From the point of view of the theoretical economist, trained in the positivism of Smith, Mill, and Cairnes, capital means one thing, namely, the material goods created through the labor of man which are devoted to the production of wealth. The term "capital" designates both material goods made by men, and society's instruments of production. With this theoretical definition we are not here concerned, except to comment that all other conceptions of capital are ultimately based on this description; a-U other conceptions presuppose 3 4 CORPORATE SECURITIES the three elements — labor, material goods, and productiveness — involved in the definition used by the classical economists. We are here concerned with the term "capital" as used in business, together with two related terms expressive of dif- ferent aspects of the fundamental idea of property value: namely, "capitalization," and "capital stock." By "capital" is meant — in ordinary usage — the actual property devoted to some productive end.^ It is the substance of the business. In some cases it is convenient to distinguish between gross and net capital, the former referring to the investment of the proprietors plus their borrowed capital and the latter to the proprietors' own capital alone.^ At all events the word "cap- ital" must be used to refer to actual physical goods, the muscle and the sinew of economic production. The terms "capitalization" and "capital stock" are repre- sentative. They refer not to physical goods, but to the values set over against the actual capital of the business. They are of accounting or representative significance; they stand for the liabilities of a business and not its assets.^ Capitalization is the sum of the various values by which the proprietary interests of a corporation care to evaluate the actual capital. That portion of the total capitalization of a business which they, the proprietors, claim represents their own personal ^ Two modern writers dealing with capital from tlie same point of view as id tiiis book have said, "Capital assets are all those funds, properties and equipment re- quired for continuous, productive use." Cleveland and Powell, Railroad Finance, 322 (1912). ' Ripley uses the term "gross capital" to refer to an aggregate of funded liabili- ties where there has been no effort made to avoid duplications,_ and "net capital" to the sum of such liabilities where all duplication has been avoided. Ripley, W. Z., Railroads Finance and Organization, 61 (1915). This distinction is of the utmost importance in railroad finance, and recent public utility finance. ^ A great deal has been written from the different points of view of economic theory, finance, and accounting in the effort to distinguish between and define the different uses of the concept of capital and its derivatives. See particularly Cleve- land and Powell, Railroad Finance, Chap. Ill and XVII (1912); Ripley, W. Z., Railroads, Finance and Organization, Chap, 11 (1915). Every treatise on economics feels compelled to discuss the question, but few shed much illumination. Among the books on corporation finance, strictly speaking, the most exhaustive discussions are found in Lyon, W. H., Capitalization (1912), whose main efforts are directed toward clarifying our usage of these words. See also discussion in Cooper, P., Financing an Enterprise, Part IV (1915). CAPITALIZATION AND COMMON STOCKS 5 capital, they call "capital stock"; that portion which they admit is borrowed from others, they call "debt." In brief then, and as used hereafter in these pages, "capital" refers to the actual wealth employed in an undertaking, and "capitaliza- tion" to the representation of this wealth in terms of purely artificial and, in the end, fictitious values.* A part of these representative values, namely those contributed by the pro- prietors, is designated "capital stock"; and the other part, that contributed by outsiders, is spoken of as "debt." In a single-proprietor business, or even in a partnership, capital is the total of assets of the business. In concrete cases it is determined from an inventory of the actual property owned by the proprietor or the partnership. In businesses conducted by corporations, this simple way of ascertaining capital cannot be used, owing to the necessity of establishing a balance between the assets and the liabilities. The capital is not the aggregate of assets, because the apparent assets are generally inflated by fictitious bookkeeping entries, such as bond discount or the various balances from contingent reserve accounts. It is, on the contrary, the actual or real wealth values used by the corporation — those which have a positive and marketable value. That is, it is the amount of economic goods segregated by the corporation for its own purposes."* The term "capitalization," or the valuation of the capital. * Ripley makes the same distinction: "The property brought into being as capital remains forever entirely distinct from its capitalization, albeit linked in a causal relation thereto. Capital is reality. Capitalization is merely a record of past operation and a bench mark or standard of measurement for the future.' Eipley, W. Z., Railroads, Finance and Organization, 55 (igiS)- = There are two distinct uses of the word "capital," both accepted by business men One refers to the total property employed in a business, irrespective of its final ownership, and the other to the amount actually owned by the proprietary in- terests Thus an individual or a corporation takes $100,000 of its own money and borrows $200,000 more, investing the entire amount in a plant, its equipment, and a stock of merchandise. It is possible to refer to the capital as either $300,000 or $100 000, according to whether one follows the first or the second usage. In the present discussion the first usage is followed as more consonant both with current business practice and with the idea of capital as expressed by sound economic theory. 6 CORPORATE SECURITIES includes the capital stock and the debt. In individual pro- prietary and partnership businesses the term has no signifi- cance, as there is no occasion to represent the capital of a business other than in terms of actual property. But with the corporation the matter is entirely different. The corporation is conceived to be the recipient of a fixed amount of property which remains constant, no matter what the fortunes of the business. This is the capital stock. In addition, the corpora- tion borrows money from outside sources. The sum of these amounts represents the securities or the representative values issued against the actual capital employed in the business. In a concrete case it is often difficult to determine the exact amount of capitalization, because much corporate debt repre- sents merely temporary borrowings more or less completely offset by an ever-changing volume of current assets. The idea, however, of capitalization is that it shall represent the capital stock and the permanent or funded debt. It is the total securities or representative values issued by the corpora- tion against its actual property." Capital stock, common stock, or merely stock, represents invariably the interests of the proprietors in the corporate en- terprise. In no sense can stock represent an outside claim; in no sense can the stockholder regard himself as a creditor.^ ^ It is very difficult to determine the capitalization of a railroad. While in a simple case it may be fixed by adding together its capital stocks and its bonds one is always perplexed by a variety of other liabilities. In some railway systems, like the Lackawanna, the rentals must be capitalized. In others, like the New Haven, the current debt must be included, as this current debt was incurred in order to construct permanent additions to the property of the road. On the other hand, there must be various adjustments for joint bonds, collateral trust bonds issued on pro- prietary lines, and all contingent liabilities, as in the case of the Great Northern, Northern Pacific collateral trust joint bonds. For example, Ripley questions to the length of an appendix, the extreme difficulty of proportioning the capitalization of jointly owned termmal roads.^ Ripley, W. Z., Railroads, Finance and Organization, 609 (1915). In actual practice, great care must be .exercised in any given case and no general rule can be laid down as to what liabilities to include and what not to include in determining the net capitalization of any railroad. ' This distinction is sometimes obscursd by such anomalous cases as redeemable stock and participating bonds. Yet, as clearly brought out in the American Malting and later cases, the distinction is still recognized by the law of corporations and is fundamental to corporation finance. CAPITALIZATION AND COMMON STOCKS 7 The fundamental idea of stock is that it represents the pro- portionate contribution to the original capital or property of the corporation. Stock is the share of interest, the share of responsibility of management, and the share of profit or loss.* So far as the complexity of modern business permits, the stockholder is the business partner of the old-fashioned partnership, but lacking certain of the legal implications at- tending the position of partner. Unfortunately this original simplicity has been modified by the demands of the increas- ingly complex financial organization of business, so that in many forms of stock this original simplicity of motive is obscured or almost entirely obliterated. The import of capital stock then, is that it shall stand for the representative values of the proprietary interests; repre- sentative values which may or may not include the entire assets or actual capital of the corporation. There are two types of capital stock, unlike in the extent of the rights which the ownership implied involves. One type of capital or common stock stands for the entire capital of the business. The stockholders own everything. There are no preferred shareholders, no bondholders, no short-term note- holders. The other type represents merely the margin of assets and earnings after the claims of a host of preferred stocks, bonds, and notes have been satisfied. From every point of view, except that of legal status, these two types of common capital stock must be carefully distinguished. The simpler form of corporation with its single class of capital stock was developed logically and historically out of the partnership. Capital stock of that first type, representing the entire business, was therefore prior in point of time as » The most exhaustive discussion of capital stock in contrast to the liabilities of a corporation is Lyon, W. H., Capitalization (1912). The seeond chapter entitled '.'Trading on the Equity" is a very able exposition of the economic status of the stockholder. 8 CORPORATE SECURITIES well as first from the standpoint of simplicity. It was only in later developments of corporate enterprise that bonds, or preferred stock, or any other form of capitalization than stock alone came into use. The vast majority of all the railroads of the East promoted prior to 1840 were constructed from money subscribed by stockholders, in the same manner as stockholders now furnish the share capital of a bank. With- out exception the main railroads of New England were origi- nally built by the inhabitants along their lines who took ordi- nary common stock. Even today many sections of the New England railroads are unmortgaged, although the great na- tional railways systems, particularly since the year 1900, have paid for most of their extensions through the issue of bonds.^ Throughout the history of American railroad finance the tendency has been from the simple financial plan to the com- plex, from plain stock to stock and mortgage bonds, then to two kinds of stock and the wide variety of bonds covering the simple mortgage and the intricate, non-cumulative income bond. The financial methods of public service enterprises have undergone a parallel development. The first gas works in the older states were built entirely from stock subscription and the old Massachusetts public service corporations still have only stock outstanding. But, as in the case of railroads, when extensive enlargements requiring other than local capital were necessary, it was found easier to secure money through the sale of bonds than through the sale of stock alone. At the same time preferred stocks were introduced to meet the requirements of an investing class who were willing to sacri- fice security for high return. The development has moved more slowly in the case of manufacturing enterprises than ^ For example, note the small bonded debt of the New Haven in 1899. See Poor's Manual. This matter is further discussed by Cleveland aind Powell, Railroad Finance, 50 (1912). Ripley, W. Z., Railroads, Finance and Organization, 10 (.1915). For special studies see Volume II, Chapter VI, CAPITALIZATION AND COMMON STOCKS 9 with public utilities. Because the large industrial combinations are still on trial, as it were, before the bar of investment preju- dice and can obtain money only from people directly inter- ested, stocks still predominate in their financial plans. Yet there is clearly apparent a growing inclination to diverge from the original custom of issuing only common stock and create in addition both preferred stocks and bonds. To recapitulate then, in the wide range of the railroads, the lighting and power, and the manufacturing businesses, the original form of a common stock, representing the entire business, has been more or less superseded by a common stock representing merely nominal rights in residual equities. Common stocks of the first group — representing rights to the entire property — are now restricted to a few small rail- roads, the majority of Massachusetts electric light and gas companies, most small and medium-sized cotton mills, locally owned manufacturing companies, banks, insurance companies, and mines. There have been in almost every case some special reasons tending to hold back these types of industry from developing the more elaborate form of capitalization. Until recently the tax laws in Massachusetts levied a general prop- erty tax on bonds, but not on stocks, so that gas, electric light, and even cotton mills, found a readier sale for their tax-ex- empt stocks among local capitalists. Small manufacturing companies everywhere find the banks reluctant to extend credit to bonded plants; banks and insurance companies are prevented by law from altering the form of their original stock issues; mines find it impossible to sell bonds. Investors in any of these stocks are the actual owners of the business, subject only to the claims of the holders of floating debt and the merchandise creditors. Analogous to the common stocks of corporations possess- ing the entire rights to the corporate property are the shares lO CORPORATE SECURITmS in associations, shares in trusts, and certificates of part owner- ship. Except in the legal obligations taken by their own- ers, which are analogous to those of partners, these anomalies are common stocks in all but name. The certificates in asso- ciations are, in truth, certificates of partnerships. Owing to the unlimited liability that attaches itself to such partnership interests, these certificates of associations are not in use any- where in the United States, except in the case of the large express companies and certain small New England businesses which have maintained a kind of localized partnership char- acter for the last fifty or more years. The Adams and Amer- ican express companies' stocks are the only remaining part- nership shares widely held by the public. These partnerships were formed some fifty years ago — by means of "Articles of Association" under which the original associates and their successors agreed to engage in the express business.^" The management was restricted to a small group of officials which organized and maintained itself independently of the great body of certificate holders or partners. In this manner the management of the Association was independent of all regulation either from within or without, and it was not until the Federal Government, by the constitutional authority of the "commerce between the states" provision, placed the ex- press companies under the Interstate Commerce Commission that any control was exercised over the conduct of their busi- ness. This power of the management to conduct the affairs ^•^ The certificates of the American Express Company read as follows: "Amehi- CAN Express Company^ organized under Articles of Association, dated November 25, 1868, in which it is among other things provided: That the term of the existence of said company shall be thirty years from and after the first day of December, i86d. That the snares shall be transferable on the books of the company only in person or by Attorney, upon surrender of the script representing the same and the payment of all calls and assessments unpaid thereon. That such transfer is not matter of right, but is permitted by the Company, in case the Board of Directors shall not elect to purchase said shares for the benefit of the Company at the market value thereof. That the shares are subject to assessment for all losses and damages and other liabilities incurred in the prosecution of the business of the Company. That the receipt of this certificate constitutes the person receiving the same, from the date thereof, a member of said Company, entitled to all_ benefits and subject to all the liabilities of a shareholder therein as fully as signing said Articles of Association would do." CAPITALIZATION AND COMMON STOCKS n of the express companies without financial responsibility to the shareholders has worked greatly to the latter's disad- vantage/^ Shares of trust, or business associations survive only in Massachusetts." Historically they owe their origin to the fact that corporations cannot hold real estate for investment (mortmain). Title to property, accordingly, is taken by a group of trustees who issue their certificates of equitable in- terest in the trust property. The trustees derive their au- thority from trust agreements or articles of association, which describe in detail their powers, rights, and exemptions, to- gether with those of the certificate holders. When the trust form of organization was driven out of other states" it re- mained in Massachusetts because, sanctioned by a century of usage, a large amount of property had passed under the trust organization and the persons most concerned exercised a strong influence on the course of legislation. The exact legal status of the Massachusetts Voluntary Association is extremely difficult to determine and has given rise to much litigation and a good deal of legislation." If the associations are actually express trusts, then the holders of the certificates, beneficiaries or "cestui que trustent," can have no voice in the management. If on the other hand, the " An illustration of this is afforded by the purchase of a large interest m the Wells Fargo Company by the American Express Company at a greatly inflated price and the retention of its large holdings of New Haven stock, although not operating over this road. Altogether the management of the American Express Company, especially in the matter of its investments, has been conspicuous for its stupidity. " Except elsewhere in a iew cases where specifically permitted by law, as in the case of the Chicago Elevated Kailways. See note 29 of this chapter. "Largely because of the North River Sugar, 121 N. Y. 582 (1890), and the Ohio Standard Oil, 49 Ohio 137 (1892) cases. "There are a number of discussions of the subject, besides the innumerable ^ ^Lewfn,' The Law of Trusts, Harvard Law Review,. Vols. I, IV, and VII. Sears J H., Trust Estates as Business Corporations (1912). Wrightington, S. R., The Law of Unincorporated Associations (1916). 12 111. L. Rev. 482 (1918). Two le^gislative "eports contain exhaustive discussions of the subject. Mass. House Doc. No. 1646 (1912); No. 1788 (1913)- 12 CORPORATE SECURITIES beneficiaries are given managerial power, then the association partakes of the nature of a partnership and the holders of the trust certificates become legally bound for the debts of the trust estate. To secure a kind of control by the shareholders, yet immunity from personal liability, has been the aim of all these voluntary associations/* Such an association, with transferable shares, was decided to be legal over thirty years ago,^° notwithstanding an old English statute to the contrary;" and subsequent decisions have given the voluntary association a secure position among Massachusetts business forms/^ Until recently these volun- tary associations with transferable shares had all the advan- tages of the corporate form of organization, and were free from many of the disadvantages. Accordingly, in addition to their original purpose of holding land for investment, they have been formed, extensively, to operate cotton mills in Massachusetts and even in other states,*" public utilities in™ and out of Massachusetts,^* and other enterprises. But their prominence led to a number of statutory limitations beginning in 1913^^ which have now placed these associations in prac- tically the same position as corporations. Trust certificates are bought and sold as are corporate stock certificates and a large number of those who invest in them are ignorant of their true nature. " Gerstenberg, C. W., Materials of Corporation Finance, 11 (1915), gives an excellent example of an agreement under which one of the most important of these voluntary associations — the Massachusetts Electric Companies — was formed. •^Phillips V. Blatchford, 137 Mass. 510 (1884). An important recent leading decision is Hussey v. Arnold, 185 Mass. 202 (1904), " St. 6, Geo. I, C-18. "See among others 14c Mass. 346; 168 Mass. 566; 174 Mass. 491; 183 Mass. 202. Exhaustive discussion in legal treatises referred to under note 14 above. ^ Amoskeag Manufacturing Company of Manchester, New Hampshire, the largest single cotton mill in the United States and possibly in the world. _ 20 Massachusetts Gas Company, Massachusetts Electric Companies, Central Elec- tric Trustees. ''Texas Southern Electric. ^,Act to punish Trustees of Voluntary Associations who do not file reports with Commissioner of Corporations. Gen. Acts Mass. 1913, Chap. 376, and for publishing such reports. Ibid. Chap. .£07. CAPITALIZATION AND COMMON STOCKS 13 Certificates of part ownership based on the direct owner- ship of property are of rare occurrence except in the coastwise shipping business. In this business a vessel is bought by a group of men and the cost divided into tenths, twentieths, or any other convenient fraction. Each member of the group is then given a certificate representing the fractional part of the cost for which he is responsible. Thus one member may own one-sixtieth of a schooner, another seven-sixtieths, and another ten-sixtieths, according to the original contribu- tion. The profits of each voyage are divided among the group in proportion to the certificates of ownership. On the other hand, if the voyage is conducted at a loss, or if the schooner runs on a shoal and repairs are required, the losses are pro- portioned according to the certificates of ownership. Capital stock, whether of the type that represents all the assets of the corporation or the type that represents merely the residual equity after all other claims have been satisfied, involves two distinct ideas — a participation in the rights of ownership, and a valuation of this participation. This latter is the par value. It is the less important. The stockholder can never collect, like the bondholder, the par value of his security from the corporation. Even though paid for in full and representing for a short time the full and actual value, the equality passes with the first business transaction, for the value of the property behind the shares changes with every step in the success or failure of the corporation, as new property is added or old property lost or dissipated. The essential character of capital stock that remains permanent whatsoever the fortunes of the actual capital, is that it stands for a definite proportion of the corporate property and earnings. This involves no par value.^' The purpose of stock would therefore be fully ac- ^Gerstenberg C. W., Materials of Corporation Finance, 43 (191S). gives an ex- ample of a certificate of incorporation with shares of stock without par value. M CORPORATE SECURITIES complished if the shares were merely proportionate parts of a total, in other words, shares without par value.^* There would be, aside from doing away with the meaning- lessness of par value, certain specific advantages. The most conspicuous is that of truthfulness. Without par value there is no pretense that the actual property of the corporation is equivalent to the par value of its shares after the liabiHties are met, and there is no insinuation of overcapitalization or under- capitalization. In other words, the capital stock would stand merely for proportionate shares in the earnings of the corpora- tion, and, if the corporation be liquidated, the proportionate shares in the equity remaining after all other claims had been satisfied.^^ Another cardinal advantage would be that of forcing the prospective investor to examine the real value of stock, and not be deluded into thinking that there is some necessary connection between the par value and the real in- trinsic value.*® ^ The plan has been widely discussed and vigorously defended on the ^ound that, at most, the par value is a fiction. See particularly 26 Harvard Law Review 729, and the Report of the Railroad Securities Commission, November i, 1911. It has been vigorously opposed by Ripley, especially with reference to railroads, on the ground that it would relieve the stockholders of financial responsibility to the creditors in case of fraud (Ripley cited at length the famous case of the Cincinnati, Columbus and Hocking Valley Railroad), and would give a kind of legalized sanction to the unrestrained issue of bonus stock at the time of promotion. Ripley, W. Z., Railroads, Rates and Regulation, 575 (1912); Railroads, Finance; and Organization, 90 (1915). On the other hand, the policy has been advocated by the majority of writers on cor- poration finance. A short vigorous defense in Lyon, W. H., Capitalization, 104 (1912). A more elaborate discussion in Cooper, F., Financing an Enterprise, Chaps. XVI and XVII (1915). Perhaps the best discussion recently is that in Ignatius, M. B-, The Financing of Public Service Corporations, Chap. IV (igi8). The writer here con- siders the problem with special reference to the proverbial difficulty of public service commissions in dealing with the traditional par value of public service corporation securities. See also Lough, W. H., Business Finance, 95 (1917); Mead, E. S., Cor- poration Finance 45 (1915); Walker, W. H., Corporation Finance, 201 (1917); Qeve- iand and Powell, Railroad Finance, Chap. Ill (1912). 25 A clear statement of this advantage of truthfulness is to be found in the Report of the Railroad Securities Commission appointed by President Taft. **W© do not believe that the retention of the hundred-dollar mark, or any other dollar mark, upon the face of the share of stock, is of essential importance. We are ready to recommend that the law should encourage the creation of companies whose shares have no par value, and permit existing companies to change their stock into shares without par value whenever their convenience requires it . . . As between the two alternatives of permitting the issue of stock below par, or authorizing tile creation of shares without par value, the latter seems to this Commission the preferable one. ... It is less in accord with existing business habits and usages; but it has the cardinal merit of accuracy. It makes no claims that the share thus issued is anything more than a participation certificate." ^^ This has been admirably expressed in one of the early decisions of the Lower New York Public Service Commission: "It may well be considered a matter worthy CAPITALIZATION AND COMMON STOCKS 15 Numerous cases exist where the common stock has no par value, although such issue is not permitted by the laws of the great majority of states. New York is a conspicuous excep- tion." Under the enabling statutes of the New York corpora- tion law some very important corporations have been chartered without a par value for their common shares. The company controlling the entire traction system of New York City is a case in point.^^ In Chicago a modified plan of shares without par value has been used for the traction system.^^ In Massa- chusetts many of the voluntary trusts have no par value what- ever for their shares, while others are represented to have a par value only on liquidation.^" The most recent form of en- terprise to adopt the practice is that of mining. Here, of all industries, the amount paid in is least indicative of ultimate value.^^ of grave reflection whether in the case of at least all corporations hereafter organized a certificate of stock should have no par value, but should state only that the owner is entitled to a named proportional interest in the corporation. Every prospective purchaser would then be required to get a notion of the value of the property from a source other than the sums named on the certificate. The owner could not expect or demand returns upon a fictitious basis. The real would supersede the unreal in most investigations as to corporate values." Re N. Y. C. & H. R. R. R. Co., I Pub. Ser. Rep. (N. Y., and Dist), 294. "The change was made In 1912 after indorsement by the New York Bar Associa- tion. The Act itself is given in Gerstenberg, C. W., Materials of Corporation Finance, 47 (1915), ^ The old Interborough-Metropolitan Company was reorganized in 1915 to form the Interborough Consolidated Corporation which issued $45,740,500 par value of 6 per cent non-cumulative preferred _ stock and 932,626.92 shares of common stock with no par or nominal value. This is the most important case of no par value stock thus far issued. " The Chicago Railways Company, that controls the surface lines, was created with a nominal amount of capital stock — $100,000 — all held under a trust agreement. Against this were issued 265,100 shares. Of this amount 30,800 shares were first entitled to $8 a year accumulative dividends, then 124,300 shares entitled to the same amount, then 60,000 shares again entitled to the same amount, and finally the remain- ing 50,000 shares were to participate in any remaining earnings. In the case of the Chicago Elevated Railways, a voluntary association like the Massachusetts trusts, the trustees issued 160,000 shares of preferred stock and 250,000 of common stock. The preferred shares were redeemable at $100 and in many respects the shares may be considerd as having a par value of $100 cash, so that the idea of par value has not been entirely eliminated. '"Thus the Commonwealth Gas and Electric Company, a Massachusetts voluntary association, has 15,005 shares of preferred stock with a par value of $100 each, and 15,005 shares of common stock with no par value. The Central Electric Trustees of Massachusetts have preferred shares of a par value of $100 each, not limited in num- ber by their Articles of Association, and 50,000 shares of common stock without par value. »A recent notable example of this is the Kennecoft Copper Corporation, organ- ized in 1915. l6 CORPORATE SECURITIES Capital stock is usually, although not always, full paid. In other words, the corporation subscribes to the legal fiction that property to the full par value of the stock was paid into its treasury in exchange for the shares. When, as is generally the fact, this is not done in reality, the statutes of the various states enable the directors to pass a resolution to the effect that, in their opinion, the property received by the corporation is worth the par value of the shares issued. As directors at the incep- tion of a corporation are almost invariably irresponsible law- yers and clerks, such opinion has no value except that of meet- ing the requirements of the much abused statutes.^^ In rare cases, however, the stock is admittedly not full paid. It is then subject to assessment for the unpaid balance. This custom seems at present to be restricted to Philadelphia com- panies'^ and to Boston mining enterprises. It is of advantage to the corporation, because its directors may call for the unpaid assessments at any time, but it interferes with the marketing of the stock for that same reason. Note to Chapter I: It will be noted that two other phases of the subject sometimes touched upon in works on corporation finance, have been entirely omitted from the present discussions. These are the legal questions involved in the status of the corporation and the issue of its stock, and the practical expedients of stock issue. For the former see the exhaustive treatises of Cook, Corporations ; and Machen, Modern Law of Corporations. For the latter see any of the "practical" law books on business corporations. A very valuable collection of actual documents in connection with the issue of stock is included in Gerstenberg, C. W., Materials of Corporation Finance. »2 For illustration of this see organization of United- States Shipbuilding Company. Documents given in Ripley, W. Z., Trusts, Pools and Corporations, Chap. IX (1916). Also in Dewing, A. S., Corporate Promotions and Reorganizations, Chap. XX U914). ''Thus the old Asphalt Company of America's stock was only 10 per cent paid. The stock of the Philadelphia Rapid Transit Company was for a considerable period only partially paid. Thus, back in 1902 it was only 10 per cent paid; in 1904, 30 per cent; in 1905, 40 per cent; in 1906, so per cent; 1907 70 per cent, and later 83 per cent; and finally in September, 1908, it became full paid. Assessments were levied as the businesc grew, but the earnings failed to keep pace with the assessments. The Philadelphia Electric Company shows a similar record. In 1902 it was 20 per cent; in 1J03, 30 per cent; in 1904, 40 per cent; in 1908, 54 per cent; in 1910, 60 E^r cent; "1 '9'3, 70 per cent; in 1914, 90 per cent; and finally in 1916 it became full paid. In this case the earnmgs have more than kept pace with the assessments. This IS a striking example of the contrast in return on invested capital between an electric light and a traction enterprise, both operating in the same city. CHAPTER II THE GENERAL FORM OF BONDS General definitions, 17; Part of an issue, 18; The promise to pay, 20; The denomination, 20; The time of payment, 21; The rate of interest, 22; The place of payment, 23; The security, 24; Open and closed mortgage bonds, 24; The maturity of bonds, 27; Redemption of bonds, 31 ; Convertibihty of bonds, 33 ; Lack of voting power, 34; Conditions of enforcement, 35; Investment status of bonds, 36. Between the two classes of corporation securities, stocks and bonds, there is a fundamental difference, in spite of many- efforts to create securities which partake of the nature of both. Stocks are evidence of the right to participate in any net profits resulting from the business. The stockholders are under all circumstances partners and possess rights to the property and income of the corporation only after the rights of the bond- holders have been satisfied. Bonds are promises to pay a certain precise sum of money and a certain definite rate of interest. The treatment of the general subject of bonds^ is confused by the variety of forms that have been issued and certain anomalous cases that resist any reasonable classifica- tion. Owing to this confusion no single statement can be made 1 There are practically no thoroughly scientific studies of corporate bonds, from the point of view of corporation finance. For detailed studies the best work available is the atlas of White and Kemble which covers only railroad mortgage bonds. The investment aspect is fully, although in places superficially, treated in Chamberlain, L., Principles of Bond Investment (igii). Aside from the elaborate treatises on the law of bonds and mortgages there is a brief, compact, but dogmatic, statement of the law by Heft, L., Holders of Railroad Bonds and Notes; Their Rights and Remedies (1916). For exhaustive study of the legal phases see Jones, L. A., Treatise on the Law of Corporate Bonds and Mortgages, and Short, E, L., Law of Railway Bonds and Mortgages. The Investment Bankers Association have authorized the issue, under their auspices of a little book by Lilly, Wm., Individual and Corporation Mortgages (1018) which gives in a very clear style, the essential legal facts of the modern corporation mortgage. This book should be referred to in case more detailed informa- tion is wanted regarding the specific clauses and covenants of an indenture than are given in the following pages. 17 l8 CORPORATE SECURITIES regarding all bonds as a class^ to which . some exception can- not somehow and somewhere be found.^ There are, however, certain general characteristics of bonds to which most issues conform, and which, if absent, lead one. to regard the case as an exception. There are other characteristics which may or may not be present, such as the privileges of redemption and of conversion into stock, which are not sufficiently unusual to render the issue in which they belong an exception, but which are sufficiently unusual to require special comment. It is the purpose of the present chapter to describe certain general characteristics of bonds, reserving for the next a description of the varied standard forms. The bond, the document which is bought and sold by in- vestors, is a right to participate in a certain legal contract which the corporation enters into with a trustee. There are, therefore, two parts to each bond issue:^ There is first the single elaborate document issued by the corporation, which is in the form of a triple agreement between the corporation, a trustee, and the holders of the bonds.^ There are, secondly. * The following: strictly formal definition is excellent: "To the word 'bond,* cus- tom has given the prerogative of representing all subdivided interest-bearing contracts for the future payment of money that are drawn with formality, whether they are secured or unsecured, whether the interest is imperative under all conditions or not." Chamberlain, L., The Principles of the Bond Investment, 73 (igu). This definition is perhaps too general and it excludes all forms of "perpetual certificates of debt." * This statement is strictly true. Even if one reduces the definition to merely a promise to pay a specific sum at a definite time, there would occur to the mind the perpetual annuities issued by a few corporations which could not, by any twisting of words, be made to comply with the definition. If, on the other hand, the defini' tion of bonds is made to rest on the certainty and the regularity of the interest pay- ments, the ordinary income bond would fall outside of the field. The perpetual cer- tificates of indebtedness and the irredeemable income bond cannot by any subterfuge be included within a single definition. * There are few exceptions. _ Some bonds are not issued under a mortgage, deed of trust, or indenture of any kind, but are merely long-period promissory notes of the corporation. Such issues are now very rare and belong usually to strong corpora- tions whose credit at the time of issue was above reproach. To this class belong numerous bonds of the Boston and Maine Railroad, sold directly to local savings banks; the New York, New Haven and Hartford Convertible sYi's of 1956 and the Convertible 6's of 1948. Also some short-time bonds having a very limited market and issued by companies of poor credit, as the International Steam Pump Company's Convertible Debenture 6 per cent Notes of 1913. " For concrete examples the student may secure copies of corporate mortgages from any of the large investment bankers. Gerstenberg, C. W., Materials of Cor- poration Finance (1915), gives an excellent illustration of a corporate mortgage, that of the Jones and Laughlin Steel Company. The most elaborate and exhaustive THE GENERAL FORM OF BONDS 19 the bonds issued under the agreement, signed in the name of the corporation with the certification by the trustee that the bond is covered by the agreement. The agreement specifies in great detail the obligations of the corporation, the duties of the trustees,' and all the rights and privileges of the bond- holders. The bonds themselves merely state that the corpora- tion promises to pay "the bearer or registered holder" a sum of money on a certain date with interest in the meantime at a specified rate, and give a brief recapitulation of certain im- portant promises of the agreement under which the bond is issued. Great care is ordinarily exercised to see that the cor- responding statements in the bond and the agreement shall be the same in letter as well as import.'' When a divergence is discovered the courts are not agreed as to which takes prece- dence. mortgages are those for the great refunding issues of railroad bonds drawn within the last five years. Certain lawyers of New York have acquired a reputation for their skill in draw- ing elaborate corporation mortgages. Francis Lynde Stetson, a master of the art, has written a very illuminating account entitled "Preparation of Corporate Bonds, Mortgages, Collateral Trusts and Debenture Indentures — Some Legal Phases of Cor- porate Financing, Reorganization and Regulation," Macmillan (1917). This was a series of lectures delivered by prominent New York lawyers, specialists in their sev- eral subjects, before audiences of practicing lawyers. It will be referred to re- peatedly in these pages. ® In theory the trustee, formerly one or two individual persons and now in- variably a trust company with or without a cotrustee, holds the property in trust for the benefit of the owners of the bonds. In practice, howeper, the duties of the trustee are merely nominal, consisting at most of receiving from the corporation the interest on the bonds and paying it over to the holders. The trustee does nothing of his own initiative to protect his trust estate and will not act, even when requested by the bondholders, unless paid liberally for each and every move. (For brief outline of the customary duties of the trustee see Stetson, F. L., Some Legal Phases of Cor- porate Financing, Reorganization and Regulation, 52 [1917].) There has been much discussion, fruitful of various suggestions, directed toward increasing the active responsibility of trust companies acting as trustees under corporate mortgages. A severe criticism of present methods is to be found in a recent report of the Com- mittee on Railroad Securities of the Investment Bankers Association. This report suggests delegating the supervisory functions of the trusteeship to a committee of the bondholders. The present methods are defended by Walker, R., Railroad Mortgage Trusteeship, 25 Trust Companies' Magazine 54' (igi?)- ' Sometimes troublesome litigation arises when the two statements do not agree. For example, in a certain income bond issue of the Mount Vernon-Woodberry Cotton Duck Corporation, the mortgage specified that the corporation should set aside a re- ' serve for depreciation, yet in the wording of the bonds such a reserve was omitted. Litigation resulted (Whitridge v. Mount Vernon Company). The courts have main- tained that the agreement shall govern in cases of discrepancy, as this forms the fundamental basis upon which the bonds are issued. Any bondholder could and would be presumed to refer to this document to ascertain his rights. Yet sometimes —and in the Mount Vernon-Woodberry case just cited — the court decided that the 'wording of the bond should control, as this was the form of the contract specifically purchased by the bondholder. 20 CORPORATE SECURITIES The first statement in a bond is the promise to pay a cer- tain sum of money. This statement, more than any other, distinguishes the bond from the share of stock and indicates clearly that the bondholder is a creditor and not a partner in the corporate enterprise. But although the statement itself is important from the legal point of view, the details such as "gold coin" and "present weight and fineness" have at the present time more apparent than real significance, as the present United States laws make all forms of currency redeemable by the government in gold.^ Yet if, as in Europe after the Great War, the government should some time authorize a de- based or irredeemable paper currency, the power of the bond- holder to demand payment in gold would assume great impor- tance. Still, too often, the word "gold" is given undue prominence in bond issues having little security in order to obscure the absence of real elements of security by focusing the attention on an empty symbol of strength. The face value of the promise or denomination of the bond, as it is called, was uniformly one thousand dollars in our American private finance until within the last twenty years. Before that time government bonds had been issued in small denominations to meet the demands of small savers, but cor- porations still clung to the tradition that a bond must be of one thousand dollars in denomination. The practice was bad, since it drove the small investor into the purchase of stacks, the par value of which was usually one hundred dollars, or into placing most if not all his capital in one bond — either course being contrary to sound investment principles. But during the last few years some of the strongest corporations, as well as many weak ones, have issued, hundred-dollar bonds and in some cases even bonds of a denomination of fifty dol- Exception, see note 13. THE GENERAL FORM OF BONDS 21 lars. This practice is growing, so that an investor with a few hundred dollars may obtain the strength of a mortgage obliga- tion and have an investment fund of ample diversification. Corporations object to the issue of bonds of small de- nomination because of the additional initial expense and the greater clerical labor in attending to their interest payments. This slight expense is of inconsiderable importance compared with the advantage to the corporation of a wide distribution of its securities among small investors. Such distribution not only insures a wide market in case of the issue of new bonds, but also makes less probable the quick depression of the market price because of some sudden increase in the floating supply. It may be said without hesitancy, that the advantage arising from the higher selling price of the bonds, because of their small denominations, many times offsets the increased initial cost and that the advantage of a steadier market which comes with small holdings again more than offsets the in- creased expense in caring for the interest payments. Included in the promise to pay there is ordinarily the pre- cise statement of a definite time, the maturity date of the bond. This is the characteristic which distinguishes bonds from redeemable preferred stock, although even this may be abrogated at certain times." Thus the privilege of paying off an issue of bonds before they are due may be retained by a corporation," and it is quite common to allow a certain latitude of time during which the corporation managers may pay the bonds if they see fit to do so." Sometimes, al- though not frequently, the corporation may recognize the »An interesting innovation-in government rather than corporate finance-is the "unltundbar" German war loans. This may be freely translated as loans, the general terms of the redemption and maturity of which, the government will not now declare itself on This is a step beyond the second and third Italian loans (5 s of 1916, SS of 1917) which have no maturity but which are redeemable at the option of the government after certain specified dates. ^"See subject of "redemption," discussed later in this chapter. "Some bonds are referred to by the limiting dates. Thus an issue of bonds 22 CORPORATE SECURITIES possibility of some contingency which may lessen the security or intrinsic value of bonds. As in such an event the bond- holders might well demand the immediate payment of the bond by the corporation, the latter obligates itself in the bond to the immediate payment of the principal should that contingency arise. In public service obligations, an early maturing franchise may introduce just such a contingency.^^ Following the promise to pay the principal amount at a definite time is the statement of the fixed rate of interest to be paid periodically.^^ In rare instances this varies from time to time,^* but almost universally the interest rate is fixed and which is due in thirty years but payable in ten years in referred to as 10-30 year bonds. ^ The First Lien Collateral Trust Bonds of the Continental Gas Electric Corpora- tion, due in 1927, contain the following provision: "The principal thereof will be- come due on November i, 1924, in the event that certain changes in the franchise of one of the underlying companies, as stated in the mortgage shall not have become effective prior thereto." ^^ In very rare cases the rate of interest is not specific. Thus the Chicago, Bur- lington and Quincy Railruad Trust Mortgage of July, 1873, pruvided that the bonds issued under it should "bear interest at the rate of seven (7) per cent per annum, payable semiannually, both principal and interest in currency, or at the rate of six (6) per cent per annum, payable semi-annually in gold." " In these rare instances the rate begins small and increases gradually to a maxi' mum. Such bonds, issued with variable increasing interest rates, ordinarily owe their origin to some period of expansion during which the shares of some poorly paying enterprise were acquired through the issue of bonds: The interest rate on such bonds was made low at first, as the property acquired had little earning capacity; it was to be increased in accordance ^vith the prospective increase of the acquired property's earnings. Very frequently this prospective increase was not brought about and the corporation found itself burdened with an increase of fixed charges without any offsetting advantage. The device has been used chiefly in railroad and public utility consolidations. In the former, two rather notable, but unfortunate cases exist. The Cincinnati, Hamilton and Dayton General Mortgage Bonds of 1939, bear interest as follows: 1909-1911, no fixed rate, 4J/^ "at the discretion of the Board." 1911-1914, 1% fixed rate, 3J^ "at the discretion of the Board.'* 1914-1916, 3% fixed rate, iH "at the discretion of the Board." 1916 to maturity, 4^% fixed rate, "at the discretioji of the Board." The Toledo, St. Louis and Western Collateral Trust Bonds of 1917, were issued to acquire a bare majority of the Chicago and Alton Railroad's shares. They bore interest at z per cent from 1907 to 1912, and 4 per cent from 1912 to 1917. The dividend on the Chicago and Alton Railroad's shares ceased altogether after January, X911, and the burden of these bonds caused the receivership in October, 1914, of the Toledo, St. Louis and Western Railroad. In the public utility field two large issues are notable. In 1904 the Consolidated Gas Company of New York issued New York and Westchester Lighting Company's General Mortgage Bonds of 2004, in order to pay for certain partially developed utility properties just north of New York City. They bore interest at the rate J^ per cent interest beginning July i, 1905, which increased gradually to 4 per cent annually from July i, 1914, to maturity. The Perpetual Interest-Bearing Certificates of the Public Service Corporation of New Jersey, issued to pay for the shares of five electric railways, bore interest at the rate of 2 per cent annually during 1904- The interest rate increased gradually J4 per cent each year until 1912, after which they bore 6 per cent interest per- petually. See also Chapter II, note 34* THE GENERAL FORM OF BONDS 23 unchangeable. It varies in accordance with the specific secu- rity, the investment market at time of issue, and the character of the enterprise. Naturally the higher the security the lower the rate of interest, although some corporations consistently issue bonds at lower interest rates than their credit warrants, and sell them at substantial discount. The period of issue and the character of the enterprise determines the rate, as cor- porations are bound to follow custom. That is, if some elec- tric companies "are issuing 6 per cent first mortgage bonds, others of equivalent credit must follow the same course; if the scarcity of investment funds forces the highest grade rail- way bonds to a 5 per cent level, as in the spring of 191 8, in- ferior kinds of issues must be brought out at a consistently higher rate, or else sold at a very heavy discount. Most cor- porations arrange the interest rate of the bonds, so that the discount at which they are sold shall not exceed 10 per cent. During a considerable period before the Great War the rates on the same type of security remained remarkably constant. Four per cent predominated for railroads, 5 per cent was con- sistently used by public utilities, and 5 and 6 per cent by in- dustrials.^^ In connection with the promise to pay, the bond and the deed of trust — if such exist — state also the place at which the principal and interest are payable, usually a trust company or bank in a large city. Although it has become a universal prac- «The following results were shown from a statistical study of 300 important bond issues (entirely a random selection) chosen 50 each from the railroad publ.i utility and industrial fields, and classified according as they were issued from 1889 to 1900. and from 1900 to 1914. The results are as follows: Railroad Public Utility Industrial No. No. No. No. No. No. No. over under No. over under No. No. under ever 4% 4% 4% Aver. 5% 5% S% Aver. 5% 6% 5% 6% Aver. 1889-1900 26 17 7 4.32% 34 6 10 4-94% " tl I ° l-f3 1900-1914 35 " 4 4-2|% 31 5 12 4.92% .8 27 4 I 5.53% Averages 4.28% 4-93% 5.5o% 24 CORPORATE SECURITIES tice/* because a convenience to all concerned, this specific men- tion of a place of payment is not required by law. After the promise to pay, the bond usually states in abbre- viated form the kind of security upon which the bondholder may rely for the enforcement of the corporation's promises. This is either a mortgage on certain property or a specific agreement reinforcing the mere promise to pay. In the former case the bond is called a mortgage bond and in the latter a debenture. In case the bonds are not protected by a specific mortgage a promise is usually made by the corporation to pro- tect the issue in case its property is subsequently mortgaged. The question of the protection of the bondholder from abuses of subsequently created mortgages suggests at once the allied question of "open" or "closed" bond issues. A "closed" issue is one in which no more bonds can be issued under the mortgage deed of trust or agreement. The transaction is finished. If specific property is pledged, there can be no more bonds issued having the same hold on it, although other and succeeding mortgages may be created without limit. An "open" issue, on the other hand, permits the further issue of bonds with the same lien as those already outstanding, and in the case of subsequent failure, the holders of all these issues stand on the same footing.^^ To give protection to the bond- "Very few issues can be found in which some place of payment is not mentioned. Exceptions, however, exist. For example, no place was mentioned in the New York, New Haven and Hartford aj^ per cent issue of 1912. In such rare cases it may be assumed that the principal office of the company or its principal agency is the place of payment. " For the sake of appearance even an "open" mortgage usually bears a limit, but the amount named is far in excess of the probable volume of bonds to be issued. This limitation is usually of no substantial value to the investor in the bonds, as the privilege of subsequent issue, if abused by the company, will destroy the value of the earlier issue, just as readily as if there were no limit of issue. In actual prac- tice, the restrictions to the unlimited issue of the Chicago Railways Company's First Mortgage s's — protected by special statute and the necessity of certification by the municipality itself—protects the investor far more than mere limitation of the amount of issue. Theoretically the issue is unlimited, practically it is limited by safeguards much stronger than the mere statement of a theoretical limit never likely to be reached in practice. The larger, more firmly established railroads, such as the New York Central, have discarded the iiction of a limitation and have created a strictly unlimited issue of bonds. THE GENERAL FORM OF BONDS 35 holders of such issues, it is customary to define the conditions or restrictions under which subsequent bonds may be issued/^ These restrictions constitute an important part of the contract under which the first of the series of bonds are sold and upon which the earlier bondholders rely in order to protect their issue from inflation. They usually refer both to the property securing the bonds and the income available for the bond interest. In regard to the former, the corporation agrees not to issue further bonds except for refunding certain specific underlying issues and for the payment of new construction up to a certain percentage of its cost or for other equally specific purposes.^" Among public service corporations the issue of new bonds is usually limited to 70 or 80 per cent of the actual cost of the improvements to be covered by the bonds. In this way the stockholders are forced to supply from 20 per cent to 30 per cent of the money required for new construction.'" Established railroads usually retain the privilege of issuing additional bonds up to the full cost of the new construction. In regard to income, it is usually stipulated that no new bonds can be issued unless the previous net earnings'^ are well over the interest both on the old bonds and those it is proposed to issue. In ^ The provisions for the subsequent issue of bonds under an open mortgage must be very carefully drawn, from the legal point of view, so as to protect the corpora- tion in the exercise of its apparent rights, quite as much as the bondholders in pre- venting the undue dilution of their lien. For brief, clear statement see Stetson, F. L., Some Legal Phases of Corporate Financing, Reorganization and Regulation, 33 (1917). ^ The purposes for which the subsequent bonds may be issued should be defined with great care. Often the corporation retains for itself unwarranted privileges in the freedom of subsequent issues. Thus the great "open-end" mortgage of the Dayton Power and Light Company permits the issue of bonds to pay for the stocks — not bonds or property — of street-car lines without defining the equity the stocks must have, ^ This provision is susceptible to much abuse by an unscrupulous management. By making heavy charges for engineering services, heavy intermediate profits on materials furnished, and fictitious valuations for new real estate — either through the directors and their associates or through subsidiary or allied corporations — it is pos- sible to so inflate the construction costs that the 70 or 80 per cent which the terms of the open mortgage may cover will equal the entire actual cost. The only protection for the bondholder in such cases is through a valuation conducted by the trustee of the mortgage acting as bondholder's agent, or by a disinterested body, such as the Public Service Commission of the State, " In rare cases the gross earnings are also defined. Thus in the open-end mortgage of the Mobile Gas Company it is required for further issue of bonds, among other things, that the gross earnings must be four and a half times the in- terest on the already issued and to be issued bonds. 26 CORPORATE SECURITIES public service open mortgages it is ordinarily required that the earnings shall be from one and one-half to three times the bond interest.^^ The commonest proportion is twice the interest charges. If the issue is itself of apparently doubtful character, like a debenture, the restriction is stronger, in which case three times interest charges is common.^^ A proportion as high as three to one is somewhat unusual among mortgage bond issues, but it affords liberal protection to the holders of deben- tures,^* The issue of open mortgages was comparatively unknown until about 1901, but since that time it has become very com- mon in all fields of corporate financing except that of indus- trials.^^ In practice it is well-nigh universal among the issues ^ This restriction may be emasculated by the overestimatian of net earnings sometimes indulged in by corporations desirous of observing the letter but not the spirit of the mortgage contract. A wholesome provision, but an unusual one, is that contained in the mortgage covering the Refunding and Extension Mortgage 6's, 1957, of the Birmingham Railway, Light and Power Company which requires that: *'io per cent of the gross earnings shall have been expended for maintenance in the preceding 12 months before computing the net earnings of the company. 23 The contract protecting the American Gas and Electric 6 per cent Debentures of 2014 (American Series) requires that no new debeiiture bonds shall be issued "unless the net income of American Gas and Electric Company (after deducting ex- penses and interest on outstanding secured indebtedness of the Company maturing not less than five years from the date of this issue) as determined by a certified public accountant, to be approved by the Trustee, for twelve months within the fourteen calendar months immediately preceding any application is at least three times the interest charges for a like period on the Debenture Bonds outstanding, those applied for, and interest upon any indebtedness of the Company other than the secured in- debtedness above mentioned. ^ In addition to the main restriction to the cost of .property and the net available income, there are sometimes, but not frequently, inserted in open-end mortgages other special provisions. For example, especially in industrial bond issues, it is provided that the net quick assets shall equal or exceed the outstanding bonds. In rare cases a city may reserve the authority of issue for the bonds of its public utilities, or the investor may require the city's certification for the issue of further bonds under an open mortgage. Thus, additional first mortgage bonds of the Chicago Railways Company can be issued only after the comptroller of the city has certified that the improvement made out of the proceeds of the bond is in accord with the ordinance imder which the company's charter was granted. This ordinance, accepted by the voters April 2, 1907. gives to the company a monopoly, subject to city purchase, of the street railway lines and provides that the Board of Supervising Engineers of the city must approve of extensions which may be paid for by the sale of the trust mort- gage bonds. But for this restriction, however, the amount that may be issued is un- limited. All of the bonds issued retain a first lien on the entire property and "as against the city and any licensee of the city and any and all other persons having or claiming to have any interest or benefit under this ordinance, the lien securing said bonds and obligations shall at all times be deemed and recognized to be a first lien upon the entire street railway system hereby authorized, including all rights granted to the company by this ordinance." 2' It is not unknown even in the field of industrials. On January 2. igi4, Swift and Company authorized $10,000,000, thirty-year 5 per cent general mortgage bonds, the total amount that could be subsequently issued being absolutely unlimited. The deed of trust permits the issue of "other amounts subsequent thereto, as the business of the company may require in the judgment and discretion of the Board of Directors." THE GENERAL FORM OF BONDS 27 of public service corporations and in some cases it has been outrageously abused. The advantages and disadvantages of open and closed issues of bonds are not easily compared. In either case, much more depends on the fundamental honesty of corporate managers than the strict language of legal con- tracts seems to imply. If the management wishes to deceive the bondholders, the fact that the bond issue is closed may not serve as an obstacle.^' On the other hand, if the management intends to safeguard the interests of its bondholders, liberal provisions for issuing new bonds are not likely to be abused. Generally speaking, closed issues of bonds are better from the point of view of investment, but less desirable from the point of view of the corporation. An investor in a closed series knows exactly where he stands if the corporation fails. On the other hand, the corporation may get into trouble be- cause it cannot obtain money for improvements when its prop- erty is fully covered by a previously existing mortgage,^' and in that case the bondholder is adversely affected through the general disaster of the corporation. In the majority of cases the provisions of open mortgages are not abused by corpora- tion managers and the existence of an easy and simple method of financing extensions operates to the advantage of all se- curity holders.^* The length of period of bonds varies greatly according to " Further discussions. Volume IV, particularly Chapters IV and VII. ^ This is the pica always advanced by corporation managers. Yet there is al- ways available the possibility of selling more stock to the stockholders. ^ One matter which corporation managers should observe with care concerns the conditions of marketing the successive instalments of bonds. It is a distinct advan- tage_ of closed mortgage bonds that the market for them requires less artificial pro- tection. All security prices are determined in the end by supplj^ and demand. If a corporation suddenly, and without proper safeguards for maintaining a market for the old bonds, issues a block of new bonds under an open mortgage, the supply will be temporarily increased. As a result the market price. of the old bonds, as well as the new will fall. Allied to this disadvantage, is the fact that the early buyer of an open-end issue of bonds does not know, nor can he be safeguarded agamst, the subsequent sale of a later block of bonds on more advantageous terms. In the spring of 1914, investors bought the first instalment of an open issue of the Montana Power Company's First Mortgage Bonds for 94. Four years later in the spring of 1918, when the company was in a far stronger position, and with a greater margin of earnings, another in- stalment was offered at 89. 28 CORPORATE SECURITIES the credit market at the time of issue, the prejudices of in- vestors, and type of security behind the bonds. A classification of periods is Httle more than approximate, yet such phrases as "short-term" and "long-term" have crept into the vocabu- lary of finance. Without holding too: rigidly to the limits given, one may say that obligations which mature in less than five years are of the nature of notes, meaning by note merely a short-time bond in which the safeguards are much more the temporary credit of the corporation than its permanent assets. Bonds which run from five to fifteen years may be con- veniently designated as short-term, while those that run from fifteen to forty years may be called medium-term bonds. Those which will not mature for more than forty years should be called long-term bonds and belong to a special class because of the difficulty of projecting conceptions of property value into the distant future. Each general class is distinct, whether or not the limits just mentioned would be generally acceptable. Notes and short-period obligations are sold mostly to banks and business men who are in a position to turn their resources quickly. They are usually of the form of debenttire bonds without specific security, or else secured by the pledge of other bonds which the corporation proposes to market before the short-term obligation matures. Medium- and long-term bonds, on the other hand, are sold to investors, savings banks, and in- surance companies which desire permanence of investment rather than early convertibility into money. Because their purchasers desire, above all else, unqualified security, they are ordinarily protected by a mortgage on permanent, tangible property and long-term "rights" and franchises. Long-term bonds were comparatively unknown in this country until the period of railroad reorganization from 1893 to 1897. ^^ As a class they may be said, even, to have arisen ^ Comparatively unknown. Bonds of fifty years' maturity were sometimes issued in the period before the Civil War, but hundred-year bonds were practically unheard THE GENERAL FORM OF BONDS 29 as a result of the refunding of the older short- and medium- term bonds of defaulting railroads into long-period bonds. ^^ The practice having been established among the larger trunk line roads, it was adopted by others. Over two-thirds of the large railway systems of the country have issued, at one time or another, bonds of a hundred years or more. This practice followed on the wake of the realization that the debt of Ameri- can railroads would never be paid off and that the lien placed upon the roads was, in a sense, quite as permanent as the stock. The extreme limit of longevity of a bond was reached when the West Shore Railroad placed on its lines a mortgage due in the year 2361.^^ Bonds extending over fifty years are not issued by public service corporations, except by the large metropolitan traction and lighting companies, the property of which approaches, at least in theory, the permanence of that of steam railroads.^^ If exceptions to this principle exist, they are the issues of very strong, widely known corporations with high credit.^" Even then the long-term bonds of public service companies are to be looked upon much more as high-grade, secured, non-voting stocks than as real bonds.**^ Long-term of. In fact, the number of hundred-year bonds issued before 1880 can be counted on the fingers. When issued, they were usually of inferior value, such as second or third mortgage bonds on weak railroads and their issue was regarded as a kind of pre- ferred stock possessing the name of a bond. With the improvement of credit of the issuing roads some of these old closed hundred-year bonds are now numbered among the strongest securities available to the American investor. Thus, in 1880, the old Louisville and Nashville Railroad issued a closed second mortgage bond on its St. Louis extension, due in 1980. The security at the time was meager and the interest rate was only 3 per cent. Yet because of the improvement of the road's general credit, the increasing importance of the St. Louis line, the large expenditures sub- sequently made, these bonds are now among the choicest available. It might be said in this connection that the prospective investor may often obtain very high-grade bonds by searching out some of these old long-term, divisional bonds, long since for- gotten. '"Discussed in detail in Daggett, S., Railroad Reorganization, 365 (1908). Dag- gett points out that the lengthening of the term of railroad bonds during the reor- ganization period was regarded by investors as an advantage on the presumption that interest rates were falling. ''This is exceeded by the farcical date of maturity of the Elmira and Williams- port 5 per cent Income Bond of 2&62. 2^ For example, see the Brooklyn Rapid Transit, First and Refunding 4's, 2002; and Manhattan Railway Consolidated 4's, 1990. Consolidated Gas Co. (N. Y, and Westchester Lighting General Mortgage 4's, 2004. 23 An extreme case is Commercial Cable Company's First Mortgage Bonds, due 2397. '^For example, the American Gas and Electric 6's Debentures of 2014, issued 30 CORPORATE SECURITIES bonds are practically unknown among manufacturing compa- nies,^^ owing to the wise conviction on the part of investors that all the values of an industrial enterprise are fluctuating and uncertain. The extreme limit of maturity is reached in the few cases in which American private corporations have issued perpetual certificates of debt, or '^irredeemable annuities," as they are sometimes called. These are bonds, in point of view of se- curity and the obligation of the corporation to meet the regular interest payments, but they have no date of maturity. How- ever described, they are an anomaly — a debt that is never due^and our practical, perhaps simple, American conscious- ness has never adopted the idea. In the comparatively few cases where they have been issued they have commanded a market price but little above a preferred stock of equivalent income yield, although the strength of the obligation and the security behind it has been conspicuously greater/^ All long-term bonds ostensibly secured by property are a confession of irredeemable debt. As such they are wrong in principle. No property, not even property rights, can un- in July, 1914. This corporation and its associate, the American Power and Light Company, are alone among the public service holding companies in having hundred- year bonds. This issue of debentures is of the nature of a first preferred stock. The company has very strong credit — in fact, the strongest of the General Electric Company s operating subsidiaries. At the time of issue the company had a surplue available for interest over twelve times the requirements, its common stock was selling for 1 86 per cent and its 6 per cent preferred stock at 96 per cent of par in the market. This issue was a mistake, as the long period of the maturity prejudiced the investors, who would have been willing to pay as much or more for a preferred stock with far less concessions from the company. It should be noted, too, in this connection that the Public Service Corporation of New Jersey is one of the few corporations in _ the United States that has issued perpetual certificates of debt. They are, in this case, a kind of collateral preferred stock secured by a deposit with the Fidelity Trust Company of the stocks of five electric railways. Chapter II, note 14. '''Bethlehem Steel Company Purchase Money 6*s, issued in 1898, and due in 1998, are unusual among industrial bonds for their long life. But these bonds owe their unusual maturity to the fact that a small group of financiers wanted to secure the control of the old Bethlehem Iron Company the stock of which was then paying 6 per cent. These bonds were offered in exchange. They were regarded as little difierent from a stock. 8^ For example, the yield of the two most notable issues of their kind, the Lehigh Valley Railroad s Consolidated 4J^ and 6 per cent Annuities ranges about 4^ per cent. With the present large earning capacity of the Lehigh Valley road it is prob- able that a small issue of preferred stock of the same size — about $12,000,000 — would sell to yield the investor practically the same rate. THE GENERAL FORM OF BONDS 31 questionably retain its economic value beyond half a century,, or be projected into an unknown future far beyond the limits of any human life. "Little of all we value here, wakes on the morn of its hundredth year." In reality, long-term cor- poration bonds are merely unsecured promises of a corpora- tion, conceptually immortal, yet subject to all the hmitations of economic, political, and social conditions. Most bonds contain a provision which enables the com- pany to pay them before maturity. This privilege may prove of importance to the company, if it becomes necessary at a future time to create a large new issue to be secured by the same property as that covered by the outstanding issue. In addition, many bonds, mortgages, or debentures, contain the provision that the issuing corporation shall redeem a propor- tion of the outstanding issue each year. This is called the sinking fund. It increases the apparent security from the point of view of the investor, and assures him at all times of a market for his bonds; it also facilitates the ultimate redemp- tion of the issue at its maturity. As the sinking fund is a form of the reserve to be deducted from the net earnings of the corporation, it will be described in connection with a more comprehensive treatment of the latter subject.^^ The conditions under which bonds may be called for one purpose or another are, however, an important part of the con- tract under which they are issued. Almost universally, bonds are sold to the bankers at a discount from their par value, so that they may be reoffered to the investing public at par or below. Under these circumstances the corporation would not care to buy them back from the public unless at a discount — certainly not at a premium. Yet conditions often arise which make it highly desirable for the company to buy back its own "Volume III, Chapter VIII. 32 CORPORATE SECURITIES bonds/^ Sometimes the company agrees to sell its property free from debt, sometimes a change of state law may necessi- tate the refunding of old bonds. It has even been found ex- pedient to call bonds to prevent the bondholders from receiv- ing excessive profits. ^^ Usually bonds are called when it is necessary to create a larger bond issue than was originally con- templated and bankers insist that the underlying bonds be bought in by the company and the old mortgage canceled. Ordinarily the bankers will pay enough more for new bonds which are secured by an absolute first mortgage on the entire property, to make it thoroughly worth while for the company to redeem its old bonds/^ In order to make the bond attractive ^ So desirable is this privilege that corporations are sometimes willing to pay heavily for the insertion of a redemption price in the bond contract after the bond has been issued. Thus the First Mortgage Bonds of the Houston, East and West Texas Railway, a proprietary company of the Southern Pacific, were not callable at any price. To those of the bondholders who would allow the bonds to be stamped with an agreement permitting the Railway Company "to have the right to redeem this bond at 105 per cent of the par value" the Southern Pacific Company guaran- teed unconditionally the punctual payment of the principal and interest of the bond. In the spring of 1917 the Philadelphia Company offered to establish a sinking fund of 2 per cent for its First Mortgage and Consolidated Mortgage Bonds, provided the holders permitted the insertion of a call price. ^^ The Union Pacific road had certain so-called Oregon Short Line Participating 4 per cent Bonds, which were entitled to a regular interest payment of 4 per cent and in addition a proportion of the income received from the Northern Security Stock, The latter was held back owing to litigation. Before it was made available, however, to the holders of the participating bonds, the latter were called at 102^2. ** A concrete instance will illustrate this. A small gas light plant serving the center of a city of 20,000 inhabitants was built at a cost .of $238,000. On this property the operating company executed a mortgage and issued $200,000 first mortgage bonds which were sold to the bankers at 84, and by them to the public at gij/i- The bonds were callable at 103. Three years later, the city haying grown and the gas com- pany having prospered, the stock of the company was bought by the electric light interests of the city. The purchasers formed a new company which acquired title to the physical property of both the gas and electric light systems, together with an electric distributing system for three smaller adjoining towns. The only lien con- sisted of the $200,000 bonds on the gas property alone. The total assets of the new company had a value of approximately $2,500,000. The consolidated company wished to bond the entire property for $2,000,000. Two possibilities were open: either to issue outright $1,800,000 first and refunding mortgage bonds, subject to the underlying gas lien; or. else to call the latter bonds and issue new first mortgage bonds. Conversations with bankers led to the following results: first alternative — $1,800,000 first and refunding bonds, for which the bankers would pay 80, or $1,440,000 in money; second alternative — $2,000,000 first mortgage bonds, for which the bankers would pay 85, or $1,700,000 in money. But from this amount $206,000, at the outside, would have to be deducted for calling the under- lying bonds, thus leaving $i,494>ooo- In other words, the bankers would pay enough more for an absolute first lien on the property to make it profitable to the company to call the underlying: bonds. As a practical matter the company would not pay the call price for the entire issue. It would either directly, or through the bankers who originally sold the issue, quietly buy in the bonds at a price presumably less than par. It might be necessary to call the bonds finally to obtain the last few. It is to protect the company against the few who "will not sell" that a call price is wisely inserted in most bond contracts. THE GENERAL FORM OF BONDS 33 to the investor it is arranged ordinarily that the company must pay slightly in excess of par for the bonds it calls. This pre- mium ranges usually, from i to 3 per cent with the latter figure of most frequent occurrence.*^ For bonds of long maturity or bonds likely to be called for their own sinking fund or for the purpose of refunding just prior to maturity, it is usual to provide that the premium grows less as the date of payment approaches.*^ As the call price ordinarily influences not the slightest the attitude of the in- vestor toward the issue," it is wise policy for the company to make this price par. The company is not therefore compelled to pay an exorbitant price to the investor or speculator who refuses to sell his bonds at their intrinsic market value, and insists that the company pay the premium involved in calling them." To increase the marketability of bonds, or rather to make "A random selection was made of some 178 bond issues witli the call privilege to determine the points of maximum frequency. The extremes were 130 per cent Liggett and Myers, and P. Lorillard 7 per cent of 1944 — and par. ^Thus in the mortgage of an issue of bonds of the Dayton Power and Light Company, it is provided that the issue may be called at: 105% from 1911 to 1936. 104% during 1937. 103% during 1938. 102% during 1939. 101% during 1940 and up to the date of payment in 1941. " This point is of importance to the company at the time the bonded debt is created.^ Contrary to the usual presumption the call price ordinarily plays no part in making the bond attractive to investors. Except in unusual cases the investor buys the bonds at a discount. Under such circumstances, calling the bonds at par will give him a capital profit or increase his yield if he has amortized the discount, so that the remote possibility of an unusual profit represented by a premium will not appreciably increase the attractiveness of the bond to him. " A good illustration is afforded by the case of the Sanford Light and Fuel Company's First Mortgage Bonds. The Sanford Light and Fuel Company operated a small electric utility property at Sanford, Florida. A large corporation, the Southern Utilities Company, acquired the stock of this local company, together with the securi- ties or properties of some twenty other public utility companies operating in Florida and Georgia. Large amounts of capital were furnished by Philadelphia, New York, and New England bankers. A general first mortgage bond was created to cover the company's entire property after all the underlying liens had been paid except that of the Sanford Company and one other. Meantime the holders of the outstanding bonds of the Sanford Company, about $36,000 in all, were advised by a New York broker not to exchange their bonds for those of the larger corporation, notwithstand- ing their larger property lien. The larger company was powerless to insist on the refunding unless it called the bonds at a price considerably above their market price. The purpose of the New York brokers was probably to create a "nuisance value for the Sanford bonds such that the Southern Utilities Company would feel compelled to pay in cash the call price, thereby releasing funds which, in the reinvestment, the New York brokers would probably be able to turn into their own securities. 34 CORPORATE SECURITIES them appeal to the speculative instinct more or less present in the minds of all investors, the privilege of converting them into stock is attached to certain issues. This privilege is usually carefully guarded so that the holder of the convertible bonds may not profit too liberally by the rise in the fortunes of the company. There are two ways in which this is done. One is to make the bonds convertible only during a short period of time/^ and the other is to include a provision which permits the company to call the entire issue at any time.*" As the peculiarities of convertible bonds give them a separate and distinct standing as a class, it is better to discuss the details of their issue separately. (Chapter VII.) Bondholders do not ordinarily have any voice in the man- agement of the corporation. Although not reluctant to be- stow on the bondholders some of the risks of the enterprise that belong more properly to partners than creditors, the ex- ecutives guard assiduously their power of control over the administration of the company.*^ Yet it is just this absence of a voice in the management by what is the largest financial interest in the corporation, that may create intolerable condi- tions often verging on actual fraud. The bondholder is made to suffer quietly without power of remedy, while the stock- holders, who have no actual investment, mismanage the cor- poration's property.*^ *' The Hundred-Year Refunding Bonds of the Brooklyn Rapid Transit Com- pany were convertible only up to July, 1915, although they do not mature until 2002. ^^ For example, the Baltimore and Ohio Convertible Debenture 4*s of 1911, were redeemable at par throughout their life. " There are, of course, certain exceptions, as for instance, the Erie Convertible Issues of 1953, where it is provided that the bonds shall carry the same voting power as the same par value of stock. ^ An issue of the Chicago and Northwestern Bonds, due 1915, carried the voting privilege. There are many variations of part-voice in the management. For example, the Adjustment 5*5 of the New York Railway Com- pany (the surface lines) have the privilege of electing apart of the board of directors. ^ Such a situation resulted in the old Chicago, Rock Island and Pacific and the Missouri Railroads. Both illustrate the bad results to the bondholders of unscrupulous railroad management. In the former case the Chicago, Rock Island and Pacific Rail- road's Collateral Trust 4 per cent Bonds were secured by the deposit of the stock of the Chicago, Rock Island and Pacific Railway, the operating company. But the voting power of that stock was lodged in the bands of certain Wall Street speculators who THE GENERAL FORM OF BONDS 35 One of the most important provisions m every mortgage, deed of trust, or other agreement under which bonds are is- sued is that defining the conditions under which the bond- holders may enforce their claims in case the corporation does not fulfil its promises. Ordinarily the promise broken is that of meeting the interest payments, although there are many cases in which a corporation is called on to comply with the specific provisions of the bond agreement regarding a sinking fund or other particular covenants. In practically every case it is expressly stipulated that the trustee may declare the prin- cipal of the bonds due and payable, in case the corporation fails to meet its interest charges and the default continues for longer than a few months — usually three.^" After the default in the interest and the lapse of the period of grace, the trustee has the legal right to initiate a suit against the corporation, but does not, as a general thing, act until requested to by the hold- ers of a majority of the outstanding bonds, and — what is more important from the trustee's point of view — until he has been provided with money to defray the cost of litigation. In order to obtain the strength of concerted action it is customary for prominent holders of the bonds, or bankers, to form them- selves into protective committees which act for the scattered bondholders. Ordinarily an adjustment is reached between the bondholders' committees and the old stockholders, as a re- sult of which some concessions are made by all parties con- cerned. The bankrupt corporation is reorganized, usually, into a new corporation in which the bondholders, through their failed to maintain the physical property of the road. As a result, the bondholders, when adjustment was required in 1914, found that the stock behind the bonds was of little value. (For other discussions of the Rock Island bonds see accounts given in Daggett, S., Railroad Reorganization, Chap. IX (1908); Ripley, W. Z., Railroads, Finance and Organization. 524 fT. (1915). In the case of the Missouri Pacific the improvident management of the Goulds, depleted in the same manner the value of the physical property of the road and the junior bondholders in the end were forced into the surrender of their lien. For Gould mismanagement, see Ripley, W. Z., Rail- roads, Finance and Organization, 516 3. (1915). "The period through which foreclosure proceedings must be delayed after default, varies from one month to the extreme limit of three years— a proposed bond issue of the old Philadelphia and Reading road. 36 CORPORATE SECURITIES representatives, have considerable voice in the management. The single bondholder is usually powerless to enforce the payment of either the interest or the principal of his bond, and in many cases his hands are effectually tied by a provision which requires the approval of a majority of the bondholders before the trustees take the necessary protective steps. Seldom is it possible for the single bondholder or even his committee to secure the strict enforcement of the terms of the mortgage or agreement. So many legal and business obstacles can be thrown in his way by the corporation officials and so little value have the assets of a bankrupt corporation in liquidation, that experience has shown that bondholders, like stockholders, arc bound to bear some losses of a corporation failure.^" Aside from details of specific security there are certain investment considerations which bear upon the general sub- ject of bonds as contrasted with stocks. Perhaps the most general is the width of market. Banks, insurance companies, and investment companies will not ordinarily purchase stocks. Accordingly the problem of securing money for a new enter- prise and even the problem of financing an expanding business would be much more difficult were it not possible to issue bonds. They are the form of investment of the cautious- minded, conservative saver who looks upon a business en- terprise as an instrument of producing a steady income rather than a sudden or fictitious profit. Corporate bonds may be roughly divided into four classes, but vaguely separated from each other." The highest grade ^ For further discussion of the procedure to enforce the payment of honded obligations see Volume V, particularly Chapter III. ^^ There have been many attempts to classify bonds from the point of view of investment security. The results have not always fitted with subsequent facts. Two annual publications by Moody, J., attempt to classify all corporate securities' — Analysis of Railroad Securities, Analysis of Public Utility and Industrial Securities. There have been many books written purporting to embody a science of investment bonds. Chamberlain, L., Principles of Bond Investment" (1911), Lowenhaupt, F., Investment Bonds (1908), Mundy, _ F. W., "Railroad Bonds as Investment Secur- ity," 30 An. Am. Ac. Pol. Soc. Sci., 312 (1907). The Great War has so changed THE GENERAL FORM OF BONDS 37 consists of those bonds which are the legal investments for the savings banks of the New England states and New York. Such bonds have paid their interests regularly, and are obli- gations of corporations — usually trunk line railroads — which have earned and paid dividends on their capital stocks for a long period of time.^^ The second class consists of very high-grade bonds which do not meet the technical legal requirements permitting savings banks to purchase them. Many of these bonds are of a higher grade than "savings bank bonds," but fail to meet some in- significant provision of the law which is of material impor- tance for the vast majority of bond issues, but which is of little consequence in the particular case.^** They would include the first mortgage bonds on important parts of those railroads which, by reason of a poor dividend record, are not admitted to a savings bank standing. They would include also the old the social and economic background upon which the principles of a science of invest- ment rest that the pre-war books have become obsolete, and the future is too un- certain to permit of intelligent forecast — much less the prediction of concrete invest- ment values. ^^ The exact qualifications which a bond must meet in order to be classed as "legal" vary with each state. The laws of the five New England states and New York have been the basis for nearly all of the statutory trust fund restrictions for other states. Of the laws of these six states, Massachusetts and New York are most rigid, Rhode Island and Maine the least so. Any bond which meets the requirements of all these states is likely to be of a very high investment grade, although there are strange anomalies^ to be found. Generally speaking, the savings bank laws represent the investment wisdom of the preceding generation rather than that of the present. There are many bonds, therefore, which were once unquestionably sound, but which the contingencies of an ever-changing economic background have rendered of inferior quality, although they still retain their legality. The bonds of the New York, New Haven and Hartford and the Boston and Maine railroads are illustrative cases. As the laws are constantly changing the student should consult the latest summaries issued by the banking departments of the several states. Although there have been numerous publications dealing with trust investments, the best available source of information is the State and City Supplement of the Commercial and Financial Chronicle. Before treating of the debt of each state the editor gives a comprehensive and thoroughly reliable summary of the state laws controlling the investment of trust funds. ^'For example, the First Mortgage 4 per cent Bonds (extended 1947) of the old New York and Erie Railroad is certainly one of the strongest corporation obligations now available for investment, a first mortgage of $5,500 per mile on the original stem of the Erie system, the shortest line between New York and the Lakes. The average net earnings of the last five years have been over 102 times the interest requirements and over six times the total outstanding bonds of this issue. The bonds have with- stood three separate reorganizations. They are not legal for savings banks, not even those of New York, because the operating railroad company pays no regular divi- dends. Yet the Debenture 4 per cent Bonds of the Chicago, Milwaukee and St. Paul Railway, without anything like the fundamental security, were legal, merely because of the dividend record of the St. Paul system, long after the road's credit involved serious doubts. 38 CORPORATE SECURITIES closed first mortgage bonds of public utility companies show- ing net earnings four or five times the interest charges. The investor who desires unquestioned security together with rea- sonable return, so far as that is humanly possible, would do better to purchase the bonds of this class rather than those legal for savings banks; the feature of special legality gives the latter a glamor and creates for them a fictitious demand which considerably enhances their market value but decreases their yield." The third class consists of the great majority of bonds ofifered on the stock exchanges and particularly by the bond houses. Most of those belonging to this class are probably sound investments, although those issued under great open- end mortgages degenerate easily into a lower class, if the credit of the issuing corporation shows evidence of decline. These bonds are the investments of the conservative business men who can set aside time, at regular intervals, to make a short statistical study of their securities. The yield is ordinarily greater than that of the preceding class by more than one- half of one per cent and, if the risks are well distributed, this margin will fully equalize any occasional losses. The speculative bonds constitute the fourth class. The continued payment of interest on this class is a matter of doubt and the security upon which they rest is not of substan- tial intrinsic value. Many of these speculative bonds are actively traded in on the various stock exchanges and may show fluctuations in market price that parallel the more spec- ulative stocks. These bonds are in no sense investments. "Taking ten well-known savings bank bonds, the average yield was found (Janu- ary I, 1916) to be about 4.38 per cent. Ten bonds, selected at random, equally high grade but not legal for New York and New England savings banks — four underlying divisional bonds (one of the Erie, one of the Louisville and Nashville, one _ of the Baltimore and Ohio, and one of the Southern Pacific), three closed underlying gas bonds (one of New York City, one in St. Louis, one of Chicago), and three closed underlying electric light bonds (one of New York, one of Detroit, and one of Phila- delphia) — show an average net return of 4.90 per cent. This is a difference of one- half of one per cent. It represents the loss in annual return due to the greater demand necessarily existing for Savings banks and public trust fund bonds. THE GENERAL FORM OF BONDS 39 Yet if a man is cursed by the craving for speculation in secur- ities the dice are less likely to be loaded against him and his careful judgment will be more dependable in bond than stock speculation. It should be noted in passing that the investment character of bonds has frequently suffered from the purely fictitious handicap of state tax laws. On the assumption that stocks represent ownership in property already directly taxed, and that bonds are mere symbols of money loaned, many states — especially in New England and the East — tax bonds, but allow a large variety of stocks to go untaxed. The direct effect of these tax statutes is to turn the fund of the small and conscientious saver who declines to evade the law away from bonds and into stocks. The small saver is notoriously ignorant of investment values, and he is far more likely to sustain a loss through investment in the kind of stocks he would naturally select than in the average of investment bonds. Yet the savings of just this type of investor are of the utmost consequence for society to conserve because of the social significance of wide-spread habits of thrift. Only through the influence of such habits can society secure the capital necessary for industrial progress and for the repair of the wastes of war and the obsolescence of the instruments of production. Consequently, such tax laws operate against the conservation of social capital. CHAPTER III BONDS SECURED BY PLEDGE OF SPECIFIC PROPERTY The classification of bonds, 40; First mortgage bonds, 41; The after-acquired property clause, 44; Divisional bonds, 45; Special direct lien bonds, 46; Second and later mortgage bonds, 48; General and consolidated mortgage bonds, 50; Refunding mort- gage bonds, 50; Collateral trust bonds, 54; Short-term notes, 64. There are various methods of classifying bonds, each de- pending on some characteristic which is deemed fundamental.^ The two methods most in use depend on either the kind of security behind the bonds or else the type of industry in which the issuing company is engaged. Although there are distinct differences in the kinds of bonds customarily issued by dif- ferent enterprises — railroad bonds differing in many respects from mining bonds — still the differences are not fundamental. Any exhaustive classification according to types of enterprise would be of little value as a study in bonds ; it would be a classification of investment risks. A classification, on the other hand, according to the nature of the security behind the bond is both valuable from the point of view of the investor, and illuminating as a study of the nature of bonds. It is in this matter of security that bonds differ fundamentally among themselves and the marked variations from standard forms occur. The following classification though not exhaustive will prove convenient. * For discussion of four different schemes of classiiication of bonds see Cham- berlain, L., Tlie Principles of Bond Investment, Chap, VIII (1911). Every writer on corporation iinance has some sjjecial classification. See especially Gerstenberg, C. W., Materials of Corporation Finance, 13 (1015). Also Ignatius, M. B., The Financing of Public Service Corporations, Chap. IX (igi8). There is also a brief but clever classification by Selden, G. C, "The A. B. C. of Bond Buying," 22 Mag. of Wall Street, 485 (:9i8). 40 BONDS SECURED BY PROPERTY 41 Classification of Bonds According to Security I. Bonds specifically and directly secured by property. (Dis- cussed in the present chapter. ) 1. A first or senior lien on specific physical property: (a) General first mortgage bonds (b) Divisional bonds (c) Special direct lien mortgage bonds, such as those on terminals and real estate. 2. A secondary or junior lien on physical property: (a) Second and subsequent mortgage bonds (b) General and consolidated mortgage bonds (c) Refunding mortgage bonds. 3. A lien on specific securities owned by the corporation : (a) Collateral trust bonds (b) Secured short-term notes II. Bonds secured largely, if not entirely, by the general credit of the corporation. (Discussed in the succeeding chap- ter.) 1. Obligatory promises: (a) Receiver's certificates (b) Assumed bonds (c) Guaranteed bonds (d) Joint bonds (e) Debentures 2. Conditional promises: (a) Income bonds (b) Participating bonds First mortgage bonds, as the name implies, are secured by a mortgage or deed of trust which, in theory at least, con- veys the physical property held under the mortgage to a trus- tee for the benefit of the bondholders in case the interest or 42 CORPORATE SECURITIES the principal is defaulted.^ One is compelled to interpolate the phrase, "in theory at least," because the modern practice of the courts in appointing receivers at the first intimation of financial difficulties, tends to defeat both the letter and the spirit of the mortgage bond. At all events, except under the authority of the court, first mortgage bonds cannot be superseded by later liens. The fundamental security of a'first mortgage bond consists therefore, in the assurance that, ex- cept by a decree of a court, the bondholder has the first claim to the physical property in case his rights are in jeopardy. In America, mortgage bonds owe their origin to periods of financial stress. The first sections of the early railroads of the Atlantic seaboard were built entirely by stock subscription just as the New England cotton mills are now built. This custom prevailed down to 1840. It was found often that more money was required to finish and extend the early sec- tions than had been anticipated, and the stockholders, not wish- ing to increase their subscriptions, consented to the use of the railroad already built as a basis for loans.^ This was in the period before 1850, when the nation was dependent on Eng- land for the capital required to finance internal improvements, and the English bankers required a security for their loans which should possess a specific lien on physical property. Once the practice of issuing mortgage bonds had been established, it was found difficult to obtain capital from the sale of other forms of securities, but comparatively easy to sell this forrii. As a result, railroads came to be built entirely out of the pro- ceeds of mortgage bonds, the promoters retaining for them- 2 The custom of securing a debt by a deed of trust is of very ancient origin. The researches of archeologists in Asia Minor have recently brought to light a deed of trust for an olive press as security for a debt, which was executed upwards of 5,400 years ago. The fullest and most exhaustive discussions of the relative priority of bonds is found in railroad finance, where the subject is most complex. The White and Kemble's "Atlas of Railway Mortgages'* is an elaborate series of charts which portray by means of colored lines the relative position of mortgages on all the rail- roads of the country. 'See Cleveland and Powell, Railroad Finance, 43, 51 (igia); Ripley, W. Z., Railroads, Finance and Organization, 10 (1915). BONDS SECURED BY PROPERTY 43 selves the stock for which they had contributed little except promoting ingenuity." From railroad mortgage bonds the practice extended first to horse railroads and lighting com- panies and very much later to manufacturing companies. A great variety of so-called first mortgage bonds exist. Railroads,^ traction companies, lighting companies, power dams, manufacturing corporations, and even mines and quar- ries, have issued their first mortgage bonds. Yet from the point of view of investment strength, there are great differ- ences in the significance of the mortgage form of these differ- ent classes. In some cases, as with mines, the property ac- quired through foreclosure of the mortgage would be almost worthless, because if the mine could not be made to pay by the original owners, the chances are even less favorable for the bondholders. On the other hand, a railroad, provided it does not run through a desert, is practically sure of earning some return to its bondholders. It has a fundamental economic value which a mine or a manufacturing plant has not, through the monopoly of business given to it by mere geographical location. This economic value is inextinguishable. Even the courts will safeguard it. For this reason railroads have been able to bond their properties for a far higher proportion of their full value than have other forms of business enterprise. The ultimate basis of all economic values, as will be ob- served frequently hereafter in this study, is the social service evidenced by earning power. This is the ultimate basis of the security of railroad bonds. Accordingly, the confidence of the investing public in these bonds is based on the assumption that a particular railroad will always perform a social service * For further general discussion see Cleveland and Powell, Railroad Finance, Chap. IV (1912); Ripley, W. 2., Railroads, Finance and Organization, Chap. I (1915)- ' For study of railroad mortgages, where the greatest variety exists, see Mitchell, T W I Tour. Ace, 357 (1906). Also for specific liens, the exhaustive "Atlas of Railroad Bonds," by White and Kemble, already referred to. For brief, clear state- ment of the specific covenants of a corporation mortgage see Lilly, Wm., Individual and Corporation Mortgages (191 8). 44 CORPORATE SECURITIES entitling it to some return on its capital and that the bond- holder, possessing a prior claim to this return, is assured of a kind of social protection. This confidence in earning capacity as the real basis of security, though only half-consciously real- ized, explains why certain types of bonds, not based primarily on earning power, are not recognized as high-grade securities, even though the cost value of the property pledged far exceeds the total issue of bonds. An illustration of the point just noted may be seen in the case of bonds secured by a first mortgage on standing timber. These constitute one of the few types of first mortgage bonds based on a mere appraisal of physical property. Timber, standing uncut in the forest, has absolutely no earning power. It is only after the timber is cut, driven to the mill, and manu- factured into lumber that it possesses an economic exchange value. The interest on the timber bonds can be met and the principal ultimately paid only as the timber is cut and mar- keted. If something interferes with the regular and syste- matic exploitation of the timber, nothing is realized with which to meet the bond obligations, no matter what the appraised value of the timber may have been.' First mortgage bonds, or mortgage bonds in general, may or may not contain the "after-acquired property clause."^ ' Because of the unfortunatejresults of just such events timber bonds have never been popular with the general investor, notwithstanding the large apparent equity back of them. There was a case of a bond issue on an immense tract of timber^ in Nova Scotia, worth, according to conservative appraisal based on, a scientific cruise, several times the amount of the bond issue. It turned out, however, that the operators could not market the timber quickly enough, and in consequence they defaulted even on the first coupon. An extended study of timber bonds was published by the American Academy of Political and Social Science, May, 1912, entitled "Timber Bonds as Investment Securities." The contributions to the pamphlet were written by men directly or indirectly interested in the marketing of these bonds. The studies are uncritical and nowhere emphasize the fundamental objections to timber bonds cited in the paragraph above. ^ For example, an old-fashioned after-acquired clause was worded so as to have no loophole. ' All the present and the future to be acquired property of said rail- road company in and relating to its said railroad, and all the right, title, interest and equity of redemption therein." Trust mortgage, C. B. & Q. R. E. Co., July, 1873, page 6. BONDS SECURED BY PROPERTY 45 When present, the mortgage is made to cover not only the ex- isting property but that subsequently acquired as well. From the point of view of the investor, this after-acquired property clause very much enhances the value of the bonds, because all property subsequently bought or built passes automatically under the lien of the mortgage. It is, however, a source of annoyance to the corporation for it stops the issue of any further first mortgage bonds on new property. For that rea- son, the after-acquired property clause is now seldom inserted in closed mortgages, although it is still common in open-end mortgages. If it exists in any underlying mortgage, it is usu- ally avoided by creating a new corporation which assumes title to the additional property. This new corporation issues first mortgage bonds which are then assumed or guaranteed by the old parent corporation. This legal subterfuge explains the existence of many of the subsidiary corporate entities fre- quently created by our large railway systems for no apparent reason. Divisional bonds are usually first mortgage bonds secured by a section or division of a railroad's property. They are usually either the relics of old bond issues existing before a consolidation or a reorganization, or else the still outstanding bonds on the integral parts of a great system. The idea has been carried over into other types of enterprises, so that a bond on a part of a street railroad, a section of a hydro- electric company's transmission lines, or even a single build- ing of a manufacturing plant has been called a divisional bond. The significance or economic value of divisional mortgage bonds is even more subject to individual qualifications than is the case with general first mortgage bonds. If the division covered by the mortgage is essential for the conduct of the railroad's business, the bonds will be protected at all hazards. Even the interest on the first mortgage bonds on a large part 46 CORPORATE SECURITIES of a railroad system may be defaulted, while that on the un- derlying bonds of the important divisions are paid.' On the other hand, if the division covered by the mortgage is not of great importance to the railroad — perhaps even an occasion for loss — the officials may be entirely willing to default the interest on the bonds and allow the bondholders to take the property and operate it as best they can. It is therefore of great importance in determining the position of a divisional bond to ascertain three things : ( i ) whether or not the prop- erty covered by the mortgage is self-supporting; (2) whether or not it is essential for the business of the whole system; (3) whether or not the bond is guaranteed as to principal and in- terest by the corporation of whose property it is an integral part.' If the bond meets none of these conditions it may be of little value, even though it is the divisional bond of a strong railroad system. On the other hand, if it meets these condi- tions, it may be in a position of unquestioned strength, even though it is the divisional bond of a bankrupt road.^° Special direct lien bonds are bond issues secured by a direct first mortgage on real estate, terminal property and bridges, and similar special structures. The purpose in issuing such special bonds is usually to sell securities at a lower interest rate than the general credit of a corporation warrants, be- cause of the feeling in the minds of ijiany investors that a direct lien on valuable real estate is to be preferred to a gen- eral lien on widely scattered properties. ^^ Such investors pre- ^ Instances of this are cited in Volume V, A recent case that emphasizes the principle very forcibly is that of the bankrupt Atlanta, Birmingham and Atlantic Railroad. Although the failure was so serious and the subsequent reorganization so drastic that even holders of receiver's certificates were forced to undergo sacrifices, the underlying divisional bonds of the Atlantic and Birmingham Railroad were pro- tected in every way. * For discussion of the value of guarantees, see succeeding chapter. ■*" For further discussion of divisional bonds in the growth of railroad systems, see Ripley, W. Z.p Railroads, Finance and Organization, 134 (1915). " Specific lien bonds on real estate are not confined to transportation companies; consider Western Union Telegraph Company's Real Estate 4}^'s of 1930, secured by BONDS SECURED BY PROPERTY 47 sume that, terminal property in large cities may be taken by the trustees of the mortgage and sold for other purposes, in case the railroad fails to meet the interest and principal of its terminal bonds.^^ Quite generally in order to make the secur- ity stricter in case of receivership, a large corporation may arrange to have its real estate owned by a subsidiary corpora- tion which leases the property to the parent company," In that case, if the main corporation goes into the hands of re- ceivers, the trustees under the mortgage may hold the real estate independent of the rest of the corporate property/* Frequently too, the special terminal and special real estate corporation and its bonds are created in order to avoid placing the new and valuable property under the lien of an old general first mortgage having the after-acquired property clause. The device of an independent terminal corporation is also resorted to when the terminal is built by several railroads, no one of which is willing to assume the financial responsibility alone/° These same observations apply to other types of special security bonds. Land-grant bonds, frequently issued in the early days of railroad building, are, as the name implies, se- cured by the pledge of land granted to the railroad by Con- gress or the state. Other forms are dock bonds, bridge bonds, wharf bonds, ferry bonds, warehouse bonds." the company's land, buildings, and equipment in New York and Ciiicago; Armour and Company's First Mortgage Real Estate 4^'s, 1939. •^This is not always true. Probably most city terminals do not pay from any point of view the cost of construction. The great terminal in Washington is an example of a foolish and extravagant expenditure. With the default of the Chicago Terminal Company's 4's, investors recognized that a terminal bond to be sound ought to be secured by a mortgage but little, if any, larger than the value of the land or else guaranteed by a strong railroad corporation. The holders of the Georgia Ter- minal Company's First Mortgage Bonds, secured ostensibly by valuable terminal prop- erties, were asked, in the reorganization plan of March. 1914, ta accept almost worthless common stock, and that only after they had bought 16 per cent of a pre- ferred stock at par. Seldom have terminal bonds been so ruthlessly sacrificed. "This device is explained in more detail in connection with joint bonds, because this special corporation ^ is practically a necessity if its property is to be used by more than one corporation. (Chapter IV.) "The best illustration of security by lease is that of the equipment obligations, for discussion of which see Chapter V. t ,-m t j ^ For further discussion see subject of joint bonds, Chapter IV; also Cleveland and Powell, Railroad Finance, 78 (1912). . "Brief discussion, Cleveland and Powell, Railroad Fmance, 77 (191s). 48 CORPORATE SECURITIES Some issues of bonds bear in their name the representation of greater security than they actually possess. The "first lien" and "prior lien" bonds are not always of the nature of first mortgage obligations. This divergence between the form and the substance is especially conspicuous in the case of the obligations of a railroad corporation which merely leases the lines and equipment from another corporation. Sometimes the two corporations are indistinguishable in name except by the substitution of the word railroad for railway.^^ A similar confusion of terms is often involved in the use of the words "first and refunding" to imply a first mortgage bond. It is true that the mortgage may be a first lien on actual property, but the property covered may be relatively insignifi- cant compared to the entire property of the corporation.^^ In such cases the term "first" is a mere subterfuge employed for the purpose of evasion. All such conscious misrepresentations are unwise, inexpedient, and tend to destroy public confidence in corporate securities by obliterating apparent and funda- mental distinctions. Second, third, and later mortgage bonds are, as their names imply, subsequent in their lien to preceding bonds. This ques- tion of priority of lien, while nominally concerned with the relative position of the bondholders at any division of assets, is actually a matter of the relative priority with regard to the payment of interest. Interest is paid first on the first mortgage bond, then on the second, and so on, each issue following in the order of its relative lien on the physical property. If the "Thus the Chicago and Alton Railroad syi per cent bonds are called First Lien," which may be a fact as regards the railroad. Yet the property of the railroad consists almost entirely of the equity in the Chicago and Alton Railway^ which has its own bonds outstanding. The first lien of the railroad is therefore not on physical property, but merely on a leasehold of physical property covered, quite fully, by another mortgage. ^ Thus the so-called First and Refunding Bonds of the Missouri Pacific Railway were merely a first mortgage on 167 miles of line out of a total of 3700 for the entire system, and these 167 miles constituted a relatively insignificant part. BONDS SECURED BY PROPERTY 49 earnings of the corporation are ample, there is little difference between a first and a seventh mortgage, for the interest on all issues is paid before any dividends can be set aside for the stockholder.^' But if the earnings fall off so as to endanger the solvency of the corporation, the relative position of the various mortgages becomes a matter of primary importance. Interest may be paid on the prior mortgage bonds although lapsed on the later issues; and in the adjustment of sacrifices at the time of a reorganization the first mortgage bonds are affected least and the later mortgage bonds most. The mere name does not necessarily of itself signify the real character of a bond's security. Especially is this true of the bond issues of the older railroad systems. What pur- ports by its name to be a third mortgage may in fact be an absolute first mortgage by reason of the fact that the two earlier mortgages have been paid up or else refunded into a later mortgage.^" Yet the prejudice of the investor against the idea of a second or third or sixth mortgage bond, no matter how sound, has led the railroads to cease the issue of bonds named in this manner and to adopt the words "general" or "consolidated," or "refunding," or similarly illusive names for their later bond issues.^^ These names are used notwithstand- ing the fact that the property securing the bonds is fully cov- ered by first and earlier mortgages. In fact, so seldom are words "second," "third," or "fourth" now used in describing new mortgage bonds that when the name appears, it may be j)resumed to refer to some old, underlying mortgage bond that ^^ Thus there are five successive mortgages on the property of the old New York and Erie, the original stem of the Erie Railroad. Yet so small is the aggregate of these liens, as compared with the value of the physical _ property securing them, that the investment yield on the fifth mortgage bonds is practically the same as that on the first. ^ Thus, the absolute first mortgage bonds on the Long Island system are called the Second Mortgage 7's. ^ Alexander J. Hemphill, Chairman of the Board of Directors of the Guaranty Trust Company of New York, testified September 9, 1913, before the Interstate Com- merce Commission, that a fourth mortgage of a railroad does not appear as a very attractive investment if it is so designated. 50 CORPORATE SECURITIES has withstood panics and reorganizations. Instead, there- fore, of implying weakness it may indicate a strength underly- ing the whole debt structures of the railroad system.^^ Equally confusing in name are those few examples of bonds which have different kinds of security for different parts'of the same issue, all bearing the same title and indistinguishable except by reference to the original indenture under which they were issued.^^ An entirely different kind of confusion arises from those issues having identical security but of entirely different names.^* General and consolidated mortgage bonds are in effect issued under blanket mortgages which come after all the pre- ceding mortgages. ^° In a large number of instances, espe- cially in the older railway systems, the so-called general or consolidated mortgage bonds have become, in effect, first mortgages on the entire system, owing to the fact that the earlier first, second, third, etc., mortgages have become due and have been paid. Ordinarily a general mortgage bond agreement contains the after-acquired property clause, so that, once such an issue has been executed it is difficult, if not im- possible, to issue any first mortgage bonds having a first lien on any of the company's property. At the present time it is common to call general or con- solidated open-end mortgages by the term "refunding," in " The Lone Island Railroad Second Mortgage Bonds referred to in the previous note. The Fifth Mortgage Bonds of the New York and Erie are regarded as so sound that they sold in 1912 (before the Great War) on a 4 per cent basis, probably as high as any non-savings bank railroad bond. 2^ The Rogue River Electric Company Prior Lien 5's of 1937, are of an author- ized issue of $700,000. Of these bonds, numbers i to 250 have a lien on the property of the company superior to that of the remainder of the issue. 2* The Erie Railway Consolidated 7*s^ 1920, are secured by all the property of the old New York and Erie Railroad, having been created in 1870 at the time of the first Erie reorganization. The New_ York, Lake Erie and Western Consolidated 7's, 1920, secured by a deposit of certain of the coupons of the Erie Railway 7's, have, therefore, the same fundamental security. ^ For illustration, the Erie Railroad's General Lien Bonds, due 1996, are pre- ceded by a large issue of Prior Lien bonds, by no less than six different and suc- cessive blanket issues, and by a large number of divisional mortgage bonds of great variety. BONDS SECURED BY PROPERTY 51 order to throw emphasis on the fact that the issue is designed primarily to pay off the prior existing Hens. Such a term conveys, to the mind of the investor, an impHcation that the issue is of increasing security and it is therefore the more readily salable. After the earlier issues have been paid off what purports to be on its face merely a refunding mortgage may be, in reality, a first mortgage.^" The practice of refund- ing issues is of comparatively recent prominence." In earlier financial history, complete refunding and unification was ac- complished only at the time of a reorganization, because of the practical impossibility of inducing the holders of a multi- tude of different issues to consent voluntarily to the exchange of prior lien bonds into the refunding issue. Without such exchange, of course, the equity to the holders of the refund- ing issue was so small as to make the bonds practically un- salable. The first great piece of financing of this kind^^ was that of the old Atchison, Topeka and Santa Fe Railroad at the time of the reorganization of 1889. At that time forty- one different issues, aggregating over $160,000,000, were re- funded into two blanket issues. Subsequently, in the railroad reorganizations of the middle nineties, large refunding issues were uniformly used. Of late years, especially since 1910, many railroad systems have discarded the limping step-by- step policy of financing improvements and have issued instead great blanket, refunding mortgages of long duration, with the conscious purpose of retiring all the previously issued bonds ^ Thus the New York and Harlem Refunding 3^*s of 2000 are now first mort- gage bonds, the old first mortgage bonds, which underlay the 3^'s when the latter were issued, having been paid off. ^ There are of course, exceptions to this statement. The Chicago, Burlington and Quincy Railroad issued a large refunding mortgage in 1873, which expressed clearly the idea underlying all modern refunding mortgages. ^ "Whereas it is desir- able to fund all said several classes of absolute indebtedness into bonds of one class as nearly uniform in character as may be, to be secured by a single mortgage." Trust deed for the $30,000,000 Refunding Mortgage of 1873, page 4. This mortgage has been referred to several times already. It was one of the first comprehensive refunding mortgages issued by our large railway systems. ^ Similar refinancing had been accomplished in the Northern Pacific reorganiza- tion of 187s, and that of the Wabash of 1887. Neither was, however, as important or as extensive. 52 CORPORATE SECURITIES and making future improvements by the sale of bonds secured by this one general and refunding mortgage. Often a little broader idea is conveyed by calling an issue an "extension and refunding," or an "improvement and re- funding" mortgage bond. Especially would such double terms be used if emphasis is to be laid on the use of some of the new money for betterment. Although large in amount such great open-end bond issues may not be a first lien on any of the company's property and only an inferior junior lien on the main portions.^" The idea, however, in this entire group of bond issues is that there exist underlying mortgages and the general, the consolidated, the refunding, the improvement or extension mortgage, by whatever name it is called, is subject to all these underlying liens. The student of finance is left to his own resources to ascertain how real is the actual lien on the physical property. The provisions and conditions of issue of bonds under these comprehensive refunding mortgages are defined only vaguely or not at all. The great Refunding and Improvement Mortgage of the New York Central dated October i, 1913, and due 2013, permits an issue of bonds up to three times the capital stock, which now amounts to $250:000,000 out- standing and will subsequently amount to $400,000,000. So that the total issue of these bonds may now reach $750,000,- 000 and could later be extended to over a billion dollars. There are no restrictions on the first $500,000,000 of the bonds to be sold to pay for improvements and extensions, but further issues must be restricted to 80 per cent of the cost of the addi- tions to the property of the road. Although by name a re- ^ Thus, the great Refunding and Improvement Mortgage of the New York Cen- tral is a third lien on the main lines east of Buffalo, a fourth lien on those west of Buffalo, and a second and third lien on various branch lines. As far as the writer can discover, it is not a iirst lien on any physical property. (The recent additions are fully covered by the underlying Consolidated Mortgage of 1998, the stocks de- posited are all subject to prior liens, and the Beech Creek bonds are only second liens on physical property.) BONDS SECURED BY PROPERTY 53 funding issue, it is a misnomer, as the underlying bonds may be extended, at the option of the company, until one month before the maturity of the bonds, or September, 2013. Bonds under this mortgage may be issued to acquire stocks of other companies or for other corporate purposes; they may be at any rates of interest that the directors fix, and the conditions of redemption and the terms of payment may be modified and changed. The directors of the road may even make some of the bonds convertible into stocks under conditions which they define/" Nevertheless, while the provisions of this New York Central refunding issue may be extreme in their vague elas- ticity, they are in accord with the spirit of railroad finance at the present time as a consequence of which the small, closed, clear-cut mortgage bond is rapidly becoming extinct. This change of point of view is an acknowledgment on the part of railroad financiers, investors, and of the public that railroad debt is permanent, and this view has been tacitly accepted by the law and by public opinion. As the strength of refunding issues of bonds rests largely on the increase in the equity behind them, when the prior iiens are paid, it is important that the corporation assure the investor that the prior liens will not and cannot be extended. Sometimes, in spite of the fact that the refunding mortgage contains a provision implying that the underlying bonds will be retired when they fall due, the company finds it possible to evade the provision of the refunding mortgage and extend "" It is notable that the New Jersey Public Service Commission, on the whole liberal toward corporations, disapproved of this mortgage as applied to property within New Jersey, because it "departs so radically from the old-established principle that loans ought not to exceed assets." For details see decision dated December 19, 1913- It should be noted in passing, however, that no matter how broadly and loosely drawn, the bonds are bonds and their holders have the protection of a right of fore- closure in case of default. They stand ahead of all debentures. They are of con- spicuously greater strength than preferred stocks. In April, 1914, irresponsible par- ties, in order to injure the sale of these very bonds, alleged that "the position of these bonds is scarcely better than that of a preferred stock without voting power." Such a statement is utterly false. It is a case either of profound ignorance of finan- cial principles or wilful misrepresentation. 54 CORPORATE SECURITIES those bonds/^ Great care should be exercised in drawing the refunding mortgage to be sure that the obHgation of the cor- poration with respect to the underlying bonds is clear- Collateral trust bonds are not secured as a lien on physical property, but rather by a lien on securities deposited with a trustee as collateraL^^ Their ultimate security is therefore indirect or secondary, as it rests not on the deposited collateral but rather on the physical values of the property represented by this collateral. Issued at first but sparingly,^^ collateral trust bonds have now assumed a far-reaching significance in our American finance, a significance which is bound to in- crease as financial policies and procedures grow more complex. They were used at first by railroads in order to bring into a single merchantable issue of bonds a variety of divisional and branch bonds in themselves unmarketable because of their insignificant size^* or else when some legal obstacle prevented the issue of ordinary bonds.^^ Later the railroads used col- lateral trust bonds to build extensions and to efifect consolida- ^ This is illustrated by an unfortunate refunding operation of one of the sub- sidiaries of the Standard Gas and Electric Company. There were $416,000 First Mortgage Bonds of the Tacoma Gas and Electric Company, due May i, 1915. There was also an issue of Tacoma Gas Light Company Refunding Mortgage Bonds, due 1936. Of the latter $416,000 were reserved to retire the issue of the underlying bonds due in 1915. Yet when these matured, instead of retiring them by the bonds reserved, they were extended. Such tactics on the part of corporation officials, although perhaps legally permissible, react against the general credit of their company and investment confidence in general. 22 For brief study of the indenture securing^ collateral trust issues see Stetson, F. L., Some Legal Phases of Corporate Financing, Reorganization and Regulation, S7 (^9^7)- For legal matters concerning the issue of collateral trust bonds, see Jones, L, A,, Treatise on the Law of Pledges, Including Collateral Securities (igoi). See also a very important recent decision, Watson v. C. R. I., etc., 169 App. Div. (N. Y.), 663 (1915). Also Machen, A. W., Modern Law of Corporations. ^^ Prior to the Richmond and West Point Terminal Railway and Warehouse Company's Collateral Trust Bonds of 1887, the issue of collateral trust bonds occurred only in special cases when the issue of ordinary mortgage bonds was inexpedient. ^* See infra, note 39. ^ To protect its second mortgage bonds on the old Union Pacific Railway, the United States Government, in 1873, prohibited the road from issuing further direct mortgage bonds. Yet it was involved in a policy of extension in the Northwest to maintain its strategic position. These extensions were accordingly financed through the issue to the parent company of direct mortgage bonds covering the new construc- tion. These small Issues were then made the basis of a collateral trust issue of bonds by the parent road. BONDS SECURED BY PROPERTY 55 tions.^° Subsequently, after 1897, they appeared to some ex- tent in the industrial field." Since 1906 their most extensive use has been in the financial plans of public service holding companies. Here the financial structure has, in some cases, been so complicated that collateral trust bonds of one holding company are security for those of another. In one or two instances this process of pyramiding equities has been carried up several steps.^' Collateral trust bonds are now used by every type of cor- poration for a variety of purposes. The most reasonable — as it was historically the first — use for this class of bonds is to realize money from a multitude of small bond issues, no one of which is sufficiently large to command a wide market. A considerable variety of such small issues are put under one trust and a single large collateral trust bond is issued. The bonds of such an issue will command a wider investment mar- ket than those of the small issues.^' In such cases holders of ^^ For an exhaustive study of the collateral trust bond in railway finanee see Mitchell, T. W., "The Collateral Trust Mortgage in Railway Finance," 20 Q. J. E. 443 {1906). Also Ripley, W. Z., Railroads, Finance and Organization, 143 (1915), and Cleveland and Powell, Railroad Finance, 73 (1912). "^ Asphalt Company of America Collateral Trust Gold Certificates and Interna- tional Mercantile Marine Collateral Trust 4H's- ^ For further discussion with reference to holding companies, see Volume IV. ^ A good illustration taken from railroad finance was that of the Missouri Pa- cific First Collateral Mortgage 192a. Of these there were outstanding $9,636,000 secured by the deposit of the bonds mentioned below. None of these issues had an independent market, all being parts of the Missouri Pacific system. Should the bond- holders of this issue be comi)elled — as was threatened at the time of the receivership of 1915 — to foreclose their lien, take over these little bond issues, and subsequently the lines of road covered by the bonds, the properties obtained would have little value if operated independently of the whole railroad system into the structure of which they had been long since interwoven. Miles Principal BoNPS Secured upon Main Line: Maturing Mortgaged Amounts Kansas City & Southwestern 6's 1926 27.00 $550,000 Kansas City & S. W. of Missouri 6's 1926 20.70 407,000 Council Grove, Osage City & Ottawa 6's 1920 69.53 1,110,000 Topeka, Salina & Western 6's 1923 51.73 1,273,000 Missouri Pacific Railway in Kansas 6's 1920 19-42 300,000 Council Grove, Smoky Valley & Western 6's... 1917 27-30 417,000 215.68 $4,057,000 Bonds Secured upon Branches and Scattered Properties: St. Louis Oak Hill & Carondelet 6's 1917 6.30 $400,000 Iron Mountain of Memphis 6's 1920 1.09 500,000 Fort Scott & Eastern s's 1920 26:27 394.000 Fort Scott Belt Terminal 5's 1920 3.91 195,000 Fort Scott & Southern 5's 1920 53.07 383,000 56 CORPORATE SECURITIES the collateral trust bonds have the full security of the bonds deposited and whatever additional value goes with a wider market. Distinctly the best form of a collateral trust bond of this description, from every point of view including that of the credit of the corporation, is that issued by the public service holding company where the security is the first mortgage bonds — not stocks — of the subsidiary operating companies. Such bonds of small operating companies have an independent value and as such would strengthen rather than weaken the collateral trust bonds; yet the subsidiary bonds themselves, being in such small amounts, would attain only the narrowest market individually.*" Nevertheless, however, the procedure in connection with collateral trust bonds of this sort amounts to financial legerdemain in which the corporation masses together a collection of securities which, if taken separately, would not be acceptable investments to the public. In other words, the money locked up in odds and ends can be withdrawn by the corporation through the issue of collateral trust bonds and used for other corporate purposes. The second reason for the issue of collateral trust bonds Bonds Secured upon Branches and Scattered Properties. (.Continued.) Miles Principal Maturing Mortgaged Amounts Omaha Southern s's 1922 25-44 $382,000 Nebraska Southern 5's 1922 16,12 242,000 Kansas, Nebraska & Dakota 6's 1916 131.00 2,osS,ooo Grouse Creek 6's 1927 24.97 376,000 Pacific Railway in Nebraska s's 1920 73.00 1,093,000 Interstate Railway 6's 1920 101.43 1,622,00a Toplin & Western s's 1922 4.59 69,000 Rooks County R. R. 6's 1920 18.25 275,000 485.44 $7,988,000 Total mileage and principal amounts 701.12 $12,045,000 '° A good illustration of this kind of bond is the Collateral Trust 5 per cent Bonds of the American Public Utilities. These bonds are secured by the deposit with a trustee of an equal par value of the bonds of subsidiary; controlled companies, pro- irided the bonds to be deposited meet the following conditions; 1. At least one-half of the share capital of the subsidiary " operating company must be controlled by the American Public , Utilities Company. 2. The bonds deposited as collateral must be secured by a mortgage on all or substantially all of the property, and franchises of the subsidiary op, crating company. 3. The interest rate on the bonds deposited must be at least s per cent. BONDS SECURED BY PROPERTY 57 lies in the legal obstacles which so frequently prevent the use of simple and direct means of financing. Usually an old mortgage contains the after-acquired property clause so that each separate addition to the total corporate property must be financed through an independent corporation, else it auto- matically comes within the lien of the old mortgage. But small independent corporations cannot issue marketable secur- ities alone; they can, however, issue securities which become the basis of a large collateral trust issue. Sometimes states (as Texas in the case of railroads) require a separate home- chartered corporation. This corporation has no independent credit, but its obligations may, with others, form the basis of a collateral trust bond issue. Sometimes subsidiary corpora- tions possess valuable franchises or privileges which might be jeopardized if the main corporation should attempt to operate the property directly; in such cases the subsidiaries may ob- tain the money required by using their own securities which are acquired by the parent company and used as collateral. A third explanation of the use of collateral trust bonds, rather less important but nevertheless common, is that of avoiding direct liability for damages. This reason is probably of most importance with businesses exposed continuously to the danger of suits by the public for personal or property dam- ages. Strange and otherwise unaccountable subterfuges of corporate law and finance are resorted to in order to reduce to a minimum the chance of loss through such suits and the collateral trust bond is one of these devices. For illustration, a large, rich, and prosperous electric company operating in a city builds a hydro-electric development. The new dam causes the hitherto sluggish river to overflow and the company is confronted by damage suits from farmers. If the company owns the hydro-electric property in its own name the farmers can collect their damages from it directly. This responsibility 58 CORPORATE SECURITIES may be eluded if the main company causes to be incorporated a separate hydro-electric company and places a mortgage on its property equal to its value. In the event of successful suits the farmers can only throw the smaller corporation into the hands of receivers and in the subsequent reorganization they can obtain no satisfaction, as the foreclosure of the mort- gage will exhaust the property of the little company. But the bonds issued under such a mortgage would have little market value. Accordingly the main company deposits them as collateral with a trustee and upon their security it issues its own collateral trust bonds. The kind of collateral deposited as security for collateral trust bonds may be divided roughly into three classes accord- ing to the economic significance of this collateral in the event of the foreclosure. In very rare cases the securities deposited possess an independent and entirely free market, a market in no wise subject to the vicissitudes of fortune of the issuing corporation. Such a collateral trust bond is that of the Adams Express Company's 4's, 1948, secured by the deposit of over a quarter of its own issue and large blocks of fifty-one differ- ent railroad bonds. All of these bonds, practically without exception, are listed on the New York Stock Exchange, and no one of them, except in an indirect and slight degree, is de- pendent on the earnings of the express business.*"- A similar, perhaps stronger although not so greatly diversified, list of col- lateral is that securing the Union Pacific Railroad's lo-year notes, due 1928. The note issue was for $20,000,000 to secure which the Union Pacific Railroad pledged $30,000,000 par value of the underlying bonds of six of our strongest rail- roads." " The security behind the Adams Express Company Collateral Trust 4'a is given in detail in Poor's "Manual of Industrials," under the "Adams Express Company." ^ $2,000,000 Chicago & Northwestern General 4's of 1987. $2,500,000 Chicago & Northwestern General 5's of 1987. $3,000,000 New York Central Refunding & Improvement 4}4's of 3013. BONDS SECURED BY PROPERTY 59 j A second group of collateral trust bonds consists of those which are secured by a deposit of securities of corporations allied to the issuing corporation but which may be operated independently. Admitting a probable sacrifice of values the securities of these companies could be marketed through the organization of wholesale bankers, although this would take time and would, almost surely, involve the holders in at least a temporary loss. Such a bond is the Collateral Trust 4's of the American Telephone and Telegraph Company. The se- curities behind these bonds are the stocks of subsidiary Bell telephone companies all interrelated with each other and the parent company, but yet capable of having an independent ex- istence. While a failure of the parent company, involving a default on the collateral trust bonds, would seriously cripple the subsidiary companies, it would not render their stocks valueless and unmarketable. Each one of the subsidiaries could be financed independently of the parent and the great majority of their stocks have open and easily ascertained market values.*^ In case of a default, therefore, the collateral could be sold at such prices as would cause little if any loss to the holders of the bonds.** Closely related to this class, yet $1,000,000 Pennsylvania Railroad Consolidated 4^*3 of i960. $2,500,000 Pennsylvania Railroad General 4^'s of 1965, $6,000,000 Southern Pacific Refunding 4's of 1955. $4,000,000 Baltimore & Ohio Refunding s's of 1995. $54000,000 Illinois Central — Chicago, St. Louis & New Orleans Joint ist & Refunding 5's of 1963. $4,000,000 Denver Union Terminal ist 4j^'s of 1964. (Guaranteed by Union Pacific, Chicago, Burlington & Quincy and Atchison Railroads.) The market value of these pledged bonds in June, 1918, at the time the Union Pacific Railroad issued the notes was over $25,000,000, " There are a great many collateral trust bonds of public utility companies that would come under this category, as, for example, the American Public Utilities Com- pany Collateral Trust s's mentioned in note 40, above. This bond is secured by the deposit of an equal amount, p^r value, of the bonds of subsidiary companies, located in Michigan, Indiana, Minnesota, Wisconsin, each having an independent earning capacity in excess of the interest on the deposited bonds; such bonds, therefore, could be sold on the open market or foreclosed and the properties themselves reorganized. ^A great variety of collateral trust bonds coming within this class are yearly pressed for market among bond buyers. Great care should be exercised by the issuing company to safeguard the corporation's credit among investors^ and even (rreater care must be exercised by the investors themselves to safeguard their interests. The collateral deposited should consist of many different parcels covering properties that can be independently operated. In addition great care should be exercised to ascertain that each parcel of collateral gives control of the subsidiary enterprise, so 6o CORPORATE SECURITIES ^ different from it, are the collateral trust bonds of one enter-/ prise issued to secure control of an independent but allied cor- poration. Such issues are very common in railroad finance/^ In the third type of collateral trust bonds the security de- posited covers the same enterprise as the bond itself. That is, the collateral has little or no independent value. Such cases, which are very common, are illustrated by the numerous in- stances in which a company wishes to give stocks of its own the glamor of a bond and so deposits them as the collateral for a collateral trust bond. The most conspicuous case of such financial sleight of hand was that of the Chicago, Rock Island and Pacific Railroad bonds, secured only by the stock of the Railway, the operating company. On foreclosure the bond- holders found that their bonds were such only in name, their real security being stock encumbered by a host of prior lien bonds.*® Collateral trust bonds of this character are bonds only in name. They are actually not different from the stock deposited to secure them, nor are they of more substan- that if the trustee is compelled to bid in the collateral at a foreclosure sale, the bondholders will be possessed of the absolute control of fundamental property. This is particularly important if the collateral is represented by a bare majority of a single issue of stock. In that case the agreement under which the bonds are issued should provide that if the total outstanding stock of the corporation be increased, sufficient new stock should be acquired and deposited under the trust so that the col- lateral would at all times insure a control. This is exactly what is provided in the agreement covering the Atlantic Coast Line's (Louisville and Nashville) Collateral Trust 4 per cent Bonds. ** These great railroad collateral trust bond issues are a sort of combination of the first and second classes mentioned in the above discission. They owe their exist- ence, in almost every case, to strategic rather than financial exigencies. Such are the Collateral Trust Bonds of the Atlantic Coast Line secured by the deposit of a majority of the Louisville and Nashville Railroad stock, and those of the joint obligation of the Great Northern and Northern Pacific Railways, secured by the deposit of practically the entire shares of stock of the Chicago, Burlington and Quincy Railroad. These collateral trust bonds, owing their existence to strategic reasons alone, frequently become of little value, because of some shift of railway policy. If the underlying stock becomes of no intrinsic value, independent of the corporation issuing the bond, the bonds themselves also become of little value. In extreme cases, weight of the collateral trust bonds may bring disaster to the company issuing them. The Collateral Trust Bonds of the Toledo, St. Louis and Western Railroad, secured by Chicago and Alton stock, were directly instrumental in causing the receivership of the former corporation in 1914; those of the St. Louis and San Francisco Railroad, secured by Chicago and Eastern Illinois stocks contributed in no small measure to the disaster of the former road. For further discussion, see Volume IV, Chapter IV. " There are a number of collateral trust bonds, secured by underlying^ unmarket- able and essentially worthless stocks. One of the most interesting abortions of the collateral trust bond was the so-called Refunding Notes of the Cincinnati, Hamilton and Dayton, issued in 1904, and secured, in large part, by the practically worthless stocks of the bankrupt Pere Marquette and an unimportant subsidiary. BONDS SECURED BY PROPERTY 6l i I jual security — in fact they may be weaker because devoid of the voting privilege and the inhibiting power of the stock- ' older to restrain the issue of prior lien debt and the exploita- tion of their assets by unprofitable contracts," and the dis- integration of the property.** Should the trustee under a collateral trust bond, secured only by stock, be compelled, finally, to bid in the deposited securities, the old bondholders would probably find themselves possessed of stock in itself unsalable and involving them in further investments of money in order to give it value. This was exactly what happened when the holders of the Rock Island Railroad Collateral Trust Bonds, previously mentioned, acquired possession of the railway stock. It should be re- membered, in every case of this character, that had the enter- prise covered by the securities been of itself of value, one may rest assured that the managers of the company would not have permitted the default on the collateral bonds. We may there- fore presume that the collateral bondholders will not be al- lowed to secure possession of their collateral until, for one reason or another, it has become of little value. It is bad judgment on the part of bankers and corporation officials and moreover, a species of deceit to call collateral trust bonds by another name. Especially is this true when they are called first mortgage bonds. *^ While there may be a *^ Such a case of exploitation of a subsidiary by a parent company, involving the sacrifice of the interests of the collateral trust bondholders, is that of the Chicago and Eastern Illinois. The common and preferred stocks of this road were acquired by the St. Louis and San Francisco Railroad and deposited as collateral for certain bonds. The St. Louis and San Francisco also controlled the St. Louis, Memphis and Southeastern. It then forced the Chicago and Eastern Illinois into an unprofitable contract with the latter subsidiary, as a result of which, amon^ other things, the earnings of the Chicago and Eastern Illinois were so low as to indicate little or no value for the collateral trust bonds secured only by its stock. " It is important that the holders of collateral trust bonds be assured of the proper upkeep of the actual physical property behind the collateral securities. Thus the agreement covering the Atlantic Coa.st Line's (Louisville and Nashville) Collateral First 4's provides that the Atlantic Coast Line will "cause all repairs, renewals and replacements necessary to maintain the railroads, structures, locomotives, cars and other equipment, tools and other property of the Louisville and Nashville Company in their present good order and condition to be made out of the earnings." *^ For example, the corporation resulting from a long series of reorganizations of the original whiskey distilling "trust" issued a series of bonds known as the 62 CORPORATE SECURITIES J semblance of excuse where the collateral is itself a first mort' gage on physical property, one may assume that the word "mortgage" is used in such cases for the purpose of evasion. Accepted usage long ago established the presumption that, whenever the term "mortgage" is used it means a direct lien on specific, physical property. For similar reasons the terms "collateral mortgage," "mortgage collateral," or even "first lien"^° bonds, without the designation "collateral trust" should not be used as titles for bond issues secured by collateral alone, because such terms are evasive and tend to confuse the in- vestor. On the other hand, it should be remembered that some collateral trust bonds are stronger than that name imphes, being secured not only by the deposit of collateral but also by a direct mortgage as well.°^ It has been said that collateral trust bonds are analogous to collateral loans from banks.°^ But this analogy is more ap- parent than real. It is true that in both cases the security be- hind the loan is of the same nature but the conditions of issue are fundamentally different. In the case of a collateral loan from a bank, the loan is of short duration and secured by col- lateral with a current open-market value by which the bank is "Distillers' Securities Corporation First Mortgage Twenty-five Year, 5 per cent Con- vertible Gold Bonds." These bonds are not first mortgage on physical property, but are secured merely by a deposit of certain stocks. ™ The bonds of the Southwestern Power and Light Company are called "first lien," whereas they are "secured by a first lien on all the property now owned by nine subsidiary companies, through deposit with Trustee of the entire capital stocks of and all the bonds of these companies." N. W. Halsey and Company circular, November, 1915. "^ Thus, the New York Central and Hudson River, Lake Shore Collateral Trust 3j^'s are now, by the implications of the consolidation of December, I914, a second mortgage on the New York Central's east-of-Buffalo lines, and a third mortgage on the west-of-Buffalo lines. " "As to the security back of this note issue, we shall attempt to picture it to you by a simple parallel. "If you go to your own bank and pledge $2,000 of excellent collateral as security for a $1,000 loan — if you show them the title to a parcel of unencumbered real estate worth about $3,000 and agree as a consideration for the loan not to mortgage it until your loan is paid — if finally you get one of the richest men in your community to endorse your note, and pay interest at the rate of 7 per cent per annum, the security of the bank will closely approximate the security of the holder of one of the Collateral Trust Notes here offered." Circular letter, dated August 13, 1913, of E. H. Rollins & Sons, describing an issue of $4,000,000 Huntington Land and Im- provement Company's Collateral Trust Bonds. BONDS SECURED BY PROPERTY 63 able to check constantly the value of the security. Collateral trust bonds, on the contrary, invariably run for some years, frequently for long periods,^^ and the value of the collateral may diminish greatly before the bonds are due. Ordinarily in such cases the trustee of the bondholders cannot compel the substitution of more valuable collateral to maintain the original equity.''* It is a species of deceit to represent to the investing public that the real value of a large issue of collateral trust bonds can be gauged by the market quotations of the collateral at the time of the issue of the bonds. The market quotation is al- ways for one or two bonds and never for an entire issue ; and if the collateral trust bondholders or their trustee should try to sell the large mass of collateral deposited as security the open market, as registered by a few transactions, would vanish entirely. Objectionable also is the practice of bankers in rep- resenting the value of collateral by its par value as if this were a matter of concern should the bondholders be com- pelled to acquire the collateral through a default in the interest payment on the bonds. Even though collateral deposited as security for bonds continues to pay interest or its dividends, it may have a low market value and a low intrinsic value, as evidenced by the earnings of the actual property it repre- " American Gas and Electric Collateral Trust Bonds of 1907, due 2007. " Thus, when the Adams Express Company's Collateral Trust Bonds 4's of 1948 were issued in i8g8, over $13,000,000 par value of high-grade bonds was pledged as collateral behind the issue of $12,000,000 of bonds. The collateral pledged was certainly worth $13,000,000 and tended to appreciate in_ value during the next four years. But after 1906, the collateral declined steadily in value, and by January i, 1918, it was worth approximately $8,883,000. This is one of the few issues where the collateral is subject to an entirely independent market not affected by the vicissi- tudes of the issuing corporation. ^ This is illustrated by certain of the Collateral Trust Bonds of the Electrical Securities Corporation, an offspring of the General Electric Company, which owns all its common stock. From time to time the Securities Corporation has issued col. lateral trust bonds, based on the deposit of the bonds of electric enterprises, many of them enterprises in the course of construction. The credit of the company is high which has enabled it to sell its collateral bonds above what the value of the deposited collateral would warrant. Thus the Fourteenth Series had a par value of $1,000,000 and was secured by $1,250,000 par value of other bonds. But the actual market Value was less, at the time of issue, February, 1916, than the face value of the bonds 64 CORPORATE SECURITIES Secured short-term notes are usually merely short-term collateral trust bonds which owe their existence to the de- mands of temporary financing.'*" They are a kind of emer- gency security and the banker who sells this kind of bond usu- ally insists that the corporation shall pledge specific property as security for the payment, unless the corporation is free from underlying obligations and can agree not to mortgage any of its assets during the hfe of the notes." When specific securities are pledged, it is common to insist that the funda- mental value of the collateral pledged be not impaired by the unrestrained issue of underlying securities.^^ And even more important is it to be certain that the actual property, whatso- ever its nature, behind the securities pledged shall not be de- stroyed wantonly by those who control the enterprise.^' The security pledged by the corporation is frequently a mass of odds and ends that happen to be in its treasury."" Al- of the collateral deposited. (The among specialists in public utility Bond and Approx. Mar- Market Maturity ket Price Value ist. s's 1941 70 $87,500 1st. 5'S I9S3 88 220,000 Ref. 5 6 1929 75 86,250 ist. s's 1943 80 200,000 ist. s's 1932 82 82,000 1st. s's 19SI So 160,000 ist. s's 1941 86 64,500 1st. 5*5 1941 71 96,000 issued- This is shown by a summary statement quotations were the current "street" quotations, bonds.) Par Value of Bonds Corporation $125,000 Appalachian Power 250,000 Colorado Power I IS, 000 Consolid'd Power and Light Co. 250,000 Fort Wayne and Northwestern 100,000 Mesaba Railway 200,000 Mississippi River Power 75,000 Wash., Baltimore and Annapolis 135,000 Yadkin River Power $996,250 " The financial policy of using short-term notes is discussed in Volume IV, Chapter VII. Railroad financing by short-term notes discussed at length, Ripley, W. Z., Railroads, Finance and Organization, 146 (1915); Cleveland and Powell, Railroad Finance, 47 (1912). " As in the case of certain note issues of the United Fruit Company. 68 The Five-Year Collateral Trust Notes of the United States Public Service Company, due 1918, are issued under the provision that none of the subsidiaries whose securities are collateral for the notes, can issue additional securities or incur floating debt, except for operating expenses, unless the new securities or notes are straightway deposited as additional collateral. "^ For further discussion of the manner in which the apparent security of short-term notes may be destroyed, see Volume IV, Chapter VII. *• The collateral used by the New York, New Haven and Hartford Railroad is an illustration of the heterogeneous mass of securities sometimes pledged. The follow- ing is a list of that securing the 5 per cent notes due May i, 1915; BONDS SECURED BY PROPERTY 65 though sometimes this collateral consists of first mortgage bonds of a high order, which for one reason or another it is inexpedient to sell at the time the notes are marketed, the col- lateral deposited as security is usually of inferior character. As the notes mature quickly the investor does not require as Stocks Central New Eng-land Railway Co. Common Stock Preferred Stock Hartford & Conn. Western R. R. Co New York, Ontario & Western Ry. Co. Common Stock Preferred Stock Rutland Railroad Co American Telephone & Telegraph Co Concord & Montreal R. R Connecticut & Passumpsic Rivers R. R. Co. Northern R. R. (of New Hampshire) Pennsylvania Railroad Co The Rhode Island Co Waterbury Gas Light Co Bonds American Telephone & Telegraph Co. 4H% Gold Bonds, due 1933 Chicago, Burlington & Quincy R. R. Co. (111. Div.) 3/4% Bonds, due 1949 ■• Chicago & Eastern Illinois R. R. Co. 5% Bonds, due 1937 - Chicago, Rock Island & Pacific R. R. Co. 4% General Mortgage Bonds, due 1988 - New York, Westchester & Boston Ry. (Jo. 4j4% First Mortgage Gold Bonds, due 1946 New York and Stamford Railway Co. 4% First and Refunding Mortgage Gold Bonds The Vermont Company. 5% First Mortgage Gold Bonds, due 1931 Central New England Railway Co. 4% First Mortgage Gold Bonds New York, Providence & Boston R. R. Co. 4% General Mortgage Bonds, due April i, 1942 The New York, New Haven & Hartford R. R. Co. 6% Convertible Debenture Certificates, due Jan. 15, 1948 Z]/2% Non-Convertible Debenture Certificates, due April T, 1954 • • ■■ 3J4% Convertible Debenture Certificates, due Jan. i, 1956 354% Non-Convertible Debenture Certificates, due March i , 1 947 - . • ■ .-,... Providence Securities Co. 4% Fifty- Year Gold Debentures, due May l, 1957.... Notes Housatonic Power Co. New York and Stamford Railway Co The Connecticut Co The Rhode Island Co Central New England Railway Co •. . The Harlem River & Port Chester R. R. Co Hartford & Conn. Western R. R. Co Rutland Railroad Co Number of Shares or Par Value Book Value 47,920 37,360 17,482 $868,566.55 1,052,335.91 1,201,063.69 291,600 22 314 :2.469 1,464 922 1,168 96,855 8,374 13,105,185.62 3,212.00 2,364.977.1s 37.782.56 395,765-70 208,162.44 130,750.27 71,907.64 24>352,336.4I 847,971-88 6,300 6,290.55 10,000 9,150.00 22,000 25,300.00 38,000 38,000.00 2,000,000 2,000,000.00 678,000 599,880.00 846,000 846,500,00 85,000 88,502.50 247,000 247,000.00 600,800 600,800.00 2,100 2,100.00 852,100 852,100.00 9,000 9,000.00 719,000 7I9-000.00 1,150,000.00 185,000.00 1,325,000.00 1,725,000,00 200,000.00 3,000,000.00 819,781.71 150,000.00 66 CORPORATE SECURITIES permanently valuable collateral as with the ordinary collateral trust bond just described; but in rare cases the bankers who undertake to sell short-term notes may even require the cor- poration to limit the dividends or otherwise increase the equity behind the notes by diverting net earnings to the upbuilding of the plant.°^ " The Chesapeake and Ohio Railway Company, sorely in need of money to pay for capital improvements, with low credit for its general bonds, authorized $40,000,000 S per cent Five-Year Notes in 1914. Besides being secured by a specific pledge of 141,270,000 Improvement Mortgage Bonds, the railroad agreed to set aside out of earnings, $2,000,000 for the first year, $3,000,000 for the second year, and $4,000,- 000 for each of the three remaining years during the life of the notes. These sums were to be used solely for capital expenditures, and no dividends were to be paid except from earnings in excess of these reservations. CHAPTER IV; BONDS SECURED BY CREDIT Nature of straight credit bonds, 67; Receivers' certificates, 68; Assumed bonds, 69 ; Guaranteed bonds, 71 ; Joint bonds, 74 ; Deben- tures, Tj; Income bonds, 82, Participating bonds, 87; Convertible bonds, 87. The bonds first issued by the railroads in England and the United States were based on the general credit of the issuing corporation. Specific security in the form of a mort- gage lien developed later; it may be said that in England mortgage bonds are relatively rare even now. Bonds issued on the general credit rest, as all other corporate securities ulti- mately rest, on the earning capacity of the corporation. The only merit of a mortgage security lies, at the last analysis, in the preference it gives over other creditors; in other words, the mortgage feature of a bond is of value in the relatively superior position it gives the holder of the bonds, if it ever be- comes necessary to distribute the assets of the bankrupt cor- poration. So long as the earnings are adequate, it is a matter of legal distinction only, whether the bond is covered by a lien on specific property or merely by the promise of the cor- poration to pay. Bonds, the security of which rests primarily or entirely upon the general credit rather than upon a lien on specific property of a corporation, may be divided roughly into seven classes.^ These seven classes include receivers' certificates ; as- sumed, guaranteed, and joint bonds j debentures; income and participating bonds. As diversification in the character of bonded debt has been carried furthest in the field of railroad 'The outline of these claSSei has been given already in tie opening pages of the previous chapter. 67 68 CORPORATE SECURITIES finance, most of the distinctions to be drawn can best be illus- trated by railroad bonds. This is not saying, however, that parallel cases may not be found in other fields. The most fundamental type of all straight credit obliga- tions is that issued by corporate receivers. When a railroad or public service corporation or even a manufacturing com- pany passes into the control of the court, following threatened or actual default on its obligations, the court sometimes au- thorizes its agents or receivers to obtain money by issuing short-term notes. Such notes are known as "receivers' certifi- cates."^ Resting in a sense on both the physical property and the general credit they represent a transitional form of securi- ties between those discussed in the previous chapter and these described here. They depend for their strength chiefly, how- ever, on the inclination of the court under whose authority they are issued, to enforce the final payment of interest and prin- cipal. As authorized by the judicial arm of the law they bear a resemblance to civil loans, yet they rnust be satisfied, ulti- mately, by the property of the bankrupt corporation. In this, however, the court will permit them to take precedence over certain or all of the mortgages of the old corporation, and sometimes even over all of its obligations except taxes and claims for current wages and supplies. As they are issued to meet temporary financing, receivers' certificates are of short maturity and are usually paid off or refunded before the prop- erty of the company passes out of the jurisdiction of the court.^ At all events the courts will not permit the reorganized rail- ^ For discussion of the conditions of issue see Volume V, Chapter III. For legal discussions see Carr, W. A., "Receivers* Certificates," i Penn. Law Series, 593 (189s); Hardy, C. A., "The Power of a Court of Equity to Authorize the Issue of Receivers' Certificates," 44 Cent. Law Jour. 344 (1897); Machen, A. W., Jr., Modern Law of Corporations. ^ Ripley remarks that in a railroad reorganization "owners of receivers* cer- tificates occupy an impregnable position." Ripley, W. Z., Railroads, Finance and Organization, 389 (1915}. This is true theoretically, but the unfortunate Atlanta, Birmingham and Atlantic, and the Pittsburgh, Shawmut and Northern cases (see note 4) show how little in financial structures is impregnable. BONDS SECURED BY CREDIT 69 way corporation to assume the management of the property until the receivers' certificates are in some way provided for." Owing to their short maturity and their anomalous nature they are not so favorably regarded by investors as their security would warrant. Aside from the obligations of the court, which imply a kind of quasi-public credit, the strongest kind of "general credit" bonds are those issued directly by a small subsidiary corpora- tion, all the assets of which are merged in the property of a larger and successful company. Such bonds are said to be assumed by the larger corporation. At the time of the merger the larger corporation may formally agree to be responsible for the subsidiary bonds, exactly as if they represented its own obligations. Yet this is not necessary. If the purchasing cor- poration acquires the physical property of the smaller corpora- tion, which passes out of a legal existence, then the purchasing corporation automatically assumes the responsibility for the bonds of the previously existing smaller corporation. As- sumed bonds are, in effect, a double obligation secured, first by a direct lien on specific property or property rights, and sec- ondly by the direct or implied pledge of the general credit of the corporation which has acquired the property covered by the direct lien. Assumed bonds are exceedingly corhmon in the field of American railroads. There is probably no system of magni- tude which has not a variety of assumed bonds each one of * Generally, receivers' certificates are paid off with money, the holders not being asked to participate in the succeeding reorganization. In very rare cases efforts are made to force them to take new securities; thus in the Atlanta, Birmingham and Atlantic Railroad's reorganization plan of March 21, 1914, it was sought to induce the holders of $5,000,000 receivers' certificates to accept 40 per cent of their claim in new first and general mortgage thirty-year bonds, at gn per cent par value, and the other 60 per cent in cash. In the final reorganization plan of the same company the holders of receivers' certificates were forced to accept income bonds of subordinate and meager value. This case is extreme in the sacrifice forced on the holders of receivers' certificates. But it may not be exceptional. The holders of the present Pittsburgh, Shawmut and Northern Receivers' Certificates, now in default, are not in a strong position. For more extended discussion, see Volume V, Chapters III and V. 70 CORPORATE SECURITIES which has had a dififerent origin, a relic of some long-forgotten episode in the railroad's history. Generally these assumed bonds arise through reorganization or consolidation. The Erie Railroad, as we know it today, has been through three com- prehensive reorganizations, yet there remain in existence and outstanding in the hands of the public some of the original first mortgage bonds, issued by the first road in 1847. At each succeeding reorganization these bonds have been assumed by the new corporation that was created to acquire the property of the old. When an old, previously reorganized road fails a second time, the receivers are usually very careful to con- tinue the interest on the old assumed bonds inherited from the previous reorganization, as these are quite likely to be specifically secured on the oldest and probably most valuable part of the system.** More usual even than bonds assumed under reorganization are those assumed through consolidation. A small main line railroad property with one or more issues of mortgage bonds on its line, is acquired by a larger railroad system. These bonds may be called and paid off by the larger corporation, but more frequently they are not callable and, when it is known that the road is seeking to buy in the bonds, the holders will ask a prohibitive price." It is therefore more economical to allow • This is true of the New York and Erie First Mortgage 4 per cent Bonds issued in 1847, alluded to above. They cover the main stem of the Erie road from Piedmont to Dunkirk. The security of this kind of assumed bonds is illustrated b7 some of the current reorganizations. During the receivership of the Missouri Pacific Railway, the old Pacific Railroad of Missouri First Mortgage 4 per cent Bonds, issued in ii868, and covering the central trunk of the system, were sold at an average of 93, or on a less than 4;^^ per cent basis. The Wheeling and Lake Erie Railroad passed into the hands of receivers June, r9o8, and remained bankrupt for over eight years. The Railroad was incorporated in 1899 as a result of the reorganization of the Wheeling and Lake Erie Railway. But during all the receivership the interest on the old Wheeling and Lake Erie Railway First Mortgage 5 per cent Bonds, which were assumed by the Railroad in 1899, was regularly paid. Except for the months following the opening of the European War these bonds were quoted above par. A similar situation existed for the old assumed 6 per cent bonds of the St. Louis and San Francisco Railway. Their interest was paid uninterruptedly and at the beginning of 1916, sold for no per cent, although the Railroad which assumed them at the reorganization of the Railway in 1896 had been in the' hands of receivers since May, 1913. Similar illustrations may be _ drawn from the assumed bonds of the_ Rock Island, the Missouri Pacific, and Missouri, Kansas and Texas railroads, all in the hands of receivers during the early part of the European War. 'Chapter II. BONDS SECURED BY CREDIT 71 them to run to maturity. Such bonds therefore remain se- cured, not only by the original property, but also by the gen- eral credit of the large corporation. In some cases, these as- sumed bonds bear on their faces the obligation both of the original small corporation and of the large corporation as well. In other cases, they appear at first sight to be merely the obligation of the original small corporation and it is only through an examination of the subsequent history that one learns that the bond issue of some insignificant stretch of line with an unfamiliar name has been assumed by a large railroad and is an investment security of unquestioned merit.' Guaranteed bonds are distinctly different from assumed bonds and weaker from the point of view of a credit obliga- tion. They imply a double obligation, that of the issuing cor- poration and that of the guaranteeing corporation. This guar- antee may arise as a direct contract obligation of the guarantor, and be endorsed as such on the bond itself.® This is the com- mon form. Or it may arise indirectly through some indirect or supplemental contract, no evidence of which appears on the face of the bond. The contract may perhaps be mentioned only incidentally in the mortgage or deed of trust under which the bonds were issued. The commonest form of such indirect guarantee is that of the lease. A large corporation enters into a contract of lease with a smaller corporation, agreeing to pay to the latter a certain sum of money each year for a definite period of time. This sum may be just equal to the interest on the bonds and the necessary corporate taxes and expenses of 'The old underlying bonds of the Atlantic Coast Line furnish an illustration. This is one of the few large systems which have grown steadily without receivership or reorganization. As a result there are 17 small issues of assumed bonds, of which $4,000,000 is the largest. The little Richmond and Petersburg Railroad, 26 miles long, was the nucleus from which the whole _ system grew. And there still remains a little issue of $300,000 on this stem, a relic of the remote past. ' For illustration, the guarantee by the Southern Pacific Company of the bonds of the Houston, East and West Texas Railway, a typical form, reads as follows: "For value received, the Southern Pacific Company hereby guarantees unconditionally the punctual payment of the principle and interest at the time and in the manner therein specified." Other reference to this case see Chapter II, note 38. ^2 CORPORATE SECURITIES the smaller corporation,' or it may represent a sum sufficient to pay interest on the subsidiary company's bonds and something on its stock." The guarantee may be of both interest and principal — the commonest form^^ — or interest alone/^ or of principal only. This latter is rare, but cases exist.^^ There are instances also of personally guaranteed bonds. These are fortunately rare as they are, at best, a makeshift. Sometimes they arise through the efforts of one man or group to sell bonds on an undeveloped and as yet unproductive piece of property.^* Sometimes the guarantee is regarded merely as a temporary expedient until the property becomes productive." Guaranteed bonds are not as strong from the point of view of credit obligations as assumed bonds. In fact, the writer is of the opinion that most bond guarantees in themselves are barely worth the paper they are written on. The true value of the bond lies in the earning capacity of the physical prop- erty or the business good-will of the issuing company." * A good illustration of such a case is that of the tends of the Georgia Midland •Railway, a road leased by the Southem Railway. It has outstanding First Mort. gage 3 per cent Bonds. All its stock is owned by the Southern Railway. The latter has leased the Georgia Midland for $52,000 a year, which sum is just sufficient to pay the interest on its bonds and leave $2,500 for its corporate expenses. To show the indirect character of this guarantee it is noticeable that no mention whatever is made in the bond itself of the obligation of the Southern Railway, and only once in the Deed of Trust itself is the existence of the lease mentioned, and then only incidentally. " Thus, in the lease of the Beech Creek branch of the New York Central and Hudson River Railroad the latter not only guarantees 4 per cent interest on the first mortgage bonds, and s per cent interest on the second mortgage bonds, but also 4 per cent dividends on the outstanding stock. ^ Like that of the Southern Pacific Company or the bonds of the Houston, East and West Texas, cited in note 8, above. ^ The Southern Pacific Company guarantees the interest only on the two main issues of the Houston and Texas Central Railroad, but guarantees both the principal and interest of its largest underlying issue. ^3 The writer has been told of a case of a coal * company bond with principal guaranteed by a well-known trust company in New England. The enterprise was of the most speculative character. As a matter of fact 40 per cent of all the sums received by the promoters in the sale of their bonds was handed over to the trust company. This amount compounded at 4 per cent equaled exactly the principal of the bonds at the date of their maturity. Chamberlain cites a case of similar purport in which a national bank acted as the guarantor. Chamberlain, L., Principles of Bond Investment, 79 (191 1). " Huntington Land and Improvement Company. '° Billings Gas Co., First Mortgage 5's, 1937. i"This general principle is excellently illustrated by a variety of bond issues of companies subsidiary to or closely allied with the lines of the Southern Pacific Company. The Southern Pacific Company is merely a holding company organized under the laws of lientucky. It operates no railways, but it owns the stocks of all BONDS SECURED BY CREDIT 73 Although there are cases in which a holding or controlling corporation will maintain the interest or rental on an unprofit- able subsidiary's bonds, for strategic reasons only/"^ the rule holds good almost always that the strength of a guaranteed bond is no greater than that of the corporation issuing it and the earning capacity of the property directly covered by it/^ This fact is clearly shown at the time of reorganization. If the corporation making the guarantee fails, its receiver may the lines constituting the Southern Pacific system of railways, and it has profusely guaranteed a great variety of the bonds of these lines. Theoretically, at least, its own guarantee of one issue is quite as good as that of another; so that, from the invest- ment point of view, these different guaranteed issues would be of equal value so far as the guarantee was concerned. Their difference of value would arise from a difference in the intrinsic merit of the bond issues, quite independent of the Southern Pacific Company's guarantee. This difference is striking. Of the 17 subsidiary issues having the full guarantee of the Southern Pacific Company, no two sell on exactly the same investment basis. They range (taking the spring of 1916 as an appropriate time for comparison) from 4.30 per cent for the First Mortgage 4's of the Central Pacific Railway to 7.40 per cent for First Mortgage Bonds 4's of the San Antonio and Aransas Pass Railway. The general unsecured credit of the Southern Pacific Company, as evidenced by its ordinary debentures, was 5.32 per cent- Interesting further light on the situation is shown by the fact that some of the bonds of the Hpiiston, East and West Texas First s's are fully guaranteed by the Southern Pacific and some are not. Yet the New York Stock Exchange market prices of the guaranteed and unguaranteed bonds of this issue are the same. See note 17, below and liote 44. See also Chapter IIj note 38. " Three examples from different industries show the strategic importance of many subsidiary companies which fail in themselves to earn their interest charges, but whose bonds are reasonably secure. Railroads, The San Antonio and Aransas Pass Railway occupies a strategically important position with reference to the Southern Pacific Com[>any's Texas lines. Its First Mortgage 4 per cent Bonds of 1943. are guaranteed principal and interest by the Southern Pacific Company. The San Antonio and Arkansas Pass Railway itself has earned the interest on its bonds only one year out . of the last five. In fact, in 1914-15, it barely paid the direct costs of operation. Yet its strategic importance to the Southern Pacific Company's lines is such that the guarantor company very wisely meets the bond interest deficit. Public Service. The Westchester Lighting Company haS a franchise for 3 part of the Borough of The Bronx and supplies gas and electricity north of New York City as far as North Kisco. During several years the company has failed, according to its published accounts, to earn its fixed charges, although its territory is rapidly developing and it bids fair to be a very valuable component of the Consolidated Gas Company. A large part of the bonds of the Westchester Lighting Company are guaranteed by the Consolidated Gas Company, and because of the strategic impor- tance of the property to the larger corporation the credit of these bonds is unques- tioned. Industrial, The National Starch Company, although it has been a financial failure and has accumulated a large deficit, holds the title to exceedingly valuable trade-marks, some of which have been in existence for over half a century. Its stock is owned, and the company is controlled, by the Corn Products Refining Com- pany, which has guaranteed the principal and interest on its bonds. ^ These bonds, in spite of the continued failure of the National Starch Company, enjoy a high credit, based on the great importance of the trade-marks to the controlling company, ^ This principle applies with special force to the guarantees by a large public service holding company of the bonds of its subsidiary operating companies. The chances are that the only assets of the holding company are the common stocks of the operating companies; other than in the dilution or distributions of possible losses such a guarantee adds nothing to the security of the subsidiary bonds, since the only value of this guarantee lies in the equity over and above these aii4 similar bonds. 74 CORPORATE SECURITIES continue or repudiate its previous contracts, among which are its various leases and guarantees. If the guarantee is unprofit- able he will repudiate it, so that the final security, here as else- where, is the earning capacity of the property covered by the bonds. Nor does the larger corporation have to fail to be able to repudiate its guarantee. It may simply notify the bondhold- ers that it will be no longer responsible. Although the bonds may thus become legally a direct liability of the guaranteeing corporation, the only result of attempting to enforce this lia- bility would be to throw the corporation into the hands of re- ceivers, when the guarantee may be legally repudiated by the receivers.^^ Of course, so long as the property covered by the bonds earns more than the charges, the guarantee will never be repudiated not even during receiverships."" Closely associated with guaranteed bonds are joint bonds; in the case of these the dual or plural character of the obliga- tion consists merely or primarily of a joint guarantee. Joint bonds ordinarily may arise through the co-operative endeavor " The First Mortgage Bonds of the Western Pacific Railway were guaranteed by the Denver and Rio Grande Railroad. During the year ending June 30, 1914, the Western Pacific incurred a deficit after fixed charges of over $4,000,000 which had to be made good by the parent road. The latter later notified the First Mortgage bondholders that it would no longer meet the deficit on the bonds. Early in 1915 the Western Pacific passed into the hands of receivers. Apparently the directors of the Denver and Rio Grande reasoned that, should the protective committee of the Western Pacific Railway's bondholders try to enforce the guarantee, the parent road would merely pass into the hands of a friendly receiver, who would immediately repudiate the guarantee. Any deficiency judgment which the bondholders might secure against the Denver and Rio Grande would rank, in the subsequent reorgani- zation, as an insignificant junior claim to be satisfied only after a host of other hens on the corporate property. In other words, the directors of the Denver and Rio Grande believed their guarantee to be worthless. Fortunately for permanent justice the Equitable Trust Company, trustee for the Western Pacific Railway bonds, instituted suit against the Denver and Rio Grande Railroad to recover damages for the repudiated guarantee. Finally, on May I7, 1917, the United States District Court for the Southern District of New York directed judgment for upwards of $3i,ooo,ooo against the Denver and Rio Grande Kailroad. the latter has, of course, appealed. But whatsoever the outcome of the appeal, the courts decision must always remain a wholesome and vigorous defense ot simple corporate honesty and a strong deterrent to a corporation which might think It could repudiate its guarantee within impunity. =» During many receiverships there are guaranteed bonds, the interest on which is regularly paid, although the direct obligations of the failed corporation are de- faulted. This simply means that the property covered by the guaranteed bond is self-sustainmg. In rare cases the interest is continued for strategic reasons, as was ff "tt„ ''r. I '■'=<=5'^"f «* the St. Louis and San Francisco on the guaranteed bonds ot the Ozark and Cherokee Central. BONDS SECURED BY CREDIT 75 of several corporations, particularly railroads, to build struc- tures or branches of road that can be used jointly. Such undertakings include terminals in large cities, wharves, docks, bridges involving considerable cost, or connecting lines for the interchange of traffic. Quite generally these joint bonds are the direct obligation of some small local corporation created by the roads for the purpose of taking title to the property covered by the bonds. For example, a terminal joint bond is usually the direct obligation of a company created to own and operate certain terminal properties. The railroads divide up among themselves the stock''^ and enter into contracts to use its facili- ties, paying for them in accordance with the proportion of space occupied or the number of trains or cars that leave the terminal. These rentals received from the operating roads are supposed to be at least equivalent to the interest on the terminal company's bonds, although it is merely a matter of bookkeeping whether the bond interest comes from the rail- roads directly or comes indirectly through terminal charges.^^ One issue of terminal bonds is guaranteed by twelve different railroad corporations, including some of the strongest in the "■ This division of stock among the controlling railroads and with it the divi- sion of control, leads sometimes to controversies. The stock of the New Orleans Terminal Company was owned in equal amounts by the Southern Railway and the St. Louis and San Francisco Railroad, the roads guaranteeing the terminal company's bonds, jointly and_ severally. Each road agreed to meet half the bond interest. For mutual protection the stock of the Terminal Company was lodged with a trust company under an agreement giving the two roads an equal voice in the manage- ment and providing that, in case either road defaulted on its share of the interest money, its half-interest should be delivered over to the other. The St. Louis and San Francisco Railroad defaulted and the receivers brought action to prevent the trust company from delivering its stock to the Southern Railway. 162 App. Div. (N. Y.) 301 (1914). ^ An excellent example of a terminal bond combining a variety of special fea- tures is that of the Boston Terminal Company which owns the "South Station." These bonds are a direct obligation on one of the largest terminals in the country. In addition the New York, New Haven and Hartford Railroad, with three of its subsidiaries, and the Boston and Albany RaiIroad,_ a subsidiary of the New York Central, have agreed to make good any deficiency in the case of foreclosure of the bonds. This amounts to a guarantee by all these roads of the principal and interest. These bonds are tax exempt in Massachusetts, where all railroad bonds can be taxed by the local authorities. As a result of these features the Boston Terminal Company's 3^ per cent Bonds have sold on a 3.85 per cent basis when the general credit of the New Haven railroad was on a 5.80 per cent basis, and that of the Boston and Albany on a s.io per cent basis. This divergence is indeed greater now than when the terminal bonds were issued, yet it indicates the economy to the roads of paying for the terminai by the issue of such special bonds. 76 CORPORATE SECURITIES country .^^ Bridge bonds, similarly, are issued by separate cor- porations created by the roads using a bridge.^* Similar joint guarantees are extended to wharf and connecting line roads.^^ In the case of the joint guarantees of the securities of a "little corporation," it should be remembered that, although the bonds may be a direct obligation of the terminal, bridge, or connecting railway company, it is the joint guarantee of the corporations actually issuing the property which constitutes the real security of the bonds. And although in some cases, dis- cussed at length before, the sale value of the actual tangible property may be a sufficient security for the bonds, such cases are rare. In almost all instances a joint terminal, bridge, or connecting railway company bond is based merely on the gen- eral credit of the guaranteeing corporations. If they should cease to use the bridge or connecting road it would have prac- tically no value to any other corporations or for any other pur- poses. If the guaranteeing railroads should fail, their receivers ^ Kansas City Terminal Railway Company's bonds* Each of the twelve railroad corporations mentioned below unconditionally guarantees to pay one-twelfth of the principal and interest of these bonds. Atchison, Topeka and Santa Fe Railway Chicago, Rock Island and Pacific Rail- Company, way Company. Chicago and Alton Railroad Company. Kansas City Southern Railway Company, Chicago, Burlington and Quincy Railroad Missouri, Kansas and Texas Railway Company. Company. Chicago Great Western Railroad Com- Missouri Pacific Railway Company. pany. St. Louis and San Francisco Railroad Chicago, Milwaukee and St. Paul Rail- Company. way Company. Union Pacific Railroad Company. Wabash Railroad Company. If any of the railroads defaults on its share, the remaining companies have agreed to make good the deficiency, but will, at the same time, exclude the defaulting road from the use of the terminal. 2* A good illustration is offered by the bonds of the Paducah and Illinois Railroad Corporation. This little corporation was created for the purpose of building a con- necting link between two great systems of railroads. This consisted of a steel double-track bridge across the Ohio River near Metropolis, Illinois. Over this link moves a great part of the interchange of traffic between the great Hill systems of the Northwest and the Atlantic Coast line systems of the Southeast. Before the building of the bridge this interchanged traffic was handled by a car ferry. All the stock of the Paducah and Illinois Railroad is owned by the Chicago, Burlington and Quincy Railroad and the Nashville, Chattanooga and St. Louis Railway. These roads have agreed to use and pay for the facilities of the connecting bridge road. They have also jointly and severally unconditionally guaranteed the principal, the interest, and the sinking fund payment of the bonds. ^ The first mortgage 4^ per cent bonds of^ the New York Connecting Railroad Company are guaranteed prmcipal and interest jointly and severally by the New York, New Haven and Hartford Railroad and by the Pennsylvania Railroad which have built the road as a connection between the two roads across New York City. BONDS SECURED BY CREDIT -j-j could repudiate the contracts under which the terminals, bridges, or connections are used and the bondholders would have little income-producing property to fall back upon. The strength, therefore, of such issues lies theoretically in the multiplicity of guarantors and practically in the general credit or inherent financial strength of the strongest. It does not lie in the physical property directly covered by the mortgage, although in form these joint bonds may be first mortgage, gen- eral mortgage, collateral trust, and even equipment bonds.^" For this reason, such bonds as a class are considered general credit bonds rather than bonds directly secured by property. Aside from assumed and guaranteed bonds there is a large class of straight credit obligations unsecured by any direct or indirect pledge of property. They are called debentures. Such obligations are merely promises to pay a certain sum of money at a given time. They are, in effect, promissory notes resting solely on the general credit of the corporation,^^ although it is now customary for the corporation to issue debenture bonds only under an elaborate legal instrument which defines spe- cifically the terms and conditions of their issue.^* Many writers on corporation finance generally and on rail- road finance specifically emphasize the weakness from an in- vestment point of view of ordinary debenture bonds. The general ground for this alleged weakness lies in the fact that they have not, like mortgage bonds, the right of foreclosure.''^ 2«See Chapter V. ^ At one time the term ''mortgage debentures" was used to refer to bonds secured by the pledge of some collateral. This usage is, however, no longer acceptable. ^ Prior to rSgg, most debenture bonds recited on their face the conditions, if any, under which they were issued and the specific covenants, if any, made by the cor- poration. This often necessitated lengthy bonds. Since the above date most deben- tures have been issued under an agreement or indenture, in which a trusty company is mentioned which shall supervise the execution of the covenants. A brief agree- ment of this character: American Power and Light Company 6 per cent Notes of 1921, reproduced by Gerstenberg, C. W., Materials of Corporation Finance, 291 (1915). Brief discussion, see Stetson, F. L., Some Legal Phases of Corporate Financ- ing, Reorganization and Regulation, 66 (1917). ^ This disparagement is expressed by such quotations as this; "The similarity (of the debenture) to the income bond is close, in that the interest on the deben- 78 CORPORATE SECURITIES One writer went even so far as to suggest that they are in- ferior to preferred stocks in so far as they have no voting power.^" This disparagement of debenture bonds would seem to be ill considered. While it is perfectly true that they have no right of foreclosure, it is equally true that a default in the interest or principal of debenture bonds precipitates failure and receivership.^^ In the final reorganization, securities are given a preference according to their relative priorities ; and the ques- tion whether a security does or does not possess a lien on specific property is more a legal fiction than a matter of prac- tical consideration.'^ As a rule debenture bonds are of shorter life than the first mortgage bonds, because of the presumption that a corpora- tion's future moral obligation to meet its debts cannot be pre- dicted as certainly as the future value of its property. But it has been pointed out earlier" that long-term mortgage bonds are little more than debenture bonds owing to the insecurity of property values in a distant future. Among railroads de- benture bonds are issued during periods of what might be called "waiting-time" financing, when it is inexpedient to sell long-term mortgage bonds because of previously existing mortgages and temporarily poor credit, yet when the market can absorb an obligation of longer maturity than the so-called tures is "payable if earned' and not otherwise." Ripley, W. Z., Railroads, Finance and Organization, 142 (1915), A much fairer account is that of Lyon, W. H., Capitalization, 3S (1912), and also Mead, E. S., Corporation Finance, 306 (1915). °° Moody, Analysis of Railway Securities, 138 (1910). " It was the threatened default on interest of the Chicago, Rock Island and Pacific Railway Debenture 5's that precipitated the need of a receivership and reor- ganization of this railway. Practically all the reorganization did, aside from securing new money, was to refund these debentures into preferred stock. Had the deben- tures no stronger lien on the corporation's assets than preferred stock, it is certain that no receivership would have occurred. "^ Thus, the $1,500,000 Long Island Railroad 5 per cent Debenture Bonds of 1934, are preceded only by three small issues of prior lien bonds issued before 1890. They are followed by four large issues of other bonds. The largest is guaranteed by the Pennsylvania Railroad, and aggregates over $54,000,000. Nevertheless, the word "debenture" in their title has prejudiced investors against them and their market price has never been commensurate with their fundamental security. »» Chapter II. BONDS SECURED BY CREDIT 79 short-term notes." They are issued by both strong and weak roads. Generally speaking the road of strong credit is apt to finance improvements by ordinary debenture bonds, while the weak roads are more apt to use a general mortgage or a refunding mortgage bond, in order to give the appearance of mortgage security although it has not its substance.^'* It has been said that railroad debentures "are signs either of financial weakness or of markedly high credit,"^° but this generalization should not be applied too strictly.^'' Some rail- road corporations have issued no bonds except debenture bonds. This is true of the English railways and the more im- portant roads in New England. There are only debenture bonds of the New York, New Haven and Hartford, the Bos- ton and Albany, and the Boston and Maine Railroad, although certain of the important subsidiaries are covered by mortgages. In England the practice is distinctly adverse to any form of mortgage and the debenture bonds of the English roads are but little dififerent from what we would call first preferred stocks. Such debenture bonds are weak from the investor's point of view owing to the fact that the corporation may in- "This is well illustrated hy the issue of the New York Central Railroad Deben- ture 6's sold to stockholders in February, 1915. At that time the New York Central's credit was at a low ebb. The year that had just closed showed less than 4 per cent earned on the stock, although 5 per cent was paid by deferring the last quarterly dividend. It was the least encouraging year of the New York Central since 1895. Yet the company had a large floating debt of $131,000,000 due within the next ten months incurred very largely by the Grand Central Terminal improvements. This must be funded. The road could have sold its Refunding and Improvement Mort- gage Bonds of 2013, had it so chosen, but these were quoted on an interest basis of about 5.3 per cent. It could have continued the wasteful process of renewing its floating debt with the bankers, but the interest and renewal commissions on this money then amounted to well over 6 per cent. Clearly its_ long-terra mortgage^ bond credit was too poor for an issue of high-grade bonds, and it had to do something to encompass an unmanageable floating debt. It followed the middle course and issued $100,000,000 iS per cent debenture bonds, due in 20 years. "Thus, the ten-year, 1915, 3^4 per cent Debenture Bonds of the Pennsylvania Railroad and the fifty-year, 1933, Sinking Fund Debenture Bonds of the Chicago and Northwestern Railway illustrate the debentures of strong roads; the Refunding 4 per cent, 1951 Bonds of the St. Louis and San Francisco Railroad and the First and Refunding 5 per cent, 1959 Bonds of the Missouri Pacific Railway, illustrate the second class. "Ripley, W. Z., Railroads. Finance and Organization, 142 (1915). " The Long Island Railroad Debentures of 1894, the Chicago, Rock Island and Pacific Railway Debentures of 1912 and the Chesapeake and Ohio Railway Deben- tures of 1910 were issued at times when the credit of the roads was unmistakably "mediocre. 8o CORPORATE SECURITIES crease its outstanding obligations almost without limit, as there is seldom any provision prohibiting further issues. With each new outpouring of debentures the market values of the old issues fall.^* Debentures are found most often in our American finance among industrial corporations, owing to the long cherished prejudice among bankers and stockholders against a direct mortgage on a manufacturing plant. They seldom occur among public service companies where the general feeling of the investor is to demand a direct lien on physical property. When existent, they have been usually issued either by very strong corporations, such as the Consolidated Gas Company of New York or the Detroit Edison Company, or else very weak corporations, such as the Columbia Gas and Electric Company.^' The great disadvantage of all debenture bonds is the un- certainty of security. The very name implies this uncertainty and of itself militates against the standing of the bond.^° Rec- ognizing this, bankers are usually unwilling to offer their cus- tomers debentures of any but the strongest corporations, unless some provision is made to prevent a weakening of the com- pany's credit. Sometimes the arrangement under which the debentures are issued specifically provides that no more shall be authorized while these are outstanding, but most common 5" Thus the 3!^ per cent debentures of the New York, New Haven and Hartford Railroad, which were quoted as high as 105 in 1902, a 3.31 per cent basis, fell to 74, or a 5.3 per cent basis in 1914 (before the European War), due largel7 to the de- creasing credit of the roads as new debentures were put out. Had the older bonds been mortgage obligations, they would have fallen in value, but not to the same extent. ^ The generalization of Professor Ripley quoted in note 36 is seemingly truer for public service corporations than for railroads, probably because the investing; public is now less accustomed to public service company debentures than to railroad deben- tures. The corporation of medium credit can afford, least of all, to run counter to investment prejudice. *'The Long Island Railroad issued $1,500,000 5 per cent Debentures in 1894. It was specifically mentioned in the agreement under which the bonds were issued, and on each bond itself, that shouM any mortgage be created subsequently these debentures would be specifically provided for, that is, reorganized as a prior lien on the property. This was done by three successive mortgage bond issues. Yet, in spite of its remarkable position and basic security (note 33), the issue has never com* manded a corresponding price. In matters of investment there is much in a namel BONDS SECURED BY CREDIT 8l is the provision that no mortgage may be created on the prop- erty without including the issue of debentures. In this manner the holders of the debentures are assured that no later issue of securities will cut in under their position and destroy the strength of their security.*^ This provision is just. The pur- chaser of a debenture bond naturally judges the strength of the issue by the property and earning power which is unmort- gaged. But if the corporation exercises the legal right to place new mortgages on the property unmortgaged at the time of the sale of the debenture, the strength of the issue may be un- dermined or perhaps destroyed, and the holders of the deben- tures be powerless to prevent it. The credit of the Boston and Maine Railroad was so high for years that it borrowed money on its mere promise to pay. But as the credit of the company declined from negligence and the mismanagement of its prop- erty, more and more of its assets had to be specifically mort- gaged so that the property upon which the earlier creditors based their trust was gradually withdrawn from their con- trol.''- In one case, that of a New England railroad, a state law obligates the corporation to include all its debenture issues should it ever create a mortgage on its property.*^ *^ This is specially important in the case_ of industrial debentures because of the fluctuation in the earning capacity of industrial enterprises and the rapid depreciation of the physical property. Thus, when the syndicate originally sold the American Can Company's Debenture s's much emphasis was laid on tne fact that the company had no mortgage bonds and that it agreed not to create any so long as these debentures were outstanding. The debentures of the General Rubber Company were issued under a contract which provides that the company must maintain its net quick assets consisting of cash, accounts, and bills receivable and merchandise, at not less than 120 per cent of the amount of the debentures outstanding; and furthermore, the company agrees not to place any mortgage upon its property without including all the debentures, nor to issue any obligations (except notes given in the regular course of business) which should not explicitly reserve for the debentures the prior right to receive payment. *^ Special care should be exercised by the investor in debenture bonds, and, short- term notes — usually nothing more than short-period debentures — to ascertain his pro- tection against the future issue of bonds that can be placed ahead of his own. Great care is required in buying the debentures of public service companies — public service holding companies in particular^for a large part of these are unprotected in just this important particular. Unfortunately, too, numerous cases exist m which the corporation has abused its liberty by placing new mortgages on the assets of its underlying companies— the only assets possessed by the holding company. *'The Boston and Albany which has no less than eight separate issues of deben- tures aggregating $25,000,000, all of which — according to an old Massachusetts state law, dating back to 1834— must be covered by a mortgage if the road ever sees fit to create one. 82 CORPORATE SECURITIES It was suggested at an earlier point that the investment value of guaranteed bonds rested on the earning capacity of the issuing company and not on the guarantees. It is sig- nificant, in view of this presumption, to compare the invest- ment position of the guaranteed bond with that of the ordinary debenture, since both rest ostensibly upon general credit. The theory can be seen best in the light of a concrete case where bonds of nearly every conceivable form rest on the general credit of one corporation. The funded debt of the Southern Pacific Company affords perhaps the best example because of such variety. Using this company as a basis of computation, it appears that the straight debentures command a conspicu- ously better market price among investors than mere guaran- tees without substantial security, notwithstanding the fact that both are based on the same corporation's general credit." Income bonds are the weakest of all obligations resting on general credit.*" They involve no definite contract between the holders and the trustee to insure the payment of the inter- est, although the company promises to pay the principal at a definite future time.*" The interest is paid when earned, else the holders of income bonds can enforce their claim, but they cannot force the corporation to pay the interest unless they can prove that it was earned within the period during which it accrued. It should be noted in passing that income bonds "The Southern Pacific Company has extended its full guarantee to 17 different issues. Two of them, the San Antonio and Aransas Pass 4's, 1943, and the Los Angeles, Pacific Ref. 4's, 1950, have little value aside from the Southern Pacific Company's guarantee. The average yield of these two was 7.03 per ce"t. That of the straight debentures of the Southern Pacific 5.32 per. cent (spring of 1916). The same general relationship has been maintained during the period of the Great War. In the summer of 1918, the average of the two guaranteed issues was 8.12 per cent and the Southern Pacific Company's Debentures 6.05 per cent. See Chapter IV, note 16. ^ Discussions of income bonds, see Ripley, W. Z., Railroads, Finance and Organi- zation, 139 (1915). Also numerous instances cited m. Daggett, Railroad Reorganiza- tions. There are many leading cases cited in legal treatises. ^" There are even exceptions to this. The Brunswick and Western Railroad (a subsidiary of the Atlantic Coast Line) has a small issue of irredeemable s per cent income bonds. Except in the rigfht of the bondholders to insist on a rigid system of accounting, such "irredeemable income bonds" are indistinguishable from non-voting preferred stock. BONDS SECURED BY CREDIT 83 are frequently called "adjustment bonds''*^ or "preference bonds''*^ owing to the unpleasant associations that attach them- selves to income bonds in the minds of investors. Except in rare instances income bonds are issued only at time of financial reorganization or readjustment when it is sought to replace the old fixed charge bonds by a new bond, the interest on which may be allowed to lapse during periods of depressed earnings. In this way the resources of the com- pany are not strained to pay unearned capital charges. The interest on the older issues is ordinarily not cumulative, so that if it is not earned in any one period the corporation is not under any obligation to make up the deficiency in later more pros- perous years. In some cases the interest payments are not cumulative for the first few years, but are cumulative there- after.*'' In rarer cases the interest is made to become fixed on what amounts to a sliding scale. '^'' In still rarer cases the cor- poration obligates itself to establish a reserve fund from which to draw the income bond interest during periods of low earn- ings." Income bonds are seldom issued at the time of the pro- motion of a corporation,''^ for the reason that experience *'" At the time of the reorganization of the Atchison, Topeka and Santa Fe Rail- road in 1895, $51,000,000 Adjustment 4 per cert Bonds were Issued which were to all intents and purposes, income bonds. They were designated as adjustment bonds be- cause income bonds had at the time an unpleasant sound to investors. ^ For example, at the time of the reorganization of the Central of Georgia Rail- road there were issued First, Second, and Third Preference (Income) Bonds. See Dewing, A. S., "The Position of Income Bonds as Illustrated by Those of the Central sf Georgia Railroad," 15 Q. J. E., 396 (1911). *^ The interest on the Atchison Adjustment (Income) Bonds was non-cumulative up to July I, 1900, and cumulative thereafter. In rare instances the interest be- comes cumulative after the occurrence of a specified event. The interest on the Mid- land Valley Railway Adjustment (Income) 5's becomes cumulative if the old construe- tion company of the old management exercises its option to purchase the preferred Stock between 1914 and 1923, the price being determined by a sliding scale beginning at $35 a share in 1914, and ending at $55 a share in 1922. "The most unusual case of this kind was that of an issue of Cincinnati, Hamil- ton and Dayton 4H per cent Income Bonds. (See Chapter II, note 14.) ^ The notable case of the Atlanta, Birmingham and Atlantic Railway Income s's, 1930. An amount not exceeding 20 per cent of net earnings, or not over $100,000, in any one year, may be set aside until the fund reaches $300,000. This is called the "Income Bond Reserve Fund." It is held by the trustee for the benefit of the income bondholders. =^ It appears that they were popular among Baltimore promoters during the period of industrial promotions just before 1900. The Mount Vernon-Woodberry Cotton 84 CORPORATE SECURITIES has shown them to be unpopular among investors. Sometimes corporations too weak to sell preferred stock have sought to market income bonds rather than straight mortgage or de- benture bonds.°* The use of income bonds is objectionable because the un- certainty of interest payments is very likely to cause confusion. Controversies over the rights of the various parties concerned have come constantly to the courts. As the payment of their interest turns upon the computed net earnings, the whole problem resolves itself into a problem of accounting. Gross earnings and direct operating expenses may be easily deter- mined, but net earnings can be fixed only after there have also been included the depreciation and maintenance charges and special reserves. These are inexact and flexible ; they may be increased or decreased within wide limits by the management without breaking any canon of accountancy or the law. Money once paid to the holders of income bonds is forever gone, but money invested in the improvement of the property is re- tained by the stockholders. As the stockholders of the corpo- ration and the holders of income bonds are usually different groups of people, there is a temptation to manipulation and misrepresentation. The stockholders may decrease the published net earnings by heavy reserves for depreciation and large maintenance charges and in such ways create a secret increase of real capital at the expense of funds which should be paid Duck Company, for example, had a large issue of income bonds, and among other Baltimore enterprises which did the same was the Gottlieb, Bauernschmidt, Straus Brewing Company. "^ To such a situation is to be attributed the issue of $10,000,000 Cumulative Ad- justment 7 per cent Bonds of the Denver and Rio Grande Railroad sold to its stock- holders at par in 1912 in order to provide for improvements and the accumulating deficit of the Western _ Pacific Railway. The interest was payable only out of the surplus net earnings, "in such amounts as the Board of Directors shall determine." In case the full 7 per cent is not paid the unpaid balance shall accumulate and be payable at the maturity of the bonds in 1932. Except in becoming a fixed liability at the maturity date, these income bonds were intended to be no different from an ordinary cumulative preferred stock. An unforeseen contingency has arisen, however. With the legal subterfuges brushed aside, it appears that the bonds became a lien, to be foreclosed in the case of interest default, when the road failed to maintain its guar- antee on the Western Pacific Railway bonds. (See Chapter IV, note 19.) BONDS SECURED BY CREDIT 85 to income bondholders.^* The controversy between a cor- poration and its income bondholders usually turns upon the accounting of depreciation, and the courts, through a long series of decisions, have made it clear that the maintenance of property and an adequate charge for depreciation are neces- sary elements in the use of any kind of material property.^^ The question is one of fairness, but it is not always easy of determination when the two interests are selfishly conflicting.^^ In one notable case the responsibility was thrown upon the accounting system of the Interstate Commerce Commission/^ and recent issues of public utility income bonds, when created, usually provide specifically for some system of adjusting dif- ferences over accounting.^^ But such shifting of responsibihty ^ The Central of Georgia Railway tad outstandings three issues of income bonds. For years the management, which held the stock closely, made excessive charges to maintenance, rebuilt the roadbed out of earnings, bought new equipment, and even supplied the money for operating a steamship line. All these expenditures were repre- sented as legitimate expenses which should be deducted from gross earnings. As a result, the management was able to show that the income bond interest had not been earned until the time when the road had been rehabilitated and was in a position to pav dividends on the common stock. See Dewing, A. S., "The Position of Income Bonds, as Illustrated by Those of the Central of Georgia Railway," 15 Q. J. E., 396 (1911). A similar controversy raged between the income bondholders and the con- trolling interests of the New York Railways (New York City surface lines). Here the matter turned largely on what were proper depreciation reserves and bow far special reserves to care for contingencies were proper charges to earnings. ^^ For discussion o£ legal question, Machen, A. W., Modern Law of Corporations. ^ One of the most instructive of these controversies is that concerning the income bonds of the Mount Vernon-Woodberry Cotton Duck Company. The company had never been successful and after several reorganizations had succeeded in absorbing most of the original issue of $6,000,000 income bonds. A committee, representing $164,000 less than 3 per cent of the entire issue, sued the company on the ground that their interest should have been paid rather than that the mills of the company should have been maintained. It was clearly a "nuisance" suit. As was said at the time, the small minority could "delude their better judgment into the belief that they might harass the majority interest into paying them an undue value" (page 22). "They alternately weep over the alleged efforts of the corporation to maintain the ef&ciency of its plants, and deplore the alleged failure to sustain its good-will" (page 50). Whit- ridge V. Mt. Vernon-Woodberry Company. Answer of defendant. Fortunately, the court decided that the company was right in maintaining the physical values of its plants, rather than paying unearned income bond interest. Further discussion of the circumstances of this case, Dewing A. S., Corporate Promotions and Reorganizations, Chap. XIII (1914)- " Income bonds of the new Atlanta, Birmingham and Atlantic Railway Company. The contract provides that interest shall be paid only in case there shall be net income of the railway company available for that purpose, as the term '*net income" may be defined by the rules and regulations of the Interstate Commerce Commission, as from time to time in force. Letter of E. T. Lamb, President, dated December 15, 1915. ^The Hudson and Manhattan Railroad Company's Adjustment Income 5's, 1957, mortgage contains the following provision: "The surplus income applicable to the payment of interest on the bonds issued hereunder shall be the surplus remaining after deducting from the gross earnings and income of the company from all sources the following items: 86 CORPORATE SECURITIES does not actually solve the problem as no commission — much less any iron-bound rules — can decide what are rigidly justi- fiable expenditures for proper and adequate maintenance. Because of the likelihood of controversies and suits many students of the subject have been of the opinion that the issue of income bonds had been definitely discarded from American finance. It is with disappointment, therefore, that one notes their returning use during recent railroad reorganizations. The temptation to placate impatient security holders by what is a bond in name but not in substance, seems to have been too great to resist. The possibility of future controversies does not trouble reorganization managers all too busy trying to settle present ones.^^ The possibility of trouble has caused the stronger corpora- tions, which find themselves embarrassed by income bonds, either to acquire them for their own treasury^" or else to make special provisions for insuring the payment of interest/^ and finally the extinction of the principal.^^ Another way of seek- "(a) All expenses and charges for operation, maintenance, repairs, renewals, replacements, insurance, general expenses, losses, damage claims and all proper charges in respect of depreciation or obsolescence of tunnels^ tracks, equipment, power plants and other properties, and all other charges against income in respect of its property or its operation or the conduct of its business, including all amortization properly chargeable to income under the rules or principles of, accounting prescribed by the Public Service Commission of New York or the Board of Public Utility Commissioners of New Jersey, and any and all other sums which should properly be paid or appro- priated, or set apart, or provided for out of income to secxt-re the proper,^ safe and adequate maintenance, eqnipfnent and operation of the tunnels, lines of railroad and other properties of the company or to preserve its earning capacity, . . ." ^^ The reorganization of the St. Louis and San Francisco Railroad in 1916, in most points wise, involved the issue of two separate income bonds. The Adjustment Mortgage 6's, 1955, have cumulative interest, whereas the Junior Income 6's, i960, have non-cumulative interest. Both are protected by "reserve funds." Of nine small railroad reorganizations, consummated in the years immediately before the assumption of federal operation, five plans provided for income bonds. Past experience shows that this is merely sowing trouble for the future to reap. ^'^ Thus, a large part of the Charleston and Western Carolina Income 5's, 1946, is owned by the controlling Atlantic Coast Line. ^'^ An extreme case is that of the Elmlra and Williamsport Railroad Income, 5's of 2862. Clearly when issued they were a kind of anomalous preferred stock, since the interest was not to be paid unless earned and the principal not for upwards of a thousand years. But the road was acquired by the Northern Central Railway, which guaranteed the interest payment, and this Northern Central is itself an important subsidiary of the Pennsylvania Railroad, which has further guaranteed the interest. The result is that what purports on the surface to be an income bond of little value is really a fixed interest-bearing bond of very substantial worth, '^ Thus, the retirement of the Milwaukee, Lake Shore and Western Income 6's, of igii, was provided for in the Chicago and Northwestern Railway General Mortgage 3^'s, of 1987. BONDS SECURED BY CREDIT 87 ing to avoid controversy and trouble is to give the holders of income bonds a direct voice in the management of the cor- poration, just as if they were preferred stockholders."'' In the case of two large metropolitan traction income bond issues, the holders elect one less than a majority of the directors so long as the full income bond interest remains unpaid.^* A last type of bond, more like a stock even than the income bond, is the so-called participating bond. Such an obligation participates, or shares, with the stockholders' earnings above the regular specified interest rates on the bonds. Whenever issued, the conditions of this participation are defined with great care. This type of bond has been used very seldom in American corporate finance. In fact there exists only one important case, that of the Union Pacific Railroad's Oregon Short Line Participating 4's, issued in 1903, and retired in 1905."= One class of bonds remains unmentioned thus far — con- vertible bonds. But these partake largely of the nature of "^ The income bonds of the Chicago, Terre Haute and Southeastern Railway are 5 per cent cumulative (after igiz) and the methods of computing earnings are very carefully defined in the mortgage. The holder of each bond of $i,ooo par value is entitled to lo votes, as if he held lo shares of stock. °* The Hudson and Manhattan Railroad Income s's referred to before (note 58 above), and the New York Railway Company's Adjustment Income s's. The pro- visions of the latter mortgage, intended to protect the income bondholders, are very elaborate. They well illustrate the cumbersome legal subterfuges involved in trying to create a security which is neither a stock nor a bond._ Nevertheless, in the autumn of 191 8, there were two separate suits pending, on entirely different grounds, which the income bondholders had initiated in order to recover reserves which they con- tended had been illegally set aside from earnings. ^ This case is invariably mentioned by financial students as an example of partici- pating bonds for the simple reason that practically none other exists. The Union Pacific's credit was not as high in 1903 as later. In order, therefore, to dispose of an issue of $36,500,000 collateral trust 4 per cent bonds at a price greater than mere collateral trust bonds of the Union Pacific would warrant, the directors added the feature that tlie bonds could "participate" with the stockholders on any dividend in excess of 4 per cent declared on the deposited collateral — namely, the old Northern Securities Company's stock. Dividends on this deposited collateral were held up by litigation, and when participation seemed imminent, the bonds were called at 1025.^ per cent. For details see Ripley, W. Z., Railroads, Finance and Organization, 164, 20s (1915). „ , J. ^ • »t Participating certificates were used as a temporary expedient in the reorganiza- tion of the Gulf, Florida and Alabama Railway. Lough, also, has dug up a case of participating bonds in the financial plan of the Anglo-Netherlands Sugar Corporation, Lough, W. H., Business Finance, 160 (1917). Yet, When all the cases have been cited it will be found that participating bonds are so rare in modern corporation financial practice that they, as a class, are of little or no significance. 88 CORPORATE SECURITIES stocks, since it is hoped that the bondholder will consent to be- come a partner and not a creditor, if the enterprise can in the future be made to appear sufficiently attractive. They stand for an indirect method of increasing the stock or of creating an artificial market for the bonds by attaching to them a speculative element which is foreign to the fundamental con- ception of funded debt. For this reason, it seems more logical to consider convertible bonds as a separate and distinct form of security. (See Chapter VII.) In surveying this subject it should be remembered that there may be any number of varieties of bonds combining one or more of the characteristics of various groups. It has been pointed out already that a joint guaranteed bond may also be a collateral trust or first mortgage bond; an income bond may be strengthened by a second mortgage or even a first mortgage to secure the payment of the principal when due, or again by the deposit of specific collateral. In fact there is no limit to the ingenuity which may be exercised in devising com- plicated forms of bonds designed to meet special circumstances. In some cases these forms are contradictory in spirit, as in the case of a first mortgage income bond, while in other cases they merely combine in a different way provisions which are usually found separate. The only requirement of a bond description that is of consequence is that the title shall imply exactly the security upon which the obligation rests. Any attempt to breathe new meanings into old names, or to give new names to old meanings for the purpose of confounding and deceiving the investing public, must be frowned upon as at best inex- pedient. Such practices defeat their purpose as tending to destroy, at the outset, the spirit of mutual confidence which is the bed-rock foundation of credit in every form. CHAPTER V EQUIPMENT OBLIGATIONS ^ General definition of equipment obligations, 89; History of their issue, 90; Extent of present use, 92; Chief reasons for issue, 94; Economy, 94; Avoid after-acquired property clause, 98; Subordinate reasons, 98; The Philadelphia plan of issue, 99; Equipment bonds, loi; Security pledged, 103; Treatment in reorganization, 109; In- vestment strength, 112. One class of bonds is so individual, and yet so important that it should be given a separate treatment. This includes the so-called equipment bond and car-trust certificate, which are together spoken of as the equipment obligation. These were used only in railroad finance until a year or two before the Great War, but the issue of securities analogous to equipment obligations is now being extended to other corporate enter- prises having a large amount of capital tied up in salable ma- chinery and equipment. Thus what was until recently merely an incidental financial expedient now bids fair to play an im- portant role in American corporate finance.^ Broadly speaking, an equipment obhgation is a loan of money based on a direct lien on a specific lot of rolling stock. But, as a class, such obligations cannot be defined precisely be- cause of the varying conditions usually required to render this lien direct and explicit, together with the cumbersome restric- tions necessary to maintain a reasonable equity behind a lien on heterogeneous property forever in motion and susceptible to rapid depreciation. Equipment obligations are peculiar in form, in security, and in economic position. They may be bonds similar to other railroad bonds, they may be certificates * Much of this chapter has been printed already under a similar title — Dewing, A. S., "Railroad Equipment Obligations," 3 Am. Ec. Rev., 353 (June, 1917). "For illustration see note 15. 89 90 CORPORATE SECURITIES of participation in a contract to purchase and hold a specific lot of rolling stock, or they may be shares in a permanent associa- tion. They are secured by tangible property, yet a kind of property which is movable from place to place and declines in value more rapidly than atiy other used as a basis of corporate obligations. They rest on the general credit of the corpora- tion using the equipment, yet this general credit has little to do with determining their investment position, which is as a whole stronger than that of any other form of corporate security. Their legal status has never been fully determined by the courts, yet their legality has never been seriously questioned and they have been given priority over first mortgage bonds in the ultimate test of relative strength. With all these con- tradictions, it is clear that only the most general statements can be rigidly applied to the group as a whole, and that innumerable exceptions and modifications crop out as attempts are made to draw definite and straight lines of demarcation. It is clear, too, that equipment obligations constitute an extremely com- plex, but extremely interesting group of corporate securities. The first recorded instance of anything like the modem form of equipment obligation was in 1845. The Schuylkill Navigation Company contracted for the purchase of barges to be partly paid for from borrowings. The construction of the barges was to be under the control of the board of managers of the company but "the ownership was to be vested in three trustees, to be held as security for the payment of the loan."^ After the board of managers had built the barges, they trans- ferred them to the trustees who in turn leased them back to the navigation company.* "Rawle. F., 8 Am. Bar Assn. Rep., 322 (1885). * This case seems to have been sporadic although * almost identical in form with the issue of equipment obligations at the present time under the so-called Philadelphia plan. In this Schuylkill Navigation case, cars as well* as barges were afterward in- cluded and the trustees issued bonds bearing interest and payable in ten annual instal- EQUIPMENT OBLIGATIONS 91 The modern form of car trust association is to be traced to the Railroad Car Trust of Philadelphia created in 1868 for the purpose of furnishing equipment to the Lehigh Coal and Navigation Company. The idea arose, according to Rawle, in the mind of the president of the road, but the legal details, extremely perplexing in their bearing, were worked out by one Charles Gibbons, a Philadelphia attorney." Presumably their origin is to be attributed to the efforts of this lawyer to surmount a legal obstacle. The Pennsylvania courts would not allow that a "conditional sale" of the moving equipment by the trustee to the road should serve as the basis of an obliga- tion as against a third party." That is, the trustee could not' hold unquestioned title to the equipment, even though the title remained in his name, if he sold it to the road on the usual instalment plan.'' Accordingly he adopted the legal subterfuge pf holding absolute ownership of the equipment until it had been entirely paid for by the road. Such a legal subterfuge has proved sound, provided it involves no intentional deceit nor injustice. As advanced by the Supreme Court long ago in one of its few adverse decisions : "Contracts by which rail- ways, insufficiently equipped with rolling stock of their own, lease or purchase under the form of a conditional sale such equipment from manufacturers are not of uncommon occur- ments. The plan was subsequently modified to permit the trustees to sell the equip- ment and redeem the bonds with the proceeds. For description of early forms see Rawle, F., 8 Am. Bar Assn. Rep., 277 (1885). = In February, 1896, Mr. Oliver Adams, writing to the Commercial and Financial Chronicle (Vol. 62, p. 259) regarding the death of his father, William Adams, which occurred in England on January 31, 1896, said, "In 1873 he, in conjunction with my- self, inaugurated the system of equiping railways in the United States with rolling stock on what is now known as the car trust plan." Although Mr. Adams did much to further the idea he cannot be considered the first in the field. Cited also 81 Com. & Fin. Chron., 1760 (1905). The Commercial and Financial Chronicle is hereafter abbreviated in references — Chron. ' Early case, Lehigh, etc. n. Field, 8 Watts and Sergeant 232. ' Pennsylvania is probably the only state which does not permit the "conditional sale" to form a proper basis for security of a lien on equipment. Although this anomaly has proved very annoying to the railroads and their attorneys, the circum- ventions adopted by lawyers to avoid it have given rise to the strongest known form of equipment obligation, presently to be described under the Philadelphia plan. Several writers seem to have somewhat overemphasized this accidental circumstance, for at the present time it has little more than an historical interest. 92 CORPORATE SECURITIES rence, and when entered into bona fide^ for the benefit of the road have been universally respected by the courts."^ Although conceived in the beginning as a means of enabling new^" or impoverished roads" to acquire equipment when their own borrowing capacity was small, equipment obligations are now used by the strongest roads in the country as a means of borrowing to better advantage than through the issue of gen- eral mortgage bonds. The growth of their use was slow at first because associated with emergency financing. By 1890 the total outstanding volume of equipment obligations was less than $50,000,000, while in 1899 the amount had declined * It is very important that the equipment trust be bona fide. Important decisions adverse to equipment obligations have brought out the fundamental principle that there shall be no direct or constructive fraud attendant upon their issue. The entire proceeding must be clear and nothing must occur to give rise to the implication that some creditors are in danger of being defrauded. Under no circumstances must directors of railroads become parties in such manner that they may profit individually. See Drury v. Cross, 74 U. S. (7 Wall) 299; Twin Lick Oil Co. v. Marbury^ 91 U. 5. 3B7; Warden v. U. P. Rd. Co., 103 U. S. 651. One of the most interesting of the adverse cases showing constructive fraud in a variety of lights is McGourkey v. T. and O. C. Ry., 146 U. S. 536 (1892), the decision from which the above quotation is taken. It actually shows the strength of the equipment obligations issued under the form of the Philadelphia plan because it involved the admission, by every member of the Supreme Court, that such obligations, when issued bona fide, were legal. Furthermore, although the entire evidence showed that the form of the lease was resorted to in this case merely as a legal subterfuge to cover up actual fraud — never has there been a clearer case of attempted fraud — the Chief Justice of the Supreme Court and one other dissented on the ground that ev.en constructive fraud did not invalidate the priority of the equipment trust lien in favor of a third party. ^McGourkey v. T. and O. C. Ry., 146 U. S. 551 C1892). A careful summary of the court decisions and legal opinions down to 1885, when the fundamental attitude of the courts was being shaped is given by Rawle, F., Car Trust Securities, 8 Am. Bar Assn. Rep., 277. The legal phrases were carried down to 1894 in Car Trusts in the Uniteci States, by Gherardi Davis and G. Morgan Browne, Jr. See also Heinsheimer, N., "The Species of Contract Known as Car Trust," i Counsellor, 194 (1892). For important decisions note particularly U. S. v. N. O. Rd. 79 U. S. (12 Wall) 362; Fosdick v. Schall, 99 U. S. 235; Meyer v. Western Car Co., 102 U. S. i. These cases have, apparently, established the fundamental law of equipment obliga- tions. Their strength, from the legal point of view, is shown by the fact that there are few, if any, important recent Supreme Court decisions dealing with the legal status of this form of security. Kneeland v. Am. L. & T. Co., 136 U. S. 87 (1890), touches the subject indirectlj^. Although a multitude of railroad failures have in- volved the adjustment of equipment obligation claims, the law upholding their strength has been so firmly established that it has not been thought worth while to carry to the court of last resort a point of possible difference. There is very little statutory law relative to equipment obligations; what there was, down to 1894, was gathered by Rawle, F., Acts Relating to Car Trusts in Force in Various States (1893). " Stated directly as late as 1894, by Davis and Browne, op. cit, as the chief reason: "Inasmuch as a very large number of railroads are not, at the time of their organization, in a condition to purchase a sufficient amount of rolling stock outright, and as, at the same time, manufacturers and owners of rolling stock would often hesitate to accept the obligation of a railroad of perhaps doubtful future, even when secured by collateral, in payment for cars and engines, some other security or means of protecting the manufacturer became necessary.' ^^ The savinff to impoverished roads with poor credit is strongly emphasized by Ripley. Ripley, W. 2., Railroads, Finance and Organization, 171 (1915). EQUIPMENT OBLIGATIONS 93 to approximately $42,000,000." Due largely to the use of the equipment loans by the strongest roads in the country, the total of such obligations rose with great rapidity between 1902 and 1905 — from less than $90,000,000 to approximately $200,- 000,000/^ Since then the practice of financing separately the purchase of equipment has become so common that at the be- ginning of 191 5, the roads of the United States and Canada had outstanding over half a billion dollars of equipment obligations," an amount over twelve times as great as that in 1899.''' This custom of issuing various forms of rapidly maturing obligations to pay for new equipment, having been firmly estab- lished among railroads, has been adopted by other corpora- tions. After steam railroads, the most frequent use is by electric traction roads,^^ but these issues have been largely put out by roads with poor credit. Following the same idea other corporations have mortgaged movable equipment and issued certificates of debt or similar securities against the mortgage and the equipment. ""In 1890, $49,478,215 and in 1899, $42,058,348. These figures are those of the I. C. C. adjusted by the editor of the Commercial and ^Financial Chronicle. 81 Chron. 1760 (1905). They include the Canadian Pacific, but not the other Canadian roads. The equipment obligations of the Canadian Pacific alone amounted to approxi- mately $2,000,000 for both years. ■^81 Chron. 81 (1905). Same basis as previous computation. " Coggeshall and Hicks, New York bankers, computed with great care the out- standing equipment obligations as of December 2, 1914, as $519,000,000. Freeman and Company, New York, have also published a detailed manual giving the outstand- ing trusts, as of January 2, 1917. " The following table shows the growth in the amount of outstanding equipment obligations, among some of the stronger roads. (Even thousands.) 1900 190S 1915 Pennsylvania $11,572,000 $40,000,000 $40,130,000 New York Central 2,462,000 51,802,000 Southern Railway '. . . 2,430,000 13,470,000 17,134,000 Norfolk and Western 1,154,000 6,800,000 12,500,000 A few strong roads have discontinued the practice: TTnion Pacific 2,257,000 Northern Pacific 3,000,000 140,000 Atchison 481,000 400,000 With one road the amount seemed to vary with its credit: Missouri Pacific (including Iron Mountain) 1,043,000 12,970,000 7,397.000 " For example, three issues of the Hudson and Manhattan Railroad and one ot the Connecticut Company. The practice is being extended as _ electric traction com. panics are turning about for means to support a declining credit. ,94 CORPORATE SECURITIES In one case, that of a large mail-order house, rapidly matur- ing "shares" have been issued on the security of a warehouse. At the time these shares were sold they were alleged to be like equipment obligations. While similar in the fact that they mature faster than the security depreciates, the differences are so great that the use of the idea is productive only of confu- sion, bordering on misrepresentation." There are various reasons that have led railroads to use equipment obligations, but two are of especial importance — economy and the avoidance of the after-acquired property clause. Subordinate reasons call for Httle comment as the present rapid increase of equipment loans never would have occurred had the railroads not found it possible to borrow more cheaply in this way than by the issue of junior securities. Most railroads long ago mortgaged to the full their main lines, so that the only available basis of credit remaining is an inferior lien. The securities based on this inferior lien would naturally command a low market price — another way of stat- ing the fact that the new money obtained from the sale of these junior securities would cost the road a high rate of inter- est. When at first the issue of equipment obhgations was looked upon as a sign of weakness investors avoided them as an inferior makeshift security. The rates paid by the carriers were, therefore, no lower than what would be paid on the junior securities." But gradually banks and investors realized i^ Printed on the bankers' circular offering $750,000 Montgomery Ward Ware- house Associates 6 per cent Preferred Shares (January, 1914) occurs the following; "The security of the investment is like that given by a Railroad Equipment Trust, in that the margin increases year by year, the property behind the issue is essential to the conduct of the business of the Lessee Corporation, and that Corporation will eventually acquire entire ownership. In this case, however, the property is real estate, not rolling stock, and the margin at the start is larger than that usually given by Rail- road Equipment Trusts." '° The early equipment obligations were issued almost exclusively to give new or impoverished roads equipment, and the low credit of the road was carried over to the equipment obligations. All issued before 1885 bore high rates of interest. For illustration, the Ohio Central Car Trust created in 1880 bore 8 per cent interest. Rates equally high were by no means uncommon prior to 1885. EQUIPMENT OBLIGATIONS 95 that equipment obligations constituted a: special class by them- selves to which the ordinary canons of railroad credit did not apply. The strength given them by the early court decisions has, too, so increased the demand for them that the rates at which equipment issues are taken by the pubHc now compare favorably with those of any other single class of corporate securities. This low rate of yield for equipment issues is shown em- pirically by comparing their average yields with that of the senior and junior issues of the same road.^^ To accomplish this comparison, the average yield of all equipment issues of a single road, that commanded a general market,^^ was com- puted, and compared with the yields on the road's other securi- ties. The following table shows the result : Average Average Average Yield of Yield of Yield of Equipment Premier General A -ri Obligations Securities Credit Class A— -Roads of very strong credit : Securities Pennsylvania 4 . 05 4 . 042 4 . 354 Chicago and Northwestern 4,10 4.242 4-507 Norfolk and Western 4.10 4-197 4-54 ^^ In the actual computation a more or less random selection was made of six roads typical of each of four grades of railroad credit: Class A, roads of very strong credit; Class B, roads of medium credit; Class C, roads of poor credit; and finally Class D, roads in the hands of receivers. The spring of 1916 was selected as, on the whole, the best time to use as the basis of the calculation, and March 16, 19^6, was chosen arbitrarily as the day to use as the basis for bond prices. The reasons for selecting this time were as follows: Some recent date should be chosen, or else one considerably antedating^ the European War, in order to minimize the influence of inter- national factors on railroad credit. During the spring of 1916 many roads were in the hands of receivers, but these same roads were enjoying some degree of prosperity, so that their credit was not regarded as hopeless. Subsquent to the spring of 1916, plans for the reorganization of several of these roads had been published so that the market values of their various securities depended more on the treatment at the hands of reorganization committees and only incidentally upon their fundamental credit position. Furthermore, since the middle of 1916, a. variety of circumstances has rendered the railroad credit situation abnormal. Foreign short-term loans were offered; railroad credit itself declined; the government assumed railroad operation, and after the end of the Great War money was very scarce and railroad credit very low. Banks are large customers of railroad equipment obligations. On the whole, therefore, economic and monetary conditions seem to make the spring of 1916 a better time to select for a comparison of railroad credits than any time since. The spring of 19 16 has been used several other times in this book when it has been necessary to deal with specific quotations of securities or specific investment yields. -^ Although these issues are not regularly quoted in_ the exchanges, this com- putation was relatively simple. Three investment houses in New York make a spe- cialty of these issues. From one or all of these it is possible to obtain a "bid" on practically every equipment issue and a firm "offer" of a great many issues. Further- more half a dozen brokers are more or less specialists in "equipments" and their "sub- ject offers" afford a close market. No distinction was made between "Philadelphia plan" certificates and equipment bonds. 96 CORPORATE SECURITIES Average Average Average Yield of Yield of Yield of Equipment Premier General Obligations Securities Credit Class A — Roads of very strong credit — Securities Continued. Atlantic Coast Line 4.12 4-323 4-8; Delaware and Hudson 4. IS 4.08 4.41 New York Central 4.30 4.246 4.698 Average 4.137 4.188 4.536 Class B — Roads of medium credit: Southern Pacific 4. IS 4-S7S 4.966 Baltimore and Ohio 4.17 4.516 4.865 Central of Georgia 4,25 4.52 4,96 New York, New Haven and Hartford 4. 30 4-40 5-392 Hocking Valley 4.30 4.72 4.87 C. C. C. and St. Louis 4.35 4-9S 5-35 Average 4-253 4-6i3 5-o67 Class C — Roads of poor credit: Chesapeake and Ohio 4-30 4.60 5.18 Southern Railway 4. 35 4-923 6.04 New York, Ontario and Western... 4.40 4.95 5. 45 Seaboard Air Line 4.40 4.987 6.10 St. Louis Southwestern 4.90 5.10 7.40 Chicago and Alton 4.90 5.70 7.50 Average 4.54 5.04 6.28 Average for solvent roads 4-3io 4-6i4 S-294 Class D — Roads in hands of receiver: Chicago, Rock Island and Pacific... 5.05 4.97* t Missouri, Kansas and Texas 5.30 5,40 St. Louis and San-Francisco 5.33 4. 95 Missouri Pacific 5-4o 4-7o International and Great Northern.. 5. 70 6.75 Pere Marquette 6 . 00 8 . 20 Average 5.47 5.83 * The yields computed for the premier securities of roads in the hands of receivers are not as reliable as the previous calculations, because based only on one or two separate securities. These are, however, the old underlying first mortgage bonds on the main line trunk stem. Such securities have their values but little affected by the receivership of the whole system. t The general credit securities were in default and no computation of invest- ment yield is possible. They were quoted all the way from 44 per cent of par for the debentures of the Rock Island road down to 6 per cent of par for the debentures of the Pere Marquette. The yield for the senior bond issues of the same roads was computed by averaging the yields on all the first mortgage, main-line bonds. In some cases not more than one or two issues could be used, but as these command a wide general market they indicate clearly the position of the road's funda- mental credit. The junior or general credit of the road was computed in the same manner from the average yield on the EQUIPMENT OBLIGATIONS 97 refunding and the general mortgage bonds" and the debentures — if any — but without reference to the guaranteed issues.^^ Summarizing these results, therefore, it is apparent that the average investment yield for solvent roads was 4.31 per cent for the equipments, 4.61 per cent for the senior mortgage bonds, and 5.29 per cent for the junior or general credit bonds. The economy of borrowing through equipment obligations is apparent. It is also apparent that the equipment obligations of insolvent roads maintained a credit even superior to that of their underlying first mortgage bonds. This conclusion is in accordance with the actual practice of railroad adminis- tration. A road which cannot sell bonds can always sell equip- ment obligations and that at rates which make the borrowing in no sense a burden.^^ Even when refunding and debenture bonds can be sold easily it is ordinarily more economical for the management to issue equipment obligations to cover such expenditures as must be made for new rolling stock.^* It is almost needless to comment that it is vastly more economical for any road, strong or weak, to buy its own rolling stock by the use of equipment obligations than to use the cars of other carriers on the so-called per diem rental basis. One writer goes even to the extent of saying that a certain road of con- spicuously weak credit could have saved its expenditure for ^In several cases, first mortgage bonds on unimportant branch lines were con- sidered as general credit obligations. Convertible issues of all kinds were omitted. ^ The practice of some statisticians of using the guaranteed Issues of a road as a basis of computing its general credit is misleading. Besides the anomalous char- acter of a guarantee — as shown by the Western Pacific case on the one hand, and the Ozark and Cherokee Central case on the other — the value of a guaranteed bond rests, in the minds of investors, much more on the earning capacity of the property than upon the general credit of the guarantor. For further discussion see Chapter IV. ^ Of course the rates on equipment loans are controlled by the general invest- ment market, and the road with strong credit invariably gets the better terms. When investment conditions were strikingly unfavorable, December, 191 7, the Seaboard Air Line Railway negotiated a small issue, amply secured by high-grade locomotives on approximately 7}| per cent basis. But all corporations were then paying at least this on short-term obligations. *• It stands to reason that money cannot be borrowed on equipment and used for other purposes. In the old Ohio Central case C146 U. S. 536), one of the few in- stances of the abuse of equipment obligations, over a quarter of the total money bor- rowed on the equipment was used to purchase a coal property and to pay off previous indebtedness of the road. 98 CORPORATE SECURITIES car hire "twice over" had it been able to issue equipment obli- gations, even if it had paid as high as 6 per cent.^° The second advantage concerns the after-acquired property- clause. Bridges, terminals, and branch lines are frequently built by subordinate corporations so that the new property may not pass, automatically, under some old mortgage which contains a clause to the effect that all property subsequently owned by the road becomes subject to it. In the same way, the retention of the title to the rolling stock by the trustee of an equipment obligation holds it back from the lien of any such prior mortgage,^" and makes it possible to use the rolling stock as the basis of its own purchase-money indebtedness. In addition to these two main reasons there are, as has been said, others which sometimes influence the issue of equipment obligations. The tax laws of a state may subject bonds to a personal property tax, while the equipment certificates, being certificates of part-ownership in physical property, escape." Again the bankers of the road may believe there is a better de- mand for the road's obligations with banks than with private investors, and equipment obligations are especially favored by banks. Still again the car and locomotive manufacturers are often willing to accept an equipment obligation for part or for nearly the whole payment of railway purchases, on cheaper terms than the railroad can obtain by selling its own bonds and using the proceeds to reimburse the manufacturers. This is ^Ripley, W. Z., Railroads, Finance and Organization, 172 (1915). Referring to .the expenditures of $1,000,000 yearly by the old Wabash lor car hire. "Leading early case U. S. v. N. O. Railroad, 79 U. S. (12 Wall) 362. J" One of the reasons for the large use of equipment obligations in Pennsyl- vania is that when the legal instruments securing them are adroitly worded the interest on them escapes the Pennsylvania tax laws. But the lawyers drawing the various documents must carry out the letter of the subterfuge. The attention of the writer was drawn to an instance in which the lawyers slipped up in this particular and called the payments by the railroad "interest" instead of rentals.'* This verbal error in the letter of the documents rendered the holders of these particular equip- ment obligations subject to the Pennsylvania tax. EQUIPMENT OBLIGATIONS gg especially true at a time of slack business activity combined with high interest rates. In substance, all equipment obligations are direct liens on rolling stock, but as now issued they may be divided into two great classes — those issued under the Philadelphia plan of a lease and those issued under a direct mortgage, sometimes, without reason, called the New York plan. As the Philadel- phia plan is at once the most individual and the most com- plex, giving rise to the strongest kind of railroad obligation, it will be described first in considerable detail. The Philadelphia plan^^ of issuing equipment obligations, as it has now been crystallized into more or less regular prac- tice, consists of a device whereby the railroad makes an initial payment towards the purchase of a definite number of cars or locomotives, but does not acquire the title to the property until it has met the unpaid balances.^' The road uses the equipment under a lease, but never obtains even conditional ownership until it has paid the entire purchase price. The procedure is made clear by observing the steps of a typical case.^° A railroad desires to acquire some new cars. It enters into a contract with the manufacturer, who builds the cars according to the specifications of the road. When the equip- ^ Certain specific reasons explain the association of equipment obligations with Philadelphia and Pennsylvania, (i) They originated among Pennsylvania corporations. (2) The conditional sale is not a legal basis for direct ecjuipment obligation. (3) Car trust certificates, although having mortgage bond security, yet as certificates of part ownership in physical property, have been considered non-taxable when held by Pennsylvania holders. (The best legal opinion now is that this question has never been finally adjudicated.) Great care must, however, be exercised in carrying out the le^al fiction that the issues represent physical property, rather than notes. (See precedmg note). (4) The location in Pennsylvania of large equipment companies. (5) The example of the Pennsylvania Railroad, although this reason has been eltective only a short time. ^ The best and clearest account of the course of the procedure is, in the opinion of the writer, an editorial in the Commercial and Financial Chronicle. 82 Chron. 839 (1906). 30 All the principles suggested in the next few paragraphs are excellently illus- trated by two equipment trust agreements— Erie Railroad, Scries N, and Erie Rail- road, Series L — reproduced in Gerstenberg, C. W., Materials of Corporation Finance, 299 and 313 (191 5). The latter is nearer the Philadelphia form, although neither .is in close accordance with the form. (Both are of the so-called New York form, in which the receiver of the railroad could, unquestionably, maintain a provisional title to the equipment in case of a receivership.) lOo CORPORATE SECURITIES ment is ready for delivery, the road then enters into an elab- orate agreement with some individual, trust company, or asso- ciation created for the purpose, under which the latter shall acquire and pay for the equipment nearing completion and lease it to the road/^ The individual, trust company, or asso- ciation becomes the actual and legal owner of the equipment, not merely the trustee. About one-tenth of the necessary money is supplied by the road and the other nine-tenths is obtained from bankers and ultimately from investors through the sale of participation certificates based on the security of the equipment itself and the pledge of the lease. This lease involves at least five provisions. First, the rail- road or lessee promises to pay the owners or lessors each year an amount of money necessary to meet all the interest on the notes or participation certificates then outstanding, together with a certain instalment on the unpaid portion of the entire issue. Secondly, the railroad promises to keep the equipment repaired and insured, and also to replace any cars burnt or destroyed. Thirdly, the railroad promises to put a name plate on each car describing it as the property of the owner or lessor and to use no lettering so as to imply that the road is itself the actual and legal owner of the rolling stock. Fourthly, the road promises that, in case it fails to meet any part of its obligation, especially if it fails in its payments, it will assemble at one point the entire equipment covered by the lease and deliver it over to the lessor or owner. Lastly, the lessor agrees that on the payment of the last instalment it will execute a bill ^ In very rare cases there is no trustee, the manufacturing company leasing the equipment directly to the road — as in St. Louis and San Francisco R. R. Series M (1907) the Pullman Company leased the cars directly to the road. During the earlier period of equipment obligations,* associations of officers or em- ployees of the railroad would be formed for the purpose of holding the equipment. Subsequently a single individual, usually a banker, acted in this capacity. He would assign the lease, not the equipment, to a trust company. Later still a trust company has assumed the role of owner and_ lessor. In rare cases a permanent association maintains a continued and separate existence, owning and. leasing equipment and issuing its own certificates in successive car trusts. The old* St. Louis and San Francisco Railroad Company used such an equipment company * to finance certain of its car trusts. The practice is not, however, common. EQUIPMENT OBLIGATIONS loi of sale to the road conveying to it the title of the rolling stock. From this description it is clear that the whole purpose of the agreement is to avoid giving the railroad even a semblance of a title to the equipment while it is using it, but at the same time provide an arrangement which shall enable the road to pay- gradually for it and ultimately to own it. The security is never the credit of the road but the merchantable value of the rolling stock itself ; yet the road has the full and free use of the rolling stock while it is paying for it as if it were its own."^ When equipment obligations are not issued under the Phil- adelphia plan the railroad acquires the rolling stock and then deeds it in trust to a trustee as in any other mortgage. Or the trustee acquires the equipment directly and delivers it to the road under a conditional sale agreement. Such obligations, being based directly on the credit of the issuing road, with the collateral pledge of the equipment, are called equipment bonds. '^ They are an outgrowth of the original Philadelphia ^ The Committee on Railroad Bonds and Equipment Trusts of the Investment Bankers Association found that trustees had been negligent in insisting that the pro- visions of the lease be fully lived up to. The committee suggested certain reforms. Chamberlain, L., gives an outline of these in a recent popular article. He also sum- marizes certain clauses that should be present in an equipment trust agreement. (i8 Moody's Magazine, 135.) The suggestions on the part of the committee are excellent, but its effects are likely to be frustrated by one drfficulty : Who shall pay the trustee for continuously checking up the trust? ''Unfortunately the nomenclature on this subject is by no means clear. The rail- roads and especially the investment bankers have seemingly sought to befog the public mind. If issued under the straight Philadelphia plan, the obligation is not that of the railroad (although it may be and is often guaranteed by the road), but merely of the trust estate of the equipment. The trustee may be represented by a private person, a trust company, a car manufacturer, an association, or all these acting to- gether. The point is, the certificate is the right to participate in certain property held under trust, which includes: (i) the equipment, (2) the legal instrument or lease under which the owners or trustees look forward to the final sale to the railroad. An equipment bond, on the other hand, is merely the promise of the road to pay the bearer or registered owner a certain sum, a promise resting on the pledge of equipment with a trustee. An "equipment bond" is not issued under the Philadelphia plan, ex- cept by the use of a misnomer. There have been and are today many attempts to com- bine the two ideas, but, on analysis, it will appear that the obligation is reducible to one or the other class. The term "equipment note" is sometimes used, and may refer either to the Philadelphia plan certificates or to the bond. Also various roads have tried to combine the two forms by acquiring the equipment, deeding it to a trustee, and then leasing it. This is an unfortunate subterfuge. Some roads, too, have issued an out and out equipment bond, but have sought to give it the appearance of a Phila- delphia plan certificate by bringing in the lease idea. An editorial in the Commercial and Financial Chronicle succinctly reviews the confusion in names, and attempts to clarify the essential differences in form. The statement given there is the clearest in print. 82 Chron. 36' (1906). 102 CORPORATE SECURITIES car trust certificates^* and represent a distinct emasculation of the strength of the eariier obhgations. The road has some kind of a provisional title to the equipment/^ whereas in the Phil- adelphia plan it has not the slightest semblance of a title. Therein lies the strength of the Philadelphia form of obliga- tion/" Except in legal details the two methods of issue are based on the same idea, namely, a mortgage on equipment. The issue of equipment obligations seems to be a matter of individual policy among the roads. Before 1892, it could be said with considerable show of evidence that their issue was, with a single exception, confined to weak roads, but since 1900, roads of the strongest credit have resorted to this means of borrowing. Among the strong roads, the Pennsylvania had in 1915, over $40,000,000 of equipment obligations, and the New York Central over $50,000,000." On the other hand, the roads under the management of J. J. Hill had not a single dollar of equipment obligations,^^ nor had the Delaware, Lackawanna and Western, nor the Union Pacific railroads. Among the roads of weak credit the St. Louis and San Francisco was overloaded with equipment liens, whereas the Western Pacific "* The extensive issue of straight equipment bonds, without even the form of the Philadelphia plan, is comparatively recent. It is to be traced to the adoption of the use of equipment loans by the roads of strong credit, outside of the Pennsylvania system, and would not go back more than ten or twelve years. It is true that some of the coal roads were using equipment bonds before 1890, but the instances are rare. There were probably no straight equipment bonds prior to 1885. ^^ Even then under the conditional sale, except in Pennsylvania and possibly one or two other states, the title is considered to remain with the trustee. One of the latest decisions covering this point states; "The title to the equipment sold under the contracts _ here involved remained _ in the vendors until fully paid for. The interest of the railroad companies and their mortgages was but an equitable interest, and_ sub- i'ect to the terms of the conditional sale." Metropolitan Trust Company v. Railroad Equipment Company, 108 Fed. 918 (1901). ^° An excellent illustration of the difference of strength in the two kinds of issues is afforded by the reorganization of the Norfolk and Western Railfoad. There were at the time of the failure two groups of equipment obligations: (i) Equipment Mort- gage 5 per cent Bonds of 1888, $4,114,000 outstanding. These were not issued under the regular Philadelphia plan, (2) Car trust obligations, various issues and maturities, $3,125,000 outstanding. These were issued under the Philadelphia plan in its simple form or with certain unimportant modifications. In the reorganization, the equipment bonds were _ refunded or disturbed as it is called in reorganization parlance— the holders receiving new bonds and stock, whereas the car trust obligations were paid in cash, although it required over half the $5,555,000 of money raised for immediate needs. For plan see 62 Chron. 641 (1896). "See note 15. "^ Except about $1,000,000 equipment obligations of the Colorado and Southern Hailw^y. EQUIPMENT OBLIGATIONS 103 and the Boston and Maine, weak roads in opposite parts of the country, had no equipment obHgations. Nor can there be any sectional generalizations, although the far-western roads as a class show the least inclination to issue such obligations, and the coal roads in eastern trunk line territory perhaps the most. In the end it is a question of special policy.^* The physical equipment itself that is covered by the lien is usually diversifaed.*" It covers in the great majority of cases both locomotives and cars.*^ When issued to cover a single class of equipment this class is usually of the standard form used in large quantities by different railroads/^ The equipment obligations of the original issue rarely cover more than 90 per cent of the original cost of the equipment, although the "For extended discussion covering; policies of different roads see 55 Rail. Age Gaz. 1596; 56 Ibid. 668. *• Of the 320 separate equipment issues of American railroads existing at the beginning of 1915, only 78 or 24 per cent were mortgages on one kind of equipment alone, the remaining 242 issues or 76 per cent covered more _ than one kind. In making this and some of the later statistical computation the writer has made liberal use of the very valuable publication of the Guaranty Trust Company of New York entitled "Railway Equipment Obligations." " The following are two typical equipment trusts. They have been selected at random merely by way of illustration. I. Mobile and Ohio Railroad Company. Equipment Trust, Series F, 4j^ per cent interest. Dated March i, 1912. Due $23,000 each March i, and $22,- 000 each Sept. I, until 1922. Equipment cost $500,615. Obligations issued $450,000. Security: 4 Pacific locomotives, 2 Mikado locomotives, 6 steel passenger cars, 4 steel underframe mail and baggage cars, i steel underframe express car, 334 steel gondola cars, 50 steel underframe automobile box cars, i. Louisville and Nashville Railroad Company, Equipment Bonds, Series A, 5 per cent interest. Dated June 2, 1913. Due $325,000 to June i, 1923. Equipment cost $7,226,420. Obligations issued $6,500,000. Security: 20 freight locomotives, 4 Pacific type locomotives, 26 steel under- frame passenger cars of three types, 2 steel underframe baggage and mail cars, 8 steel underframe baggage cars, 5 steel postal cars, 3,000 all-steel hopper and gondola cars, 39,000 freight and gondola cars of eight types, 80 cabooses. An extreme case of diversification is represented by Chicago Rock Island and Pacific Railway Company's Equipment 5 per cent Notes, Series H. Dated July i, 19IJ. Due $441,000 semiannually to July I, 1923- Equipment cost $5,521,348. Obligations issued $4,410,000. Security: 25 Mikado type locomotives, 30 six-wheel switching locomotives, 30 Pacific type locomotives, 2 mountain type locomotives, 1,500 steel underframe box cars. 500 steel gondola cars, 50 caboose cars, 18 steel chair cars, 20 steel coaches, | steel three-compartment passenger cars, 7 steel smoking cars, 10 steel baggage cars, 8 steel dining cars, 4 steel horse express cars. " Steel gondola cars are most frequently used when the issue covers only a single form of equipment. There were in 1916 approximately 21 equipment issues covering these cars alone. I04 CORPORATE SECURITIES stronger roads, such as the Pennsylvania^^ and the subsidiaries of the New York Central/* have issued notes for the full purchase price of the equipment. In very rare cases an equip- ment trust has been formed to cover rolling stock already used, so as to give the road money to make repairs.*^ It is extremely difficult to form an accurate idea from the outside of the real cost and value of the equipment covered by any issue, unless it is of one standardized pattern.*^ The provision in the lease agreement that is of most real conse- quence is that dealing with the rapidity with which the total loan is to be paid. Under all circumstances, railroad equip- ment wears out rapidly and is growing obsolete constantly.*^ ^^ Of a total of nine series of etiuipment issues of the Pennsylvania Railroad out- standing April, 191 5, all were originally issued for the full value o£ the equipment acquired. " For example, Kanawha and Michigan Railway, Equipment Car Trust of August 15, igo6. ^ The Detroit, Toledo and Ironton Railroad Equipment Notes of 1914' The issue is explained, of course, by the low credit of the road. This trust was created when $2,000,000 was borrowed to repair 1,763 coal cars. It is unusual in bearing 6 per cent interest and maturing in three years. The borrowing was excessive as new cars could have been bought for less money. This railroad and its predecessor have afforded the case celebre of equipment issues. See note 65. *^ The following table gives a few averages of the cost of standard equipment. The averages are deduced from a random selection of different equipment issues cover- ing a single class of rolling stock; they include practically all of each type outstanding between November 1, 1914, and February i, 1917. Kind of Number of Total Num- Total Cost per Equipment Series ber of Pieces Cost Unit Locomotives (not special type) 17 473 $8,213,443 $17,362 Steel underframe box cars 13 30,63:6* 35.067.383 1,112 Steel underframe refrigerator cars 6 3.525 6,285,055 1,782 Steel gondola cars 8 10,500 12,491,946 1,182 It is difficult to check these figures by the actual contracts. A writer in the An- nalist estimates the average net cost of a standard 40-ton steel underframe box car for the eight years from 1908 to 1916 to be $947, with extremes from $844 to $1,200. The .average in the above table of $1,112 seems to indicate excessive prices paid or else inflation of the costs. Owing, however, to the extreme variation in demand, there is a remarkable difference of cost of the same equipment according to the time of purchase. This subject is ably discussed with statistics in the New York Times Anna- list. 7 Annalist 116 (Jan. 24, 1916). In considering all equipment cost statistics, particularly those given in the above table, it should be remembered that costs have increased enormously since the beginning of the Great War. Most of the above series were issued before 1915, and so were secured by equipment bought at pre-war prices. In 1918, the prices of many forms of equipment were over double the pre-war costs. The spring of 1919 showed a decline in equipment costs, thereafter a steady increase. " It is usually contended by railroad engineers that obsolescence is greater with locomotives than with any other form of equipment. While this may be true, it should be remembered that an obsolete locomotive can be used on branch lines and for company work, whereas obsolete freight cars are uneconomical however employed. Obsolete passenger cars are even worse because besides being inefficient, they usually tend to create ill feeling in the minds of the patrons of the road. In the opinion of the writer that class which suffers least in value through use ■ — both physical depreciation and obsolescence — is th.^ steel underframe tank car for the transportation of petroleum products. EQUIPMENT OBLIGATIONS 105 Were there no means of fully maintaining the equity behind an equipment lien, therefore, it would be the weakest kind of corporate security. But it is actually the strongest; for by making it mandatory on the part of the road to pay off the obUgations faster than the equipment wears out, the equity to the noteholders is not only maintained but increased. To achieve this result, certain definite presumptions must be made, the most important of which is the true rate of depreciation,*^ ^''The depreciation of rolling stock has been the subject of many elaborate studies. Unfortunately these have led to no unanimous conclusion and, unfortunately also, little has been written by practical railroad men. There were three brief essays by the distinguished accountant of the Union Pacific lines: Mahl, W., 43 Ry. Age Gaz. 418 (1907). 48 Ibid. 400 (1910), 48 Ibid. 1249 (i9io). Also from the point of view of accountants Stockwell, H. G., "Depreciation, Renewal and Replacements," Account- ants' Year Book, Am. Assn. Pub. Accountants for 1909, 192. The Master Car Builders Association estimates for cars as follows: wooden bodies and wooden underframes 6 per cent annually; wooden bodies and steel underframes 5^ per cent; metal bodies, steel underframes and trucks 5 per cent. This basis was taken by the statistician of the Guaranty Trust Company in figuring margin of safety for equipment obligations. See Railway Equipment Obligations (3rd Ed.). 9- Chamberlain uses a rough estimate of 15 to 20 years as the life of equipment; Chamberlain, L., Principles of Bond In- vestment, 309 (1911), The Pennsylvania road has used 3 per cent for freight cars and 4 per cent for locomotives. Rates have varied. See Lill, T. R., Jour. Account., (Jan., 1917) giving statistics. Now, while it is perfectly true that the development of steel construction, particularly the steel underframe, has very much increased the serviceability of the car itis not clear from records that the salable life of the car is any longer. The investigations of the Master Car Builders Associations and the various studies that have appeared from time to time in the railroad periodicals have assumed the existence of, and have sought to determine a theoretical period of usable life for railroad rolling stock. Such a computation is not sufficient for the holder of equipment obligations because, from his point of view, the value of rolling stock is not its theoretical usable value, but its salable value. The two criteria are essentially different. A car may have a theoretical life, based on an arbitrary depreciation con- stant, long after it ceases to have a second-hand sale value. It may be held in reserve for frei§:ht congestions when it cannot be sold — except at the very time of the freight congestion. Moreover, the constants worked out by the manufacturers are based on mere decline in physical value through use, and presume only an arbitrary and slight, if any, constant of obsolescence. Furthermore, the an- nual cost of repairs increases as the car ages, so that there comes a time when it is cheaper for a road with credit to "scrap" the cars than to meet the constantly in- creasing cost of repairs. In fact, after a time the value of the car becomes a kind of constant scrap value, the u.se and sale value being functions of the repair charges. From these theoretical considerations and such figures as the writer is able to gather from practical railroad men, he is of the opinion that collections of mixed equipment, such as are cited on a previous page, consisting of ordinary locomotives to about a third of the total amount and the other two-thirds standard cars readily usable by other roads, have a salable life of about is'^A years. At the end of this time it has a scrap value of about 15 per cent of its original cost. This scrap value suffers only slight diminution during the next five to ten years, provided sufficient sums are annually spent in repairs to take care of the obvious decays and breakages. For pur- poses of computation we may assume, therefore, that the equipment declines 85 per cent in value during the first igj^ years of its life. The decline in salable value appears to be more rapid during the first three years of the equipment's use and less rapid during the last four or five years, than an arithmetically regular decline would imply. The first year, this decline is fullj; a half more than what the average of the period would be, whereas the decline during the last year is only about a half that of the average. From the fourth to the eighth year, the decline is the average. If these assumptions are approximately correct, we may construct a table showing the percentage of oris?in?iI cost represented by the decline in salable value for each year. It would be something like this: io6 CORPORATE SECURITIES To value the equity behind the equipment obHgations calcula- tion must be based on the sale value of second-hand equipment. B Percentage inning of Depre- ot Year ciation of Money Value Immedi- Volume of Original of Deprecia- ately after Certificates Cost dur- tion during Instalment Outstand- ing Pre- Preceding Paid ing ceding Year Year $900,000 810,000 720,000 630,000 540,000 450,000 360,000 270,000 180,000 90,000 9.5 8.4 7-4 6-3 6.3 6.3 6-3 $95»ooo 84.000 74*000 63,000 63,000 63,000 63,000 63,000 63,000 Value of Equipment $1,000,000 905,000 821,000 747,000 684,000 621,000 558,000 495,000 432,000 369,000 Equity be- hind Out- standing Cer- tificates $100,000 95(000 101,000 117,000 144,000 171,000 198,000 225,000 252,000 279,000 Percentage of Value of Equipment Represented by Outstand' Certificates 90% 89% 87% 84% 79% 72% 64% 54% 42% 24% directly after payment of last instalment. The preceding table is based on the assumption that the equipment declined about 85 per cent in value during the first 13^ years, at which time it has a scrap value of about 15 per cent of cost, and that the decline is most rapid at first. Under such circumstances, the relative equity behind an issue of ten years serial equipment bonds can be seen at a glance.*® The computation assumes that the equipment cost $1,000,000 of which 10 per cent, or $ioo,ck)o, was paid before the equip- ment was received, and 10 per cent of the balance the first of each year following. Per cent Per cent rst year decline 9-5 8th year decline 6-3 2d 8.4 9th " 63 3d " " ;-4 loth " 6-3 4th " 6-3 nth " 6-3 5th " '* 6-3 i2th '• 5-4 6th " " 6.3 13th '• 3-2 7th " 6.3 14th 15th