ioil CORNELL UNIVERSITY LIBRARY FROM M.-^.Rivej-a FEB i7 M Cprnell University Library HG4011.L99 C8 V.I -2 Corporation finance olin 1924 032 540 126 Cornell University Library The original of tliis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924032540126 CORPORATION FINANCE PART I OAPITALTZATIOl^ PAET II DISTEIBUTi:S^G SE0UEITIE8 EEOEGA^IZATIOifS BY HASTINGS LYON CounseCor-at-Law, New York City. Lecturer on Finance, Columbia University BOSTON NEW YORK CHICAGO JBAN FRANCISCO HOUGHTON MIFFLIN COMPANY COPYRIGHT, 1912, BY W. H. LYON COPYRIGHT, IQI6, BY HASTINGS LVON ALL RIGHTS RESBKVSD CAMBRIDGE . MASSACHUSETTS PRlNTBD IN THE U , 5 . A PREFAClfi Since the publication of Capitalization in 1912 suggestions have been made from time to time that a discussion in the same gen- eral manner of other topics of corpora- tion finance would be helpful to students of the subject. Messrs. Houghton Mifflin Com- pany agreed to an extension of the work that would amount to another volume, and to a change of the title to one sufficiently inclusive to cover the new matter. So the title Corpora-' tion Finance has been adopted for the entire work and the new chapters are being pub- lished as Part II. The new volume deals more especially with two topics, the distribution of corporate se- curities and the financial side of corporate reorganizations. It also presents some discus- sion of the disposition made of corporate income. Though both law and accounting must be referred to in explaining financial matters, I hold an opinion that corporation finance has a distinct channel, and that it is the duty of any one undertaking a presenta- tion of any aspect of the subject to steer a course between the legal and the accounting sides of corporate business. iv PREFACE Since Capitalization was written, I have changed my mind about the special desira- biUty of using as illustrations existing securi- ties and corporations, and in this second vol- ume have confined the examples mostly to hypothetical cases. The passage of a few years, with their varying econpmic, social, and personal winds, makes the facts presented in an old corporation manual resemble the snows of yesterday. The book has been written out of the ex- perience of a number of years in association with banking houses engaged in the business of buying and selling corporate securities and as a lawyer occupied in working out the financial arrangements of corporations. It assumed form in the course of presenting the subject in courses of college and graduate students. I hope the book will continue to be used by students of the subject, not only in the schools, but especially by the many young men en- gaged in financial work who find difficulty in getting help to understand the complex matter of their profession. It will be useful, also, I believe, to the large number of people who invest in corporation securities, either on their own account or for financial institu- tions. The number of investors who want a thorough comprehension of what they are PREFACE V doing increases rapidly. It may in some cases possibly help a lawyer to get a better under- standing of the needs of his client. And all citizens who want to base on knowledge their opinion of the proper attitude of the Govern- ment toward corporations will find in the book a statement of the fundamental prin- ciples of corporation financing. In attempting a work of use to so wide a range of people, I have necessarily had to make some parts of it rather elementary for the more informed, and some parts somewhat difficult for those entirely unfamiliar with securities. It omits many things that might properly come within its scope. I am glad to express my appreciation of the kindness of Mr. John Tatlock, president of the Westchester Avenue Bank, in reading much of the manuscript. My partner ta the practice of the law, Mr. William Lilly, helped especially with the discussion of Corporate Reorganizations. For the first volume Mr. Carl Owen, a member of the law firm of Horn- blower, Miller & Potter, and Mr. Lawrence Chamberlain, of the bankingJiouse of Hemp- hill, White & Chamberlain, read a consider- able part of the manuscript. Hastings Lyon 87 Wall Street, New York Citt August, 1916 CORPORATION FINANCE PAET I CAPITALIZATION CONTENTS The Instkumentb of Corporation Finance ... 1 How the corporate form of enterprise makes it possible to meet the differing desires of capitalists — Corporate secur- ities discussed from the standpoint of risk, income, and control — Common stock — Preferred stock — Participat- ing stock — Convertible stock — Special rights of control given to stock — Redeemable stock — ^ Bonds — Special rights of control given to bonds — Mortgage bonds — De- benture bonds — Income bonds — Convertible bonds. II Trading on the Equity 50 Capitalization in relation to earnings' — Principles gov- erning the borrowing of capital in business as applied to corporations — The common shareholder as proprietor — Borrowing limited by liability of net earnings to fluctuate — Variation of net earnings depends on the variation of gross income as related to the variation of the operating ratio — Preferred stock as a means of trading on the equity . — Relative size of common and preferred stock issues as affecting the amount of control in the shares of each — How a minority of shares can control a corporation. Ill Watered Stock 83 Capitalization in relation to assets — Common objec- tions to slock- watering — As fraud on the buyer — As an excuse for making high charges for service — Proper pur- poses of stock-watering — Satisfying various interests — CONTENTS In carrying out underwriting operations — Why it may be more dangerous for the corporation to finance without watered stock than with it. IV Financing an Expansion 108 On common or preferred stock — Fashions in investing — Blanket mortgages — Open and closed mortgages — First and refunding mortgage bonds — ^Second mortgage bonds — Guaranteed bonds — Collateral bonds — Merg- ers — Combinations — Consolidations — Holding com- panies — Leases — Joint bonds. Amortization 144 Amortization and refunding of corporate debts — Special circumstances calling tor amortization — Methods of amortization — Tests of their relative merits — Serial maturity — Sinking-fund — Repurchase of the security — Burden of the debt — Best plan of amortization. VI Form 166 Illustration of corporate securities -^ Stock certificates — Full paid — Transfer agent — Registrar of transfers — Coupon bond — Registered bond — Denomination — In- terest rate — Term — Right to redeem — Interest dates — Registered vs. coupon form — Interchangeable — Taxa- tion — Trust deed. VII The Market and the Price . . , 200 The value of a "quick," "close" market — Effect of the size of issue od m»rket — Value of listing on the New York CONTENTS xi Stock Exchange — Neglect of small issues there — Com- parisou with the London Exchange — Appearance of bonds — Effect of open mortgage on market ■ — Why small de- nominations do not extend the market' in America. VIII Cafitauzation and tee State 330 Questions arising in a consideration* of state regulation of corporate capitalization — What is an adequate return on capital — True interest — Premium for risk — What is a fair capitalization — Original cost — Cost of reproduc- tion — Cost of replacement — Public service commissions in Massachusetts, New York, and Wisconsin — Their con- trol of capitalization, return on capital, and competition. CAPITALIZATION A BOOK ON CORPORATION FINANCE THE INSTRUMENTS OF CORPORATION FINANCE If our inquiry into corporation finance can follow the tree trunk and a few main branches, we shall probably gain a more thorough un- derstanding of the financial structure of cor- porations than we can get by looking from the outside at the obvious foliage of multitudin- ous security forms and financial plans. Books on the subject have mostly confined them- selves to answering the question "What?" and have largely ignored the question " Why ?" So far as possible we shall find the determining causes first, and afterwards con- sider the results they work out. We shall confine our inquiry to the capitalization of corporations, and not enter on many matters that the general subject of corporation finance might properly lead into. On pressing the inquiry, we are able to find several main formative mfluences which S CAPITALIZATION esplain the various developments of corpor- ate capitalization. The desire to apportion the elements of risk, income,* and control in- volved in an enterprise largely accounts for the numerous forms of securities. A know- ledge of this line of inquiry makes the short- est way to an understanding of the many kinds of stocks, bonds, and other financial paper of corporations. The present and pro- spective earning power of a corporation, with the desire of those in control of its affairs to make as much as they feel they safely can on their own capital investeij, gives another principal influence determining the financial plan. It partly decides the kipds of securities the corporation finances on, and more espe- cially their relative amounts. We shall dis- cuss this relation of capitalization and earn- ings under the head of "Trading on the Equity." Another line of inq^iiry follows the relation of assets to capitalization; the extent, that is, to which they determine the form and amount of security issues. We shall take this up under the head of "Watered Stock." Next after these three forces existing in every case, we find the desire to extend the enterprise of a corporation affecting the finan- cial plan and leading to a number of new kinds of securities. A consideration of "Fi- nancing an Expansion" will look into the THE INSTRUMENTS S working of this influence. Iri a discussion of "Amortization" we shall see in what ways a desire to pay off long-term indebtedness may shape corporation bond-issues. A number of influences determining details and affecting larger matters naturally group under the captions of "Form" and "The Market and Price." On the subject of " Capitahzation and the State" we shall raise the questions in- volved in government regulation of capital- ization and earnings, and describe what the public service commissions of the three states which have carried this mattpr farthest have done. Corporation finance has developed through the promoters, organizers, or managers of corporations bargaining with capital-owning members of the community. Usually both these parties deal through a third party, the investment banker. Though mot an agent in any legal sense, the banker nfevertheless does act as an intermediary, and frequently occu- pies, with considerable dignity, the rather difficult position of having an interest in both the other parties to the transaction. As a matter of fact, the banker, rather than really representing either party, almost occu'- pies the position of an umpire, and decided on the fair bargain all round. Of course he charges as much as he can for his services and 4 CAPITALIZATION any risks he takes. In many transactions his entire concern Hes with the investor, whom he calls his chent; and it always should lie most in that direction. Whatever his inter- ests, the banker, assisted by the advice of his lawyers, has, without doubt, exercised the chief directive influence in the development of corporation finance. Since our subject has grown, and is grow- ing, in this way, we can get much help in un- derstanding it by examining this bargaining among the parties, and tracing through the various transactions. From a financial viewpoint the corporate form of conducting business presents one most significant feature, — the opjportunity it af- fords for dividing and recomfeining the inci- dents of ownership in varying proportions. By "incidents of ownership" we mean man- agement, income, and risk. Personal owners can to a limited extent separate the incidents of ownership. A lease will put management entirely on one side, to- gether with a part of income and a part of risk, and set the rest of income and risk on the other side. In the same manner a mortgage will effect the division, but place the manage- ment entirely on the opposite side, with part of the income and part of the risk, and leave together the rest of income and risk. THE INSTRUMENTS 5 If a man owns property and leases it, he hands management entirely to others. By mortgaging the property, he»Tetains manage- ment entirely to himself. Though a partner- ship may further divide the ownership after the incidents have been split, it has no means to distribute the incidents themselves in any other manner or proportions. And a trustee holding formal title does not effect any other distribution. The situation will becdme somewhat plainer by putting it more concretely. John Smith owns a farm worth $5000. Ho has all the incidents of ownership. JVtanagement and risk rest entirely with him; income goes en- tirely to him. In the course "of time he feels unable to carry all the burden of management. Maybe he would like to keep part of the management, exercise some control, and con- tinue a fairly large share of the risk. By hir- ing a man to run the farm, hetcould relinquish administration and retain control, but he would continue all the risk. He would suc- ceed in dividing management into adminis- tration and control, but he would not succeed in dividing risk at all. He is unwilling to con- tinue all the risk unless he also continues the entire management, and this is just what he is seeking to avoid. He can let the farm on shares; that is, the 6 CAPITALIZATION rental is not to be fixed, but to be a certain proportion of the income. But this would be to relinquish management entirely, yet retain the full nature of his original risk. He has, so to speak, spUt risk perpendicularly but not horizontally. He can lease the farm for a fixed rental. Through this course he would part with all the management and decrease his risk and income. By selling the farm and taking a mortgage back, he would likewise part with the entire management and further decrease his risk and incomq. If, instead of a first, he takes a second mortgage, he will not diminish risk and income so much. Personal ownership aflFords no course be- tween, on the one hand, an absolute retention of all management, or at least control, in the case of a possible hiring of administration, with the retention of a large share of the risk and income, and, on the other hand, an abso- lute parting from management, with a conse- quent parting from a large share of income and risk. Further, the limited number of possible divisions afforded of the incidents of ownership forces the apportioning of income and risk along fairly rigid lines. Through a peculiar personification of owner- ship and enterprise, the corporation makes possible a parceling-out of the incidents of ownership in many combin^ions, an allot- THE INSTRUMENTS 7 ment of management, risk, and income in varying proportions. The line of apportion- ment no longer remains rigi(J, but becomes very flexible. Actual practice has already carried far the division, sub-division, and rearrangement. The corporate form immediately divides, or marks the line of division of management, into administration and control. Sharehold- ers possess control, but through directors delegate administration to oflBcers. Varying rights given special classes of stock make a widely varying apportionment of income, con- trol, and risk. Common shareholders accept a maximum of risk in expectation of a maxi- mum of income. They may share the incident of control equally or in varying proportions with other classes of stock. Sharing con- trol in varying proportion does not mean here through unequal divisions in the total amounts of common and other classes of stock, but that each share of one class represents an essentially different amount of control from each share of the other. If two classes of stock enjoy exactly equal rights, except that one has a preference as to income and perhaps assets, they do not divide control, but risk, and the combination of con- trol plus risk in one, as compared with the combination of control plus risk in the other. 8 CAPITALIZATION makes the ownership represented by one class entirely different from- the ownership represented by the other. But the rights may differ, aside from the preference of one as to income and assets or either. We may speak of these divisions and com- binations of income, control, .and risk, creat- ing different kinds of ownership, as horizontal divisions. With that idea in mind we may make a diagram like this representing a sim- ple case: — Capitalization, $3,000,000 $1,000,000 common stock Greatest risk: half present control; no limitation of income. $1,000,000 preferred stock Less risk: half present control; limited mcome. $1,000,000 first mortgage bonds Least risk : littlfe or no present control, but contingent complete control; lim- ited income. Now, if we make some further stipulations about this corporation, as that its net earnings are $200,000, that the preferred stock is 6 per cent non-cumulative, and that the bonds are 5 per cent, without any rights of control con- tracted for except the right qf foreclosure on default of payment of interest or principal, we can make the diagram a little more de- finite; — THE INSTRUMENTS Capitalization, $3,000,000 $1,000,000 common stock $1,000,000 preferred stock 6 per cent non-cumulative $1,000,000 5 per cent first mortgage bonds Great risk: 50 per cent of actual pre- sent control; 45 per cent of present in- come which may increase in amount. Much less risk: 50 per cent of present control; 30 per cent of present income, which cannot increase in amount. Lieast risk: no actual present but full contingent control; 25 per cent of in- come which cannot increase in amount. We have not yet mentioned another divis- ion of ownership, that represented by the number of shares of stock or the number of bonds. Though in practice corporation financ- ing carries this division much further than private financing, the division itself is not pecuHar to the corporate form. It appears in the partnership as complete in its nature as in a corporation, and makes a division into amount of ownership rather than kind, — into quantity rather than quality. To carry out the metaphor of a horizontal division as indicat- ing a division into kinds of ownership, we may call this division indicating quantity of ownership a perpendicular division. Further, to carry the metaphor into a dia- gram with the same facts as before, we have : — Common stock, par, $100. Ownership divided into 10,000 parts. Preferred stock, par, $100. Ownership divided into 10,000 parts- Bonds, par, $1000. Ownership divided into 1000 parts. 10 CAPITALIZATION Now, these two kinds of divisions of owner- ship accomplish two very diflPerent results. The perpendicular division of amounts of ownership makes possible the fitting of every man's pocket-book or financial ability. As already stated, however, this is not peculiar to the corporation. A partnersliip can accom- plish it, and to a limited extent in practice has accomplished it. One of three or more part- ners may have one third or one fourth or any other fractional amount of the total owner- ship. Nothing in the nature of a partnership prevents this from being carried very far, pos- sibly even so far as the quantity divisions of ownership in the United States Steel Corpor- ation or the Pennsylvania Railroad, whose security-holders number tens of thousands. The horizontal division into kinds of owner- ship makes possible a more difficult fitting than fitting a man's pocket-book. It makes possible the fitting of his ty^e or state of mind. One man may be more or less willing to take a chance than another. The same man may be more willing at one time than another. He may be unwilling to take any risk whatever without having some control. We saw by the example of the man owning a $5000 farm how difficult it might be, under personal ownership even in a very simple case, to meet a man^s state of mind regarding THE INSTRUMENTS 11 what he wants of the incidents of control, risk, and income. We cannot consider corporate financing apart from ownership, nor ownership apart from owners. Ownership and owners enter into the consideration as necessarily as the various gases enter into the composition of water. Personal ownership has not developed the ability to fit types and states of mind closely. The fact that corporate ownership has, accounts for a great part, perhaps for the greatest part, of the success of the corporate form of enterprise. A corporation's stock regularly carries the largest share of actual present control and also regularly the largest share of risk. Organ- izers of a corporation may contract out to holders of other classes of securities some of the control exercised by the stock, and to that extent place control with the .other class of se- curities. For example, a corporate agreement may stipulate that the corporation shall not extend its plant until earnings equal at least twice the interest on its first mortgage bonds. Such a stipulation cuts off a very material power, or part of control, from the stock and places it with the bonds. If made at the time of organization the stock never possesses the power. But the stock may possess the power 12 CAPITALIZATION at the time of organization and later part with it for the sake of gaining some other advantage. The usual gain in parting with an advantage of this kind already pos- sessed is the securing of additional capital in the enterprise, which will not come in ex- cept on this stipulation, or because of it will come in on sufficiently better terms than otherwise. Though regularly carrying the largest share of actual present control, the stock may itself divide into two or more classes having obvi- ously divergent interests, with the result that each class will exercise for different purposes the amount of control it possesses. If there is common stock and preferred stock with a lim- ited dividend, the common shareholders may throw their influence in favor of a more haz- ardous conduct of the enterprise with an ex- pectation of greater profit accruing to them. Since the preferred shareholders, however, do not get income beyond the limited dividends, if the corporation pays these limited dividends to their full amount, the preferred shareholders will throw their influence in favor of the safer conduct of business against the hazards the common shareholders would gladly undertake for the hope of greater profits. Interests of both classes of shareholders might coincide. If the corporation should not THE INSTRUMENTS 13 earn enough to pay the full dividends the pre- ferred stock is entitled to, the preferred share- holders might desire the more hazardous con- duct of the business as eagerly as the common shareholders. If the amount of preferred and common were the same, and each had the same voting power, each class would enjoy control equally. In practice this might not lead to a dead-lock in policy, even though the interests of the two classes were diverse: one shareholder owning a large amount of com- mon and a small amount of preferred might vote his preferred to favor his common. If the amount of common were twice as great as the amount of preferred, and a share of each class had the same voting rights, the quality of control would in a way differ just as truly as if the amounts of each class were equal but a greater voting power were given the common than the preferred. In either case the common shareholder in a dash of inter- ests would be more likely to have the corpor- ation's policy incline to his advantage. We shall discuss this more fully later. A corporation having only one class of stock outstanding, and no other securities, offers, of course, the simplest type of stock. Such a se- curity carries all the control, all the income, and all the risk. It effects onlya vertical divis- ion of ownership, like the di\^ision of a part- 14 CAPITALIZATION nership. An enterprise financed entirely with one class of stock gains, of course, the regular corporate advantages, — an jeasy separation of administration and control, an easy verti- cal division into a large number of shares that makes a market possible, and limited liabil- ity. Such financing does not take advantage of the appeal to different types of mind. It is the proper form, however, if a satisfactory division of income, management, and risk cannot be made. A mining corporation espe- cially cannot well divide the peculiar hazards of the enterprise. Since any class of mining securities must retain so much risk, investors will not sacrifice anything of income or con- trol. A satisfactory adjustment cannot be made. So it naturally follows that nearly all mining corporations, including oil companies, have only one class of stock and no other se- curities. If they do have any preferred stock or bonds, such issues are alinost always of comparatively small amounts. Coal-mining companies have issued bonds to some extent. The business rests on a more assured basis than mining for metals. Manufacturing companies frequently issue no securities but their commpn stock. Prob- ably the general greater simplicity of our in- dustrial corporation financing comes about from the fact that the enterprises they are THS INSTRUMENTS 15 engaged in inherit directly old established kinds of business. Traditionally they ciing more closely to the form of private enter- prise. So far our financial ingenuity has di- rected itself for the most part:to the compara- tively new forms of business, — the railroads and other public-service corporations. With the coming of the big industrial combinations more complex forms of financing appear, and will probably make their way generally into industrial corporations. Even of our big in- dustrial enterprises many are still largely family affairs, — such, for example, as the Arlington Mills manufacturing cotton and wool at Lawrence and Meth^ien, Massachu- setts, which have their entire capitalization of $6,000,000 in common stock. The business may have been hazardous in the beginning and, like mining, not have offered the basis for more than one form of security, and sub- sequently may not have needed any other for Jts financing. The Mergenthaler Linotype Company has its entire capitalization of $12,786,700 in common stock on which it pays .15 per cent dividends. Some very large concerns have no capitali- zation but their common stock. The Singer ^Sewing Machine Company has its entire cap- ital in $60,000,000 common. The Pullman Company has no securities but its common 16 CAPITALIZATION stock, amounting to $120,000,000. Though a holding company may have only common stock outstanding, that fact does not neces- sarily indicate simplicity, for the subsidiary companies may have complex capitalizations. An issue of preferred stock at once creates two kinds of ownership, — ofie, that of the preferred shareholder, with the less risk and presumably a corresponding limitation of in- come; the other, that of the common share- holder, with the greater risk and no limita- tion of income but the earning power of the business. If a corporation has no securities but stock outstanding, obviously the pre- ferred and the common share the entire ownership. In that case the common share- holder gets the advantage of trading on the equity, or taking a greater risk in expectation of a greater income, which y^e shall discuss later, without running the risk he would, if there were bondholders, of having the pro- perty taken entirely out of his control under adverse circumstances. To offset the advan- tage just mentioned, the holder of common stock must share immediate cpntrol with the preferred stockholder. Conversely, the pre- ferred stockholder gets the advantage of less risk and the advantage of a large share of immediate control. Compared with a bond- holder, he accepts the disadvantage of not THE INSTRUMENTS 17 being able to get possession of the entire con- trol for his own benefit in case his income is less than he anticipates. Income on preferred stock is limited usu- ally to some definite amount. Commonly this runs all the way from 4 per cent to 8 per cent. Commonly, too, this limited income off- sets the lessened risk gained by the prefer- ence. Some large issues of preferred stocks showing varying dividend rates that are fixed are: Union Pacific Railroad, 4 per cent; Baltimore & Ohio Railroad, 4 per cent; Kan- sas City Southern Railway, 4 per cent; Southern Railway, 5 per cent^; Interborough- Metropolitan Company, 5 per cent; St. Louis Southwestern Railway, 5 per cent; American Agricultural Chemical Company, 6 per cent; Boston & Maine Railroad, 6 per cent; United ^States Rubber Company, second preferred, 6 per cent; Central Leather Company, 7 per cent; Crucible Steel Company, 7 per cent; International Harvester Company, 7 per cent; United States Steel Corporation, 7 per cent; United States Rubber Company, 8 per cent. Preferred stock may not reach its limit of income at the stated dividend rate, but its pre- ference may end there. It may have the right, after the common receives a certain dividend, to share with the common in any further dividend disbursements. If it has this right 18 CAPITALIZATION to further income, it adds the name of "par- ticipating" stock. For exan^ple, a holder of the preferred stock of the Chicago, Milwau- kee & St. Paul Railway is ehtitled to 7 per cent before the company can pay anything on the common. After the company has also paid 7 per cent on the commqn, the preferred shareholder has a right to share equally with the common shareholder in kny further dis- tribution of dividends. If the company should pay the common shareholder 8 per cent, it would also have to pay the preferred share- holder 8 per cent. It may be that whatever the company pays on the common it will have to pay that much extra on the preferred. That is the case of the Chicago & Alton Railroad, which has a comparatively small amount of preferred stock outstanding. On this Stock the com- pany must pay 4 per cent dividends before paying any dividends on the common; then, if it pays 1 per cent on the common, it must pay 5 per cent on the preferred. It did so pay extra dividends of 1 per cent, August, 1908; 4 per cent, August, 1909; 2 per cent, February 1910; August, 1910, none, ithe present Chi- cago & Alton Railroad issued the stock when the company in 1906 consolidated the Chi- cago & Alton Railway and the former Chicago & Alton Railroad, and wanted, by the use of THE INSTRUMENTS 19 this security, to get in comparatively small ^amounts of the preferred and common stocks of the old railroad company then outstanding. Other examples of 'participating stocks are: Bufifalo, Rochester & Pittsburgh Railway Company, 6 per cent preferred; after 6 per =cent is paid on both classes, both share equally. Wisconsin Central Railway, 4 per cent preferred; after 4 per cent is paid on both classes, both share equally. Minneapo- lis, St. Paul & Sault Ste. Marie Railway, 7 per cent preferred; after 7 per cent is paid on both classes, both share equally. Westing- chouse Electric and Manufacturing Company, 7 per cent preferred; after 7 per cent is paid on both classes, both share equally. In the case of the Chicago Northwestern Railway 7 per cent preferred stock: after the common stock has received 7 per cent, the preferred is entitled to additional divid^ids up to 3 per cent more, then common is to receive a fur- ther 3 per cent. Under this arrangement the preferred is receiving 8 per cent and the common 7 per cent. Unless there are some further restrictions, this seems a very honest course, as the common stock amounts to nearly six times the preferred) and its holders would naturally rather have a surplus accumu- late till the full 3 per cent extra could be paid on both preferred ajid commpn stocks. The 20 CAriTALIZATldN right to further dividends may not amount to full participation, but only to receive an additional sum, as in the case of the Pitts- burgh, Cincinnati, Chicago & St. Louis Rail- way 4 per cent preferred stock, carrying the right, after 3 per cent is paid on common, to an extra 1 per cent. The company is now pay- ing 5 per cent on its preferred and 4 per cent on its common stock. AUis Chalmers Com- pany preferred is entitled to 7 per cent, and, after 7 per cent is paid on the common, the preferred is entitled to 1 per cent extra. Income from preferred stock may vary in another way through a right of conversion into common stock. If a preferred stock is convertible, its holder may under certain con- ditions exchange it for common stock. This is ordinarily called a "privilege" of conver- sion. Since it is stipulated for and cannot be taken away, it is really a right rather than a privilege. It may be exercised immediately, or after a certain date, or within certain dates, according to the conditions. It may be exchangeable par for par, or in any other proportions provided. Since the right has not been given to preferred stocks nearly so often as to bonds, the conversion idea will be dis- cussed more fully in connection with bonds. It is enough here to note that it is applied to stocks. ^Of course the conversion of a pre- THE INSTRUMENTS 21 ferred stock into common does not make nearly so great a change as the conversion of a bond into stock. As the preferred stock generally possesses equal voting power with the common, conversion of the stock would not ordinarily make any change in the quality of control, except as aflfected by the quantity of each class outstanding. The holder gives up a lesser risk in favor of a greater income. The Associated Merchants Company has an issue of 5 per cent first preferred and one of 6 per cent second preferred. The holder of the first preferred may exchange into either com- mon or second preferred. Dominion Iron and Steel Company has an issue of 7 per cent pre- ferred, convertible at any time into common. Dominion Coal Company preferred did carry a right of conversion which ; expired May 1, 1910. AUis Chalmers preferred is convertible into common any first of May up to and in- cluding May 1, 1921. The element of lessened risk gives preferred stock its name. Of all the stock in the cor- poration that part which is "preferred" must receive dividends to a certain amount be- fore the corporation can pay any on that other part, which in distinction from the pre- ferred is called "common." If the corporation has no preferred shares, its stock is still fre- quently called common to indicate the lack 82 CAPITALIZATION of preference. Such nomenclature, however, seems unnecessary. If the corporation does not pay the stated rate of dividend on the preferred stock in any year or series of years, and, by stipulation, it must make up the deficiency out of earnings of later years before it can pay any return to deferred shareholders, the stock is called "cu- mulative." Otherwise it is "non-cumulative." In the event of a dissolution of the corpora- tion all shareholders without special stipula- tion, both common and preferred, will share equally in the distribution of assets. The pre- ferred stock may carry the stipulation, how- ever, that preferred shareholders are entitled to receive up to the par value.of their stock in any distribution of assets before the common shareholders are entitled to anything. In that case the stock is said to be "preferred as to assets." By statute preferred stock may be preferred as to assets witholit such special stipulation. This is the case in New Jersey. Ordinarily the right of control vested in preferred stock ranks equally with the amount of control vested in the common. Sometimes the control vested in the preferred is not as great as that vested in the common. Usually in such cases so long as the income stipulated for remains unimpaired the pre- ferred shareholders accept a • less control. If THE INSTRUMENTS 23 the control vested in the preferred is greater than that vested in the common, usually it is for some specific purpose; especially, the pre- ferred often can veto any increase of bonds or the amount of the preferred itself. Such an extra power obviously protects the lesser risk the preferred shareholder stipulates for. It will be noted that in many cases the extra con- trol represents a special caution of takers of securities issued as a result of a reorganization. Examples of this veto power are: — Atchison, Topeka & Santa F6: A majority of all preferred outstanding must consent to any increase in preferred or to any new mort- gage. (Reorganization.) Erie: A majority of a\\ first preferred out- standing must consent to any increase in first preferred or any new mortgage. (Reorgan- ization.) A majority of all second preferred outstanding must consent to any increase in ^either second or first preferred or any new mortgage. (Reorganization.) Chicago, Great Western Railroad: A ma- jority of all preferred outstanding must con- sent to any increase in preferred or any addi- tional mortgage. (Reorganization.) Southern Railway: A majority of all pre- ferred outstanding must consent to any in- crease in preferred or to any mortgage in excess of $120,000,000. (Reorganization.) 24 CAPITALIZATION Reading Company: A majority of all first preferred outstanding must consent to any increase in this stock or any additional mort- gage; except that if the com|)any paid 4 per cent dividends for two years it could issue 420,000 ($50) shares to convert the second preferred. A majority of all second preferred must consent to any increase of either first or second preferred or any additional mortgage. (Reorganization.) As examples of cases in which not a ma- jority of total stock, taking all classes to- gether, is necessary for action, but a majority of each class must approve, may be cited : St. Louis & San Francisco first and second pre- ferred and common and Oregon Railroad and Navigation Company preferred and common. In both cases a majority of each class must consent to the issue of further stock of equal rank, or the placing of any mortgage. This, however, is the common situation. Two thirds of all preferred stock outstand- ing of the Norfolk & Western Railway must consent to any increase in preferred or any new mortgage. (Reorganization.) If the Wisconsin Central Railway should fail for two successive years to pay 4 per cent dividends on its preferred,, the preferred shareholders would have a right to elect a ma- jority of directors. This is apother example THE INSTRUMENTS 25 of special control vested ifi the preferred further to safeguard the lessened risk. Control vested in preferred stock may have a limitation in that the corporation, on the vote of the common stock, may have the right to redeem the preferred under stipu- lated conditions at a stipulated price. In that event the stock is called "redeemable." Such a limitation takes away much of the value of the stock for purposes of control of the cor- poration, but does not affect the power of the preferred shareholders to protect their in- terest while the stock remains outstanding. Common shareholders exercised their right to redeem the preferred in a most dramatic way in the course of the convict in 1901 be- tween E. H. Harriman and J. J. Hill for rail- road ownership in the Northwest. A group of men known as the "Harriman-Kuhn, Loeb Syndicate" endeavored to get control of the Northern Pacific Railroad. The road had : outstanding $80,000,000 common stock and $75,000,000 preferred. J. J.. Hill and J. P. ^Morgan owned common stock amounting to $26,000,000. Harriman and his backers bought into Northern Pacific until they had $37,000,000 common and $42,000,000 pre- ferred, — a clear majority of $1,500,000 of all the stock of the road. Tlie Hill interests bought further into the road until they had 26 CAPITALIZATION $42,000,000 common, — a clear majority of $2,000,000 of the common. Then the Harri- man people discovered their weakness. The preferred possessed equal voting power with the common, but was subject to redemption at par up to January, 1917. The Hill in- terests, having a majority of the common, announced their intention of redeeming the preferred! They did redeem it. All the Harriman people got out of their contest was one representative on the I>{orthern Pacific board. The Southern Pacific Company had an issue of nearly $75,000,000 ($74,866,463) 7 per cent preferred stock, redeemable at the option of the company at 115 at any time be- tween July, 1905, and July, 1910. The com- pany redeemed the stock in July, 1909. This stock, by the way, was convertible; holders had the right after July, 1905, to convert into common at par. When the company called the stock for redemption, it gave holders the choice of taking the redemption price of 115, of converting into common under the con- vertible right, or of taking 4| per cent bonds par for par plus $20 in cash for each share. Whether one large preferred stock issue, that of the Southern Railway, is redeemable or not, is perhaps open to question and has not been officially decided. THE INSTRUMENTS 27 The May Department Stores Company, operating department stores in St. Louis and other cities, put out a preferred issue, for the retirement of which they created a sinking- fund. The issue amounted to $5,000,000. The company must set aside $150,000 yearly be- fore any dividends are paid on the common, in order to retire preferred at not over 125, at which the stock is callable. For the first three years the company may add the sink- ing-fund to the general surplus. It could not, however, declare a dividend on the common till it had $250,000 in the special surplus, nor more than 4 per cent in any year till the special surplus account amounted to $1,000,000. Examples of issues of redeemable preferred stock are : — Erie first preferred, redeemable at par; Erie second preferred, redeemable at par; St. Louis & San Francisco first preferred, redeemable at par; St. Louis & San Francisco second preferred, redeemable' at par; Domin- ion Coal, redeemable at 115; American Smelt- ers Securities Company, subject to call on any interest date after 1930. National Lead Company, redeemable at par beginning 1910; The Mackay Companies, redeemable at any time at 106; American Cotton Oil Company, subject to call at 105; Borden's Condensed Milk Company, subject to call at 110. 28 CAPITALIZATION Instead of having extra cpntrol the pre- ferred may have less control vested in it than the common. The American Tobacco Com- pany preferred shareholders had no right to vote at any meetings except 'those convened for increasing or decreasing the capital stock, dissolving the corporation, "or passing upon other matters with respect to which the statute expressly gives the potver to preferred stockholders to vote." The American Smelt- ers Securities Company gives its preferred shareholders no voting power unless divi- dends for one year remain unpaid. Since it is the essential idea of a stock that its holders possess immediate control of the company, such securities as these are on the border-line between stocks and bonds. They help show, however, the possft)ilities in a cor- poration of dividing and recombining the ele- ments of ownership. A stock like Dayton & Michigan Railroad preferred, which carries no voting power whatever, is hardly a stock at all, but essentially an income bond. So far consideration of particular stocks has brought out only special features of each. Several representative stocki^, giving all the features of each, are: — Boston & Maine Railroad 6 per cent non-cumulative pre- ferred; Atchison, Topeka &. Santa Fe Rail- way 5 per cent non-cumulative, preferred THE INSTRUMENTS 29 both as to dividends and assets, requiring consent of a majority of tKe preferred out- standing for any increase in the preferred or any further mortgage; Interborough Metro- politan Company 5 per cent cumulative, pre- ferred both as to assets and dividends; Minne- apolis, St. Paul & Sault Ste. Marie Railway 7 per cent non-cumulative, sharing equally with common after common pays 7 per cent; The American Cotton Oil Company 6 per cent preferred, non-cumulative, subject to call at 105; Associated Merchants Company 5 per cent cumulative first preferred (pre- ferred both as to dividends and assets), con- vertible at par into either common stock or second preferred. On first thought it may appear that the only control bonds have is putely contingent. If the corporation does not pay interest the bondholders possess either a right to have a receiver appointed to manage the property in their interest, or to foreclose aind sell the pro- perty for their benefit; that is, they have a xight to assume the entire control, but only under certain contingencies. As a matter of fact, the corporate mortgage has become a most elaborate document, and through it the bondholders secure to themselves very sub- stantial amounts of actual present control. This does not mean that bondholders have a 30 CAPITALIZATION right to appear at shareholders' meetings and cast a vote in any way. The control they pos- sess is of a definite kind and consists not of the right to initiate policies, but rather of lim- itations, in favor of the bondholders, on the power of the shareholders. If the corporation has only voting stock, the general law and the corporation's charter lay down the only limit- ations on the shareholders' control or direc- tion of the business. When the corporation issues bonds, however, investors will prob- ably insist, as a condition precedent to pur- chase, on limiting within narrower lines the scope of action of the shareholders. The very issuing of bonds is in a way a granting of control to the bondholder. It compels the shareholder to be in the position of a borrower for the term of the bonds. It gives the bondholder controjl to the extent that he can for a term of years insist that a certain part of the corporation's income be used in a special manner, namely, to pay in- terest on his debt. If the bonds are callable the shareholder has refused to part with so large an amount of control as giving the right to the stipulated income for the maximum term involves. Suppose an isSue of 5 per cent 20-year bonds callable at any time as an en- tire issue at 105. In the absence of other lim- itations the shareholders can by paying the THE INSTRUMENTS 31 amount stipulated cancel all the ownership of the bondholders. As illustrations of the way in which a part of control may rest in the bondholder through limiting the power of the shareholder, we may call attention to several issues. Armour & Company has outstanding $30,000,000 real estate first mortgage 4| per cent 30-year bonds, due June 1, 1939. They are a first ^mortgage on real estate valued at $40,000,- =000. The mortgage provides that the unin- cumbered quick assets of the company and its auxiliary companies shall at all times ex- ceed the aggregate debt of the company and auxiliary companies, including the outstand- ing bonds of this issue. The company can pay dividends only from earnings made subse- quent to the fiscal year ending October 24, 1908. Such a stipulation gives the bond- holders a very definite share of control in the conduct of the business. Shareholders have parted with control to such an extent that they can create further indebtedness only under special conditions, namely, that the corporation has quick assets of a certain amount. They have so far parted with con- trol that they cannot reahze on their quick assets to an extent that will reduce them below a certain proportion. American Telephone and Telegraph Com- 32 CAPITALIZATION pany has 4 per cent debenture bonds, due March 1, 1936, outstanding to an amount of $22,724,000 out of an original issue of $150,- 000,000. They are convertible into common stock at 126.44 before March 1, 1918, and are redeemable after March 1, 1914, at 105. The company cannot create any mortgage, or any collateral trust indenture covering securities now owned, or purchased with proceeds of these bonds, without including these bonds as also secured on the new assets. During the term of the bonds the company cannot have outstanding unsecured bonds or notes in ex- cess of $150,000,000, except obligations pay- able within one year not exceeding $10,000,- 000, unless additional money from the sale of stock shall be paid into the treasury, in which case the company may issue additional unse- cured bonds or notes to an amount equal to the money paid in. So the bondholders again in this case exercise control to the extent of limiting the debt-creating power of the share- holders. Bondholders of the Westinghouse Electric and Manufacturing Company exercise con- trol in many directions. The company has an issue to the authorized amount of $20,000,- 000 of 5 per cent bonds, due January 1, 1931, convertible into assenting (now common) stock at 200. These are debenture bonds and THE INSTRUMENTS 88 contain a covenant that no mortgage shall be placed on the properties described in the trust indenture. The company cannot issue notes in addition to the outstanding $6,000,- 000 except against after-acquired securities of the appraised value of 120 per cent of the new notes issued. It cannot issue further bonds unless net earnings are at least double the in- terest charge of the company and its subsid- Jaries, including the securities proposed to be issued. The company may issue these bonds, up to an amount of $5,000,000, beyond the $20,000,000 immediately authorized, equal in amount to the proceeds paid in from the sale of new stock. Quick assets must equal the aggregate amount of indebtedness, including the indebtedness of subsidiary companies ex- ^clusive of collateral notes. Indebtedness out- side of the bonds cannot exceed 25 per cent of the par of the bonds outstanding. The company cannot issue any stock entitled to preference over the assenting (now common) stock. It cannot sell any stock for less than 10 per cent below the market price of the assenting (now common) stock. Chicago Bell Telephone Company first mortgage 5 percent bonds, due December 1, 1923, $5,000,000 outstanding, $50,000,000 authorized, carry control in Several respects: 1. The company cannot issue bonds additional S4 CAPITALIZATION to the $5,000,000 for one yiear after their issue; then not in excess of $5,000,000 per annum. Such a provision is common. It is an assurance to the underwriters or pur- chasers of the security that the company will not throw more bonds on the market within a given period. This gives time for the public to absorb the issue, and guards against the price-depreciating influence of an additional supply of the security, which is particularly acute if the first amount issued is not fully ab- sorbed. It also gives the corporation a chance to get the benefit of the capital raised by the bonds already issued and reflect it in larger earnings. So that the price of the security will not be further depressed by lowering the percentage of earnings above fixed charges. 2. Total outstanding bonds of the company must not exceed 50 per cent of the value of its property, or 60 per cent of the value of its real estate. 3. After the company has $15,000,000 of these bonds outstanding, it cannot issue further bonds to exceed 75 per cent of the cost of additional improvements and extensions. Of the Nashville (Tennessee) Railway and Light Company Refunding and Extension 5's, due July 1, 1955, $2,000,000 are issued, $6,000,000 are reserved to retire underlying bonds, and $7,000,000 are issuable only: (1) For 80 per cent of the cost of improvements THE INSTRUMENTS 35 and additional property acquired since Janu- ary 1, 1908; also on condition that (2) the outstanding bonded debt must not exceed five times gross earnings for previous twelve months; (3) net for previous twelve months must equal at least one and one half times total interest charges; (4) at least 10 per cent of gross earnings for the preceding twelve months must be expended for maintenance and included in operating. Birmingham (Ala- bama) Light and Power Company 6's contain similar provisions. York (Pennsylvania) Railway 5's, due De- ^cember 1, 1937, authorized .to the sum of $10,000,000 and outstanding to the amount of $3,400,000, stipulate: "Of the balance of the bonds $2,000,000 are reserved for the specific purposes provided in the mortgage and the remaining bonds, $4,600,000, can only be issued at the cost price of the purposes specified, provided the net earnings, after payment of all interest and taxes for twelve months prior to the date of issuance, shall be rat least equal to interest and taxes for one year on all outstanding bonds and any or all of the purposed additional bonds." As another example of control vested in bonds for the purpose of limiting the power of the shareholders to create debt, the Na- tional Enameling and Stamping Company 36 CAPITALIZATION has authorized and outstanding $3,500,000 refunding, first mortgage real estate, sinking- fund 5's, due June 1, 1929, which provide that the hquid assets of the company must at all times equal the aggregate debts of the company, including outstanding bonds of this issue. Peoria Railway Company first and refund- ing 5's, due serially, February 1910-26, au- thorized $3,600,000, contain a stipulation controlling the disposition of part of the earn- ings in the covenant of the company to main- tain a depreciation and maintenance fund from 1909 to 1925 to aggregate $1,865,000. The serial maturity retires only 40 per cent of the issue before 1926. So far the examples given have illustrated only how in particular cases the bondholders of a corporation exercise control. The nature and amount of control that they exert vary according to special stipulations. Bonds, how- ever, divide into several distinct classes, each with its identifying control characteristic. Only such general characteristics will enter into the further discussion. Of course, in ad- dition to these, each issue, as already shown, may carry further peculiar restrictions of the shareholders' power. Of these classes (1) mortgage, (2) debenture, and (3) income bonds naturally group together. THE INSTRUMENTS 87 A mortgage bond, as the 'name indicates, represents a fraction of a mortgage placed upon part or all of the property of the issuing corporation. It gives the strongest kind of contingent control. Under the stipulations of the mortgage, in case of failure of the corpora- tion to pay principal and interest when due, or on any other default of like rank, bond- holders, acting by such majorities and in such manner as the mortgage provides, can take possession and operate the property them- selves, or sell it under their right of fore- closure. In this way they can directly take the mortgaged property entirely away from the shareholders. So far as the incidents of ownership are concerned, obviously a second mortgage dif- fers from a first in accepting a greater risk and demanding a compensating greater income. The control it exercises is the same in kind as the control of a first mortgage: namely, the actual present control in limiting the freedom :of action of the shareholders by the obligation to pay principal and interest, and complete contingent control, in case the shareholders' management should fail in this obligation. The contingency giving the second mortgage bondholder active control happens sooner than the contingency giving the first mort- gage bondholder active control. The same 38 CAPITALIZATION principles apply to a third oriany subsequent mortgage. It should be mentioned here that a bond may have the security of a first mortgage as to part of the property, and a second mort- gage as to the rest. Such bonds do not call for special discussion at this time. They are gen- erally recognizable under names like "first and refunding mortgage bonds," or "first and consolidated mortgage bonds." Debenture bonds, on the other hand, do not bestow upon their holders the powerful right to contingent direct control conferred by a mortgage right of foreclosure. The holder of a debenture, speaking broadly, and assuming the absence of special stipulations, has only the rights of a general creditor, and has less power than the mortgage bondholder to take control from the hands of the shareholders. Usually the debenture bondholder has the ad- vantage of particular stipulations that put him in a stronger position than an ordinary creditor, but still leave him far from being as firmly intrenched as a mortgage bondholder. The existence of debenture bbnds usually in- dicates one of two very different situations, — - either from the unavailability of mortgages, which seldom are considered of any advan- tage beyond the second and almost never beyond the third, or because .the corporation THE INSTRUMENTS 39 Is so strong that it does not need to oflPer a mortgage security. As an 'example of de- benture bonds may be mentioned the New York, New Haven & Hartford convertible 3|'s, 1956, and various other issues of this company. It may be noted that this cor- poration has no mortgage bonds of its own outstanding. Subsidiary companies have mortgage bonds. The Boston & Maine has debenture 4^'s, 1929, and other debenture issues. This corporation also has not issued any direct mortgage bonds. The Boston & Albany has debenture 4's, 1933, and others. This road (now leased to the New York Cen- tral) presents a case of a line financed, as it stands at present, without any mortgage. The Chicago, Milwaukee & St. Paul has de- benture 4's, 1934, $28,000,000 issued, $50,- 000,000 authorized. The Chicago & North- western 5's, 1933 ($5,000,000). The New York Central & Hudson River Railroad 4's, 1934 ($34,000,000). Income bonds give the holder almost no control, either immediate or contingent. The stipulation of their issue is only to pay inter- est if earned. So failure to pay interest, unless earned, does not confer upon the holder any right to take control from the owners of the stock. Obviously the income bondholder has less control than the owner of any other secur- 40 v.Ari 1 AL,1ZAT1UJN ity we have discussed; and together with this minimum of control he assumes considerable risk. It results that the income bondholder may find that he has purchased a lawsuit rather than a security. The Central of Georgia Railway furnishes one of the best-known examples of the in- come bond. That corporation has outstand- ing three issues, all put out in 1895 and due in 1945. They are non-cumulative and bear in- terest, payable only if earned, not exceeding 5 per cent in any one fiscal year. As a matter of fact, the corporation did not pay the full 5 per cent on the first incomes till 1901, paid only 3 per cent in 1902, then 5 per cent tiU 1908. It did not pay anything on the second incomes till 1904, then 2 per cent; 5 per cent in 1905 and 1906; 3.73 per cent in 1907; then entirely stopped paying. On the third in- comes it paid 5 per cent in 1905 and 1906, no- thing till then and nothing after. The income bondholders took the matter into the supreme court of Georgia. An auditor appointed by the court found that the railway company had wrongly kept back $542,000 net income of a subsidiary, the Ocean Steamship Com- pany, and other items, making a total of $860,909 available beyond what the corpora- tion itself had shown. The court thereupon held the company liable for full interest on THE INSTRUMENTS 41 the three classes of income bonds from earn- ings of 1906-07, and in February, 1911, the corporation paid the balance 'of 1.27 per cent on the second preferreds and the 5 per cent on the thirds. In November, 1909, the bondholders again brought action to recover full income interest on the three classes of bonds from earnings of 1907-08. In May, 1911, the company offered to pay, and did pay in June," the full income on the firsts for 1908, and 2.821 per cent on the seconds, and for 1909 and 1910, 2.312 per cent on the firsts. These payments were made without regard to any further claims the income bondholders might make. It is interesting to set down the operating ratios in comparison with the interest pay- ments on these income bonds before the de- cision of the court. '06 '97 '98 '99 '00 '01 •Oi •03 ■01 '05 •06 •07 '08 •09 Interest ' Kr3t incomes 1.6 2.25 « » 3.«5 B S 5 5 a S S Second incomes 2 5 s 2.73 Third incomes 5 B Operating ratio 86 69 71 74 73 72 70 76 74 79 These high operating ratios, especially the 76 per cent in 1907, the 74 per cent in 1908, 42 CAPITALIZATION and the 79 per cent in 1909', would raise a question, at least, if the company, in addi- tion to holding back the net earnings of its subsidiary, were not also, under the guise of maintenance (operating), sinking earnings in really capital expenditures expected to show results later in the form of dividends on stock. We have gone into this at such length to show a case of ill-advised apportionment of control, risk, and income. Omitting the ques- tion as to whether the anticipated income would compensate for the risk, very appar- ently the investors who bought the bonds should not have taken the risk without get- ting more control. If they had insisted on either the contingent control of a right of foreclosure, or the active control of voting power, they would not have got into a position offering such possibiHties of disputes. Other examples of income bonds are: Florida East Coast Railway, $20,000,000 ($25,000,000 authorized) 5 per cent non-cu- mulative second mortgage, due 1959; New Orleans and Northeastern Railroad, $1,500,- 000 4| per cent non-cumulatiYe income mort- gage, due 1952. Apparently the mortgage lien was stipu- lated for in these cases to give the right of foreclosure on failure to pay principal. Fail- THE INSTRUMENTS 43 ure to earn and pay interest does not give a right of foreclosure. All these bonds present the astonishing feature of being non-cumula- tive without any active control. Convertible bonds present a further class with respect to control. We have already dis- cussed the somewhat limited class of convert- ible preferred stocks. The number of con- vertible bonds is much greater and offers a more significant form of security. When a holder converts a preferred stock into a com- mon, he ordinarily affects only his risk and income and does not change the quality of his control. If a convertible bondholder, how- ever, changes his bonds into stock, he jumps immediately from a control that is merely restrictive or contingent to a control that is active and immediate. He has also probably made a greater change in his risk than a converting preferred shareholder. Conditions governing conversion are nu- merous, and the profitableness of convert- ing under allowed conditions is a matter of calculation. Convertible bonds offer a large enough field for a volume to themselves. We ,shall examine only several prominent issues to get an idea of the working of the class. The purpose of making any security convert- :ible into one of junior rank is to gain present safety combined with a chance to get some 44 CAPITALIZATION of the benefit of speculative profits on condi- tion of giving up the preferred position. We would call attention to the fact that the "participating" idea combines present safety in the senior security-holder with the benefit of sharing future speculative profits. The holder of a participating security does not have to give up the preferred jjosition to enjoy the greater income, and in that respect the common shareholder has made a less advan- tageous bargain. In the case of a convertible security, if the holder takes a'share of the en- hanced profits, he has to give up his advan- tageous position as to risk. The common shareholder has then lost some of his profits, but has gained a position of less risk. Take a concrete case to show the point: Suppose two corporations, A and B, capitalized: — Corporation A Cbrporation B (3,000,000 S per cent convertible bouds. $3,000,000 5,per cent participating boadi. £,000,000 commas stock. 5,000,000 common stock. Suppose in corporation A the bonds may be converted into common at 150, and that when the corporation makes 10 per cent on its total capitalization the stock does go above 150 in the market. In corporation B the bonds participate equally with the common above 5 per cent. Assume that in both corporations earnings advance to 10 per cent on the total capitaliza- THE INSTRUMENTS 45 tion, and in corporation A none of the bond- holders convert. Then: — Corporation A Corporation B Net $800,000 Net $800,000 Interest Surplus Bondholders get Shareholders get 150.000 Bondholders get . 650,000 Shareholders get 5 per cent Bondholders get 13 per cent Shareholders get 300,000 . 500,000 10 per cent 10 per cent In corporation A the bondholders cannot share directly in the prosperity of the com- pany without giving up their priority. Sup- pose they all convert. They get 5 per cent more income and the shareholders 3 per cent less and all security-holders get 10 per cent, the same as in corporation B. Now suppose a severe depression in the business sets in, and earnings on the total capitalization drop to 3 per cent. Then: — Corporation A Corporation B Net $310,000 Net (240,000 .Former bondholders, now shareholders, get . . 3 per cent Bondholders get . . S per cent Former shareholders and Shareholders get . , l,S per cent still shareholders get . 3 per cent If net earnings should drop 2 per cent more, they would not be sufficient to pay the 5 per cent to bondholders in corporation B. The shareholders' equity is wiped out, and the bondholders would get control. In corpora- tion A the former shareholders would still be getting 1 per cent and cannot, be wiped out. So much for the advantage to the common shareholder of the convertible bond over a possible bond with a participating stipula- 46 CAPITALIZATION tion. It has the disadvantage of projecting another element of uncertainty into the affairs of the corporation. It adds something incalculable from the financial scheme to the already many incalculable considerations in the nature of the business. As a matter of fact, for example, not every convertible security-holder gives up his priority in order to gain a greater income. Very many do not. The directors of the corporation cannot calcu- late how many will. They cannot foresee just how much will be required for interest, and consequently how much available for divi- dends and how many shares it will have to be distributed among. On an actual conver- sion also the common shareholder suffers a lessening of the quantitative control in his stock. In the case of corporation A we have just taken, the shareholder having 10,000 shares starts out with one fifth of the active control. If all the bondholders convert, this owner of 10,000 shares finds that he now has only one eighth of the active control. This makes a very appreciable difference in the value of his holdings from a control stand- point. Some specific examples of convertible bonds are: — Atchison, Topeka & Sante Fe convertible debenture 4s, due June, 1955. They are re- THE INSTRUMENTS 47 deemable on any interest date after pub- lished notice at 110 and interest, and are con- vertible at par, at any time prior to June 1, 1913, into common stock at 100. If they are called for redemption in the mean time the conversion privilege may be exercised, but not later than May 31, 1913, and shall cease upon the day preceding the one named for payment. At the time of writing, the stock is on a 6 per cent dividend basis and selling at 103. The right of conversion is operative. A thousand-dollar bond can be exchanged for ten shares of stock worth $1030. We should expect to see the bonds selling at 103. As a matter of fact, they are selling at 104f. Con- vertible bonds do not always follow the price of the stock down. Notice, too, that it does not follow that a convertible security will al- ways be converted as soon as it is profitable to do so. These Atchison bonds cannot, at the time of writing, be considered worth more than par on their merit as an invest- ment. Delaware & Hudson Company convertible debenture 4s, due June 15, 1916, are convert- ible up to June 15, 1912, into common stock at 200. The stock pays 9 per cent and is sell- ing at about 162. Since the bonds are worth on their investment merit 97f , the price they are selling at, the stock would have to ad- 48 CAPITALIZATION vance above 194^ plus commissions in order lo reach a profitable conversion point. Union Pacific Railroad Company convert- ible debenture 4s, due July, 1927, are redeem- able as a whole, but not in part, on or after July 1, 1912, at any interest date after ninety days' notice, at 102^. The right of conversion continues up to thirty days of the date of re- demption. They are convertible at par, on or prior to July 1, 1917, into common stock at 175. The bonds are selling nqw at 101, some- what above the present investment value, though the stock is selling at only 161, or considerably below the par of conversion. Pennsylvania Railroad Company convert- ible debenture S^s, due October, 1915, are redeemable at 100 and interest at any interest date on ninety days' notice, with a right to convert up to thirty days before the redemp- tion date. They are convertible at any time into stock at 75 (par value, 50), equivalent to 150 as quoted on the New York Stock Ex- change. The bonds are selling at 96j, the stock at 120j. The bonds would have to be at 80 in order not to lose by conversion with the stock at that price. American Telephone and Telegraph Com- pany convertible debenture 4s, redeemable March, 1915, or on any dividend date there- after, on twelve weeks' notice, at 105 and THE INSTRUMENTS 49 jnterest, with the right of copversion contin- uing up to thirty days of date of redemption. They are convertible, up to March 1, 1918, at par into stock at [26.44. The bonds are seUing at 106, or away above the investment value. n TRADING ON THE EQUITY We shall borrow from an English usage the term "trading on the equity," as express- ing better than any other brief phrase a fun- damental business procedurfe. Its origin is from the expression "equity of redemption," which describes a mortgagor's right in the property he has mortgaged, that is, the right to get back the title he has pledged to the mortgagee as security for the capital ad- vanced. The business man mortgages his property to get more money in his business, in order that he may engage in it on a larger scale, and all to the end that he may make a greater return on his own capital invested. To do this he undergoes the disadvantage that he must assume the greater risk. We shall not use the term "equity" in its strict legal sense, but in the common loose accept- ance of the word in business^ of any owner- ship in a property that assumes a larger risk than some other interest. To take the simplest possible case, a man- ufacturer, say, finds that in good years he is making 15 per cent on his capital of $20,000. TRADING ON THE EQUITY 61 He reasons that if he can make 15 per cent or even 10 per cent on capital in his business, he will make much more for himself by borrow- ing money at 6 per cent, or even at 8 or 9 per cent. Thereupon he goes into the money market in one form or another and finds that, though he can borrow $20,000 at a nominal face interest of 6 per cent, a further actual discount brings the real interest up to 8 per cent. He borrows $20,000 pn these terms. Suppose he is able to continue making 15 per cent on the invested capital. Before borrow- ing, his afiFairs at the end of his fiscal year stood like this : — Personal capital invested . . . $20,000 Percentage earned on capital . 15 per cent Return on capital 3,000 After borrowing, his annual statement would show: — Personal capital invested . Borrowed capital invested . Total capital Percentage earned on capital Total return on capital $20,000 20,000 $40,000 15 per cent . $6,000 8 per cent on borrowed capital . 1,600 Return on personal capital . . $4,400 That is to say, by borrowing at 8 per cent he has increased the return on his own invest- ment from 15 per cent to a point where it now makes him 22 per cent. 52 CAPITALIZATION Suppose, however, an especially bad year, either in business of that particular kind, or in general business conditions, comes along, and the proprietor can makp his enterprise earn only 5 per cent on the capital invested. How would his annual statement stand then? It would show : — Personal capital invested . . . $20,000 Borrowed capital invested . . . 20,000 Total $40,000 Percentage earned on capital . 5 per cent Total return on capital . , . $2,000 8 per cent on borrowed capital . 1,600 Return on personal capital In this bad year the proprietor has made only $400, or 2 per cent on his own capital, as a result of borrowing, wh;ereas, if he had not borrowed at all, he would have made 5 per cent, or $1000. In the bad year he has lost $600 by trading on the equity against the $1400 he made in the good y^ar by following the same policy. Of course the proprietor ex- pects that the gains of his good years will Tnuch more than offset the Ipsses of his bad years. Notice that in the bad year the proprie- tor's equity in the property ''protected" the lender, so that he received his full 8 per cent in the bad year when the capital as a whole TRADING ON THE EQUITY 53 yielded a return of only 5 per 'cent, and, more- over, that, he has not had the worry of con- ducting the business in a year of comparative misfortune. In a very elementary way this explains the whole principle of trading on the equity. It also illustrates a simple case of the adjust- ment of risk and control dwelt on in the chap- ter on "The Instruments of Finance." The trader on the equity in the case of a corporation is the common shareholder. Holders of other corporation securities are taking shelter under the protection of the equity of the invested capital of the common shareholders, and the common shareholder takes advantage of the protection he offers by his capital to get other funds into the busi- ness on terms that he expects will make his own capital more profitable than it would be otherwise. Stated in the simplest possible manner, a corporation disburses its gross income in the form of: — Operating expenses (where, for our present purposes, we will include taxes as well as maintenance, etc.). Interest. Dividends. We by no means take this as a model of accounting practice, but simply to keep the 54 CAPITALIZATION elements entering into trading on the equity down to their simplest terms. Safety or danger in this manner of conduct- ing business depends on the interplaying re- lations of gross income, operating expenses, and interest charges, and the range of fluctua- tion of "gross" and " operatitig." Net income offers the fir§t and immedi- ately significant figure. Its amount and fluc- tuation, however, depend directly on the amount and range of fluctuation of gross in- come in relation to the amount and range of fluctuation of the percentage of the gross in- come used in operating expenses. We may call this the "business risk," because it de- pends on the nature of the business and the ability of the management. Though no finan- cial plan can affect either, the business risk should be a controlling influence in the ar- rangement of any scheme of financing an enterprise. Surplus, which is the fund out of which dividends may be paid, gives the next and secondarily significant figure, and the one directly affecting the shareholder. It de- pends on the fluctuation of net earnings in relation to the amount that interest charges consume. We may call this the "financial risk" as distinct from the bu§iness risk. The thinner the equity or margin the shareholder TRADING ON THE ^EQUITY 55 works on, the greater the risk that the share- holder runs and that he places on the bond- holder. To carry on the illustration already used, suppose the proprietor of the business de- cided to extend his borrowing to the utmost limit of his credit and found that he could raise $80,000 additional capital. The lend- ers are taking a greater risk and insist on a greater income, say 10 per cent. This is a regular principle. As the equity gets thinner, interest charges increase mOre rapidly than the increase in the capital advanced. The more money the proprietor borrows, the more interest he has to pay on each borrowed dollar. Now the annual statement will show: — Personal capital invested . . . $20,000 Borrowed capital invested . . . 80,000 Total capital invested . . $100,000 Percentage earned on capital . 15 per cent Total return on capital . . . $15,000 Ten per cent on borrowed capital . 8.000 Return on personal capital . . . $7,000 — or 35 per cent on the personal capital in- vested. When the proprietor had borrowed only $20,000, he made 22 percent on his own capital. By larger borrowing he has made a clear gain of 13 per cent more on his personal ifunds. 66 CAPITALIZATION Heretofore the proprietor, ihowever, could suffer a decline in the prosperity of his busi- ness that reduced earnings from a basis of 15 per cent to a basis of 5 per c6nt on the total capital invested in the business and still make something on his personal capital. Suppose now that the earnings on invested capital fall, not to 5 per cent, but to 8 per cent. Then: — Total return on capital . • • $8,000 10 per cent on borrowed capital . 8,000 Return on personal capital . . . $0,000 If the return on invested capital should de- cline to 5 per cent, the proprietor would face an annual deficit of $3000, and very quickly would have to go into bankruptcy. Business risk, as we have seen, depends on: the amount of gross; its range of fluctuation; the percentage of gross used in operating expenses; the range of fluctuation of this percentage. In their very nature businesses vary greatly in these respects. We shall take several corporations, en- gaged in different kinds of business, to illus- trate these variations caused by the nature of the enterprise. Let us first consider fluc- tuations in gross earnings. The five-year period chosen for illustratibn includes the year 1908 so as to get the effect of the change from a time of business activity to a time of TRADING ON THE EQUITY 57 business depression. A plus mark indicates an increase and a minus mark a decrease in gross earnings over those for the preceding year. Percentage of the fluctuation in gross earnings over preceding year 1905 1900 1907 1908 1909 United Slates Steel Corporation .... American Woolen Company Denver and Rio Grande Railroad C-ompany Detroit Edison Company (electric lighting) Twin City Rapid Transit Company (operat- ing electric railway in Minneapolis and St. Paul) Shawinigan Water and Power Company (hydraulic electrical power company) * + 6 +16 +19 + 7 + 9 +38 +19 +11 + 8 - 8 - 1 +37 + 7 +63 -37 -37 - 6 +23 + 6 +2J +3* +80 + 4 +«S + 9 +19 Without looking at the balance-sheets, any one would come to the general conclusions about probable variations ifi the range of fluctuation in gross earnings of the several classes of business used for illustration which the figures given actually show. Industrial corporations feel a business depression most strongly. People do not embark on new enter- prises. This fact immediately causes the con- sumption of materials to fall ©ff . Established businesses economize as closely as possible and cause a still further decline in the demand for materials. Such conditions show with spe- cial acuteness in the earnings of a company like the United States Steel Corporation. to8 CAPITALIZATION In times of business depression employ- ment is less assured; if the situation is pro- longed, wages may decline. As a result peo- ple economize. They do not curtail in the daily expenditure of nickels akid dimes. Such outlay has become a habit. They cut ex- penses in the irregular, unfrequent payments of larger amount. Clothing comes under this head. People make the old things "do." That fact accounts in part for the compara- tively wide fluctuation in gross earnings of corporations like the American Woolen Com- pany. Moreover, in times of depression the competition for business becomes keener, the industrial corporation in order to keep its share cuts prices, and the lower prices cause a further decline in gross income. The lessening volume of business done by the industrial corporations directly affects the earnings of the railroads. A considerable part of the transportation business comes from industrial products. Much of the other business does not, however, fall off in the same proportion. A depression that results from "over-extension" does not cause poor crops. Railroads may have as large a ton- nage of agricultural products as ever. So we should expect to find some fluctuation in the gross earnings of a railroad, but not as great as in those of an industrial corporation. , TRADING ON THE EQUITY 59 When we come to public service corpora- tions, such as street railway companies and electric lighting companies, =we should not ex- pect earnings to decline as much as in the case of the classes of corporations already discussed. Such part of the expenditure of nickels in street-car rides as is not a necessity is a habit, and, moreover, a growing habit. The street railway continues to charge a nickel — just as before. It does not, like an industrial corporation, have further to reduce profits, already reduced because of a smaller output, by cutting prices. It is a matter of fact, too, that people do not lessen their con- sumption of such things as =electric lighting. The price for this service^ also, is not cut during times of depression. Earnings of pub- lic service corporations, therefore, do not de- cline; they rather advance. Though at some future time the rate of advance may show a greater check than now during a trade dull- ness, earnings from these businesses probably never will show marked declines in times of depression. All this means that in arranging to finance a corporation, the promoters or managers must consider the nature and prob- able fluctuations of gross earnings in the business it engages in. We have had to go into this discussion of variations of gross earnings first in order pro- 60 CAPITALIZATION perly to develop the general subject. It is the fluctuations in net earnings, however, that fully represent the business risk, and net re- sults from the relation of grOss earnings and operating expenses. If operating expenses consume a large proportion of gross earnings, the fluctuation in gross constitutes a greater business risk than in the case of a corporation in which the proportion of operating expense is smaller. This increase in the business risk results from the fact that a corporation can- not cut operating to keep the proportion of operating the same in the face of a declin- ing gross. It has built up an organization to conduct the business on the larger scale. It cannot reduce this organization as rapidly as the business falls off. Having once built up the larger plant, the corporation can never contract the organization temporarily to the scale of the diminished business. The very magnitude of the plant requires a larger force in proportion to the output. Moreover, wages do not fall as rapidly as prices. Let us compare the percentage of operating expenses with the fluctuations of gross earnings. TRADING ON THE EQUITY 61 Percentages of fluctua- Percentage of gross tion of gross as com- used in operating pared with previous for the year year igos 1906 1907 1908 1909 1905 1906 1907 I9D8 1909 United SUtcs Steel Corpora- tion -1-19 + 8 -37 +84 73 74 77 80 79 American "Woolen Company +flS + 6 - 8 -37 -feo »D 91 93 88 93 Denrer & £io Grande Bail- road Company . + « + 9 - 1 - S +A 60 61 62 64 69 Even these figures showing„a rising percent- age of gross used in operating as the amount of gross declines do not tell the full truth. In the endeavor to keep down expenses during a period of falling gross income, corporations commonly do not keep their maintenance up to a proper and usual standard. If mainten- ance were kept up, the percentage of operat- ing during a period of depression would be -much higher than it is. The increase in the operating ratio from ^64 to 69 when gross earnings, so far from showing a decrease, show rather an increase of 4 per cent, seems to be an instance against the general principle that the operating ratio increases as the gross declines, and should therefore decrease as the gross tends to re- sume its former amount. Really it illustrates the fact that a corporation is likely to cut maintenance unduly during a period of de- pression and throw the burden of making up 62 CAPITALIZATION the maintenance on periods of activity. In the case of the Denver & Rio Grande figures, maintenance is responsible for a great deal more than its natural share of the increase in 1909. Maintenance was 16 per cent greater than for the preceding year against an increase of 9 per cent for all other operating charges. If, then, a company manufacturing steel, and a company manufacturing woolens, un- dergo about the same degree of fluctuation in gross income, apparently the company manufacturing woolens at an average oper- ating ratio of 92 per cent cannot safely trade on as thin an equity as a company manufac- turing steel at an average operating ratio of 77 per cent. Neither can safely trade on as thin an equity as a railroad with a much nar- rower range of fluctuation of gross, and an operating ratio averaging 63 per cent. Going on with the comparison of operating ratios, take in the same order as before the "Detroit Edison Company (electric ligbtin?) . . . Twin City Rapid Transit Company (street railway in Minneapolis and St, Paul) Percentage of fluctua- tion of grass com- pared with previous year 1905 +15 +88 +19 +S7 + 7 +88 + 8 +188 Percentage of gross used in operating for the year S8 64 TRADING ON THE EQUITY 63 Thus it appears, if these may be taken as typical operating ratios, that an electric light- ing company or a street railway company can safely trade on a thinner equity than a rail- road, not because their operating ratios are less, but because they are not so subject to declines in gross earnings as a railroad. To complete the comparisons, consider the operating ratios of a hydraulic electrical power company. The Shawinigan Water and Power Company . . . Percentage of fluctua- tion of gross com- pared with previous year 1905 1806 1907 1908 1909 +11 +63 +it +16 Percentage of gross used in operating for the year 190S 1908 1907 1908 1909 14 14 Here we have an operating ratio materially lower than those of the railway, traction, and lighting companies, — hardly one fourth as great, and scarcely more than a fifth of those of the industrials cited. This comes about from the fact that the labor cost is practically nothing in comparison with the capital in- vested, and from the substantial nature of the works, the maintenance is low. A hydraulic electrical plant represents a Jarge amount of capital used in construction of an exception- ally solid kind. It runs almost automatically. 64 CAPITALIZATION The promoters or managers of a company operating one would be safe in trading on a thinner equity than would be proper in almost any other common form of enter- prise. Having discussed the business risk, the interplay of the fluctuations ^of gross income and operating expense in determining net, we are now ready to consider what we have termed the financial risk. This, as we have stated, depends on the relation of interest charges to net earnings. Here, instead of hav- ing two variables, we have only one. Interest charges are a fixed quantity. We have seen that though operating expehses do not de- cline proportionately with gross, their act- ual amount does, nevertheless, fall. Interest, however, does not decline at all, but stays absolutely rigid. We have this situation, then, — with a declining gross an even more rapidly declining net, and a sjurplus declining more rapidly still towards vanishing point. Suppose we have a corporation earning, gross, $1,000,000, operating ratio, 75 per cent, with gross liable during a period of depression to fall 35 per cent from normal, and its oper- ating ratio to increase to 80 per cent. Let the corporation be carrying an interest charge of $125,000, or 5 per cent on $2,500,000 bonds. The result is: — TRADING ON THE EQUITY 65 Gross Operating Net Interest Surplus Situation at normal Situation in depression $1,000,000 650,000 $750,000 620,000 $250,000 130,000 $125,000 125,000 $125,000 5,000 -That is, during a period of depression with a decline in gross of 35 per cent, and an increase of 5 per cent in the operating ratio, net has declined 48 per cent, and surplus has declined 96 per cent. Recalling the earlier part of this discussion, we remember that gross of the United States Steel Company fell off 37 per cent in the de- pression following the Panic of 1907, with a 3 per cent increase in the operating ratio, and gross of the American Woolen Company at the same time suffered a decline of over 45 per cent, with an increase in the operating ratio of 5 per cent. Obviously the sharehold- ers of an industrial enterprise subject to such fluctuations as this cannot safely authorize the creation of an indebtedness large enough to reduce their equity to a point where in prosperous times the corporation will have to disburse half of net earnings in interest jcharges. If they do, they will be running a pretty good chance that during the next de- pression, not they, but a reluctant body of bondholders, not at all pleased at the author- ity thrust upon them, will bf in control. 06 CAPITALIZATION Suppose, in a corporation, the gross earn- ings of which are now, in normal times, $1,000,000, liable to suffer a decline of 35 per cent in gross during a period of depression in the business, that for every 7 per cent de- cline in gross the operating ratio will advance 1 per cent. The operating ratio is now 75 per cent. This approaches the case of the Steel Corporation. Decline Per cent in gross Gross operating Operating Net Interest Surplus «1,000,000 7fi $750,000 $250,000 $126,000 $126,000 7 per cent 930,000 76 706,000 *«4,000 125,000 199,000 7 864,000 77 666,973 198,927 126,000 73,927 r 804,357 78 687,398 176,969 126,000 61,959 7 748,05« 79 690,961 158,091 125,000 33,091 7 695,688 80 656,650 189,138 125,000 14,138 The situation shown graphically (see dia- gram opposite) may become a little clearer. The curve of operating will fall as the curve of gross falls, but not at the same rate. That part of the diagram between the curve of operating and the curve of gross represents the amount of net. Interest is a constant amount. The curve of operating, plus inter- est, indicating that part of earnings which, subtracted from gross, gives the surplus, re- sults from simply adding the constant, inter- est, to the curve of operating, and gives a line exactly parallel to the curve of operating. Since the curve of operating does not parallel TRADING ON THE EQUITY 67 the curve of gross, but approaches it, the graph shows at a glance the effect on surplus of add- ing the constant, interest, to the operating. If the managers of the corporation want to 81,000,000 873,000 730,000 trade on an equity as thin as that, or thinner, they can do so safely only by the creation of a preferred stock-issue. Then if earnings fall below the amount required to pay the pre- ferred dividends, control vested in the com- mon stock does not pass away from it. In actual practice it will become necessary to finance on preferred stock sooner than this. Generally speaking, bondholders want assur- ance that earnings will not fall enough to endanger their interests, and such assurance 68 CAPITALIZATION involves an expectation that tliey will not fall anywhere near that point. On the other hand, the preferred shareholder wants an ex- pectation that earnings will not fall far enough to endanger the payment of his stipulated dividends. This also works out substantially what the common shareholder desires. He wants to feel assured that earnings will not fall to a point to endanger his retaining the control he possesses; he wants the expecta- tion, at any rate if the preferred dividend is cumulative, that earnings will be sufficient to pay them. Here we can properly discuss the size of issues as affecting control. Speaking of con- trol in the first chapter, we discussed it for the rinost part from the standpoint that, if a share of stock of one class possessed equal rights of voting with a share of stock of another class, the control vested in the two shares was the same. We called attention, however, to the fact that if the issues of the two classes were of different sizes, the result might be that the control vested in one class differed essentially in kind from the control vested in the other. For illustration suppose a cjorporation capi- talized at : — $2,000,000 common stock; $1,000,000 5 per cent preferred stock; $1,000,000 5 per cent bonds. TRADING ON THE tEQUITY 69 Assume, further, that net earnings amount only to $100,000, or just enough to pay the interest and the preferred diviidend. It would be greatly to the advantage of the common shareholders for the corporation not to de- clare the preferred dividend, but to keep in- vesting the surplus back in the property until such a time as the additional capital invest- ment showed eflfect in earnings large enough to pay dividends on the common stock. Com- mon shareholders have a majority of all shares, and directors elected by them in their interest might naturally enough adopt this course of conduct. If they should, it would be diflScult to prove that they had not acted within their proper discretion. Where the preferred shareholders are in the minority they should see to it that their stock is cumulative. If it is non-cumulative in the case just given, they niight lose heavily for the benefit of the common shareholders. Even if cumulative they lose through the de- ferred benefit of the dividend, entailing a loss of interest or enjoyment of income during the period through which the dividends are de- layed. The greater security through building up a protective margin of earnings in part offsets this. Another less flagrant way in which the greater size of the common stock-issue in the 70 CAPITALIZATION assumed capitalization might work to the dis- advantage of the preferred might arise out of a power in the common to create debt to the disadvantage of the preferred'. Capitalization assumed now stands: — $2,000,000 common; $1,000,000 preferred 5 per cent; $1,000,000 bonds 5 per cent. If the company earns, say, 6 per cent on its total capitalization, the corporation can dis- tribute net in this way: — Interest, $50,000; Preferred dividend, 50,000; Common dividend, 140,000; or, stated in approximate percentages, the amount of net taken by Interest, is 20 per cent; Preferred dividend, is 20 per cent; Common dividend, is 60 per cent. Restated in terms of percfentages payable on the several classes of securities: — Bonds yield 5 per cent; Preferred yields 5 per cent; Common yields 7 per cent. Suppose now the common shareholders, seeing that the corporation earns on the total capital a greater percentage than it pays for borrowed money, decide to trade on a little thinner equity and vote to issue $2,000,000 more 5 per cent bonds. We will assume that TRADING ON THE -EQUITY 71 the company can continue earning 6 per cent on the total capital invested in the business. Capitalization now stands : — $2,000,000 common; $1,000,000 preferred, 5 per cent; $3,000,000 bonds, 5 per cent. Net earnings now amount to $360,000, dis- tributed to Interest, $150,000; Preferred dividend, 50,000; Common dividend, 160,000; and the approximate percentage of net taken by Interest is 42 per cent; Preferred dividend is 14 per cent; Common dividend is 44 per cent. Restated in terms of percentages payable on the several classes of securities — Bonds yield 5 per cent; Preferred yields 5 per cent; Common yields 8 per cent. Common shareholders have gained an addi- tional 1 per cent return by reducing their equity. How do the preferred stockholders come out in this transaction.'' Notice that the per- centage earned, the margin of safety above the amount required for interest and pre- ferred dividend, has fallen from 60 per cent to 42 per cent of net earnings. 72 CAPITALIZATION See what will happen through a period of depression as the percentage in the net earn- ings the corporation can make on its total capitalization steadily declines from 6 per cent down. Per cent earned net on capital- ization 6 per cent B 3 Amount when to- tal capitalization (»1,000.000 bonds) IS IM,000,00O $240,000 200,000 160,000 150,000 Amount when to- tal capitalization ($3,000,000 bonds) is $6,000,000 $360,000 300.000 240,000 180,000 Amount re- quired for inter- est and pre- ferred dividend $100,000 Amount re- quired for inter- est and pre- ferred dividend $200,000 So if the net earnings of the company should fall to three per cent oh the total capi- talization, the preferred shareholders, with- out the additional bonds, would still have net earnings 50 per cent in excess of the amount required to pay their dividend. With the additional $2,000,000 of bonds net earnings would be 10 per cent less thaii the necessary sum. Looking at the matter froiri another stand- point, suppose gross earnings should decline 40 per cent, with a consequent rise in the operating ratio from 75 per cent to 80 per cent. If the company can majke 6 per cent on capitalization with an operating ratio of 75 per cent, its gross earnings are : — TRADING ON THE EQUITY 73 $4,000,000 capitalization ($240,000 net) »6,000,000 capitalizatioa ($360,000 net) Gross $960,000 -$1,410,000 A decline in gross of 40 per cent, accompan- ied with a 5 per cent increase in operating, would reduce net to: — »4,000,000 capilalizaUoD (»«40,000 net) $6,000,000 caintalizatioD $360,000 net) Net $115,200 $172,800 Or with the smaller debt such a decline in gross would leave net over 15 per cent in excess of the amount required to pay dividends on the preferred. With the larger debt it would leave net 14 per cent less than the sum needed. If, instead of creating $2,000,000 addi- tional bonds, the common shareholders had voted to increase the preferred stock by that amount, everything so far stated of the effect on the preferred of the increase in securities would still apply. They would not by this procedure, however, add to another risk of the preferred shareholders, that is to say, the risk of having their equity completely wiped out and the property pass entirely to the disposal of the bondholders. Without the additional bonds net earnings would have to decline over 80 per cent to throw the property into the 74 CAPITALIZATION hands of the bondholders. With the addi- tional bonds a decline of 58 per cent in net would throw the property into the hands of the bondholders. As a matter of fact the increase in the pre- ferred would really lessen this danger. After the increase net would have to decline 86 per cent to take the property out of the control of the shareholders. The lessening of that risk would not, however, compensate for the in- creased risk of a cut in dividends. By this time the reason must have become clear for the veto power so frequently given preferred stocks, requiring the assent of pre- ferred shareholders to any increase in bonds or preferred; or, generally, the purpose of the veto given any class of security on an increase in the amount of that class or any class hav- ing a prior claim on earnings or assets. It should be observed that by voting an increase of $2,000,000 in the preferred in the case we have been considering the common shareholders would have voted the balance of power out of themselves. In the state of aflfairs we have been consid- ering, when the amount of one class of stock is greater than the amount of another class, it has become apparent that the voting power of the minority class, though equal share for ^hare with that of the majority, becomes TRADING ON THE EQUITY 75 valueless on any clash of interest between the two classes. As examples of corporations issuing more than two kinds of stock we may consider the capitalizations of — The Colorado & Southern Railway Common $31,000,000 (paying i per cent) l9t preferred 4 per cent non-cumulative 8,500,000 (paying 4 per cent) Sd preferred 4 per cent non-cumulative 8,500,000 (paying 4 per cent) Bonds > 49,309,00Q Average 4.31 per cent > Of this company — bonds of subsidiaries not counted. The Erie Railroad Common 8112,378.900 (paying 0) Ist preferred 4 per cent non-cumulative 16,000,000 (paying 0) Sd preferred 4 per cent non-cumulative 47,89S,400 Bonds The Reading Company Common S70,O0Q,000 pays 6 per cent 1st preferred 4 per cent non-cumulative 28,000,000 2d preferred 4 per cent n'on-cumulative 42,000,000 (Second preferred can be converted into one half 1st preferred and one half common). The capitalization of the Reading Com- pany is the result of a reorganization. No- tice that the total preferred just equals the common. So in a clash of interests between the common and both classes of preferred, the preferred stock possesses just as much con- trol as the common. But suppose the com- pany should not be earning enough to pay any dividends on the second preferred. Then the second preferred might cast its vote with the common in favor of a policy of returning 76 CAPITALIZATION earnings to the property until the corpora- tion could earn enough to pay dividends at least on the second preferred. In the matter of the creation of indebtedness the interests of the second preferred ordinarily coincide with the interests of the first preferred. The St. Louis and San Francisco presents another situation. Its capitalization is: — Common $29,000,000 (paying 0) lat preferred 4 per cent non-cumulative (redeemable) 8,000,000 (pajring 4 per cent) £d preferred 4 per cent non-oumulative (redeemable) 16,000,000 (paying 0) First and second preferred in this case are protected against the issuance of further se- curities of equal or prior rank, by a special veto power. No such further securities can be issued without a consent of a majority of the securities equal or junior to them in rank. The American Smelters Securities Company has out- standing: Common $30,000,000 (not paying) Preferred A — 6 per cent cumulative 17,000.000 (paying 6 per cent) Preferred B — 5 per cent cumulative 30,000,000 (paying B per cent) Recall that in this case the preferred stock has no voting power unless dividends for one year remain unpaid. This provision, consid- ering the fact that both classes of preferred, acting together, would give a large majority, together with the fact that thfi stock is cumu- lative, serves to protect it. TRADING ON THE EQUITY 77 H. B. Clajlin Company is capitalized at: Common $3,880,100 (pays 6 per cent) 1st preferred 4,600,300 (pays 6 per cent) 2d preferred Z,370,eU0 (pays 6 per cent) The general principle of trading on the equity goes farther in the case of the corpor- ate form than in the case of an individual en- gaged in a business. So far, we have consid- ered the matter as if capital invested in a given business always had the same earn- ing power. As a matter of fact the earning power of capital depends very largely on the ability of those controlling and administer- ing the particular enterprise in which it is employed. When an individual proprietor trades on the equity he assumes more^of the risk than any one else investing capital. The exception to this general rule is the silent partner of a partnership. He invests his money in the business without assuming any power in the management, yet he assumes just as much risk on his capital as those who actively man- age the affairs of the undertaking. He does this because of his confidence in the ability of the active partners in the special business. He is willing to assume a risk equal to theirs, be- cause he believes they are able to make his capital return him a large income. If we may, for an immediate convenience, use the word "uncontrolling," it is the "un- 78 CAPITALIZATION controlling" shareholders who are the silent partners of a corporation. Though they are "uncontrolling," they are not necessarily the minority shareholders. They may hold, and frequently do hold, a majority of the shares of the corporation. They own the scattered shares, and the controlling shareholders own the shares that are massed. It is a well-known fact of American finance that, if the majority shares are scattered, a rather small minority •of the stock held by an individual share- holder, or a little group of shareholders work- ing together, can control the corporation almost as surely as if they held an absolute majority of all the stock outstanding. This works on the mathematical basis of an in- verse ratio. The more shareholders there are in a particular corporation the fewer shares can control. That fact forms part of the found- ation for the desire on the part of the pro- moters of a corporation that the shares should be broadly distributed. If the corporation's bankers should chance to be essentially dis- tinct from the promoters, their desire for a wide distribution of the shares arises from the fact that the shares probably will then be more tightly held and therefore afford a better basis for the market in the security*. This is an im- portant reason for seeking a wide distribution of corporate financial paper. It is another TRADING ON THE EQUITY 79 subject, however, from the one under consid- eration. We do not have to seek far for the reason why from a quarter to a third of the shares of an American corporation will usually assure control. Scattered shareholders, though own- ing a majority of the stock, have no means of getting together in order to act in concert. They have no means of making their major- ity effective. Since they bought their stock relying on the ability of those in control, they will continue, at least so long as the affairs of the corporation go well, to rely on the group working in concert. So long as the corpora- tion pays dividends, the isolated owner of the comparatively small number of shares is likely to assume that the affairs of the cor- poration are running well. When he bought his stock he had no intention of taking an active interest in the affairs of the enterprise. Frequently the periodic reports of the cor- poration do not contain any really informing matter. Whether they do or not the isolated shareholders seldom take the trouble to read them, and usually would not understand them if they did. Naturally when the con- centrated minority in control ask the isolated shareholder for his proxy he either does the easy, and as far as he knows the best thing, fills out the convenient blank they have sent. 80 CAPITALIZATION and returns his proxy as requjested, or else he does the one easier thing, simply drops re- quest and blank in the waste-basket and does not bother to send his proxy to any one. Very rarely any one outside the group in control asks him for his proxy, in fact, practically never, unless the corporation's affairs have been going from bad to worse. So the man whom the controlling minority has designated as the person -for the isolated shareholder to make his proxy out to, con- tinues to go annually to the legal head office of the company and vote his suit-case of proxies in favor of the prepared list of resolu- tions. All this is neither in adverse nor favor- able criticism of the system. Though it often works badly, it more often works well; and perhaps greater activity on the part of the isolated shareholder would not much reduce the percentage of failures. All this is a matter of common knowledge, and has been rede- scribed here simply to show how the isolated shareholders, perhaps owninga large majority of the shares of the company, come to occupy the position of a silent partner in a partner- ship, and add their capital to enable a con- trolling group to trade on an even thinner equity than they otherwise could. For we cannot continue to assume, as we have assumed up to this point, that any busi- TRADING ON THE EQUITY 81 ness can be engaged in on a scale to suit any- body's purse. It takes millions to measure the necessities of modern corporate enterprise. A group of men, having confidence in their own judgment of an enterprise, and their ability to manage it, may not, even after extending their borrowing capacity to the utmost, be able to raise enough money to engage in a particular project. They must take in part- ners, that is to say, other shareholders. Yet they base their confidence in the project partly on their own ability as managers, and would not entrust their own funds in it unless they felt assured that they would continue in the management. They can at the very least practically double their own funds and corre- spondingly increase their borrowing capacity without running any risk ©f having their management interfered with,. They can do this even if the people who take 49 per cent of the stock form a close group, concentrat- ing the voting power, or control value of the stock. If they judiciously scatter the stock, they can let from 70 to 80 per cent pass out of their own possession and still run no substan- tial danger of losing control. See what this accomplishes. Assume that in a business of the kind they purpose engag- ing in, it is possible to raise, say, 66f per cent of the capital on bonds. If their own capital 82 CAPITALIZATION amounts to $300,000, they 6an sell enough stock to realize $700,000 more, and make an investment in the enterprise of $1,000,000 represented by common stock. They can now borrow $2,000,000 more, and have en- tire control of a business wi^h $3,000,000 of invested capital, or ten times their own capi- tal employed in it. If the project were one requiring at least that amount of capital, they could not have taken it up and have retained control without resorting to the corporate form. Acting as individuals, with their $300,- 000 on hand they could have borrowed $600,- 000 more, and had a total of only $900,000, or less than a third of the amount required. If it had been possible for them, under a partner- ship form, to raise the entire amount re- quired, they could not at the'same time have retained the undisturbed management. They could not accomplish anything like the same result even with the additional partners in the minority. Such partners would have an active voice in the management. Their acts, even unauthorized by the other partners, would bind the entire partnership. The corporate form, then, offers what is substantially a much enlarged opportunity for trading on the equity. Ill WATEBED STOCK Though not intending to be controversial, we may seem, nevertheless, in discussing the subject of watered stock, to be putting our- selves in the position of advocatus diaboli when we say we purpose here to name the perfectly right and proper things stock-water- ing may accomplish. To show, however, that we know about the evils charged against the practice we shall state them at the very out- set. It is charged that stock-watering works a fraud on the investing public through enabling unscrupulous men to deceive people, by a certificate marked "par value, $100," with the idea that the corporation has assets of equivalent value. Such deception is common. Promoters of "fake" corporations have a thoroughly organized business. It must be owned that those who are deceived have only taken the view that, nominally at least, the law itself takes. For the law generally says that when a stock certificate of the par value of $100 is issued, it shall have back of it assets of the value of $100. To be siire, the law goes 84 CAPITALIZATION on to say that it will not inquire too closely into the actual value of those things which the corporation states to be of the value of $100. Having opened the door so far, the camel, if we may use this metaphor from the arid desert when speaking of watered stock, has thrust his whole body in, till we have certificates of "the par value of $100" that did not represent any assets at all when is- sued, yet are perfectly law proof. Doubtless "of the par value of $100 " does deceive many people. It is only fair to ask if we cannot do away with the evil without doing away with the thing itseK and whatever good it may have. Two possible remedies suggest themselves. One is to do away with the statement "of the par value of $100," and let the certifi- cate stand simply as, say, one share of ten thousand, representing i^^tTTjth of the total ownership. That should put :the prospective purchaser on inquiry as to whether the total ownership is worth anything, and conse- quently how much T^i^^th is worth. Sev- eral eminent financiers came out against this idea and several in favor of it -in a recent con- gressional inquiry. The proposals seem to me in accord with the facts, and I should favor it even aside from whatever its adoption would accomplish towards doing away with WATERED STOCK 85 the deceit practiced on innocent purchasers. If the certificate did not describe itself as of the par value of anything, it would not repre- sent itself as having any special amount of assets behind it. Under such circumstances watered stock would be hke the Kantian con- ception of time and space, a category of the human mind, with the mind taken away. A second proposed remedy for this decep- tion of the unsophisticated purchaser is a pro- spectus act requiring a statement in any pub- he offering of stock of the exact way it became "fully paid up," commissions paid, and other information sufficient to enable the prospect- ive owner to- see just what assets do stand back of the stock, and form some estimate of its probable value. Though this remedy does not seem quite to strike at the root of the matter in the way that remo"^ing "of the par value of" does, still, might not this do away with the evil complained of without destroy- ing the good there may be in the thing itself.'' A second charge made against watered stock is that it enables corporations, by giving a false appearance of large capital expendi- tures, to charge more for their services than they otherwise could. It must be owned that corporation managers do take advantage of large capitalizations to give an impression that the enterprise is making a small or very 86 CAPITALIZATION moderate return on invested -capital. Gener- ally speaking, people do not press this charge of evil against watered stock except in the case of public service corporations possessing a monopolistic or quasi-monopolistic character. The fact that many public service corpora- tions are not paying any dividends at all, and that some occasionally fail to pay interest, proves that the possibility of raising rates under the cover of any given capitalization is not unlimited. It is not part of our purpose at this point to discuss the relatSon of rates and capital investment. We simply raise the ques- tion now whether the abolition of watered stock, if means can be found to effect it, would prove helpful enough to make it worth while. There is this much at any rate to be said, that some of the meritoriously useful results of watered stock can be gained ap- proximately in other ways, so that corpora- tion finance would not be so enormously the loser by its abolition as it would be if that were not the case. One needs to remember, too, that a par value of capitalization greater than the value of assets may arise from other causes than stock-watering. Suppose a corporation with a capitalization of $1,000,000 has a plant that fairly cost $1,000,000 and is capable of earn- ing the anticipated return on the investment. WATERED STOCK 8? Assume that on account of a high fire hazard and consequent very high premium charges the managers decided not to insure. If a fire now destroys one half the assets, the cor- poration has outstanding a capitaHzation of $1,000,000 against assets of the cost of only $500,000. Again disclaiming any intention of entering oh a discussion of proper capitalization, we may still perhaps fairly raise one of the ele- mentary questions to keep in nuind as a back- ground of our discussion. Take two corpora- tions : — Corporation A Capitalization $1,000,000 Actual cost of assets . . . 1,000,000 Net earnings 50,000 Corporation B Capitalization . . . . , $1,000,000 Actual cost of assets . . . 500,000 Net earnings . . . . : 50,000 Assuming that one corporation is as likely to continue its earnings at $50,000 as the other, and that the relative difference in earning power is not due to a difference in manage- ment but to other conditions, obviously the assets of one are worth as much as the assets of the other. Though some may incline to disbelieve the 88 CAPITALIZATION statement, there are, nevertheless, perfectly straightforward and proper reasons for water- ing stock. Promoters and financiers resort to it under circumstances in which they could not possibly take advantage of the dollar mark to sell for more than real value or use the diluted capitalization as a cover to con- ceal excessive rates. They cannot take advan- tage of the dollar mark when they are dealing with too sophisticated people, and they can- not use the diluted capitalization as a cover for excessive rates if the issuing corporation is engaged in manufacture and subject to active competition. Watered stock can take a very useful and entirely proper part in corporation finance through affording a still further means than those dealt with in the earlier chapters of effecting divisions and recombinations of the incidents of ownership, — income, control, and risk. The commonest resort to stock- watering is in so-called underwriting, or syn- dicate, operations. They afford the easiest way to illustrate the situation. Assume that the promoters and bankers are arranging the financial plan for a corporation to engage in a new enterprise which requires the expenditure of, say, $3,500,000. The bank- ers are ready to advance $3,000,000 secured by a mortgage, provided the promoters will put WATERED STOCK 89 $500,000 in the enterprise. This equity of the promoters, however, is too thin for the bankers to be content with nothing but a fixed inter- est return. On account of th6 thinness of the equity the bankers assume a considerable risk and want a compensating share of speculative profits. We have already seen several ways in which they might procure this. They might make the bonds participating. The bankers are not, however, going into this enterprise as a per- manent investment; they look forward event- ually to selling their securities, making their profit on the transaction, and using their funds in a new enterprise. Though participating bonds would assure them a share in the specu- lative profits, such bonds are a comparatively unfamiliar security and would sell at a dis- advantage in the investment market. The bankers might take convertible bonds, which, as we have seen, would give them an oppor- tunity to take advantage of the future pro- sperity of the company. Neither of these forms gives the bankers any means of separating what we may call the speculation from the investment. The participating bond indis- solubly combines the two, and the convertible bond will not yield any profit through in- creased income from the speculation so long as the holder retains any advantage from the 90 CAPITALIZATION investment. In the case of the convertible bond the holder must give up entirely his in- vestor's prior claim and come out wholly from the protection of the equity, or he must con- tinue content with an income limited entirely to the investment basis. Neither the partici- pating bond nor the convertible bond accom- plishes what the bankers desjre. They want eventually to separate the investment and the speculative parts of their bargain. They may sell the investment and retain the speculation, as part of their bankers' profits. Or they may sell both. In that event they would dispose of the investment to one set of people having the type of mind or requirements calling only for an investment, that is, a limited risk with an assured though limited income, and dispose of the speculation to another entirely diflFerent set of people who are willing to assume the greater risk for the chance of the greater pro- fit. If in return for their funds they receive both stock and bonds they can do just this. An adjustment of the situation becomes a matter of bargaining betweefi the promoters who are advancing $500,000 and the bankers who are advancing $3,000,000 for the enter- prise. Assume that the prompters want the same possibility of later separating their in- terest in the corporation into more specula- tive and less speculative parts. They cannot WATERED STOCK 91 take part bonds and part stock for the funds they supply to the corporation, because the bankers insist that the bonds must have an equity back of them of a full $500,000. The bankers consent, however, to giving the pro- moters a claim that will come in ahead of the speculative interest the bankers want as part of their return for the funds they supply. Let us suppose as a result of the bargaining that the promoters and the bankers come to an agreement on this plan as satisfying their various requirements. In return for the $3,500,000 of funds sup- plied for its purposes the corporation will issue: — $3,500,000 5 per cent 25-year bonds; 1,000,000 7 per cent preferred stock; 4,500,000 common stock. Of these securities the bankers, in return for supplying $3,000,000 of cash, will get: — $3,500,000 5 per cent bonds; 3,500,000 common stock. In return for supplying $500,000 in cash the promoters will get: — $1,000,000 7 per cent preferred stock; 1,000,000 common stock. That is, the bankers, in return for funds, for eyery $100 supplied, get: — $116.66 par value 5 per cent bonds; 116.66 par value of stock. 92 CAPITALIZATION The promoters, in return for funds, for every $100 supplied, get: — $200 par value 7 per cent preferred stock; 200 par value common stock. As a matter of fact, the way the parties will view the transaction is that the bankers get 5 per cent 25-year bonds at 85.71, and with the bonds get a bonus of 100 per cent of com- mon stock, and that the promoters get pre- ferred stock at 50, with a bonus of 100 per cent of common. Assume now that the corporation gets to a point where it can earn 10 per cent on the cash invested. Its earnings will then amount to: — Net . $350,000 Interest ; . 175,000 Available for preferred . . . 175,000 Required for preferred . , . 70,000 Available for common- . j . 105,500 or only a little over 2 per cent on the com- mon, hardly sufficient out of which to pay a dividend. If the business is of the type not subject to large declines in gross, now that the corpora- tion is earning 60 per cent above interest charges the bankers may begin to market the bonds. Suppose they are able to get an aver- age of 95.71 for the bonds, "they have made in the transaction, 10 points gross, or 12§ per cent on the funds involved, and have besides WATERED STOdK 93 a possibility of further profit in the common stock they hold. In order that this may not be thought an enormously profitable trans- action for the bankers, it is only fair to say here that it has perhaps cost them between four and five points to sell the bonds. The promoters are getting 14 per cent on their cash invested, and have their further possibility of profit in the st^ck they hold. Presumably they cannot yet on this showing of earnings dispose of their preferred stock advantageously. Assume now that the affairs of the corpora- tion continue to prosper till it can earn 15 per cent on the funds invested. Earnings increase to: — Net $525,000 Interest and preferred dividends require ...... 245,000 Available for common . . . $280,000 or a little in excess of 6.2 per cent. Probably the directors of the corporation will not de- clare a 5 per cent dividend on this showing. To do so would leave little available for emer- gencies, or to build up the property against future recessions in business. So far, too, we have said nothing about a sinking-fund to amortize the bonds. Earnings available for dividends have, however, given the common stock a substantial value. The directors may 94 CAPITALIZATION declare a dividend at the rate of 4 per cent, and so enable the holders to make, if they wish, a market for the security. We have assumed that this is a new enter- prise, and at the time of the negotiations be- tween the promoters and the bankers had yet to go through the construction process. It would be at least two years before the project got on an earning basis, or, say, two and a half to three years before the bankers could begin to place the bonds with the investing public on the basis of assured earning power. The bankers do not want to tie up so large an amount of funds for so long a time. Hav- ing assumed the responsibility for supplying $3,000,000 of funds, they may now proceed to get the amount underwritten. That is, they will find people who will advance the money till the corporation can show established earn- ing power, when they may either place their securities with the general lot for the bankers to offer for sale, or may withdraw them from the general mass and keep them for personal investment. Terms of these underwriting agreements vary a great deal, and we shall not attempt to go into them. The amounts taken by each underwriter or member of the underwriting syndicate, as it is called, may also vary widely, both within one syndicate and between one syndicate and another. In WATERED STOCK 95 the case of some underwritings a compara- tively few members may form the entire syn- dicate; it may comprise only other bankers who are taking participations. The members of other underwriting syndicates may be pri- vate capitalists widely scattered, and some of rather small resources, so that many parti- cipations may amount to as little as $5000. It seems to be the tendency to scatter the under- writing more broadly, and make the amount required for participation smaller and smaller. Often now, in fact, the idea of a syndicate with the original bankers subsequently mak- ing a general market issue to investors is hardly even pretended, and the so-called un- derwriting amounts really to the issue of the securities. So far as that gives the people who are supplying the money a larger proportion of earnings it seems desirable. The danger lies in the possibility of people, not familiar enough with financial matters to discriminate between a speculation and an investment, supplying funds at this point when they can- not afiford to assume the amount of risk neces- sarily accompanying the transaction. Assume that the bankers oflFer participation in the underwriting and the capitalists take it on these terms: the capitalists, in return for funds supplied the bankers, for every $100 supplied, get: — 96 CAPITALIZATION $111.10 (approximately) par value of bonds; 55.05 (approximately) par value of stock. Since the named terms of the underwriting would be bonds at 90 with a bonus of 50 per cent of common, we can state the matter ac- curately. The capitalists, in return for funds supplied to the bankers, for every 900 sup- plied, get: — $1000 par value of bonds; 500 par value of stocks. We are assuming that the promoters are keeping their preferred and common, either because of their confidence in the f utiue of the company, or because it was part of their bar- gain with the bankers that they should keep them for a stipulated time in order that their securities might not interfere with the bank- ers' market. If under no further obligation in the way of taking these securities off the underwriters' hands and placing them with the "ultimate consumer," — that is to say, in the hands of investors, — the bankers have made their profit and are out of it. They have made over four and a quarter (4.29) points on the bonds, which they bought at 85.71, and have disposed of at 90, and they liave $2,000,000 par value of common stock, which will be worth something if the company prospers. In the case of a genuine underwriting, the WATERED STOCK 97 bankers have a moral obligation at least to do their utmost to take the securities off the hands of the underwriters and place them in the hands of investors. Assuming that capi- talists have underwritten the securities, and the corporation has established an earning power equivalent to 10 per cent on the $3,000,000 of funds supplied, the bankers will then receive all bonds the underwriters wish to turn in for the public issue "and offer them to investors at, say, 95. We will suppose the offering successful and the "public" buys all the bonds. If not, the underwriters have to take them up on their own account. The un- derwriting capitalists have made five points on their bonds and have still in their hands an amount of common stock equal to half the amount of bonds they underwrote. That is, if a capitalist's participation in the syndicate had been to take up $50,000 of bonds and $25,000 of common stock, he would have put the bankers in funds to the extent of $45,000, have made a cash profit of $2500, and have $25,000 of common stock with speculative possibilities. We have had to touch on the matter of underwriting in order to bring out the way in which water in the securities of a corporation may act as a solvent to effect divisions of risk, income, and control for results otherwise im- 98 CAPITALIZATION possible to get exactly. By mfeans of the stock bonuses the bankers, in the first place, and the underwriters, in the second place, have been able to separate the resultant of income and control coming originally into their hands. Everyone has got what he wanted out of the transactions. Bankers* and capitahsts, with regard to this particular project at least, show the speculative type of mind. If they were not wilhng to assume the greater risk in expectation of the larger profit they would not have gone into the undeveloped enterprise. Each in turn has passed on the less risk and the limited income and kept the potentially unlimited income as a compensation for the risk he ran when embarking his funds in an enterprise while it was yet problematical whether the corporation would ever return a fair income on its capital. During the bargaining between the bankers and the promoters, the bankers saw that they were contributing three things. In the first place, they made the enterprise possible at all; in the second place, they assumed, for a time at least, a large risk; in the third place, they undertook a definite labor of distributing se- curities of the corporation to investors. Per- haps without reasoning over the matter in detail their minds ran somewhat in this way: For the labor of selling these securities we WATERED STOQK 99 want a specific sum of money. We shall add something to this sum partly to pay for the risk we run. To make the payment for the risk adequate we want some kind of an inter- est in the company, in case, as a result of our assuming this risk, the company, when oper- ating, proves successful; and finally (just hinted in this last statement), since the pro- moters cannot get more favorable terms else- where, and cannot go ahead without accept- ing our terms, or their equivalent, we shall exact a still larger interest because we make the project possible at all. Watering the stock has enabled the making of a fair compensa- tion for services performed. If the bankers had exacted a larger cash compensation to cover fully their estimate of the risk, they would have placed a further handicap on the corporation. By agreeing to take, for part of their compensation, their chance on the pro- sperity of the corporation, they by so much give a pledge of their good faith to purchasing investors. Underwriters reason in much the same way. They are content with a smaller compensa- tion for thus secondarily supplying the funds than the bankers required in case they had to find the funds directly. The bankers have al- ready done the work of investigating the pro- ject in order to draw a conclusion about its 100 CAPITALIZATION merits, and can pass on the results of this in- vestigation with their expert opinion to the underwriters. The project could not go ahead without the support of the bankers. They oc- cupied a better strategic position in bargain- ing, and made a corresponding exaction. They agreed to supply the whole of the re- quired funds, in this case $3,000,000, whereas each of the underwriting capitalists agrees only to supply part, some, say, $25,000, and some, $50,000. No particular underwriter was necessary to the bankers. These reasons sufficiently explain why the bankers could make a better bargain with the underwriters than the promoters could make with the bankers. The underwriters want a cash com- pensation, which, when secured, they can count as so much certain. They would not as- sume so large a risk for a cash compensation of the size they are hoping for. Again the stock bonus serves to complete the pay. Everyone taking this common stock, so far, knows perfectly well that it represents only a right to earnings made above a cer- tain amount. If the earnings never exceed a certain amount, the stock will never be really worth anything. As the expectation grows better and better founded that the corpora- tion will earn in excess of the sum required for prior charges, the common stock may com- WATERED STOCK 101 mand speculative prices based on the proba- bility that the corporation will be making something available for dividends. If the underwriting were without restric- tion as to sale, were not, in fact, really an underwriting, but essentially a placing of the securities in the hands of capitalists, any one of the capitalists, without waiting for the cor- poration to establish an earning power, might resell part, or all, of his participation. He might find someone ready to purchase the underlying security, the lien on the property with the promise of a definite income, but not ready to pay anything for the speculative chance. The capitalist might sell some of his bonds, without any stock, to Ihis investor for 85. Remembering that the capitalist paid $900 for each $1000 bond and $500 par value of stock, we may infer that the investor valued the stock as worth not in excess of $10 a share, and the capitalist valued it as being worth at least that. Accepting this as a fair appraisal of the speculative value involved, we can estimate a cash equivalent of the bar- gain the bankers made with the promoters. For each $857.10 the bankers received a $1000 par value bond and $1000 in par value of stock. According to the estimate just made the money equivalent for this stock would be for every $100 par value. So, if, instead 102 CAPITALIZATION of accepting part of their compensation in the speculative possibilities I EXPANSION 123 their lien directly on the property to some ex- tent offsets, from the market standpoint, the advantage of being the direct obligation of the parent company. In actual security they have all the effect of a direct first mortgage, but the fact that they have to be described as "virtually a first mortgage," or something to that effect, certainly does not help them market-wise. The public knows that a direct first mortgage is, at any rate, a first mortgage, for whatever it may be worth, but a collateral bond may be almost anything. For an illustration the St. Louis & San Francisco Railroad Company showed both forms of financing an exparlsion by branch lines. Ozark & Cherokee Central first mort- gage 5s, due October, 1913, $2,880,000, are secured by first mortgage on the road from Fayetteville, Arkansas, to Okmulgee, Okla- homa, 143.65 miles. The St. Louis & San Francisco Railroad Companyguarantees both principal and interest. St. Louis & San Fran- cisco Railroad 4^s, due February, 1912 (called for redemption August, 1911), $3,351,000, were secured by the deposit in trust of the entire capital stock and first mortgage bonds, $4,500,000 each, of the Arkansas Valley & Western Railway Company, 175.25 miles, running from Western Junction to Avard, Oklahoma. 124 CAPITALIZATION A modification of this seoond form, illus- trated by the St. Louis & San Francisco 4f s, due August, 1912, seems almost ideal for a corporation looking forward to systematic expansion of this kind. Such comparatively small issues, as railroad finance goes, of two or three millions sell at a disadvantage com- pared with a larger issue. They are not large enough to form a basis for general active trading such as the big issues afford. Any bonds which have a really active market sell at a considerable advantage over bonds of equal security which may have a good, but not a quick and very close market. An in- vestor can at any time either buy or sell a really quick bond at a selling price of not more than a quarter of a point less than the price at which he could buy. With a less active security, though still one with a good market, in trying to make a quick sale he might find that he would have to take a point or more less than the price at which he could buy. The constant quotation and the close market make a really active security much more desirable collateral at the bank. Such issues as the $14,376,000 Missouri Pacific Railway Company 5 per cent 30-year gold bonds, due January 1, 1917, show an appreciation of these principles on the part of those controlling the finances of the cor- FINANCING AN EXPANSION 125 poration. The authorized issue amounts to $15,000,000, and the right to put them out is Hmited to so much per mile of actually com- pleted mileage of railroads whose first mort- gage bonds are deposited in trust to secure bonds of this issue. The bonds outstanding are secured by the deposit in trust of $17,215,- 000 first mortgage bonds covering 1120.43 miles of railway of seven subsidiary compan- ies. A similar issue of the Missouri Pacific, the $9,636,000 of an authorized $10,000,000, are protected by a stipulation that they shall not be issued to exceed 80 per cent of the par value of the first mortgage bonds of the sub- sidiary companies deposited to secure them. This issue is secured by the deposit of the first mortgage bonds of no less than twenty sub- sidiaries ranging from two miles to one hun- dred and thirty-one miles of line. A general collateral mortgage of this kind provides an issue large enough to assure act- ive close trading in the market. It has all the advantages of being a direct obligation of the well-known parent company and essentially a first mortgage on the property of the subsidia- ries. By having a large authorized amount, with proper restrictions as to issuing only on the deposit of stipulated quantity of collateral comprising securities of actually operating properties, the parent company can keep on 126 CAPITALIZATION financing extensions out of the one issue. As it requires new funds from tiifie to time, it has an actually existing market for the securities it wants to finance on. In ca^e of default, the bondholders occupy a better position in bar- gaining on a reorganization than the bond- holders of small properties not bound to- gether in this way. That is to say, a railroad needs all its branches more than it needs any single one. So far the discussion has assumed a cor- poration expanding simply through an ex- tension of its own enterprise. We have not touched on the possibility of expanding through joining in some way with an existing independent enterprise. The words "con- solidation," "merger," and sometimes "com- bination," are loosely used to indicate such an expansion without any discrimination as to the manner of joining. They may indicate one of two very different things: (1) physical merger, or (2) combination through stock ownership. That is, a corporation may ex- tend either through acquiring title to the assets of another corporation or by acquiring all, or a controlling amount, of the stock of another corporation. We shall leave for a little later considera- tion the matter of creating a new corporation for the purpose of consolidating two or more FINANCING AN EXPANSION 127 existing corporate enterprises through taking over their assets, or combining them by stock ownership. Provided the shareholders of one corpora- tion act in a situation giving them the legal right, they can vote to sell the assets of their corporation to another corporation. Under such circumstances any of the methods of financing already indicated will serve to finance the acquisition of the new assets. If the selling corporation has bonds outstanding that are not to be retired before the merger, the purchasing company can assume them, just as an individual might purchase any property subject to a mortgage and assume the mortgage. When the purchasing com- pany has an existing blanket mortgage, which is, say, a first mortgage, it will become a second mortgage on the new assets. If legal diflSculties prevent a physical merger, or other considerations make it un- desirable, one corporation may combine with another through stock ownership. The finan- cial problem then is: How shall one corpora- tion acquire the stock of the other? Perhaps the stockholders of one corporation will take the shares of the other in payment for their own. They swap stock. Then the stock of the "combined" corporation goes into the treasury of the "combining" corporation. 128 CAPITALIZATION and the amount of "outstanding" stock of the "combining" corporation becomes so much larger. When this procedure is imprac- ticable, the purchasing corporation may sell its own stock to raise funds for the purchase of the stock of the other corporation. Or it may acquire part by swapping and the rest by purchase. Collateral bonds afford a means of financ- ing the purchase of stock in another corpora- tion. The purchasing corporation may bor- row money on temporary loans to make the purchase, then fund the temporary loan into the permanent one of bonds, with the pur- chased stock as collateral security. American railroad finance affords some rather notable examples of extension by this means. The Atlantic Coast Line Railroad owns $30,000,000 of Louisville & Nashville Rail- road stock out of the total issue of $59,917,- 220, and has outstanding, secured on this stock, $35,000,000 Atlantic Coast Line Rail- road, Louisville & Nashville collateral, 4s, October, 1952. The Northern Pacific Railway and the Great Northern Railway are both obligors on the $215,227,000 of bonds known as the Chicago, Burlington & Quincy joint 4s, July, 1921, by means of which the two obligor roads own approximately 98 per cent of all FINANCING AN EXPANSION 129 the capital stock of the Chicago, Burlington & Quincy Railroad. The Oregon Short Line Railroad has out- standing $45,000,000 ($100,000,000, author- ized) refunding 4s, December, 1929, secured on $108,000,000 Southern Pacific Company stock ($374,451,800 outstanding); also on $7,206,400 preferred and $10,255,400 com- mon stock of the Baltimore & Ohio and $8,000,000 New York Central & Hudson River Railroad stock, besides $23,443,000 San Pedro, Los Angeles & Salt Lake 4s. Remembering that the Union Pacific Rail- road Company owns $27,350,700 out of $27,460,000 capital stock of the Oregon Short Line Railroad Company, recalling also that the Southern Pacific Company owns the $13,800,000 preferred stock and $67,274,200 of the $67,275,500 common stock of the Cen- tral Pacific Railway Company by means of $30,618,500 Southern Pacific ^Company, Cen- tral Pacific stock collateral 4s, 1949, we can begin to get an idea of how useful some finan- cial organizers have found this stock collat- eral bond device in acquiring control of and combining properties. Rock Island furnishes the standard model of pyramiding in this way to acquire control of large properties with a relatively small amount of capital. 130 CAPITALIZATION One corporation hardly combines with an- other unless the other owns all the stock, ex- cept directors' qualifying shares. In a looser sense the acquisition by one corporation of a majority of the stock of another may be con- sidered a combination, possibly the ownership of less than a majority, if enough to give con- trol on the principles already discussed, may be so called. From that point the ownership by one corporation of stock in another grades off through all the degrees of intercorporate relationship, till it may become so small as just to indicate a sense of friendliness. Financial plans suggested so far for expan- sion have not contemplated the creation of new corporations except as s.ubsidiaries. In- corporating a new company, to which two or more existing corporations become the sub- sidiaries, will accomplish any of the results of combination already spoken of. It should be borne in mind that if one corporation acquires absolute control of another through owning all the capital stock of the other, the owning or principal corporation can at will turn the combination by stock ownership into a physical merger or consolidation by taking the necessary legal steps. A new corporation can combine two or more others with itself through any of the de- vices already spoken of, as swapping its stock FINANCING AN EXPANSION 131 for the stock of the others, or acquiring the stock of the others through the issue of col- lateral bonds. The United States Steel Cor- poration was, as everyone knows, a new cor- poration formed to combine a number of others. Most of the big consolidations of the past two decades were effected in this way. Long-term leases afford another simple form of combination. Railroad finance espe- cially takes frequent advantage of them. They are applicable, however, to combinations of industrial enterprises and are sometimes used for that purpose. Most commonly the transaction takes the form of the shareholders of one corporation voting to lease its property to another corpor- ation in return for the other^s agreement to pay a rental equal to a certain percentage on the stock of the lessor company. Ordinarily the lessee company directly guarantees the payment of a stipulated dividend on the stock of the lessor, which thereupon sells in the market as guaranteed stock. If the lease is for a long term, as ninety-nine or nine hun- dred and ninety-nine years, the combination on its face does not differ very much in results from a physical merger financed by bonds secured on the new assets. In the case of the lease, if the lessee corporatipn fails to pay the guaranteed dividend on the lessor's stock, 132 CAPITALIZATION the shareholders of the lessor corporation can take back their property. Likewise in the case of the physical merger, the purchasers of the bonds secured on the assets of the merged corporation can take the property on any failure of the purchasing corporation to pay interest. There is one important diflFerence: A receiver of the lessee corporation, generally speaking, can repudiate the lease, but a re- ceiver of a corporation which has issued bonds to pay for new assets cannot repudiate the bonds. Looking at the matter from another stand- point, a lessee corporation conceivably might take advantage of a lease to niake the leased property relatively unimportant, but the shareholders of the lessor corporation, in event of a receivership of the lessee, would have no recourse except to their own property. On the other hand, holders of bonds issued to pay for the property of the merged corpora- tion very likely would occupy such a position with regard to the risk as to be the first to move for a receiver of the cbnsohdated cor- poration, and would have recourse to the earn- ing power of all the assets to recover their interest. Provided the shareholders of the corpora- tion which it is desired to merge can and will authorize the lease, the financing problem, of FINANCING AN EXPANSION 133 course, becomes very simple. In fact there is none. The lessee does not have to provide any funds to put the transaction through. It assumes a larger obligation in expectation of a still larger income. Presumably the leased property is more valuable to the lessee, for one reason or another, than to the share- holders of the lessor corporation. Whatever reasons would apply for a merger or consoli- dation of any kind might apply for a com- bination by lease. We have not undertaken to go into these reasons, but simply to indi- cate how, when found desirable, the managers of the corporations concerned might carry it out. We may examine several examples of guar- anteed stock which sufficiently indicate the purpose and scope of this form of financ- ing. The American Telegraph and Cable Company has $14,000,000 guaranteed stock outstanding. The property of the company is leased to the Western Union Telegraph Company for fifty years from May 12, 1882, at a rental of 5 per cent on the stock. The lessee is to maintain and renew the cables and equipment. The line of the Boston & Albany Railroad extends from Boston, Mas- sachusetts, to Albany, New York, and makes, with branches, a total of 304 miles. The cor- poration has capital stock outstanding to the 134 CAPITALIZATION amount of $25,000,000, and has leased its property to the New York Central & Hudson River Railroad for ninety-nine years at a rental of guaranteed dividends of 8 per cent on the stock, organization expenses, interest on bonds, taxes, expenses of maintenance, etc. The Boston & Albany Railroad Com- pany received $5,500,000 New York Central 3 1 per cent 100-year debentures to pay for certain property not included in the lease, the income from which yields about .77 per cent additional per annum on the stock. Divi- dends are paid quarterly at the following rates : 2 per cent in March, 2| per cent in June, 2 per cent in September, and 2j per cent in December. The line of the Boston & Providence Rail- road extends from Boston, Massachusetts, to Providence, Rhode Island, with branches, making a total of sixty-three miles. The property is leased to the Old Colony Railroad for ninety-nine years from April 1, 1888, at a rental of interest on bonds, dividends of 10 per cent per annum on the $4,000,000 stock, and $3000 per annum for organization ex- penses. The Old Colony Railroad is leased to the New York, New Haven & Hartford Rail- road for ninety -nine years from March 1, 1893, and the lessee assumes all liabilities. The Pittsburg, Fort Wayne & Chicago Rail* FINANCING AN EXPANSION 135 way extends from Pittsburg, Pennsylvania, to Chicago, with a branch, a distance of 470 miles. The capital consists of $38,875,300 special improvement and $19,714,286 com- mon stock. The special stock is subject to the common, and was issued to the Pennsyl- vania Railroad for improvements. The pro- perty is leased to the Pennsylvania Railroad in perpetuity from July 1, 1869, at a rental of interest and sinking-fund on bonds and 7 per cent per annum on both classes of stock. The lease was assigned to the Pennsylvania Com- pany on the lessee's assuming all obligations of the lessor. The rate of dividends guaranteed indicates the, valuation placed on the leased property. Though ordinarily it runs from 4 per cent to 8 per cent, it may, however, be almost any- thing. For example the Maine Central Rail- road guarantees 2 per cent on the $300,000 capital stock of the Rumford Falls & Range- ley Lakes Railroad. The Maftie Central Rail- road also guarantees 2 per cent on the $4,392,538 capital stock of the Portland & Ogdensburg Railway, running from Portland, Maine, to Lunenburg, Vermont. These repre- sent low points. Of course the lessee always guarantees interest on any bonds of the lessor. The Philadelphia & Reading Railway pays 12 per cent on the capital stock of the 136 CAPITALIZATION Philadelphia, Germantown & Norristown Railroad. The Delaware & Hudson Com- pany pays a dividend of 6j per cent on the $345,360 Rome & Clinton Railroad stock. The old Metropolitan Street Railway Com- pany of New York City guaranteed 16 per cent on the $1,000,000 capital stock of the Eighth Avenue Railroad. To make the discussion complete, we need to consider a type of holding company some- what different from the ordinary holding company formed for the purpose of com- bination. Usually the companies taken with an industrial consolidation are competitors. That is so from the very nature of the case. Any two or more concerns making the same kind of goods must to some extent be in com- petition. Companies taken into a railroad consolidation ordinarily are roads that lead into each other's lines in such a way as to form an extended system. In fact, so far as interstate lines are concerned the federal law prohibits a complete consolidation of any other kind. There is a class of companies, however, which unite concerns that are not physically connected in any way, and cannot from the nature of their business be com- petitors; at least, they cannot be in selling, though perhaps they might be in buying. One or two examples will explain the situa- FINANCING AN EXPANSION 137 tion better than any amount of further gen- eral statement. The American Light and Traction Com- pany has outstanding $11,146,700 common and $14,236,200 6 per cent cumulative pre- ferred stock. This company owns at least 97 per cent of the stock of the following con- cerns: Milwaukee Gas Light Company; De- troit City Gas Company; Grand Rapids Gas Light Company; Madison Wisconsin Gas and Electric Company; St. Joseph Gas Company; St. Paul Gas Light Company; Binghampton Gas Works; Consolidated Gas Company, Long Branch, New Jersey; Muskegon Trac-. tion and Lighting Company; St. Croix Power Company of Somerset, Wisconsin; Southern Light and Traction Company. The North American Company, with $29,793,300 capital stock outstanding, con- trols the Milwaukee Electric Railway and Light Company; Milwaukee Light, Heat and Traction Company; Milwaukee Central Heating Company; Racine Gas Light Com- pany; Kenosha Gas and Electric Company; Watertown, Wisconsin, Gas and Electric Company; Detroit Edison Company; Union Light and Power Company, St. Louis; St. Louis County Gas Company; Suburban Electric Light and Power Company, St. Iiouis; United Railways Company of St. 138 CAPITALIZATION Louis; Mississippi River Power Distributing Company; West Kentucky Goal Company. Such concerns as the Electric Bond and Share Company present a type still further away from the holding company for the ordin- ary form of consolidation. They are really financing concerns, and perhaps look to do- ing more thoroughly from the beginning, with subsidiary companies in the construction stage, what companies like the American Light and Traction and the North American have done with companies already estab- lished. The Electric Bond a'nd Share Com- pany and similar organizations put out gen- eral issues of collateral bonds secured on the first mortgage bonds of ne\*- traction, elec- tric lighting, or other public utility concerns. The issuing companies reserve the right to substitute collateral, so that, whenever the affairs of a subsidiary company warrant, they can take out from under the trust deed the securities of that particular corporation and put them on the market. When they do that they have to return other collateral of a re- quired standard. Though this principle has been applied so far only to public service corporations, no- thing in the idea prevents it from being ap- plied to industrial undertakings. Only the financing, generally speaking, jof industrials is FINANCING AN EXPANSION 139 not as well organized as the financing of pub- lic utilities. As we have seen all along, the railroads present the most developed and most conaplex forms of financing. Likewise the organization for financing railroads has developed further than the organization for financing the public utilities, and that in turn further than the organization for financing industrials. Though somewhat aside from corporation finance in any strict sense, the practice of financing real estate by means of collateral security-issues presents a matter of interest. Such issues follow two general forms. In one a real estate development company issues its own general obligation secured on the equity of redemption of specific real estate. That,is, the company finances its developments, so far as it can, on regular real estate mortgages; then finances the equity by the issue of its ob- ligations secured on the equities of a number of properties against each of which a specific first mortgage is outstanding. Such develop- ment companies may vary this general plan in many ways. Mortgage guarantee companies and simi- lar institutions issue the other type of real estate collateral securities. They simply place a number of real estate first mortgages as col- lateral under an issue of their bonds. Since 140 CAPITALIZATION the collateral mortgages do not all fall due at the same time, the issuing company must reserve the right of substitution. This is not a matter of corporation finance at all, but simply a device for splitting-up real estate mortgage securities into uniform and rela- tively small amounts to fit the pocket-book of the small investor who likes that kind of se- curity. The issuing company makes its profit out of the diflference between the rate of inter- .est the mortgages pay and the interest the collateral bonds bear. In return it adds its own obligation to the obligations of the mort- gagors, and further lessens risk by the distribu- tion of security. Railway terminals often give rise to a form of financing a little different from any yet mentioned. Located in the hearts of big cities, they frequently do service for more than one railroad. Companies using them are likely to finance them through a separate corporation, and become in one form or other joint obli- gors on any securities issued to the public to raise the funds to pay for land and construc- tion. One example will illustrate the whole situ- ation. The Kansas City Terminal Railway Company owns and operates the new joint terminal in the city from which the company takes its name. The property serves to give FINANCING AN EXPANSION 141 ten railroads an entrance into this big West- ern commercial centre. They are the: Atchi- son, Topeka & Santa Fe Railway; Chicago & Alton Railroad; Chicago, Burlington & Quincy Railroad; Chicago, Milwaukee & St. Paul Railway; Missouri, Kansas & Texas Railway; Missouri Pacific Railway; St. Louis & San Francisco Railroad; Union Pacific Railroad; Wabash Railroad, Each company agrees to pay one tenth of the principal and interest on the bonds issued by the terminal company, one tenth of the taxes, and its share of the operating expenses. Each is also jointly as well as severally liable; that is, if any one or more of the railroad com- panies entering into this undertaking should default on the agreement, the others would have to make good the amount defaulted. The terminal company .has authorized $50,000,000 first mortgage 4 per cent bonds, due January 1, 1960, subject to call as a whole on January 1, 1930, or on apy interest date thereafter. Some $12,500,000 of these are already outstanding. It is estimated that the property will cost when completed about $30,000,000. The property comprises: — 1. A union passenger station and fifty-one acres for trackage. 2. A six-track line of 6.61 miles as an ap- proach or throat to the station. 142 CAPITALIZATION 3. A four-track line 2.36 piiles long con- necting the throat with the main line of the Chicago, Burlington & Quincy Railroad. 4. A four- track line 6j miles in length along the north side of the city and connecting with the throat. 5. Two double-track lines 6.72 miles in length reaching the stockyards and the rail- roads from the west. Plans for the whole include 188 miles of main and industrial railroad tracks, four lo- cal freight stations, passenger, freight, and switching yards, in addition to the big union passenger station. Terminals like these are to-day one of the most important keys to the railroad situation. We have gone into this description at some length to show the nature of the property financed by these joint undertakings, and to bring out some of the reasons, besides the ob- vious one of convenience, for the joint financ- ing. Aside from the matter of convenience, they would be too great a burden on the single line. The Kansas City Terminal is one of many. To cite just another, the Boston Terminal Company owns the property known as the South Station in Boston, which gives an entry into that city to the New York, New Haven & Hartford Railroad and the Boston FINANCING AN EXPANSION 143 & Albany Railroad, — ■ now, by lease, part of the New York Central system. These two companies pay a rental in monthly install- ments of a sum sufficient to meet operating expenses, 4 per cent on $500,000 of stock which the railroads themselves own, and the interest on the $14,000,000 first mortgage 31 per cent bonds, due 1947, which the terminal company has outstanding. This situation of a separate terminal cor- poration leads to mentioning a tendency to what we may call a corporate division of labor. Organizers of corporate enterprise and their lawyers are multiplying subsidiary corpora- tions. They often form a new one for each division of the business. A single enterprise may have a corporation to erect buildings, another corporation to own and operate them, a corporation for the purchase of raw materials, one for its transportation, another for the manufacturing operation, and still another for the selling organization. Only time can tell whether this tendency will spread more widely and extend to still further division, or whether the investing public will insist on a greater simplicity in securities and a massing of the credit of the whole enter- prise. AMORTIZATION In the chapter about "Trading on the Equity" we discussed considerations affect- ing the desirability of corporate indebtedness. Stating the case briefly, the borrowers in a business by creating a debt take a greater risk on the capital they have committed, and the lenders accept a lower return and less in- fluence in the management for their capital in consideration of a smaller risk. Let us repeat an elementary matter just for the sake of having the facts directly before us. Take, for example, a business that will aver- age a return of, say, 8 per cent on all the cap- ital invested in it. Then an investment of $1,000,000 will give an average annual return of $80,000. If by placing a tnortgage on the property the managers of the business can borrow $500,000 at 6 per cept, they will, to be sure, have to pay $30,000 annually for this capital, but will have $50,000 left for income on their own $500,000 invested in the business. Borrowing increased their return from the 8 per cent they would have received without the hired capital to 10 per cent. They are AMORTIZATION 145 running the risk that next year the business may earn only $50,000. In that event they will still have to part with $30,000 to the lenders and have only $20,000 for themselves. Out of a return on the total capital of 5 per cent they will receive only 4 per cent. If the business comes up to expectation, however, and earns an average of 8 per cent on all capital, the owners, who are the shareholders, gain largely. This expectation of greater gain furnishes the regular business reason for bor- rowing. Such a reason, however, is not temporary but permanent. If the transaction is based on a good business principle to-day, it continues good business to-morrow and always. Never- theless, in spite of the permanence of such a reason, an individual conducting a business might wisely contemplate paying off his debts, because he is liable to accident and death at any time, and might not wish to have his es- tate exposed to the greater hazard of trading on the equity. This consideration of prudence does not apply to a corporation, which is per- petual in its nature. Since to have a debt is good business, why should a corporation which has once created one ever amortize it? There are two rea- sons. Amortization (1) permits a corporation to readjust its financial plan to changed or 146 CAPITALIZATION changing conditions, and (2) meets a require- ment of those advancing the borrowed money, or procures the money on sufficiently more favorable terms to make the provision for retiring the debt good policy. In the ordinary situation, if the corpora- tion were the only party to the debt bargain it might not amortize the debt at all, or pro- vide only for reducing instead of retiring it. From the single standpoint of a debt, as such, being good business, one without any matur- ity would be ideal. Some English railroads do have perpetual debts, usually debentures of one form or another. American corpora- tions have not commonly adopted such a form of indebtedness. There are a few in- stances of it. For example, the Public Service Corporation of New Jersey, operating the traction lines in that populous section ad- jacent to New York City, has outstanding about $20,000,000 perpetual interest-bearing certificates. Perpetual indebtedness does not, however, for the present at any rate, accord with the American custom. As a business expedient it is of doubtful propriety. There are other considerations besides the merit of being in debt. American corporate creditors do not want to rely solely on the " market " for converting their asset into cash. They want an obligation to return the principal at a AMORTIZATION 147 time certain, which they can wait for if they wish. Of course, this is notably true of that vast majority of smaller corporations whose securities never have an active market any- way. From the standpoint of the debtor party a perpetual debt does not affqrd the corpora- tion the desirable periodic opportunity for readjusting financial arrangements in accord with changed conditions in the particular enterprise or the general business situation. We should remember, however, that pay- ing the creditor and paying the debt are very different matters. American railroad corpor- ations have regularly adopted the practice of paying the creditor, but not of paying the debt. In other words, they do not amortize a debt but refund it. Since a continuance of the debt seems de- sirable from the argument so far, why do so many corporations other than railroads pro- vide for amortization by sinking-funds or by serial repayment.'* Are they mistaken in their policy, or do they consider business reasons beyond those indicated.'* We have already twice mentioned one reason, the opportunity amortization gives for readjusting financial arrangements to accord with changed condi- tions, whether in the general business situa- tion or in the particular enterprise. It may be 148 CAPITALIZATION that in the course of time the corporation can- not advantageously use so much capital in the business as at present and will therefore desire to pay off part of the debt. Refunding would meet the contingency of conditions changing for the better, and enable the cor- poration to borrow on more favorable terms or in large amounts. The business may have grown so prosperous, its earning power so in- creased, or the general business situation may have grown better, so that, wJiereas at first it may have had to pay, say, 6 per cent for its bor- rowed money, it can at the maturity of this issue now borrow at, say, 4| per cent. This is taken up at length in the section on the interest rate. Or the corporation may want to increase its borrowings in order either to trade on a thinner equity or to extend the business. By a refunding operation it can do either of these things advantageously. It can issue the new bonds at the lower rate, or it can put them out in a larger amount than the issue they refund. On the other hand, if con- ditions make it desirable to retire or reduce the debt, the corporation cannot do either unless it has provided funds. Then, too, when a specific asset stands back of a specific liability, and that asset by its nature decreases during the hfetime of the debt, conservative corporate management AMORTIZATION 149 compels an amortization of the debt at least as rapid as the decrease in the value of the asset, or the building-up of a special fund to stand in place of the decreasing value. Equip- ment bonds stand in just this position, and form an exception to the general rule that raihoads do not provide means for the retire- ment of their debts. The bonds are issued for the purchase of specific cars and locomotives and are secured by title to 'the equipment bought. A serial maturity retires them faster than the depreciation. Serial repayment is the rule, too, in the case of the Great Lakes steamship bonds issued on the security of single vessels. It is also the rule with bonds issued on the security of natural resources which diminish with use, as bonds on timber- lands and coal or other mines. With the railroad equipment and the steamboat the decrease in the value of the asset is regular, and the debtor corporation must, in prudence, provide with correspond- ing regularity for amortization. In the case of bonds issued on natural resources, prudence dictates that amortization n€ed only be pro- vided to keep pace proportionately with the quantitative decrease of the asset. Regu- larly the amortization agreement provides that a certain amount per thousand feet of timber cut or, per ton of coal mined be set 150 CAPITALIZATION aside for the sinking-fund. This sum should be large enough at least to maintain the ratio of assets to liabilities. Further to as- sure the bondholders the corporation usually agrees to cut or mine annually an amount sufficient to provide for the retirement of all the bonds by the time of their maturity. It is common, in fact, to have such bonds actually mature in series. Assets of a timberland, unless conserved by forestation, or of a coal mine, necessarily diminish with use. With the ordinary public service or manufacturing corporation this does not follow. Reasonably careful manage- ment requires that the corporation at the very least spend enough in -maintenance to keep up the value of its assets. If the corpor- ation keeps its assets in the same proportion to its debt it satisfies the (temands of pru- dence. A debt results from an agreement however, and it is an old maxim that it takes two par- ties to make a bargain. So f.ar we have dis- cussed only the considerations affecting one party, the debtor corporation. What the cor- poration may consider adequate for the de- mands of prudence, the creditor party may not deem nearly equal to his desire for safety. For example, if the value of a special asset pledged as security decreases from its very AMORTIZATION 151 nature, as in the case of the railway equip- ment or the steamship, the creditor will not rest satisfied with any less assurance of the maintenance of the equity than that given by serial repayment. Amortization in this way requires that certain of the bonds defin- itely fall due each year. Since failure to pay the maturing bonds constitutes a default of principal, with the consequent loss of right to control the property, a corporation cannot fail merely as a matter of convenience to keep up the amortization. Though amortization may not be so import- ant to the creditor in cases other than those already mentioned, he may nevertheless re- quire it as a condition of investing. Stating the actual situation more nearly, the banking- house arranging to finance an issue of bonds may insist on a sinking-fund as a measure of protection to their clients. That leads im- mediately to the main part of the discussion. Assuming that the debt is to be amortized, in what manner shall the corporation provide for its repayment ? For the sake of facilitating statement, the discussion will assume the common case of a corporate debt represented by bonds and se- cured by mortgage to a trust company for the benefit of the bondholders. Principles of amortization, however, would be the same 152 CAPITALIZATION for other forms of debt as for that. Several questions will test the merit of the plans of amortization now in use. 1. What gives assurance that the stipula- tions for amortization will be, carried out ? 2. How will the amortization provisions affect the market for the security ? 3. How evenly do they distribute the bur- den of the debt ? 4. What work do they involve in carrying them out ? 5. What assurance do they give that they equal the requirements .'' 6. How does the cost to the corporation compare with that of other forms of amortiza- tion ? To explain question 3, - — the burden of a debt comprises the obligation to pay interest and the obligation to pay principal. Serial repayment and sinking-funds have for their very purpose the distribution of this burden of principal payment over a period of time. Since principal payment, however, makes only part of the burden, the manner of dis- tributing this may disturb the equality of in- terest payment and result in an uneven dis- tribution of the whole debt burden. Ideally the burden of principal and interest combined should weigh evenly through the period of the debt. AMORTIZATION 153 Methods of amortization fall under several heads : — - (a) The bonds may mature serially. (b) The corporation may build up a re- demption fund by depositing cash with the trustee. (c) It may invest the redemption fund in securities other than those it has issued it- self. (d) It may use the fund to purchase securi- ties of the issue being amortized. Serial maturity meets with an objection in the answer to the second of the test questions — as to the eflPect of the amortization provis- ions on the market for the security. Such a ma- turity makes impossible a uniform quotation in terms of price, and, therefore, with one or two other considerations affecting the mat- ter, makes difficult the creation of an active market such as exists on the stock exchange and through street trading in inany securities capable of a uniform quotation in terms of price. Take, for example, the New York Cen- tral Railroad equipment 4| per cent bonds, due serially from January 1, 1911, to January 1, 1925, inclusive. A price quotation for the entire issue except par (100) would be impos- sible. Anywhere below par the bonds having the shortest time to run are worth the most in terms of price. That is to say, a 4^ per 154 CAPITALIZATI0N cent bond having only three years to run would sell at 99.17 in order to yield 4.80 per cent. If it had nine years to run it would have to sell at 97.83 in order to yield 4.80 per cent. Without making any allowance for the invest- ment demand at the time running to short- term or long-term securities, if the nine years' bond were worth 97.83, then the three years' bond would be worth 99.17. A uniform quotation can be given, to be sure, in terms of basis, as, say, "any matur- ity, price to yield 4| per cent," or "price to yield 4f per cent, less one eighth." Such a quotation is too technical for -any but the ini- tiated buyer. It involves too many consider- ations. Furthermore, fashions of investing, as already indicated, throw out of gear the possibility of quoting uniformly in even such a complex manner. As a matter of fact, de- pending on a good many considerations, in- vestors at one period show a preference for short-term securities, at anbther for long- term. During a time of short-term invest- ment preference, a bond due in two years might command a 4f per cent basis, but one of the same serial issue due in ten years might not command better than a 4f per cent basis, less one fourth ; that is to say, a quarter of a point lower in real price than the shorter maturity. AMORTIZATION 155 Such an impossibility of a practical uni- form quotation does actually detract from the marketability of a security, and in conse- quence lessens its value; for Kjuickness of the market is an element of actual value. Doubt- less the serial maturity, and therefore the lack of one quotation for an issue as a whole, explains some part of the fact that equip- ment bonds have sold at relatively low prices considering their intrinsic merit as a security. Of course, in the case of equipment bonds the importance of amortization, and the assurance of it that a serial maturity gives, outweigh the matter of the market diffi- culty. Another disadvantage of serial maturity, though not necessarily inherent in the form itself, exists in the use of the form in practice. Since the annual or semiannual maturities in practice are generally of equal or nearly equal amounts, the serial repayment makes an un- even distribution of the burden of the debt. A few figures will express this more quickly and plainly than words. Take a debt of $1,000,000 bearing 6 per cent interest and having a serial maturity of $100,000 annually. That is to say, the debt is repayable in ten equal annual installments of principal. Burden of the debt will then dis- tribute itself in this manner: — 156 CAPITALIZATION Amortization Int?rest Total debt charge charge burden 1st year $100,000 $60,000 $160,000 2d year 100,000 54,000 154,000 3d year 100,000 48,000 148,000 and so on. The amortization charge, or amount of principal retired each year, remains con- stant with the result of a steadily diminish- ing interest charge. Consequently the total burden of the debt bears heaviest the first year and steadily grows lighter. When the enterprise is new, the heaviest charge comes at a time when the corporation can least conveniently carry it. If the serial repayment offsets the dimin- ishing of an asset through depreciation, as in the case of equipment bonds, such an imeven distribution of the debt burden becomes in- evitable. The rate of depreciation does not adjust itself to meet the financial convenience of a corporation. As already stated, however, an unequal debt burden is not inherent in the nature of serial maturities. Proper computa- tion could so grade the serial repayment that it would be small in the beginning and ad- vance each year the exact amount the in- terest charge declined. The discussion will illustrate this further on. So much for serial repayment. On account of its interfering with the opportunity to AMORTIZATION 157 make a market that an issue uniform in ma- turity as well as in other respects affords, it seems undesirable except under special cir- cumstances, as in the case of equipment bonds. There remains for us a discussion of sinking-funds. We can dismiss with a word or two the possibility of cash deposits to build up a fund with the trustee available aiid sufficient to retire the debt at its maturity. A trust com- pany cannot on the average afford to pay an interest rate sufficient to offset the interest the corporation pays on the bonds outstand- ing. If it can pay three, or even four, per cent, and the bonds bear interest ^.t five per cent, obviously the corporation loses heavily on its sinking-fund, besides adding to the risk of its own business whatever risk there may be of the trust company failing. This form is ob- jectionable mostly from the sixth considera- tion, the cost to the corporation. As a second form of sinking-fund, the cor- poration could apply its annual amortization charge to the purchase of securities other than its own. If this charge were properly graduated, it would distribute the burden of the debt. A requirement in the trust deed that securities purchased for the sinking-fund be placed on deposit with the trustee would guard against the corporation impairing the 158 CAPITALIZATION fund under special stress. "Question arises immediately, however, of the safety of the securities purchased for the fund. A diffi- culty closely connected with the question is the proper adjustment of inpome return on the sinking-fund securities to offset the inter- est payment on the corporation securities being amortized. If the outstanding bonds yield six per cent, unless the securities in the sinking-fund average to yield six per cent, the corporation suffers loss. Again, if the securi- ties being amortized carry a high rate of in- terest, any attempt to get an offsetting inter- est rate in the sinking-fund securities would simply mean the addition of another risk to the risks inherent in the enterprise. Getting the sinking-fund securities into cash available to meet the maturity of the outstanding bonds offers another difficulty. Unless all the paper purchased for the fund matures before the outstanding bonds, the corporation assumes the risk of the market in disposing of them. To have all the sinking- fund securities mature in time to meet the payment of the outstanding bonds, yet not so long before as to cause substantial loss through a large cash deposit in the bank, would be impracticable. All this calls for a great deal of work and the exercise of careful banking judgment. AMORTIZATION 159 Any attempt to make money on the sinking- fund obviously creates too great a temptation and leads directly to danger. The best skill and judgment in the world would not be able, with due regard to other considerations, ex- actly to adjust the income on the sinking-fund to meet the interest on the debt. Enough has been said to show that a sinking-fund of this class cannot be a matter of exact calculation. There remains a third form of sinking-fund amortization. To take advantage of this, a corporation must issue its bonds subject to call. In order to offset what an investor in- clines to regard as a disadvantage, the uncer- tainty as to when his loan may mature and involve the necessity for reinvestment, the corporation usually makes the price at which the bonds are subject to call some point above par — say, 105. The fact that the call price limits an advance in the market price also weighs in the minds of many investors. If the corporation must call some of the bonds every year, or may call any, or all, before the stipulated certain maturity, naturally a pur- chaser will not pay more than the call price and run the risk of loss from having his bonds called earlier than the full term. The sur- prising thing is that he will ever do so. Yet occasionally callable issues go to a market price higher than the call price. If the cor- 160 CAPITALIZATION poration is under no obligation to call, but re- serves the right to call simply as a privilege, this does not surprise so much. The pur- chaser may argue that the corporation will not exercise the privilege, particularly if it have outstanding second mortgage securities that would thereby become a first lien and present an obstacle to the corporation If it should wish to take advantage of an enhanced credit in a general refunding operation. If the corporation has only one issue, callable at, say, 102, bearing five per cent interest and having fifteen years to run, which would make the call price of 102 a 4.80 basis, and the bonds should advance to 106.50 or approx- imately a 4.40 basis, the corporation might be tempted to call the bonds at 102 and re- fund by selling bonds at its apparent credit for a security of that class, "on a 4.40 basis. For example, It might refund with 4s at 95^, which would be close to the 4.40 basis. The longer the security had to run the more prob- able a situation that would make the refund- ing profitable. For considerations quite aside from amor- tization, however, ordlnarilj^ a corporation should make its bonds subject to call. It should do this in order to enable it to take care of contingencies that might arise In the business that would make the right to call of AMORTIZATION 161 the utmost importance. The possibility of wanting to create a much larger first mort- gage issue to extend the business when the corporation could not finance on a second mortgage at all, or could do so only at a much greater disadvantage, is only one of many conditions that might arise to make the right to call tremendously important. Since the corporation for such reasons as these should reserve the right to call the issue as a whole anyway, the further disadvantage of making the issue subject to retirement in part, and certain of retirement in part from time to time for amortization purposes, does not add much to the disadvantage under which the issue may suffer. We shall discuss the calling of bonds further under the general head of "Form." If a corporation issues bonds subject to call, and amortizes them by calling the re- quired amount each year, it keeps the ad- vantage of a uniform issue with a correspond- ing uniform price quotation, and consequent better market position than an issue fall- ing due serially would have. Ordinarily the trustee must, in this form ofamortization, if it can, purchase the sinking-fund bonds on the open market at a price lower than the call price. If the market price is not below the call figure, the trustee must draw bond num- 162 CAPITALIZATION bers by lot up to the required amount and call the bonds drawn. The Mortgages con- tain full provisions for this, and for notifica- tion to the holders of coupon bonds by pub- lication of the numbers of the bonds drawn for call, and by letter to the holders of regis- tered bonds. Often, however, the corporation agrees to call all the sinking-fund bonds at the agreed price, no matter what the market price may be, and thereby adds an attractive little element of speculation to the security. If an investor should buy his bonds at an issue price of 97, and should have them called in several years at 103, he w(»ild profit hand- somely. In the best actual practice of amortizing by this method, corporations have adopted the form of keeping the bonds "alive" in the hands of the trustee for the sinking-fund and applying the interest on these bonds to the purchase of further bonds for the fund. The next page shows such a fund actually worked out. A sinking-fund in the form just discussed gains the desired result of equalizing the bur- den of the debt. It does not call for the diffi- cult task of judgment of investing in other securities for a sinking-fund. It accomplishes directly the end in view, the amortization of the debt, and gives an assurance almost, if AMORTIZATION 163 SINKING-FUND COMPUTATION The a. B. Company Issue, $1,000,000 6 per cent 15-year bonds. Denominations, $1000, $500, and $100. Due 1st April, 1924. Interest payable 1st April and October. Issue to be purchased or drawn each year at par and kept alive by trustee. Annual interest, $60,000 Sinking-fund, $46,«00 Interest Total accrued amount on bonds ToUl Bonds Cash bal- of bonds Amount held in amount purchased ance in held in of smk- sinking- to invest for sink- sinldng- sinking- Year ing-fuDd fund each year ing-fund fund fund 1 October 1910 $46,200 246,200 «46,200 $46,200 1911 46,200 »2,772 48,972 48,900 $72 95,100 1912 46,200 S,708 51,978 51,900 78 147,000 1913 46,200 8,820 55,098 55,000 98 202,000 1914 48,200 12,120 58,418 58,400 18 260,400 1915 46,200 1S,624 61,842 61,800 42 322,200 1916 46,200 19,332 65,574 65,500 74 387,700 1917 46,200 23,262 69,536 69,500 36 457,200 1918 46,200 27,432 73,668 73,600 68 530,800 1919 46,200 31,848 78,118 78,100 16 608,800 19i0 46,200 36,{i34 82,750 82,700 50 691,600 1941 46,200 41,496 87,746 87,700 46 779,300 19S» 46,200 46,758 93,004 93,000 4 872,300 19*3 46,200 54,338 98,642 08,500 42 970,800 1 April 1924 28,124 28,166 29,100 66 999,900 not quite, as strong as serial repayment that this will be done. The plan 'leaves the issue uniform in all respects and, therefore, sub- ject only to the considerations of the callable feature, leaves it in the best possible position market-wise. It is mathematically certain that the amortization provisions equal the requirements. The cost to the corporation is as small as possible in order to gain the de- sired advantages. 164 CAPITALIZATION Though this form of sinkJing-fund is the best in use and contains the essential quali- ties of the best possible plan of amortization, it can nevertheless be simplified and strength- ened in several respects. The nominal keeping the bonds alive in the hands of the trustee shows how slowly the mind advances in prac- tice. The idea of a "fund" for amortization prevails over the essential idea of amortiza- tion itself. The plan of the bonds continu- ing to draw interest probably results from the thought of a constant sinking-fund payment plus a constant interest payment making the burden of the debt constant. Keeping the bonds "alive" merely renders this plausible. Though they are in the hands of the trustee, which at law may prevent the extinction of the debt, the trustee has a double trust, one to the holders of the outstanding bonds and one to the corporation, to keep the purchased bonds, so far as the principal of the debt is concerned, as though they were dead and canceled. Indeed, in most cases the trustee must stamp the bonds, "Purchased and held for the sinking-fund," which would effectively prevent their negotiation. To all intents and purposes the bonds are dead. Their continu- ing to draw interest is a mere device to equal- ize the burden of the debt. Actually to can- cel the purchased bonds would accord with AMORTIZATION 165 the real situation and make a more artistic arrangement. The business would then take the form of the corporation, annually or semi- annually, appropriating a sum equal to the base sum obtained by computation plus the amount of interest on the bonds kept alive in the sinking-fund under the present form. The corporation would give this annually increas- ing sum to the trustee for Ihe purchase of bonds on the market or by call. It should be the duty of the trustee to cancel them when bought. The reluctance of trust companies to assume any real responsibility in connec- tion with bond issues of which they are trus- tees is well known. However, to give the bondholders as strong an assurance of amor- tization as serial maturity involves, failure on the part of the corporation to provide at the proper time the stipulated amount for the purchase of bonds should constitute a default involving the same consequences as failure to pay interest when due. It should be the duty of the trustee to notify the bond- holder of any failure on the part of the cor- poration to provide for the amortization. Such a duty does not go beyond a mere admin- istrative responsibility no greater than trust companies already accept in the execution of trusts. VI FORM No. . Shares No. 1 STATE OF GEORGIA THE CHATTANOOGA, ROME AND COLUM- BUS RAILROAD COMPANY This certifies that is the owner of Shares of One Hundred Dollars each, of the full paid Capital Stock of the Chattanooga, Rome and Columbus Railroad Company, transferable only on the books of the Company, in person or by Attorney, on surrender of this Ce'rjtificate. Rome, Georgia, 19 . . . Secretary. President. No. {On stub) . Shares Issued to .19. Received above de- scribed Certificate, 19... (On back) For Value Received . . . hereby sell, assign and transfer unto Shares of the Capital Stock represented by the within Certificate, and do hereby irrevocably consti- tute and appoint Attorney to transfer the said Stock on the Books of the within named Company, FORM 167 with full power of substitu- tion in the premises. Dated 19. .. In the presence of. (Right end) Registered this day of 19 . . . Central Trust Company of New York, by Secretary. (Left end) Countersigned this day of 19 ... . by Transfer Agent. No. 2 Common Stock No Shares. CHICAGO AND INDIANA COAL RAILWAY COMPANY This certifies that entitled to Shares of One Hundred Dol- lars each of the Common Capital Stock of the Chicago and Indiana Coal Railway Company, transferable only on the books of the Company, in person or by Attorney, upon the surrender of this Certificate. This stock is subject to an issue of a six per cent, non-cumu- lative Preferred Stock of said Company. All dividends paid by said Company in any year, except said six per cent, upon the Preferred Stock, shall be paid upon this Stock. This Certificate is not valid unless counter- signed and registered by the Registrar of Transfers of the Company. 168 CAPITALIZATION In Witness Whereof, the said Company has caused this Certificate to be signed by its President and Treasurer, this day of 19. . . Treasurer . ._ President. No.. Dated. {On stub) (On back) For value received, . . . hereby sell, assign transfer unto and .19... Shares Issued to Shares of the For Capital Stock represented by the within Certificate, and do hereby irrevocably constitute and appoint Received the above de- scribed Certificate of the Common Stock, 19... Attorney to transfer the said Stock on the Books of the within named Com- pany, with full power of substitution in the pre- mises. Dated 19 In presence of (On end) Countersigned and Registered this day of 19.. . Metropolitan Trust Company of the City of New York, Registrar of Transfers, by Secretary. FORM 169 No. 13 Preferred stock No Shares. CHICAGO AND INDIANA COAL RAILWAY COMPANY This certifies that entitled to Shares of One Hundred Dollars each of the Preferred Capital Stock of the Chicago and Indiana Coal Railway Company, trans- ferable only on the books of the Company, in person or by Attorney, upon the surrender of this Certificate. This Stock is entitled to a preference to the aggre- gate amount of six per cent, in dividends which may be declared in any fiscal year out of the net earnings of the Company, which dividend shall not be cumulative. All dividends paid by said Company in any one year, except said six per cent., shall be paid upon the Com- mon Stock. This Certificate is not valid unless countersigned and registered by the Registrar of Transfers of the Com- pany. In Witness Whereof, the said Company has caused this Certificate to be signed by its President and Treasurer this day of 19 . . . Treasurer President. (On stub) (On back) No For Value Received, Dated 19 . . . hereby sell, assign and Shares transfer unto Issued to Shares of the Capi- For tal Stock represented by the within Certificate, and do Received the above de- hereby irrevocably consti- 170 CAPITALIZATION scribed Certificate of the tute andjEppoint Preferred Stock, Attorney to transfer the 19 . . . said Stock on the Books of thewithin named Company, with full power of substitu- tion in the premises. Dated. 19.... In presence of (On end) Countersigned and Registered this day of 19... Metropolitan Trust Company of the City of New York, Registrar of Transfers, by Secretary. Some of the expressions on these stock cer- tificate forms may require explanation to people unfamiliar with financial paper. " Shares of one hundred dollars each " : That is to say, $100 is the "par value"; so that if the authorized capital of the corporation were $1,000,000, it would have a total of 10,000 shares. If the certificate should read: "Shares of ten dollars each," then, of course, the total number of shares of a corporation capitalized at $1,000,000 would be 100,000. To get a further understanding of what this statement may mean, read the discussion of "Watered Stock." "Full paid": A corporation may issue shares to subscribers who have paid up only FORM 171 part of the amount agreed. In that event an assignee of the shares would get only what property the assignor had, and might be liable to the corporation for the amount due. The liability of the shareholder to the corpor- ation is also an asset of the corporation to which creditors have a right. To indicate that no such liability to the corporation exists, its certificates bear the words "full" or "fully " paid. "Countersigned this day of 19 . . . bp Transfer Agent" : Legal title to a share of stock lies in the reg- istered owner; that is, in the person whose name appears on the books of the corpora- tion as the owner. An assignee of the shares in possession of the certificate has it in his power to have the legal title transferred to him on the books of the corporation. If a corporation is of some ma^itude, and its shares are frequently dealt in, it may main- tain a formal transfer agency. Depending on the frequency of transfers, this may be an en- tirely separate office, or a department in the corporation's own general offices, or a trust company which has undertaken to do the work. The president and the secretary may sign the certificates in blank, or may author- ize the transfer agent to sign them with a stamp. The counter-signature of the transfer 172 CAPITALIZATION agent becomes a means of validating the certificate. The corporation may close its transfer books for a definite period over divi- dend dates, or before shareholders meetings, in order to give itself time to make up the list of shareholders to whom it must mail divi- dends, or to determine who is entitled to vote at the meetings. "Registered this day of 19. . . Central Trust Company of New York by Secretary " : A trust company ful- filling the duties of registrar of stock simply acts as a check on the transfer agent in guard- ing against mistake or fraud in the number of shares issued. The signature of the registrar gives an assurance that the number does not exceed the amount authorized. Of course the situation demands that the registrar be ab- solutely separated from the transfer agent. The purpose of registering stock differs en- tirely from that of registering bonds, but an- swers to that of a trustee's "certification" of bonds. In respect to transfer of title, all stock by its very nature occupies the same position as registered bonds. The wording of the power of attorney form appearing on the back of a stock certificate fully explains its purpose. In the ordinary course of sale through a broker, the owner of the stock would simply fill ip the date line. FORM 173 sign, and get his signature -witnessed. The seller does not know the purchaser, and can- not fill in his name. If the seller should fill in the blank for the attorney, that particular person would either have to appear at the transfer agency or exercise the "power of substitution" to make out a new power of attorney. (Form of $1000 Coupon Bond) $1000 U.S. Gold. £205.15.2 Stg. M.4200 D.R.W. Francs 5160. Guilders -2480. No United States of America. ST. LOUIS AND SAN FRANCISCO RAILROAD COMPANY General Lien 15-20 Year PeriCent. Gold Bond. St. Louis and San Francisco Railroad Company (hereinafter called the Railroad Company) for value received, hereby promises to pay to bearer, or, if regis- tered, to the registered holder of this bond, one thou- sand dollars in gold coin of the United States of America of or equal to the present ^standard of weight and fineness, on the first day of May, 1927, at its office ^or agency in the City of New York;" or, at the option of the holder, in London, England, 205 pounds 15 sh. 2d. Sterling; or in Frankfort o/M. or Berlin, Germany, 4200 marks, D.R.W. ; or in Amsterdam, Holland, 2480 guilders; or, 5160 francs if paid in France, Belgium or Switzerland; and to pay interest on said principal amount from May 1, 1907, in said cities and countries respectively, in said respective currencies, at the rate 174 CAPITALIZATION of ... . per centum per annum, payable at such office or agency in like gold coin semi-annually on the first day of November and of May in each year, upon pre- sentation and surrender of the annexed coupons. Both the principal and interest of this bond are payable without deduction for any tax or taxes which the Railroad Company may be required to pay thereon or retain therefrom under any present or future law of the United States, or of any state, county or munici- pality therein. This bond is one of a series of coupon bonds and registered bonds of the Railroad Company, known as its General Lien 15-20 Year Gold Bonds, limited to the principal amount of $109,850,400 at any one time out- standing, and all issued and to be* issued under, and equally secured by, a mortgage and deed of trust, dated August 27, 1907, executed by the Railroad Com- pany to Bankers Trust Company and N. A. McMillan, as Trustees, and under and by an Agreement dated December 31, 1908, made by and between the Rail- road Company, said Trustees and the Holders of all of the then outstanding General Lien 15-20 Year Gold Bonds. For a description of the properties and franchises mortgaged, the nature and extent of the security, the rights of the holders of bonds, and the terms and conditions upon which the bonds are issued and secured, reference is made to ^aid mortgage and deed of trust and to said Agreemept. The bonds of this issue are subject to redemption at the option of the Railroad Company at a premium of two and one half per cent, and accrued interest, on any interest day prior to May 1, 1922, and at par and accrued interest on May 1, 1922, or*on any interest day subsequent thereto. This bond shall pass by delivery unless registered in the name of the owner on the books of the Railroad Company, such registry being noted on the bond by the FORM 175 Railroad Company. After such registry, no transfer shall be valid unless made on said books by the regis- tered holder in person, or by his attorney duly author- ized, and similarly noted on the bond, but the same may be discharged from registry by a transfer thereon to bearer, and thereupon transferability by delivery shall be restored; but this bond may again from time to time be registered or transferred to bearer as before. Such registration, however, shall not affect the nego- tiability of the coupons, which shall continue to be transferable by delivery. The coupon bonds are for $1000 each and are num- bered consecutively from 1 to 109,851 inclusive, but the Railroad Company may, in lieu of any one thereof, issue ten coupon bonds for $100 each, bearing the same serial number and lettered consecutively from A to J. The holder of any coupon bond for $1000 may, at his option, surrender for cancellation his bond with all unmatured coupons thereto appertaining in exchange for a registered bond without coupons, as provided in said mortgage and deed of trust. This bond shall not become valid or obligatory for any purpose unless and until it shall have been authen- ticated by the certificate hereon endorsed of the Trust Company at the time being one of the Trustees under said mortgage and deed of trust. In Witness Whereof, St. Louis "and San Francisco Railroad Company has caused this bond to be signed by its president or one of its vice presidents, and its corporate seal to be hereunto affixed and to be attested by its secretary or an assistant secretary, and coupons for said interest with the engraved signature of its treasurer or an assistant treasurer to be attached hereto, as of the twenty-seventh day of August, 1907. St. Louis and San Francisco Railroad Company. By President. 176 CAPITALIZATION Attest: Secretary. {Form of Coupon on $1000 Bond) No On the first day of 19 • • ., unless the bond hereinafter mentioned shall have been called for pre- vious redemption, St. Louis and San Francisco Rail- road Company will pay to bearer at its office or agency in the City of New York, U. S. A., on surrender of this coupon dollars U. S. Gold; or in London, England, £ ; or in Frankfort o. / M., or Berlin, Germany, M ; or in Amsterdam, Holland Guilders; or, if paid in France, Belgium or Switzerland, Francs; being six months' interest then due on its General Lien 15-20 Year Gold Bonds No Treasurer. {Form of Registered Bond) No $ United States of America. ST. LOUIS AND SAN FRANCISCO RAIL- ROAD COMPANY Registered General Lien 15-20 Year Per Cent. Gold Bond. St. Louis and San Francisco Railroad Company (hereinafter called the Railroad Company) for value received, hereby promises to pay to or assigns, thousand dol- lars in gold coin of the United States of America, of or equal to the present standard of weight and fineness, on the first day of May, 1927, at its office or agency in FORM 177 the City of New York; and to pay interest on said principal amount from the first day of May or of No- vember, as the case may be, next preceding the date of this bond, at the rate of per centum per annum, payable at such office or agency in like gold coin semi-annually on the first day of November and of May in each year. Both the principal and interest of this bond are pay- able without deduction for any tax or taxes which the Railroad Company may be required to pay thereon or retain therefrom under any present or future law of the United States or of any state, county or municipality therein. This bond is one of a series of coupon bonds and registered bonds of the Railroad Company, known as its General Lien 15-20 Year Gold Bonds, limited to the principal amount of $109,850,400 at any one time outstanding, and all issued and to be issued under and equally secured by a mortgage and deed of trust, dated August 27, 1907, executed by the Railroad Company to Bankers Trust Company and N. A. McMillan, as Trustees, and under and by an Agreement dated De- cember 31, 1908, made by and between the Railroad Company, said Trustees and the Holders of all the then outstanding General Lien 15-20 Year Gold Bonds. For a description of the properties and fran- chises mortgaged, the nature and extent of the secur- ity, the rights of the holders of bobds, and the terms and conditions upon which the bonds are issued and secured, reference is made to said mortgage and deed of trust and to said Agreement. The bonds of this issue are subject to redemption at the option of the Railroad Company at a premium of two and one half per cent, and accrued interest, on any interest day prior to May 1, 1922, and at par and accrued interest on May 1, 1922, or on any interest day subsequent thereto. 178 CAPITALIZATION This bond Is transferable by the registered holder thereof in person, or by attorney duly authorized, on the books of the Railroad Company, upon surrender and cancellation of this bond, and thereupon a new registered bond will be issued to the transferee in ex- change therefor, as provided in said mortgage and deed of trust. This bond also, in the mdnner prescribed in said mortgage and deed of trust and upon payment of the charge therein provided for, is exchangeable for coupon bonds of the denomination of $1000 for the same aggregate principal sum, and bearing all unma- tured coupons. This bond shall not become valid dr obligatory for any purpose unless and until it shall have been authen- ticated by the certificate hereon endorsed of the Trust Company at the time being one of the Trustees under said mortgage and deed of trust. In Witness Whereof, St. Louis and San Francisco Railroad Company has caused these presents to be signed by its president or one of its vice presidents, and its corporate seal to be hereunto affixed and to be attested by its secretary or an assistant secretary, this day of 19... St. Louis and San Fbancisco RaIlhoad Company. By , President. Attest: Secretary. Denomination: The ordinary denomination of bonds is $1000. For coupon bonds that is the maximum. Registered bonds may come in denominations of $5000 and multiples of $5000. Frequently bonds come in smaller denominations than $1000. A denomination FORM 179 of $500 is common. And there is some tend- ency to issue denominations as small as $100 to meet the purchasing ability of people of small means. So far the demand has not been great enough to make the issue of the smallest denominations common. When $500 and $100 denominations are issued at all, they form only part of the entire issue. In the form presented the denomination is translated into its equivalent in sterling, marks, and francs. This, of course, makes the bonds more available for the English, German, and French markets. Sometimes part of the issue is put out with an even amount in the foreign currency — as £200. So long as the bond stays abroad, that is ad- vantageous. If the investor should want to resell in the American market, that would be a greater disadvantage than it is an advant- age in the foreign market. Since this is the natural primary market for an American se- curity, such a resale is not an unlikely event. It is difficult to make the bonds of different currencies interchangeable for the very reason that would make it desirable to have them interchangeable, namely, because the denom- inations in the various currencies do not come out even. Interest rate: Though the rate of interest has been left blank in the form, as a matter of 180 CAPITALIZATION fact, these particular bonds have been issued as 5 per cents. The reason for leaving blank the place for naming the rate of interest the bonds are to bear is because the mortgage is still "open"; that is, more bonds can be is- sued under it, and the directors desire to have authority to make the bonds to be issued in the future bear a different interest rate. Owing either to a change in market condi- tions or to a change in the! position of the corporation, either of which is very likely to happen, especially over a series of years, the bonds may sell on a different basis from the one they sell on now. Since fconds sell at a disadvantage at almost any premium, and also if at too great a discount, it is thought desirable to leave the interest rate blank in order that it may be changed to one at which the bonds will sell most &,dvantageously. Presumably this will be a rate at which the bonds will sell at some discount from par. The rate will be changed ofily in case that will have a favorable effect greater than the somewhat unfavorable effect of breaking up the uniformity of the issue as a whole. The interest rate on some issues has been changed in this way. For example, of the Chicago Burlington & Quincy, Illinois division, bonds dated 1899 and due 1949, $49,650,000 are S^s and $34,165,000 are 4s. Chicago, Milwaukee FORM 181 & St. Paul Railway general daortgage bonds, due 1989, are part in 4s and part in 3js. Chi- cago & Northwestern general mortgage bonds, due 1987, are also part 3§s and part 4s. Term : Considerations of purpose of issue, the credit of the corporation, the condition of the market, all affect the decision of the term for which a corporation shall issue its bonds. The term itself may be absolute or uncertain. That is, the bonds may run for a length of time that neither the debtor corporation nor the creditor bondholder can change. Or they may run for a term which the corporation, on the one hand, can shorten but cannot increase, and the bondholder, on the other hand, cannot affect. In that case it may be either that the corporation can redeem the bonds at any time, or at some special time, or within some special times. If the corpora- tion may redeem the bonds anly at or after a date which is nearer to the time of maturity than it is to the time of issue, we call them "optional," otherwise simply "redeemable." The bond used for illustration presents both situations. It is optional in that the corpora- tion has the option to redeem it at par only on or after May 1, 1922. Since the corpora- tion may repurchase it by paying a premium of two and a half per cent at a,ny interest date before May 1, 1922, it is als^6 called redeem- 182 CAPITALIZATION able. We will discuss this further under the head of "right to redeem." Returning to considerations affecting the term of bonds, the purpose of issue requires first attention. When speaking of amortiza- tion we discussed the idea of continuing the indebtedness in order to continue the advant- age of trading on the equity. If the corpora- tion issues the bonds for general corporate purposes, as, say, for constructing or extend- ing its plant, the purpose of issue does not affect the term of the bonds. As a matter of safe conduct of the business, in order to assure a continuance of eaf-ning power the corporation should spend on its general pro- - perty suflBcient funds to take care of deprecia- tion and maintenance and so keep good the equity protecting the bondholder. When the corporation issues the bonds for a special pur- pose, however, the nature of the assets it acquires with the proceeds may have an im- portant bearing on the life of the bonds. The term should be well within the probable earn- ing life of the assets. The corporation should not have to continue paying interest on property no longer productive of income. A bondholder must see to it that his security remains sufficiently unimpaired to protect him. For these reasons equipment bonds, for example, should not run much, if any, FORM 183 longer than ten years. To take an illustration outside of private corporations, a munici- pality should not issue bonds for paving pur- poses to run for a longer term than the paving will last. Bonds issued to provide funds for the construction of an oflBce building should mature well within what is likely to be valu- able life of the building. This would take into account possible changes in the style of oflSce buildings, a kind of depreciation due to obso- lescence. Another consideration, the credit of the corporation, may affect the tejm of the bonds. If those in control anticipate that some time in the future it will enjoy better credit, they will not want the bonds to run so long that the corporation will have to pay a rate of interest based on its period of poor credit for a good many years beyond the time when it should enjoy better credit. A new corporation presents this particular case. It has no estab- lished earning power, or lacks the prestige of long continued good income. A corporation that has recently gone through a reorganiza- tion offers the same considerations. Those who have authority to fix the term of the bond will not want to make it exceptionally long. It will be advantageous, as soon as may be after the corporation has xeached as good a credit as can be anticipated, to refund on a 184 CAPITALIZATION lower basis. On the other hand, they must make the term long enough not to embarrass the corporation by the necessity for refunding before its credit has reached a point where it can refund advantageously. Converse considerations gUide the decision on the length of term in issuing bonds of an old corporation at the height of its credit. Presumably the corporation wants to con- tinue trading on the equity. Since that is the case, it can make a good bargain now that will save it from the trouble of refunding for some time, and may save it the necessity of making a poorer bargain in refunding at the end of a shorter term. General market considerations, aside from the credit of the particular clorporation, also affect the decision on the term of the bonds. When long-term interest rates are high, or to say the same thing in other words, when the price of bonds is low, obviously a corporation would be inflicting a handicap on itself to issue securities of very long term. So, as we should expect, during seemingly acute peri- ods of high interest rates the corporations issue securities of an exceptionally short term. At the time of high lopg-term interest rates before and after the panic of 1907, con- cerns like the New York, New Haven & Hartford Railroad and the New York Central FORM 185 Railroad issued many millions of notes run- ning for three or five years. Wlien they fell due, the corporation managers felt that inter- est rates continued higher than they would be later, and refunded the first short-term securities with new issues running for similar periods. As a permanent method of financ- ing, a constant succession of short-term notes would be expensive. In addition to the in- terest the investor demands, the corpora- tion has to bear the cost of selling each issue. Without intending to indicate any special reason for the term, we shall name several im ' portant issues of exceptionally long life. Lake Shore & Michigan Southern first mortgage 3^s (dated 1897), due 1997. Missouri, Kan- sas & Texas first and refunding 4s (dated 1904), due 2004. Also of the same road the first mortgage 4s (dated 1890), due 1990, and second mortgage 4s (dated 1890), due 1990. Morris & Essex Railroad fiyst and refund- ing 3|s, guaranteed by the Delaware, Lacka- wanna & Western (dated 1900), due 2000. Texas & Pacific Railway first 5s and second consolidated 5s (both dated 1888), and both due 2000. Norfolk & Western Railway first consolidated 4s (dated 1896), due 1996. St. Louis Southwestern Railway first mortgage 4s (dated 1891), due 1989. Union Pacific 186 CAPITALIZATION Railroad first and refunding is (dated 1908), due 2008. Manhattan Elevated Railway 4s (dated 1890), due 1990. Fashions in the term of securities change. At one time for no very well-defined reason investors like those of long life, at others those of short life. Consideration of what the fashion is will also influence the decision on the term of the security. The fashion prob- ably has little or no relation to any conscious thought about probable advance or deprecia- tion in the future value of gdld. An investor might well reckon with that question; though with doctors disagreeing, we can hardly won- der at the investor's refusing to take much account of the matter. If the managers of the corporation plan to make a general mortgage issue under an open mortgage with a large amount held in reserve for refunding existing issues, the bonds must bear a date long enough to cover all the un- derlying issues and cover a period beyond sufficient to make them worth while as the means of the refunding operation. Bonds of corporations operating under franchises limited to a fixed period should mature well within the life of the privilege. Right to redeem: The right to redeem bonds some time before the obligation to pay them matures may perhaps properly form part of FORM 187 the discussion of the term they are issued for. We have several times mentioned the desira- bility from the corporation's standpoint of retaining this right. When the first provision for financing shows itself insuflicient, power to redeem the issue as a whole may become important in order to provide a basis for new financing. If the corporation's credit im- proves more rapidly than the organizers an- ticipated, the right to redeem may become important in order to enable them to take advantage of the improved credit. It may be that they anticipated the improvement in the credit, but could not at the time place sufficiently short-term securities to advant- age. The right of redemption of any part of the issue, in addition to the right to call the issue in its entirety, may appear desirable for sink- ing-fund purposes. We discuss this under "amortization." Instead of the right to re- deem in part, with the option of purchasing in the open market for sinking-fund purposes, the trust deed may obligate the company to call at the stated price the bonds for the sinking-fund. Commonly the right of redemption in it- self counts as a disadvantage in the market, and the corporation offsets this disadvantage by placing the call price of the bonds some- 188 CAPITALIZATION where above par, as 102, 103, 105, sometimes even as high as 110. Assuming that the cor- poration sells the bonds at a discount, their redemption before maturity would from the standpoint of mathematics be an advantage rather than a disadvantage, for then the in- vestor would be getting the benefit of his dis- count within a shorter time. From the stand- point of the corporation this means paying a higher basis interest. The right of redemp- tion presumably limits the possibility of an advance in the market price of the bonds to the call price. No one will pay a price for a bond and run the risk of having the corpora- tion call it at a lower price within a very short time. When there is no obligation to call, and the likelihood is improbable, the price of the bonds does sometimes rise above par. A right of call also presents the disadvantage to the investor of uncertainty as to" the term of in- vestment and the possibility of imposing on him sooner than he anticipates the care and labor of making a new commitment of his capital. This would be a stronger objection at a time when long-term bonds are in favor. Generally it ought not to weigh very heavily against the bonds in the market. Barring this last objection, and assuming the investor con- tent with the possibility of his bonds going as high as the call price, he ougM to regard the FORM 189 possibility of redemption prior to maturity as an advantage. Indeed, French investors regularly do. Making the call price above par is rather cumbersome and something of a matter of self-deceit on one side or the other, seller or buyer, or possibly both. If it is improbable that the corporation will call them, whatever disadvantage the right of call might be sup- posed to make ought not to weigh much against the market price. A probable exer- cise of the right of call ought to adjust itself as readily and no more to the. disadvantage of either party when the call price is par than when it is at a premium. Interest dates: Corporations regularly pay bond interest twice a year. Compilers of "basis" tables showing the computed actual return bonds make on the capital invested in them assume a semiannual payment of inter- est. Months run in couples in the minds of those dealing in bonds as a business. Those complementary months in order are January and July, February and August, March and September, April and October, May and No- vember, June and December. A corporation issuing bonds will ordinarily choose to pay interest in those months in which the nature of the business is most likely to provide the funds, or to make one of the dates come near 190 CAPITALIZATION coinciding with the close of the corporation's fiscal year. The big dates, on which much larger amounts of interest are paid than at other times, are January and July, and the requirements for funds to pay interest and dividends at these times make a special de- mand on the money market. Generally peo- ple like to get their incomes at these times. The interest dates of a security may make a difference with individual investors, who may like to have their incordies paid at spe- cial times, or may wish to place their invest- ments so as to have their incomes distributed through the year. Sometimes the less fre- quent interest dates, like March and Sep- tember, are chosen to meet this demand. Registered and coupon: Though investors fully understand the difference in form be- tween registered and coupon bonds, they do not understand so well all the consequences of the two forms. The distinction in form is simple enough. A coupon bond has attached to it a sheet of what in effect are small pro- missory notes representing the interest. One falls due each interest date. To collect his interest the owner must "clip" his coupon and forward it, presumably through his regu- lar banker, to the place of payment named in the bond and coupon for collection. Transfer of title requires no formality. Property in FORM 191 the bond passes by transfer of the document. A registered bond, on the other hand, has the name of the owner entered upon it, and also on the books of the corporation, kept either at the office of the corporation or by some bank or trust company acting as fiscal agent of this corporation. The company thus has the address of the bondholder and at the proper dates mails the checks for interest to him. Ownership of a registered bond can be transferred only by changing the name regis- tered on the company's books. That is, with respect to the transfer of title, registered bonds stand in the same position as stock. Relative advantages of the two forms from the standpoint of the investor are the ready transferability of coupon bonds, and the safe- guarding from theft of the registered form. Many considerations, however, argue strongly in favor of the coupon form. "Owners of reg- istered bonds may find in the comparative difficulty of transfer a greater disadvantage than they anticipate. It may cause delay in selling, and especially such delay in getting the proceeds of a sale as to be embarrassing. A broker cannot safely sell until he is certain there will be no difficulty about effecting a transfer. The corporation's agent for registry, if competent, is bound to be -extremely care- ful about his authority to transfer, and may 192 CAPITALIZATION cause long delay in effecting a delivery by in- sisting on better evidence than that first sup- plied him. Procuring a transfer in the case of settling an estate always causes considerable trouble. A dealer cannot safely register a bond in the name of the purchaser and send it forward with draft for collection. The registry fixes title, and legaj situations un- known, perhaps, to the purchaser as well as to the dealer, may intervene to deprive the dealer of his lien. Very possibly before pay- ment and delivery the purchaser may die. In that event a great deal of trouble and long delay may take place before the dealer can get paid. From the standpoint of the purchaser regis- tration may affect the situation of his estate with regard to the inheritance tax. In one case a man in New York State left his pro- perty by will to a younger man, whom the testator had always treated as his son, but never formally adopted. Some bonds of a corporation of another jurisdiction formed part of the estate. The jurisdictions took different views of the situs of the property represented by the bonds. Under the law of the jurisdiction of the corporation property in a debt has its situs where it is owed, and the bonds therefore formed an estate of the testator in that jurisdiction. According to the FORM 193 law of New York State the situs of a debt lies at the domicile of the creditor, and the bonds therefore formed part of the testator's estate in New York. As a consequence the estate had to pay an inheritance tax on those bonds in both jurisdictions. To aggravate the situation the tax was heavier in both juris- dictions because of the collateral inheritance. The point of the story is that the testator, against the advice given on general principles by the dealer selling the bonds, had insisted on having them registered. Though the law would have been the same for coupon bonds, the situs of the corporation would have had no means of acquiring jurisdiction to enforce its tax. As it was, the agent for the transfer had no right to make it without evidence that the estate had paid the inheritance tax. In such a case as this it would hardly be accounted moral turpitude to dodge one tax if possible. Jurisdictions are much in conflict over this very point, and for that reason alone, if for no other, it would be Well to keep on the side of safety by not registering. Some in- vestors, however, insist on having registered bonds. Interchangeable : Because some investors want registered bonds and others will take only those in the coupon form, a corporation confers a privilege of some value to the pur- 194 CAPITALIZATION chaser in making its bonds interchangeable. If that is the case the corporation will, on request from the holder of a bond in one form, deliver in its place a bond in the other form. Usually only the big corporations with large bond-issues outstanding extend this privilege. To carry it out requires considerable trouble on the part of the corporation or its agent for making the transfers. Registerable as to principal: Many corpora- tions, perhaps most with bond-issues under a number of million dollars, do not issue bonds registered both as to principal and interest, but issue coupon bonds which are registerable as to principal. When issued, the bonds are all alike coupon in form, but have blanks on the back in which the name of an owner may be indorsed. The corporation provides for enter- ing this name on the company's books, and the bonds become registered as to principal. Coupons remain attached to the bond, and interest is collected by their tneans as in the case of any coupon bond. The coupon bond form presented for illustration provides for such registration as to principal. In a few instances corporations have issued bonds only in the coupon form, but provided for detaching the coupons and leaving them in the possession of the corporation or its agent, and indorsing the name of the owner Form 195 on the body of the bond and entering his name on the books of the company as the registered owner. The bond then becomes registered both as to principal and interest. By indorsing it as payable to bearer, so en- tering it on the books of the company, and reattaching the sheet of coupons, the com- pany can transform it back into a coupon bond. This requires practically no more trouble than simply registering as to princi- pal, and is perfectly feasible for a corporation with a relatively small amount of bonds out- standing. Bonds registerable as to principal only may regularly be retransformed into full coupon bonds by indorsing to bearer and entering them on the books of the company as bearer bonds. Domicile, or place of 'payment : The bond form presented as a specimen makes both principal and interest payable at the office or agency of the company in fhe city of New York, or, at the option of the holder, in Lon- don, Frankfort, Berlin, Amsterdam, France, Belgium, and Switzerland. Since the particu- lar issue of bonds represented by the form was intended especially for the European market, it was made payable in rather more places than usual. If a bond is intended to be sold in England or in Europe, it is regularly made payable in London and, say, Berlin, as 196 CAPITALIZATION well as in New York. On account of the pos- sibility of avoiding taxation^ French invest- ors rather like to have their income payable in London. Therefore it is not so important, in order to effect sales among the French in- vesting class, to have the bonds payable in Paris. Likewise, if it is intended that a bond be sold entirely in this country, it may have more than one place of payment. It may be that the bankers handling it .expect to sell it mainly in the Middle West. In that case Chicago will be one of the places of payment named. Part of the issue, however, may be sold in the East, and in that case the bonds will also be made payable in -New York. Usually the place of payment is made more specific than simply stating the city. Ordin- arily the bond states that it is payable at, say, the Columbia-Knickerbocker Trust Com- pany, in the city of New York. It is then sometimes said to be "domiciled" at the Columbia-Knickerbocker Trust Company. In the case of most of the smaller issues, at any rate, the trustee is made fiscal agent for the purpose of paying interest, and the bonds therefore domiciled with the trustee. Larger issues may be domiciled with some institu- tion other than the trust company acting as trustee. Those corporations having such FORM 197 large amounts of securities outstanding as alone to require the services of a whole staff, maintain their own fiscal offite at their gen- eral head office, and make the American domi- cile of their bonds at that place. Taxes: To discuss the taxation of securities would require a whole treatise to itself. Such a provision as the sample form of bond con- tains commonly appears in bonds. It has httle or no actual present practical effect, and is valuable to the holder and contains some- thing of a menace to the corporation in event of a change in the system of collecting taxes. No matter what the taxation provisions of a particular jurisdiction may be, bonds com- monly sell at prices based on the assumption that the purchaser does not pay taxes on them. In event of any attempt being made by the Federal Government or any of the State Governments to collect an income tax after the Enghsh fashion "at the spurce," presum- ably such a promise to pay interest without deduction for any tax which the railroad com- pany may be required to retain therefrom would work to impose the burden of that tax- ation, which might amount to 2 per cent, on the corporation and to relieve the bondholder. That would probably be so, at any rate so long as the railroad is its own fiscal agent for the payment of interest ds in this bond, 198 CAPITALIZATION Whether on the appointment of some finan- cial institution as agent to pay interest, the collection of taxes at the source, that is, the requiring of the paying agency to deduct from the interest the amount of the tax and pay that amount over to the Government, would be a tax which the railroad company was re- quired to retain therefrom, might be a matter of uncertainty, to be known only after ad- judication. Our multiplicity of taxing juris- dictions, however, combined with the wide scattering of the securities of any particular corporation, makes improbable any wide at- tempt to collect any heavy taxation at the source. The State of Pennsylvania does col- lect a small state tax from Pennsylvania cor- porations on securities of the corporation known by the corporation to be in the hands of Pennsylvania investors. As matters stand, and as they seem likely to continue, such a tax provision as this in a bond seems not likely to have much effect. Trust deed : Such a reference to the trust deed as this, "For the rights of the holders of the bonds, and the terms and con- ditions in which the bonds are issued, refer- ence is made to the said mortgage and deed of trust," definitely makes the provisions of that document part of the terms of the bond. American investors might well be more in- FORM 199 sistent on looking up the stipulations of the trust deed. They might sometimes find there provisions giving a majority or even a minor- ity of the bondholders a riglit to do things materially affecting the lien and encroaching on the regular rights of a security holder. The chapter on the "Instruments of Corporation Finance" emphasized the limitations on the shareholders' control which the trust deed might make in favor of the bondholders. Though that is the usual situation, a trust deed may, and sometimes does, place limita- tions on the rights of the bondholder in favor of the shareholder. VII THE MARKET AND THE PRICE Everything a corporation can do to make its securities more marketable will help it command a higher price for them. Though that sounds rather a truism, marketability has something of a special meaning with refer- ence to securities, and a corporation can do many things of detail, besides offering its es- sential assurance of payment, to give its se- curities a broader appeal and therefore help them pass more readily from hand to hand. The discussion at this point is not dealing with the fundamental things in connection with corporation security -issues. The more a corporation oflPers of income and control and the less of risk, obviously the readier accept- ance its securities will find. We have already dealt with these fundamental considerations in the chapters on "The Instruments of Cor- poration Finance" and "Trading on the Equity." By price, too, we mean here the es- sential thing which is measured, not by the market quotation in dollars, but by the re- turn the man who furnishes the capital demands for his funds. What sounds com- THE MARKET AND THE PRICE 201 plex in words is simple enough in figures. This is only to say that a 4 per cent 20-year bond at 91, yielding approximately 4.70, is selling essentially higher thaii a 5 per cent 20- year bond at 102§, yielding approximately 4.80. If a security has a quick close market it possesses a quality of value which will add to the price people will pay for it something be- yond what they would pay for the amount of control and freedom from risk the security offers. A "quick" market is one in which a security may be sold without delay. The "closeness" of a market depends on how great a difference there is between the buying price and the selling price of a security at any given moment. A market for a particular se- curity may be so close that 'the buying and selling price are only an eighth apart; in that case a man would be able to buy at, say, 99f and to sell at 99^. Such a transaction is often possible in bonds of the big, active, railway issues, and results from the competition for business among dealers and brokers off the stock exchange. Since members of the stock exchange cannot do business for less than one eighth commission, such a transaction would be closer than any that could be put through the exchange, where there would have to be a real difference of a quarter of a point in price 202 CAPITALIZATION just to cover commissions. However active and steady quotations might be on the ex- change, so that a whole series of transactions went through at 99J, and apparently a man could either buy or sell at that price, really the seller would be getting 99|, after paying his one-eighth commission, and the buyer for the same reason be paying 99f . Off the ex- change dealers and brokers who are not mem- bers can "split" the commission, and in order to put through a transaction frequently do. Indeed, they sometimes do business on so small a profit as one thirty-second of one per cent. Such a close market as this represents the extreme and carries with it the corollary of being a quick market. Since it is the degree of stress in the working of demand and supply on each other that makes both, the speed of a market bears a direct relation to the distance apart of a market. A quick market is at the same time a close market, and a slow market is a wide one. These are expressions of a gen- eral state of affairs. In the market for any particular security, it may be necessary to sacrifice something of speed in order to get the closest possible quotations, and conversely to abandon something of closeness in order to get the greatest speed. Transactions such as those; just mentioned indicate the highest degree of closeness. THE MARKET AND THE PRICE 203 With regard to quickness of k market it may be possible in a given security to put through a transaction either way, buying or seUing, in a matter of seconds. A 'security with a wider, slower market might have its buying and selhng prices half a point apart, and re- quire several hours to find either a seller or a purchaser. So on, all the way to a difference of from five to ten points between the buying and selling prices and a time "of several days or weeks required to find perhaps either seller or purchaser. Beyond these points of market width and slowness, a security can hardly be said to have any market at all. It may never- theless involve little risk of loss of income, and, if a bond or other evidence of debt, of principal, and may be yielding the holder an excellent return. A quick, close market presents an element of distinct value, and the quicker and closer the more valuable. Even if a" buyer of securi- ties intends to hold them permanently as an investment, it is, nevertheless, worth some- thing to him, though maybe not the price he would have to pay, to be able, in event of an unforeseen contingency, to sell his security without too great delay, and at a price not too remote from what he would have to pay for it if he were a buyer. Marketability becomes more and more important as the security is 204 CAPITALIZATION held by a man actively engaged in business with an uncertain demand fdr funds, or such a financial institution as a bank, which may need to realize on its assets at any time. Every investor must decide for himself in how great a degree he requires marketability, and how much it is worth to him. It is not our purpose to go into a general discussion of the elements of a securities market, but simply to point but the effect of marketability on price in order to lead to a discussion of things, apart from considera- tions of income, control, and risk, which may affect the position market-wise of a particular issue. Magnitude of an issue exercises a large in- fluence in the creating of a market. As be- tween an issue of $1,000,000 and one of $20,- 000,000, each having the same ratios of equity, earning power, and all the other matters that go to make up the amounts of risk, income, and control in each, the larger issue will prob- ably in the long run command the higher price. Its very size means that more people must become familiar with it and interested in it. The volume of dealings .after it has once been placed will be greater, and dealings make the market. So the sheer size of an issue influ- ences marketability. This depends on the size oj the enterprise, THE MARKET AND THE PRICE 205 however, and its demand for capital, and is not one of the matters the corporation, as such, really exercises control over, except, as mentioned in the chapter on "Expansion," through looking forward to future needs, and authorizing more securities of a given class than it immediately issues. A corporation planning an issue of securi- ties has, however, an opportunity to arrange it in various ways, aside from the fundament- als of income, control, and risk, that will help the securities find a broader iand more active market. Obviously we do not use the term "broader" here as synonymous with "wider" as already used, but to indicate the security as appealing to more people. As one means to this end the corporation can prepare the issue in a way to meet the requirements of the stock exchanges, say the New York Exchange, or more than one, and through its bankers get the issue listed. Though such a course opens to the issue the possibility of being traded in on the exchange, it does not by any manner of means insure such dealings. Unless the issue is of some magnitude, and has already excited consider- able interest among investors, news of the listing is likely to be almost the last thing heard of it from the New York Exchange. The name will continue to appear on the 206 CAPITALIZATION official sheet with a nominal bid and asked quotation, but with no reported transactions whatever. Quoted bid and asked prices are likely to prove wholly illusory on any attempt to put through a transaction. An offer to pur- chase at the quoted asked price may fail to bring out any of the paper. At the same time an offer to sell at the quoted bid price may fail to uncover any takers. Listing an issue of from one to several millions in the New York Stock Exchange simply courts a general neglect. Brokers on that exchange stand ready and expect to deal in the entire list, and do not much form into groups especially interested in particular issues-, and that fact accounts in part for the neglect of the smaller amounts listed. The organization of the stock exchange market as it stands at present in New York works against them. Dealers in securities on the London Stock Exchange tend to split into groups, each in- terested mainly in a particular part of the list. Doubtless the custom of doing business through "jobbers," who, when approached by a "broker," do not know whether the trans- action the broker has on hand is a buying or a selling one, and therefore name both the price at which they are prepared to sell and that at which they stand ready to buy, works in favor of the smaller issues. A jobber must THE MARKET AND THE PRICE 207 at the same time be interested -in both sides of the market. Brokers there do'more in the way of acting as actual investment advisors to their clients than here. They feel the need of being well acquainted with the securities they deal in, and in order to get the more intimate ac- quaintance tend to restrict their dealings to a smaller number of issues. Those particularly interested in Canada, for example, make a point of dealing in "Canadians," and so on. When even a small issue is listed on the Lon- don Exchange it has from the start a little group of brokers interested in it. As a result, issues amounting to no more than from one to several million dollars may have a fairly close and active market. It would be possible there either to buy or sell a bond or share of such issues within, say, a day or two, at not more than a point apart for the buying and selling price. In New York, on the other hand, bankers are reluctant to list small issues on the ex- change, because the listing, instead of help- ing to build up a broader market, simply in- creases their difficulties in "protecting" the market. The investment business is not yet with us as well developed and as well under- stood as in England. On account of the lack of a coterie of brokers interested in a par- ticular issue both on the buying and on the 208 CAPITALIZATION selling side, some holder in haste to realize might sell a security at a sacrifice price, and the low quotation made and published would unsettle all the other holders and make them inquire anxiously of the issuing banker about the value of their security. The situation all comes down to the fact that the issu- ing banking-house itseH offers the only real market for most relatively small issues. Eagerness of such houses for business has de- veloped a system of trading whereby an in- vestor is induced to swap securities he already holds for some of the specialties of the par- ticular banking-house seeking to do business with him. Listing the small issue on the ex- change simply offers a rival house a place where, concealing its own hand in the matter, it can offer the other banker's "specialty" for sale, and so practically compel the issuing house, in order to protect the market, to buy back its own securities . In the language of the street it has to "hold the: basket." The time does not now seem close at hand when the New York Stock Exchange will afford a market for the relatively small issues. A corporation putting out an issue of $15,000,000 or more almost must prepare the issue for listing on the New York Exchange. Investors will think it rather queer if it is not listed. It does not follow, however, that the THE MARKET AND THE PRICE 209 stock exchange will offer the only, or even the principal market, or, for that matter, even an important market for the security. The dis- cussion at this point does not refer to stock. When shares are listed, especially large issues, the exchange becomes practically the only market for them; but even for those bonds most actively dealt in on the exchange, the transactions there are probably only a very small part of the total transactions in the issue. Dealings over the telephone from se- curities house to securities house, and by the street trader going from office to office, learn- ing of a buyer here and a seller there, on the average enormously exceed the transactions on the exchange. Such exchange transactions as there are give each day a published quot- ation which affords an index of the course' of the market in the security. An investor who considers marketability an important matter wants that daily published quotation to keep him informed of what he can do in case he should want to realize. Exchange dealings like this in the larger issues do not present the dis- advantages to the issuing house that the list- ing of smaller issues does, for.several reasons. In the first place, the large issues probably are widely underwritten by bankers who are themselves dealers in securities, and extens- ively subscribed for by smaller dealers, who 210 CAPITALIZATION besides getting the regular dealers' quarter- point concession oft" the pride at which the issuing bankers publicly place them on the market, count on the demand being so large as to send the market price somewhat above the issue price. From the very start a large number of dealers are interested in the secur- ity, and their efforts immediately estabhsh a trading market. When an issue is small, however, a single banking-house can, and frequently does, handle it without the help of other houses or dealers. At the most, two houses join in mar- keting the issue. Such underwriting as may be done is not by bankers and dealers who would be interested on their own account in creating a market, but by capitalists who are ready to assume the kind of a risk involved in that special security. Except in the case of an enterprise in the construction stage, that is, without an established earning power, there is probably no underwriting at all. The issu- ing banker has to bear alone all the burden of creating a market. Again, investors purchasing securities of large issues expect to take the risk of some fluctuation in the market, of a possible de- cline in price. When the market falls off some- what from the issuing price, they do not hold the issuing house blamable. They recognize THE MARKET AND THE PRICE 211 that when they bought they then accepted the risk of the market. They understood that they were called upon to exercise some judg- ment both of the merit of the security and of general market conditions. Since in the case of small issues the house putting them out is the market, purchasers hold that house responsible both for the in- trinsic merit of the security and for its market position. Because the purchaser usually is not as well situated to judge of either the sound- ness of the enterprise or the general state of the market for a security of the class offered, it is not unfair that he should place greater responsibility on the issuing house. From the very magnitude of the corporation putting out large issues the investor knows, or can know, something about it. Reports of its earn- ings are published in the daily papers, or, if not in them, at least in the financial papers. There, also, are published quotations of se- curities of a similar kind for him to judge the general market condition from. Such considerations as these govern the matter of listing in order to extend the market for an issue. It is desirable to list the larger issues, and therefore they must meet the hst- ing requirements in form. Whether prepared to meet the require- ments of the New York Stock Exchange for 212 CAPITALIZATION steel engraving, etc., or not, a security should at any rate be prepared in such a way as to present a good appearance and to offer some reasonable obstacles to counterfeiting. Aside from questions of wear and tear, since most securities have rather a long life to run, to avoid decay they should be printed on a very high-grade paper. If this paper can be of some special make, as an additional precaution against counterfeiting, so much the better. Though for a small unlisted issue it may not be thought necessary to have the entire de- sign especially prepared, it should at least be printed from a carefully guarded plate. A high-grade piece of steel engraving probably makes the best precaution possible against counterfeiting. Considering how poorly many securities are prepared, how ready a market many of them have, and how little they are scrutinized to discover possible counterfeit- ing, it is a wonder that "green goods" men do not direct more of their energies in this direction rather than confining themselves to the carefully prepared and closely scrutinized government and national bank notes. How- ever, there have been notable cases of counter- feiting securities, and the danger is well worth guarding against. Knowledge of the existence of this danger on the part of some investors, and an appreciation of a good appearance on THE MARKET AND THE PRICE 213 the part of all, does, however, add to the marketability of a security, and it commands therefore a price much more than enough higher to make up for the cost of a good appearance. Whether bonds shall be issued under an open or a closed mortgage presents another consideration of marketability. Doubtless the investing public generally prefers a closed mortgage. It does not want to take the chance of having the protecting equity made thinner through the issue of further securities of the same rank as theirs. Besides, it fears that the bringing-out of additional amounts of the same security will have the natural effect of increasing the supply on the market, to depress the price. Even provisions in the trust deed assuring the maintenance of the equity do not overcome the handicap on that account. They require too nauch explaining. A "closed mortgage" tells its whole story in two words. The chapter oh "The Instru- ments of Corporation Finance" mentioned a number of provisions looking to the main- tenance of the equity in the event of further issue of securities under an open mortgage. We shall not go more fully into the matter here. Though the fact that a mortgage is "open" may tend to depress the price of the security. 214 CAPITALIZATION its value in future financing is likely to do far more than offset its immediate adverse influ- ence. Securities with a junior lien would sell at a serious disadvantage. The fact that se- curities of an issue are already outstanding and have a current market quotation makes a good foundation for more of the same issue. It is hard to assign a relative weight to each of these influences. All this discussion is, of course, apart from the matter of the mort- gage being open, technically, because of bonds reserved to retire underlying issues, and refers only to the possibility of issuing more bonds for actual new expenditures on the property. The replacement of the bonds of underlying issues with bonds of the junidr issue can work only to the advantage of the outstanding bonds of the deferred security. It is true that if there were not reserved bonds of the new issue, the bonds of the old issue would have to be replaced with some security more renlote than the new issue, which in turn would be- come the prior security with the larger equity protecting it. Since, however, the reserved bonds will not when issued work to the posi- tive disadvantage of the bonds of the issue then outstanding, they are not looked on with such disfavor as authorized bonds to be issued for expenditures on the property. Since the chapter on "Amortization" went THE MARKET AND THE PRICE 215 rather at length into the desirability of a uni- form issue, that is, all of the same maturity, instead of maturing serially, we shall not go into that matter further here, but mention it now merely because of its bearing on the gen- eral subject of this section. The discussion of amortization also mentioned the probable effect on price of making the bonds callable, and of providing a sinking-fund. Also the chapter on "Form" considers the market effect of such matters as rate, term, denomination, place of payment, and making the bonds registerable and interchangeable. A corporation can arrange all these things in such a way as will give its securities the wid- est appeal. For example, some people prefer a registered and some a coupon bond. If the corporation provides both, it does not exclude from the number of purchasers of its securities those who strongly prefer one or the other. And the experienced buyer, himself prefer- ring one or the other form, but quite aware that some other investors do not feel the same way, appreciates an interchangeable bond, so that his particular part of the issue may, in case he should wish to put it on the market, appeal to as wide a range of purchasers as possible. Most of the matters mentioned here as dis- cussed elsewhere will not be mentioned fur- 216 CAPITALIZATION ther now than just the reference. The matter of denomination may be worth a few words more. Though a good many issues provide bonds of $500 denomination, $1000 is the standard. It seems improbable, under the present method of seUing securities in Amer- ica, that bonds will be issued much in smaller denominations. The smaller amount will not stand the expense of selling. The only reason for issuing bonds in denominations of, say, $100 is to fit the pocket-books of people who cannot invest $1000 at a time. It costs as much to sell a $100 bond as to sell one of a $1000. A small investor would not, however, pay a higher proportionate price for the $100 bond than the larger investor pays for one of a $1000. If the banker is making a two-point profit, gross, on the issue, he makes a gross profit of $20 on each $1000 bond, but only $2 on the $100 security. Cost of selling and of putting through the transaction on the $1000 bond might be, say, $10. It requires just as much work to sell the $100 man his bond, and the clerical and other work of putting the transaction through are just as great. So it would cost the banker $10 to put through the $100 transaction on which he has made, gross, only $2. He would be doing business in the smaller denominations at a loss. Because the distributing agents of securi- THE MARKET AND THE PRICE 217 ties in France are the branehes of the big banks, where the small investor keeps his de- posit, the seller is closely in touch with the buyer at all times, and therefore it cannot cost nearly as much for the selling expenses of these small transactions in France as in Amer- ica. There the small investor is legion and well trained. He comes in and buys over the counter. In America he would have to be sold to just as the larger investor is now sold to. The investment banker would have to culti- vate his confidence instead of already having it, as in France, because of being his depositary banker to start out with. Uiltil the small in- vestors become more numerous in America, and some changes take place in the methods of distributing securities, probably it will not be worth while to issue bonds in smaller de- nominations than at present. Sometimes a corporation can make its se- curities comply with requirements to meet a special demand. If it has the possibility within its power to comply, for example, with the requirements for savings banks or trustee investments within a particular jurisdiction, it gains immediately the chance of tapping large amounts of loanable capital. For the most part a corporation can do little in the matter of mere arrangement to aid in this direction, but sometimes it (jan put itself in 218 CAPITALIZATION the proper position. Only a study of the sit- uation in each case can determine what the corporation can do toward this end. In some jurisdictions a corporation may make its securities tax exempt, and if it can look for a large market for them in that par- ticular jurisdiction, it may considerably help their sale by complying with the provisions for tax exemption. A corporation can make its bonds tax exempt in New York, for in- stance, by recording them on the payment of one half per cent recordirtg tax. A Penn- sylvania corporation can make its bonds tax exempt in that state by paying a small annual tax. By having a Pennsylvania corporation the issuing body, large amounts of railroad equipment securities have been made tax exempt in the state, and thereby appealed especially to the wealthy Philadelphia mar- ket. Stock of a Massachusetts corporation is tax exempt in the state, but not stock of a foreign corporation. In order to get that ad- vantage in the important Boston market for investments, some foreign corporations have already taken out new charters in Massachu- setts and transferred their aSsets to the cor- poration under the new charter. And, by way of a wink at the possibilities, some enter- prises, especially holding conipanies, have or- ganized as unincorporated associations under THE MARKET AND THE PRICE 219 the Massachusetts law, in order to avoid the federal corporation tax. Thjs, however, is aside from our subject and a general matter of corporate organization rather than espe- cially of corporation finance. VIII CAPITALIZATION AND THE STATE Any state regulation of corporation finance may rest on one or more of three general purposes: — 1. To protect creditors. 2. To protect prospective shareholders. 3. To protect the general public from hav- ing to pay an excessive ijeturn on capital invested in the business. Since the protection of creditors is purely a legal matter, it does not enter into the scope of our discussion here. In ^the chapter on "Watered Stock" we went into the question of protecting prospective purchasers of cor- poration securities, and shall not take it up further. Our subject at this point is the pro- tection of the general public from the ex- action, in the form of rates or other pay- ment for service, of an excessive return on capital. So far the demand for stafte regulation of the financial arrangements of corporations in order to prevent a possible excessive charge has not been much made with -reference CAPITALIZATION AND THE STATE 221 to any but public utility corporations. Al- though already a few people begin to advo- cate a more general state supervision of charges, most of those who consider the ques- tion so far are content to rely on competition to control the charges of manufacturing and commercial corporations. People rather com- monly feel, however, that the state must care- fully scrutinize the charges of corporations that are wholly or partly monopolistic, or of an inherently monopolistic nature. Immediately the question arises, What is a fair or an unfair charge? The usual reply says that a charge which gives more than an ade- quate return on a fair capitalization is not a fair charge. It goes on to explain that the state must not allow corporations to fix rates to earn a return that on its face appears no more than adequate, but is really exorbitant because based on an excessive capitalization. Ordinarily the argument dpes not go much farther than this. It does ndt bring out any statement of what is either an adequate re- turn or a fair capitalization. Yet it would seem necessary to determine each precisely before it were possible to discuss the fairness of a rate dependent on both. What is an adequate return .^ If you want to buy into the railroad business to-day you can purchase Denver & Rio Grande Railroad 222 CAPITALIZATION preferred stock at a price to yield you, say, 7.09 per cent on your capital.^ Or, if that in- vestment does not please your fancy, you can buy Central Railroad of New Jersey common stock at a price to return you an income of say, 2.85 per cent. Denver & Rio Grande preferred pays 5 per cent dividends, non- cumulative, and the total earnings of the road available for dividends amount to 8.12 per cent on the stock. Central Railroad of New Jersey common pays 8 per cent dividends and the road earns 18.6 per cent on the stock. In the case of the Denver & Rio Grande the fact that you cannot get more than the present 5 per cent dividend, on account of the rate lim- ited in the preference, and the apprehension that you may get less because the earnings are not so greatly in excess of the amount re- quired for the preferred dividends, determine the price you pay for the stock, and conse- quently the return on your capital. Central of New Jersey, on the other hand, offers you an 8 per cent dividend that you feel absolutely confident of, and the hope that you will get some of the 10 per cent it is earning on the stock beyond that. So you would have to * The fact that since this was written the Denver and Rio Grande has stopped paying dividends on preferred stock and the Wabash, mentioned a Httle later, has gone into the hands of a receiver, illustrates the element of risk. CAPITALIZATION AND THE STATE 223 pay, say, 280 for the Central of New Jersey stock, but could buy the Rio Grande pre- ferred for, say, 70. Suppose you try to escape the life of hopes and fears of stocks into the seeming compara- tive Nirvana of bonds, and get the calming assurance that the railroad must pay the stip- ulated income. You can take your choice be- tween Pennsylvania Railroad consolidated 4s of 1943 at, say, 103.25, giving you a return of 3.80 per cent on your investment, or of Wabash first refunding and extension 4s of 1956 at, say, 63, giving you a return of about 6.50 per cent. Obviously we cannot conae to a decision about the fairness of a charge by considering simply one class of capitalization, or what the company may choose to pay immediately in dividends, but must consider total capitaliza- tion and what the company earns available to pay returns on that capitalization. For the classification of the capital, its priorities, and so on, hardly concern the public in this mat- ter. Let the corporation arrange its capitali- zation as it sees fit, and trade on any equity it may care to. Denver and Rio Grande earns, say, 4.50 per cent on its entire capitalization; Central of New Jersey on its entire capitalization earns 16 per cent. Which earns the "ade- 224 CAPITALIZATION quate return" and which has the fair capi- talization ? Or is it perchance the fact that neither has either ? The futility of general statements and sur- face comparisons becomes plain. We cannot determine the adequacy of a return without knowing whether or not the capitalization is fair. Even before that we must settle on some- thing which we can accept on general princi- ples as an adequate return on capital invested in an enterprise. It is a truism of economics that any given income from capital represents two things: one, what is called true interest, or the return due to capital as such ; the other, the premium for the assumption of the risk in employing the capital in any particular direction. In economic theory true interest is the reward for saving, the compensation due to the sacri- fice of immediate enjoyment. That part of actual interest which we call premium for the assumption of risk is paid as compensation for hazarding the savings in any special investment. True interest represents that part of in- come which the law of supply and demand in relation to capital governs, quite apart from the assumption of risk. If no risk entered into the employment of capital, or if the risks in all uses were exactly uniform, the return at CAPITALIZATION AND THE STATE 225 any given moment on all employments of capital would be exactly the same. Such true interest would change from day to day, fluc- tuating with the demand and supply. This phenomenon clearly appears in the daily prices paid for money borrowed in transactions in- volving approximately similar risks, as call loans, sixty day prime paper, and so on. Quotations, that is, interest rates, vary from day to day, depending on the amount of money seeking employment of the particular kind, the demand for funds in the particular employment, and the changing nature of the risk due to general business conditions which constantly vary. Besides the risk of the particular employ- ment, a time speculation risk enters into any commitment of funds. This is only another form of stating that true interest varies from day to day. At the end of the term for which the funds are committed, will "capital be more in demand or less than now ? Will general business conditions be better or worse.? This time speculative risk accounts for the fact that the call money rates and the ninety -day rates on risks essentially similar, except for the time element, vary so widely. Though the longer the time the greater the commercial risk, the speculative time risk in the demand and supply of funds is so much more im- 226 CAPITALIZATION portant that the influence of the commercial time risk can hardly be traced. All this elaboration of statement simply at- tempts to get at the elements we must con- sider in finding the basis of true interest, plus the time speculative risk, to which we must add the premium for risk in the particular employment in order to arrive at our desired adequate return. We cannot eliminate the time speculative risk. Because the element of time necessarily enters into every transaction, that specula- tive risk necessarily inheres in every transac- tion. Since a corporation employs its capital as a whole for all intents and purposes in per- petuity, it seems that the particular time risk to consider should be that inherent in per- petual securities like stocks. Risks of the special employment, however, enter into all such securities to so high a degree that it is impossible to see from them anywhere near true interest plus the time speculative risk. Though really true interest would have to be on a loan without the time risk, that is, on a call loan, we will hereafter speak of true in- terest as if it included the time speculative risk. We might consider English consols. They offer a perpetual security with a minimum of special risk. They yield an income of, say, CAPITALIZATION AND THE STATE 227 3.20 per cent. Probably this is too low to take as a fair return on a perpetual commitment of capital without special risk, because particu- lar privileges such as exemption from taxation, being a legal trustee investment, and so on, much more than offset whatever special risk may be considered as inherent Jn the security. Giving up the idea of finding a perpetual commitment of capital with a relatively small special risk, let us consider some long-term securities. United States Government 3s of 1961, which lack the circulation privilege, yield a little less than 3 per cent. Again, how- ever, privileges creating special demands for these bonds probably reduce the income from them below normal true interest. Loans like those of the cities of New York, Boston, Philadelphia, and Chicago yield, say, from 3.80 to 4.20 per cent. Such loans involve rela- tively little special risk. Considering the special demands created by the fact of tax exemption, and being a legal savings-bank in- vestment in those states which most closely restrict the investing of such institutions and at the same time have the most savings-bank funds to invest, it seems highly probable that the effect of such demands niore than offsets the slight special risks in securities of this kind, and that they yield a return really less than the estimated true interest on such a 228 CAPITALIZATION long-time commitment. At best that must be only a guess. If a hazard were to be made as to what, at the present time, would be a fair true interest rate on a long-time commitment of capital, the surmise might place it as some- where between 4| and 4f per cent. This offers a leeway of one half per cent. Such a possible variation, however, would make a consider- able difference to an investor. It amounts to $500 a year on $100,000. If it is impossible to arrive at a fair estimate of true interest, even on a commitment of any particular length, to say nothing of a per- petual commitment, what can we do with the much more difficult problem of estimating a fair compensation for assuming the special risk of the business? We cannot arrive at it as insurance risks are determined. We should find it of no use to appoint an actuarial board to make estimates. There are not a sufficient number of enterprises operating under ap- proximately the same conditions to work out a law of averages. The only possible estimate of this risk is the appraisal at large. In the particular circumstances, so far as he can as- certain them, what does each investor com- pute it? These opinions working on each other, and forming a market, establish the common estimate of the risk. Events fre- quently prove this conclusion wrong. If any CAPITALIZATION AND THE STATE 229 government agency should aitempt estimat- ing the risk of enterprises, how much more frequently would they be right than the con- sensus of opinion expressed in the market ? An estimate by a governmental agency in the case of a projected enterprise could be effective only in one situation. If the govern- ment estimate were higher than a market esti- mate, it would not affect the market estimate, and the project would go ahead just as if the Government had made no estimate at all. When the government estimate chanced to coincide with that of the market, we should have exactly the same result. If the Gov- ernment, however, should estimate the risk lower than the market, and fix the adequate return on capital correspondingly, investors would not put their funds into an enterprise in which they estimated the risk as greater than the possible return would justify, and the project would never get under way. So much for the effect of any attempt by a gov- ernment agency to measure the risk of a pro- jected enterprise. How about an established business? Should the Government be per- mitted to take advantage of "hindsight," and after the event has proved of a business that its promoters were justified in undertak- ing it, step in and say that the measure of re- turn shall be the measure of risk now appar- 230 CAPITALIZATION ent? Or should the Government make what we may call a retroactive estimate of the risk, and, from the standpoint of the present, attempt to measure the risk originally as- sumed? Human judgment cannot be counted on to be fair under such circumstances. It is so easy now to look back and feel sure that the telegraph, the telephone, the Union Pa- cific Railway, in fact, practically any estab- lished business, was bound from the start to be successful in a large way. Yet at the be- ginning of all these things there were more thousands who believed that the anticipated profits did not justify the risk to be taken than tens who believed that they did. It is impossible from the standpoint of the present to get the same view backward that the stand- point of twenty-five or fifty years ago pre- sented forward. It is unfair to get the meas- ure of reward for a risk assurned in the past by a present estimate of the risk now existing. We have then several very distinct dif- ficulties in any attempt, assuming that the capitalization is fair, at deciding on what con- stitutes an adequate return. We must first determine what the "true interest" should be on a permanent committing of capital. Our judgment of that must necessarily vary from day to day as circumstances shift, and the outlook changes. No statutory fiat could CAPITALIZATION AND THE STATE 231 in any fairness determine that true interest should be regarded for a period of years as so and so. Assuming, however, that true in- terest could be established, we have seen the difficulties in attempting any estimate of the risk. Fixing the conditions, including the re- turn on capital committed, would not, with regard to new enterprises, be unfair to the capitalist contemplating putting his funds into them, because he has the option of com- mitting his capital or not. If such conditions with regard to new enterprises were made so stringent as to prevent the embarking of cap- ital in them, they would tend to give too great an advantage to established businesses by relieving them of potential competition. We have pointed out the difficulties of being fair in any attempt to make artificially, as by legislative enactment, the conditions under which an established business shall operate, including the return on capital, different from those imder which the capital Was committed to the enterprise. It is not ea,sy to see a solu- tion of the difficulties, unless, indeed, some- thing might be done along the line of the long- term franchise, guaranteeing against a change of conditions for a sufficiently long time for the investor, or the enterprise in the invest- or's behalf, to set up an insurance fund against the risk of change. Whatever change 232 CAPITALIZATION may be made, it should not throw the entire burden on the people who committed their capital to an enterprise relying on the condi- tions as to freedom of action in charging for services permitted at the time the project was taken up. Though it may not be good pubUc policy to permit the enjoyment in perpetuity of conditions that have proved more advan- tageous than could have been anticipated, it is likewise not good public policy to make those conditions immediately more onerous than anticipated. It must be kept in mind,, too, that the con- ditions under which one enterprise does busi- ness are never just like those under which any other enterprise operates. Therefore, the esti- mation of risk, and consequently of an ade- quate return, must vary with every property. Obviously no statutory enactment could cover the situation. Only some agency that could consider the merits of =each case could handle the matter. Up to the present, so far as the Government has dealt with the matter, it has done so, for the most part, in just this way through such agencies as the Interstate Commerce Commission and the various state commissions on railroads, and other public service corporations. To go on with the discussion, let us assume, however, that it is possible in some way to de- CAPITALIZATION AND THE STATE 233 termine what is an adequate return on cap- ital committed to a particular enterprise. That does not get us halfway. We have next to consider what is the fair capitalization on which such an adequate return shall be paid. It may seem, in changing from the word "capital" to "capitalization," that we are shifting our premises. The further discussion, it is believed, will show that we are not in- dulging in this logical fallacy. Though it may prove more convenient to speak in terms of capitalization, the actual question is always as to what the capital, the assets value, in the enterprise really is on which 3, return is to be allowed. Much confusion has come in at this point over the question of securities sold at a dis- count. One set of people corttend that every such transaction represents a capitalization watering operation, another that the dis- count is a necessary part of Ihe cost of con- struction. Neither is right, as a great many people, including both the managers of some corporations, and also some* public service commissions, are well aware. The discount has nothing to do with capital cost, but is simply and entirely deferred interest and re- presents part of the investor's estimate of the risk involved. The discount has to do entirely with the question of adequate return and not 234 CAPITALIZATION at all with the question of fair capitalization. Though it may conceivably be a matter of public concern as to how far it is desirable to go in deferring interest in this way, such de- ferred interest should be confined to its pro- per place in a discussion of return on capital- ization, and not be allowed to confuse by coming in at the wrong point. It may be re- marked, however, that the various statutory provisions against selling securities at a dis- count have an element of stupidity in them. Discussion of the proper basis for a fair capitalization, or return fox capital com- mitted to an enterprise, runs along two broad lines. One is that it might be on orig- inal cost; the other that it might be on the cost of reproduction. Both have their objec- tions as a basis of determining the capital investment, or capitalization, on which the adequate return is to be allowed. Let us consider first the f aii:ness of original cost as a basis. The special objection to it is that it deprives the corporation of the benefit of the unearned increment, or increased valu- ation due to the growth of the community. The corporation, especially if a railroad cor- poration, may itself have been the most im- portant influence iu bringing about such an increased valuation. The number of people who believe that a return to the railroad, or , CAPITALIZATION AND TJHE STATE 235 other public service corporation, based on the original cost would be a fair .return, is much greater than the number of ipeople who be- lieve that no unearned increment is fair. We have just this situation, John Smith owns an acre of property on the prairie worth $10. A railroad builds near this location and establishes a station and switching-yards close at hand. Smith's acre becomes desirable as a site for a grain elevator, and shortly is worth $1000. The community grows up, and land equivalent to that which the railroad bought for yards cannot now be bought for less than $1,000,000. When the corporation was buy- ing prairie land it did not have to pay, per- haps, more than $1000 for its entire location. By this time. Smith's property, which jumped immediately to $1000 in value, has now ad- vanced to the point of being worth $10,000. Those who advocate an adequate return on a fair capitalization, and would base their fair capitalization on the original cost of the pro- perty, would say that Smith is entitled to earn an adequate return on $10,000, but the railroad should be permitted to earn only an adequate return on $1000. Smith may earn ten times as much as the railroad, in face of the fact that his original investment was only one hundredth as much. Yet Smith, we will assume, has not done anything himseK to in- 286 CAPITALIZATION crease the valuation, but the railroad has been the most important contributor to the wel- fare of the community, and the community would not even have come into being at all except for the railroad. Not to permit owners of the railroads or other public service corporations, that is to say, their security -holders, to get any benefit from the unearned increment, is to place this class in the community at a disadvantage as compared with other classes. Though that would work no harm if it were made to apply only to projects undertaken hereafter, it would work a distinct unfairness if made retroactive and applied to those enterprises which were entered upon in the definite ex- pectation of getting the benefit of such in- creases in value. Such a probability was one of the conditions surrounding the enterprise at its initiation, which its projectors certainly had a reasonable right to expect to continue. If that condition had not existed it is conceiv- able that they would not have engaged in the undertaking. Cost of reproduction would perhaps give a more equitable basis for that fair capitaliza- tion sought after as a foundation for state regulation of rates. Such a basis would treat the investors in the securities of public serv- ice corporations on a level with other owners CAPITALIZATION AND THE STATE 237 of property in the community, and give them the benefit with every one else owning pro- perty, of the unearned increment of value which the commimity activity has created. Perhaps we should have defined earlier the basis of capital cost to be taken, whether original cost, or cost of reproduction, or any other cost is assumed as the proper cost prin- cipal. It should mean actual moneys paid out, in the case of original cost, or that would be required to be paid out in the case of the cost of reproduction, plus a proper charge on moneys expended for interest up to at least the time of going into operation. As already pointed out, such interest does not include the entire discount on bonds sold. On bond money only the basis rate should be allowed during construction. A rate at least as large as the basis on which the bonds were sold should be allowed on funds represented =by stock. Inas- much as such funds carry a larger risk, the interest rate allowed to be charged up to the cost of construction on account of them might well be larger. A valuation estimated on the cost of repro- duction alone might well be unfair, in that a decrease in the cost of materials, or a fall in wages, might make the reproduction cost lower than the original. As against this, how- ever, it may be argued that a monopolistic 238 CAPITALIZATION public utility would be little or no worse off on such a valuation, for the purpose of basing an allowable return on capital, than a manu- facturing enterprise without state regulation of charges, which, nevertheless, would be liable to competition from a plant built at a lower capital cost under similar conditions of construction. Danger of unfairness lies, too, in mistaken estimates of the cost of reproduc- tion. Those having to do with the financing of new enterprises know how difficult engineers find it to estimate construction costs, and how commonly they underestimate. If this is the case with the most expert engineers whose reputation is at stake, and whose fig- ures will be tested by the actual performance of the work, it is easy to see what injustice might be done by engineers estimating on behalf of the state, whose figures will not be checked up by the actual carrying-out of the work. Cost of replacement affords another possi- ble basis of valuation. Cost of reproduction, which we have just been considering, con- templates the present cost of building an ex- actly similar property in the same location. Cost of replacement contemplates the pre- sent cost of building a property that will per- form the same service as the property now in existence. We see at once that cost of repro- CAPITALIZATION AND THE STATE 239 duction and cost of replacement may come to very different sums. Engineering mis- takes, now easy to see and to avoid, may have made the present property cost more than would one built new at the present time that would do as much work. Even more likely, new inventions or devices for doing the work may make it possible to construct a property at a much cheaper cost that will perform that same service. Again, this basis of valuation applied to public service corpora- tions would not, perhaps, in its general tenor, be unfair, because capital invested in a manu- facturing corporation is subject to the same possibility of loss through similar improve- ment in methods, giving a new competitor an advantage. If valuations are to be based, however, on analogies to manufacturing cor- porations, these additional elements of risk need be kept in mind in determining that com- pensation which is to be counted fair. With these very general considerations in mind, indicating the difficulty of the problem, we may now go on to see what some of the states have done through commissions in dealing with it. What has been stated will afford any one a basis for a critical examina- tion of their work. On the other hand, the statement of their work will show many other things needful to consider. We shall make 240 CAPITALIZATION little attempt to comment, but will simply examine what they are doing. For our purpose we will take the Gas and Electric Light Commission of Massachusetts, the Public Service Commission of New York, and the Public Utilities Commission of Wis- consin. These are the only commissions with a jurisdiction over public service corporations other than steam railways that have a long enough history to show much accomplished. The statements for New York represent a study of only the first district. The general jurisdiction of these commissions include : — - A. Establishment of uniform accounts. B. Publication of statistics. C. Quasi-trade journal functions. D. Service. 1. Improvement of service. a. Upon commission's own initia- tive. b. Upon complaint. 2 . Extension or abandonment of serv- ice. a. Upon commission's own initia- tive. b. Upon complaint. E. Safety. F. Valuation of property. 1. Physical property. 2. Other property. CAPITALIZATION AND THE STATE 241 G. Capitalization. H. Regulation of rates. I. Policy of the commission as to the admission of new companies into the field, the consolidation of companies, and as to the transfer and sale of rights of companies. From the standpoint of a discussion of cor- poration finance we are interested only in that part of the jurisdiction including (1) Valuation. (2) Capitalization. (3) Regulation of rates. (4) The limitation of competition as an off- set to the limitation of earnings through rate regulation. The discussion will take up the work of all three commis- sions under each head. Valuation (Massachusetts) Valuation of Physical Property In the case arising from a petition of the mayor of Salem and customers vs. the Salem Gas Light Company, the commission states with some definiteness what it will consider in its valuation of any company's property. It quotes the court in the case of Smith vs. Ames as the authority to be followed : — 242 CAPITALIZATION And in order to ascertain the yalue, the original cost of construction, the amount and market value of its bonds, the present as compared with the original cost of construction, the probable capacity of the company under the rates pre- scribed by the statute, and the sum required to meet operating expenses are all- matters for con- sideration, and are to be given such weight as may be just and fair in each case. Valuation of Property Other than Physical The commission has no occasion to place a value on the non-physical property, because it never allows a company to increase its capital to exceed the value of the physical property. Whenever possible, through its rate-regulat- ing powers, it compels a cotnpany, capital- ized in excess of this, to reduce its capitaliza- tion to this limit. In case of the consolidation of two companies, it never allows the capital of the new company to exceed in amount the sum of the separate capitals of the former companies. Valuation (New York) Valuation of Physical Property Information about the method of valuing a corporation's physical property as a basis for rate-making, comes from two cases. Ex- perts of the commission made an appraisal of CAPITALIZATION AND THE STATE 243 all the property of the Bronx Gas and Elec- tric Ccaaipany. This included cost to repro- duce and depreciation. The commission un- dertook similar appraisal work on the Kings County Electric Light and Power Company. It makes such appraisals either in connection with bond or rate cases, or in anticipation of reorganization applications. The significance of a consideration of cost to reproduce and depreciation will be clear after a study of the methods of valuation the Wisconsin commis- sion employs. Valuation of Property Other than Physical In prescribing uniform accounts, the com- mission orders that franchise accounts shall be charged only with the amount actually paid to the state for the right, exclusive of taxes. Furthermore, the corporation must amortize this amount during the life of the grant. It must similarly charge all other intangible assets at their actual money cost alone; and must amortize this amount during the life of the asset. Valuation of Phtsical and Other Property (Wisconsin) The commission must value all the pro- perty of every public utility. It holds a pub- lic hearing, after notice to the corporation. 244 CAPITALIZATION before the final determination of, the value. The commission may at any time, upon its own initiative, make a revaluation. It must publish separately in its annual reports the value of all property used, and the value of the physical property used, by all public utilities. In compliance with the law, every bit of physical property of every utility in the state is to be valued, and constant revaluations are to be made to keep these values up to date. In the case of Hill et al. vs. The Antiago Water Company, the commission makes a comprehensive explanation of the methods of obtaining a valuation as the basis of rate- making. There are three such valuations : — (1) Original cost. (2) Cost of reconstruction. (3) The present value. Which of these valuations the commission may use depends on the special circumstances of each case. When it includes only proper charges, and when there have been no unnecessary wastes or mis- takes, of such nature that no one but the owners should be held responsible for them, then the original cost of construction woijld seem to repre- sent the investment that has been made in the physical property of the plant. CAPITALIZATION AND THE STATE £45 Thus the commission states the circumstances under which the original cost properly repre- sents the investment value of the plant. It ascertains this cost from the construction ac- counts. They should show: the cost of the various parts of the plant; the cost of engi- neering, superintendence, and management; the amount allowed as interest during the period of construction; the amount, if any, at which bonds were discounted; the basis on which contracts for construction were let; the basis upon which stock was issued; promotion expense, cost of franchises, and other items. In short, each of the various items entering into the cost of the plant should be shown in detail. The commission has this further to say con- cerning the original cost valuation: — The original cost, even when shown in detail, may not be the same as the value upon which the investors are entitled to reasonable returns. The question here is one of equity between the in- vestors and the customers. The former are en- titled to reasonable returns on a reasonable valu- ation; the latter are under obligations to pay rates which will yield such returns. The problem is to find the valuation equal to both sides. This value may not always be represented by the amount of money actually invested. The plant may have been built when prices were unreasonably high or low; there may have been excessive promotion 246 CAPITALIZATION fees, private understandings with the promoters, and so on. All of these things niust be taken into consideration. Subject to such considerations, if satisfactory records have been kept, the original cost as estimated from the construction accounts is accepted as correctly showing the value of the investment. If the records of original construction cost are wholly or partly lost, so that the orig- inal cost cannot be correctly ascertained, the value has to be determined by what it would cost to reconstruct the plant. The commis- sion describes the method of obtaining this cost: — To begin with, it is necessary to obtain a com- plete inventory of the physical property. This inventory must be secured by actual inspection, aided by the records and such other information as may be had from the company. This inventory should include not only the different parts of the property of the plant, but the amount or quantity of labor and material required to place it in posi- tion as a part of the complete plant. The next step consists of finding a suitable price per unit for the labor and material required. The prices are usually those which constitute the average market price for the last few years, modified by local con- ditions. From these facts the total cost of labor and material that enters into a plant can be com- puted. In addition it is necessary to ascertain the time required for construction, in order that the interest on the cost during the construction period CAPITALIZATION AND THE STATE 247 may be estimated. The probable cost of engi- neering, superintendence, insurance, and various other factors are also to be computed. The sum of the costs of all these elements is considered to constitute the cost of construction new. As a third possibility the commission may use the present value. The total amount of depreciation is deducted from the cost of re- construction new, giving the present value of the plant. In many cases companies have charged rates ample to cover operating ex- penses, including depreciation, together with a fair amount for interest and profits, but have distributed to the stockholders the amount which should have been reserved for deprecia- tion. This practice, the commission argues, is one way of paying dividends out of capital. Since part of the stockholdprs' capital has been returned to them, and their investment decreased proportionately, it is only fair that the sum upon which returns are to be esti- mated should be reduced accordingly. An alternative to reducing the investment valua- tion is to keep the plant value up to the cost of reproduction new, and make the managers pay back from earnings the amount diverted from depreciation. In all cases the franchise is to be valued at its actual cost alone, and no other intangible assets are to be considered. A further element contributing to the value 248 CAPITALIZATION of the investment is the cost of business. This consists of the deficit from operation during the development period. Thepommission con- siders it as necessary a cost as the cost of plant construction, and believes it should be treated as part of the capital invested. An alternative to charging this cost to capital would be to amortize the amount by charging it directly to the consumers as an addition to the price or rate. In that c^se it becomes a temporary charge, borne onlry by those con- sumers who exist during the amortization period. The commission considers this in- equitable to the unlucky consumers who are burdened by it. Capitalization (MASSAbnusETTs) Though originally the board had no control over capitalization, it was not slow in making clear that a power of regulation was desirable. As a result it has to-day a most effective con- trol. From the first the board made it evident that it would consider as capital, upon which dividends were to be earned, only an amount equal to the actual cash paid in. This is shown in the following statement: — Over-capitalization (watered stock) is a per- petual and unjust burden on the consumers. The stockholders are entitled only to a fair and rea- sonable dividend on the actual amount of cash CAPITALIZATION AND THE STATE 249 paid in. The money used in the extension of plant, if paid out of surplus, should not be cap- italized, but should be for the benefit of the con- sumers by reducing the price of gas. What annoyed the board was the compan- ies' practice of capitalizing surplus earnings by issuing stock and scrip dividends upon them. This practice, with the board's views concerning it, is illustrated in the case of the Springfield petition of 1893. The Springfield Gas Company had been incorporated with a capital of $50,000, subsequently increased to $500,000, mainly through the issue of stock dividends, which in nearly every case had been equaled in value by additions to the company's plant. In discussing this situa- tion, the board said in part: ^ — The consumer is in duty bound to pay three charges : — (1) the fair cost of gas; (2) fair dividends on a reasonable amount of capital; (3) such excess as will give the company suffi- cient surplus to meet extraordinary acci- dents and to conduct its business with the highest economy. If he pays more, and the company converts the excess into new capital, increasing it to a figure beyond the fair amount demanded for the busi- ness, he is burdened with too high a price for the gas and a dividend charge upon lnjs contributions. 850 CAPITALIZATION As a result of continual agitation on the part of the board, the foUowi^ig law, prohibit- ing the issue of stock and scrip dividends, was passed: — - No company shall declare any stock or scrip dividends or divide the proceeds of any sale of stock or scrip among its stockholders, nor shall any company create any additional new stock or issue certificates thereof to any person, unless the par value of the shares so issued is first paid in cash to its treasury. After the passage of this law, the board still lacked the complete control over capital- ization it desired. So it secured the passage of stock and bond laws in 1894 and 1896 to the effect that: — A gas or electric company shall issue only such amounts of stocks and bonds as the board may from time to time vote. The board shall render a decision upon application for such issue within thirty days after final hearing. The board shall make out a certificate of its decision, including a statement of the purposes to which the proceeds of the issue are to be put, a copy of the certificate going to the company, which shall use the pro- ceeds for no other purposes than those described. If when the board approves an issue of stocks and bonds, it determines that the fair structural value of the company's plant is less than the out- standing stock, it may prescribe conditions and requirements it considers best adapted to make CAPITALIZATION AND THE STATE 251 good these impairments of capital stock, or before allowing an increase it may require the capital stock to be reduced to an amount not exceeding the amount of such impairment. In case of an authorized increase of capital stock, the shares shall be offered proportionally to the shareholders, at not less than the market value thereof at the time of in- crease. This value is to he determined by the board. If the increase does not exceed 4 per cent of the existing stock, without offering the same to the stockholders, and in other cases, if after the time allowed to the shareholders any shares remain unsubscribed for, the directors may sell them at auction to the highest bidder at not less than par to be paid in cash. The purposes for which companies wish to issue new securities are three : — (1) The purchase of existing plants and properties; (2) The construction of new plants and construction of additions to present plant and facilities; (3) Refunding of bonds and floating in- debtedness. In the case of a petition for permission to is- sue securities for any of these three purposes, the board follows the ironclad rule that the amount authorized shall in no instance be more than actually necessary to secure the exact amount of funds required. This is well shown in the case of an applica- 252 CAPITALIZATION tion of the Fall River Gas Works for the ap- proval of an issue of new capital stock to the amount of $50,000. It wanted the funds to purchase the plant of the Manufacturer's Gas Light Company, and to enlarge its own plant. It was found that the purchase price was equivalent to 780 of the shares of the buyer. Upon investigation the board was satisfied that this price represented the fair structural value of the plant, not including the franchise and intangible assets. The board ruled that 1620 shares of stock were ample, the proceeds of 780 shares to be devoted to the purchase and 840 to improvements. An illustration of an application of this principle in a petition on account of new con- struction is found in the board's action upon a petition of the Brookline Electric Light Com- pany (1897), for an issue of $200,000 of bonds in order to make additions and extensions to the company's plant. The board thoroughly investigated the company's plans, and exam- ined its plant. Finding that the fair structural value of the plant equaled the outstanding stocks and bonds, and that the proposed ex- tensions and additions were needed and would require the amount petitioned for, the board approved the issue. The board applies at every opportunity the clause of the act demanding that if at the time CAPITALIZATION AND THE STATE 253 of approval by the board of an issue of stocks or bonds the fair structural value of the com- pany's plant is less than the outstanding stocks and bonds, the board may prescribe the requirements it considers best adapted to make good these impairments, and may de- mand that the stock be reduced. Thus, in 1889, in the case of the application of the Dedham and Hyde Park Gas Company for ap- proval of an issue of mortgage bonds to en- large and reconstruct its plant, when it found that the stock exceeded the plant's value by about $20,000, it allowed the petition only upon condition that the company reduce its capital stock from $100,000 to $80,000. In the treatment of petitions for the issue of stocks and bonds for refunding opera- tions, the board exercises the greatest caution. Difficulty arises in the determination as to whether the debts have arisen from expejndi- tures for extensions or for repairs and renew- als. The board constantly guards against cap- italizing depreciation. The petition of the Boston Electric Light Company for $50,000 of an issue of $250,000 to fund a part of the floating debt illustrates this situation. Though the company had an- nually appropriated large sums out of income to depreciation, because of the rapid progress in electric lighting methods the sums applied 254 CAPITALIZATION had not been suflSeient to make up for this loss. Recent legislation had compelled it to remove its overhead line in a part of the city and to place new conduits under ground. So the company found itself facing an extraor- dinary rate of depreciation. Probably public convenience would demand still further im- provements in the near future. The board ruled: "Clearly, this situation imposes on the corporation, in its own as well as the public's interest, the duty to apply from its income a sum much larger even than heretofore to the payment of its floating debt and toward the cost of new improvements." Denying the pe- tition, the commission said: "The cost of re- newals and reconstruction necessarily inci- dent to the proper conduct of the business, and of replacing property no longer required, is fairly chargeable upon earnings, but only actual additions to the plant upon capital." Capitalization (New York) A public service corporation in the State of New York may issue stock, bonds, notes, or other evidences of indebtedness, payable at more than twelve months from the date of issue, when necessary: (1) for the acquisition of property; (2) for construction, completion, extension, or improvement of iits facilities; (3) for the improvement or maintenance of its CAPITALIZATION AND fHE STATE $55 service; (4) for the discharge or lawful refund- ing of its obligations; provided the corpora- tion has secured from the commission an order authorizing the expense accounts, such as ex- penditures for replacements, and insure that in the future capital will not be impaired. To guard against improper uses of the money obtained from the sale of securities, the com- mission includes in its certificates of approval the requirement of monthly reports of receipts and disbursements on such accounts, with the further requirement that the books of account shall be open to audit by the commission. As a result of the investigations of finances and appraisals of property conducted by the commission, many of the original applica- tions have been modified, or even withdrawn, while the examinations were in progress. The commission has in several instances been forced to deny applications, or parts of ap- plications, because the funds to be obtained were to be devoted to making replacements. It allowed the capitalization only of those expenditures which added increased value to the plant. Capitalization (Wisconsin) In its report for 1909-10, the commission pointed out weaknesses in the provisions of the law giving it jurisdiction over stock and 256 CAPITALIZATION bond issues. When a corporation desired to issue stocks, bonds, or other ievidences of in- debtedness for money only, the scope of the commission's inquiry was hmited to ascer- taining merely whether such an issue would be legal or not. The commission makes this criticism ; — The law as it now stands is of little value as a means of ascertaining many important facts relat- ing to the past issues of the securities of public service corporations, which should be matters of record in connection with any ne"w issues of securi- ties. The financial history of such corporations is vital to investors, and if made a matter of record, will accomplish much in the Way of preventing over-capitalization of such corporations. ... It might be well to strengthen the law in other re- spects. At present the corporation determines the amount and character of the securities it wishes to issue, also the purposes for, and the terms upon which, the same are to be issued. The legislature could prescribe the purposes for which such secur- ities could be issued, determine the character and limit the amount of the same to that which would be reasonably required for such purposes, and leave to the commission to ascertain whether the proposed purposes are within the terms of the statute and whether the character and amount of the issue are reasonably required for such pur- poses. The law as amended in 1911 would seem to be proof against any of the defects of the CAPITAUZATION AND THE STATE 857 former law complained of by Ihe commission. It reads : — No public service corporation shall issue any stock or certificate of stock except in considera- tion of money, or of labor or property, at its true money value as found and ddtermined by the commission, actually received by it equal to the face value thereof; or any bonds, notes, or other evidences of indebtedness, except for money or for labor or property at its true money value as determined by the commission, actually received by it equal to 75 per cent thereof. No bonds, notes, or other evidences of indebtedness shall be issued at less than 75 per cent of the face value thereof, plus the amount of any discount paid or incurred upon the issuance of such bonds, notes, etc. No stocks, bonds, or other evidences of in- debtedness, except such as are issued for money only and payable one year or less from the date thereof, shall be issued without the consent of the commission. In case of an application for the right to issue stocks, bonds, etc., for money only, the corpora- tion shall file with the commission a statement setting forth : — (a) purposes for which they are to be issued; (6) the amount and character of the proposed issue; (c) the terms on which they are to be issued ; (d) the total assets and liabilities, and the 'pre- vious financial operations and business of ihe 258 CAPITALIZATION corporation, in such detail as the commis- sion may require. For the purpose of enabling it to determine whether the proposed issue complies with the provisions of the act, the commission may make any such inquiry or investigation, hold such hearings and examine such witnesses, books, papers, documents, or contracts as it may deem important in enabling it to reach a determination. It may also make a valuation of all the property of the corporation. If the commission decides that the pro- posed issue complies with the law, it gives the corporation a certificate of authority stating (1) the amount of such stocks, and bonds, reasonably necessary; (2) the purposes for which they are to be issued; (3) the terms upon which they are to be issued. The cor- poration must not apply the "proceeds to any purposes not specified in the certificate. In case of an application for an issue in re- turn, as a whole or in part, for anything other than money, the corporation shall file a cer- tificate showing also (4) the description in detail and estimated value of the property or services for which they are to be issued; (5) the amount of money, if any, to be received in addition to such property, services, or other consideration. CAPITALIZATION AND THE STATE 259 The commission shall obtain the true valu- ation in detail of such property, service, or other consideration, and shall make examin- ations and investigations as before. The commission's certificate of authority in these cases shall contain, in addition to (1), (2), (3), the true value of the property or service or consideration other than money as found and determined by the commission. A corporation may issue stock, bonds, or other evidences of indebtedness, when neces- sary for organization expenses and all other expenses reasonably required in connection with all the financing and construction of the property; for the acquisition of property, and for the construction, completion, extension, or improvement of its plant;- or other facili- ties for the improvement of its service; or for the discharge or refunding of its legal obliga- tions. No corporation shall make such issues for any purpose not chargeable to its capital account. If it should make such an issue for purposes not chargeable to capital account, it must set aside annually such a sum as to amortize the amount by the time the obliga- tions become due. Eegulation op Rates (Massachusetts) It is difficult to determine just what the board has accomplished in the way of price re- 260 CAPITALIZATION ductions. Though each year between twelve and twenty gas companies have reduced their rates, in most cases they have not made the reduction as a result of complaints. Average prices paid by coal-gas consumers have fallen from $1.72 in 1886 to $.91 in 1909. Changes in methods of production and distribution, however, have resulted in such reductions in costs, from time to time, that it is impossible to draw definite conclusions as to how far this appreciable downward trend in prices has been due to the efforts of the board. More- over the board has been unable to make any general action to the end of bringing about a general price reduction, but it has been forced to confine itself to those irregular cases which chance, in the form of complaints, has brought under its jurisdiction. However, it is fair to say that because of the board's exist- ence prices have probably responded more quickly to the diminutions in costs due to in- ventions and improved methods of produc- tion. Cost-reducing improvements in apparatus and methods are sure sooner or later to bring about a general price reduction. However, in such a business as electric and gas lighting, where nearly every company enjoys a mono- poly in its own territory, under ordinary con- ditions improved methods are likely to be CAPITALIZATION AND THE STATE 261 much slower of general adoption than in the case of competitive industries. A company making satisfactory profits without fear of competition will hesitate a long while before installing new apparatus or adopting new methods, which, although likely to diminish costs and so increase profits, will necessitate a large initial expense. Presumably the exist- ence of the board has gone far toward over- coming the tardiness of prosperous companies in installing new and cost-saving apparatus. The commission keeps informed about the latest and most improved methods of manu- facture. Whenever a company is brought be- fore it by a petition for a reduced price, it bases its decision upon the costs by the most improved methods of manufacture. An order for one company to reduce prices leads to others. No community, learnmg that another obtains gas or electricity cheaper than itself, is content until it has brou^t its grievance before the board. Thus, thanks to this nat- ural determination of every consumer to pay no more than the next fellow, the board is in a position sooner or later to scale down prices throughout the state to the cost level of the most eflScient means of production. As a result the companies tend to adopt improved devices and methods more quickly than they would altogether of their own accord. 262 CAPITALIZATION On the petition of the customers of the Springfield Gas Company fol- a reduction in the company's price, the board stated the charges contributory to a proper price: — The consumer is in duty bound to pay three charges : — (1) fair cost of gas; (2) a fair dividend on a reasonable amount of capital; (3) such excess as will give the company suffi- cient surplus to meet extraordinary acci- dents and conduct its business with the highest economy. "Fair cost" obviously means the fair man- ufacturing cost. In satisfying itself as to whether or not the compariy is employing the proper methods to supply the public with gas or electricity at a fair manufacturing cost, the board subjects thfe companies to thorough tests. The second charge upon consumers is a fair dividend on a reasonable amount of cap- ital. What the board considers a reasonable amount of capital has already been stated under the head of "Capitalization." In an investigation arising out of a* petition of con- sumers of the Chelsea Gas Light Company, the board found that the prices were not higher than those of other companies, that the company was economically managed, CAPITAUZATION AND THE STATE 263 that for several years it had been making only about 6 per cent on the capital; but it also found that the amount of capital was unusu- ally large. It appeared that the present man- agement had received a company heavily capitalized, due largely to a distribution of stock dividends. The board considered that under such circumstances low dividends would not be considered a reason for keeping prices at their present level, and ordered a reduction. According to the board no single uniform rate of income return to be allowed on invest- ment can be set. It says (1909) : — To assume that some single rate of dividend can be applied to such investments would not infrequently put a premium on managerial inef- ficiency, invite a failure to regard properly the company's obligations to the public, and thus imperil the public's interests. In fixing a fair rate of return for individual companies, certain fea- tures of local history and condition should not be overlooked. It would be short-sighted policy which would overlook the relation of the actual investments of the shareholders to the total in- vestment in the business, of which the value of the company's plant may afford the best indication. When the plant value is high compared to the capital stock, along with a high grade of service and a relatively low price, it affords a convincing indication of high efficiency in the management 264 CAPITALIZATION and a commendable regard of the public's inter- est. Under such a management, the public inter- ests will not be prejudiced, but may rather be con- served by a moderate increase in dividends over what might be claimed under other conditions. The board defines pretty distinctly what shall constitute a proper surplus to contrib- ute to the charge upon consumers. It shall be sufficient to enable the company to meet extraordinary accidents and to conduct its business with the highest economy. Again quoting the commission : — The board believes that the policy of creating a surplus should be commended rather than con- demned. The history of the business shows the lowest prices where this policy has been pursued, as it allows an increase of facilities without a cor- responding increase of dividend-demanding cap- ital. The surplus in thig case cariinot be considered the exclusive property of either the shareholders or the consumers. It would seem that the com- pany is under obligation to use this in order that substantial advantages will accrue to the public. From an examination of the works it is apparent that there is an immediate demand for Investment in the plant of a portion of this surplus. This policy should be continued. Thus the surplus will act as an insurance against loss if prices are re- duced and consumption is not increased. In justification of the idea of the joint own- ership of surplus by the company and the pub- CAPITALIZATION AND THE STATE 365 lie, the board's argument in the case of the Worcester petition of 1902 is to the point: — But it must not be forgotten that however skill- ful and wise may have been the management, the company has been able to acquire its present ac- cumulations only by the exercise of a monopoly, which it has enjoyed by the favor of the state, and which is in a measure assured to it by law. This is certainly a most important contribution by the public to the company's prosperity, for which the public is entitled to a special consideration. When both parties have so clearly contributed to these results, neither ought to claim the exclusive rights to the benefits they confer. In the case of J. A. Gale and other con- sumers of the Haverhill Gas Company, the board calls attention to the debt owed by the present consumers to those of the future, and at the same time to the fact that when the surplus exceeds certain limits, it should re- vert to the present consumers in the form of reduced prices. Regulation of Rates (New York) The commission can act on the rates of common carriers only on complaint. It has not established any definite principles of rate- making. Speaking of a failure to provide for depreciation, in favor of high dividends, the commission says: — 866 CAPITALIZATION The stockholders, having obtjained in the form of dividends the earnings that should have gone for maintenance charges, should not now object because renewals and increased maintenance and interest charges make dividends temporarily im- possible, nor should this presumably temporary situation stand in the way of reduction of fares, if other considerations justify such a reduction. Regulation of Rates (Wisconsin) The Wisconsin commissioil states of the charges which make a proper rate : — Under normal or ordinary conditions, public utilities are entitled to earnings that will cover the operating expenses, including depreciation, and a fair return on the investment. These items may be said to constitute the cost ta the users of the services that are furnished. (Manitowoc Gas and Electric Company, December, 1908.) With the installation of the accounting systems prescribed by the commission, a company's expenses of operation and every- thing connected with its finances may be ac- curately determined. The commission makes no attempt to give a normal rate of deprecia- tion, but states that the rate is a variable de- pendent upon the circumstances peculiar to each case. The method of ascertaining the investment value or amount upon which the rate of profit is to be estimated has been given under that heading. In the case of Hill et al CAPITALIZATION AND THE STATE 267 vs. The Antiago Water Company, the com- mission discusses the proper return on the investment. The interest rate it states to be a variable, governed by the conditions of each case. Profits above interest, it says, shall be high enough to encourage new capital to enter the field. Since risks are greater in new en- terprises, higher profits shall be allowed them. As the utility becomes older and the risk de- creases, profits shall decrease accordingly. It is the duty of the commission to protect the consumer from monopoly prices and discrim- inations. The only instance in which the com- mission attempts to name at all definitely what is a proper rate of return is in the case of the Chippewa Railway Light and Power Company, in which it says : -^ Many authorities held that it [the rate of return] should range from eight to ten per cent on a fair valuation of the plant; many place it as low as six per cent. It is not unlikely that the figures thus mentioned represent the maximum and minimum rate under approximately normal conditions, and that, as in the case of depreciation, the actual rate allowed should depend on the con- ditions in each case. Policy as to the Admission op New Compan- ies INTO THE Field (Massachusetts) The board, upon application in writing by any company, chartered under the laws of 268 CAPITALIZATION the commonwealth, after notice and hearing, may authorize the company to go into the gas or electric business. It may engage in such business in the territory or any part thereof that the J)oard may designate, but shall not do so unless authorized by a two-thirds vote of the shareholders. In granting this authority the board shall prescribe the time, not less than six months, within which the company *shall erect and equip a plant for carrying on its business, and shall designate the minimum capacity of the plant. If the company ^ils to erect the plant within the time required, the authority becomes void, and shall not be granted again for two years. No other conipany or person in the community where a company already exists may lay pipes or erect wires without the consent of the mayor t)r aldermen or board of selectmen. Any company aggrieved by the decision of the municipal authorities on the coming of a new company, may, within thirty days after notice of such decision, ap- peal to the board of gas commissioners, which shall thereupon give notice and hear all par- ties concerned. The decision of the board shall be final. Practically all the cases of such new com- panies have come before the board through appeals by the old company from the action CAPITALIZATION AND THE STATE 269 of the municipal authorities. One of the first was the Boston Electric Light Company vs. A. W. Perry (1889). Perry had purchased a small, private, electric lighting plant. He moved the apparatus to a block he owned, and from there he ran wires across Summer Street to blocks that he leased. He had ob- tained no permit to do this, as he did not know that it was necessary. Later he had asked for one, and, as no remonstrants ap- peared, the aldermen had granted it. The company, stating that it had seen no notice of the hearing, showed that the grant from the aldermen allowed Perry to light a valua- ble and substantial part of the city. Since he did not possess a general franchise, he did not have to furnish gas upon a reasonable demand as the corporation had to; the cor- poration argued that though Perry could, per- haps, furnish light to certain sections more cheaply than it could, nevertheless to let the decision turn on this alone was an injustice to the company, which could furnish light to the whole city at a less rate than Perry. The board agreed with this argument. The board gave a very full statement of its reasons for protecting the large company in such a case in the hearing on an appeal by the Edison Electric Illuminating Company (1895) from an order of the aldermen permitting 270 CAPITALIZATION O. H. Durrell to run pipes across the streets. As between corporations and individuals it seems to be a wise policy to entrust the light- ing of towns and cities, so far as it requires a public franchise, to perpetual bodies, sub- ject to state supervision and regulation, and capable of continuous ownership. Such bod- ies serve the community as a whole more safely and economically. The commission says : — The large lighting companies, holding valuable franchises, are compelled to submit to the orders of this board in regard to the quality and prices of light. The large company is required to satisfy all reasonable demands for extension, and in fact to furnish the whole community with light. It is clear that if isolated plants are permitted to exercise public franchises over limited areas in the city, the burden of each company will be en- hanced, for such a removal of ats customers, as would result from the multiplication of business, would of necessity add to the cgst of light to the whole community. If it were shown that a company rendered in- efficient service or charged unreasonable rates, or defied legal restraint, these circumstances might be conclusive in favor of introducing competition. The multiplication of plants, exercising public franchises, and each lighting a limited area of the public territory, would, in the first place, lead to great confusion, and, in the second place, would be detrimental to the general consumer, who must CAPITALIZATION AND THE STATE 271 always be dependent upon the large general com- panies, and for whom the companies must main- tain a sufficient plant and lines. It is equally true that the board is willing to protect an existing company which is giv- ing satisfactory service, from the invasion of its territory by a large company. The board's action, in the case of an appeal by the Haver- hill Electric Company from a decision of the aldermen in favor of the Haverhill Illuminat- ing Company, shows this. The contract of the electric company to light the city had just ex- pired. Some time before its expiration, the city advertised for street-lighting bids. The bid of a certain group was successful, and they incorporated into the Haverhill Illumin- ating Company, and received from the alder- men power to carry on the business of supply- ing electric light and power to the city. At the hearing there was no attempt to show that the service of the present company was poor or its prices high. The evidence showed that its equipment was as efficient and eco- nomical for the work required as that which the new company proposed tp install. The permit rested solely on the fact that the illuminating company offered to do the street-lighting at a price which would amount to about $6000 less than the price of the old company. The old company had $250,000 272 CAPITALIZATION invested in the business. The new proposed to invest $150,000. It was inore than prob- able that this latter investment would be too small to carry on a business of a volume equal to that then being done, and it was very- doubtful if the company planned an extension of its business. There was no attempt to show that there would be a profit in the undertak- ing; in fact, the testimony amounted to an admission that it would be unprofitable. It seemed to the board that though the admission of the new company might, for a while, result in lower prices, the competition would in the end prove expensive for the community. The ultimate result would be a union or consolidation which Would bring an undue burden of capitalization upon the pub- lic, and an excessive investment in plant and apparatus. The existing investment of $250,- 000, which was adequate, would be increased to $400,000, at least, and that amount would rapidly grow larger. In view of these facts the board did not hesitate to uphold the protest of the old corporation. It is clear that the board has developed a fixed policy, by reason of which the existing company is vastly more secure in its position than it ever had been before the creation of the board. In the first place, the board prac- tically denies the right of individuals to enjoy CAPITALIZATION AND THE STATE 273 franchises, in competition with the perpetual, state supervised corporations. It considers that the corporation has proved itself the best equipped unit to give the whole community the most economical service, and in view of this fact, it considers that the enjoyment of a right to furnish a part of the community by an individual results simply in a burden upon the corporation which it should not be forced to bear. With regard to the admission of a new corporation into the field, the board's policy is just as decisively in favor of the existing company. As long as the corpora- tion obeys the law, serves the community efficiently, and charges reasonable rates, the board considers it deserving of retaining its position against all comers. The burden of the proof in every case rests upon the com- pany seeking to enter the field. If it cannot prove that the existing company is not living up to the three requirements named, it has not shown the necessity of its establishment. Capital invested in supplying any community should be kept to the lowest limit which in- sures efficient service. The board adheres to these principles so strictly that in one case it sustained an existing company, which was giving only a mediocre service, against a com- pany seeking authority to serye the same ter- ritory, on the condition that the existing com- 274 CAPITALIZATION pany should bring its service up to standard within a certain, stipulated time. (Appeal of Easthampton Gas Company, 1908.) Policy as to Consolidation -of Companies (Massachusetts) The statutes allow the purchase and sale of the rights of one company by another, or the consolidation of two or more companies, only on the board's approval. ThuB the board has full control of a company's actions in this direction. The board bases its decision, in cases of this kind, upon its estimate of whether or not the community will benefit froiji the proposed changes. A study of two cases shows this. In 1889 the New Bedford^ Gas Company and the New Bedford Electric Company pe- titioned for authority for the sale of the plant and franchise of the electric 'company to the gas company. At the hearing the Edison Electric Illuminating Company appeared in opposition. Since the consolidation seemed to promise no public benefit the board refused to allow it. At the request of the petitioners the board later reopened the case. The new evidence showed that the incandescent elec- tric lighting company confined itself to one section of the city, that it "was making no effort to increase this area, and that it could CAPITALIZATION AND THE STATE 275 make no considerable extension except at an expense practically prohibitive. It also ap- peared that considerable economies might re- sult from the operation of the business by the gas company. These would be effected by the use of fuel of little or no market value in the place of coal, by a reduction in labor costs, and by the removal of the electric plant to unoccupied land which the gas company owned. The gas company was ready to erect a plant with facilities for lighting the whole city. The board believed these facts pointed to improvement in both quality and price and permitted the consolidation. The Worcester Gas Light Company and the Worcester Electric Ligh,t Company ap- plied for authority (in 1891) for the gas com- pany to engage in electric lighting. Plans had been made for the purchase of the rights and property of the electric light company by the gas company. The electric Ught company had just completed an addition costing $125,000, making a building of ample size to meet the wants of the community for years. It had managed its affairs with strict economy, and pursued a conservative policy. The board was unable to find that any appreciable sav- ing in the conduct of its affairs or the manu- facture of jits product could be secured by the change. The businesses used no article 276 CAPITALIZATION in common. Coke for fuel would be available from the gas works only a few weeks a year, and even then transportation charges would be prohibitive of its use. The wide separation of the plants and the difference in the training of the employees would make, necessary sepa- rate superintendents and employees. The present dividends of the gas company were eight per cent, of the electric light company, five per cent. The contract between the two would probably require $300,000 extra cap- ital. With no facilities for reducing the cost of electric light, the stockholders of the gas com- pany would doubtless suffer- a reduction in dividends. This could be prevented only by advancing the prices, lessening the service, or using the surplus profits of the gas company. Any of these courses would be contrary to the pubhc interest. It would be- for the interest of the consolidation to increase the sales of gas rather than of electricity, and the public would object to such a policy. The board refused to permit the combination. Policy as to the Admission of New Compan- ies INTO THE Field (New York) Without having first obtained the permis- sion of the commission, no corporation shall begin the construction of a street railroad, or exercise any franchise or right under any pro- CAPITALIZATION AND THE STATE 277 vision of the railroad law. The commission shall grant its approval, whenever it shall, after due hearing, determine that such con- struction or such exercise of the franchise or privilege is necessary for the public service. The provision concerning gas and electrical companies is substantially the same. Decisions of the commission have done little toward formulating a definite policy, to be followed in acting on applications for the exercise of franchise rights and other powers mentioned in clauses of the act re- lating to the admission of companies into a new field. It has, however, come out flatly in defining its position as to the admission of new companies into a field already satisfac- torily supphed: "If additional companies are allowed to enter a field already adequately supplied, the public in the end must pay higher rates or accept poorer service." In the case of the application of the Longacre Elec- tric Light and Power Company, in 1908, the commission stated its views at length. This company petitioned for the approval of a proposed bond-issue. Since the proceeds from the sale of the bonds were to be used to build a plant, the request amounted to an appHcation to begin business. The board denied it. The applicant did not prove that the exist- 278 CAPITALIZATION ing companies were not properly serving the public interest and convenience, and that it would be to the pubhc advantage to have a new company authorized to enter the field. If a competing company were to enter the field, it was unlikely that it would continue independent operation for any length of time. Competition was not desirable, the board said. The existence of competing companies leads to much more frequent opening of the streets, resulting in injury to pavements and more expense to the taxpayers. Competition involves duplication of plant and equipment. It is an established fact that one company can generate current for the whole of Manhattan more cheaply than several companies, each trying to serve the entire borough. As a re- sult of duplication of capital and the less economical methods of production and dis- tribution which accompany competition, the cost of furnishing current is higher than under efiicient monopoly. Furthermore the exist- ence of duplicate plants and wires is almost always urged as a reason for higher charges when the state attempts to lower rates. Practically all the advantages claimed as the probable result of competition can be secured through the powers of the commission. Until it has been demonstrated that these are inef- CAPITALIZATION AND THE STATE 279 f ective, it would be unwise to adopt a method which has proven ineffective in the past. pomct as to the consolidation of Companies (New York) No public service corporation, foreign or domestic, can hold any part of the capital stock of another public sertice corporation unless authorized to do so by the commission. Except as stock shall be transferred or held as collateral with the consent of the commission, no corporation of any description, domestic or foreign, other than a public service corpora- tion of the same sort, can hold more than ten per cent of the capital stock issued by any public service corporation. No franchise or right under any franchise, to own or operate a public service enterprise, can be transferred, or leased, without the commission's approval. It is apparent that the commission has a check over the control of companies by hold- ing companies. There are, however, no cases of application for the right to acquire the stock of other corporations which bring out facts worthy of notice. The commission is in a position to accom- plish much toward conserving the public in- terest through its control over leases. The widespread bankruptcy of the New York sur- face lines was due to no one thing more than 280 CAPITALIZATION the extravagant terms on which many lines had leased the property of others. In some cases the Metropolitan Street Railway Com- pany had made leases under which it had agreed to pay twenty-one per cent upon the inflated capital of the companies whose lines it leased. The commission makes it evident that it will allow no more leases upon such terms. "Leases made under which extrava- gant rentals are paid lessen the available net income." "Only five applications were pre- sented _to the commission for the approval of contracts and agreements. Only one was similar to the numerous leases of the Metro- politan system in the past, and that was dis- approved." ; Policy as to the Admission of New Com- panies INTO THE Field (Wisconsin) No license, permit, or franchise can be granted to any person, partnership, or cor- poration to engage in any public service en- terprise, where there is in operation under an indeterminate permit, as provided in the act, a public utility engaged in a. similar service, without first securing from the commission a declaration, after a public hearing, that public convenience and necessity require such second utility. CAPITALIZATION AND THE STATE 281 An indeterminate permit may be granted, where the existing public utility is operating without an indeterminate petmit (1907). By an act of the legislature in 1911, all existing franchises and permits possessed by public utility corporations were made indeterminate permits. The commission stating its views on com- petition between public service corporations, says: — There are many important differences between public service and commercial enterprises. The former usually require a much larger investment in plant, equipment, and other fixed property, which in turn means heavy annual charges for interest, repairs, and maintenance. The condi- tions which surround the former, are also of such a character that the service which they render can usually be furnished at a much lower cost by one plant than by two or more in the same local- ity. The differences between them extend to the principles of competition. In most of the ordi- nary commercial undertakings, the expense can usually be stopped, whenever competition has reduced prices below a profitable level. This cannot be done in the case of public service cor- porations. The investment in these corporations cannot be withdrawn and converted to other pur- poses. The interest and maintenance charges go on at about the same rate, whether the plant is in operation or not. Hence it often happens that it is better for the owners that such plants should be 282 CAPITALIZATION kept In operation, even if they fail to earn more than the actual operating expenses. Duplication of such plants is a waste of capital, whenever the service can be adequately furnished by one plant. It necessarily means that inter- est and maintenance must be earned on a much greater, if not twice as great, an investment, and that the actual cost of operation is likely to be relatively higher. Competition in this service, therefore, usually means a bitter struggle and low rates, until one of the contestants is forced out of the field, when rates are raised to the old level, if not above it. In this way it often happens that the means which were thought to be preventive of onerous conditions become the very agents through which conditions are imposed. In fact active and continuous competition between pub- lic service corporations, furnisljing the same lo- cality, seems to be out of the question. This has been shown by experience. Such competition is also contrary to the very nature of things. Two distinct and separate corporations are not likely to remain separate very long ^.fter it becomes clear that the service rendered by both can be more cheaply and effectively furnished by only one of them. (Application of Lacrosse Gas and Electric Company, August, 1907.) That conditions may arise, under which competition to a certain extent is permissible, the commission states in these words : — The legislature doubtless intended that through the administration of this law destructive compe- CAPITALIZATION AND THE STATE 283 tition and rate wars and competition in all forms injurious to the public should bd eliminated. The legislature could not have desired to eliminate all competition absolutely. If such a construction were to be placed on the law, it would in most, if not in all, cases be impossible for any railway to be constructed in the future to enter any city, in which there is an existing railway, because it is axiomatic that in the railway world, within proper limitations, every railway competes with every other railway, largely independent of the exact geographical location of the competitors. (Petition of the Milwaukee and Ox River Rail- way.) Enterprises of a speculative nature will not receive the commission's sanction. It was one of the purposes of the statute, under which this application was made, to insure the public against the undertaking of hazardous en- terprises. It was doubtless contemplated to pre- vent the projection of lines for speculative pur- poses and through which the innocent purchasers would be made to suffer losses. (Petition of the Milwaukee and Ox River Railway.) PAET U DISTRIBUTING SECURITIES REORGANIZATIONS CONTENTS Raising IWds fob the Capital Account theough AN Appeal to the Stockholder 1 Why corporations do not more frequently distribute their own securities — Some corporations which cannot raise funds through the bankers — The process of creating treasury stock and power of the corporation to deal with it — Authorized and unissued stock — Offering unissued stock to stockholders ipro rata — ■ Stockholders' rights and the dis- tribution of surplus — Computation of value of rights, and of stock after the distribution of surplus through them. II Raimng Funds through the Banking Houses . . 35 Relations of the corporation with the investment banker — Business of an investment banking house — ' Investment bankers deal on " their own account " — Extent of invest- ment banking business — Capital required — Relations of the investment banker with the banks — Profits of the investment banker — Investment bankers and various classes of enterprises — Is there a money trust? — ■ Method of selling securities — Advertising — Salesmen — Organi- zation of investment banking house — Work of the bank- ing house in creating and supporting a market — Work of the telephone trader and the street broker. Ill Syndicates." Joint Accounts and Undebwritings . 102 CoBperation of banking houses in the sales of securities — ^Participations in joint accounts — Loans for carrying the securities — Work of the syndicate manager — Undi- vided and divided carrying — Undivided or unlimited lia- bility account and the sharing of profits or losses — Di- vi CONTENTS vided or limited liability accounts — Distribution of un- sold securities — Sellers' and brokers' commisaions — The transactions and accounting of the syndicate — Agree- ment to form a joint account — Elements of the account — Legal relationships of a syndicate — Underwriting syndi- cates — Subscriptions and allotments — Public offerings — Protecting the market. IV Listing on the Stock Exchange 157 Reasons for listing an issue of securities on the stock ex- change — Increased difficulty of protecting the market — Expense of listing — Transfer agent and registrar of trans- fers — Requirements for mechanical execution of securities — Committee on the Stock List — Requirement of docu- ments relating to issue for examination — Detailed infor- mation required — Listing stock, voting-trust certificates, ■ certificates of deposit, bonds. V Corporate Income 175 Condensed form of income account inadequate for analy- sis of business — Divisions of gross income — Divisions of operating expense — Conducting operations — Mainte- nance — Taxes — Fuller form of income account — Effi- ciency of plant — Efficiency of managenient — Insufficient maintenance and diminishing capital — Additions to capital accounted for as maintenance — Form of income account for manufacturing plant — Surplus and dividend policy. VI Special Nature of the Income op a Holdinq Company 196 Principle of the consolidated income account — Effect of fixed charges of subsidiaries on income of holding com- pany — Possibility of increasing debt of subsidiaries and effect on income of holding company. CONTENTS vu VII Origin of the Complexity op LienS 209 Shows the varying liens a given security may have on several properties through the building-up of a railroad system, and presents an example of the manner of financ- ing the creation of such a system. vni Reohganizations 220 Definition of reorganization, readjustment of the capital account, recapitalization — Default and application for receiver — Duties of receiver — Financing in receivership — Protective committees for security-holders — "Official" committees — Powers of committee — Calling for deposit of securities — Certificates of deposit — Listing deposit certificates — Policy of security-holders with regard to depositing ~ Foreclosure suit — Duty of the trustee — Appraisal and auditing — The financial plan of reorganiza- tion — • The reorganization agreement '— Filing reorgani- zation agreement — Giving depositors an opportunity to withdraw — Declaring plan operative or inoperative — Extensions of time to deposit — Decree of foreclosure — Upset price — Provision for cash requB-ements — Assess- ments — Sales of new securities — Creation of voting trust — Underwriting and purchasing syndicates — Leases in reorganization — Readjustment of the capital account — When it can be successful — Example — BecapitalizatioD, purposes, and how accomplished. Index 309 CORPORATION FINANCE CHAPTER I KAISING FUNDS FOR THE CAPITAL ACCOUNT THROUGH AN APPEAL, TO THE STOCKHOLDER People who are starting a new corporate enterprise must in some way provide the capital for it. Finding the capital forms part of the work of the promoter. When perform- ing this labor he often resembles Gilbert's policeman in that "his lot is not a happy- one." He is too likely to have to cool his heels in many an anteroom before he accom- plishes the desired result. In the discussion of "Watered Stock" in the preceding book on Capitalization, we have already indicated something of the nature of the promoter's services and the method of rewarding them. For the present let us assume a corporation in existence and conducting a going enter- prise. When the managers of such a cor- poration decide that the business requires new capital, or that new capital could be used to advantage in the business, they can attempt to procure it directly through the corporation or they can seek the aid of other 2 CORPORATION FINANCE people who make a business of procuring capital for corporations. If those in control of the affairs of a cor- poration seek the aid of those who make an occupation of providing capital, — invest- ment bankers or brokers, or, to use a term which includes both, dealers in securities, — they must pay these people for their services. Naturally the question arises whether or not the corporation can cut out the middlemen and, by appealing directly to those who have capital to invest, get the entire amount of funds which the investor is parting with. Of course this question is simply the special part the distribution of securities plays in the whole general question of the middle- man and his rewards. It is no part of our purpose, however, to enter at length into the general question, but simply to discuss the issue with special reference to securities. Corporations have not bqen successful in making an appeal directly to the capitalist. By capitalist we mean only some one with money to invest, whether large or small in amount, some one who controls capital to a value of from one hundred dollars up to many thousands. Locating the capitaUst and persuading him to invest his capital in a particular enterprise requires special skill and influence. When a dozen opportunities RAISING FUNDS 3 to invest are being offered skillfully and in- fluentially, as is always the case, an offering made without skill and influence is not likely to meet with acceptance. Middlemen, or dealers in securities, per- form a real service. Some description of the manner of performing this service will ap- pear as our discussion develops. A corpora- tion engaged in the special business which it was organized to carry on does not have the facilities, to say nothing of the special knowl- edge and ability, to engage in the business ordinarily carried on by the dealer in securi- ties. A given corporation ordinarily demands new capital only at considerable intervals. It cannot maintain a permanent organiza- tion to satisfy these occasional demands. Dealers in securities make a business of doing for many corporations what, for any one of them, though probably their most important affair, is one that ordinarily de- mands attention only at infrequent and ir- regular intervals. They perform services of two kinds. They do the actual work of in- ducing the capitalist to make his commit- ment in the particular enterprise, and they assume the risk of success in performing this service. Generally speaking, corporations do not meet with success in new financing xmless they can and do command both serv- 4 CORPORATION FINANCE ices. People who are willing to act as bro- kers for a corporation in selling its' securities on commission, and without assuming the risk of the market, naturally will not sell if they find selling so difficult as to be un- profitable. Ordinarily corpor,ations resort to dealers of that character only when they fail to find some dealer who will assume the risk. Generally only small corporations at- tempt to raise funds in that way, and then the attempt usually results in disappoint- ment. Risk in these transactions is a very real thing. The most skillful and best informed in these matters may fail to estimate cor- rectly the appeal a particular issue of securi- ties will make to the public at a given price. Even if they are not mistaken in their esti- mate of the popularity of the issue, general, financial, and business conditions may shift rapidly, before the securities can possibly be disposed of, and cause the bankers who have purchased or underwritten them a heavy loss. The corporation can well afford to pay for the insurance. Generally it is almost a vital matter that the corporation secure the money and usually a relatively small difference in the cost of securing it is not at all vital. If the corporation is carry- ing through a refunding operation, creating RAISING FUNDS 5 a new issue of bonds to sell and to enable it to pay off bonds which are falling due, it must have the money or suffer a default. If the corporation requires new capital for ex- tensions, it may be of the utmost importance to it, under the conditions existing, that the new capital expenditure be made. Though the difference between a 5^ per cent and a 5f per cent basis ^ which would be a differ- ence between 93.25 and 90.12 in the price of a 25-year 5 per cent bond — is important, it is not vital. Though it may not be expedient generally for a corporation to turn itself into a banking house in the endeavor to raise capital with- out the expense of the services of a mid- dleman, it may under some circumstances procure for itself new funds required. The •corporation may be a "family" affair: that is to say, a very few people may own practi- cally all of the stock and may not want any "outsider" to have a substantial interest in the business. Many such corporate busi- nesses conduct their affairs much in the manner of a partnership. People who are essentially partners organize in the corpo- rate form for the sake of ijie limited lia- bility, for the precision of the corporate form in providing for the contribution of capital and division of profits, or for any other of 6 CORPORATION FINANCE the advantages which the corporate fonn possesses. The stockholders are so few and so closely associated that thejr are like a fam- ily. Often more literally family corporations conduct business enterprises. Such corpo- rations frequently result from the death of the man who established the business and during his lifetime carried it on as his per- sonal enterprise. On his death, in order to keep the business in the family and provide for its management and the distribution of profits, it is incorporated. Under such cir- cumstances the existing stpckholders may be able and may prefer to supply any new capital needs of the corporation. Many corporations cannot appeal to the banker for help. No financial organization may have been developed to procure capi- tal under the special conditions. At the time of writing banking organizations are ade- quate to supply the financial needs of any railroad, electric railway, gas, electric light, or hydraulic electrical enterprise which economic conditions justify. These are, of course, the kinds of business which, as shown by the principles developed in the discus- sion, in the previous book oil Capitalization, of "Trading on the Equity," 'are, when once established, least subject to business risk. Our financial organization is also adequate RAISING FUNDS 7 to procure capital for the larger industrial enterprises. Even for these, however, it is not as well developed as for the public service corporations. Many smaller industrial en- terprises, thoroughly justified by economic conditions, cannot obtain capital through well-organized established channels. It may be objected that the amounts involved in these smaller enterprises do not justify the effort bankers must make to raise the capi- tal. Many of the costs would be nearly as large as for the big capital demands of the great corporations. Costs of investigation and of advertising in various ways, to make the enterprise sufficiently well known to command capital, would be disproportion- ate to the amount of capital required. The banker would have to charge enough for his services in such a case as -actually to im- pose too heavy a burden on the business. Bankers, however, have overcome such dif- ficulties for the smaller public service en- terprises, and in the course of time will probably devise means for providing cap- ital, in spite of the greater business risk, for the smaller industrials. Meanwhile those in charge of the affairs of these smaller indus- trial enterprises must get their capital as best they can. Such as they cannot provide themselves they must appeal to acquaint- 8 CORPORATION FINANCE ances for. On a personal appeal men famil- iar with the industry of which the partic- ular enterprise is a part may see an at- tractive opportunity for a commitment of capital. So from various sources the man- agers of the enterprise find the necessary capital. Family corporations and the small indus- trials do not, however, compose the large body of corporate enterprises which present the problem of raising capital we are dis- cussing. Generally a corporation which can procure capital through the regular chan- nels of the banking houses had better take advantage of the opportunity and not at- tempt financing itself. Under some circumstances, however, a corporation that is not a family affair may successfully finance itself. Especially if it had a surplus and its stock has a market value substantially above par, it may, on condition of cutting down the surplus, suc- cessfully appeal for funds. It may do this by taking advantage of the fact of the surplus, in connection with the right of its shareholders to purchase any additional capital stock the corporation may be issu- ing for cash. We will have to delay at this point to ex- plain, for the benefit of those who may not RAISING FUNDS 9 be familiar with them, the various proce- dures possible in the issuance of corporate stock. The chapter on "Watered Stock" in the first volume on Capitalization gave some indication of the process of "getting stock out" as fully paid on the transfer of property to the corporation. Ordinarily the incorporators transfer the property at the time of incorporation in order "to get the stock out," as the phrase is, and put the cor- poration in a position legally to begin busi- ness. The organizers of the corporation may, as described in the earlier chapter, distribute none or only a part of this stock, to satisfy the interests of the various parties to the laimching of the corporate enterprise. The organizers may have had the stock issued as ^uUy paid stock on the transfer of the prop- erty only to get the corporation into a better strategic position for future financing. If that is the case, they will hand back to the corporation such part as they do not require for the purpose of carrying out the bar- gain under which it was formed. Stock so turned back to the corporation, or "donated" as the process is termed, carries the name of "treasury stock." Of course the lawyer in charge of the incorporation proceedings must be careful to comply with all legal require- 10 CORPORATION FINANCE ments, and must incorporate in some juris- diction which enables him to carry the trans- action through without jeopardizing the po- sition of directors and shareholders. To explain the matter more clearly, let us consider a supposed situation of a corpora- tion which has provided for future finan- cial requirements. We will assume that the charter of the corporation authorizes $2,000,- 000 of preferred and $6,000,1)00 of common stock. The organizers had the corporation issue and distribute all the preferred stock. They had property transferred to the cor- poration for which it issued $4,000,000 of common stock. Of this common stock, so issued, they had $2,000,000 donated back to the corporation. We will assume, too, that the corporation has given a mortgage under which it may issue $5,000,000 bonds, of which it has actually issued and sold $1,000,000. The capitalization, then, will stand in this way: — Cajntalization Authorized Issued Outstanding Cominon stock $6,000,000 2,000,000 5,000,000 $4,000,000 2,000,000 1,000,000 $2 000.000 Preferred stock 2,000,000 1 000,000 Bonds RAISING FUNDS 11 Let us now also assume a balance-sheet for our corporation. We do Hot recommend this balance-sheet as a model for account- ing practice, but present it simply to illus- trate certain financial facts : — Asaeia LiabilUieB Eeal estate plant Common stock is- and equipment. . . $3,000,000 sued and out- standmg $i8,000,000 Material and goods. Preferred stock is- inventory 350,000 sued and out- standing 2,000,000 Bills and accounts g^^^j^ ^^^^^ ^^j receivable 150,000 outstanding 1,000,000 2000 shares of com- Bl"' a^f accounts mon stock held in P^^'ble 200.000 treasury Surplus 300,000 $5,500,000 $5,500,000 The 2000 shares of common stock which have been issued and given back to the cor- poration are not, of course, an asset. When outstanding they will become a liabihty rep- resented on the assets side by whatever are the proceeds of their sale. Rather than be- ing placed in the assets column, a notation might be made to indicate the situation. They do represent a greater freedom of ac- tion on the part of the corporation in its financing. If the corporation has only au- thorized and unissued stock to dispose of, in order to raise cash it must get par for that stock. It may generally, to be sure, pay a reasonable commission for selling it. Even 12 CORPORATION FINANCE with this Hmitation the cofporation obvi- ously must realize a certain minimuin on a cash sale of any of its authorized but not theretofore issued stock. If the corporation, however, has some so-called treasury stock, it may generally deal with that stock sub- stantially as it pleases. Of course the direc- tors must obtain a price fair to the corpora- tion and otherwise see that the sale does not injure existing stockholders. Many jurisdictions, both sby statute and by judicial interpretation, have been making it increasingly difficult for the managers of a corporation to arrange any way for the cor- poration to sell any stock for less than par. On the other hand, some jurisdictions have come to a recognition of the true business situation as outlined in the earlier chapter on "Watered Stock." Though at the time of this writing the idea of "stock without par value" has not received much legislative recognition, the fact of an increasing num- ber of people who appreciate the truth back of it gives rise to the expectation that it will receive more general legal adoption. The difficulty and often impossibility of steering a legal course for a corporation to sell stock for less than par causes much of the unsound capitalization plans. If the stock of a cor- poration is not worth par, and yet the di- RAISING FUNDS 13 rectors may not legally arrange for its sale at less than par, they must resort to bor- rowing, — that is, to the issuance of bonds. So the fixed charges become disproportion- ate, as explained in the discussion of "Trad- ing on the Equity," and endanger the con- trol of the shareholders. If the corporation has no treasury stock at its disposal, it may, nevertheless, not have exhausted its authority to issue stock: that is, it may not have issued all the stock au- thorized by the charter. If it has not, the stock not yet issued is called, as we have in- dicated, "authorized and unissued stock." If the corporation has exhausted its author- ity to issue stock, it must procure additional authority from the State before it can finance itself on stock. Unless the charter permitted by the law of the State gives to the corpor- ation authority to sell unissued stock without first offering it to stockholda:s, the directors must offer the existing stockholders a right to purchase, in proportion to their present holdings, the stock about to be issued and sold. Directors who have treasury stock of the corporation available are generally not obliged to give existing stockholders a chance to purchase ahead of any one else. They can come to a fair bargain with bank- ers and sell them the treasury stock. As 14 CORPORATION FINANCE already stated, the price need not be equal to par or it may be any price above par. Since stock which is merely "authorized and unissued" is often called "treasury" stock, we need to emphasize -the distinction. Treasury stock has been issued or "gotten out," to use a common phrase, and in some way, usually by gift, returned to the corpora- tion. That is, the corporation has a right to sell the stock for the benefit of the corpora- tion. The incorporators can generally get the stock issued at the time of incorporation more easily than later. Property is being turned over to the corporation for which stock can be issued in payment. It is agreed that some of the stock be given back just in order to afford the corporation the greater freedom of action in disposing of it. A corporation cannot as a general principle buy back its own stock. That would diminish the fund to which creditors have a right to look for security. As already stated stock received back by the corporation cannot be an asset, any more than a promissory note bought back by the maker before its due date is an asset of the maker. Special statutory provisions in some jurisdic- tions to some extent modify the general prin- ciple that a corporation cannot buy back its own stock, but even these are likely to amount to provisions for a reduction of capital stock RAISING FUNDS 15 and require essentially an amendment of the charter. When arranging for the issuance and sale of unissued stock, the directors must first offer the stock to the existing shareholders. That requirement would not in itself irk- somely restrict the management. But some jurisdictions clearly hold that existing stock- holders have a right to subscribe, in propor- tion to their holdings, to the new stock at par. If the stock is worth more than par, obviously a sale of new stock at par amounts to a partial distribution of surplus. Though the management may not consider such a course good policy, they cannot help them- selves in such jurisdictions on a sale of au- thorized and unissued stock. Since the right of the existing stockholder to subscribe at par for new stock seems in accord with the principles of the common law, the manage- ment would make the offering at par unless in a jurisdiction where statute or judicial decision had established another principle. Massachusetts, for example, by statute re- quires that quasi-public corporations must offer any increase in capital stock to their shareholders at a price to be determined by the Public Service Commissioners of the State. This necessity for offering unissued stock first to existing shareholders requires that 16 CORPORATION FINANCE the bankers, if they are called in, handle the situation in a special way. It may be that the management of the corporation feels it to be important that the funds for which the stock is being sold should be assured. They may not be willing to take the chance that stockholders will supply all of it. Or, if the situation is such that they might feel rea- sonably confident that the appeal to the stockholders would procure all the funds, they may wish to have the whole transaction handled by those who are expert in the busi- ness, and be willing to pay bankers for their services. In any event, bankers cannot make an absolute purchase of the stock on their own account unless they are ready to turn round and offer the stock to share- holders at the same price the bankers have just paid to the corporation for it. If the stockholders should take it all at this price, the bankers have had their labor for noth- ing. If the stockholders should not take it all, the bankers, in order to get any return for their work, would have to offer the rest to their clients at a higher price. Since such a matter as the price to the stockholders can- not be kept secret, obviously the bankers would not meet with success in offering the stock to their clients at a higher price. Under such circumstances the corpora- RAISING FUNDS 17 tion, instead of arranging for an immediate sale of the stock to the bankers, gets the bankers to underwrite the issue. The terms "underwrite" and "underwriting," as we shall consider in a later discussion, mean various things as loosely Used in current financial talk of the street. Just at this point we are using the word in its more nearly original sense in the business of insuring. The bankers, on the payment of a stipulated sum called an "underwriting commission," the equivalent in this case of a premium for insuring the success of the transaction, agree to "take up" or purchase any of the stock which the existing stockholders do not buy. Or, it may be that the corporation, after offering the new stock to its stockholders, may make a public offering of the stock. It could make a public oflfering", and prefer the applications of its own stockholders. In any event, the bankers agree to buy at the issue price any of the stock or other security which the corporation does not succeed in selling. Since the bankers are receiving an under- writer's commission for their service as in- surers, they can continue to offer the stock to their clients at the same price that the corporation was asking, and, if they are suc- cessful in selling, they will have received something for the transaction. 18 CORPORATION FINANCE To illustrate the situation, suppose the corporation wishes to sell $3,000,000 of stock. Assume that the stock is of the "au- thorized and unissued" class which the cor- poration must oflfer to its stockholders at par. Let us assume that the essential facts for the purpose of our discussion are these: The corporation has assets which on an ap- praisal would be given a reproduction value of $12,000,000. It has net earnings of 10 per cent on this value. Since a bond issue would only confuse the discussion, we will assume that the corporation has no bonds, but has a stock issue of only $9,000,000 of common stock outstanding of a total of $12,- 000,000 authorized. We will assume further that the directors estimate that the corpora- tion can earn 10 per cent on a further in- vestment of $3,000,000, and that they con- sider the investment desirable for the better protection of the capital already committed to the enterprise. Stating these facts in tabular form in order to have them more clearly before us: — ABseti LiahUitiea Reproduction value of Stock outstand- plant and other assets $12,000,000 jng $9,000,000 ^$12,000,000 authorized) Net earnings $1,200,000; or, the cor- poration is earning 13^ per cent on the outstanding stock. RAISING FUNDS 19 Let us assume that the stock is seUing at 133, or approximately a value of $10 for each one per cent of earnings. Now let us assume that the corporation arranges to sell $3,000,000 of stock at par, that the proceeds will be advantageously expended on the capital account of the cor- poration, and that the corporation will be able to increase its net earnings by the amount of 10 per cent on the new assets. The statement will then change to this form: Assets Liabilities Reproduction value of Stock outstand- plant and other assets $15,000,000 ing $12,000,000 Net earnings $1,500,000, or, the cor- poration will be earning 12i per cent on its capital stock. Obviously, under these circumstances the stock of the corporation, after the issuance of the new stock, will not be worth quite so much as before. Though in the case we have assumed, the issuance of the new stock will not make a great difference, it will, never- theless, make a measurable change. If the estimates prove correct, net earnings on outstanding stock will decline five sixths of one per cent. We have placed a theoretical value on the stock for purposes of our dis- cussion of $10 for each one per cent of net earnings on the stock. On that basis the stock, after the new stock is issued, should 20 CORPORATION FINANCE be worth approximately $8.33 less a share than it is worth now. Clearly this result must follow any issu- ance of new stock sold at par whenever the corporation has a real surplus, unless the corporation can increase its rate of earnings by reason of the new capital. It may be that the new capital will enable the making of improvements that will increase the per cent of net income the corporation can earn on capital invested in the enterprise. If it is anticipated that such a result will follow, of course the value of the stock will not decline with the new issuance. Unless the rate of earnings will increase, any issuance at par of new stock of a corporation with an actual surplus must mean a reduction of the amount of surplus to each share of stock outstand- ing, or of the total assets for each share with which the corporation can earn an income return for that share. In the case we have just assumed, the capital and surplus for each share, as measured by the appraisal of the assets on a reproduction basis, amounted to $133^ per share, and, after the issuance of the new stock, capital and sur- plus for each share amount to $125. It hap- pens that in the problem we have taken, the ratio of assets and the ratio of earnings remains the same. This would not always RAISING FUNDS 21 be the case. Regularly the market price of the stock would be based on net earnings rather than on assets, and assets taken into consideration primarily as indicating some- thing of the probable continuance of earn- ings. Though all our discussion about the eflFect of the new issue, so far as determining exact prices of the stock is concerned, is highly theoretical, probably actual results under similar conditions would approximate our entirely theoretical results. Under such circumstances as we have dis- cussed the corporation can readily obtain new capital on an appeal to its own stock- holders. The corporation can finance itself. Acting in accordance with the principles we developed in our discussion of "Trading on the Equity," it may prefer to borrow the new capital it desires. In that event it will ar- range for an issue of bonds instead of plan- ning to issue more stock. Such circumstances as we have described, however, of a sub- stantial surplus, and an income which tends to show that the surplus is not just a matter of bookkeeping, but causes the stock to sell at a considerable premium, do not compel the corporation to resort to borrowing be- cause it cannot legally obtain capital in- creases in any other way. Let us consider how an appeal to the stockholders for new 22 CORPORATION FINANCE capital could be made, and the way it would work out. Assume that our corporation has an- nounced its intention of raising new capital by- offering to its stockholders at par $3,000,000 of its authorized and unissued stock. Note that the present issued capital stock amounts to $9,000,000. An increase of $3,000,000, under the legal principles we have stated, whereby a stockholder has a right to sub- scribe to new stock in proportion to his present holdings, would give the holder of three shares of the old stock a right to sub- scribe to one share of the new. Or, a holder of one share of the old has a right to one third of a share of the new. Though the holder of a single share of the old stodk cannot get an actual fraction of a share of stock, the right to a third of a share cannot be taken away from him. This reads like ja paradox. We mean that the holder of a single share has the right either to sell his right to subscribe for the new stock, or to purchase the rights of the holders of two other shares, and in this way complete his power to demand a share of the new stock. This is what is meant by a "right" when the term is used in speakmg of the offering of new stock to the existing body of stockholders. Directors of the corporation announce that RAISING FUNDS 23 stockholders of record of a ^stated day will have the right to subscribe for the new stock in the proportion of one share of the new for three shares of the old. This announcement — at least, that part of it which says "stock- holders of record of day of " — bears some resemblance to a declaration of a dividend. As we shall see, the transaction resembles a declaration of dividends in more respects than just its language. Through these "rights" the stockholders are about to get an immediate distribution of surplus in a way that amounts to an extra dividend. We have assumed that the old stock is sell- ing at about 133 and that after the increase the stock of the corporation will be worth about 125. On this basis a man owning three of the old shares has the right, on paying $100, to buy a share of stock which will have a market value of $125. Since a single "right" — that is, the interest of one share of the old stock in the issuance of the new — ■ may be bought and sold, obviously the value of this right equals one third of the $25 which the holder of three shares may re- alize on exercising his right to subscribe. Or, to state the situation briefly, each right has a value of $8.33. For the sake of clear- ness let us show the transa(jtion in tabular form: — 24 CORPORATION FRANCE Total stock outstanding $9,000,000 Amount to be issued 3,000,000 Right: — three of old to subscribe for one of new Market value of new stock $125.00 Subscription price for new stock 100.00 Value of subscription rights of three shares of old stock 25.00 Value of right ". . . . 8.83 It is not to be assumed that these values all settle themselves in the .precisely accur- ate mathematical manner indicated. Prob- ably the price of the old stock fluctuates a good deal in anticipation of the announce- ment of the forthcoming rights. Though we have taken too small a corporation for our discussion to represent a reasonably typical issue of stock listed on the New York Stock Exchange, the results come to the same thing as if we had multiplied the amounts of old and new stock by three or four to present an issue of Stock Exchange size. Dealings in rights will begin immediately on the an- nouncement that they will be given. The corporation will issue, to stockholders of record of the day stated, certificates repre- senting the rights, and these certificates will be handled in just the same ^ay as the certi- ficates of shares of stock themselves. So by making this appeal to and through its own stockholders, a corporation with a RAISING FUNDS 25 real surplus, part of which its managers are willing to distribute and have represented as capital stock rather than as surplus, can raise new capital without resorting to the bankers. Instead of increasing its capital stock the corporation may even borrow in this way by offering bonds to its own share- holders at something less than their actual market value. Presumably the corporation has a perfect right to do this so long as it gives to each stockholder the right to sub- scribe in the manner just ouftlined, and pro- vided it is not by so doing impairing the capital of the corporation. If the stock of the corporation is selling only a little above par the situation offers less assurance that the corporation will be able to raise new capital by an appeal to its own stockholders. Issuance of new stock may reduce the market value of the stock to a point where a general decline in the market may carry the price to par 6r below. To il- lustrate this situation, assume a corporation with — Stock outstanding $25,000,000 To be issued 5,000,000 Market price for old stock 105 To cut our computation short by using the market estimate of values, the capital and surplus of the corporation has a value, on 26 CORPORATION FINANCE the market price of the stock at 105, of $26,- 250,000. On reahzing par for the $5,000,000 new stock, the capital and surplus of the corporation will have a value of $31,250,000. But the corporation now has 300,000 shares of stock, so each share should be worth approximately 104. At this price the rights would be worth only 80 cents. On a decline of two points in the market for the stock, they would have a value of only 40 cents. Unless one owned a considerable number of shares this is hardly a sufficient inducement to put through the transaction in order to realize on it. With a price only four points above par a very small general decline in prices would wipe the premium out entirely and carry the quotation below par. Of course no one would pay the corporation par for stock which can be bought on the market at less than par. A situation like this, with so narrow a range of safety in the market, perhaps hardly affords a sound enough basis for a banker to underwrite the new issue of stock. Certainly, if the raising of the new funds were of great importance to the cor- poration, it could not safely rely on procur- ing them from stockholders without getting the banker's insurance. We have dwelt at some length on the prin- ciples underlying an estimate of the value _. . RAISING FUNDS 27 of the stock of a corporation after a declara- tion of rights. Of course in practice the mat- ter is taken care of by the market estimate. We are assuming now a stock with an active market. When the corporation announces its new issue and the right of shareholders to subscribe at the terms offered, dealing in the rights will begin immediately. Assume our former case, in which we estimated the value of the rights at $8.33. The market will probably place an estimate on the value of the rights at about that point, and the mar- ket value so estimated will indicate at what •price the stock will sell when it goes ex-rights. When the stock goes ex-rights the corpora- tion will issue certificates to the stockholders of record at the designated time. Up to that time trading in the rights will be for delivery when issued, and the price of the rights will approximately indicate the quotation on the stock when it goes ex-rights. The price of the rights may not be exactly their value computed in terms of the price of the stock. It is likely to run a little less. Otherwise a stockholder desiring to sell his rights would not afford a purchaser a good bargain. The purchaser might just as well buy the stock without taking the trouble to buy the rights first. Rights are likely to sell at a point that will give an opportunity for 28 CORPORATION FmANCE a possible arbitraging between the quotation on rights and the quotation on stock. If, for example, the rights we have been dis- cussing, which entitle the holder of record of three shares of the old st6ck to subscribe for one share of the new at 100, were quoted at 7.75, and the stock were selling ex-rights at 125, they would afford an opportunity for a successful arbitrage transaction. Under the stated circumstances let us sup- pose a speculator has been able to pick up 300 rights at an average price of $7.75, and the quotation on the stock remains at 125. He can assure his profit on the transaction by selling 100 shares short at 125. At the designated time he can present his certifi- cates for rights to the corporation and get a certificate for 100 shares on the payment of $10,000. Let us see how he h^^s come out on his transaction: — Cost of 300 rights at 7.75 , $2,225.00 Cost of 100 shares at 100 10,000.00 Cost of Commission on short sale 12.50 Costs $12,237.50 Realized on short sale of 100 shares at 125 , $12,500.00 Less costs of transaction 12,237.50 Profit on transaction t $262.50 These figures are given simply for clear- RAISING FUNDS 29 ness of illustration. Probably the rights would not sell low enough to make such a profit possible. The costs include something more than those stated — as the transfer tax and interest on the $2225 capital tied up in the rights during the interval before the cer- tificate could be obtained on the subscription from the corporation. Some speculative risk would be involved, during the time required to pick up the rights, of the quotation of the stock declining or the price of the rights go- ing up before enough were acquired to com- plete the transaction. It should be mentioned that though in the New York market a right is that interest in the new stock which belongs to one share of the old, in some markets the term is used as meaning that interest in the new stock which entitles one to subscribe to one share. Stockholders usually greet with pleasure an announcement of forthcoming rights. So far as the offering of the rights may indicate the opinion of the directors that the corpora- tion may now distribute its earnings a little more freely, it affords a proper basis for self- congratulation on the part of the stock- holder. But of course the corporation cannot lift itself financially by its own boot-straps. If the directors have been declaring divi- dends at the rate of 8 per cent per annum 30 CORPORATION FINANCE and are likely to continue an 8 per cent rate on the new stock, the stockholders are get- ting greater immediate benefits from their holdings. Before the issuance of the new stock the corporation was earning, we as- sumed, 13^ per cent on the outstanding stock. On an 8 per cent dividend rate, they were carrying 5^ per cent to surplus. After the issuance of the new stock to stockholders at par, we assumed that the corporation earns 12^ per cent on the stock outstanding. Now on an 8 per cent dividend the directors will be carrying 4|^ per cent to surplus. What constitutes proper surplus provision depends, of course, on the nature of the business. As- suming that 4^ per cent on the amount of stock outstanding in this case makes ample provision for surplus, then the giving of rights has resulted in benefit to the stock- holder. A present payment is of greater worth than one deferred. The offering of the rights raises a presumption in the mind of the stockholder that the dividend rate i will not be cut, and that he will get the benefit of this immediate greater distribu- tion. If the management should be in a legal position to sell the stock at a premium so that they could obtain the full market value for it, they could treat the stockholder just RAISING FUNDS 31 as well as under the plan of offering rights. To give the same results in an increased dis- tribution they would have to increase the dividend rate, and an offering of new stock at the premium would raise np such presump- tion of increased distribution as an offering of rights. Market considerations, however, may favor the offering of rights rather than the sale at a premium. Distribution of the new stock by means of rights probably ab- sorbs much of the shock of throwing a large block of new stock on the market. If the old stock were selling at 133, it is improb- able that the new stock could be sold at that price. Even though the stock of the corpora- tion would be worth just as much if the cor- poration should realize 133 for the new stock and could continue, as we assume, to make as large returns from new capital in the en- terprise as on the old, still the sudden large increase in the market supply would depress the market price. In the case of the rights the expectation of the increased distribu- tion of earnings acts as an offset to the de- pressing influence of the increase in the sup- ply of stock in the market. Probably, too, more stockholders, rather than selling the rights, actually purchase the new stock on a granting of rights than would purchase at a premium that would represent the full 32 CORPORATION FINANCE market value. So the offering of the rights probably in this way widens the demand. Aside from these market and psychologi- cal considerations, theoretically the results should be the same in the long run whether the corporation gives its stockholders rights or sells at the full obtainable price. Assume in the case of our corporation that the direc- tors were able to sell the stock at 133, the same price as that of the old stock. The sale of $3,000,000 of par value would then realize $3,990,000. If the corporation, as before, earns 10 per cent on the capital committed to the enterprise, net earnings will now in- crease by $399,000, from $1,200,000 to $1,- 599,000, or 13^ per cent on the $12,000,000 of stock now outstanding. Theoretically the stockholder would be a little better off in this case than in the distribution of rights. According to our earlier calculation, if the corporation received par for its new stock, net earnings on the total stock would be 12J per cent. The corporation could carry 4^ per cent to surplus and distribute 8 per cent. If the corporation could sell all the new stock at 133, it would, as just stated, be making 13^ per cent on its total stock. It could carry 4^ per cent to surplus and dis- tribute 8.83^ per cent to stockholders. A stockholder owning four shares of stock and RAISING FUNDS 33 purchasing a fifth at 100 would have five shares on which he would be receiving an annual income of $40. If he should purchase one of the new shares at 133, he would, under the conditions assumed, have five shares from which he would have an annual income of $44.16f . This would be a difference amount- ing to 12^ per cent on his extra investment of $33. This is really, however, at the ex- pense of the surplus of the corporation, be- cause the 4^ per cent on the stock carried to the surplus account is $540,000, but in the latter case it is on greater assets and there- fore really a smaller surplus reserve. Highly theoretical considerations of this kind, however, have little value, and we have not attempted, in the discussion at this point, to do much more than bring out that fact. The legal situations discussed are usu- ally controlling, and if they should not be con- trolling market consideratioiis would govern the decision of the directors as to the method of placing the new stock on the market. Question may arise in the mind of some one about the rights of preferred stock- holders to participate in a distribution of new stock. The New York pourts, at least, have held that when preferred stock is en- titled to cumulative dividends at a fixed rate and to preference in the distribution of assets, 34 CORPORATION FINANCE and to no further dividend or distribution, and the preferred dividends are paid and the capital of the corporation unimpaired, the corporation is not obUged to allow pre- ferred stockholders to subscribe to the new stock. It hardly needs saying that the holders of convertible bonds do not have a right to subscribe to new stock. The stockholder's legal right to subscribe is limited to new stock sold for cash. The presumptive right of the stockholder does not apply to an issue of stock in payment for property. The discussion set out in this chapter has sought to bring out the possibility of a corporation financing new capital require- ments by an appeal to its own stockholders and to show the considerations surrounding that possibility. Incidentally have been mentioned as briefly as possible some legal considerations governing the issuance of new stock, which indicate that the directors of a corporation, when they contemplate financ- ing on new stock, may not have a free hand to do whatever they might consider most desirable as a financial expedient. Questions arise which are matters of grave considera- tion for the lawyers in charge of the legal side of the new issuance, and involve careful scrutiny of the statutes and decisions of the particular jurisdictions involved. CHAPTER n RAISING FUNDS THKOUGH THE BANKING HOUSES In the preceding chapter, "Raising Funds for the Capital Accoiuit through an Appeal to the Stockholder," were mentioned two reasons why corporations, if they can, gen^ erally resort to the banking houses to raise new funds for the capital account. It pointed out that corporations are not equipped to do this work, which is never more than occa- sional in character, and that they ought not to take the risk of failure to raise the required amount of funds, if they can avoid it. We should add as a further and important rea- son the professional character of the banker and his ability to give expert advice in finan- cial matters. It is the business of the banker to know the market, to know what kind of (Securities will be most acceptable to it at a given time. Are capitalists at the moment speculatively inclined,'' If so the time may be opportune for an issue of stock rather than for an underlying security. Or do capitalists show a conservative tendency and a prefer- ence for the promise of inte^st rather than for a hope or expectation of dividends? Are 86 CORPORATION FINANCE interest rates high or low? If the corporation is to finance on an underlying security, should it run for a short or for a long term? On all these matters, discussed in the first volume in the chapter on "The Market and the Price," the banker is an expert, and if the corporation were to undertake the work of raising funds directly it would find it highly advantageous to seek the banker for profes- sional advice. On all such matters as those discussed in the chapter on "Form of Securi- ties," the corporation needs the advice of the banker. Just how does the corporation establish its relations with the banker? It is difficult ' ) generalize. Sometimes thje banking house was interested in the enterprise at the time of its promotion. The chap.ter in the first volume which discusses "Watered Stock" indicates something of the -nature of this relationship. Some banking houses refuse, nder any circumstances, to be interested in nterprises in the promotion stage. Others ivill, very rarely, concern themselves with a, promotion. Some organizations, partly banking and partly engineering in charac- ter, are rather frequently interested either in the promotion of a new Enterprise or in such a reconstruction as amoimts essentially to a promotion. BAISING FUNDS 37 A banking house which takes the position of a promoter does not appear publicly in its banking house capacity as a promoter, or as in any way interested in an enterprise in its promotion stage. When the enter- prise has demonstrated an earning power through actual operation, the banker may appear publicly as identified with the under- taking. We are interested at this point, however, in the banker as, promoter only as showing one of the ways in which the re- lationship of banker to a corporation may originate. If the corporation went through its pro- motion period without any banker, and its organizers raised the necessary capital as best they could among themselves and their friends and such capitalists as they might reach, later, when it needed to make an addi- tion to the capital account from funds raised from sources outside itself, presumably the officers sought a banking house that would undertake to provide the funds. Usually bankers have a number of such opportuni- ties pressing on their attention all the time, and the officers of the corporation may have io visit a number of bankers before they find one ready to undertake the financing re- quired. A rejection of the proposal may not in the least indicate an urifavorable criti- 38 CORPORATION FINANCE cism of the financing. Commitments of the banking house already made may sufficiently tie up the capital of the house and require the entire attention of the bg,nkers/ Though people are familiar with the term "banker," as applied to these organizations for arranging long-time or relatively long- time commitments of capital, people are not generally familiar with the working of these banking houses. Bankers of the kind we are speaking of are ternied "investment bankers" to distinguish them from commer- cial banks and bankers. Such investment bankers are engaged in financing relatively fixed capital; commercial blinkers properly finance only circulating capital or capital in the course of consumption. Eeople sometimes designate "investment bankers" as "private bankers," partly because they are not dealing with the public as generally as are the com- mercial banks, and partly because they more frequently do not incorporate, but do busi- ness as individuals and firms. Since in many of our States individuals and firms engaging in a commercial banking business, without tak- ing out charters as national or state banks, are termed "private bankers,'" the term "pri- vate bankers," as applied to those people who finance relatively permanent capital, is not exclusive, besides not being as descriptive as RAISING FUNDS 39 the term "investment banker." We use the term "banking house" in speaking of in- vestment bankers rather than the term "bank," which we Hmit in our use to an organization acting under a charter, or at least to an organization which takes deposits. Generally these banking houses are not incorporated. Though some have been in- corporated in recent years, there is no no- ticeable tendency in the direction of incor- poration. Usually partnerships of varying size, ranging from two to fifteen or sixteen partners, carry on the business. Some banks, more especially trust companies, have in- vestment or bond departments which do the work of investment banking houses in every respect. These banking houses vary a great deal in the range of work they undertake. Some oc- cupy themselves exclusively, or almost exclu- sively, with municipal finance. Though they may get into other fields, they are likely to do so as brokers, or as a result of trading, or to carry some other kinds of securities to satisfy the needs of their clients. Such houses do not especially concern us. Other houses make the financing of public-service cor- porations, other than steam railroads, their principal interest. Even in the field of pub- lic utilities houses may specialize, as in the 40 CORPORATION FINANCE securities of gas, or of electric light and power corporations, or in the securities of street railway corporations. While speaking of houses chiefly interested in the financing of public service corpora- tions, we should especially mention certain organizations which carry on together the work of engineering and operating concerns and financing houses. They both operate and supply the funds for the corporations they are interested in. Sometimes they orig- inally did the engineering work for the con- struction of the corporations. Though such organizations are not numerous they are im- portant. By reason of special skill and ability in their chosen fields they efiFect economies in operation and construction. They pur- chase plants which have not proved profit- able under the existing management and through their special skill turn them into profitable enterprises. Through the magni- tude of their operations they can also effect economies in the purchase of supplies. Such engineering-banking organizations specialize in the field of public utilities more than do bankers who are not also engineers. A house of engineering bankers confines itself to gas plants or to electric light properties or to street railways. Other banking houses concern themselves RAISING FUNDS 41 especially with financing the steam railroads. Only two or three have the necessary capital and financial connections to. handle the larg- est issues of railroad securities. Railroads, however, often have smaller issues, as for the construction of branch lines or for the purchase of equipment, within the financial ability of ten or a dozen other houses, and commonly these other houses get the financ- ing of such issues. Many houses which do not act directly as bankers for railroads, or seldom do so, still make railroad financing their principal interest by 'participating in underwriting transactions and acting as dis- tributors of the securities. A good many banking houses have refused to go outside of these fields. They take the general ground that only a municipal bond, secured by the taxing power of some governmental agency, or a bond of a railway or other public ser- vice corporation, with its relative stability of earning power as pointed out in the chap- ter on "Trading on the Equity" in the first volume, afford the proper basis for safety. Further, under modern conditions these en- terprises are relatively non-competitive. In spite of franchise difficulties they do not lie as open to attacks tending to a rapid de- struction of values. Hence, that especially indeterminate element, the quality of the 42 CORPORATION FINANCE management, though very important, does not assume the relative importance in a rail- road or other public service enterprise as in an industrial undertaking. The general class of public service business makes it more subject to analysis and to the deduction of general principles than is the case with an in- dustrial enterprise. Therefore the banker can formulate and apply tests from experience with a greater assurance that his judgment is sound. For these reason^ many banking houses interested in the financing of corpora- tions have refused to go outside of the public utility field. There is no reason why a bank- ing house, recognizing the li&,bility of indus- trial corporations to greater fluctuations in earnings, and in other ways the greater busi- ness risks involved, should not undertake the financing of industrial enterprises, and many do. Besides differing in the kinds of corpora- tion financing they undertake, these houses differ in other respects. Some take deposits from clients who purchase securities from them and from corporations for which they supply the funds for the capital account. Ordinarily these deposits, from the nature of the business, are individually of consid- erable size, and the banking house is other- wise not taking the place of a commercial RAISING FUNDS 43 bank or a savings bank. A few of the bank- ing houses have foreign exchange depart- ments and, with respect to foreign trade transactions, conduct a banking business concerned only with the financing of com- modities in the course of consumption. Banking houses differ ii^ the way they conduct their business as well as in the kinds of corporations they finance. Some do essen- tially a wholesale business. They assume the responsibility to the corporation, but, to a considerable extent, reach the ultimate consumer through some intermediary bank- ing house. We will discuss the general man- ner in which they do this in a subsequent chapter on the syndicate operations of joint accounts and underwritings. Some houses ^ake a larger part in the active trading on the street than other houses, to some extent speculate in bonds, and generally pay special attention to the needs of capitalists and financial institutions. To whatever extent these houses may act as distributors to the final consumer, the capitalists who ulti- mately supply the funds to the corporations, they usually initiate some of the business they do: that is, they are the only interme- diary between the borrower and the lender. Though sometimes the only business they initiate is municipal, usually, if they really 44 CORPORATION FINANCE enter the field of corporatioin finance at all, they finance directly the issues of the rela- tively smaller corporations and come in with the wholesalers on syndicate operations in the issues of the larger corporations. From time to time some one expresses an unfavorable criticism of the profits made by investment bankers. Before proceeding to discuss this directly, let us consider the gen- eral nature of the business. Banking houses should be differentiated from brokerage houses. To use the language of the street, an investment banker deals on his own ac- count, a broker deals only as agent. That is to say, an investment banker assumes the position of a merchant and Tjuys and owns the securities he sells. In this respect he conducts his business like aiyr merchant who keeps a stock of goods and counts on mak- ing a profit on the turnover. London offi- cially classifies investment bankers as mer- chants and not as bankers. Though it is easy to make the analogy of the investment banker with a merchant carrying a stock of goods of securities, the analogy is not closely accurate. Though securities in their mar- keting possess many of the characteristics of goods in the process of consumption, they are not, of course, commodities in the same sense as are wheat and cotton. As a mer- RAISING FUNBS 45 chant, the investment banker is more strictly- like a buyer who goes round among many sheep-growers and buys wool in relatively small quantities, which in turn he sells to a few manufacturing concerns. So the invest- ment banker buys capital from the grower, the capitalist who has accumulated savings, and sells the capital to the corporation. But the investment banker sells "short." He has already sold capital to the corporation in return for the corporation's credit, and has borrowed most of the capital to put with a little of his own to make delivery. He then proceeds to cover on his short sale of capital by buying from the capitalist with the credit with which the corporation paid for the capital from the banker. In using the word "credit" here, we do not qonfine it to its strict meaning of promise or obligation of the corporation, but include an interest in the corporation which may be represented by stock. From whatever angle we choose to view the business, the essential and im- portant fact is that the investment banker assumes the risk of the transaction. Since the business is one of credit, which probably is more sensitive and fluctuates more widely and more quickly than aSny commodity prices, the assumption of risk in selling and buying capital, or buying and selling credit. 46 CORPORATION FINANCE whichever way one chooses to look at the matter, means the assumption of a greater burden than that of the merchandising of ordinary commodities. A little later, when we are considering the amount of bankers' profits, we must keep in mind this fact of the assumption of risk. A broker, on the other hand, simply acts as intermediary be- tween the buyer and seller for a commission and does not assume any risk of the market. The total number of banking houses of this kind in the United States is not great. Of about 4000 offices, at the time of writing, in some way dealing in securities, practically all are brokerage offices of b.ne kind or an- other. The membership of the Investment Bankers' Association of America includes most of the banking houses eligible for mem- bership. Financial qualifications for mem- bership are that the applicant shall be en- gaged in buying and selling securities on Its own account and shall have a capital of at least $50,000 engaged in thi^ business. With a capital of less than $50,000 a banking house could hardly enter the field of corpora- tion finance in any way to deal directly with the corporation. At the time of writing the membership of the Association comprises 340 main offices and 176 bt'anch offices of these houses. Practically the entire organ- RAISING FUNDS 47 ized business of financing the capital ac- count of our corporations genters in these houses. The total number of branch offices is undoubtedly much greater. The branch offices listed as members have, most of them, considerable autonomy in managing their affairs. Probably most readers will be surprised that the amount of capital necessary to qualify for membership in the Investment Bankers' Association is so small rather than that it is so large. People are likely to as- sume from the magnitude of .the transactions undertaken that the business must require the banking house to have a large capital. But the business does not require a large capital tied up in plant like a manufacturing organization. The investment banker is en- gaged in dealing in credit and requires capi- tal only as an assistance in commanding credit. When the banker supplies the cor- poration with capital, he receives the cor- poration's securities at the same time. How much of the capital the banking house must advance itself and how much it can borrow on the transaction depend on the nature of the securities, the position, senior or junior, that they occupy in the corporation's plan of capitalization, and, especially, whether they are of a kind to comm9,nd a relatively 48 CORPORATION FINANCE quick and close market. Depending on these conditions the banker can borrow from 50 to 90 per cent of the money necessary to complete the transaction of purchasing the securities from the corporation. Though the loan will rarely be so small, in actual practice, as 50 per cent, the lender produces the same effect by insisting on mixed collat- eral and by accepting only a percentage of slow and wide market securities as collateral for a loan. A reader entirely unfamiliar with finan- cial transactions may wonder where the in- vestment banker borrows the money. He borrows at any national bank, state bank, or trust company ready to undertake the business. Since the banks located in the financial districts naturally get the business of the dealers in securities, they come to be known as "financial banks." Instead of financing commodities in the course of con- sumption, they are, so to speak, financing securities in the course of consumption; that is, in the process of sale to the capitalists who commit their funds to the enterprise of the corporation issuing the securities. The bank in making the loan primarily con- siders the marketability of the securities put up as collateral. It is of the first importance to the bank that its loans should be liquid. RAISING FUNDS 49 That is why, from the standpoint of a bank, it engages in the business of financing com- modities in the course of consumption. As the commodities pass from one stage to an- other of the process of consumption, of mar- keting and use, the loans fall due and are re- paid. If the bank can get an equally liquid loan in any other way it is just as good bank- ing for it to do so. One danger lies in loaning on securities. Prices for the securities are very sensitive to credit and other market conditions and vary widely with general business conditions. Security prices fluctu- ate more widely than commodity prices. Panic conditions may make them not liquid at all. If the bank, however, takes as col- lateral securities with a quick market and watches the changes in price, it engages in thoroughly sound banking. The market- ability of securities, however^ varies widely, and ordinarily a bank would not require that all of its collateral for loians should have as quick a market as the most active stock exchange securities. The investment banker knows that he wUl have no difficulty in getting a loan on his active collateral. He wants to get accepted as collateral as many of his inactive securities as possible. Neces- sarily the investment banker must get some of his collateral released from time to time 50 CORPORATION FINANCE as he proceeds with the sale ;of the securities, and substitute other securities in the place of those released. He may endeavor to get less active collateral accepted on these sub- stitutions. If he meets with any success, the process is known by the expTessive term of "milking the collateral." The amount the bank will advance on the security of given collateral depends on the marketability of the collateral just dis- cussed and on the possible or probable range of fluctuation in the market price. A bank would probably make a larger loan on the security of a good municipal bond than it would on the security of nlost very active high-grade railroad bonds. Though the mu- nicipal bond would not have as active a mar- ket as the railroad bond, th^ probable range of price fluctuation within a short time is not so great. In the same way a bank would not loan as much on stock collateral with the most active stock exchange market as it would on a well-secured bond with a good but much less active market* A bank might loan as much as 95 per cent of the market value of the very best municipal bonds and as much as 90 per cent of the market value of high-grade active railroad bonds, when it would not loan more than 75 per cent of the market value of an active stock. A bank RAISING FUNDS 51 which makes a business of loaning on iSnan- cia,l collateral of this kind mijist, of course, keep in the closest possible touch with the market for securities and watch the fluctua- tions in prices and their bearing on the loans of the institution. We can now take up directly the state- ments of those who criticize the size of bank- ers' profits and who declare that they are an unwarranted charge on the community. Usually the critic accompanies his criticism with the advice that the corporations should seek their capital directly from the capitalist and cut out the banking-house middleman and its profits. We have already mentioned several reasons why the corporations are not successful when they attempt to do this, and have shown under what circumstances a corporation can, on appealing to its stock- holders, get directly to the capitalist. Let us examine this charge of undue profits to the investment banker. Such critics charge investment bankers with making a profit of two and a half per cent and sometimes as much as five or ten per cent. It is true that the diflference be- tween the price the banker pays for the se- curities and the price at which he expects to sell them does range from about one per cent to the higher figure charged against 62 CORPORATION FINANCE them. The banking house bases its purchase price on its estimate of what it can sell the securities for. When the banker has decided on what price he can probably get for the se- curities, he offers the issuer a price of one point or more below this. The amount of dif- ference he makes between his. anticipated sell- ing price and the price he offers to the issuer, he bases on the length of time the securities have to run, market conditions, and the probable amount of expense and labor in- volved in selling them. He can afford to make a smaller gross profit on short-time securities, not only because ordinarily they are easier to sell, but also because when they fall due he may have a chance to reinvest the fund and make another profit. Market conditions will influence him because, if they are stable, the transaction does not involve as much risk as when they are unstable; there is less chance that changing financial conditions will force him to sell at a lower price than he paid. If current interest rates are high, he will also have to take into con- sideration the possibility of loss on the in- terest account. Most of all, the probable difficulty of selling the securities will influ- ence him. If they are of the kind which, how- ever secure, will require a large amount of personal effort and consequently, under the RAISING FUNDS 53 most favorable conditions, can be disposed of only from day to day oveY a considerable period of time, the banker will have to esti- mate a charge for the cost of selling, includ- ing the tying-up of his capital, and also for the risk of change in market conditions in- volved in the length of time necessary to complete the transaction. Let us compare the profit the investment banker hopes to make with charges for serv- ice in other forms of financial work. Brokers in real estate mortgages make a minimum charge of one per cent for negotiating the highest grade of real estate mortgages on New York City property. Such mortgages as they will handle on a one. per cent com- mission are a legal investment for New York savings banks. When dealing in bonds that are a legal savings bank investment, the investment banker, acting only as a broker in the trans- action, often charges as little as one six- teenth of one per cent and sometimes only one thirty-second of one per cent. The us- ual commission for selling securities of this character is one eighth of one per cent, or $1.25 per $1000 bond. If a mortgage on improved property in New York City exceeds in the slightest de- gree three fifths of the appraised value of 54 CORPORATION FINANCE the property, it is not a legal investment for the savings banks. For mortgages which do not fall within the savings bank class the broker immediately advances his rate of commission to two per cent or more. His risk is not increased, for he assumes no risk or responsibility. He does not buy the se- curity as does an investment banker the securities he deals in. The mortgage broker charges the increased commission because he finds it harder work to locate a buyer for a mortgage which does not fall within the legal limitations of a savings bank invest- ment. There is a broad market for invest- ments within the savings bank class and it is not difficult to convince an investor of the merits of such a security. The difference between these two rates of commission does not express the full situa- tion. The mortgage may run for only three years, the bond for thirty years. When the mortgage falls due, it may be paid off. Then the broker will have another chance to make a commission on selling the investor a new mortgage. But the bond broker may not for thirty years have an opportunity to re- invest for his client the capital placed in bonds. Investment bankers are fully aware of the value to them of more frequent periods in the investment of capital and are glad to RAISING FUNDS 55 handle short-term securities, one maturing, say, in three or five years, oh a smaller anti- cipation of profit than that sought for han- dling a long-term bond. Dealers in commercial paper, which runs from thirty to ninety days, receive a regular commission of one quarter of one per cent for selling it. Allowing for only the longest maturities the fund is reinvested four times a year, giving the note broker, if he is for- tunate enough to command the reinvest- ment each time, an opporturiity to make one per cent a year out of a giveij fund of capital. Both these commissions — that of the mort- gage broker and that of the note broker — are only for the work of locating the capital and inducing the capitalist to make the commit- ment. Note brokers sell almost entirely to banks, and each transaction reaches an amount of some magnitude. The high-grade real estate mortgage, although usually hav- ing only a local market, is a well-known secur- ity in its market. On account of certain market disadvantages, the uneven denomi- nations, and the fact that no two mortgages are exactly alike, the work of selling is greater than the work of selling the most active bonds. It is not nearly so great as the work of persuading a capitalist to commit his funds to a relatively unknown though a thoroughly sound enterprise. 56 CORPORATION FINANCE More than any other merchant the invest- ment dealer assumes a moral responsibility for the goods he sells, irrespective of their grade. A dealer in merchahdise is not ex- pected to guarantee the wear of his goods unless he represents them to be of the best class. Though a merchant in investment se- curities does not represent everything that he sells to be as safe as government bonds, those who buy from him are disposed to hold him responsible if the investment proves unprofit- able and the interest and principal are not paid promptly. A default is a severe blow to his prestige and to the confidence in his judg- ment, by virtue of which he holds his clientele. These facts justify the profits that the in- vestment merchant is accilsed of making. The larger differences between buying and selling price are a consideration for the diffi- culties of the business. Thie credit of cor- porations varies widely, as does the market for their obligations. Thousands of people know the value of the Pennsylvania Rail- road's promise to pay and need no persua- sion to buy its securities. Few people know the value of a similar obligation made by an electric light company in some small city of a remote State. Though the security may seem safe to those who are ejqperts, the larger public has to be convinced of it. RAISING FUNDS 57 Each investor to whoin such securities are offered must be persuaded to believe in them. It may take a year of negotiation to in- duce him to buy. Bond salesmen have often found it necessary to wait ag long as that to sell good but slow paper. Meanwhile, the dealer's capital is tied up in the bonds he has bought and his money is being spent to convince the investor. The pur- chase and resale of securities which, though good, are but little known, involves more capital, time, labor, and risk than are re- quired for the purchase of standard securi- ties that always command a market, and it is altogether reasonable that such opera- tions should pay a larger profit. If the investment merchant were unwill- ing to undertake this more hazardous and laborious sort of business, the small munici- palities in Western States might have to do without their transportation or lights, or to get them at a higher cost. Such communi- ties are without the capital required for their development, or, if it can be locally obtained, the cost would be higher than that at which it can be procured in the financial centers. The dealer is paid for making a market and for the cost of the selling; he does not in any way deceive the purchaser. The investor does not expect, and knows 58 CORPORATION FINANCE that lie is not purchasing, a security imme- diately salable through any other channel than that through which he bought it. Usu- ally the dealer stands ready in case of need to repurchase the securities so sold at a rea- sonable concession. High standards prevail in this business. In comparison with the work done and the responsibilities assumed, the charges are moderate. Though it is admitted that there is risk in the merchandising of securities, also it should be admitted that often there is actual loss. With all the experience and skill the merchant can bring to bear on his purchases, the conditions under which he works are so complex that he often cannot foresee the outcome. If the hoped-for per cent of profit is not made, the transaction may turn to the loss of many per cent, besides the cost of selling. If a dealer has not been shrewd enough to sell out in advance of falling prices, or does not gauge accurately the duration and rapidity of the decline, he may take heavy losses. Probably no investment ban- ker went through the transition, from the period of rising security prices culminating in 1905 to the subsequent period of declin- ing prices and the panic of 1907, without taking large losses. Bonds bought in the hope of selling at three fourths of one per RAISING FUNDS 59 cent above the purchase price were sold at a loss of from four to five per cent. Except in the case of specialty bonds sold through a careful education of the investor in the merits of the particular seci:^ity, a sale in a declining market must be practically imme- diate in order to be really profitable. If a dealer misjudges the appetite of purchasers, he gets "hung up" with an issue of securi- ties which the investor will not even masti- cate, to say nothing of digesting. A closing-up of the market, the refusal of investors to purchase, is a common, periodic phenomenon, which becomes particularly acute in London. It takes place whenever investors generally think the present is not a good time to buy. If an investment mer- chant fails to foresee its coming, he has to carry a heavy burden of securities that he cannot sell. Security selling differs from other selling in that purchasers are under less pressure to buy. People must eat — must buy from the grocer. Clothes wear out and the tailor must be seen. No such necessities help the seller of securities. Capital can linger in the bank for months, until enticed by lower prices or driven out by fear of higher. Any one not familiar with the facts would infer that an investment merchant's great- 60 CORPORATION FINANCE est difficulty is in finding securities to buy. That is not the case. Goods are pressed on him as on any other merchant. Day after day promoters, new and old, cool their heels in his anteroom. Out of the many things offered him, which is the best for his clients? Which is most likely from subsequent suc- cess to enlarge his reputation as a merchant and further that confidence forming the very life of his business? A corporation manager without an established connection with some security-selling house is likely to have a weary time when he wants to place an issue. His securities may be good and in every way merit confidence. But the pressure to get access to the capital supply is enormous. A given merchant may much desire to take on the business, but he is already so largely committed that he could not sell any more securities if he should buy them. The cor- poration manager may have to visit many merchants and wait a long time before he can find a buyer. This situation does not arise through any unfair discrimination. The capital supply is a very limited one. The capital demand exceeds it and absorbs it as the sand of the desert absorbs rain. Contrary to the general idea, the busi- ness of investment banking is highly com- petitive. This results from the comparative RAISING FUNDS 61 ease with which the investmfent banker may- borrow a large part of his capital for certain kinds of transactions. Probably he does not stand in any better position in this respect than does the merchant in fairly standard commodities, who can do business from rented oflBces and salesrooms and borrow money with which to carry his merchandise. He does occupy a better position than most manufacturers, who, to be sure, may be able to finance their commodity in the case of production readily enough, but who must usually have a large capital invested in plant, on which they can borrow, and that with difficulty, perhaps one third. As we have seen, a capital of $50,000 used in the purchase and sale of securities fulfills the capital requirement for membership in the national organization of the Investment Bankers' Association. Though so small a capital wUl limit the classes of business a new organization can engage in, it will enable men with the necessary professional experi- ence to enter the business oh their own ac- count. Constantly men who have acquired the training in one of the older houses organ- ize their own houses and start in for them- selves. If a man has demonstrated his abil- ity to place securities, — that is, to induce investors to commit their capital to the par- 62 CORPOEATION FINANCE ticular enterprises whose securities he has to sell, — and has proved himself a success in this branch of the business, — even though he has no capital himself, he may be able to persuade some one with capital to join him in organizing a new banking house. He has established a clientele. Sonie of his chents have dealt with him mainly because of the house he represented, but many, and very likely the much larger number, have dealt with him because of personal liking or be- cause of personal confidence in him. Such a connection is a valuable asset for the new house and the nucleus for the most valuable asset of any house, — a well-established cli- entele, a list of capitalists who do most and perhaps all of their investijig through the house. Some of the older banking houses have become parents in this way of several new banking houses, in one case of possibly a score. The general process is no different from the process in other kinds of business, but easier than in some, and the relative ease of the starting of new organizations makes the competition for the good-will of capitalists very keen and es^tends the num- ber of organizations to which a corporation may appeal when in need of new funds for the capital account. RAISING FUNDS 63 Referring especially to the relationship between the banking houses and the corpora- tions, accusations have been made in recent years of a money trust. In these charges it has been said that corporations could pro- cure funds only through the good-wUl of cer- tain financial interests and, if these interests were not well disposed, the corporation could not get help anywhere. It is true that the cap- ital requirements of some of our largest cor- porations are so great that probably only one or two banking houses, or groups of finan- cial interests, have the financial strength to handle them, and the corporation there- fore cannot be financed without the assist- ance of one of these financial groups. A concentration of control over capital has been necessary to meet the magnitude of the requirements of modern business. If any smaller enterprise were likely to be a thorn in the flesh of one of these big business under- takings, the banking connections of these undertakings perhaps might make it diffi- cult for the smaller enterprise to get finan- cial backing. Business is competitive and the methods of competition extend into the financial as well as into other business fields. Probably it is a fair generalization to say that, with the exception of the very largest corporations which are limited for the rea- 64 COKPOKATION FINANCE son just given, any corporation has at least several entirely independent and competi- tive banking houses to which it may appeal for financial support. The business of financ- ing our medium-sized corporations is an open field and no favors. Our smaller indus- trial enterprises find difficulty in getting capital on account of their very smallness. A banking house must do a large amount of work in making a corporation well enough known to capitalists for them even to give consideration to its securities. It takes even more work to make the small corporation known than the large one. The large cor- poration has already advertised itself. It is impracticable to build up a course of deal- ings in the securities of small corporations which will give them the valuable element of marketability. With all the work involved the possible profits in providing $100,000 of capital for a small corporation will not com- pensate a banking house for its preliminary labor: especially if the banking house is or- ganized to handle issues of a larger size. Banking houses have overcome much of the difficulty of financing small corporations in the case of public service enterprises. Be- cause of the more nearly uniform nature of the business the bankers do not have to do as much "educating" of the capitalist. He RAISING FUNDS 65 knows the general nature of the business and the kind of risks involved. Each industrial enterprise is more nearly a law unto itself. Banking houses have devel'oped some spe- cial methods of financing the public service corporations. The holding company and the engineer bankers operating a series of prop- erties all help in the financing of the rela- tively small public service corporation. So the small public utility gets financed and the small industrial enterprise goes begging. We have wandered somewhat away from the matter of the accusations- of the existence of a money trust. Some of the accusations doubtless originate with those in control of enterprises, either under way or in the course of promotion, who have had no experience with the demands of capitalists. Many peo- ple of this kind come to the "street" to raise capital and do not succeed. They charge their failure to the money trust, which for some reason does not wish them to succeed. As a matter of fact their proposals are prob- ably of a kind no banking house could han- dle. Many come with promotion projects and these, however meritorious, 'do not interest most banking houses. Some actually are meritorious yet, because they are in the pro- motion stage, cannot get a hearing. Many are not meritorious, yet the promoter feels 66 CORPORATION FINANCE confident of his judgment and charges up to the malevolence of the money trust a failure which results from the class of his business and its demerits within that class. Managers of going concerns, who have not had occasion before to appeal to the banking houses, come to the street with proposals impossible of acceptance. Until they are educated in the requirements of the bankers, — which means, in the last analysis, the re- quirements of capitalists who will ultimately- advance the funds, — these managers will blame the money trust for the non-acceptance of their proposals. The most important and the most general reason for the inability of many of these corporation pianagers to get funds is the simple fact that there is not money enough to go round. For every dollar of capital in existence a multitude of people are seeking a dollar to further their interests. The demand for capital is unlimited, provided the terms are not too unfavorable, and the supply of capi- tal is strictly limited on any terms what- ever. An insistence that the risk be not too great is most likely to be that part of the terms which the seeker for capital cannot meet. Out of a hundred people seeking capi- tal the capitalist will supply it to that one who will ofifer the most favorable terms, the RAISING FUNDS 67 best bargain in risk, income, and control. The investment banker acts ,*for the capital- ist, and will commit himself to that enter- prise which he believes most likely, under existing conditions, to meet with the favor of the capitalist, in view of other opportuni- ties for commitment which other banking houses are oflFering. The man who comes to the street for funds, however, does not see the pressure of all the other enterprises seek- ing capital. If he did see the pressure, he probably would consider the enterprises all inferior to his own. He even regards those enterprises which are financed as inferior to the one dear to him. His preference for his own is natural. But it leaves him with no reason for the banker's rejection but the machinations of the money trust. Some get confirmed in their impression of monopoly by certain aspects of the ethics of the investment banking business, which are unfamiliar to them. It is a general prin- ciple of investment bankers to decline to consider a proposal for financing while it is before another house. As soon as one house rejects it, then another house feels free to take it up. This aspect of the business has something in it of the ethics of the lawyer and the physician, in refusing to take away the client or patient of another member of 68 CORPORATION FINANCE the profession. It does not^ however, have the full foundation of injury to the client's interests and to professional reputation ex- isting in the case of the lawyer and phy- sician. Besides this matter of professional feeling, a banking house does not want to spend its time considering a piece of busi- ness which, before it can arrive at a conclu- sion, may be taken care of elsewhere. The ethics of the situation serves to protect the banker's time. To be sure, it equally serves to cause delay to the man seeking capital. But in determining which one is to occupy the better position in this respect, the banker has the advantage in the number of enterprises which are constantly pressed upon his atten- tion. Besides, the existing disposition of the situation settles it the right way in the end. If several people are considering a piece of business at the same time, all but one of them are bound to do their work fruitlessly. Though the limitation to one at a time delays the seeker for capital, it greatly lessens the amount of useless work in the world. Some people who come to the street for money, without especially knowing the bank- er's ethics of the situation, have themselves an ethics of business which prevents them from taking their proposal to more than one banker at a time. Others, who chafe under RAISING FUNDS 69 the restriction, nevertheless know the un- wisdom of trying to avoid it. Frequently, however, men come to the street whose own ideas of business include making as many proposals as possible and closing with the first one who will come to terms. When the fact that they are dealing with several peo- ple comes to the attention of one of the sev- eral, as it probably will, that one is likely to decline further negotiations, and so with the others as they find out the situation. So the man who is seeking the funds gets an idea of monopoly, that a money trust exists. Let us assume that our banking house has made an agreement with the corporation to supply it with funds on the delivery of the issue of securities which the corporation has authorized. If the amount involved is so great that the banking house does not care to assume the entire risk of the transaction, it will have distributed the risk by getting one or more other houses to join it in the transaction. To use the language of the street, it will have formed a "joint account," and the other houses will have taken a "par- ticipation" in the account. Later the bank- ing house which initiated the joint account, or the several members of the account act- ing together, may still further distribute the risk by arranging an underwriting syndicate. 70 CORPORATION FINANCE This, however, will not be formed until after the securities are purchased, 6r until at least a binding agreement to purchase them has been made. One banking House may form the joint account in anticipation of commit- ting itself to the purchase. Though simple enough in the idea of distribution of risk, in details these joint accounts are somewhat complicated transactions. We will take a fuller discussion of them for our next topic. As soon as the banking house has defin- itely contracted to purchase an issue of se- curities, it will begin to plan for its sale. It is not an investment institution like an in- surance company or a savings bank, but em- ploys its capital and organization simply as a means of assuming the risk of the trans- action and of establishing the direct connec- tion between the corporation and the body of capitalists who will ultimately be supply- ing its fixed capital requirements. In pursu- ance of this end the banking house may make a formal public offering inviting capitalists to subscribe to the issue, or it may under- take to sell the bonds without a formal pub- lic offering. This statement does not mean that in either case the banking house will not publicly advertise the securities, but rather distinguishes between the manner of advertising. If the banking house, or syndi- RAISING FUNDS 71 cate, extends a formal invitation to sub- scribe, it will say in so many words that it is offering the securities for sale and will re- iceive subscriptions at the price named up to the stated hour of the stated day. Such an advertisement does not mean that the banking house is relying upon it to inter- est enough capitalists to take up the entire issue. It does not even mean that it has an expectation, or hope, that it will interest a large enough number of capitalists to place the entire issue. More probably the house, or the syndicate of several houses, has been hard at work creating an interest in the issue for a considerable time before the ad- vertisement appears. The house may have informed its clients by personal interview or by letter that such an issue would be brought out. Its salesmen may have quietly, but rather busily, talked it up for a number of weeks. Just before the house inserted the advertisement in the newspapers it probably sent circulars to all its clients containing the information about the issue and inviting subscriptions. The advertisement appear- ing in the newspapers, in all probability, simply focuses this anticipatory work. The banking house or syndicate does hope that the issue will prove suflBciently popular to attract enough people, other than regular 72 CORPORATION FINANCE clients, to make a demand that will take up the issue or materially diminish the amount that will remain unsold. If the issue is highly successful, the house may stop taking sub- scriptions even before the day and hour an- nounced in its advertisement. In that event it will announce that the issue was oversub- scribed and the books closed at the time stated. Such a procedure gives the regular clients of the house an opportunity to get the full amount they have subscribed for, or near to it, and leaves unsatisfied a demand on the part of many, who may seek to purchase the bonds in the open market at a price higher than the subscription price; thus giving the regular clients an opportunity to make something immediately on a resale, if they wish to do so, or to feel that they have made a highly advantageous purchase. Closing the books before the announced time may also be taken by the investing public to be a better indication that an issue actually has been oversubscribed, than an announcement to that effect when the books have been kept open for the full time advertised. It seems rather the better practice, how- ever, to allow the full length of time an- nounced. Many people who want to sub- scribe may interpret the announcement that the books will be closed by the stated time RAISING FUNDS 73 as meaning that they will remain open till that time, and some regular clients of the house may be among that number. The house is at full liberty to prefer its own regu- lar clients in making an allotment of the securities. Subscriptions of such a charac- ter that the house would favor them may be late in coming in. The extra work involved in handling an actual large oversubscription hardly offsets the various reasons for keep- ing the subscription book open. Of course it is undesirable, from the mar- ket point of view, that an impression should get out that the offering was hot wholly suc- cessful. Undoubtedly banking houses often announce that an issue was fully subscribed for or oversubscribed, when that is, at best, only technically the case. S,ome subsidiary organization of the banking house may have put in a "subscription" large enough to pro- vide for the amount not really, as well as technically, subscribed for; or another joint account may have been formed to "sub- scribe" for and take over the bonds. Since the possible use of such subterfuges is well known in the street, an announcement of an oversubscription is likely to be taken with a grain of salt unless there is corroborative evidence. The future conduct of the mar- ket, the course of prices in the particular 74 CORPORATION FINANCE security, may indicate that the announce- ment is really true. On the other hand, if the original offering house, or even another house, appears to be offering the bonds in substantial amounts or with a degree of con- tinuity, people in the street surmise that the oversubscription announcement may have been made with a mental reservation. Such a formal advertisement for sub- scriptions is more likely to be made of the larger than of the smaller issues. In the case of most issues the banking houses are more likely to advertise the issue for sale without stating formally that subscriptions will be received and the books closed at a definite time. If the house advertises that the books will be closed at a certain time, it draws attention to that time and causes an expec- tation that it will make some announcement of the favor with which the issue is received. In the event that investors do not fully take up the issue the banking house faces the dilemma of being obliged to resort to some subterfuge, or of having emphasized the lack of the complete immediate success of the issue. If it simply advertises the securities for sale, it can announce that they have all been sold; if the public fails to take all the securities at once, it does not have to say anything. When the banking house takes RAISING FUNDS 75 the position of an underwriter to the issu- ing corporation, it offers the securities for sale on behalf of the corporation. The trans- action will need to take the form of a sub- scription, with bankers bound to take up and pay for any part of the issue remaining un- sold. Often, especially in the case of small issues, the banking house does not advertise the issue in the public press at all. After the banking house has presented its advertisement in the public press, and the "public" has failed to purchase all of the securities, the house faces the second and difl&cult part of its selling problem. It must dispose of the rest of the issue by the much slower process of convincing capitalists, not in the mass but one at a time, of the merits of the security and that it is a good bargain at the price. It will do this largely through the efforts of its salesmen. Probably Jay Cooke first showed the power of salesmen in the marketing of securities. He succeeded, by the use of salesmen and extensive adver- tising in other ways, in raising the large sums required by the North for the Civil War. Cooke's salesmen did not form part of a distinct profession like that of the se- curities salesmen of to-day. It did not re- quire a wide comparative- knowledge of securities and of financial '.conditions and 76 CORPORATION FINANCE methods to oflfer bonds of the United States Government. The selling of Civil War is- sues was a big canvassing campaign con- ducted in much the same way and by much the same kind of people as, book canvass- ing. It demonstrated, however, that personal contact is as powerful in the selling of securi- ties as in any other kind of selling. Though the modern investment banking house with its force of salesmen did not^develop at once as a result of Jay Cooke's example, the men who now go out to meet the capitalist in his office have formed a well-recognized class for a generation. Banking houses recruit their force of sales- men from various sources. Sometimes the men have been successful in selling of other kinds and have looked to the investment banking business as of a higher grade. They may come from almost any other occupa- tion. The tendency in recent years has been for a house to train its own salesmen and for the most part to recruit its apprentices from recent graduates of colleges. It will take such young men into its offices, giving them a little guidance to sources of infor- mation about corporations :and investment banking matters. Occasionally the manager or office employees of the house will set them to some office task. Though some houses RAISING FUNDS 77 give them a measure of regular instruction, for the most part they leave them a good deal to their own resources to acquire an under- standing of what is going on about them and a knowledge of securities. S'ome houses will not keep them at this for more than three months before letting them go out of the office to make their first e^orts at selling; other houses will keep them in the office for two or three years. They are essentially in the position of students during this period and receive only nominal compensation for nominal services. The difference in the time of this part of the apprenticeship required by diflferent houses depends on varying ideas about the minimum of financial matters a man ought to know before he should be per- mitted to approach a possible and prospec- tive client. Though the banking house picks these young men with an eye to their probable capacity for the work they are to undertake, the employer finds it difficult to say which of those he has chosen will succeed in selling and which will fail. When they are per- mitted to go out and seek the capitalist face to face, they have a difficult task ahead of them. Naturally the house does not entrust them during this apprentice period with any well-developed territory. So they must for 78 CORPORATION FINANCE the most part first discover the capitalist. They will not have any great difficulty in identifying the capitalists in the smaller communities and in securing at least a brief interview with them. But competitors find it equally easy to learn of the capitalist mem- bers of the small communities and to gain access to them. In the larger communities the problem of finding the capitalists at all is much harder. Since the number of sub- stantial capitalists in any community is necessarily a small percentage of the inhabi- tants, a canvass of the entire population is obviously impracticable. To describe some of the many devices to locate them would extend this discussion unduly. The reader will, of course, see that not all capitalists are available material for the se- curities salesmen to work on. Most men owning, and actively engaged in, their own business use all their capital in it. Of active business men only those whp have a surplus to invest outside of their own business can take any part in furnishing funds to those corporations which look to the general in- vesting public for supplying their capital account. Those business men who do have surplus funds for investment, and those capi- talists who are not actively engaged in a business of their own, may not invest all or RAISING FUNDS 79 any of their capital in the financing of cor- porations. Ownership and improvement of real estate require financing as well as cor- porate enterprises. A large proportion of capitalists with surplus funds, on which they do not want to accept the risk of unprotected ownership, invest in ordinary realty mort- gages, — rural mortgages if they live in the country, or in close association with the country, and urban mortgages if they live in the city. Under most circumstances it is natural for the man with surplus funds to turn first to the ordinary real estate mortgage for in- vestment. It offers the simplest form of security. Though some people begin to sus- pect that investment in real estate mortgages is a more complex matter a^id more worthy of analysis than investors have commonly thought, involving, as it does, the whole problem of shifting realty values and eco- nomic rent, on the surface it is much simpler than what, to the novice in investment, is the labyrinth of corporate securities, with their finely differentiated gradations of risk, income, and control and all the intricacies of business income. Moreover, people who invest in mortgages for the riiost part invest locally. They can see the tangible property in which their funds are inve'sted. The mat- 80 COEPORATION FINANCE ter has a degree of reality about it which an investment represented by a piece of cor- poration paper does not possess. All these considerations incline the man getting his first experience in investing to select the or- dinary real estate mortgage. Many capi- talists all their lives adhere= exclusively to this form of investment. So our young bond salesman will find that he not only has the task of finding capital- ists, but of finding that selection of inves- tors among the class of capitalists whom he can interest in financing corporations. When he has found a man whom he knows to be an investor, and whom he knows as willing to consider an investment in corporation se- curities, he has only begun his selling task. Only the very wealthiest of capitalists are wealthy enough to have funds to invest at almost any time. Our salesman must, in the first place, command the confidence of the capitalist. A reasonably cautious man does not invest a thousand dollars or more through an entire stranger. Our salesman cannot reasonably expect to do business un- til the capitalist feels acquainted with him and has formed a good opinion of him. Even though the capitalist may be thoroughly familiar with the name of the banking house which the salesman represents, and knows RAISING FUNDS 81 that it is a house of the highest reputation, he will still want to feel personally well ac- quainted with the salesman. Investing is too intimate a business to transact with, or through, a stranger. After the salesman and the capitalist have reached the degree of acquaintanceship at which the capitalist is wUling to make an investment through the salesman, our young man may still have to wait a long time before the capitalist is in funds and ready to invest. So our young salesman will not be likely 'to put through many transactions during his first few months of work in the endeavor. When the salesman has once put through a piece of business with an investor, he has made a client, for a man who has money to invest at one time will probably have money to invest at another time. Even if the inves- tor lives up to his full income, he will prob- ably have some investments maturing, part of his capital paid back from time to time. If our salesman has grit to stick to the work, energy and resourcefulness in prosecuting it, he will gradually build up a clientele which will be as valuable an asset to him as the clientele of any professional man. But after all, this aspect of the selling problem of bank- ing houses does not differ greatly from sell- ing through a personal representative in any kind of business. 82 CORPORATION FINANCE When most young men ficst entertain the idea of selling securities, they think of visit- ing financial institutions, espfecially of calling at the banks. In the largest financial centers some salesmen, who have developed in that direction and to that point, do confine them- selves largely to the financial institutions. Outside of the largest centers, and even in those centers except for the specialized sales- men, selling to these institutions will form only a small part of the work of the bond sales- man. In the first place, selling to them at all must depend upon having available to offer the kind of securities they buy. If the sales- man is approaching the investing officer of a savings bank or an insurance company, he must be able to offer securities in which they may legally invest. If he is; endeavoring to sell to an ordinary bank of deposit, he prob- ably will not have a chance pf success unless he is offering some very active market se- curity protected by an equity. Some trust cofnpanies, acting more in the capacity of savings banks than of commercial banks and, outside of the States in which the sav- ings bank is well developed as a financial institution, some national and state banks which people use much as savings banks, may invest to some extent in relatively slow market securities. Some of these banks un- RAISING FUNDS 83 doubtedly go too far in this direction: for any security which is a legal investment for savings banks in the important savings banks States enjoys a rather ready market. Institutional business of this kind is much more highly competitive than selling to pri- vate investors. The personal relationship of the salesman and the purchaser is not so important. The institution will buy from any salesman who offers, at a time when it is in funds for investment, securities which are of a kind and at a price to make them the best offering presented. The fact that an institution once buys from a particular salesman does not carry any probability that the next time it has funds to invest it will invest them through the same sales- man. It makes a regular business of buy- ing. Most capitalists make the business of investing only an incidental matter. They are much more likely to rely on one or, at most, a few salesmen through whom to make their commitments. It is the list of private investors, who are clients of a banking house, that furnishes the best foundation for finan- cial strength. Salesmen for the banking houses vary in quality. Some have little knowledge of se- curities or skill in salesmanship and are hardly more than canvassers, but they never- 84 CORPOEATION FIJJANCE theless succeed in doing soriie selling. From the low level they grade up to men expert in salesmanship and often having an extended knowledge of financial matters. These higher grade men achieve a good professional stand- ard and become real financial advisers to their clients. Most banking houses have a simple or- ganization. If the organization is complex, it is so because of activities other than those strictly of the investment banker. Com- mercial loans, foreign exchange, engineering and operating departments, outside of the business of finding funds for municipal and private corporations, sometimes extend the scope of the banking house to that of a com- plex concern. In the house that confines it- self to dealing in securities, the work of any one man may take him into all the fields cov- ered by the work of the house. Usually an investment banking organization makes at least four general divisions of the work — the selling, the buying, the statistical, and the cashier's departments. We have already discussed the work of the bond salesman in selling. The work of the sales department looms large in the bank- ing house as in any other merchandising or- ganization. The buying department may buy only if the selling department caij sell. RAISING FUNDS 85 On the other hand, it is as true of the securi- ties business as of any other that goods well bought are half sold. In the office a member of the firm, or a sales manager, will have charge of the selling. It will be his duty, and, if the house is one of some magnitude, that of his office assistants, to keep closely in touch with the salesman. They may send the salesman a daily letter of information and advice. They will write letters at the request of the salesman and of their own initiative to clients of the house. Usually the salesman wUl send in daily reports of his work. These reports contain information the salesman has gathered about the needs and holdings of his clients. From these reports the office organization makes a record of such matters as when the client is likely to be ia funds for investment, what kinds of securi- ties he win invest in, and the names of any securities the salesman may have learned that he already owns. When clients feel complete confidence in their banking house as really an expert ad- viser in financial matters, they will sometimes voluntarily give the salesman a complete list of their securities. In some cases the client has made his first and all subsequent com- mitments with the banking .house and the house has a record of all hi^ holdings as a 86 CORPORATION FINANCE matter of course. Such information is valu- able to the house. From the investor's stand- point it is desirable that the house should have it. As a result of having this informa- tion the banking house can often advise him of possible advantageous changes in invest- ments. Though possession of this informa- tion may offer a temptation to the banking house to suggest changes disadvantageous to the client, considering all his circumstances, for the sake of stimulating business, the house, looking forward to its best interests in the long run, will not suggest them. The better the client's financial affairs prosper un- der the advice of the bankers, the closer the client's business attachment to the banker and the less chance some .competitor has to win away his allegiance. It is part of the duty of the office sales organization to keep the mailing list revised to include all live prospects and to exclude all dead ones. The house does not confine its mailing list to those whom it may count as its clients because it has actually done busi- ness with them, but wants on the list the names of all people to whom it is worth while for that house to send its circulars describ- ing the securities it has for sale. In all these matters of selling, the banking house does not differ widely from any selling RAISING FUNDS 87 organization. One aspect of its selling, how- ever, is especially important. Its supply of any one issue of securities is limited, and it must not sell any more of a "particular issue than it can deliver. To avoi4 getting into an "embarrassing situation the salesmen must make all sales subject to confirmation from the office and promptly notify the office by telephone or telegram of any sale. The same prompt notification must be given as be- tween the main office and the various branch offices, so that each may know at all times the balance of any particulaf issue available for sale. We shall have something t6 say at another place about the work of the banking houses in buying and will only mention it here. Some houses are large enough to have ex- perts in their own employ for the investiga- tion of properties the financing of which they are considering. The fact that a house has its own engineer and its own lawyer does not mean that it does not also employ out- side experts, but only that the expert em- ployees make the preliminary investigations and the house retains the independent pro- fessional men for final reports only after its own men have made favorable preliminary reports. Undoubtedly the buying depends upon the selling. What will investors pur- 88 CORPORATION FINANCE chase under existing conditions and what price will they pay? The answer to these questions supplies the guide to the buying. Those members of the banking organization in charge of the buying n^ist keep in the closest possible touch with those in charge of the selling. Nevertheless, banking houses can and do accomplish much in educating capitalists in investment. They constantly educate them in types of securities, and in kinds of enterprises. Though they follow, they to some extent shape, the demand for securities. This is to say that, to a consider- able extent, they decide what enterprises can most advantageously use new capital. In this way they do largely 4irect the flow of capital into industry and exert a strong influ- ence upon the economic life of the community. The name alone of the "statistical depart- ment" largely describes it. It serves both the buying and the selling sides of the bank- ing organization with statistical information. It prepares the circulars for use in the sell- ing; and the preparation of a good circular, one that will not unduly emphasize either the good or the bad aspects of a security, one that will be honest yet a good selling cir- cular, requires excellent judgment. A cau- tious house will submit its circular to the attorneys who acted on the legal side of the RAISING FUNDS 89 issue to be sure that it does not contain any unintentional misrepresentation of the legal aspects of the security. The responsibihty of a banking house for what appears on its circulars goes far. In a rather well-known case the dealers in a security were held liable for a representation on a circular, made in good faith on the opinion of eminent coun- sel, that the legal situation was as stated, when afterwards the courts held that the opinion of counsel was a mistaken one. Cli- ents constantly make inquiries of banking houses about the market standing and in- trinsic value of particular securities. The statistical department looks up all matters of this kind; and in general it is the duty of the department to supply all the people in the organization with information about se- curities. . To assist it in its duties the statistical de- partment will have at hand up-to-date copies of the various financial manuals and of the Commercial and Financial Chronicle, all run- ning back at least as far as to the time of the organization of the house. It is some- what the insignia of honor to have the bound volumes of the Chronicle, as the standard weekly periodical of the business is known, Tunning back to the first volume. The de- partment will probably have also other finan- 90 CORPORATION FINANCE cial periodicals. It will take an information service, by which up-to-date information of earnings and other facts wili be supplied on printed cards, to file and serve as a supple- ment to the information in the manuals and keep them up to the latest news. It may- somewhat extensively clip and keep on file information coming out generally in the press. It will collect and file for reference the circulars through which other houses advertise their securities. It will gather copies of mortgages and trust deeds and other legal documents, which are the original "sources" of much of the information about securities. Since these documents are regu- larly printed, it is not difficult to get them when they first come out, on application to the house bringing out the issue. Afterwards they are hard to get and quick access thereto is often wanted. The cashier's department keeps the ac- counts and records of the banking house; attends to receiving, paying for, delivering, and collecting payment for, securities that pass through the organization. It also has charge of the loans from the banks and the collateral deposited to secure them. The partners will have attended to the bank con- nections of the house and to the more im- portant matters in connection with arrang- RAISING FUNDS 91 ing the loans, but the cashier's department attends to all details. In making deliveries of securities to out-of-town clients the cashier will usually, on the instructions of the client, send them by registered mail, insured, to a designated bank with draft attached. Un- less the client gives contrary instructions, however, the cashier may estimate whether it may not be cheaper to deliver the securi- ties by an express company, in which case the express company is the insurer. The cashier's department will have to compute all accruals of interest, and all other matters of price and "bases" of true income on all purchases and sales, whether the purchases are of the issue from the corporation or of securities from a client. During the process of distributing securi- ties the bankers must support the market. After they have sold the securities they must make a market for them, so far as the nature of the issue permits. We wUl discuss later the matter of listing securities on the stock exchange. If the bankers, while they have any part of an issue to sell, should permit quotations at prices less than their offering price, on the exchange or o5 the exchange, — for hardly anything in the way of a trans- action fails to become known on the street, — it will become impossible for them to dis- 92 CORPORATION FINANCE pose of the securities. Of course no one will pay the bankers their price for the security if it can be bought from some one else at a lower price. While the bankers are selling an issue they must keep the market clean of the security, and must be careful in their selling to place securities where they are not likely, for the time being, at least, to be offered in the market. The banker will prefer the small investor in making sales to this end of keeping securi- ties off the market. If the securities are offered publicly and are oversubscribed, the bankers will allot small subscribers all of the security they subscribe for, or a proportion- ally greater part than the large subscriber, and the allotment of the large subscriber will be proportionally cut down. The small subscriber is more likely to be an investor, or, stated the other way, the large subscriber is more likely to be a speculator simply hoping to make a market turn on the possi- bility of an oversubscription, and intending to put his securities right bapk into the mar- ket, whatever happens. We should remember that since the mar- ket in listed stocks is on the exchange, and practically no dealings take place in them off the exchange, then in building up a mar- ket in a stock the banker will especially have RAISING FUNDS 93 to watch the exchange. The market will be largely off the exchange in other securities, whether listed or not. When building up a market in such securities the banker will enlist the interest of brokers who are not connected with the stock exchange, and of smaller dealers whose clients may want to purchase some of this particular issue, but who would prefer to purchase through their regular dealer. Through allowing such bro- kers and dealers a commission, though only a quarter of a point, for purchases or sub- scriptions through them, the bankers stimu- late their interest in the issue. Once such a dealer or broker has handled the security for some of his clients he feels something of an interest in the security, and may go on recommending it or offering to deal in it. Interest of this kind will prove very useful in working up a really active market. In underwriting syndicates bankers lay a much stronger substructure for a market. Through them, many other banking houses are interested with that vital interest arising out of a financial stake in the transaction. Every one of them becomes" in some degree a trading post for the security thereafter. Usually these syndicates are thought of only as a means of getting sufficient distributing power to dispose of the issue in the first 94 CORPORATION FINANCE instance. They are also highly important as a base for that trading which makes an active market and gives an issue that valu- able quality of marketability." When a banking house has disposed of an issue, it will not drop the matter entirely and turn its attention absolutely to other mat- ters. For the sake of its own clients it must maintain a trading position in the security. Though these clients may have had no thought but investment at the time they bought the securities, situations will arise which, without any prior thought of specu- lation, will require some of these clients to sell. In such circumstances the bankers will have to be ready to take the securities off the hands of the client or else lose his good-will. Unless the bankers have built up a tradmg market with known quotations, they will have to pay, in order to satisfy the client, a price somewhere near the price at which he bought the securities, even though financial conditions are such that all securities have suffered in their market value for causes quite outside the issuing corporation. If the security has had a regular course of deal- ings with known quotations, the client is more likely to have drawn his own conclu- sions. In any event, he knows that he can- not get more than the market price. So, for RAISING FUNDS 95 their own protection, the satisfaction of their clientele, and for their general reputation, the bankers will endeavor to build up a course of dealings in any issue of large enough size to make a market really possible. In building up such a market the bankers perform a service of value to the corporation for future issues. The dealings constantly advertise the corporation. Its outstanding securities sell at a higher price because of their marketability. Quotations for outstand- ing securities make the basis for estimating what their new issues will colnmand. One should take these facts into account when considering the value of the Work the bank- ers do. Since we shall not discuss the nature of the market off the exchange as a special topic, we may appropriately consider it here. As the "curb" market is in itself an exchange of a kind, we do not now refer to that in speaking of the market off the exchange. Through the weave of telephone wires the whole financial section of a city, which Is a financial center, is one great exchange. Either the sales manager of the banking house, or some special "trader" or telephone man, constantly watches opportunities to do busi- ness of a trading nature. Through its sales- men the house offers to its clients especially 96 CORPORATION FINANCE the securities it owns, those "on its list," as the phrase goes. None of these securities may exactly meet the requirements or ideas of the client. He may haye definitely in mind some particular issue. The salesman, finding that the securities on his list do not satisfy the client, may suggest some other security obtainable in the market. When the client expresses a preference for such a security, the salesman will communicate with his oflBce and name the price limit the client will pay. It then becomes the task of the trading man of the house to make the purchase; even if it is a listed bond he will probably inquire around the street to see if he can pick it up more advantageously than by putting in an order on the exchange. He may telephone to the trading men in several banking houses in the effort to locate the bonds he wants. For special reasons he may not care to disclose the fact that he is in the market for the security. In that case he will make use of the services of one of the many street brokers who come into his oflBce every day. Mention of the street broker calls for a further word about him. He is not, as some one might natvu-ally surmise, a member of the curb exchange, but a man who daily makes the rounds of the dealers in securities RAISING FUNDS 97 to see if he can match up orders and by so doing make a Uttle commission for himself. Such a broker may have received an order to sell some C. B. & Q. Collateral Joint 4's. In the course of his rounds Ke steps into the office of Jones & Compan^". On learning that they are not interested in his Joint 4's, or in any other security that he may have an idea he would be able to supply or to sell, he will ask Jones & Company's trading man if he wants to buy or to sell anything. iJones & Company's order may call for some X. Y. Z. Debenture 4's and the trading man may indicate this to the broker, and some idea of the price he would pay, as, say, 98|. The broker now has something further to work on. In the course of the next hour of his rounds he may find that Robinson & Company display some interest in selling X. Y. Z. Debenture 4's, but want 98^. The bid and asked price are an eighth apart, with- out allowing any commission. The broker may succeed in bringing Jones & Company up and Robinson & Company down an eighth each. That would allow the broker an eighth. It may be that the purchaser will not come up the full eighth, but will make the price he will pay three quarters plus a sixteenth. The offer will be expressed that way instead of 98^. The broker will regret- 98 CORPORATION FINANCE fully put the transaction through on that basis. It means that he makes a commission of only one sixteenth, but after all he has done a piece of business. He may give up his principals and let them clear the transac- tion. Very likely, however, one of the houses is taking advantage of his .services for the very reason that it does not wish to appear as principal in the transaction. In that case the broker will have to clear the transaction himself. Very likely the broker has desk- room in or near the offices of some banking house, which, in return for such services as the broker can render, will clear the bro- ker's transactions. This is a matter of some importance, because it involves having a bank account large enough to get a check certified with which to pay for the security. Of course, on delivery of the security the same day the broker will in return get a check in payment to refund the account, so there will be no loss of interest. But for a little while the account will be debited the cost of the bonds. Since the transaction may run up to $50,000 or more, the reader will see that the minutes or hours between the time the broker has to pay for the security and the time he gets paid for it are impor- tant ones for him to bridge. If a broker can make arrangements for RAISING FUNDS 99 these clearings, he need not have any capi- tal. He is acting entirely as broker. Desk- room, a place to telephone from, and where he can be reached by any one who may want his services, are the material needs of his business. Otherwise his office is wherever he happens to stand. Since the street broker was the only broker concerned in the transaction, he could put the purchase and sale through cheaper than it could be done on the exchange. There one broker would be acting for the seller and one for the buyer, and each must, by the rules of the exchange, charge a full eighth. So the transaction would cost a quarter of a point on the exchange. The street broker, though expecting an eighth, in this instance has put it through for a sixteenth. Of course, if both the banking houses had been mem- bers of the exchange, but without a partner actually on the floor, which would be the usual situation, some floor broker would put the transaction through, as permitted by the rules, for another member on the basis of $2 for an amount of $10,000. Under such circumstances the employment of the street broker would not have had the advantage in the matter of commissions. Even then the street broker would have the advantage of working quietly. A bid far a large block. 100 COEPORATION FINANCE $25,000, $50,000, or more, on the exchange would have more of a tendency to stiffen prices than the efforts of a street broker to find some one ready to sell, but not offering to sell for the same reason, namely, the tend- ency of an open offer of a good-sized block to depress the market. Visits of these street brokers and tele- phone caUs from banking house to banking house indicate the course of -the market, and when they result in transactions they make the market. The trading man in the bank- ing house becomes intimately acquainted with the ways of the market and sensitive to its indications. From the tone of brokers and other trading men he "knows that the market in X. Y. 5's, which were worth 98|- at 10 A.M., has softened, and that if he wished to purchase at 11.30 A.M. he could probably get them at three quarters or better. One phenomenon, somewhat amusing, shows the sensitiveness and range of this outside general market in securities. Often when the trading man starts an inquiry he finds his own inquiry coming back to him from many quarters. Assume that he starts out an inquiry through a street broker for a good-sized block of X. Y. 5's. The next house at which the broker inquires may not have any, but may surmise that it might get RAISING J'UNDS 101 some from another house and* its trading man will, phone an inquiry. That house does not have any of the bonds, but, eager to do busi- ness, its trading man may recollect that at some time in the past he had been offered a block from Montreal and telegraphs to some Montreal dealer. The Montreal man may have an idea that he could get them in Lon- don and cables. The London correspondent may in turn cable to New York, and the trading man of the New York house receiv- ing the cable, and knowing nothing what- ever of the real origin of the inquiry, may telephone to the very house that first sent the inquiry on the way. Usually the inquiry will come back by a much shorter route to the man who started it. Within an hour after starting the search the trader may recognize his own inquiry in half a dozen telephone calls. This is significant in showing the scope of the market off the exchange, and how far- reaching and thorough is th.e search of the outside market to find a buyer or a seller for a given security at the most advantageous price. CHAPTER III syndicates: joint accounts and undeewritings When a corporation requires at one time an amount of financing too great for the bank- ing house which has undertaken to supply the corporation's need foi* capital, or to which the corporation is applying, to supply alone, the banking house seeks cooperation. How great the amount must be for the bank- ing house to seek aid depends, of course, on the particular house and its "placing power"; that is, its ability to distribute securities and lodge them in the hands of investing financial institutions or individuals. With a particular house the amount may also vary from time to time. It will depend on the other commitments of the house at the time, its opinion of the probable course of the mar- ket, and, in general, all the considerations which enter into a determination of the amount of risk it is willing to assume at a given moment. Such cooperation in the sale of securities takes the form of joint accounts and under- writings. Though these two business meth- ods — joint account and underwriting trans- SYNDICATES 103 actions — differ in degree rather than in kind, they differ enough to make the two terms desirable. Joint accounts are more common than underwritings. Though 'an underwriting may not follow a joint account, ordinarily a joint account precedes an underwriting. Some- times an underwriting transaction is entered into without any joint-account transaction preceding it. A description of the two trans- actions will make the situation clearer than any amount of preliminary general statement. Let us assume that a banking house has committed itself to purchase, or learned that it can purchase, an issue of corporation bonds. The transaction is larger than at the moment it cares to undertake to handle entirely on its own account and it seeks the assistance of several other banking houses. Ordinarily the house is in the position of extending an invi- tation rather than of asking a favor. It has the business in hand. Though it has done part of the work already, it will not stand in any better position with regard to the profits than the other houses which cooperate. Each house invited to cooperate either states that it is not in a position to do so, or that for some other reason it does not care to, or else indicates how large a participa- tion it wishes to take. The word "partici- pation" is the technical term for the share 104 CORPORATION FINANCE in the transaction that each house takes. Profits are divided and losses shared in pro- portion to the size of the participation. We will assume an issue of $5,000,000, and that the house of Brown & Company regu- larly does the financing for the issuing cor- poration, or for some other reason is in a position to purchase this particular issue from the corporation. Of the several houses Brown & Company invite to participate in the purchase and sale of the securities, Jones & Company, Smith & Company and Robin- son & Company decide to join in the under- taking. It is decided that Brown & Com- pany shall keep a participation of $2,000,000; Jones & Company to take a participation of $1,500,000; Smith & Company, a parti- cipation of $1,000,000; Robinson & Com- pany, a participation of $500,000. The num- ber and amounts of the participations may vary to almost any extent. Our supposititious case, however, may be taken as fairly repre- sentative. Assume that Brown & Company have agreed to pay the corporation 95.50 for the bonds. We will assume also that the situa- tion demands that the corporation receive all the money in one payment. This, of course, would be the case in a refunding operation, If the corporation had bee^ financing on SYNDICATES 105 short-term securities in anticipation of a better market and had, say, $4,500,000 of such "notes" about to mature, it would re- quire the cash in order to meet the maturity. Let us suppose also that the corporation needs some cash for the extension or im- provement of its plant or line. The sale of $5,000,000 bonds at 95.50 will meet the pay- ment of the $4,500,000 of notes that are fall- ing due and will provide in addition the esti- mated requirement of $225,000 of cash. To facilitate expression and speak in the ordinary language of the street, we may use the term "syndicate" to express either the joint account or the underwriting as a form of cooperation in the sale of securities. The syndicate must be prepared on the stipulated day to pay the corporation $4,775,000 and iake delivery of the securities. After the negotiations for the purchase of the securi- ties and the determination of the price, the requirement of making payment presents the first matter that must be settled in the formation of the joint account. Presumably, the banking houses forming the syndicate are not prepared to pay for the bonds out of their own capital, but must arrange for a loan in order to "take them up." Financing the purchase and holding of the bonds dur- ing their sale is one of the most important 106 CORPOKATION FINANCE parts of the whole transaction. It is called "carrying" the bonds. Since many details necessarily come up in the course of the transaction, and because it is important that some one have authority to act in these matters of detail, one mem- ber of the syndicate must occupy the posi- tion of "manager." Because Brown & Com- pany were able to purchase the bonds and brought the other members of the syndicate into the transaction, they would naturally become syndicate manager in the particular transaction we are describing. As syndicate manager they might arrange a loan to carry the entire issue of bonds for the syndicate. The bank advancing the funds would take the bonds as collateral security for the loan. It would not, however, adyapce as a loan the entire amount the syndicate must pay for the bonds. Let us assume that this particu- lar security is of such a character, is assured of a sufficiently good market, and has. such qualities as an investment that a bank would feel justified in lending 85 per cent of the purchase price. Then the bank will loan $4,058,750 on the security of the entire issue as collateral. The syndicate must pay $4,- 750,000, or $716,250 more than the bank will loan, in order to take delivery of the bonds from the corporatioii when the time SYNDICATES 107 comes. This $716,250 the syndicate must supply from its own capital in order to swing the transaction. Let us assume that the syi^dicate manager has undertaken to procure a loan or loans on the entire amount of bonds and that 3rown is the particular individual of Brown & Company who is handling the matter. He will call on each of the other members of the syndicate to supply funds in proportion to their participation sufficient to make up the required $716,250. Recapitulating, the several participations stand as follows: — Brown & Company $2,000,000 Jones & Company i 1,600,000 Smith & Company 1,000,000 Robinson & Company •. . . . 500,000 $5,000,000 For these $5,000,000 bonds the syndicate must pay the corporation $4,775,000. Brown & Company, the syndicate managers, are arranging a loan at the bank for 85 per cent of the purchase price, or a total of $4,058,750. This leaves $716,250 to be contributed by the syndicate members in proportion to their participations as follows: — Brown & Company g. $286,500 Jones & Company 214,875 Smith & Company 143,250 Robinson & Company 71,625 $716,250 108 CORPORATION FINANCE When the day comes for taking delivery of the bonds and paying the corporation for them, each of the members of the syndicate pays into the bank which is making the loan its proportional contribution as just stated. According to instructions the corporation will deliver the bonds at the bank, accom- panied with a draft for the $4,775,000 pur- chase price, and the bank will make the pay- ment with the loan of $4,058,750 which it is making to the syndicate, and the $716,250 the syndicate manager has deposited as the contribution of Brown & Company and the other members to make up the balance. This detailed description of the banking transac- tion is not meant to indicate that the busi- ness always follows exactly that form, but simply to state a form that it might follow and make clear the immediate sources of the money paid over to the corporation. By this method it is seen that < the bonds are "car- ried " through a loan op loans arranged by the syndicate manager on behalf of the entire syndicate. Such a method of financing the payment for the bonds is called "undivided carrying." Following another method it might have been the agreement that each member of the syndicate should finance the payment, and take up the bonds, to the amount of its SYNDICATES 109 participation in the account. This method is called "divided carrying." If the account were arranged in this way, then each mem- ber would arrange its own loan at its own bank or banks, and the corporation, under instructions, would deliver to it there bonds to the amount of its participation. If worked out by the "divided carrying" method, the situation would stand this way : — Syndicate member Participation Value at 95.50 Brown & Company $2,000,000 $1,910,000 Jones & Company 1,500,000 1,432,500 Smith & Company 1,000,000 955,000 Robinson & Company 500,000 477,500 $5,000,000 $4,775,000 85% of purchase price of 15% of purchase price advanced 95.60 procured by each by each member from capital member on loan to " take up " the bonds $1,623,500 , ^286,500 1,217,625 214,875 811,750 143,250 405,875 71,625 $4,058,750 $716,250 We will assume now that the method of carrying the bonds has been settled as either "undivided carrying," the syndicate mana- ger arranging the loan to carry the entire issue, or as "divided carrying," by which each member arranges its own loan and carries its own participation. The origin of these terms is obvious enough. We wUl as- 110 CORPORATION FINANCE sume also, as would probably be the case with an issue of this size, that the joint-ac- count syndicate will not seek further coopera- tion, by arranging an "underwriting" syn- dicate, but will proceed to sell the bonds directly to investing financial institutions and to individual investors. The next thing to settle is the selling price. Of course this was determined essentially before the purchase price was decided on. When "Brown & Com- pany agreed to take the bonds at the price of 95.50, they had already come to a conclu- sion as to the price at which the bonds could probably be sold. From the price at which they believed the bonds could be sold they deducted an amount which they considered would pay the expenses of the business, if the bonds sold as readily as it was thought they would, and leave what, all things con- sidered, they would regard us a fair profit. In this way Brown & Company determined the price they were willing to pay for the bonds. If they had done something toward arranging the syndicate, or actually had ar- ranged the syndicate before finally agreeing to purchase the bonds, thg. purchase price was determined in this way on consultation with the other syndicate members. It should be stated before proceeding that special arrangements for carrying the bonds SYNDICATES. Ill might be made other than those described. One member might agree for some special advantage, or because of some special abil- ity, to carry all the bonds and. advance all the capital necessary. Or, if one member did not arrange to carry all the bonds, the sev- eral members might carry them in amounts other than the amounts of their participa- tions. It is safe to say, however, that only a very small minority of joint-accounts ar- range for carrying the bonds in any other way than those described. This seems a proper place to mention the profit or loss in interest. If the syndicate bought the bonds on a 5 per cent basis and is able to borrow at the banks at 4 per cent, obviously the carrying itself does not make an item of expense to the syndicate, but yields a profit to the account. If the bonds are bought on, say, a 4.5 per cent basis, how- ever, and the syndicate must pay the banks 5.5 per cent interest on the loan, again obvi- ously the carrying makes an item of expense to the account. The street picturesquely says of the situation, in which the rate of interest paid is greater than the rate of interest re- ceived, that "the bonds are eating their heads off." We must return now to the question of the selling price. Let us assume that the syndi- 112 CORPORATION FINANCE cate agreed to the purchase price of 95.50 because it believed the bonds could be sold at a price of 98.50, and that the bonds would be easy enough to sell to make the difference of three points cover the expense and give a fair profit. Mention of the selling price raises the whole issue of division of profits arid the bearing of losses. Unless otherwise stipulated the ac- count will be entirely regular; that is, profits will be received and losses borne in propor- tion to the respective participations. This is the ordinary unlimited liability account. More commonly the banking houses call it "undivided liability." The word "unlim- ited" describes the situation more accu- rately. In an unlimited liability account profits are received and losses borne in proportion to the participations, entirely irrespective of the amount of the securities the member of the syndicate may sell. It is the regular understanding in these transactions that each member of the syndi- cate will engage in selling the securities. "When a banking house joins a syndicate the other members assume that it expects to sell an amount of bonds approximately equal to its participation. Unless a "selling commis- sion," which we will discuss a little later, is arranged for, it makes no difference in the SYNDICATES 113 distribution of profits or the bearing of losses whether the house sells bonds* to several times the amount of its participation or does not sell any bonds at all. If a house which has been "taken aboard" does not sell any bonds, or does not sell bonds to an amount some- what approaching its participation, then the house is said to have been "given a ride." A house which fails to do its share of the sell- ing wiU suffer the penalty of being regarded as an undesirable associate in joint-account transactions and, on a frequent repetition of failure, will not again be invited to join. Assume that this particular joint account is successful and results within a reasonable time in a sale of aU the bonds at the agreed price of 98.50. Members of a syndicate nat- urally do not sell the exact amount of their participations in any case. In the particular case we are discussing we will assume the several members sold these amounts: — Brown & Company $2,250,000 Jones & Company 1,000,000 Smith & Company 1,150,000 Robinson & Company , . . . . 600,000 On this transaction in selling $5,000,000 of bonds the total of the difference of three points, between the price at which the bonds were bought and that at which they were sold, amounts to $150,000. 114 CORPORATION FINANCE Of course this is not net profit any more than any difference between a purchase and a selling price. Actual expenses of the syn- dicate itself amount to considerable sums. Such expenses must necessarily vary widely in different joint-account transactions. Any figures given here are not to be taken as typi- cal or even as approximating the figures of any account that ever existed. Like all other figures on the matter, they are presented simply to illustrate the principle and meth- ods of syndicate transactions. Expenses con- nected with delivery of the securities from the issuing corporation to the syndicate and from the syndicate to the purchasers, legal expenses, telegrams and telephone calls, cir- culars and advertising are a few of the many expenses of conducting the account. The sev- eral members of the account themselves bear all the direct cost of the selling, salaries and traveling expenses of salesmen, and their own office overhead charges. We will assume that during the process of sale the interest accruing on the bonds amounted to $2500 more than interest paid out on the loans to carry them. We use the word "accruing" advisedly. No interest may actually have been paid on the bonds between the dates within which they were sold. Since they are sold at 98.50 and interest, SYNDICATES 115 on each sale the amount of interest accrued to the date of sale is added to the sale price. We wUl also assume that all the expenses of the syndicate amount to $27,500. So, add- ing the profit from the interest account and deducting the expenses, the syndicate has left $125,000 as syndicate profits. Although Jones & Company did not sell bonds equal in amount to their participa- tion and the others all sold bonds in amounts more than their participations, the syndi- cate manager will distribute this $125,000 to the several members strictly according to their participation. The participation of — ■ Brown & Company was 4 tenths Jones & Company 3 Smith & Company 2 Robinson & Company 1 10 Since one tenth of the profits is $12,500, it follows that the syndicate manager will dis- tribute to — Brown & Company » $50,000 Jones & Company . 37,500 Smith & Company 25,000 Robinson & Company 12,500 $125,000 Again, we must remind ourselves that though these sums are profits of the syndi- cate, the several members cannot count them 116 CORPORATION FINANCE as net profits. Each member has had to bear selling expenses, including perhaps some ad- vertising, certainly office overhead and the pay and expenses of salesmefli. If, instead of proving a profitable transac- tion, the syndicate should find that it could not sell the bonds at 98.50, but that, on the contrary, financial conditions had become such that it could not sell the bonds for as much as it paid for them, what would hap- pen? We will assume that the syndicate meets such a condition of affairs. If the syn- dicate is not satisfied simply to hold the bonds in expectation of a better market, when it can sell them without a loss, it can choose between lowering the selling price to one at which it can "move" the bonds now or distributing the unsold bonds to the mem- bers and dissolving the syndicate. Ordinarily the members will not want to continue the syndicate to hold the bonds for a better market. The better market is always prob- lematical and may well seem too remote. Some members may want to liquidate the account and take their loss. The syndicate is not so likely to lower the selling price as it is to distribute the bonds. Some members may hold the opinion that the market will improve and feel reluctant to take a loss. Various considerations will determine the SYNDICATES 117 decision. Suppose the syndicate determines to distribute the bonds and dissolve. We will assume that it has sold $2,000,000 of the total issue of $5,000,000. Again, for the pur- pose of this distribution it does not make any difference how many bonds each mem- ber has sold; the unsold bonds will be dis- tributed to the members in proportion to their participations. To show more specifi- cally the working of the transaction, we will state an assumption of the amount of bonds each member has sold, and say that Brown & Company have sold . . . .• $200,000 Jones & Company have sold ,. . . . 300,000 Smith & Company have sold .-. 900,000 Robinson & Company have sold. ., 600,000 $2,000,000 Robinson & Company have sold more than the amount of their participation; Smith & Company, almost the amount; Jones & Com- pany, only one fifth; and Brown & Company, only one tenth of their participations. Of the total issue $3,000,000 of bonds remain unsold. Just as in the casd of the profits these will go to the members in proportion to their participations. Brown & Company will get four tenths; Jones & Company, three tenths; Smith & Company, two tenths. Al- though Robinson & Company have already sold much in excess of their participation. 118 CORPORATION FINANCE they will nevertheless have to "take up" one tenth of the unsold bonds„. So the unsold bonds will be distributed as follows : — Brown & Company must take up $1,200,000 Jones & Company must take up. .... . 900,000 Smith & Company must take up 600,000 Robinson & Company must take up . . 300,000 $3,000,000 With an original participation of only $500,- 000, Robinson & Company have become re- sponsible for a total of $900,000 of bonds. On the $2,000,000 of bonds sold the syndi- cate made three points between the purchase price and the selling price, a total of $60,000. Let us assume a loss on the interest account in carrying and expenses to a total of $30,000. The manager would distribate the $30,000 net syndicate profit in this way: Brown & Company, $12,000; Jones & Company, $9000; Smith & Company, $6000; Robinson & Com- pany, $3000. The joint account is now closed. The several members are carrying on their own account the bonds distributed to them and may dispose of them in such ways and at such prices as they see fits. Instead of having the syndicate distribute the unsold bonds, let us assume that, after holding them for a considerable time, it de- cided to reduce the price to one at which the bonds will "move" in the existing market. SYNDICATES 119 The members of the syndicate decide that the bonds will sell at 94. Op offering them at that price the syndicate succeeds in their disposal. A marked advance in interest rates undoubtedly accompanied sa sharp a decline in the market. We have assumed, too, that the syndicate carried the bonds a consider- able period before it determined on the re- duction in price. So we can fairly assume a loss in the interest account, which we will place at an average of one pjer cent for four months on an average loan of $3,000,000. This would make a loss in interest of $10,000. The syndicate has sold $3,000,000 of bonds at one point and a half below the purchase price, a loss of $45,000. "We will assume that the holding of the bonds for the joint ac- count has increased the total of syndicate expenses to $45,000. So the account has total costs and losses of $100,000 against which it can offset only the =$60,000 advan- tage of selling price over purchase price made on the first $2,000,000 of bonds. Syn- dicate members would have to bear the loss of $40,000 in this way: — Brown & Company would stand a lois of $16,000 Jones & Company would stand a loss of 19,000 Smith & Company would stand a loss of 8,000 Bobinson & Company would stand a loss of . . 4,000 $40,000 120 CORPORATION FINANCE We should keep in mind that the syndi- cate apportions the losses in this way in the face of the fact that Robinson & Company sold more than their total participation at the full advantage of three points above the purchase price. It does not make any differ- ence in the result, either, how many each member sells of the $3,000,000 of bonds which the syndicate sells at the price of 94. Even if the members sell these bonds in amounts as disproportionate to their par- ticipations as the $2,000,000 they sold at 98.50, the losses would be distributed as indi- cated. If it is objected that this is obviously an unfair situation, we may answer that the parties knew the kind of a transaction in which they engaged and its liabihties. A group of people, who probably know each other exceptionally well, are willing to ac- cept the hazards of fortune and take the chances of loss for the sake of the chances of gain in the cooperation. To keep this fact absolutely clear we can hardly too often reiterate that each member of the syndicate must add to his share of the account loss the large direct cost of selling. Sometimes a group of investment bankers wish to cooperate without running the risk of this unlimited liability of the regular joint account, "undivided," as the word is, as to SYNDICATES 121 liability. They may in that case agree to an account limited or " divided "„ as to liability. Such an account would naturally also be divided as to carrying. Each member of the syndicate would take up and carry an amount of the bonds equal to its participation and would proceed to sell the bonds as if on its own account, except that it cannot vary from the syndicate price so Ibng as the ac- count continues. Each member would be responsible for the expenses of the syndicate in proportion to its participation. Other- wise each member, subject to the syndicate price, deals with its share of the bonds as if they were its own, is responsible for selling, and enjoys the profits and suffers the losses of its own participation. At the close of the syndicate each member must take for its own account that part of its participation which it has not succeeded in selling. If the houses of Brown, Jones, Smith, and Robin- son, in the transaction just sketched through, had formed an account divided both as to carrying and as to liability (lirtiited liability), and, instead of the amounts before indicated. Brown & Company had sold $300,000 and Robinson & Company had sold $500,000, the transaction would have worked out as follows: — 122 CORPORATION FINANCE Mernher PaTtid-pation Sold during life of account Mwi itill tell Brown & Company Jones & Company $2,000,000 1,500,000 1,000,000 500,000 $300,000 300,000 900,000 500,000 $1,700,000 1,200,000 100,000 000.000 Robinson & Company $5,000,000 $2,000,000 $3,000,000 Obviously this makes a very different show- ing from the regular unlimited liability trans- action. Occasionally some variations are made in the general form of the joint-account trans- action as described here. People entering into a syndicate sometimes make stipula- tions which modify the full unlimited lia- bility without narrowing the account to the strictly limited liability form. Such syndi- cates present possibilities of modification far beyond anything yet attempted in prac- tice. If such modifications are desirable we may well leave them to recommend them- selves. Before going on to a brief description of the management of an acciDunt, we should mention one way in which joint-account syndicates commonly modify the effects of inequalities in selling. As we have seen, some members may sell bonds to an amount out of proportion to their participation. SYNDICATES 123 Selling commissions afford some mitigation of these inequalities. If the account agree- ment provides for a commission, as it ordi- narily does, then the members actually sell- ing bonds get the stipulated commission on the sales to augment their profits or lessen their losses. Suppose a half a point selling commission had been allowed in the trans- action in which Brown & Company sold $200,000, Jones & Company, $300,000, Smith & Company, $900,000, and Robinson & Company, $600,000 at the price of 98.50 and all the rest of the bonds had been dis- tributed. Then the $30,000 6f net syndicate profits on the sale of the $2,000,000 at 98.50 would have been cut down Isy the half a pomt on the $2,000,000, or by $10,000. The result would change in this way: — Jlf«n!>er What each re- ceives as •pfo-poT' tionate distri- bution of profits of teO,000 when halfver cent selling commis- sion allowed Selling commis- sion on bonds act- ually sold Profits plus com- mission (.tm.OOO) What was re- ceived when no commie- sion allowed and dis- tributed BrowD & Company Jones & Company Smith & Company Bobinson & Company . . $8,000 6,000 4,000 «,000 $1,000 1,500 4,500 3,000 $9,000 7,500 8,500 5,000 $12,000 8,000 6,000 8,000 $20,000 $10,000 $30,000 $30,000 Such a statement sufficiently shows that the allowance of a selling commission may con- 124 CORPORATION FINANCE siderably change the results in favor of the member which performs a disproportionate share of the work. Many brokers and other dealers in securi- ties may desire to sell some of the bonds of this issue. Regular clients :of such brokers and dealers may wish to buy some of the bonds of the issue, but naturally prefer to purchase through their customary channel. To get the benefit of such possible extension of the market the syndicate may allow a broker's commission. If the syndicate allows its mem- bers a selling commission, as just described, presumably the member which makes a sale through a broker entitled to a commission will have to pay the broker's commission. Since the selling member's commission we have assumed is one-half a point, — that is, one-half per cent on the par of the securi- ties, — the broker's commission would be one eighth or a quarter, — that is, that frac- tion of one per cent on the par of the securi- ties. Both the size of the member's commis- sion and of the broker's commission would ordinarily have some relation to the differ- ence between the price the syndicate paid for the securities and the price at which it is selling them. The syndicate established that difference between the purchase and the selling price on its estimate pf probable diffi- SYNDICATES 125 culty in selling the securities- Of course, by this we mean the difference originally estab- lished. If a change in the market forces a lowering of the price, or perniits an advance, that is quite another matter. A member must not share its selling commission, ex- cept with a broker in accordance with the syndicate agreement, and a broker must not share his commission with any one. Fairness to all, both that the members may have an equal chance to sell and that purchasers may all receive the same treatment, demands a single price to all. A member or a broker discovered in "splitting commissions" would suffer an injury in reputation that would tend to make it difficult to participate in further business of this kind. So far we have not considered the internal management of the account, but have stated simply its general form, liabilities, and inci- dents. In the details of its management a joint account presents a somtewhat intricate situation. Here are several independent sell- ing organizations selling the same issue. All the bonds are deposited as collateral for a loan or several loans. To make delivery of any of the bonds to a purchaser on a sale, they must be released as collateral. The possi- bility of overselling the issue, that is "sell- ing short" of the bonds, must be guarded 126 CORPORATION FINANCE against. Such matters all require careful attention. The syndicate manager takes charge of all these details of the account, keeps the syndicate books, and generally performs the service of a clearing house for joint-account affairs. The largest amount of detail work comes in arranging for the delivery of the bonds. Members must promptly report to the manager all sales of the securities. Quick- ness in reporting sales is essential in the busi- ness of selling securities. Consider the situation first in the case of undivided carrying, in which the manager has arranged the loan or loans to carry the entire issue. This offers the simplest state of affairs. Brown & Company are the man- agers. A salesman of Robinson & Company telegraphs to the office of his house that he has sold ten of the bonds. On receiving the telegram Robinson & Company immediately telephone to Brown & Company the fact that they have sold ten bonds. In the course of the day Robinson & Company have occa- sion, in a similar way, to telephone to the syndicate manager the successive further sales of three, two, and five bonds. Robin- son & Company want these bonds the next day to deliver. But the bank which has loaned the syndicate the fun^ds to carry the SYNDICATES 1£7 bonds has possession of all of them as secu- rity for its loan. It will not give up any of the bonds unless the syndicate reduces pro- portionately the amount of money it has borrowed. We have assumed that the bank loaned 85 per cent of the purchase price. Since the bonds cost the syndicate $955 per bond, the loan was at the rate of $811.75 for each bond. The manager must pay off this amount for each of the bonds it asks the bank to release. Since Robinson & Com- pany want twenty bonds to deliver the next day they must supply the manager with suf- ficient funds to pay for each bond. The amount Robinson and Company actually turn over may be anything between this and the full $985 which they will receive from their clients when they deliver the bonds. Robinson & Company had already paid out of their own capital 15 per cent of the pur- chase price, to make up thfe difference be- tween the $811.75 that the bank loaned and the $955 that the syndicate paid, or $143.25 for each bond on the amount of their partici- pation. By one arrangement, perhaps one of the simplest, Robinson and Company, for each bond they want to deliver, pay over to the syndicate manager $841.75, which is the sum of $985 Robinson & Company will re- ceive from their client less the $143.25 they 128 CORPORATION FINANCE have already paid. Obviously this would leave all the gross profits — that is, the dif- ference between the purchase and selling prices — in the hands of the syndicate man- ager for him to distribute at the close of the transaction. It would also return to the member capital it has tied up in the transac- tion from time to time as the member sells bonds. If the transaction should prove to be a very quick one, the bonds all sold, and the syndicate dissolved in the course of a week or ten days, this releasing of capital would not be important; but if the syndicate should continue for a number of months it would be a matter of consequence. On the other hand, if Robinson & Company should sell more than the amount of their participa- tion, they would, for each bond of this excess amount, have left in their hands $143.25 of syndicate capital which they would have to account for to the syndicate manager. If the syndicate agreement were that each member must pay to the syndicate manager the full selling price in order to get delivery of bonds, then the manager would have ac- cumulating, for the member's account, this $143.25 for each bond sold. Of course the manager may distribute this fund of unneces- sary syndicate capital back to the members, from time to time as it accumulated. As SYNDICATES 129 will be indicated later, several other plans are possible. Though the term is not com- monly used, the amount the members pay the manager in order to get bonds for delivery is sometimes called the "take-down price." Often it is stated simply that the member "pays" the manager for the bonds. We have assumed the situation of an ac- count undivided as to carrying, in which all the bonds are carried by a loan arranged by the manager. If the syndicate has divided the bonds for carrying purposes and each member has arranged the loan for the amount of its own participation, deliveries to pur- chasers would be made only through notifi- cation to and instruction from the mana- ger. In this way the manager keeps entire control of the account and can adjust the amount of bonds each member is carrying in proportion to that member's participa- tion. Members must report all sales to the manager promptly, as in the case of the un- divided carrying account. The manager will either direct the member to make delivery from bonds the member is carrying or will procure bonds from some other member for the member who has made ihe sale. If the member makes delivery from the bonds it is carrying, it will be accountable to the syndi- cate manager for the difference between the ISO CORPORATION FIllrANCE purchase price, which the member has already paid, and the price at which the bonds are sold. If the manager wishes to supply the member which has made the sale with bonds for delivery from those which some other member is carrying, then the manager will call on the selling member to pay just the same as in the case of the undivided carrying account, and, of the money so paid in by the selling member, the manager will pay over to the carrying member, from which the manager wants to take the bonds, a sum equal to the purchase price of the bonds, which is the amount the carrying member had borrowed and advanced to carry them. The carrying member then has the funds to pay off the pro rata of its loan and is reimbursed for the pro rata of the capital advanced for the syndicate operation. To recapitulate, let us take the case of the first account presented. We assumed that the syndicate sold all the bonds at the full price of 98.50 and that the syndicate expense totaled $27,500, of which profit on the inter- est account reimbursed $2500. Assume that this account was undivided as to carrying and that the members were to pay the man- ager the full selling price when calling for bonds to deliver. Then, taking a single bond as the unit transaction, we get these results: SYNDICATES 131 Selling price which members paid to manager when they took bonds for delivery $985.00 Manager used to pay off pro rata of loan at bank in order to release bonds from col- lateral 811.75 Manager pays back to mem- bers their contribution to the syndicate capital 143.25 Manager uses to pay syndicate expenses, which totaled $27,- SCO, less $2500 made on in- terest account, or $25,000, i.e., for each of the 5 000 bonds of the issue 5.00 Seller's commission 5.00 Syndicate profits distributed to members in proportion to their participations 20.00 $985.00 All the conditions governing the conduct of the account are not necessarily determined at the time the syndicate is formed. Ordi- narily only absolutely necessary matters are stipulated at the time the members agree to join. After the formation of the syndicate the members hold a meeting to settle such further things as need to be determined. Even so important a consideration as the exact selling price may be left to this meeting. The several banking houses' joining in the account will not sign a formal legal document drawn up by their lawyer's. They will simply confirm by an exchange of letters the 132 CORPORATION FINANCE understanding arrived at in the formation of the account and in the sub^^equent meeting. Our discussion of the account has shown in a general way the powers and duties of the manager. We assumed, what would ordina- rily be the case, that the member who had control of the issue, or who was most influ- ential in forming the syndicate, became manager. Such an account as we have dis- cussed has really the characteristics of a partnership and the manager would in no sense be a dictator. Each member would have an opportunity to exert an influence in determining the conduct of account affairs. Naturally the manager would keep the books of the account and attend to the distribution of profiits or apportionment of losses. Showing the informal manner of the or- ganization of such a syndicate as we have described these letters might be the only evi- dence in writing of its terms: — July 8th, 1916. Messes. Jones & Company, Dear Sirs : — We are writing to confirm our conversa- tion of this morning to the eff.ect that you will join Smith & Company, Robinson & Company, and ourselves in a joint account for the purchase and sale of $5,000,000, Central & Western R.R. Co. 5%, 20 year bonds due August 1st, 1936, for SYNDICATES 183 which a price of 95.50 and interest will be paid to the corporation, New York delivery and payment. You are taking a participation of $1,500,000 in the account. We are to be manager of the account. The account will be divided c^rying, unlimited liability. The rules for the conduct of the account will be agreed on at a meeting of the syndicate members to be held as soon as possible. Will you please let us know if your understand- ing of our agreement is in accord with this letter? Very truly yours, BBOwfcr & Company. July 9th, 1916. Messrs. Brown & Company, Dear Sirs: — Your letter of the 8th inst., referring to the joint account for the purchase of Central & Western R.R. Co. bonds, correctly states our imderstanding. Very truly yours, Jones & Company. July 10th, 1916. Messrs. Jones & Company, Dear Sirs: — We are writing to confirm the under- standing for rules of the account, entered into at a meeting held at our office this morning of the jnembers of our joint account in* Central & West- ern R.R. Co. bonds. We determined that the selling price should be 98.50 and interest. A member shall have a 134 CORPOEATION FINANCE selling commission of a half &nd may allow a broker's commission of a quarter. Expenses of a member for purposes of the account shall be de- ducted from the amount allowed him as commis- sions. Delivery shall be only on the manager's order and on receipt by him of the selling price and interest without allowance for commissions. Members may offer and sell the bonds without restriction as to territory. All advertising shall be done and circulars prepared and printed by the manager at the expense of the account in the name of Brown & Company, Jones & Company, Smith & Company, and Robinson & Company, in the order stated. Unless earlier terminated by agreement the account shall continue until all the bonds are sold. Will you please confirm this understanding of the rules of the account? Very truly yours, Beown & Company. July 11th, 1916. Messrs. Brown & Company, Dear Sirs : — Your letter of the 10th inst., referring to the rules of the joint account for the purchase of Central & Western R.R. Co. bonds, correctly states our understanding. Very truly yours, Jones & Company. Since these syndicate transactions are regularly entered into and carried out in good faith, and the parties are thoroughly SYNDICATES 135 familiar with them, serious difficulties seldom arise. The agreements, however, might well be more fully expressed. Notice that these letters say that the mem- bers may offer and sell the bonds without restriction as to territory. If banking houses located in different cities compose the syndi- cate, the agreement sometimes restricts the sellrug of each member to that member's special territory. Assuming that Brown & Company have their principal office in New York City, Jones & Company in Boston, Smith & Company in Philadelphia, and Rob- inson & Company in Chicago, then Jones & Company might have all of New England reserved for them. Brown & Company have the City and State of New York and northern New Jersey; Smith & Company, the State of Pennsylvania and southern New Jersey; Robinson & Company, Ohio, Illinois, Michi- gan, and Wisconsin. Any member would be free to sell in the unrestricted territory. Un- der such an arrangement the syndicate might agree that each member should do its own advertising and in its own name only. Gen- erally syndicates do not restrict their mem- bers territorially. The larger houses have offices in several cities and find their clientele over a rather large area. If their territory were restricted they would not be able to 136 CORPORATION FINANCE exert their full selling power". Besides, it is rather problematical how many more bonds a house would sell by reason of having reserved territory. Unless otherwise expressly stipulated the syndicate comes to an end when its purpose is accomplished by the sale of all the securi- ties. By mutual agreement the account may be closed at any time, and the agreement forming the account ought to stipulate that the vote of a majority, or a majority in inter- est, should govern for this as well as for other questions that may arise. Recapitulating the considerations entering into the formation and carrying out of a joint-account transaction, wfe may consider it then as represented by the agreement form- ing the account and the supplementary agree- ment providing for what we may call the rules of the account, and summarize them by an outline of the matters that need be taken care of. Agreement forming the Account should provide jar these Matters: — 1. Name. The name or names in which the purchase is made and the order in which they are to appear. 2. Purchase price. 3. Carrying. Divided, undivided, or special. SYNDICATES 1S7 4. Liability, Unlimited, limited, or liiAited but unlim- ited as to selling; and option to limit and proportional lessening. All other matters of the account are to be provided for in rules of the account expressed in a supplementary agreement. Rules of the Account should provide for: — 1. Selling price. 2. Broker's commission. 3. Member's selling commission. Shall there be any at all? If a commission, shall it begin at once? Or only after the member has sold his proportion? 4. Duration of account. To continue until securities are sold, un- less sooner terminated by agreement of members. To continue for a definite period and to be terminated at the end of that period, unless members agree to extend. 5. Take-down price. Selling price. Or selling price less member's commission. Purchase price less any j)ro rata already paid by members. Selling price less any pro rata already paid by members. Selling price less commission and any pro rata already paid by members. 138 CORPORATION FINANCE 6. Delivery. Only on manager's ordei*. Without manager's order. 7. Territory. Unrestricted. Restricted. 8. Advertising. By manager in name of all at expense of account. Or by each in the name of all and at his individual expense. Or by each in his own name and at his own expense. Since a joint account is one of the common- est transactions with our bond houses, it speaks well for the general good faith and mutual understanding with which these un- dertakings are carried out that the cases which express the law applicable to them do not arise out of the joint accounts of the bond houses. Such cases have their origin in almost any other form of endeavor carried on by joint effort. In its legal aspects the joint account comes under the special classifica- tion of "Joint Adventure." So far as it is discussed in general treatises* on the law it is dealt with in works on "Partnership." Even the most extensive of these works, however, hardly more than mentions it. A joint adventure, or "jojnt account," as the bond houses call their particular form of SYNDICATES 139 joint adventure, may, indeed, properly be considered as a special form of partnership, and the legal considerations gbverning it may be considered as differing from those of the general law of partnership only as the special nature of joint adventure requires them to differ. Frequently the cases point out, by way of stating a general principle to cover some special point in issue, that, though a joint adventure is not in a strict legal sense a co- partnership, the rules of law applicable to the partnership relation govern the rights and duties of those jointly engaged. Ordinarily, in the cases of joint adventure the rules of a general partnership apply to the questions involved, and the court prop- erly limits itself to the remark that, though a joint adventure is not fully a copartnership, the law of partnership applies. The court has no occasion to discriminate more precisely. However, some of the distinctions are in- teresting and important. Since the general treatises afford little help to a clear under- standing of the law of joint adventure as ap- plied to the joint account, it may be helpful to present a brief discussion of some of the legal issues involved in the entering into, and conduct of, a joint-account transaction. Though in applying the analogy of the 140 CORPORATION FINANCE law of partnership to joint adventurers the courts are careful not to say that a joint ad- venture is a partnership, nievertheless, the seeker finds upon a search through the cases that the precise differences from a partnership are somewhat elusive. The essential partnership nature of joint adventure is dwelt upon because of its bear- ing on the matter of liability. Members of a joint account have, as to third parties, — that is, as to those with whom the account deals, — the general liability of partners. A stipulation in the agreement for the account that they are not acting as partners has sim- ply the effect of calling attention to the fact that the transaction is a joint account, with whatever limitations on the general law of partnership such fact may imply. The most important difference in the legal aspects of a joint adventure and a partner- ship seems to lie in a limitation, in the case of the joint adventure, of the doctrine of agency as applied to partnership. Speaking broadly, a person dealing with any member of a part- nership may consider that member the agent of the partnership for all purposes of the part- nership business. Any partner can bind his copartners in any transaction within the scope of the partnership. Obviously the scope of a joint account is limited to lie specific pur- SYNDICATES 141 poses of the account. Apparently any one dealing with the syndicate — that is to say, with a party to the joint account purporting to act on behalf of the joint-account syndi- cate — is bound to know the specific purposes of the syndicate transaction and cannot hold the syndicate liable on an undertaking out- side the scope of those specific purposes. This doctrine is carried far enough to involve, per- haps, a real distinction between a joint ad- venture and an ordinary partnership formed to carry on a business of a specific and limited kind. Suppose our corporation, instead of having $5,000,000 of bonds to sell, must, in order to meet its capital requirements, dispose of $25,000,000. Our syndicate o| Brown & Com- pany, Smith & Company, Jones & Company, and Robinson & Company may be in a posi- tion successfully to negotiate the purchase of the issue, but may not want to undertake to sell so large an amount. Distributing such an issue, to its ultimate lodgment in the hands of permanent investors, involves a really tre- mendous effort. Because one can say "a mil- lion dollars" as readily as saying "a hundred dollars," any sense of the real magnitude of the sum involved in the larger figure easily eludes one. If the permanent investors should each take $5000 of the bonds, on the average. 142 CORPORATION FIJJANCE the bankers would have to find 5000 investors who may be induced to prefer this particular investment rather than one of a hundred of others equally available at the same time. The number of people who are in a position to invest $5000 at one time is very limited. So, though a few financial institutions may buy the bonds in larger blocks, probably the $5000 average is too high rather than too low. Our syndicate, however, does not want to lose the opportunity to do business. In or- der to undertake this particular piece of busi- ness it must secure cooperation on a much larger scale than is afforded by these four houses working together. They must get the full advantage of the clienteles of numerous houses. In order to get this larger cooperation more houses must be taken into the syndicate. But Brown & Company and their associates feel that they can get some return and are en- titled to it for their business advantage in being in a position to buy the bonds and for their work in organizing a syndicate of the size necessary to handle so large a transaction. So they first decide to form a syndicate com- posed of the four houses in order to purchase the bonds from the corporation and to sell them to another syndicate which they will organize. Of course, too, if they actually SYNDICATES 143 effect the purchase before they complete the organization of the second syndicate, they are assuming a risk for which they are entitled to compensation. To distinguish the general nature of the two syndicates, we call the first a "joint account" and will call this second syndicate an "underwriting syndicate." It would be in the interests of clear expression not to use the term "syndicate" in connection with joint accounts, but to confine its use to the underwriting. As a matter of fact, on the street these terms are used interchangeably, with a tendency, however, to make the dis- crimination we have indicated between the terms "joint account" and "underwriting." On this matter of nomenclature I have re- marked elsewhere: ^ The term "joint account" implies, in securities transactions, an undertaking entered into by the parties for the purchase and sale of securities, in which the rights and liabilities of all the parties are essentially the same in proportion to their inter- est. This is in distinction from an "underwriting syndicate" in which the parties are not on the same basis, or rather, in which, strictly speaking, there are two accounts. It seems desirable to reserve the terms "syndicate" and "underwriting ' Report by the writer to the Investment Bankers' As- sociation of America on " Joint Account Letters and Forms, and Some Considerations of the Law ol Joint Account." 144 CORPORATION FINANCE agreement" for this form of undertaking and use only the words "account" or "joint account" for undertakings of the kind discussed here. It seems also desirable to keep the terms "sub- scribers," "subscriptions," and "underwriting" for the syndicate agreement and use the terms "members" and "participations" for the joint account. We will assume that the original syndicate bought the bonds for 95.50 as before, and we will also assume that it sells them to this second syndicate at an advance of one point, or at 96.50. Again warning should be given that any figures stated in the discussion must not be taken as typical. In practice the fig- ures vary widely and in the discussion specific figures are stated merely for the sake of clear- ness. In organizing the second syndicate the members of the original group, in becoming members of the second, must clearly state that they are making this profit. Since the relationship of parties to a joint adventure is of a fiduciary nature, they must exercise the utmost good faith toward each other. One may not make a secret profit. So the state- ment of the profit of the original account regularly appears in the underwriting syn- dicate agreement. Members of the original account could not well avoid, if they would, making substantial subscriptions to the un- SYNDICATES 145 derwriting. They must do this to show their belief in their own undertaking. Though they might have the fullest confidence that the undertaking by the second syndicate would result in all the anticipated profits, they might, for perfectly good and proper reasons, prefer to stay out of the underwriting. They might be able to employ their capital in some matter that promised better returns than those to be anticipated from the most suc- cessful result of the underwriting. Naturally, however, the people who are invited to sub- scribe would be suspicious of =the proposal if the people who are extending the invitation failed to be among those subscribing. Although joint-account agreements are ordinarily informal, — just an exchange of letters, as already indicated, — underwriting agreements, on the other hand, are ordinarily formal. The number of subscribers makes the full formal statement more important for the avoidance of misunderstandings. Generally the houses organizing the underwriting syndi- cate hand, or mail, to those whom they are inviting in, a copy of the subscription agree- ment, and each subscriber signs a separate copy. It will not do, in discussing syndicates, or indeed almost any other topic in the sub- ject of "Corporation Finance," to speak in general terms without some express reserva- 146 CORPORATION FINANCE tion. Sometimes underwritings of very large amounts, involving a considerable number of subscribers, are the most informal. When it becomes known that a syndicate is about to purchase a large issue of securities, repre- sentatives of other houses, which enjoy busi- ness relations with one or nlore of the pur- chasing houses, are likely to telephone and ask that they be put down for a certain amount. This subscription will generally be acknowledged by mail, but the letter will not state any of the terms of the agreement other than naming the subscription price. If the subscriptions received total more than the amount of the whole issue, some or all of the subscribers will be scaled down in the "allotment." By "allotment" is meant the formal acceptance of the subscription. The subscription blanks which have been sent out contain a stipulation reserving the right to reject all or any part of the subscription. In legal terms sending out the application blanks is a mere bid for an offer; signing and sending them in constitutes the offer. Since the offer is for all or any part of the amount applied for, the allotment of less than the full amount constitutes an acceptance in accordance with the terms of the offer and completes the con- tract. In forming the underwriting syndicate the SYNDICATES 147 members of the original syndicate become managers of the second syndicate. Or it may be that only one of the members of the joint account, or first syndicate, becomes manager of the underwriting syndicate. The manager of the underwriting syndicate has much more power than the manager of the joint account. For one reason this is necessary because of the larger numbers of the second group. An expression of opinion cannot be had so read- ily from so many people. The second syndi- cate may have up to say two hundred sub- scribers. Since the size of the .issue makes the whole situation more difficult -to handle, some central authority must have the power to act quickly. The group that formed the joint account presumably comprises houses with more capital and wider reach. They are more powerful houses and are in a position to im- pose terms. The power of the manager or managers of an underwriting syndicate often extends to making or changing the selling price, and in a general way the manager or managing group directs the policy of the busmess as well as takes care of the details. As one of the cares of the position the manager will have the duty of protecting the market. Until the syndi- cate has disposed of the entire issue, it is of course essential that no bonds should be 148 CORPORATION FINANCE offered for sale at less than the price at which the syndicate offers them. If sales in the general market are reported at a lower price the syndicate naturally cannot command the price it has set. Since the syndicate sold in the first place at its price all the bonds that have been sold, one might well inquire who has any bonds of the issue to sell at a lower price. People often purchase bonds on a new offering in the belief that the particular bond at the price, with the particular issuing houses back of it, under the existing general conditions of the market, will be in such demand that the issue will all be purchased at once and the price in the general market will go up. When such people have purchased and have seen that the securities were not all sold at once on issuance, they know that their speculative hopes will not be realized promptly. Since they bought as a speculation and cannot make the immediate profit, they prefer to sell at once at such loss as may be necessary rather than keep their capital- tied up and run the risk of further loss. So they promptly turn around and offer their bonds on the market. Such a throwing of securities back on the market makes one of the dangers of the syndicate transaction. Avoiding such a situation so far as possible, and taking care SYNDICATES 149 of it when it does arise, comprises a large part of the strategy of any undertaking to market an issue of securities. When securities are offered at less than the syndicate price, the only thing the managers can do to protect the market is to buy in such securities. The man- agers will usually try to trace the source of the selling and generally will succeed in the endeavor. They will make a mental note of who the seller is and when he wishes to pur- chase securities of some future issue which is oversubscribed the managers will not favor him in allotting the bonds. Some one may wonder how the managers can find out who the seller is. Ordinarily such a seller would place his securities in the hands of a broker to sell and the broker would not disclose^ "give up," as the phrase is — the name of his principal. But every bond has printed on it the particular number it bears in the issue. When the managers delivered the bonds to the selling house they noted in their books the numbers of the bonds deliv- ered. In turn the selling house noted the numbers of the bonds it delivered to each purchaser. So when the managers buy in some bonds to protect the market they can look for the numbers and always trace the transaction through to the first purchaser. If the first purchaser is a broker, who has just 150 CORPORATION FINANCE passed the bonds on to his principal and taken the broker's commission to which he is en- titled, he may, and probably will, refuse to name the principal. The broker has run into trouble through his dealings with his prin- cipal and next time may be a little more cau- tious in dealing with him. Besides the check the managers have through the numbers on the bonds, they may trace the source of the selling through many indications readily apparent to a man skilled in the practices of the street. Some recent syndicate agreements have sought to guard against speculative purchases by providing that the selling house shall be responsible for the character of its sales. Under such an agreement, if a house has made a sale to a man who turns out to be a specu- lator who throws his securities back on the market, the syndicate manager has the au- thority to buy the bonds in at the price at which they are offered, turn them back to the selling house, and charge up against the sell- ing house, as a loss to be borne by it, the dif- ference between the price at which the man- agers bought the bonds in and the full price at which the syndicate holdg them for sale. The possibility of having to bear the full bur- den of such a loss would tend to make a member house very careful to get the bonds it SYNDICATES 151 sells into the hands of purchasers who are buy- ing for investment. At the time of writing one cannot foresee whether this experiment will succeed and the provision be increasingly- used, or whether the difficulties of the situa- tion are such that a provision of this kind will come to be regarded as undesirable. Very large investors in securities may be- come members of joint accounts or subscribe to underwritings in order to get the advan- tage of the lower price in their purchases of securities. It is understood that these par- ticipations are for investment. When the syndicate takes delivery of the securities from the issuing corporation, such partici- pants pay for and take up the;amount of their participation. Such a transaction is called a "withdrawn participation." Whatever the arrangement as to other participants, as to an individual or institution taking a with- drawn participation, the transaction would be a strictly divided or limited liability ac- count. The other members of the syndicate get the advantage of having that amount of the securities taken absolutely out of the market. Owing to certain abuses, which it was believed had crept into the practices of insurance companies in taking advantage of such participations, the State of New York made it illegal for them to engage in syndi- cate transactions. 152 CORPORATION FINANCE We have discussed the formation of the underwriting syndicate as if there were al- ways two syndicates whenever an interme- diary makes, or attempts to make, a profit between the price received by the corporation and the price paid by the underwriters. Heally, one of the several largest of the invest- ment banking houses — the- few investment bankers sometimes called the wholesaling houses - — often occupies the position we have described as taken by the first syndi- cate in the underwriting transaction. These wholesaling houses occupy their position by reason of their capital, their credit resources, and the influential positions they occupy both with the large issuing corporations and with the dealers in securities, who are in direct touch with nearly all the frequent buyers of securities for investment ia the country. They also have foreign connections in one or more of the European financial centers, — ■ London, Berlin, Frankfort, Amsterdam, Paris, — and have been able to take some, or all, of an issue out of this market entirely. Usually, on the sale of the securities held by an underwriting, the syndicate advertises them for sale in several cities- simultaneously. Often these advertisements sg,y that on such a day up to such an hour, or up to such an hour of such a day, subscriptions will be SYNDICATES 153 received for the purchase of securities of the issue. Either phrase means that subscrip- tions will be received immediately and re- corded. If, by the stated hour, the applica- tions are greater than the amount, the issue is oversubscribed. The syndicate managers then proceed to allot the securities. Just as in the case of the allotment to the subscribers to the underwriting syndicate, the managers may not allot, in exact proportion to the subscriptions, to those who have applied to purchase the securities. The managers will especially favor the smaller subscribers. The presumption is greater that they are purchas- ing for permanent investment rather than for speculation. Usually they make the best possible purchasers of securities from the distributor's standpoint, because they buy to keep. The securities are lodged away and only infrequently will come out on the market to add to the floating supply and to tend to keep the price down. The distributors must keep the general market price up to the price they are asking while they are distributing the securities. They earnestly want the price to stay up and, better, to advance after they have sold the entire issue and have nothing further to gain or lose directly. But these investment bankers want to bring out an issue of securities another day, and nothing 154 CORPORATION FINANCE is a better silent selling argument than the fact that the clients to whom they are ap- pealing made money from an earlier purchase. So, in making the allotments of an over- subscribed issue, the managers favor those whose purchases will make for the best future for the issue. Sometimes when the market is strong and a new issue catches the attention of the in- come-buying public as a particularly attrac- tive investment, many people will surmise that the issue will be largely oversubscribed, with a consequent scaling down in the allot- ments; and in order to get as large an amount as they really want, they will subscribe for a much larger amount of the security than they want, in order to get, if possible, approxi- mately the amount they actually do want. Such applications, representing an anticipa- tion of scaled allotments, account for most of the very large oversubscriptions on the pub- lic offering of securities. If the syndicate fails on the public offering to sell all the bonds, the business takes the usual course already described. Some time necessarily intervenes between the agreement to pur- chase, when the price is agreed to on existing market conditions, and the offering of the bonds to the public. Even if the purchasing bankers correctly estimated* market condi- SYNDICATES 155 tions at the time of the purchase, conditions sometimes change rapidly, and on the offering the pubhc may take only a stnall percentage of the issue. An attempt to sell the bonds at the syndicate price may result unsuccessfully, and the subscribers to the underwriting may have to take up nearly all the bonds and ultimately sell them at heavy losses. Sometimes the issuing corporation appears as offering the securities on the public sale, or perhaps the syndicate managers on behalf of the corporation. In such a case the sub- scribers to the underwriting, instead of being in the position of owners of the issue, and sell- ing it on their own account, are in the position of guarantors who are insuring the success of the sale. If the public does not buy aU the bonds the subscribers to the underwriting must take up the unsold balance as pur- chasers. The term "underwriting" accords more strictly, perhaps, with the position of a guarantor syndicate insuring the success of the sale. The street usgs it, however, without any discrimination between the two methods of handling the transaction. Both methods come to the same results. Our discussion of syndicate transactions has assumed some specific figures for the sake of clearness. One must not suppose, however, that amounts alone govern the adoption of 156 CORPORATION FINANCE the method of handling the "transaction and determine whether only one* banking house shall be concerned, or more than one, or whether there shall be one or two syndicates between the corporation and the investor. The size of the issue in relation to the capital, selling power, and other compaitments of the banking house or houses does determine. An amount of $100,000 of securities or less might well aflford the basis of a joint-account transaction. With only a little more than that amount an underwriting syndicate might take the securities over from an original joint account. Sometimes a banking house which has subscribed to an underwriting may pro- ceed to form a joint account of its own to handle its allotment of the issue. Any dis- cussion can give only a general idea of these joint undertakings for the sale of securities. They shade into each other in a way that eludes precise description. Their purpose, the one thing common to all, is to join finan- cial resources and selling power suflBcient to provide the amounts of capital required from time to time by the magnitude of economic enterprises. CHAPTER IV LISTING ON THE STOCK EXCHANGE If a corporation should list an issue of its securities on the Stock Exchange, it would not, merely by so doing, provide any funds for itself. So far as listing alone is concerned the corporation by the mere authorization of the securities has accomplished as much toward procuring capital. Listing securities does not sell them; it only provides one means for making a market in them; that is, afford- ing an opportunity for holders to sell them after they have been sold in the first instance. We have already discussed the importance of having a market in an issue of securities. An active course of Stock Exchange dealings affords a quick and close, a free and open market, practically the best market possible. For reasons stated in the first Volume (p. 205) the New York Stock Exchange offers little advantage for creating a market in small issues, and purchasers of securities of small issues do not expect to have them listed there. Investors do expect to see large issues listed on the Exchange, and with the largest issues expect an active course of dealings there. So, when bankers are offering a large issue for 158 corporatio'n finance sale, they announce that application has been made to list the issue on the New York Stock Exchange. They have not already listed it at the time of offering the security for sale for one or both of two reasons. The undesirableness of hav- ing the security listed during the time the bankers are engaged in selling it has already been indicated. Such a listing offers a com- petitor a special advantage in trading pur- chasers out of the security, and a special opportunity for the speculative purchaser to close out his speculation. If the issue is on the Stock Exchange list while the banker still has part of the issue to sell, its appearance there will greatly increase the difficulty of protecting the market. At the same time it is possible for the bankers, especially with a somewhat speculative issue, by developing a course of trading, to .utilize the Stock Ex- change in disposing of securities. By buying in enough to protect the market, and by taking advantage of the buying of others at or above the price at which the bankers are willing to sell, they may dispose of a large part of an issue by means of the Stock Ex- change market. Besides the difficulty of protecting the market as a cause for delay in listing, the bankers and their counsel may not have had LISTING ON THE EXCHANGE 159 an opportunity to bring the matter before the Stock Exchange authorities \n time to have the issue hsted before offering it for sale. As we shall see before the discussion is ended, the preparation of an application for listing re- quires a large amount of work in itself. All the other work of preparing the issue, getting the proper resolutions of the corporation, drawing up the trust deed, may have kept counsel under such pressure that they could not attend to any further matters. The bur- den of meeting the listing requirements is likely to fall on them. The Stock Exchange authorities require that applicants for listing submit specimens of all securities to be listed. It takes some time for the engraving concern doing the mechanical work of preparing and printing the issue to present a specimen for the Exchange authorities to examine. This would be true even for an interim certificate, or subscription receipt as the Stock Exchange Committee terms it, representing the defin- itive security while it is in course of prepara- tion. Bankers frequently utilize such interim certificates, it may be remarked, to make de- livery when they oflfer the issue for sale. Often the definitive certificate of stock, but more especially the definitive bond, — that is to say, the final piece of paper to represent the security, — cannot be pi^epared in time 160 CORPORATION FINANCE for the bringing out of the issue. Time is of the essence when the bankers are bringing out a new issue. Financial conditions often change rapidly. Capitalists may be in an in- vesting mood for the present but in the im- mediate future may refuse to purchase any- thing. The bankers must take no chances of losing their market. This fact explains the interim certificate, and would be sufficient often, if there were no other reason, to ex- plain the failure to have the issue listed by the time it is brought out. Once the issue is sold and the listing is com- plete, the bankers will have to watch the market until they are sure that the course of dealings is well established. During the process of sale they will have done everything possible to build up a market as described in the preceding discussion of raising funds through the banking houses. Building a market, in the sense of establishing a course of trading, is much like building an arch; if the process is complete the market will sup- port itself. A buying demand will exist suf- ficient to meet without breakdown any pres- sure to sell. The bankers who brought out the issue can now welcome the speculators; every speculative purchase and sale means one more transaction to help make the mar- ket more active and therefore more stable. LISTING ON THE EXCHANGE 161 Though this is not the place to discuss the function of speculation, we may remark that the result of speculation resembles the effect of a gyroscope in its stabilizing power. Listing does not cost heavily in the direct charge imposed by the New York Stock Ex- change. The Exchange exacts a fee of only $50 for each $1,000,000, or fraction, of the par value of securities, or, in the case of stock without par value, $50 for each 10,000 shares. The expense of complying with the require- ments of the Exchange in the furnishing of information would substantially increase the total cost. Besides the costs, which, once met, do not recur, the corporation will have to bear the continuous expense of maintaining a transfer agency and a registrar of transfers in the Borough of Manhattan, New York City. From the standpoint of the work of the Exchange this requirement of maintaining a transfer agency and a registrar of transfers conveniently near is most important. With the volume of transfers necessary as a result of active dealings it would be impossible to put through the business if every time a transfer were required the certificate had to be sent out of town. This applies with greater force to the American exchanges, with their daily settlements, than to the 162 CORPORATION FINANCE foreign exchanges, with their settlements at longer periods. Since any real Stock Ex- change activity in the securities of a corpo- ration requires an organization to take care of the transferring anyway, the matter of the location does not work greatly to the disad- vantage of the corporation. Some of the transfer agencies for the largest and most ac- tive issues are considerable, and, in active times, very busy organizations. Their work and problems deserve a more extended de- scription than we have space for. It is hardly necessary to say that the Stock Exchange sees to it that the registrar of transfers forms no part of the same organizatioBi as the transfer agency. A trust company regularly attends to the duties of registrar. If transactions are not numerous, another trust company may perform the duties of transfer agent. Prin- cipal and interest of listed bonds and divi- dends on stock must be made payable at the office of the transfer agency. The corpora- tion must not change its transfer agency or its registrar of stock without the approval of the Stock Exchange authorities. The corporation must agree to publish and submit an annual report to its stockholders at least fifteen days before its annual meeting. This report must show an income account and balance-sheet and an income account and LISTING ON THE EXCHANGE 163 balance-sheet of all constituent, subsidiary, owned, or controlled companies, and must contain a statement of the physical condition of the corporation. This requirement of annual publicity, together with the amount of information demanded at the time of listing, has proved an obstacle to the listing of the issues of some corporations. Doubtless the desirability of listing has overcome the un- willingness of the managers of other corpora- tions to furnish such information. The cor- poration must agree also not to dispose of its stock interest in any subsidiary, owned, or controlled company, or to allow any constitu- ent, subsidiary, owned, or controlled com- pany to dispose of a stock interest in other companies, except for retirement and can- cellation, unless under existing authority or on direct authorization of stockholders of the holding company. If the corporation issues any stockholders' rights it must notify the Exchange, and must make all rrights transfer- able, payable, and deliverable in the Borough of Manhattan. The Stock Exchange demands great care in the mechanical execution of securities as a prerequisite to listing. The reader will find some discussion of the importance of these requirements at page 212 of the first volume. The Exchange requires that securities must 164 CORPORATION FINANCE be engraved and printed in a manner satis- factory to the committee on the stock list from at least two steel plates. 1. A border and tint plate from which a color should be printed underlying important parts of the face printing. 2. A face plate containing the vignettes and descriptive or promissory parts of the document. This should be printed in black, or in black mixed with color. Everything must be done to make as effec- tual security against counterfeiting as pos- sible. Classes and denominations of securities should be made distinguishable by printing them in different colors. The entire amount of the capital stock of a corporation which has listed its stock on the Exchange must be transferable at the transfer oflSce in the Bor- ough of Manhattan. If a corporation also makes a transfer of its shares in other cities, all certificates must, nevertheless, be inter- changeable and identical in color and form. The corporation must not nlake any change in the form of a security without the approval of the Stock Exchange authorities. The Committee of the Governing Board of the Stock Exchange, which considers all appli- cations for listing and reports on them to the Board, is called the "Committee on Stock List." Besides the requirements already LISTING ON THE EXCHANGE 165 stated, in the case of bonds, it also makes the following stipulations: — The panel, coupons, and denomination of bonds must be engraved and printed in a manner satis- factory to the Committee; coupons must bear a vignette. The text of bonds should redite conditions of issuance, terms of redemption, by sinking fund or otherwise, default, iuterchangeability or ex- changeability of coupon and registered bonds, and conversion into other securities. Registered bonds must carry a power of assign- ment in such form as the Committee may ap- prove. The Committee recommends that registered bonds be made interchangeable with coupon bonds. Registered bonds interchangeable with coupon bonds and coupon bonds exchangeable for fully registered bonds shall bear a legend reciting the fact. Coupon bonds issued in denominations of less than $1000 should provide for exchangeability into coupon bonds of $1000, the smaller bonds to bear a legend reciting such privilege. Registered bonds made such by detaching cou- pon sheets are not eligible for listing. In the case of stock the Committee makes these requirements : — The border and tint plate for one-hundred share certificates of stock shall have said denom- ination engraved thereon in words and figures; 166 CORPORATION FINANCE the plates for smaller amounts shall bear some engraved device whereby the exact denomination of the certificate may be distinctly designated by perforation; also conspicuously upon the face the words, " Certificate for less than one hundred shares." Certificates for common and preferred stock shall recite preferences of the preferred. Certificates of stock should recite (1) owner- ship; (2) par value; (3) whether shares are full paid and (4) non-assessable; (5) terms of redemp- tion; (6) preference as to dividends; (7) distri- bution of assets upon dissolution or merger; (8) voting power, or (9) other privilege; and must (10) bear the following legend: — "This certifi- cate is not valid until countersigned by the trans- fer agent, and registered by the registrar." Though a detailed statement of the infor- mation required by the Exchange will make somewhat tedious reading, besides conveying the precise information, the reader can make it serviceable by way of a partial review of the subject of "Corporation Finance." Re- quirements stated are as of the 1st of January, 1916. The applicant for listing must file the following papers: — For stocks: — 1. Seven copies of charter, with amendments to date, one copy attested by the Secretary of State where incorporated or other proper public authority. LISTING ON THE EXCHANGE 167 2. Seven copies of by-laws, with amendments, one copy attested by secretary of corporation. 3. Seven copies of leases and special agree- ments, one copy of each attested by secretary of corporation. 4. One copy of resolutions of stockholders and directors authorizing issue, each attested by sec- retary of corporation. 5. One copy of resolutions of board of directors or executive committee, attested by secretary of corporation, authorizing, by name, official to ap- pear for listing securities. 6. Opinion of counsel (not an officer or director of the corporation) as to legality of (a) organiza- tion, (6) authorization, (c) issue, and (d) validity of securities.^ 7. Detailed distribution of securities. 8. One copy of resolution appointing transfer agent and registrar, attested by secretary of cor- poration. 9. Certificate of proper public authority for issue. 10. Certificate of registrar of amount of securi- ties registered at date of application. 11. Report of a qualified engineer covering actual physical condition of property of recent date. ' The Committee will not accept the'opinion of an officer or director of an applying corporation nor of a firm in which the officer or director is a member, as counsel on any legal question affecting the corporation; nor will it accept the opinion of an officer or director of a guarantoi* corporation on any legal question affecting the issuance of guaranteed securities. 168 CORPORATION FINANCE 12. Map of property and coiitemplated exten- sions. 13. Specimens of all securities to be listed. For bonds: — 14. All papers required for listing stocks and also seven copies of the mortgage or indenture, one copy (a) certified to by trustee, (6) with copies of all certificates of proper recording. 15. Trustees' certificate. 16. If bonds are convertible into stock, certi- fied copies of (a) action of stockholders, and (&) o{ directors, authorizing issue and reservation of stock specifically for conversion.. 17. Certificate of disposition of securities re- deemed or refunded. 18. Certificate as to collateral deposited. 19. Certified copy of release ,or satisfaction of underlying mortgages. For securities of reorganized cor-porations: — 1. All papers required above for listing stocks or bonds, as the case may be.^ 2. Certified order of court confirming sale on foreclosure or other authority for reorganization. 3. Certified copy of plan of reorganization. 4. Income account; balance-sheet at close of receivership, if available. 5. Balance-sheet at date of organization. ^ Opinion of counsel shall also state that proceedings have been in conformity with legal requirements, that title to property is vested in new corporation, and is free and clear irom all liens and encumbrances, except as distinctly speci- fied; and also as to equities of securities of predecessor cor- poration. LISTING ON THE EXCHANGE 169 For additional amounts: — 1. Nos. 4, 5, 6, 7, 9, 10 of paj»ers required for original listings. 2. Nos. 1, 2, 3, 8, and 11 of said papers for stock, if any changes have occurred therein since last listing. 3. Nos. 14, 15, 16, 17, 18, and 19, of said papers for bonds, if any changes have,occurred therein since last listing. 4. Certified copy of proper public authority for increase. For certificates of deposit, voting trust, etc. : — 1. Papers required above for listing stocks or bonds. 2. Certified copies of any legal proceedings and court orders. 3. Seven copies of deposit or trust agreement, one certified to by proper authority. 4. Seven copies of circulars, i§sued by trustees or committee, one certified to by proper author- ity. 5. Amounts deposited. 6. Detailed distribution. Besides filing the specific papers just de- tailed, the petitioner for listing must in his application convey the following informa- tion: — A. Title of corporation. B. (1) Date of organization; (2) name of State authorizing incorporation. C. (1) Duration of charter; (2) and of charters 170 CORPORATION FINANCE of constituent, subsidiary, owned, or controlled companies. D. (1) History of corporation; (2) if a consoli- dation, merger, or reorganization, history of predecessor, and constituent, subsidiary, owned, or controlled companies, or firms, showing (a) names, location, and stock issues; (b) conditions leading to new organization. E. (1) Charter rights; (2) nature of business, character and amount of annual output, number of employees; (3) special rights or privileges granted directors by charter or by-laws. F. (1) Whether capital stock is full paid; (2) non-assessable; and (3) if personal liability at- taches to shareholders. G. (1) Issues, dividend rat^, and par value; (2) total amount of each, authorized and issued; (3) increases and authority therefor, including (a) action by stockholders, (b) by directors, and (c) by public authorities, etc.; (4) amount un- issued, (a) options or contracts on same, (6) spe- cific reservation for conversion. H. If preferred stock; (1) whether cumulative or non-cumulative; (2) preferences, including (a) voting power; (b) dividends; (c) distribution of assets on dissolution or merger; (d) redemption. I. Voting power of obligations of debt. J. (1) Dividends heretofore paid; (2) by pred- ecessor, or constituent, subsidiary, owned, or controlled companies; (3) earnings for preceding five years, if available. K. Description of property (1) owned in fee; (2) controlled; (3) leases; (4) franchises; (5) lo- cation, nature, and acreage; (6) railroads, mile- LISTING ON THE EXCHANGE 171 age completed, operated, and contemplated, and trackage rights; (7) traffic agreements; (8) equip- ment; (9) character of buildings and construc- tion; (10) timber, fuel or mining lands, water rights (see paragraphs T to Z, below). L. (1) Purpose of issue; (2) application of pro- ceeds; (3) amount of issue for securities, con- tracts, property, description and disposition of securities acquired; additional property acquired or to be acquired, with particulars, as required by paragraph K. M. (1) Mortgage, and (2) other indebtedness, (a) date of issue, (&) maturity, (c) interest rate, (d) redemption by sinking fund or otherwise; (3) similar information regarding mortgage and all indebtedness of constituent, subsidiary, owned, or controlled companies. N. Other liabilities, joint and several, (1) guar- anties, (2) leases, (3) traffic agreements, (4) track- age agreements, (5) rentals, (6) car trusts, etc.; (7) terms of each, and provision for payment. 0. Fiscal year. P. Financial statements; (1) income account of recent date for at least one year; (2) balance- sheet of same date; (3) similar figures for prede- cessor, constituent, subsidiary, owned, or con- trolled companies; (4) final balance-sheet; (5) when reports published; (6) for corporations consolidated within a year, income account and balance-sheet of all companies merged and bal- ance-sheet of applying corporation. Q. Names of (1) officers; (2) directors (classi- fied), with residence; (3) transfer agents, and (4) registrars, with addresses. 172 CORPORATION FINANCE R. Location of principal and other offices of corporation. S. Place and date of annual -meeting. In addition to the above, corporations which are owners of mines must recite : — T. Patented and unpatented claims, by num- bers. U. (1) A geological description of the country; (2) location and description of mineral and other lands; (3) ore bodies; (4) average value; (5) char- acter of ore; and (6) proper methods of treat- ment, V. History of prior workings, showing (1) re- sults obtained; (2) production each year. W. (1) Ore reserves compared with previous years; (2) estimate of engineer as to probable life of mines; (3) probabilities by further exploration. X. (1) Provisions for sraelting and concen- tration; (2) cost of (a) mining, (b) milling and smelting, (c) transportation; and (3) proximity of property to railway or other common carrier. Y. Income account, (1) receipts; (2) expendi- tures; (3) disposition of income. Z. Properties in process of development; if income account not available, what guaranties for working capital and for completion of develop- ment. Bonds. An application for an original listing of bonds shall recite all information required for listing capital stock, and A. (1) Amount, denominations, and numbers; (2) full title; (3) amount authorized and out- LISTING ON THE EXCHANGE 173 standing, authority therefor, including (a) action by stockholders, (6) directors, and (c) public authorities, etc.; (4) whether bonds are coupon (registerable as to principal) or registered, inter- changeable or exchangeable; (5) exchangeability or convertibility into other securities, and terms. B. (1) Date of issue and maturity; (2) inter- est rate; (3) places at and dates for payment of interest and principal; (4) where registerable or transferable; (5) kind and standard of money, and options; (6) tax exemption; (7) whether redeema- ble or purchasable in whole or in part, showing (a) dates, (6) price, (c) duration of published notice, (d) disposition of redeemed or purchased bonds. C. Mortgage or indenture provisions for (1) serial issues; (2) values in United'States gold coin, issuance in foreign languages and that the Eng- lish version governs; (3) terms of exchangeability of bonds payable in foreign places for bonds pay- able in United States. D. (1) Security-mortgage, indenture of trust, or other agreement; and, (2) liens; (a) properties covered, (6) mileage of railway lihes, (c) buildings, (d) equipment, (e) securities, (/) rights, (g) priv- ileges, (h) titles, (i) franchises, (j) leases, etc.; (3) other liens covering same or -any part of same properties; (4) guaranty and terms. E. (1) Names and addresses of trustees, and any unusual additions to or limitations of powers; (2) provision for declaration of principal due and payable in event of default of interest or other default, and waiver; (3) percentage of outstanding bonds controlling trustee. F. Purpose of issue and application of pro- 174 CORPORATION FINANCE ceeds, similar to that called for by paragraph L of the "Requirements for Listing Stock." G. Disposition of bonds refunded and mort- gage securing same. Requirements for listing of additional amounts. Refer to previous applications and last appli- cation by number and date; and recite: — A. Title of corporation and name of State au- thorizing incorporation. B. (1) Securities applied for; (2) amounts authorized; (3) authority, including (a) action by stockholders, (6) by directors, and (c) by public authorities, etc. C. (1) Dividends (2) by constituent, subsidi- ary, owned, or controlled companies, since pre- vious application. D. (1) Purposes of issue; (2) application of proceeds; (3) amount, description, and disposi- tion of securities exchanged for new issues; (4) additional property acquired or to be acquired, with particulars as required hj paragraph K of the "Requirements for Listing Stock." E. Income account and balance-sheet of recent date, with similar figures for constituent, subsidi- ary, owned, or controlled companies. F. Names of officials, location of offices, place and date of annual meeting, as covered by para- graphs, Q, R, and S of "Requirements for List- ing Stock." {Note) Increases of capital stock ar^ not eligible for list- ing until thirty days after notice of increase, or proposed increase, has been given the Exchange; increases of stock by conversion of listed bonds (of which notice shall be given the Exchange) may be immediately listed By the Committee and registration authorized. CHAPTER V CORPORATE INCOME This discussion of corporation finance so far has assumed enough knowledge of ac- counting for an understanding of the elemen- tary terms of the balance-sheet and the in- come account. The brief consideration of the subject in this chapter is presented for the benefit of those who do not have this prelim- inary acquaintance with the elements of ac- counting. The reader should not assume, however, that the statements made in this chapter are intended to present a model of ac- counting practice. The immediate discussion attempts only to give, as directly and briefly as possible, enough of an explanation to en- able the reader to grasp the significance of corporation accounting in relation to corpora- tion finance. Though we have just used the term "cor- poration accounting" we must not assume that the accounting of corporations differs in any essential way from the accounting of any other method of conducting business. The nature of the business governs the method of accounting rather than the nature of the proprietorship; that is, whether the proprietor 176 CORPORATION FINANCE is an individual, a partnership, or a corpora- tion. The seeming though not real exception should be made of the holding company. This presents some special aspects of income which we shall discuss in the* next chapter. Throughout our discussion so far we have used an old and still the more familiar nomen- clature of accounting, and made statements in a condensed form. For the purpose of making easy the process of comparison and present- ing the financial discussion in its simplest form this has been desirable, and for these reasons the old condensed form of statement is still the one generally used in presenting the results of accounting to show conditions for the purpose of financing the capital account. Our income account so far has presented only the items — Gross Income. Operating Expense. Net Income. Fixed Charges. Surplus Available for Distribution. Only the slightest thought is needed to see that such a statement presents a totally in- adequate analysis of income and expenditure on account of conducting a business, and that elements of a very different nature must be included under a single head. With this con- densed statement all sources of income of CORPORATE INCOME 177 whatever nature must be included under the head of "Gross Income." Obviously, how- ever, if business for the manufacture of ma- chinery includes the ownership, for some special reason, of $100,000 New York City 4 per cent bonds, the $4000 a year of income from this source is a very different thing from the money received for the sale of machinery. One can get no complete understanding of the business situation without recognizing tiie distinction and knowing such a situation when it exists. The chapter in the first volume on "Trad- ing on the Equity" set out the varying na- tures of gross incomes on account of the na- ture of the business producing the income, and made the general assumption for the pur- pose of the discussion that all the income of the corporation came as a result of conducting the business. If the corporation is wholly or in part a holding company, the nature of the income is a very different thing. We shall dis- cuss this more at length in the next chapter. The next item of operating expense obvi- ously must include even more diverse ele- ments. For example, lacking a special head for "Taxes," moneys paid out for that pur- pose must come under the head of "Operat- ing." Yet the difference between an expendi- ture imposed on the business by the State and 178 CORPORATION FINANCE entirely outside of the control of the manage- ment needs no further pointing out. If the nature of the business is manufacturing, and the income account has no flther head, the cost of the raw material must come under the head of " Operating Expense." Again, the essential difference between the cost of the material and the cost of converting it into the finished product needs no elucidation beyond the mere mention. This is a distinc- tion that applies as between a manufacturing business and a transportation or other public service business. The distinction between a merchandising business, in which the very goods which are bought are sold without any change in form, is even greater than the dis- tinction between a manufacturing business and a public utility. Another distinction in the nature of expen- ditures, which needs to be made to get an un- derstanding of the business situation involved, is the difference between the cost of carry- ing on the operations of the business itself and the cost of maintaining the plant in a condi- tion for the efficient conduct of the business, and generally the maintenance of the capital investment unimpaired. This distmction is usually made in accounting as between the cost of "Conducting Operations" and the cost of "Maintenance." CORPORATE INCOME 179 Fixed charges do not present the same kind of essential differences. They include any costs which the management of the business cannot cut off of its own volition. The man- agement must meet them, and they do not diminish on a diminishing scale of business. Interest and rentals are the essential fixed charges; both incurred for the sake of addi- tional capital in the business on the general principles discussed in the chapter on "Trad- ing on the Equity." With these remarks we have our income account recast into the following form: — Operating Revenue. (Classified according to the kinds of business carried on.) Operating Expense. Conducting Operation^ Maintenance. Net Operating Revenue. Taxes. Income from other Sources. Deductions from IncoIie. Interest. Rentals. Available fob Dividends. Dividends. Surplus. Contingent Liabilities. Such a form of accounts applies especially to a corporation conducting a transportation business. It is a skeleton adopted from the form of report required by the Interstate 180 CORPORATION FINANCE Commerce Commission. It would present the essential facts of a public service enterprise of the nature of an electric light or power company, a telephone or telegraph company. A gas company has some of the aspects of a manufacturing enterprise. In our previous discussion we have taken for our operating ratio — that is, the propor- tion of earnings consumed in the cost of oper- ating — the whole of operating expenses in- cluding the cost of conducting operations, the cost of maintenance and taxes to boot. As a single figure summarizing certain totals this percentage serves a useful pvrpose. For fur- ther analysis we need to know about the items included in the total. To form conclu- sions about the combined efficiency of the management and the plant, we need to know specifically the cost of conducting operations. We say advisedly the combined efficiency of the management and plant. Consider the case of a railroad. Its location, the manner of its construction, and the nature of its traffic fundamentally affect its cost of conducting operations. If its grades are low, its curva- ture slight, and its construction heavy, it can use heavy, powerful locomotives and haul long trains at a minimum of expense for fuel and labor. If its traffic is dense, it gets the reduced cost of doing business resulting from CORPORATE INCOME 181 a large volume and a full utilization of its capital investment. The percentage of grades and curvature, the weight of rail, and vari- ous other figures serve to indicate at how great an advantage or disadvantage the man- agement operates due to the nature of the construction of its plant. The traffic density shows the advantage it has owing to the loca- tion of its plant, the territory the road runs through. The kinds of traffic carried show whether or not the management has the ad- vantage of high-grade traffic paying the higher rates or must haul a heavy tonnage at small profits. All these things help to show the efficiency of the plant and do not go to credit of management except in so far as the management brought these conditions about. If the management can claim credit for the conditions, it must first discount the cost of bringing them about and deduct the capital charge before it can make a showing of busi- ness wisdom. No single figure expresses these advantages or disadvantages due to plant. These conditions can be takeh into considera- tion only in a general way in checking up the percentage of earnings expended for the cost of conducting operations. If we make allow- ance for plant conditions, we can then take the percentage of earnings consumed in the cost of conducting operations as indicating 182 CORPORATION FINANCE the efficiency of management. If it is low as compared with the average under similar conditions, we may draw the inference that the management displays a high degree of efficiency. Cost of maintenance indicates whether or not the management is returning enough of the earnings to the property to maintain the efficiency of the plant. If it is not doing so, the operating ratio — that is, the percentage of earnings expended in operating expense — does not afford a proper index of the condi- tion of the business. A showing of net earn- ings is being made essentially out of capital. During dull years corporations commonly do this, and even maintain dividends in this way. Paying dividends out of capital has to take some more obvious form in order to be con- sidered reprehensible and to run counter to the legal prohibition. If a lausiness, which is not essentially a "capital business" in its nature, makes a full allowance for mainte- nance, it is returning enough to the property to take care of depreciation. In the words a "capital business" we have coined an expres- sion for our immediate purpose. By the term we mean some business in which the labor and other costs are not greatly significant in comparison with the capital cost. For example, the proprietorship and conduct of an apart- CORPORATE INCOME 183 ment house may well be regarded as a busi- ness. The cost of capital in such a business, if it be considered one, far outweighs other costs. If the business consisted of conducting a single apartment house, the management probably could not advantageously expend enough in maintenance to cover the full amount of depreciation. If the case were that of a large corporation owning and operating a considerable number of apartinent houses, it might conceivably consider some new con- struction as essentially in the nature of main- tenance, and amply provide for depreciation in that way out of earnings. Directly opposite to an insufficient main- tenance resulting in a showing of earnings not really made but amounting to an essential conversion of capital, the management may return to the plant more earnings than are necessary to keep the capital unimpaired. If earnings are diverted to capital by way of maintenance the management is developing a concealed asset which may be discoverable by analysis. Cost of proper maintenance comes much nearer to a standard than cost of operat- ing, which depends directly on conditions of plant which cannot be standardized. The expense of maintenance dej>ends directly on the cost of materials and of labor. These are the same for one enterprise as for another of the 184 CORPORATION FINANCE same kind. An examination of maintenance costs in a given business over a series of years indicates the amount a management must average to expend to keep the capital value of a property unimpaired. By comparing the proper average cost with the amount the management of a given enterprise actually ex- pends for maintenance, a skillful analyst of accounts in the given business can make a pretty close estimate as to whether capital is just being maintaiued or is being encroached upon or added to through the operation of the maintenance account. It should be re- marked that what is said of an excessive maia- tenance account does not apply to railroads since 1907. Since that date the accounting regulations of the Interstate Coromerce Com- 3nission have stipulated against such practices. In that year expenditures for other purposes than strict maintenance were limited to $200 for any one item. Since 1915 even the $200 has not been allowed. Especially in railroad enterprises, for which so much accounting information is available through the accounting requirements of the Interstate Commerce Commission, skillful analysts of railroad reports can draw many important inferences from an examination of the accounts besides the information the re- ports convey directly. With some knowledge CORPORATE INCOME 185 of the physical condition of the road derivable from various sources they can come to some pretty accurate conclusions about the operat- ing skill of the management from an examina- tion of the cost of operating account. Of course the ability to draw the inferences from the accounting reports depends largely on the volume of material available for com- parison. The most accurate and extensive reports of a single enterprise leave too much open to surmise. Variations in the cost of operating may indicate that the management is now more eflScient or less eflScient than formerly. They do not show at all that the best management the corporation has had may not be worse than a management of aver- age efficiency. Variations in the cost of main- tenance, unless over a very long term of years, with a fuU knowledge on the part of the an- alyst of variations in the cost of materials and labor over all those years, give no answer to the question as to whether the property is be- ing over-maintained or under-maintained. For these purposes the analyst must have a fund of information gained from a knowledge of the business extensive enough to give him valuable averages for enterprises conducting that kind of business. Only the railroad busi- ness at present offers a sufficient fund of in- formation to make analyses of this kind really 186 CORPORATION FINANCE scientific. The various public utilities are just beginning to aflford the basis of general infonnation. For any kind of manufacturing enterprise conclusions are much more hazard- ous. In the railroad field, however, analysts of accounts have long made deductions from them that have gone much below the surface in arriving at opinions about the value of specific railroad securities. The general form of income accounts pre- sented so far serves substantially for a trans- portation or other public utility concern. With a manufacturing concern- the cost of raw materials comes in to make such a fundamen- tal difference in the nature of the business that expenditures cannot be accounted for in this manner and give anything like an adequate idea of the manner in which the business is being conducted. A form of income account which might be used would follow this outline: — Shipments Billed. Cost op Shipments. Cost of Materials. Cost of Manufacturing and Selling. Maintenance. Net Mantxpactuiung Phofits. Other Income. Total Net. Interest. SuEPLus FOB Dividends. CORPORATE INCOME 187 With this form giving the "Cost of Ma- terials," the item "Cost of Manufacturing and SeUing" gives a clue to efficiency of management and plant, and "Maintenance" gives a clue as to whether or not the capital of the corporation is being milked or fed through the maintenance account. What has been said on this matter applies as fully in principle to a manufacturing business as to any other. One can hardly overstate how important it is that a corporation should show, as com- pletely and accurately as possible within the reasonable limits of an annual report, a state ment of its affairs so far as accounting science can show them. The precise form that the report should take is no part "of our subject. That is the province of the expert accountant, and affords a sufficiently large world for his profession to conquer. But the capitalist who has presented for his investment the securi- ties of a corporation, without being shown a reasonably full accounting statement of the affairs of the corporation, ought to refuse even to consider them. If he commits his capital to such an enterprise, he takes the position of a man who buys a pig in a poke, or purchases "sight unseen." If the corporation is a holding company, the investor is purchasing almost equally sight unseen unless he also sees rea- 188 CORPORATION FINANCE sonably full information about the affairs of the subsidiaries. The discussion in the next chapter will develop the reas6n for this. As the outline of the income account has indicated, the corporation may not distribute in the form of dividends all the profits which are stated to be "available for dividends." All the phrase means is that of the earnings stated for the period of the report the corpora- tion has the legal right to distribute to share- holders that amount as profits of the business. Legal right and financial expediency ordina- rily in this respect come to two very different results. It is generally desirable to adopt such dividend policy as to avoid, so far as possible, the necessity for rediicing dividends during ordinary periods of depression. From the viewpoint of the corporation itself the investor occupies a much more important place in the financial scheme than the specu- lator. The investor seeks steadiness of in- come and commits his capital to such invest- ments as seem likely to give it. He does not want merely an average of five per cent or six per cent over a period of years; he does want the actual five or six per cent every year. So the management of a corporation would ordinarily find it desirable to pitch its divi- dend policy at such a point that they feel con- fident they can maintain it. CORPORATE INCOME 189 The directors will, therefore, not declare as dividends the entire amount legally available for that purpose, but will set aside part of it to surplus account. The amount so set aside does not, of course, ordinarily, except for accounting purposes, constitute a distinct fund. The directors sim- ply invest those earnings back in the plant in extending or bettering it. Though ac- counted for in a separate account as surplus, they really make essentially an addition to the capital account. By reason of the exten- sions or betterments the corporation should increase its earnings. The surplus ought to be sufficient to enable the corporation in its dullest years to earn the amount required for its regular dividend rate. When the earn- ings, as a result of this policy of accumula- tion of surplus, reach a point where they can be relied upon to do more than this, then the directors can increase the dividend rate. If the directors are not certain that earnings have reached a point to justify an increase in the regular dividend and the sur- plus cannot be invested back iu the plant to the best advantage, they may increase the distribution, but expressly announce the ad- dition as a "special dividend" by way of giving warning that it is not to be relied upon as a regular disbursement of income. 190 CORPORATION FINANCE Just how much of earnings should be set aside as surplus for the sake of establishing the continuity of dividends presents a ques- tion requiring much wisdom in judgment. The general subject of corporation finance needs the results of much study on this prob- lem. Only a few kinds of business yet afford even the materials for this study. Due to the requirements of the Interstate Commerce Commission the railroads have made public an abundance of material for that form of business. Various state public service com- missions are bringing out enough material for the several kinds of public utilities. But for the various kinds of manufacturing business, not only is the material not available, but the problem is more difficultj In the public utilities field, however, this study is especially needed as part of the foundation for rate- making. Public service commissions purport to fix rates at a point that will allow a fair return on the capital. Earnings must be large enough to allow interest and dividend rates sufficient to attract new capital to the enter- prise to provide the extensions and better- ments demanded by a commimity growing either in size or in its demands for quality of service. As already stated, investors demand, or prefer, a steady income, and will advance funds on more advantageous terms on the CORPORATE INCOME 191 assurance of a steady income Ihan on the fact of an equivalent average income. So, part of the problem of rate determination is what rate of steady income reasonably assured will prove sufficiently attractive to procure neces- sary new capital for the enterprise, and what amount of surplus set aside under circum- stances of favorable earnings will give that reasonable assurance of continuity. Rates must be established at a point which will enable the payment of the required steady in- come and provide for a surplus fund which will in a degree guarantee thei continuity of this income. That word "guarantee" indi- cates the essential nature of a surplus fund; it might with sufficient propriety be described as a "guaranty fund." We have said that the directors invest the surplus back in the plant. In most cases they do. It may happen, however, that they can- not advantageously make this investment, or that they have special reasons for not doing so. Under such circumstances they may invest in special ways some or all of the earnings which form the "surplus after dividends," just as a sinking fund is invested. The cor- poration then has a distinct surplus fund which affords earnings from sources outside the regular business it carries on, and shows its guaranty nature more distinctly than an 192 CORPORATION FINANCE investment back in the plant. Though cre- ated primarily for the purpose of assuring continuity of dividends, the surplus fund also goes to the building of a larger equity back of the bonds. The stockholder wants as much of the earnings available for dividends dis- tributed to him as possible without interrupt- ing the continuity of dividends, and always welcomes any increase in the disbursement. The bondholder always likes to see earnings go back into the plant. The market places a value on the stock of a corporation on the basis both of the dividend payments and of the earnings available for dividends. Since a present income which may be immediately enjoyed is more valuable than a future income, the earnings not declared as dividends will not enhance the price of the stock nearly so much as those earnings which are immediately distributed to the stock- holders. But the purchaser wUl estimate the value to him of the surplus earnings in so far as, in the first place, they give an assurance of the present rate of dividend disbursements continuing, and in the second place, in so far as they hold out a prospect of an increase in the dividend rate at some time in the future. The capitalist contemplating a purchase of the bonds of the corporation is interested in the amount of earnings left after operating CORPORATE INCOME 193 and taxes, and, therefore, available for the payment of interest. From his viewpoint the less of this paid out in dividends the better. Directors are generally under no obligation to declare any dividends, no matter what the earnings are, and cannot be compelled to de- clare them unless the circumstances of their refusal have an element that is essentially fraudulent. If the stockholders differ from the directors on this matter of dividend policy, their remedy is to elect other directors as the terms of the present directors expire. A board of directors may declare a dividend whenever the affairs of the corporation show that it has a surplus, and up to the amount of the surplus. If the surplus has all been invested back in the plant, and the corporation has no cash to pay out in dividends, it may, unless there is a statute to the contrary, borrow money to procure the funds for the disbursement; or it may declare a stock dividend. As already described in the chapter on financing by an appeal to the stockholder, the sale of stock, with a market value at a premium, to stock- holders at par, amounts essentially to the declaration of a special dividend. The decla- ration of a stock dividend comes to the same thing, except that the stockholders are not called upon to pay anything for the stock instead of making a payment less than the 194 CORPORATION FINANCE market value. A stock dividend regularly has the nature of a special distribution rather than of the ordinary dividend payment. Though directors who have consistently turned earnings back into the property may sometimes declare a stock dividend just to give the stockholders something in the way of a dividend distribution and keep them satis- fied with the management, usually a board of directors resorts to it for special purposes. It may be desirable to increase the number of shares so as to reduce the market price of the stock. Stock that sells close to par sells at an advantage over stock that sells at a high premium. Again, it may be that a close cor- poration has conducted the enterprise. The few stockholders have held the stock repre- senting their interest in the business. No oc- casion has arisen for any trading in the stock, and the number of shares in relation to the value of the assets has not been material. But the owners of the business now wish to liquidate all or part of their interest by selling it to the general capitalist public. To do this successfully they need to have their stock have a market value at the maximum not greatly in excess of par. They may effect the result by declaring a stock dividend large enough to amount to a distribution of the surplus in that way. Such a procedure, how- CORPORATE INCOME 195 ever, is rather in the nature of a recapitaUza- tion than of a dividend. Sometimes, instead of borrowing money to pay a dividend when the corporation has a surplus, which is entirely invested in the plant, the directors, wishing to maintain the appearance of regularity in dividend payment and anticipating a date when the corporate income will produce a cash surplus, may declare a dividend to be paid by the issuance of dividend warrants. These are simply in the general nature of notes of the corporation payable at a time when the directors antici- pate that the corporation will be in funds. Such payments maintain the semblance of regularity of dividends and give the stock- holder something on which he can actu- ally raise cash and so really do give him the benefit of a continuity of income. The term "dividend warrant" used in the explanation of this transaction is sometimes used in another sense as simply indicating the checks (or it may be drafts) by which a corporation disburses a regular cash dividend. CHAPTER yi SPECIAL NATXIRB OF THE INCOME OF A HOLDING COMPANY A PRESENTATION of the earnings' of a hold- ing company offers some special problems. The corporation may be eiitirely a holding company and not conduct any operations at all, or it may be partly a holding company and partly an operating company. Hereto- fore we have generally been viewing the earn- ings of a corporation as the result of directly conducting a business. For the most part, when discussing earnings, we have assumed simply that the earnings were those of an operating company. We can come to a true understanding of the income account and of the relationship of earnings to the various security issues of the plan of capitalization only by tracing them clear through from their origin as "income from operations." Each corporation intervening between "income from operations" and any part of income available for interest or for dividends creates a difficulty of analysis. Securities of holding companies are some- times presented to the capitalist with the statement that earnings available for interest INCOME OF A HOLDING COMPANY 197 amount to so many times the amount required for that purpose, or that the earnings available for dividends amount to such a per cent on the stock. The presentation does not go back of the income of the holding company and may mislead those who are not familiar with the special nature of the earnings of a holding company and do not reflect on the situations that may arise through the intervention of an operating company. Another way in which those who are raising funds through the sale of securities of a holding cornpany may mis- lead the unwary is by failing to protect the investor from the possibility of having new claims superior to his own created against earnings and assets. ' Let us take a concrete situation to show the difference between the earnings of a holding company and those of an operating company. Assume a holding company — D — capital- ized and earning as follows: -^ Holding Company D CapitaUxation Bonds, 5 per cent • $1,000,000 Stock 1,000,000 Net earnmgs 100,000 Obviously the statement can be made of the bonds of this corporation that the earnings available for interest are twice the amount required for that purpose. If the corporation were an operating company deriving its in- 198 CORPORATION FINANCE come from rendering a public service, such a showing would indicate a minimum of risk in the bonds as an investment. Let us now make the further assumption that the holding company owns all the capital stock of three subsidiaries, Corporations A, B, and C, and that it has no other assets. Since the holding company owns all the stock of the subsidi- aries, the number of shares of that stock does not matter; the holding company is entitled to aU the dividends which the subsidiaries may declare. ^ So the only element of real concern to us at this point, in connection with the capitalization of the subsidiaries, is the amount of bonds they ha,ve. Let us assume that the subsidiaries have bonds outstanding as follows: — Bonds of subsidiaries Corporation A, 5 per cent bonds $1,000,000 Corporation B, 5 per cent bonds. . 1,000,000 Corporation C, 5 per cent bonds . . 1,000,000 For our purpose here we do not need to set out the entire income account of each of these * Since corporation statutes regularly require directors to be stockholders in the corporations in which they are direc- tors, in actual practice a few shares would appear in the names of the directors. These are called "directors' qualify- ing shares." Even of these shares the directors may have the mere legal title. The holding company may have paid for them and have the entire equitable interest. For every practical purpose we may speak of the holding company as owning all the stock of the subsidiaries. INCOME OF A HOLDING COMPANY 199 corporations. So, without presenting this, we will show simply the totals of the several items of the income account -for all three, — that is, a consolidated inconie account. Let us assume, then, that the consolidated income account of these three subsidfaries makes this showing: — Consolidated income account of subsidiaries Gross earnings $500,000 Operating expense '..... 250,000 Net earnings 250,000 Interest 150,000 Surplus available for dividends ........ 100,000 To simplify the problem we can further assume that the management of the enter- prise carried out by the holding company and these three subsidiaries has not adopted a policy of building up a surplus. Accordingly, let us have all this surplus available for divi- dends declared as dividends out of the treasury of the subsidiaries. The holding company, then, receives this $100,000 into its treasury. We can neglect the expenses of the holding company, which, since it dojes not conduct any operations, would be merely nominal, a matter of keeping a not very extensive set of books, and assume that this entire $100,000 becomes net earnings of the holding company. Looking back to the statement of net earnings of the holding company one will see that we have assumed this as the situation. 200 CORPORATION FINANCE Suppose now that a period of business de- pression sets in and causes a decline of 10 per cent in gross earnings. Assume, too, that the management cannot keep maintenance up and at the same time effect a reduction in the cost of operating. This might very well be essentially the case. Since we will make the same assumption in the set of figures we will adopt for comparison to bring out the situa- tion, it does not, anyway, affect the sound- ness of our argument. On this decline of 10 per cent in gross we have, therefore, this showing for the consolidated income account of the subsidiaries: — Income account after gross has declined ten per cent Gross income $450,000 Operating expense 250,000 Net income 200,000 Interest 150,000 Surplus available for dividends 50,000 Owing to the inflexible nature of the interest charge a decline of 10 per cent in gross earn- ings has cut the surplus available for divi- dends in two. Then with respect to the hold- ing company we have this showing: — Net earnings of Holding Company D . . . $50,000 Interest charge of Company D . 50,000 A decline of 10 per cent in the gross earn- ings of the subsidiaries has entirely wiped out the margin of safety for the bonds of the holdr INCOME OF A HOLDING COMPANY 291 ing company, which, before the period of business depression, had earnings available for interest of twice the amount required. Compare this situation with what the situa- tion would be if D were an operating company- able to show net earnings of twice the interest charge, with all the conditions of operating the same as for the subsidiary operating com- panies just set forth. We will assume then that an operating company shows net earnings of $100,000. Working under the same condi- tions with an operating ratio of 50 per cent, the cost of operating then would be $100,000, and we have as an income account for oup Corporation D as an operating company: — Income account of Corporation D as an operating company Gross earnings $200,000 Operating expense 100,000 Net earnings 100,000 Interest 50,000 That is, we have just the same relationship between net earnings and interest charge as before when our Corporation D was a holding company. Earnings available for interest are twice the amount required for that purpose. Now, let us again assume a decline of 10 per cent in gross earnings during a period of business depression, and we find our income account of corporation D as an operating company makes the following showing: — 202 CORPOEATION FINANCE Income account of Corporation D as an operating company after gross has declined ten per cent Gross earnings $180,000 Operating expense 100,000 Net earnings 80,000 Interest charge 50,000 When D was a holding company we found that, under the conditions stated as to the subsidiaries, a decHne of 10 per cent in gross earnings of the subsidiaries reduced the earn- ings of D available for interest from twice the amount required right down to an amount leaving not a dollar in excess of the interest charge. With D as an operating company making earnings available for interest of twice the amount required, then suffering a decline of 10 per cent in gross, we have a margin of safety of earnings available for in- terest of 60 per cent in excess of the amount required. We have kept the same conditions in the cases compared. In both cases we assumed that the corporation would not be able to reduce operating at all on the decline of gross. The results would not have been different essentially if we had made some reduction in the operating cost in both cases. Our only reason for not doing so has been to keep the problem as simple as possible. This discussion has traced through the ar- gument to show the difference there may be between the earnings of a holding company INCOME OF A HOLDING COMPANY 203 and those of an operating company due to possible existing fixed charges of the subsidi- aries in the case of the holding company. We will go on with the discussion to show the possibility, unless guarded against, of in- creasing the fixed charges of the subsidiaries, and the effect of such an increase on the safety of the bonds of the holding company. Let us assume an existing situation of the holding company as before: — Cajntalization holding Corporation D Bonds 5 per cent $1,000,000 Stock 1,000,000 Debt of subsidiaries Corporation A has .... $1,000,000 5 per cent bonds Corporation B has .... 1,000,000 5 per cent bonds Corporation C has .... 1,000,000 5 per cent bonds For the purposes of this discussion we must make an assumption as to the actual total investment in the enterprise as a whole car- ried on by these three operating companies and the holding company. Let us assume, then, that the enterprise represents a total capital investment of $4,000,000. If dis- tributed equally among the 'operating com- panies this would give an equity in each of $333,333.33 above the par of the bond issue. Then assuming a gross income of the sub- sidiaries of $500,000, and the same operating conditions as before, we have: — 204 CORPORATION FINANCE Consolidated income of subsidiaries Gross earnings $500,000 Operating expenses 250,000 Net earnings 250,000 With net earnings, then, of $250,000 on a commitment of $4,000,000 of capital to the en- terprise, it appears that the business earns 6.25 per cent on the actual investment. Now, let us assume that for some reason the management of the enterprise wishes to ex- tend the plant, and has Corporations A and B each issue an additional $1,000,000 of bonds, which are disposed of at 80, and use the pro- ceeds in plant extension. This makes an additional investment in plant of $1,600,000. We will assume that the business earns the same rate of return on this additional invest- ment as on the capital originally committed, or 6.25 per cent. Then net increases by just $100,000. Let the operating ratio remain at 50 per cent. Since net was $250,000 before, it is now $350,000. With an operating ratio of 50 per cent, the operating expenses will, of course, be $350,000, and the gross $700,000. Stating this in tabulated form and we have: New income account Gross earnings ., $700,000 Operating expense 350,000 Net earnings 350,000 Interest charge (increased on account of the $2,000,000 new bonds) 250,000 Surplus available for dividends 100,000 INCOME OF A HOLDING COMPANY 205 On the showing we have made we have in- creased the debt of the subsidiaries, but have not caused any increase in the earnings of the holding company. Now, asstime that gross earnings dechne 10 per cent and we have this showing (assume that the operating cost is not reduced) : — New income account on decline o;f ten per cent in Gross earnings $630,000 Operating expense 350,000 Net earnings 280,000 Interest 250,000 Surplus available for dividends ...?..... 30,000 That is, we have available for dividends on the consolidated earnings of the subsidiaries, or as the net income of our holding company, the sum of $30,000. But the hblding company has an interest charge of $50,000. Before the increase in the debt of the subsidiaries a decline of 10 per cent in gross reduced the earnings of the holding company available for interest from twice the amount required for that purpose down to an amount which left no surplus. Since the increase in the debt a corresponding reduction in gross of the sub- sidiaries would reduce the earnings of the holding company available for interest down to only 60 per cent of the sum required. Of course this possibility of increasing the debt of the subsidiaries can be guarded 206 CORPORATION FINANCE against, and the investor who is not wilUng to take this chance should be sure that it is guarded against. To safeguard the situation the stock of the subsidiaries should be de- posited as collateral security for the bonds of the holding company. Though the directors of the holding company should be left free to vote the stock except in the Qvent of default, the trust deed under which the stock is de- posited should contain a covenant that the subsidiaries shall not incur any additional debt. The entire discussion in this chapter has obviously assumed that the bonds of the subsidiaries are outstanding in the hands of investors, and therefore exist as a claim against the earnings of the subsidiaries which must be satisfied before the holding company can get any revenue from the earnings. Examples presented to illustrate the prin- ciples involved have been those of a corpora- tion which is entirely a holding company; that is, one not doing any operating directly at all. Such examples were chosen for the sake of simplicity. If a corporation is partly an operating company and partly a holding com- pany, the same situations may arise with respect to that part of the earnings which are derived as a result of the operations of the subsidiaries. And if the corporation which is offering securities for sale does not own all of INCOME OF A HOLDING "COMPANY 207 the stock of another corporation, but only a majority, or an amount suffi(5ient to control, or even any amount of stock less than that, the same principles apply so far as the earn- ings derived as a result of the ownership of that stock are concerned. If the corporation owns less than a controlling interest in the stock of another corporation, 'one considering the securities of the holding company will ordinarily regard the stock owned as simply in the nature of an investmeint, and place a value on it as such. In the chapter in the first volume on "Financing an Expansion" we discussed the creation of subsidiaries as a device to enable the giving of a first mortgage or other direct lien on specific assets when the existence of a blanket mortgage created by the existing corporation would prevent the creation of any claim ahead of or equal to it if the corpora- tion should own the specific assets directly. The relationship of a holding company and a subsidiary may arise when one corporation desires to have an interest in another, but cannot advantageously buy all of the stock, or a sufficient amount to effect a merger. Or, if it can buy all of the stock, legal reasons — as the necessity of a public service corpora- tion operating in a given State having a char- ter from that State — may make it necessary 208 CORPORATION FINANCE or expedient to maintain separate corpora- tions. Legal reasons for the desir^ability of main- taining separate corporate entities, the ad- vantage of financing with the large issues of the securities of a holding company rather than with the relatively small issues of the directly operating units, and the better or- ganization possible if the dir'ectly operating units are boutid together by a holding com- pany, make very real advantages which have fostered the growth of holding companies especially in the public service field. Our dis- cussion has several times indicated the ad- vantage of the large issue in the possibility of making the security known and creating an active market. This chapter has simply pointed out the need for full information. CHAPTER Vn ORIGIN OF THE COMPLEXITY OF LIENS In the case of railway bonds the reader of financial advertisements and Circulars, who is not entirely familiar with the processes of cor- poration financing, may not readily under- stand how it comes about that a bond may be secured by a first mortgage on part of a rail- road system and have a second mortgage or other junior lien on other parts of the system. Though the chapter in the first volume on "Financing an Expansion" contains the clue to the situation, it seems desirable to extend the explanation by presenting a concrete illustration of the building up of an assumed simple railway system showing the result in diversified liens. Let us assume that at about the same time one group of men formed a corporation to build a line of railroad from X to Y, and another group of men formed another cor- poration to build a line from X to R. One corporation, the X. Y. Railroad Company, financed its construction by an issue of $5,- 000,000 X. Y. 20 year first mortgage 5's and $7,500,000 of common stock, and the other corporation, the X. R. Railroad Company 210 CORPORATION FINANCE similarly financed its construction by issuing $6,000,000 X. R. first moHgage 5's and $6,000,000 of common stock. Our earlier rail- road mileage was built in just that way by different groups, in what would now seem small sections. No group had developed financial power enough to bujld or own a line from the Atlantic to Chicago. The group in control of the X. Y. Railroad Company, we will suppose, now sees the de- sirability of having a line fropi X. to Z. The mortgage securing the X. Y. first mortgage 5's is a blanket mortgage, and the group in control of X. Y. wants to be able to oflFer a first mortgage on the new mileage in order to finance it. So they incorporate the X. Z. Railroad Company and have the new corpora- tion proceed to authorize $4,000,000 X. Z. first mortgage 5's. The X. Y. Railroad Com- pany owns all the $5,000,000 of stock of the X. Z. Railroad Company. Since the lien of the X. Z. first mortgage 5's has attached to the property, the manage- ment of the X. Y. Railroad Company, as soon as the construction of the X. ,Z. is completed, vote the stock of the X. Z. Railroad Company for a physical merger of the X. Z. property to make it an integral and directly owned part of the X. Y. property. The X. Y. Railroad Company is now taking all the assets of the COMPLEXITY OF LIENS 211 X. Z. corporation and dissolving the corpora- tion; it will, therefore, assume the bonds of the X. Z. corporation, — that is, become the BONDS OF THE M X RAILWAY CO. kWWI R X Division First 69 $6,000,000 Z X Division First 6s 94,000,000 ^^ Z X Division First and Refunding 4>i 3 ^^ $20,000,000 lllllIl M X Division First 4X8 $25,000,000 Detenture 4>is $30,000,000 The position abovo or to tlie left of the line Indicates the position the claim. $6,000,000 TX First 5S retired by the Z X First and Refunding 4>Js of course do not appear on this map which represents the situation after the final consolidation. general obligor on and place its general credit back of the X. Z. first mortgage 5's, which, of course, continue to have their first mortgage lien on the line of railroad running from X. to Z. The X. Z. first mortgage 5's then 212 CORPORATION FINANCE become the X. Y. Railroad Company X. Z. Division first mortgage 5's. Since the mort- gage securing the X. Y. Railroad Company first mortgage 5's is a blaSiket mortgage, stipulating that the lien of the mortgage shall extend to all future acquired property of the X. Y. corporation, now that the X. Y. Rail- road Company has acquired the property of the X. Z. Railroad Company, the lien of the X. Y. first mortgage 5's will extend over the X. Z. line. The X. Y. Railroad Company, however, has acquired the X. Z. line subject to the existing first mortgage, and therefore has bought, to speak in legal terms, the equity of redemption in the property. So the lien of the X. Y. first mortgage 5's is a mortgage on this equity of redemption, or, as we say, a second mortgage on that psirt of the prop- erty of the X. Y. Railroad Company which forms the X. Z. Division. While all this has been going on, let us assume that another group of promoters in the city of M. has been projecting and build- ing a line of railroad from M. to X. This is a much larger undertaking than any of those we have been considering. Its projectors capitalize the M. X. Railroad Company at $25,000,000 first mortgage 4|'s, $15,000,000 6 per cent preferred stock and $25,000,000 of common stock. The M. X. Railroad Cojn- COMPLEXITY OF J.IENS 21S pany proves a profitable enterprise and in- creases in financial strength. Meantime the X. Y. Railroad Company has prospered and its management has seen certain advantages that would result if it could add the X. R. Railroad Company to its property. It buys up quietly a good deal of the stock of the X. R. Railroad Company and makes an offer to the remaining stock- holders which results in its acquiring enough of the stock to control the situation. Let us assume that, under the laws of the jurisdic- tion in which the X. R. Railroad Company is incorporated, a vote of seventy-five per cent of the stock of a corporation is sufficient to authorize a sale of the assets of the cor- poration. Of course, the sale must be at such a price as will afiFord the minority of stock- holders a proper compensation. A majority sufficient to vote a sale of the ^.ssets must not exercise their power in such a way as to work a fraud on the minority holders. It would not be necessary for the X. Y. Railroad Company actually to acquire three quarters of the stock of the X. R. Railroad Company. If by means of a depository committee, or otherwise, they can count on a three-quarters vote to approve the proposal, they can go ahead. It may be that the management of the X. Y. Railroad Company does not want the stock of the 214 CORPORATION FINANCE X. R. Company unless it can get enough to put through the merger. In that event, it will prefer not to begin buying the stock, since it may not be able to acquire enough on suflfi- ciently advantageous terms. It can organize a depository committee of stockholders of the X. R. Railroad Company and agree to pay a stated amount for the X. R. property pro- vided it gets enough assenting stockholders to put through the transaction. Then, if it fails to gain the adhesion of enough of the stockholders of the X. R. Company the de- pository committee can simply return the certificates to the stockholders, and the X. Y. Railroad Company is not possessed of any stock it does not want. The management of the X. Y. Railroad Company, then, votes to acquire the X. R. property on certain terms, and the stock- holders of the X. R. Railroad Company vote to accept those terms. We will assume that any minority stockholders of the X. R. Railroad Company are nearly enough satis- fied with the transaction not to oppose it, and the transfer takes place. In view of the en- larged scope of their activities the manage- ment of the X. Y. Railroad Company has the name of the corporation changed to the X.Y. & R. Z. Railroad Company. How did the old X. Y. Railroad Company COMPLEXITY OF LIENS 215 provide the funds to acquire the new X. R. property? Let us assume that at this time the X. Y. first mortgage 20 year 5's were closely approaching maturity. Then the X. Y. Railroad Company authorized a first and refunding mortgage bond issue. It author- ized bonds to be issued under this mortgage of $20,000,000. Of this amount the mortgage provides that $5,000,000 are to be issued immediately to provide funds to meet the maturity of the X. Y. first mortgage 5's. The mortgage reserves $4,000,000 to provide for the retirement of the X. Z. Division first mortgage 5's when they mature. It author- ized the issuance of the remaining $11,000,000 from time to time to provide funds for new construction or the purchase of additional property or the purchase of the securities of other railroads. Since the X. Y. Railroad Company has now had a long record of good earnings it can borrow money on more ad- vantageous terms than it could while in the process of construction. We will assume that it makes these new bonds 4f 's and has them run for a term of fifty years. It carries out the refunding operation and retires the $5,000,- 000 first mortgage 5's. The X. Y. Railroad Company then buys stock of the X. R. Railroad Company, from time to time bor- rows funds at the banks temporarily to make 216 CORPORATION FINANCE immediate payments, and, as it acquires the stock, issues additional 4|'s to pay off the bank loans. We will assume, as would ordi- narily be the case, that the new 4^'s first and refunding mortgage is a blanket mort- gage. Then after the X. Y. Railroad Com- pany had carried out the merger of the X. R. line with its existing properties and had be- come the X. Y. & R. Z. Railroad Company, these new first and refunding 4j's have a first mortgage on the line from X. to Y. (the previously existing first mortgage has been retired), a second mortgage on the line from X. to Z., — ^that is, subject to the X. Z. Division first mortgage 5's, — and a second mortgage on the newly acquired line from X. to Z., — that is, subject to the existing X. Z. first mortgage 5's. Of course the X. Y. & R. Z. Railroad Company assumes payment of the X. Z. first mortgage 5's and they become X. Y. & R. Z. Railroad Company X. Z. Divi- sion first mortgage 5's. Meanwhile, the affairs of the M. X. Railroad Company continue to prosper. Its manage- ment becomes impressed with the advantages of bringing the M. X. and the X. Y. & R. Z. together in a single system. Just as the X. Y. had done in the case of the X. R., now the M. X. proceeds to acquire stock of the X. Y. & R. Z. To finance these purchases the M. X. COMPLEXITY OF LIENS 217 provides a collateral trust issue, the M. X. Railroad, X. Y. & R. Z. coUajteral trust 4-|'s, of which it authorizes $20,000,000. Let us assume that by means of this issue the M. X. Railroad Company acquires practically all of the stock of the X. Y. & R. Z. So the manage- ment of the M. X. creates an extensive rail- road system, and for some time operates it in this form. Let us assume that the manage- ment comes to see an advantage in unifying the system into the ownership of a single corporation. It must get the consent of its X. Y. & R. Z. collateral 5 per cent bond- holders. Their security is the stock, and in effecting a merger the stock will no longer exist. So the management of the M. X. Railroad Company offers these collateral bondholders a new security. To make the problem simple, let us assume that the col- lateral trust 4 J's have a market value of just par. At the same time the management of the M. X. Railroad Company wants to pro- vide funds for an extension "from M. to P. that will cost about $5,000,000. The management of the M. X. Railroad Company organizes the M. P. corporation, and constructs the line from M. to P. The M. P. corporation authorizes $5,000,000 of first mortgage 5 per cent bonds. The man- agement of the M. X. Railroad Company 218 CORPORATION FINANCE then organizes a new corporation, the M. X. Railway Company, with the same amount of stock as the M. X. Railroad Company and proceeds to authorize $30,000,000 of deben- ture 4^'s and to make tenqis to have the M. X. Railway Company take over all the properties of the M. X. Railroad Company. Holders of stock in the M. X. Railroad Com- pany are willing to take the stock of the M. X. Railway Company share for share, provided that it owns all the properties which they now own. In the trust deed securing the debentures the railway comf)any agreed not to create any new lien that wolild come ahead of the debentures, and if it should create any new mortgage at all, that it would secure the debentures equally with any bonds issued under the mortgage. Of the $30,000,000 au- thorized, $5,000,000 could be issued only on the deposit under the trust deed of the ^5,000,000 first mortgage 5's authorized by the M. P. Railroad Company. Holders of the M. X. Railroad Company X. Y. & R. Z. collateral trust 4^3 are willing to accept these new debentures in place of their collateral trust securities. The new de- bentures give the same income return. Though the new issue is larger than the old, it is given a stronger position in that no mortgage can be placed ahead of it. This improved position COMPLEXITY OF LIENS 219 I extends to the line of the M.X. To ofifset H part of the larger amount of debentures there is the additional security of the line of the M. P. on which the debentures "have virtually a first mortgage claim through the deposit of the first mortgage security of the M. P. Rail- road Company. For the other $5,000,000 additional of the debenture issue the trust dfeed provides that they may be issued only on evidence to the trustee of additions to the capital account of the railroad for a like amount. So, all things considered, the hold- ers of the collateral bonds are willing to accept the new security in place of the old, and the exchange is made. Of course, on the transfer of the property the new corporation assumed all the outstanding bonds of the old corpo- ration. {Note) The White and Kemble maps show the various liens of bond issues on the railroad systems of the United States. CHAPTER Vm EEOEGANIZATIONS So far our discussion has considered only those changes in the capitahzation of corpo- rations which result from the ordinary con- duct of their affairs. We have contemplated the original issuance of securities at the time of organization and such additions as may be made from time to time to supply the funds for increases in the capital account required by an expansion of the business. We have also considered such changes as may result through the redemption of outstanding secur- ities, either for sinking-fund purposes, or to allow their replacement by a larger issue with the same lien, or to absorb a surplus for which the corporation has no other immediate use. We have indicated the change which may result from the issuance of a convertible se- curity through the conversion of part or all of an issue of bonds into stock or through the conversion of part or all of an issue of pre- ferred stock into common stock. All such changes in the capitalization of a corpora- tion come about in the ordinary course of the financial management of the business. We REORGANIZATIONS 221 have still to consider extraordinary changes which may take place in the financial plan of an enterprise. Such extraordinary changes may come ( about as a result of insolvency or may take i place without insolvency. They may be made to remedy some existing defect in the financial structure or to meet some new and unforeseen requirement of the business. If , they are made as a result of insolvency, they may accompany foreclosure proceedings or be accomphshed without foreclosure. When they accompany foreclosure we say the cor- poration has gone through a "reorganiza- tion." If the change in the plan of capitaliza- tion takes place as a result of insolvency without foreclosure, we may say that the cor- poration has undergone a "readjustment' of the capital account." In the event that it has become desirable to make a rear- rangement of the corporation's finances, al- though it continues as an entirely solvent or, indeed, it may be, an exceptionally pros- perous concern, — in that event we will speak of the rearrangement of finances as a "re- capitalization." Let us first take up a matter of reorganiza- tion. We will assume a railroad corporation, the X. Y. Railroad Company, capitalized as follows: — 222 CORPORATION FINANCE Various issues of divisional bonds ag- gregating •- . . . $10,000,000 First and refunding mortgage 4| per cent bonds 25,000,000 M. X. Railroad Branch Line collateral trust 5's 5,000,000 General mortgage 5 per cent bonds. . . 20,000,000 Preferred stock, 6 per cent cumulative 10,000,000 Common stock 25,000,000 We will assume that the corporation has committed some default in its obligations to its general mortgage bondholders which en- titles them to foreclose on the property under their mortgage. The bankers who financed the corporation may stipulate, and the cor- poration may agree, that breaches of various agreements on the part of the corporation shall constitute defaults entitling the bond- holders to foreclose under their mortgage. Of course, the default regularly leading to foreclosure is a failure to pay either principal or interest when it falls due. The mortgage regularly stipulates that a failure to pay in- terest shall make the principal due and pay- able. We will assume, then, that the manage- ment of our corporation foresees that it will not be able to pay the interest falling due on its 5 per cent general mortgage bonds at the next interest period. The earnings of the corporation are suflBcient to continue the payment of interest on the first and refunding EEORGANIZATIONS 223 4|'s and on the underlying divisional bonds. We have to consider the $5,000,000 of collat- eral bonds secured by the deposit of all the stock and bonds of a branch line. The earn- ings of the branch line have fallen to a point where the net is not sufficient to meet the in- terest charge on account of the collateral bonds secured by the deposit of the branch line securities. So far as the claim of these collateral bonds against the issuing corpora- tion is concerned, they are, of course, a general obligation merely and junior to the general mortgage 5's. The interest date on these bonds is, let us say, a month later than that of the general mortgage 5's, and the failure to pay this interest when it falls due will nat- urally follow the failure to meet the interest charge of the general mortgage issue. Directors and officers of the corporation consult with the bankers who have done its financing and they decide to be ready to apply for a receivership. That the receiver- ship should be foreseen and planned for under such guidance is usually in the best interests of all the people who have any concern about the property. Such managers of affairs are best equipped to proceed along a well-de- fined line of action and to harmonize the conflicting interests. We will refer to them as "the management." If th.e various inter- 224 CORPORATION FINANCE ests should be permitted to proceed at hap- hazard, they would cause a much greater delay in reaching a settlement and largely increase the total losses. Usually it is desir- able that the receiver be appointed by a federal court. It is especially important that the federal court should assume control of the property if it is a line of railroad running through or into more than one State. For the purpose of getting a federal receivership counsel for the management, looking forward to the anticipated default, will prepare a creditors' bill in which bondholders or other creditors, living in some State other than the State in which the corporation is incorporated will appear as the petitioners for the receiv- ership. The fact that the petitioners are citizens of a different State from that in which the corporation is incorporated gives the necessary diversity of citizenship to en- able the federal court to take jurisdiction and appoint a receiver. If a state court appoints a receiver, the receiver can take only the property in the jurisdiction of the court. The court has no jurisdiction outside of its o^n State and for property of the corporation in another State another appointment of a receiver will have to be made. Even if no quarrel arises among different sets of creditors and even if the REORGANIZATIONS 225 courts of other States would appoint the same man appointed by the court of first jurisdiction, the delay in the appointment and his responsibility to the several courts would cause expensive and otherwise serious difficulties and delays. The mere fact of a default in the payment of interest will not in itself give the court a sufficient ground for the appointment. The court must be shown that a receivership is necessary to prevent loss or injury to those financially interested. If there is a default, however, sufficient other grounds can usually be found to justify the apiX)Uitment. When the receiver is appointed, the man- agement of the property owned by the cor- poration is taken out of the hands of the offi- cers of the corporation and vested in the court appointing the receiver. H^ is simply the officer or agent of the court. On all large matters of policy and on any question out- side of the ordinary matters of operation he must go back to the court for authority. The appointment of a receiver does not change the nature of the legal rights of the security-holders. He acts, however, as an agent of the court exercising its equity juris- diction. While the property is in the posses- sion of the court acting as a court of equity, legal rights may not be enforced except with 226 CORPORATION FINANCE the permission of the court. The principle underlying this suspension of the legal rights of the security-holders is that the prompt en- forcement of the legal rights of any one set of security-holders or other creditors might work such an injury to other people who have a financial interest in the property as to amount to an essential injustice. The law says in sub- stance to the defaulted bondholder that the damage he may do another by a prompt en- forcement of his right will be so much greater than the damage he will suffer by delay that the real justice of the situation demands that he suffer the delay. It is the duty of the receiver immediately on his appointment to take possession of all the property covered by the inortgage secur- ing the bondholders, or subject to the satis- faction of the demands of the creditors, who made the application for his appointment. The corporation no longer has any voice in the management of the property. The re- ceiver operates the road with essentially all the powers that the corporation had before his appointment. The directors of the corpo- ration, however, necessarily looked at every question from the viewpoint of the interest of the stockholders. The receiver must pur- sue such a course as will best conserve the property for the benefit of all people finan- REORGANIZATIONS 227 cially interested. Whenever extraordinary matters come up, or he is in doubt about what course he ought to pm-sue, he should consult the court. The receiver may do some things which have an important bearing on the financial position of the business. If any part of the property which comes into his possession consists of leased property and he considers the terms of the lease not advantageous to the business, he may elect to disaflolrm the lease: that is, he may discontinue operating the leased property and turn it back to the les- sors. He is not obliged to do this at once, but may take possession of the leased property and operate it long enough to learn whether it is profitable or not. He may find, among other property that has come into his possession, certain cars and lo- comotives which the corporation had bought under the terms of an equiprdent trust agree- ment. Just as in the case of the leased line the receiver may elect to disregard this agree- ment. He may then turn the equipment back to the equipment bondholders. If the receiver finds the equipment necessary to run the business properly, he may retain it for his use, and he will, in that event, be obliged to pay whatever the use is reasonably worth. The retention of the equipment, though the 228 CORPORATION FINANCE receiver may refuse to recognize the terms on which it was bought, is "justified on the ground that the railroad is a pubHc service corporation, — that is, a business affected with a special public interest^ — and the im- portance of continuing to render the service to the pubUc overrides other* considerations. This general principle pervades the manage- ment of a railroad property in the hands of a receiver. The most usual demand made on the re- ceiver for new financing arises out of the general physical condition of the property. Ordinarily this is seriously depleted by the time it comes into the receiver's possession. The management of a corporation naturally pays interest at the expense of maintenance just as long as it can, until it is confronted with the fact that the cost of conducting operations has increased because of the bad condition of the property. The property may have reached such a state of deterioration that it would be impossible to continue oper- ations, no matter how great the cost, without first spending substantial sums on mainte- nance. If the receiver is to operate the prop- erty, he must raise the fundk to meet these necessary expenditures. This brings up the problem of financing a business in a receivership. Since the business REORGANIZATIONS 229 is in such a condition that it cannot meet its obhgations to its existing creditors, obviously no one will advance funds to the business without some special assurance of payment. To meet the situation the law must allow any one who supplies new funds a preferred posi- tion. To provide the funds the court author- izes the receiver to issue receiver's certificates, and in its order gives them such priority as it considers necessary. It may, and usually does, give them a lien on the assets and earn- ings of the business ahead of every other lien on the property except for taxes. The order of the court may, however, place the lien anywhere, and might place it, only just ahead of that of the bonds in default. The court also determines the rate of interest the cer- tificates may bear and the price at which they may be sold. If they should fall due before the receivership is terminated, they would ordinarily have to be refunded by an- other issue of certificates. Those outstanding at the time of the adoption of a plan of reor- ganization have to be provided for in the plan. Bondholders are entitled to notice of the application for the issuance of receiver's certificates and to appear in court and show that they are not necessary, or that it is not necessary to give them a lien ahead of the bonds. 230 CORPORATION FUNTANCE Let us assume that in the case of the X. Y. Railway Company the general mortgage bondholders make application for the issu- ance of $500,000 of receiver's certificates to put the property in condition, and that after a hearing the court grants thejapplication and orders that they bear interest at the rate of 6 per cent and fall due in three years. The court authorizes the receiver to sell them at 98i. In discussing the receivership we have run a little ahead of the story. At the same time that the creditor's bill making the applica- tion for the receivership was being prepared the management was also forming a bond- holders' protective committee. To do this, they get four or five men whose names are likely to be favorably known to the bond- holders to serve on a committee to take care of the interests of the bondholders during the receivership. The committee, it is antici- pated, will also follow up the rights of the bondholders through the foreclosure. Pre- sumably they will supervise the work of drawing up the plan of reorganization. It is desirable from the standpoint of the manage- ment to have the personnel of this committee all determined and ready to announce as soon as the application for the receivership is made. The prompt announcement of a pro- REORGANIZATIONS 231 tective committee may forestall the appear- ance of another committee. For the forma- tion of a protective committee is purely a volunteer matter. Any group of men may announce themselves as a protective commit- tee for any of the issues of securities and ask holders of the issue to place their interests in its hands. If the management does not have a committee ready to be announced, other volimteers are sure to appear. Though the management does form a committee which announces itself promptly, it is still possible that other committees will appear. Even in that case the committee arranged by the man- agement gains strength from the very fact of being the first. It stands in the posi- tion of being the "oflBcial" committee. Later committees must assume the position of being in opposition. Of course the management hopes that if its committee is early in the field these opposition committees will not appear. No security-holder can be compelled to en- trust his interests to any committee. But the influence of any committee depends on how large a proportion in holdings of owners of the issue it can win the adherence of. As one device for getting bonds deposited, the com- mittee may offer to pay depdsitors the inter- est installment immediately in default and take the deposited bonds as collateral for the 232 CORPORATION FINANCE advance- The present cash,, the immediate continuance of income, may loom rather large in the eyes of the bondholder, and, seeing no special reason why he should, not deposit, it may induce him to act. The mortgage secur- ing the bonds may give to the holders of a majority of the bonds, or to the holders of seventy -five or of eighty-five per cent, certain powers, so that the action of the specified pro- portion will be binding on the rest. If such provisions are in the mortgage they form part of the contract with all bondholders, and the minority have no legal right to complain if the specified majority exercise the authority the mortgage gives them. If the committee can get the required majority to entrust their affairs to it, then it can take advantage of such powers as the required majority may have. Quite apart from these special provi- sions the weight of the committee in the pro- ceedings looking toward reorganization will depend upon the i^number of security-holders it represents. Of course, in saying " number of security-holders " we mean the holders of a given number of bonds ; that is, it is the num- ber of securities held rather than the num- ber of people holding them that counts. Be- sides, there is a wide difference between not representing all the security-holders and hav- ing those security-holders who have not chosen REORGANIZATIONS 233 the "official" committee to represent them represented by another committee. While getting ready with the committee to solicit the support of the holders of the most important defaulting bond issue, the manage- ment will at the same time endeavor to have a harmonious personnel on the committees to represent the holders of other issues of securities. There will be a committee for every issue of bonds, debentures, or notes in default, and for each stock issue. Some of the issues which are not in default, and in which defaults are not anticipated, also may have protective committees. This may prove ad- visable because matters may come before the court in the receivership, .particularly the question of placing the lien of receiver's cer- tificates ahead of the lien of bonds not in default, which will affect their interests, and in which they will need to be heard. Of course, the holders of all securities prior to those in default have a lively interest in the processes of the receivership and the reorgani- zation, and may need constant representa- tion to see that their interests are protected. Though the interests of the holders of the various security issues are necessarily diver- gent, there is a great difference between hav- ing protective committees which will work together as harmoniously as their divergent 234 CORPORATION FINANCE interests will permit, and having committees which will clash more than their jeopardized interests make inevitable. So it will be part i)f the problem of the management endeavor- ing to shape the general course of the re- organization to have as attractive a personnel as possible appear to solicit the representa- tion of holders of the various other issues of securities as well as of the holders of the prin- cipal issue in default. Leaving for the moment the consideration of these various other committees, let us trace through the procedure of the principal committee; that is, the one to represent the holders of the principal issue in default. The bondholders will signify their consent that the committee shall represent them according to the terms of the protective committee's agreement by depositing their bonds with some trust company designated as depository and accepting a depository receipt or certif- icate for them. It is important from thfe viewpoint of those expecting to guide the reorganization that this protective committee's depository agreement should give the committee broad powers. Such broad powers far as the fore- closure proceedings are concerned, to his pro- portionate share of the price established at the sale of the property as the selling price. Those who have joined in the reorganization agreement, however, have cast their lot with the property or business itseK, and to that end have given the reorganization managers the disposition of their interest in the proceeds of the foreclosure. Since this is the regular and normal thing, the procedure will provide for cutting out some of the motions that simply counteract each other. Let us assume, as ordinarily the case would be, -that a property is being sold at the foreclosure subject to the underlying mortgages. We will also assume that the court has named $16,500,000 as the upset price, and that of this amount it will take $1,500,000 to provide for obligations of the receiver and other obligations which the court requires to be taken care of. This will leave $15,000,000 as that part of the proceeds which would be available to satisfy the general mortgage bondholders. We will assume that the mortgage secures an issue of $20,000,000. That is to say, at the price named the general mortgage bondholders are entitled to sev- enty-five cents on the dollar of the par value 258 COEPORATION FINANCE of their bonds. If this entire amount of $16,500,000 were to be paid! in cash at the foreclosure sale, it would mean that every general mortgage bondholder would get for each $1000 bond $750 in cash. Then those bondholders who want to stay by the prop- erty and have come in under the reorganiza- tion agreement would simply pay back the cash for the next securities provided for by the reorganization agreement. If the busi- ness were ever put through in this way, it would mean probably that the reorganization managers had borrowed a large porportion of the amount required to be paid at the sale, and would repay the loan when they were paid back by the bondholders who had agreed to the reorganization plan. To require the reorganization managers, when purchasing the property under the foreclosure, to pay the full purchase price in cash, most of which they would have to borrow until the very money they paid was paid back to them on present- ing the bonds which had been deposited with them, would greatly embarrass the process of reorganization. So, when the managers make their bid at the foreclosure sale and have the property awarded to them, they are per- mitted to make payment in part with the bonds which have been deposited under the re- organization agreement. That is to say, since REORGANIZATIONS 259 every bondholder would haVe received sev- enty-five cents on tlie dollar, if the foreclosure price were paid in cash, then the purchasers at the sale will be permitted to make pay- ment in bonds which will be received in pay- ment at the rate of seventy-five cents on the dollar. Let us assume that 95 per cent of the bond- holders deposited under the reorganization plan. Then the reorganizatioij managers have $19,000,000 of bonds they can pay in as part payment of the purchase price. That is equiv- alent to a payment of $14,250,000 and leaves $2,250,000 of cash to be provided. Since it is not within the bounds of prob- ability that any holder will appear at the fore- closure sale other than the reorganization managers, the upset price which, within every reasonable expectation, will become the pur- chase price, assumes a large importance in the reorganization process. The court must be careful to fix it high enough to give the depositing bondholders everything they are justly entitled to get out of the property. Exactly what they are justly entitled to get may be very difficult to determine. No matter how active a market there may be for railroad securities, there is -not an active market for whole railroads. However, the appraisal of the general investing public — • 260 CORPORATION FINANCE that is, the market values of the securities — is shown by such dealings as there may be in them. The present earnings and condition of the property will be helpful in arriving at some conclusion about what may be fair terms for the minority non-depositing bond- holders. Since the majority is essentially buying out the minority interest, the value of which is being fixed on the basis of the value of the entire property, the majority, represented by the reorganization managers, want that value for present purposes estimated as low as pos- sible. If they have to pay the minority hold- ers too great an amount for their interest, the purchase of the property will not be a desir- able one. The price may be absolutely too great, - — that is, more than the interest is really worth, — or it may simply involve the payment of more cash th^tn the managers can provide the means of raising. Assuming that the reorganization managers do not regard the price as top high, how will they provide whatever cash may be neces- sary? This question brings us to another aspect of the reorganization. The plan of reorganization shows the means the managers have provided for raising the cash. But they must have some assurance that these means will prove sufficient. So the bankers interested REORGANIZATIONS 261 in the reorganization will enter into an agree- ment with the reorganization managers un- derwriting the cash requirehients; that is, guaranteeing the sufficiency of the means provided in the financial plan of the reorgan- ization. The bankers, in turn, to protect their position will form an underwriting syndicate. This banking transaction does not differ in any essential respect from the-assumption and shifting of risk involved in any purchase or underwriting of securities and the formation of a syndicate as described in an earlier dis- cussion. Whatever the precise form for rais- ing cash which the plan of reorganization may set out, it will amount essentially to selling some of the new securities provided for in the new plan of capitalization. The means which a reorganization plan may provide for meeting the cash require- ments of the reorganization are ordinarily thought of as two: (1) an assessment of the stockholders of the old corporation; (2) the selling for cash of some of the bonds or other securities arranged for in the reorganization plan. Though thought of and spoken of as separate means, both come really to the same thing, a selling of some of the securities of the new corporation for cash. The firsf means is usually stated somewhat in this way: On the payment of $20 for each share of the stock of 262 CORPORATION FINANCE the old corporation against which the fore- closure proceedings are being taken, the stockholders of the old corporation will be given a share of stock in the new corporation on purchasing a par value of a certain issue of bonds of the new corporation at a certain price. The manner in which this is put some- times has the superficial appearance of "tak- ing care of" the stockholders of the old cor- poration and recognizing that they have still an equity in the property. In most cases the appearance of preserving an equity will van- ish on closer examination, and it will be seen that the amount of what is called an assess- ment on the old stock is based upon the an- ticipated value of the stock of the new cor- poration, or the combined assessment and price to be paid for the new securities amoimts to the estimated value of the new securities to be received. In a word, the so-called "assessment" is really a purchase of the new securities. No holder of the old stock can be obliged to pay the assessment and purchase the new securities. When he bought his stock it was fully paid-up stock, and the liability of the purchaser was absolutely lirdited to what he had already put into it. Of course, there is nothing to prevent him from entering into special -agreements over the stock that wilj REORGANIZATIONS 263 create new liabilities, but these new liabilities do not and cannot arise from the mere fact of his existing status as a stockholder. If he deposits his stock at the instance of a protec- tive committee signifying his joining in the depository agreement, he creates new liabil- ities in connection with his stock. His status as a stockholder precludes any obligation to deposit his stock. So when the so-called "assessment" is made it cannot impose any duty to assent to its terms and become bound to its obligations. The situation may strongly invite the stockholder, however, to pay the so-called "assessment." Most people feel a distinct aversion to marking entirely off their books anything they have ever carried as an asset. If the stockholder does not come in and pay the assessment, he must coAfess to himself that he has suffered a total loss and has no possibility of salvage. His interest in the en- terprise will be entirely gone. He feels that the property owes him something. It does. It owes him whatever he invested in purchas- ing the stock. He feels a natural creditor's desire to collect some of the debt if possible. His only chance of collecting from the prop- erty some of the debt it owes him is to ad- vance some more money to it,'and, by helping .get it under way in its reconstituted form. 264 CORPORATION FINANCE hope that it will ultimately pay him back more than the additional amount he is now putting in. Though the investment may be good, the motives on which it is made rest upon a subconscious reasoning that is mostly fallacious. However, these rriotives are often taken advantage of to raise, or help raise, the cash requirements of the business in reorgan- ization. The other method of raising cash accom- plishes the same result with less appearance of indirection. In arranging the capital plan of the new organization the managers will make one or more of the new bond issues large enough so that part of the issue will be available for sale to raise additional cash be- yond the amount necessary for the require- ments of distribution among the depositing bondholders. If the so-called "assessment" plan is tried, and managers estimate that all or any given percentage of the old stockholders paying the asssessment would provide the cash needed, then the underwriters have to be prepared to stand in the breach and provide any part of the necessary cash which the old share- holders do not supply. As already stated, this procedure is in no sens6 different from that of any underwriting syndicate operation. If the new funds are to be provided by the REORGANIZATIONS 265 sale of bonds, then the position of the under- writers is just the same as in the case of a syn- dicate purchasing any issue of securities. It should be pointed out that the assess- ment method is not confined in its operation to the common stockholders *or to any other class of stockholders. The reorganization plan may apply it to any class of security-holders junior to the issue on account of which the property is being foreclosed or even to that issue itself. If in case of the capitalization plan presented at the beginning of this dis- cussion, for example, the default had been in the first and refunding 4^'s, the chance to pay an assessment and participate in the reorganization might have been presented to the holders of the general mortgage 5's. With the foreclosure at the instance of the holders of the general mortgage 5's the as- sessment plan may be presented to both the preferred and the common stockholders. Each situation presents its own aspects, and the reorganization managers must decide on the best methods. Most reorganizations utilize the psychological appeal of the assessment, either alone, or combined with a more frank selling of new securities. ! If an assessment forms any part of the re- organization plan, presumably the cash will be called for before the foreclosure sale, to be 266 CORPORATION FINANCE returned if anything should still prevent the reorganization from being accomplished. It may be remarked that for the series of reor- ganizations which Mr. Stuart Daggett con- sidered in his book on Railroad Reorganiza- tions, he points out the fact that a short time after the reorganization the new securities could regularly have been boilght at less than the assessment price. Obstructionists are most likely to appear in connection with the fixing of the upset price. If the price is placed too high the re- organization managers and their supporting syndicate cannot carry the reorganization through. It will require more cash than they «an raise without jeopardizing the success of the reorganizing enterprise. Minority holders may endeavor to get the price higher simply for the direct benefit that may accrue to them. It should be remembered, however, that a minority holder may have a much more important interest in some other issue and may be seeking to get a better bargain for the other issue. This is not a legal treatise, and we will not go into a discussion of all the legal resources of those who are trying to make better terms. Even though their contentions might ultimately be rejected absolutely, time is of the essence with the reorganization syndicate. It has made its REORGANIZATIONS 267 agreement with the reorganization managers on the basis of existing financial conditions. These may change at any tinae and make the transaction on the proposed terms a certain loss. The reorganization managers may deem it business expediency to make terms with objectors which the managers do not regard as really just, but which they are financially able to meet. The objectors have a "nui- sance" value, and sometimes are very well aware of the fact. Objectors .may, however, simply cause such delays as to prolong the situation beyond the time for which the syndicate is bound, and it may then throw up the entire matter. The necessary time limit of its agreement with the syndicate puts the reorganization committee under pressure to be able to declare the plan operative within the time allowed. In connection with the discussion of cash requirements we will quote the statement of the provisions for this purpose made in the reorganization plan, dated November 1, 1915, of the St. Louis & San Francisco Rail- road Company; — Provision for cash requirements For the purpose of meeting the estimated cash requirements of the plan, Messts. Speyer & Co., J. & W. Seligman & Co., Guaranty Trust Com- pany of New York, and Lee, Higginson & Co. 268 CORPORATION FINANCE have undertaken to form a purchase syndicate, of which they will be syndicate managers. The purchase syndicate, among othqr things, will (a) purchase $25,000,000 prior lien mortgage bonds, Series B (five per cent) ; $43,180,000 common stock (trust cer- tificates), for the sum of $25,000,000 (and accrued interest on the bonds), against which will be credited the amounts paid by stockholders as a condition of partici- pating in the plan, and will offer the prior lien mortgage bonds and common stock (trust certificates) so purchased, to the ex- tent and on the terms stated in the plan, to depositing holders of stock who shall have complied with the conditions of the plan; (6) purchase at the request of the reorganiza- tion managers additional prior lien mort- gage bonds, to an amount not exceeding in the aggregate $5,000,000. No provision has been made for underwriting the cash required for payment to holders of non- assenting refunding mortgage bonds and general lien bonds of their distributive share of the pro- ceeds of the foreclosure sale, as, in the judgment of the reorganization managers, the failure to deposit undeposited bonds has been in the main due to existing conditions in Europe, where such non-deposited bonds are mainly held, but it Is intended, on the completion of the reorganization, to set aside, under such restrictions as the reorgan- ization managers shall deem proper, the new securities and cash to which, under the plan, hold- REORGANIZATIONS 269 era of non-deposited refunding mortgage bonds and general lien bonds would be entitled if de- posited under the plan, if deemed practicable until the expiration of one year after the conclu- sion of peace by treaty, to be deliverable on the terms stated in the plan, at any time during such period, to holders of such bonds who may desire to avail themselves of the benefits of the plan and shall give satisfactory reason for their previous inability to deposit the same under the plan; the securities and cash deliverable in respect of any non-deposited bond to be available for providing, if necessary, the moneys required to pay the cash distributive share of such bond. Such refunding mortgage bonds deposited under the agreement of June 20, 1914, and such general lien bonds deposited under the agreement of May 28, 1913, as may be withdrawn from said respective agree- ments, will not be entitled to avail themselves of such provision. Guaranty Trust Company of New York has undertaken to form a loan syndicate, of which it will be syndicate manager, which among other things will, against the pledge by the purchase syndicate of such of the prior lien mortgage bonds and common stock (trust certificates), specified in subdivision (a) above, as shall not be purchased and paid for in full by, In formulating reorganization plans, there- REORGANIZATIONS 281 fore, the committee faces the necessity of raising an immediate $2,545,000 in cash. Be- sides raising this cash, it must also see to it that fixed charges are cut down to a point at which the net earnings will cover them with a sufficient margin to make another receiver- ship improbable. Of course, the cutting of fixed charges had to be provided for before the committee knew just how much cash it would have to raise for the non-depositing bondholders, since the bondholders would have a right to withdraw on the announce- ment of the plan, and possibly some more might come in at that time. Out committee met the situation in a thoroughgoing way. It decided to offer holders of bonds half the amount of their par in interest-bearing se- curities, half the amount of their par in pre- ferred stock, and to add to that a share of the new common stock for every $1000 bond. They decided, too, that the new bonds should bear interest at the rate of only 4 per cent, as against the 5 per cent on the old bonds, and that the new preferred stock should be cumu- lative and entitled to preferential dividends of 6 per cent. The result would be that if the full dividend should be paid on the new pre- ferred stock, the old security-holders would be getting the same income as before, and if anything should ever be paid on the new 282 CORPORATION FINANCE common stock, that would be so much extra. That is: — Old security Interest on $1000 bond at 5 per cent $50 New securities Interest on $500 bond at 4 per fient 20 Dividend on $500 preferred stock of 6 per cent _30 $50 We have assumed that 95 per cent of the holders of the defaulted bonds deposited them, and indications were that as large an amount would be on deposit when the plan should be declared operative. So the com- mittee has to provide new securities for the owners of $19,000,000 of general mortgage 5's and for the owners of $4,750,000 collateral 5's. Since they are planning to give owners of each of these issues half their par value in new 4's, they will have to provide a total of $11,875,000 of the new 4's to meet this re- quirement. An equal amount 'oi new preferred stock will have to be provided to carry out the idea of the committee for the reorganization. With the earnings of the corporation in- suflScient or barely sufficient to cover the dividend requirements, the committee can hardly count on selling the new preferred stock to provide cash. So it must provide an issue of the new 4's sufficiently large so that REOEGANIZATIONS 283 some may be disposed of to furnish the ready- money necessary. Since satisfying the old bondholders will require close to $12,000,000, and since the new bonds will riot be worth par, the committee wiU have to plan for about $15,000,000 of the new bonds for immedi- ate issuance. The committee feels the need, however, of looking forward to future cap- ital requirements, and decides to make the authorized issue of the new 4's amount to $20,000,000. The additional ,$5,000,000 need not be considered in the immediate reorgani- zation plans. Let us see, now, what the fixed charges will be on the assumption that $15,000,000 of the new 4's are to be presently issued : — Interest on underlying bonds .. $500,000 Interest on first 4^'s 1,125,000 Interest on new 4's , 600,000 $2,225,000 Against these prospective charges the cor- poration net earnings now are $2,800,000. On this showing of an amount available to meet the interest requirements of the new 4's of $575,000 in excess of the $600,000 demanded, the new bonds have a substantial value. Let us assume that the market is such that if they are made to run for the term of twenty-five years, as the committee plans, they should sell at 85, or approximately a 5.05 basis. 284 CORPORATION FINANCE The reorganization committee has to con- sider the position of the preferred and com- mon stockholders of the old corporation. In accordance with the principles already dis- cussed, it wishes to give them an opportunity to participate in the reorganized enterprise and so forestall any endeavor on their part to block the reorganization, aijd at the same time to take advantage of the desire of such as may want to continue with the enterprise to raise part of the cash requirements. With a look toward this situation in particular and toward the rounding-out of the reorganiza- tion plan in general, the committee decides that the capital stock of the new corpora- tion shall be $20,000,000 of common stock, in addition to the $12,000,000 of preferred stock already considered. The committee decides to give the preferred stockholders of the old corporation an opportimity to partici- pate in the reorganization by allowing them, for each share of the old stock they hold, to purchase, by the payment of $50, an amount of the par value of $50 of the new 4's and $100 of the new common stock. Since it is estimated that the new 4's should be worth 85, that would make that part of the pur- chase which is the $50 in bonds have a value of $42.50, and therefore be equiva- lent to letting the old preferred stockholder REORGANIZATIONS 285 buy the new common stock for $7.50 a share. Along the same lines the committee decides to let the old common stockholders for each share of the old common stock they own buy an amount of $50 par value of the new 4's and $75 par value of the new common stock on the payment in cash of $50* Again, on the estimate of the new bonds being worth 85, this is making the new common stock cost the old common stockholders $7.50 for each $75 of par value, or at the rate of $10 a share. Assuming that the new stock should be worth approximately this amount, this means that the old preferred stockholders are being per- mitted to realize a computed value of $2.50 a share on their old stock. Sjnce their claim is superior to that of the common stock- holders, it is natural that they should be shown some preference in the reorganiza- tion. Let us see how the committee is coming out with its common stock issue. To meet the distribution of one share of the new stock to each deposited bbnd will take $2,375,000 of the new stock. If all the old preferred and common stockholders should want to partici- pate, they would take more common stock than the committee has in mind to provide. Such unanimous participation, too, would 286 CORPORATION FINANCE call for $15,000,000 of the new 4's instead of the $3,000,000 the committee has planned to dispose of to meet the cash requirements, and would provide $15,000,000 in cash. Of course, no such result will follow the offer. Even for the preferred stockholders the com- puted value of the new securities offered them is so small that a small change in market con- ditions would wipe it out. The managers know that the syndicate to be formed to underwrite the reorganization plan will be remarkably fortunate if enough of the old stockholders come forward to supply all the cash needed. We now have the new financial scheme of our hypothetical reorganization committee pretty well formulated. It results then in this manner: — Securities untouched in reorganization Underlying bonds averaging 5 per cent $10,000,000 First mortgage 4j's 25,000,000 New securities Generai mortgage 4's (authorized $20,000,000) 15,000,000 Preferred stock, 6 per cent cumula- tive i 12,000,000 Common stock 20,000,000 Summarizing the disposition of the new securities, we have: — REORGANIZATIONS 287 General mortgage 4's To holders of old general mortgage 5's and collateral trust 5's $11,875,000 To be disposed of to meet cash require- ments 3,125,000 $15,000,000 Preferred stock To holders of old general mortgage 5's and collateral trust 5's $11,875,000 To be held for disposition at any future time to meet the corporate require- ments 125,000 $12,000,000 Common Stock To holders of old general mortgage 5's and collateral trust 5's $2,375,000 To satisfy subscriptions of old preferred and common stockholders (estimated) 2,000,000 To be held for disposition at any future time to meet the corporate require- ments , 14,125,000 To syndicate for part of its compensation 1 ,500,000 $20,000,000 It will be noted that besides the cash com- mission stated in the list of cash requirements, we have provided the additional compensa- tion of $1,500,000 of the new common stock as shown in the list just given for the distribu- tion of the stock. The old bondholders at whose instance the property rs being reorgan- ized would probably regard this provision as more advantageous for them than a larger cash commission. The cash would have to be 288 CORPORATION FINANCE provided through the sale of a large amount of the underlying security, the new 4's, and would by so much lessen the proportion of assets to debt of that security. They would also consider it desirable that at least part of the bankers' compensation should be in such form that the bankers would be more likely to have a continued interest in the business. We have assumed a substantial specula- tive value for this new stock. Earnings are already sufficient almost to covet the require- ments of the new preferred, stock. Let us assume that the default took place during a time of financial panic followed by a period of business depression. As a result of the bad business period the receiver has not been able to show a material increase in earnings. With a period of reviving business a substantial increase in earnings may reasonably be expected. Practically all of any increase in net will become available for dividends on the common stock. Though presumably a policy of dividend payment would not be undertaken immediately on any increase in net, a stockholder may reasonably expect that within a few years dividends will be forthcoming on the common stock. Under the plan outlined there is only a relatively small amount of stock to absorb increased earnings, the total of $5,875,000 in the hands REORGANIZATIONS 289 of the old bondholders, the old preferred and common stockholders, and in the hands of the syndicate. The large block of $14,125,000 of stock held for corporate requirements is practically, and may be made actually, treas- ury stock. If any of it is disposed of, it will increase the assets, and consequently, it is to be presumed, also the earning power, of the corporation. A word should be said about the preferred stock provided in the plan proposed, though the reorganization committee may be able to get the old security-holders to convert part of their old interest charge into a mere divi- dend, expecting that the old security-holders would probably insist that they shall not run the risk of their expectancy of preferred divi- dends being made more rembte through the creation of a prior claim against the earnings. In order to get its proposal accepted, the committee will have to make it one of the pro- visions of the preferred stodk that no such prior claim shall be created. It may be able to modify this provision to one permitting such a claim to be created on the approval of two thirds or three quarters of the pre- ferred stockholders. Such a provision might seriously hamper the financing of the corpora- tion in future years and the preferred stock might very well be made redeemable. It 290 CORPORATION FIN5ANCE might, perhaps, also be made convertible, so that if the corporation should greatly prosper it would disappear through the conversion process. It should be noted that our hypothetical plan does not reduce the par of the new secur- ities to be distributed to the old bondholders, but, in order to render more palatable the adulteration of the security of the bond- holder, the plan even increases the par value of the new securities offered to him. Though part of the new securities is in stock, and the possibility of income return is the only thing of importance, the investor's mind, never- theless, clings to par values, and the old security-holder does not feel such a sense of loss if the par of his holdings remains unim- paired. In our hypothetical reorganization we have had the cash requirements supplied by the bankers and the old stockholders. These sources would be possible in such a case as presented, largely because the earning power of the railroads, even at its low ebb, was still almost suflScient to meet the interest re- quirements. Under those circumstances, as already pointed out, stock would have a spec- ulative value. On that basis old stockholders will come forward with some funds. The new bonds, so greatly reduced in amount from REORGANIZATIONS 291 those in default, have so substantial a value as to be marketable. To be sure, they will sell at a discount, but that is because the interest rate is made so low, 4 per cent. Though it would more normally be 5, the 4 per cent rate was decided on in order to allow so substantial a par value to be offered as to placate the old bondholders, and still sub- stantially cut down the fixed charges. If the financial condition of the corporation had been worse, the burden of supplying new cash might have been thrust upon the bondhold- ers. They would have to supply it in order to prevent the property from going entirely to wreck. Depending upon conditions, any class of security-holders may be asked to sup- ply cash, even those holding the current debt of the corporation. Calling on the bond- holder to contribute new cash is found to be unpopular. He is certain to have some of the feeling of "throwing good mdney after bad." Stockholders contribute any part of the new funds only under the strongest inducement. Though the contribution is for them also a throwing of good money after bad, they are reluctant utterly to part even with the "bad" money. Bondholders can be made to contrib- ute only when their position comes to approx- imate that which shareholders are usually in: they must contribute some or lose all. 292 CORPORATION FINANCE Indeed, though the general procedure of one reorganization is much the same as that of another, the financial plans present very wide variations depending on the particular conditions of each case. Rather than follow through an actual reorganization which would present many problems of detail that might confuse one considering the subject for the first time, we have taken an imaginary case which we could make as simple as we chose. It should not be understood that the hypo- thetical case presented is even typical. The elements were chosen to show the situation as simply as possible. Our imaginary case does not present one often very important situation, that of the lease. If a reorganization involves an enter- prise with leased property, those in charge of the reorganization must come to terms with the owners of the leased property. Of course, they may not consider it desirable to retain the leased property in the enterprise. The receiver may already have exercised his right to disaffirm the lease and cut this part of the property loose, or it may otherwise be cut loose in the course of the reorganization. Since it is not owned by the corporation undergoing reorganization, it does not form part of the property in the foreclosure sale. Generally the owners of the leased property REORGANIZATIONS 29S do not want it back on their hands to operate. They have no operating organization. So they are likely to make terms, if they can, in the reorganization. Frequently the making of terms results in changing the status of the property from its former lease to an actual ownership. The leased property is consoli- dated into the reorganized enterprise. Some- times, but not usually, an arrangement is made reducing the rental. The whole matter is part of the general problem of reducing fixed charges. The lease may be in so strong a position as to be undisturbed, like the un- derlying bonds. It may be so weak that it is not desired at all, and can be cut off even more effectively than the stockholders' equity. Or it may be strategically in the position of the bonds in default, and have to suffer a scaling down in some way. Reorganization expenses are allocated di- rectly to the depositors, and are not provided for in the cash requirements. Any security- holder who has deposited and subsequently withdrawn will have to pay his pro rata of the expenses up to the time of his withdrawal. That would ordinarily be up to the time of the announcement of the plan of reorganiza- tion. In an organization more complex than the one we have presented, the reorganization, committee would have to determine what 294 CORPORATION FINANCE proportion of the expenses each issue in- volved in the reorganization would have to bear. We have presented only one device for scaling down fixed charges, that is, by a sub- stitution of stock in the place of interest- bearing securities. This is the best method, but is not always followed. A plan more commonly adopted in earlier reorganizations than recently was the substitution of income bonds for bonds with less elastic interest provisions. The objectionable characteristics of income bonds were discussed in the first volume. In substance, from the standpoint of a security-holder in reorganization, income bonds give practically no greater assurance of payment of income than a preferred stock, and lack the voting power which helps the preferred stockholder protect his position. The "adjustment bond" is 'another device resorted to in reorganizations to effect an immediate reduction in fixed charges. The reorganization committee may ask the old bondholders, whose securities carried interest, let us say, at 5 per cent, to take new bonds carrying interest for the first year say of 3 per cent, for the second year of 3 per cent, for the third year of 4 per cent, and the fourth year reaching the interest return of the replaced securities of 5 per cent. Though these rates REORGANIZATIONS 295 involve an immediate cutting-down of the bondholder's income, they include a definite and absolute promise that the income will be restored by the steps indicated. This places the security-holder in a stronger position than the expectancy of income offered by a pre- ferred stock. From the standpoint of the probable permanency of the reorganization it is not so good as the preferred stock. If the reorganization committee relies upon it to effect the entire scaling down and does not materially reduce the principal amount, fixed charges wUl go back to their original amount at the end of the four-year period. Since the committee is not likely to get the bondholders to accept a reduction of both principal and rate of income, the principal amount will probably remain unimpaired. The adoption of the device of the adjustnient bond indi- cates a reliance on increasing earnings. If this expectation should not be realized, the corporation would again face reorganization. For the reorganization plan we have fol- lowed through, we have had the reorganiza- tion managers assume the burden of the work of effecting the purchase and of distributing the securities. The position of the under- writing syndicate involved only the taking-up of such of the securities provided for the rais- ing of cash as the old stockholders did not 296 CORPORATION FINANCE subscribe for. After formulating the new financial plan, the reorganization managers might have turned the whole matter over to the syndicate if they had made such an agree- ment. In that event, the syndicate, which we have termed the "underwriting syndicate," would be denominated the "purchase syndi- cate." It would have bought the property at the foreclosure sale, turned it over to the new management for the securities, and dis- tributed the securities in accordance with the provisions of the agreement the syndicate had made with the reorganization committee. This agreement would have included the same distribution of the new securities as we have discussed. In this, as in every other aspect of a reorganization, the details may vary widely. In the space at our disposal there is opportunity to discuss only the gen- eral principles involved. ; READJUSTMENT OF THE CAPITAL ACCOUNT We have restricted our use of the word "reorganization" to situations involving a foreclosure, or otherwise a sale of the property at the instance of creditors. Common use applies this term more brop.dly to include any substantial change in the financial plan, not only when there is no sale at the instance nt creditors, but even when the change does REORGANIZATIONS 297 not at all result from insolviency. It seems in the interest of a more careful nomencla- ture to reserve the term "reorganization" to cover such cases as we have already dis- cussed. Sometimes substantial changes are made in the plan of capitalization as a result of insolvency without involving a judicial sale. This can most advantageously be done when, though the assets are ample, some business reason has made it impossible for the corpor- ation to meet its interest charges or its ma- turing obligations. It can sometimes be forced through when a class of creditors realizes that a reorganization involving a judicial sale would cut them off or would reduce the amount they are apt to realize from their claims below the amount they believe the values really in the property ought to pro- duce for them. It may especially be utilized when the stockholders believe that the in- solvency is temporary and are willing to aid substantially in having the finances arranged in some way that will not involve cutting off their equity. Any creditor whose claim re- mains unpaid can eventually force a judicial sale of the assets, and those interested in effecting a solution of the corporation's finan- cial troubles can hold this whip over those who are inclined to block, or refuse to support. 298 CORPORATION FHSTANCE endeavors to procure an adjustment without such a sale. If the financial diflSculties are surmounted without a judicikl sale in a way that involves substantial changes in the finan- cial plan, we will say that there has been a "readjustment of the capital account." A readjustment involves much the same matters as we have discussed under the head- ing of "Reorganization," but it is carried through without the judicial sale. The prop- erty is not, however, transferred to a new cor- poration, and new securities, including the new stock, issued in payment for the property transferred to the new corporation. Since, generally speaking, no property is being transferred in any way, any new stock issued must be paid for in cash at par. Either the stock of the corporation must be worth par in spite of the present embarrassment, or worth so near par that parties having an interest in the situation are willing to pay par for it in order to straighten out the situation and avoid greater loss in some other direction. Of course, it would be rather extraordinary that the common stock of an insolvent cor- poration should be worth par. Ordinarily, if new stock is to be issued an issue of preferred stock would have to be authorized. Or, if there is an existing issue of preferred stock, a new issue with a prior preference may be REORGANIZATIONS 299 created. The stockholders may be sufficiently interested in carrying out the readjustment to contribute some of their ;holdings to the corporation, which, becoming treasury stock, the corporation may proceed to sell at less than par. This would involve practically unanimous action, otherwise some of the stockholders would be making a sacrifice for the benefit of other stockholders who are not sacrificing at all. The readjustment of the Westinghouse Electric and Manufacturing Company fol- lowing the financial crisis of 1907 presents a good illiistration. The company had been expanding its business rapidly, and as a re- sult had a large floating debt, the maturities of which the corporation was unable to meet in the face of the existing stringent financial conditions. This debt consisted of two classes: (1) merchandise debt or credit given by con- cerns which furnished materials to the com- pany, and (2) bank debt, the result of floating the company's paper generally throughout the country and of borrowings from the local banks. The business depression which set in after the general financial crisis of the fall of 1907 caused a marked falling-off in the earn- ings of the company and made its situation one of great difficulty. Several plans for read- justment failed before one finally succeeded. 300 CORPORATION FINANCE A business situation prove'd really the piv- otal point. Merchandise creditors naturally looked forward to continuing business with the rehabilitated company. It frequently happens that in smaller enterprises than the Westinghouse business adjustinents are made on this principle. If those in charge of a busi- ness are known to have such abilities and reputations that they will continue in the same business and use the same materials after their financial difficulties are adjusted, their merchandise creditors are likely, rather than force them through bankruptcy, to make a composition with them in the expectation of continuing their good-will. Such creditors expect to benefit through the profit of future business more than enough to make up present losses. By forcing the debtor into bankruptcy they would lose his good-will and probably gain nothing over the composition. The West- inghouse difficulties presented a case in which those who were creditors on account of current liabilities were most immediately concerned. The merchandise creditors wanted to con- tinue in the good-will of the dominating in- terests in the enterprise for the sake of future business. The local banks also looked to fu- ture business. These two divisions of the creditors were the easiest to deal with. Other bank creditors presented a more REORGANIZATIONS 301 difficult problem for those who were seeking to arrange the finances of the company. For the various reasons which make it necessary or expedient for a concern like the Westing- house Company to seek a foroader area of credit than the local community, it had through note brokers placed large amounts of its paper with banks throughout the covmtry. These banks had nothing to gain from busi- ness relationships with the concern. What- ever they were to rescue from the situation they had to salvage at once. They were not so easy to deal with. Under the plan that finally gained accept- ance, merchandise creditors to the amount of some $4,000,000 agreed to take stock of the company at par in the settlement of their claims. The plan offered the bank creditors 50 per cent of their claims in convertible long- term bonds. They were given an option of several proposals in settlement of the other 50 per cent of their claims: (1) to take 30 per cent in four, five, and six year notes and 20 per cent in stock; (2) to take it entirely in fifteen year notes; (3) to take it entirely in stock. There was about $8,000,000 of this bank debt. The concern required some actual cash, however, to get its affairs straightened out. The stockholders were asked to subscribe to 302 CORPORATION FINANCE $6,000,000 of stock at par. Though the con- cern was embarrassed with its large float- ing debt, its assets and earning power in normal times made its stock valuable. Dur- ing this period, however, the stock was not selling in the general market at par, and the purchase of stock at par was equivalent to making a cash contribution to the treasury of the company. Only the large stockholders saved the situation at this point. With some banking assistance they came forward and subscribed for the necessary amount of new stock. Of course, no compulsion could be put on the stockholders, and, as the corporation was issuing this stock for cagh, it had to be sold for par. Non-local bank creditors did not look with much favor on the proposals made to them. A gradual revival in business conditions, how- ever, made it seem probable that the new securities would have a sufficient value at least to let them out whole, iand finally they agreed to the plan.^ Only the threat of a judicial sale makes possible a voluntary readjustment of the ' The facts here presented about £he Westinghouse re- adjustment are gathered from Dewing's Corporate Promo- tions and Reorganizations (Harvard University Press. 1914). The reader is referred to that volume for a complete and interesting discussion of this readjustment of the capital plan. REORGANIZATIONS 303 capital account: Do this or worse things will happen to you. Even with this threat, gen- erally anything requiring a unanimous con- sent cannot be carried through. Some recal- citrant (from the viewpoint of those trying to carry through the readjustment) will refuse to act except under court compulsion. Yet, if the number of people who are directly affected is not too great, and if the situation is strong enough, sometimes practically unani- mous action may be had. In a sufficiently strong situation the writer once succeeded in getting all of the second mortgage bondholders of an enterprise to agree to accept the posi- tion of third mortgagees in order that cash might be provided by a smaller issue of bonds with a second mortgage claim. BECAPITALIZATION By the term "recapitalization" we mean a substantial change in the financial plan of the corporation that does not result from in- solvency. Quite the contrary situation is the most frequent cause of recapitalization. Those in control of the corporation bring about an increase in the outstanding securities to make their par present more nearly the actual capital value of the business. This situation frequently arises when an incorporated fam- ily enterprise is being turned into one for 804 CORPORATION FINANCE general market purposes. Many enterprises have their origin, not in an original large promotion, but through the growth of some small business undertaken by an individual or a very small group of individuals. Very likely the business was not lincorporated at the beginning, but was started as entirely a matter of direct individual proprietorship or as a partnership affair. Some of the various reasons for incorporating finally led the pro- prietors to take the step of incorporation. The business grew and the owners added to the capital account out of the earnings, so that the present value of th© plant is far in excess of the capitalization. It may be that the business has passed through the hands of several generations in this way. Or it may be that the business met with rapid and large success. In recent years then automobile in- dustry has presented examples of especially swift expansion, and the building-up of as- sets out of earnings. Whatever the business, let us assume that for some reason a time has come when the owners are willing to part with their exclusive ownership and admit outside capitalists to an interest in the business. It may be that one of the preseiit owners wishes to withdraw and the owners are not able or are not ready for any other reason to buy out his interest. Perhaps an owner has died and REORGANIZATIONS 305 the beneficiaries of his estate want to Hqui- date his interest in the business. Very likely the present owners wish now to expand the business more rapidly than they can exclu- sively out of earnings. For one of these rea- sons, or for any other, they want access to the general market for capital, and are pre- pared to part with some of their stock interest. Their present stock, however, is worth too high a premium to be disposed of advantage- ously in the general market. So they must recapitalize. Let us assume the case of a business which has taken advantage of the principle of trad- ing on the equity and in times past has bor- rowed some capital by issuing bonds, so that its capitalization now stands in this way: — Stock .- $250,000 Bonds 1,000,000 Its earnings, however, show that the capi- talization does not represent the actual val- ues in the business. Let us say that the in- come account shows in a normal year: — Net earnings $525,000 Interest 50,000 Available for dividends $475,000 A careful management would advise carry- ing $50,000 of this to a reserve account, and leave for actual distribution $425,000. This S06 CORPORATION FINANCE approaches 200 per cent on the present capi- talization, and would exceed 7 per cent on a capital stock of $6,000,000. Let us assume that an appraisal would show a valuation of assets of $7,000,000 so that the corpora- tion, considering its $1,000,000 of bonds, may properly increase its capital stock outstanding by $5,750,000. The owners decide to increase the capital stock authorized to $8,000,000 and declare a stock dividend of 230 per cent. Let us assume that the purpose of the stockholders in doing this was to permit such of them as chose to dispose of part or all of their ownership in the business, and that, as a matter of fact, the owners of a quarter interest wish to dispose of all their holdings, and enough others wish to realize some cash to dispose of one twelfth more of the ownership of the business. Since the stock is "full paid," they can dispose of it at any price they see fit. If the recapitalizing were done with a view to providing cash for corporate purposes, the private owners would have agreed to con- tribute such a pro rata of the stock dividend to that end. They may sell, let us say, $2,- 000,000 of the stock at 90, and raise $1,800,- 000 for the corporation. Putting through such a transaction by means of recapitaliz- ing would depend upon unanimous consent. REORGANIZATIONS 307 and would be practicable only in the case of corporations with a very small number of shareholders. Sometimes the situation may be just the opposite of that we have described. Though a corporation may be solvent., it may have so large an amount of stock outstanding and its earnings be so small that there can be no hope of a policy of dividend declaration on the existing stock. This situation is more likely to exist with corporations which have large amounts of preferred Stock, especially if it is cumulative and has arrears of divi- dends. In such case the corporation can sim- ply go through the legal procedure for re- ducing capital stock. INDEX Accounting, for corporations, n, 175; importance of conlplete, for purposes of corporation fi- nancing, II, 187. Adequate return, what is an, i, 221, 224. Adjustment bonds in reorganiza- tions, n, 294. Advertising, sale of securities, n, 70; issue of securities, reasons for not, II, 74. Alive in sinking fund, keeping, bonds, I, 162; criticism of, i, 164. ALis Chalmers Company, parti- cipating stock, I, 20. Allotment, meaning of, n, 146; on public offer, ii, 153. American Agricultural Chemical Company, preferred stock, i, 17. American Cotton Oil Company, redeemable stock, i, 27; pre- ferred stock, I, 29. American Light and Traction Company, subsidiaries, i, 137. American Smelters Securities Company, redeemable stock, I, 27; preferred ordinarily has no voting power, i, 28; classes of stock, I, 76. American Telegraph and Cable Company, guaranteed stock, I, 133. American Telegraph and Tele- phone Company bonds, stipu- lations limiting power of share- holders, I, 31; convertible bonds, I, 48. American Tobacco Company, preferred stock had limited voting power, i, 28. American Woolen Company, fluctuations in gross earnings, I, 67; compared with fluctua- tions in operating, i, 61. Amortization, permits readjust- ment of corporate debt, i, 145; reasons for, i, 145, 147; lender insists on, i, 146, 150; deprei elation of assets, i, 148; trading on the equity, i, 148; Great Lakes Steamship bonds, i, 149; of debt on mining property, i, 149; railway equipment, l, 149; of debt on timberland, i, 150; tests of plan, i, 152; classifica- tion of methods, i, 163; by serial ipaturity, i, 153; charge of, I, 156; by cash deposit, i, 167; by purchase of securities of other corporations, i, 157; bonds subject to call, i, 159; by repurchase of securities, i, 159; by repurchase, sugges- tions for improvements in form, Ii 164; failure to keep up should constitute a default, I, 165. Annual report required by Stock Exchange, ii, 162. Appearance of securities, impor- tance of, 1, 212. Apportionment of risk, income and control as formative cause in corporation finance, i, 2. Appraisal, in course of reorgani- zation, II, 28. Arbitraging in stockholders* rights, ji, 28. Arkansas Valley & Western Rail- way Company bonds, i, 123. Arlington Mills, financed on one cla^ of stock, I, 15. 310 INDEX Armour & Company bonds, stip- ulations limiting power of shareholders, r, 31. Assets, preference as to, class of stock enjoying, i, 7; new, and first mortgage, I, 116; depre- ciation of, and amortization, i, 148; and term of bonds, i, 182; treasury stock not, ii, 11. Associated Merchants Company, preferred stock, 1, 29. Assuming bonds, of subsidiary by parent corporation, i, 121; in case of merger, i, 127. Atchison, Topeka & Sante Fe, preferred stock, I, 28; converti- ble bonds, I, 46, Atlantic Coast Line Railroad, Louisville & Nashville collat- eral, bonds, I, 128. Auditor's report, in reorganiza- tion proceedings, ii, 248. Authority to issue bonds, i, 113. Authorized and unissued bonds, I. 113. Authorized and unissued stock, I, 109; what must sell for, n, 11. Baltimore & Ohio Kailroad, pre- ferred, I, 17. Bank, distinguished from bank- ing house, n, 39; financial, ii, 48; securities as collateral for loans, n, 48. Bankers, part of, in developing corporation finance, i, 3; rela- tions of, with clients and cor- porations, 1, 4; getting part of profits in watered stock, I, 88; profit in marketing bonds, i, 92; promoters and underwrit- ers, bargaining with, i, 98; in- sistence of, on blanket mort- gage, I, 115; underwriting sale of stock, n, 16; engineers, ii, 40. Banking house, advantage of in providing capital, n, 8; dis- tinguished from bank, u, 39; work of, n, 39; simple organi- zation,- n, 84. Basis rate, uniform quotation in terms of, i, 153. Bill, creditors', ii, 224. Birmingham Light & Power Company bonds, i, 35. Blanket mortgage, definition of, 1, 114; bankers' insistence on, i, 115; extending over new assets as second mortgage, i, 121. Bondholders, actual present con- trol exercised by, i, 29; limita- tion on control of shareholders in favor of, I, 30; want assur- ance of income, i, 67; non-de- positing in reorganization, posi- tion of, IJ, 240. Bonds, and shares, number of, creating perpendicular divi- sions of ownership, i, 9; con- tingent control of, I, 29; mortgage, i, 31; debenture, i, 36; income, I, 36; mortgage, strongest contingent control, I, 37; second mortgage, i, 37; debenture, contingent right of control, I, 38; debenture, why issued, I, 38; first and consoli- dated mortgage, i, 38; first and refunding mortgage, i, 38; in- come, mortgage lien common- ly given, I, 42; convertible, con&ol of, I, 43; participating and convertible, compared, i, 44; interest rates of, and cur- rent rates, i, 110; term of, and the money market, i, 110; versus preferred stock in fi- nancing an expansion, I, 110; financing expansion on, i, 112; authority to issue, i, 113; au- thorized and unissued, i, 113; subject to call in financing ex- pansion, I, 114; subsidiary, as collateral for bonds of parent company, i, 122; stock collat- eral in financing combinations, I, 128;' guaranteed, in financ- ing railway terminals, I, 141; INDEX 311 coupon, form of, l, 173; reg- istered, form of, I, 176; de- nomination of, I, 178; issues, with two interest rates, i, 180; optional, i , 181 ; redeemable, i, 181; term of, considerations affecting, i, 181; long-term, examples of, i, 185; registered versus coupon, i, 190; regis- tered, and inheritance tax, i, 192; interchangeable, i, 193; registered as to principal, i, 194; domicile, i, 195; offered to stockholders, n, 25; and stock, as collateral, n, 50; brokers' commissions, n, 53; special in- formation required for listing, u, 72; text of, for listing, n, 165; documents, filed for list- ing, n, 168; Usting additional amounts, n, 174. Bonuses, stock, use of, i, 98. Borden's Condensed Milk Com- pany redeemable stock, i, 27. Boston & Albany, debenture bonds, I, 39; guaranteed stock, I, 133. .Boston & Maine, preferred stock, I, 17, 28; debenture bonds, i, 39. Boston & Providence Railroad, guaranteed stock, i, 134. Boston Electric Light Company, case of, I, 253; vs. Perry, 1, 269. Boston Terminal Company, fi- nancing, I, 142. Breadth of market, definition, i, 205. Brokers, bond, on London Stock Exchange, i, 205; raising funds through, n, 4; differentiated from investment bankers, ii, 44; commissions of, n, 53; mortgage commissions, n, 53; commissions, in commercial paper, n, 55; street, work of, n, 96; syndicate, commissions to, n, 124. Bronx Gas & Electric Company, case of, I, 243. Brookline Electric Light Com- pany, case of, I, 252. Buffalo, Rochester & Pittsburgh Railway, participating stock, I, 19. Burden of the debt, definition, i, 152; sprial maturity and, i, 155; depreciation of asset and, I, 156. Business depressions, why in- dustrial enterprises feel acute- ly, I, 68; why public service corporations are least affected by, I, 59; why railroads feel less than industrials, i, 59, Business, expansion of, how cor- poration can finance, i, 103. Business risk, indicated by varia- tion of net income, i, 54; de- pends on what, i, 56. Buying securities, work of bank- ing house in, u, 87. Call, stock, subject to, i, 25; bonds subject to, and financing an expansion, I, 114; bonds, subject to, and amortiza- tion, I, 159. Capital, alternative of raising, di- rectly or through middleman, n, 1; dealers take risk of pro- viding, n, 3; raising through brokers, n, 4; adequate organi- sation for providing, for some corporations,ii,6; advantage of banking house in providing, ii, 8; new, appeal to stockholders for, n,'21; amount required by investment banker, n, 46; of investment bankers largely supplied by borrowing, n, 47; inexperienced seekers for, n, 65; demand for, unlimited^ supply, limited, ii, 66. Capital, when corporation may undertake to provide itself, ii, 5; why some corporations must raise it without middleman, n, 6; when corporation can pro- vide itself, n, 8. 312 INDEX Capital account, adding to, through maintenance, n, 183; readjustment of, ii, 296. Capital stock, new, of public service corporation offered to shareholders, i, 251. Capitalists, part in developing corporation finance, I, S; fit- ting financial ability of, i, 10; fitting type of mind, i, 10; in underwriting syndicates, i, 95; finding, n, 77; investors in mortgages, n, 79. Capitalization, return on total, must be considered in deter- mining fairness of charge, i, 223; cost, original, as basis of, I, 234; cost of reproduction as basis of, 1, 234; cost of replace- ment as basis of, i, 238; public service commissions and, i, 240; control over: Massachu- setts, I, 248, New York, r, 254, Wisconsin, i, 255; changes in plan of, as result of insolvency, n, 221. Capitalizing unearned incre- ment, I, 235. Carrying, bonds for syndicate undivided, n, 108; syndicate bonds, divided, ii, 109; syndi- cate bonds, special, ii. 111. Cash deposit, amortization by, I, 157. Cashier's department of invest- ment banking house, n, 89. Caveat emptor, doctrine of, and watered stock, i, 104. Centra! Leather Company, pre- ferred, I, 17. Central of Georgia Railway in- come bonds, history of, i, 40. Central of New Jersey Railroad, stock, I, 222; earnings, i, 223. Certificate, stock, proposal to do away with par value, i, 84, 104; ordinary stock, form of, i, 166; common stock, form of, I, 167; preferred stock, form of, i, 169; stock, power of attorney on, i. 172; of stockholders' rights, n, 24; of deposit, listing, ii, 169; voting trust, listing, a, 169; receivers', ii, 229; of deposit, reorganization, ii, 238; of de- posit, reorganization, dealings in, II, 240; listing, on Stock Ex- change, n, 240. Charge, a fair, what is, i, 22; fair- ness of, disguised by watered stock, I, 85; protection of pub- he, by the State, against exces- sive, I, 220; excessive, accusa- tion of, generally made only of monopolistic enterprises, i, 221; return on total capitaliza- tion must be considered a fair, I, 223. Charter, limiting amount of stock, I, 109; and authority to issue bonds, I, 113. Chelsea Gas Light Company, case of, I, 262. Chicago & Alton Railroad, par- ticipating stock, I, 18. Chicago " Bell Telephone Com- pany bonds, stipulation limit- ing power of shareholder, i, 33. Chicago, Burlington & Quincy, Illinois division bonds have two interest rates, i, 180. Chicago, Milwaukee & St. Paul Railway, participating stock, I, 18; debenture bonds, i, 39; bond issue with two interest rates, i, 180. Chicago Northwestern Railway, participating stock, i, 19. Chippewa Railway Light & Power Company, case of, l, 267. Cincinnati, Chicago & St. Louis Railway, participating stock, I, 20. Circular,^ securities, distribution of, II, 71; bond work of prep- aration, II, 88. Civil War Bonds, selling by Jay Cooke & Co., II, 76. Clearing securities, ii, 98. INDEX 313 Client, banker's interests with, i, 4; investor becomes, of sales- man, II, 81. Close market, definition, I, 201. Closed mortgage, I, 113; and in- vestors, I, 115; or open as affecting marketability, i, 213. Closer market for some securities off stock exchange than on, i, 201. Collateral, bonds, issued on bonds of subsidiary, i, 122; versus guaranteed bonds in financing expansion, i, 123; systematic financing of expansion on, i, 124; on stock, as a means of financing combinations, i, 128; milking, u, 60; syndicate re- leasing, n, 127; trust bond issue, example of, n, 217. Collateral for loan, seciu:ities as, n, 48, Colorado & Southern Railway, classes of stock issued by, i, 73. Combination, definition, i, 126; through stock ownership, j, 127; through holding company, 1, 130; by lease versus collateral bonds, 1, 131; through leases, i, 131; of corporations which are not competitive in selling, i, 136. Commercial and Financial Chroni- cle, as financial trade paper, ii, 89. .Commercial bankers, distinguish- ed from investment bankers, 11, 38. Commercial paper broker's com- mission, n, 65. Commission, commercial paper brokers, n, 66. Commission, for business on Stock Exchange, i, 201; under- writing, II, 17; for procuring loans on mortgages, n, 53; for selling bonds, n, S3; syndicate for selling, n, 123; by syndi- cate to brokers, n, 124; split- ting, by syndicate brokers and membfers, not allowed, n, 125. Committee, on stock list, ii, 164; protective, formation, ii, 230. Common shareholders, accept maximum risk, i, 7; expect maxinium income, i, 7; incident of control and, i, 7'; and pre- ferred possible conflict of in- terests, I, 12; as traders on the equity, i, 53. Common stock, and preferred, amounts of varying quality as well as quantity of ownership, 1, 13; ^nd preferred, compared, I, 16; jvith more control than preferred, i, 28; possible power of, to create debt to disadvan- tage of preferred, i, 70; financ- ing an expansion, i, 108; certifi- cate, form of, I, 167. Competition, in investment banking, n, 60; regulation of, Massachusetts, i, 267; regula- tion of. New York, i, 276; regulation of, Wisconsin, i, 280. Computation, a sinking fund, i, 163. Conducting operations, as part of operating expense, ii, 178. Confirmation of syndicate sales, n, 126. Consolidation, definition; regu- lation of, Massachusetts, i, 274; regulation of. New York, I, 277. _ Consols, income from and true interest, i, 266. Construcjtion, interest to be a) lowed during, and capitaliza tion, I, 236. Construction Company, financ- ing an expansion by means of, I, 120. Control, risk and income, appor- tionment of, as a formative cause in corporation finance, I, 2; incident of, and common shareholder, i, 7; by minority 814 INDEX shareholders, i, 79, 81; through stock-ownership, 1, 130. Convertible bonds, conditions of conversion, i, 43; control of, I, 43; and participating, com- [ pared, i, 44; cannot separate speculation and investment, i, 90; versus watered stock in fi- nancing, I, 90. Convertible bondholders not en- titled to stockholders' "rights," n, 34. Convertible preferred stock, i, 20. Corporate form, significant fea- ture of, financially, i, 4; person- ification of owner and enter- prise, I, 6; divides management into administration and con- trol, I, 7; flexibility of incidents of ownership in, i, 7. Cost of service, meaning of, Massachusetts, i, 262. Counterfeiting, securities, safe- guarding, n, 164; danger of, in securities, i, 212. Coupon bond, form of, ii, 173. Credit of corporation and term of bonds, I, 183. Credit of old corporation given to subsidiary construction com- pany, I, 121. Credit, risk of dealing in, n, 44. Creditors' bill, n, 224. Crucible Steel Company, pre- ferred stock, I, 17. Cumulative preferred stock, i, 69. Dayton & Michigan Railroad preferred, no voting power, l, 28. Dealers in securities assume risk, n, 3. Debenture bonds, i, 36, 38. Debentures, covenant against creation of prior lien, n, 218. Debt, creation of, to disadvan- tage of preferred stock, i, 70; reasons for amortization of, i, 146; i*erpetual, business rea- sons for, I, 146; perpetual, ob- jection to by corporate credi- tors, I, 146; perpetual, objec- tion to, from standpoint of corporation, i, 147. Dedham'& Hyde Park Gas Com- pany, case of, I, 253. Default, failure to keep up amor- tization should constitute, i, 165; giving right to foreclos- ure, n,222; remedies of trustee, II, 247. Deferred interest, discount is, i, 233. Delaware & Hudson Company, convertible bonds, i, 47. Delaware, Lackawanna & West- ern bonds, long term, i, 185. Delivery of syndicate securities, n, 125. Denomidation of bond, I, 178; small, 'in France, i, 179, 216; small, high cost of selling, i, 179, 216. Denver & Rio Grande Railroad, fluctuations in gross earnings, I, 67; compared with fluctua- tions in operating, i, 61; pre- ferred .stock, I, 221; earnings, I, 223. Depreciation, amortization and, I, 148; burden of debt, and, i, 166; as part of maintenance, ii, 182. Depositories for protective com- mittee-, foreign, ii, 244. Depository agreement, protec- tive committee's broad powers, n, 234; protective committee's extract from, n, 235. Depository committee, to assure assents to sale of property, ii, 214. Deposit, taken by investment bankers, ii, 42; certificate of reorganization, n, 238. Depositing securities, reorganiza- tion, e^ension of time for, ii, 265. INDEX 315 Development of corporation fi- nance, influence of bankers and promoters, i, 13. Diagram of effect of variation in gross and operating, i, 167. Directors qualifying shares, ii, 198, note. Discount, bonds sell at disadvan- tage at too great a, i, 180; se- curities sold at, not overcapi- talizing, I, 233; bonds of Wis- consin public service corpora- tions must not be issued at, of over twenty-five per cent, i, 257. Divided carrying, n, 109. Divided liability, syndicate, ii, 121. Dividends, investor's point of view, n, 188; policy of, ii, 188; speculator's point of view, ii, 188; special, n, 189; discretion in directors, as to, n, 193; stock, II, 193; stock, to reduce market price of a stock, n, 194; warrants for, n, 195. Division of corporate labor through subsidiaries, l, 143. Divisional first mortgage bonds, I, 121. Domicile of bonds, i, 195. Dominion Coal Company, re- deemable preferred stock, i, 27. Donated stock, li, 9. Drawing by lot bonds subject to call, I, 161. Dry capitalization versua watered stock, L, 102. Edison Electric Illuminating Company, case of, i, 209. Eighth Avenue Railroad guaran- teed stock, I, 136. Electric Bond and Share Com- pany, as special type of holding company, i, 138. Engineering bankers, n, 40. Equipment agreeirient, receiver may refuse to recognize, li, 227. Equipment, railway, amortiza- tion and, I, 149. Equity, trading on the, definition of term, i, 50. Erie Railway, redeemable pre- ferred stock, I, 27; classes of stock, i,"75; bonds, i, 119. Ethics of investment banking business, n, 67. Expansion, financing, on common stock, I, 108; financing, and trading on the equity, i, 109; financing, on bonds, i, 112; financing, on preferred stock, I, 112; financing, through sub- sidiary corporation, i, 120; systematic financing, on col- lateral' bonds, I, 124; by lease, simplicity of financial problem, I, 132. Expenses of members of syndi- cate, u, 114. Expenses of syndicate, ii, 114. Family corporations, ii, 5. Fall River Gas Works, case of, I, 252. Fashions, in investing, I, 110; serial maturity and, I, 154; terms of bonds and, l, 186. Filing reorganization agreement, u, 253. Financial ability, fitting, n, 10. Financial banks, n, 48. Financial institutions, and se- curities salesmen, ii, 82; com- petitive nature, of securities business with, ii, 83. Financial plan, influences deter- mining, I, 2; readjustment of, permitted by amortization, I, 145. . Financial risk, as indicated by variations of surplus, i, 54; effect of fixed charges on fluc- tuating net, I, 64. Financing expansion (see Expan- sion), preferred stock versus bonds,' 1, 110; bonds subject to call and, i, 114; by means of 316 INDEX construction company, i, 140; through subsidiary corpora- tions, I, 120. First and consolidated mortgage bond, I, 38; meaning of, i, 116; or refunding and financing an expansion, i, 116. First and refunding mortgage bond, I, 38; definition, I, 116. first mortgage, on new assets, i, 116; misleading use of term, I, 117; bonds, divisional, i, 121. Fixed charges, what are, ii, 179. Florida East Coast Railway in- come bonds, I, 42. Foreclosure, defaults leading to, n, 222; preparing for, n, 246; who may take action, n, 248; franchise in, ii, 251; upset price in, n, 256; part payment in bonds, II, 258; providing cash requirements, n, 260; sale un- der, II, 270; decree of, n, 271. Foreign bondholders, special de- pository for, under reorganiza- tion, II, 244. Foreign exchange departments of investment banking houses, u, 43. Formative influences in corpora- tion finance, i, 2. Fractional right of stockholder, n, 22. Franchise and term of bonds, l, 186. Franchise, in foreclosure, ii, 2S1. Fraud on public worked by watered stock, i, 83. French market, small denomina- tions and, I, 179; advantage of right of redemption, i, 189. Full paid, significance of term, I, 170. Future acquired property mort- gage, I, 114. Gross earnings, how distributed, I, 53; variations of, different kinds of business, I, 57. Gross income, differing sources, II, 177. Guaranteed bonds of subsidiary by parent corporation, i, 122. Guaranteed bonds as means of financing railway terminals, i, 141. Guaranteed bonds versus collat- eral, in financing expansions, I, 123. Guaranteed stock arbing from lease, li 131. Harriman, E. H., Northern Pacific contest, i, 25. Haverhill Electric Company, case of, I, 271. Haverhill Gas Company, case of, I, 266. Hill, J. J., Northern Pacific con- test, I, 25. Hill vs. Antiago Water Company, case of, I, 244, 266. Holding company, combination through, 1, 130; special type of, 1, 136; insuflScient statement of earnings, n, 196; special nature of income, n, 196; effect of de- clining' earnings of operating companies, n, 200; income compared with that of an op- erating company, n, 201; effect of increasing debt of subsidi- aries, M, 204. Horizontal division of risk, i, 6. Incidents of ownership, separated by lea^e, i, 4; separated by mortgage, i, 4; what consti- tutes, 1, 4; effect of letting, on shares, i, 6; how distributed by partnership, i, 5; and trustee, i, 6; limited division of, under personal ownership, i, 6; flexi- bility 9f, in corporate form, i, 7; watered stock is affecting divisions of, i, 88. Income, as incident of ownership, I, 4; common shareholders ex- pect maximum, i, 7; prefer- INDEX 317 ence as to, i, 7; from preferred stock, 1, 17; unsatisfactory con- trol of, I, 39; mortgage lien of, 1, 42; greater, expected by trad- ing on the equity, i, 51; con- fident expectation of, wanted by preferred shareholders, i, 68; from consols, i, 226; from municipal bonds, i, 227; from United States Government bonds, I, 227; corporate, IT, 175; gross, differing sources, ii, 177; bonds, in reorganization, n, 294. Income account, condensed form, n, 176; for public service cor- poration, n, 179; larger form, n, 179; for manufacturing business, ii, 188. Income bonds, i, 36. Indebtedness, business principle of, I, 144; reasons for perma- nent corporate, I, 145. Industrial corporations, small, difficulty in providing capital, II, 7; special difficulty in financ- ing small industrial corpora- tions, a, 65. Industrial enterprises, why they feel depressions acutely, i, 58; why financing of, not as well orgarized as that of public ser- vice corporations, i, 139; finan- cing by investment bankers, ii, 42. Inheritance tax, registered bonds and, I, 192. Inquiries for securities, n, 100. Insolvency as cause of changes in plan of capitaUzation, ii, 221. Insurers, underwriting syndicate in position of, n, 155. Insuring the provision of capital, II, 4. Interborough Metropolitan Com- pany preferred, i, 17, 29. Interchangeable bonds, i, 193. Interest, change in relation to gross income, i, 54; rates of, bond and current, i, 110; con- siderations affecting determi- nation- of, 1, 179; dates, consid- erations affecting, i, 180; true, what is, I, 224; perpetual securities and, i, 225; time risk in, i, 225; deferred, dis- count is, I, 233; allowed during construction and capitaliza- tion, I, 237; account of syndi- cate, II, 111; in default, ad- vancing payment by protective committee, ii, 231. Interim certificate, pending de- finitive security, ii, 159. International Harvester Com- pany, preferred stock, i, 17. Investing, fashions in, i, 110. Investment banker, why corpo- ration resorts to, n, 35; general limitations of business of, ii, 36; how corporation estab- lishes relations with, n, 36; multiplicity of proposals for business, ii, 37; as promoter, n, 37; distinguished from com- mercial bankers, ii, 38; distin- guished from private bankers, 11, 38; and industrial enter- prises, n, 42; taking deposits, n, 42; doing wholesale and re- tail business, ii, 43; foreign ex- change departments of, ii, 43; as dealer in credit, risk of, ii, 44; and brokers, differentiated, ti, 44; as merchant, II, 44; profits of, n, 44; capital re- quired, n, 46; number of, ii, 46; capital of, borrowed, ii, 47; amount of profit of, u, 51; moral responsibility for securi- ties, n, 56; losses of, n, 59; work of, in building a market, n, 93. Investment banking, competitive nature of, n, 60; ethics, n, 67. Investment banking house, keep- ing in communication with salesmen and clients, u, 85; mailing list, ii, 86; work in 318 INDEX buying securities, n, 87; statis- tical department of, li, 88; work in educating capitalists, II, 88; cashier's department, ii, 90; trading in issues it has sold, II, 94. Investment Bankers' Associa- tion, number of members, li, 46; qualifications for member- ship, II, 46. Investment, separating from spec- ulation, I, 87. Investors, closed mortgage and, i, 115; expect risk of market on large issues, i, 210; small, pre- ferred, II, 92. Issues, size of, as affecting con- trol, I, 68; large, advantage of, I, 124; small, neglect of, on New York Stock Exchange, i, 205; large, importance of list- ing, 1, 208; of securities limited, and danger of selling short, ii, 87. Issuing stock, n, 9. Jay Cooke, selling Civil War bonds, II, 75. Jobbers on London Stock Ex- change, X, 206. Joint accounts, ii, 69, 102; reason for forming, u, 103; invitation to participate in, n, 104. Joint adventure, legal situation of securities syndicate, ii, 138. Kansas City Southern Railway preferred stock, l, 17. Kansas City Terminal Railway Company, financing of, I, 140. Kings County Electric Light & Power Company, case of, i, 243. Kuhn, Loeb-Harriman, Northern Pacific syndicate, i, 25. Lacrosse Gas & Electric Com- pany, case of, I, 281. Lake Shore & Michigan Southern bonds, long term, I, 185. Large issues, necessity of listing, I, 208; advantage of, i, 124. Lawyers, with bankers in devel- oping corporation finance, i, 4. Lease, dividing incidents of own- ership, I, 4; as means of com- bination, I, 121; giving use to guaranteed stock, i, 131; re- ceiver may disaflSnn, u, 227; in reorganization, u, 292. Legal considerations of syndicate transactions, n, 139. Lender protected by equity of proprietor, i, 52; insists on amortization, i, 150. Letters forming syndicate, n, 132. Liens, complexity of, li, 209. Limited liabihty syndicate, n, 121. Listing, Qn New York Stock Ex- change does not necessarily assure trading there, i, 205; does not in itself sell securities, n,157;i expected forlargeissues, II, 157J increases difficulty of protecting the market, n, 158; why not, before public offering, n, 158; application for, n, 159; fee for, ii, 161; annual report required, ii, 162; mechanical execution of securities for, it, 163; Committee on Stock List, n, 164; interchangeable bonds, II, 165j printing requirements, II, 166; registered bonds, n, 165; text of bonds, ii, 165; re- quirement of documents, n, 166; stock certificates, ii, 166; securities of reorganized cor- porations, II, 168; additional amounts of stock, n, 169; cer- tificates of deposit, n, 169; general information required, n, 169; voting trust certifi- cates, n, 169; bonds, special information required, ii, 172; additional amounts of bonds, n, 174. Loan to syndicate to take up se- curities, a, 105. INDEX 319 London Stock Exchange, market for small issues on, i, 206. Longacre Electric Light & Power Company, case of, i, 277. Long-term bonds, examples of, i, 185. Loss of syndicate members, dis- tribution, n, 119. Losses of investment bankers, n, 59. Mackay Companies redeemable preferred, i, 27. Mailing list of investment bank- ing house, II, 86. Maintenance, as part of operating expense, u, 178; analysis of, li, 182; adding to capital account through, n, 183. Management, as incident of ownership, l, 4; corporate form divides into administration and control I, 7; operating account as showing efficiency of, n, 181. Manager, of syndicate, ii, 106; of syndicate work of, n, 126; of underwriting syndicate, n, 147; of underwriting syndicate, powers of, w, 147. Manhattan Elevated Railway bonds, long-term, i, 185. Manitowoc Gas & Electric Com- pany, case of, I, 266. Manufacturers' Gas Light Com- pany, case of, I, 252. Manufacturing business, income account for, n, 186. Market, condition of, and term of bonds, I, 184; class, i, 201; quick, I, 201; slow, i, 202; breath of, i, 206; protecting the, 1, 207; n, 147; Stock Ex- change quotation as index of, I, 209; insecurities, closing up of, II, 59; building, n, 93, 160; supporting, u, 91; off the Ex- change, n, 95; insecurities, sensitiveness of, n, 100; wide, n. 202. Marketability, an element of value, I, 203; size of issue and, I, 204; savings bank require- ments and, 1, 217; tax exemp- tion and, I, 217; trustee re- quirements and, I, 217. Massachusetts Gas & Electric Commission, valuation of phy- sical 'property, I, 241; valua- tion of property other than physical, i, 242; control over capitalization, i, 248; regula- tion of rates, i, 259; regulation of competition, i, 267; regula- tion of consolidation, i, 274. Massachusetts requirement that public service corporation offer shareholders at price deter- mined, n, 15. May Department Stores Com- pany, redeemable stock, i, 27. Members of syndicate, contribu- tion to purchase, n, 107; ex- penses of, ir, 114; selling com- mission, n, 123. Merchants, investment bankers do business as, ii, 44. Mergenthaler Linotype Com- pany financed on one class of stock, I, 15. Merger, assuming bonds in case of, 1, 127; physical, example of, n, 213. Middleman, in raising capital, n, 2; service, in raising funds, n, 3. Milwaukee & Ox River Railway, case of, I, 282. Mining property and amortiza- tion, I, 149. Minneapolis, St. Paul & Sault Ste. Marie Railway participating stock, 1, 19, 29. Minority, why a, may control, i, 79; how small, of shareholders may control, i, 81. Missouri, Kansas & Texas bonds, long term, i, 185. Missouri Pacific Railway Com- pany collateral bonds, l, 124. Money market, term of bonds and, I, 111. 820 INDEX Money truat, charged that exists, II, 63; charged by inexperienced seekers for capital, ii, 66. Mortgage, separating incidents of ownership, i, 4; corporate, elaborate document, i, 89; first and consolidated, i, S8; first and refunding, i, 38; open and closed, I, 113; blanket, what is a, I, 114; future acquired prop- erty, I, 114; closed, investors and, I, 115; first, misleading use of term, i, 117;cominissions for procuring loans on, n, S3. Mortgage bonds, i, 36; second, i, 87; strongest contingent con- trol, I, 376. Morgan, J. P., and Northern Pacific contest, i, 25. Morris & Essex Railway bonds, long term, i, 185. Municipal bonds, income from, i, 227. Nashville Railway & Light Com- pany bonds, stipulation limit- ing power of shareholders, i, 34. National Enameling & Stamping Company bonds, stipulations limiting power of shareholders, T, 35. National Lead Company redeem- able preferred stock, i, 27. Net income, variation of, de- pends on fluctuation of gross and operating, i, 54. New Bedford Gas Company, case of, I, 274. New Capital, corporation not organized to provide, n, 3. New York & Erie Railroad bonds, I, 118. New York Central & Hudson River Railroad; debenture bonds, I, 39; equipment bonds, I, 153; short-term notes, i, 184. New York, New Haven & Hart- ford Railroad debenture bonds, 1,39. New York Public Service Com- mission, I, 240; valuation by, of physical property, r, 242; valuation of property other than physical, i, 243; control over capitalization, i, 254; reg- ulation of rates, i, 265; regular tion of competition, i, 276; regulation of consolidation, i, 279. New York Stock Exchange, neg- lect by, of small issues, i, 205; importance of listing large issues on, i, 208. Nomenclature of syndicates, n, 143. Norfolk & Western Railway, long-t&m bonds, I, 185. North American Company sub- sidiaries, I, 137. Northern Pacific and Great Northern, Harriman-Hill con- test over, I, 25; C, B. & Q. collateral bonds, i, 128. Notes, issued in panic time, i, 111; continuous financing on, expensive, i, 186. Obstructionists to reorganiza- tions, n, 266. Ocean Steamship Company, earnings, and Central of Geor- gia Railway, i, 40. Offering of securities, public, n, 70. Open mortgage, i, 113; or closed, as affecting marketability, i, 213. Operating account, for showing efiiciency of plant, n, 181. Operating expenses, in relation to gross income, i, 64; why they cannot be cut proportionately with decline in gross, i, 60; elemeats of, ii, 177. Operating ratio, analysis of, n, 180. *. Optional bonds, i, 181. Oregon Short Line Railroad, collateral bonds, i, 129. INDEX 321 Organization of investment bank- ing houses, II, 84. Original cost as basis for capitali- zation, I, 234; Wisconsin, j, 244. Overcapitalization may result from causes other than stock- watering, 1, 86; securities sold at a discount not, i, 233. Oversubscriptions, and closing books, n, 72; sometimes merely technical, n, 73. OwTiership, creation of different kinds of, i, 8; horizontal divi- sions of, 1, 8; quantity of, 1, 9; quality of, i, 19. Ozark & Cherokee Central bonds, 1,23. Panic and note issues, i. 111. Par value, explanation of term, i, 84, 170; desirability of remov- ing from certificates, i, 104. Parent corporation, two ways of giving credit for benefit of sub- sidiary, I, 121. Participating and convertible bonds compared, i, 44; partici- pating bonds M. watered stock, 1,89. Participating stock, I, 18. Participations in, underwritings, " withdrawn,"n, 15; of original syndicate members iu under- writings, n, 144. Partnership, power to separate incidents of ownership, i, 5; not fitting types of minds, i, 10. Pennsylvania Bailroad bonds, i, 48, 223. Peoria Railway Company bonds, limitations on power of share- holders, I, 36. Perpendicular divisions of owner- ship, I, 9. Perpetual debts, business reasons for, I, 146; objections to, by creditors, r, 146; objections from corporate standpoint, i, 147; and interest rate, I, 225. Personal ownership, limited num- ber of possible divisions of in- cidents, 1, 4, 6, 11. Philadelphia, Germantown & Norristown Railroad, guaran- teed bonds, I, 136. Pittsburgh, Fort Wayne & Chi- cago Railway, guaranteed stock, 1, 135. Plant, efficiency shown by analy- sis of operatmg account, ii, 181, Portland & Ogdensburg Railway guaranteed stock, x, 135. Power of attorney on Stock certi- ficate, i, 172. Power of substitution, meaning of, I, 173. Preferred and common share- holders, possible conflict of in- terests, 1, 12. Preferred stock, and common, amounts of varying quality as well as quantity of ownership, 1, 13; at once create two kinds of ownership, i, 16; income from, I, 17; convertible, i, 20; redecEjable, i, 25; ver^ng on income bond, i, 28; with less control than common, i, 28; should be cumulative if in mi- nority,- I, 69; creation of debt to disadvantage of, i, 70; effect of increasing, i, 73; why often given veto on creation of debt, I, 74; versiD bonds in financing an expansion, i, 110; financing expansion on, i, 112. Preferred stockholders not en- titled to " rights," n, 33. Premium, bonds sell at disad- vantage, 1, 180; for risk, i, 224; appraisal at large, i, 228; can- not be determined by statu- tory enactment, i, 229; difficulty of determination of govern- ment agency, i, 229; unfairness of retroactive determination, i, 229. Present value as basis for capi- talization, Wisconsin, i, 244- 322 INDEX Price of stock in relation to di- vided policy, II, 192. Private bankers, distinguished from investment banlcers, n, 38. Profits of investment bankers, II, 44; amount of, il, 51. Profits of syndicate, division of, II, 113; distribution, ii, 115. Promoters, part of, in developing corporation finance, i, 3; taking profits by means of watered stock, I, 90; wanting to be able to separate investment and speculation, i, 91; bankers and underwriters, bargaining among, i, 98; investment banker as, u, 37; inexperi- enced, II, 65. Prospectus act to protect public against watered stock, i, 85. Protecting market, i, 207; ii, 147; difficulty if issue listed, ii, 158. Protective committee, formation of, II, 230; announcement of, II, 231; interest payments ad- vanced by, II, 231; for various issues, II, 233; broad powers of, depository agreement, ii, 234; depository agreement, extract from, II, 235; expenses of, n, 241; extension of time to de- posit, II, 241; form of an- nouncement of, n, 242. Proxy as a means of giving mi- nority shareholders control, i, 79. Public ofifer, of securities, n, 70; of securities, preparation for, II, 71; allotment on, ii, 153; speculative subscriptions on, II, 154. Public service business subject to analysis, ii, 42. Public service commissions, scope of, I, 240; and reorganizations, II, 272; approval of reorganiza- tion securities, ii, 272. Public Service Corporation of New Jersey, perpetual interest bearing certificates, i, 146. Public service corporations, why least affected by business de- pressions I, 59. Pullman Company, financed on stock, 1, 15. Purchase syndicate, ll, 296. Pyramiding of Rock Island, i, 129. Qualifying shares of directors, n, 198, note. Quality of ownership, i, 9. Quantity of ownership, i, 9. Quick market, i, 201. Quotation, uniform in terms of basis, •!, 153; uniform price quotation impossible with se- rial maturity, i, 153; Stock Ex- change as index of market, i, 209. Railroads, corporation finance most developed in, l, 15; why less affected by business de- pressions than industrials, i, 58; terminals, financing, i, 140. Railroad issues, the largest han- dled by few banking houses, II, 41. Rate of interest, considerations, determining, i, 179. Rates, regulation of, Massa- chusetts, I, 259; New York, i, 265; Wisconsin, i, 266. Reading Company, classes of stock, I, 75. Readjustment of the capital account, n, 296; use of term, II, 221. Real estate, financing on collat- eral securities, i, 139. Recapitalization, ii, 303; use of term, ir, 221. Receiver, appointed by federal court, II, 224; appointed by state court, ii, 224; jurisdic- tion to appoint, n, 224; oflScer of court, 11, 225; duty of, to act for all parties in interest, n, 226; ifiay disaffirm lease, n. INDEX 323 227; may refuse to recognize an equipment agreement, n, 227; [ should consult court on unus- ual matters, ii, 227; usually takes deteriorated property, ii, 228; certificates of, authoriza- tion, u, 229; lien of, u, 229. Beceivership, decision to apply for, n, 223. Reconstruction, cost of, as basis for capitalization, Wisconsin, I, 244. Eedeemable bonds, i, 181. Redeemable preferred stock, i, 25. Redemption, right of, an advan- tage in French market, i, 180; reasons for retaining, i, 186; ofiFsetting market disadvantage of, I, 187; should it be a pre- niiuni, I, 189. Reduction in value of stock through new issue at par, n, 19. Refunding bond issue, example of, II, 215. Refunding issue and term of bonds, I, 186. Registered bonds, form of, i, 176; versus coupon bonds, i, 190; inheritance tax and, i, 192; as to principal only, i, 194; listing requirements, ii, 165. Registrar, of stock, i, 172; of transfers, exchange require- ments of location, n, 161. Regulation of capitalization by state, purposes of, if 220. Reorganizations, ii, 220; plan of, n, 249; agreement, ii, 252, 253; cash requirements, n, 260; as- sessments, n, 261; selling new securities, n, 261; underwriting syndicate, ii, 264; obstruction- ists, II, 266; cash requirements, extracts from provisions for, n, 267; sale under, il, 270; public service commissions in, n, 272; public service commission's approval of securities in, n. 273; publication of notice of distribution of new securities, II, 273; voting trust, ii, 273; example of financial plan of, ii, 275; lease in, n, 292; expenses of, II, 293; adjustment bonds in, n, 294; income bonds in, u, 294. Reorganized corporations, docu- ments filed for listing securities of, n, 168. Reproduction, cost of, as basis of capitalization, i, 234, 236, 238. Repurchase, of securities, amor- tization by, I, 159, 164; of stock by corporation, ii, 14. Retail business of investment bankers, ii, 43. Return, adequate, what is, I, 221 ; on total capitalization must be considered in determining fair- ness of charge, i, 223. Rights, stockholders', announce- ment of, n, 22; value of, n, 23; certificate of, ii, 24; to sub- scribe to bonds, n, 25, when difficulj; to finance on; ii, 25; arbitraging in, ii, 28; financing on nature of benefit to stock- holders, II, 29; meaning of term in New York, n, 29; fi- nancing on, compared with selling stock at a premium, ii, 31; preferred shareholders not participating in, n, 33; con- vertible bondholders not en- titled to, II, 34; do not apply to stock issued in payment for property, il, 34. Risk, as mcident of ownership, I, 4; common shareholders accept maximum, I, 7; greater, ac- cepted by trading on equity, i, 50; financial, indicated by vari- ation of surplus, I, 54; of busi- ness, indicated by variation of net income, i, 54; premium for, I, 224, 228; in raising capital. II. 4. 324 INDEX Rock Island, pyramiding on stock collateral bonds, i, 129. Rome & Clinton Railroad guar- anteed stock, I, 136. Bumford Falls and Rangeley Lakes Railroad, guaranteed stock, I, 135. St. Louis & San Francisco Rail- road, redeemable preferred stock, i, 27; classes of stock, i, 76; financing subsidiaries both by guaranteeing securities and using as collateral, i, 123. St. Louis, Southwestern Railway, preferred stock, l, 17; long- term bonds, I, 185. Sales, syndicate, confirmation of, II, 126. Salesmen, for banking houses, difficulty in selecting, ii, 71; recruiting, for banking houses, n, 76; training for banking houses, n, 76; securities, culti- vating investor, II, 80; relation- ship of investor as client, ii, 81 ; securities and financial, institu- tions, II, 82. Savings banks, legal investments for, and marketability, i, 217. Second mortgage, bonds, i, 37; on old assets, i, 117. Securities, danger of counterfeit- ing, I, 212; importance of good appearance, i, 212; sold at dis- count, not overcapitalizing, i, 233; as collateral at bank, n, 48; advertising, for sale, II, 70; clearing, ii, 98; mechanical exe- cution of, for listing, ii, 163. Selling an issue short, danger of, II, 87. Selling price, determination of, ii, 110; syndicate, n. 111. Serial maturity, amortization by, I, 153; makes uniform price quotations impossible, i, 153; and fashions in investing, i, 154; and burden of debt, i, 155. Shareholders, limitation of con- trol in favor of bondholders, i, 30; Wh^ minority may control, I, 79; new capital stock in Massachusetts public utilities must be offered to, x, 251. Shawinigan Water and Power Company, fluctuation in gross earnings, i, 57; compared with fluctuation in operating, i, 63. Short time securities, why handled on smaller profit, ii, 52. Singer Sewing Machine Com- pany, financed on stock, i, 15. Sinking fund, of other securities, I, 157; computation, i, 163; from surplus, ii, 191. Size of issue and marketability, i, 204; as affecting control, i, 68; effect of, in trading on New York Stock Exchange, i, 205. Slow maiiket, i, 202. SmaU corporations, difficulties in financing, u, 64. Small denomination, relative high cost ofselling, i, 216. Small issues, market for, on the London Stock Exchange, I, 205. Southern' Pacific Company, old redeemable preferred stock issue, I, "26. Southern Railway, preferred stock, I, 17, 26. Speculation, separating, from in- vestment, I, 89; on public offer of securities, ii, 154; after se- curities sold helpful, n, 160. Splitting commissions, syndicate brokers and members not al- lowed, II, 125. Springfield Gas Company, case of, I, 249, 262. Statistical department of invest- ment banking houses, ii, 88. State regulation of corporation finance, i, 220. Steamship bonds and amortiza- tion, I, 149. INDEX 325 Stock Exchange, closer market for some bonds off, i, 201; as market, ii, 157; expected that large issues will be listed on, II, 157; listing on, u, 157; why issues not listed on, before public offering, ii, 158; fee for listing on, n, 161 ; requirement of location of transfer agent and registrar of transfers, ii, 161; Usting certificates of de- posit on, n, 240. Stock, control and risk, i, 11; giv- ing up part of control, i, 11; one class, kinds of corporation financing on, i, 14; participat- ing, I, 13; more than one class, I, 75; certificate, proposal to do away with par value, i, 84; bonuses, i, 98; amount limited by charter, i, 109; authorized and unissued, i, 109; treasury, I, 109, II, 9; swapping, i, 127; as collateral, in financing com- bination, I, 128; forms of certi- ficate of, I, 166; common, form of certificate, i, 169; donated, II, 9; issuance of, ii, 9; issued, authorized and unissued, and treasury, example illustrating, n, 10; selling, for less than par, II, 12; treasury, corporation free to deal in, il, 12; without par value, u, 12; obligation of corporation to realize par for, causes financial embarrass- ment, n, 13; right of stock- holders to purchase, in propor- tion to holdings, ii, 13; right of corporation to repurchase, ii, 14; distributing surplus by selling, at less than market value, n, 15; offering, to stock- holders, II, 15; right of stock- holders to subscribe for, at par, II, 15; bankers underwriting sale of, II, 16; method of offer- ing, to stockholders, n, 17; re- duction in value of, through new issue at par, ii, 19; selling at a premium compared with stockholders' rights, ii, 31; as collatetal, ii, 60; form of list- ing, re?quirement, ii, 166; as dividend, ii, 193; as dividend, to reduce market price, ii, 194; Stockholders, appeal to for new capital, II, 21. Stockholders' rights, to purchase new stock in proportion to holdings, n, 13; to subscribe for new stock at par, n, 15; announcement of, ii, 22; frac- tional, II, 22; value of, ii, 23; certificate of, li, 24; to sub- scribe to bonds, n, 25; when difficult to finance on, ii, 25; meaning of term in New York, II, 29. Street broker, work of, n, 96. Subscription books, closing of, n, 72. _ Subsidiary, financing expansion through, I, 120; bonds of, as- sumed, I, 121; bonds of, as collateral, i, 122; bonds of, guaranteed, i, 122; tendency to divide corporate labor by means of, i, 143. Supporting market, ii, 91. Surplus, variation of, as indicat- ing financial risk, i, 54; and capitalization, Massachusetts, I, 264;! taking advantage of, in providmg new capital, ii, 8; distributing, through sale of stock, ;n, 15; disposition of, ii, 189; what is correct amount, II, 190; as sinking fund, ii, 191. Swapping securities, i, 127, 208. Syndicates, operations of, and watered stock, i, 88; formation of, I, 94; loan, ii, 106; selling price, determination of, ii, 110; interest account of, ii. Ill ; sell- ing price, II, 111; undivided liability, n, 112; unlimited lia- bility, n, 112; profits, division of, n, 113; expenses of, ii, 114; members, expenses of, ii, 114; 326 INDEX profits, distribution of, n, 115; distribution of unsold bonds, II, 117; distribution of losses, II, 119; selling commission, ii, 123; commissions to brokers, n, 124; securities, delivery of, II, 125; releasing bonds as col- lateral, II, 127; "take-down" price, or paying manager for bonds, II, 128; selling price, determination of, ii, 131 ; letters forming, ii, 132; elements of account, ii, 136; length of, ii, 136; legal considerations of, ii, 139; nomenclature, ii, 143; speculative subscriptions on offer of securities, ii, 154. Taking up unsold bonds, ii, 118. Tax exemption and market- ability, I, 198; 217. Taxation of securities, English system of collecting at the source, i, 197. Taxes, as operating expenses, ii, i77. Telephone man, work of, n, 95. Term of bonds, considerations affecting, i, 181; nature of assets and, i, 182; credit of cor- poration and, I, 183; market conditions and, i, 184; trading on the equity and, i, 184; ex- amples of long, I, 185; fashions in investing and, i, 186; fran- chise and, I, 186. Terminals, railroad, financing, i, 140. Texas & Pacific Railway, long- term bonds, I, 185; Timberland, amortization and, i, 150. Time risk in interest, i, 225. Trader in bonds, ii, 95. Trading of investment banking house in issues it has sold, ii, 94. Trading on the equity, definition, I, 50; watered stock and, 1, 106; financing an expansion and, i. 109; amortization and, i, 148; term of bonds and, i, 184. Transfer agency, exchange re- quirement of location, n, 161. Transfer agent, duty of, i, 171. Treasury stock, i, 109; ii, 9; not an asset, II, 11; corporation free to deal in, ii, 12; stockholders do not have right to purchase pro rata, u, 13. True interest, i, 224. Trust, nfoney, charged that ex- ists, II, 63. Trust company, and responsi- bility for amortization, i, 165. Trust deed, incorporated in bond by reference, i, 199. Trustees, legal investment for, and marketability, i, 217; remedies of on default, ii, 247. Twin City Rapid Transit Com- pany, fluctuation in gross, i, 57; compared with fluctuation in operating, i, 62. UnderwrRers and bankers, bar- gaining between, i, 98. Underwritings, ii, 69, 102; wa- tered stock in, I, 88; syndicate, 1, 94, 95; commissions, n, 17; membfil'S of original syndicate take participation in, n, 144; agreenfents, formal, ii, 145; withdrawn participations, n, 151. Underwriting Syndicate, and market in securities, u, 93; transaction, n, 141; managers protecting market, n, 149; in strict sense of insurers, n, 155; in reorganizations, ii, 264. Undivided carrying of bonds for syndicate, ii, 108. Undivided liability, syndicate, n, 112. Unearned increment, capitaliz- ing, 1, 235. Unincorporated associations to avoid federal tax, i, 218. Union Pacific Railroad Company. INDEX 327 preferred stock, i, 17; con- vertible bonds, I, 47; collateral bonds, 1, 129. United States Government bonds, income from, i, 227. United States Rubber Company, preferred stock, i, 17. United States Steel Corporation, preferred stock, I, 17; fluctua- tion in gross earnings, i, 57; compared with fluctuations in operating expenses, i, 61; a holding company, i, 131. Unlimited liability syndicate, ii, 112. Unsold bonds, distribution to syndicate members, ii, 117. Upset price in foreclosure, ii, 256. Valuation of physical property, Massachusetts, i, 241; New York, I, 242; Wisconsin, i, 243. Valuation of property other than physical, Massachusetts, i, 241; New York, i, 242; Wis- consin, X, 243. Variables of corporate income, diagram, i, 67. Voting trust, listing certificates, n, 169; in reorganizations, ii, 273. Wabash railroad bonds, i, 223. Warrants for dividends, n, 195. Watered stock, evils charged against, i, 83; may accomplish proper results, i, 83; working fraud on public, i, 83; pro- spectus acts to protect public, 1, 85; to disguise charges, i, 85; not the only cause of over- capitalization, I, 86; as a means of effecting divisions in the in- cidents of ownership, i, 88; in underwritings, i, 88; versus participating bonds in financ- ing, I, 89; as a means of arranging bargain between promoters and bankers, i, 90; versus convertible bonds in financing, i, 90; to adjust bar- gain between bankers and un- derwriting capitalists, i, 96; versvs dry capitalization, T, 102; doctrine of caveat emptor, and, I, 104; tradmg on the equity and, i, 106; view of Massachusetts Public Service Commis.sion, i, 248. Westinghouse Company, read- justmefat of, II, 299. Westinghouse Electric & Manu- facturing Company, partici- pating stock, I, 19; bond.s, stipulations limiting power of shareholders, i, 32. Wholesale Ijusiness of investment bankers, ir, 43. Wide market, i, 202. Wisconsin Central Railway, par- ticipating stock, I, 19. Wisconsin Public Utilities Com- mission, I, 240; valuation of property, i, 243; control over capitalization, i, 255; regula- tion of rates, I, 266; regulation of competition, i, 280. Withdrawn participations in un- derwritings, II, 151. Worcester Gas Light Company, case of, I, 275. Worcester, petition of, i, 265. York Railway Company, bonds, limitatton on power of share- holders, i, 35. For GjUege Courses in Composition EXPOSITORY WRITING By Mervin James Curl, Formerly Instructor in English, UnivsrsHf of Illinois. " It is a human textbook. 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Harris's Intervention and Colonization in Africa JefEery's The New Europe, 1789-1889 Johnson's Readings in American Constitutional History Landon's The Constitutional History and Government of the United States Lowell's The Eve of the French Revolution Murdock's The Reconstruction of Europe Perkins's France in the American Revolution Perkins's France under the Regency Perkins's France under Louis XV, Two Volumes Ploetz's Manual of Universal History Ropes's The First Napoleon Schapiro's Modem and Contemporary Exiropean History Semple's American History and Its Geographic Conditions Slater's The Making of Modern England Stanwood's History of the Presidency, Two Volumes Taylor's The Origin and Growth of the American Constitution Taylor's The Origin and Growth of the EngUsh Constitution Taswell-Langmead's English Constitutional History Thomdike's The History of Medieval Europe Usher's Industrial History of England GOVERNMENT Johnson's Readings in American Constitutional History Leacock's The Elements of Political Science Stowell's International Cases. Vol. L Peace. VoL H. War and Neutrality. HOUGHTON MIFFLIN COMPANY 1941 THE HIST ORY O F EUROPE MODERN AND CONTEMPORARY EUROPEAN HISTORY By J. Salwtn Schapiho, Ph.D., of the College of the City of New York. Seventh Impression. Revised to the close of the Great War. 774 pages. 2S maps. A textbook written especially for American college classes. With the point of view of the impartial historian, Professor Schapiro interprets European civilization on the basis of intellectual and material progress. Military and political events alone no longer constitute the complete scope of a textbook in history; social and economic problems and achievements have come to earn an equally important place. That the author recognizes this significant tendency is proved by his emphatic and generous treatment of the development of the democratic ideal, its influence and its expressions, found in such movements as socialism, syndicalism and feminism. An accurate perspective is secured for the stu- dent, inasmuch as increasingly more attention is given to the periods as they approach oxu" own time. THE HISTORY OF MEDIEVAL EUROPE By Ltnn Thobnotkb, Ph.D., of Western Reserve University. Edited by James T. Shotwell, of Columbia University. 640 pages. 24 maps. A textbook written especially for American college classes. It " traces the history of the European and Mediterranean countries from the decline of the Ronian Empire, from the beginning of Christianity, to the discovery of the American continents, and to the eve of the revolt of the Protestants from the chm-ch of Rome." In attention to the significance of economic and social conditions, to the influence of geog- raphy upon civilization, and in furnishing a vivid and selec- tive background for the events of history, this volume is a distinctive addition to the list of textbooks on European history of the Middle Ages. A particular appeal to the student is made by the focusing of iaterest and attention upon a few of the greatest personalities of the times, like Gregory the Great, Mohammed and Justinian. HOUGHTON MIFFLIN COMPANY