Cornell University Library KF2301.R28 Railroads; finance & organization, 3 1924 019 289 648 £0 X- 1^ DATE DUE Frienc i^^='W^ A \ c ■ , f ' I '. CAYI.ORD fntNTKplNU.a.A. i I I 'go) OJnrnpU iCaui i>rl|onl library Cornell University Library The original of tiiis 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/cu31924019289648 RAILROADS FINANCE AND ORGANIZATION BY THE SAME AUTHOR RAILROADS RATES AND REGULATION 8vo. Pages xviii + 659, with Index. $3.00 Net TABLE OF CONTENTS CHAPTER I The History of Transportation in the United States. II The Theory of Railroad Rates. III The Theory of Railroad Rates (corUinued) . IV Rate Making in Practice. V Rate Making in Practice (continued) . VI Personal Discrimination. VII Local Discrimination. VIII Problems of Routing. IX Freight Classification. X The Trunk line Rate System : A Distance Tariff. XI Special Rate Problems: The Southern Basing Point System; Transcontinental Rates; Port Differen- tials, etc. XII The Movement of Rates since 1870; Rate Wars. XIII The Act to Regulate Commerce of 1887. XIV 1887-1905. Emasculation of the Law. XV The Elkins Amendments (1903) : The Hepburn Act of 1906. XVI Effects of the Law of 1906; Judicial Interpretation 1905-1910. XVII The Mann-Elkins Act of 1910. XVIII The Commerce Court: The Freight Rate Advances of 1910. XrX The Long and Short Haul Clause: Transcontinental Rates. XX The Conflict of Federal and State Authority; Open Questions. LONGMANS, GREEN, AND CO. RAILROADS FINANCE & ORGANIZATION BY WILLIAM Z. -ggLEY, Ph.D. Nathaniel Ropes Professob or BO^&mics in ELarvabd University WITH 29 MAPS AND DIAGRAMS LONGMANS, GREEN, AND CO. FOURTH AVENUE & 30TH STREET, NEW YORK LONDON, BOMBAY, CALCUTTA, AND MADRAS 1915 ^^nis COPVEIGHT, 1915 BY LONGMANS, GREEN, AND CO. PEEFACE MoEE than a generation and a half ago, the people of the United States set about the great task of subjecting their com- mon carriers to pubhc control. J^ was at first ahnost a matter of brute force, so resolute was the opposition to be overcome, so firmly intrenched and so stoutly defended were the private interests affected. But since 190&-10 the battle may in gen- eral be regarded as won. The railroads have surrendered, first to the legislatures and afterward to the courts. They seem to have acquiesced, in the inevitable, to have accepted it in good faith. They are at the mercy of the public, which has assumed the grave responsibihty for a wise exercise of its authority, so hardly won. The day of the battle axe and the mace has thus drawn to a close. A different and a more con- structive task confronts the future. For evidence is at hand that the rude treatment of the pubhc champions, essential for a time, if not supplanted by a finer and more sensitive manipu- lation, may work havoc with the dehcately adjusted and the nicely poised machinery of finance. Nor is it merely that too stringent regulation may, perchance, harm a few thousand investors who happen to hold railroad securities here or there; or that it may embarrass some two milhon employees and their famihes. Neither widows nor orphans, nor brakemen nor supply houses, — just as all their claims to consideration may be — are of primary importance. The present danger is less that clumsy or injudicious regulation may bring hardship to investors, than that it shall defeat its own set purpose and its proper aim, which is the attainment of an adequate public service at reasonable rates by the 100,000,000 people of the United States, dependent upon the railroads as upon no other single instrumentahty for their material well-being day by day. Adequate service at reasonable rates is what the people really demand, and what they will continue to seek, blunderingly vi PKEFACE enough, perhaps, until they get it. The point to carry forward, however, is that they cannot hope to reach this goal, under private ownership at least, imtil the investors' interest is accorded just and full consideration. A dim and belated per- ception of this fact is now apparent in the momentous Five Per Cent. Rate Increase decision recently handed down by the Interstate Commerce Conunission — the leading opinion expressly authorizing a widespread increase of rates since 1887. In entering upon this seccyid phase of the problem of pubUc regulation, the people just now seem to be wandering about a bit distractedly, as in a labyrinth of involved relationships. They are conscious of power, but are not quite sure how best it may be utilized to achieve their ends. Such is always the weakness of popular government. It lacks the incisive direct- ness and efficiency of autocracy, pubhc or private. One notes what Lippman has fitly described as "the faltering method, the distracted soul and the murky vision of what we call grandil- oquently the will of the people." It is this predicament which justifies our volume. It is not, in spirit, merely a technical treatise upon railroad finance, a stock exchange handbook or a bankers' manual. As such, it could hardly hold one with enthusiasm uninterruptedly to a somewhat arduous task for a term of years. Nor yet would the book be esteemed as a bald and barren academic chronicle of past events, discon- nected with present affairs. It aims to be a constructive essay in government, systematizing information for others in a single great department of the business of the state; and offering, it may be, helpful suggestions at a critical time. And this in- stant is, indeed, a critical time for the advocates of private property in railroads under public regulation. For there are but two outlets from the present maze. One pursues the accustomed way of private ownership under collective control; the other leads directly on to government appropriation. The evidence upon this point is conclusive. The logic is inexor- able. Unless the people will to so far encourage private capi- tal by the prospect of a satisfactory retm-n upon its ventures, that the funds necessary for future development in a rapidly growing country shall be amply forthcoming, no alternative PREFACE VU than a government taking is possible. Above all, the service must not lapse one jot or tittle. The industrial Ufe of the nation depends upon it. And if private resources fail, as fail they must without due encouragement and security, the state must shortly intervene and raise the funds itself, or else guaran- tee a return certain, thus virtually taking over the property. A mixed proprietorship for good and all is unthinkable. What then is the solution offered? It is constantly suggested rather than directly affirmed throughout the body of the text. Were it more clearly stated, there would be less need for an explanatory preface. This, then, is the golden thread by which alone we are to be led forth from the labyrinth, — a mutual sense of high responsibihty between the public and those who own or direct the railroads of the country. There must be accountabihty on both sides: an obhgation upon the managers to render safe and adequate service at fair ratesj and, no less emphatically, recognition by the state of the right of investors, under efficient and honest management by their own agents, to a reasonable return. Especially is this volume addressed to the managements, — executives, bankers and directors, — who, standing intermediate between the two great parties in interest, have it so much in their power to promote an honest purpose and a better understanding, and to contrib- ute, thus, to bringing their principals together. Bankers, espe- cially, are not in intimate daily contact with the great body of patrons which the railroads serve, as are the operating men. It is my belief that many of our railroad troubles are traceable to their overweight of influence upon directorates.' Too often in the past have they stood aloof, irresponsible alike to the government and the owners, in a financial realm above, to which mere mortal citizens and stockholders might not aspire, — to paraphrase a famous extenuating utterance of counsel for the late E. H. Harriman upon a certain investigating occasion. Their office and privilege it is, at this decisive juncture, to insist upon upright practices, to root out corruption with an unfalter- ing hand, to censure all dealings of their subordinates which ' On banker management, ct. F. H. Dixon in Journal of Political Econmny, vol. XXII, 1914, p. 937 et seq. viii PREFACE are not straightforward and aboveboard, and to visit their joint condemnation upon all others in the business, wherever engaged, who fail to measure up to these high standards. Any- body's misdeed is every body's business. Traitors to the com- mon good, who, as on the Louisville & Nashville in 1913, in direct violation of law and decency, issued 11,805 free passes, over half of them to pubUc officials,' are equally reprehensible with miscreants, both operating and banking, Hke those re- sponsible for the New Haven, the Rock Island or the "Frisco" disasters, which imposed great losses upon the investing class. Each sought selfish and private ends, obhvious to the debauch- ing effect of it all upon pubhc morals and material welfare. Each should be regarded by all right-minded men as foremost among the enemies of the republic. The foregoing statement affords one explanation for the quite abounding account of the shortcomings of our American railroad financiering within these covers. The stream of the text, especially in certain chapters, flows across a somewhat dreary landscape. But facts are facts. It takes too much time, besides missing the main point, to call a spade an instru- ment of husbandry. But there is another warrant for entire frankness. Outspoken and rigorous analysis of wrongdoing has a scientific as well as a moral side. Pathology is as well recognized a department of medicine as therapeutics. The laws of health can be worked out only in a fulness of knowledge as to the nature of disease. And until the cause and the com- pleted course of disease are thoroughly understood, the prac- titioner is weU-nigh helpless to effect a cure. Yet the student of medicine, because his attention for a time is fixed upon phys- ical disorders, does not lose faith in the curative possibiKties of his art. Neither does he conclude that all men are bodily unsound, because his clinic reveals so much hmnan defective- ness. Just so would we conclude our study with the aflirmation that never in our history, and probably nowhere else in the world, has the standard of probity, the quickened sense of responsibility, both public and private, among American rail- road men, been more pronounced than it is at the present time. 1 I. C. C. Rep., 63rd Cong., 2nd sess.. Senate Doc. no. 532. PREFACE ix American railways are avowedly among the best in the world. But they are not perfect. May we not hope that by the eradication of certain outstanding evils, they may still more completely merit general confidence. Is it an idle dream to an- ticipate such a combination of individual and collective effort, that the prime advantages of initiative and efficiency which spring from private ownership, may be sustained, without sacrifice of the guarantee for the common weal which a firm, just and steady supervision can alone assure? Aside from the foregoing suggestions, ethical and abstract as they are in large measure, certain definite propositions for remedial legislation are advanced. One is that the railroads of the country be relieved of the steadily increasing burden of state regulation in, matters of finance, as distinct from those already concerned with rates or operation, through the assump- tion of such authority by the Federal government. If the work is to be done at all, as seems inevitable, judging from the trend of events, will it not be better and less harassingly per- formed by the United States, acting alone, than by forty-eight independent, relatively petty, conflicting and often jealous state commissions? The other leading proposal is that some afi&rma- tive action be taken, now that the Federal authority is firmly estabUshed, to permit, nay even to encourage, such co-opera- tion among carriers as shall tend to eUminate the economic wastes of competition, without endangering its manifest advantages to the pubUc at large. This means the repeal or amendment of the anti-poofing section of the Interstate Com- merce law. It might bring about good results. One novel feature of the statistical charts, both in this and in the preceding volmne, deserves mention. It will be observed that each one is laid out for a considerable period of time ahead, the object being that the interested student may add the new data as it becomes available, in pencil or otherwise. It is, in fact, an admirable exercise to require that this be done; inas- much as an acquaintance with the official sources of information is thereby formed. And in a somewhat similar way, the discern- ing teacher may make use of the ample footnote references, in the years to come, by assigning special topics of immediate or X PREFACE continuing interest, to be brought up to date. Things move so rapidly in our industrial unfolding, that an economic book is behind the times almost before the ink is dry upon its pages. But there are few more stimulating tasks for the student than to roimd out a story necessarily left incomplete in the text of a book. Thus, rightly used, a well constructed volume may gain in interest up to a certain point, pedagogically, in proportion as it goes out of date for the general reader. In order to complete this study, an expert analysis of railroad accounts is needed. It was originally intended, and was so announced preliminarily, to append a chapter by my friend and colleague. Professor W. M. Cole of Harvard University. But the limitations of space, as the subject matter grew upon my hands, rendered this bit of co-operation impracticable. With great reluctance on my part it had to be abandoned finally. • Acknowledgment should be made for assistance rendered at one time or another by a number of fellow workers in corpora- tion finance, not only directly and personally but through affording access to unpublished material as well. I have found the admirable bibliography in Cleveland and Powell's Railroad Finance most serviceable, especially in connection with matters of accounting and reorganization. Professor W. C. Mitchell of Columbia has made it possible to bring my statistical data for prices down to a late date. The careful pubhshed work of former students. Professors Daggett of the University of California, and Eliot Jones of the University of Iowa in par- ticular, has been freely drawn upon. The Railway Age Gazette, through its editor, Mr. S. O. Dunn, and the New York Times Annalist have been generous in affording opportunities to bring my work before their critical readers; and a munber of the economic journals have been equally obliging. A preliminary publication, thus, has enabled a number of mis-statements to be corrected. Without the devoted service of my secretary, Miss Elin A. Lindberg, the book would necessarily have been much longer overdue than it already is. CONTENTS CHAPTER I RAILKOAD CONSTRUCTION FINANCE Economic contrast between Europe and the United States, 1. — Land cheap and labor dear, 2. — Great scarcity of capital, 2. — Depend- ence on Europe in the early days, 3. — After the discovery of gold, 4. — The twenty years after 1873, 5. — Effects of the panic of 1893, 6. — Economic independence after 1898, 7. — Revival of European interest recently, 8. — Unfortunate speculative experience, 9. First railroads built by stock subscription, 10. — Advantageous in settled territory, but too risky in pioneering enterprises, 11. — Failure to utilize resources of credit, 12. — No quick reward for promoters, 12. — Legal liability objectionable, 13. — The device of the con- struction company, 14. — How used in early practice, 16. — In- vestors V. promoters, 18. — Manipulation of construction accounts, 20. — The Hampden Railroad in Massachusetts, 1913, 24. — Other recent experience, 27. — Permanent construction company control, 28. — Conservative practice of large companies, 29. — Recent trans- continental construction, 33. Defects of American construction finance, 35. — Over-capitalization, 35. — Irresponsible and fraudulent management, 41. — The "Frisco" epi- sode, 41. — Premature development, 43. — Standards of construc- tion, 45. — False security to investors, 47. — Recent construction company experience reviewed, 49. — Greatness of^ the achievement, notwithstanding, 51. CHAPTER II CAPITAL AND CAPITALIZATION Definitions, 53. — The practical financier v. the economist, 64. — Capital stock or indebtedness, 59. — Gross and net capitaUzation, 61. — Official statistical averages, 63. — Their correct interpretation, 64. Net capitalization of individual roads, 65. — Ehminating intercorporate issues, 66. — Market value or par value, 67. — Deducting outside investments, 68. — Joint holdings, 70. — Allowance for individual peculiarities, 71. — Earning power and capitahzation, 74. — Ex- penditures for maintenance, 77. — International comparisons, 79. — Financial classification of companies, 81. — The element of fixed charges, 83. — The test of margin of safety, 87. xii CONTENTS CHAPTER III RAILROAD SECURITIES: CAPITAL STOCK, ETC. The nature of capital stock, 89. — Significance of par value, 90. — Abolition of the "dollar mark," 91. — Its disadvantages considered, 93. Preferred stock, 95. — English origins, 95. — Nature of the preferred claim, 96. — Reasons for creating preference, 97. — An expedient for raising funds, 98. — In connection with reorganization, 98. — -As a detail in consoUdation, 100. — For concentration of control, 100. — The Northern securities imbrogUo, 103. — Controversies over divi- dend policy, 103. — Protection of minority rights by law, 104. — Prefer- ences becoming less marked, 105. Relative proportions of stock and bonds, historically considered, 105. — Growing reliance upon mortgage loans, 106. — Effect of the depres- sion of 1893-7, 108. — Present conditions unsatisfactory and menacing, 109. — The Chicago & Alton reorganization, 112. — Bor- rowing attendant upon consoUdation, 113. — Convertible bonds, 115. — The status of individual companies, 117. CHAPTER IV RAILROAD SECURITIES: MORTGAGE INDEBTEDNESS, ETC. Funded debt highly locaUzed, 121. — Shifting and uncertain liens, 124. — Evasion of "after-acquired property" stipulations, 125. — Alluring bond titles, 125. — Fallacy of the specific lien theory, 126 — DiflBculty in foreclosure, 127. — Mortgages under reorganization, 127. — Voting power of bonds, 128. — • Price at issue, 129. Perpetual borrowing, yet periodic repayment, 130. — Methods of amorti- zation, 130. — Serial maturity or sinking funds, 131. — Refunding historically considered, 132. — Debt simplification and marketabiUty, 134. — Underwriting, 135. — Direct issue v. banking support, 135. — Pennsylvania Railroad and other experience, 136. — Bankers' com- missions, 137. Different tjrpes of bonds, 139. — Income bonds, 139. — Comparison with preferred stock, 141. — Debentures, 141. — A sign of weakness or high credit, 142. — Collateral trust bonds, 143. — Their growing im- portance, 144. — Historically considered, 145. — Their use in con- soUdation, 146. — Analogy to "margin" stock exchange operations, 147. — Elasticity a merit, 147. — Danger from increasing fixed charges, 148. — Invite speculation and over-borrowing, 148. — Union Pacific and trunk Une experience, 149. — Paper v. real profits, 150. — Possible shrinkage of collateral, 152. — Its impairment through manipulation 154. — Rock Island reorganization, 154. — Other uses of collateral trust bonds, 156. — Convertible securities, 156. — Their recent popu- larity, 158. — Four reasons therefor, 159. — Investment defects 161. CONTENTS xiu Short-time borrowing on notes, 164. — Historically considered, 166. — Recent growth of the habit, 167. — First experience fortunate, later unhappy, 169. — Note issues expensive, 170. — Effect upon the money market, 170. — Eqmpment trust securities, 171. — Their compUcated character, 172. CHAPTER V THE COURSE OF MARKET PRICES The great tidal sweeps, 174. — Secondary waves thereon, 176. — The period 1900-'01, 177. — The uplift of 1905-'06, 178. — Contrasts before and after 1893-'97, 179. — The movement since 1906, 180. — Changes in operating conditions, 181. — Increasing, even excessive capitahzation, 183. — Necessary but unproductive outlay, 184. — Caring for future development, 185. — Competition with other invest- ments, 186. — Changes in interest rates, 187. — Are fluctuations increas- ing? 187. — Forecasting of events, 188. — Seasonal ripples, 189. PecuUarity of bond quotations, 190. — Effect of the value of money and commodity prices, 191. — Competing investments again, 193. — Stag- nation of investment demand, 194. Bond, stock and commodity prices compared, 195. — International comparisons, 197. CHAPTER VI SPECULATION The course of speculative activity since 1890, 198. — Movement of par- ticular issues, 202. — Speculative activity of railway bonds, 204. — — Poohng contracts, 207. — Speculation by "insiders," 208. — Abrupt changes of dividend, 209. — Secrecy in accounting, 212. — The Cincin- nati, Hamilton & Dayton, 214. — Speculation by "outsiders," 216. — The Southern Pacific pool of 1902, 217. — The Louisville & Nashville pool of 1903, 219. — The Reading and Boston & Maine episode of 1893, 220. — The Pearson-Farquhar syndicate, 1910, 223. — Pubhcity as a remedy, 222. — Regulation of capital issues, 224. — Taxation of transfers, 225. — The outlook for the future, 226. CHAPTER VII STOCK-WATERING Definition, 227. — Stock dividends, 228. — The Connecticut River epi- sode, 229. — Extra cash dividends, 229. — The anthracite predica- ment, 231. — Evasion of statutory prohibitions, 232. Over-capitahzation in construction, 232. — Replacement of property as inviting stock-watering, 233. — Incompetence or fraud, 236. — The Boston & Maine collapse, 237. xiv CONTENTS Division of an accumulated surplus, 238. — Indirect devices therefor, 239. — Magnitude of railway surpluses, 240. — Equitable interest of the public therein, 241. — The opposing views stated, 242. — The just intermediate opinion, 243. — The Massachusetts gas companies, 244. — DifiBcult to apply in practice, 245. — Refunding, a concomitant of inflation, 247. Stock-watering incidental to consolidation, 248. — Financial advantage of merger, 248. — The Kansas Pacific case, 249. — Rook Island and other examples, 250. — The New Haven collapse, 251. — Connecticut trolley finance, 252. — The Rhode Island companies, 253. — The Boston & Maine road and the Westchester Co., 255. CHAPTER VIII STOCK-WATERING (Continued) Reorganization and stock-watering, 259. — The Third Avenue Railroad case, 260. — The Chicago & Alton affair, combining all phases of in- flation, 262. The provision of new capital, 267. — Privileged subscriptions to stock, 268. — The value of rights, 269. — Is this stock-watering or not? 271. — Stock issues below par, 272. — At par or above, 274. — The com- pUcation of convertible securities, 276. — Bonds emitted at a discount, 277. — Sound accounting policy, 278. — Public interest requires amortization, 279. i CHAPTER IX STATE REGULATION OF SECURITY ISSUES The grounds of public interest in capitaUzation, 281. — Its effect upon adequate service, 282. — Mere publicity v. positive control, 283. — The Federal Securities Commission report, 284. — "Blue-Sky" laws, 285. — Recent public service commissions, 285. New York experience most important, 286. — Concrete cases outhned, 288. — Abuses prevented or corrected, 290. — An example of hberal but firm control, 292. Massachusetts poUcy, strict and inelastic, 296. — Fixing issue price of stock, 297. — Four different plans tried, 298. — Liberalization in 1908, 300. — The new Public Service Commission law, 300. The Texas Stock and Bond law, 302. — CapitaUzation and valuation. — "Squeezing out water," 303. — Distinction between old and new properties, 303. — Drastic reduction in average capitalization, 304. — Improvements and betterment penahzed, 304. — More administra- tive discretion necessary, 305. — Experience elsewhere, 306. Federal assumption of power over capitaUzation, 309. — Mere pubUcity inadequate, 310. — Individual state activity must be superseded, 311. — Prognostication, 312. CONTENTS XV CHAPTER X THE DETERMINATION OF REASONABLE RATES United States Supreme Court opinions, 313. — First period to 1898; legis- lative V. judicial control without definite standards, 314. — The early Minnesota Rate cases, 314. — The Texas Railroad Commission case, 315. — Decisions, hesitant and inconclusive to 1898, 316. — The Ne- braska Maximum Rate case, 318. — Little progress until 1904, 319. — The San Diego and Knoxville Water Co. decisions, 320. — The Consolidated Gas case, 321. — The Minnesota Rate cases, 1913, 321. — The Kansas City Stockyards decision, unique, 323. — Absolute or relative standards of reasonableness, 325. — Ultimate limitation of the rate of return, 326. — Is a partnership theory feasible? 327. Administrative state opinions, 327. — The Interstate Commerce Commis- sion rulings, 328. — Physical valuation proposed by counsel for the carriers, 329. CHAPTER XI PHYSICAL VALUATION: REASONABLE RATES Four different reasons for physical valuation; historical development, 331. — Taxation, 333. — Control of security issues, 333. — Rate regu- lation, 334. — Private railroad appraisals, 335. — The Federal law of 1913, 336. — Other public service corporation valuations, 338. — Com- mercial valuation, 339. — Federal data, 339. — Statistical results by states, 340. — Conflicts and contradictions, 341. — Results clearly prove no over-capitalization, 344. Economic analysis of criteria as to reasonableness, 346. — Actual or original cost approved, 347. — Qualifications necessary, 348. — Reproduction cost, new, merely conjectural, 354. — Its shortcomings examined, 355. — Present value and depreciation, 356. — Details considered, 359. — Market value and earning power, 360. — Intangibles; franchise value; good-will and worth of a going concern, 361. — Statistical results, 363. — Significance of the distinction between structural value and earning power, 364. — InterchangeabiUty of valuation standards for different purposes, 67. CHAPTER XII RECEIVERSHIP AND REORGANIZATION Definitions, 371. — Is foreclosure necessary to reorganization? 373. — Frequency of railroad failures, 375. — The chronicle year by year; association with financial panics, 376. — Sequence of the phenomena, 376. — Receivership declining, 377. — The causes of failure, 378. — Over- expansion, 378. — Stock-watering, 380. — Speculation and fraud, 381. — The Richmond Terminal reorganization, 381. — Internal dissen- sion, 383. xvi CONTENTS Receivership, 383. — Legal development, 384. — Economic fmictions, 384. — Meeting cash requirements; receivers' certificates, 385. • — ■ Abuses under receivership, 387. — Proposed regulation, 388. — How ter- minated, 388. Conflicts of interest in reorganization, 388. — Committees appointed, 389. — Various groups of security holders, 390. — Immediate necessity; cash for floating debts, 392. — Prospective needs; working capital and betterments, 393. — The overload of fixed charges, 393. — Elimination of embarrassing restrictions, 394. Expedients adopted, 395. — Cash, how raised, 395. — Sale of treasury assets, 395. — Fimds from new pubhc offerings, 395. — Main reliance on security owners, 396. — • Assessments upon stockholders, 399. — Status of junior bondholders, 400. — Scaling rates of interest, 401. — Reduction of the principal of indebtedness, 401. — New securities for old, 402. — Contingent v. fixed charges, 403. — Details of procedure 404. — Voting trusts, 404. General observations, 405. — Effect upon corporate structure; dismem- berment followed by merger, 405. — Over-capitaUzation, 406. — Lead- ing principles reviewed, 407. — Importance of general business con- ditions, 410. CHAPTER XIII INTERCORPORATE RELATIONS Merger, its merits and disadvantages considered, 413. — Present ten- dency thereto, 414. — Public interests concerned, 415. — The New York Central amalgamation of 1914, 416. — Its difficulties, how over- come, 418. The lease as a mode of combination, 418. — Different types described, 419. — Leases and stock ownership combined, 420. — The structure of the Boston & Maine, 420. — Advantages and defects considered, 421. Combination through the agency of persons, 423. — Community of in- terest, 424. — Prevalence of interlocking directorships, 425. Traffic agreements described, 427. — Joint ownership and operation, 429. Stock ownership among railroads, 430. — Direct investment in subsidiary companies, 430. — Minority holdings in other systems, 431. — Stock ownership in other corporations than railroads, 432. — The pure finance or holding company, 433. — The Atlantic Coast Line Co., 434. — The Reading Co., 436. — The Temple Iron Co., 437. — Legal services of the holding company, 437. — Concentration of financial control thereby, 438. — As widening the market for securities, 438. — In the promotion of secrecy, 440. — Involved intercorporate affairs of the New England Navigation Co., 441. — The Queen and Crescent corporate tangle, 443. — Avoidance of goverimiental regulation, 445. The protection of minority stockholders, 445. — Oppression by majority interests v. obstructive tactics by the few, 446. — Difficulties of proposed legislation, 449. — Typical recent controversies, 460. CONTENTS xvii Proposed legislation as to intercorporate stock holding, 452. — Federal incorporation, 452. — Publicity the surest remedy, 454. — The (Clay- ton) amendment of the Anti-Trust law in 1914 as to interlocking directorates and stock ownership, 455. — The personal liability of directors, 455. CHAPTER XIV COMBINATION: EASTERN AND SOUTHERN SYSTEMS Progress of combination historically, 456. — Steady enlargement of oper- ating units, 457. — Effect of the depression of 1893-'97, 458. — The strategy of the decade to 1910, 459. — The subsequent marked qui- escence, 461. The transportation problem in New England, 462. — Relations with out- side roads, and intricate and retail traffic, 463. — Results of traffic density, 465. — The first phase of combination, followed by consoh- dation to the second power in 1907, 466. — Monopoly of water trans- portation, 469. — The political and legal struggle, 470. — Why did monopoly fail? 471. — ■ Financial, poUtical and moral offences, 472. Combination in Trunk Line territory, 473. — Rise of the Vanderbilt system, 474. — The Pennsylvania described, 476. — Secondary roads, a menace to stabihty, 479. — Control of the lesser trunk hnes and coal carriers, 480. — Financial disentanglement after 1906, 480. — The fiscal outcome of inter-railway investment, 483. — Latest tendencies in this field, 485. Combination in the southeastern quarter of the United States, 486. — The economic and historical background, 487. — The LouisviUe & NashvUle-Atlantic Coast Line transaction, 489. — Competition now financially circumscribed, 489. CHAPTER XV RAILROAD COMBINATION IN THE WEST The HiU-Morgan group, 491. — Northern Pacific-Great Northern re- lations before 1900, 492. — The Burlington acquired, 494. — Strug- gle with Harriman for the Northern Pacific, 495. — The Northern Securities Company, 497. — Its dissolution by Federal decree, 498. The Harriman Union Pacific group, 499. — Foreclosure, reorganiza- tion and reconstruction, 501. — The Southern Pacific acquisition, 504. — Financing the Northern Pacific investment, 506. — Profits invested all over the country, 608. — The situation, strategically, 509. — Harriman's death a turning point, 510. — Five principles of Union Pacific finance, 611. — Bold borrowing, 512. — Powerful and con- centrated financial support and control, 513. — Scientific operation and territorial monopoly, 514. — Speculative aspects of Harriman management, 515. xviii CONTENTS The Gould system, 516. — Jay Gould's properties in 1892, 518. — Trans- continental plans in 1901, east and west, 618. — The Wabash-Pitts- burg extension, 520. — Structural and financial weakness, 523. — Collapse and dismemberment since 1907, 523. The Rock Island group, an example of financial weakness and corrup- tion, 524. — Formation of the Rock Island Company, 525. — Expan- sion south and west, 529. — The inevitable disintegration, 530. Membra disjecta in the so-called Hawley system, 532. — The three great independent compames, 533. CHAPTER XVI THE ANTHRACITE COAL ARRANGEMENT Nature and location of the anthracite deposits, 534. — Every invitation to monopoly offered, 536. — Predominant and increasing railroad ownership, 537. — Early attempts to maintain prices, aUke unsuc- cessful, 539. — Peculiarities of the business responsible, 540. — After 1898, conditions ripe for real monopoly, 541. — Three features of the new plan, 541. — Non-railroad operators eliminated by increased percentage allowances, 542. — Two projected independent railroads throttled, 543. — Actual corporate consolidation, 544. — Inter-raU- way relationships tightened, 544. — Proof of monopolistic combina- tion, circumstantial if not documentary, 545. — Remedial action, 547. CHAPTER XVII DISSOLUTION UNDER THE ANTI-TRUST LAW Circumstances attending its passage, 549. — Congressional intent to in- clude common carriers uncertain, 550. — Text of the Act, 551. — Its uneven enforcement by different Administrations, 652. — First in- voked against pooling in 1897-'98, 553. — Revivification under Presi- dent Roosevelt, 564. — Holding companies condemned by the Northern Securities decision in 1904, 555. — Broad constitutional principles settled, 556. — No distinction between due and undue restraint, 557. — Final construction by the rule of reason, 658. — First applied in the St. Louis Terminal case in 1912, 669. — Constructive reMef replaces mere condemnation, 660. — The Union Pacific-Southern Pacific dis- solution proceedings, 1912, 661. — Was there competition prior to the merger in 1901? 562. — Did the combination lessen rivalry? 664. — And if so, was it unreasonable? 665. — Careful attention to the dissolu- tion decree, 566. — The several plans outhned, 567. — Renewal of proceedings to set off the Central Pacific, 569. — The Anthracite Coal Trust decision, 1912, 570. — The agreement for undoing the New Haven merger in 1914, 571. — Present conditions summarized, 573. CONTENTS XIX CHAPTER XVIII POOLING AND INTER-RAILWAY AGREEMENTS Pooling defined, 575. — The physical apportionment of traffic, 577. — Money pools, 578. — Division of the field, 579. — Agreements merely to maintain rates, 580. — Concrete illustrations of procedure, 580. — Early agreements among water lines, 582. — The first railway pools, 583. — The Southern Railway and Steamship Association, 584. — Its various functions, 585. — Division of business, 586. — As modified after 1887, 587. — The Trunk Line pools, 588. — Conditions west of Chicago, 690. The legal problem, 593. — Pooling under the Common Law, 593. — Pro- hibition by the Act to Regulate Commerce, 593. — The Trans-Mis- souri Freight Association case, 592. — The Joint Traffic Association decision, 590. — Other legislation proposed, 594. — Traffic agreements since 1898, 596. — British experience, 597. — The ParUamentary com- mittee of 1909, 598. — Its significance for us, 598. — The pros and cons of pooUng, 599. — The objection of Lacreased rates, 599. — Ser- vice under compUcated traffic conditions, 600. — The southern cotton pools, 601. — Promotion of more economical operation, 603. — Equip- ment pools proposed, 604. — Agreements and railroad consoUdation, 606. Appendix I. Joint Ownership 609 II. The Operating Ratio 612 III. The Credit Mobilier 616 " IV. Ownership of Securities 619 Index 623 LIST OF MAPS AND DIAGRAMS PAGE Intercorporate Relationships, Rock Island System 153 Price Fluctuations, New York Stock Exchange, 1884^1^08 175 Index Number of Stock Prices since 1893 facing page 176 Capital Investment and Traffic since 1900 182 Net Operating Income to Investment since 1900 182 Prices of Stocks, Bonds and Commodities since 1890 191 Quotations of Selected Securities in France, 1895-1906 196 Quotations of Selected Securities in Germany, 1895-1906 196 Quotations of Selected Securities in Great Britain, 1895-1906 . . . 196 Quotations of Selected Securities in the United States, 1895-1906 . 196 Total Sales, New York Stock Exchange since 1884 199 Selected Sales, New York Stock Exchange since 1898 203 Receivership and Foreclosure since 1878 375 Intercorporate Relationships, Atlantic Coast Line System 435 Intercorporate Relationships, Queen & Crescent Route 444 Merger and Consolidation since 1892 . ... 462 Map: The Vanderbilt-New York Central System 475 Map: Independent Roads: the Pennsylvania, the Atchison and the St. Paul . 477 Intercorporate Relationships in Trunk Line Territory, 1906 481 Map: The Morgan Group of RaUroads 488 Map: The Hill-Morgan Group 493 Map: The Union Pacific Group 501 Map: The Gould System, 1906 517 Intercorporate Relationships in the Gould System ... . 519 Map: The Rock Island System . 526 Map: The Anthracite Coal Fields and Railroads . . . . 535 Shipments and Allotment of Anthracite since 1890 546 Map: The Harriman Lines 563 The Operating Ratio, 1900-1913 613 RAILROADS CHAPTER I RAILROAD CONSTRUCTION FINANCE Economic contrast between Europe and the United States, 1. — Land cheap and labor dear, 2. — Great scarcity of capital, 2. — Depend- ence on Europe in the early days, 3. — After the discovery of gold, 4. — The twenty years after 1873, 5. .— Effects of the panic of 1893, 6. — Economic independence after 1898, 7. — Revival of Einropean interest recently, 8. — Unfortunate speculative experience, 9. First railroads built by stock subscription, 10. — Advantageous in settled territory, but too risky in pioneering enterprises, 11. — Failure to utUize resources of credit, 12. — No quick reward for promoters, 12. — Legal liability objectionable, 13. — The device of the con- struction company, 14. — How used in early practice, 16. — In- vestors V. promoters, 18. — Manipulation of construction accounts, 20. — The Hampden Railroad in Massachusetts, 1913, 24. — Other recent experience, 27. — Permanent construction company control, 28. — Conservative practice of large companies, 29. — Recent trans- continental construction, 33. Defects of American construction finance, 35. — Over-capitaUzation, 35. — Irresponsible and fraudulent management, 41. — The "Frisco" epi- sode, 41. — Premature development, 43. — Standards of construc- tion, 45. — False security to investors, 47. — Recent construction company experience reviewed, 49. — Greatness of the achievement, notwithstanding, 51. The contrast in economic affairs between the long-settled European countries and the United States is in many respects marked; but in none is it more so, perhaps, than in the field of transportation. This is due to several underlying material factors, two in particular. One is the abimdance of land, coupled with a scarcity of labor. The other is the hmited supply of capital. Of these, land in its various relations to labor and population has been the more far-reaching and fundamental in effect; whereas capital supply has been rather temporary and local in influence. And with the progress of time, conditions as to capital in the United States have tended to approach more nearly to similarity with those of older VOL. n — 1 2 RAILROADS countries. But American land and labor conditions have always been unique. It is impossible to fully understand many aspects of our railroad affairs, both historical and pres- ent, without reckoning with these matters in their broader relationships. This is especially true in the domain of finance. The economic development of Europe has at all times been profoundly influenced by the fact that because men were many, land was dear and labor was cheap. In America quite the opposite condition of affairs prevails. With us, population has never pressed for subsistence upon the soil, which has cried out for cultivation; and, consequently, free or low-priced land has been accompanied by an equally marked scarcity of labor and capital. For railway purposes, in fact, land for the most part in early days was to be had for the asking. ^ In Europe, on the other hand, acquisition of the right of way was one of the heaviest items of expense. And with us, even where land had to be purchased it was done so under favoring legislation as to the right of eminent domain. This mode of facilitating construction, under legislation dominated by the landholding interests, seems to have been rarely employed in Europe. As for labor, the problem has progressively intensified in its bear- ings upon finance with the passage of time. The relative scarcity of capital in the United States, in face of the stupendous task of opening up a continent to settlement, has always affected both the development of transportation enterprises and the method by which they have been financed. European capital has consequently been of the utmost im- portance in the creation of the American railway net. The dearth of domestic funds in the early days and the phenome- nally rapid growth of our transportation system rendered us peculiarly dependent upon foreign financial markets for many years. For this reason a brief historical survey may properly serve as an introduction to our subject. 1 Land grants are treated in our Railroads: Rates and Reeulation, p. 35. THE CAPITAL SUPPLY 3 The demand for capital after the close of the war of 1812 was very great. This capital was, of course, obtainable from two distinct sources, domestic and foreign respectively. ^ As for the domestic supply, the first funds originated in successful shipping enterprises during the European wars and in the rise of cotton growing. A mere trading capital soon expanded into a considerable surplus for investment purposes. The rapid repayment of the national debt after the close of the war released these funds for other uses. In the period 1815-'30 the United States paid off $123,000,000 of its bonds. The years next succeeding were associated with risky experimenta- tion in railway construction. A modest demand at the out- set soon increased to very considerable proportions. But two particular events of the decade to 1840 both served to release funds for further exploitation and operated as well to promote speculation all over the country, in the populated East as well as along the undeveloped frontier. The first of these events was the removal in 1833 of $29,000,000 of govern- ment deposits in the United States Bank to state institutions. The other was the current distribution of the United States surplus revenue among the states after the final extinction of the national debt in 1835. The foreign sources of capital in the United States in the early days were most uncertain and inconstant. English funds came freely during the colonial period. The rapid repayment of the United States debt greatly strengthened our credit abroad. The success of British canals as investments naturally encouraged interest in American enterprises of a similar sort. From participation in the banking business, especially in con- nection with the cotton industry in the South, a considerable supply of English capital flowed into railway and other trans- portation companies. This was noticeably the case during the '30s. Approximately one-half of the capital of the Camden & Amboy — first railroad monopoly in the United States — 1 Quarterly Journal of Economics, vol. XVII, 1902, pp. 111-163. 4 RAILROADS seems to have been obtained from English sources. According to the message of President Van Buren in 1840, some two hundred milhon dollars in all was borrowed from abroad. British interest in om: foreign commerce also, of course, freed American capital for other investment. The relation of American transportation pioneers to British bankers was un- doubtedly intimate; but the frenzied speculation, the mania of state debts for internal improvements and the financial collapse in the panic of 1837 abruptly closed this source of supply. Without discrimination, all investments in the Middle West were lumped together as insecure in the minds of Eiiropean capitalists. A new period of British and European interest in American transportation followed the discovery of gold in California in 1849. John M. Forbes writes in 1854 that four-fifths of the western railways, begun since that date, were directly due to that event. Eastern financiers promptly took advantage of this encouragement and appealed to Europe for money, i En- thusiasm grew abroad until as little discrimination came to be applied in supporting all kinds of enterprises as had charac- terized their condemnation ten years earlier. Until the panic of 1873 European investors bought our railway securities eagerly. The Illinois Central is unique, perhaps, in the continued interest of foreign capitalists. This road, from its inception in 1851, was for many years actually controlled abroad. In 1876 not less than 86 per cent, of its stock was thus held. So much Dutch capital was invested in the Chicago & Northwestern in 1869 that a foreign representation of two directors was given on its board. Amsterdam was quite heavily interested in parts of the Northern Pacific.^ Many bonds of the Erie were also held in 1 Conditions at this time are well described in Pearson's American Railroad Builder, reprinted in our Railway Problems, rev. ed., pp. 61-91. Cf. also Oberholtzer, Jay Cooke, II, pp. 183, 343, 378, on the Northern Pacific. ^ Oberholtzer, p. 791 et seq., affords admirable data as to an organ- ized raid upon European banking supplies. THE CAPITAL SUPPLY 6 Europe. But the excesses of Jay Gould and his followers in this road undoubtedly contributed to the sharp check upon investment from abroad in American railroads in the early '70s.i After the panic of 1873, foreign investment gradually revived and was not again seriously interrupted for twenty years. It has been estimated that $375,000,000 of American railway stocks and bonds were held in Europe in 1876. Dur- ing this period, not only our stock exchanges but bankers in general were peculiarly sensitive to European conditions. The important Baring collapse in 1890, largely concerned with the Atchison road among other American enterprises, was a case in point. A chairman of the London & Westminster Bank stated at one of its annual meetings that one-third of the advances made by his institution in that year were based upon American railway securities. It is certain that a large part of the phe- nomenal expansion of our transportation system during the decade 1880-'90 was financed abroad. As indicating the pre- dominance of European capital at this time, the following table is significant. From this it will appear that an absolute Per Cent, of Foreign Stock 1890-'96 1905 Illinois Central 65 21 Pennsylvania 52 19 Louisville & Nashville 75 7 New York, Ontario & Western 58 12 New York Central & Hudson River 37 9 Reading 52 3 Great Northern 33 2 Baltimore & Ohio 21 17 Chicago, Milwaukee & St. Paul 21 6 majority of stock in at least five large American roads was held outside the country; and of course the bond holdings, especially in England, were even heavier in proportion; although there is no way of ascertaining their exact amount. ' About one hundred and fifty milhon dollars of railway securities, mostly land-grant bonds, in default in 1873-'74 were held in England, Holland and Germany. Yah Review, vol. Ill, 1898, p. 324. 6 RAILROADS The acuteness of the panic of 1893 and its protracted after- effects were considerably accentuated by these foreign invest- ments in Tlmerican railways. ^ Liquidation from abroad, both of stocks and bonds, assumed enormous proportions during 1893. Hundreds of millions of securities were returned to New York, at a time when we were too financially embarrassed otherwise to repurchase them. An utter collapse of prices was the result. Matters improved materially in 1895 with the reappearance of more normal conditions; and a renewed outflow of railway securities followed. A goodly proportion of our heavy excess of imports of merchandise over exports in that year was met by sales of large blocks of railway stocks and bonds. Many of these, however, were not permanently held, but were returned within a few months. Their usefulness, nevertheless, as a means of preserving the so-called balance of trade was amply demonstrated. How great was the magnitude of foreign in- vestment, even after the liquidation of 1893-'94, is shown by the following table. The total holdings of leading foreign countries in American securities of all sorts on January 1, 1899, appeared to be as follows: England $2,500,000,000 Holland 240,000,000 Germany 200,000,000 Switzerland 75,000,000 France 50,000,000 Rest of Europe 35,000,000 A total of over three billions of dollars appears, mainly consisting of railway stocks and bonds. German holdings, administered by Frankfort bankers, at this time have been 1 Careful studies of European investment in America and elsewhere in recent years will be found in the following references: Journal of the Royal Statistical Society, September, 1909; Le Rentier, Paris, 1905, sum- marized in U. S. Consular Reports, March 23, 1905; Journal de la SoaiHi de Statistique de Paris, April, 1891; Yale Review, November, 1900; Annals American Academy of Political Science, November, 1903; World's Work December, 1903. ' THE CAPITAL SUPPLY 7 analyzed even more in detail, as is shown by the next set of figures. ESTIMATES OP GERMAN HOLDINGS OP AMERICAN SECURITIES Market Value Central Pacific 112,000,000 to $15,000,000 Southern Pacific 15,000,000 17,000,000 Northern Pacific 20,000,000 25,000,000 Missouri Pacific 2,000,000 3,000,000 Union Pacific 2,000,000 3,000,000 California Pacific 3,000,000 4,000,000 Oregon Railroad and Navigation 1,000,000 2,000,000 Erie 2,000,000 3,000,000 Pennsylvania Railroad and Baltimore & Ohio Raikoad 1,000,000 Louisville & Nashville 1,000,000 Chicago, Milwaukee & St. Paul 7,000,000 8,000,000 Chicago, BurUngton & Quincy 2,000,000 3,000,000 IlUnois Central 7,000,000 8,000,000 Rock Island 1,000,000 Denver & Rio Grande 3,000,000 4,000,000 Houston & Texas Central 2,000,000 Pittsburgh, Cincinnati, Chicago & St. Louis 2,000,000 Western New York & Pennsylvania 1,000,000 Total 105,000,000 The phenomenal outbreak of prosperity in the United States in 1898 marked a turning point both in our financial and our transportation history. Within comparatively few years, a large proportion of our American railway securities were repurchased from abroad. So abruptly in fact was this effected in 1899-1900 that the foreign markets were all but drained dry. Within ten years to 1906, it was estimated that for nuie roads alone about $250,000,000 of railway stocks were permanently returned from Europe. How profoundly this change affected the control of leading systems is shown by the second column of percentages in our table on page 5. For each of the large companies actually controlled abroad in 1890-96, the later proportion of foreign ownership declined to less than 20 per cent., and in some cases became almost a negligible quan- tity. Such railways as the Northern and Union Pacific, once largely owned abroad, became entirely domestic corporations. 8 RAILROADS Only a very few, like the Chicago Great Western, are still foreign owned enterprises. The causes of this profoundly important change are several. The predominant one, of course, was the abounding prosperity of the United States, which so far strengthened us financially and added to our store of capital available for investment, as to render us for the time at least independent of Europe. Another reason probably was the pronounced movement toward consolidation which set in about 1899. Many railways like the Lake Shore and the Burlington were merged in larger systems, through exchange of their share capital for collateral trust bonds of the parent companies. These exchanges were offered at most attractive prices for the most part, so that European investors were tempted to part with their bond holdings. Whether, as bondholders instead of shareholders, they have continued their investments in this country can only be surmised. One point is clear, namely that if it had not been for this opportune reduction of European interest in American railways, many of the consolidations of 1900 could never have been effected. That intimate co-opera- tion of banking houses, insurance companies and railway man- agers, necessary to the prompt success of such operations, would have been impossible prior to 1898. A revival of European interest in American railroads began with the heavy participation of foreigners in the Pennsylvania bond issue of 1904. And somewhat later, along about 1910, our financial dependence upon Europe was again increased by unfavorable trade balances. Particular attention was then devoted to France, one of the richest sources of capital for investment in the world. It had never interested itself in the United States as a field for exploitation.' Several impor- tant railroads succeeded about this time in negotiating foreign loans at Paris, among them the Pennsylvania, the Union ' Neymarck, Le Rentier, 1902, estimated that with upwards of $4,000,000,000 invested elsewhere in Europe, with $712,000,000 in Africa, only $204,000,000 was lodged in North America. THE CAPITAL SUPPLY 9 Pacific and the Chesapeake & Ohio. But this awakening for- eign interest, particularly in France, was soon discouraged by several events. The New Haven, soon after disposing of a large issue of debentures in Paris, went to pieces; and the St. Paul, as we shall soon see, grievously shocked its constituents in connection with irregularities in financing its Pacific coast extension. American prestige was still further lessened by the bankruptcy of a number of other railroads, notably the unfortimate Gould group, the "Frisco" and the Rock Island. It is a deplorable feature of European investment — charac- teristic of several generations of experience — that interest is persistently manifested in speculative rather than conservative investment properties. Foreigners seem unable to learn the lesson that first-class American railway shares are often pre- ferable to the bonds of second or third rate speculative or heavily over-capitalized enterprises; and that a railway bond, as some one has aptly put it, "should be known by the sort of company it keeps." The outbreak of the European wars in 1914 focussed atten- tion once more upon the considerable reliance of the United States upon foreign sources of capital. Our indebtedness abroad promised indeed for a season to bring about a severe panic. But the suspension of stock exchange operations, spread- ing enforced liquidation over a considerable period of time, seems likely at this writing to have averted trouble. Careful investigation 1 pointed to foreign bond holdings of about $3,400,000,000, — that is to say about one-third of the out- standing railroad mortgage indebtedness. Almost $75,000,000, that is to say about one-seventh of the capital stock of the Pennsylvania, was thus held abroad. And a number of other companies were likewise heavily involved, more commonly, however, in respect of bonds. Should one effect of the war be to lessen these outstanding obligations to Europe, the resulting concentration of attention of resident owners upon the manage- 1 Wall Street Journal, Aug. 29 to Oct. 24 incl. 10 RAILROADS ment of their enterprises would be a clear gain to all parties concerned. Absentee ownership, an evil in any economic connection, has been particularly productive of harm in the case of American railroads. The first railways in the United States were built from the proceeds of subscriptions to capital stock. All of the smaller roads radiating from Boston were thus financed. The Boston & Lowell issued no bonds for twenty years. The Boston & Providence, constructed in 1849, put forth bonds after a time aggregating about one-fourth of its share capital; but by 1865 had practically extinguished this mortgage indebtedness. Many other small New England roads even today have almost no bonds outstanding. Nearly three-fourths of the entire capitalization of the Boston & Albany up to 1908 was still stock. These conditions are all vestiges of the earliest prac- tice in railway financing in this part of the country. Else- where much the same pohcy prevailed at the outset. The Baltimore & Ohio was largely financed by stock issues, a goodly proportion subscribed by the state of Maryland. The annual report of the road for 1844 showed $7,000,000 capital stock as against only $985,000 of bonds. The share capital of the Lackawanna road in 1854 was double its mortgage bonds. The New Jersey Railroad a year later was bonded for only about one-fourth of its share capital. And for the United States in 1855 the capital stock of all its railways exceeded the bonded indebtedness by 42 per cent. Even as late as 1868, after new styles in railroad finance had come into vogue, the capital stock of the railways of Ohio considerably exceeded in amount the aggregate of their outstanding bonds.i The southern states, led by Virginia, gave most of their aid in early days by direct stock subscriptions. This commonwealth alone took about $21,000,000 par value before the Civil War. Some of the early western roads, especially those hke the 1 Gephart, Columbia University Studies, vol. XXXIV, 1909, p. 168. CONSTRUCTION FINANCE 11 Atchison financed from Boston, depended largely upon funds raised from the issue of shares rather than from the sale of bonds. The early attempts at financing • the Union Pacific were so fashioned. The first Federal Act authorizing con- struction of the Northern Pacific in 1864 actually prohibited bond issues — a restriction which had to be removed five years later. As will be seen, a radical change took place in subse- quent years.^ This was in part, especially after 1865, due to public aid given in the form of bonds; but it was also a change rendered almost inevitable by the general conditions under which capital for transportation purposes had to be raised. The early practice of building by direct subscription to the capital stock of the company was satisfactory enough in the well-settled region of the eastern states. But no sooner did construction begin to extend into undeveloped territory than a new situation arose. The old plan had several manifest advantages. In the first place, it fixed responsibility directly upon the shoulders of the stockholders. By becoming the sole losers in case of mismanagement, a gage was given to the public for honesty and efficiency. Moreover, in case the enterprise exceeded the original estimates as to cost, additional resources were at command through loans secured by mort- gages upon the line already built. But, on the other hand, this safe and simple plan was open to a number of objections revealed by bitter experience. The first of these was that the inevitable risk in novel enterprises or in the invasion of virgin territory, called for a corresponding promise of large and quick returns. In other words, such enterprises, instead of being sohd investments appealing to a substantial local constituency, were essentially speculative. However great might be the local interest, most of the funds, except the land, must be obtained from remote capitalists in the eastern states or in Europe. The competition for such capital in view of the great opportunities for development was keen. Bonds might, per- 1 Pp. 30 and 105, infra. 12 RAILROADS haps, be sold as conferring the security of a mortgage, but even they must be accompanied with inviting bonuses of stock in order to find purchasers. In the second place, the plan of direct stock subscription was defective in that it failed to utilize the resources which a wise use of credit afforded.^ If a portion of the capital could be had on a secured-loan basis of 6 per cent, and made there- after to earn 10 per cent, with the resultant margin left over for the shareholders, it was certainly poor business to continue to raise all the funds on a direct subscription basis which called for a uniform rate of return of 8 per cent, on the whole capital employed. Under the old plan all the capital shared alike in risks and profit. Under the new plan of a divided capitaliza- tion, one portion, being guaranteed a modest return and pro- tected against loss, was issued on an assured investment basis; the other portion, speculative in nature, was dependent upon the success of the enterprise for its return. Its chances of loss were not negligible; but its hope of large returns was inviting. This fundamental principle in finance, of a division of capital into two such distinct parts, was overlooked in the early simple practice.^ A third disadvantage of the simple plan of financing by stock issues alone, was that it made no provision for immediate profits to the promoter. The demonstrated success of the enterprise must be awaited in order that the stock should rise to a pre- mium above its issue price. This presupposed a large com- mand of capital and a permanent or long-time identification of the builder with the subsequent operation of the property. Unfortunately railroad building in the past too often fell into the hands of entirely irresponsible promoters, interested solely in the profits of construction, and impatient thereafter to pass 1 This principle is admirably discussed in a recent New York case, Mayhew, etc., 2 P. S. C, 1st D., decided Oct. 20, 1911; as also in a Chicago Union Traction Co. decision, 114 Fed. Rep., 557. Cf. also Greene, Corporation Finance, 1902, and Lyon, CapitaUzation, 1913. ^ Cf. table on p. Ill, infra. CONSTRUCTION FINANCE 13 on to other fields of activity. To them the plan of stock sub- scription at par was altogether uninviting. Even if they were possessed of means, it was simpler to risk other people's capi- tal than their own. On the other hand, a prime difficulty in financing solely by means of mortgage loans upon the railroad property as brought into being, lay in the fact that much pre- liminary expense in the way of surveys, estimates and other engineering work, together with options upon the right of way and necessary terminals, had to be incurred before any dis- closure of the project was possible; and, necessarily, long before there was any property which could be made the basis of an issue of bonds. Some expedient was necessary at the outset to raise funds for these purposes. The risks in this connection were, of course, peculiarly great because it was always possible that the entire enterprise might come to nothing in the end. In such an event the promoters stood to lose every penny which had been expended in connection with the affair. Legal considerations of weight constituted yet another objection to the early plan of construction solely from the proceeds of capital stock. Inviting subscription by offerings of stock at a discount — in other words, issuing it for less than payment in full at its par value — entailed certain inconvenient consequences in case of failure of the enterprise. In the eyes of the law, hability of the shareholders of a corporation toward creditors in case of bankruptcy or fraud, had taken the place of the former individual liability of partners. The familiar statutory provision that funded indebtedness should not exceed the amount of stock also gave expression to this theory that share capital was equivalent to assets, thus constituting a security for loans. Consequently innocent shareholders were sometimes penalized through being held liable for the difference between the face value of their shares and the price below par at which they had been issued. Yet while the courts would thus hold the original shareholders assessable, such liability did not extend to third parties. An expedient was therefore 14 RAILROADS necessary in order to make the general public "innocent holders for value." This could be done by the interposition of a finance company between the railroad and the subscribing public. The railroad might then issue its securities ' to this company in exchange for services and property in any proportion at the discretion of the directors. This operation in effect made the stock full-paid and without further liability for issuance at a discount, just as if the par value had been paid for in full by'cash. The intermediary corporation set up for this purpose was generally known as a construction company. It might, of course, actually build the road and often did so; but fully as often it sublet the actual contracts. Not infrequently also in later years the construction company contributed to the evasion of hampering stipulations as to "after-acquired" property in general mortgages, in raising funds for branch line construc- tion. ' All of these services are financial rather than physical. This point cannot be too strongly emphasized. The construc- tion company is a fiscal and not an engineering concern. It is an intermediary, standing between the railroad and the contrac- tors. Consequently the absence of a construction company, as in the case of the St. Paul (Puget Sound) extension, does not necessarily mean that a railroad projecting a new line actually does the work itself. In either case professional engineering and contracting firms usually build the road. The normal operation of a construction company nowadays may be made clear without specific figures.^ A corporation is formed with a cash capital sufficient in amoimt to undertake the preliminary work. This company enters into an agreement with the railroad by which it is to receive stated amoimts of bonds and stock upon each section of road as completed. It proceeds forthwith to build the line to the limit of its cash resources; and progressively receives the securities from the ' P. 125 infra. ' Meade, Corporation Finance, 1910, p. 114, gives an admirably example with detailed figures. CONSTRUCTION FINANCE 15 railroad as provided in the contract. These securities might, of course, be at once offered to the public (as indeed seems to have been done in the Colorado-Utah case on the Denver Northwestern in 1902 ') . But inasmuch as a more favorable market would be had on completion of the work, the construc- tion company more often makes use of the railroad securities as issued to secure temporary loans, based upon these as coUat- eral.2 With the funds thus raised, equal to 60 per cent., more or less, of the face value of the railroad securities deposited, fresh funds are obtained for another section of construction. Hereupon the same financial operation is repeated. The addi- tional railroad securities received in payment for work done, are once more made the basis of new loans. Thus the process is repeated to the end. The wind-up has to do with the final disposition of the securi- ties in the hands of the construction company. The road is, let us assume, complete and in operation. The bonds last received and presumably unpledged are sold, with or without bonuses of stock as the case may be; and with the proceeds the temporary loans next in line are repaid. These, in turn now released, are used to clear up the next layer of indebtedness. Loan after loan is thus paid off, leaving the construction com- pany at last with sufficient cash to settle with its own share- holders, distribute its assets and dissolve. These assets consist of two distinct portions. The first is the profit in cash from sale of bonds over and above the construction cost of the property. The other part is the residue of the capital stock of the railroad, left over after giving the necessary bonuses to promote the sale of the bonds. An essential of successful promotion, usually, is the reservation, after meeting such requirements, of a con- trolling interest in the capital stock as a whole.' This has usually been possible under the liberal statutes of most states. ' The construction contract is reprinted in Meade, op. cit., p. 110. ' Cf. p. 309, infra. ' P. 40, infra. 16 RAILROADS Little or no cash payment for stock at issue being necessary, the amount could readily be made large enough to meet all possible needs. The final act preceding dissolution is to parcel out these holdings of railroad stock among the shareholders of the con- struction company. Or, on occasion, this share capital may be held en bloc by means of a voting trust or other agreement. The foregoing description is not altogether typical his- torically. In a measure it presupposes a group of capitalist- promoters already in possession of or commanding large funds. For the construction company launches forth upon its career with a considerable paid-up cash capital to meet preliminary expenses. Suppose, as in the early days and sometimes at present, that the promoter having few resources, must in the first instance secure the capital for the construction company itself. Or he may conceivably have funds, but may desire to minimize his own risks at the expense of outside investors.' This primary difficulty of financing the construction company, for example, seems to have been great in connection with the building of the Kansas City, Mexico & Orient Road since 1900. The most inviting layout of securities was offered to investors, principally European, in connection with this striking enter- prise in order to interest them prehminarily.^ In order fully to appreciate construction company prac- tices in the early days, one must imagine a company of pro- 1 The avoidance of undue personal liability seems to have been the only motive actually revealed in the New York Hepburn Committee in- vestigation of 1879 in connection with the construction contracts of the elevated roads by the New York Loan and Improvement Company. This finance concern was the intermediary, its large stockholders being also directors of the railroad, which issued its securities through this me- dium in exchange for completed construction. (Vol. II, pp. 1-135.) The Contract and Finance Company and the Millbrook Company, in the N. Y., Westchester & Boston promotions, exercised functions not yet disclosed. ^ P. 48, infra. Two construction companies were concerned in build- ing this road. The iuvitation to subscription to their capital stock contained the following estimates as to the division of assets of the con- struction company on completion of the work. For each 100 shares of Union Construction Company (selling in 1910 for $13,000) investors were promised as follows: CONSTRUCTION FINANCE 17 meters not only devoid of capital but without any considerable assets in the way of character. The border hne between speculation and fraud is sometimes ill-defined. But, to say the least, these two unfortunate features of speculation and fraud were too often associated with operations of this kind. From this circumstance the construction company has fallen into an ill repute, not perhaps wholly deserved. The follow- ing hypothetical example would seem to correspond pretty closely with the methods of the notorious Credit Mobilier and other companies concerned a generation ago in the construc- tion of our transcontinental roads.' $18,000 K. C, M. & O. 1st mortgage 4s (bonds). $18,000 K. C, M. & O. 4 per cent, preferred stock. $16,000 K. C, M. & O. common stock. $ 6,666 K. C, M. &. O. town site stock. $58,666 Similarly for each 100 shares International Construction Company stock there were promised on dissolution: $17,225 K. C, M. & O. 4 per cent, bonds. $16,940 K. C, M. & O. 4 per cent, preferred stock. $12,600 K. C, M. & O. common stock. In addition to the above, each share of construction company stock received as a bonus: 5.5 shares Mexican Timber Field Company. 20 shares Rio Grande Coal Fields Company. 800 shares Mexico & Orient Town Site Company. 10 shares Chihuahua & Sinaloa Development Company. 20 shares Sierra Madre Development Company. These extra bonuses for each 100 shares of construction company stock aggregated $56,402 par value. (Wall Street Journal, March 10, 1910.) Subsequent proceedings in connection with reorganization have resulted in an elaborate agreement of January 15, 1914, as to the conflict- ing claims of the railway and construction company to these assets. There is some evidence that the promoter set up all these diSerent companies in order to play one off against another and keep control himself. ' On the Credit Mobiher two elaborate government reports of 1873 are available: Wilson Report, 42nd Cong., 3rd sess., H. R. 78; and the Poland Report, 42nd Cong., 3rd sess., H. R. 77. White's history of the Union Pacific Railway, 1895, is the best secondary source. Details are reprinted in chap. IV of our Railway Problems. (Rev. ed.) On Jay Gould's subsequent frauds upon the Union Pacific, consult Daggett, Railroad Reorganization, p. 232. The so-called Jay Cooke "pool" was the original construction company on the Northern Pacific. Oberholtzer, II, pp. 157 and 244. 18 RAILROADS A knot of promoters planning an enterprise, first formed a railroad corporation and authorized, let us say, capital stock to the amount of $1,000,000. This consisted of 10,000 shares, par value $100. The stock was issued to themselves part-paid ($10 per share) — $100,000 in all being temporarily borrowed by them individually for the purpose. A glowing prospectus then offered for sale two milUons of bonds with the proceeds of which the road was to be built. These bonds were sold at 80, with perhaps a bonus of stock thrown in, thus reahzing $1,600,- 000 in cash. From this the promoters reimbursed themselves for the $100,000 already advanced, by charging a 5 per cent, commission for marketing the bonds. This enabled them to pay off their personal loans. It left $1,500,000 cash in the treasury of the railway corporation as well as a controlling portion of its own capital stock. The next step was the organi- zation by these same directors of a construction company, which built the road for an actual outlay of $1,200,000. The railway directors now voted to pay their construction com- pany $1,500,000 in cash for this work and in addition the remainder of the share capital of the road. A profit to them- selves of $300,000 plus the prospective value of the capital stock, which had cost them nothing, obviously resulted. If the enter- prise were henceforth profitably operated, all well and good. If not, it might fail even to pay interest on its bonds. If bank-' ruptcy ensued, a receiver, possibly representing the old stock- holders rather than the bondholders, was appointed. ' In any event the promoters had reahzed 300 per cent, on their first investment, itself borrowed, from the profits of the construc- tion company. Moreover, they still controlled the railroad through its capital stock. Thus were the foundations of a number of large fortunes laid; enough, that is to say, to envelop American railroad construction in an atmosphere of disrepute by no means generally deserved. Anticipated profits from speculation in land along the pro- • P. 383, infra. CONSTRUCTION FINANCE 19 posed right of way were an important inducement to the con- struction of railroads in the early days. "In imagination every acre of land from Walker's Point to Snake Hollow has been plowed, sowed, fenced and is bearing forty bushels of wheat," says an early newspaper critic in Wisconsin in 1854. The promoters having decided upon their location, either pur- chased or pre-empted the most desirable tracts. From the sale of these, either to the railroad company for terminals or to the general public for town sites, ample returns for the risks of pioneering were expected.^ The scrupulously conducted enterprises gave the full benefit of these land dealings to the railroad company; the others reserved the profits to the pro- moters. It is indubitable that without the profits from land sales, the construction of railroads would have been greatly delayed in the early days. It is also clear, however, that in some instances the railroads themselves were materially dam- aged by participation in matters of this sort. The Lake Superior & Puget Sound Land Company operations were inextricably entangled with those of the Northern Pacific at the time of its downfall in 1873. It would take us too far afield to attempt to deal with the details of these land operations in recent years. Sometimes where the officers of the railroad have honestly shared the profits of their sagacity and fore- sight, as in the case of the Great Northern ore lands in 1906, no criticism may be directed against current practices. But when, as in the recent gutting of the "Frisco,"^ those in con- trol of the railroad made secret profits of almost $9,000,000 out of the Brownsville and other extensions, the utmost con- demnation is merited. There is an interesting possibility' that the Millbrook Company, which played some part in the collapse of the New Haven system in 1912-'13, was in reality engaged in real estate speculation along the line of the newly- ' Hassler, Railroad Rings, 1876, gives a number of concrete examples; also Oberholtzer, Jay Cooke, II, pp. 162-330. 2 P. 41, infra. » P. S. C, Mass., Opinion, Oct. 14, 1913, p. 14. 20 RAILROADS constructed Westchester road out of New York City. Over $3,500,000 not otherwise accounted for by the directors seems to have been turned over to this concern.^ The plight of the bondholders of a prematurely or dis- honestly constructed railroad in the early days was unfortimate. Even if the receiver on taking possession truly represented their interests, the road might not have been completed through to an advantageous terminus. It might run up a tree, miles from connections or sources of traffic. Possibly, as on the Union Pacific, the parent company might have guaranteed interest or dividends on branch lines, the stock of which was still held by the promoters.^ Necessary terminals, bridges or ferries might also be separately organized as corporations owned by the old directors. An inadequate supply of equipment, cars and locomotives might seriously embarrass the road; or the rolling stock might be controlled by a car trust, officered by the original promoters. Interminable delay and montmaental legal costs in disentangling the conflicting rights of different classes of security holders, might make it expedient to agree to a compromise with all these blockading interests. Such might be the most practicable and the cheaper policy; and from this compromise, those originally intrenched in the enter- prise might wrest still further profits. Pecuhar difficulty, even with the best intentions, attends the keeping of construction accounts in such manner as to show the true condition of affairs. Routine operation must often be carried on for a considerable time on the completed portion of line, while construction is under way at the rail head. It is difficult at best to keep the two affairs separate. Failure to distinguish them in the accounts leads to confusion and often- ' The Interstate Commerce Commission has been directed by the Senate to renew its examination of such details. Morgan & Co. published certain facts on March 9, 1914. " 50th Cong., 1st sess., Senate Exec. Doc. no. 61, pp. 53, 65, 101 and 165, discusses the subject of branch line finance. Cf. Greene, op. cAt., p. 63, and Lyon, op. ait. CONSTRUCTION FINANCE 21 times invites manipulation. To cite only one detail, how shall the large volume of traffic in construction supplies be cared for? Shall it be charged full rates and credited to operation, or carried free as an item of construction cost? The only safe- guard is to intrust the new work to a distinct corporation devot- ing its entire energies to that purpose. Thereafter from time to time settlement may be effected between this concern and the already operating properties. One of the serious abuses of early imstandardized railroading may be described in this connection. It had to do with juggling of the construction accoimt, particularly with the item on the assets side of the bal- ance sheet denominated "cost of road." The method may be described by the following illustration. Suppose the earnings of a railway to be $1,000,000. If its operating expenses be $600,000 for the same period, the "operatuig ratio," so-called, will be 60; that is to say working expenses amount to this percentage of earnings.^ This operating ratio, showing the proportion of income left over after paying expenses, might be changed arbitrarily at any time by varying the definition of expenses of operation as distinguished from addition to capital. Suppose $200,000 to be the cost of some permanent improve- ment, such as a steel bridge, heavier rails or possibly a new piece of line. This item of $200,000 if paid for out of earnings, that is to say merged in the routine expenditure of the road, would raise the cost of operation to $800,000. The operating ratio would then become 80 and the road would appear to be in a somewhat languishing condition. If, on the other hand, the $200,000 above-mentioned were charged to new construc- tion and paid for by the issue of an equivalent amount of securi- ties, the operating account would not be affected. On another supposition the item of $200,000 may represent, not an addi- tion to the plant or assets but a maintenance expense, called for in order to replace worn-out equipment or even to make needed repairs.^ Such an item ought properly to be charged » Vide Appendix II, infra. '' Cf. p. 77, infra. 22 RAILROADS to operating expenses. The original $600,000 of such outgo ought to have included all such items. But if, instead of being charged to that account, it be entered on the construction account and paid for by the issue of new securities, the operat- ing expenses would be apparently that much smaller. They would then become $400,000, and the operating ratio would be only 40. By charging operating or maintenance expenses in this way to new construction, the conduct of the property would be made to appear unduly profitable. The same thing would of course occur if, during the time that plant and equip- ment were new, not subject to heavy repair outlays, no pro- vision were made for the future when such charges would in due time fall in. Manipulation of construction accounts seems to have been not uncommon in the past. Its prevalence was one of the strongest arguments for prescription of the form of railroad accounts by law. Such juggling has been associated with most of the roads which at one time or another have figured in coiu-t or bankruptcy proceedings. During four years after 1868, Jay Gould while in control of the Erie ran up the construc- tion account from $49,000,000 to $108,000,000. The assets remained practically unchanged. A part of this inflation was due to the entry of discount on illegally issued bonds among the assets ;i but another part undoubtedly arose from charging actual operating expenses to construction account in order to deceive the public as to the condition of the road. Similarly on the old Union Pacific the operating ratio varied all the way from 23 to 61. From this latter figure in 1870 it declined to 41 in 1879.2 The U. S. Pacific Commission of 1888 states tha^t the construction accounts of several railways at that time were thus inflated, either wilfully or because of the chaotic state of affairs at the time. Despite the best efforts of the government in recent years to bring about standardization, most of the above-mentioned ' Cf. p. 277, infra. ' 50th Cong., 1st sess., Senate Exec. Doc. 61, pp. 53 and 87. CONSTRUCTION FINANCE 23 accounting practices cropped out in connection with the construction of the St. Paul extension to the Pacific coast. * Desiring to create a favorable market for the sale of securities in France, all interest, rents and revenues for the three years of construction work were included in the income account for 1910 alone. At the same time operating expenses were reduced by crediting items, such as salvage from cars destroyed, as far back as 1907. By this means the income of the St. Paul was overstated in that given year by more than five miUion dollars. This operated very unfavorably, of course, upon the next year's comparative results, which were based solely upon twelve months' operations. The effect upon the stock quotations was naturally pronounced. Notwithstanding the gravity of these offences, the dehnquencies in the accounting of the Puget Soimd company itself were even more significant. Most of the classical expedients above-mentioned for over-stating income were resorted to. After the opening of the main fine in 1909, construction work upon the branches continued for some time. Expenditures for construction and operation were thus being made simultaneously. It was possible, therefore, to include large amounts in cost of construction which should have been charged to operation. Construction material was actually charged higher rates than those provided for ia pub- hshed tariffs. Interest items were manipulated, and no charges whatever for depreciation of equipment were made. Had the estabhshed accounting practice been adhered to, the re- ported income of 12,255,000 would have been practically eliminated, and the dividend of 2 per cent, paid to the parent company out of "income" would really have come from capital. It may confidently be expected, however, that the Interstate Commerce Commission, now sure of its authority since the recent decision of the Supreme Court in the Kansas City Southern case,^ will rigidly enforce the law in future. » 29 I. C. C. Rep., 508. Pp. 34 and 37, injra. 2 231 U. S., 423. P. 233, infra. 24 RAILROADS An interesting picture of early American practice is af- forded by the following excerpt from letters of John M. Forbes with reference to the situation on the so-called River Roads in Wisconsin in 1873.' Forbes, representing eastern bond- holders, discovered that six of the twelve members of the board of directors, including the president, were also stockholders in a construction company. The following dialogue refers to a contract by the terms of which the construction company was released from any obhgation to build after its funds were exhausted, despite the fact that the railroad companies had already paid $25,000 a mile for fifty-five miles of road which had not yet been constructed. "Question to the president: 'What have you been doing with the company's money? ' "Answer. 'I have been paying the notes which I have given as president.' "'What are the notes? Where is the record of them? Is it in the treasurer's account?' "'It is not in the company's books, but can be ascertained.' '"What were the notes given for?' "Answer. 'Chiefly to meet the obligations of two con- struction companies, of which I was president also, and which built the roads of each company by contract.' "'Then you, as president of the railroad company, are paying yourself as president of the construction company, without the supervision of the treasurer or of any one else, and without any auditing of your accounts?' "'Yes.' " 'Has the construction company received the full amount of money, of stocks, of lands, for which they agreed to con- struct and equip the roads? ' "'Yes, they have, leaving unfinished about forty miles of Turkey branch and twelve miles on the lower road.'" The imminence of financial abuse in connection with con- '■ Reprinted in Ripley, Railway Problems, rev. ed., p. 85. CONSTRUCTION FINANCE 25 struction by inter-related corporations is well illustrated by the unhappy experience of the Hampden Railroad in 1913 in Massachusetts.^ A short connecting hnk between the Boston & Maine system and the New Haven lines to New York for summer passenger traffic to seashore resorts in northern New England was desired. For this purpose about fifteen miles of road was built out of Springfield, Mass. This work was done for the so-called Hampden Railroad by the Woronoco Con- struction Company, the Boston & Maine planning to guarantee the interest on the bonds and 5 per cent, on whatever capital stock it was necessary for the Hampden Railroad to issue in order to finance the enterprise. One Gillette, chosen by the president of the New Haven road, which then controlled the Boston & Maine, was selected to put through the enterprise. He first organized the Hampden Investment Company, which took the entire capital stock of the railroad corporation of the same name. This concern then negotiated loans upon the deposit of this railroad stock as collateral. The same individual "who was the Hampden Railroad corporation" thereupon entered into an agreement with his own personally conducted construction company to do the work. This concern was to be paid upon the cost plus 10 per cent, commission as profit for its services. No adequate supervision was apparently exercised by the principal railroads, either as to the conduct of the work or its ultimate cost. The construction company immediately sublet the contracts for building the road for about two-thirds of the price generally agreed upon with the Boston & Maine. Its actual service, for profits sometimes as high as 40 per cent, in addition to its guaranteed 10 per cent., consisted largely in securing the right of way. Obviously under this general arrangement the greater the actual outlay, the greater the profit to the construction company. No better premium on reckless expenditure or downright fraud could well have been devised. The final result is significant. Despite 1 27 I. C. C. Rep., 604; P. S. C, Mass., Opinion, Dec. 24, 1913. 26 RAILROADS the fact that this was a single-track line with no equipment and no terminals, the outlay was approximately $250,000 per mile. The average capitalization for the railways of the United States and the other roads in Massachusetts is about one- fourth that figure. Other railroads built about the same time for the heaviest traffic through rugged country and in the most perfect way, including all appurtenances, — the Virginian and the Carofina, Cfinchfield & Ohio, for example, — cost only about $120,000 per mile.^ The rental to be saddled upon the Boston & Maine under such conditions would be at least four times the average rental of all its other leased fines, including parts of its main stem. This extraordinary operation seems to have gone on with- out any supervision whatever by the then-degenerate man- agement of the consofidated New England railroads imder the Mellen r^gime.^ Nor did the savings bank or other financial institutions which advanced the necessary fxmds seem to have exercised due care in the premises. The matter necessarily came before the Massachusetts Pubfic Service Commission in connection with its approval of the necessary issue of securi- ties. By a majority opinion about $1,000,000 of the alleged actual cost, representing roughly the profits of the construction company, was disallowed. But a capitafization for this insig- nificant property of $220,000 per mile was still permitted. As the vigorous dissenting minority opinion stated, this decision, to be sure, reduced the alleged cost per mile by an amoimt about equal to the total average capitafization of other Massa- chusetts railroads; but in law, economic principle and soimd public policy it rested upon an utterly untenable basis. It practically legafized fraud upon the stockholders of the Boston & Maine Railroad. Whether it was subsequently to permit a final incidence of the burden of an excessive rental upon 1 Railway Age Gazette, vol. LVI, 1914, p. 935. ^ Similar construction companies seem to have played some part in other trolley operations of the New Haven road, the same individuals who directed the Woronoco Company being apparently in charge. (27 I. C. C. Rep., 680.) CONSTRUCTION FINANCE 27 the general public, happily still depended upon approval by the commission of the lease of the property upon the agreed basis. The whole episode illustrates the danger incident to interlocking directorates. No person in control of a railroad ought to be allowed to stand in such a relationship that in one capacity it is to his interest that work should be done at the lowest possible price, while in another capacity it will be to his profit 'to have it performed for a majdmum figure. The exer- cise of good faith, disinterested judgment or prudence is ren- dered difficult under such conditions. Recent experience in another case is valuable as showing the manner in which, even though honestly administered, the finances of a railway and a construction company tend to become ahnost inextricably entangled. The Atlanta, Bir- mingham & Atlantic road was projected in 1905 to combine several existing properties and to build a new through Une several himdred miles long connecting Birmingham, Ala., Atlanta and the seaboard. Building was done by the Atlantic & Birmingham Construction Company, with a capital stock of $8,000,000, cash paid in full. It was to receive bonds and stock of the railroad in payment for work done in the usual way. It also controlled coal lands, water and other terminals and various concerns necessary to the operation of the prop- erty. The cost evidently greatly exceeded the estimates and the railroad went into the hands of receivers in 1906. About $30,000,000 seems to have been spent upon the enterprise, a sum about equal to the total fimded indebtedness.' The ^ The following statement of receipts to 1909 indicates the nature of the operations by which capital was raised: Share capital, Construction company, cash $ 8,000,000 Sales of raiboad bonds at 87^ 3,800,000 Sales of railroad stock, preferred shares at 50, common shares at 15 1,000,000 Terminal and coal company bonds, etc 8,000,000 Joint collateral trust notes of the railroad and of the construc- tion company 7,400,000 Construction company collateral notes 800,000 Odds and ends $29,000,000 28 RAILROADS peculiar feature, differentiating this case from other recent ones, was the interlocking of railroad and construction com- pany finance. Being in straits in 1906, a large issue of collat- eral trust notes was made jointly by the two companies on the security of their combined properties. Bonds and stocks of coal companies, steamship hnes, terminal corporations and the railroad, so far as unpledged, were deposited under this agree- ment. The result of course was that, although the railroad was completed and in operation, the construction company was automatically kept alive as a finance concern during the term of these outstanding joint securities. It could not be dissolved nor could its assets be distributed to stockholders, as is usual imder more favorable circumstances. Meanwhile, a maze of financial entanglement obtained, not only in respect of capital account but of physical operation as well.i A construction company may occasionally, not as in the foregoing instance by force of circumstances but by dehberate choice, continue in existence long after the railroad is finished, and by holding all or a majority of the railroad stock absolutely control its destinies. Thus the Aroostook Construction Com- pany, organized in 1893, not only still holds the Bangor & Aroostook Railroad in Maine in the hollow of its hand; it also administers the affairs of a number of necessary subsidiary companies, operating telegraphs or holding lands or terminal properties. With a funded debt in 1911 of $22,495,000, the capital stock of the railroad amounted to only 13,000,000. This was all owned by the construction company. The stocks of all these inter-related corporations were so apportioned among a very small number of persons that a perfect equihb- rium in control maintained. Still further to insure concentrated and continued control, the construction company was placed in the hands of three voting trustees. The profitableness of this arrangement would seem to arise as much from the fact 1 Railway Age Gazette, vol. XLVI, 1909, p. 224. CONSTRUCTION FINANCE 29 that all extensions of line were built by this construction com- pany as from its regular dividends upon the shares of the rail- road which it owns. Meeting the cost of construction by bond issues, the amount of such shares thus closely held, would seem to be immaterial as affecting the pubhc interest. Market prices many times the par value per share for the construc- tion company stock, would seem to reflect the private advan- tage of the restricted capitahzation of the railroad. The hberal provisions of the Maine law in this regard, the property being entirely intra-state, seemed to provide for no supervision as to the nature or amount of the securities which might be put forth. The Southwestern Construction Company is another corporation of the same type serving as a holding company for a highly elaborated nexus of inter-state roads. It serves to bind together a number of properties comprised in the "Queen & Crescent" system in the South.* By way of contrast with the irresponsible, wasteful or fraudulent methods which too often prevailed in connection with the opening up of the West and South, the experience of a sound and conservative company may well be cited. In conformity with the early practice, the nucleus of the great Chicago & Northwestern system began in 1847 by subscrip- tion to the capital stock of a small company. No bonds at first seem to have been contemplated. But it soon became apparent that resort to borrowing must be had. Of the cost, which was $405,000 for the first 42| miles of line from Chicago to Elgin, 111. in 1850, about two-thirds was raised on share capital, apparently taken at par. Four years later, with 260 miles of hne and a total outlay of $8,300,000, less than $3,000,000 had been received from sale of bonds. No bonds were issued for less than par until the panic of 1857. The following apolo- getic explanation from the president of the company at that time is worth quoting: '■ Diagram on p. 444, infra. The Virginian Railway stock prior to 1912 was all held by the Tidewater Co., which seems to have built it. 30 RAILROADS "The discount on the bonds is simply the amount of interest to be paid, over and above the rate stated, which interest (represented by the discount) is embraced in the face of the bonds, and will be paid at their maturity instead of semi-annually." The relatively high proportions of capital raised for many years by the Northwestern through the issue of stock, instead of resorting to the expedient of borrowing, is indicated by the following figures: Capital stock Bonds Per cent, bonds 1861 . $ 6,000,000 35,800,000 36,500,000 53,000,000 63,700,000 122,000,000 152,000,000 $ 3,500,000 16,200,000 50,100,000 91,500,000 156,000,000 163,000,000 36 8 1871 31 1 1880 67 8 1885 . 63 3 1896 1906 56 1 1911 51 7 It is apparent that the first fundamental change in policy came in the 70s, probably as a result of the long depression following the panic of 1873. The contrast between capital stock more than double that of indebtedness in 1871 as against only three-fourths as much in 1880, is striking. Either capital was hard to obtain at home or else the purchase of leased lines through issues of bonds accounts for this change in policy. The natural trend of capital of a conservatively financed company back to at least an equivalence between shares and bonds seems to have occurred on the Northwestern progressively after the middle of the '80s. The top-notch of indebtedness, relatively, coincides with the speculative period which cul- minated in the railroad panic of 1884. Since that time, and paj-ticularly since 1900, the continued emission of new stock at par, partly in order to raise necessary funds for extension and partly also to furnish a broader base on which to distribute growing surplus earnings, is noteworthy. At least until the problems raised by rate regulation on the one hand and increased CONSTRUCTION FINANCE 31 operating costs on the other since 1909 assumed their present importance, this conservatively managed property prospered greatly in its affairs. And even under the pressure of ad- versity, it seems able to bear up bravely, furnishing adequate service without greatly enhanced rates and at the same time continuing a satisfactory rate of return to its shareholders. Scanning thus the history of this company, one seeks in vain for construction companies or other subsidiary corporations existing for the profit of insiders in the management. With high credit based upon a consistently honorable record, large commissions to underwriting syndicates operating in con- nection with the provision of new capital, have been imneces- sary. And, as we shall see, the corporate structure of the Northwestern system is simple. A large proportion of its plant is owned outright. There are no conflicts of interest between the company and the rights of minority shareholders in fines controlled by lease or through stock ownership. Its accounts are in consequence simple and intelfigible. Such an achieve- ment is a credit to all concerned whether in operation or finance. The Great Northern is another conspicuous example of the same sort. And there is fittle question that the type is more common than the numerous pathological examples in our text would lead one to suppose. But only by the study of disease can the laws of health be determined. The same principle holds good in corporate finance. The enlargement or extension of an old and well-estabUshed system is a much simpler affair than the financing of a new and independent railroad. In recent years the construction company as a fiscal agent has become practically obsolete in the former class of enterprises on the standard systems. The superfluous credit of the main* company is extended to cover the new construction.^ Such building, however, for various ^ Good honest expansion is represented in the building by the construc- tion department of the Union Pacific of the Oregon Short Line for about $25,000 per mile of Une. Daggett, p. 233. 32 RAILROADS reasons, is not usually done directly by the parent railroad. The requirements of law in the different states usually compel separate incorporation within each commonwealth. It may often be necessary to conceal the identity of the enterprise, under the existing strategy of the situation, until all essential property and rights have been secured. Moreover, it is gen- erally advisable to keep the old and the new properties finan- cially separate. Inextricable confusion may otherwise be introduced into their affairs. The accounting aspect of it has already been treated. Financial entanglements are most hkely to occur through the operation of the "after-acquired prop- erty" clauses in the general mortgages of the older company.* Sometimes, as in the case of the Atchison, however, after the parent company has arranged for separately financing the extension, it may contract to build the local road itself in return for the issue of its securities. Or the parent company may arrange to furnish equipment and to operate the new line under a formal agreement.^ Such was often the case on the old Burlington system. The financial coimection between the two companies, so far as the raising of new capital is con- cerned, may assume various forms, conditioned, it would appear, largely by the financial strength of the parent road. The Chicago & Northwestern practice, already described, is typical in this regard. The Great Northern has also consistently financed its extensions by advances from surplus, or by the sales of its own shares at par. The shares of the local road are then taken in exchange for construction advances. A more usual arrangement, perhaps, is to finance the new construction by the issue of bonds by the local road. The parent company may thereupon indorse these bonds or guarantee the payment of interest upon them.' Such has been a common practice in the Pennsylvania system. In*such cases the capital stock of 1 P. 125, infra. " Cleveland and Powell, p. 74, for cases. ' The abuse of this practice in the case of the old Union Pacific has already been described. P. 20, supra. CONSTRUCTION FINANCE 33 the new road may have a merely nominal value, being held by the parent company in order to insure control. The parent company may then, if it choose, deposit these bonds with a trustee and issue its own securities based upon them as collat- eral. The Illinois Central, Rock Island and Union Pacific have at times resorted to this expedient. Many independent short roads and feeders, particularly in prosperous communities like Wisconsin, have been constructed by local enterprise and credit through the activity of farmers, thus seeking an outlet to markets. The right of way costs little; the labor is contributed by the subscribers; and the first fight construction is financed by local borrowing. Be the enterprise a fittle more ambitious or, as in the Southeast local funds less ample, the aid of city bankers may be neces- sary. These bankers contribute funds, such as possibly $8,000 per mile in bonds, having as equity the labor and right of way put into the property prior to the loan. The capital stock held by the bankers may then, perhaps, be sold to some larger com- pany with which the fines connect. A good deal of normal and healthy local development, free from construction abuse, has undoubtedly taken place in this way.^ The recent financing of two ambitious construction projects illustrates the prevaifing practice at present among estabfished companies. The Western Pacific extension of the Gould system in 1903-'10, called for the building of almost 1,000 miles of line in order to provide an independent outlet to the Pacific coast.^ The credit of the Denver & Rio Grande, an allied Gould property, afforded the foundation for its financing; but it, in turn, reUed for support upon the Missouri Pacific. Two- thirds of the capital stock of the new company and an equal proportion of the first mortgage bonds, were given to the Rio Grande in exchange for advances of cash. In addition, as ' Certain cases before the state public service commissions indicate the possibility of abuse quite the same in type as that already instanced. P. 309, injra. " P. 517, infra. VOL. II — 3 34 RAILROADS proved necessary, a still further large issue of second mortgage bonds and thereafter of short-term notes was made by allied roads in the Gould system. In order to insure a market for the remaining portion of the bonds of the new company, these older roads agreed to make up any deficit needed to meet operat- ing cost and interest. The parent roads, in order to raise these large sums, were obliged, of course, to issue their own bonds based upon the deposit of the Western Pacific shares. But few securities of the new railroad were marketed publicly. Some- what simpler was the financing of the Chicago, Milwaukee & St. Paul extension of 1,500 miles to the Pacific coast in 1906-'09. The bulk of the capital was in first instance raised through the issue by the parent road of $100,000,000 of new shares at par to its own stockholders. Payment in instalments upon these shares was distributed over the period necessary for construc- tion. In return for these advances of cash, the Puget Sound company turned over to the parent road $100,000,000 of bonds together with its entire capital stock aggregating an equal amount. Additional issues of bonds have since been necessary to provide for branch lines and feeders. These bonds were issued as before to the parent company. Few of them were publicly sold. It will be noted in each of these recent cases that the large issues of capital stock, closely held in the treas- uries of the older roads, practically equalled the original amounts of the mortgage bonds. These stocks, as it would appear, were put forth without any consideration in cash. Whether securi- ties thus issued merely for the purpose of providing a corporate connection between the old and the new roads and preserving a relativity between stock and bonds, invite criticism on the charge of stock-watering, will soon be considered. The St. Paul has since covered its financial tracks by positive merger of the two companies in 1913. It would appear, however, that the excess of capitalization over cash investment were as great as in the cases of financing by construction companies. ^ ' Pp. 23, supra and 37, infra. CONSTRUCTION FINANCE 35 Among several immediate results of the American practice as to construction, particularly where intermediate finance com- panies are employed, the first and most important is probably an excessive issue of securities in proportion to actual invest- ment. The construction company almost inevitably invited over-capitalization. Instead of substantial subscription to capi- tal shares for cash, bonds were put forth and stock was thrown in for Httle or nothing. This, to be sure, was probably neces- sary to some degree. The point to be made is that the prac- tice was overdone. In other words, exception is taken, not to the nature of the financial plan but to the extreme Umits to which it was carried. A few concrete illustrations may serve to make the practice and results plain. The experience of the Credit Mobilier with the building of the Union Pacific is highly involved and, in many respects, discreditable. Fortunes were lost and made, and many reputations were besmirched. The final outcome seems to have been this: that about $111,- 000,000 of securities were issued in order to raise $74,000,000 of cash, to construct a railroad which actually cost about $60,000,000. In other words, capitaUzation exceeded cost in the proportion of two to one. Another classical example is found in the activities of the North River Construction Com- pany in building the West Shore Railroad in the '80s.' In this instance, the railroad company was to dehver stocks and bonds amounting to $75,900,000 in exchange for an actual investment of only $29,000,000. One of the flagrant instances, not only of over-capitahzation but of subsequent fraud upon the stockholders of the railroad, was the building of the Cen- tral Pacific Railroad from Sacramento to Ogden.^ This work was done imder the so-called Crocker contracts. These were carried out by a certain Contract and Finance Company, whose ' A full account of this affair is given in Bradstreets, April 25, 1885. Details are given also from week to week during 1883-'84 in the Railroad Gazette. 2 U. S. Pacific Railroad Commission Report; 50th Cong., 1st sess., Senate Exec. Doc. 51, p. 69 et seq. 36 RAILROADS sole stockholders were Messrs. Stanford, Huntington, Hopkins and Crocker, all directors at the same time of the Central Pacific Railroad Company. The profits from these agreements, in the words of the U. S. Pacific Railroad Commission, "will be found to pervade all contracts for construction, for repairs, for branch lines, for leases of the auxihary lines, for the express, for the sale of material, and for the sale of coal." They accrued ahnost entirely to the benefit of these persons who, theoretically, stood to represent the interest of the shareholders of the rail- road. The commission condemned the course pursued as "wholly indefensible" and "necessarily absolutely destructive of all business security." For much of the original construc- tion the cost to the railroad in securities was approximately $100,000 a mile, whereas the physical investment amoimted to about one-half this figure. For one section, for example, concerning which the facts were ascertained in detail, the total cost of the road and equipment was $3,500,000. These four directors of the raihoad voted themselves $8,300,000 in railroad securities in payment. Precise details concerning many parts of the hne are not to be had, because the books "were purposely destroyed by direction of Stanford, Hunting- ton, Hopkins and Crocker. The evidence on this point appears to be conclusive." Even the bonds alone always exceeded at par the actual cost of construction. The stock represented no investment whatever. This seems, in fact, to have been the general rule at that time.^ ' Hassler, Railroad Rings, p. 18; and Cleveland and Powell, Rail- road Finance, p. 62, give a number of interesting minor examples. As illustrating the uses of railroad stock in early days, B. H. Meyer in his History of Raiboads in Wisconsin cites the following par value of gratuities in promotion of legislation in 1858: $175,000 to members of the senate, $355,000 to the assembly, $ 16,000 to clerks, $ 50,000 to the governor, and $246,000 to others. It would appear that this ought to "loosen the joints" of legislation. Yet, Stickney mentions the ease of a French half-breed member of the legisla- CONSTRUCTION FINANCE 37 From the point of view of public interest in security issues, certain features of recent direct construction by sound and established companies are open to criticism. The St. Paul transcontinental extension is a case in point. Its construc- tion account seems to have been manipulated without excuse either on the ground of lack of public credit, disaffection of its own shareholders or inordinate risk of the enterprise. Recall- ing our outline of its financial operations on preceding pages,' it appears that the total cost of construction was in the neigh- borhood of $155,000,000, — $100,000,000 of which was raised from the sale of St. Paul stock to its own shareholders advanced in exchange for bonds of the new company, and the balance from bond issues of the Puget Sound company. Yet in the first annual report of this latter corporation for 1910, its prop- erty investment was entered on the books at $236,000,000. A year later the Puget Soimd company valued its corporate estate at $269,000,000. How may we account for the discrepancy between a cash outlay of $155,000,000, more or less, and the book valuation of $269,000,000? The explanation is simple. Something had to be added to the property investment on one side of the account in order to balance the total of long- term obligations by which the funds were actually raised, and the $100,000,000 of capital stock, put forth for nothing. Cer- tain provisions of state law have a bearing upon the matter. The Puget Sound was a Washington corporation and the law there provided that bonds could be issued only up to a face value of double the capital stock. The law, following the rule in most other commonwealths, also forbade the issue of capital stock except for an equivalent at par in cash or property. If all funds were to be raised from bonds, allowing a sufficient margin for unforeseen contingencies and preserving the requi- site relation between bonds and stock, there was no other ture in Minnesota who, when offered the choice, took $10 in cash rather than $100,000 in stock of a projected raihoad. '■ Pp. 23 and 34, supra. Map on p. 477, infra. 38 RAILROADS alternative than to issue this large amount of stock. But in order to meet the second provision of law, in form although not in substance, a property valuation must appear, large enough to cover both bonds and stock. How simple, there- fore, merely to write up the property valuation sufficiently to meet the needs of the case. Moreover, this large issue of capi- tal stock makes it easy in future years to distribute large earnings without the appearance of an inordinately high rate of dividends. The whole episode constitutes an additional argument in favor of physical valuation. It also emphasizes the need of comprehending all construction accounts under the jiu'isdiction of the Interstate Commerce Commission. For the practice followed in this case amounts to an absolute violation of the prescribed rules for accounting of operating railroads. It may well be asked at this point what other course the St. Paul might have followed under the circumstances. The answer is ready. Inasmuch as the parent company not only controlled but financed the whole affair, it might just as well have taken payment for its advances to the Puget Sound partly in bonds and partly in stock. No spicing of the bond issue by so large a stock bonus was needed under the circum- stances. Conformity with the state law might truly have been obtained by an original issue of $25,000,000 of Puget Sound bonds and $75,000,000 of stocks in exchange for the cash originally raised. The stock would then have been put out full-paid in cash, and subsequent bond issues to a total of $150,000,000, sufficient to provide for future expansion, could have ensued. To the parent company the same measure of control as at present would have resulted although with lessened safeguards against loss in case of bankruptcy. But the Uke- hhood of failure is too remote to receive serious consideration. The real inwardness of the operation is disclosed at this point. The larger the stock issue, the wider the base on which future earnings may be distributed as dividends; and the greater the CONSTRUCTION FINANCE 39 burden which the pubhc may be called upon to bear by way of rates for service. Incidentally, although by no means irnim- portant, in addition to the public aspect of the matter is the possible deception to outside shareholders who conclude that an entirely fictitious valuation of assets of the parent company is in reality a true one. To reply that the parent company has no interest in the capital valuation of its subsidiary road, but merely in the returns which it may receive as dividends, might not satisfy a future bondholder who purchased securities on the strength of the balance sheet statement as to the total value of the assets. Under present conservative management all may be well. But who shall say that some day, abuses like those on the Alton and the "Frisco" may not occur? The charge of over-issue of securities in connection with construction calls for further explanation. It is primarily directed, of course, against the excessivfe emission of shares of stock. Bonds must oftentimes be put forth at a discount where pioneer risks obtain, even by the most conservatively financed enterprises.^ They might, of course, be sold at par, whatever the risk, were the rate of interest sufficiently high. But such a poUcy at once lays a heavy burden upon the company in the days of its infancy and weakness. Fixed charges must be kept low at the outset (or else manipulated out of construction account, as already described), even though a day of reckoning at maturity of the bonds is certain. For then the debt must be discharged at par, regardless of the net proceeds at issue. But the discount, distributed over the intervening years and reflected in the rising market quotations, offered a reward over and above the current interest rate, which tempted the investor at the outset. Bonds put forth at a discount are thus merely an expedient for postponing the requisite reward to capital imtil an anticipated future when the enterprise can afford to pay. It is clear, moreover, that oftentimes a substantial flavoring of capital stock must be added to bonds, to the end 1 P. 277, infra. 40 RAILROADS that the appetite of investors in pioneer roads may be still further stimulated. Criticism of construction finance in this connection has to do, not with those shares issued to the public in connection with bonds at less than their face value, but with the excessive amoimt of such shares over and above these, which were re- tained by the promoters for purposes of control. The construc- tion profits were the promoters' cake; in issuing enough stock to leave them a majority of railroad stock thereafter, they were enabled to eat it too. For, as ah-eady observed, a common feature of the construction contracts, not usually stated in connection with the pubhc offering of securities, was the reserva- tion at the wind-up of a controlhng interest in the capital stock of the raihoad by the construction company itself. ^ The further profits of the professional promoter over and above those already realized from actual construction, were then dependent upon the sale of these remaining shares to the public. This might be honestly done; or a market might be made by the improper manipulation of operating accounts. But in either event a "vast issue of paper obhgations" was created; '^ in no wise related either to the actual investment or to the earning power of the railroad. This retention of control of the capital stock, quite irrespective of the share capital already put forth to promote the sale of bonds, affords the basis for the conclusion that construction company methods were too often essentially tainted so far as the public interest was concerned. A comparison of pioneer enterprises Hke the building of the Great Northern and the Northwestern, already described — simply and directly financed from within — with the construction of the Union, the Central or the Southern Pacific, financed through construction companies, makes this point quite clear. ' Such a clause reserving half the capital stock appears in the Colorado- Utah Construction Company offerings of Denver, Northwestern & Pacific RaUroad securities in 1902. " U. S. Pacific Railway Commission, 1888, p. 52. CONSTRUCTION FINANCE 41 Irresponsible or possibly fraudulent corporate management, menacing alike the interest of the pubhc and investors, has too often been a second unfortunate accompaniment of American railroad construction. A complete divorce between actual administrative control and real ownership has too often resulted from the methods of finance employed. Practically all the funds were contributed by bondholders, having no voice in the management until bankruptcy occiu-red. Yet the pro- moters as managers controlled a majority of the capital stock. They had in fact given no cash hostages to fortime. Their profit had already been taken from construction. While subsequent operation might serve for their further enrichment by a continuation of construction company methods, as already described, their relation to the company was no longer construc- tive in form. Nor was the relation of the management to the public any more satisfactory. No one was really responsible for what occurred. Such an anomalous situation arose in the '80s respecting the hability of the Central Pacific to the United States for unpaid interest on Federal grants in aid of con- struction. A practical impasse existed. "The United States cannot sue, because the debt is not due. The corporation will not sue, because it is controlled by the wrongdoers. The (other) stockholders dare not sue because, under the laws of California, they are personally liable for the obUgations of the company." ' Recent experience, most unfortunately, is not free from sim- ilar instances of grave abuse in connection with the finances of construction. The most shameful case in years — most to be deplored at a critical time because of the unmerited but natural imphcation that similar practices prevail widely on other roads ^ — is revealed by the official investigation of the receivership of the St. Louis & San Francisco in 1914, and by subsequent proceedings in the courts.^ This railroad in 1897 entered upon a policy of expansion in the Southwest. Within 1 U. S. Pacific Railway Commission, 1888, p. 80. 2 63rd Cong., 2nd sess.. Senate Doc. 373, 1914; 29 I. C. C. Rep., 139. 42 RAILROADS a decade, 2,375 miles of line were added to the system — an increment in itself double the original mileage. This pro- gramme ended abruptly in 1907. No further extensions took place; but it required six years of further financial mismanage- ment to bring about the final collapse. Most of this new mileage was constructed independently, generally by syndi- cates or construction companies in which the directors and prominent officers, notably B. F. Yoakum, chairman of the Board of directors, were heavily interested. The properties were then turned over to the " Frisco " at greatly enhanced figures. It was the accumulated burden unloaded upon the railroad in pursuance of this policy which finally broke its back. Roads Amount paid in Profit $ 2,097,043.95 5,300,000.00 2,700,000.00 ■ 1,000,000.00 3,423,432.10 3,046,635.00 2,000,000.00 3,981,000.00 3,000,000.00 $ 369,278.82 St. Louis, San Francisco & New Orleans . St. Louis & Gulf 837,400.00 1,385,633.62 556,150.00 St. Louis, Okla,homa & Southern 719,574.90 589,767.32 New Iberia & Northern 500,000.00 St. Louis, Brownsville & Mexico Colorado Southern, New Orleans & Pacific 3,011,928.95 375,000.00 Total $26,586,111.05 $8,444,796.51 The foregoing simimary of these syndicate operations is more eloquent than mere descriptive text. The second instance with a profit of $837,400 upon an investment of $5,300,000 is noteworthy, considering that the deal was consummated within little more than a year. It may be noted in passing that in the sale of this property to the " Frisco," the com- mon stock, amounting to $6,000,000, was simply thrown in for nothing in order to give good measure. An equally irre- gular transaction concerned the construction of a line to Brownsville, Texas. In this instance, as the table shows, a profit of 75 per cent, on the investment was made, with heavy CONSTRUCTION FINANCE 43 participation on the part of Yoakiim. The cost of this road was $8,932,000. For this the " Frisco " paid $12,123,000. A substantial allowance should be made for interest; but even then the price paid was surely excessive. Few construction companies figured openly in these dealings; but the so-called Gulf Construction Company stood in the background. A pitiful apology^ by Yoakum for his singleness of purpose in making profits, not jm his stockholders but jrom them, set forth that his gains on an investment of $810,000 were only $288,000 — that is to say, only $151,000 in excess of a 6 per cent, return on the capital. The whole episode is dishearten- ing as a revelation of corporate wrongdoing. It must not for a moment be considered as typical. Yet it and the New Haven collapse in 1913^ indicate the possibihties of abuse in the ab- sence of strict governmental regulation of railroad finance both in the interest of the pubhc and of private investors. With the Hampden Railroad case, already described, it seems bound to bring about restrictive legislation by the Federal government to prevent such occurrences in future. The financing of the St. Paul extension may also very properly lead to the inclusion of all construction accounts, not at this writing subject to the same regulation as for operating companies, under the jurisdiction of the Interstate Commerce Commission. Premature or excessive building was imquestionably a third result of American construction methods. Irresponsi- bility joined hands with energy and optimism in bringing about a vast amount of over-building. Jay Cooke's "Banana Belt" along the proposed Northern Pacific with its "monkeys and orange groves" was the object of popular derision at the time.^ Duluth, "the Zenith City of the Unsalted Seas," and its Hinter- land have hardly disappointed those gifted with prevision in the early '70s. But it has taken time to bring those iridescent 1 Railway Age Gazette, 1913, p. 1197. 2 P. 251, infra. 3 Oberholtzer, Jay Cooke, II, pp. 127 and 309. 44 RAILROADS dreams to fulfilment. The paths of raib-oad promotion are littered with disappointment. The railroad panic of 1884 was a notable example of disaster resulting from such causes.' And many of the receiverships of 1893-'97 were the necessary outcome. Lines were pushed far in advance of population and into regions impromising even in the remotest future. Had the promoters been forced to link their fortunes permanently with the railroads by actual personal investment, looking to dividends as a reward rather than to the profits of construction companies and such devices, much loss might have been avoided. The chief sufferers, of course, were foreign bondholders or investors in New England and the other eastern states. But the loss from impaired American credit and prestige fell also upon even the most conservative enterprises. Nor can it be doubted that the recent scandals on the New Haven and "Frisco" systems will for many years lay an undeserved burden upon the financing, both at home and abroad, of the great majority of sound and honestly managed properties. And companies Hke the St. Paul, with enviable reputations in the past for straightforwardness toward the pubUc and their own shareholders, will be viewed with popular distrust even more than their recent lapses from virtue deserve. A grievous waste of money in building the Grand Trunk Railway in Canada,^ partly due to downright extravagance and fraud, but a part also to failure properly to correlate the stand- ard of construction and the probable traffic, has recently occurred. At the outset in 1903 when the agreement for lease of this road from the government by the Grand Trunk Pacific for 3 per cent, on the cost of construction was made, the pre- liminary estimates were $30-35,000 per mile. But by 1911 the original appropriation of $61,415,000 had risen by actual expenditure to $109,000,000, with the probability of a total ' The activity of the period is described in Ripley, Railroads: Rates and Regulation, p. 27 et seq. * Report National Transcontinental Railway Investigating Com- mission, 4 George V, 1914, sessional paper no. 123. CONSTRUCTION FINANCE 45 outlay at completion of $161,300,000. Counting principal and interest to 1922, when the 3 per cent, lease becomes operative, the total cost now promises to rise to $235,000,000. Exhaus- tive investigation already discloses that east of the St. Lawrence river alone $40,000,000 was needlessly expended. On 806 miles of line eleven contractors made profits of $8,800,000 on work which was entirely done by sub-contractors. Evidently construction company methods are not imfamiliar to our Canadian neighbors. Every detail, such even as retention of control of the common stock by Mackenzie & Mann, the construction company, will be found in evidence. The methods employed in padding construction company accounts were precisely of a stripe with those used on the Hampden Railroad above described. The standard of construction was also imdoubtedly influ- enced by the modes of finance employed. Imperfect and makeshift work was often an economic necessity; sometimes merely a financial product. About 200 miles of the old New York & Erie was built on piles, as was also the South Carolina Raihoad, "excavation having been avoided as much as possible and embankments omitted altogether, by which the expense of grading has been very Uttle."^ The report of the receiver of the Texas & Pacific in 1885 as to the "wretched con- dition" of the property due to "inferior construction and in- ferior material" ^ was by no means an isolated case. John M. Forbes in his reminiscences^ strongly condemns the "cheap contractor's road to sell" as distinct from the "solid one adapted to be held and used for business purposes." Such makeshift properties unloaded on the Burlington system came to be known in Boston as "cats' tails." All forms of construction were necessarily experimental at first. Every detail, whether of gauge, of equipment or even of actual location of the right 1 Ann. Rep. State Engineer on N. Y. Canals, 1862, p. 145. 2 Cmn. & Fin. Chron., vol. XLI, p. 714; Cleveland and Powell, p. 64. ' Ripley, Railway Problems, rev. ed., p. 90. 46 RAILROADS of way, was subject to change, — it might be many times be- fore matters became finally standardized. The reaction against permanence of construction, as well as the actual financial necessities of the case, in any event encouraged cheap and makeshift construction. But the American professional pro- moter certainly left in his tracks a record of imperfect work unique in the history of transportation. A direct result of the scarcity of capital and the experi- mental or speculative nature of American railways was in general a markedly lower construction cost than prevailed in other countries. It is certain that even at the present time American capitalization per mile of line is approximately half that of the Prussian state railways, and less than one-quarter of that of railroads in the United Kingdom. First cost would naturally have been less in any event than in Europe because of the abundance of free land and the practice of conferring the right of eminent domain upon such enterprises. This latter privilege obviated the necessity of acquiring the right of way by individual bargaining, often at exorbitant prices. There is evidence to show that $20,000 a mile in England was often required for such purchase of the right of way.' As for the cheapness of such items as ties, the abundance of available timber in America was doubtless more than counterbalanced by the higher cost of rails and a far more Uberal scale of wages. On the other hand, as against the manifest dangers of cheap or makeshift construction, a far greater elasticity of pohcy undoubtedly resulted therefrom. An early location might be abandoned in favor of a better one without great loss. Expen- sive cuts and fills, bridges or stone-work did not stand in the way of improvement. The eUmination of grades through costly tunnels did not, as in Europe, make the introduction of new and larger types of rolhng stock an utter impossibility because of insufficient clearance. All along the fine a habit of mind was engendered of regarding the existing plant as being » Cf. Railway Age Gazette, 1913, p. 1137. CONSTRUCTION FINANCE 47 merely provisional — at any time subject to change or abandon- ment. Yet, of course, even this sound practice must be appUed with certain limitations. It is a truism to assert that the amount of the original investment and the consequent standard of construction must be consistent with the nature and volume of the anticipated traffic. On the one hand, an underbuilt and inadequately equipped road, considering its business in sight, is always operated ineffectively. A "streak of rust in the desert" can scarcely be expected to yield satisfactory returns. Yet in an economic desert, be it only a temporary one, a streak of rust may be all that the country can support. Contrariwise, it is equally clear that an investment dispropor- tionately great, locking up capital unduly and consuming profits in excessive overhead charges, is equally wasteful. The Virginian Railway, the Western Pacific, and the Atlanta, Birmingham & Atlantic, all alike yielding inadequate present returns upon the cost, probably represent an investment disproportionate to present needs. The pohcy of building as cheaply as possible and of subsequently making improvements as the business grows, is probably safest in the long run.' The expediency of such a pohcy is suggestively discussed in a recent Supreme Court case^ concerning the proper methods of accounting to be adopted imder such circiunstances. The decision, quite apart from its legal merits, commends the prevalent American practice as to the inter-relation of invest- ment and prospective earning power. A definite objection from a pubhc point of view to the ex- pedient of a construction company is that it so often gives a false sense of security to those who invest in the enterprise. In fact, it may be a purely financial device for the enticement of the unwary. The purchaser of railway bonds, even although, as is customary, those securities are only issued in payment 1 Cf. Railway Age Gazette, vol. LIII, 1912, p. 474, on capitalization and traffic. 2 Kansas Cily So. v. U. S.; 231 U. S., 423: p. 233, infra. 48 RAILROADS for the line as built, often fails to consider the chance that the road may fail of completion, therefore to a large degree under- mining the value of its bonds. A railroad not put through to its ultimate destination is largely a worthless affair. Instead of reaching a seaport or an important terminal it simply rims up a tree. A recent case of heavy loss to Enghsh bondholders arose in connection with the Kansas City, Mexico & Orient road.^ This was a proposition started in 1900 to build a line about 1,700 miles from Kansas City southwest to a seaport at the mouth of the Gulf of Cahfornia. About $24,000,000 of bonds were marketed by the promoter, largely upon the faith of an agreement with the International Construction Com- pany to complete the road in return for bonds and stock of the railway. Despite the fact that the construction company and its alhes had a cash capital of $13,000,000 — supposed to constitute a sort of guarantee fimd to insure the completion of the road — the enterprise collapsed in 1913 and the road was sold under foreclosure the following year. A large amount of new capital was necessary in order to render the first invest- ment even partially profitable. In the Wabash-Pittsburgh extension, also a recent affair, encouragement to would-be bondholders was given by what purported to be a traffic agreement between the connecting railroads concerned and the new terminals in Pittsbvu-gh. This agreement was secured by a construction syndicate in advance of the offering of securities. It was represented as assuring the earning of interest upon large issues of bonds. The financial frailty of construction syndicates as a reliance in case of disaster has been too often a matter of record. There can be little doubt that without the apparent security afforded by such agreements with construction companies, the risk to the investor would have been more clear. No greater value obviously attaches to any such guarantee than the financial standing of the contracting party warrants. The truth of the '■ P. 16, supra, footnote. CONSTRUCTION FINANCE 49 matter is that the raikoad and the construction company are mutually dependent. Each relies for its profit upon the success of the other. If one fails, the other succumbs also. Reviewing the experience with construction companies in the past, failure to complete the enterprise for the contract price is common. Usually in those cases of collusion between the ofiicers of the railway and the construction company, the latter concern was by its contract reUeved from Uabihty to complete the road if unable to do so. The railroad, in other words, agreed to pay over its securities for as much line as was completed ^ regardless of the fact that the object had not been attained. The experience of John M. , Forbes with the so- called River Roads, elsewhere cited in this chapter, was imfor- tunate in this way. The railroad was stripped of all its moneys and lands although the Une was by no means finished. The North River Construction Company, which built the West Shore road, is another example of the worthlessness of the guarantee of such a concern to fulfil its contract, and thereby create any real earning power for the enterprise. The lack of pubhcity concerning the exact nature of the agreement between the two parties and as to the financial resources of the pro- moters, lies, of course, at the root of the difficulty; and yet, on the other hand, in cases of competitive building between rival roads, it is difficult to reconcile this need of pubhcity for investors with the secrecy demanded, perhaps, by the strategy of the situation. It is easier to criticise after the fact than it is actually to achieve. Some allowance must be made for extra- ordinary exigencies. But normally it is indubitable that an open and above-board financial pohcy, simple and direct, pays in the long run. Involved and circuitous methods breed distrust and invite corruption. Such is the lesson of our experience. A most significant fact, as bearing upon the railway situation today, is the present unhappy plight of practically all of the * Cleveland and Powell, p. 63, give several instances of such contracts. VOL. n — 4 50 RAILROADS roads financed recently by means of construction companies. The present-day instances, scattered through the preceding pages, have without exception been disastrous in their out- come. Practically all of the properties concerned are bankrupt and in the hands of receivers. The array is rather striking. The Moffatt road, piercing the Rockies west of Denver; the Kansas City, Mexico & Orient, affording the shortest outlet from Kansas City to the Pacific as well as the direct line from Chicago to the city of Mexico; the Atlanta, Birmingham & Atlantic, seeking to give better access to the Alabama steel and iron fields from the Atlantic seaboard; the Wabash exten- sion to break the Pennsylvania Railroad monopoly of the rich Pittsburgh iron and steel district; the " Frisco " fiasco in the construction of feeders to its trunk lines throughout the Southwest; the Hampden Railroad in Massachusetts, providing an air-hne connection between New York and Maine summer resorts; the New York, Westchester & Boston as the stem for a radiating system of suburban lines into the metropolitan district; every one of these enterprises under- taken within the last decade is in a state of financial collapse. By way of contrast, other great raihoad enterprises not prosecuted by the aid of construction companies, have at least, if not yet on a paying basis, been carried through to comple- tion. Being in operation they are economically serviceable to the communities concerned. In this category may be mentioned the St. Paul extension to the Pacific coast, the Western Pacific continuation of the Gould system as a trans- continental railroad, the San Pedro, Los Angeles & Salt Lake connection between southern California and Utah, not to mention the numerous feeders built by the other existing great systems; all of these have had a more happy issue out of their early difficulties. Is this record to be interpreted as necessarily an indictment of the construction company? Such a con- clusion would seem to be unwarranted. Some of these enter- prises, two at least, have failed because they were conceived CONSTRUCTION FINANCE 51 in iniquity and were fraudulently carried forward thereafter. In the case of the others, disregarding minor local circum- stances, one common feature characterizes them all. They were independent railroads, seeking to invade or develop the territory of already strongly intrenched systems. They, therefore, all alike antagonized both powerful operating and banking interests. They were exposed not only to fierce com- petition for traffic, but suffered from the absence of specific banking support; if not even actually incurring acute hostihty in raising funds. For a new railroad to invade Southern Pacific, Union Pacific or Pennsylvania territory or the districts already well occupied by the Southern and aUied Morgan roads, is a serious matter in any event. The conclusion, already sug- gested by the course of other events, that the main lines of communication in the United States have now been pretty completely built, and that construction in future will consist principally of the extension and development of existing sys- tems, is in the main confirmed. Despite the foregoing rather depressing comment upon American construction methods, the magnitude of the achieve- ment, as a whole, must constantly be kept in mind. To have opened up a continent to settlement within the short space of seventy years is an accomplishment unparalleled in history. The creation of the greatest railway net in the world, practi- cally within two generations, in spite of all the obstacles opposed by nature and the limitation of capital resources, should be a matter for national pride. Such a result was attainable only by incurring great risks on the part of pioneers, promoters and capitahsts. It is all too easy to look back upon the record and to call attention to the faults and shortcomings of those to whom this great achievement is due. Happily it is clear that for the most part the financial methods concerned were con- sistent with the highest standards of probity and good judg- ment. One's decision in individual cases depends upon whether the profits came from the legitimate upbuilding of the road and 52 RAILROADS its territory served, or whether they were made by unloading weak properties upon the world of unsuspecting and innocent investors. But wise legislation and sound practice in future require that mistakes of the past should be clearly understood in order that they may be guarded against in future. More- over, it is beyond question that many railroads, honestly administered in this generation, have never fully outhved the excesses of a misspent youth. CHAPTER II CAPITAL AND CAPITALIZATION Definitions, 63. — The practical financier v. the economist, 54. — Capital stock or indebtedness, 59. — Gross and net capitahzation, 61. — Official statistical averages, 63. — • Their correct interpretation, 64. Net capitalization of individual roads, 66. — Ehminating intercorporate issues, 66, — Market value or par value, 67. — Deducting outside investments, 68. — Joint holdings, 70. — Allowance for individual peculiarities, 71. — Earning power and capitahzation, 74. — Ex- penditures for maintenance, 77. — International comparisons, 79. — Financial classification of companies, 81. — The element of fixed charges, 83. — The test of margin of safety, 87. The definition of railway capital is a far simpler task than its actual determination; and yet even that is not altogether easy. Great confusion in analysis arises from the divergent points of view and opposing interests of the various parties concerned. Three angles of approach may. be distinguished: that of the accountant, the practical financier and the econ- omist or legislator. The mental attitude of the professional accountant may be dismissed in a few words. It is based upon technical requirements as to the keeping of books. The bal- ance sheet sets forth in opposing columns the assets and lia- bihties of a corporation. Stocks and bonds, together with other outstanding short-time obligations, are enumerated as liabilities; on the ground that, inasmuch as funds have been contributed by investors in exchange for these securities, the corporation stands indebted to them for an equal amount. Thus placed on the balance sheet, the accountant's definition, quite naturally, is that capitalization "means the figure of permanent liabilities of a corporation, liabilities that are not intended for early redemption." ' This conception of capital- 1 W. M. Cole, Accounts, 1908, p. 166. 54 RAILROADS ization as a liability is confusing to the layman. However necessary for the keeping of accounts, it is too narrow for the purpose of economic analysis and may be set aside without further comment. The practical financier defines capitalization "as the amount at which the property is carried on the books; that is, in the capital accoimt. . . . Stated in another way, the book assets (or capitalization) of a corporation represent property. It may be said to include all of the assets." ' In other words, to the financier capitalization is synonymous with the book entry of "property investment" on the balance sheet. Instead of being, as the accoimtant viewed it, a liability, capitalization goes in with assets. From this point of view there is no inquiry as to the real value of the property; that is to say, as to the capital in use. No definition of capital is, in fact, attempted; nor is any relativity between actual assets and outstanding securities contemplated or desired. No questions are asked as to how the property investment came into being. In too many cases, a veil of secrecy is thrown over the corporate records in this regard.^ This fact is pertinent to our subse- quent discussion, as it will develop. The third point of view is that of the economist and, it may be added, of most legislators. The starting point is a clear definition of capital. Thus conceived, capital consists of the tangible assets, such as real estate, rails, locomotives and cars, and, in addition, all the attributes of a going concern known as good-will, including among other things profitable con- tracts, alliances and reputation. In brief, the capital of a corporation is its actual corporate estate. Cleveland's defini- tion of capital is worth quoting. It consists of "those assets of the corporation which have been provided and which are intended for continuing, productive use." To the economist, 1 Testimony of W. H. Williams, Jan. 18, 1911, before the U. S. Rail- road Secm'ities Commission, pamphlet; p. 4. ^ Cf. Cleveland, Railroad Finance, p. 324. CAPITAL AND CAPITALIZATION 55 as contrasted with the practical financier, the distinction be- tween this capital and capitalization is clear and essential. The corporate estate is commercially represented by securi- ties outstanding. It is the aggregate of this paper certification of value, taken at par, which constitutes capitahzation.^ These securities are the principal agencies by means of which money was raised to construct and operate the railway; but the property thus brought into being as capital remains forever thereafter entirely distinct from its capitalization, albeit linked in a causal relation thereto. Capital is a reality. Capitaliza- tion is merely a record of past operation and a bench mark or standard of measurement for the future. As both a record and a standard of value it deserves attentive consideration. The significance of the line of cleavage between the financier and the economist now becomes clearer. To the financier capitalization is property investment — an asset; to the economist it is the mere face value of the securities outstanding — i-a liability or obligation. To the former the term capitaliza- tion? applies to "all the actual capital realized from the sale of stoi^ks and bonds,^ regardless of the mode in which such capi- Ukl has been procured." It may have been raised by the issu- ance of stocks or bonds above or below par. It may have been created out of surplus earnings. In either event the existing relation between capital and outstanding securities is upset. When stocks or bonds are sold at a premium, the increase in available resources (capital) is greater than the addition to outstanding securities. The same thing follows in the very common practice among American railroads of turning back ' Cleveland, Railroad Finance, nowhere actually defines capitaliza- tion. His substantial agreement with the above statement must be in- ferred from his definition of over-capitalization as "the amount by which the represented shares and capital liabilities of a corporation exceed the value of its capital assets." ' W. A. Wood, Modern Business Corporations, 1906, p. 31. It is tacitly assumed that the book value represents the facts; at all events book values, balancing the securities outstanding, afford the basis upon which financial operations are carried on. 66 RAILROADS surplus earnings into the property. The financier is content under such circumstances to let the fact pass lumoticed; unless perchance an unscrupulous management, as in the case of the Alton/ may seize upon the opportunity to abruptly capitalize this surplus for its personal enrichment. This ever-present danger impels the guardian of the public interest to demand that the distinction between actual resources and outstanding securities be kept at all times clear, as an element in the deter- mmation of reasonable rates. The relation, if there be any, between capitalization and rates must be reserved for subse- quent discussion.^ For the moment we must be content merely to point out the contrast in the point of view of what may be called the uisider and the outsider. To the former it is often more convenient that the fact of surplus earnings stand forth not too prominently on the books. In other words, to the financier the par value of securities outstanding, that is to say, capital liabilities, in their relation to actual assets is of little or no importance. His attention is concentrated upon earning power. To the publicist, on the other hand, the terms capital and capitalization must be so used as in themselves to con- stitute a financial record, particularly as to the causal relation between securities sold and funds in hand. Securities outstand- ing, particularly bonds, redeemable at par regardless of the issue price, are not only present and actual, but potential lia- bilities. The relation between them and present assets is a vital one. Par value of outstanding securities is specifically termed capitalization in order to sharply distinguish it from capital in use, that is to say, property investment. And the preservation of a definite relation between the two is essential, as our subsequent treatment of stock-watering, it is hoped, will disclose. To permit capitalization to be manipulated without regard to actual capital is held to be against public policy, not necessarily because it constitutes a financial wrong, but be- cause it does not make for intelligent publicity. 1 P. 262, infra. » Chapter XI, infra. CAPITAL AND CAPITALIZATION 57 The foregoing distinction in terms does not, of course, exclude the possibility that the capital and capitahzation of a railroad are equal. They may often be so. The failure in commercial usage clearly to distinguish between these terms probably arises from this fact. The two are often used inter- changeably, on the tacit assumption; first, that the real value of the property, judged by its earning power, is equal to the amount of its certificated worth on paper; and, secondly, that therefore in some way the asserted value is a reahzable one in terms of cash. Usually in the case of going concerns, in normal times, these assumptions are more or less true, — the degree of approximation to truth being indicated by the deviation of the market price of the securities above or below par. Only in those instances where the assumption is absolutely true, that is to say when the securities are commercially worth their face value, can it be said that the capitalization and the capital are equal. In all other cases the value of the actual investment is more nearly represented by the aggregate market price of the securities; while the capitalization is a purely artificial total, arrived at by taking the amount of these securities at par instead of at the market price. Although purely artificial, it is difiicult to disabuse the public of the impression that it repre- sents a very real thing. It may or it may not, according to circumstances. But the r61e played by capitalization in con- nection with public regulation is an important one. It is often assumed that its regulation has to do with the limitation of dividends. This is not true. The distinction between capital and capitalization is, as has been already said, primarily a matter of intelligent publicity. Both the shareholders and the community have a right to know whether a railroad's assets are being kept intact, are being dissipated, or are appreciating in value as a result of its financial policy. * '■ Williams, op. cit, p. 5, acknowledges this danger in the statement that, mider his terminology, the facts concerning property created out of surplus earnings "would not commonly be revealed by a superficial ex- amination of the accounts." 58 RAILROADS The case of the St. Paul Puget Sound extension, outlined in the preceding chapter,' clearly illustrates the necessity of the distinction between capital and capitalization as used by the economists. Approximately $155,000,000 of capital was raised to, finance this extension, — about an equal par value of bonds being issued for the purpose. Yet on the balance sheet of the company for 1911, the property investment is stated as $269,000,000. The discrepancy between the two is roughly accounted for by the existence of $100,000,000 of Puget Sound stock, issued to the parent (St. Paul) company for no cash con- sideration whatever. Yet, inasmuch as this stock, reposing in the treasury of the parent concern, pays dividends sufficient to warrant a face valuation of $100,000,000, this figure is arbitrarily assigned it as an asset. It was in fact so valued before the road began to operate at all. In other words, $100,000,000 of Puget Sound stock outstanding on the liability side had to be balanced by an equal addition on the opposite page of assets. This action, it was claimed, was taken in order to conform to the law of Washington which forbade the issue of bonds above twice the amount of the capital stock. The financier maintains that the cardinal point, known to the pubHc, is the earning power of the new railroad. But the economist demands that the additional fact should appear on the books that capitalization, the basis of dividend disbm-se- ments, exceeds the capital by approximately $100,000,000. This could readily enough have been done by a statement of deferred assets on the Puget Sound balance sheet, showing discount on securities sold of $99,999,000. For, ia any event, as the Interstate Commerce Commission says in condemning the accounts,'' " even if the laws of the state of Washington com- pelled it to issue a large amount of stock representing no invest- ment in order to legahze its issue of bonds, there was no neces- sity for including the par value of that stock in its property ' P. 37, supra. 2 29 I. C. C. Rep., 514. Railway Age Gazette, vol. LVI, p. 499. CAPITAL AND CAPITALIZATION 59 investment account." Physical valuation, now under way, finds its application at this point, not only for the St. Paul but for the entire railway net of the United States. It is quite possible that the St. Paul extension might not have been built so soon without the likelihood of a sufficiently liberal return to pay the going rate of interest on enough bonds to create the prop- erty, together with substantial dividends upon $100,000,000 of capital stock issued for no cash consideration whatever. But that is another question. The point to carry forward is that a transparent record of all the facts in the case is a prerequisite to the determination of what constitutes a fair rate of return upon the investment, — the term "fair" unply- mg, of course, that the return shall be sufficiently ample to assure an adequate forthcoming supply of capital for further development throughout future years. ^ The primary division of railway securities is into the two groups, respectively, of capital stock and evidences of indebted- ness. The distinction between these two is fundamental. The shareholders, represented by the capital stock, are the owners of the property, charged with the responsibility of its adminis- tration, for good or ill. The holders of its evidences of indebt- edness, on the other hand, be these bonds or promissory notes, are merely creditors of the enterprise. At first sight it would thus appear as if only the stock of a railway constituted its capital, while its bonds or promissory notes were of the nature of charges thereon. But in practice this is not so. For, al- though bonds in form represent a mortgage, yet their issue and sale were probably the means of collecting the funds neces- sary to create the property against which the mortgage lies. In the two most recently built transcontinental railways, for example, the Chicago, Milwaukee & St. Paul extension and the Western Pacific, practically all the funds were raised by the ' Chapter X, infra. 60 RAILROADS issue of bonds, taken by the parent or allied lines. ^ These facts are well recognized in English financial parlance, which designates the two groups as share and loan capital, respectively, as a result of these circumstances. The stock of few corpora- tions stands for the entire investment. It seldom measures the full value of the property. Oftentimes it represents, as has been shown, no part of it at all. For the full value of that property one must take account of both share capital and bonded debt. Not all of the indebtedness, however, can be held to have been incidental to the creation of the property. Some of it may have been incurred in connection with its current opera- tion. This distinction usually appears in the differentiation of funded indebtedness from current liabilities. Funded in- debtedness represents long-time investment by creditors, while the other forms are merely incidental to its recent conduct. No separation in this regard appears in the official Statistics of Railways of the United States prior to 1896, which up to that time indiscriminately included all current liabilities, such as bills payable, audited vouchers, and wages and salaries due, on the ground that, although being circulating as distinct from fixed capital, they nevertheless represented actual investment in the enterprise. But since 1896, at the instance of the Ameri- can Association of Railway Accounting Officers, these latter forms of indebtedness have been separately classified. How con- siderable an item these current liabilities may be, appears from the fact that in 1912 they amounted to approximately $5,800 per mile of line for the whole United States. Still another modification of the official data appears in the Statistics of Railways for 1908, in the reinclusion of short-term railway notes in capital. In 1896 they had been deducted from it as being one form of current obligations. These notes, as will appear later, have been much resorted to since 1905. They 1 Although the parent company raised the funds in first instance by sale of its own stock to shareholders, as we have just seen. CAPITAL AND CAPITALIZATION 61 originally stood for unsecured indebtedness; but in these later years, being incurred in order to raise funds for improvements, are properly treated as railway capital. The revised official statement in 1908 permits the separation of mortgage and collateral trust bonds, of plain bonds, debentures and notes, of income bonds, equipment trust obligations and miscellaneous obligations. All of these are included in capital under the head of funded debt.' There still remains the most important consideration of all in the determination of railway capital. A clear distinction between gross and net capitalization is always necessary. The absence of this practically vitiates all of the Federal as well as other private data concerning railway capital between 1899 and 1907. Prior to this time the practice of inter-investment of railways was not common. Methods of financing were simple and direct. Most railways were merely operating common carriers. The overwhelming majority of stock and bond issues were based upon the real property or earning power of the issuing company by itself. Therefore the figures given by Poor's Manual of Railroads and the United States Statistics of Railways were approximately correct. The principal ex- ceptions were the Pennsylvania and Southern Pacific companies, and some of the anthracite roads, notably the Philadelphia & Reading and the Erie. These latter companies had extensive reserves of coal lands, purchased through the sale of bonds. Obviously such bonds were not a part of their railway capital as such, and inordinately swelled the volume of capital appar- ently devoted to transportation. But soon after the resump- tion of prosperity in 1898, largely as a result of consolidation into large systems, railway companies began on a large scale to acquire securities of other roads either for investment or control, and oftentimes to raise funds therefor by the issue of their own stocks or bonds.^ Such collateral trust bonds or securities, based upon the deposit of other stocks or bonds, 1 P. 139, infra. ^ Pp. 143 and 430, infra. 62 RAILROADS were, of course, merely duplications of existing issues, unless used as a means of inflation otherwise. Hence the amount of "securities owned" should have been deducted from the gross capitalization in order to obtain the net amount of capital to be supported by operating income. From 1898 to 1907 such duplication of securities issued, progressively falsified the re- turns as to capital, obtained by totalizing all issues of stocks and bonds by railway companies. Nor did the distinction between "capital in the hands of the public" and "owned by other railwaj'^s" in the Federal statistics enable the net capital to be accurately ascertained. The railways of the United States thus held not less than $12,100 out of a total of $65,926 per mile of line in 1905. This apparently left a balance of about $54,000 capital outstanding per mile of line "in the hands of the public." This form of statement roughly sufficed for the returns made by each system as to its own finances. But obviously it was often impossible for any company to ascertain what portion of its securities, openly issued to the public, had ultimately found a lodgment in the treasury of other companies outside its own system. Hence even these data were open to grave objection. The imperative need of correct returns as to the amovmt of railway capital to be supported by current earnings led to a comprehensive and detailed investigation of the whole subject. A special report in 1908 of the Interstate Commerce Commis- sion on Intercorporate Relations of Railways was the result. And not only was a careful analysis made for the year 1906, but the system of annual returns was so remodelled that the actual net capital outstanding year by year could be made known thereafter. These official figures, then; first, show the total of outstanding securities based upon railway property, as distinct from such capital based upon other securities; and secondly, they show this total after elimination of all such securities held by the railways themselves. For 1906 the grand total of outstanding securities for the railways of the United CAPITAL AND CAPITALIZATION 63 States amounted to $9,342,900,000 of funded debt and $8,884,- 200,000 of capital stock. From this gross capitalization there should be deducted $1,440,300,000 of funded debt and $4,114,- 800,000 of stock held by railway corporations, thus leaving in the hands of the pubhc $7,902,600,000 of debt and $4,769,- 300,000 of capital stock. Making allowance for railways under construction, there remained an average of $36,173 of funded debt and $21,877 of capital stock per mile of line in the hands of the public. This total net capitahzation per mile of line of $58,050 for the railways of the United States was intended to be taken as a bench mark for subsequent calculations. It amounted to a substantial reduction — $10,000 per mile of line — from the official figures prior to that time. The correspond- ing data year by year are contained in the following table: Net capitalization, United States. ^— {Per mile of line) 1906 $52,050 1907 58,200 1908 57,200 1909 59,200 1910 62,600 1911 63,900 1912 63,500 1913 65,900 These returns, it will be observed, supposedly exclude all mis- cellaneous investments of railways in other enterprises, — from ore lands, mines and lumber companies, street railways and steamship lines, to newspapers and opera houses. How accurately do these figures of net capitalization, thus carefully compiled, actually represent the facts? Is it true indeed that railway securities based upon railway properties alone have increased in volume so rapidly during the last few years? Great improvements have certainly taken place since 1906 in statistical technique. The method employed is theo- retically sound. But careful examination proves that the results are, after all, only approximate; and that thej' may at tunes be positively misleading. The difficulty arises primarily 64 RAILROADS from the growing complexity of intercorporate relations, now happily since 1912 showing signs of abatement under pressure of the law. Lest, however, too weighty conclusions should be drawn from these figures, a positive warning is demanded. It should be remembered that all calculations are based upon par value, — an insecure basis even for operating .railway prop- erties. But the gravest error arises from the magnitude of outside investments, capitalized in the free and easy way permitted by the several commonwealths. For example, data for 1910, as given above, apparently denote an abrupt increase in the net capitalization of all the railways of the coimtry. Yet, $700 of this increase per mile of line is due to the fact that the New Haven railroad in despair abandoned further attempts to evaluate its outside investments. In consequence no deduction for its outside ventures was made, as against $158,000,000 of such capitahzation taken out in the previous year. Fortunately the outlook for an accurate register of the course of capitalization in future brightens. The standardiza- tion of railroad accounts is progressing. Physical valuation of railway property is under way. And corporate entanglements are being dissolved under pressure from the Federal Depart- ment of Justice. The net capitahzation of American railways per mile of line, all statistical doubts aside, has substantially increased during the last twenty years and particularly since 1905. In other words, issues of securities have grown much faster than mileage. Under any circumstances such a movement would be normal. The only question is as to whether the increase has exceeded the growth properly suited to the economic development of the country. An increased capitalization, quite aside from intercorporate financing, may be accounted for naturally enough in various ways. It should not, by itself, be interpreted as indicating a tendency toward undue financial expansion, popularly characterized as stock-watering. Enor- mous investments by roads already existing in 1890 have been CAPITAL AND CAPITALIZATION 65 rendered necessary by the steady filling up of the country and the growing density of traffic. Between 1890 and 1911 the density of traffic has increased for passenger service by nearly two-thirds, and for freight service it has more than doubled. On the great trunk lines the density has vastly exceeded even these notable figures. To accommodate this business many roads have been double and some have been quadruple tracked. In the period above-mentioned, while only 66,000 miles of new line have been built, trackage has increased by 128,000 miles, or nearly twice as fast. The demands of the public for better, and particularly for speedy and specialized, service constantly requires more capital per mile of line. And the mere filling up of the coxmtry and the growth of large cities put a heavy strain upon the roads for all sorts of improvements. It would be of great value and interest to compare the growth of these demands with changes in the volxime of capitalization per mile. But the unfortunate circumstance must be recognized that data for any such analysis simply do not exist. In this field such inquiries must be matters of guesswork. Determination of the net capitalization of individual rail- ways, along the lines of analysis indicated above, is extremely difficult, owing primarily to the growing complexity of inter- railroad relationships. The report on Intercorporate Relations of Railways of 1908 made no attempt in this regard, its interest being solely the determination of the net capitalization, not of individual companies but of the railways of the coimtry as a whole. Yet a mode of analysis is outlined which is highly serv- iceable. Few companies currently report their financial opera- tions in detail for the edification of their stockholders and the public, but the fashion is growing. The Northern Pacific in 1912, for example, gave for the first time a detailed statement of securities held in its treasury. The Chesapeake & Ohio in the following year rendered a report, unique and praiseworthy, regarding capital expenditures. A four-year statement of the VOL. II — 5 66 RAILROADS related movemenli of capital and capitalization was given. During this period $69,700,000 was realized from the issue of $69,400,000 of securities at par. Capital expenditures of $57,000,000 were made out of funds arising from an increased capitalization of $51,000,000. Full data were given concerning the premimns and discounts on all these dealings, including not only purchases and sales but retirements. Such voluntary- publicity is highly encouraging. The first step in an analysis is to eliminate all duplication, by subtracting from the total of outstanding securities of all companies within a given system the amoimt of such issues which are held within the group. In 1901 the Reading Com- pany acquired $14,500,000 par value of the capital stock of the Central Railroad of New Jersey, paying $160 per share for this majority holding. The Reading Company then raised the necessary funds by issuing its new collateral trust bonds, based upon the deposit of this stock. Obviously the value of this investment should be deducted from the total capitalization of the system, which included the Jersey Central lines; as otherwise the purchased stock and the Reading bonds based upon it, added together, would create a fictitious total. The necessity of considering the foregoing complications may be emphasized by a few more concrete instances of the magnitude of inter-railway investments. The gross capitaliza- tion of the Pennsylvania Railroad in 1906 was about $110,000 per mile; but of this sum about $60,000 stood for security holdings, leaving a net capitalization of only about $50,000 for a system of largely two and often four tracks. In a sinMlar way the apparently heavy capitalization of $95,000 per mile of the New York Central shrank to less than $60,000 when allowance was made for investments equal to nearly $40,000 per mile. The most conspicuous example of this kind is, of course, the Union Pacific Company. Practically one-quarter of its net income in 1906 was derived from investments, — enough, in fact, to permit payment of its fixed charges and the cus- CAPITAL AND CAPITALIZATION 67 tomary 4 per cent, dividend on the preferred stock without moving a ton of freight or carrying a passenger.' Without approving in the least of the dangerous financing by which this result was obtained, one must nevertheless concede that its reported gross capitalization of $133,000 per mile of line in 1905 needed substantial correction before comparisons were made with other roads not engaged in a general banking and brokerage business. In four years prior to 1907, according to testimony before a Massachusetts legislative committee, not less than $157,000,000 in capital had been raised by the New Haven road through sale of securities, of which $103,000,000 had been expended for investments in other companies and $10,000,000 for real estate for terminal purposes. Distribute this sum over the line mileage of the company and a deduction of a large amount from its gross capitaUzation would be the result. The fair market value of investments by one road in other companies, rather than merely the par value, ought properly, of course, to be the basis of all calculations of net capitaliza- tion. In the case of the Reading company, it paid $160 per share for its holdings. This would make the actual cost of $14,500,000 par value equal to $23,200,000. The market price of this stock was at one time nearer $300 per share. On the other hand, the Illinois Central held all of the capital stock and all but $96,000 of the $49,111,000 bonds of the Yazoo & Mississippi Valley. Whatever they may have cost the parent company, the fact that this subsidiary road for years failed to earn its fixed charges by a large sum certainly would cause calculations based upon par value for its investments to deviate widely from recognized fact. Unfortunately, however, it is practically impossible to take account of such market prices in any general investigation. Aside from the mere labor involved, it is often impossible to ascertain the market value of inactive securities, some of which may have reposed in safe deposit boxes for many years; some perhaps, such as the capital ' Quarterly Journal of Economics, vol. XXI, 1907, p. 672. Chap. XV, infra. 68 RAILROADS stocks of the new transcontinental lines, have never had a public quotation. One must be content to inventory such holdings within a system at par. This may do injustice at times; but, on the whole, it seems probable that plus and minus errors will largely balance. Eastern roads will be generally prejudiced by basing conclusions upon par values; while roads in the West and South will be benefited by it. Par values, at all events, are the best one can find, and must suffice for general purposes. After the present Federal valuation is completed, one may proceed more confidently to seek results in detail. This present inquiry is attempted merely to outhne soimd methods of analysis. The concrete figures are of little consequence. Having allowed for duplication of capital within a given system, it is then necessary to reckon with outside investments.' These may consist of holdings of stocks and bonds in other railway systems, or they may represent investment in other enterprises than transportation. As for the first of these, — in- vestments in other railways outside its own system, — these are somewhat imperfectly given by the Report on Intercorporate Relations. The amovmt of what are designated as "Minority Holdings" of railways in other roads, however, in all probability gives returns sufficiently accurate for our general purposes. They include all of the investments of this kind which are sub- stantial in amount. Majority holdings in other companies would bring those roads "within the system," as just described; and would appear in the tables vmder that heading. As for the miscellaneous investments, their scope is surprisingly wide. It is clear that the value of all these investments must also be subtracted from the total of securities outstanding for each system, in order to leave only the net capitalization dependent upon earnings from operation for its support. The table on ' U. S. Statistics of Railways, 1911, p. 34, shows how difficult this matter is to handle statistically. But our text is theoretically sound as to reasoning. Some day it may be verifiable statistically. C/. idem, 1913, p. 30. CORPORATE FINANCIAL ANALYSIS 69 ■hMs u ^ q ■Sia ^ 4^1 922S22os<='ooooooooooQooooo iogoogoooooooooooooQOooooo O^OO^O^l-^ Tj CO 05 00 T^ co" CO rH o o o o o o O O 05 O t> (N o o o o o lO o o o o J" co" i-T cd' CD* >0 00 >0 00 o ■>*__oo CO o i-Tr-Tc^rco' CO ooooooooooooooooooooooooo OOQOOOOOOOOOQOOOOOOOOOOOO o o^o^o o^o o o^o o o o o^o o o o o o^o^o o o o o cfl o^co"^>^cD'^^(:c^c-0iC0CDN-l>-O00^O*OOb»C005C005OOc00005C^ C^00cD^iOOO0Si-i(NOC0OsO_(N00C-"Nr -^dn" -^^ CO TtH" th" lO" c^ t-i-lN':OC0i>C0C0OC^r--I{N T-Hi-I o O O O O Q o o o o o o o o_ o o CD ,-r'^'~(M~ oT 0» CO O I> 00 ^^^ CO 00 CO t-Ti-rT-rTjTi-r M lO 03 1-1 00 e« (N (N "o -* o o o o o o_ r-Tco" C3i 05 IN CO nToT .-I t~ (N t> o o o o o o o~o w o CO t> oca I-H O iO 00 o o o o o o oToo lO CO rH 00 (N ■* o o o o o o t-'co" 05 O K> o 2 CO O OS o o o o o o (N-QO" IM O oToo o ■* lO CO o o o o o o coco" t> 1-1 o o o o o o CD t^ CO CO o o o o o o 00 •<:t^ lo 00 »0 CO CO t^ 00 00 t-H CO O CD I-H i-M CO ■* o o o o o o o o o o o o i>r iS (n" CO Ttl rt (N O 00_ TO lO t^__ CO CO CO CD 00 »H lO lO e3 ■((l-.^li-llOOOOCOTjHNOt^COOOllNO'OCOOOllOOTlHOOCO OT)O'*'^0iC0C0TtH00C0TH00.-HO"0OC000b- 00 (N CO__00 I^ 00 "-I lO ■* C0__0 t~__CO_U3 t^ t~ O 00 ■* CO t^ ^^ '^■'T, CD t> t-" co" lo im" oT ■*" oT co" CO oT i>^ CO in" oo" o ■-<" i-T in" in ■<*" >-<" n" in" *J >— I T-H ^ "•3 o-g' POOSi d^^l-^l o a o a =8 ^ U^ a uP -Sjid ^ -a w 2 °^ fl^ ^ 2 S fcn £?^ 5 ffl d . i o J g'-i g -w a g ^ s: '^- 2 o -s s '- .g J a ^+3 Sa-*^ ifl+3 O-p S fe R"t< ^ ot-^cocdodcdc^Moot^^io-^cij CD r-i T-( §) a . a S" lO 05 ^ OV> >0 © 5" • . 05 O lO . O --I t- Earni] per trai: mil r)Hcorooj.-io>(NooooiMiMooooOT|Hrt . .io-*iTO .eot~ o cJcq(N^Ni--ic2^ COOOOt^MTh-^OCOOOOiCDCDOOCD en CO o i> ^__m >i3 CD CD • 00 o (M_02 TtH io^i^i>^o_t-(^a> co_>o^io_t> 1 en | 1 B - rA' y-^ r-T C^r-^C^TtH'.H'c^r-rT-rcN 1 arges, es and aran- eed Qtals oooooooooo .oo .oooooooooo o >OCDCO(MOrtCOCDt^l> .OiO .01000^000010 LO 00 00 00 CO ■__ • ^^ -<„ ■ '^ ^ °° "^^ O, '^_ "., '^„ "O <^ t* ^ i-T T-H~ i-T i-T ih" i-T co" i-*' " i-H^ ih" ■ CO CO T-T t-T co "^ co" t-T -^ lo f-l* ja « 3 -^ ai I— I Q_g M ►< Net earnings from operation oooooooooo .ooooooooooooo ^ COCDt^cOCO^OCOtNO .oot-^ioooo^oooooo I>00(M1OCD001OCO00t-h .1000.-llO lO Cr iC CO « ross nings rom ration OOOOO^OOOOOOOOOOOOOOOOOO o OOOOOiOt>OOt^OOOOCOOOOOOOOOOOCC o OiOi-HiOOlMCOCOCOOOOfNOOOli-^OCOiOOT-HiM-^OC CO OOOOt>OCOt^l>C5THOO'-l'-HOst^CNtNlOi>OCOOS'^c:3'N o" 9^ ,-1 y-l I-!.-! INCqi-l rt(N"-ICOi-l(N tH ■a <^ OOOOOOOOOOOOOOOOOOOOOOOO o P. o OOOOOOOOOOOOOOOOOOOOOOOC lO S'-S 00 O^ t^ ■* 1> 10_ 0__ CO_ 0_ CD_ CO__ 00__ 0_^ O lO ^_^ O O 10_ CD_^ 0__ 0__ O C , o ° 03 cr<-H"c*:rorcr!>rrcD"co'ij:raro' od' ■S .S commM'*-*iOiOlOiOlOCOC0000000000503030^COcC lO ^3 6© rt rt .-H 1-1 o .-icoiooO'-(ioocoi-Hcoo5(Ncoi>»-H'^coiot^(roo^i>coc Ttl C010f--ro.-li-IOCO'^0>10(N(Ml>-(Nl010l^.-IOC<|10(N10 S '^i IM CO CO lO rcD'io'c4'i>"-^ocrco'io'arcD'cd'c ^ §^ N. Y. Centra Pennsylvania Norfolk & Wi Great Wester Wflhfl„qh g: pqp c p: M 13 1 76 RAILROADS returns fairly representative. Thus by combining the operat- ing returns for the Pennsylvania Railroad, the Pennsylvania Company, the Philadelphia, Wilmington & Baltimore, the West Jersey & Sea Shore, the Northern Central and the Long Island railways, a sufficient proportion of all the Pennsylvania system's mileage is comprehended to permit grafting the results upon the figures of net capitahzation derived from the preceding table. Equally difficult is it to secure entire uniformity because of the different forms of accounting employed. Most of these figures have been taken from the Manual of Statistics for 1907, supple- mented by examination of individual reports. The greatest ambiguity is in the treatment of fixed charges. The practice respecting sinking funds is quite varied. The Northwestern regularly credits its income from "Omaha" stock against fixed charges, thus reducing them substantially. In this table taxes are included with fixed charges for purposes of comparison. Nor has it always been possible to treat rentals uniformly; but in the main it would appear that guaranteed rentals hke those on the Boston & Maine system are included with fixed charges; while rentals contingent upon earnings, as in the Peimsylvania group, are excluded from the statement of fixed charges, as given. It should also be noted that these figures for earnings are those reported for parent companies. They are not com- piled, as were the data concerning capitalization, by aggre- gating the precise returns for each separate corporate miit. Jointly-held terminal companies are seldom included in state- ments of the great systems. Undisclosed profits or losses may readily disappear in intercorporate accounting within each sys- tem. It has recently been charged that the Illinois Central has not made clear its obhgations assumed in the guarantee of bonds of the Yazoo & Mississippi Valley road. It is probable, however, that general balances are heavily on the profit side; in other words, that more surplus earnings are left undivided than losses are concealed. As for the figures of traffic density, weighted averages of the component parts of each system have CORPORATE FINANCIAL ANALYSIS 77 been computed when not reported for the system as a whole. The principal exceptions are the Pennsylvania, New York Central and Union Pacific, where only parent company results are given. In comparing net earnings with capitaUzation, how does one know that the properties are being uniformly maintained out of expenditures for operation? May not some be deteriorat- ing through postponement of proper maintenance, while others are being steadily improved by a Uberal policy in this regard? ' A case in point is the experience of the Chicago & Alton under Hawley management. This road initiated 4 per cent, dividends in 1907, showing them, however, as barely earned. In the succeed- ing two years, expenditures for maintenance of way dropped from 13,120 per mile of line to $2,494 in 1909. Had not the road been thus "skinned," as it appears, the dividends would have been far from earned. The property had not recovered from the recent Harriman piratical raid sufficiently to render such tac- tics safe. Yet a bald comparison of expenditures for main- tenance of way and equipment per mile of line would be unfair. The need for such outlay varies more or less in proportion to the load of utihzation.^ Maintenance, if compared, should be given in terms of density of traffic. Thus in 1907 the Union Pacific expended $3,175 per mile of fine for maintenance of way; the Northwestern expended only $2,333. But the density of traffic of the Union Pacific road was 60 per cent, greater. Main- tenance of way expenditure in terms of 100,000 ton-miles of freight density were only $268 for the Union Pacific, against $324 for the Northwestern, per mile of line. Despite appear- ances, due regard being paid to density of traffic, the North- western was pursuing the more conservative pohcy of the two. ' C/. pp. 236 and 262 infra. Also Quarterly Journal of Economics, vol. XXVIII, 1914, p. 637. 2 Cf. Railroads: Rates and Regulation, p. 65. 78 RAILROADS Expenditures per Mile of Line, 1912 Mainte- nance of way, etc. Mainte- nance of equipment St. Paul Northwestern Mo. Pacific Illinois Central Seaboard Southern Rock Island Atchison Boston & Maine Great Northern Southern Pacific Northern Pacific D. &R. G N. Y. Central Pennsylvania Norfolk & Western . . . . Chicago Great Western Wabash New Haven Baltimore & Ohio D., L. &W Reading Erie $1,173 1,192 1,198 1,615 1,094 1,106 1,057 1,513 2,595 1,251 1,451 1,305 1,255 3,879 5,437 2,396 997 1,547 3,265 2,551 4,717 4,100 2,626 «1,289 1,218 1,151 2,909 1,050 1,426 1,033 1,554 2,857 1,066 1,637 1,196 1,696 5,392 9,298 3,819 1,310 2,113 3,846 3,738 6,222 8,186 4,257 The mode of analysis directed above to the determination of standards of maintenance of way, may be applied by modifica- tion of detail to maintenance of equipment. But the standard of service in this case, naturally, becomes the train, car or engine mileage, according to circumstances. As illustrating the wide range of expenditure for these purposes by the roads included in our foregoing tables, the preceding figures for 1912 are sig- nificant. A superficial view may be had by the comparison of similarly circumstanced properties. But even then the true explanation for differences may call for further investigation.' ' Data concerning density of traffic for 1906 will be found in the table on page 75. But train, car and engine performance is the true standard, CORPORATE FINANCIAL ANALYSIS 79 Why should the Pennsylvania, for example, in 1912 spend something like twice as much per mile of line for maintenance of equipment as the New York Central? And Southern Pacific spent 50 per cent, more than the Great Northern per mile of hne for the same purpose. Even the then-degenerate " Frisco " expended almost as much as the latter, judged by this rough standard. It is certain, if the comparison were made, not on the basis of mileage but according to the performance of equipment, that the true relation would be disclosed. And yet such comparisons per mile of hne, vahd enough for judging maintenance of way expenditures, are oftentimes most unscien- tifically and indiscriminately apphed in stock market analyses. The need of rigid methods of analysis is indeed at times great. The principal conclusion supported by our table on page 75 is that, as a rule, the net return upon the net capitalization of all American railways as a unit, after settlement of fixed charges, is far from excessive.-' From an average of 6 per cent, for the United States, this balance for interest and dividends ranges from less than 3 per cent, on the Chicago Great West- ern to 10 per cent, on the Union Pacific. The D., L. & W., with net earnings of 15 per cent., is abnormal, as already noted. Of course, the actual rate of return on the capital stock of parent companies is higher than this, they being the residuary legatees of profits after interest on bonds and subsidiary com- panies are cared for. But even with this allowance the rate appears not to be excessive, as inspection of the last column demonstrates. For comparison the returns from other coun- tries are as follows:^ 1 Cj. also data as to physical valuation, chapter XI injra. How much more pronounced this would be if based upon data for 1912-'14! But our aim is to elucidate relationships, not to ascertain statistical facts. 2 Bull. 24, Bureau Railway Economics, 1911. 80 RAILROADS 1909 Capitaliza- tion per mile of line Net op. rev. per mile of line Per cent, net earnings to capitaliza- tion United Xingdom 274,700 141,300 110,700 59,259 8,302 5,641 6,529 3,505 3. Prance (6 Go's) 4.2 Prussia-Hesse 5.88 5.9 This low rate of return for American railways, as a whole, being expressive of a ratio between two variables, may be due to either one of two facts. Either the earnings are imduly low, or the capitalization is too high. As to the second assump- tion, whatever may have been true of conditions a generation ago, it certainly does not appear that at present the capitaliza- tion is unduly high, as measured in terms of cost or physical value. And this comparison with leading European states appears to support this view, when our railway net is considered as a whole. For our capitahzation per mile of hne is distinctly the smallest in the list. But, on the other hand, when we take the average for the United States and hne up individual com- panies alongside it, the ill effects of excessive capitahzation in specific instances at once appear. This comparison may, perhaps, best be made by putting our railway systems uito typical groups, ranging in order from what may be termed financially conservative systems to unwisely ordered ones. At this point, however, it should carefully be noted that these comparisons should not always be regarded as indictments of existing managements. Nowhere than in the field of corporate finance is it clearer that the evil men do, fives after them. The flagitious past of some of these companies, hke the Erie imder Jim Fisk and Jay Gould, or the Chicago & Alton as reorganized by the late Mr. Harriman, m.ust be held accountable for their present financial hardships in a large measure. The difficult task of rescuing these properties from their slough of over- CORPORATE FINANCIAL ANALYSIS 81 capitalization requires talent of a high order coupled with infinite patience. Reasonable capitalization, from one point of view, being entirely a matter of relativity between two variables, it makes little difference whether low capitalization and modest earn- ings or high capitalization and rich returns be coupled up. But in either case it is imperative that the burden of fixed charges be low in order that the balance may be satisfactory. The first two groups of properties, therefore, at the head of the list of conservatively financed roads are both characterized CONSEBVATIVELY FINANCED RoADS Class I. — Group A: Northwestern .... St. Paul Illinois Central . . . , Atchison Group B : Great Northern . . Union Pacific Northern Pacific . , Norfolk & Western Pennsylvania .... Capitahza- tion per mile $31,000 30,800 39,400 50,600 $57,600 64,800 65,000 88,000 86,400 Per cent, net to capital- ization 9.2 8.9 9 6.6 7.1 10 7.4 6.2 8.3 Per cent. fixed charges to net earnings 30 30.4 46 37 43 21 24 34 42 by fixed charges of from $1,000 to $3,000 per mile; that is to say, by fixed charges absorbing less than half and ordinarily not more than one-quarter or one-third of net earnings from operation. The balance remaining, therefore, is sure to be satisfactory; that is to say, from 4 to 8 per cent, on net capi- talization. But the marked contrast between these two groups in the first class is that one is capitalized between $30,000 and $50,000 per mile, with earnings per mile centring about $3,000; while the other is capitalized very much higher, VOL. II — 6 82 RAILROADS at $50,000 to $100,000 per mile. (Baltimore & Ohio alone exceeding that figure, but its net earnings are correspondingly large, viz., from $4,000 to $7,000 for the same unit.) This difference in earning power is, of course, largely the result of differences in density. The granger roads all have less than 1,000,000 ton-miles of freight traffic per mile; while the second group rises to 5,000,000 ton-miles per mile of line. (The Great Northern alone has a density more closely allied to that of the granger roads. Its profits result from extraordinary economy in operation.) The important point is that the relativity between the two variables is such that the net earn- ings stand to capitalization at between 6 and 10 per cent.; and that the fixed charges to be deducted are relatively moder- ate in amount. Fixed charges, it will be noted, on the Delaware, Lacka- wanna & Western are enormous — $11,600 per mile of line. This is more than twice the fixed charges on the Erie. But earnings are likewise so phenomenal, more than twice those of the Pennsylvania or New Haven systems, that, while fixed charges absorb two-thirds of net revenue, a substantial balance remains. This balance focussed on the small capital of the parent company explains the phenomenally high market price of its securities.-^ The prejudicial effect of a heavy burden of fixed charges may next be demonstrated by segregating in a second class the companies thus characterized. But at the same time the systems in this class all enjoy ample or high net earnings. In other words, while heavily burdened, they possess sufiicient earning power in normal times to support it. The real test of this group is appUed in times of depression. Under these circumstances the stabihty of the surplus after fixed charges is apt to be endangered. By way of contrast, the Pennsyl- vania, in the preceding group of roads with low fixed charges, having financed its new improvements by stock issues instead ' C/. p. 231, irtSra. CORPORATE FINANCIAL ANALYSIS 83 Indifferently Capitalized Roads Class II. Boston & Maine. . New York Central New Haven Baltimore & Ohio Reading CapitaUza- tion per mile $ 55,000 84,500 96,600 106,000 169,000 Per cent, net to capital- ization 6.9 6.5 8.7 7.2 4.1 Per cent. fixed charges to net earnings 80 63 47 43 64 of bonds, witnessed during the depression of 1908 a decline in gross earnings of $52,400,000, while reducing its net earnings after fixed charges by only $2,971,000. The Union Pacific, having followed the same policy, is equally impregnable finan- cially. Among these five companies, fixed charges (including fixed rentals) consimie between $3,000 and $4,000 per mile; that is to say, from 40 to 80 per cent, of net earnings. This is a burden of fixed charges approximately twice as great as in the first class. But, on the other hand, the rate of their earnings, sometimes attaining nearly $8,000 per mile, a comfortable bal- ance usually remains, notwithstanding. Systems in this class are commonly so financed that this balance after fixed charges and rentals, while seemingly small, is focussed upon a parent company in itself modestly capitalized. The result is that a normal rate of return is thereby estabhshed. This point has already been illustrated by the case of the Boston & Maine. But the peculiarity of several of these companies is the fluctuat- ing nature of this rate of return. Alternately fat and lean balances foUow changes in industrial property. On the other hand, the fixity of the return upon much of the capitalization concentrates the growth for future years upon a small basis of capital stock. The financial potentialities of some of these 84 RAILROADS companies may be very great. Yet for the present they do not afford the guarantee of steady returns possessed by the groups of roads in the first class, as fortified by the advantage of low fixed charges. Most of the companies in this group, it should be observed, are financially strong by reason of heavy density of traffic, high rates or both, giving them an ample earning power per mile of line. But in the case of other companies not in the enjoyment of such high earnings, the disadvantage of propor- tionately heavy fixed charges is very clear. Nor is it possible to overcome this disability readily, even by maintaining the total capitalization upon a low basis. This may be shown by the following group of roads, assignable to a third general class. These are capitahzed at less than $50,000 per mile. Heavily Capitalized Roads Class III. Seaboard Missoiiri Pacific Capitaliza- tion per mile $40,700 33,700 Per cent, net to capital- ization 4 6.7 Per cent. fixed charges to net 73 80 with earnings proportionately low, but they are at the same time saddled with fixed charges which absorb three-quarters or more of their net earnings. Low earning power — whether resulting from low density as on the Seaboard, or from low rates applied to a fair density of traffic as on the Missouri Pacific — and high fixed charges are a dangerous combination, even with modest capitaHzation. Railways in the fourth class, as respects their financing, are characterized by abnormally high capitalization, ranging from about $50,000 per mile of line on the Rock Island system to over three times that figure on the Erie Railroad. This ab- CORPORATE FINANCIAL ANALYSIS 85 solutely high capitahzation is not by itself their maia claim to distinction; inasmuch as several properties in the preceding class were capitalized above $100,000 per mile. The prime characteristic is a distorted relativity between capitalization and earning power. But it must be firmly grasped that it is this relativity and not the absolute volume of capital out- standing which is of moment. The Reading, capitalized nearly thrice as heavily as the Southern and with fixed charges equally greater, earns $7,000 net per mile, as compared with $1,800 on the Southern. But in both cases capitalization is so huge by comparison with earnings that a negligible balance remains for distribution. Net earnings from operation to meet fixed charges usually in this class of roads yield less than 4 per cent, on capitalization. Obviously not much balance can be ex- pected after fixed charges are paid out of this. At this point, however, one may note a further subdivision of the roads in this fourth class. The first group (A), heavily capitalized in Geossly Oveb-capitalized Properties Capitaliza- tion per mile Per cent, net to capital- ization Per cent. fixed charges to net earnings Class IV. — Group A: Chicago Great Western Rock Island Group B: Southern Wabash Reading Erie $90,000 50,000 $ 47,500 92,500 169,000 169,000 2.8 5 3.8 3.5 4.1 3.9 74 82 93 64 78 proportion to earning power, is somewhat more favored in respect of fixed expenses; less than half of net being devoted thereto on the Chicago Great Western. Strongly contrasted therewith is another group (B), even more heavily capitalized both absolutely and in terms of revenue power; and, moreover. 86 RAILROADS utterly swamped by fixed charges, which absorb as much as nine-tenths of the relatively scanty income. All the roads in this group (B), whether with high or low fixed charges, may assuredly be characterized as over-capitaUzed from every point of view. Entirely apart from every consideration of value of the physical property, even the criterion of reasonable earning power in relation to capital issues utterly fails. Inde- fensible financing is clearly expressed in the market value of their jimior securities. In most instances the causes of finan- cial impotence lie buried in the past. Present managements appear to be striving manfully to rescue them from collapse. But the difficulty is enormous. Factors, which on conserva- tively financed roads make for prosperity, on roads of this class become almost unsupportable burdens. Thus even growth of traffic, entailing as it does the necessity for heavy capital outlay, brings no rehef. For, there being no adequate surplus earnings over fixed charges to draw upon, there is no recourse except to issue more securities. The one road in this group somewhat more favored than the rest is the Reading. Product of scandal and fraud of a generation ago, it is nevertheless true that its tangible assets of undeveloped coal lands are of great value. Its potential strength has, however, always, been its actual weakness. Staggering for a generation under a bur- den of debt incurred in order to acquire a future monopoly of this indispensable commodity, its general traffic, together with its large share of the hard coal trade conducted at monopoly prices, seem likely to carry it on to a successful issue. Time, which with its ever-recurring interest pajnnents so preys upon its fellows in this financial class, must ultimately prove its salvation. But in the meantime the pubhc is taxed to pay interest upon the value of the coal supply of the indefinite future. The foregoing analysis of the finances of individual systems has, it is hoped, firmly established the fact that reasonable capitalization is entirely an affair of proportionality. Mere CORPORATE FINANCIAL ANALYSIS 87 absolute figures can afford little index as to financial status, either from the point of view of the investor or the public. A modest capital issue per mile of line may represent an im- proper fiscal policy; while a sound warrant for heavy capital- ization may be at hand on another road. A common term in corporate finance is the margin of safety. This is the percentage of net earnings which remains after providing for fixed charges, including taxes. As applied to a railroad it gives expression to the relationships set forth in the preceding paragraphs. To be specific, the margin of safety of the Pennsylvania Railroad for 1912 of approximately 60 per cent, means that this proportion of the net earnings was left over after satisfaction of all imperative payments, such as interest on debt and taxes. In other words, out of every $100 of net earnings per mile — such figures being given, of course, on a mileage basis — 60 per cent, remain for pay- ment of dividends and surplus. A high margin of safety thus denotes financial strength. This figure, it will be observed, is the reciprocal of that given in the right-hand coliman of the table on page 75. Those percentages exhibit the proportion of fixed charges to net earnings, which in the case of the Penn- sylvania was 42 for 1906. The margin of safety is the differ- ence between this and 100 per cent. If charges are 40 per cent, of net earnings, 60 per cent, remain as a margin of safety. Stated either way, this relationship between charges and net earnings lies at the core of financial analysis. As we shall see in the study of reorganization,' a vanishing margin of safety is a practically certain sign of impending bankruptcy. That is the reason why so much of our attention in the next chapter will be devoted to examination of the relativity between stock and bond issues. The correct interpretation of the margin of safety must be based upon a clear imderstanding of the fact that it is merely ' P. 409, ivfra. 88 RAILROADS a relation between two variables. This should already have been clear from our preceding exanaination; but it is worth further emphasis. Two roads may conceivably have equal margins of safety; one because it has generous net earnings coupled with heavy fixed charges, the other with slender in- come but a low proportion of bonded indebtedness. Yet, of the two the former, despite its larger earnings, may be rela- tively less secure than the latter. The New Haven showed a steadily mounting margin of safety for several years prior to its collapse in 1912. This was due to generous advances in net earnings coupled with a slow growth of fixed charges. This principle has been demonstrated during the recent lean years when operating expenses and particularly wages have risen so much faster than gross earnings. A number of roads like the Illinois Central and the St. Paul, seemingly secure so far as their margin of safety was concerned, found this assur- ance of continued dividend payments considerably reduced. On the other hand, certain companies like the Pennsylvania and the Atchison, having financed their later needs either through stock issues or bonds convertible into stock, were able to maintain, possibly to increase their margios of safety even ia the face of declining net earnings. In other words, both net earnings and fixed charges declining iu somewhat the same proportion, the margin of safety, which expresses the relativity between the two, held practically constant. CHAPTER III ' RAILROAD SECURITIES : CAPITAL STOCK, ETC. The nature of capital stock, 89. — Significance of par value, 90. — Abolition of the "dollar mark," 91. — Its disadvantages considered, 93. Preferred stock, 95. — EngKsh origins, 95. — Nature of the preferred claim, 96. — Reasons for creating preference, 97. — An expedient for raising funds, 98. — In connection with reorganization, 98. — As a detail in consolidation, 100. — For concentration of control, 100. — The Northern securities imbrogho, 103. — Controversies over divi- dend pohcy, 103. — Protection of minority rights by law, 104. — Prefer- ences becoming less marked, 105. Relative proportions of stock and bonds, historically considered, 105. — Growing reliance upon mortgage loans, 106. — Effect of the depres- sion of 1893-'7, 108. — Present conditions unsatisfactory and menacing, 109. — The Chicago & Alton reorganization, 112. — Bor- rowing attendant upon consolidation, 113. — Convertible bonds, 115. — The status of individual companies, 117. The capital stock of a railway, in contradistinction to its bond issues which stand for indebtedness, represents ownership and responsibility for management. This capital is divided into shares, usually of a par value of $100 each. Theoretically this par value is presumed to represent an actual investment of funds in the enterprise; and the total capital stock, together with the bonds, is supposed to equal the aggregate assets of the company. But in practice there is no such relation at all, as the wide range of market quotations for stocks above and below par readily proves. The stock may, in fact, have had no value at all at the outset save for purposes of management and control. Nevertheless, the existence of this par value, stated upon the face of each certificate, serves two very im- portant purposes. It defines the basis upon which earnings are distributed in the form of dividends, thus enabling the public to measure the relative profitableness of operation. 90 RAILROADS And in the second place, it roughly defines the liability of each shareholder in case of failure or fraud. It is of the essence of the corporate form of organization that this liability shall be limited to the amount of the investment. Each holder of a share stands to lose its cost to himself; but he cannot be called upon further to satisfy the claims of creditors, as might the partner in a business concern. This is the principle of "limited liability," which on a large scale has. made possible the co- operation of many scattered investors in complicated enterprises. The stated par value of each unit of share capital, then, supposedly represents an amount actually invested in the enterprise.' This supposition may assume concrete form in the case of shares which at issue were only in part paid up; which were, in other words, emitted without a corresponding enhancement of the company's assets. These assets are the sole security of creditors, primarily bondholders. And unless these assets at least equal the face of the indebtedness, the bondholders are bound to suffer. From this circxunstance flows the long-standing rule in Massachusetts and other states, prohibiting any issuance of evidences of indebtedness greater than the amount of capital stock.^ But the principle that the capital stock is a trust fund for the benefit of creditors may go even farther than this. If the full face value of shares was not paid up, as it was asserted to be — that is to say, if the assets do not equal the capital stock — the shareholder may be called upon to make up the unpaid balance. Eighteen states in 1910 required by law that all railroad stock issues should be paid in full at their face or par value. West Virginia alone expressly sanctioned the issuance of stock at less than par. The necessity of this important rule in exceptional cases may ^be shown by a concrete example. About 1888 one Harper owned a narrow gauge railway in 1 Cf. chap. I, especially p. 22. Other details concerning privileged subscriptions to share capital with accompanying "rights" are treated in chap. VIII. 2 CJ. Chapter IX, infra. CAPITAL STOCK 91 Ohio, about twenty miles long.' This had never even earned operating expenses, and was acquired practically for the value of scrap iron. It was subsequently described as badly built, with heavy grades, narrow cuts and fills, only temporary bridges and very light rails. Harper proceeded to organize the Cincinnati, Columbus & Hocking Valley Railroad Com- pany, capitalized for $600,000 in stock and $1,200,000 in bonds. He personally subscribed for 2,500 of the 6,000 shares, no cash, however, being paid in. To this company he delivered his narrow gauge road in exchange for the bulk of its securities, and then turned over part of the bonds thus received to various contractors for extending the line tQ larger towns at each end, and for making it a standard gauge road. How thoroughly this was done appears in evidence, among other things, to the effect that the new rails were merely spread out on the old narrow gauge ties. There were no stations, no water tanks, and there was no business. It was "probably worth for scrap $2,000 per mile, or, as a railway, $4,000, or for twenty-eight miles, say $112,000, for which Harper received $1,670,000 in securities." The bonds not exchanged for work done were publicly sold. The company failed, of course. The unsatisfied creditors sued Harper for the par value of his 2,500 shares, taken on subscription, but not paid for. And the Federal court held the claim good; viz., that Harper as a stockholder was liable for full payment in money at par or its equivalent, in view of the fraudulent nature of the transaction. The foregoing extreme case of fraudulent over-valuation of a company's assets in connection with the issue of its stock shows the danger lurking in the recently advanced proposition to aboHsh the par value of share capital altogether. This proposed elimination of the "dollar mark" is advocated by most eminent counsel. It was indorsed by the New York Bar Association and a statute was passed in New York in 1912 for the creation of industrial corporations with shares having no 1 Prestm v. etc.; Circuit Court, S. D. Ohio, W. D., Aug. 28, 1888. 92 RAILROADS nominal or par value.^ The principle of the law was that "shares in a corporation represent only aliquot interests in its capital, whatever that may be, and that their nominal or par value is no indication of their actual value or of the actual value of the corporation." Publicity respecting the actual assets is, however, rigidly required. It is claimed in behalf of this legislation that it is in furtherance of sound business methods, in that corporations may raise funds by the sale of shares at their actual value, regardless of a theoretic standard of par, instead of resorting to an increase of indebtedness. Much testimony in favor of this plan as applied to railroads was presented to the Federal Securities Commission of 1910, which body in fact indorsed it in its report.^ The argument is so sound up to a certain point that it merits quotation. Accord- ing to this commission, a share of railroad stock represents two things instead of one: That a certain sum has been paid in, and that the holder of the stock has a certain share in the ownership of the property, of whatever value that may prove to be. The second of these things is what ultimately gives the stock certificate its value. In the case of a railroad bond the fact that it calls for one hundred or one thousand dollars is a determining factor in what it is worth. But in the case of stock, the fact that the certificate represents one hundred or one thousand dollars is far from being the determining factor. It is but one incident among many. Even in theory it pur- ports merely to show that this was the amount originally paid by the subscriber when the road was built. It does not create an obligation to pay its face value, nor does that face represent its money value as a share. The value varies with the develop- ment of the property as a whole. If it has been wisely located and well managed it will be worth more than the amount it represents. If it has been unwisely located, or badly managed, it will be worth less than the amount it represents." . . . » Harvard Law Review, vol. XXVI, 1913, p. 729. * Report, p. 27. Cf. Railroads: Rates and Regulation, p. 575. CAPITAL STOCK 93 "The principal of a bond is a fixed sum, its interest a fixed charge. The value of a share of stock is essentially variable, its profit essentially indeterminate." "There is a persistent tendency to ignore this distinction; to emphasize unduly the face value of the stock; to treat the shares in a railroad or other public service corporation as claims against the commimity for the number of dollars they represent, rather than as fractional interests in a more or less hazardous enterprise, in which the investors took risks of loss and chances of profit; to allow corporations to claim immunity from pubhc regulation when the dividend on the face value of the shares is below the prevailing rate of interest; and to subject them to vexatious attacks when this dividend is above the prevailing rate of interest, even when such profit may be a fair compensa- tion for risks actually incurred in the past or a necessary in- centive for the investment of new capital and the taking of new risks in the future." In practical application, with elimination of a stated par value, each share instead of theoretically at least standing for $100 paid in, would become a "certificate of participation" in earnings. Dividends would be declared, not in a percentage of capital stock but as a fixed sum of money per share. The plan has already been adopted by public service companies. Street railway lines, notably the Massachusetts Electric Com- panies in New England, are organized as voluntary associations. The United States and the Adams express companies have no par of stock, but issue "interests" or "shares of interest," as they are termed. The Great Northern Railway iron ore properties in 1907 were thus financed and set apart. It has been proposed to reorganize the surface trolley lines in Chicago in a similar way. The first year's experience of the New York statute for industrial companies has been indeterminate. Promoters and bankers have made little use of it, fearing lest so radical a departure from long-accepted practice should arouse distrust among investors. 94 RAILROADS The proposition to eliminate the par value of capital stock, whatever its advantages from the standpoint of private finance in the way of safeguarding investors against fraud, seems to be open to serious objection when applied to common carriers or other public service companies, even when accompanied by the safeguard of full pubhcity. It would tend to release the promoter from positive habihty for over-capitalization of an enterprise at the outset. There being no par value, there is no obligation to pay in any stated sum per share. The equiva- lence of assets and capitaUzation, which ought to obtain in the case of a company holding valuable rights from the public, becomes non-existent. And what is of great importance for the future under the growing tendency to ascertain the physical valuation of the property, all standards by which to readily measure the reasonableness of the general scale of charges disappear. The scientific accoimtant must have some absolute basis for his bookkeeping.^ Without some such starting point the relation between a fair return upon the investment and a surplus arising either from issue of shares at a premixun or inordinately high rates becomes diflSicult to state. And finally, the abolition of par value, permitting carriers to issue capital stock for relatively small sums in cash, cannot but encourage speculative interest in railways — an element of danger much to be deplored. But par value or no par value, one thing is beyond question clear. Capital stock must be in fact what it purports to be. If it pmports to represent one himdred dollars paid in on every share, one hundred dollars or its full equivalent must actually have been invested. Such a principle lies at the root of all soimd pubhc or private financial policy. Originally all railway shareholders seem to have stood on an equahty in respect of their rights and obligations. But 1 W. M. Cole, Accounts, p. 163. C/. also Cleveland and Powell, Railroad Finance, p. 43. CAPITAL STOCK 95 in Great Britain preference in favor of certain holders soon began to be made. The first to appear were founders' shares, taken as the name indicates by original stockholders in connec- tion with promotion. These, entitling the owner to a dispro- portionately large share of profits, naturally command a high premimn. This expedient has never been adopted in American practice. Another distinction between different classes of shareholders appeared in England in connection with the rail- way mania of 1845.' The Great Northern Railway, being seriously embarrassed in enforcing its calls for payment, per- mitted shareholders to split their subscription into two halves, one guaranteeing a fixed dividend in preference over the other which was entitled to receive merely the balance of earnings. These latter were known as deferred shares, partly because the subscriber was relieved from immediate calls for payment. The plan was subsequently adopted by a number of other British railways. In America the practice of dividing capital stock into classes, whether or not in imitation of the English plan, does not appear until a considerably later time. The simplest device was to create a preference as to dividends upon a relatively small part of the stock, leaving to the so-called common shareholders whatever balance might be left. By reason of this preference one would suppose that the preferred stock would command a much higher price than the common shares. But this need not be so. For usually there is coupled with the preference as to dividends, the further provision of lim- itation of the rate of return to a fixed percentage. Thus the Union Pacific Railroad had at one time outstanding $100,000,- 000 of preferred stock, strictly limited in return to 4 per cent. Nor was this 4 per cent, return cumulative in this in- stance. If not earned in any given year, the deficiency did not become a charge upon earnings of subsequent years. As a result, the market value of the preferred shares was relatively 1 McDermott, p. 164. Withers' Stocks and Shares, p. 32. The Econo- mist, 1900, p. 739. 96 RAILROADS stable; but at a far lower price than the common stock com- manded. All surplus earnings over and above the stipulated per cent, going to the ordinary shares, gave the latter a peculiar, albeit a speculative, value. This arose, naturally, from the fact that it was the residuary legatee of all future increments of revenue. As between two railways having equal share cap- itals, and being otherwise similarly circmnstanced except that one had split up its capital into common and preferred sorts, while the other had not, one would expect wider price fluctua- tions for the common stock of the former than of the latter. Fluctuations in earning power in other words would be focussed upon a smaller base. The same concentration of changes in market value, based upon earnings, occurs also, as will soon appear, when the entire capital stock is relatively small as compared with the bonded indebtedness. The nature of the preference accorded to one class of shares may be of many sorts.^ Sometimes, as on the Chicago, Mil- waukee & St. Paul, both classes of stock share aUke after the first preference is met. In other cases, as on the Chicago & Northwestern, the 7 per cent, preferred shares are entitled to an additional 3 per cent, preference, after the common shares have received 7 per cent. Not until 10 per cent, is thus paid upon the preferred may any additional dividends be declared upon the common stock. The Seaboard company limited the non-ciunulative feature to a period of five years, ending in 1910. The Reading company, by reason of repeated reorganizations, has a still more comphcated arrangement. There are two classes of preferred shares ahead of the common stock, both 4 per cent, non-cumulative. After 4 per cent, has been paid for two consecutive years on the first class, the second may be converted into common and first preferred stock in equal parts. ^ For details of preferred shares, consult Commercial and Financial Chronicle, vol. LXVI, pp. 804 and 835; and Investor's Supplement, 1897-'08. CAPITAL STOCK 97 Both the Colorado & Southern and the Erie also have two distinct classes of preferred shares. A peculiar instance of preferred stock may be mentioned in this connection. Many railways have only one class of share capital, all being common stock. The Great Northern has only one class, but it is all preferred. No common stock has ever been issued. This peculiarity is due to a charter right dating from 1865, which authorized the issue without limita- tion of such classes of preferred shares as it deemed proper. Under this charter the company claims exemption from state supervision of all capital issues of a preferred sort, and care- fully refrains from any emission of common stock at all. Prob- ably the most complicated scheme of all was the mode of financing of the old Chicago Great Western. This followed the English practice, with no less than four distinct grades of preference in its capital issues. The reasons for creating a preference in the share capital of a company are at least five in number. The early Enghsh practice of "splitting" shares, above-mentioned, seems to have been a device for coping with certain difficulties regard- ing payment of subscriptions. But in the United States the original cause was probably in part sentimental. A new enterprise could be made a dividend payer from the outset by concentrating the first meagre revenue upon a small proportion of preferred stock. Regular dividends even upon only a por- tion of the total capital considerably enhance a company's credit and its reputation among investors. Sometimes indeed, as on the "Frisco" up to 1913, an entirely specious appearance of prosperity may be kept up for years. This company was borrowing immense sums through the sale of securities at heavy discoimts to meet its current obligations. But the effect of the continuation of preferred dividends up to the eve of bankruptcy, both upon bankers and the public, was utterly misleading.^ A second reason for the issuance of preferred stock was to ' 63rd Cong., 2nd sess., Senate Doc, 373, p. 19. C/. p. 41, supra. VOL. II. — 7 98 RAILROADS raise new capital for extensions or improvements. Possibly the condition of the money market may be such at times as to preclude borrowing, that is to say, issuing bonds or notes. Or, as imder the laws of many states, the bonded debt may aheady fully equal the capital stock, so that further borrowing is impossible. Furthermore, the issue of new shares may be preferable, as they do not create fixed charges to become an embarrassment in periods of depression. But the preference clause must be added in order to appeal effectively to conserva- tive investors. Such was undoubtedly the motive in the financ- ing of the Southern Pacific company in 1904. Called upon to repay large advances for improvements by the Union Pacific, it could not issue bonds. Nor could it issue new common stock at the market price of $45 per share then prevailing. No other course than the issue of preferred stock was open. Five years later, surplus revenues having increased, the entire issue was retired at $115 per share. This provided a substantial bonus to those original shareholders who had come forward to aid the company when the issue was put forth. And temporary financing was effected without increasing fixed charges. This was the issue, by the way, concerned with the notorious Keene stock market pool, elsewhere described.^ A third and most important cause of preference in share capital has to do with financial reorganization.^ Bankruptcy is occasioned by inability to meet fixed charges, that is to say, interest upon funded or current obligations. It may be brought about by temporary causes, such as the industrial depressions of 1893 or 1907. The natural growth of business may ulti- mately bring increased revenues sufficient to cover such impera- tive needs; but time is necessary. On the other hand, the bondholders with prior liens upon the assets are in a position to dictate terms to the stockholders, who stand to lose all in foreclosure proceedings. A fair compromise would seem to be to accord preference as to future earnings to those whose claims ' P. 217, infra. 2 cf. p. 371, infra. CAPITAL STOCK 99 as bondholders must first be satisfied. The new company, by the exchange of part of its fmided obligations for preferred stock, is relieved for a time of an undue biu-den of fixed charges; and surplus earnings as they emerge go to those to whom they rightfully belong. This practice appears as early as 1877 when preferred shares were exchanged for the old bonds of the bankrupt Lake Superior & Mississippi River Railroad. Again in 1888 in connection with reorganization of the Chesa- peake & Ohio, a mixed lot of bonds and preferred shares were used to satisfy the claims of the original bondholders. But the most general acceptance of the plan appears in connection with the numerous reorganizations attendant upon the panic of 1893. Six of the seven most important rehabilitations of railroad properties within the succeeding four years of depres- sion made use of this expedient.^ It is evident that by the de- vice of preferred shares the old bondholders were given rights to such earnings as might accrue up to the limit of the return to which they were entitled by their former holdings; and yet the new shareholders very properly reserved to themselves all increments of revenue over and above this amount. Occa- sionally also, preferred shares may arise in a reorganization as they did on the Chicago & Alton after 1898. A specially attractive "participating" type was offered in exchange, in order to call in the last remnants of old railroad stock out- standing. A definite prohibition of the issuance of bonds or additional securities of any sort taking precedence over the existing pre- ferred stock in future, without its consent, is a precautionary- measure not infrequently taken. Most of the new preference shares of the period of 1893 were thus protected. Such ought always to be the case. In fact the assent of any class of se- curity holders ought to be required for an additional issue of other securities having a prior claim on earnings or assets. Otherwise, as Lyon ^ puts it, the common shareholders by 1 Cf. p. 402, infra. ' Capitalization, p. 70. 100 EAILEOADS "trading on a little thinner equity" through new bond issues or more preferred stock may endanger the margin of safety of the preferred shares already outstanding. Preferred shares not only may arise out of disintegration of railway properties through reorganization. They may also be an outcome of consolidation. The two properties to be joined may be of very unequal earning power. They may also possess assets of widely different value. One may be a great earner at present; the other may have valuable franchises or potential earnings in future. It is to the interest of both to combine. The shareholders must come in, if at all, on different terms. The simplest device is to accord a preference as to dividends to the one class, and indefinite possibilities of future profit to the other. The issuance of preferred shares completely solves such problems. The fifth and final reason for preferred stock issues is that they may serve as an expedient for concentration or retention of control, with a minimmn amoimt of investment. Such concentration may, of course, be as effectively applied to the common stock. In the Hudson Companies, which control the North river tunnels, all voting power is vested in $5,000,000 of common stock, while $16,000,000 of preferred shares are a nonentity in management. Legitimate enough when used to safeguard the interests of former bondholders after a reorgan- ization, as employed by the Wisconsin Central or Ontario & Western, such a device employed in the Rock Island Company, is most prejudicial to common stockholders.^ Fortunately the experience of this latter company shows it to be a plan which largely defeats its own end. Any large class of stock, deprived of its voting rights, may be expected to make little appeal to the investing class. The disadvantage of creating distinctions in share capital is that they give rise to conflicts of interest between the dif- ferent classes of holders. These conflicts most commonly 1 P. 153, infra. CAPITAL STOCK 101 arise : first, with respect to relative claims upon assets in case of disaster; secondly, with reference to the current control of the property through exercise of voting power; and thirdly, as bearing upon the policy of the company in the matter of dividends. Controversy over the rights of different classes of share- holders in the division of assets usually arises in connection with bankruptcy or reorganization. Signal contests of this sort have arisen on the Baltimore & Ohio and Northern Pacific roads.' Does a preference as to dividends imply or bestow a preferred claim upon the assets in case of foreclosure? Es- pecially is this difficult to determine where, as on the Northern Pacific road, the preferred shares were exchanged in reorganiza- tion for old bonds which were direct liens on land. In other words, a nice issue is raised as to the distinction between pre- ferred share capital and income or prior lien bonds. Where both are accorded preference both as to earnings and assets, the two kinds of secm-ities are practically identical. Sufficient litigation upon this point has been had, to enforce the need of clear definition of such rights in the charter. The same ques- tion as to relative liens upon property also arises in connec- tion with the disposition of surplus assets. In the attempted segregation of Union Pacific investments in other roads after 1908, the preferred shares were a continual stumbling block. The distribution finally took place in connection with the disso- lution of the Union-Southern Pacific merger in 1913.^ The Southern Pacific stock held by the Union Pacific was in part exchanged under order of the Supreme Court of the United States for an equivalent in Baltimore & Ohio shares held by the Pennsylvania. About eighty-two milhon dollars of Balti- more & Ohio stock, thus received, was then distributed among Union Pacific common stockholders. This division of assets ' Commercial and Financial Chronicle, vol. LXV, pp. 216, 804; vol. LXVII, p. 664; vol. LXII, p. 1212. 2 Chapter XVII, infra. 102 RAILROADS was accompanied by a reduction in the rate of dividend upon Union Pacific common stock from 10 to 8 per cent. In this distribution the preferred shareholders did not participate. Appeal was made to the courts for recognition of their rights. It was alleged that these Baltimore & Ohio shares constituted part of the capital of the Union Pacific road and that in any division of this capital all stockholders were entitled to share aUke, inasmuch as such dissipation of assets lessened the margin of safety protecting the continuance of regular returns upon even the preferred shares.^ It seems not unlikely that a similar question might arise were the Reading company to attempt the segregation of its coal lands. Irrespective of the rights of shareholders, however, the wisdom of distributing assets when the liabiUties created to acquire these assets are still outstand- ing seems open to question. Disputes concerning control of the property not infrequently arise as between common and preferred shareholders in connec- tion with the exercise of voting power. Stipulations concerning rights of this sort are of great importance. The Wisconsin Central charter entitles preferred shareholders to elect a major- ity of the directors in case of failure to pay the full prescribed dividend for two years in succession. Voting rights, as we have seen, are at all times vested in the relatively small amount of preferred shares of the Rock Island company.^ The common shareholders, although overwhelmingly outnumbering the pre- ferred shareholders, have practically no voice in the manage- naent. The same thing was long true of the New York, Ontario & Western. On the old Richmond & Danville, the courts put a stop to an attempt by the preferred shareholders to utilize their temporary voting rights to conclude a lease of the East Ten- nessee road for 99 years in their own interest entirely.^ In this connection the provisions concerning retirement or conversion 1 First decision of April 2, 1914, denied this claim. ' Pp. 153, supra and 525, infra. ' P. 381, infra. CAPITAL STOCK 103 of special classes of shares are oftentimes of great importance. Southern Pacific preferred shareholders, for example, might convert their holdings into common stock after 1905; and the company might redeem them at $ll5 for five years after 1910. Other issues bearing the same option were subsequently put forth, some of them carrying the privilege of exchange for bonds. Under this arrangement practically all the preferred stock was exchanged for common shares. The issue was in many respects analogous to a convertible bond with a sinking- fund stipulation. The importance of a clear definition of the voting rights and also of provision for retirement or conversion w£is well illustrated by the Northern Securities imbroglio in 1901.' The outcome of the spirited buying campaign for control of the Northern Pacific road between the Harriman and Hill interests finally resulted in the ownership by Harriman of a majority of about $1,000,000 in the total capital stock of the company. But this majority was principally in the preferred shares. The Morgan-Hill party controlled a clear majority of the common stock; and at the time dominated the board of directors. Harriman control, however, despite ownership of a majority of the total capital, was thwarted by a retirement clause applicable to the preferred stock. Thus the control of the entire property depended upon the exercise of this retire- ment privilege on any January 1st prior to 1917. Normally the Harriman party would have assumed charge at the annual meeting in October; but this could be prevented by post- ponement of the election of new directors imtil after the first of the new year, when the preferred stock became subject to retirement. It was a complete deadlock, resulting in truce and subsequent compromise between the contending parties.^ The third possibility of dispute attendant upon the creation of distinct classes of shareholders has to do with dividend policy. Most preferred shares of railroads, in sharp distinction to preferred shares of industrial concerns, are non-cumulative » P. 493, infra. " P. 497, infra. 104 RAILROADS as to dividends, — that is to say, dividends not declared in one year are forfeited forever. Occasionally, as on the Rutland Railroad since its reorganization in 1902, the cumulative fea- ture may be added. The preferred shares in this case, by exchange in the ratio of ten for one, came to constitute 98 per cent, of the entire capital stock. But the disabilities of the road were such that by 1911, 179 per cent, of back dividends upon these preferred shares were heaped up as a heritage from its checkered past. In this case as on the P^re Marquette, whose preferred shares also were cimiulative, no earnings above charges were available for distribution. The real difficulty arises, however, when earnings are ample. Question may then be raised whether they shall be distributed as dividends or put back into the property in the form of permanent improve- ments. A typical controversy of this sort arose upon the St. Joseph & Grand Island Railway about 1911.^ Controversies arising in connection with the conflicting rights of different classes of shareholders illustrate the possi- bility of abuse of power by a strongly intrenched majority. Under existing corporation laws the rights of minority stock- holders have too often been sacrificed.^ The Federal Securities Commission of 1910 ^ in order to meet this situation recom- mended legislation which should compel a railway company, acquiring control of the common stock of another road but not of its preferred shares, either to buy the preferred stock or to make the preference cumulative. For, as they said, the con- tinued existence of a non-cumulative preference under such conditions oflfers constant temptations to unfair deahng, if not to actual fraud. On the whole, it appears as if the proportionate differentia- tion of share capital followed certain well-trodden paths of development. Preferred shares amounted to about one-seventh ' P. 141, infra. » P. 445, infra. ' Report, p. 31. Cf. Railroads: Rates and Regulation, p. 573; also p. 463, infra. CAPITAL STOCK v. BONDS 105 of the total capital stock of American roads in 1890. This proportion reached a cuhnination in 1898, when about 27 per cent, of total share capitaUzation was preferred. This, as will be seen, was a direct outcome of the widespread reorganizations incident to the panic and depression of 1893-'97. It was also in part probably connected with the financing of new railway consoUdations. Since 1900, however, the proportion of pre- ferred shares has tended to decline; amounting in 1913 to only about one-fifth of the aggregate share capital of the railways of the country. Normally it may be expected not to deviate widely from this proportion. The tendency for 1911-'13, is not without interest. During three years an increase of common stock for the railway net of the United States of $643,000,000 was accompanied by a positive decline of $19,000,000 in pre- ferred shares outstanding. Yet certain indications of impend- ing danger through over-borrowing, imless arrested in time, seem likely to bring about a number of reorganizations; in which event preferred stocks may again come into prominence as in 1893-97. Thus would a cycle again be completed. The relative amounts of capital stock and bonds in railroad finance have varied from time to time, swinging like a pendulum above and below substantial equality. In the beginning, as outlined in our first chapter, stock issues played an important part; but gradually, for a number of reasons, borrowing on a more or less generous scale came into vogue. Bonds were put forth, partly because the final cost of new roads exceeded original estimates, partly because imperfect construction had to be brought up to standard, and partly because of the unfore- seen need of working capital. Shares came to play a subordi- nate role at last, serving often merely as a bonus to promote the sale of bonds. Borrowing for purposes of construction first attained marked prominence between 1855 and the close of the Civil War. Speculation was rampant. The railway net was being rapidly extended, almost without regard to 106 RAILROADS economy of construction. And, most important of all, state aid was being widely granted, either through subscription to bonds, official guarantee of interest or exchange of state and municipal bonds for railway bonds. Prior to 1870 the state of Massachusetts alone had loaned $11,290,000 in these ways. New York had taken $8,200,000, likewise in bonds. Southern states like Tennessee had substituted bonds for stock subscrip- tions, as a stimulus to new enterprises. During the Civil War period, however, in the East, the financial centre of the country, the huge issues of United States bonds seem to have absorbed much of the loanable capital of the country. The Pennsylvania, New York Central and Illinois Central, for example, either ceased augmenting or actually decreased their bonded indebt- edness: Bonds were still the main reliance in the pioneer enterprises with stock issues rather as a bonus than a mainstay. As soon as the war was over, and particularly upon the estabUshrnent of closer financial relations with Europe, bond issues reassumed prominence even on eastern roads. Jay Cooke and other American bankers turned their activity from financing the Federal government to such enterprises as the construction of the Northern Pacific. But all European capital for railroad purposes came to this country in the form of mortgage loans. The high degree of reliance upon bonds is shown by the financing of the Union Pacific. Its one thousand odd miles of line completed in 1869 were paid for by bond issues more than double the amount of the capital stock. The late '60s, with the exploits of Jay Gould and his associates, greatly augmented the proportion of bond issues as compared with stock.i The Erie had always led in this sort of fiinancing. Even as early as 1851, it had $14,000,000 of bonds outstanding, with only $6,000,000 of stock. An extreme example of over- issue of bonds occurred on the old St. Paul & Mississippi. When this was acquired by James J. Hill in 1878, it had $33,- 1 Compare oui Railway Problems, chap. I. CAPITAL STOCK v. BONDS 107 000,000 of bonds outstanding as against only 16,500,000 of stock. What a nucleus for the present Great Northern system, which built its success almost exclusively upon stock firiancing! Commodore Vanderbilt, on the other hand, was much averse to the issue of bonds by the New York Central; and was finally persuaded to do so only on condition that he buy and hold them himself. As for the transcontinental lines, such as the Union and Northern Pacific, no other resource than bond issues was possible; and the same thing was true of most speculative construction in the West. Matters went on thus imtil the chapter was ingloriously closed by the panic of 1873, when nearly five hundred million dollars of bonds, railroad and other, defaulted in interest. The period of twenty years from the reorganizations incident to the panic of 1873, continued to show heavy reliance of railway financiers upon borrowing as a means of finance. This was especially true of the trunk fines during the decade of the rate wars after 1874. The Baltimore & Ohio, which until this time had been conservatively mortgaged, became hopelessly involved in debt within a few years. By the late '80s, the percentage of its income absorbed by fixed charges, ran up from about one-third to nearly nine-tenths. With the begin- ning of ofiicial data for the United States in 1889, it appears that for the country as a whole, stock and bond issues had reached a rough equivalence; although in part of the South, in New England and the Far West stock issues still appreciably exceeded the bonded indebtedness. Above this proportion of equality, it was not possible for bonded indebtedness to go under the corporation laws of many states. Several years after this time the general trend was still in the direction of increased bond issues so far as new financing was concerned. To borrow, in other words, was easier than to secure stock subscriptions from shareholders. Mortgage indebtedness continued to grow at the expense of stock, wherever it was possible. The pro- portion of reasonable safety was exceeded in many cases, until 108 RAILROADS the rude shock of another financial panic again restored a proper balance. The four years of industrial depression following 1893, were marked by the bankruptcy and reorganization of a great many railways. No less than one-sixth of the mileage and one-quarter of the aggregate capitalization of the carriers of the United States fell into the hands of receivers, because of inability to meet fixed charges out of current earnings. The imwise and reckless amount of borrowing in the preceding years is well evidenced by this fact. It was inevitable, there- fore, that the extensive readjustments of railway capital inci- dent to the reorganizations of this time should have as a prime motive the reduction of fixed charges in proportion to income. This reduction was effected by the exchange in many cases of bonds, on which default of interest had occm-red, for preferred stock with a dividend lien contingent upon earnings. Fifty- seven companies, reorganized during this period, effected a reduction of fixed charges to the amoimt of $19,600,000. The seven principal ones cut the proportion of net income required to meet fixed charges by nearly one-third. Atchison in 1895 lessened its fixed charges by $4,185,000; Northern Pacific in 1896 by $4,755,000. Prior to 1895 the annual increase in rail- way capital had shown usually a large preponderance of bonds. During 1895 a change took place, stocks increasing during that year $127,000,000 and funded debt only $28,000,000. For the year 1896 stocks increased $265,000,000, while funded debt actually decreased $45,000,000. The next year, for the first time in many years, the amount of stock outstanding exceeded that of the entire funded debt. With the retm-n of normal conditions in 1897, the trend in favor of bond issues instead of stock as a means of railway financing once more became pronounced. At the present time mortgage indebtedness has again so far increased as to consti- tute, in the opinion of conservative students, a menace for the future. The extent of this resort to bonds, rather than stocks, is shown by the accompanying table. CAPITAL STOCK v. BONDS 109 Tar Values — Total Outstanding Securities, Active Corporations — June 30, 1913 Funded debt $11,185,500,000 Capital stock 8,610,600,000 Preferred $1,379,000,000 Common 7,231,500,000 Total capitalization $19,796,100,000 The complete reversal of the tendency away from borrow- ing of the lean years 1893-'97 is manifested by the foregoing table. The two forms of capital, representing ownership and indebtedness respectively, remained about even mitil 1902. But year by year after the panic of 1903 bond issues predomi- nated. By 1908, 56 per cent, of outstanding capital was represented by such mortgages. The next four years wit- nessed Uttle change imtil 1912 set an even higher record in this regard. In that year bond issues exceeded capital stock per mile of line by nearly one-third. For the railway net of the United States gross stock issues equalled $35,000 per mile of hne as against $46,000 in bonds. Otherwise stated, there were outstanding about $11,000 more of bonds per mile of hne than of share capital. Within the period 1900-'13 railroad stocks increased by 45 per cent.; while the funded debt grew by about 80 per cent. — nearly double the rate. Thus it has come about that, despite the relatively low rate of return upon bonds, fixed charges of one sort and another now absorb about three-fifths of gross income. The original causes for the gradual relegation of stocks to a subordinate role as compared with bond issues have already been set forth. They had to do with imperfect and experi- mental promotion. These causes were quite different from those of the extensive bond issues of the generation following the Civil War. An important factor at this time was the attitude of the state legislatures, theoretically at least, toward the emission of raihoad stocks at a discount. Such prohibition seems to have been borrowed from banking experience, which was the main guide in matters of corporation finance. Rail- 110 RAILROADS road stocks, however, at that period ahnost always stood below par. To issue new stock below par was a legal impossi- bility in most states, even without the heavy financial loss which in any case would attend issuance at the necessary discount. Bonds alone could be put forth to sell at or near their face value. Stocks and bonds could, however, under the law be marketed jointly, on the theory that all the discoimt was on the bonds. The wisdom of such legislative prohibition is perhaps open to debate. An enterprise might conceivably be better off with $2,000,000 of capital stock issued at a discoimt and with no fixed charges, than with $1,250,000- of stock and $750,000 in bonds. But, at all events, little choice was afforded to companies whose shares stood below par. There was no alternative except to raise funds by means of borrowing. Present-day conditions, however, are radically changed. The general level of market prices for railway stocks, imtil very recently at least, was well above par.^ The shares of a much smaller proportion of railroads now have quotations which are below their face value. Why has it not been feasible to raise more new capital by the issuance of capital stock? That this has not been done, requires some explanation. In the first place prosperity and a steady growth of income always invite increased borrowing. Such was certainly the condition for some time after 1900. Bonds are readily salable in good times. Borrowed capital yields larger retxu-ns than the interest rate upon the loans, thus rewarding shareholders more liberally by concentrating the increased earnings upon a smaller amoimt of capital stock. The interplay of motives is exhibited by the following table. Upon the assumption that the business in hand is sufficient to yield ? per cent, upon the total investment, this table gives the results of a division of this total capital into varying proportions of bonds and capital stock. It will be noticed that proportionately to an increasing amount of bonds at a relatively low interest rate, the dividend upon the ' Cf. chap. V, infra. CAPITAL STOCK v. BONDS 111 capital stock tends to augment. Thus contrasting Plans 1 and 5, it appears that through borrowing three-fourths of the capital at 6 per cent, instead of borrowing none at all, the dividend rate is increased from 7 to 10 per cent., although the Average Plan Proportion Interest rate Proportion Dividend rate return on of bonds on bonds of stock on stock total capital 1 All 7 7 2 1 3 4 1 8i 7 3 1 2 5 i 9 7 4 2 5J i 10 7 5 f 6 i] 10 7 6 4 5 61 i 9 7 total net returns from operation remain unchanged. It will be noted coincidently that along with an increasing indebtedness, the interest rate upon the bonds tends to rise. The figures given above are purely arbitrary; but they are intended to bring out this fact. It arises necessarily from the greater risk attendant upon the lessened margin of assets over and above the loans. And the gradation of the interest rate up to the point of saturation of credit fixes in its turn the upper limit of profitableness to shareholders from the operation. Thus, upon the assumption in Plan 6, it appears that the borrowing limit, determined by the given interest rate, has been over- passed, whereby the balance remaining for dividends has actually declined by comparison with Plan 5. There can be no doubt that a strong incentive toward increased bonded indebtedness in recent years has been of the nature indicated by the foregoing presentation. Another inducement toward increased bonded indebtedness of late has been the desire to perpetuate control of subsidiary roads by means of a relatively small and closely held capital stock. Unless thus closely held, a restricted share capital is 112 RAILROADS an invitation to speculative raids. This is well exemplified in the pitiful history of the Cincinnati, Hamilton & Dayton, to which further reference will shortly be made. Nor do new bond issues by any possibility expose a controlled company to such piratical tactics as John W. Gates employed in the Louisville & Nashville stock financing of 1902.i Moreover, sale of bonds only can be resorted to either for drawing upon European stores of capital, or the huge investment surpluses of the great insurance companies and savings banks. Stock sales are more apt to be restricted to private investors; while institutions and trustees, even in the most conservative states hke Massachusetts, are often permitted to purchase railway bonds, if properly secured and if not issued in excess of the outstanding capital stock. Hand-to-mouth financing also usually leads in the direction of mortgage loans. Great enter- prises Uke the Pennsylvania or New York Central terminals in New York, extending over many years of construction, might at any time be embarrassed by an abrupt cloture of financial resources. Forced repeatedly, as in 1903, 1906 and 1907, to the issue of short-term notes at high rates of interest, in order to carry out interrupted undertakings, these loans at maturity had to be refunded by the sale of long-term bonds under more normal conditions. The contrast between an old-fashioned financing on the basis of a share capital with a small debt, and modem resort to extensive borrowing, was never more strikingly illustrated than in the reorganization of the Chicago & Alton after 1898." Under a conservative management 8 per cent, dividends were paid upon a small capital, and the surplus earnings were used either for improvements or to diminish the bonded debt. Within seven years to 1906, without change of the capital stock, by a comphcated series of questionable operations, the bonded debt was expanded from $33,900,000 to $114,600,000. Leaving details as to the public phases of such transactions aside for 1 P. 219, infra. 2 P. 262, inSra. CAPITAL STOCK v. BONDS 113 future consideration, the important point to note is that by substitution of new low-rate long-term bonds for maturing high-rate ones, the increase of fixed charges was still kept within the bounds of net earnings. Interest charges were in fact expanded from $2,790,000 to $3,470,000, or less than one- quarter. In the meantime the total bonded debt had increased more than threefold. The company remained safely solvent, to be sure; but all earnings went to bonds instead of primarily supporting a large share capital. And this share capital, once possessing real investment worth, was soon degraded to a speculative foot-ball. Enter once more the Cincinnati, Hamil- ton & Dayton as an awful example of similar proceedings. Its outstanding bonds ran up within two years to 1906 from $12,000,000 to four times that figure, while the floating debt grew from $200,000 to over $10,000,000. ^ What actually happened to each of these unfortunate properties was the substitution of something hke financial Plan 5 upon our table on page 30a for Plan 2 with one important modification. The proportion of loan capital was vastly increased, but with the added circumstance that the state of the pubhc mind en- couraged borrowing at very low rates of interest. Conse- quently, instead of resting content with borrowing three-fourths of the old capital at 6 per cent., it was possible to borrow some- thing hke twice as much at a figure nearer 3 per cent. In other words, to confuse terms, stock-watering took the form of an over-issue of bonds. In those days a bond was a bond, — without query as to its character or security. Loans in almost unlimited amounts could be contracted without question. "A. O. T." (Any Old Thing) as it was jocularly put, was quoted upon the ticker well above par. Yet a third reason for the recent relative expansion of bond issues is their intimate relation to the consoUdation of once independent properties into great systems. Analysis shows that among these extensive recent borrowings, collateral trust 1 P. 214, infra. voii. II — 8 114 RAILROADS bonds played a very large part. One railway after another, beginning with the New York Central purchase of the Lake Shore in 1898, acquired connecting companies by offering its own bonds, secured by deposit of the purchased shares as collateral, in exchange for the stock of the merged company. An enormous volume of such bonds, constituting mortgages, not of real property but of other securities, was put forth after 1899. About 15 per cent, of the entire indebtedness of active companies in 1912 was collateral trust bonds of this sort, aggregating $1,279,000,000. These secxmties were of course merely duphcation of pre-existing issues; and, as already explained, cannot be regarded as expanding the railway capi- tahzation of the coimtry by anything like their face value. But the danger in a disproportionate growth of fixed interest- bearing obligations as compared with stock, looms up just the same in time of depression. All goes well imder prosperity. An apparent profit from collateral trust bonds may even appear when, for example, a company borrows by such bonds at 4 per cent, and therewith purchases stocks which pay 5 per cent, in dividends. But let traffic and net earnings decline, and the difference between contingent and fixed charges be- comes painfully apparent. Nor has this difference to do with the mere mode of consofidation. The danger would be as great if title to the new property had been taken in fee instead of through stock ownership. But this latter expedient is so much easier! The important point in either case is that bond issues entail financial burdens entirely independent of the volume of business. In connection with these recent consolidations the circum- stance may also be mentioned that one railroad, having in- vested in the stock of another in order to secure control, may be loath to permit an increase of the capital stock of the sub- sidiary company because of the necessity of its participating as a shareholder in the new subscription. Under such cir- cumstances the treasury of the parent road would not be CAPITAL STOCK v. BONDS 115 disturbed were funds for the subsidiary to be raised by bond issues. The awkwardness of becoming responsible for the success of new stock of a subsidiary road was demonstrated in connection with the increase of capital of the Maine Central in 1912-'13. The Boston & Maine in order to make a market for the new shares was obliged to issue short-term notes in order to take up far more than the proportion necessary to insure its continued control.' That many of these recent bond issues were convertible into stock affords a measure of solace to the conservative on-looker. Such indebtedness may be less dangerous than where the conversion privilege is absent. Some companies, notably the Pennsylvania, the Union Pacific and the Norfolk & Western, were able greatly to reduce their fixed charges by the automatic conversion of their funded indebtedness into stock. But it will be noted that this outcome is confined to those companies sufficiently prosperous to invite such con- version by stock quotations at or above par. The reasons for the popularity of the convertible bond, revived after more than a generation of disuse, are niunerous.^ But their appeal to speculatively-minded investors, tempted in an over-loaded market since the appearance of the great industrial companies by other forms of investment, and their usefulness in permitting gradual growth of share capital through conversion pari passu with the growth of earnings incident to extensive improvements, are sufficient for mention in this connection. Were these bonds all to be considered as actually convertible, the over-expansion of railroad borrowing in proportion to share issues would be materially reduced. But the fact is that imless either the Interstate Commerce Commission in the pending rate cases becomes avowedly liberal in its policy, or the present trend of railroad expenses is materially altered, these convertible issues ' P. 170, infra. Cf. testimony of Floyd Mundy before the U. S. Securitiea Commission of 1910. * Treated in detail in the next chapter. 116 RAILROADS seem likely to remain outstanding as downright mortgage indebtedness for an indefinite period. An indication of the over-weight of borrowing dming these years was afforded by the applications for new capital by raikoads in New York during the Ufe of the up-state Public Service Commission. For the five years to 1912 such applica- tions aggregated $440,000,000 in bonds, as compared with only $50,000,000 in capital stock. For the United States as a whole, despite the dangerous proportion of bonds, above- mentioned, all that was accomplished after 1908 was to arrest the prevailing tendency. No salutary reaction towards stock occurred. One reason for this was the inability even of high- grade roads to borrow on any terms, to say nothing of the weaker properties whose backs were already bent alijaost to the breaking point by the burden of their outstanding obhgations. Reference has been made to the long-standing policy of many states which hmits the issue of bonds or other evidences of indebtedness to the amount of the capital stock. Certain events of late are indicative of a change of sentiment in favor of greater elasticity, - — and this, too, at a time when, as we have seen, borrowing is aheady excessive. Since 1854 the bonds of Massachusetts railroads were protected: first, by a statute of the sort above-mentioned; and secondly, by the require- ment that a railroad having issued bonds should not subse- quently mortgage its property without at the same time making provision for the continued security of all prior issues. This latter provision made it possible to put forth debentures with- out the formahty of a deed of trust. But in 1913, in connection with the creation of a public service commission of a modern type, these safeguards were substantially modified. The railroads demanded and secured as the price of their acquies- cence in this legislation, a clause permitting bonded indebtedness to be created equal to twice the capital stock. Such was already the law in some western states, which sometimes even CAPITAL STOCK v. BONDS 117 authorized bonds to thrice the amount of the share capital.' The danger of such a provision may be well illustrated by possi- bihties in financing the practically bankrupt Boston & Maine Railroad in the ensuing year. Despite its desperate condition, aheady overwhekned with fixed rentals and interest, this legislation opened the doors to the creation of practically another 150,000,000 of indebtedness on top of all the rest. And yet what else could be done, with its capital stock selling at about a third of its face value? No resource through further stock issues was possible. The wisdom of opening the door to a doubled borrowing capacity seems, nevertheless, open to debate. Full appreciation of the danger of over-borrowing is evident among more conservative railroads. Large issues of capital stock were put forth at the end of 1909 by the Pennsylvania, New York Central and Chicago & Northwestern. Some of these companies like the New Haven were already water- logged with bonds, until they had violated the provisions of Massachusetts law aiming to keep fimded debt less than share capital. Some were so rapidly expanding their earnings that a broader dividend basis was evidently warranted, or was at all events expedient in order not to excite pubUc comment by high rates of earnings upon the existing capital stock. And pending Federal legislation, contemplating an official oversight and control of all capital issues in future, probably was not without effect. Furthermore, the increasing difficulty of selling long-time bonds at a low rate of interest was influential at least until 1912 in encouraging resort to stock whenever possi- ble. To put forth bonds at high rates, as will shortly appear, operated to depreciate the quotations of older issues.^ This difficulty of issuing bonds was due partly to general distrust among investors of the railroad situation imder rising costs of operation and fixed returns under government regulation; 1 The new St. Paul refunding mortgage, for example. ' P. 187, infra. 118 RAILROADS partly to the existence of high rates for money the world over; and partly to the fact that excessive borrowing by the low- grade railroads was slowly breaking the back of their credit. But on the other hand, in order to sell stock it must generally be put forth above par; and, in addition, in order to make a successful appeal to investors, the prospective dividends must exceed the rate of return from competing bond investments. Altogether, the lesson to be drawn from this unfortimate situation is that the time to Umit borrowing must be prior to the first over-balance of indebtedness. A considerable depart- ure from an equivalence of bonds and stock commits a weak company irretrievably to continued loans as a resource. Bor- rowing as a poUcy acquires a deadly momentum with the course of time. A downward path leading inevitably toward bankruptcy is apt thus to be entered upon.^ The experience both of individual companies and of the American railway net as a whole indicates a sort of financial cycle, conditioned more or less by alternations of prosperity and depression. The first effect of industrial reaction is to curtail the issue of capital stocks. Thereafter the only re- source is a continuation of borrowing, following a clearly defined course. Resources in the way of ordinary bonds being in turn exhausted, recourse is had to issues of notes and other secondary obligations; until at last, with yet more protracted depression, the strain from 'over-weight of fixed charges in proportion to earnings is relieved by the drastic operation of reorganization. Once more the company, having by this proc- ess substituted, as we shall see, contingent for fixed charges, enters upon a career of renewed vitahty. Such a cycle is, of course, completely traversed only by the weaker railroads, the degree of weakness depending upon the length and acute- ness of the period of strain. But the stronger companies mani- fest to some degree their subjection to the same inevitable ^ Cf. Report of the Committee onCapitalization, National Association of Railway Commissioners, Oct. 13, 1911. CAPITAL STOCK v. BONDS 119 sequence of events. The only safeguard is a rigid adherence at all times to the policy of maintaining a wide factor of safety of fixed charges over and above minimum earning power. The individual peculiarities of railroads in respect of the proportion of stocks and bonds have been already in a measure considered in relation to the margin of safety, i It is obvious that the connection between this margin and the relative amount of indebtedness is direct. Companies like the Erie, the Southern, the Wabash and the " Frisco," with bonded in- debtedness ranging sometimes as high as 85 per cent, of the total capital, are obviously less capable of withstanding the strain of reduced earnings during a period of depression. More favorably situated is the group of properties like the Atchison, the Northern Pacific, the Baltimore & Ohio and the Illinois Central with an approximate equivalence of share and loan capital. Strongest of all, of course, are those roads like the Norfolk & Western and the Great Northern which, either by rigid adherence to the policy of raising capital through stock subscriptions or else, like the Pennsylvania and the Union Pacific, by putting forth their bonds whenever necessary with an inviting convertible provision, have succeeded in restrain- ing their funded indebtedness within an even smaller fraction of their outstanding capital. A unique position so far as positive foreclosure is concerned is occupied by the Canadian Pacific which, strictly speaking, has no funded debt at all, unless its debenture stock be so called. As for the Delaware, Lackawanna & Western, it literally has no bonded debt at all, all of its outstanding securities being capital stock. Practi- cally all of its great property, with the exception of a very small issue in 1913, is unmortgaged. This small special investment fund, based upon land sales, constitutes its only departure from an established procedure of raising needed funds through sales of stocks. The contrast is great between such a fortunate condition of affairs and that of the Central of Georgia, with ' Chapter II, supra. 120 RAILROADS funded indebtedness more than ten times its capital stock, or, as an extreme instance, the New Orleans, Texas & Mexico with fixed interest-bearing securities totalling 96 per cent, of its en- tire capitalization.! Of course it is always possible that the entire capitalization, stock and bonds together, may be so small as compared with the total assets that a disproportionate amount of bonds need not give rise to an unfavorable interpre- tation. Such may be the case on the Bangor & Aroostook in 1911 with bonds seven times the amount of the capital stock.^ But by and large, the principle seems well estabhshed that the bonds of a railroad ought not normally to exceed 40 per cent, of its entire capitalization. Stocks and bonds are variously proportioned in different parts of the coimtry and certain differences are discernible in a large way between large* and smaller roads; the lowest pro- portion of indebtedness occurs in the eastern states, where bonds on the largest roads form 55 per cent, of the total capitaliza- tion. The range is about the same on the principal roads in the West. The exceptionally favorable status of the Great Northern and Union Pacific operated to reduce the average considerably throughout this territory. The heaviest burden of indebtedness rests upon the carriers in the southern states, where outstanding bonds in 1912 aggregated almost two-thirds of the existing capitalization. This is due, of coiurse, to the exceptional status of one or two of the large properties. ' " Frisco " Investigation, 1914, 63rd Cong., 2nd Bess., Senate Doc. 373, p. 68. 2 P. 28, supra. CHAPTER IV RAILROAD SECURITIES: MORTGAGE INDEBTEDNESS, ETC.» Funded debt highly localized, 121. — Shifting and uncertain liens, 124. — Evasion of "after-acquired property" stipulations, 125. — Alluring bond titles, 125. — Fallacy of the specific hen theory, 126 — Difficulty in foreclosure, 127. — Mortgages under reorganization, 127. — Voting power of bonds, 128. — Price at issue, 129. Perpetual borrowing, yet periodic repayment, 130. — Methods of amorti- zation, 130. — Serial maturity or sinking funds, 131. — Refunding historically considered, 132. — Debt simpUfication and marketabihty, 134. — Underwriting, 135. — -Direct issue v. banking support, 135. — Pennsylvania Railroad and other experience, 136. — Bankers' com- missions, 137. Different types of bonds, 139. — Income bonds, 139. — Comparison with preferred stock, 141. — Debentures, 141. — A sign of weakness or high credit, 142. — Collateral trust bonds, 143. — Their growing im- portance, 144. — Historically considered, 145. — Their use in con- solidation, 146. — Analogy to "margin" stock exchange operations, 147. — Elasticity a merit, 147. — Danger from increasing fixed charges, 148. — Invite speculation and over-borrowing, 148. — Union Pacific and trunk line experience, 149. — Paper v. real profits, 150. — Possible shrinkage of collateral, 152. — Its impairment through manipulation, 154. — Rock Island reorganization, 154. — Other uses of collateral trust bonds, 156. — ■ Convertible securities, 156. — Their recent popu- larity, 158. — Four reasons therefor, 159. — Investment defects, 161. Short-time borrowing on notes, 164. — Historically considered, 166. — Recent growth of the habit, 167. — First experience fortunate, later unhappy, 169. — Note issues expensive, 170. — Effect upon the money market, 170. — Equipment trust securities, 171. — Their complicated character, 172. The most striking feature of all funded indebtedness, as con- trasted with capital stock, is its high degree of localization. A railway company's share capital represents the equity — that is to say, the surplus value over and above its debts — in all its ' The best general references on bonds are as follows: Greene, Cor- poration Finance, 1902; Rolhns, Money and Investments, 1907; Lown- haupt. Investment Bonds, 1908; Lough, Corporation Finance, 1909; 122 RAILROADS property as a unit. There is no differentiation of real estate from wharves or bridges, rolling stock or marine equipment. The capital stock comprehends the whole within its range. Bonds, on the other hand, are evidences of borrowing upon the security of particular possessions. Any specified stretch of mile- age, any bridge, ferry or machine shop, even franchises or traffic agreements may be separately mortgaged. And such property, thus covered by a loan, remains the sole security for the payment of interest or discharge of principal at maturity. This is a feature of great importance to investors, seldom appreciated until bankruptcy throws it into strong reUef . Such multiphcity of distinct loans, each secured by a separate piece of property, tends to become more and more accentuated with the age of the road, especially in the case of companies with a checkered and precarious past. The fimded indebtedness of the Reading com- pany affords a good illustration of such financial complexity carried to its extreme limits. Not alone the financing of its coal properties in addition to its railway lines, but repeated bankruptcy and reorganization over a long period have con- tributed to this result.^ On the main line of the Philadelphia & Reading Railroad between Philadelphia and Mount Carbon, for example, there are no fewer than ten distinct bond issues, heaped up one on top of another. These are secured in every conceivable way. They cover different stretches of road, ran- ging from 54 to 116 miles in length. Some are convertible, some are consolidated, some are improvement bonds. Some are confined to the main line, others spread out over the many branches of the road. They overlap and interlock in the most Meade, Corporation Finance, 1910; Chamberlain, The Principles of Bond Investment, 1911; Cleveland and Powell, Railroad Finance, 1912; Lyon, Capitalization, 1912. Special references on different types of securities are cited in footnotes. The file of the New York Commercial and Financial Chronicle, especially the Investor's Supplements, is invaluable for matters of detail. ' The best illustrations of the financial intricacy of such railway bonded indebtedness are afforded by the excellent series of maps in White and Kemble's Atlas of Railway Mortgages. NATURE OF INDEBTEDNESS 123 complicated fashion. They vary in rates of interest, in term, in provisions as to trusteeship and foreclosure. And each new issue or maturing old one is apt to inject new complications all along the line. Matters are both mixed and evanescent. De- tailed examination demonstrates more clearly than in any other way this leading financial principle, that mortgage indebtedness of a railway is a matter, not of corporate vmity but of particu- larity to the last degree. As an extreme instance of the highly specialized character of a bond issue, an experiment upon the St. Louis & San Francisco Railroad in 1904 may be cited. This company had acquired a large part of the capital stock of the Chicago & Eastern Illinois in order to obtain an entrance into Chicago. Funds for this purpose were borrowed upon the stock deposited as collateral, with an agreement to pay 10 per cent, dividends upon it until finally redeemed at $250 in 1942. Meantime the "Frisco" was sadly in need of funds to meet costs of improvement and ex- tension. No tangible property remained unmortgaged. The expedient was therefore adopted of making a traffic contract between two subsidiary roads, the St. Louis, Memphis & South- eastern and the Chicago & Eastern Illinois, on terms peculiarly favorable to the former road, and then to base a mortgage upon this profitable contract. In other words, by this arrangement one controlled road was given an advantage over another; and the profits from this agreement to the former were to be used for interest upon a $16,000,000 bond issue by the " Frisco." Fixed charges of nearly a million dollars were thus created, which of course had to be raised at the expense of the other party to the contract, the Chicago & Eastern Ilhnois. Such charges became a prior hen upon earnings ahead of the guaranteed dividends upon the capital stock. The lawfulness of this arrangement was called in question in court proceedings. Aside from its legality, however, the case is significant as illustrating the possibilities of highly specialized borrowing in case of need. The American practice of financing by means of mortgages 124 RAILROADS of specific property has had important results, especially with rapidly growing systems. For, even in normal cases, the path of localized borrowing, once entered upon, must be pursued to the end. Thus a mortgage upon a hundred-mile operating division or upon a given bridge immediately stands in the way of any first lien upon the property of the company as a whole. These local liens, by taking precedence over any subsequent ones, render their security less sound. Such prior liens must first be extinguished; or else, for that property thus already embarrassed, the succeeding loan becomes a "second mortgage." And yet such practice is inevitable in any expanding system. Any general mortgage upon the entire property immediately becomes a partial or localized one after new construction or consolidation with other properties has taken place. SakolsM gives a good example. The Denver & Rio Grande in 1912 had approximately $34,000,000 of First Mortgage Gold Bonds outstanding. These were true to name when originally issued so far as the then-existing assets of the road were concerned. But with the lapse of time these first mortgage bonds by a process of exclusion came to be a first lien on only 129 miles of main stem, with liens secondary to $82,500,000 of bonds later issued on the entire 2,400 miles in the system. These old first mortgage bonds may conceivably be as well secured as ever, since they really rest upon the general standing of the system as a whole. The point to be noted, however, is the fallacy of the view that a first mortgage on specific property remains so indefinitely without further notice. Simple financing is possible only in these rare instances where all increments of capital for extension or improvement are obtained from new stock issues, or from surplus income reserved from dividends for the pur- pose. In all other instances, companies are hampered in con- tracting fresh loans. Previous borrowings may be far less than the value of the property, yet specific first mortgage security for any but particular bits of possession may be hard to find. The cost of such piecemeal finance is surely much enhanced as a result. NATURE OF INDEBTEDNESS 125 It is relatively easy to evade the stipulations of a blanket mortgage as to "after-acquired" property.^ This is accom- plished through the medium of a construction company. Having to build a new division or branch line, the first requisite financially is to be able to offer to investors first mortgage bonds on the new property. Yet old mortgages of the parent company, with their lien on all assets which may subsequently be acquired, stand in the way. The construction company, therefore, first borrows the necessary funds by using the new divisional bonds as collateral. The new line, as it comes into being, thus auto- matically becomes subject to the first lien of these securities. Then, and not until then, does the parent road, owning all the stock of the new company, vote to transfer the new line to itself, thereby assuming the bonds secured by the new assets. In consequence, the first mortgage bonds of the original company become junior mortgages upon the new road. The disadvan- tage, of course, is that the new corporation may conceivably be hampered in future borrowing, as it has in reality now subjected itself to a double mortgage indebtedness at one and the same time. As for the original bondholders, their position is strength- ened or not according to the value of the new acquisition in contributing to the financial strength of the system as a whole. Various alluring euphemisms are current in the market- places in order to satisfy the deep-rooted conviction in the in- vesting mind that somehow the security of a bond is its lien upon specific things, rather than its claim to the profits derived from their use. A mortgage must be "first" whatever else it is. Lyon has disentangled the ingenious phraseology used on the Erie. Its first five mortgages are openly numbered in order, each of them, nevertheless, being a first lien on something or other. Evidently something novel and taking was now needed for the sixth mortgage. The name changes from the ^ew York & Erie Railroad to the Erie Railway; and the in- 1 Lyon, Capitalization, p. 130. 126 RAILROADS strument is denominated a "first consolidated mortgage." It is not, in point of fact, a first lien on anything; but it is the first one to be "consolidated." Then follows a seventh set of se- curities yclept "first consohdated 4s." This again is fiterally true only because the preceding consohdated mortgage bore 7 and not 4 per cent. Then, the Railway is transformed into a Railroad; and an eighth general "convertible 4" mortgage appears upon the tapis. As Lyon observes, this might truly have been called the "first general" mortgage, were it not that emphasis is now laid upon the breadth of lien in order, perhaps, to distract attention from the altitude or distance above the ground of the security. It would be interesting in a similar fashion to run over the nomenclature of other roads. All authorities upon railway finance have emphasized the fallacy of the view that a mortgage is really secured by any specific piece of property. In ordinary real estate or commer- cial practice this is indeed true. But the theory is entirely in- applicable to a railway. Few of its separate possessions are in and of themselves of a worth equal to the face of the loans based upon them. It seldom happens, even, that the entire property can be sold for enough to satisfy the face of its outstanding obli- gations. The separate units to a far higher degree have no value except as part of a going concern. No matter how much a bridge or a terminal may have cost, its value depends upon use. And railways are peculiarly economic imits from an oper- ating point of view. The right of way is not even fit for farm- ing land when trains cease to run. Rails become scrap iron. Rolling stock and movables alone can be auctioned off piece- meal fashion. The real lien of a railway mortgage, therefore, is not upon property as such, but upon earning power. And earning power is dependent upon such efficient operation as can alone take place when each separate possession can be treated as an integral part of the whole. The inherent weakness in the prevailing theory is revealed whenever the test of bank- ruptcy is apphed. NATURE OF INDEBTEDNESS 127 Foreclosure upon mortgages for many practical reasons is a difficult matter. A considerable time after default is usually allowed before summary action may be taken in any event. And for a long time there was no power by which bondholders could compel the trustee to take action.' Sometimes, more- over, even the bondholders themselves could not institute pro- ceedings without the consent of the trustee. Inasmuch as these trustees were either officers of the railroad or representatives of a strongly intrenched management, with interests directly opposed to those of the bondholders, great delay and incon- venience in the satisfaction of claims often resulted. This is equally true of collateral securities, as witness the protracted struggle over the Rock Island bonds after 1913. Even were the trustee favorably disposed, there were often obstacles in the way of foreclosure in the early days, arising from guarantees or prior liens of the state governments. Actual foreclosure might also be rendered impossible, either because of the depreciated condition of the property or because through consolidation it had become too large or unwieldy to sell to advantage en bloc. For all the reasons above-mentioned, but few instances are on record in which bondholders have actually succeeded in enfor- cing their technical right to foreclosure for the satisfaction of their claims. The legal theory proved clearly unworkable in practice. Satisfaction was afforded only through a general agreement which would temporarily at least set aside particular rights and claims for the benefit of the property as a whole. Such an arrangement takes place through a financial operation known as reorganization. The main purpose served by the right of foreclosure in funded indebtedness is that it may compel a financial reorganization of the company. This is an operation of the utmost delicacy in view of the conflicting interests involved; and the number of these is often very great. In the Union Pacific reorganization of 1895, there were no less than fifteen separate official com- » P. 384, supra. 128 RAILROADS mittees, each representing many separate issues of securities. The Atchison in 1889 had to readjust the interests of forty-one distinct groups of bondholders. Only a few of the senior issues could be satisfied by an outright foreclosure sale. All the rest would have had their equities expimged by such drastic proce- dure. Their safety lay in continued operation of the property as a whole, with such postponement or proportional reduc- tions of their claims as could be agreed upon among them- selves. The former of these two courses is the one usually adopted. New securities, with interest returns, not fixed as before but contingent upon earnings as they appear in future, are commonly exchanged for the old ones on which default has occiurred. And it is an odd circumstance, shown by long expe- rience, that the company, having failed because of its overload of capitalization, usually emerges from its reorganization with a larger volmne of securities than ever. This is due to the fact that dissenting bondholders can be tempted to acquiesce in the new plan, only through offers of larger par values than before, as an offset for the postponement of their claims on current earnings. As Daggett, the prime authority upon reorganiza- tion, aptly observes : " There is a magic in the par value stamped upon a certificate which affords a certain consolation to those from whom sacrifices in interest are demanded. An unimpaired (usually increased) principal, moreover, constitutes a real ad- vantage when the date of maturity arrives." ^ The right of bondholders to control the policy of a railroad is entirely contingent and negative. It is voiced through a body of limitations upon the freedom of action of the shareholders, and consists usually of provisions for assimiing control in case of default upon payment either of principal or interest. Certain mortgages are "closed" by Hmitation of the total issue. This prevents the shareholders from continuing to borrow further on the same terms. Sometimes the instru- ment provides that the aggregate indebtedness shall never ^ Details in Chapter XII, infra. NATURE OF INDEBTEDNESS 129 exceed a certain ratio of average earnings. Most common is the provision by which voting power is assumed on failure to fulfil the terms of the agreement. Some bonds, like one of the large issues of the Erie, have proportionately equal voting rights with the stock at all times. The Chicago & North- western Sinking Fund Bonds also carry the voting privilege. But, in the main, the responsibihty for direction rests solely upon the shareholders unless default occurs. There are many other practical details as to the issue of bonds which may be merely mentioned in passing. It goes without saying that the price at which such securities maybe sold depends upon two factors: first, the amount issued in rela- tion to the property upon which it is based; and secondly, the interest promised in relation to the prevailing market rate. The best testpf normality is that the bonds shall be salable at par at the going iiijterest rate. If a higher rate than this is necessary to hold them at their face value, it is an evidence of weakness. / And obviousJly the issue of bonds at a discount is an expensive and waste;tful proceeding, even at best.' For all such securities at ma.t\iTity must be paid off at par; and any larger principal sum to be paid at that time than was realized at the date of issue is a positive loss. Sometimes this may be offset by a saving in the current rate of interest paid. Issuance at a discount may at times be necessary in order to strengthen the appeal to in- vestors, who commonly prefer to buy at what seems to offer somewhat of a bargain. But by and large there can be no doubt that the soundest financing is characterized by such adjustment of principal and interest as shall enable emission at somewhere near par value. It should also be understood that the value of a bond depends in a measure upon the length of its life. This follows directly from the fact that the premimn or discount at its issue has to be pro-rated over the ensuing period of years. The preference of investors for long-term bonds, which offer I Cf. p. 277, infra. VOL. II — 9 130 RAILROADS some opportunity of a rise in price because of the expected fall in the general rate of interest, is another factor to be reckoned with. It commonly leads to somewhat higher quotations relatively to their interest rate, for long-term securities. Such details, however, appertain to private finance rather than to the pubhc aspects of the question. They are fully described ia the standard hand-books on the subject. Periodic readjustment of the funded indebtedness of a cor- poration is an essential feature of sound policy. Occasionally, as with some Enghsh debentures and certain American trolley lines, perpetual interest-bearing seciu-ities are put forth; but American investors usually prefer the prospect of repayment at a time certain. Even this, however, does not imply that railroads contemplate the ultimate extinction of their bonded indebtedness. For this, as was pointed out in oiu" fifst chapter, would be poor business policy. The trend, in fact, is quite the other way, as we have seen. How then are the two plans of continued borrowing and periodic repayment reconciled with one another? Obviously, as Lyon observes, "by paying the creditor but not the debt." The loans are not amortized, but merely refunded. These two operations of amortization and refunding should be carefully distinguished. Amortization or debt discharge ' is usually effected in either one of two ways. The first plan provides, for serial maturity. Thus, many equipment bonds and of late some note issues call for a fractional discharge of the debt year by year. There are two serious disadvantages in such practice. One is the impos- sibility of imiform market quotations, inasmuch as any price other than par would be affected directly by the length of term remaining. And then again, with an even yearly distribution of repayment, the heaviest charge would occur when the cor- poration could least well bear it. '■ The necessarily elaborate details are given in the standard text- books of Cleveland and Powell, Lyon, Chamberlain and Meade. PAYMENT OR REFUNDING 131 The second and more common method of providing for the payment of indebtedness is by means of a sinking fund. Assets are set aside beyond the control of the railroad periodically, that they may accumulate at compound interest. Such assets may consist of securities of other corporations, with the attendant disadvantages both of risk and inability to convert into cash on maturity of the outstanding bonds; or else such investment may take place in the bonds of the railroad itself. These, again, may be bought in the open market; or they may be withdrawn by exercise of a reserved right of redemption. Corporation bonds ought in any event to be issued subject to call. Many contingencies may arise in which such a right is important to the railroad, particularly in connection with refunding or re- organization. The merger of New York Central lines in 1913- '14 would have been much simpler had the old Lake Shore and Michigan Central debentures made provision for peremptory redemption. Had not the Union Pacific "participating bonds" with which the Northern Pacific affair was financed in 1901 been callable, a most amazing security they would have been.^ But investors dislike any uncertainty of term in a bond. This ob- jection is overcome by fixing the redemption price at some figure slightly above par. Amortization, however, so far as the actual principal of the debt is concerned, is not essential to sound finance. The same object may in large measure be attained by regularly setting aside adequate sums for depreciation even at the expense of dividends.^ The main point is that the debt being practically perpetual through refunding, the assets should not be permitted to diminish in value. The most recent type of amortization has to do, not with discharge of the principal but with extinction of the discount at which the bonds may, perhaps, have been issued. Such amortization is a necessary feature of conservative practice. The best state railroad com- 1 Pp. 164 and 506, infra. * Chesapeake and Ohio short-term notes in 1914 enabodied this novel principle. 132 RAILROADS missions require it in connection with the regulation of security issues.' Thus, the New York Public Service Commission in 1912 required a sinking fimd in order to take up gradually the discount on bonds issued below par by the Third Avenue Rail- road in connection with its reorganization. The piecemeal character of funded indebtedness results after a period of years in the accumulation of a complicated mass of securities, conflicting and uncertain as to fiscal rights. At the same time these separate issues are comiag to maturity successively, so that arrangements must be made from time to time, either for discharging the debt or raising funds by new securities to take the place of the old ones. The financial oper- ation known as refunding obtains in these connections. A sort of fiscal house-cleaning is requisite in order to open the way to safe and consequently advantageous financing in future. New consolidated imifying or general bonds are issued, repre- senting in part, perhaps, the aggregate equity over and above all previous borrowing. Such an issue should necessarily provide fvmds for retiring all prior liens as they fall due. Theoretically this plan would in time substitute one "blanket" loan for a multiplicity of localized ones. And where it has been issued by a system, which, by reason of consolidation of separate proper- ties, has greatly enhanced revenue power, it would seem to be warranted. But unfortunately in practice many old bond- holders may decline to exchange their prior liens; so that the net result is merely the addition of another "junior" security to the long Ust.^ [;3'j Refunding operations among American railroads, historically, seem to occur more or less in waves of frequency, which are in- fluenced to some degree by movements of the money market. Thus, for example, a notable era of refunding occurred about ' Chapter IX, infra. ' Cf. p. 99, supra, on preferred stock to call in such reluctant security holders. And also p. 247, chap. VII, infra, on the relation between re- funding and stock-watering. PAYMENT OR REFUNDING 133 1897.^ The close of the century brought a goodly munber of 6, 7 and even 8 per cent, bonds to maturity. In the meantime the prevailing interest rate for such securities had descended to somewhat less than a 4 per cent. rate. A number of large companies were able, therefore, to considerably reduce their fixed charges by substituting new bonds for the older issues at the low rate. Another pronounced concentration of refunding has taken place since 1908. The Burlington m that year au- thorized a bond issue of $300,000,000. Three years later the Great Northern authorized the largest bond issue on record, to the amount of $600,000,000, and the St. Paul speedily fol- lowed suit. Then came the Pennsylvania with yet another authorization of bonds to an indefinite amount depending upon the capital stock. Other large roads, such as the New York Central, the Southern, and the Illinois Central are at work along similar hues. The Baltimore & Ohio announces another such open mortgage, also for $600,000,000, in 1914. Coming, as they do, at a time when no saving of interest may result, the advan- tage to flow from these refunding operations is confined almost entirely to other considerations. The element of economy in refunding operations, depends to a large extent upon the state of the money market. A con- dition of affairs precisely opposite to that of 1897 prevailed in the United States during the second period above-mentioned. The long-continued and steady decline of the rate of interest had given place at last to a much higher basis of return, especially for railway bonds. Interest at the rate of 5 to 6 per cent, had superseded rates of 3| to 4 per cent, early in the century. This untoward circxmistance, due in part to general causes and in part to the peculiarities of the market for railway securities,^ robbed the railroads of any saving of interest through refunding. 1 Cmn. & Fin. Chron. LXIV, pp. 492, 499, 540, 1202; XLVII, p. 54; Investor's Supplement, Mar. 1889; Bradstreets, 1897, pp. 147, 162, 164, 243, and 1899, p. 260; London Economist, 1897, p. 273. 2 P. 186, infra. 134 RAILROADS In fact, it imposed heavier burdens with each renewal of matur- ing funded indebtedness. This tight money market, as will appear, has also been responsible in a measure for the wide- spread resort to short-term notes in place of long-time bonds. It cannot be said, therefore, that a reduction of fixed charges is an essential detail of refunding. The Southern Railway in 1914 was embarrassed by having an old partly-issued mortgage, authorized for the low interest rates prevalent some years ear- lier. To continue further issues at this rate would necessitate a heavy discount. The proper procedure was to refund the old mortgage by a new one at about the current rate of interest then prevailing. The operation may conduce to economy, or it may work in precisely the opposite direction. The fixed motives for periodic refunding have to do, therefore, not with a saving of interest but rather with considerations of market- ability for the bonds. The most important commercial oflice of refunding is that it automatically simplifies an over-complex burden of funded obligations. With sometimes as many as eight or ten different mortgages overlying one another, as in the case of the Erie, a confusion of rights and an almost inextricable tangle of con- flicting stipulations are apt to come about. The result is that the status of each issue is so ill-defined that considerable risk to the holder may arise in time of trouble. Few investors care to buy bonds under such circumstances. Protracted litigation has not uncommonly resulted. Such a comphcated refunding as that of the St. Louis & San Francisco in 1901-'02 operated to replace fifteen different types of bonds by a single unified issue having a clearly defined legal status. Simplification is the first service of refunding. And then, in the second place, a greater marketability of bonds as a result of refunding may arise from the fact that a continuously open market for the new issues is made. A small highly localized and ancient issue of bonds cannot sometimes be bought and sold except at wide fluctuations in price. Quotations are infrequent. On the other UNDERWRITING SECURITIES 135 hand, the investment status of the refunding bonds being clear, and the size of the issue being greater, a far freer and more unrestricted course of purchases and sales follows as a matter of course. Where bonds may perhaps be called upon to serve as collateral for loans, such a close and active market may be highly important. Securities are marketed in either of two ways, which differ fimdamentally in risk. They may be issued directly to in- vestors through announced public offerings, in which case the railroad takes its chances both as to price and as to the amount sold. Such is usually the practice among sound companies regarding the issuance of new stock, inasmuch as the dealings are normally privileged and are confined to supposedly loyal shareholders. 1 Most commonly in the case of bonds another practice has come to prevail, which dates from the early '70s. In borrowing, a wider market must be sought; and at the same time the vagaries of the money market and of general invest- ment demand must be taken into account. Sometimes, also, the railroad may be so placed, as in meeting short-term notes or bonds at maturity, that it must with certainty count upon a stated return from the transaction. Under such circumstances it is preferable to dispose of the entire issue to bankers at a price. Where the issue is large, and where appeal to a broad clientage must be made, even the most powerful bankers in their turn prefer to distribute the risk still more. Not wishing to put all their eggs in one basket, they may organize an under- writing syndicate. The entire issue is thus taken at a price which includes an underwriting commission for the service. By this means a successful outcome of the offering is guaranteed. The same end may be attained in another way. The securities may still be issued by the railroad, but imderwriters agree to take the residue, not otherwise directly sold, at an agreed figure. The railroad in either event is relieved of all financial ' Cf. p. 267, infra. 136 RAILROADS risk. Such an assurance is often most convenient. It may be a downright necessity. Both the underwriting price and the com- mission depend of course, upon the nature of the risk assimied; which in turn is conditioned by the state of investment de- mand, by the credit of the railroad and by the particular terms of the offering. Naturally the stronger companies, confident of their credit, will avoid the expense of commissions; but even the best of them may at times be compelled to resort to underwriting at whatever cost. Both of the recent panics of 1903 and 1907 afford significant examples of such financial need. The experience of the Pennsylvania Railroad, one of the strongest companies, diu-ing recent years is significant in this connection. Three times within the last decade it has put forth securities through underwriting syndicates.^ The first experience in 1903 had to do with the issue of stock to share- holders for the purpose of financing the New York terminals. With the market price at $145 it was assumed that $90,000,000 of new shares offered at $120 would surely find a ready sale. On the day of the announcement panic prices prevailed. The railroad had to have the money. It therefore paid 2| per cent, commission for an underwriting at $120. Inasmuch as the market price of the stock soon dropped temporarily to $112, it is obvious that without this guaranteed sale the railroad would have faced a serious crisis in its affairs. Two years later an offer of $100,000,000 of convertible bonds was again made to stockholders for the same purpose. It was doubtful whether this limited clientage could absorb so large an issue. In the light of the preceding experience, the Pennsylvania paid 2| per cent, commission for an underwriting. And yet again in 1908, in the wake of the panic of 1907, the same company once more sold mortgage bonds to bankers at 92, a flat sale including the banker's commission, which made it equivalent to an ' Testimony of President Rea, September 9, 1913, before Mass. Public Service Commission (pamphlet). UNDERWRITING SECURITIES 137 underwriting. As illustrating the risk avoided by means of such transactions, the experience of other strong companies is worth quoting. An underwriting syndicate guaranteed an offering of $75,000,000 of Union Pacific bonds to shareholders in 1907. The quotations promptly dropped far below 90, which was the subscription figure. In consequence all but $2,000,000 of the issue had to be assumed by the underwriters. The Atchison, Topeka & Santa F6 at about the same time attempted to place a considerable issue of bonds with its share- holders without underwriting support. Under the same panic conditions a contemporaneous offering by the Erie was yet more disastrous in its outcome. The imderwriting sjmdicate was compelled, even, to dissolve with three-fourths of its bonds still on hand. The relief to a railroad, concerned not with banking but with transportation, through resort to under- writing is thus apparent. Whether the service rendered is in each case worth the commission depends entirely upon circumstances. 1 Underwriting of railroad securities is open to certain abuses. The New Haven had an unhappy experience in 1913.^ This company, then in the throes of financial disorganization, had for several years a contract with J. P. Morgan & Co., whereby in return for a commission of 1| per cent, this banking house agreed to serve as sole agents of the road in underwriting its bond issues. Offerings of stock or convertible debentures were, however, not included. Following the collapse of the Mellen r6gime, the New Haven needed $67,000,000 to meet maturing notes and other pressing obligations. The money market in July was so unfavorable that apparently the con- vertible feature had to be attached even to 6 per cent, bonds ' The large direct offering of St. Paul bonds in 1914, saving about 3 per cent, in commissions, even in a tight money market demonstrates the great value of high credit based upon a wide margin of safety. ' Mass. Pubhc Service Commission, 99, pp. 4-17. The banker's statement of commissions and underwritinge is in Railway Age Gazette, LVI, 1913, p. 517. 138 RAILROADS in order to make them marketable. At all events, whether necessary or not, this was immediately interpreted by the bankers as releasing them from their obligation to support the company, inasmuch as "convertible" bonds were virtually stock. They demanded 2§ per cent, commission to meet this special case. The matter came before the state commission for approval six months later. In the meantime a substantial improvement in market conditions had ensued, which certainly did not seem to warrant a commission of nearly $2,000,000 at the time the application was made. The whole arrangement was characterized by the commission as "not in accord with ethical business standards or sound public policy." ^ Many unpleasant details of underwriting will be found in the New York investigation of life insurance companies in 1906.^ Aside from the downright fraud perpetrated upon the policy holders, this investigation marks a turning point in financial experience. For, from this time forward, the unwieldy surpluses of the life insurance companies were no longer subject to speculative call and manipulation. Dishonest commissions to insiders, which, of course, came out of net receipts to the railroads, were much discouraged. Among these life insxu-ance underwritings, one of the Burlington issues may be mentioned in passing. The Equitable company assmned all the risk in this transaction and paid the necessary calls upon it for cash, despite the fact that most of the profits were dispensed to private individuals. The society subsequently bought, in the open market, securities actually underwritten by itself to the extent of more than two million dollars. The Union Pacific syndicate of 1902 under the management of E. H. Harriman, who at the time held this railway in the palm of his hand, pro- vided not only for underwriting the issue but also included an 1 P. S. C, 165, Dec. 24, 1913. ' Joint Committee, etc., to Investigate and Examine into the Business and Affairs of Life Insurance Companies, Albany, 1906; summarized as to railroads in vol. VII, pp. 31, 67, 134, etc. KINDS OF BONDS 139 agreement for a secret pool which should unify control of the stock and withhold it from the market for a period of five years. Happily the publicity attaching to this great investiga- tion cleared the atmosphere. Dishonesty, nevertheless, occa- sionally comes to light, as in the "Frisco" receivership of 1913.^ A considerable issue of bonds was sold in Europe on the very eve of bankruptcy, by means of commissions stated to have been as high as 7| per cent, over and above the ordinary under- writing fee. The credit of American railroads received a severe shock in consequence. The actual differentiation of funded indebtedness of Ameri- can railways into various classes of securities is shown by the following table from the official Statistics of Railways for 1913 : Mortgage bonds $ 8,186,366,000 Income bonds 250,290,000 Plain bonds, debentiires, notes, etc 1,107,076,000 Collateral trust bonds 1,189,636,000- Miscellaneous 82,858,000 Equipment trust bonds 369,285,000 Total $11,185,511,000 It may next be in order to describe the essential features of some of these types of indebtedness. The income or preference bond is a form of security devised largely in connection with the widespread reorganizations of 1893-97. Disappointed bondholders were induced to accept them in exchange for their old securities, the companies mean- time being relieved from the burden of fixed charges by the promise to pay interest only on condition that it was earned. It seeks to combine the lien of a mortgage with the contingency of interest payment if earned. It differs thus from preferred stock, in the addition of a prior claim upon assets in case of bankruptcy. Attaining a considerable volume ten years ago, the amount of such issues has not greatly increased in recent ' 63rd Cong., 2nd sess.. Senate Doc. no. 373, p. 29; or 29 I. C. C. Rep., 139. 140 RAILROADS years. The only attempt at their revival was in the first misuccessful Wabash reorganization plan of 1914. As has been observed, the income bond "is an attempt to combine two contradictory commercial principles. . . . Security for both interest and principal is the essence of the creditor's position, while contingency depending upon success is the essence of the stockholder's position." The two interests are incompatible and conflicting. Experience has proved this to be the case.* I Stockholders, controlling management, have it in their power ' to devote all surplus earnings to maintenance and improvement, rather than to pay interest upon the bonds. Surplus revenue is thus "ploughed in" until both stock and bonds are able to participate in earnings alike. Meantime, however, the income bondholders have been deprived of revenue. Nor can they ever recoup these losses of interest, as might happen in the case of cimiulative preferred stock. Interest lost for one year is gone forever. The tedious suits of the Central of Georgia income bondholders under the Harriman regime, settled in 1910, clearly demonstrate the nature of the difficulty inherent in this class of security. One party wished to upbuild the prop- erty by devoting large sums to maintenance, even concealing revenue from its subsidiary concern, the Ocean Steamship Company, and otherwise juggling its accoimts. The bond- holders demanded proper consideration of their rights and eventually secured it.^ If, on the other hand, as in the Reading reorganization, this contingency, is guarded against, the trust agreements may be so rigid as to embarrass the management in securing further loans needed for development. Nor has the conferring of voting power upon income bondholders solved ' Daggett, Railroad Reorganization, p. 365. The income bonds on the Atchison contributed materially to bring about the second reorganiza- tion. P. 338. CJ. Chapter XII, infra. ' Described in detail in Quarterly Journal of Economics, XXV, 1911, p. 396 et seq. The matter was finally settled in 1911 by agreement of the Illinois Central to retire all three issues at prices to include the withheld interest. KINDS OF BONDS 141 the problem satisfactorily. As a matter of fact, such securities are scarcely distinguishable from preferred stock; and recent financing has tended frankly to recognize that situation. The close similarity between income bonds and preferred stock is exemplified by a recent contest between shareholders on the St. Joseph & Grand Island.^ The Union Pacific practi- cally controlled this small company, through ownership mainly of its common stock. It was in position to make good use of its property as a short line between important points. Net earnings of the road had in the past been substantial, sufli- cient, in fact, to pay the full dividend upon the first preferred shares. And during eight years of control by the Union Pacific, approximately four million dollars of such earnings had ap- parently been put back into the property in the form of improve- ments. Inasmuch as the preferred stock was non-cumulative as to dividends, this entire diversion of earnings into betterments entailed an irreparable loss to the holders of this class of stock. On the other hand, it immediately inured to the benefit of the Union Pacific by hastening the time when the common stock, by reason of enhanced earning power, might be placed upon a dividend basis. Meantime, it was alleged, the Union Pacific was quietly picking up the preferred shares at low prices conditioned by the cessation of dividends. Whatever the actual merits of the case, the issue raised as to the differentiation between income and capital, or improvement, account was precisely analogous to that raised by the Central of Georgia income bondholders, referred to in the preceding paragraph. A debenture is a special variety of bond. In England a form of security known by this appellation is quite common, forming, in fact, approximately one-quarter of the outstanding capitahzation of its railroads. But the British debenture is quite different from Our own, although one or two companies, notably the Chicago Great Western, have adopted the foreign ' The U. S. Investor for January 21, 1911, p. 115, reprints the statement of the aggrieved preferred shareholders. 142 RAILROADS model. The English debenture is merely a form of stock without voting power but with absolute preference as to divi- dend. In the United States, on the other hand, a debenture is a bond; but it has no specific mortgage lien, and hence is without foreclosure power. In other words it is merely a promise to pay, depending for security upon the general credit of the road. Yet the holder of a debenture is often somewhat more protected than the ordinary note holder or general creditor by reason of special stipulations in his behalf. The similarity to the income bond is close, in that the interest on debentures is "payable if earned" and not otherwise. Being thus, in form at least, somewhat less secure than an ordinary mortgage bond, other attractive features, such as convertibility into stock, protection against subsequent bond issues without participation rights or a higher rate of interest, are necessary in order to secure successful flotation. Thus the St. Paul debentures of 1910 were marketed in France with the provision that the capital stock of the Puget Sound extension was not to be sold while these securities were outstanding. ^ And the Atchison serial debentures of 1902, although unsecured, courted popular favor by a proviso that one-tweKth of them should be retired annually out of earnings. Debentures, strangely enough, are a sign either of financial weakness or of markedly high credit, according to circum- stances. In the former case assets may already be mortgaged up to the limit, inasmuch as liens beyond the second and third degree on the same property are not marketable. The Rock Island in 1914, according to its management, had exhausted all of its borrowing resources "save notes or debentures." Or, on the other hand, the strength of the company may be so great that it need not offer the security of a positive mortgage. This may be a matter of prime importance. In either case debentures may be issued irrespective of the amount or nature of the prior liens already outstanding. Moreover, debentures ' C/. pp. 23, supra. KINDS OF BONDS 143 may be retired on short notice without the formaUty requisite in the case of bonds. Some strong companies, like the New York Central, the Atchison and others, have largely relied upon such securities in recent years. The latter, in fact, issued one of the first American debentures as early as 1884. The New Haven has also repeatedly issued debentures, one alleged reason being the conflicting laws of the New England states, which stood in the way of a single uniform mortgage. Cer- tainly it had little or no actual mortgage indebtedness on its own main stem carrjdng the right of foreclosure; even al- though by 1913 financing by loans overshot the danger point. This feature is significant under the existing prostration of the carriers in this part of the country. On the other hand in the case of weak companies like the Wabash, large issues of deben- tures have been -at once a source of disappointment to investors and an embarrassment in the financing of the road itself. For the stipulations as to future loans, necessary to attract popular favor, proved to be quite as effectually a bar to subsequent borrowing as if ordinary mortgages had been heaped one upon the other. So unwieldy in fact were the Wabash income debentures, created in connection with its earlier reorganiza- tion, that one of the first steps in an attempted rescue from bankruptcy, was their practical elimination through conversion in 1906-'10. Collateral trust bonds, ' so-called, constitute by far the most important type of funded indebtedness next to the ordi- nary simple mortgage. Approximately one-tenth of the total borrowings of the railways of the United States in 1913 assumed this form. This is the more notable, inasmuch as this huge volimae of more than one billion dollars of collateral trust loans was in large measure the creation of the decade after 1900. It is indubitable that without this form of bond relatively few ' The best single reference is Quarterly Journal of Economics, XX, 1906, pp. 445-467. 144 EAILROADS of the great railway consolidations could have taken place. Three great financial expedients characterized this notable period: the community-of -interest idea, the holding company and the device of the collateral trust bond. The last two of these are indissolubly connected. The holding company as a means of effecting combination was directly dependent upon the use of the collateral trust bond.^ A collateral trust bond differs from the ordinary bond in that it is a mortgage secured, not by any real property or fran- chise but by the deposit of stocks or bonds of other companies with a designated trustee. Its lien upon actual property therefore is not immediate but indirect, through the medimn of such other securities as are thus deposited as collateral. The collateral trust bond, fvurthermore, depends for its interest upon such revenues as may accrue from these stock or bond holdings, together with such additional guarantee as the issuing company may find it expedient to give. A concrete illustra- tion will make the practice clear.^ In 1902, 306,000 shares of the Louisville & Nashville out of a total of 600,000 shares, as a result of an untoward speculative raid, were turned over to a much smaller company, the Atlantic Coast Line Railroad. This latter road, thus assmning control by ownership of a majority of the stock, paid for the piu-chase by an issue of $35,000,000 of its own collateral trust bonds, together with certain other considerations in cash and securities. These Atlantic Coast Line bonds bore 4 per cent, interest and con- stituted a mortgage upon the Louisville & Nashville shares. These shares were in fact deposited with a trustee for that pur- pose. It is evident that the Atlantic Coast Line independ- ently could never have issued bonds to this large amount, it being nearly three times the entire capital stock ($12,600,000) of the company. But the bonds, calling for an interest charge of $1,400,000 annually, were to be supported by the dividends of $1,530,000 upon the purchased stock. It was anticipated, 1 Cf. chap. XIII, infra. ^ P. 219, infra. KINDS OF BONDS 145 of course, that the enhanced earning power of the conjoined properties would still further guarantee the success of the issue. At the outset this plan, including the additional con- sideration given, netted a heavy loss to the issuing company; but in the course of a few years, increased dividends upon the deposited stock brought about a large direct profit, aside from the operating advantages. The first use of the collateral trust bond dates from the early history of the Union Pacific. In 1873 Congress, in order to protect its heavy loans to the company, prohibited by law any further increase of the bonded indebtedness of the road subject to its lien. This greatly embarrassed all projects for expansion through construction of either branch lines or extensions. To finance these by means of small independent companies was out of the question. Small corporations could not successfully sell bonds, nor would it be wise to lose control of them; con- sequently the Union Pacific advanced funds for construction, taking the stocks and bonds of the new companies in payment. Its treasury was then reimbursed by the issuance of the 6 per cent, collateral trust bonds of 1879, secured by the deposit of these securities. Thus the needed extensions were built without violating the letter of the Federal prohibition. The foregoing illustration indicates the earliest and, for a long time, the most important reason for the resort to collateral trust bonds. Indeed, in a country divided uito so many inde- pendent states, it is difficult to see how much of our construc- tion could have been effected otherwise. Most charters issued by states authorize construction only within certain strictly defined territory. Subsequent extensions can be legally made only by means of new charters or amendment of the old one. The latter expedient may require modification of original liberal charter rights. It is safer to organize new and independent corporations. Moreover, of course, construction beyond state boundaries must of itself entail the foiination of a separate VOL. u — 10 146 RAILROADS company with a charter of its own. None of these new and subsidiary companies can be successfully financed by themselves. It is more profitable that the necessary funds should be pro- cwced by the parent road. Its bonds or stocks will sell to far better advantage in distant markets. The undoubted advan- , tages in this plan have led to its adoption by most of the large companies, notably the Union Pacific, Atchison, Burlington, and Rock Island roads in the West; and the Louisville & Nashville and inihois Central in the South. In recent years, particularly since the resumption of general prosperity in 1897, the collateral trust bond has been largely utiHzed as a means for financing the consolidation of railways. To the holding company as a mode of combination, it is in fact indispensable. The New York Central & Hudson River after 1898 acquired control of the Michigan Central and Lake Shore by the exchange of its own collateral trust bonds for the stocks of these roads deposited as collateral. Among many similar operations within the last decade, one of the most prominent was the joint purchase of the Burlington road in 1901, by the Great Northern and Northern Pacific companies. In this case the bonds became a joint obligation of both companies, being se- cured by the deposit of their Burlington stock as collateral. The variations of procedure are many. Control of another road may first be acquired by purchase for cash, with subse- quent reimbursement through mortgaging the secm-ities pur- chased. This was a common mode prior to 1900; but was obviously open only to strong companies with ample cash resources. Another plan was the immediate exchange of the new collateral trust bonds for the desired stocks or bonds to be acquired. This method has been largely utilized in building I up the Rock Island system. Or a third method may be adopted; namely, first to procure the necessary funds by sale of the collateral trust bonds, and then with the proceeds engage in the necessary business.' ' Quarterly Journal of Economics, vol. XX, 1906, pp. 445-467. KINDS OF BONDS 14? The collateral trust bond, as used in the acquisition of secur- ities of other companies, is precisely analogous to "margin" operations by individuals upon the stock exchanges. Its advan- tages and dangers to individuals and corporations are precisely alike. There is no difference whatever in principle. Payment in full in cash for purchases of securities ties up a large amount of capital indefinitely. Both principal and interest are lost, being offset only by the income derived from the stocks or bonds acquired. But if such operations can be based upon credit instead of cash, an indefinite expansion of the scale of operations becomes possible. The property acquired, as Mitchell observes, pays its own purchase price. It is a great economizer of funds. Thus E. H. Harriman in 1896 obtained control of .110,000,000 par value of Illinois Central stock with an outlay of less than $1,500,000 of Union Pacific cash. The stock, paying 5 per cent, dividends, was bought by an issue of bonds bearing only 4 per cent. In other words, bonds could be sold on sufficiently good terms to pay even the necessary premiums on the stock, and entail little if any burden upon the parent company. The manner in which the segregation of the Maine Central from the Boston & Maine was financed in 1914 shows the facility with which a collateral trust operation may finance itself, — a fiscal creature swallowing its own tail for sustenance in fact.^ De- siring to prevent its control from going to unfriendly interests, the Maine Central bought back 159,601 shares of its own stock; and having no available funds, paid for it by means of collat- eral trust notes, secured by the deposit of the stock acquired. Could anything be simpler! Nothing, perhaps, except the issu- ance by the Cincinnati, Hamilton & Dayton in 1904 of $15,000,- 000 of collateral gold notes, based in part upon the deposit of $7,750,000 of its own capital stock as security.^ As a means of railway consolidation, the collateral trust bond has certain well-defined merits. The foremost one is its elasticity. Whereas actual mergers and even long term • Pp. 166 and 170, infra. ^ Cf. p. 214, infra. 148 RAILROADS leases are practically indissoluble, a control by means of stock ownership, financed through an issue of collateral trust bonds, may be readily enough terminated by selling the stock and retir- ing the bonds with the proceeds. Thus, when in 1909 the Rock Island system found the St. Louis & San Francisco road too heavy a financial burden, the connection was severed by simply retiring its collateral trust bonds through the sale of "Frisco" stock. This stock was the only tie between the two roads. Sometimes, however, with additional complications in the nature of guaranteed dividends, leases and preferred shares, as in the Union Pacific about 1908, segregation of assets becomes extremely difiicult.^ Southern Pacific stock could not be distributed as a bonus to Union Pacific share- holders without substituting for this stock some other security — collateral or cash — inasmuch as it was held as security for Oregon Short Line bonds. This predicament emphasizes the need of reserving the right to substitute collateral; to the end that whenever conditions warrant, securities may be taken out from imder the trust deed and sold or otherwise used. In the above-mentioned case, could Central Pacific stock have been substituted as collateral for the Southern Pacific shares, a marked simplification of structure would have been the result. On the other hand, the collateral trust bond may readily be- come a source of danger where it imposes a heavy burden of fixed charges upon a company. Most of the early issues of this sort down to 1901 were based upon the deposit of bonds of subsidiary companies. The New York Central-Lake Shore collateral trust bonds in 1898 and the Burlington joint 4s, three years later, started the fashion of issuing such securities not upon bonds as collateral but upon deposited stocks. This change was undoubtedly due to a shift of the main purpose for which such bonds were put forth. Instead of being used for the extension of existing fines into new territory, they were used for purposes of consolidation. Fixed charges were thus created ' Cf. Chap. XVII, infra, for account of the plan subsequently adopted. KINDS OF BONDS 149 for the' parent roads, which were supported not by assured, but only by contingent income — income contingent, that is to say, upon its being earned by the companies whose stocks were deposited. The most serious danger lurking in the collateral trust bond, however, is its invitation to corporate speculation and over- extension of credit. The ease with which a strong company may engage in stock market operations on a large scale by such means is most clearly demonstrated by the experience of the Union Pacific road between 1901 and the death of Mr. Harri- man in 1909. The cost of its investment in Northern Pacific stock, subsequently converted into Northern Securities Com- pany's stock, was about $76,900,000. This had been financed by means of collateral trust bonds, for the most part based upon operations of the Southern Pacific road, also within its control. The profit in hand and on paper when these operations were closed out amounted to about $82,900,000 or 113 per cent. These profits, it will be noted, as described more in detail else- where, ^ were promptly reinvested in stocks of other roads all over the coimtry. But the new purchases were made at the high prices prevailing before the panic of 1907; and, although largely increasing its revenue, could not have been closed out without losses quite commensurate with the previous gains. But, in the latter case, it may be urged that the stocks ac- quired were bona fide investments, paid for in full from cash in hand. On the other hand, the large sums due the Union Pacific by the Oregon Short Line, which was the cat's-paw in these speculative plunges, as appeared in 1910, shows how burdensome was the diversion of funds from their legitimate uses for operating development into the channels of outside investment. The stock market operations of the trunk lines in their acquisition of the hard and soft coal lines in 1900-'06 affords yet further illustration of the amazing development of credit 1 Chapter XV, infra. 150 RAILROADS which is possible with the use of collateral trust bonds'. The following table shows the amount of these purchases and the paper profits at prices prevalent in August, 1905: Amount purchased Profit ' The Pennsylvania group: Baltimore & Ohio com Baltimore & Ohio pfd Chesapeake & Ohio Central of N. J Norfolk & Western Reading com. , Reading 1st p^d Reading 2nd pfd The Vanderbilt group: Lake Shore Reading com Reading 1st pfd Reading 3rd pfd Big Four Lehigh Valley Michigan Central Chesapeake & Ohio Miscellaneous : Ontario & Western Soo Line com Soo Line pfd $30,293,300 21,480,000 16,000,000 14,500,000 32,000,000 13,952,000 6,065,000 14,265,000 50,000,000 13,952,000 6,065,000 14,265,000 11,224,000 3,200,000 20,000,000 16,000,000 30,000,000 7,066,000 3,533,000 $13,500,000 4,200,000 6,400,000 8,400,000 16,500,000 6,000,000 300,000 8,800,000 50,000,000 6,000,000 300,000 3,800,000 4,400,000 2,500,000 10,000,000 6,400,000 3,000,000 9,500,000 5,000,000 These large sums were paper profits entirely. Any attempt to liquidate such holdiags on any large scale would oT^viously have led to rapidly cnmibling quotations. Yet when in 1906 some of these holdings were sold out, the actual profits were large. The Lake Shore was credited with having made an average profit of $30 on about 100,000 shares of Reading stock. On the Chesapeake & Ohio the Pennsylvania Railroad cleared possibly $4,500,000. Its Baltimore & Ohio investment, sold to the Union Pacific in 1906, assuredly yielded large gains. These profits undoubtedly went into the great projects for improvement about New York. But suppose that mstead of 1 Estimated. KINDS OF BONDS 151 profit, there had been heavy losses, as in fact there were on paper in the case of many purchases made prior to the break of 1907. When the Reading was practically taken out of the market in 1903, its common stock sold for nearly $70 per share (par value $50) . Within a year the price fell to $37. Similarly the Union Pacific reinvestments, in 1906 of proceeds of its North- em Pacific operations, within the next two years registered a loss on paper of many million dollars. Nor can there be ques- tion that, as in the case of the New York Central, many of these companies would have been better off, had they devoted these huge sums, tied up in stock market operations, to the prosecution of their legitimate function of transportation. The New York Central certainly, had it had the undivided support of the Lake Shore, would not have been compelled to pile up still higher the burden of its capitalization in order to complete its terminal improvements at New York. Not all of these operations were financed by the use of collateral trust bonds. But even if not, capital had to be raised somehow to pay for these purchases. And hardly ever, when the securities have been resold, have the proceeds been used to reduce the capitali- zation to its former level. The entire development of these years represents a most dangerous tendency. And for its first suggestion as to ways and means, the collateral trust bond must be held largely accountable. Merely because the outcome of these purchases by means of borrowed money, chanced to have a favorable issue, due to a rapidly rising level of prices, does not in the least detract from the force of the criticism. The collapse of the Rock Island in 1913-'14, wherein such outside speculations turned out badly, is a case in point, as we shall soon see. Certain other uses of the collateral trust plan may be mentioned. It is commonly employed in the fimding of troublesome floating debts. The securities are usually issued for a short term and are rather of the nature of notes based upon specific collateral. Of far greater general importance is its 152 RAILROADS use in making effective appeal to certain classes of investors. Many conservative people who would never dream of purchasing railway stocks, will trustingly invest in a collateral trust bond whose sole security is the deposit of such stocks. This matter came prominently to the fore in connection with the New York Life Insurance Investigation of 1905. As a result of this examination, the insurance companies were prohibited from investing in stocks of railway or other corporations. The laws of foreign countries also restrict the investments of insurance companies in much the same way. Yet the reserves of these companies may, and undoubtedly do, con- tain large amounts of collateral trust bonds, based upon stocks as collateral. The mere substitution of a bond for a stock by this means evidently largely widens the market for railway securities. Two distinct elements of danger in collateral trust bonds to conservative investors deserve mention, in addition to those already outlined. There is the possibility, in the first place, of imsuspected shrinkage in the value of the underlying railway property, whereby the equitable interest of the collateral bond- holders is lessened; and, secondly, there is risk of impairment of the collateral through downright manipulation of the under- lying securities. Both dangers could scarcely be better dem- onstrated than in connection with the disintegration of the Rock Island system in recent years. The details of inverted pyramiding of securities are elsewhere given. i Essentially, the financial structure was this: Control of the operating com- pany, known as the Chicago Rock Island & Pacific Railway, was purchased in 1902 by a holding corporation, the Chicago Rock Island & Pacific Railroad, through exchange of the latter's collateral trust 4 per cent, bonds for the Railway stock. This stock was deposited as security for the bonds. Above the Railroad there was set up yet a second holding corporation, the Rock Island Company, where preferred shareholders exercised 1 Cf. pp. 205, 236, 394, and 524, infra. KINDS OF BONDS 153 control over the entire system. At this writing, the true con- dition has not probably been revealed in all its ugly nakedness. But the two points of danger to investors above-mentioned are Intbbcokpobate Relationship of the Rock Island System RDCK ISLAND CO. STDCR S13B,4D5,BS2 TDN R. R.[a. CHICAGO tkEAS 1INDI5RRCQ EVAN5VILLE&lERRE^I^yTER.RI0 Size of rectangles indicates relative amounts of capital stock outstanding. Cross-hatching shows per cent of capital stock owned by controlling company. already clearly established. Shrinkage in earning power of the actual railway property had proceeded so far by 1914 that a suspension of dividends was necessary. This immediately induced a protracted struggle on the part of the holders of the 154 RAILROADS Railroad collateral trust 4s to gain possession of the underlying security for their bonds, — that is to say, the capital stock of the operating Railway. In so doing they were obliged to con- tend with the owners of the capital stock of the Rock Island Company, — the capstone of the pyramid — whose stock would be wiped out through loss of the Railway. The indenture imder which the collateral trust 4s were issued was far from being a simple document reciting that in the event of default the bondholders should become owners of the Railway stock, to do with it as they pleased. The Rock Island Company pre- ferred shareholders, that is to say those in control of the entire system, demanded an assessment upon all interested parties, including the collateral trust bondholders, in order to rehabili- tate the physical plant. It is evident already that protracted litigation wUl be necessary; and that, even in the event of successful foreclosure, the collateral trust bondholders will receive back a vastly different property from the one which was originally pledged as collateral for their bonds. Impairment of the worth of collateral through manipula- tion of accounts or securities — the second danger to holders of bonds of this tjrpe — followed in the Rock Island system in the wake of the imfortunate purchase of the "Frisco" railway. This particular experiment in collateral trust finance, imlike the Union Pacific experience with the Northern Pacific, turned out badly. The Railroad company had purchased "Frisco" stock to the amount of $28,900,000 in 1902; but inasmuch as the road proved an encumbrance rather than a profitable investment, the shares were resold in 1909 at a loss of approximately $7,000,000. This loss arose through the necessity of retiring about $7,000,000 of the collateral trust bonds based upon the "Frisco" stock, as a condition precedent to the sale. In other words it cost $6,945,000 more than they realized at issue, to buy back enough of these bonds to release the " Frisco " stock. Nor is this the whole story. This loss properly belonged on the shoulders of the preferred stockholders of the Rock Island KINDS OF BONDS 155 Company; inasmuch as they possessed the sole voting power and control of the parent holding corporation and thereby of all the constituent roads in the system. They were responsi- ble for the transaction. But this loss was apparently passed along to the security holders of the operating Railway company, that is to say ultimately to the owners of the Railroad collateral trust 4 per cent, bonds. For the old Railway company — the only physical basis of earnings — was made to sell a block of its own bonds to the public and to advance the proceeds thereof to the Railroad, taking in exchange $7,500,000 of that com- pany's debentures. What marvellous involution! What lifting of one's self by one's bootstraps, — or rather by those of others! The Railroad company thereafter was caused to pay interest to the Railway company on these debenture bonds, from the very dividends received on Railway company stock; and the holders of the Railroad collateral trust 4s had their security, to wit the Railway stock, lessened by the amount of this debenture, which was an unsecured loan. A pretty tangle this to be straightened out in the process of reorganization! And small comfort was there in the priceless possession, according to the balance sheet of the old Railway company for 1913, of $5,447,000 in bonds of the Toledo, St. Louis & Western as a relic of the other ill-advised plunge in Alton.^ The investor's risk in holding collateral trust bonds appears in another case. The Kansas City, Mexico & Orient Railway, a highly speculative venture now in receivership,^ offered at one time $10,000,000 in first mortgage 4 per cent, bonds for sale. These for a time paid interest, but the market for them was merely nominal and at a large discoimt. Therefore, in order to make a more attractive issue, these hitherto unsalable bonds were deposited, together with a choice assortment of stocks of one kmd and another, as collateral for $10,000,000 of "First Mortgage Collateral Trust 5s." In brief, because a 4 per cent, first morgtage bond would not sell, a 5 per cent. 1 P. 531, inSra. ^ P. 16, supra. 156 RAILROADS issue was based upon it with a stronger appeal to speculative buyers from bonuses of El Oro & Rio Grande Development Company stock. If the bonds sold, the Development com- pany 'would begin with a cash working capital of $200,000. No wonder, as the New York Evening Post observed, the "Money Trust" is jealous. The use of collateral trust bonds in making a market for securities is illustrated in another connection by the Railroad Securities Commission of 1910. The state of Texas rigidly limits the capitalization of railroads within its borders. This legislation has in practice rendered it extremely difficult to raise capital for the improvement of Texas roads by direct sale of their securities; for, if already capitalized out of proportion to official valuation, no further issues are permitted. Under such circumstances companies organized in other states, and owning Texas lines in need of capital for efficient operation, make use of a simple collateral device. Instead of issuing Texas railroad securities, they pledge the credit of the parent company and put into a collateral trust any hitherto impledged securities of these Texas roads. Bonds are thus issued under the authority of another state, although the proceeds are to be spent in Texas. One further feature of collateral trust issues as affect- ing financial conditions of the market is important. A large issue of such bonds may so far glut the market that even the strongest companies cannot dispose to advantage of high- grade securities. Thus the Pennsylvania endeavored for several years to sell its Baltimore & Ohio stock, but was prevented therefrom by the flood of collateral trust issues competing for favor, i The convertible bond, so-called, has come into extraordi- nary favor since 1901. The aggregate of live convertible issues now authorized has attained the large sum of almost a billion 1 Testimony of President Rea, Mass. Public Service Commission, September 9, 1913. Also p. 483, infra. KINDS OF BONDS 157 and a half dollars.^ Such a bond, as its name implies, may under a specific contract as to time and ratio be exchanged for capital stock. Securities of this character combiue the double assurance of a first lien on assets at the start, and participation in growing profits, when success of the enterprise has become certain. Such bonds were common in the highly speculative period after the Civil War. The St. Paul 7s of 1873 are a good example. The most widely known convertibles, however, were those of the Erie road. Daniel Drew and "Jim" Fisk used them to good effect in their classic contests with Commo- dore Vanderbilt for control of that property. They were a necessary adjunct to the reckless stock market speculation of the period. The plan was simple. Having quietly secured authorization by stockholders for a large issue of convertible bonds. Drew would create the appearance of a shortage in the supply of outstanding Erie stock. Other speculators having sold short would cover at high prices, Drew supplying them by selling shares which he did not yet possess, but which were borrowed for the purpose. And then, when Vanderbilt who was seeking control of Erie, and all other dealers who were covering their commitments at high prices based upon a cal- culated shortage, had become loaded up with agreements to buy, Drew would convert his bonds into stock, flood the market, break the price and close out all his contracts for delivery at large profits. The scandals of the time so eloquently described by Charles Francis Adams in his Chapters of Erie,^ gave a bad repute to this class of security, which lasted for many years. Revival of interest in convertible bonds seems commonly nowadays to be associated with periods of financial distress. They are not, however, storm signals like short-time note issues, soon to be described. But they are apt to be resorted to at a time when an added fillip to investment in railways seems to be ' Montgomery Rollins, Annals Amer. Acad. Pol. Science, vol. XXXV, 1910, pp. 572-592. His Convertible Securities, 1909, contains details of all issues, conversion tables, etc. * Reprinted in Ripley, Railway Problems, chap I. 158 RAILROADS needed. In the dull period of 1893 several strong companies made use of them. Some of these were really expedients for selling new stock at par for improvements, although the old shares were being quoted at a discount. In other words, the combined security of a bond with a fixed rate of return, and of the speculative chance of added profit upon conversion when the stock rose above par, enabled the company to secure new capital at more favorable rates than it otherwise could have done. The next period of activity in convertible bonds was associ- ated with the great consohdations about 1901. The most notable instance was the $100,000,000 issue of the Union Pacific in order to finance the purchase of the Southern and Northern Pacific. Other important companies hke the Penn- sylvania and the Baltimore & Ohio resorted to the same device in 1902. The prime motive in adding the conversion privilege at this time seems to have been to overcome the prejudice against bonds not secured by a direct hen upon real property, but upon securities of other roads to be purchased with the proceeds. In other words, many of the issues of this period of active consolidation were collateral trust bonds, elsewhere described. As such they needed some privilege, or opportunity for pecuhar profit, in order to dispose of them on favorable terms. Subsequent appearances of convertible bonds on a large scale have been principally associated with the two financial depressions of 1903 and 1907. At both times large companies hke the Atchison and the New Haven have seen fit to add the conversion privilege to their new bonds, in order to make effective appeal to investors. Where weaker roads have been forced to resort to short-time notes, the stronger ones have used convertible bonds. At other times, as in 1905, the issues of bonds of this class by roads hke the Erie, the Pennsylvania, the New Haven and the Atchison, have assumed large propor- tions. There can be httle doubt that bonds of this sort have KINDS OF BONDS 159 steadily risen in general favor in recent years. During the period of high money rates and sluggish investment demand about 1913, practically all the bond issues, railroad or industrial, carried the conversion privilege. There appear to be no less than four substantial reasons for the popularity of the conversion privilege. The most im- portant one is the successful appeal which it makes to the in- vesting public. To assured interest return, it adds a speculative chance of participating in future profits as they accrue. That was the main reason for its extended use in the early days of railway construction. And since 1900, with the active com- petition of industrial and mining securities with railway bonds, it has been foimd by experience that the addition of the right of conversion is necessary to insure a successful flotation. A second factor is found in the nature of the security behind many of these new convertible bonds. The majority of them are either debentures — that is to say, carrying no prior hen on specific assets, but rather a general obhgation of the company as a going concern, — or else collateral trust bonds, based upon the deposit of other securities of controlled roads. The more or less imperfect character of the security in either case renders the conversion right necessary as an offset. In the third place, the reason which made "convertibles" simply invaluable to Daniel Drew in the '70s, is still not without significance. In several notable cases, the control of railways by particular financial interests has been menaced or lost by imexpected operations upon the stock exchange. The Louisville & Nash- ville in 1902 was ruthlessly torn from the Belmonts by a clever ruse incident to the issue of a large amount of new stock. The Illinois Central was hkewise deprived of its long-standing independence despite a substantial concentrated minority con- trol. And the contest for the Northern Pacific, culminating on May 9, 1901, clearly demonstrated the need for ownership of a positive majority of all classes of outstanding share capital, in order to assure control. The final victory of the Morgan- 160 RAILROADS Hill party over Union Pacific interests was determined by its power over retirement of the large issue of preferred stock. Yet the law does not contemplate control of competing lines by actual majority ownership with favor. A device whereby control may be practically assured, as in the Peimsylvania dominance of outljong properties, without an actual majority ownership of shares, is consequently welcome. A large issue of convertible bonds may aid in the solution of such a problem. It constitutes a reserve which may be drawn upon by the existing management in case more stock is needed in an emergency. This feature has undoubtedly in several cases led to the addition of the conversion privilege to new bond issues. The final and most fundamental advantage of convertibility as applied to funded debt — an advantage bound to make it of continuing importance in future — is that it affords oppor- timity for gradually transforming fixed charges into contingent ones. Fimds raised by the sale of ordinary bonds permanently saddle a heavy burden of prior hens upon earnings ahead of the capital stock. These charges must be paid whether earned or not. This was the great lesson enforced by the bankruptcies of 1894. Yet on the other hand, of course, the seciuity is so great that capital may be obtained at low rates of return. This latter advantage would not follow an issue of new stock to finance improvements, particularly in the case of companies whose share capital stands at a premium and whose rate of dividends is high. When the St. Paul in 1906 financed its Pacific coast extension by an issue of new 7 per cent, stock at par, it was virtually paying a higher rate for the capital needed than the new enterprise could possibly earn for some time. As a device for distributing siu-plus earnings of the parent company, it might be most effective. But regarded as a means of financing a new line, it was certainly expensive. The convertible bond seems to answer the purposes of a company thus situated more satisfactorily than either straight KINDS OF BONDS 161 bonds or stocks. For it enables the new capital for the incipient and uncertain stages of the enterprise to be had on a funded- obligation basis. And thereafter, as the earning power of the extension emerges, the fixed charges become transformed into contingent ones, with the progress of conversion of bonds into stock. And this process of conversion is automatic in its action. The plan in short is that of an automatic sinking fund. As profits grow, the price of the capital stock rises, until on passing the price at which exchange may be effected, the profit in conversion leads to the freer exercise of the privilege. The ultimate outcome is a corporation freed of the incubus of a heavy fimded debt, yet with net earnings demonstrably suffi- cient to support its capital stock. The prime instance of the successful apphcation of such methods to a great enterprise is the financing by the Pennsylvania Railroad of its great New York terminals in 1902 and 1905. The expedients of the New York Central in raising funds for similar purposes by means of stock and debentures seem clumsy and expensive by contrast. The great strength of the Union Pacific under the Harriman regime, viz., its low percentage of fixed charges to net earnings despite extensive borrowings for development and speculative purposes, has resulted largely from its success- ful use of convertible bonds as a means of raising new capital. The Norfolk & Western and the Atchison afford yet other examples of successful borrowing of this sort. Certain disadvantages of convertible bonds remain to be mentioned. Common stockholders not infrequently regard them as a violation of their rights. In a sense the convertible bondholder is a shareholder with a preference both as to earn- ings and lien on assets, whose rights are intervened between the ordinary stockholder and his property. The ordinary bondholder is not thus regarded as an intruder, his interest rate being both moderate and fixed. Strenuous protest from shareholders is not imlikely to arise, as in the case of the Atchi- son issue of 1905. Furthermore, it sometimes happens that VOL. II — 11 162 RAILROADS convertible bonds, instead of being automatically eliminated by rising quotations for the stock to the conversion point, may remain outstanding as bonds for a long period and may block the way to further borrowing on favorable terms. And yet, while outstanding as bonds, they may be entitled to all the privileges of the stock. This embarrassment occurred in the Pennsylvania financing of 1909. With large amounts of unconverted bonds outstanding, further needs of the company were met by putting forth new stock, the right to subscribe to it being confined to shareholders. This addition of new stock obviously withheld the shares from rising in price to the conversion point, and still further postponed the time at which the convertible bondholder might with profit exercise his privilege. This difficulty was met by the New Haven in a similar case of about the same date, by extending the privilege of subscription to new shares to stock and convertible bond- holders alike. Unless specifically provided for by contract in advance, however, the convertible bondholder may have his privilege of exchange at a profit indefinitely postponed by such emissions of new capital stock. Contrariwise, the long- continued issue of convertibles, as in the case of the Atchison in 1912, may act as a heavy drag upon the price of the stock. The Union Pacific distribution of profits made in Northern Pacific stock to common shareholders in 1914, with propor- tionate reduction of the dividend rate, was vigorously opposed by convertible bondholders. The drop in price of the stock, without a corresponding reduction in the conversion figure, naturally operated to the bondholders' disadvantage without any offset through participation in favors granted. Yet read- justment of the conversion figure was opposed by the share- holders. In brief, outstanding convertible bonds may give rise to all the conflicts of interest possible as between different classes of shareholders. Still other disadvantages obtain. The convertible bond fluctuates widely in price, often following closely the movement KINDS OF BONDS 163 of the stock quotations. Large profits have been made, and likewise heavy losses, by persons who in reaUty sought invest- ments stable in price. Such bonds are speculatively handled on the exchanges, being often "sold short" just hke stocks. Union Pacific convertible 4s have at times been as unstable in price as the stock itself. Moreover, the operations incident to conversion or redemption may be complicated. Ordinary investors may not understand them. Instances are not want- ing, as in the case of St. Paul bonds of 1893 convertible into preferred stock, not at maturity but within ten days after any dividend date, where many holders failed through ignorance to take advantage of their rights at the proper time. And finally, in some cases the bond convertible into stock at a ratio below par may be open to all the disadvantages of the issue of shares at a discount. Thus in 1903, and again two years later, the Erie road issued bonds to finance the purchase of the Cincinnati, Hamilton & Dayton road (afterward abrogated) and for purposes of improvement, convertible within ten years into common stock at $50 and $60 per share respectively. The low market price of the stock at the time did not indicate much hope of exercise of the privilege; but if it ever occurs, it will in effect violate the general prohibition by New York state of the issue of capital stock below par. A special act of the legislature rushed through in the closing days of a preceding session had amended the law by permitting conversion of bonds to take place, "at not less than the market value." The danger of a resort to expedients for watering stock is too apparent to need further comment. In practically all other cases, the privilege of conversion is fixed at par or above, sometimes as in the case of the Delaware & Hudson 4s, at as high a figure as 200.' In conclusion, it goes almost without • Cj. Erie convertible 5s of 1912, exchangeable for stock at 66f. 1 P. S. C, N. Y., 2nd D., (1912), 238. In Massachusetts the Supreme Court has forbidden the issue of bonds convertible into stock years in advance, on the ground that it constitutes an evasion of the Anti-Stock Watering law. C/. p. 276, injra. 164 RAILROADS saying, that an increase of capital stock must always be author- ized in connection with an issue of convertible bonds, sufficient in amount to cover the requisite number of new shares after the exchange of bonds for stock has been effected. A peculiar modification of a bond, in order to give it a specu- latively attractive character, occurred in the case of the Oregon Short Line Participating Bonds of 1904. These securities, to the amount of $36,500,000, were based upon a deposit by the Union Pacific interests of their holdings of Northern Securities stock. In other words, they were not ordinary but merely collateral trust bonds; and the participating clause was added in order to overcome this disability and assm-e their successful flotation. In addition to a guaranteed 4 per cent., these bonds were to receive annually a supplementary interest equal to whatever dividend in excess of 4 per cent, might be declared upon the Northern Securities stock which imderlay them. A pecuhar comphcation arose in this connection. Dividends upon Northern Securities stock, being held back by litigation, threatened to pour forth in mass upon its termination, while in the meantime the regular 4 per cent, had to be paid from other sources. Were the participating bonds to share in all ex- cess dividends above 4 per cent., when all these back dividends appeared at once, what an amazing bonanza they would have been.^ A provision for retirement at 102§ pointed the way of escape. It enabled the company to release the underlying collateral, upon the issuance of the decree of the Supreme Court dissolving the Northern Securities Company. This was effected in 1905. Incidentally this episode emphasizes the need of including the right of retirement at a fixed price among the other stipulations of a bond issue. Short-time borrowing by railways may be for several pur- poses, quite different in character and significance. Notes may be issued merely in order to anticipate assured income, as ' P. 506, infra. SHORT TERM LOANS 165 is done frequently by cities or towns in order to cover current expenses until receipts from taxes suffice. Such financing is purely normal and requires no comment. Or notes may be emitted under financial stress by companies struggling on the verge of bankruptcy. In this case the episode is abnormal and usually merely postpones the evil day of reckoning. A third cause of short-time borrowing has within recent years assumed such proportions as to demand careful examination. Such borrowing for short periods of time threatens to disturb the general money market as well as the supply of long- term bonds. In the past it has commonly been associated with periods of financial disturbance, arising naturally of course in a tight money market when ordinary bonds are imsalable at any fair price. Every crisis since 1878, with the exception of the distinctively railway panic of 1884, has witnessed this phenomenon. But it has steadily as- sumed larger and larger proportions; and seems to be less critically regarded than heretofore. This is probably due to the fact that it is now resorted to by the strongest and most conservative railways; whereas it was formerly only a device for staving off impending bankruptcy by railways of the weaker sort. As a device for merely postponing trouble, note issues are in bad repute. The Jay Cooke flotation of Northern Pacific notes just prior to the financial collapse in 1872 was almost identically repeated twenty years later on the eve of the panic of 1893.^ The floating debts of important railways ran up by $124,000,000 at this time. The most prominent examples were the Union Pacific collateral trust notes of 1891-'94, and those of the Northern Pacific and the Atchison.^ In all three cases, the notes falling due in a panic period precipitated bankruptcy. But the subsequent resort to note issues at the two periods of financial distress of 1903 and 1907 have been due to entirely ' Oberholtzer, Jay Cooke, II, p. 93, and chap. XII, infra. ■ ' Daggett, Railroad Reorganization, pp. 199, 237, 287. 166 RAILROADS different causes. They represent forced borrowing, of course; for it is inconceivable that any company should pay high rates of interest for short loans, if regular bonds could be sold. But the significant feature was that they sometimes represented true development work rather than impending bankruptcy. No longer negatively palhative in character, they became, instead, positive and constructive. In point of fact, note issues have been utihzed of late for almost every conceivable purpose for which long-time bonds used formerly to be emitted. They may serve to finance consolidations; to procure funds in connection with financial reorganization, as on the Interna- tional & Great Northern; and to effect segregation, as by the Maine Central when it bought back itself from the Boston & Mame m 1914.i The particular cause of the appearance of note issues in these years was the imperative need of providing facilities for handling an enormous growth of traffic. The freight block- ade of 1899 was mainly due to insufficiency of equipment to handle the business offered. The trouble in 1903 under similar traffic pressure was inadequacy of terminals.^ Many large companies, notably the Pennsylvania, had in consequence committed themselves to large projects of terminal develop- ment. These commonly proved more costly than was antici- pated; and, moreover, the panic of 1903 caught them imawares, midway in construction. The work could not be interrupted, even temporarily, without heavy loss upon all investments already made. It was imperative to go on at all cost. Bonds could not be floated at any price. Notes were a last resource. It should be added, however, that other causes also contributed to the financial pressure. While the Pennsylvania was making extensive improvements at New York, it was also, in con- jimction with the New York Central, engaged in wholesale purchase of the stocks of the anthracite and other secondary trunk lines, in order to steady both the hard coal and the 1 P. 147, supra and 170, infra. ^ P. 184, infra. SHORT TERM LOANS 167 general rate situation.' In other words, progress towards combination was already under full headway. The growth of borrowing on short-time notes in recent years is highly significant. It was estimated that approxi- mately $136,000,000 of such securities were issued in 1903-04 in connection with the "rich men's panic." With the next financial reaction, three years later, such loans aggregated about three hundred milHon dollars, most of them made within the first five months of 1907. Ordinary bonds dmring this time amoimted to less than two-thirds of this sum. The Penn- sylvania Railroad alone thus borrowed $60,000,000. A brief respite then ensued; but in 1912 approximately $500,000,000 in corporation short-time notes of all kinds were outstanding, over half of these representing specific public issues by rail- roads. The larger part of these obligations, estimated at $567,000,000, fall due during 1914, one trunk line alone having to meet maturing obHgations of upwards of $100,000,000. A rough indication of the growth of such borrowing is afforded by the official Federal statistics. Within six years, plain bonds debentures and notes doubled in amount, reaching a total of $1,107,000,000 in 1913. The immediate outlook for abate- ment of , this stop-gap financing by means of long-time bonds is doubtful, depending upon a resumption of general trade activity. The course of events depends, moreover, upon the general movement of rates for money. In 1903-'04 the short- term notes yielded about 4.5 to 5 per cent. Three years later the rate of interest ranged between 5 and 6 per cent., some roads like the Erie being forced to pay as high as 8 for accom- modation. A more normal use of credit resources through the issue of long-time bonds, even at relatively high rates, becomes well-nigh imperative under such circumstances. Continued temporizing with the money market by companies with sufficient credit to be able to issue bonds at all, would seem to be imwise. 1 Pp. 150, supra and 480, infra.^ 168 RAILROADS Exhaustion of the regular supply of loanable capital, not so much for the purpose of financing stock market operations incident to the spread of consolidation as because of even more general causes, has been responsible for the continuation 'of the second wave of note issues, which dates in the main from the panic of 1907. The perfection of credit machinery, coupled with the flow of funds to New York as a borrowing centre, had during the preceding period demonstrated the ease with which temporary suppUes of capital could be had on short notice. In other words, the growth of the borrowing habit was encouraged by the ease of indulging in it. But in addition, it is indubitable that many temporary loans in recent years have been made by strong companies in order to protect the market prices of some of their older bond issues. Most stand- ard roads had many outstanding bonds of imquestioned security, issued at much lower rates of interest than have of late pre- vailed. The managements naturally felt great disinclination toward entering new securities of the same class at higher rates into competition with the older bonds. The effect could not be other than to depreciate their market price. They preferred to resort to temporary financing even at considerable expense, hoping for a change of wind. And then, moreover, they hesitated to commit themselves to long-time issues at the prevailing high interest rates, hoping continually, by coquet- ting with the money market for a time, for a decline in the current rates for funds. These short-time notes may be secured by the deposit of collateral or, as in the case of the Pennsylvania, they may rest solely upon the credit and reputation of the company. Under such circmnstances they would rank as an investment intermediate between income bonds and preferred shares as a hen upon current earnings. It goes without saying, also, that the value of the notes depends largely upon the purpose for which the money is borrowed. If the funds are to be spent upon improvements to produce increased revenue, the SHORT TERM LOANS 169 situation is quite different from that of putting forth notes merely to refund maturing issues, the proceeds of which have been long since spent, possibly for more or less dubi- ous purposes. Such was the pitiable situation in 1913-'14 when almost one hundred milUon dollars of short-term notes of the shattered New Haven system called for re- newal. As for the outcome of these large note issues, it is unfor- tunate, perhaps, that in the beginning it was successful. In other words, the notes were mainly paid off without inconven- ience from the proceeds of regular bond issues after the lapse of from one to three years. Even some of the issues of 1907 were actually bought up by the companies themselves in advance of maturity. Surplus funds drawing 2 per cent, interest could profitably be devoted to this purpose. The fact, however, that in most cases these first notes happened to fall due at times when the needs of the companies could be permanently cared for, does not detract from the possible danger lurking in their use. As events soon demonstrated, notes chancing to mature at an inconvenient time, the situation easily became desperate, and this, too, quite apart from the excessive cost of such hand- to-mouth finance in any event. The first road to learn this lesson was the Erie, which was barely saved from default and another bankruptcy by the intervention at the last moment of E. H. Harriman, when its notes fell due in 1908. Within a few years the WheeHng & Lake Erie and the "Frisco" went into bankruptcy, not, perhaps, because of, but certainly on the occa- sion of, the maturity of short-time notes. The latter, for example, thus borrowed $6,000,000 m 1911, $9,000,000 in 1912 and $10,000,000 in 1913. But the clearest demonstration of the danger of excessive resort to note issues occurred in connec- tion with the collapse of the New England roads in 1913-14. Both the New Haven and the Boston & Maine had come to make use of these once temporary expedients for routine purposes of finance. The difficulties of the former in renewing its obliga- 170 RAILROADS tions are described in detail elsewhere.* As for the Boston & Maine, its short-term notes maturing in 1914 aggregated $27,- 000,000, the larger part issued on a 7| per cent, basis. Of this total not less than $20,000,000 of notes covered the purchase of stocks in subsidiary companies. The resulting interest charges were in many cases much greater than the income from the new investment. The least defensible transaction was the issue of short-term notes in order to take up a proportion of new stock of the Maine Central in excess of the number required for continued control. Over and above the necessary quota of new stock issues of this subsidiary, 33,300 shares actually cost the parent company in short-term notes about $110. This was apparently done in order to make a market on which the outside public purchased the remaining 42,000 shares for par. Aside from the above-mentioned danger, financing through the issue of short-term notes is necessarily most expensive. The issues, of course, always have to be underwritten; and the at- tendant banker's commissions, especially in cases where the issues are renewed time after time, reach a formidable total. And, in addition, the cost is greatly increased whenever such notes are issued at a discount, because, obviously, this dis- count has to be taken up on the early maturity of the notes. The prevalent policy of temporizing with the money market, even at such expense, may be either far-sighted or short-sighted according to whether the prevailing financial conditions are temporary or permanent. But the repetition of bankers' com- missions at short intervals usually makes such financing cost more than if, as the President of the Pennsylvania, puts it, "you take your medicine at the start." From a yet wider point of view, the seriousness of the recenti tendency to resort to short-term financing is that it accentuates the condition of affairs which it seeks to remedy. By with- drawing from trade the floating supply of capital, extensive note issues by railroads compel merchants to draw upon the ' P. 276, infra. SHORT TERM LOANS 171 available long-time investment funds of the community for the daily needs of business. In other words, extensive note issues discourage, if they do not preclude, ordinary borrowing by means of long-time bonds. The appeal is usually to the large sources of ready capital. Until the reform of the New York life insurance companies, they invested heavily in such notes. Short-time notes are commonly in large denominations for the convenience of such lenders. Frequently, too, the notes used to be secured by deposit of collateral, ordinarily free holdings of stocks or bonds of subsidiary companies. But many in re- cent years are issued upon the mere credit of the company, being otherwise unsecured. Many are thus rendered semi-speculative in character. This naturally leads to wide fluctuations in value. It is sometimes difficult to separate such liabilities from the ordinary funded debt. They should always, naturally, be re- garded as current liabilities, of the nature of floating debt. But in 1910, leading companies like the Erie and the Baltimore & Ohio failed to so designate them. This is a most deceptive practice. On the whole, viewing the developments of the last decade, one is almost tempted to hope that a few more sharp lessons may serve to remind railway financiers of the risks incident to the growth of this short-note habit. Car trust certificates or equipment bonds are highly special- ized liens upon particular items of railway property. ' A com- pany having mortgaged all of its tangible assets, and being unable to issue new capital stock, is in dire need of new cars and engines. The relative economy of issuing equipment trust notes on the one hand or of paying large sums for car hire on the other, depends upon the state of the money market and the credit of the company. The Wabash and the Boston & Maine about 1912-'13 afford good examples of the wastefulness in ' Chamberlain, Principles of Bond Investment, 1912, p. 292, is par- ticularly good on this. Cf. also Cleveland and Powell, op. cit., pp. 81-94; and Cmi. & Fin. Chron., vol. LVI, p. 181; vol. LXXXII, p. 1296. 172 RAILROADS operation of the needy road. The Wabash was expending over one million dollars yearly for car hire, which could have been saved twice over, could the necessary funds have been borrowed at 6 per cent, for the purchase of equipment. ^ But this course is not always open. There are practical as well as legal objec- tions to direct loans based upon the acquired rolling stock as collateral. A roundabout plan is in use, which practically amounts to borrowing the equipment, instead of the money; and pajdng for it gradually as surplus revenues permit. An independent syndicate is formed, which purchases the desired rolling stock, — ^as ui 1903 on the Pennsylvania system some thirteen thousand freight cars. Or it may be that one of the great railway equipment companies enters into the agreement. The cars are then leased to the railway for a short term of years, under an agreement providing for interest and gradual payment of principal. Only upon the final payment does actual title to the property become vested in the railway.^ In the meantime, it would appear to have no equity in the property. The lease thus made is then assigned to a trustee, and "car trust certif- icates" are issued and sold to investors. The requisite interest upon these bonds, of course, are derived from the rentals paid to the trustee by the railway company under the terms of the agreement. This cumbersome process seems to be an out- growth of the inelastic character of the mortgage bonds of the railway already outstanding. The deed of trust itself is a highly complicated instrument, providing for repairs, mainte- nance and replacement of the property, and its final delivery at maturity. Bitter experience of former years, as upon the Erie in the '70s where car-trust certificates at maturity found the rolling stock completely worn out have compelled the most elaborate safeguards against fraud. Recently the process seems to have been simplified somewhat by the abandonment of 1 Cf. Railway Age Gazette, vol. LVI, p. 668, contrasting different roads; and idem,, vol. LV, p. 1596. * Cf. Com. ^ -^ y^ Comparison of Increstses in Capital Investment and Trttffic, 1900 to 1913 Inclusive % 1900 1901 1902 1903 1904 I90S 1306 1907 1900 1909 1910 1911 1912 i9l3 6.50 500 ~- Ratio of Net Operating Income to Property Investment fixed charges will soon be discussed. The effect upon market quotations of the above-named operating tendencies was natu- rally at once direct and great. PRICES OF STOCKS 183 The second factor which contributed to the fall of market prices, according to our foregoing list, was a marked increase in the outstanding issues of securities, and particularly of bonds, within the preceding decade, i Many roads augmented their capitalization in undue proportion to their growth of assets. Others, even more imprudent, permitted their capitalization to outrun greatly the increase of earnings. Matters of this sort are fully described in our chapter on over-capitaUzation.^ Market quotations progressively and inevitably declined be- cause of doubt, too frequently confirmed, as to the ability of the roads to mauitain their dividends. Yet such companies were probably the exception. The larger number were undoubt- edly compelled within the period under consideration to put forth large issues of stocks and bonds for purposes of improve- ment. Double and even four tracking; steel in place of wooden structures; heavier rails and larger rolling stock; and, espe- cially, much more ample terminal facilities; — all of these neces- sitated large expenditures. And wherever such new capital was obtained through extensive issues of shares at par or below the market price, the effect was also to reduce proportionately the market quotations. The value of rights, in other words, came off the price.* On roads like the Great Northern or the Lackawanna such deductions were very great. The relativity between earnings, income and security prices was thus seriously disturbed. Certainly an important reason for the retardation of market prices behind the advance of net earnings was for a time the somewhat inordinate increase in merely nominal capitahzation. Almost every financial operation tended towards additional security issues. Pure stock dividends following long-continued reinvestment of surplus earnings in the property, or even offered without such warrant; additional subscriptions of new capital in order to increase facihties — nearly all of these operations used to offer a bonus to stock- 1 C/. pp. 63 and 108, swpra. ' Chapter VII, suTpra. > P. 270, suwa- 184 RAILROADS holders or bond syndicates in some form or another. There were liberal "commissions" or stockholders' "rights" in order to encourage participation. And the result was that net earn- ings were to some degree distributed over a wider base than before. Were this not so, the market prices of many roads would imquestionably be far higher than they are today. Whether the new capital for expansion or improvement could have been obtained without such substantial encouragement must remain largely a matter of opinion. Similar "plums" by industrial combinations certainly tempted new capital away from railwaj-^s. And such competition, of course, had to be counteracted in some way. On the other hand, for roads like the Pennsylvania the gradual process of completer utiliza- tion of plant, built to accommodate years of growth ahead, has greatly lessened the force of whatever criticism these com- ments may seem to imply. The third cause of declining market quotations following 1909 was the large expenditures which were necessary, proba- bly never in themselves to be directly productive of revenue. This was peculiarly true in the more densely settled districts of the North and East. The growth of population had brought an irresistible demand for abolition of grade crossings, not only in cities but all along the right of way. Larger and better stations and expensive terminal facilities, while adding to the value of service rendered, would never yield proportionate returns in revenue. Many of these expenditures were for passenger service.' The Pennsylvania station in New York City cost $114,000,000 and the New York Central termmal over $80,000,000. And then from all over the United States came increasing demands for safer service. Block and signal systems, boiler inspection laws, full-crew train laws, safety appliance acts, air breaks and limited hours for service; all of these improvements, although entirely proper, added relatively little to revenue capacity. Nor were they ever expected to add > 31 I. C. C. Rep., 387. PRICES OF STOCKS 185 to it directly. Nevertheless, the funded capital investment which they entailed became an immediate charge upon earnings and took priority over the capital stock. It was inevitable that any growth in this form of expenditures should operate to retard the rise of quotations. A statement of President McCrea of the Pennsylvania in the freight rate hearings was highly significant. He reported an outlay of $108,000,000 on the New York ter- minals, for a large part of which no additional return whatever could reasonably be expected. Prestige and strategical position undoubtedly count for much; but, on the other hand, an im- provement in public service for which the public in general may well congratulate itself, followed as a matter of course. Yet such enormous outlay at once and directly affected the quota- tions for railroad stocks and bonds. Liberal outlays were also required about this time, not only for public purposes quite unproductive of revenue but also in order to lay a secure foundation for the traffic of future years. Such expenditure differs from the preceding sort, in that while both may be for the moment unproductive, this latter class is intended ultimately to bring ^about a profitable use. All over the United States a point seemed to be reached a few years ago when the physical plant suddenly became outgrown.i Single-track lines were swamped with traffic. Terminals became congested beyond endurance. Great addi- tions were made, in some cases sufficient to care for growth for many years ahead; grades were reduced, curves straightened, bridges rebuilt and relocated and yards enlarged. Sometimes these additions were paid for by outside subscriptions of capital, sometimes by reinvestment of surplus earnings; but in either case the new increment of capital could not in the nature of things be utilized to its full capacity, — that is to say, made to yield immediately a normal rate of return in and of itself. The result was an apparent "watering" of capitalization. But moderately increased revenues had to be distributed ' Railroads: Rates and Regulation, pp. 62, 80, 548. 186 RAILROADS over a much wider capital base than before. Only gradually, as the growth of traflBlc "took up the slack" of the new capital investment, would this apparent "watering" disappear. The present status of the Pennsylvania company perfectly illus- trates this point. Having now largely completed additions and improvements adequate for the needs of years to come, its securities might with some confidence be expected to appreciate in value, even more than commensurate with the growth of traffic or earnings from year to year. The present market price of its stock is not low because it has been unduly watered, but because it has to bear for a time a disproportionate burden of capital cost incurred to meet the need of future years. The fifth factor partially accountable for the disheartening movement of market prices after 1906, was the competition of other forms of investment. There can be no doubt that the great and successful industrial combinations drew heavily upon the available supplies of capital. This tendency was particularly potent after the panic of 1903. In this connec- tion the divergence between the courses of the two index number curves of late, already commented upon, is significant. The closing up of the gap between the price indices of railways and industrials within the last five years was due to the relatively greater rise for industrial securities. Their steadily expanding earnings, after the weak ones had been eliminated; their immunity from price regulation by governmental authority; and the adoption of policies of financial publicity alike con- tributed to bring them into high favor. Moreover, the wonder- ful expansion of the world's consumption of metals necessitated great promotion of mining ventures. There is only about so much new capital available year by year for purposes of in- vestment. And every share of the United States Steel Corpora- tion, of American Tobacco or Sugar or of the Amalgamated Copper Company became a competitor with the securities of the railways. The potency of such competition cannot be doubted. PRICES OF STOCKS 187 An element finally to be reckoned with, in analyzing the general movement of security prices, is the possibility of a change in the general rate of return upon all capital investment. Any increase in the normal interest rate would necessarily bring down market quotations to a corresponding degree, even in the face of a constancy in the rate of net earning power. This intimate relation of the money market to prices was well exemplified in the fall of 1906 and the ensuing spring. Money was very "tight." First of all, this brought down the quota- tions for all classes of bonds; long-term securities were entirely imsalable at fair prices. The railways were compelled to issue notes at prices to yield nearly 6 per cent. This, in turn, induced the holders of stocks j^elding less than this rate at going prices, to sell them down to an equilibrium. The drastic decline of the first quarter of 1907 was largely due to this cause. Imagine such a process, operating in either direction, to become chronic instead of acute; and permanent changes in price level must inevitably follow. The latest coup to the money market was given by the outbreak of the European wars in the summer of 1914. It is too early to venture prediction as to the ultimate outcome; but for a time, certainly, the exhaustion of capital must make for much higher rates for money. Competition of the available supply the world over will be severe. This far- reaching influence may far outweigh in importance the serious although temporary embarrassment to the railroads which arose from the interruption of our agricultural exports to Europe. Attention is drawn by the foregoing diagrams of security prices to an important matter. Can there be any question, after perusal of these charts, that the secondary waves of price, as distinct from the great tidal sweeps, are more marked of late than they used to be? Are not the crests and hollows since 1898 more pronoimced than they were prior to 1893? Shall we be content with the reply that inasmuch as the tidal depth is increased, the surface waves may properly be greater? A range of twenty units on our scale sufficed to define a "wave" 188 RAILROADS in the earlier period. This was between one-third and one- quarter of the general elevation of the index number. Now- adays between crest and hollow forty units range is not unusual. This, to be sure, is still not far from one-third of the now substantially raised general level. But does that explanation suffice? One inevitably correlates this phenomenon with the great movements toward consolidation in operation and concentration of control. This movement embraces, not railways and industrials alone; it comprehends within its sweep all manner of financial agencies. Banks and trust companies, especially in New York, are arrayed in great groups, with a resultant unprecedented power of domination. The great insurance companies, happily enough, have now been in a measure forced to stand somewhat apart. But all other agencies of importance in the game of organized speculation now co-operate to a common end as they never did before. And it is, of course, almost too well recognized to warrant mention that speculation creates or exaggerates — because it lives upon change — all of the normal fluctuations of prices determined from year to year by the weather, by politics or the fortuitous course of events. Another matter, too technical to be fully treated at this time but worth a passing comment, is the relation in time between changes of prices for railway securities and other commercial or industrial events. The stock market is very properly described as a barometer of trade conditions. It is its function to forecast the future. It is rarely concerned with happenings of the day, except they be sudden disaster. And, even then, it proceeds at once to consideration, not of present status but of future effects. What then is the relation between the course of railway earnings and of the securities dependent upon them for returns? The answer may, of course, confidently follow that the security fluctuations regularly antedate the course of earnings. This is as it should be. It was well exemplified in the panic of 1903. Throughout most PRICES OF STOCKS 189 of that year security prices were crumbling away and had actually begun to recover, according to our chart, before net earnings fell off. It was not in fact until January, 1904, that this occiu-red. Gross earnings sometimes respond more quickly, owing to the ease with which expenditures may be postponed. But net earnings at this time were certainly very slow to respond to changes in general business. And much the same thing seems to have happened four years later, although the collapse was, if anything, more sudden. And then again, how about the course of railway earnings in relation to other commercial results of panic, such as changes in the volume of general business, the proportion of unemployment of labor, and more important still, the ups and downs of prices and of the cost of living? Is it indeed true, as has been confidently affirmed of Germany in 1900, "that the railroads are last to show the effects of depression and the first to recover"? On the other hand, labor was the first to feel the depression and capital was the last to recover. If this be true of the United States as well, it has large importance for the owners of railway property. For it gives assurance of a stability of returns greater than that probable upon any other form of investment. A most interesting and repaying vein of statistical research is un- covered by these queries, extending over into fields hitherto not at all worked. There yet remains for the briefest mention the speculative ripples upon the surface of the markets. These are for the most part seasonal, corresponding to the regular routine of crops, of the exigencies of banking and of general trade. At- tentive consideration over a period of many years reveals what may be called a normal cycle. But the exceptions are so fre- quent, especially since 1910, that no confident prediction is ever possible. Speculative campaigns "for the rise," so-called, are usually favored by the periods of easy money in late winter and very early fall. June and January "rises" are traditional, but are of course, when they occur, the periods during which 190 RAILROADS professional speculators expect to dispose of their holdings, accumulated during the preceding dull months of easy money. Not infrequently also, plans are laid for uplifted prices, based upon advance crop news, in August or early September. Such an advance enables the professional manipulator to dispose of any stocks on hand. He then prepares to buy again at such lower prices as are apt to prevail during the crop-moving period when "money is tight," public speculation lags, and Congress and the state legislatures convene. But all of these fluctua- tions have httle to teach in a large way. The cycle is as apt to occur in the hollow of a great wave, as upon its crest. Such matters must be of daily importance to the banking community or the stock broker, but have little significance for the student of transportation in any large way. The movement of prices for railway bonds ^ is subject to many influences similar to those which play upon stocks; but, nevertheless, many entirely different factors enter into con- sideration. How different the course of bond prices has been is evidenced by the accompanying chart,^ covering the period since 1890. Disregarding the abrupt fluctuations of the 1 Statistical data on the movement of bond prices are given by W. C. Mitchell in the Journal of Political Economy, vol. XIX, 1911, p. 272; and vol. XXI, 1913, p. 510; N. Y. Times Annalist, May 19 and 26, 1913, with charts since 1870; and file of the Wall Street Journal. Chamberlain, The Principles of Bond Investment, p. 473, has charted the movement for 1856-1911. ^ Thirty-five railways and five express and allied companies, all afford- ing continuous records since 1890, are comprehended in the series. Roads Uke the BurUngton, Lake Shore and even the Rock Island are omitted because of change of financial status within the period. Moreover, the hst excludes preferred shares in the main as being less sensitive to changes of sentiment or conditions. In this regard the index differs widely from our former series. In short, this is really a more scientific selection than that of the Wall Street Journal. It is probably more reliable than any other evidence to be had. The index numbers for commodities are the well-known ones of the United States Bureau of Labor, slightly modified for purposes of precision. For both securities and general prices, the average for the decade 1890-'99 is taken as 100; and the arithmetical mean for each year is based thereon. Professor Mitchell has periodically published the data in the Journal of Political Economy. BOND PRICES 191 panics in 1903-'07, a slow and silent retreat in bond prices took place until the Balkan War in the fall of 1912. From that time imtil the close of 1913 a more marked decline ensued, carrying the low point even beneath that of the depression of 1907. Evidence was not wantmg of a recovery during 1914 which promised, had not the European wars occmred, to restore more normal conditions. All m all, a species of slow ^nn 260 240 ZZD 200 180 160 140 ISO 100 80 60 40 20 — RELATIVE PRICES Of RAILROAD STOCKS BOM08 AND COMMODITIES * , \ 269 240 220 200 180 160 140 120 m. 80 60 40 20 / \ 1 =£ 1 '*•* ■~-, •4 1 J i \ / \ 1 f \ 1/ '» 5S I rn i 1 0/ \^it /e >d ,( i< c s • o / \ : / % u. /^ ^ _^ '*^ / ~ N- ,' - \ <'^ \ / y 'A ^s -= 1f^ in •^ .^ -S 'v -•i ='• 'i ,ti ((>> > IV 1 cj \ AI m H ,C Ml L, EL! 18 io ■8 i 19 00 •0 5 IS 10 '1 5 panic in this field of conservative investment well deserves careful examination. The primary influence affecting the market quotations for bonds is the value of money. This is the principal factor which differentiates the course of bond prices from those of stocks, assimiing that the factor of security, or, in other words, of risk is elimmated. As money becomes tighter and capital more diflScult to obtain, new funds for corporate purposes may be had only at higher rates of interest. In consequence, the price of already outstanding securities tends to decline to a 192 RAILROADS point where the same yield is afforded as upon current issues. Higher rates of interest in general mean declining bond prices and vice versa. During the period under consideration, changes in the value of money operated cmnulatively in two distinct ways. There was first to be considered the phenomenal rise in commodity prices in general. This followed the notable upward trend indicated upon the diagram. (P. 191.) Perhaps the most striking feature of this graph is the manner in which the upward movement of prices has coincided with the down- ward course of bonds. It is evident that in general such a rise of commodity prices must greatly curtail the volume of savings of the people concerned. Surplus income available for investment must steadily dwindle; unless, as almost never happens, salaries and wages rise pari passu with the increase in the cost of living. Bonds represent the investment of these surplus funds; so that any reduction in ability to save, must find reflection in a lessened demand for securities. But the effect of the rise of commodity prices has operated even more particularly to bring about this result in recent years. Changes in general commodity prices have been most unevenly distrib- uted, especially as between raw materials and manufactured goods. Agricultural products, with pressure of population upon the earth's surface, have risen phenomenally; while industrial progress has tended to retard the upward movement in the price of manufactured goods. This has enabled many of the less highly developed nations to absorb an undue pro- portion of the world's output of gold. Many of these outlying countries have thus withdrawn gold in large amounts from Europe. It has been estimated that more than half of the gold mined since 1906 has been taken in this way. The result- ant increase in the value of gold in European countries particu- larly, has led to heavy withdrawals of investment from the United States. It seems to be the cmnulative effect of such general and particular changes in the value of money which lies at the root of the decline in bond prices. BOND PRICES 193 A change in the value of money is the only factor which causes the market quotations for bonds to move in a distinctly different way from that for stocks. The remaining influences are common to both groups of securities in large measure. Nevertheless, sufiicient contrast obtains in certam details to make it worth while to review the situation. So far as the effect of a rise in prices upon wage increases and enhanced cost of operation for railroads are concerned, stocks suffered as well as bonds from steadily declining net revenues. Certain conditions appear, however, as a result of the keen competition for capital in the investor's field, giving rise in fact to the econo- mic phenomena of non-competing groups. Given a certain vol- ume of surplus income awaiting investment, business extension which is apt to follow in the train of rising prices, naturally withdraws a considerable volimie of this capital from possible investment in bonds. Even more particularly, the growth of great industrial combinations since 1900 has injected a large aggregate of industrial bonds and preferred stocks of the so- called trusts which make an effective appeal to conservative investors. Great public works, such as the Panama Canal and the enlarged Erie waterway, together with the growth of expensive armaments and general govenimental extravagance, all serve to lower the capital available for the purchase of rail- road bonds. The United States has also been seriously affected in recent years by heavy withdrawals of European capital. Much liquidation of foreign-held American bonds took place, particularly on the outbreak of the Balkan War midway of 1912 and of the European wars two years later. This con- siderable movement, which threw upon our markets large quantities of railroad bonds, was due to the higher rate of interest which European investors could obtain on investments, governmental or other, at home. It was this same competition from favorite home securities which brought about the sur- prising decline in the older government bonds abroad. Most of these last-mentioned circumstances, it will be observed, VOL. n — 13 194 RAILROADS were far more potent in their effect upon bond prices than upon those of stocks. The result, in brief, was that by the end of 1913 the old standard 4 per cent, general mortgage railroad bond had been practically superseded by new issues which could not be floated for less than 4| per cent, or even more."^ Finally, almost utter stagnation in investment demand, quite apart from the preceding influences, must be held accoimt- able for the downward trend of the prices of both railroad stocks and bonds. It is the conservative investor interested in bonds who has been perhaps most influenced by agitation over government ownership of the telephone and railroads; over the active programme of Federal prosecution of industrial combinations; and such other manifestations of public hos- tility to big business as have made their appearance within the last few years. The objection to the payment even of banker's commissions on bond issues is yet another manifestation of this public spirit. The stagnation in investment demand has peculiarly affected the bond market in yet another way. The savings banks and life insurance companies used to be promi- nent buyers of securities. Savings banks, where strictly supervised as in Massachusetts and New York, are debarred by law from investing in any bonds of doubtful security; and the luifortimate collapse of several large railroads, formerly highly esteemed for investment purposes, has tended to elimi- nate savings banks in part from among the ready purchasers of securities of this class. An appreciable increase in purchase of government bonds has been accompanied by a positive decline in the holdings of railroad bonds and notes. As for the life insurance companies, they, too, since the New York in- vestigation of 1905, have absorbed very much smaller propor- tions of railroad securities than formerly; and are actually 1 For the passing of the 4 per cent, bond in the American market, consult Osborne, Speculation, etc., Columbia University Studies, vol. LVI, 1913, p. 58. BOND PRICES 195 under orders to dispose of all of their holdings of railroad stocks within a short term of years. The lessened demand from insurance companies in the investment market is also due to the growing habit of borrowing by policy holders on the security of their insurance policies. Higher cost of living coupled with greater improvidence, has reduced the surplus for outside investment by the life insurance companies themselves. Such purchases by life insurance companies used to be particularly serviceable in steadying the market during times of depression; for panic periods with bargain prices were harvest times for all piu-chasers possessed of ready cash. Such were the life insur- ance companies, by virtue of the fact that their income from premiums, being based upon the fixed laws of mortality, moved with a deliberation and regularity not found in other lines of business. The reduction in this life insurance demand has without doubt contributed appreciably to the general decline in market quotations. The special plea made by the railroads of the country to President Wilson in the fall of 1914 on behalf of their reopened case for advanced rates, stated that over five himdred million dollars of railroad securities would mature within a year. The problem of renewing these obligations in the face of prevailing bond conditions was one certainly calcu- lated to cause apprehension enough in any event. The almost certain effect of the European wars in increasing the interest rate on capital, because of the great waste of fixed assets, seems bound to add to the difficulty. Comparison between the course of prices for different classes of railroad securities and the movement of commodity prices is afforded by the diagram on p. 191. It is significant in the light of the foregoing discussion of fundamental economic influences at work. The upper curve for forty common stocks of railroads, in soaring so far above the others since 1900, represents the equities, real or speculative, which the prosperity of these years produced. The far greater enhancement of prices than for the ten dividend-paying stocks was due to the 196 RAILROADS hopes and promises of many of the inherently speculative securities. The subsequent decline on the appearance of adversity is of course equally marked. In the meantime the standard dividend payers progressed far more soberly and in consequence were less notably depressed by the later dis- couraging tendencies. And then, too, the contrary movement BOND PRICES 197 of commodity and railroad bond prices, already discussed, is thrown into relief. For, as we have already seen, while com- modity prices have moved strongly upward, bond quotations for a decade to 1914 moved in the opposite direction.' A significant side-light upon the course of security prices is afforded by international comparisons. The marked variety of experience in different countries affords the basic support for the principle of a wide distribution of investment in order to scatter risks.^ The accompanying diagrams for chosen securities in four leading countries emphasize this point. It will be noted that the trend in the United States has been strongly upward; in Germany the enhancement of prices has been less marked, with a notable depression in 1901 apparent nowhere else except in France. The French price movement for railways has been slightly downward; while the progressive depreciation of British railway investments has been extreme. Such international comparisons, rough and fragmentary as they are, afford an interesting background for the examination of the course of events in our own country. 1 The significant contrariety between bond and commodity prices is by the use of a somewhat exaggerated scale shown diagrammatically in the Annual Financial and Export Review of the N. Y. Globe, Jan. 10, 1914. Cf. also bond prices since 1856 in Chamberlain, The Principles of Bond Investment, p. 473. 2 H. Lowenfeld, Investment an Exact Science, enl. ed., p. 30. CJ. also his All about Investment, 1909; and Financial Universe, serially. The American securities are, however, not representative. CHAPTER VI SPECULATION The course of speculative activity since 1890, 198. — Movement of par- ticular issues, 202. — Speculative activity of railway bonds, 204. — — Pooling contracts, 207. — Speculation by "insiders," 208. — Abrupt changes of dividend, 209. — Secrecy in accounting, 212. — The Cincin- nati, Hamilton & Dayton, 214. — Speculation by "outsiders," 216. — The Southern Pacific pool of 1902, 217. — The Louisville & Nashville pool of 1903, 219. — The Reading and Boston & Maine episode of 1893, 220. — The Pearson-Farquhar syndicate, 1910, 223. — PubUcity as a remedy, 222. — Regulation of capital issues, 224. — Taxation of transfers, 225. — The outlook for the future, 226. It is inevitable that in a relatively new and rapidly growing country, like the United States, speculation in railroads, as the chief agency in its industrial advancement, should be more common than in Europe. Risks must be run by hardy pioneers; and the rewards and losses attendant upon success or failure must be correspondingly large. Yet one might properly anticipate that with the passing of the pioneer stage a more settled order of business would ensue. It is a striking fact that this is not so. At no time in our history have stock ex- change operations in railroad shares been carried on both absolutely and relatively upon any such scale of magnitude as dxuing the decade to 1910. This is perhaps the more remark- able in view of the coincidently great development and activity of speculation in the shares of the great industrial combinations. Speculation has not been continuously rampant of course. Periods of extreme dulness have often prevailed. But such wild outbreaks of general pubhc interest as occurred in April, 1901, January, 1903, October-November, 1904, November- December, 1905, and August, 1*906, are certainly unprecedented in our history. And that organized manipulation by powerful SPECULATION 199 groups of railway capitalists has been a potent factor in this field is beyond dispute. Of course the kaleidoscopic changes of the railroad map due to rearrangement of the great trans- portation systems have centred much of this activity upon cer- tain companies; but all ahke have been affected to a certain 260 SALES OMTHE NEW YORK STOCK EXCHANGE 1 I \ 1 lie 20> ISO \ \ A 'o _ \ 1 \ J- A V \ i\ \ 1» c o !5 ^ V 1^/ \ •~~y \ 1 V, 7 O Qf V \ «0 40 \ J \ A / art \ \ / ^ Q V \ \ V . f^, :P l7^ k~ \ •s ^ '/\ ■^ '•>' •'<.J>o^, \\ ~ '6ft '90 '92 *94 '96 '96 '1900 '02 '04 '06 '08 'Jo *12 degree. Happily there are indications that with the probable settlement of many of the larger problems in consolidation, and with the passing of some of the more daring leaders, this period may now be viewed retrospectively as more or less of a closed chapter in our economic history. The course of speculation during the last quarter century is illustrated by the accompanying chart, showing the num- ber of transactions annually upon the New York stock exchange. This diagram, hke all others dealing with finance, portrays the extraordinary change in general conditions which has super- vened since the panic period of 1893-'97. A total of eighty to 200 RAILROADS one hundred million sales annually before this period of depres- sion now rises to nearly threefold that amount. Even the sharp depression of 1903 marks an aggregate of dealings twice as large as in the prosperous year preceding the panic of 1893. And lest this speculative development be ascribed to the rise of the great industrial combinations during the last decade, supple- mentary curves relating to a few chosen railroads have been traced upon the same scale on the diagram. The lower one shows that annual sales of Union Pacific common stock alone for three years prior to 1908 amounted to practically half the average yearly transactions of the New York exchange in every form of listed security, mining, industrial or railroad, between 1884 and 1898. The middle curve is even more strik- ing. It shows the deahngs in common stocks of the three speculative leaders. Union and Southern Pacific and Reading. From practically nothing in 1898, all three railroads having recently been reorganized, the transactions in these three stocks alone attained an aggregate in 1906 of nearly one hundred million shares. The total New York stock exchange deahngs of every description prior to 1898 reached this figure but once before, and that was at the height of the extraordinary specula- tive excitement of 1886. The rapid pace in speculation during the first decade of the century was set by the opening year, 1901. ^ The events of that time are famihar: primarily trust promotion and wide- spread consolidation of railways, culminating in the Northern Pacific panic of the 9th of May. Deahngs upon the New York stock exchange increased more than fivefold in that year as compared with 1896. Activity in standard companies hke the New York Central and Ilhnois Central had begun as early as ISg?.'' By 1900 the second-class trunk fines like the Baltimore 1 Broadly reviewed in Quarterly Journal of Economics, vol. XIX, 1905, pp. 167-209; more in detail in Columbia University Studies, vol. LVI, 1913, p. 172. ' The course of speculation in different companies is diagrammatically eliown by weeks in U. S. Industrial Commission, vol. XIII, pp. 936-945. SPECULATION 201 & Ohio had fallen into line. And in the following year, the movement extended to the transcontinental group, led, of course, by the Union Pacific. In this latter company, whereas for 1899 deaUngs did not average over 100,000 shares in a week, they culminated in the first week of May, 1901, in a total of 1,980,000 shares. This was a volume of transactions almost equal to twice the entire capital stock. On April 24, 1901, no less than 652,000 shares of Union Pacific changed hands in a single session of five hours. The classic Erie was entirely supplanted by the Harriman company. Such specialized activity fomented a speculative craze all along the fine. The aggregate of deahngs in particular companies during the cal- endar year is shown by the following table. Atchison St. Paul Rock Island Erie New York Central . Northern Pacific . , Pennsylvania Reading (common) Southern Pacific , . Union Pacific Wabash (pref.) ... Shares Sold 12,100,000 12,500,000 8,100,000 11,300,000 2,800,000 5,000,000 5,800,000 5,500,000 11,300,000 22,400,000 3,000,000 Outstanding 1,020,000 558,000 600,000 1,123,470 1,150,000 800,000 4,069,300 1,398,000 1,978,000 1,045,000 240,000 Times sold 12 22i 13i 10 2i 6i H 3i 5f 21i 101 Thus was the fashion set for "milHon-share days." For the week before May 9 they averaged nearly twice that figure; and on April 30, 3,200,000 shares changed hands in a single stock exchange session. Only once before, in Decem- ber, 1886, had a milhon-share day occurred. High-water mark seemed thus to have been reached. And yet the year 1906 carried the yearly total of transactions to an even higher point. 202 RAILROADS The distinctive character of the speculative period succeeding 1900 is thrown into sharp relief by the course of events since 1908. The drop of the curves on the accompanying diagrams affords eloquent testimony to the speculative dulness which succeeded this upheaval. The closing days of 1913 were the quietest on the New York stock exchange since 1888. Average dealings fell even below the stagnant period of the depression of 1894-'95. Many of the old speculative leaders — Harriman, Morgan, Gates and Hawley — had died. Even had they been alive, however, it is doubtful whether the public could have been galvanized into activity. The total sales of the New York exchange for the entire month of November, 1913, but slightly exceeded the transactions on the single closing day of April, 1901, above-mentioned. Million-share days had steadily decreased in frequency. There were 18 in 1906; in 1907, 42; in 1910, 24; and in 1911, 12. They practically disappeared in the next two years. The amount of trading was thus unprec- edentedly small. The absence of speculation was also evi- denced by the extreme breadth of the market, such as it was. No less than three-eighths of the sales, to be sure, still consisted of Union Pacific, Steel and Reading stocks; but this was far less than the customary proportion. The middle line on the next diagram, on the other hand, makes it appear as if the Harriman and Reading stocks together were rather more than less prominent, proportionately during the dull times. The fact that in so limited a market, 265 different issues of shares could change hands within a week in November, 1913, estab- lished a new record for breadth of trading. The march of events since 1898 for different classes of rail- road securities is set forth upon a second diagram. Dealings in typical stocks are shown by separate curves. Most notable, of course, are the speculative leaders, Union Pacific and Reading common. The sharp contrast between the speculative ' ' booms ' ' of 1901 and 1906 is at once evident. Reading became the leader in the latter year; although activity in Union Pacific common SPECULATION 203 stock reached its climax, and held the centre of the stage some- what longer. More than forty-three million shares of Reading common stock changed hands in 1906; in other words, its com- 40 «.6 I \ \ ^(\ t \ SALES OMTHE NEW YORW 1 STOCK EXCHAN® 1 1 I \ \ \ / \ \ /; \ / \ r \ V IT J.0 \ \^ ze 1 r \ (| \ V 22 20 1 \ i f 1 1 / '/ -X / y^'' ' 1 / j 1 / \ N ^ -A ^ V ^ •■^ ImJ 1 1 \ 7" ->.w. ^ »97 rsa '99 1900 '01 '02 '03 "0* '05 '06 '10 '11 '12 '13 mon share capital was sold thirty-one times over within a twelve- month. The " commoditiBS clause " of the Hepburn Act offered the occasion; but the real cause lay in the absolute mystery which attached to every act of a company so financially involved in structure. An irresistible temptation to speculation was afforded both from within and without. Most of the other railroads, Erie, Rock Island, St. Paul, and Atchison appear to 204 RAILROADS have exhausted their energies in 1901, and responded but feebly in 1906 to renewed manipulation. Moreover, some of these roads, notably the St. Paul and Atchison, evidently were passing out of the erratic speculative stage and into the cahner zone of investment. The entire collapse of speculative interest in Rock Island and Erie at this time appears to be due to pubUc appreciation of the permanent worthlessness of their common capital stocks as waterlogged concerns. The position of Penn- sylvania shares is pecuUar and puzzling. As a substantial investment company it would seem to have become involved in speculation largely because of the difficult financing of the New York terminal developments during this period. Yet there can be no doubt that all of the more conservative and reputable roads were more or less affected by the prevaiUng furor. Especially was this the case in trunk line territory; where the problem of control of all the minor companies by the Pennsylvania and Vanderbilt interests was being worked out; and, of course, was of necessity being done in secret so far as the general public was concerned. Various recent changes in fashion of investment have coincidently tended of late to promote greater activity in speculation in bonds. Foremost among these are the income bonds created during the reorganizations of 1896-'97. Thus, during 1901 the Mexican Central first income 3s were handled more than twice over. The uncertainty, even at best, of fore- casting the time when interest may be paid, with the added chance of changes of policy as to maintenance or of manipula- tion of accounts, as in the recent Central of Georgia case, renders such issues pecuharly hable to change.' The debentm-e bond, without its right of foreclosure, leaving it merely as a prior Hen on earnings instead of assets, is a more sensitive crea- ture than an old-time bond. And most important of all, the widespread resort to convertible bonds of late years extends the natural susceptibility of stocks to changes of wind or weather 1 Cf. pp. 77 and 140, mjrra. SPECULATION 205 into the domain of funded obligations. Such securities as the Baltimore & Ohio convertible 4s and especially the various Union Pacific convertible bond issues and the Oregon Short Line Participating 4s of 1904, all necessarily follow at a modest distance the fluctuations of the stocks upon whose welfare their own future depends. Such phases of recent financing have served to counteract the steadying influences upon bond values of the passing of even the memories of the great bankruptcies of 1893-'97. Single traders in a time like 1901, and to a considerable degree ever since, may deal in a hundred thousand shares in a day; and small pools may handle several times that amount. The number who, single handed, operate to the extent of 15,000-25,000 shares in a day is said to be considerable. An episode of December 27, 1909, was illuminating, not only in regard to the volume but the technique of such speculation. The principal, a prominent officer of the Rock Island company, distributed to each of twenty brokers an order to buy 2000 shares of his own road "at the market." Intending, of course, to distribute an equal number of identical orders to other brokers to buy, and thus to create an impression of great activity, covering up his own unbalanced dealings, he never- theless for some reason failed to do so. The sudden unsatisfied demand for 40,000 shares rushed up the price by thirty-one points in five minutes and threw the entire exchange into an uproar. The motive in such "wash sales" was statistically shown in the evidence in the Montreal & Boston case in 1905. It appeared that the promoters of this mining company had in one day bought 94,000 shares (mainly from themselves) for $271,000, and sold 87,000 shares (mainly to the public) for $275,000. An appearance of general interest in the stock was thus created; and on the basis of it the quotations were "washed" up from $1 to $2.50 per share. Meantime they were being quietly imloaded upon the pubhc at the inflated price. 206 - RAILROADS The well-known manipulation of quotations for Rock Island securities finds a counterpart in subsequent pool operations in Reading stocks. The highly involved corporate organization of this company, as has already been suggested, the faciUty with which its actual financial status may be concealed by ex- pert accounting, the "commodities clause" of the Act of 1906, the prolonged htigation over the standing of the anthracite coal combination under the Sherman Act, periodic threats and rumors of strikes in the mines, possible segregation of accumu- lated reinvestment of surplus earnings in plant through extra dividends, — all these factors have served to lend an air of portentous mystery to every movement of its shares. The extremely Hmited floating supply — so large a proportion of its shares being closely held for investment or else locked up in the treasuries of other trunk hne roads ' — is also a feature of moment. The rise in interest in it is manifested by the following table showing the number of transactions in Reading common by years: Years Shares sold Years Shares sold 1904 10,694,000 1909 29,342,000 1905 22,318,000 1910 28,196,000 1906 43,764,000 1911 21,900,000 1907 39,141,000 1912 22,289,000 1908 35,165,000 1913 13,674,000 The outstanding common shares numbering 1,400,000, it thus appears that its common capital stock — residuary legatee of earnings after satisfaction of the fixed demands of its pre- ferred shares — was handled in 1904 seven and a half times over, in 1905 sixteen times over, and in 1906 thirty-one times over. The slightly flagging interest in it was revived again in the spring of 1909, when in three months its common capital was handled four times over. During the third week in April, 1909, sales of its common stock equalled one-half the total out- standing within five full working days. All this activity has naturally been accompanied by the widest and wildest ranges 1 P. 150, infra. SPECULATION 207 of quotation. From 1904 below $40 per share, to more than four times that figiu-e in 1906, its erratic course has been a source of bewilderment to all observers. More than once the violence of its changes, as when in January, 1 906, it was rushed up from $139 to $164, only to fall again within a month below its former level, and within a year to $70, has seriously menaced the general stability of the New York stock exchange. Plun- ging, attempted cornering, manipulation of the crassest order have been carried on by what appear to be some of the most powerful speculative pools in history. The specific form of contract entered into by the partici- pants in these pools has several times been made public as a result of subsequent investigation.^ In the Southern Pacific pool of 1902, to be described later, the gist of the compact was contained in the following paragraph : "Further we hereby authorize the said agent and manager to sell at his discretion the whole or any part of the certificates purchased, and in like manner to repurchase and again sell, so buying and selling at his discretion, provided, however, that the said certificates be not sold at a price that will subject us to any loss on the entire transaction." The agreement in the Hocking Coal pool, which, together with the one in Rock Island, collapsed in 1910, reads as follows : "The undersigned, being desirous of purchasing at least 20,000 shares of the common stock of the Columbus & Hocking Coal and Iron Company, do hereby agree to purchase the same or so much thereof as in the opinion of the hereafter appointed managers may be deemed advisable in the proportions set opposite the respective names of the said subscribers, and we hereby appoint , our agent and manager, to make such purchases at such time or times before the first day of September, 1909, unless sooner dissolved by the majority of the stock subscribed, in such manner and amount, and at such prices as in his judgment shall be to our mutual advantage. Each one signing this agreement to pay on demand for so much of said purchases as his subscription (as near as may be practicable) bears to the whole amount subscribed, as such agent or manager may require. Also to return the same amount of certificates or part thereof at any time when called for at any time before the first day of Sep- 1 On manipulation cf. address of Samuel Untermyer, Annual Meeting, Amer. Econ. Ass., 1914; in Amer. Econ. Rev., Supp. March, 1915. 208 RAILROADS tember, 1909, on receiving from the manager the amount paid therefor, with interest at 5 per cent, per annum. We further agree on any call from said manager to deUver to the said manager the same certificates theretofore deUvered to us by him. Further, we hereby authorize the said agent and manager to sell at his discretion the whole or any part of the certificates purchased and again buy, so buying and seUing at his discretion. It is further agreed that any profits or losses incurred through the purchase and sale of said certificates shall be divided in proportion to the amoimt subscribed for by each one signing this agreement. No one signing this agreement shall have the right to call for a statement of accounts growing out of transactions herein authorized except on the request in writing of 60 per cent, in amount of certificates subscribed." ' Turning now to the consideration somewhat in detail of specific instances of speculation in railroad securities, they may perhaps best be grouped in two classes: speculation by "insiders" in shares of their own companies; and manipula- tion by "outsiders," either for its own sake or else with a view to wresting control from those who may be at the time in power. In both cases, the interests of the general body of shareholders are bound to be sacrificed for the benefit of a selected few. Of the two classes of speculative activity, the latter is probably less prejudicial in effect, inasmuch as the two contending parties are more apt to be evenly balanced in resources. Sooner or later, moreover, the affair is boimd to become pubhc property. In such a struggle, the ordinary stockholder becomes merely a spectator, albeit a heavily interested one, unless it happens to come about that he holds the balance of power between the contending parties. In this contingency, of course, his position is a very strong one. But in those cases of speculation where the "insider" is pitted against the general pubhc, including the great body of other shareholders, every advantage is upon the side of the privileged directorate or administration. All others are helpless, except in so far as the courts have been able to protect the rights of minority shareholders in cases of flagrant abuse of power. 'Other details in Pujo Committee Report of 1913; 62nd Cong., 3rd sess., H. R. Rep., No. 1593, p. 47. SPECULATION 209 One of the most serious of recent breaches of good faith between directors, their own shareholders and the general public in the interests of speculation, was the manner in which in August, 1906, the Union Pacific dividend was advanced to its present high figure. This incident marked the culmination of the furious speculative campaign in the shares of this com- pany which carried its common stock from a merely nominal figure in 1898 to nearly $200 per share in 1906. From this elevation it dropped to $100 in the following year. During this orgy of speculation 1,220,000 shares of Union Pacific changed hands on August 16th; and more than twice as many on the following day. The total for six sessions was 10,500,000 shares. This contributed to a monthly total of 31,000,000 Union Pacific transactions, never exceeded but on three pre- ceding occasions, namely in April-May, 1901; October, 1904; and January, 1906. Over one-third of all the sales on the New York stock exchange consisted of Harriman shares. ^ It is not, however, the fact but rather the manner of increas- ing the Union Pacific dividend which is subject to criticism. The Southern Pacific road was the largest single outside invest-- ment of the Union Pacific. It had been gradually fattened through many years by reinvestment of all its surplus in better- ments. The harvest time had now come. Directors of both roads met in the same room at practically the same time. The Southern Pacific common stock was placed upon a 5 per cent, dividend basis. From this source and others, the Union Pacific company abruptly raised its rate from 6 to 10 per cent., where it remained until 1914. The fact of this advance was rigidly concealed for two days, giving opportunity to those interested to reap large profits from the inevitable advance in price attendant upon publication of the fact. No official investigation has revealed the extent of these private operations. It appears to be well estabhshed, however, that aside from whatever interest the directors and their friends had in the stock market, a power- ' Columbia University Studies, vol. LVI, 1913, p. 67. VOL. n — 14 210 RAILROADS ful "social pool" in the stock, which did not close out its hold- ings at the time, overstayed the market; and suffered heavy losses during the great decline of prices which soon took place.' The foregoing Union Pacific incident recalls a discreditable episode in the early days of the New York Central road. On December 19, 1868, the directors, after a midnight meeting, announced an 80 per cent, dividend in new stock and a 4 per cent, cash dividend. The Financial Chronicle of that day thus conunents upon the episode: The real occasion of the dividend is to be found in the specula- tive operations of parties associated with the management. It is a matter well understood in the better informed circles of Wall Street, that, some few months ago, a knot of capitalists, mostly in the direc- tion, combined for the purchase of $7,000,000 of the stock of the com- pany; and in order to facilitate the purchase and the carrying of the stock, a loan was contracted with a London banking house upon the stock as collateral, the loan to run for two years, if necessary. The stock was systematically depressed previous to the purchase, and was bought at from 84 to 95, averaging about 90. The declaration of this dividend is the consummation of the scheme. The cUque reahze about 60 per cent, profit on 17,000,000 of stock, or say 14,200,000, and a family prominently connected with the road makes a stiU larger profit. But how has it fared with the ordinary stockholders? At the time these gentlemen formed their magnificent scheme, the stockholders outside the "ring" were not only held in utter ignorance of the private plans of the directory, but the stock was systematically depreciated below its real value, so as to frighten them into selling to the directors and their friends. This operation is a fair illustration of the manner in which direc- tors speculate upon their exclusive knowledge of the affairs of cor- porations, to the injury of the non-official stockholders. Still a third classic instance of the use of dividend increase, apparently to make a market for securities unloaded by "in- siders," is the Atchison 7 per cent, dividend of 1887, increased from 6 per cent, on the very verge of bankruptcy. No elaborate 1 The degenerate Morgan-MeUen management of the New Haven (p. 255, infra) seems in the main to have refrained from speculation. But, as in the BiUard transactions, it clearly worked the market in further- ance of its plans. Cf. also p. 170, supra. SPECULATION 211 defences of this action have ever cleared the reputations of the guilty directors.' Abrupt increases of dividend in connection with specula- tion for a rise by "insiders" are not the only means of sur- reptitiously taking advantage of foreknowledge of futiu-e events. Oftentimes the actual pohcy of the company in respect of sur- plus income devoted to betterments may be known only to a privileged few, the real condition of affairs being concealed by means of involved accoimts. This it is which in part renders the stocks of non-dividend companies so susceptible to specula- tive manipulation. The necessarily low quotations of non- dividend stocks naturally offer an additional incentive; as a rise of a point or two in value of a stock which cost only $25 represents proportionately eight times as much profit as an equal rise of price of a share which cost $200. But it is imquestion- ably also the mystery attaching to a non-dividend security which is an aid to the professional manipulator. Chance and change — the daily bread of speculation — have no concern with a security offering a rate of constant return. Speculation has promptly shifted from the preferred to the common shares of all such roads as the Reading and Atchison, just as soon as the preferred stocks began to pay regular dividends. The Lehigh Valley road, on the other hand, was for a time speculatively interesting largely because of its unrevealed potentiahties. Between 1893 and 1904 the pohcy was rigidly pursued of sus- pending dividends, even on the preferred shares, and of devot- ing every penny of income to development of the property; and yet, of course, no one outside of the management knew how extensive the betterment in reality was.^ The result has been an erratic career on the stock exchanges quite equal in range of prices to the wildest antics of Reading common shares. Within the year 1910, the quotations ran up to $242, down to $125, and up again to $175. This was associated with the ' Daggett, Railroad Reorganization, p. 198. 2 21 I. C. C. Rep., 160; also p. 233, infra. 212 RAILROADS Pearson-Farquhar plans, subsequently described, for an ocean- to-ocean line, which would have entailed extensive issues of new stock as well as greatly increased dividends. Meantime the general body of stockholders and the pubUc remained in prac- tical ignorance of the meaning of it all. The highly involved in- tercorporate accounts of the Rock Island company, especially prior to their simphfication in 1906, undoubtedly promoted its speculative activity for the same reason. A merely negative policy of secrecy in administration only differs in degree from one of positive deception. Entirely fictitious statements as to earnings may be effectively utilized by "inside" speculators for a rise. Herein lies the possible advantage of even temporary control of a property, held, if necessary, by means of operations on margin, instead of by actual ownership. Prior to the careful analyses of expense accoimts, prescribed by the Interstate Commerce Commission, it was always possible to "skin" a road, that is to say, to postpone the customary and in the long run necessary outlay for maintenance. Savings thus effected could be utilized for enlarged dividend disbursements. On the strength of this show- ing, the speculators could dispose of their holdings at a profit, and leave the road practically gutted. In the old days a fictitious appearance of prosperity might easily be created by sending out orders to get traffic at any cost; thereby producing large gross revenues, and at the same time reducing mainte- nance expenses in the same proportion as the rates were cut. Net earnings would rise with the enlarged gross revenues, but the property, of course, would be steadily depreciating in condition. Such were the tactics charged against the old Atchison management in 1890, in order to enable the then- embarrassed Barings to unload their heavy investment in the road. Such action they were compelled to take in an endeavor to avert a collapse of their South American enterprises. Such also was the programme apparently threatened by the Gates syndicate in 1902, while temporarily in control of the Louisville SPECULATION 213 & Nashville road. A general disturbance of the entire rate situation in the South promptly forced the bankers responsible for the southern system and other roads in that territory to take over the property from the Gates syndicate at a large profit. The series of events leading up to the collapse of both the Baltimore & Ohio and Atchison roads in the '90s affords in- structive examples of deliberate falsification of accounts by "insiders" in order to create a market in which to unload upon the public.' In the case of the Atchison, income was apparently overstated during four years to 1893 by more than $7,000,000 in the aggregate. Of this simi nearly $4,000,000 consisted of rebate accounts, carried as an asset but having no value what- ever. Ordinary expenditures were charged to capital account; uncollectible traffic balances were carried as assets; and arbi- trary additions to earnings were made under orders from the East. Annual deficits, in one year no less than $3,000,000, were thus covered up; and an exhibit of steadily increasing earnings was publicly made. The revelations in 1896 in connection with the reorganization of the Baltimore & Ohio road were no less scandalous. During seven years and two months, dividends amounting to $6,269,000 had been declared, of which expert accoimtants averred that less than a million had really been earned. Net earnings had been systematically overstated, operating expenses had been charged to capital account as new construction; depreciation had been inade- quately charged off by manipulation of profit and loss accoimt; and, in the meantime, new capital had been issued to the amount of $50,000,000, and floating debt had risen from $3,500,- 000 to $16,000,000, without any corresponding new investment in the property. Deception amoimting practically to a fraud upon stock- holders, and seemingly not unconnected with "inside" specula- 1 Details in Daggett, Railroad Reorganization, Harvard Economic Studies, 1908, pp. 21 and 208. 214 RAILROADS tion, has recurred several times in recent years. When in 1905 the voting trust on the Kansas City Southern Railway, set up in 1900, expired by limitation, the stockholders coming into possession of their property discovered that it was almost completely gutted.' Much the same situation on a larger scale was disclosed by the bondholders' investigation of the Rock Island in 1914.2 The St. Paul episode of 1910 was slightly different; but at all events comcidently, if not wilfully, invited stock market activity. For, as we have already seen,^ as a result of deliberate manipulation of accounts the price of the common stock ran from $113 up to $133, only to drop sharply back soon afterward, and finally to fall below par in 1912. The history of the Cincinnati, Hamilton & Dayton road affords illiuninating evidence of the disastrous effects upon a company of a series of speculative managements; manage- ments, that is to say, chiefly interested in temporary control for purposes of speculation and sale to others, rather than of permanent development. Before it was first scuttled in 1886, it was conservatively financed, and was regularly paying dividends. Its shares were selling at or near par. At this time a New York banker named Ives piu'chased control by means of the well-known stock exchange device of pyramiding.* Using each purchase of stock as collateral for loans with which to purchase more stocks, the price was run up to $150 per share, and by systematic manipulation was held near that figure. It is obvious that failure to support the price would lead to calls for more margin and thus bring about utter collapse of the artificial control. Branch roads were then purchased and heavy bond issues by them were floated by means of guarantees by the parent company. Ambitious projects for 1 5th Ann. Rep., 1905; summarized in Meade, Corporation Finance, p. 217. 2 P. 236, infra. 3 P. 23, supra. * Bradstreets, vol. XV, p. 552, gives a good summary of these transactions. SPECULATION 215 extension to St. Louis, as a formidable competitor of the Balti- more & Ohio, almost forced that company into its purchase, just as the West Shore road was unloaded upon the New York Central, and the Louisville & Nashville in 1902 was forced upon the Atlantic Coast Line. The scope and outcome of this Dayton project are best described in the annual report of the road for 1888. At this date [June, 1886] the capital stock of your company was $3,500,000 common and $1,000,000 preferred. When Mr. Stayner and Mr. Ives resigned the presidency and vice-presidency respec- tively, August 9, 1887, the capital stock outstanding, as they stated it, had been increased to $4,000,000 common, and $11,000,000 pre- ferred bearing 4 per cent. The bonded debt of the company June 15, 1886, outstanding was $996,000 7 per cent., $1,434,000 6 per cent, and $400,000 5 per cent, consolidated sinking fund bonds. This debt had been increased at August 9, 1887, by $64,000 consolidated sinking fund 5 per cent, bonds and $2,000,000 second mortgage 4^ per cent, fifty-year bonds. To represent this enormous increase of liability and conversion and appropriation of securities owned by the company, amount- ing in the aggregate to about $14,500,000 par value, your company, August 9, 1887, had betterments of its road, real estate and addi- tional equipment representing an expenditure of less than one mil- lion dollars. Your company had in addition credit on the books of Henry S. Ives & Co. for a deposit of upwards of $12,000,000, subject to check on demand, but when the firm of H. S. Ives & Co. made an assignment for the benfit of creditors, August 11, 1887, the assets of that firm included less than $1,000 in cash. But the unhappy history of the Dayton road does not stop at this point. Its later manipulation has mainly had to do with repeated attempts to turn it over to some of the trunk lines, always, of course, at a profit. Within three years prior to 1905, the road was passed in succession through the hands of no less than four syndicates. The first pool was originally formed in 1902 to purchase the Pfere Marquette road, which ran crosswise of the main trunk Unes up into Michigan. The plan was, by threat of extending it east and west to Buffalo and Chicago, to force it upon the Vanderbilt roads at a profit. This project failed, leaving the bankers with a heavy burden 216 RAILROADS of unsalable and non-dividend paying securities. In the mean- time another independent cross line, the Chicago, Cincinnati & Louisville, had been constructed almost into Chicago by a second sjTidicate. A third pool already controlled the Dayton road. These three groups all overlapped in membership. All parties finally decided to join forces. The Pere Marquette was sold to the Dayton road, by payment in Dayton bonds and notes at the rate of $125 for Marquette stock which had cost $85 per share. This recompensed the first syndicate liberally. ;The second syndicate, which had built the line toward Chicago, was paid for its services in Marquette notes. The third syndicate, controlling the Dayton road, now made its profit in turn by selling the combined properties to a fourth syndicate in 1904. And it was this interest which so nearly succeeded in disposing of the road to the Erie at $160 per share in the following year. This was brought about by threats to turn the entire property over to the so-called Hawley interests, which were engaged at the time in piecing together various odds and ends in trimk-line territory, i Fortunately the Erie management discovered the true state of affairs in time, and all arrangements for merger were abrogated.* At last the Baltimore & Ohio in 1911 agreed to take the Dayton; and within three years poured $21,000,000 into its depleted coffers while still the deficits went on increasing year by year. The sum of $11,200,000 had to be charged off as loss on the PSre Marquette purchase alone. Thus did the improper profits of the bankers, as usual, come home to roost on the shoulders of the public' Tummg next to speculation by "outsiders," in order either to gain control of a company from others, or else merely to 1 P. 632, infra. ^ Other examples of manipulation by speculative "insiders" will be found on p. 381, infra, in connection with the reorganization of the Rich- mond Terminal Company; and on p. 249, infra, in the Kansas-Union Pacific merger. The recent " Frisco " affair is described at p. 41, supra. ' I. C. C. investigation, May 20, 1914. SPECULATION 217 manipulate prices in their own interest, a tj^jical example is afforded by the Keene Southern Pacific pool of 1902.' This episode is significant as showing the sort of attack which in- terests in control of a road must be at all times ready to repel, unless they actually control the property by ownership of a majority of the voting shares. The general situation must first be understood in order to comprehend the plan of campaign. The Union Pacific road, then in process of reconstruction, ended at Ogden, Utah. It was dependent for its through connection to San Francisco upon the Central Pacific road, which was a part of the Southern Pacific system. In order to acquire this necessary link in the transcontinental chain, the Union Pacific in 1901 purchased a practically controlling interest in the Southern Pacific, although it was considerably short of a majority of the shares outstanding. But the major part of this extended system, reaching through Southern California to New Orleans, seemed at the time to be quite a distinct property, for transportation purposes, from the small portion needed by the Union Pacific to complete its direct through line to the Golden Gate. The Union Pacific company at once caused its recent acquisition to embark upon an exten- sive programme of betterments. No dividends were paid by the Southern Pacific, in order that all net revenue (and there was a substantial amount of it) might be devoted to upbuilding the property. Nevertheless, just as in the case of the Lehigh Valley road, the actual extent of this rehabilitation and im- provement remained for the general public largely a matter of conjecture. The Keene pool, as appeared in the course of subsequent litigation, was dated January 29, 1902, and was to be continued until April 1, 1903. It was to become operative upon the purchase of 200,000 shares of Southern Pacific stock, which • The following account is based upon litigation lasting throughout 1903, testimony in which was currently reported in the financial and rail- way journals. 218 RAILROADS amount might be increased to 400,000 shares. As there were only 1,970,000 shares outstanding, and as the Union Pacific had only acquired 750,000 shares from the Huntington and other estates in 1901, such concentration of ownership in other hands was a matter of some importance. As a matter of fact, it appeared later that some 244,000 shares were actually ac- quired. The form of pooling contract adopted was much like that in the Hocking Valley Coal pool, which has already been described. Having acquired this substantial proportion of the capital stock, the next step was to bring about a rise in its market quotations in order to unload upon the public. There is no evidence at all of an intention to continue the investment in the stock. Much of it in fact was not really owned, but was merely carried on margin. The plan was simple. The South- em Pacific company was to be forced to modify its programme of devoting all net income to betterments; and was to be com- pelled to begin payment of dividends upon its capital stock. Such action would obviously serve the purpose. An elaborate campaign of publicity was then inaugurated. It was alleged that the Union Pacific was not really upbuilding the entire Southern Pacific road at all, but was merely "fattening" the Central Pacific link, in order at the proper time to cut it off and turn it over to the controlling company, thus completing the Union Pacific direct line to the coast. This in turn led to a spirited contest for control of the next annual meeting, recalling in many respects the struggle over the Illinois Central in 1907. Injunctions were sought to prevent the Union Pacific from voting on its 750,000 shares of Southern Pacific stock at the annual meeting on April 8, 1903, — only two days, by the way, prior to the original date of expiration of the pool. This action failed.^ In the meantime the Harriman party had suc- ceeded in accumulating enough proxies from other stockholders 1 A secret transfer of 300,000 shares of Southern Pacific from Harri- man to William Rockefeller was made with an agreement for resale. A flood of stock from this unknown source broke the Keene pool, it is said. SPECULATION 219 to insure their control. Thus balked in its programme, the pool was compelled to liquidate its holdings. This it did in the rapidly declining market of 1903, at very heavy loss. It was estimated at the time that the holdings which had cost about $16,700,000 were closed out at a loss to the pool members of approximately $3,000,000. Thus ended the chapter, about as disastrously as the Reading pool in 1906. In form precisely like the Southern Pacific pool, although differing in outcome, was the Gates raid upon the Louisville & Nashville road in April, 1903.^ This road being about to issue $5,000,000 of new stock, it appeared likely that the market quotations would decline substantially by reason of the in- creased floating supply. Many traders in consequence sold the stock "short," expecting to cover their contracts at the lower figure. The Gates pool quietly bought all the shares offered, thereby acquiring some 306,000 shares out of a total of 600,000 outstanding. With this clear majority, they forced the bankers in charge of the southern road, which could ill afford any disturbance of the rate situation, to take it off their hands. The pool appears to have profited handsomely by the transaction, having acquired 102,000 shares for less than $110 per share and the balance at $125; and then having turned it over to J. P. Morgan & Co. at about $130 per share for the first lot, and $150 per share for the second. It was then placed in the hands of the Atlantic Coast Line company "for safe keeping" at $160 per share. In much the same way and at about the same time, the Monon line from Louisville and Chicago was bought up by a speculative pool and finally turned over for joint control to the Southern and the Louisville & Nashville roads.^ Such episodes as these are not only iUuminat- mg in themselves, but they serve to explain the extraordmary 1 This transaction was investigated upon complaint of the Kentucky Raiboad Commission by the Interstate Commerce Commission in 1902-'03. The complaint and answers are reprinted in the 23rd Annual Report of the Raiboad Commission of Kentucky. Cf. p. 489, infra. 2 A. D. Noyes in the Forum, Oct. 1902, p. 204. 220 RAILROADS fervor of speculation which, as we have already seen, culminated at about this time. The speculative acquisition of the Boston & Maine Rail- road by President McLeod of the Reading road in 1892, however laudable the desired end in view for his company may have been, reveals the hazards of such modes of finance. ^ Early in that year, shares of the New York & New England and Boston & Maine companies began to advance mysteriously, and in October virtual control of both by the Reading was expressed through the election of McLeod as president. The operation was difficult to imderstand, as the Reading had always been impecunious and was then in a peculiarly precarious condition. On February 20, 1893, it suddenly went into bankruptcy. The story is succinctly told in the report of the directors in the following January. In substance it was a case of speculation "on margin," and of the margin having been "wiped out." On the 25th day of October, 1892, President McLeod authorized the purchase of shares in the New York & New England Railroad Company, and ultimately 32,000 shares were acquired. President McLeod originally put up his own securities as collateral to protect the purchasing brokers. Subsequently, as collateral to secure these purchases. President McLeod, without having previously obtaiued the authority of the board of managers, drew from the treasury of the company and pledged the following securities [treasury securities enumerated]. The fact of the withdrawal and use of the securities was first formally brought to the attention of the board on December 14. On December 24 resolutions were passed ratifying the action of Mr. McLeod and indemnifying him for advances made on his individual account to the extent of $400,000. Messrs. F. H. Prince & Co. and Messrs. Ervin & Co. [the brokers through whom the purchases were made] subsequently gave notice of their intention to sell the shares for the purpose of reimbursing their advances, and ultimately, in pur- suance of such notice, all of the shares were sold. After crediting the company with the net proceeds of sale, the total loss on the Boston & » U. S. Industrial Commission, vol. IX, pp. 561-576, contains testi- mony on the subject. Daggett, Railroad Reorganization, p. 123 et seq., traces its effect upon the Reading company. Bradstreets, vols. XX and XXI, contain many additional details. SPECULATION 221 Maine Raiboad stock was $918,008.09, and on the New York & New England stock $553,996.15, or a total of $1,472,004.24. The most recent spectacular collapse of an ambitious attempt to create a transcontinental railway line on the basis of borrowed money occurred in July, 1910. ^ From some unrevealed source large blocks of railroad stocks had been pressed for sale upon the exchanges for some weeks. It had been known since January that some mysterious pool had been quietly accumulating large holdings in various roads, especially of the Rock Island company. The shares in other apparently imrelated properties, like the Lehigh Valley, had also been advancing sharply. The entire plan was disclosed when suddenly it was announced on July 28 that an English 5301- dicate, heavily interested in a chain of roads from the Atlantic to the Pacific, had been forced by the steady decline in quota- tions to transfer all its holdings en bloc to a leading American banking house. The nucleus of the transcontinental system was to have been the Rock Island. It was to have been carried to the west by the Denver & Rio Grande, a supposedly Gould property, which in turn controlled the recently completed Western Pacific road to the coast. But in order to hold these, the Missouri Pacific had also to be included. Eastward, the line was to be made up of the Wabash and the Lehigh Valley roads to Atlantic tide water. No details have ever reached the public. But it was rumored that an investment of ap- proximately $30,000,000 was finally liquidated for about half that smn. Had the affair not been terminated by private arrangement, in other words, had this huge volume of securities been openly forced upon an already over-loaded market, a disastrous panic might have been precipitated. A common mode of protection against the raids of outside speculative cliques is the creation of a voting trust.^ With a 1 The financial journals of July 28, 1910, and the following week abound in descriptive matter. ' Cf. Daggett, op. cit.; and the Yale Law Journal, vol. XIII, 1904. 222 RAILROADS body of trustees, commonly five in number, all shares of capital stock are deposited, in exchange for so-called voting trust certificates. The important point, however, is that such exchange of securities is for a stated period of time; and vests all voting power on the stock in the hands of the trustees. This assures stability of control- and continuity in policy. It has been a common feature of most of the great railroad reorganizations in recent years. Some voting trusts have been continued for many years, notably on the Ontario & Western road. When entered into for an indeterminate period, only terminable upon the declaration of dividends successively for a given time, it may operate disadvantageously to shareholders; but in the long run seems to be a convenient and necessary safeguard.' What remedies may be applied to check this speculative activity, in itself a menace to the safe and sane operation of the railroads of the United States? A powerful one has already been applied in the beneficent publicity features of the recent Hepburn Act of 1906, and, as still further amended in 1910, in the Mann-Elkins law.^ "Blue Sky" legislation contributed to the same end.' Little more in the way of specific legislation would seem to be needed; although liberal appropriation for administrative oversight by means of expert accountants must of course be currently made by Congress. So far as checking speculation by "insiders" is concerned, the strict prescription by the Interstate Commerce Commission of the practice as to making depreciation charges would seem to be most effective. The matter technically bristles with account- ing perplexities, and has been most bitterly opposed by leading railroad men. Some of this objection is more or less valid. Yet much imnecessary bitterness in discussion of the subject has been engendered by a misconception of the rules of the ' Cf., however, the Kansas City Southern episode, p. 214, supra. ">■ Ripley, Raihoads: Rates and Regulation, pp. 515 and 586. » P. 285, iJi/ra. SPECULATION 223 Commission. It is alleged that the insistence upon a clear differentiation between capital and income account in the mat- ter of charging for depreciation or for betterment and new construction, will compel the companies to capitalize all better- ment work instead of caring for it in part from surplus income by charging it to operating expenses. This by no means seems to follow. No actual policy as to the form of pa3anent to be adopted in cases of improvement work is enforced by law. The only requisite is that, whatever the policy of the road may be, it shall be made evident in the published accounts for the benefit of all parties concerned. No one can question for a moment the expediency of oftentimes adjusting maintenance outlay in some measure to the exigencies of the moment; either by postponing it in part, or, if possible, by going to the other extreme and expending freely for maintenance in order to save in direct operating cost. Not even the excuse of arti- ficially creating a favorable income return in order to success- fully float new bonds or stocks is valid or admissible in the case of most companies in normal times. The accounts should reveal to all, and especially to public authority, the precise policy which is being pursued. Padded or starved income statements have in the past been one of the most prolific sources of profit to "insiders" in the case of speculatively managed roads. Most sound roads, of course, do not resort to such practices; but laws must be drawn to meet possible offences, even if they be exceptional. It is a matter for congratulation that such manipulation is becoming increasingly more difficult under the accounting supervision of the Interstate Commerce Commission. Beneficent in its effects, also, will be all further careful regulation of intercorporate accounting. The consolidated balance sheet, as used by the Rock Island and Reading com- panies, is another fecund source of evil. The classic financial reorganization of the Alton road was so adroitly covered up in the accounts, that, as has been technically shown m the Journal 224 RAILROADS of Accountancy, the holding company could pile up a surplus or incur a large deficit without danger of discovery. Not a trace of the very recently revealed and entirely unsuspected indebtedness of the Oregon Short Line to the Union Pacific company, to the amount of $72,000,000, could be found in the reports of either company, until the directors chose to let it be known.i Such things should not be. Nothing so invites speculation as mystery. Whether the so-called "insiders" profit by it or not, is not the main question. Such secrecy certainly provokes speculative manipulation in others. So far as publicity can reasonably go, it should be applied with the utmost vigor. Speculation thrives in the main upon securities of low market value. Such low quotations are usually the result of an over-issue of securities, in other words, of capitalization more or less in excess of either physical value or earning power. A second restraining influence upon speculation in future may therefore indirectly flow from enforced publicity, so far as it puts an end to the evil known as stock-watering.* This form of financial abuse is much less prevalent than formerly; it is in fact now non-existent probably in the case of most of our substantial roads. Yet in so far as publicity or physical valua- tion may serve to restrain the excessive output of securities by a few erring companies, speculation may reasonably be expected to diminish as a consequence. One of the most powerful checks may ultimately be found in some prohibition of excesses in inter-railway financing. Wholesale investment of corporate funds of one railroad in stocks of other railroads, especially upon a credit basis, has been a conspicuous and unwholesome feature of the last few years. The collateral trust bond has been a useful means of accomplishing this purpose. Of course, as a means of building up a logically unified system, particularly in linking ' New York Evening Post, Financial Supplement, Oct. 1, 1910. 2 Chap. VIII. SPECULATION 225 together naturally connecting roads into a through line, such intercorporate financing is necessary and proper. But when applied, as by the Union Pacific and the trunk line roads, to control or mvestment in naturally competing or even entirely remote and disconnected properties, it may become a pubhc menace. Particularly does it invite corporate speculation, that is to say, the purchase and sale of one road by another, not as an incident to operating efficiency, but merely for the sake of profit. It is not a wholesome condition of affairs that a railroad, chartered for the conduct of transportation, should be engaged m stock exchange operations of this sort; and that a large part of its revenues should be derived either from such sources or from its investments m scattered and wholly unre- lated roads. It is greatly to be hoped that the possibility of pubhc interference to prevent such tendencies, even though fraught with the danger of cripphng suitable private initiative, may be rendered more remote by greater circumspection on the part of the directors of some of these great quasi-public companies. Positive discouragement of imdue speculation in railroad securities in future may possibly also be looked for in the im- position by the states of taxes upon all stock exchange trans- actions.' A rich source of income exists therein; but the tax must, of course, be so apphed as neither to hamper legitimate transactions nor to lead to escape by migration to other states. So far as it is practicable, a substantial tax upon all transfers of stock would seem to promote the general welfare, without unduly burdening the necessary processes of exchange. And finally, a healthy public sentiment which shall frown upon manipulation of stocks for private profit, especially by those who occupy positions of trust, or which views large fortunes acciunulated by such means as improperly acquired, cannot fail to exercise some influence. After all is said and done, the ' Various other reforms, such as the revision of commission rates, are proposed in Columbia University Studies, vol. LVI, 1913. VOL. u — 15 226 RAILROADS high regard of one's contemporaries is among the most coveted rewards of life. The comitry would seem to have passed through an extraordinary period of moral awakening of late. We may perhaps never again be called upon to witness such an orgy as this last decade has revealed. The outlook is far more satisfactory in this regard than it was five years ago. The foregoing outline of speculative manipulation of rail- way securities tells but a sorry tale at best. It presents the most unpleasant aspect of railroad financing, embracing a range of operations from mystification and petty deceit to utter fraud. But the conclusion must be carefully avoided that, because such offences have at times been committed, American railroad finance on the whole is unsoimd. Such an opinion would be absolutely vmfounded. A large majority of our common carriers are certainly on the whole as honestly administered as are private businesses. Nor has the standard of integrity in the main ever been so high as it is at present. But, as always, the innocent are condemned to suffer with the guilty. No single group of persons has a deeper interest in the prevention of such breaches of trust in future than that charged with the present management of this great industry. '■ 1 Other data will be found in the Pujo Committee Report of 1913; 62nd Cong., 3rd seas., H. R. Rep., No. 1593, pp. 33-54. CHAPTER VII STOCK-WATERING Definition, 227. — Stock dividends, 228. —The Connecticut River epi- sode, 229. — Extra cash dividends, 229. — The anthracite predica- ment, 231. — Evasion of statutory prohibitions, 232. Over-capitaUzation in construction, 232. — Replacement of property as inviting stock-watering, 233. — Incompetence or fraud, 236. — The Boston & Maine coUapse, 237. Division of an accumulated surplus, 238. — Indirect devices therefor, 239. — Magnitude of railway surpluses, 240. — Equitable interest of the pubUc therein, 241. — The opposing views stated, 242. — The just intermediate opinion, 243. — The Massachusetts gas companies, 244. — Difficult to apply jn practice, 245. — Refunding, a concomitant of inflation, 247. Stock- watering incidental to consolidation, 248. — Financial advantage of merger, 248. — The Kansas Pacific case, 249. — Rock Island and other examples, 250. — The New Haven collapse, 251. — Connecticut trolley finance, 252. — The Rhode Island companies, 253. — The Boston & Maine road and the Westchester Co., 255. Stock-Watering — a much abused term — may be defined as an increase of nominal capitalization of a corporation with- out a commensurate additional investment of funds. The baldest and simplest form — probably the one primarily responsible for the odium attached to the term by the general pubUc — is the outright declaration of a stock or bond dividend. In this case no new capital whatever is put into the company. The new stocks or bonds are a gift to shareholders.' The stock dividend, as will thus be seen, fully meets the contingency of an increased, if not indeed an excessive, revenue power. It makes more generous provision for distribution of earnings in future; and in so far it saddles a heavier burden upon the patrons of the road. But it does not affect a surplus aheady ' The stock dividend is carefully to be distinguished from stock sub- scriptions with "rights" to shareholders — a mode of financing to be con- sidered in the next chapter. 228 RAILROADS accumulated from heavy earnings in the past. Its effect is in no sense retroactive. Flagrant examples of such stock dividends are scattered through om- history. They occur nowadays with relative infre- quency among railroads; but they were lately common among express companies and other quasi-pubUc concerns. The 100 per cent, dividend declared by the Adams Express Company in 1898 is a case in point. In the Hepburn investigation of 1879, stock dividends by railways were prominent abuses. Sheer fraud was often practised in issxiing stock for speculative purposes. Between 1868 and 1872, for example, the share capital of the Erie was increased from $17,000,000 to $78,000,- 000, largely for purposes of stock market manipulation. Con- vertible bonds were put forth in amoimts "limited only by the capacity of the printing press." For^this reason, in 1869, the governing board of the New York stock exchange actually refused longer to permit quotation of Erie securities. ^ On March 16, 1876, an extraordinary payment was made by the St. Paul road. A 14 per cent, dividend on the preferred stock was declared: "Seven per cent, on the net earnings of 1874 and 7 per cent, on the net earnings of 1875. This dividend is payable in consolidated sinking-fund bonds of the company." The 80 per cent, stock dividend of the New York Central in 1868; scrip dividends on the Reading during the '70s; the 50 per cent, dividend of the Atchison in 1881; the 100 per cent, stock dividend of the Louisville & Nashville in 1880, by a pen stroke adding $20,000,000 to "cost of road" upon the balance sheet; the widely-mooted 100 per cent, dividend of the Boston & Albany in 1882; the 40 per cent. Great Northern distribution of 1898; a doubling of capital by the Atlantic Coast Line in 1900, flavored with a 5 per cent, extra dividend in cash; — all these, and many more, have had much to do with instilling ' The Windom Committee, 1874, p. 72; Poor's Manual of Railroads, 1884; New York Chamber of Commerce Report, 1883; and the Report of the Cullom Committee, 1886, p. 51, abound in data of this period. STOCK-WATERING 229 into the public mind the belief that stock-watering is an evil well-nigh inseparable from the business of a common carrier. A typical example of a stock dividend, giving rise to much public feeling in a conservative community, occurred upon the Connecticut River road in 1893. This property was leased for ninety-nine years to the Boston & Maine road on a guaranteed rental of 10 per cent, dividends. In addition, by evident prearrangement, on the day of executing the lease a dividend of 50 per cent, was made to Connecticut River stockholders. This was paid by giving ten-year 4 per cent, bonds to each share- holder, equal in amount to one-half the face value of his stock holdings. This obviously saddled the Boston & Maine with the heavy burden of a 12 per cent, annual rental for the Ufe of the lease; for, of course, it wa,s boimd to discharge this new funded debt at maturity. The effect upon the Connecticut River road was to change a bookkeeping surplus of $1,000,000 into a substantial deficit. As was oflScially said in a vigorous message from the Governor on the subject: "An issue of bonds to pay a stockholder's dividend is contrary to good practice and to sound principles of corporate financiering. It is safe to say no more unconscionable transaction has occurred in the railroad history of the state." ' Be the financial contingency, not of excessive present earn- ings but of an uncomfortably large surplus on hand, the stock dividend affords no rehef. For the stock dividend involves no gift of cash to shareholders. What is needed, in this case, is the declaration of an extra cash dividend. This is not "stock- watering" in itself, but is apt to be a correlated event. There is no addition of new stock to be supported by future earnings. But a "plmn," instead of being paid in cash, may be so given as to reduce the income of the parent company and thereby enable it less obviously to be embarrassed by riches in future. ' A lease in 1913 of the Northern Central to the Pennsylvania Rail- road with a stock dividend of 40 per cent, and a cash dividend of 10 per cent, would appear to be a close parallel. This was long contested. 230 RAILROADS The distribution may sometimes take the form of a gift of securities in subsidiary companies. The Great Northern dividend to shareholders, in 1906, of Lake Superior ore-land certificates worth $90 on the open market, was of this sort. It has been competently estimated that, including this gift, the entire rate of return to stockholders of the road was not less than 147 per cent, within a single year. To be sure, these ore certificates were acquired through the far-sighted sagacity of a great administrator, but the effect in arousing public sentiment was very marked. Only eight years before, the same shareholders had received a 50 per cent, dividend in stock of the Seattle & Montana, which was subsequently exchanged for Great Northern shares. And substantial "rights," incident to new calls for capital, have been hberally sprinkled over the entire history of the company. The Northern Pacific road in 1908 met a similar situation by an outright cash disbursement. A substantial extra dividend of 11.25 per cent, was paid out of assets of subsidiary companies, imdiselosed upon the books of the parent concern. The positive embarrassment of riches of the Union Pacific company, due to appreciation in the value of its stock holdings in other roads, was thus relieved in 1913 by an extra dividend of 33| per cent., made in the form of a dis- tribution of $82,000,000 of Baltimore & Ohio stock held in its treasury.' Sometimes the double complication of an unwieldy surplus and immediately and prospectively over-heavy earnings can be overcome by a single operation. Both stock and cash dividends may be combined in some manner. A prominent instance occurred on the Delaware, Lackawanna & Western. Operating under a special charter of 1849, it was protected from harassment by subsequent state legislation as to owner- ship or operation of coal mines. But by this same charter it was specifically forbidden to declare stock dividends. Con- servatively financed in the face of enormously increased revenues ' Chapter XVII, infra. STOCK-WATERING 231 from its anthracite coal business after 1898, it was for some years earning as high as 50 per cent, on its capital stock. Since 1906 dividends were paid at the generous rate of 20 per cent. — double the highest regular rate on any other railroad — but even this, combined with extensive appropriation of surplus earnings to betterments, left an unwieldy balance. The market value of the stock rose in consequence to about $650 per share. The accounting surplus rose to $18,790,000, or nearly two-thirds of the total of stock and bonds outstanding. The "commodities clause" of the Hepburn Act of 1906, in effect prohibiting all railroads engaged in interstate commerce from owning or operating coal mines, suggested a remedy for all its embarrass- ments. On July 1, 1909, an agreement was entered into with a specially organized corporation, by which all its coal was to be sold for 65 per cent, of the market price, the buyer to assume all transportation charges from the mine. Stockholders of the parent railroad were then offered the valuable right to subscribe to shares of the new coal company; and at the same time a cash dividend of 50 per cent, was declared by the rail- road, to enable them to take advantage of the offer without expense to themselves. And finally, on top of all, a clear stock dividend of 15 per cent, was also given. How this last detail was reconciled 'with the prohibition in its ancient charter is not clear. But the 50 per cent, cash dividend and the new corporation coincidently capitalized with the proceeds thereof, were simple enough to arrange. The net result, taking the coal company shares at their first quoted market prices, was a divi- dend equal to 187.5 per cent, per share. This established a new record, even among the most prosperous of the anthracite coal roads. Perhaps the most extraordinary feature was that all the cash requirements of the transactions were met out of the surplus profits for the year, over and above the regular 20 per cent, dividend. This surprising fruitfuhiess has since been followed in 1911 by yet another 35 per cent, extra divi- dend. In recent years most of the other anthracite companies 232 RAILROADS have been similarly burdened with riches. The Lehigh Valley in 1912, like several of its fellows, segregated its coal properties in a separate company and made it the occasion for a generous distribution of surplus. The Reading company will doubtless also follow suit in due time.^ The preceding operation shows how easy it is to evade any simple prohibition by law of the declaration of stock dividends. Such a prohibition of the issue of paid-up stock for less than par is found in the Corporation Act of the state of New Jersey. But any company so disposed — the United Fruit Company, for example, twice in recent years — merely declares a cash dividend and coincidently offers its shareholders for subscrip- tion at par an equal amount of new stock. The letter of the law is fully complied with. The Pittsburg & Lake Erie followed this plan when in 1910 40 per cent., and the next year 25 per cent., extra cash dividends were declared and then made applicable to subscriptions for new stock. An ex- treme instance of this sort among common carriers was the 300 per cent, dividend of the Wells-Fargo Express Company in 1910. This amoimt in cash was distributed, coupled with the right to subscribe two-thirds of it to new stock of the company. The capital stock was thus trebled; each stock- holder received 300 per cent, on the par value of his holdings in cash; and, in addition, could sell his right to subscribe to new shares for a substantial sum. The valuable "plums" and "melons" of the Pullman company and even the Lackawanna bonus were entirely eclipsed by this transaction. Turning from the simple and direct payment of stock and cash dividends, above described, as a means of xmduly increasing capitalization, attention may now be directed to analysis of the larger financial operations in connection with which stock-watering more or less indirectly takes place. No fewer than seven particular occasions present themselves as ' Ripley, Railroads: Rates and Regulation, p. 552, gives details. STOCK-WATERING 233 opportune for inflation of capital issues. These are as follows: in connection with construction; through replacement of property; by division of an accmnulated surplus; as a con- comitant of refunding; as an incident of consohdation; as a feature of financial reorganization; and, finally, in connection with the provision of new capital through issuance of shares or bonds. It is believed that this scheme of classification com- prehends practically all phases of the subject. They will be discussed in order. Over-capitaUzation as an accompaniment of construction has already been discussed in our opening chapter.' It need not detain us fm-ther in this connection. The importance of the subject is emphasized by the propositi 6n pending in Congress to so enlarge the jurisdiction of the Interstate Commerce Com- mission as to include all operations and accounts of construction companies along with operating railroads. The need of wider authority has been brought to public attention by a number of recent scandals, particularly those of the St. Paul Pacific coast (Puget soimd) extension and of the St. Louis & San Francisco. A large body of experience, dating from the earUest days of railroading, has clearly proven the imminence of finan- cial excess in this cormection. The persistence of these practices is well exemplified also, although on a small scale, in a number of recent cases before the state railroad commissions.^ The capitaHzation of expenditures for replacement of prop- erty, which ought to have been paid for from income, is prob- ably one of the most common corporate errors of the time. It has frequently engaged our attention heretofore.' Improper manipulation of betterment and maintenance accounts^ leads readily and immediately to the augmentation of capitaUzation without a corresponding investment of new fvmds. The intricacy of the subject is discovered by the case of the Kansas ' P. 35, supra. * Nebraska Railway Commission, 6th Ann. Rep., 1913, p. 255; and P. S. C, Missouri, vol. I, 1913, p. 141. ' Pp. 21, 77 and 140, supra, 1 P. S. C, New York, 2nd D., 1910, p. 132. 234 RAILROADS City Southern before the Supreme Court of the United States in 1913.1 The company desired to pay for the entire cost of a much better re-location of a part of its main line from the proceeds of a bond issue, without any deduction whatsoever for the cost or value of the old bit of line which was abandoned. This was defended on the groimd that operating expenses would be so substantially reduced in consequence of the re-loca- tion as to fully support the enhanced interest charges. Both the Interstate Commerce Comnaission and the Supreme Court held, however, that such action amounted virtually to the payment of dividends from capital. For, the argument ran, all dividends or interest upon the securities originally issued to pay for the old line, if continued, evidently imposed two burdens upon present earnings; those, namely, associated both with the original and with the new investment. The govern- ment also made the vahd plea that it was really the first invest- ment which alone made the second one possible. This the company denied, alleging that the reduced operating expenses would fully offset the larger fixed charges.^ The controlling argument in the foregoing case is one which turns upon the distinction between two kinds of depre- ciation; namely, one due to ordinary wear and tear, and another, weU termed "functional."* This second form of 1 231 U. S., 423. 2 Cf. Ripley, Railroads: Rates and Regiilation, p. 67. In this con- nection an ingenious argument against the American practice of charging betterments to income account may be mentioned. It is to the effect that capital outlay is at least subject to a greater degree of pubhcity than revenue expenditiire; and consequently that deceptive or speculative action is more likely to be thwarted. The argument naturally has no force imder our present American regime of governmentally standardized accounting. See McDermott, Railways. ' P. 357, infra. The rapid obsolescence on American railways is well described by a leading eflBciency engineer as follows: " Roadbeds do not wear out any more, they are realigned with grade revisions; ties do not gradually decay, they are cut to pieces by the heavy traffic; rails do not last their life, they are displaced by heavier sections; stations do not wear out, they have to be torn down to make STOCK-WATERING 235 depreciation is the "result of changes attributable to the inadequacy of the existing property to meet the demands of the future," and "therefore chargeable to future earnings," augmented avowedly by reason of the improvement. Apply this argument to the recent construction of the Lucin cut-off by the Central Pacific. At a cost of $9,000,000 a new line, 104 miles long, was nm straight across the Great Salt Lake on trestles and embankments. This reduced the distance by forty-four miles and eliminated all sorts of heavy curves and grades. Assuming that the old, crooked, round-about line, built as well as the then resources permitted, represented an original and subsequent investment equal to that of the cut-off, would the rejection and dismantling of this old property under such circumstances, according to the Supreme Court's ruling, require traffic henceforth to be carried free?' At first blush this would appear to follow logically, inasmuch as the deduction of the amount of the old investment from the new would reduce property account to zero. But the answer to this specious argument has been already given. The old investment remains outstanding as capital — the new investment must properly be supported by its own future economies of operation. In a parallel case respecting betterments charged to income, on the Illinois Central, the Supreme Court held rightly enough that "instrumentalities that are to be used for years should not be paid for by the revenues of a day or year." ^ Whether such modes of accounting encourage piecemeal instead of root-and- branch improvement is, of course, well worth consideration. The boundary line is indeed vague between mere neglect way for palatial structures; round-houses are scrapped because electrical equipment has come in; locomotives used to last fifty years, the average age of locomotives in actual freight service now is not over ten years; wooden passenger cars make way for steel cars. A two-per cent, assess- ment made once used to be sufficient for depreciation. It is a question whether 3 per cent, a year will take care of modern obsolescence." — Re- view of Reviews, Sept., 1914. ' Atlantic Monthly, June, 1914, p. 807. 2 206 U. S., 441. (1907.) 236 RAILROADS to differentiate income from capital, and downright deception of others in this regard. Expenditures may be capitalized, not for real betterments but for pretended ones which ought to be paid for from earnings. Real improvements may be paid for in excess of their actual value. Or, even worse, current expenses in the form of bills payable, wages and supphes may be met by issues of interest-bearing scrip. Floating debt may be allowed to accumulate in paying cm-rent expenses, while dividends which ought to have been cut off continue to be paid; and then this floating debt may be refunded into permanent securities.^ Is it not clear that in each instance capitahzation is expanded unduly in proportion to the actual worth of the property? Such things are usually done so as to disguise the facts. But, however details may vary, the prin- ciple is fundamentally the same. The resources of the future are improperly exhausted for the benefit of the present. Failm-e to charge replacement outgo to income rather than capital account has accompanied recently the financial distress of two important roads. Both affairs were deceptive in the extreme, — on the Rock Island wilfully and perhaps even fraudulently so, while on the Boston & Maine the mistaken policy seems to have been due rather to ignorance, neglect or inefficiency. The facts as to the Rock Island were brought to fight in 1914 in connection with reorganization proceedings. After the management had issued a highly encouraging state- ment, indicating a fiberal upkeep of roadbed and equipment for 1913, an expert investigated the matter from another angle for the bondholders. ^ He reported a corporate starvation poficy so extreme that about 20,000, — that is to say, one-half — of the company's freight cars were worn out and should be retired at a cost for replacement of $15,000,000; also that inadequate or, as it was termed, "deferred maintenance work" would necessitate another $8,000,000 expenditure. These two ' C/. the Frisco failure, p. 41, sujrra. " Report by Vice-President McKenna of the St. Paul, May, 1914. STOCK-WATERING 237 items alone transformed a reported surplus of $13,600,000 for the preceding year into a profit and loss deficit of $10,291,000. Obviously the only way to save the property was to capitaHze this deficit at once by an assessment upon security holders.' A similar experience, this, to the Atchison and the Baltimore & Ohio twenty years before, repeated almost word for word! The complete collapse of the Boston & Maine Railroad in 1913 affords a second recent instance of the penalty imposed by years of self-deception in matters of replacement and de- preciation.^ Large sums, which under the dictates of ordinary intelligence and prudence ought to have been invested in the property from earnings, were for years diverted to the payment of excessive dividends, — not absolutely excessive in the sense of affording an unreasonable return on the capital but relatively so, in the sense that they brought about a progressive impoverish- ment of the road. Such deceptive financiering need not neces- sarily be in' the nature of a fraud upon stockholders, however great the losses which they may be called upon to bear through having innocently dissipated their capital, thinking they were merely spending their income. Undoubtedly it has thriven in the past upon the pretended need of secrecy in the matter of accounts. From the public point of view, in the last analysis it invariably entails an imdue burden of securities upon the shoulders of the community, to be supported out of current earnings, while at the same time exposing patrons to the exas- peration of a halting, unsafe and inadequate service. The primary lesson to be learned by railroad managements is that, not more than current earnings, but at all times far less, should be distributed in the way of dividends. The moral for the public is that it must be prepared to countenance such rates as shall yield a substantial simi in addition, not only regular normal rates of return upon capital but to provide for future contingencies, especially the "costs of progress."^ 1 P. 392, infra. 2 27 I. C. C. Rep., 593; c/. p. 255, infra. ' P. 185, swpra. 238 RAILROADS Relief from the embarrassment of an exuberant surplus by means of extra cash or stock dividends is a simple operation. But corporate surpluses are by no means confined to ready cash, quick capital or marketable assets. A profit and Ipss ac- count merely evens up the difference between assets and liabili- ties on the balance sheet. A surplus seems substantial enough; but in reality it is a hazy and elusive thing. In the first place it depends entirely upon the particular valuation placed upon the assets. A stroke of the pen in writing off property account may serve to obliterate it entirely. But even if the valuation of assets be sound, the surplus may be an unrealizable one. A large part of it, instead of being a cash fund or convertible securi- ties, may be a mere statement of past earnings appropriated to a future use, and in the meantime inextricably entangled in the business. As thus invested, it is subject to the same risk of obsolescence or depreciation as the rest of the plant. It may not even be property at all but merely reputation, built up by heavy expenditures for advertising and the like.^ Such a sur- plus may indeed prove in time of trouble to be a weak reed instead of a staff. The Western Union, when taken over by the American Telephone Company, had its surplus of $18,- 800,000 promptly written off by more than two-thirds. The Illinois Central, too, acted the part of prudence a few years ago in transferruig its "dividend reserve fund" to profit and loss; perceiving that, although theoretically such a fund might be drawn upon to eke out dividends, in fact it was a mere book statement, not serviceable at all when needed. And the Mis- souri Pacific, upon emerging from imintelligent Gould manage- ment, found it wise to eliminate a lot of dead wood from its surplus account. Nevertheless, a surplus representing undis- tributed earnings over a term of years may sometimes under conservative administration attain large proportions. And it may well be that by the growth of assets in this way, the prop- 1 Cf. the New Jersey cases authorizing capitalization of development expenses, p. 308, infra. STOCK-WATERING 239 erty has reached a condition of acute under-capitalization. The temptation under such circumstances to reimburse the treasury of the company for such uncapitahzed outlay, and thereby to re-estabhsh an equivalence between assets and out- standing securities, may become at once irresistible and venial.^ There are a number of ways by which undivided earnings may be capitalized, other than by means of either cash or stock dividends. The Villard administration of the Northern Pacific in 1888, just on the eve of bankruptcy, shifted accumulated charges of improvements to income through a number of years over to capital account; and an attempt was then made to sell securities in order to balance the books. But it failed to accomplish what the Alton management after 1898 so adroitly performed for the benefit of "insiders."^ Under happier auspices the Union Pacific in 1914 finally distributed its large surplus to common stockholders, in the form of a donation of $82,000,000 of Baltimore & Ohio stock from its treasury, — stock which it had received in exchange for its speculative investments in the shares of other companies.' Ostensibly this "plum" was a distribution of profits accruing from suc- cessftil financial transactions since 1900, and not resulting from transportaition at all. It would appear as if the public interest were not concerned, inasmuch as the outcome was a profitable one. But suppose the speculation had failed? Would not the road have been impoverished to that degree, with necessary deterioration of service? Nor is that all. Collateral trust bonds were originally issued to acquire many of these stocks. They were generally convertible, to be sure, so that fixed charges became largely transformed into contingent ones. But the fact is indisputable that this one-time indebtedness, now ' Cj. New Jersey experience again, as to stock dividends. Footnote p. 308, injra. 2 P. 262, inira. ' Validated by N. Y. Court of Appeals decision, July 15, 1914, de- claring that $15,000,000 profit on conversion of stocks and $38,000,000 on stock market operations in Northern Pacific, etc., were profits not capital. P. 567, injra. 240 RAILROADS transmuted into capital stock/ remained outstanding as an absorbent of future earnings; although the assets which it once served to purchase had been handed over to stockholders as a gratuity. That the surplus earnings from past years still undistributed, together with the increment in the value of tangible property, notably land, preserved an equivalence of assets and liabihties on the books, even after the withdrawal of this huge bonus, obscures but does not alter the fact that the distribution was at bottom "afifected with a public interest." American railways have liberally utilized surplus earnings to build up their properties. The Pennsylvania Railroad for years adopted the "dollar for dollar" practice of devoting Uterally one-half of its income to reinvestment in the plant. During 1887-1911 the sum of $262,000,000 was put back into the Pennsylvania lines east of Pittsburgh from earnings, — an amoimt, that is to say, nearly equal to two-thirds of the total cost of construction of its 2,000 odd miles of line.^ The Chicago & Northwestern in like manner during the twenty-year period to 1913 so divided up its net income of $200,800,000, that $77,700,000 of this amount remained undistributed, either in the form of direct appropriation from earnings for improve- ments, or of income carried to surplus account. In the South, the Louisville & Nashville in the eight years before 1907 put back into its plant over $18,000,000 of imdivided earnings — equal to over 30 per cent, of its share capital. The total surplus thus built up in 1912 is said to have amounted to upwards of 90 per cent, of its entire capital stock. The opinion in the Western Rate Advance case' of 1910 stated that the unappro- priated surplus of all the railroads in the United States at that time amounted to $800,642,923, of which $606,500,000 had 1 Even although the dividend rate ia reduced from 10 to 8 per cent, coincidently with the distribution of assets. Cf. also the New Haven de- bentures based upon N. Y., Ontario & Western or other collateral. 2 20 I. C. C. Rep., 243. Even during the decade to 1913, out of $530,000,000 added to property investment, $164,000,000 came from un- distributed earnings. » 20 I. C. C. Rep., 243, 307. STOCK-WATERING 241 been accumulated in the ten years to 1909.» Such facts are impressive. They certainly do not fairly represent recent tendencies, since 1909. Surpluses of this sort are not now being heaped up. But they indicate how important the ques- tion of the interest of the public in such surplus earnings may at times become. The fact of the existence of substantial surpluses, arising partly as a result of our conservative American practice of putting a portion of earnings back into the property, and partly as a result of the exceptionally rapid development of the coim- try, naturally gives rise to the question as to how far the public has an equitable interest therein.^ The rate-making aspect of the matter will shortly be considered in connection with physical valuation.' The question in so far as it touches the regulation of capitaUzation must be approached somewhat differently.'* In practice the issue generally arises over the right of the railroad to distribute its surplus in .stock or cash dividends. Two clearly defined and opposing views are dis- cernible. The older and simpler one is that stockholders have an inalienable right to all earnings of the company; and that ^ Cf. evidence in the 1910 Rate Advance case; 61st Cong., 3rd sess., Senate Doc. no. 725, "surplus" in index. ^ Well discussed by J. H. Gray, Amer. Economic Review, vol. IV, Supp. 1914, p. 36; by L. G. McPherson, Railway Age Gazette, vol. LIV, 1913, p. 1118; and in Whitten, Valuation of Public Service Corporations, 1912, pp. 176-189. 3 P. 331, infra. * Various differences in principle regarding the determination of a reasonable basis for capitalization and for rate-making obtain. One de- pends upon local accounting practice and state regulation of capitalization; the other, most rates being interstate, is largely a Federal concern. The treatment of obsolescence or misplaced investment is also different. Market value may be a standard for capitalization, but seldom for rates. Under physical valuation, cost of reproduction may be appUed in rate-making, but original cost or investment should be used for capitalization, assuming that the increment of land valuations, as in Texas, is excluded. Most physical valuations and cases before administrative commissions have had to do with rate-making; but the Massachusetts Validation Commission of 1911, the Third Avenue Street Railway case in New York and some judicial decisions are mainly concerned with sound capitalization. Cf. chap. XI, infra. VOL. n — 16 242 RAILROADS if they choose to permit a portion of current income to remain invested in the property, they in no wise forego thereby their right to take it over to themselves without interference at any future time. Such a view was well expressed by the manage- ment of the Great Northern when in 1883 it made an extra distribution in the shape of an issue of $10,000,000 of bonds, "payable 10 per cent, in cash and 90 per cent, in property, constructed or acquired with stockholders' money, — thus re- turning to them $9,000,000 in the nature of a forced loan taken from them by sequestration of $11,000,000 of profits diuing previous years." In confirmation of this view, it deserves to be kept in mind that until a comparatively recent date, there was nothing in the charters of railways, in state constitutions or in the law of public service callings, to indicate that invest- ments by railways from earnings would be differently treated from investment by direct subscription of shareholders. This point has ofteji been raised in connection with the inclusion of surplus earnings in the "fair value" of the property for rate- making purposes.' To decline so to do might lead to absurd results. For otherwise, as between two railroads of different earning power, each pursuing the poHcy of reinvesting one-half its income in the plant, the more profitable one, although it might upbuild its property hugely by comparison with the other, would not be permitted to enjoy the fruits of its self- denial in any corresponding degree. A penalty upon pru- dence and thrift would surely be imposed. The other view, which upholds the claim of the public to substantial enjoyment of the surplus of public service corpora- tions, has been freely expressed in recent rate cases. Oddly enough, judicial decisions throw little light upon it. The argiunent is well put by Whitten^ as follows: If a company has charged rates, not alone adequate to pay a fair and reasonable profit to the stockholders, but also to permit the build- ing out of earnings of extensions and improvements aggregating as ' Chap. X, infra. '' Valuation, p. 176. STOCK-WATERING 243 much as the total investment of the security holders, there is some justice in the argument that unless this has been done for the benefit of the consumers it represents pure extortion. Profits in excess of a fair return should either be distributed to the consumer in lower rates, or if used for extensions and improvements, should be deemed to be held in trust for the exclusive benefit of the consumer. Nor is this all that may be urged in the public behalf. To permit a railroad to capitalize its surplus earnings fully, it is said, and thereafter to permit it to enjoy a return upon this additional investment is, in fact, to permit the shareholders to have their cake and to eat it too;i or, in other words, to make the patron pay more in the future, and forever, because he had already paid an unreasonably high rate to create the surplus in the past. Our own decision in the matter is intermediate between the two extremes of opinion above stated. In the first place, a just decision will depend upon circumstances, particularly upon the actual source of the surplus itself. An appreciable part of it may be due to the growth of land values.^ In the West- ern Rate Advance case of 1910, the Burlington road claimed a total valuation of $530,000,000 according to which its surplus amounted to $272,000,000. The Commission found, in turn, that $150,000,000 of this latter sum was due to the increment in real estate, while only $122,000,000 represented property acquired out of earnings.^ Another instance in the South is afforded by the Atlanta & West Point in Georgia. Reinvest- ment of all earnings in the plant for many years, but particularly the enhanced value of terminal property in Atlanta, seemed fully to warrant doubling the capital stock in 1910 and basing earn- ings and rates thereupon.* An additional complication, of course, is that not infrequently there may have been large grants ' Precisely the line of reasoning in a Lehigh VaUey rate case; 21 I. C. C. Rep., 160. 2 P. 351, infra. Cf. Whitten, Valuation, chap. VI. 3 20 I. C. C. Rep., 332. * Commissioner Clements in Hearings, Interstate Commerce Com- mittee, 1912, on H. R. bill 12811, p. 8. 244 RAILROADS in aid of construction originally made for nothing. This must also be taken into account.' An entirely different problem is presented by the surplus distributed by the Union Pacific in 1914, — a surplus resulting from successful speculation in the stocks of other railroads.^ Decision should be made, also, in the light of the general conditions prevailing at the time. A generation ago it was the common practice to divide all profits in sight and to finance new construction by the issue of securities. Such policies were fully sanctioned by the public opinion of the day. But a few roads, undoubtedly well in advance of their time, during the '80s began to devote a good part of their earnings to new con- struction and betterment. Without outrage to pubhc opinion much of this at that time might well have been added to divi- dends. The shareholders' rights in such a surplus certainly deserve determination in the light of the then-prevalent prac- tice. To apply the standards of the present day, when pio- neering chances have been supplanted by rate-regulatory risks, would be manifestly imfair. The dilemma is most puzzling in those instances where the source of the smplus has been ex- ceptionally intelligent management, coupled with manifestly fair treatment to the pubhc. Such an issue is presented, as we shall soon see, by certain Massachusetts gas company cases. The sharp differentiation of a surplus thus created, from sur- pluses arising through public donations or an increment in land values on the one hand, or an extortionate rate policy on the other, is sufficient to discourage loose generalization. In fine, each case must be judged upon its own merits. A sane treatment of property derived from surplus will be found in the policy of the Massachusetts Gas and Electric Light Commission. It is well expressed in the Haverhill Gas Co. case.' In this instance a public service company by excep- ' P. 351, infra. 2 P. 239, supra. 3 16 Ann. Rep., 1901, p. 9. Cf. 20 I. C. C. Rep., 307, and also address of F. E. Barker, Convention of R. R. Commissioners, 1913. Also Quar- STOCK-WATERING 245 tionally careful and conservative management, coupled with a rapid gain in wealth and population of the community supplied, accumulated a substantial surplus over and above the custom- ary rate of 10 per cent, dividends. This conservative poUcy was encouraged by the commission, on the ground that it in- sured steady dividends and also resulted m the highest effi- ciency at low cost. Such a use of surplus, it was held, conferred substantial benefit upon the public and the shareholders alike. It seemed particularly desirable in the '90s, in view of the prospective keen competition of electric light with gas. Fin- ally, however, the demand for a reduction of rates on one hand, and for capitalization of this surplus on the other, brought the matter squarely up for decision. The commission has con- sistently adhered to its view that by every principle of law such a surplus is the property of the corporation; but, at the same time, that there is imposed upon such a public monopoly "the duty to employ it for the joint advantage of the consmners and the corporation. It need not be dealt with as the exclusive property of either." Unfortunately this admirable theory has been difficult to apply in practice. After fifteen years of litigation, during which the Massachusetts courts have steadily upheld the theory of private property rights, the public in Haverhill has not yet succeeded in securing any reduction in the price of gas. The supreme court of the state in 1913, in the similar Fall River case, completely over-ruled the commis- sion. This body had sought to prevent further issues of stock for extensions while the company at the same time was regu- larly distributing its surplus in the shape of extra dividends over and above a regular rate of 12 per cent.i Such experience tends to confirm the view expressed by Commissioner Prouty^ as to the practical impossibility of making amends to those who have once paid excessive rates, by laying hold upon such sur- terly Journal of Economics, vol. XIV, 1899, p. 509; and idem, vol. XV, 1900, p. 254; vol. XVII, 1902, pp. 342 and 643. ^ 1 214 Mass;, 529. 2 15 I. C. C. Rep., 415. 246 RAILROADS pluses. Supervision of capitalization, as of rates, must be continuous and foreseeing, not spasmodic and tardy. It can never be retroactive successfully. Harm must be prevented. Once done, it cannot be corrected. But is the accumulation of a surplus to be regarded, indeed, as a menace? Is it not in fact just the opposite? We shall see. Somewhat similar points have been recently considered by the Interstate Commerce Commission. In the Spokane case,^ counsel for the shippers contended that the ample sur- pluses of the Pacific railroads should in some way be distributed by the Commission, acting as a trustee for the public, through a reduction of rates. But it was pointed out in the decision that, under a imiform scheme of rates, one road by reason of cheaper construction or easier operation might pile up a surplus while the other did not. Could it then be said that this surplus had been improperly accumulated, so long as its rates had been no higher than those of its competitors? Similarly in the Eastern Rate Advance case in 1911,^ assent within certain limits was given to the accimaulation of surplus in order to provide for necessary improvements which for the time being, or in their nature permanently, did not yield a return. Large investment of a non-productive sort such as passenger stations, the aboUtion of grade crossings or the installation of safety appliances, might properly be cared for in this way. But, the opinion added, stockholders must also contribute to such sur- pluses through a reasonable sacrifice in dividends. This was undoubtedly what the Railroad Securities Commission of 1911 had in mind in declaring that surpluses might most fairly be utilized to meet the necessary "costs of progress." An ad- mirable policy, voluntarily adopted by a public service cor- poration, is that of the American Telephone and Telegraph Company.* The directorate set forth the advantages to the company of a large surplus, as strengthening credit, assuring 1 15 I. C. C. Rep., 376, 415. « Ann. Rep., 1912. ? 20 I. C. C. Rep., 243, 265. STOCK-WATERING 247 steady dividends, procuring new capital on favorable terms, and maintaining a high state of efficiency in operation at low cost. The promise was held forth that such reserves and betterment should not be made the basis in future of larger dividends, but should constitute a trust to be administered in the public in- terest. These reserves, it was hoped, were to remain as assets "indivisible, inviolable and inalienable," — not, in other words, at some future time to be divided up among the' shareholders. Under such circumstances, the advantage to the public of large reserves, thus invested, is that reduced charges and improve- ment in service will naturally follow by reason of the economies in operation introduced. ^ Refunding,^ as affording an opportunity for surreptitious inflation of the volume of outstanding securities, is of relative unimportance, judging by the experience of our public service commissions. Usually the operation merely perpetuates, it does not create, an undue volume of indebtedness, — allow- ance being made, of course, for changes in the prevailing rate of interest and the condition of investment demand.' The offence, if there were one, was usually committed at the time of the original issue. But the necessity of refunding some- times affords an opportunity for the intervention of adminis- trative authority to correct a previous over-capitahzation in whole or in part. The hard-fought Delaware & Hudson case, outlined in our review of the New York experience,* illustrates the manner in which the refunding of floating indebtedness may be critical in the larger affairs of consohdation of railroad properties. In Texas, refimding operations have been of peculiar interest. The railroad commission of that state inter- preted the law, rigidly restraining all further issues of securities until capitalization had been brought down to the level of property valuation, as prohibiting even the refunding of exist- 1 The theory of partnership in surplus is well stated by H. V. Hayes in North American Review, vol. CXCVIII, 1913, p. 341. Cf. also his Pubhc UtiHties, 1913. 2 P. 130, sMpra. " P. 186, supra. ' P. 289, xnfra. 248 RAILROADS ing bond indebtedness.^ The matter became acute about 1905- '06, when a large number of bonds of Texas roads reached maturity. The physical valuations applied by the commission as a standard of measurement were generally well below the volume of bonds outstanding, to say nothing of the capital stocks; and revaluation was denied on the ground that accounts could readily be kept up to date by adding the yearly reinvest- ments of income to the original figure. If prohibited from refunding the maturing bonds, dollar for dollar, obviously the roads would be unable to issue enough new ones to take up the old. Enabling legislation to mitigate the rigor of the law was urgently sought, but in vain. The only escape for the companies was to issue new bonds to the full amount of their physical valuation and then to leave the balance as a floating debt. To the outsider, it appears as if this policy of excision were imduly severe. If, as in the Delaware & Hudson case, there was evident over-capitalization to be corrected, it seems as if the wiser plan would be to permit refunding, but to insist upon guarantees that the company would make amends within a reasonable time by a gradual process of amortization.* Consolidation of railroad properties offers an excep- tionally favorable opportunity to increase capitaUzation sur- reptitiously. The English practice of "splitting" securities had its beginnings in connection with merger operations. New classes of stocks known as preferred and deferred shares were put forth, each of them equal in volume to the total original stock outstanding.^ A prime advantage of consolidation, of course, is that the constituent companies may be so gerryman- 1 P. 303, injra. ^ Certifications of refunding operations by other state commissions are given at p. 293, infra. Even later ones approved by public authority will be found in the following cases: permitting the St. Paul to exchange $470,000,000 of its own bonds for those of the St. Paul extension, IP. S. C, Missouri, 1913, p. 305; and prescribing the terms of exchange, discount, etc., of 128,000,000 of Iron mountain bonds, ibid., p. 105. ' McDermott, Railways, p. 164. STOCK-WATERING 249 dered that successful ones with surplus earnings may average their rate of return downward by combination with other properties less favorably situated. A weak corporation, whose stock is quoted say at $50, may be merged in a second corpora- tion whose stock is worth $150 per share. The latter may then issue new stock of its own in exchange for the $50 stock, share for share. Such an operation as this may not only deceive the public, by establishing a fictitious capitahzation far in excess of the worth of the investment; but it may also constitute a fraud upon the shareholders of the more prosperous company, diluting the value of their holdings. In ordinary offerings of new shares at favored prices, the stockholder finds compensa- tion for the fall in the value of his shares in the bonus or "right" which he received. ^ But in these cases of consolidation, the bonuses or rights may go to the favored holders of shares in the weaker company alone. It is conceivable, of course, that advantage may flow to both concerns from the merger, par- ticularly through the extension of the credit of the stronger to enable the weaker one to make the expenditures necessary to bring about reduced operating costs. This has been done of late by parent roads outside Texas to subsidiaries therein, sub- ject to the drastic limitations of the Stock and Bond law.^ The classical instance of stock-watering in connection with consolidation is the merger of the Kansas and Union Pacific roads in 1880.' Jay Gould first quietly picked up, at a nominal price per share, a large amount of stock of the Kansas Pacific, then just out of bankruptcy. The Union Pacific, at the time, was a prosperous company paying dividends regularly. Both roads ran due west across the plains beyond the Missouri river, 1 P. 269, infra. 2 P. 156, m-pra. The analogy with electric lighting properties (p. 289, infra) is imperfect, inasmuch as the latter may concentrate all operation in the stronger plant, while in the case of railways both must still operate in their respective territories. ' Pacific Eailway Commission Rep. 1888; 50th Cong., 1st sess., Exec. Doc. no. 51, pp. 55 et seq. Cf. also p. 17, supra. 250 RAILROADS the Union Pacific from Omaha, and the Kansas Pacific from Kansas City. (Map, p. 500.) The latter had at the time no important western terminus. Under threat of building his mori- bund road through to a point where it would be a very trouble- some competitor, Gould bludgeoned the directors of the Union Pacific into an agreement to merge on equal terms. His holdings were taken over share for share by exchange for Union Pacific stock. The combined companies then continued to pay 6 per cent, on the new total capitalization and the following year increased the rate to 7 per cent. By this stroke Gould made very large profits, and the shareholders of the Union Pacific were deprived of a portion of the earnings which otherwise would have belonged to them. As for the public it was called upon thereafter to provide sufficient earnings to pay 7 per cent, dividends upon Kansas Pacific shares, which, prior to the merger, had been worth almost nothing. Another notable inflation of capitalization in connection with railroad consolidation took place on the formation of the Rock Island company. In 1902 this purely financial corporation bought up the old Chicago, Rock Island & Pacific Railway, capitalized at $75,000,000, and substituted therefor its own stock to the amount of $117,000,000 together with $75,000,000 of collateral trust bonds, secured by the stock of the property acquired.! xhe entire history of the New York traction com- panies is studded with similar occurrences. One instance may suffice. In 1906 the Interborough-Metropolitan company pur- chased $105,540,000 in securities of merged lines and issued in place thereof $138,309,000 of its own stock and $70,000,000 in bonds. The subsequent bankruptcy of this company, the loss of large sums by confiding investors and the utter break- 1 Cf. pp. 152, sujira, and 524, infra. The Kansas City, Fort Scott & Memphis Railroad was purchased in 1901 by the Railway of the same name, adding 131.6 miles of Une and 129,346,310 of capitaUzation, with attendant commissions, and subscription profits to the syndicate of $2,282,000. Hardly a labor of love! 63rd Cong., 2nd sess., Senate doc. No. 373, p. 56. STOCK-WATERING 251 down of the service, are matters of recent history.^ It must be clear that, in both these cases, a pm-ely fictitious capitaliza- tion was created, not corresponding in any way to the real worth of the property. Whether similar exchanges of seciirities, share for share, with branch-Une companies absorbed by a main line, amount virtually to stock-watering or not, would seem to depend entirely upon circumstances. The manipulation of branch-hne finances upon the old Union Pacific road was notorious. Regarding the modes of acquisition of subsidiary companies by the Great Northern road, charges have repeat- edly been made in Minnesota that each merger resulted prac- tically in additional fictitious capitahzation. In Texas the details of all railroad mergers of this sort are most rigidly scrutinized, in order to prevent such an increased capitahzation. Mere consohdation of roads in the Missouri, Kansas & Texas system in 1891, for example, increased the aggregate of stock and bonds by $12,475,000, or $19,207 per mile of road. This, it will be noted, was before the enactment of the Stock and Bond law.^ Whether the public interest is prej- udicially affected in such cases or not would seem to be depend- ent largely upon whether the companies absorbed were worth the price paid for them; or, in other words, whether efficiency and earning power were promoted in a degree suitably propor- tioned to the enhanced capitahzation. And, even so, the ex- pediency in the pubhc interest of requiring amortization of the increase in capitahzation, as required by the best modern practice, is obvious.' All previous demonstrations of the evil of dilution of capi- tahzation as a concomitant of consohdation were echpsed by 1 Pp. 283, 287, and 292, infra. ^ Report of the Railroad Commission to the Governor on the subject of mergers, Nov. S, 1904; reprinted in full in the Dallas News of Nov. 27, 1905. Also p. 302, infra. { ' Cf. New York Pubhc Service Commission practice, reviewed on pp. 277, 288, infra. Also the vigorous dissenting report on p. 18 of the Draft Bill for Regulation of Public Utihties, of the National Civic Fed- eration, Oct. 23, 1914. 252 RAILROADS the utter prostration of the once substantial New York, New Haven & Hartford Railroad; officially termed "one of the most glaring instances of maladministration in all the history of American railroading." ^ Within nine years to 1912, the out- standing securities of this company increased from $93,000,000 to $417,000,000, although the operated railroad mileage in- creased only fifty miles. Issues of new stocks and bonds during this period brought in about $340,000,000. Of this sum, $40,000,000 was spent for the purchase of hues previously operated under lease or otherwise indirectly. For betterments and equipment, $96,000,000 was expended. This left a sum of about $204,000,000, which in nine years was invested in prop- erties outside its own railroad sphere, — that is to say in trolley companies, steamship Unes and even electric light and power plants. A tale of more reckless disregard of the interests of the public and of investors alike — a more complete breakdown of service in the form of intolerable losses and delays and appalling accidents — has never been spread upon the records. It is an involved affair in entirety. We must be content to outline it by territorial samples. The Connecticut trolleys in the New Haven system were originally leased as the Connecticut Railway and Lighting Company. This aggregation of roads had been formed by the consohdation of nine smaller concerns in 1900. Bonds to the amount of $9,350,000 and shares amounting to $15,000,000 — a total of $24,350,000 — were exchanged for a former combined 1 Best outlined in 27 I. C. C. Rep., 581, and 31 idem, 15. Vide also p. 442, infra. Cf. also Report to the Joint Board on the Validation of Assets and Liabilities of the New York, New Haven & Hartford Railroad under chap. 652, Acts of 1910, by George F. Swain, Engineer in Charge; pub- lished in Report of the Mass. Joint Commission on the New York, New Haven & Hartford Railroad Company, February 15, 1911, pp. 51-154. [Known as the Validation Report.] Other details concerning steamship lines are given in the above I. C. C. reports, supplemented by the further testimony taken in May, 1914; also Report U. S. Bureau of Corporations on Transportation by Water, pt. 4, 1913, p. 17. The second extended I. C. C. Rep. has just been issued (July, 1914); 31 I. C. C. Rep., 31. STOCK-WATERING 253 capitalization of $8,210,000 at the time of consolidation.' This flagrant over-capitalization was characteristic of the general situation in that state. The absence of rigid governmental oversight, outside of Massachusetts, created a striking contrast in this regard, to which attention will be called in another con- nection.^ Where the New Haven railroad agreed by purchase, and lease to support this inflated capitalization, the operation practically, of course, amounted to dilution of the value of its own securities to a corresponding degree. The Massachusetts VaUdation Commission in 1911 found that, even making no allowance whatever for depreciation, $13,000,000 of a total par investment of $40,000,000 of the New Haven railroad in these Coimecticut trolleys represented no tangible value whatever. Still less, apparently, did it represent earning power. The roimd-about processes by which the New Haven ob- tained control of its troUey lines in Rhode Island may best be described by direct quotation from the report of the Interstate Commerce Commission.' "In 1902 the United Gas Improvament Company, generally under- stood to be an institution backed by Philadelphia capital, entered the troUey field in Rhode Island. A corporation known as the Rhode Island Company was organized, which issued its capital stock in the sum of $2,000,000 to the Improvement company, receiving in return $2,000,000 in cash. The Rhode Island Company thereupon leased three trolley lines, which embraced in the main all the lines in Provi- dence, Pawtucket, and the immediate vicinity. "The Improvement company now proceeded to organize what was known as the Rhode Island Securities Company for the purpose of holding the stock of the Rhode Island Company. The Improve- ment company turned over to the Securities company the $2,000,000 of stock in the Rhode Island Company; and received therefor without any further consideration $12,000,000 of the capital stock of the 1 Report of Commission de Public Service Corporations, Connecticut, 1909, pp. 8-11; New York Evening Post, Nov. 23, 1912; 31 I. C. C. Rep., 108. 2 P. 296, infra. ' 27 I. C. C. Rep., 581; and 31 idem, 41 and 85. 254 RAILROADS Securities company and $3,500,000 of its 4 per cent, bonds. This resulted in the issue to the Improvement company of $15,500,000 of securities for $2,000,000 in money. "This was in 1902. In 1904 the New Haven began its campaign for the acquisition of the trolley lines of southern New England, and soon after purchased a block of the stock of the Rhode Island Com- pany. In 1906 it perfected arrangements for the acquisition of the .entire stock of that company. Instead, however, of purchasing that stock directly, it arranged to do it indirectly by taking over the Se- curities company. What the New Haven did was to organize a third corporation, the Providence Securities Company, which exchanged its 4 per cent, debentures guaranteed by the New Haven company for the stock, bonds and notes of the Rhode Island Securities Company substantially at par. There was a cash payment of $10 per share by the stockholders of the Rhode Island Securities Company and an adjustment of $3 per share against this on account of interest; there were certain bookkeeping entries one way and the other, but the up- shot of the whole transaction was that the New Haven company issued its obUgations to the Improvement company and others and received in exchange Ut substantially doUar for dollar these inflated securities of the Rhode Island Company. "Representatives of the New Haven company earnestly insisted that this company had not watered the stock of the Rhode Island Company, and this, strictly speaking, is true. The Improvement company turned in the water and the New Haven company converted that water into wine. In whatever aspect the transaction is viewed the New Haven gave $13,500,000 for nothing." The net result of this operation was a total investment of about $24,000,000, although the state authorities subsequently esti- mated the property to be worth only about one-fourth of this figure.^ Nor were the earnings of these Rhode Island trolleys, at any time, sufficient to justify the prices which the New Haven paid for them. The reckless expenditure, in order to secm-e monopoly control, simply saddled the New Haven treasury with a huge aggregate of inflated securities which did not begin to cover the cost of raising the funds for -their purchase. 1 President Mellen himseK on May 20, 1914, before the I. C. C. con- ceded that the price was twice their value. A committee of the directors had already reported adversely upon this purchase, but were overruled by Messrs. Mellen and Morgan. STOCK-WATERING 255 The 113,500,000 given for nothing in the Rhode Island trol- leys was well matched by the investment in the New York, Westchester & Boston Railway, — a four-track electric road, extending about twenty miles out from New York.^ This affords an instance of inflation, not only in connection with franchise purchase but also as a piece of original construction. Eight thousand shares of New Haven stock, worth $1,200,000, were first exchanged for 24,000 Westchester shares, worth in the words of President Mellen, subsequently, "about ten cents a pound." Then about $11,000,000 more was paid for $5,000,000 invested in construction by the promoters, — this by command of J. P. Morgan without any adequate accoxmting even to the directors. All in all, to 1912 the New Haven invested $35,000,000 in this enterprise; although the value of tangible property, reported to the New York Pubhc Service Commission, was only $12,000,000. An annual deficit of $1,250,000 still obtains.2 While the foregoing events were taking place, the New Haven was also seeking the control of the Boston & Maine Railroad in order to consohdate its own transportation com- panies south of Boston with those of northern New England. The financial mechanism by which this was accomplished is described in another place. ^ So far as inflation of capitaliza- tion is concerned, in order to elude the prohibitions of the legis- lature and the courts of Massachusetts, the Boston & Maine stock was for a brief period in 1908-'09 sequestrated in the hands of one J. L. Billard. To him the stock was sold at $125 per share, within a few months to be once more returned to the New Haven company at $150 per share. "Upon the face of 1 31 I. C. C. Rep., 35 and 74; 3 P. S. C, New York, 2nd D., 286. ' The Mass. Validation Report of 1911 accepted an inventory of $12,300,000 for plant and estimated $8,900,000, "for cost of the franchise, control of the situation, etc." ' P. 415. infra. 256 RAILROADS the transaction, therefore, Mr. Billard made, without the investment of a dollar in excess of all expenditures by him, slightly over $2,700,000 as a result of this transaction."^ Moreover, the objection that this unearned paper profit was not an actual one, because the final payment was not in cash but in notes, was met by the significant fact that the notes given in connection with the final transfer were guaranteed as to face value by the New Haven railroad company. Upon the record, therefore, the cost to the New Haven company of these profit- less transactions was almost $3,000,000, — a sum which, of course, was a part of the large amount which had to be raised by the issue of securities by the parent road. Other minor instances of inflation under the Mellen ad- ministration may be mentioned in passing. Without any substantial new investment, the capitalization of the Portland Union Station Company was run up from $350,000 to almost $6,000,000, with entailed fixed charges of $180,000 a year. Even after public opinion had become thoroughly bent u'pon subjecting the New Haven to control, the Western Trolley Merger bill was jammed through the Massachusetts legislature in 1913 as the price of acquiescence by the railroad in the crea- tion of a public service commission. This permitted the ac- quisition of the stock of three voluntary associations, which as holding companies controlled the trolley lines in western Massa- chusetts. This opened the door to the capitahzation of $22,- 398,000 of floating debt, premiums on stock and other items, without let or hindrance by public authority.^ In conclusion, the Interstate Conmierce Commission made it clear as a result of its elaborate investigations, that if the New Haven had confined itself exclusively to the operation of 1 27 I. C. C. Rep., 584. Corroborated by testimony of Billard, May 7, and of Mellen, May 17, 1914, further elaborated in 31 I. C. C. Rep., 31. Civil suits for the recovery of $3,824,000 were instituted against Billard et al. by the New Haven on Oct. 6, 1914, and are still pending. ' Ann. Rep., Mass Railroad Com., 1912, pp. 167-175. STOCK-WATERING 257 its railroad property, it would have had for the fiscal year 1912 a surplus of $1,794,000 over and above 8 per cent, dividends upon its stock, instead of a deficit of nearly $1,000,000. The losses are thus epitomized in the second official report to the Senate.' Boston & Maine $23,223,725.68 N. Y., Westchester & Boston 11,457,156.09 Hartford & Worcester St. Railway 73,394.27 Springfield Railway companies 203,221.15 Worcester Consolidated St. Railway 10,500.00 Worcester & Southbridge St. Railway 15,580.00 Connecticut Company 12,535,386.01 Rhode Island Company 18,352,336.41 Total $65,871,299.61 "There was a loss in the recent sale of the New Haven interests in the Merchants & Miners Steamship Company of $3,594,500. "From all of the foregoing and from a careful consideration of the method in which expenditures, not specified herein, have been made, it is submitted that a reasonable estimate of the loss^to the New York, New Haven & Hartford Railroad Company by reason of waste and mismanagement will amount to between $60,000,000 and $90,000,000." Another viewpoint is afforded by the earning power of these outside properties which were so costly to acquire. During 1913, the Rhode Island trolley system earned a surplus of $88,000, and the Connecticut trolleys one of $109,000; while the Millbrook company reported a deficit of $179,000, the New England Steamship Company one of $355,000, and the New York, Westchester & Boston one of $1,405,999. Matters inevitally went from bad to worse. Shareholders with dismay witnessed a decline in the market price of New Haven stock from about $185 in 1905 to less than $50 per share in 1914. Dividends, after years of uninterrupted payment, had to be suspended during a wearisome period of recuperation. The dismal chapter seems about to be closed in 1914 by the resolu- tion of the system into its component parts under compulsion 1 31 I. C. C. Rep., 62. VOL. n — 17 258 RAILROADS from the Federal Department of Justice. The interest of the public appears in the fact that, under other circumstances, the railroad might conceivably have continued to furnish a safe and adequate service without further advance in its rates and fares, and yet at the same time have returned to its stock- holders a fair dividend upon their investment. CHAPTER VIII STOCK-WATERING {Cmtinued) Reorganization and stock-watering, 259. — The Third Avenue Railroad case, 260. — The Chicago & Alton affair, combining all phases of in- flation, 262. The provision of new capital, 267. — Privileged subscriptions to stock, 268. — The value of rights, 269. — Is this stock-watering or not? 271. — Stock issues below par, 272. — At pax or above, 274. — The com- plication of convertible securities, 276. — Bonds emitted at a discount, 277. — Sound accoimting poUcy, 278. — PubUc interest requires amortization, 279. Financial reorganization offers a fruitful field for an increase of capitalization irrespective of assets, whether for railroads or industrial corporations.' Occasionally a company succeeds in emerging therefrom with the same volume of out- standing securities with which it went into bankruptcy. By far the larger number come forth saddled with heavier issues than ever before. Even more impressive is the volume of securities in comparison with the assets. Almost never does any real excision under reorganization take place.^ All this is, of course, highly paradoxical; inasmuch as it was the over- load of stocks and bonds which brought on the trouble, — an overload so disproportionate to the earning power of the prop- erty that its back broke under the burden. But the explana- tion is not far to seek. It is never the total capitahzation of a company which is the source of danger. The volume of capital stock is immaterial. It is the fixed charges upon indebtedness to which the road succumbs. Yet some way must be discovered under reorganization by which the old bondholders may be induced to forego their right of foreclosure. This ahnost always ' P. 406, infra. 2 Simon Sterne, Forum, vol. X, p. 37; vol. XVII, p. 19. 260 RAILROADS happens through offering them securities in exchange like in- come bonds or preferred stock, contingent upon earnings for their support. But the consent of bondholders to such substitu- tion is in any event difficult to obtain. The most inviting speculative bonuses, even in the form of a modicum of common stock, must be dangled before their eyes in order to obtain consent for the substitution. This is what is even now occur- ring in the pending reorganizations of the Wabash, the Rock Island and the "Frisco," not to mention several minor roads. It is a difficult and yet an important matter to control reor- ganization in the interest of the company as a whole and the public to be served, instead of particular classes of security holders. Otherwise the readjustment may only make bad matters worse. An admirable example of the well-advised exercise of governmental control is afforded by the hard-fought controversy upon the Third Avenue Street Railroad in New York. The experience merits review.^ In 1907-'08 this com- pany went into the hands of receivers. Its financial history was a disheartening record of fraud. Stocks and bonds of subsidiary companies stood u|pon the books at a cost of $9,950,- 000 — nearly twice their face value — despite the fact that one of these companies was in the hands of a receiver, another was practically worthless, and none of them, judged by earnings, was conceivably worth more than par. Over $500,000 of cap- ital had been devoted to paying interest charges; $6,000,000 had gone into operating expenses; $1,000,000 for lawyers' fees; $1,000,000 into an untraced construction account; while for $5,000,000 there was absolutely no record. In 1909, after foreclosure proceedings, a reorganization committee of bondholders as intending purchasers prepared a plan for the organization of a new company and appUed for authority to issue the necessary securities. The plan of read- justment frankly admitted a huge discrepancy between the assets of the property and the capital liabihties proposed. The 1 Also p. 287, infra for further references. STOCK-WATERING- 261 * outstanding bonds and stock of the old Third Avenue road amounted to $58,560,000; the new capitaUzation was prac- tically identical in amount. The plan followed the common rule in the reorganization of companies characterized by much watered stock and depreciated bonds. Fixed charges were cut down by substituting for the old mortgages, new income bonds calhng for interest only as earned; and a heavy assess- ment was levied upon stockholders under penalty of having their former holdings cancelled. The PubUc Service Commis- sion upon this showing declined to permit the new company to be capitaUzed for an amount equal to the outstanding securities of the old road, alleging properly enough that the reorganization was an opportune time for bringing capitalization and assets more nearly into equivalence. After this first rebuff, a somewhat improved plan of re- organization was in due time presented for approval. The stockholders, instead of being required, as before to subscribe heavily to new stock equally valueless with the old, were now given a certain proportion of bonds in return for their assess- ment. But even under this second plan, the outstanding securi- ties aggregated $73,600,000, whereas the physical assets were avowedly worth only $44,000,000. This excess of habihties was, of course, the fruitage of the stock-watering and fraud of past years. Even on the basis of reproduction cost entirely new, plus necessary working capital, current assets amounted to only $68,000,000. This figure made no allowance for de- preciation, obsolescence or inadequacy, and it included $11,625,- 000 for "development expenses," such as brokers' commissions and discount on bonds. The Public Service Commission there- upon in 1910 disallowed the second application. The case then went to the supreme court; and a decision was finally handed down,^ purely on law points, which upheld the appeal of the reorganization committee. An ancient section of the 1 N. Y. 145 App. Div. 318; 203 N. Y. 299; 96 N. E. Rep. 1012. Precedent followed by Nebraska; 5th Ann. Rep. Railroad Commission, 177. 262 RAILROADS . * Stock Corporation law was unearthed, which by oversight was not repealed when the Public Service Commission Act was passed. This gave free rein in the matter of capitalization to reorganization managers. The next legislature promptly- revised the statute. But, in the meantime, the commission was obliged to approve this second plan despite the utter discrep- ancy between capitalization and assets. Naturally, however, under such circumstances the new securities could not be marketed at anything like par. It was estimated that $55,- 000,000 par value would produce only about $33,000,000 in cash. At this point, the commission in 1912 once more in- tervened.i The policy imposed was the only sound one for dealing with matters of this sort. It was directed that an amortization fund be set aside aimually out of earnings, suffi- cient to cancel all the exceiss of UabiUties over assets by 1960, when the bonds matured. Heavy depreciation charges were also required. A similar wholesome plan has since been adopted in the case of steam railroad issues by the New York up-state commission, notably in approving of the New York Central bond issue of $70,000,000 in 1914. Such may be said in fact to have become the established practice. It is obvi- ously the only prudent one. Practically all of the possible abuses or frauds described in the preceding pages under the caption of stock-watering are found combined in a single instance in recent years — the reorganization of the Chicago & Alton road by the late E. H. Harriman and his associates during the eight years following 1898. The case is an illuminating one; for it shows how an unscrupulous management may, at one and the same time, enormously enrich insiders at the expense of the investing public, and prejudice the interests of shippers, both by crippling the road physically and by creating the need of high rates for service in order to support the fraudulent capitalization. The » 3 P. S. C, 1st D., 51. STOCK-WATERING 263 imperative need of public supervision of the finances of common carriers cannot be better demonstrated than by a plain recital of the facts in the case, based on the sworn testimony ehcited by the Interstate Commerce Commission in the course of its official investigation of the matter.' For many years prior to 1898, the Alton road had been very conservatively financed, in the face of a profitable and constantly expanding business. According to the books at the close of that year, the assets amounted to $39,900,000. These assets were represented by some $22,230,000 of common and pre- ferred* capital stock and about $11,000,000 of indebtedness outstanding. The balance appeared upon the books of the com- pany as surplus. The stocks had long been in receipt of 8 per cent, dividends and commanded prices ranging from $150 to $200 per share. At this time the late E. H. Harriman and three associates formed a syndicate and bought up practically all the shares, paying top-notch prices for them. In the short space of seven years, they expanded the total capitalization of the road from $33,950,000 to $114,600,000, an increase of over $80,000,000. In improvements and additions to the property out of this augmented capitalization, their own accoimts showed only about $18,000,000 expended. It thus appears that securities aggregating $62,600,000 were put forth during this time without one dollar of consideration. This sum was equal to about $66,000 per mile of line owned — a figure con- siderably in excess of the average net capitalization of the rail- roads of the country. The first step taken by the syndicate, after it had acquired practically all the capital stock of the Alton road, was to issue $40,000,000 of 3 per cent, bonds. This amount, it should be noted in passing, was $6,000,000 more than the total capitaliza- tion at the time. It was stated that these bonds were issued in order to retire maturing obligations amounting to $8,500,000, 1 12 1. C. C. Rep., 340. Further details and analysis are to be found in The Journal of Accountancy, July, 1907, especially at p. 223 et seq. 264 RAILROADS to make improvements and additions and for other corporate purposes. These bonds were issued to stockholders, i.e. to the syndicate, at 65 per cent, of par. The bulk of these was promptly resold to the public, including the New York Life Insurance Company, at prices ranging from 82 to 94. Had these bonds been sold directly to the public, the Alton road would have realized about $8,000,000 more than it in fact received. As it was, this sum went as profits to the syndicate. The next stage in the reorganization was the declaration of a 30 per cent, dividend to the shareholders, i.e., to the syndi- cate. Nearly seven million dollars was thus paid by the railway company out of the proceeds of the bond issue — there being no other funds available. This cash dividend, made out of the proceeds of a bond issue, was covered up by a readjustment of the road's accoimts. At the outset the existence of a large bookkeeping surplus was noted; and it was estimated that appropriations for betterment and improvement, paid out of income d^i'.g many years past, together with other items of ancient tdstory, had rendered the property worth much more thaix appeared upon the books. Consequently, against the increased habihties created by the new bond issue, was set off among the assets the item of $12,444,000 for "construction expenditures uncapitaHzed." Thus was conservative financing in the past made to enrich, not the railroad company but the private individuals who owned its stock. And the payment of a dividend out of the proceeds of a mortgage remained undisclosed to the world at large. Other minor details of the transaction, such as the use of $8,600,000 of the proceeds of the bond issue to pay coupons then due on other obhgations, and the turning of other debts of the com- pany, which should have been paid, into an apparent asset to be capitahzed, were all directed to the same end. The main result of the creation of 132,000,000 of bonded indebtedness, was less than $6,000,000 in cash to be spent upon the property. STOCK-WATERING 265 The third transaction by the members of the syndicate was to sell all their holdings of stock in the old Chicago & Alton Railroad to a new company, the Chicago & Alton Railway, of which they were the incorporators. For the preferred stock, which had cost less than seven milUon dollars, and which had received a special dividend of 30 per cent., the new company paid them $10,000,000 in cash. For their 183,224 shares of common stock of the old company, which had cost $32,000,000 and on which they had received a special dividend of about $5,500,000, they took in exchange 390,318 shares of the new railway company. Part of this was then resold by them to the Union Pacific railroad, which was absolutely controlled by Mr. Harriman; and about three-fourths of the common shares finally turned up in the treasury of the Rock Island Company. To meet its obhgations to the syndicate, including the purchase of a piece of new road at an exorbitant price, the new railway company was called upon to raise some $13,000,000 in cash. This was effected by mortgaging the shares of the old railroad company, just purchased, for $22,000,000. These new col- lateral trust bonds were taken by a member of the syndicate at 60, although they soon openly commanded a price of from 78 to 86. The exact amount of profit to insiders at this point was never disclosed. One detail of the new mortgage may be added. It was supposed to cover some thirty-four miles of road in process of construction; yet it subsequently developed that no funds were reserved from the proceeds for that purpose. New securities had to be issued in order to complete it. All these operations were obscured in the pubUshed accounts of the company. The balance sheet of 1906 included the item "cost of road, etc.," at $117,000,000. In the preceding year it had been only $66,700,000. On the liabihties side, this dif- ference was partially evened up by an increase in "funded debt" from $27,000,000 to $72,350,000. To the uninitiated it would appear as if the proceeds of large new bond issues had been expended upon the road. Yet so completely was the treas- 266 RAILROADS ury gutted, that the new Rock Island management on assum- ing control was compelled to issue car-trust notes in order to procure equipment indispensably needed to meet the demands of traffic.^ The incentive for this capital expansion appears in the profit of $23,600,000 made by the syndicate as a result of its finan- ciering — profit a large part of which should have accrued to the railroad company. First, there was the profit on the initial sale of bonds at an absurdly low price; then a 30 per cent, extra dividend from the proceeds of a bond issue; then a sale of preferred stock at a fancy price in cash to the new railroad company. This was followed by a sale of remaining stock to the Union Pacific and Rock Island companies at exorbitant figures; by the sale of a branch Hne for more than it was worth; and lastly by the sale of the final large bond issue to insiders at a ridiculously low price. All this was capped by the supreme insult of a payment of over $100,000 to the main conspirator as an extra salary for financing the enterprise. The only excuse offered, or palliation suggested, for these predatory transactions was that, despite the enormous increase in the total capitahzation of the Alton road, the character of its securities was so readjusted that it could still be counted upon to meet its fixed charges out of earnings. Although dividends on the stock had to be discontinued and the market price of its shares shrivelled to almost nothing, so low were interest rates on the new bonds and so thoroughly concealed were the main facts until the new issues were floated, that the Alton did actually, as was alleged, get some $22,000,000 of cash for improvements and additions at an additional charge on larger earnings of $660,000 a year; in other words at a cost of only about 3 per cent. The new plan, in brief, substituted bonds and guaranteed stock at low rates of return for common 1 For a time alternate management by the Rock Island and Union Pacific companies was agreed upon, in view of their joint investment, but in 1907 it was turned over to the "Clover Leaf," a Hawley road. P. 532, infra. PROVISION OF NEW CAPITAL 267 stock which formerly paid large dividends. Interest require- ments did not expand in proportion to indebtedness.^ But how about the burden of this indebtedness when it matured? Bonds which reaUzed to the company less than two-thirds of their face value must then be redeemed at par. And, in the second place, the control of the property was now most effec- tually divorced from the real ownership. For the real value was fully covered by the bonds outstanding, while responsi- bility to the public for the management of the road was vested in the possessors of an almost worthless stock. Provision of new capital for extensions and betterment — a very necessary and frequent financial operation on a growing property — may or may not lead to imdue inflation of capital- ization in proportion to assets. Everything depends upon the terms under which the fimds are seciu'ed. The problem natu- rally divides itself into two distinct parts, having to do with offerings of bonds and stock, respectively. These two are so different in essence, that they should be considered separately. But in one respect both stock and bond offerings resemble one another closely. Just in so far as the subscription price to stock- holders for either class of securities is below such a fair market value of the new offerings as would enable them to be fully taken by others, the subscribers gain at the expense of the corporation. Its capitaUzation will be enlarged in relation to the capital, more than it need be. But offerings of this sort to shareholders possess several collateral advantages over an appeal to the general public. Bankers' commissions on a pubUc imderwriting are saved; and whatever bonus is given goes to augment the loyalty of stock- holders, who may thus the more confidently be rehed upon to come forward again. Offerings of new securities to shareholders on specially favorable terms, moreover, may be made a means of increasing nominal capitahzation and of thus making pro- '■ P. 110, supra. 268 RAILROADS vision for more generous returns to stockholders than it would be best to advertise by an outright increase of the regular dividend. It is this last motive which sometimes lays the corporation open to the charge of stock-watering. Whether this charge is deserved or not would appear to depend upon the amount of bonus conferred, which may readily range all the way from so considerable a sum as practically to constitute a stock dividend, to a "right" with no greater value than is sufficient to induce the shareholders to accept the proffered terms. It may be a voluntary offering at such discoimt below the market price as to stamp the operation as a mere bhnd for increasing capitalization. It may be a forced offering, due to inabihty of the company to sell bonds pubhcly for the com- pletion of improvements partially effected, or to meet some other imperative need. The particular mode of financing chosen to meet needs for new capital will largely depend upon whether the present shareholders can be relied upon to take up the new securities. Obviously, if the new investment is bound to yield a larger re- turn than the current rate of interest on bonds, the shareholders may reserve the surplus earnings to themselves in either one of two ways. The corporation may borrow at the going rate by issuing bonds, whicli of course do not participate in present or future surplus earnings but leave that increment to be divided among shareholders ;i or the company may issue new capital stock for subscription among its shareholders. But unless all this new capital stock be taken by shareholders, it is better to issue bonds; for otherwise the growing earnings will have to be shared equally between the original and the eleventh-hour investors. This alternative has led to the use of a device by which shareholders, who are not in a position to subscribe to new capital, may transfer their "rights" to others and still share in the benefits of the increase. This is the method of the so-called "privileged subscription." ' P. 110, supra. PROVISION OF NEW CAPITAL 269 A single illustration may serve to make the procedure clear. Suppose a corporation, whose stock conmiands a price of $200 per share and regularly pays 8 per cent, dividends, doubles its capitalization by the issue of one new share at par ($100) for each share then held. At first sight it would appear that each shareholder would receive, for $100, a new certificate which he could at once turn about and sell for $200, that being the original market price. But, obviously, the increase of the share capital by 100 per cent, dilutes the value of each share. One might expect that the market price would be cut in half. This will not happen, however, if the company is clearly able to continue to pay its regular dividend. The value of the total capitaUzation rests upon its probable income. Nevertheless, after the issue of the new shares, these and the old ones alike will probably at first sell down towards $150. At that price the original shareholder will continue to possess his one share; and in addition he will have the "right" to obtain a new share for $100 which will obviously be 'worth approximately $50 to any one else. He has split his investment by allowing the immediate value of his original share to be cut by one-quarter; and by accepting $50 for the "right" which he has sold. He would appear to be no better off than before. He would appear to have eaten a quarter of his cake. But the crumb of comfort lies in the fact that, if the company is demonstrably able to continue to pay the same regular dividend, his income is not affected; and hence the price of his original share may soon rise toward its former level. He will then have profited by an extra dividend of $50 per share, whether he himself sub- scribed to the new stock at par, or sold the right to do so to another person. The foregoing example is an extreme, though by no means an impossible one. Instances could be given of rights ranging all the way up to $200 per share. In some companies, like the Illinois Central during the '90s, stockholders have received as much as 4 or 5 per cent, annually from rights, in addition to 270 RAILROADS their regular dividends.' Stockholders' bonuses have been notably liberal, also, on the Canadian Pacific. Ten privileged subscriptions within the brief period 1902-'13 were offered, with rights ranging in value from $5 up to a maximum of over $20 per share at the end. The total market value of these rights was 176 per share. The aggregate return, comprising both rights and dividends, exceeded 15 per cent, annually during six years of this period. The most extraordinary case is that of the Great Northern Railway, whose stockholders' returns from subscription rights have greatly exceeded their income from the regular 7 per cent, dividends. The method commonly used is to increase the share capital by successive steps of from 10 to perhaps 33| per cent, at a time. Thus in 1904 the Southern Pacific authorized a new issue of preferred stock at par to all common shareholders, in the proportion of one new share for each five shares owned. The market price of the stock was then about $118. If each old share had entitled its possessor to one new shaKe at par, which would command a price of $118, the right would have been worth $18 per share. But the premium above par on one new share had to be divided among five old shares; and, moreover, this premiima had to be reckoned at the price of the stock, not before but after the increase in its amount. In other words, the value of the rights had to "come off" the price; just as in the preceding instance it cut the price from $200 to $150 per share. Taking out one value of the right for the drop in market value, and dividmg the balance into five parts, each equal to a right, we find that the right was worth one-sixth of the premimn, or $3 per share; the market price after the increase becoming $115 per share. The old shareholder could purchase somethmg worth $115 for $100, for each five shares held; or he could sell his rights for $3 a share to any one else, who by purchasing five at $3 each, could acquire the same privilege of subscription at par. Such 1 Quarterly Journal of Economics, vol. XIX, 1905, pp. 231-269. Also Annals Amer. Acad. Pol. Science, May, 1910. PROVISION OF NEW CAPITAL 271 is the nature of the computation of values in privileged sub- scriptions. As for various technical details, those are of special rather than of general interest. Whether the stockholder sub- scribe and then sell his new shares; "sell short" at once and "cover" by the new shares when issued; merely sell a portion of his present holdings and replace the old with new shares; or sell his privilege outright — these are matters of financial detail. The main questions of wider concern are: whether transac- tions of this natm-e constitute stock-watermg or not; and what attitude public authorities ought to adopt toward them.i It is clear that the "privileged subscription" must offer the new shares at less than the market price, else all incentive to sub- scribe will be absent. This was the error in the Massachusetts anti-stock-watering law, as we shall soon see. Occasionally, as in the notable Pennsylvania subscription of 1903, the market quotation may drop below the offered price, so that outside underwriting support may be needed to prevent utter failure of the transaction.^ This, however, rarely occurs, and — except to the corporation in need of funds — the important point is not so much the relation between the market and the sub- scription price, as the relation between the subscription price and par value. It is the amount of new capital acquired in proportion to the new capitalization liability created, which affects the pubUc in future. From this viewpoint it appears indisputable that all issues of capital for less than par value paid in are in the nature of stock-watering. It will be ob- served, however, that an offer of stock below par may arise from two diametrically opposite situations. The company may be over-prosperous, seeking, that is, to dispose of surplus earnings in this way; or it may be already in such straits, — so heavily burdened with indebtedness, — that it can have ' Cf. Evidence in Proposed Advances in Freight Rates, etc., 61st Cong. 3rd sess., Senate Doc. no. 725, p. 4149, and index under "Stock- holders' Rights." 2 P. 136, mpra- 272 RAILROADS recourse to no other expedient than the issue of capital stock for whatever it will bring, regardless of par. Stock issues below par, as a means of distributing surplus earnings, differ only in degree from outright stock dividends. When the Great Northern road in 1898 issued new stock of a par value of $100 to its shareholders at $60, it nearly doubled its capital liabihty in relation to its addition of funds. How surplus is distributed by this means is readily demonstrable.' Thus, a company having assets of $125,000,000 capitalized at only $100,000,000 has a surplus of $25,000,000. If 100,000 new shares are issued at $80 in cash, this brings up its capitaliza- tion to $110,000,000, and its actual capital to $133,000,000. Its surplus has now dropped to $23,000,000, the diminution being exactly equivalent to the discoimt at which the shares were put forth. If the shares of the Great Northern had been put forth at par instead of $60, the capital requirements of the company for extension and betterment could obviously have been met by an issue of a very much smaller amoimt of new stock; and the public in future years would have been relieved of the necessity of providing income for the support of a capi- talization never actually paid for in cash. From this pomt of view, accordingly, the issue of stock for less than par value is detrimental. Even less defensible is the emission of capital stock below par by a company already unprosperous. In England a generation ago. Parliament committed a grave blimder in permitting certain of its embarrassed railroads to issue shares for less than their face value. The discoimt in British par- lance is known as "nominal additions to capital." That is their equivalent for our phrase, watered stock. In 1909, out of a total share and loan capital for British railways of £1,195,- 000,000, such nominal additions to capital due to stock issue below par, amounted to £189,000,000, — that is to say, about ' Cf. the Canadian Pacific special deferred land payment notes of 1913, issued to stockholders at 80. PROVISION OF NEW CAPITAL 273 15 per cent, was watered stock.i This has been a fertile source of trouble. The company whose shares have never attained the level of par, which by implication means that its mcome has never warranted substantial dividends, can surely derive no benefit itself from a still further enlargement of its capi- talization; and the public can ill afford the chance of being some day called upon to pay rates for service which shall support the additional burden.^ To railroads or other cor- porations in this plight, only one conservative course is open. There must be rigid economy; and every penny of income above interest charges must be devoted to upbuilding the plant to such a point that additional borrowing on favorable terms will become possible. The only alternative, possibly, would be to issue a small amount of preferred stock, which by reason of its preference could be successfully issued at or above par. Statutory prohibition of issue below par has been the policy in Massachusetts for many years. Eighteen common- wealths have actually embodied it in their constitutions. West Virginia stands alone in expressly giving sanction to issuance for less than par. While, in rare and peculiar cases, such prohibition may have worked hardship, and in cases of consolidation of companies may at times have been ineffective, it has in the main been productive of great good. The proposal of the Federal Securities Commission of 1910 to abolish par value altogether, offers an ingenious way out of the predica- ment of a company so embarrassed that it cannot sell bonds except at ruinous rates. This plan, already discussed,' would permit stock to be sold for its actual value, — that is to say, for what it would bring. It is our conclusion, however, that the invitation to speculative activity, together with other • McDermott, Railways, p. 176. In France bonus shares are generally regarded as bogus shares. '^ Cf. the Erie issue in 1912 of bonds convertible into stock at 66|. Is it a vaUd defence that this was capitalization of past earnings put into the property? Cf. p. 290, infra. ' P. 91, supra. VOL. II. — 18 274 RAILROADS disadvantages already stated, are sufficient to warrant con- demnation of the proposal. At all events, as long as stock continues to bear the dollar mark, that sign should mean something. It is pure misrepresentation to allow a security to go forth, bearing upon its face a value which is wholly or in part fictitious.^ The latest rules of the Interstate Commerce Commission for drawing up the balance sheet recognize this fact. A special item, denominated unextinguished discount on capital stock, must exhibit the difference between capital liability created and the funds acquired therewith. In other words, the accounts must show the difference between the nominal and the actual investment of the owners.^ With privileged subscriptions to new stock at or above par, the case is quite different. No stock-watering, using this phrase as above defined, would seem to be involved. More- over, the effect of a new issue at par is to decrease the "water" in an already over-capitalized company; for it tends to equalize the investment and the nominal capitalization. Suppose a railroad to be equitably worth $90,000,000, with a share capital of $100,000,000. Each share, as assets, is worth $90. If 250,000 new shares be issued at par, the capital investment rises to $115,000,000, whUe the capitaUzation becomes $125,000,000. This would bring the value of each share to $92.' Thus in an already over-capitalized concern the average investment rises with each new issue at par. If on the other hand the company were already imder-capitalized, a similar issue of new stock would reduce the market value of each share. In this sense, the issue of stock at par is not stock-watering at all. Yet it is a very efficient means of distributing both present surplus and future earnings, the more so in proportion as the market price 1 Cf. discussion by Commissioner Maltbie; Pubs., American Economic Association, 3rd Series, vol. X, p. 417; as also p. 386. And American Law Review, vol. XXVI, p. 816. ' Cf. p. 37, supra. ' Compare especially the Antigo Water Company case, 3 W. R. C. Rep., 647 et seq. PROVISION OF NEW CAPITAL 275 of the shares rises above par. Excessively valuable rights, over and above a figure necessary to insure the needed new capital, serve to conceal the real earning power of a system and to confuse the pubhc mind in matters of rate regulation. In order to prevent an undue distribution of surplus earn- ings by means of "privileged subscriptions," it is possible to issue new shares of capital stock at a figure above par. This premiiun of course may still be so far below the prevailing market price as to yield a profit to the participating stock- holders. The success of the issue to the corporation in need of funds is thus assured. And from the public point of view, the increase of capitalization is actually less than the accession of funds for improvement of the service. A considerable premium in the market value of shares, such as to make this an important question, has appeared only since 1900 for the larger part of the United States. But in the densely populated portions, with old established and prosperous companies, it has long been a matter of public interest. On the Pennsylvania, in 1913, premiums on new shares issued within a dozen years amounted to over $43,000,000, all of which funds, of course, went directly into the property without at the same time being represented in any way in its capitalization. The experience of Massa- chusetts, soon to be reviewed, in attempting to regulate the amoimt of these premiiuns will throw more light upon the subject. In passing, it may be mentioned that the nature of rights has several times in Massachusetts come before the courts for interpretation in connection with trustees' accounts. The first decision had to do with a stock dividend of the Massa- chusetts Electric Companies. In this instance the court decided that the company was in no position, financially, to make a distribution of this sort and that, in consequence, the dividend was paid from capital account and must be treated accordingly as the principal of the trust. A different inter- pretation was given concerning the Delaware, Lackawanna & 276 ' RAILROADS Western dividend in stock of another company.^ This opinion ran to the effect that the dividend was declared from accumu- lated profits and, therefore, might well be treated as income. These two decisions, in short, recognize the distinction, al- ready described, between the status of a weak and a strong corporation. If the price at which new capital stock is issued is a matter of public concern, what shall be done in respect of the terms under which bonds, convertible at some future time into stock, are offered? A nice question of this sort came before the Massachusetts Public Service Commission in 1913.^ The New Haven road petitioned for the approval of an issue of $67,562,- 000 of convertible debentures for the purpose of funding its floating debt and for improvements. The majority opinion of the commission gave consent perfunctorily; but the dissent- ing one went into the matter with care and marked ability. Authorizing an issue of bonds convertible into stock at par for a period of ten years beginning in 1918, it was urged, in- volved practical approval at present of the price of an issue of stock in the distant future.' As the Massachusetts law then stood, the initial price of new stock, although fixed by the stockholders, was subject to the approval of the commission, as to the pubhc interest involved. In 1905 the market price of New Haven stock was $185. In 1913, it was $78. With so wide a range, where might it not stand after the lapse of ten years? The practical impossibility of an administrative body foreseeing what conditions might prevail at conversion, was pointed out. This dissenting opinion was upheld by the supreme court which, principally on this ground, reversed the approval accorded by the public service commission.* In ' Gray v. Hemenway, decided June 12, 1912. Cf. p. 231, supra. 2 1 P. S. C, 99; decided Oct. 14, 1913. ' P. 163, infra. * 216 Mass. Rep. 432. Whether the price which the company receives for its securities originally, is the price for which they are sold; or whether it is the price under which conversion takes place, is a rather difficult point to settle, depending upon whether the matter be viewed in the interest of the corporation or of the stockholder. PROVISION OF NEW CAPITAL 277 New York, on the other hand, the Erie bonds of 1912, con- vertible into stock at 66f , seem to have successfully run the gauntlet of public approval.^ Is the issue of bonds at a discount similar in nature and effect to the emission of new capital stock below par? For many years, under steadily declining rates of interest, this question promised to become only of historic interest or, at all events, to be confined to the financing of new or highly spectila- tive properties. But since 1909, with the prevalent high rates for money, few public service corporations have cared to risk the appearance of extra hazard by offering bonds at higher rates than 5 per cent. They have in consequence been forced to put forth bonds at figures ranging well below par. Bond discount played a large part in the construction accoimts of pioneering roads. Most of them after 1840, as we have seen, were built from the proceeds of bond sales; and so specu- lative did these enterprises appear, that not only substantial discoimts below par for the bonds but large bonuses in stock as well were needed to carry the construction forward. Of the first $22,400,000 expended by the Northern Pacific Rail- road, approximately $6,000,000 — that is to say, 27 per cent. — was charged to interest and discount.^ In the Minnesota Rate cases in 1910 the Master in Chancery found, and by the way, disallowed, as a part of the original cost of construction of the roads concerned, no less than $24,700,000 charged to discounts and commissions in selling bonds.' How formidable such an item may become with weak or discredited roads 1 P. S. C, 2nd D., 1912, 1, p. 238. Cf. also the Erie issues of 1903-'05, convertible at $50 or $60. The Raih-oad Securities Commission of 1910 recommended in addition to the requirement of amortization of discount on the bonds, the additional restriction "that after conversion the laws governing the amortization of discount on stock sold below par should apply also to the unamortized discount on convertible bonds. While the convert- ible bonds themselves may be sold below par, the conversion price of the stock should equal its face value." 2 Washington Railroad Commission Reports 1907-'08. » Whitten, Valuation, p. 285. 278 RAILROADS appeared in connection with the receivership of the "Frisco" in 1913.' Within a decade this railroad had sold bonds for $32,000,000 less than their face value. Two distinct items are recognizable in such cases. The" bankers' or underwriters' commissions are, of course, entirely distinct from the actual bond discount. Thus, securities may be sold at $85 to a syndicate which markets them at $90. But from the point of view of the railroad, the two expenses are cumulative and may be treated indistinguishably. The accounting practice in the matter of bond discoimt must be clearly understood. Suppose a company organized with $100,000,000 of bonds sold at 80, the stock, which as yet has no value, being given as a premiiun. Upon the books there must appear first among the liabilities, $100,000,000 of indebted- ness. Had the bonds been sold for par and the proceeds all been expended upon the road, this would be balanced on the assets side by a similar amount for " cost of road." But actually, the road cost only $80,000,000, that being the proceeds of the bond sale. The almost universal practice has been to even up the balance sheet by an item among the assets, of $20,000,000 as "discount on bonds." In the accounts of the Erie during the black period of its fraudulent mismanagement, the item "discoimt on sale of convertible bonds" rose from $4,700,000 in 1868 to $47,000,000 five years later. Inasmuch as the total capitahzation was then only $155,000,000, almost one- third of its listed assets were thus purely fictitious.^ The ostensible addition to the investment, according to these balance sheets, was due solely, of course, to the necessity of balancing up the liabilities created through the fraudulent issue of large amounts of bonds. No such proportionate investment had taken place during the interval. An equally flagrant example of misrepresentation occurred on the old Atchison road prior > 29 I. C. C. Rep., 139. ^ Hepburn Committee, pp. 18 and 843; also Ripley, Railway Prob- lems, chap. I. PROVISION OF NEW CAPITAL 279 to reorganization. Its books showed among assets no less than $40,000,000 as discount on bonds and allied items. As the total "cost of road" item was only $95,000,000, discount on bonds was well on toward half the entire book value of the property. It was really deferred interest; or rather, a substitu- tion of low immediate interest payments for enlarged capital obligations falling due at the end of the term. Thus, for example, fifty-year 5 per cent, bonds, issued at 84.2, in the long rim really cost 6 per cent. The discount, therefore, in all these cases should properly have been charged to income account, not reckoned as an asset at all. The liability which must be met on maturity of the bonds is in no wise diminished by this accounting practice. But what else could be done? This sum might have been taken outright from the first earnings and charged to income, or even perhaps prorated over the life of the bonds. Conceivably the earnings were not yet sufficient to permit such deduction. Additional bonds might have been issued to place this sum in the treasury; but the difiiculty would then be that they again swelled the liabilities. Hence in the good old days the company too often chose to cover up the item entirely by juggling its statement as to cost of property. The best practice respecting bond discount lies intermediate between two extremes; of prohibition on the one hand, and entire freedom on the other. A fair mean would seem to be struck by permitting the issue of bonds below par wherever actually necessary, but requiring amortization over the life of the indebtedness. Massachusetts is imique in following out the first course. No bonds may be emitted below par.i New Jersey for some years stood at the opposite pole by per- mitting public service companies to issue bonds as low as $80 without any approval whatsoever by public authority. Wis- consin has improved upon each. Its commission has most 1 Even the proceeds of a premium on bonds at issue may be applied only after approval, as held in the Boston & Albany bond issues of 1912. The Gas and Electric Light Commission prescribes such terms and rates of interest as to insure marketing at par. 280 RAILROADS intelligently distinguished between bond issues below par as a necessary incident to new or hazardous enterprises, and their emission as a subsequent means of inflating capitalization.' It would seem as if this distinction were an entirely proper one. It conforms to sound business policy. The Interstate Commerce Commission, to be siu^e, has as yet no control over actual financing; but its prescribed form of accoimts requires that sufficient unextinguished discount shall be charged off from income year by year to take up the slack on maturity of the bonds. The Seaboard Air Line, for example, having in 1909 issued a large block of bonds at 70, in connection with reorgani- zation, had 110,588,000 of unextinguished discoimt on its books in 1912. By charging off $248,000 a year for this purpose, it made provision for the future when this debt had to be paid off at par. At times, as the Federal Railroad Securities Com- mission urged, if the service is needed and the capital can be had on no better terms than by borrowing at a discount, the expense of deferring interest is properly enough a part of construction cost. But always to permit such discounts to go in capital account, surely puts a premiimi on poor credit. For, obviously, the poorer the credit the greater the discount; and hence the larger the capital basis to be supported by rates for service. No company should be encouraged to capitalize either its poverty or its lack of credit. 1 Cf. especially the Antigo Case, 3 W. R. C. R., 647; and the Superior Case, 10 ibid. 735. The Michigan Commission sometimes permits the oapi- taUzation of discount and in other cases requires amortization. The prac- tice varies in the different states. In New York the Pubhc Service Com- mission requires discount to be charged to a suspense account known as "Unamortized Debt Discount and Expenses." Maryland forbids charging discount to capital. The New York Subways in 1911 sought in vain to have discounts included in cost of construction. In Washington the com- mission has an arbitrary rule allowing 5 per cent, on 75 per cent, of the cost of reproduction. The Cleveland (1909) and Chicago (1906-'10) street railway settlements allowed something "for services in procuring funds." Whitten, Valuation, etc., chap. XIII, gives other details. CHAPTER IX STATE REGULATION OF SECURITY ISSUES The grounds of public interest in capitalization, 281. — Its efEect upon adequate service, 282. — Mere publicity v. positive control, 283. — The Federal Securities Commission report, 284. — "Blue-Sky" laws, 285. — Recent public service commissions, 285. New York experience most important, 286. — Concrete cases outlined, 288. — Abuses prevented or corrected, 290. — An example of Uberal but firm control, 292. Massachusetts policy, strict and inelastic, 296. — Fixing issue price of stock, 297. — Four different plans tried, 298. — Liberalization, in 1908, 300. — The new Public Service Commission law, 300. The Texas Stock and Bond law, 302. — CapitaJization and valuation. — "Squeezing out water," 303. — Distinction between old and new properties, 303. — Drastic reduction in average capitahzation, 304. — Improvements and betterment penalized, 304. — More administra- tive discretion necessary, 305. — Experience elsewhere, 306. Federal assumption of power over capitalization, 309. — Mere publicity inadequate, 310. — Individual state activity must be superseded, 311. — Prognostication, 312. • A SUBSTANTIAL econoituc warrant exists for the exercise of control by the state over the issue of securities of public service corporations. But grievous misconception prevails as to the exact way in which over-capitalization, so-called, really puts the public interest in jeopardy. Aside from the losses to private investors, what, in point of fact, are the evil consequences to be feared and averted? The prevalent view imderlying most anti-stock-watering legislation is that' the prevention of over- capitalization is incidental to the making of reasonable rates. This was pecuUarly true in the early days before the courts evolved the doctrine of the fair value of property as a basis for charges. In this connection stock-watering impinges upon physical valuation.' It seems to be true that, although the connection between capitahzation and rates is not immediate, 1 Chapter X and XI, infra. 282 RAILROADS the volume of outstanding securities may oftentimes be in- directly a factor of considerable moment in rate-making. But there is a far more weighty plea in the public interest for the prevention of unwise financing. The strongest argument against over-capitalization is that it tends to interfere with proper maintenance — with the making, that is to say, of needed improvements and the render- ing of satisfactory service. This is frankly conceded nowadays by official spokesmen of the carriers themselves. ^ Public interest in this regard merely confirms the dictates of business prudence, in the demand that a corporation should always hold itself in readiness to issue stocks or bonds advantageously in case of need. This it certainly caimot do, except imder pro- hibitive penalties, if its bonds stand at heavy discoimts and its stocks are quoted at merely nominal figures. This point cannot be too strongly emphasized. It is not primarily that the public suffers, as a result of over-capitahzation, because a railroad is imable to pay a return on all its outstanding securities without raising rates; but that interest and dividends may for a while be paid by the diversion of earnings which ought properly to be spent on maintenance and improvements. However the matter be viewed, it is the effect of over-capitalization upon maintenance, development and adequate service, and not its effect upon the level of charges, which should occupy the fore- front of the argument. See how things work out in practice! The expropriation of the siu-plus of the poor old Alton road^ may or may not have affected its abihty thereafter to charge higher freight rates than its competitors. However that may be, the fact that the treasury was so completely gutted that the Rock Island interests on taking over the property, were compelled at once to issue equipment notes at ruinous rates in order to do any business at all, was the feature of pubUc concern. All ' Railway Age Gazette, vol. LVI, 1914, p. 61. 2 Details p. 262, supra. STATE FINANCIAL REGULATION 283 experience confirms this view. Consider the utter break-down of service in New England in 1912-'13, the intolerable delays and appalUng accidents, as a result of the New Haven collapse. It was because all financial resources had been dissipated in seeking "monopoly at any cost," that not a penny remained, or could be raised, for the real business of transportation. Or, if you please, consider the metropolitan traction companies in New York.i Millions of dollars were lost through the knavery of their managements; but fares remained at five cents through- out. Where the pubUc suffered was through the pitiful col- lapse of the service. Despite the fact that the maximum life of street railway equipment was ten years, the surface roads made practically no allowance for depreciation from the organi- zation of the Metropolitan Street Railway in 1893. For five years preceding the receivership not a new car was bought; and it was beyond the power of the company to buy. So completely had every resoiurce been exhausted, that funds were not to be had on any terms in order to put the service on its wheels. In brief, it was the collapse of the service attendant upon financial prostration due to stock-watering, which aroused public opinion and led to reform. To protect the standard of service in this way is, perhaps, even more vital an element in goverimiental poHcy than everlasting insistence upon reason- able rates. When service collapses, unlimited losses amounting to total confiscation fall upon the commimity. Unreasonable rates may take a part, indeed, but never the whole. Public poUcy in the matter of protection of common rights with regard to rates and service and, incidentally, of the interest of investors in the domain of railroad finance may assume either of two forms. The more modest one relies upon mere pubhcity as a safeguard against abuse. The other, more radical in type, seeks positively to regulate the amount and nature of the securities issued and thereby to exercise a strict and definite control over every detail of financial management. 1 C/. footnote p. 287, infra. 284 RAILROADS In view of the imminence of legislation by both the United States and Canada in this field, it is important to understand the advantages and limitations of each of these plans. Strict and complete publicity, without further specific regulation, is the policy ably advocated by the Federal Rail- road Securities Commission of 1910.-^ This body held that too much stress was being laid upon "keeping down the nominal amount of stock, and too httle upon getting the actual amoimt of capital needed and having it properly used." Emphasis was also laid upon the ease with which state statutes for this purpose might be evaded. Moreover, it was repeatedly urged that the Federal government in seeking to standardize railroad finance must beware of the appearance of a guarantee of quality. As phrased by the Railroad Securities Commission (1911): " We are told that if it was possible to standardize food by a pure food law, it ought to be possible to standardize railroad securities by a securities law. It is possible — to the same extent and no more. The pure food law enables a man to know what he is buying. It does not certify that the thing he buys is good for him. That is left to his intelligence. The government cannot protect the investors against the consequences of their unwisdom in buying unprofitable bonds, any more than it can protect the consumers against the consequences of their unwisdom in eating indigestible food." The importance of this warning, that not even an imphed guarantee of securities approved for issue follows their certifi- cation by a pubhc commission, is found in the embodiment of such a disclaimer in all of the newer pubhc service commission laws.^ The two general pohcies, mentioned above, as to the attitude of the government toward corporations — first, the older view ' Ripley, Railroads: Rates and Regulation, p. 573. 2 Commission Regulation of Public Utilities, compiled by the National Civic Federation, New York, 1914, with its model or draft biU published, Oct. 23, 1914; Annals Amer. Acad. Pol. Science, LIU, 1914, no. 142, con- tains many papers on the whole subject. Cf. evidence for the I. C. C. before Senate Committee on Interstate Commerce, June, 1914, and es- pecially American Economic Review, vol. IV, 1914, pp. 588-601. STATE FINANCIAL REGULATION 285 that, being creatures of the state, they should be guaranteed by it to the public in all particulars of responsibihty and manage- ment; and the modern, quite opposite theory that, in the absence of fraud, an ordinary business corporation should be given a wide latitude in matters of organization and govern- ment — are admirably contrasted by the Massachusetts Committee on Corporation Laws of 1903.i The attendant revision of corporation law in this state marked a turning point in policy. The modern theory was accepted, that for ordinary business corporations the state owes no duty beyond providing clearly that creditors and stockholders shall at all times be accurately informed of all facts attending both organi- zation and management. Such, hkewise, is the poUcy adopted by modern European states with respect to private corpora- tions.^ Great interest in this field of late is shown in the passage since 1908 by no fewer than eighteen American com- monwealths of so-called "Blue-Sky" laws.' These statutes seek, in the main, the protection of confiding investors against fraudulent promotion; but their significance for us at this time lies in their avowed acceptance of the pohcy of complete pubhc- ity. With that, however, they are thus far content. Is a passive policy of mere pubUcity in matters of finance, being thus more and more apphed to ordinary corporations, adequate for dealing with railroads and other pubhc service companies? The answer, so far as our separate state govern- ments are concerned, is found in the action already taken during the last few years. For a long time Massachusetts and Texas stood alone in dealing with railroads by a more positive programme of strict financial regulation. Their experience is reviewed later.'* But since 1908, partly as a result of activity ' Ripley, Trusts, Pools and Corporations, chap. XV. 2 Ihid., pp. 393-428, on England and Germany. ' Arthur N. Ay res, Governmental Regulation of Securities Issues, Political Science Quarterly, vol. XXVIII, 1913, pp. 586-593. * On state commissions in general, cf. Ripley, Railroads: Rates and Regulation, chap. XX. 286 RAILROADS by the Federal government in rate regulation, no fewer than thirteen other states have followed in their train and have set up pubhc service commissions of one sort and another.' Unlike the Federal government, these states have not been content to stop at rate regulation or even supervision of operation. They haVe all extended their authority over financial matters as well. These new powers of regulation seem to be intended less for the immediate protection of capital than for the attain- ment of reasonable charges and satisfactory service. In out- fine, the laws define the issue or exchange of securities as the exercise of a special privilege caUing for a formal license from the state. Such authorization is given only after pubfic pro- cediu-e in order to ascertain: (1) the amount and character of the expenditure, that is to say, the exact purpose for which the new securities are to be issued; (2) the pubfic necessity or advantage of such action; and (3) the precise terms of the offering, together with the effect upon the financial status of the corporation.^ Formal proof in these matters is foUowed by permission to issue the securities. And such authorization must in due time be succeeded by certification that the details of the prescribed programme have been duly observed. The experience of New York in regulating capital issues is most illuminating — because of the magnitude of the interests involved; because, imfike the western states, financial rather than rate regulation has been the main object of interest; and because of the exceptional abiUty and intelfigence of the mem- bers of the administrative boards. For many years the old ' The thirteen states which have recently embarked upon such financial regulation, in addition to Massachusetts and Texas, are New York, Ohio, Missouri, Indiana, New Hampshire, Michigan, Wisconsin, Nebraska, Kan- sas, Arizona, California, Vermont, and New Jersey. For details consult Commission Regulation of Public Utilities, chap. XII. ^ The necessity of strict definition of such delegated legislative powers arises from judicial decisions to the effect that without specific rules for the guidance of an administrative board in exercising control over the issue of securities the statute is unconstitutional. {State v. Great Northern Rail- way, 1907, 111 N. W. Rep., 289.) NEW YORK FINANCIAL REGULATION 287 railroad commission had been an utter nonentity, abjectly subservient to the powerful railroad and trolley companies. In 1893, just before the formation of the Metropohtan Street Railway, when, for some reason, the commission refused its approval of a $6,000,000 stock increase of the Pavonia Ferry road, Thomas Ryan and his friends had the securities printed just the same and then exchanged them for a hke amount of Metropohtan Street Railway stock.' To this high-handed proceeding the railroad commission interposed no objection. Under the initiative of Governor Hughes, two separate public service commissions were created in 1907, one having jurisdic- tion over corporations within the First or metropohtan district; the other, with headquarters at Albany, being charged with responsibihty for the rest of the state. It is this Second or up-state commission which has mainly had to do with railroads; but the same principles have been involved in supervising the financial operations of the public service companies in New York City. Some measure of the restraint exercised by the metropohtan commission may be gathered from the fact that, within four years from its creation, only $89,000,000 out of a total of $307,000,000 requested by the companies, was approved. As for the up-state conamission, within the first six years it authorized the issue of $439,890,000 of bonds and $50,820,000 of stocks by railroad companies alone.^ Within this time, ' The details of Metropolitan Street Railway finance are contained in the first four years' reports of the First District Commission. They are also reviewed in a series of articles by H. A. BuUock in the Boston Transcript, Oct. 3-14, 1908; in McClure's Magazine, Nov. and Dec, 1907, and Jan. 1908; and Annals Amer. Acad. Pol. Science, vol. XXXI, pp. 635, 612. 2 State Regulation of PubUe Service Corporations in the City of New York (P. S. C, 2nd D., statement of Sept. 1, 1911), p. 45; 1 P. S. C, 2nd D. (1912), 113. Securities may not be authorized for more than one year with- out the approval of the commission, and then only for: (1) acquisition of property; (2) construction, completion or extension of facilities; (3) im- provement or maintenance of service; (4) discharge or lawful refunding of obligations. In other words, three distinct purposes are contemplated: in- vestment for the future on capital account; reimbursement of past expendi- ture on capital account ; and refunding of obligations. .The Seventh Annual Report of the up-state commission (p. 100) succinctly sunmiarizes the mam principles of its capitalization policy. 288 RAILROADS practically every railroad in the commonwealth appealed to it for allowance of security issues for almost every conceivable purpose. The experience though brief is certainly most significant. Concrete cases best describe the New York practice in improving and standardizing public corporation finance. In the field of railroad building, a bar is set against the classical abuses and financial manipulation.^ Capital accoimts must be closed when building stops. Operating expenditures may not be capitahzed even for a brief period; nor is allowance for experimentation at the expense of the public permitted.^ In- sistence upon the clear distinction between capital and income account which lies at the foundation of all soimd financing, is continued throughout. In the second place, the issue of secu- rities in order to pay for mere replacement of property has been severely condemned in a nmnber of instances. The Lehigh & Hudson River road in 1909 was thus forbidden to sell bonds in order to reimburse its treasury for payments not properly chargeable to capital. On the other hand, expenditures made for investment in the property from income may with entire propriety — and, since amendment of the law in 1910, legally as well — be paid for through the issue of stocks or bonds. The Erie, in 1912, having satisfied the commission that within five years it had spent $12,000,000 out of earnings upon its property, was permitted to capitalize it.' As to whether non-revenue-producing expenditures, such as abolition of grade crossings, should be entirely capitalized, is a nice question depending upon one's view of the nature of surplus revenue.^ 1 Chap. I, supra. " 3 P. S. C, 1st D., 63. In this field of construction finance the admi- rable review in Whitten's Valuation of Public Service Corporations outlines the poUcy. Allowance is made for expenses of promotion (p. 265); for working capital (p. 296); for interest during construction (p. 258); for contractor's profits (p. 248) ; and for general overhead charges such as en- gineering (p. 229). But capitalization of early losses is not permitted (p. 551). Cf. the opposite policy in Wisconsin; 10 Wis. R. C. Rep., 872; and New Jersey, infra. ' 1 P. S. C, 2nd D. (1912), 238. « P. 240, aupra. NEW YOEK FINANCIAL REGULATION 289 The up-state commission, noting a disposition to meet all such expenditures through the sale of securities, has wisely declared that the tendency "should be checked and repressed" in the interest of conservative finance. As to the dangerous plan of paying for improvements through the creation of a floating debt, the New York boards are in accord with the Federal Secvuities Commission in conde mnin g it flatly. Another group of New York cases is concerned with the issue of securities in connection with consolidation. In the wide field of public utilities it doubtless appears in the common interest to permit a strong concern with low operating costs to absorb small, weak or otherwise handicapped competitors.' Yet the price paid for purchase is a vital element to be con- sidered. The up-state commission in such matters adheres to the prudent plan of requiring amortization of the difference between the inventory cost of the physical property acquired and the price actually paid. The Delaware & Hudson case in 1908 showed the necessity of curbing the tendency to water the stock of a strong company through the purchase of subsidiaries at exorbitant figures. This railroad requested authority to issue bonds in order to take up notes representing acquisition of the Hudson Valley Railway together with certain imdeveloped coal properties. Investigation revealed a good deal of scandal associated with the purchase of these properties, prior to the creation of the commission. The original trans- action was a thing accomphshed. The up-state commission had no power to change ownership or to review the expediency of issuing the original notes; but it positively dechned to permit long-time bonds to be issued, on the ground that the properties covered by the mortgage were inadequate as to both intrinsic worth and earning power. The case went in the following year to the Court of Appeals, which hmited the commission's power through the declaration that the legislature 1 P. S. C, 2iid D., no. 176, 1914, Rockland Light and Power Co. case. Cf. p. 248, supra. VOL. II — 19 290 RAILROADS had not intended to make this administrative board the financial manager of corporations or to empower it to substitute its judgment and discrimination for that of the directors or stock- holders.i So much for power to correct misdeeds in the past. But a closer reading of the opinion affirms the inherent right of the commission to prevent the recurrence of such abuses in future. Quite similar is another recently contested case before the New York comts.^ The New Haven railroad, it appeared, had paid over $900,000 in 1912 for a trolley fine which the commission found to be actually worth only $400,000. It consequently fimited the amoimt of New Haven stock which might be issued in payment therefor. The lower court held that whatever the property cost was controlfing upon the commission, unless actual fraud was proven. But this opinion was unanimously reversed by the Coiu't of Appeals, in the first New York decision holding that cost of property is not necessarily a controlfing factor in capitafization. There was no question of good faith involved, inasmuch as two power- ful rivals were bidding agaiast one another at pubfic auction. The payment of dividends from capital has Ukewise been prevented by the rulings of the New York up-state commission. The record in this regard showed a sfight disposition to wobble; but, in the main, the poficy was soimd. The leading decision concerned the right of the Erie, in 1909, to pay a scrip dividend to meet its interest requirements. The commission by a divided vote in the preceding year had permitted this company to stave off a threatened receivership, by issmng bonds to anticipate several years' interest payments, on condition that a Uke amount should be put back into the property during the period in question, out of earnings. Fears were entertained, in view of the absence of positive guarantees by the railroad, that a sound and conservative poficy was threatened. But a • 197 N. Y. 1; a precedent followed by Nebraska in 1912 in Fifth Ann. Rep. Railway Commission, p. 177. 2 158 App. Div., 251; reversed in 210 N. Y., 456. NEW YORK FINANCIAL REGULATION 291 subsequent decision prohibiting a stock dividend of 80 per cent, for "property and services," as a cover for largely increased earnings and in order to distribute previous depreciation credit and surplus, manifested adherence to the only wise course to be allowed.^ The distinct matter of corporate reorganization, with its attendant increase of securities or perpetuation of preceding excessive issues in the railroad field, has seldom directly engaged the attention of the up-state commission. But the protracted struggle in the Third Avenue Street Railway case ^ shows that the metropoUtan commission from this viewpoint also has taken its responsibilities seriously. The closest analogy, indicating the attitude of the up-state commission, is that of the Watertown Electric Light Company in 1909. The com- mission apparently refrained from an imduly drastic policy in scaling down securities.' Unlike Texas, soon to be reviewed, the policy pursued did not seek to undo at one fell stroke a long coxurse of financial excesses in the past. Nevertheless, a whole- some restraint and corrective was appUed so far as practicable. It will be observed that the same broad question is raised in both merger and reorganization cases as to the proper func- tion of public regulation. Is it to be limited to present and future action, or is it to be retroactive in effect, seeking to correct or compensate for financial excesses in the past? It is evident that an attempt to disentangle these successive periods of time is a matter of the utmost difficulty. The results of men's misdeeds generally long outhve them. And yet im- patience, in seeking to undo the past at once, may result in as grave inconvenience and injustice as neglect to consider it at ' Bronx Gas and Electric Light Co., 1909, case no. 1160. 2 P. 260, supra. ' C/. the Binghamton case (203 N. Y., 22, 1907) where it was held that the commission had no power to permit an issue on condition that certain outstanding stock be cancelled; but that it could merely be determined whether the proposed issue was in accordance with the statute. Cf. the Fall River Gas Co. case, 1913, 214 Mass., 529. 292 RAILROADS all. This follows from the well-known principle that financial excesses are bound sooner or later to be reflected in correspond- ing market quotations for the securities. Innocent holders for value, considered in connection with the substitution of new securities for old under reorganization proceedings, for example, may or may not already have incurred heavy losses through depression in price of their securities. One point is, however, clear — that the sooner a corrective policy, aiming to place the company upon a firm and substantial footing, is adopted, the sooner may the healing forces of nature bring about some measure of restitution. In several respects the New York commissions have been more liberal, and perhaps wisely so, than those oT Massachusetts and some other states. There has been steady insistence from the outset, as in the Interborough Rapid Transit case, upon public offerings of all secm-ities, to the end that the companies may realize the largest possible amoimt from their financing. But, as we have already seen, the issuance of stock below par and, when necessary, of bonds at a discoimt has been allowed ^ — the commissions being contented to provide the necessary safeguards through amortization within a reasonable period. The contrast with Massachusetts policy in these respects will soon appear. The extended experience of the metropolitan commission with the New York City Railway has led, however, to a rigid prescription of the manner in which discounts shall be handled in all such cases.^ Neither the public nor investors may longer be deceived by an item in the balance sheet of "Construction and Equipment $5,000,000," believing it to be a good asset; when, as a matter of fact, $4,500,000 of this sum was discount on notes sold at 70 and redeemed at par within three months. Comparative liberality of policy in New York, too, appears in the allowance of bond issues to provide working ^ P. 272, supra. On prescription of the ratio of stocks to bonds, note the Kings County Lighting Co. cases; P.S.C, 1st Dist., 1911, no. 1273. ' The commission regulates more largely through rigid accounting rules, aiming to prevent any capitalization of discounts. NEW YORK FINANCIAL REGULATION 293 capital and promotion and development expenses.^ Restraint has also been imposed for the protection of minority stock- holders, as in the refusal to permit the lease of the Ontario & Western by the New York Central.^ And, finally, in the matter of refunding, the New York commissions have in various instances permitted the issuance of the new securities, but only when guarantee was offered, though giving more ample security, that the new bonds, if issued at par, should at least approximate their seeming worth. The foregoing instances by no means cover all the details of these complicated proceedings, even in outline; but they at least afford evidence of the necessity for close supervision both in the public and private interest, and of the highly satisfactory manner in which the responsibilities imposed by the law in New York have been met. The spirit actuating the service is well summed up in the following quotation from a recent report: " WhUe the commission does not, ia making authorization of securi- ties, in any way guarantee that the securities so authorized are a good investment, yet it is earnestly endeavoring to bring it about that the financial statements on the basis of which such securities are sold may be such that the investor will not be misled." It is thus apparent that the features of complete pubhcity and strict regulation are esteemed to have equal weight under the New York law and practice. It is broadly significant, also, that in New York state the experience has been quite parallel to that of the United States in respect of conflict of authority between the administrative and the judicial branches of the government.' The carriers in both instances have sought refuge from decisions of the commissions in restraining orders of the courts. A notable ' New Jersey is even more liberal here, as wiU soon appear. (7/. p. 299, infra, for Massachusetts. 2 a P. S. C, 2nd D. (1913),'261. Cf. p. 450, infra. ' Ripley, Railroads: Rates and Regulation, chap. XIV. 294 RAILROADS instance now in controversy is afforded by the New York Central Commutation Rate case. The commission ordered certain reductions in fares, from which appeal was promptly taken to the appellate court. In January, 1914, a decision was handed down, annulling the order on the ground that the real merits were not passed upon. The inevitable result followed. Resort was promptly had to the legislature, which responded to local pressure and passed a special bill reinstating the rates annulled. This is the lesson of experience everyivhere. Until the courts cease to hold it to be their fimction to review such cases on economic grounds and in the broadest way, the legisla- ture is debarred from vesting fuU responsibihty in the agent to whom it has delegated legislative power. Resort to special legislation is bound to follow adjudication of this character. It is certainly to be hoped that the New York Court of Appeals will follow the precedent laid down in the Illinois Central decision in 1910 by the Supreme Court of the United States.! ' One abortive New York case has been m-ged as an example of the failure of governmental supervision of security issues. In reality, it emphasizes the necessity for doing this work in a thoroughgoing fashion. The old board of raiboad commis- sioners in 1907 approved of a large issue of securities in 1907 by the Delaware & Eastern Railway, formed by consoUdation of several smaller properties, three days before the effective date of the public service commission law. Litigation halted the proceedings, however; so that the proposed action was submitted for approval to the new board. It authorized the issue of about $6,500,000 of securities in 1909, an amount much less than requested but deemed sufficient to construct the proposed line. The order specifically reserved decision as to the use of the proceeds for other than actual construction, such as promotion, marketing securities, interest on con- struction, etc. The company thereupon widely advertised its > lUd., p. 538. NEW YORK FINANCIAL REGULATION 295 bonds as "officially approved," while, as subsequent events divulged, utilizing the proceeds without regard to the restric- tions of the order. In 1910, the company went into the hands of receivers; and upon investigation it appeared that an issue of over $1,000,000 of securities had been accompanied by less than $40,000 worth of actual construction. The promoter promptly disappeared for ever and aye. The commission, however, was debarred from legal action; inasmuch as the company's affairs were in the hands of Federal receivers, plans for reorganization were imder way, and the principal offender was beyond recall. Constructive work was in consequence directed entirely to the re-financing of the project and a plan for final reorganization by which funds were to be seemed solely from stock issues. Fixed charges, at all events, were not to be allowed to create trouble in future. The case is obviously not typical, for the commission's order in the first place was flatly disobeyed. Liabilities leading up to the failmre had in fact been entered into before the creation of the new commission. No system of examination of accoimts or prescription thereof had come into effect, nor had a definite policy as to capitalization been evolved. The experience emphasizes the need, nevertheless, of the avoidance by a commission of anything like the appearance of a guarantee of investments. Hazard is inseparable from all pioneer enter- prises, for which the public must pay. All that a commission can do is to satisfy itself of the reasonable probability of a successful outcome. Regulative commissions stand between two fires. On the one hand, they cannot lawfully adopt so strict and narrow a poUcy as to throttle enterprise. On the other, they must not be so liberal as merely to "rubber stamp" promoters' schemes. In its inexperience this commission was possibly artless; but its subsequent record in scores of cases, of insistence upon conservative finance, fair returns to capital and adequate service to the public should extenuate the fault. 296 RAILROADS The experience of Massachusetts in seeking honest capi- talization by law is significant in several respects.* It reveals the possibility of too great strictness in financial regulation, or rather, of misplaced strictness in focussing attention upon the issue price rather than upon the provision in proper ways of an adequate supply of capital for the needs of the service. It also emphasizes the need of elasticity in procedure — not governing, that is to say, through rigid statutory rules; but, after laying down the law in general terms, giving play for the exercise of discretion in its apphcation. Yet, while defective for a time in these respects, no impartial student can deny that the effect of this Massachusetts legislation has on the whole been salutary. Had the New Haven system in its degenerate days before 1913 been subject, in fact, to as strict regulation imder the laws of Connecticut as Massachusetts sought to impose, the disaster might never have occm-red. The best evidence of the soundness of this legislation at bottom is foimd in the statistics of capitahzation of street railways. The steam roads are so largely interstate that comparisons are impossible. Connecticut until 1913 gave absolutely free rein to its trolley lines. Massachusetts held them in check. The average capitahzation of street railways in Connecticut in 1912 was $115,810 per mile of hne. The corresponding figure for Massachusetts, including the Boston Elevated system and its other costly city fines, was only $63,300 — approximately one-half the Connecticut figure.'^ In other words, taking Massachusetts as a standard, over-capitafization in Connecticut was about $52,500 per mile. Such evidence is conclusive as to the benefit of restriction. But the point may, ' The following references wiU be found serviceable: Ripley, Trusts, Pools and Corporations, 1909, pp. 121-148; C. J. Bullock, Publications American Economic Association, 3rd series, vol. X, 1909, pp. 384-429; Quarterly Journal of Economics, vol. XXII, 1908, p. 640. A good historical summary will be found in the Fall River Gas Co. case, 214 Mass., 529. 2 Railway Age Gazette, vol. LII, 1912, p. 15-32. Ripley, Trusts, Pools and Corporations, p. 127, gives additional data for international and state and city comparisons in 1899. MASSACHUSETTS FINANCIAL REGULATION 297 nevertheless, be carried forward that it is possible to overdo a good thing. The Massachusetts policy has been mainly concerned with fixing the issue price of capital stock, because of the circiun- stance that the New England roads have been so largely financed by this means. Bonds have played a relatively sub- ordinate r61e. The aim has always been to hmit the issue of securities to the bona fide investment of capital. The issue of stock merely as a bonus to promote the sale of bonds has never been tolerated. The lines of this legislation were for the most part laid down in the early days, when financing by subscription to share capital was everywhere the rule. Most of this stock, moreover, was sold in the beginning at a fair percentage of its face value. As a result, with the demonstrated success of the enterprise, stocks steadily rose above par, instead of merely approaching it, as has been the case in other parts of the coimtry where share capital had at the outset no real worth. The main effort in Massachusetts, then, for many years, was to divide fairly the premium on new shares between the stock- holders and the pubUc. This task was imposed upon the railroad commission, which, while having only advisory powers in matters of rate-making since 1869, was given full authority in the sphere of regulation of the issue of securities. But a review of the experience seems to indicate too micro- scopic attention to the mere matter of issue price, to the neglect of the broader issues of financial policy, such as charges to depreciation, the relative proportion of stocks and bonds, and the insistent demands for new investment in plant for the sake of the service. The cardinal principle at law in Massachusetts has been to require that no securities of pubhc service companies should be issued except for cash and at not less than par value.^ The wisdom of the general plan is almost universally recog- nized; but the practical means of attaining the desired end 1 Cf. chapter XI, infra, as to valuation for rate-making. 298 RAILROADS without xinduly hampering enterprise, have varied from time to time. The first plan, before 1871, was to prohibit all issues of stock except at par. This was manifestly unfair both to the corporation and to the public. It often deprived the- former of whatever premium the stock would command at public sale; and it sometimes permitted distribution of an accumulated surplus by means of excessively valuable subscrip- tion rights. The second plan, in effect from 1871 to 1878, was to require that all new shares should be sold at public auction.! -phis was perhaps borrowed from the long-standing English custom of "auction clauses," requiring gas companies to put forth their securities in this way. But this violated the traditional rights of stockholders to preference in all such transactions. Furthermore, it opened the way to contests for control between rival interests, which violently disturbed market prices. At this point, in 1893, came the illuminating experience with the Connecticut Eiver road, elsewhere set forth.^ This led to the anti-stock-watering law of 1894, pro- hibiting the issue of share capital at other than the market value, this value to be ascertained by the railroad commission. The Massachusetts law of 1894 imdoubtedly restrained the issue of watered stock. Shares were issued under it in some cases at premimns as high as $90. The Boston & Maine road put forth new shares at different times at $190 and at $165 in cash. Street railways to 1908 applied 207 times for increases of capital. In 54 instances a premium was prescribed; in 153 the emission was at par. The plan worked well as long as investors were in optimistic mood. And it happened that throughout the following decade, to 1903, the trend of market prices was steadily and sometimes strikingly upward. In ' Whitten, Regulation of Public Service Companies in Great Britain, 1914, chap. III. As early as 1877 the railroad commission applied the principle " although with considerable hesitation " that capitahzation should not exceed the value of the tangible assets minus the liabilities. (Reports, 1877, p. 127.) " P. 229, mpra. MASSACHUSETTS FINANCIAL REGULATION 299 consequence, shareholders ahnost immediately realized profits from subscriptions even at these high prices. To be sure, a very difficult task was imposed upon the railroad conmiission — that of determining in advance what the price would be after the new issue had been made. It was largely a matter of guesswork; and instances occurred in which "rights" were transferred into losses. Moreover, as was urged by the com- panies affected, this process of emitting shares at various prices introduced great inequalities as between different shareholders, in respect of the rate of return upon their investment. To the stockholder who subscribed at $190 per share, dividends at the rate of 8 per cent, obviously yielded only about one-half the rate of return which accrued to the old subscribers at par. In the determination of the reasonableness of general rate schedules, it was held this would greatly embarrass both the legislature and the courts. Other details of this legislation were foimd to work hardship in practice; such as the limitation of bonded debt to the par value of the share capital (which still left the door open to the creation of heavy current Uabili- ties), and the prohibition of stock issues to cover promotion expenses or to provide working capital. With the panic of 1903, the unduly drastic character of the law became plainly apparent. Funds for development could scarcely be raised at all. One important company was obhged to borrow on its short-time notes at 8 per cent., because of inabiUty to market its stock at the high premium fixed by the railroad commission. Nor could it issue bonds, because of the hmitation of indebted- ness to the outstanding share capital.^ Conceding fully the desirabihty of sharing between the public and the corporation the benefits of a premium upon the issue of new stock, a special commission recommended a 1 Increased to double the capital stock in 1913 as the price of permit- ting the creation of a new public service commission, as seen below. By new legislation in 1909, capitahzation for working expenses was allowed; and the Boston Elevated issued $1,000,000 bonds for the purpose in 1914. A bill is now pending to permit capitahzation of replacement outlay. 300 RAILROADS more liberal policy. Limitation of the rate of retm-n upon investment to what was practically a savings-bank rate, had dried up the sources of capital for improvement. The new law of 1908 amended the system, by permitting new shares to be offered for subscription at a price, not less than par, to be determined by the stockholders subject to the approval of the railroad commission.' The control of the state was still supreme; but an opportunity was offered for such liberality on the part of corporations and their shareholders as should insure the success of their issues. Premiums of $25 per share, carrying rights worth as high as $5, were, soon allowed. The objection to. this more liberal policy, vehemently urged, was that in times of abounding prosperity, stockholders might be tempted to fix prices of emission so low as practically to entail stock-watering. But the reservation of power to dis- approve of these terms appeared to be a sufficient safeguard .'^ It was generally recognized as a result of this varied experience that both pubfic and shareholders had rights which must be respected. Complete freedom of issue leads to inflation. Too drastic restriction dries up the springs of capital upon which the pubfic must depend for future development. A wise course fies intermediate between the two. The decfine and fall of the New England railroads in 1912-1914 has stood in the way of any decisive test of the latest principle adopted. And the entire reorganization of the old railroad board, in 1913, creating a new pubfic service commission, has brought both powers and procedure more nearly into fine with the practice of New York and the other American states.* The old advisory 1 The liberalization of the general corporation law at the same time is discussed in Quarterly Journal of Economics, vol. XVIII, pp. 269-280; re- printed in Trusts, Pools and Corporations, pp. 382-392. ' The law was construed in the Fortieth Annual Report of the Board of Railroad Commissioners of Massachusetts, p. 155, as follows: "The phrase 'so low as to be inconsistent with the public interest,' undoubtedly difficult of exact definition, must, ia connection with the legislative act of 1908, be taken to mean in any specific case an issue price materially lower than a price which would assure a ready market for the issue." ' Quarterly Journal of Economics, vol. XXVII, 1913, p. 699. TEXAS FINANCIAL REGULATION 301 railroad commission of 1869 was transformed, after forty-four years, into the present administrative board, which differs Uttle from that of New York. This legislation, however, afforded a most disquieting evidence of the power of a raihoad lobby. Despite the incisive campaign waged by Governor Foss for three years, the New Haven Railroad demanded and, as the price of its consent, received a clause enabling railroads to issue long-time securities up to tioice the amount of their out- standing capital stock. This iniquitous provision runs counter to all the dictates of business prudence. What will happen as a result remains to be seen.' At the same time, in the matter of rates, mandatory rather than recommendatory powers were in general conferred. The regulation of rajlroad capitalization in Texas imder its so-called Stock and Bond law of 1893 is instructive, especially when taken in connection with the experience of Massachusetts, just described.^ Both states strictly forbade the issue of new seciuities without approval by public authority. But the motives, as reflecting differences in the local situations, were strikingly contrasted. Texas was mainly interested in the regulation of rates at the start. Massachusetts had an eye to the welfare of investors. But both ahke since that time, as we shall soon see, soon came to recognize that the main con- sideration in regulating security issues was to safeguard the character of the service. Texas, then an undeveloped country, was newly berailroaded by companies heavily over-capitalized as a result of optimistic promotion. In Massachusetts, on the other hand, the stock-watering operators were, so to speak, "accessories after the fact." New England roads had originally been most conservatively built. Few, if any, bonds had been 1 Cf. p. 307, infra. 2 The best references from opposing points of view are as foUows: Texas Academy of Science, Presidential Address, 1902; Quarterly Journal of Economics, vol. XXII, 1907, pp. 109-119; Bull. UniversUy of Texas, no. 236, 1912, pp. 83-120. 302 RAILROADS issued. Stock had been paid for in full at par. The threat of an overload of securities, as compared with the growth of earnings, appeared late in the life of the companies.^ In this densely populated territory the increment in land valuations, and especially of terminals, had probably brought assets to more than an equality with the volume of securities outstanding. But it had become evident that without restraint stock-watering in future might take place, in order to provide a broader basis for distribution of increased earnings. Texas, on the other hand, was endeavoring to "squeeze the water" from its roads, already heavily over-capitalized in connection with construc- tion. In other words, Massachusetts was applying a close- fitting strait-jacket to full-grown corporations in order to prevent future violence; while Texas sought to withhold youth- ful and bmnptious companies from making engagements for the future, until they had grown to the measiure of the financial garments already on their backs. But whatever the motive in either case, the Texas experience confirms that of Massa- chusetts in the demonstration that it is possible to overdo a good thing; to be too rigid and strict in pursuance of a normally laudable policy; and that not all the mistakes of two genera- tions past can be corrected in the twinkling of an eye by means of a statute. The Texas Stock and Bond law of 1893 declares that the power and authority of issuing or executing bonds or other evidences of debt and all kinds of stock and shares are special privileges and franchises; and that the right of supervision and control is vested in the state. It is specifically provided that "no bonds or other indebtedness shall be increased or issued . . . over or above the reasonable value of said railroad property"; although in case of emergency, bonds and stocks may be executed to an amoimt not more than 50 per cent, over the value of the property. Under this Texas law, there- fore, it is evident not only that all bonds must be authorized 1 P. 298, supra. TEXAS FINANCIAL REGULATION 303 and approved, but that they must be actually registered. No further issues may take place until all previous over-capitaliza- tion has been expunged. Such obUteration may take place either by reinvestment of earnings in the property, or else through gradual appreciation of assets due to the growth of the country. It would appear as if valuation being based upon the cost of reproduction, land might be inventoried at present or prevaihng prices. This the railroad commission refuses to allow. Whether this is sound law or not has not yet been put to the test. In the administration of this statute, a sharp distinction is made between those properties con- structed and capitalized before the passage of the law, and the new roads built since that time. For all new construction of independent roads, the commission applies an arbitrary scale of costs which seems to be sufficiently liberal to allow for pro- moters' profits, seasoning of the property, and even a certain value for the franchise. But great hardship has arisen in the application of the law, either to old roads or to extensions and improvements attempted by these older properties. So evident did it become that an entirely different mode of treatment was necessary for the two classes of railroads, that the law was amended in 1901 so as to permit the separate and independent capitalization of extensions, regardless of the over-capitalization of the main stem. The prime result contemplated by the Texas authorities being to impose a check upon over-capitalization, it is beyond question that this has been attained. How rigid the limitations were, may be instanced by the case of the Houston & Texas Central. Between 1892 and 1906 the length of this road expanded from 507 to 694 miles, while the total capitaHzation was actually reduced by about $1,000,000; that is to say, the average stocks and bonds per mile of line dropped from $50,900 to $35,700. Similar results followed all over the state. Be- tween 1894 and 1906 the railway mileage in Texas increased by about one-fourth, to a total of 12,058 miles. The stocks 304 RAILROADS and bonds outstanding per mile of line during these thirteen years dropped from $40,802 to $31,530. This result, so ardently desired by the advocates of the law was, it must be said, some- what nuUified during the last ten years of the period in question by an increase of floating debt from $'30,300,000 to $76,500,000. The ominous significance of this growth of current Habihties lay in the fact of the commission's flat refusal to permit it to be refunded. This is obviously the logical apphcation of the law, namely, not even to permit the increased valuation of the property due to improvements of any sort to be paid for by new securities, until the outstanding capitahzation has been brought down to the limits of the actual investment. The situation is paradoxical enough, with railroad properties con- tinually increasing in worth and earning capacity, but accom- panied by a steady decUne both in the volume and, it may be added, the market prices of their shares. One effect of the restrictive Texas law has, then, imdoubtedly been to penaUze improvements and betterment. Considerable new construction, as we have seen, has taken place; but, on the other hand, the speculative or even the dishonest promoter has by no means been eliminated. The recent " Frisco " scan- dals were largely concerned with the over-capitahzation of Texas branch lines. The most serious result, however, is the discom-agement of improvements; such as the substitution of heavy rails for fight, the replacement of wooden structxires with steel, the reduction of grades, better stations, etc. The poficy of the railroad commission has been somewhat relaxed since 1907 in case of equipment security issues. And, as above mentioned, the independent capitahzation of extensions is permitted. But a heavy hand stiU rests upon all bond issues for betterment of the existing fines of the older com- panies. The fact seems to be ignored that a close inter-relation obtains between the amoimt of the investment and current operating cost.' Consequently, in the absence of large addi- ' Ripley, Railroads: Rates and Regulation, p. 66. TEXAS FINANCIAL REGULATION 305 tions to plant, the level of operating expenses stands so high that Httle or no net earnings remain. In 1906, twenty-three of the fifty-five railroads in Texas reported a deficit.' Under such circumstances whatever new capital for improvements was imperatively demanded, has had to be raised by the use of collateral trust bonds, issued upon their own superior credit by parent railroads outside the state, although secured by the assets of Texas Unes.^ The conclusion is unavoidable that people resident in other states have furnished Texas with transportation for which it does not pay. The antiquated physical valuations used as a standard for capitalization also fail to recognize the degree to which the growth of the country has tended in itself to bring the volimie of securities outstanding into accord with the present worth of the investment. Physical valuations as a consequence stand far below the assessments for purposes of taxation.' It appears that the development of the country has already automatically "squeezed" much of the water out of its railroad capitaHzation; and that economic conditions are now ripe for the inauguration of a more liberal pohcy in future.^ The Texas law seems to demand amendment in such a 1 Railway Age Gazette, 1903, p. 106; and especially 1913, p. 1151, "Hearings before the Texas Welfare Commission." ^ U. S. Railroad Securities Commission, p. 30. The Pecos Valley- branch of the Santa ¥6 system is partly in Texas, partly in New Mexico. The Interstate Commerce Commission found the former capitalized at $8,000 per mile, the latter at $42,000, with no difference in actual cost. 12 I. C. C. Bep. 345. ' Bull. Bureau of Railway Economics, 1911, on Physical Valuation discusses these antiquated inventory values. * The Texas Welfare Commission of 1912 made the following recommendations : 1. That all bonds or other such obligations lawfully issued and sold may be refunded regardless of any valuation fixed by the raihoad com- mission. 2. That bonds may be issued for betterments, improvements or extensions, regardless of any valuation theretofore fixed by the raiboad commission. . 3. That the process for issuing bonds be changed so as to authorize the issuance and sales of such securities as the money is required, either VOL. II — 20 306 RAILROADS maimer as to release the railroad commission from the arbitrary and exacting mathematical requirements of the statute; and to permit it, hke the N.ew York commissions, to exercise a reasonable discretion in authorizing railroads to issue securities for all legitimate purposes. It seems probable, also, that the law- is theoretically defective in seeking to prevent all stock- watering in connection with new construction. This point is indeed indirectly conceded, as we have already seen, by the hberal way in which construction costs are measured. Texas, above all things, stands in need of transportation development, by reason of its vast area. The discouragement to prospective investors is almost abject. It is certain that not only the issue of bonds at a discount, but even- a resort to stock bonuses, in order to promote the sale of bonds, may at times be necessary in order to procure an adequate supply of new capital xmder the risks attendant upon pioneering.^ But, whatever one may think about stock-watering as a necessary concomitant of construction, the Texas experience clearly demonstrates that a drastic attempt within a brief period to correct all the excesses of the past,^ may so completely discourage enterprise in the present as to miUtate against the public interest. The regulation of capitahzation by other states than those already described has been too brief to call for extended com- ment. Wisconsin has in a measm^e manifested an interest in this aspect of affairs since 1907; but, so far as railroads are concerned, the supervision of security issues is quite perfunctory. before, during or after construction, instead of only after construction, as is now the ease, but providing for strict application of the proceeds to the purposes for which authorized. ' 4. That the sale of bonds by new railroads be authorized providing safeguards insuring the proper application of the proceeds. 1 Cf. Commissioners Meyer and Knapp, Hearings on Rate Increases vol. Ill, 1910, p. 2513. ^ Cf. p. 291, supra, on the attempt in reorganization proceedings in New York and Nebraska to scale down excessive past issues by prohibiting an exchange par for par. STATE FINANCIAL REGULATION 307 The first law merely called for the fifing of data, after which the commission was required to certify the issue. But the law was amended in 1911 by providing that stocks or bonds should be fimited to the amounts reasonably necessary for the purposes stated. Authority was conferred upon the commission to determine whether these purposes were lawful and whether the amount was, in fact, reasonable. But no occasion has yet arisen calfing for a formal decision or opinion. This is some- what extraordinary, in view of the fact that the total number of stock and bond authorizations for all classes of pubfic service companies for the six years since 1907 amounts to 670 :— an average of about 100 cases a year. The record of the recently created New Jersey commission is more positive. A number of suggestive principles have already been laid down in the course of two years' experience. Thus it was held in a case of over-capitafization as a result of merger, whereby practically half of the securities outstanding were based upon "anticipation rather than sofid assets," that the company could not set up its capitafization or its contracts as a bar to the state's exercise of power over rates.' Offerings of securities, as in New York, niust be pubficly made in order to afford an opportunity for the company to reafize the best possible price.^ Equipment, trust bonds may not be sold at favorable prices based upon their high standing as "purchase- money mortgages," imless, as a matter of fact, new equipment is really acquired by this means.' Mortgage indebtedness aggregating possibly three times the capital stock departs so radically from the old-estabUshed principle that loans ought not to exceed assets, that the New York Central refunding mortgages in 1913 were disapproved as to property within the 1 Public Service Gas Company, December 26, 1912. Affirmed by the New Jersey Supreme Court, June, 1913. "The ultimate question is a question of business and the results cannot be predicted. In such a case the commissioners ought to move with caution. We think in this case they have done so." 2 North Hudson County Railway case, Dec. 5, 1913. ' Public Service Railway Company, Mar. 3, 1914. 308 RAILROADS state of New Jersey.^ On the other hand, the fundamental principle is clearly enunciated that regulation imphes protection against competition as a necessary corollary. It is against the pubUc interest to permit two monopolies, both subject to regulation, to invade one another's territory.^ The record of this New Jersey commission, although short, seems likely to entitle it to a commanding position among administrative boards of this type in the United States.' A few additional cases from other parts of the coimtry indicate certain significant tendencies. The contrast in attitude toward construction between the well-settled East and the imdeveloped territory in the West is striking. The general need of transportation facihties in the latter case renders it particularly difficult to resist the temptation to admit new- comers regardless of consequences. In other words, the settled poUcy in the East of recognizing and protecting transportation as a local monopoly is far less rigidly applied. Thus in Ne- braska,^ although the commission by constitutional amendment may disapprove of competition, invasion of already occupied territory is not forbidden, on the ground that it "involves such grave responsibility that the commission will not exercise it imless specifically directed so to do by the legislature." In Cahfornia such competition in invading virgin territory was obviated by the device applied to the Northwestern Pacific Railroad of an equally divided ownership of stock between the Atchison and the Southern Pacific.^ But, it appearing that 1 Decision, Dec. 19, 1913. ^ New Jersey Power Company, decided January 27, 1914. Well ex- pressed for New York in the repeated refusal by the up-state commission to permit the financing of troUey lines paralleUng the New York Central from Buffalo to the Hudson River. 3 P. S. C, 2nd D. (N. Y.), 1913, 55. Marked Uberahty in treatment is also manifested in the allowance of capitalization of expenses of development. This is unique. Cf. P. S. C. (N. Y.), 1912, 246, allowing 30 per cent, of the capitalization for the special value of "plant with a business attached." ' On stock dividend policy in New Jersey, vide Electric Railway Journal, Oct. 10, 1914, p. 725. * Railway Commission, Sixth Ann. Rep., 1913, p. 255. ' Railroad Commission, 1914, decision no. 1428. STATE FINANCIAL REGULATION 309 $35,000,000 of stock at par was carried on the books of these companies at only $7,600,000, a physical valuation of the prop- erty was demanded as a prerequisite for further bond issues. There is no evidence, however, of a disposition to imitate the rigorous Texas plan of expunging this watered stock before permitting further issues for construction. A more positive restraint in another CaUfornia case is manifest.' A railway petitioned for $15,000,000 at par of bonds to complete con- struction. The road was evidently needed; but, in view of the stated evil of over-issue of bonds, authority was granted to substitute for the above-mentioned issue, $10,000,000 in bonds and $3,000,000 in stock at par instead. This attempt to maintain a due relation between capital stock and indebted- ness recalls the above-mentioned Nebraska case which per- mitted a similar over-weight of bonds, but only on the ground that no other financial plan was feasible.^ Another recent case, in Missouri,' affords an interesting example of all of the abuses of construction company finance of the classical sort. Frank disapproval of these practices was, however, coupled with the submission of a well-ordered plan by which the road might be honestly built. The powers and intelhgence of the Michigan commission are now on trial in disentanghng the involved finances 'of the PSre Marquette road. Refusal by this body to allow issue of short-term notes against a deposit of bonds as collateral on such terms as to create a much greater liabihty than the loan represented, precipitated a receivership. The course of events in recent years, despite the activity of ' Railroad Commission, 1914, decision no. 1264. * Cf. the New Jersey disapproval, heretofore cited, of the New York Central bonds; and, on the other hand, the amendment of Massachusetts law in 1913 permitting bonds to thrice the amount of capital stock, instead of twice as formerly. ' P. S. C. (1913), 141. The prohibition of any loans by the construc- tion company based upon deposit of the railroad stock, until the property is actually created, closes the door to such abuses as occurred in the Hamp- den case in Massachusetts. Railway Age Gazette, vol. LVI, 1914, p. 1180. 310 EAILROADS the several states in regulating capitalization, has emphasized the need of legislation in this field by the Federal government. Several bills are now before Congress upon the subject. This Federal interest in capitahzation has in part arisen from the ever-increasing complexity of inter-corporate relation. Few railroads now confine their activity within the boundaries of a single state. The several scandals incident to the late collapse of the New Haven, the Rock Island, and the "Frisco" systems, each of them widely interstate in character, have demonstrated the need of Federal interference. From the railroad point of view, also, the desirability of an enlargement of the scope of authority of the Interstate Commerce Commission has been established through the well-nigh intolerable conflict of au- thority of the many public service commissions and state courts now at work in this field. ^ No fewer than six different state commissions are said to be taking a hand in the pending reorganization of the Wabash. The approval of each is neces- sary for validation of the plans, and it is impossible to obey so many masters. It is also daily becoming more clear that the confiict of state and Federal authority in the regulation of rates can be averted only by the assumption of unified financial control by the United States.^ Rates, service and finance are so completely interlocked that satisfactory regulation in each field cannot be exercised except by the assumption of full authority over all three domains aHke. The foregoing recital of the causes of Federal interest in control of capitalization seems to dispose summarily of the recommendations of the Railroad Securities Commission of 1910 in favor of a conservative policy of mere publicity. It would appear as if, in order to reheve the carriers from the ' Cf. the conflict of laws in the New Haven case in 1908 respecting validation of securities in Massachusetts of a corporation chartered in Connecticut (198 Mass., 413). The Validation Act of 1910 was a necessary consequence. But the U. S. Supreme Court decision ia the Shreveport case, just rendered, considerably clarifies the situation. * Ripley, Railroads: Rates and Regulation, chap. XX. STATE FINANCIAL REGULATION 311 conflicting and sometimes harassing exercise of power by the different state boards, the only course would be to confer equally broad powers upon the Interstate Commerce Commis- sion. Otherwise the state commissions might not be retired from the field. This, Hkewise, is the principal objection to a plan of control intermediate between mere pubhcity and strict regulation.! The prevention of the issuance of securities for im- proper purposes, and of immoral profits to insiders, as well as a guarantee that all moneys raised shall be rightly expended for the public good, might conceivably be brought about through a greater concentration of responsibility upon directors. They might be required, for example, to subscribe to a full and sworn statement on the corporate minutes as to these details and thereafter be made criminally liable at law. Did not the state commissions, endowed with much broader dis- cretionary authority over the issuance of securities, already exist, this plan might have much to reconunend it. At all events it would do away with such dummy directors as were used by the Mellen administration of the New Haven road in the cases of the Billard Company and other subsidiary cor- porations.^ But these state commissions can hardly be expected or required to withdraw from the field unless an equal measure of authority is conferred by Congress upon the Interstate Commerce Commission.' The advantages of singleness of purpose and uniformity of treatment certainly attach to such assmnption by the United States of the present functions of the different cormnonwealths. Evasion of control, now so 1 Railway Age Gazette, vol. LVI, 1914, p. 62. Embodied in H. R. 13,454 presented by Mr. Esch of Wisconsin. It provides for the issuance of a certificate of notification. A bill for positive regulation is embodied in H. R. 12,584. 2 Investigation by the Interstate Commerce Commission in May, 1914, to be embodied in a report to the Senate. ' The remedy of an interchange of views between Federal and state boards as a. means of securing harmony, illustrated in respect of safety appliances and standardization of accounts, fails at this point. 312 RAILROADS prevalent under the present system of divided responsibility, would be brought to an end. And, finally, it now appears that the objection brought forward by the Federal Securities Com- mission, — that public opinion would not support the assertion of exclusive Federal jurisdiction, — no longer holds good. At the same time, the problems of financial control are so distinct from those of rate regulation, that the administrative sub- division of work should be kept distinct. Either a separate set of commissioners or a departmental organization, as in the state bureaus, would be necessary in order to distribute the bur- den and to promote efficiency. Whether at the same time Federal incorporation is desirable would seem to be more problematical.^ But it is clear that the time has now arrived when certainty and simplification of control in the interest of all parties concerned can be secured in no other way. 1 Railroad Securities Commigsion, p. 25. CHAPTER X THE DETERMINATION OF REASONABLE RATES United States Supreme Court opinions, 313. — First period to 1898; legis- lative V. judicial control without definite standards, 314. — The early Minnesota Rate eases, 314. — The Texas Railroad Commission case, 315. — Decisions, hesitant and inconclusive to 1898, 316. — The Ne- braska Maximum Rate case, 318. — Little progress until 1904, 319. — The San Diego and Knoxville Water Co. decisions, 320. — The Consolidated Gas case, 321. — The Mirmesota Rate cases, 1913, 321. — The Kansas City Stockyards decision, unique, 323. — Absolute or relative standards of reasonableness, 325. — Ultimate limitation of the rate of return, 326. — Is a partnership theory feasible? 327. Administrative state opinions, 327. — The Interstate Commerce Commis- sion ruUngs, 328. — Physical valuation proposed by counsel for the carriers, 329. The evolution of the principles governing the reasonable- ness of rates for pubUc service in the Federal courts has been slow but sure.* Judicial determination of these principles has also logically and of necessity been accompanied by a progres- sive insistence upon physical valuation. An outline of this interpretation is essential at this point in our inquiry. The review must, however, be confined to the decisions of the Supreme Court of the United States; although many suggestive details might be gleaned from other legal sources. The chroni- 1 Authorities are as follows: Beale and Wyman, The Law of Railroad Rate Regulation (Collected cases), 1906; B. Wyman, Pubhc Service Cor- porations, 2 vols., 1911; H. S. Smalley, Railroad Rate Control, Publications of the American Economic Association, 3rd ser., vol. VII, 1906, pp. 83-110, reprinted in Ripley, Railway Problems (rev. ed.), pp. 619-641; Clark, Columbia University Studies in Economics, etc., 1910; A. C. BaiUy, Colum- bia Law Review, June and November, 1911, p. 44; F. J. Swayze, Quarterly Journal of Economics, 1912, pp. 389-424, reprinted in Ripley, Railway Problems (rev. ed.), pp. 716-744 (one of- the best); R. H. Whitten, Valua- tion of Public Service Corporations, 1912, p. 798 (Standard work); H. V. Hayes, PubUc UtiUties, 1913; R. P. Reeder, VaUdity of Rate Regulation, 1914. 314 RAILROADS cle begins with the Granger cases in 1876/ a first chapter concluding in 1898 with the Nebraska Maximum Rate decision. The leading issue during this first interval of twenty-two years was, logically, the establishment of the right of the people to rule through the agency of their legislative bodies. No suggestion of intervention by the courts for the protection of private property rights was offered at all until 1884.^ But two years later, while still holding that the state was free to fix rates within the hmits of its general authority, the previously suggested modification of unhmited legislative power was amplified into clear afiirmation that the power to regulate "is not a power to destroy, and hmitation is not the equivalent of confiscation. . . . The state cannot require a railroad corporation to carry persons or property without reward; neither can it do that which in law amounts to a taking of private property for public use without just compensation, or without due process of law."' In 1890 the pendulum swung even farther over to the side of judicial intervention, in an opinion which seemed practically to overrule the Granger decisions.* Administrative commissions, it was declared, could not be regarded as clothed with judicial functions at all. This ill-balanced decision promised for a time to undo all the con- structive work of years. Carried to its logical conclusion, as Justice Swayze says,^ it would substitute the courts for com- missions as final arbiters; and in effect would throw the whole burden of rate-making upon the judicial machinery. The vigorous dissenting opinion in this case lays bare the very roots of the subject. The point raised was fimdamental. The query in the Granger cases was: "Is the rate so unreasonable as to be arbitrary and amoimt to confiscation of property 1 94 U. 8., 113. 2 Swing Valley Water Works, etc., 110 U. S., 347. ' Railroad Commission cases, 116 U. S., 307. On "due process of law," the Minnesota Rate oases, four years later, contained further definition. ^ Minnesota Rate cases, 134 U. S., 418 and 466. ' Ripley, Railway Problems (rev. ed.), p. 719. REASONABLE RATES 315 rather than mere regulation of a rate?" These Minnesota Rate cases inquired : " Is the rate a reasonable one, and such as would afford the same profit as could be reaUzed hy one not subject to regulation?" (Our itaKcs.) Had the people the right to regulate rates, as declared in the Granger cases, then the property of the railroads was surely quaUfied by that pubUc right; ^ and no deprivation of such quaUfied property right could occiu*, so long as the legislatm-e confined itself within the Hmits of fair regulation, stopping short of confiscation. It is this minority opinion which has finally prevailed; ^ but the temporary set-back of the Minnesota Rate cases certainly appeared threatening for a time. One of a series of efforts to throw the protection of the courts aroimd the carriers, growing out of the preceding de- cision interpreting the Fourteenth Amendment, brought forth the Texas Railroad Commission opinion of 1894.' The rates of a state railroad board were for the first time successfully enjoined in a body. And, on the whole, the position as to the predominance of the judiciary over the legislature was main- tained. Two other decisions within the next two years dealt with details of the subject and are of minor importance. One* concerned the apportionment of earnings as between divisions of a raiboad and arbitrary state hnes. The other ^ is of a different interest, as will shortly appear. Summarizing the results up to the middle of the '90s, then, it appears that they were two- fold. So far as general principles are concerned. A definite ahgnment of the Fourteenth Amendment down the field had been made, with private property rights on the one side and public powers of control on the other. And, in the second place, the earher supremacy of legislatures and commissions 1 The Kansas City Stockyards case, 183 U. S., 79, delves further into this point. 2 206 U. S., 1. » Reagan v. Farmers' Loan & Trust Co., 154 U. S., 362. * St. Louis & San Francisco Railway v. Gill, 156 U. S., 649. 6 Covington, etc., Turnpike Co. v. Sandford, 164 U. S., 578. 316 RAILROADS had been duly, or as since held, unduly, tempered by judicial review.^ But although the major burden of the determi- nation of reasonableness had come to rest upon the courts, little was as yet accomplished in respect of a clear definition of the economic bases upon which their judgments were to be founded. No satisfactory standards for the accurate measurement of property rights are propounded in this first group of Supreme Court decisions down to 1898. In this regard they are hesitant and inconclusive, evidently groping in the dark for something, they know not what. Thus in 1888: "Without any proof of the Slim invested . . . the court has no means, if it would imder any circmnstances have the power, of determining that the rate of three cents a mile, fixed by the legiskdure, is unreason- able." ^ (Our italics.) Or in the Covington Tiu-npike case, eight years later': "These allegations were sufficiently full as to the facts necessary to be pleaded, and fairly raised for judicial determination the question — assuming the facts stated to be true — whether the act of 1890 was in derogation of the company's constitutional rights." (Our italics.) Evidently something was needed in the way of positive data. And even when the honorable justices ventured forth into economic analysis, their pronouncements were unsatisfactory and con- flicting. For the opinion in the first of these just-cited cases seems to rest upon original, that is to say, actual investment; that of the second, upon the effect of reduced tolls upofi divi- dends on the par value of capital stock.^ Newer and more fertile soil was broken in the Texas Railroad Commission case, however. Evident inadequacy of the rates to yield a fair ' Later developments in Ripley, Railroads: Rates and Regulation, pp. 503-593. 2 Dow V. Biedelman, 125 U. S., 680. ' 164 U. S., 578. * Cf. 35 Fed. Rep., 866, as to the effect of rates upon interest on bonds; and the disavowal in the Minnesota Rate cases of 1913, and Wyman, Pub- lic Service Corporations, vol. II, p. 976. REASONABLE RATES 317 return upon the investment, — the time, be it noted, being midway of the depression of 1893-'97, — was admitted. The figures were most general, and yet the comt declared that the facts so supported by the averments in the bill, "in the absence of any satisfactory showing to the contrary, sustain a finding that the proposed tariff is unjust and imreasonable." (Our itaUcs.) The decision continued: "Is there anything which detracts from the force of the general allegation that these rates are unjust and unreasonable? This clearly appears. The cost of this railroad property was $40,000,000; it cannot be replaced today for less than $25,000,000. There are $15,000,000 of mortgage bonds outstanding against it, and nearly $10,000,000 of stock. These bonds and stock represent money invested in the con- struction of this road. The owners of the stock have never received a dollar's worth of dividends ia return for their investment. The road was thrown into the hands of a receiver for default in payment of the interest on the bonds. . . . "It is unnecessary to decide, and we do not wish to be understood as laying down as an absolute rule, that in every case a failure to pro- duce some profit to those who have invested their money in the building of a road is conclusive that the tariff is unjust and unreasonable. . . . There may be circumstances which would justify such a tariff; there may have been extravagance and needless expenditure of money; there may be waste in the management of the road; enormous salaries; unjust discrimination as between individual shippers, resulting in general loss. The construction may have been at a time when material and labor were at the highest price, so that the actual cost far exceeds the present value; the road may have been unwisely built, in localities where there is no sufficient business to sustain a road. Doubtless, too, there are many other matters affecting the rights of the community in which the road is buUt as well as the rights of those who have built the road." (Our italics.) Is not this opinion indecisive enough as respects economic standards or principles? Original cost, replacement value and even present worth are all aUke suggested as the proper measure for reasonableness; while Justice Brewer even hints at a fourth possible basis of value "as it stood in the markets of the world." Here is a most inviting display of wares; about all we have, even today, in this particular Hne. But no choice is indicated; 318 RAILROADS nor, in all probability, could one be made owing to the paucity of data. The Nebraska Maximum Rate decision of 1898^ affords the first authoritative pronouncement upon the economic bases for the determination of rate reasonableness. It is a landmark in the development of public regulation. Real analysis on the economic side is for the first time had. Expert evidence as to value supersedes merely general admissions or allegations of the parties at law. The constitutionality of a Nebraska statute establishing maximum freight rates was in question. The state contended that so long as the rate fixed by law yielded operating expenses, under economical administra- tion, with something in addition thereto, the power of the court to intervene was at an end; in other words, that the fixation of the exact amount of profit was a question not suit- able for judicial action but was rather a matter of poUtical poUcy. According to this view, the property right in a railroad consisted in its title and possessions, the privilege to operate with efficiency, and the further right to such additional com- pensation, however small, as the people chose to grant. The carriers, on the other hand, stood out for such ample revenues as should meet all fixed charges over and above operating expenses and dividends upon their entire capitahzation, regard- less of its character, fictitious or real. Between these two extremes ran the decision of the court. A definition of property and its right to a reasonable return was in order. "The corporation may not be required to use its property for the benefit of the public without receiving just compensation for the ser- vices rendered by it. How such compensation may be ascertained, and what are the necessary elements in such inquiry, will always be an embarrassing question. . . . We hold, however, that the basis of all calculations as to tJie reasonableness of rates . . . mustbethe fair value of the 'property being used by it for the convenience of the public. And in order to ascertain that value, the original cost of construction, the amount expended in permanent improvements, the amount and market 1 Smythe v. Ames, 169 U. S., 466. REASONABLE RATES 319 value of its bonds and stock, the present as compared with the original cost of construction, the probable earning capacity of the property under particular rates prescribed by statute, and the sum required to meet operating expenses, are aU matters for consideration, and are to be given such weight as may be just and right in each case. We do not say that there may not be other matters to be regarded in estimat- ing the value of the property. What the company is entitled to ask is a fair return upon the value of that which it employs for the public con- venience. On the other hand, what the public is entitled to demand is that no more be exacted from it for the use of a public highway than the services rendered by it are reasonably worth." (Our italics.) This ample list of all possible standards of value is indeed imposing; but, after all, matters in detail were still left about as much in the air as before. Besides failing to make selection from among these numerous standards of reasonableness, sanctuary was sought in the broad generalization of "fair value." The Nebraska Maximxmi Rate decision was also imclear as to the fine distinction between value of property in use and that of services rendered. The former would measure rates by the undivided value of the plant; the latter necessitated consideration only of particular items. It is the old distinction between cost of service and value of service.^ As between these two, the court chose the fair value of the property as above indicated. But, with these reservations the opinion marks a distinct advance in legal education. It was a great decision, probably as well reasoned as the then state of economic investigation would warrant. For about six years, following the Nebraska Maximum Rate decision, little advance in economic reasoning on the subject of valuation by the Supreme Coiurt seems to have taken place. Other judges, big and little. Federal and state, were, to be sure, profoundly influenced by the phrase "fair value"; but one is still left in doubt as to what the term really meant. Nevertheless, a distinct improvement in practice was the taking of detailed evidence as to the economic facts 1 More clearly stated in the Kansas City Stock Yards case, p. 47; as also p. 325, infra. 320 RAILROADS by masters in chancery. The first San Diego Land Co. decision of 1899/ while again sufficiently broad in its inclusion of all possible elements of value, gives adherence to no well- defined standard. Present worth seems to be indicated in entitling the company to demand "a fair return upon the reasonable value of the property at the time it is being used for the public"; this, as it appears, "as against the actual cost of the plant, annual depreciation, etc.," on the ground of improper and injudicious inflation of the property accoimt over a term of years. Still, therefore, do we hang mid-air, swinging toward replacement cost, regardless of the amount of the original or actual investment! Accelerated progress along lines of economic reasoning is discernible in decisions of the Federal courts only since 1904. Legal pronouncements are more commonly buttressed by positive statistical and accounting data. Euphonious generali- zations, using Smalley's phrase, give place to more business- like construction. The starting point, carried over from the earUer cases, remains imchanged. The mainstay is still present- day replacement cost, not original or actual investment.^ But, after the lapse of four years, new elements are discerned in the second San Diego Land Company opinion. The plant is larger than the requirements of the conununity warrant; perhaps, even, the investment has been injudicious and excessive. Need patrons today pay carrying charges for the benefit of their remote descendants? Not so! Fair returns may be reckoned only upon an investment "reasonably necessary for the existing pubUc service." The quahfications introduced in the next decision' are evidently concomitants of progress in the science of accoimting and physical valuation. The Knoxville Water case in 1909,* recognized the elements of decrepitude and depreciation — an old plant obviously worth 1 174 U. S., 739. 2 189 U. S., 439. ' Omitting San Joaquin Irrigation Company, etc., 192 U. S., 201, aa touching other points. * 212 U. S., 1. REASONABLE RATES 321 less than a new one; of going value — a live plant worth more than a dead one; of over-capitalization; of organization, promotion and experimentation outlays; and of general better- ment pohcy. Sound business practice was demanded by the court as a prerequisite for the acceptance of valuation data.^ About this time, also, was handed down the leading opinion in the New York ConsoHdated Gas Company case.^ So many- sided that we shall refer to it in several other connections, its interest for the moment lies in an advance in the definition of intangible values. An important feature was the inclusion of replacement cost of real estate, greatly enhanced in value through the growth of the community. There was no departure from the standing rule of law permitting property owners to benefit by increments in land value. Actual investment was still subordinate as a standard of valuation. In the definition of franchise value as distinct from good-will; and in the treat- ment of intangibles, in general, some contribution was made to theory. As a practical matter of valuation in dollars and cents, however, the court expressly disavowed responsibility for estabUshing precedents. The disallowance of good-will and franchise value has since been confirmed in a subsequent opinion.^ Further quaUfication of intangible values incident to the possession of a monopoly may be anticipated in future. It is certainly needed. The Minnesota Rate cases of 1913,* are notable by reason > Whether certain newer conceptions of depreciation are sufficiently weighty to permit the substitution of present value, that is to say of (Je- preciated value, for straight reproduction cost, new, remains to be seen. C/. p. 356, infra. 2 Willcox, etc., 212 U. S., 19. (1909.) 3 Cedar Rapids Gas, etc., 223 U. S., 655 (1912). C/. p. 361, infra. The opinion of Justice Swayze of New Jersey in the Public Service Gas Co. case, 87 Atl. Rep. 651, is a notable contribution, along this line. At the last moment, too late for express citation, a decision of the New Jersey Court of Appeals in December, 1914, is said to support a fuU allowance for franchise value. Can it possibly be true ? Cf. p. 370, infra. * Simpson v. Shepard, etc., 230 U. S., 352; reprinted in Ripley, Rail- way Problems (rev. ed.), pp. 642-715; Political Science Quarterly, vol. XXIX, 1914, pp. 57-84. VOL. II — 21 322 RAILROADS of the declaration that where inter-blending of Federal and state activity is such that adequate regulation cannot other- wise be maintained, the proper solution is, "through the exer- tion by Congress of its paramount constitutional authority." ' But they deservedly also take high rank among opinions dealing with reasonable rates and valuation. On this side of the case there is a sharp differentiation from preceding opinions in being more like an economic treatise than a legal judgment. Data both as to reproduction and original cost had been collected through an elaborate investigation by a master. Here was a concrete instance calling for the application of well-formulated legal principles to an elaborate official presentation of facts, not for the undivided net-work of the state but road by road. The basis was still held to be the fair value of the property used; but the ascertaiimient thereof was held not to be con- trolled by artificial rules. "Not a matter of formulas, but the application of business judgment to particular transactions." Broadly speaking, the technical interest of this decision is three- fold; in the discussion of methods of apportionment between companies and states; ^ in the treatment of land values; and in the clear analysis of depreciation. Replacement cost, new, for railroad purposes, as allowed by the master for real estate, was definitively rejected in favor of the fair average market price of land. The fortuitous equivalence of wear and tear and appreciation for other tangible assets, inducing the master to disregard depreciation entirely, was held to be scientifically untenable. The treatment of the increment in land values is, ' On this matter of conflict of Federal and state power, the Shreveport cases also deserve consideration. C/. Harvard Law Review, vol. XXVIII, 1914, pp. 34-81. ' Concerning the difficult problem of apportionment of business be- tween different states or roads, the latest authoritative opinion is in this caae. (Reprint, Ripley, Railway Problems (rev. ed.), pp. 684-687.) Gross receipts are rejected in the South Dakota case, 176 U. S., 167; with a lean- ing to ton mileage in the Phosphate cases, 203 U. S., 256. Nor need every mile pay by itself; 156 U. S., 649. Railway Age Gazette, vol. LVII, 1914, p. 17, outlines complications. Cf. also footnote, p. 341, infra. REASONABLE RATES 323 perhaps, the most far-reaching portion of this leading decision.^ The ConsoUdated Gas Company case had to do with values in the great cities; this one dealt with the right of way out in the open, as well as with terminals. New phases of the subject, if not settled, were at least laid open for dissection, some of them going down to the fimdamental principles of valuation practice. Adherence, it will be noted, to the standard of present worth still prevailed. Thus: "It is clear that in ascertaining the present value we are not limited to the consideration of the amount of the actual investment. If that has been reckless or improvident, losses may be sustained which the community does not underwrite. As the company may not be pro- tected in its actual investment, if the value of its property be plainly less, so the making of a just return for the use of the property involves the recognition of its fair value if it be more than its cost. The prop- erty is held in private ownership, and it is that property, and not the original cost of it, of which the owner may not be deprived without due process of law." ■ One recent Supreme Court opinion is sharply outHned against the backgroimd of all the rest, as embodying, half- revealed, an entirely different conception, both legal and economic, of rate reasonableness. ^ Two criteria have long been recognized by the courts, one having reference to the carriers' rights, the other safeguarding the patrons. The railroad, on the one hand, is entitled to a fair return upon the fair value of the property in use; the pubhc, on the other, may be charged no more than the service is reasonably worth. One forbids confiscation; the other, extortion. One defines a minimum, the other a maximum rate. Between the two lies what has been well termed a "twiUght zone." Now all the foregoing decisions, — such being the predilection of judges, especially in the interpretation of the Fourteenth Amendment — reason from the standpoint of property rather than from that of ^ P 351 iniTOf. 2 dotting v. Kansas City Stock Yards Company; 183 U. S., 79 (1901). 324 RAILROADS public use or interest.^ It is on this ground that competent critics have urged an entire change of legal basis for the de- termination of reasonable rates; namely that regulation should be viewed, not as at present as an exercise of the power of eminent domain and, consequently, with an eye single to the effect upon income, but rather as an exercise of the pohce power which holds the pubUe interest, not property, in the foreground. The notable opinion in the Kansas City Stock Yards case thus reversed the customary process of reasoning. Curiously enough, by indirection it regained the point. of view of the old English common law, that persons engaged in a pubhc calUng might " charge for each separate service that which was a reason- able compensation therefor." It will be noted, nevertheless, that this suggested a Une of reasoning applicable only to the reasonableness of particular rates for service rendered, and not of any general schedules hke the Rate Advance case of 1913-'14. Concretely, the question at bar in the Stockyards case was: first, whether they were subject to regulation at all; and secondly, if so, whether rates yielding 11 per cent, on the investment were exorbitant. As to the first point, incisive distinctions were drawn between pubhc service companies and those in which the people had a more remote or indirect interest in their use. Concerning a fair rate of return, the practical result suggested, was that reasonableness should be measured, not by the aggregate profits, which depend upon the volume of business, but upon the inherent fairness of each charge — the value, that is to say, of each separate service to the patron. Reductions, in other words, might not be demanded '■ Cf. Smalley (Reprinted in Ripley, Railway Problems, p. 636 et seq.), noting the manner in which judicial decisions tend to ignore their own qualifications of the right to reasonable return, such as the unwisdom of the original investment, the lawfulness or honesty of practices and man- agement, and the cumulative character of elasticity of returns. Cf. also President Hadley of Yale on the Fourteenth Amendment, The Independent, Apr. 16, 1908. REASONABLE RATES 325 because profits were large; but only on the ground of their being innately excessive. "If he has a thousand transactions a day, and charges in each but a reasonable compensation, such charges do not become luireasonable because, by reason of the multitude, the aggregate of his profits is large." Is this not, perhaps, the distinction from another viewpoint between that value of property and value of service, so obscurely treated in the Nebraska Maximum Rate case? ^ Whether there are, indeed, positive or absolute standards of reasonableness, irrespective of circmnstances, was in reality not settled in this opinion. The court set aside the law redu- cing rates, to be sure; but it did so on other groimds, the reduc- tions not applying to other like businesses throughout the state. And judgment upon this point as to the standard of reasonableness was expressly reserved. Is it not, perhaps, pregnant with meaning? ^ Why do not the carriers wrest it as an argument for their own protection from the advocates of the public interest by whom it was first advanced, and turn it against its original sponsors? ^ Probably because of several vaKd economic objections. In the first place, practi- cally all railroad-made rate structures, time without end, have been profoundly and primarily infiuenced by considerations of what the traffic would bear. Volumes of testimony from the carriers' side might be cited in favor of the view that no such thing as an absolute standard of rates exists; that charges vary with every breath of commercial circumstance that blows; that rates fair at one time and in one setting, may readily become onerous and may require modification to suit the exigencies of the market; and particularly that all rates are inextricably entwined with the volume of traffic.^ And aU these are actually true. It would be supremely illogical, the ' P. 319, supra. ' Whitten, Valuation, p. 56, applies it to valuation of obsolete or mis- placed parts of a plant. 3 Cf. the Soft Coal Rate cases; 22 I. C. C. Rep., 673. * Ripley, Railroads: Rates and Regulation, pp. 71, 86 and 118. 326 RAILROADS flimsiest possible defence for the carriers, to shield themselves behind that which for so long a time has been the subject of their violent animadversion. Whatever there may be in this line of reasoning, — and it is by no means certain that there is not a great deal, although at first sight it seems to run counter to sound economic reasoning — ranges itself naturally on the side of the public. What the service is worth to the com- munity, not what it costs the carriers to produce it, is the gist of the reasoniag. Does the fixation of reasonable rates by pubUc authority call for an ultimate hmitation of the rate of return? Legally it has been clearly held that service even for positively unre- mimerative rates is not of necessity unconstitutional.' For persons engaging to perform pubhc business, voluntarily, must be aware that the prime consideration therein is not profit but satisfactory service. Consequently, in view of the larger interest, they may even be required to submit to pe- cuniary loss. They took chances. The state guaranteed nothing. Moreover, it has also been held that the rate of retm-n, that is to say the profitableness of operation, need not be the same for all classes of traffic.^ But, apart from the bare legal aspects of the matter, broader considerations of public policy come into play. The older view that transporta- tion is a private business, affected it may be with a public interest, seems to be in process of relinquishment, in favor either of the opposite contention that railroads are public property tinged with a private interest, or that private capital is merely an agent operating on behalf of the state as principal.' But, it is submitted, sight must not be lost of the fact that, in any event, it is a question of partnership and of unity of in- terest.* To compel insufficient profits for private capital is ' Minnesota Coal Rate case, 186 IT. S., 257 (1902) ; also Kansas City Stockyards, 183 U. S., 93; Ripley, Railway Problems (rev. ed.), pp. 630, 730, 732. 2 22 I. C. C. Rep., 604, 673. ' American Economic Review, vol. IV, supp., pp. 24, 49. * Already discussed in connection with surpliis; p. 238, su-pra. REASONABLE RATES 327 no less inimical to the public interest than, as too often in the past, to allow them to an unlimited degree. Public regulation in future must not be governed by the mandates of the law applied too narrowly. It may be soimd business policy to be more generous, — sufficiently generous, that is to say, to make it certain that an adequate supply of capital for future needs shall be forthcoming, i The immedi- ate danger is assuredly too great niggardliness in this regard. Now firmly established in power, both by national legislation and interpretation by the highest courts in the land, the next step for the public in the development of sound governmental policy should be a frank recognition of the need of an ample return to private capital. Any other course is bound to hamper development and, in days to come, even worse, to promote a campaign for government ownership. Whether a theory of partnership can be apphed to railroads automatically in any positive way seems doubtful. The sliding scale by which charges for service and rates of dividend are yoked together, so soimd in theory and so successfully apphed to municipal utilities,^ seems inapplicable to railroads. Some device by which the three essentials of adequate service, efficient operation and fair profits may be automatically linked up together is certainly a need of the present time. Administrative commissions, both state and Federal, with the progress of time have devoted more and more attention to considerations of value of property. Obviously, when urged by coimsel for the railroads, as we shall see, the argument would be given great weight. But even when not so urged by the carriers, administrative bodies have sought firm footing 1 C/. the dissenting opinion in the 5 Per Cent Rate Increase case, 31 I. C. C. Rep., 434; Journal of Political Economy, vol. XVIII, 1910, p. 593; American Economic Review, vol. IV, 1914, p. 573. 2 Whitten, Regulation of Public Service Companies in Great Britain, 1914; Publications of the American Economic Association, 3rd ser., vol. XI, p. 220. On American cities, vide Electric Railway Journal, Oct. 10, 1914, pp. 720, 732 and 691. 328 RAILROADS for their decisions upon positive data of this sort. The need for it in official form led the state of Texas as far back as 1893 to confer authority by statute upon its railroad commission to make such valuations whenever needed.' The Wisconsin two-cent fare opinion,^ — one of the most elaborate, thorough and judicial in presentation of all sides of the issue — is also noteworthy as analyzing the elements of cost and value to the last detail. Such a model report is in itself the strongest possible argument for the apphcation of similar scientific analysis to all problems of control of pubUc service corporations. The salutary veto by Governor Hughes of the New York two-cent passenger fare law in 1908 was based, not upon the imreasonableness in itself of such a rate but upon the entire absence of any concrete data as to the value of the investment in relation to present or prospective returns. The subsequent refiance of the New York pubfic service commissions 'upon considerations of this sort are outlined elsewhere.' Federal administrative opinions caUing for physical valua- tion are numerous. A few typical ones must suffice. The added responsibiUties under the new rate laws, together with the interpretation of the statutes as to reasonableness of rates by the Supreme Court, have given greater prominence to such matters with the passage of time. One of the earfiest cases was in 1888,^ when a fair value of $110,000,000 for the Pacific roads concerned was set over against a reproduction cost of $50,000,000. In 1905 a typical and instructive dilemma was put up to the Interstate Commerce Commission. ° The capitahzation of certain Texas roads ranged all the way from $98,600 for the St. Louis Southwestern to $22,700 for the Gulf, Colorado & Santa F6. Yet these two Unes had approxi- ' P. 301, supra and 333, infra. ^ W. R. C. R., 1907, 101. Cf. the parallel two-cent fare case before the Virginia Commission; The Railway Age, May 10, 1907. ' P. 286, infra. * Pacific Railway Commission, 1888, p. 23. 6 11 I. C. C. Rep., 263. Cf. also 9 idem, 382, on Proposed Rate Advances. REASONABLE RATES 329 mately equal gross income, operating expenses and maintenance accounts, and were competitive for business. Capitalization data under such circumstances afforded no basis for an opinion as to the reasonableness of rates to be charged uniformly by the two. All that the Commission could do was to apply data for the average cost of reproduction of like properties, similarly circumstanced. Then came the leading rate advance cases of 1911, ' for the eastern roads emphasizing fair value of the investment, while for the western roads referring rather to actual cost. Still another typical opinion^ in 1912 concerning soft coal rates, disclosed the embarrassment of the Commission in passing upon the reasonableness of rate schedules with no positive data at hand except book cost, — well imderstood to be in most cases worse than useless. No need to emphasize, further the important r61e played in administrative decisions by ofl&cial valuation! The commissions have of necessity followed the same hne of argument pursued by the courts. From the logic of the reasoning there was no escape. Federal valuation was the inevitable outcome. The manner in which the investment value of railroad properties has been forced, willy nilly, upon the attention of the government by legal counsel for the carriers, as a defense against rate orders or statutes, may be indicated by a few leading examples. One of the most prominent was the so- called Intermountain Rate cases, covering the transportation grievances of a large section of the United States, and concern- ing the final determination of a large niunber of disputed points in the field of rate regulation.^ So sturdily was the value of the property urged by counsel, particularly for the Northern Pacific in respect of Spokane rates, that a majority 1 20 I. C. C. Rep., 243 and 307. Cf. also the revived Cincinnati Southern case, in 1910; Ripley, Raih-oads: Rates and Regulation, p. 588. 2 22 I. C. C. Rep., 604. . 3 Discussed as a rate problem in Raiboads: Rates and Regulation, pp. 610 et seq.; also Railway Problems (rev. ed.), p. 464 ff. 330 RAILROADS of the members of the Interstate Commerce Commission is reported to have changed its views, and to have become con- vinced of the need of official valuation for the future. Within two years, in a succeeding case concerning lumber rates to the Pacific Coast, the injection into evidence of a valuation one- fourth larger than before, still further emphasized the need of reliable official data. The long-contested Danville, Va., rate case affords another instance of prominence assigned by railroad counsel to this aspect of the matter of reasonable rates.' Con- stantly, in fact, controversy over particular rates causes the amoxmt of the investment to crop out in evidence. But more than ever does valuation come to the fore in those controversies • touching the general level of rates as a whole. A considerable part of the testimony in the eastern Railway Rate Advance cases of 1910 ^ had to do with the amount of the capital invest- ment and the rate of return thereon. Not definitely settled, but merely postponed owing to the persistent rise of prices and operating expenses, a recrudescence of the general question of reasonableness of eastern railway tariffs as a whole, occurred in 1912-'14. Somewhat less prominently, but still standing ever in the background, the same issue of investment value and rate return presented itself in this great case.* From such a record, it is evident that the matter of physical value has not been primarily of governmental making, but has constantly been pressed upon the attention both of administrative commis- sions and of the courts on behalf of the carriers themselves. It is obviously in order, for us to examine attentively both the theory and the practice of physical valuation, as an essential element in the determination of reasonable rates for service rendered. ' Railroads: Rates and Regulation, pp. 227, 483; and Railway Prob- lems (rev. ed.), chap. XVI. 2 Railroads: Rates and Regulation, pp. 594-600. 3 31 I. C. C. Rep., 351. CHAPTER XI PHYSICAL VALUATION :> REASONABLE RATES Four different reasons for physical valuation; historical development, 331. — Taxation, 333. — Control of security issues, 333. — Rate regu- lation, 334. — Private raib-oad appraisals, 335. — The Federal law of 1913, 336. — Other public service corporation valuations, 338. — Com- mercial valuation, 339. — Federal data, 339. — Statistical results by states, 340. — Conflicts and contradictions, 341. — Results clearly prove no over-capitahzation, 344. Economic analysis of criteria as to reasonableness, 346. — Actual or original cost approved, 347. — Quahfications necessary, 348. — • Reproduction cost, new, merely conjectural, 354. — Its shortcomings examined, 355. — Present value and depreciation, 356. — Details considered, 359. — Market value and earning power, 360. — Intangibles; franchise value; good-will and worth of a going concern, 361. — Statistical results, 363. — Significance of the distinction between structural value and earning power, 364. — InterchangeabiUty of valuation standards for different purposes, 367. Physical inventories of private property of all kinds by governmental authority have long been taken at intervals for purposes of taxation. Occasionally, also, in cases of demon- strated necessity, appraisals have been made, either for direct purchase by the state imder condemnation proceedings, or in order that takings may be had for certain pubhc uses, such as railroad construction, under exercise of the right of eminent domain. Both of these forms of valuation for purchase have 1 The best authority is R. H. Whitten, Valuation of PubHc Service Corporations, 1912, with a supplementary volume, 1914. Other refer- ences in Congressional Library lists, 1905 and 1909; as also Proceedings American Society Civil Engineers, August, 1913; H. V. Hayes, Public Utilities, 1913; O. L. Pond, A Treatise on the Law of Pubhc Utihties, etc., 1913; Bruce Wyman, Public Service Corporations, 1911, especially chap. XXXII. For economic, as distinct from engineering or legal analysis, chronologically, consult Publications American Economic Association, 1906, pp. 1-145; idem, series iii, vol. XI, 1910, pp. 183-288; Political Science Quarterly, vol. XXII,, 1907, pp. 577-610 (by the author); Yale Review, 1908, pp. 366-399; Hearings on Raiboad Rate Increases, 1910, 61st 332 RAILROADS occurred under judicial authority and by "due process of law."* And now there have been added in recent years two other reasons for formal valuation of all property hke railroads, affected with a public interest. The older' of these, dating from the early '70s, as we shall see, has to do with the exercise of the power to regulate rates for common carriers. The other is even more recent. It is concerned with the regulation by the state of the issue of securities. Originally an outgrowth of rate supervision, such control of capitalization, as has been noted, is now recognized as fundamental for the assurance of safe and adequate service as well.^ Whether the economic and legal principles governing valuation for all four of these more or less distinct pinposes above enumerated are identical need not concern us at this time. It will suffice to point out that the rise of formal physical valuation has been gradual. There is nothing revolutionary in the idea. It has time- honored antecedents, notwithstanding the fact that the present aims differ so radically from those which actuated the state in first instance, and that such valuation is now intrusted to the administrative more largely than to the judicial arm of the government. The practice of valuation in itself can hardly be said to run counter to conservative sentiment, whatever may be true as to the purpose for which the valuation is to be used. Physical valuation by the government, then, is no novel experiment, fraught with vast and unknown possibilities of evil. Nor is the demand for it a sudden and portentous mani- festation of socialism, threatening to overturn the institution Congress, 3rd session, Sen. Doc. no. 725, 10 vols, (index) ; Report, Valu- ation Committee, National Association of Railway Commissioners, Pro- ceedings, 1911, p. 145 ff.; Discussion, American Economic Review, vol. IV, supp. 1913, pp. 18-68; AUantic Monthly, March, 1914, pp. 403-416. On valuation as protecting the investor, by the author in Journal of Political Economy, Jan., 1915. ^ Cf. the Minnesota Rate cases in 1890, seemingly reversing Munn v. Illinois, 94 U. S., 113; Public Service Gas Co. v. Board of Public Utility Com'rs, 87 Atlantic, 651; Opinion of Justice Swayze at p. 639, etc., men- tioned in the preceding chapter. ^ P. 281, supra. PHYSICAL VALUATION 333 of private property. After an initial period of panic at the idea, the raih-oads of the country have, in fact, come to perceive so many safeguards for their standard of rates, of income and of service, that the Federal legislation of 1913, extending the scope of valuation from a few scattered commonwealths to cover the entire United States, encountered practically no opposition at all. The special physical inventory of railroad property for purposes of taxation began in Michigan in 1900, when some seven thousand miles of hue were evaluated. Wisconsin imitated it in 1903. And then followed in order other states, still interested primarily in taxation questions: South Dakota in 1908, Nebraska and New Jersey in the following year, and Kansas in 1911. In each instance the state legislatures author- ized the task neither with a view primarily to rate regulation nor the prevention of stock-watering, but in connection with the taxation of railroad corporations. The pressing demand for an equalization of tax burdens, as between the farmers with visible and tangible possessions alone, and corporations with unknown and concealable assets and investments, lay at the root of the matter. It was only after the results were achieved and officially published, that the people became aware of their significance in connection with other matters than taxation. Regulation of the issue of railroad securities, rather than taxation, as an incentive to physical valuation first made its appearance in Texas — a true pioneer in this field. Since 1893 an inventory of practically all the lines within its borders has been made. As has already been pointed out,' the rail- road commission appears to have pressed rather hard upon developmental or improvement work; but, in the main, the influence of this law upon capitahzation seems to have been salutary. Texas, then, is luiique in having engaged in this work with reference primarily to railroad capitahzation; al- ' The experience is reviewed in chapter IX, supra. 334 RAILROADS though, latterly, several other commonwealths are worMng along the same Una. Comparatively few states have attempted physical valuation solely in connection with rate regulation. Among the few which have done so are, Washington in 1905 and Minnesota two years later. This last instance, especially its later phases, is pecuharly illustrative of the intimate rela- tionship between valuation and the control of rates.^ The legislature of Minnesota in 1907 enacted both a two- cent fare and a commodity rate law; and, upon appeal to the courts, an exhaustive inquiry was made by a master in chancery as to the reasonableness of the rates thus prescribed. Pending his decision — which by the way was adverse to the state — the railroad commission was ordered to make an official in- ventory. A number of novel points of detail were raised, especially as to the valuation of the right of way. The rail- roads contended for a proportionately higher value for real estate than for contiguous property, it being well known that the companies always have to pay more in first instance. And • they insisted upon applying this "multiple," which happened to be three, not to the original cost of the land but to its present worth. This in effect increased the "unearned increment" three times over, and made a difference of over 40 per cent, in the valuation of the real estate. Whether the cost of repro- duction, which was sought, should be $42,000 or $57,000 per mile, depended upon the solution of this and other allied ques- tions. In any case the valuation was surprisingly high, in comparison with one hastily made by a special state senate > committee two years earUer, giving only $27,000 per mile of hne as the present value.^ These Minnesota figures were markedly higher than those for the neighboring state of Wis- consin. Still higher valuations were allowed by the state of Washington in its first official returns, made in the same year. ' Steenerson et al. v. Great Northern Railway Company, 72 N. W. 713 (1897) ; and Shepard v. Northern Pacific Railway Company, 184 Fed. 765 (1911). 2 Known as the Sundberg Committee Report. PHYSICAL VALUATION 335 One of the novel features in this latter inquiry was the attempt to ascertain from the records the original costs of construction, together with all subsequent outlay for betterments. Determi- nation of the "market value" of the properties was attempted. Careful engineering study was made at the same time of all present costs of construction, in the hope of ascertaining a "unit cost" of reproduction which could be supplemented from year to year.^ Appraisal of the physical assets of a number of individual roads, entirely at their own initiative and expense rather than by pubUc order, has been made in recent years. The pm-pose is not always clear. Sometimes it has been done in order to estabUsh a new bench-mark for property, investment on the balance sheet; sometimes, as by the New Haven Railroad, in a vain attempt to justify an overloaded capitaUzation; some- times in connection with public agitation over rates; and, quite commonly of late, parallel with and as a check upon the work of state and Federal railroad commissions. There has been a decided shift on the part of the carriers from an attitude of hostiUty and apprehension toward valuation to one of toleration or approval. And a number of strong companies have set about putting themselves in an impregnable position as respects future rate regulation, by undertaking this work on their own account. The New Haven, prior to its downfall, made great use in an advertising way both of its own private inventory and of the official returns of the so-called Massa- chusetts Validation Board of 1910. Among other instances, one notes the Lehigh Valley appraisal of 1903 and that of the Lackawanna in 191 1.^ The state of pubhc opinion toward the anthracite coal roads has xmdoubtedly influenced these companies in undergoing the expense of such an investigation.' Under Federal valuation, now in process, the hearty co-operation 1 The results are set forth on p. 342, infra. '' The Canadian Pacific, from Montreal to Detroit, and the Harriman lines have also made physical valuations; but the data are not available. ' 21 I. C. C. Rep., 144, for example. Also Chapter XVI, infra., 336 RAILROADS of the roads with the government promises to furnish a large body of data independent of the official documents. Students of the subject will find many of the results of these private appraisals in the official reports on valuation of such states as Nebraska, Kansas, Wisconsin and New Jersey. The culmination of the movement in favor of railroad appraisal was the enactment by Congress in 1913 of a Federal valuation law. This was a logical sequence of the preceding legislation on the general subject of rate regulation.^ The matter had by this time risen above the plane of partisan pontics; although the Democratic national convention was the only one specifically to recommend both valuation and the control of railroad security issues. Credit for this legisla- tion, however, undoubtedly belongs to the Progressive party, and particularly to Senator La FoUette of Wisconsin.^ Demo- cratic and RepubUcan members of Congress without distinction soon joined hands in favoring the movement, which was also urged by the Interstate Commerce Commission. Favorably reported in 1912, the bill became a law in the following year. Recognizing the then chaotic judicial and administrative status of the question, as will shortly be pointed out. Congress wisely refrained from prescribing any particular plan. All afike were comprehended. Both the conflicting decisions of the courts and the divergent practice of state commissions rendered this the only expedient course. The law directed the Interstate Commerce Commission to proceed at once to ascertain the fol- lowing items: original cost to date; the cost of reproduction, new; replacement cost less depreciation; and, separately, all other elements of value, if any; together with an apportion- ment of these items as between the different states, and an analysis of the methods by which the several costs were ob- 1 The history is given in Railroads: Rates and Regulation, chap. XIII et seq. ' His elaborate speech of April 19, 1906 {Congressional Record, vol. XL, p. 5993 ff .), marks the beginning of the movement. Cf. his Autobiography for details. PHYSICAL VALUATION 337 tained. The amount and value of donations of cash or lands were called for specifically. The provisions of the statute were thus sufficiently broad to comprehend all possible elements of worth. The ascertained amount of the investment was sub- sequently to be kept up to date, furthermore, by periodic re- vision and correction, covering all extensions and improvements. The law also called for active co-operation of the carriers in the way of affording access to all records; and it defined a procedure for appeal to the courts in case of any controversy either over method or administration. On the whole, the magnitude of this task greatly increased with the elaboration of the plan. The probable cost to the government alone, is now estimated to be possibly as high as $50,000,000. Active prosecution of the Federal work took place promptly.' The coimtry was divided into five districts, comprising approx- imately 50,000 miles of main line each. Charge of the work was assumed by one of the ablest and most experienced mem- bers of the Commission, Hon. Charles A. Prouty, who resigned in order to devote his entire time to the matter. It would lead too far astray to describe the details of this work. It is a colossal task. If we bear in mind, not only that every title, record, blueprint, specification and contract since the beginning must be overhauled, but also that roadway and track parties must inventory and measure every structure, cut, and fill, taking cross-section measxirements and checking depths by test pits, even cafipering the rails for measurement of wear, some notion may be had both of the time and the expense in- volved. Will it be worth the cost? Assuming that a prime purpose is to ascertain the amount upon which the public should be required to pay returns, suppose that the valuation should alter this basis by only 5 per cent. At a rough guess of $20,000,000,000 as the total value of the railroad properties, such a change would amount to one billion dollars. An annual 6 per cent, return upon this sum would be $60,000,000. The * Details in Railway Age Gazette, vol. LVI, 1914, p. 1530. VOL. II — 22 338 RAILROADS difference, consequently, either to the pubUc or the carriers for a single year, might well amount to as much as the entire first cost of the undertaking. And then, quite aside from any consideration either of cost or specific utility, the political importance of the task as affecting the state of the public mind toward common carriers quite transcends calculation. In many states, local and private appraisals of public utilities other than railroads have been made in recent years, such, for example, as those of the St. Louis street railways ^ and of the Chicago Telephone Company in 1912, by pubhc authority; and of the New England Telephone Company and of many gas, electric light and water properties, semi-privately, all over the United States.^ It would be interesting to develop the economic principles involved in all of these outlying fields, as affordiflg a backgroimd for the special treatment of railroad valuation, did space permit; although a different economic status places railroads in a class by themselves. The difference between commercial and physical valuation is best shown by describing the processes adopted in each case. Commercial valuation is gotten by applying the market value which they possess to the volume of securities outstanding. The starting-point is the estimation set upon worth upon the exchanges. Every sort of consideration as to value enters into the calculation; possibilities for the futm-e, both of good and ill; growth of the country; restrictive legislation; potential competition, even of railways or waterways not yet built; speculative manipulation; and a host of other such intangible elements. Unfortimately, too, it includes also the imcertain fac- tor of varying investment demand, speculation, the state of the money market and the like, none of them affecting the in- dividual properties but bearing upon general trade conditions. The mere rails, terminals and equipment may indeed imder ' By the St. Louis Public Service Commission, now merged in that of the state of Missouri. " Examination of Whitten will show how widespread these activities are. Pond, op. cit, confines attention entirely to local public utiUties. PHYSICAL VALUATION 339 such circumstances form but a small part of the total com- mercial value. Physical valuation, by way of contrast, does not originate upon the exchanges and among traders. It is made by engineers and other experts in the field. It has been aptly termed a bric-a-brac valuation, as distinct from com- mercial estimates which deal with the property as an indivisible whole. Each separate physical item of property is assigned a value dependent upon its cost and the length of its life. Experts view the real estate; check up the construction engineers' plans and figures as to cuts and fills, in terms of so much per cubic yard for grading; swarm in inspection over the bridges, wharves and ferry-boats; rebuild upon paper the stations and freight terminals; literally count and measure the rails, ties and telegraph poles; re-audit bills for purchase of locomotives and cars and interpret them in terms of present prices, length of life and depreciation; in short, make an inventory or take accoimt of stock in precisely the same way and with the same attention to minute detail that a merchant or manufacturer annually devotes to his property. There is no concern for the future; potential earning power is not estimated; nor, theoreti- cally, does chance enter in. The physical valuation is item- ized, aims at precision and is matter-of-fact to the last degree. It catalogues merely the bare bones of the property. All the living tissues, those values arising from the use to which the property is put, are scheduled in another category of in- tangibles. Purely commercial valuations, in the full sense of the term, in contradistinction to the foregoing physical inventories, — that is to say, investigations based upon market prices of rail- road securities, — have been made by the Federal government alone. Both in 1900 and 1904, in response to the orders of Congress, the Interstate Commerce Commission, and later that body in co-operation with the Federal Census, totalized the market values of every species of railroad stock or bond outstanding in the United States. The inherent defectiveness 340 RAILROADS of such figures is revealed at once upon comparison of the re- sults obtained in the two different years. Thus in June, 1900, the market value of all securities outstanding was found to be $8,351,000,000, with a par value of $11,734,000,000. Exactly four years later, the market value had risen to $11,244,000,000, the par value standing at $13,213,000,000. No such change in intrinsic worth as this — an increase in market value amount- ing to more than one-third, with an increase of one-eighth in par value — could have ensued within so brief a lapse of time. Nor was the relation between market value and par value in any wise consistent. For in 1900 the securities averaged about seventy cents on the dollar of par. In 1904 this average in relation to par value had risen to eighty-five cents on the dollar. The fact was that a considerable expansion of net earnings had been made the basis of an exaggerated speculative inflation, which was immediately reflected in purely "fancy" quotations upon the exchanges.^ Moreover, in many in- stances, unduly inflated prices had been caused by competitive purchases of stocks by rival fines, for purposes of control rather than for investment. For many of these securities, even in normal times, any attempt to reafize such prices would at once have caused a ruinous decfine in quotations. The totals above named, therefore, must be regarded as in many respects fictitious and misleading. They are of interest, perhaps, as showing changes in market conditions from year to year, but not as possessing the static value which attaches to a physical inven- tory. No refiance whatever, as the law now fully recognizes,^ can be placed upon them as a basis for regulation of rates, for issues of stocks or bonds or for taxation. The positive results of the valuation which have been made of railroad properties are exhibited in the following table' — 1 Details in chapter V, su-pra. " Chapter X, infra. ^ Statistical data are derived from oflBcial Federal and state reports. The full titles of these to 1912 will be found in the bibliography in Whitten, PHYSICAL VALUATION 341 fri.2 ■Ji I 5? 0,T3 N M 1 3 a a 3 •2 s d. iz; o ^ a.2 ^■B.s d o3 o 1^ tf O §oooo ooooooo ooo ooooooo tr^ cooio aioi iloo ooo oo 88 IM CO o •* o o Oi o 000&&0000 ooooooooo m 00 CO IN__ (N_ c» o_ O P. 361, infra. 2 Reprinted in The Railway Library, Chicago, 1911. suTpra. CS. also p. 335, 346 RAILROADS there can be no doubt that the growth of the country has in most cases more than expunged the water; and that at the present time a substantial equity over and above thfe capital liabihties exists. This happy outcome of physical valuation, so far as it has progressed to date, explains the marked change of attitude of the carriers toward the whole proposition for an official inventory by the Federal government. It confirms the conclusion, already reached from another point of view,^ that on the whole the average rate of return upon the existing net capitahzation is modest enough. It is certainly not more than fair in amount. That it does not exceed 5 per cent, at the present time seems to be well established. The withdrawal of capitahzation from the centre of the political stage in favor of physical valuation as a positive scientific standard of measure- ment, is matter for congratulation on all sides. The settled legal standard of rate reasonableness, sole and controlhng in the lower courts and predominant although still embryonic in the Supreme Court, according to the preceding chapter, being present value, that is to say, "value at the time it is being used for the public," is it too late to suggest any revision of oiu ideas upon the subject? Congress, as we have already seen, has wisely directed that the valuation now under way shall include all possible data, historic as well as instant. It has thus provided for the contingency of a shift of base by the courts. May we not also contribute to this end by reviewing one by one the several standards from a purely economic standpoint? For imless economics and law are in entire accord, experience proves that real progress may not be anticipated. For the purpose of this economic analysis, four distinct bases of rate reasonableness will be examined. These, owing to the interblending of fair returns and fair worth of property, correspond to four schemes of physical valuation. They are: ' P. 79 supra. ORIGINAL INVESTMENT 347 1. Original or actual cost. 2. Reproduction cost, new. 3. Present value — replacement cost, less depreciation. 4. Market value, based upon earning power. Actual cost of property,^ that is to say original construc- tion, plus additions and betterments, despite its insecure legal footing, seems to be not only the most natural but in many respects the fairest single basis for the determination of reason- ableness of rates. It has been neglected in part because of the inchoate condition of accounting principles and practice, and in part because of misunderstanding by laymen of such sound distinctions between capital and income as were well recognized among experts. Great confusion is everywhere apparent as to what the term implies. "Book value" or cost of property, as we have already seen, seldom represents anything even approximating to the facts. The meagreness of corporate records, either because of carelessness or bad faith,^ is indeed a severely practical objection; and yet experience has already shown that original cost can be unearthed. The most sub- stantial attempt along this line is the inventory made by the Washington Railroad Conunission in 1905. The actual invest- ment was found to be obtainable for practically all of the prop- erty. How different this was from the accepted legal standard 1 This is practically the "continuous property" or Antigo theory of Wisconsin, 3 Wisconsin R. C. Rep., p. 623; the historical method under the principal and agent theory of regulation of J. H. Gray, American Economic Review, vol. IV, supp. 1914, pp. 26 and 51, and of E. W. Bemis, Proceedings National Association Railway Commissioners, 1913; of normal actual cost of Whitten, Valuation, etc., pp. 82-101, and Supp. pp. 825, 916, and also Harvard Law Review, vol. XXVII, pp. 5-23; and of the St Louis Public Service Commission and that of New Hampshire, Quarterly Journal of Economics, vol. XXVIII, 1914, p. 271. It is not the so-caUed original cost theory of the engineers; Hayes, Public Utilities, 1913, and Quarterly Jour- nal of Economics, vol. XXVII, 1913, pp. 616-629; or Allison, idem, vol. XXVII 1912, p. 30; who merely mean original cost of existing units of property, not actual outlay considered historically. 2 Cf. Railway Age Oazette, 1909, p. 220; and, for example, Sixth An- nual Report, Nebraska Raikoad Commission, 1913, p. 201; also 31 Inter- state Commerce Commission Reports, p. 365. 348 RAILROADS of fair present value appears from this data. The original cost of the Northern Pacific plus improvements was appraised at $75,500,000, as against a cost of reproduction, new, of $103,600,000. Much of this difference was due to the appre- ciation in land values, particularly of terminal properties. But whether or not the substitution of this standard of actual cost for the one generally sanctioned by the courts wiU inure to the advantage of the carriers is of course quite immaterial,^ depending probably, as in this case, upon the basis of valuation applied to real estate. The predilection of the law for present value, without distinction as to land, even to the absurd extent of holding original cost to be "totally irrelevant," ^ flows, as we have already seen, from the long-standing legal practice. The tendency to break away from this tradition and to regard donated lands, or lands whose market value has arisen from the growth of the community, differently, is of comparatively recent date. It cannot be denied that the origin,al-cost theory possesses strong attractions for those who hold that the public as a whole, and not individual members of it, should profit by the unearned increment in land.' A nmnber of details have to be carefully analyzed prior to the acceptance of original cost as the foundation for valuation. Heavy outlays experimentally, that is to say what are called development costs, are apt to be swallowed up in the accounts with the lapse of time.^ This is particularly true of destruction or abandonment by act of God or man.^ The recently con- structed San Pedro, Los Angeles & Salt Lake was, for example, 1 Sometimes it works the other way, as in Texas, 1894, with original cost $40,000,000 and replacement cost only $25,000,000. This will depend also upon the movement of prices for commodities in general. 2 Columbia Law Review, November, 1913, reprint p. 7. ' See p. 351, infra, on treatment of land values. * On the different methods of treating development experience, vide p. 288, supra. ' Functional depreciation, etc., c/. p. 234, supra. See also Statistics of Railways, Interstate Commerce Commission Reports, 1907, and WMtten, Valuation, p. 37. ORIGINAL INVESTMENT 349 washed out three times by floods, each time being rebuilt at great expense, in the search for a really safe location. Great difficulty in theory arises also from past expenditures, probably capitalized, as a result of incompetence, recklessness and dis- honesty.i One must sm-ely reckon with certain risks; but the public can scarcely be expected to pay returns upon a basis comprehensive enough to include much of this sort of expense. It is equally difficult to reckon with a too provident administra- tion of the property. Considerations suggested in the second San Diego Land case ^ are equally applicable to railroads which have intrenched themselves against all future demands for service by an investment greatly in excess of the needs of the present time. The American people seem destined to pay carrying charges to the Reading Company on indebtedness incurred in order to monopohze our anthracite coal supplies forever; but this exceptional case certainly need not be duph- cated with other properties concerned solely with transporta- tion. After reckoning with the foregoing factors, none of them more difficult, theoretically, than those attached to the other standards of valuation, there is the great advantage inherent in actual or original cost that it eUminates or mini- mizes, through compensation, the changes of valuation arising from fluctuations in the level of prices in general.' During the generation to 1900, the steady fall in commodity prices worked disadvantageously to the railroads in any appraisal of property. The greater the fall in unit costs, the narrower the basis upon which they might claim a return in rates. After that time the equally marked enhancement of prices enabled 1;Jiem by means of an up-to-date inventory to justify heavier charges for service rendered. In either case, so far as property long ago acquired is concerned, this change in the rate basis was merely fortuitous, totally disconnected with the matter 1 "Teazers," for example, in the Texas experience; Ripley, Railway Problems (rev. ed.), p. 337. 2 P. 320, suw(i- » C/. the Steenerson case, cit. sup. 350 RAILROADS in hand. It would certainly appear more equitable that the rights and obhgations of the companies should rest upon the amount of the investment honestly and fairly, that is to say, "actually created and placed in the pubhc service."' Should not this theoretical advantage go far to offset the practical difficulties which are so largely responsible for the neglect of this standard of reasonableness? Massachusetts, moreover, whatever the defects of its anti-stock-watering policy, has avoided this difficulty by its insistence that capitahzatioh shall strictly conform to actual investment. Thereafter its course is plain. For under such a poUcy, pursued from the outset, the basis of reasonable rates is plainly recorded in the volume of securities outstanding. The accounts are automatically kept up to date.^ One warning concerning actual cost needs to be displayed at this point. A mmiber of elements of value, soon to be discussed, notably costs of development, may find place either in a scheme based upon original investment, or as intangibles imder a plan based upon reproduction cost. They should not be twice included; neither should they appear both in the valuation basis and in the rate of return allowed. The choice of original cost as a basis, automatically takes care of a number of elements which under other plans deserve inclusion as "remaining property."' Moreover, even the appearance of a guarantee of the investment by the public must be scrupulously avoided. Permitting the capitalization of early deficits or losses by a subsequent replacement policy may all too readily bring about this result. With these qualifications in mind, cordial assent may be given to the able opinion of the Inter- ^ St. Louis Public Service Commission, 1912; report on the United Railways Company. ' Admirably stated in the Middlesex & Boston Rate case; P.S.C, Mass., 1914, no. 553, p. 9 ff. ' Cf. Whitten, Valuation, pp. 566 and 708. And then, too, an allowance for going value or developmental costs must reckon with the capitalization of these in the hands of later owners as distinct from those who assumed the original risks. ORIGINAL INVESTMENT 351 state Commerce Commission in the Western Rate Advance case of 1911.1 "Perhaps the nearest approximation to a fair standard is that of hona fide investment — the sacrifice made by the owners of the prop- erty — considering as part of the investment any shortage of return that there may be in the early years of the enterprise. Upon this, taking the life history of the road through a number of years, its pro- moters are entitled to a reasonable return. This, however, is mani- festly limited; for a return should not be given upon wastefulness, mismanagement, or poor judgment, and always there is present the restriction that no more than a reasonable rate shall be charged." The treatment of land values most sharply differentiates actual from replacement cost as a standard of valuation. Real estate appraisals are peculiarly important for railroads, such property not infrequently aggregating as much as one-fourth of its entire possessions. Among concrete instances of the prominence of real-estate values, that of the Illinois Central well serves to illustrate the role of the unearned increment of land in railroad finance. Carried at only $200,000 on the books — such being the original entry — the real estate of the Illinois Central was appraised at $34,000,000 in 1900. Now land, thus forming so large a proportion of assets, is set off from other forms of property by three characteristics. In the first place, with the growth of population it commonly tends to appreciate steadily in value. Most other property declines in value with the passage of time. Secondly, for the United States in particular, much of the raih-oad land has been donated by the public in aid of construction. But thirdly, it should be noted, such land as has been purchased even xmder exercise of the right of eminent domain has actually cost in most instances anywhere from one and one-half to ten times as much as ordi- nary real estate on the average in the same environment. From these circimistances arise a number of puzzling questions. Should the unearned increment be included in physical valua- 1 20 Interstate Commerce Commission Report, 307. C/. also the Minnesota Rate cases; Ripley, Railway Problems (rev. ed.), p. 699. 352 RAILROADS tion or not? Ought public land grants to be excluded from such appraisal? Is a distinction between lands now in use and those held for investment or future development called for by sound public policy? Shall real estate, if appraised at present value, take cognizance of the extra cost to the carriers by reason of severance or other damages? Space will not permit of adequate treatment of these significant economic and ethical questions; but certain tendencies may be noted. Two opposing bodies of opinion respecting land values are discernible. One maintains that railways as common carriers in the enjoyment of valuable privileges are not entitled to the unearned increment, not even for land actually purchased, much less when donated outright. Original cost is upheld as the only proper basis for appraisal, in the belief that any departure from such a policy would result in steadily increasing rate burdens, arising largely from the activities and even the very generosity of the public itself. Such is the theory of the radical legislator and of some economists.' The opposite view is that, inasmuch as all lands are held under recognized pro- prietary rights, a return upon their full commercial worth is as justifiable for land as for any other form of possession, the state making no distinction as respects either taxation or rates for service. This latter opinion is commonly buttressed by judicial decisions.^ It is the time-honored practice of the law. Probably the most detailed consideration of land appraisal is given in the Minnesota Rate cases of 1913 by the Supreme Cotu-t of the United States. It was there ruled that the present value of land, and not its actual or original cost, was to be the basis of appraisal for rate-making. Not even the qualification ' Senator La Follette of Wisconsin, J. H. Gray, dt. sup. ' Notable ones are the New York 80-Cent Gas case (WiUcox v. Cem- solidated Gas Company, 212 U. S. 19; and the Minnesota Rate oases). Whitten, Valuation, etc., chap. VI; Michigan, Washington, Wisconsin, Nebraska and South Dakota all recognize it administratively through their expert commissions. ORIGINAL INVESTMENT 353 suggested in Willcox v. Consolidated Gas Company was repeated, whereby an excessive increment of land values was to constitute an exception to the general rule."- But there was express disapproval of the use of "multipUers" as used for real-estate appraisal. It was held that a "public utility factor," assign- ing a special worth to a right of way as used for transportation, resulted in giving the carrier more than its share of the incre- ment of land values — thus being against public policy.^ Whether the Supreme Court made this concession because of insufficient evidence presented by the railways, or because it was beheved to be fimdamentally sound reasoning, we need not stop to consider. In effect this decision is in line with tendencies in the different states. The New Jersey valuation was pecuUarly hampered by an old statute which forbade any special appraisal of land according to use; but the commission indirectly recognized such a special worth by its allowance for intangibles. The practice of the New York conunissions is peculiarly instructive, as affording recognition of the rights of both parties, while still in effect Umiting the almost inevitable appreciation of assets with the grQwt^i of the community. This result is obtained by indirection through the treatment of appreciation as capital, rather than as income. It is re- quired to be entered on the accounts, periodically, as profit. All depreciation is Hkewise charged against income as a loss. It would seem to have been more logical and direct to have held to original cost, but for some reason this was not done.' ' P. 321, supra. The suggested substitution for present land value of the worth of other land equally serviceable for the public also failed of consideration. " The significance of multipliers is well shown in the Nebraska reports which give two complete sets of returns, with or without multipliers re- spectively. Most states allow anywhere from two to three times the aver- age taxable value of surrounding real estate. Cf. table, p. 341, supra. ' The following excerpt from Whitten, Valuation, p. 121, describes the practice: "Thus, land has been taken at its fair value and not at its original cost, and the annual appreciation of land has been treated as a profit. By this method, aJl property is treated absolutely alike, as Judge Hough sug- voL. II — 23 354 RAILROADS Another way of conceding the pubhc's interest would be to fix a lower maximum in the rate of return allowed upon land values than upon other forms of property, making the dis- tinction in the rate rather than the principal. Some qualifica- tion is certainly necessary, especially for undeveloped posses- sions. Washington omitted $15,000,000 outright for unused land holdings; and Nebraska ignored one-half of its railway lands, thus held. However accomphshed, the role of land •values in rate-niakihg, if not ehminated, ought certainly to be minimized. Neither the ups nor downs of real estate have any connection with the conduct of the transportation business. An element of uncertainty is introduced, sometimes, as in Wisconsin, for consistency's sake by requiring a reduction of pubhc utility rates because of a decrease in land values. The only fair criterion should be the actual investment or sacrifice on the part of the owners of the enterprise. Emphasis laid upon extraneous and fortuitous factors, as at present, is at once illpgical and contrary to the public welfare. Cost of reproduction, new,^ as a basis for rate adjudication, is identical at the outset of the enterprise with actual or original investment. The two standards separate with the lapse of time, extraneous elements such as changes of price level ob- gests. No difference is made, except that as depreciation represents a de- crease in assets, it is placed as a debit against operation, while appreciation is placed as credit because it is an increase in assets. Land has sometimes been treated like other property only to a degree; that is, each class has been appraised at its present worth or value. That has been done in this case. But if property is to be taken at its depredated value where it has depreciated, an entry must regularly be made in estimated operating ex- penses equal to the average annual depreciation. Conversely, if land, or any other property which genuinely appreciates in value, is to be taken at its appreciated value, then an entry must be made in the estimated receipts equal to the average annual appreciation. Unless this is done, it is obvious that the consumer wiU be burdened with all the estimated decreases in assets but not credited with the increases in assets. If the principle laid down by the courts is to be followed in part, it should be followed in whole." ' Cf. Quarterly Journal of Economics, vol. XXVII, 1912, p. 37; idem, vol. XXVIII, 1913, p. 616; Whitten, Valuation, chap. IV; and Supp. p. 829; Proceedings American Society Civil Engineers, September and Octo- ber, 1913. REPLACEMENT COST 355 truding themselves. The fundamental objection to this stand- ard is best stated in the two most striking appUcations made of it by the authorities of Minnesota in 1897 and 1911 respec- tively. The facts of the first case^ were briefly as follows. The original lines of the Great Northern Railway were sold under foreclosure in 1879 at a price far below the real value. A new company operated the properties until 1890, when they were all leased to the present corporation upon guarantees of interest and dividends. The Supreme Court of Minnesota, on appeal proceedings, dechned to consider either the purchase price under foreclosure or the effect of subsequent financing; and decided that reasonable rates were to be determined "by ascertaining what, under all the circmnstances, is a reasonable income on the cost of reproducing the road at the present time." An official inquiry thereupon established the cost of replace- ment as well as the rate of return to be allowed. This pro- ceeding took place in the trough of the industrial depression of 1897. Fourteen years later, at almost the crest of a wave of prosperity, the same operation was repeated with a revised standard of reproduction cost, new, based upon values in 1911.^ It is not exaggerating to assert that the replacement costs, new, for each of these two dates fourteen years apart, differed absolutely by ahnost one-third. Unfortunately, the Supreme Court of the United States in the Miimesota Rate cases, although expressly disallowing replacement cost for real estate, did ' not extend its opinion to review the principle as appfied to other forms of property. But it repeatedly indulged in the phrases "mere conjecture" and "mere speculation" as appfied to the matter in hand. The foUowing is quoted from the opinion of the court: ' "Moreover, it is manifest that an attempt to estimate what would be the actual cost of acquiring the right of way if the raOroad were not ' Stemerson v. Great Northern Railway Company, 72 N. W., 713. ' The Minnesota Rate cases, Shepard v. Northern Pacific, cit. sup., 184 Fed., 765. ' Reprint in Ripley, Railway Problems (rev. ed.), p. 697. 356 RAILROADS there is to indulge in mere speculation. The railroad has long been established; to it have been linked the activities of agriculture, in- dustry and trade. Communities have long been dependent upon its service, and their growth and development have been conditioned upon the facilities it has provided. The uses of property in the com- munities which it serves are to a large degree determined by it. The values of property along its line largely depend upon its existence. It is an integral part of the communal life. The assumption of its non- existence, and at the same time that the values that rest upon it remain unchanged, is impossible and cannot be entertained." A quotation from economic sources fits in well at this point.' "The 'reproduction theory' contemplates an imaginary community in which an imaginary corporation makes imaginary estimates of the cost of an imaginary raihoad. . . . The actual, eflScient sacrifice of the investor, as revealed in accounting and other historical studies, supplemented by engineering advice as to the adaptability and present condition of properties for the purpose intended, wiU count far more than the estimates of engineers as to what it wiU cost to buy land that wiU never be bought again, to dupKcate property that will never have to be dupUcated, and to build up a business that wiU never again have to be developed." After the respectable interment of the unadulterated doctrine of reproduction, new, by the Supreme Court of the United States, the persistent advocacy of this interpretation of "fair value," elsewhere, is the only excuse for our further attention to it.^ It still exercises an undue influence upon men's minds, tending constantly to become the sole or con- trolling standard. The fundamental economic objections are its instability and utter lack of relation to the real sacrifice made by investors in creating the property. It may not, however, be consigned to the hmbo of rejected doctrines with- out citing an ingenious economic defence.' This is to the ' E. W. Bemis, Proceedings National Association Railway Commis- sioners, 1913. " Whitten, Valuation, chap. XVIII, gives decisions of lower courts and commissions. ' J. E. AUison in reports to the St. Louis Public Service Commission, 1912 and 1913; and Quarterly Journal of Economics, vol. XXVII, 1912, p. 27; as also idem, vol. XXVIII, 1914, pp. 630-662, and Whitten, Valua- REPLACEMENT COST 357 effect that the essential feature of valuation is the reproduc- tion, not of the property but of the service rendered. All physical units except land having a definite life term, waste and wear year by year up to a certain point, say 50 per cent, of the first cost. After this point, if currently maintained, no further depreciation takes place. Such, it is alleged, be- comes the status of most physical property after a few years of operation. And yet the plant under this "normal average depreciation" may for all practical purposes serve the public just as well as an entirely new one. A corporation, therefore, having taken care of its depreciation up to this point, midway between brand-newness and utter decrepitude, by the estabUsh- ment of equivalent reserves, should be allowed reasonable returns upon the siun of these reserves and the existing struc- tural value. In other words, the property is virtually as good as new and is entitled to fair returns upon what it would cost to replace it outright. This interesting argument is defective, if at all, in faiUng to dovetail into sound accounting practice in the matters of surplus, sinking funds and replacement. It has relatively less significance for railroads than for other public service companies, particularly because the element of real estate, owned in fee and not merely enjoyed in use, dwarfs everything else by reason of its magnitude. And it contains dangerous, misleading impfications in view of the rapid rate of obsolescence under modern progressive conditions.^ Is it not more prudent to proceed upon the assumption that the entire original investment remains locked up in the enterprise? This means a rigid prescription of the amount of current return and an enforcement of the financial plan of an accumulation of reserves sufficient to replace the property new when, as is bound to be the case sometime despite the fullest maintenance of the quafity of service upon the partly used-up plant, every- tion, etc., supp. p. 1119. C}. Floy, Valuation, 1912; and Railway Age Gazette, vol. LIV, 1913, p. 1535. ' P. 234, supra: Also Quarterly Journal of Economics, February, 1915. 358 RAILROADS thing goes to pieces suddenly like the collapse of the one- horse shay. Present value, the third of our feasible standards, differs from replacement cost, new; first, in the deduction of an allowance for the wear and tear of the plant from use, natural decay and deterioration under the action of the elements; and secondly, through such appreciation in value as may arise from trying out of the plant or its adjustment of parts — called by engineers adaptation or solidification.^ The im- portance of the second factor is less generally appreciated than of that associated with age and wear. A railroad always passes through an initial period subsequent to actual con- struction, when numerous imperfections come to light and many readjustments have to be made. Current outlay is consequently heavier than under normal maintenance. Whether such expenditures are properly chargeable to con- struction or operation is, perhaps, debatable; but, however it may be treated in the accounts, it is obvious that with the passage of time a positive value has been added to the property. Although by no means inconsiderable, these plus factors will probably seldom offset the minus ones due to depreciation. The Supreme Couit of the United States in its latest discussion of reasonableness in the Minnesota Rate case, distinctly de- cHned to approve of such disposition of the matter, declaring that the precise extent of existing depreciation should be shown and deducted, as otherwise the physical valuation would be "manifestly incomplete."^ It would take us too far afield to attempt a review of technical matters of this sort. The practice of the state commissions has generally been to make a deduc- ^ The best treatment of these subjects, with a very complete bibliog- raphy, is in Whitten's Valuation, chaps. XV, XVI and XVII. 2 Reprint in Ripley, Railway Problems (rev. ed.), p. 702. Cf. also Columbia Law Review, June, 1911. The Massachusetts Validation Re- port of 1910 accepted a 100 per cent, valuation, appreciation offsetting depreciation. PRESENT VALUE 359 tion for depreciation.' The other factors have been variously handled. Washington is most liberal. Michigan and Wis- consin deduct for depreciation, but allow nothing for appre- ciation. And those commissions which make such allowances apply them, of course, in the greatest detail to the different units of property. Other factors of minor importance demand consideration in the determination of present value. Unit costs should certainly not be too narrowly Hmited to a particular time, but should be based upon a fair normal average — disregarding, it is assumed, our foregoing plea that the original unit costs are the only fair standards anyhow. QuaUfication must also be made for piecemeal construction. The gradual creation of an efl&cient agency of transportation, bit by bit, may be quite a different matter from the theoretical construction of an entire railroad as a single imified job; particularly when, as commonly happens, most new work is confined to periods of prosperity when funds are obtainable, but when also, unfor- timately, wages and prices are abnormally high. There are other puzzhng details, such as allowance for working capital in its relation to credit. And a large group of values, usually bulked together as development expenses, hangs in the offing. These last more properly require discussion under the head of intangibles and will be so treated. Finally, the fixing of present value raises a number of very important questions, more weighty for railroads than for most other public utilities, connected with the ascertainment of land values. These have already been touched upon. All in all, the determination of the worth of property at the time of its use is feasible enough as a matter of engineering. Whether as a matter of economics it is sound is quite a different question.^ 1 Quarterly Journal 0} Economics, vol. XXVIII, 1914, p. 656. Cf. also Whitten, Valuation. * Compare the wholesale condemnation of all reproduction theories in American Economic Review, vol. IV, supp. 1914, p. 27. 360 RAILROADS Twenty years ago market or commercial value, conditioned of course by earning power, was generally regarded as an aU- important element in fixing fair rates. But although many raih-oad men and an occasional judge still uphold its validity,' it is discountenanced by the best progressive opinion. As Whitten well says: " Market value has nothing to do with the rate question as thus con- sidered. It is only set up after the rates are in fact determined. To be sure, the theory is that rates are based on a fair return on the market value of the road imder reasonable rates. The impossibUity of basing reasonable rates on a market value that is itself determined by reason- able rates is apparent. It is a clear case of reasoning in a circle. We have the evident absurdity of requiring the answer to the problem before we can undertake its solution. The advocates of the market- value theory cannot really mean what they say. Market value is not reaUy a part of the process but the final result." The same argument is made in a recent judicial decision.^ "It is one of the most mischievous and yet persistent fallacies, that the value of a property determines the prices which can be charged for the use of it. The precipe opposite is the truth — the value of the property is determined by the price that can be charged for the use of it. It is not because an orchard is valuable that it yields apples. On the contrary, it is because it yields apples that it is valuable. To say that the reasonableness of rates depends upon the fair value of the property used and that the fair value of the property used depends upon the rates which may be reasonably charged, seems to be arguing in a circle." This circle argument is constantly cropping up. It has been wielded for years against physical valuation of any sort. And, as applied by the Washington Railroad Commission in fixing rates, it certainly seems highly illogical if not absurd, except possibly for misplaced or partially obsolete roads.' But it is submitted that this need not necessarily be so. AU depends ' C}. my quotations as early as 1907 in Political Science Quarterly, vol. XXII, p. 604. ^ Brunsvnck and T. Water District v. Maine Water Company, 59 Atl., 537. ' Second and Third Annual Reports, 1907-'08; Proceedings National Association Railway Commissioners, 1911, p. 148. MARKET VALUATION 361 upon whether the business is carried on under conditions of monopoly or of competition. In ordinary business, earnings determine valuation; but as railroads are operated nowadays, or at all events should be, under a firmly-established theory of regulated monopoly, the relationship is reversed. It is not earnings which determine value, but valuation which fixes earning power. The difference is in the starting point of the reasoning. This is only another way of saying that a reason- able rate of charge for a railroad is one of the results and not the cause of the fair value of the property employed.' The proper function of market valuation, viewed in another way, is to set off the intangible elements in fair value from the purely physical ones. No one denies that commercial value depends in large measure upon the present or future income- producing capacity of property; and, furthermore, that it is the use made of this property and neither its original cost nor its present cost of reproduction that fixes its present worth. Govermnental valuation seeks not to find the total value at all, but to discover what part of it is represented by real prop- erty and what part by intangible assets. Merely to make use of the total value, as dependent upon net income, as a basis for regulation would, of course, involve reasoning in the old vicious circle. Once we admit evidence as to total market value, Miinchausen-like, we are trying to hft ourselves by om: boot- straps. But that is not the present proposition in any sense. The aim is to differentiate in the total worth between two distinct sources of value: one, the actual investment in physical plant to be credited to stockholders; the other, the intangible value, some part of which belongs by right to the pubhc while other parts remain essentially the reward of private initiative. So long as these franchise gifts were of doubtful value, the people were willing to permit all profit upon them, if there were such, to accrue to the private owners of the shares; but as soon 1 Admirably reasoned by Justice Swayze in the Paterson, N. J., Gas Company case, 87 Atl. Rep. 651. C/. footnote, p. 370, infra. 362 RAILROADS as that stage of development was passed, the public insisted upon its right to some part of the advantage. In brief, the demand for valuation registers a protest on behaK of the public against paying returns indiscriminately to private stockholders upon values, a part of which the public itself may have created and granted to the corporations. It is the emergence of such values due to the growth of the country, over and above the capital investment values, which accounts for the extraordinary interest and activity of the legislatures, courts and commis- sions in this work all over the country.^ Recognition of an intangible value as property, over and above the mere physical plant, — characterized by William H. Taft in accepting the nomination for the presidency as "full value" — has been accorded by the practice of several states. The exact natm-e of this surplus value we shall have occasion to consider elsewhere, merely noting once more that it is based upon earning power or income. In other words, after the pajonent of a normal return on a fair value of the actual prop- erty, the excess earnings are capitaUzed in order to set an additional value upon the concern. A concrete example may serve to make this clear. Let us suppose that a railroad possess- ing physical property worth $10,000,000 is earning at the rate of $1,200,000 net a year. Five per cent, on the $10,000,000 of actual property, or $500,000, therefore represents the interest return on capital. But there still remains $700,000 of the annual income to be distributed. This would pay 7 per cent, upon $10,000,000 more of capitahzation — a rate of return none too high, perhaps, considering its contingent and fluctuat- ing character. The sm-plus earning power over and above the normal return on the actual property, thus capitalized at $10,000,000, is the value of the "non-physical" property. It is this excess which is termed intangible value or, as it is ' Further discussion of this side of the case by the author in Political Science Quarterly, vol. XXII, 1907, p. 606 £f., is essential to a complete understanding of the subject. It is omitted in order to avoid repetition. INTANGIBLE VALUES 363 defined in New Jersey, "the value of the remaining property." Michigan in 1900 under the leadership of Professor Henry C. Adams, was a pioneer in this field.' Estimated in general upon the above plan, the intangible value of the railroads in that state in 1900 amounted to $35,800,000, or 19 per cent, of a total worth, comprising both physical plant and intangibles, of $203,000,000 for the railroad net as a whole. Washington in 1905 gave special attention to everything affecting both density of traffic, that is to say earnings on one side and operating expenses on the other, as distinct from the bare bones of the plant.^ The results, so far as one can decipher them, indicate an intangible value on the whole about offsetting deprecia- tion; so that the market value of the properties, which was sought, approximately equalled their reproduction cost, new. As for the individual roads, the intangible value varied greatly, from an excess above reproduction cost of 20 per cent, for the Oregon Railway and Navigation Company, to 1 per cent, for the Northern Pacific. For smaller roads dependent for futm-e business upon partly depleted forests, the market value over and above physical property was necessarily nil. New Jersey foimd the value of the "remaining property" of its carriers in 1909-'ll to be about $76,000,000, that is to say, about 20 per cent, of the present physical worth.^ Here again, as in Wash- ington, capitalized earning power varied greatly as between different roads, from 11 per cent, on the Erie to 31 per cent, on the Reading. And here again, also, one notes an agree- ment with both Michigan and Washington, in a practical equiva- lence between depreciation and intangible value, the one just about offsetting the other. The foregoing figures indicate intangible values reflecting earning power, that is to say market ' See his testimony before the United States Industrial Commission, 1900, vol. IX, p. 373; United States Census Bulletin, no. 21 on Commer- cial Valuation, 1904, p. 79. The Cleveland street railway settlement by arbitration in 1909 was somewhat similar. 2 Jmirnal of Political Economy, vol. XXI, 1913, p. 332. ' Table, p. 345, supra. 364 RAILROADS value, which seem to fluctuate up and down about one-fifth of the worth of the physical plant. Whether this excess value be termed good-will, the worth of a going concern, or franchise value — points shortly to be considered — will make no differ- ence in the statistical result, however much it may affect the inclusion of all or a part of this value in the rate-making basis. The difference between capitalizing all net income, in other words making earnings the sole criterion of value, and resort- ing to a distinction between structural and intangible values, may best be shown by an illustration. Reverting to our hypothetical example on the preceding page, it will be recalled that, out of a total income for the hypothetical road of $1,200,- 000, we allowed $500,000 to stand for 5 per cent, on the $10,- 000,000 of real property, assuming that the balance of income ($700,000), capitahzed at 7 per cent., would support a valua- tion in intangibles of $10,000,000. This would constitute a total of $20,000,000. The older view holds that it makes no difference whether dividends be computed at 6 per cent, on $20,000,000, or be reckoned, as is done here, at 5 per cent, on the first $10,000,000 and 7 per cent, on the second like amount. That is indeed true, speaking only of the present. But how about the days to come? Need more than 5 per cent, ever be earned on that first $10,000,000, standing for the physical plant. All the balance of earnings, if distributed, are chargeable as dividends on the remaining half. This would make the rate of dividend rise more rapidly than if computed equally on the entire capital, as one instance will demonstrate. Suppose the earnings rise from $1,200,000 to $1,800,000. Were all seciu-ities paid aUke, this would permit 9 per cent, on the original capital of $20,000,000. But if only 5 per cent, on the first $10,000,000 were allowed, there would be a balance of $13,000,000 of income left over, which would yield 13 per cent, on the second $10,000,000 of securities. Pubhc attention to this, as an enhanced intangible value, would INTANGIBLE VALUES 365 be far more likely to be aroused than under the 9 per cent, plan of equal dividends on all aUke.^ The subject of intangible values may not be dismissed without further examination, for just now it is the most rapidly growing tip-end of the subject. Courts and commissions seem to be if not all at sea at least well out at sea, or, to change the figure, ahnost at loggerheads. Few of them have clearly dissected the value of "the remaining property," or "full value," from the point of view of the conflict of private and pubUc rights.^ Three intangible possessions, quite distinct in their nature although blending at the margins, are discernible. These are franchise value, good-will, and the worth of a going concern. The franchise has value either because of the pos- session by the company of a privilege of place, of time or of use. Thus a railroad may enjoy a strategic location and conceivably, as we may hope in future, will be protected in the possession thereof as against all comers, although perhaps not to the extent of leaving Pittsburg always at the mercy of the Penn- sylvania Railroad or New England in the palm of the New Haven's hand. But within reasonable Umits, sound pubKc pohcy approves of regulated and at the same time protected monopoly. Or, again, a carrier may for a period of time have conferred upon it certain privileges which add to its earning power.* Wherever such privileges are conferred or perpetuated by pubhc authority, it is obvious that no claim can rightfully be set up as against the public for the enjoyment of more than fair profits. It is now well-settled law that in return for a franchise which largely guarantees the integrity of an invest- ment, the company may equitably be Hinited in the rate of return to be had.'* An interesting question at this point is as to the status of such privileges of location as arise from per- ' Fully discussed at p. 110, supra. ^ Loosely used even by J. H. Gray, Economic Review, vol. IV, supp. 1914, p. 32. ' Cf. cases cited in Ripley, Railway Problems (rev. ed.), p. 740. * P. 326, supra. 366 RAILROADS petual trackage rights. The Massachusetts Validation Report, for example, allowed $6,000,000 to the New Haven for its perpetual right to the use of the New York Central terminals. The second intangible element is good-will, not inaptly- defined as the "present value of expected super-profits."' Reputation in trade is a characteristic asset of competitive business and as such has only a remote connection with railroads under present conditions. With but a single carrier in the field, the shipper has no choice and no good-will either to give or to withhold. Consequently, it is argued that no allowance therefor should be permitted in valuation.^ And yet, we submit, a large part of the business of a carrier is after all really competitive. Reputation for certainty and despatch of freight and for safety in passenger carriage may cut a not inconsiderable figure in receipts. As for the third intangible, going value, this arises from an estabhshed business as against one in its initial stages. Unquestionably a system in full operation, with estabhshed connections, an efficient organization and a created income, with its property tried out and unified, is worth more than a railroad practically on paper, except for the fact that its physical plant is geographically in place. Here, certainly, is ground for an allowance whether for capitahzation or rate- making. Nevertheless the practice of administrative com- missions varies greatly.' The prime difference between a live railroad and a dead one, financially, is the amoimt of the losses and deficits in the early years of operation. Wisconsin practice permits such losses and deficits to be treated as capital; New York, followed by Maryland, makes allowance for them in a generous rate of return when once fully estabhshed. New Jersey, unqualifiedly accepting the view that a property with a business attached has a greater value than one without it, would seem to authorize the capitalization not only of deficits 1 The Accountant, December 6 and 27, 1913; and January 27, 1914. ^ Cf. especially, 4 Wisconsin, R. C. Rep., 1 and 60. ' Quarterly Journal of Economics, vol. XXVIII, 1914, p. 284; also Whitten, Valuation, chap. XXV. INTANGIBLE VALUES 367 below a fair return, but even of expenses incurred in holding patronage. Here is fair material for debate as to policy. The subject may be dismissed with the following lucid presentation from the Supreme Court of the United States of the difficulty of valuing either good-will or franchises.^ "Then again, although it is argued that the coiui; excluded going value, the court expressly took into account the fact that the plant was in successful operation. What it excluded was the good-will or advan- tage iucident to the possession of a monopoly, so far as that might be supposed to give the plaintiff the power to charge more than a reason- able price [citing Willcox v. Consolidated Gas Co., 212 U. S., 19, 52]. An adjustment of this sort under a power to regulate rates has to steer between Scylla and Charybdis. On the one side if the franchise is taken to mean that the most profitable return that could be got, free from competition, is protected by the Fourteenth Amendment, then the power to regulate is null. On the other hand if the power to reg- ulate withdraws the protection of the amendment altogether, then the property is naught. This is not a matter of economic theory, but of fair interpretation of a bargain. Neither extreme can have been meant. A midway between them must be hit." All in all, the advance in economic reasoning during the period under review has been notable in many ways. Great activity has been accompanied by positive achievement. The main Unes of procedure have in all probability become estab- lished, with one exception — and that a rather important one. Whether the courts and conunissions have chosen wisely in the adoption of replacement cost as a standard of valuation seems open to debate. The errors and shortcomings of poUcy due thereto, have been either corrected or avoided by indirection thus far. A searching examination may yet reveal possibiUties in the substitution of actual or original sacrifice — except pos- sibly for land — for reproduction cost, which will profoundly affect the treatment of the whole subject.^ There being, as we have seen, four distinct public pur- poses of physical valuation, it is pertinent to inquire in how ' 223 U. S., 655. ^ On the trend this way, cf. Whitten in Annals Amer. Acad. Pol. Science, vol. LIII, 1914, p. 185. 368 RAILROADS far the same principles apply interchangeably. In other words, are the results of appraisal for purposes of purchase or taxation appUcable to those for rates or capitalization? It would seem as if any possession, physical or intangible, suitable for taxation might also be utilized in the fixing of rates. Other- wise a game of hide-and-seek would appear to be playable with values.' Many legal decisions indicate, if not identity, at least a very close inter-relation between these several uses of appraisal.^ But to the economist certain important distinc- tions suggest themselves. Take, for example, valuation for rate-making and taxation. They ar6 undoubtedly related. They vary in unison, particularly as affected by earning power. But both in theory and practice, appraisals for the two pur- poses are quite discordant. Thus an important part of any inventory for purposes of taxation is undoubtedly the worth of a going concern.' So long as this was iiidistinguishable from franchise value, progressive opinion insisted that while "hot assets" were worth more than "cold assets" for revenue pur- poses and hence for taxation, the difference might not be considered in measuring the reasonableness of railroad rates.^ This attitude is becoming modified, as we have seen, with a clearer vision as to the nature of intangibles; so that the value of a going concern is receiving greater recognition in both cases alike. The real difference, it is perceived, has to do with appraisal of the franchise and not with going value as such. Franchise values, as taxable imder the laws of a niunber of states, are commonly forbidden as a basis of capitalization. And yet such possessions are of substantial worth. Ten years ago the franchise of the Southern Railway was assessed by the state of Georgia for about two-thirds as much as its ' Cf. Smalley on property and not-property, in Ripley, Railway Prob- lems (rev. ed.), p. 623. ' Whitten, Valuation, p. 3 et seq. ' Cf. p. 361, supra. * Cf. the Wisconsin idea and particularly Senator La Follette: Cong. Record, vol. XL, no. 108, p. 5993. PHYSICAL VALUATION 369 tangible possessions. On the Louisville & Nashville under the laws of Kentucky, the franchise valuation equalled ap- proximately 40 per cent, of that of the real property. This same railroad on its hnes in Florida in 1902 made returns for purposes of taxation only about one-half those certificated shortly afterwards to the Federal court in injunction proceed- ings against the enforcement of a statute reducing rates. ^ The company claimed that in the latter case it was entitled to a return upon replacement cost at least, — a basis which might be highly excessive for purposes of taxation if the road were being operated at a loss.'' There can be httle doubt that the early opposition of the carriers to the project for Federal valuation was due fully as much to apprehension over tax assessments as to the anticipated effect upon rates. The experi- ence of several commonwealths tends to confirm this view of the matter. Railroad properties, except in the East, have probably in the past too largely evaded their just proportion of taxes. If the interest in valuation for rate-making purposes serves to stiffen up the assessment for taxes by comparison with other forms of property, the movement will not have been in vain. How about the identity of valuations under condemnation proceedings, that is to say for pubUc purchase, and for pur- poses of rate-making? Everything depends here upon the fact that for purchase the commercial valuation, absolutely based upon earning capacity, is final and all-important; while ^ C/. the Arkansas Rate cases, 1911, 187 Fed. Rep., 310, where tax valuation is applied to rate reasonableness. ' The Federal Census in 1904 in its report on Valuation of Railroads, p. 14, compares its commercial valuations with those for taxation. In only one instance, Connecticut, is the commercial valuation less than that for taxation. Outside of New England, the only states with a proportion of taxable assessment to commercial valuation as high as 60 to 70 per cent, are Ilhnois, Michigan, Wisconsin and New Jersey. A few others — Geor- gia, Indiana, Kentucky and Texas — assess their railroads at from 40 to 50 per cent, of their commercial value; while most of the remainder range from 7 per cent., as in Wyoming, to 38 per cent in Virginia. In New York the assessment in 1904 was only 25 per cent, of the market valuation. VOL. 11 — 24 370 RAILROADS in rate cases attention is focussed, not upon the fair value of the property alone or a fair rate of return, but upon the product of the two.' Rates, otherwise stated, are measured chiefly as to reasonableness by the ratio of net earnings to the worth of the property. Physical valuation is merely inci- dental to the ascertainment of this ratio. Obviously, there- fore, in rate cases little or no weight attaches to net earnings at all. The distinction between the two purposes appears the moment we engage in details. Condemnation proceedings always allow for depreciation. In rate-making, depreciation may be relatively unimportant for a time unless the efficiency of the transportation agent is affected thereby. Going value is also troublesome. It must be considered in public pur- chase; but has not yet found firm footing as an element in fair value for rates .^ And, finally, a franchise is undoubtedly property for purposes of condemnation; ' while only the mere cost of obtaining it, seems likely to be allowed administratively for rate-making purposes. It is evident enough that grave error may be committed in an attempt to make a single physical inventory serve many masters. 1 23rd Ann. Conv. Nat. Assn. Railroad Com'rs, 1911, p. 146. 2 Cf. Whitten, Valuation, pp. 440, 466, 500, 520 and 563; and American Economic Review, 1913, p. 380. ' WMtten, op. cU. p. 645. Addendum to footnote 1, p. 361, supra. The opinion of Justice Swayze that " logically no allowance should be made for the value of the special franchise in a case where it is not legally exclusive and where the state still retains the right to fix rates " is over- set, apparently, by the Court of Errors and Appeals by a decision of De- cember 9, 1914. It does not aflfirm that the value of the franchise is " necessarily " measured by the total market value of the securities, less physical valuation and development cost, " because this would take no account of inflation of stock values "; but it holds this excess to be "evi- dential " of a franchise value, taxable and properly a basis for rate meas- urement. A momentous conclusion, indeed, &ially reached by six out of sixteen judges who have considered the matter. Can it fail to hold water ? CHAPTER XII RECEIVERSHIP AND REORGANIZATION' Definitions, 371. — Is foreclosure necessary to reorganization? 373. — Frequency of railroad failures, 375. — The chronicle year by year; association with financial panics, 376. — Sequence of the phenomena, 376. — Receivprship declining, 377. — The causes of failure, 378. — Over- expansion, 378. — Stock-watering, 380. — Speculation and fraud, 381. — The Richmond Terminal reorganization, 381. — Internal dissen- sion, 383. Receivership, 383. — Legal development, 384. — Economic functions, 384. — Meeting cash requirements; receivers' certificates, 385. — ^ Abuses under receivership, 387. — Proposed regulation, 388. — How ter- minated, 388. Conflicts of interest in reorganization, 388. — Committees appointed, 389. — Various groups of seciirity holders, 390. — Immediate necessity; cash for floating debts, 392. — Prospective needs; working capital and betterments, 393. — The overload of fixed charges, 393. — Elimination of embarrassing restrictions, 394. Expedients adopted, 395. — Cash, how raised, 395. — Sale of treasury assets, 395. — ■ Funds from new pubUc offerings, 395. — Main reliance on security owners, 396. — Assessments upon stockholders, 399. — ■ Status of junior bondholders, 400. — Scaling rates of interest, 401. — Reduction of the principal of indebtedness, 401. — New securities for old. 402. — Contingent v. fixed charges, 403. — Details of procedure 404. — Voting trusts, 404. General observations, 405. — • Effect upon corporate structiire; dismem- berment followed by merger, 405. — Over-capitalization, 406. — Lead- ing principles reviewed, 407. — Importance of general business con- ditions, 410. Receivekship and reorganization are operations usually, although not necessarily, attendant upon insolvency. So closely are they inter-related through this common cause that it is only since the late '70s that they have become clearly differentiated. Receivership is the continuing control of a 1 Consult T. L. Greene, Corporation Finance, 1897, pp. 146-176; Poor's Manual of Railroads, vol. LXXI, 1900 (analyzes 57 plans); E. S. Meade, Annals Amer. Acad. Pol. Science, March, 1901, pp. 206-243; G. 372 RAILROADS • railroad by an oflScer appointed by a Federal or state court, who, in cases of dispute or litigation, assumes the management on behalf of all parties concerned, including the public with its right to uninterrupted service. Reorganization is the financial readjustment or settlement necessary for the restoration of peace and order, generally through the re-establishment of a proper equilibrium between income and outgo. Receivership is thus largely palliative. Reorganization is more truly reme- dial, seeking, as it does, to remove the causes of financial em- barrassment. Receivership nurses. Reorganization aims to cure. Receivership precedes reorganization. It is also natu- rally terminated by it, unless the property has been so rehabili- tated by the receiver as to be fitted for restoration to the stockholders. Foreclosure — that is to say, judicial seizure and sale of the property to the highest bidder by creditors for the satisfaction of their claims — is a third concomitant of financial failure. Whether it is an essential of reorganization is matter of debate. If, on the one hand, reorganization is merely a wholesale exchange of new securities for old for pur- poses of financial accommodation, the scope of the term is much wider than if, as otherwise claimed, no real reorganiza- tion may occur without a forced sale by judicial order. This latter seems to be Cleveland's view. Meade also defines reorganization as "a settlement of the claims of the different parties in interest on such a basis that the property can be released by the court and again managed as a going concern." It would appear as if the first and wider definition were on the whole preferable. For, according to recent experience, a radical readjustment of capitaKzation, certainly equivalent to reor- ganization, may take place as well because of extreme prosperity as by reason of financial prostration. The Alton recapitaliza- . Daggett, Railroad Reorganization, Harvard Economic Studies, vol. IV, 1908 (nine reorganizations analyzed in detail); Cleveland and Powell, Railroad Finance, 1912, pp. 215-271 (bibliography). Catalogue, Bureau of Railway Economics, 1912; and bibliography of Railway Capitalization, U. S. Library of Congress, 1909. BANKRUPTCY 373 tion of 1906 or that of the Rock Island in 1901 ' were largely methods of distributing surplus. And the Seaboard Air Line financing of 1909, so conservative that not even the conunon stock was disturbed, was likewise a reorganization, although having no connection whatever with corporate impoverish- ment. But our present concern is not with this class of cases. This chapter has to do specifically with methods for the alle- viation of financial distress. As to whether reorganization is or, is not necessarily accom- panied by foreclosure proceedings is not merely a matter of definition. Many financial readjustments, the outcome of distress, which we shall have occasion to review, have never resulted in a forced sale at all. Of Daggett's seventeen leading examples only ten were marked by actual foreclosure.^ We hold, therefore, that a comprehensive readjustment of capital relations is just as truly a reorganization, even if no judicial decree for sale is uttered at all. Thus the wholesale exchange of securities on the Reading in 1884-'87 was certainly just as much of a reorganization as if foreclosure had taken place. The old corporation was not closed out, simply because the company was loath to yield up its valuable charter rights. Whether the Cincinnati, Hamilton & Dayton settlement of 1909 with the Baltimore & Ohio was also a reorganization, in that it temporarily at least lifted it out of a financial slough, is, perhaps, more open to question. The precise function of foreclosure is of minor importance in any event since the opinion of the Supreme Court of the United States^ in the Northern Pacific Railway case. This decision held that reorganization was not a mere formal transfer of property by judicial sale, but rather an effort of security holders, inde- pendent of the closing out of the old corporation, to replace the company upon a firm and stable financial footing. In ' Treated as stock-watering; pp. 152 and 262, supra. ^ Cleveland, p. 249, gives other examples. 3 Boydete.;228U. S., 482. 374 RAILROADS other words, emphasis in this opinion was laid upon financial readjustment for purposes of corporate stability; while fore- closure was held to be merely a means to that end. So unim- portant was foreclosure held to be, in fact, that the court permitted the corporate gap between the old and new com- panies to be bridged by the claims of former general or un- secured creditors. This decision should put an end to the abuse of foreclosure proceedings on piu-ely technical grounds, in order to wind up the affairs of an embarrassed corporation and effect a preference between different classes of creditors. Railroad failures throughout our experience have been relatively frequent. The aggregate of receiverships and foreclosures sm-passes expectation, — a depressing disclosure suggestive of the reports of the British Commissioner on Wind- ing-up Corporations. Within almost 40 years since 1875, $8,262,000,000 of railroad bonds and stocks have been involved in receivership proceedings; and $7,400,000,000 have come under foreclosure sale. These figures together about equal the total present capitaHzation of the entire American railway net. Approximately one-half of the existing railroads in the United States have at some time or other passed through financial reorganization.^ About one thousand corporate foreclosure sales have taken place during the same period. The mileage affected by both foreclosure and receivership since 1875 is roughly equal to the total length of the present railway system. An examination of the pathology of railroad finance would certainly seem to be warranted in view of such a record. The chronicle of railroad distress, year by year, is exhibited upon the diagram on the opposite page, based upon the miles of line affected. The first out-standing feature is the intimate association between receivership and foreclosure and the panic periods in our history; and particularly the exceptional acuteness of the panic and depression of 1893-97. Railroad ' Railway Age Gazette, vol. LIT, p. 945, and vol. LVI, p. 4; Swain, Receivership, p. 66. BANKRUPTCY 375 failure is a certain barometer of trade conditions. Announce- ment of a receivership for the Erie, as a leading authority on banking puts it, "has been a customary feature of our com- mercial crises for half a century." In 1857, in 1873, at the time of the Grant & Ward failure in 1884, in 1893, and again within a hair's-breadth of it in 1908, did this historic prop- erty serve as a warning of financial distress. The Northern Pacific went down with Jay Cooke in 1873 and again twenty years later. The Philadelphia & Reading was in receivership in 1884 and again in 1893; its example each time being followed by the leading railroads in the southern states. All along the line, to be sm-e, are scattered sporadic failures of important companies such as the Rock Island, the Reading again and the Union Pacific in 1880, the row-of-bricks downfall of the Gould roads in 1888-'91 and the Chicago Great Western affair in 1909. These independent collapses during fair weather may be regarded as local phenomena, due to personal mismanage- ment or inherent weakness. But in the main railroad failure, 376 RAILROADS as of course one might expect, concentrates about the panic years. This was evident as early even as 1837.^ Over ten per cent, of the mileage of the coimtry and one-quarter of its railroad bonded debt, defaulted on its interest obligations in 1873-74 before modern procedure had fully developed." True receivership is first noticeable on a generous scale in 1884, when 11,000 miles of Une were taken over by the courts. In the fall of 1907 (1908) 18,000 miles of road succumbed once more. The short sharp ("Rich Men's") panic of 1903 ^lone stands forth by way of contrast, as practically unproductive of railway disorder. The year 1913, labelled on our diagram as a time of "Apprehension," is also distinctive through the prominence of railroad distress. By the ensuing autimin almost $600,000,000 of railway bonds and notes were in default, this condition contributing to the urgency of the demand for Federal permission to increase rates. But all records in this regard — it is to be hoped forever — were broken by the panic of 1893, when the control of an unprecedented mileage was handed over to officers of the state and Federal courts. On Jime 30, 1894, 192 companies were in the hands of receivers, of which 126 had been consigned thereto during the preced- ing year. The total mileage operated by these defaulting companies was 40,818. The stocks and bonds affected by receivership aggregated $2,500,000,000, — that is to say, one- fourth of the total railway capitalization of the country at that time. Thus was a dire penalty exacted for the violation of inexorable economic laws during the preceding decade of development. A second conclusion emphasized upon the diagram is the sequence in point of time of the allied phenomena. Fore- closure follows receivership in frequency hke a shadow after an interval of about two years.' This will be observed in 1 Swain, op. cit., p. 73. 2 Crowell, op. cit, p. 322. ' Swain, p. 103, finds the average length of receivership to be 2-3 years. BANKRUPTCY 377 1884, 1893, and 1907. Events appear to be shaping themselves to bring about a similar sequence at the present time. Almost 23,000 miles of line in the Gould and (old) Rock Island systems, besides a half dozen independent "construction-company" enterprises,^ are just now in process of reorganization. But the present situation is somewhat pecuhar in this regard. A larger proportion than usual of these properties in distress seems hke to pass directly into reorganization without the intervention of receivership at all. On the whole, a relative decline in Judicial interference is apparent.^ Decade by decade, there has been a decided subsidence in the railroad mileage thrown into the hands of receivers. The following table throws this into strong reUef. Receivership First Decade 1882-'91 Second Decade 1892-1901 Third Decade 1902-'ll Companies. . . Mileage Capitalization 279 37,816 ,884,000,000 222 62,266 1,543,000,000 86 17,574 $1,245,000,000 The change, furthermore, seems to be something more than a mere turn of fashion. Substantial economic forces are at work. A rigorous process of natural selection has weeded out many of the feeble and the unfit roads. Others have found refuge and strength in alhance with larger companies. A more powerful and definitely organized banking support is also probably in some measure accountable for the change. But the most important influence of all is the growth and filling up of the coimtry, — traffic having developed, that is to say, more in proportion to the facilities for transportation pro- 1 P. 49, supra. ' Railway Age Gazette, vol. LIT, 1912, p. 945. 378 RAILROADS vided. For a growing density of traffic, as we have shown/ is the most certain panacea for all the ills to which railroad flesh falls heir. Examination of the causes of receivership and reorganiza- tion, as distinct from the mere occasions upon which they come to light, is tantamount to analysis of the reasons for rail- road failure. Of these there seem to be four; which shade off into one another and often overlap, yet which, on the whole, are sufficiently distinct in kind to warrant segregation. These form a series, ranging from one extreme of mere imreasoning optimism and incompetence, — errors of judgment, perhaps, — down through various grades of culpabiUty to speculation and fraud at the other. Over-expansion or excessive competi- tion — that is to say, an assumption of financial burdens out of proportion to earning power — is the first cause of downfall. This is a commercial fault coupled, it may be, with finan- cial incompetence. The second disintegrating influence, pro- ductive of grave financial danger, is over-capitalization. This has already been exhaustively treated in a chapter by itself. Such stock-watering has often been a handy side-partner of over-expansion. Standing by itself it is indicative of error in fiscal pohcy, quite distinct from commercial or traffic misjudg- ment. A road may be finely operated, with a rich and growing territory, and still go to pieces from this cause. Thus did the Rock Island in 1913-14. Speculation and its helpmeet, fraud and deception, come next in order. A long chain of disasters has followed in their wake. The catalogue con- cludes with a minor source of trouble, — possibly rather a symptom than a cause, — not infrequently resulting in court proceedings and reorganization. This is internal dissension, a conffict of interest between different classes of security holders.^ The downfall of the Atchison, Topeka & Santa F6 system in 1889 was primarily due to over-expansion, — to premature ' Railroads: Rates and Regulation, p. 86. 2 Cf. p. 103, supra. BANKRUPTCY 379 development of transportation facilities in advance of popula- tion.i Of its 7,000 miles in 1888, 2,700 had been constructed or acquired within two years, in an ambitious attempt to make over a local property into a transcontinental system. From Chicago to the Gulf of Mexico and the Pacific Coast simul- taneously is a wide reach. Another case of over-expansion was the Philadelphia & Reading in 1884 and again in 1893; although this time, as will appear,^ it was a monopoly of anthracite properties rather than of mere carriers which was attempted. The Northern Pacific went to pieces in 1893, also, largely because of an overload of branch hnes, coupled with an effort to reach Chicago by means of a bad lease of the Wisconsin Central. Obligations assumed to the amount of over $30,000,- 000 in connection with subsidiary roads, with little or no addition to net income from them over operating expenses, proved an insupportable burden. And then there was the dis- ruption of the Gould combination in 1907,' — promising for a time to constitute the first ocean-to-ocean system. A variant of inordinate expansion — all circumstances considered — or what perhaps more truly merits the name of over-competition as a cause of insolvency, is noticeable in the troubles of the considerable group of "construction-company" roads at the present time. The attempt of any independent interest to invade a territory already occupied or pre-empted by one of the large systems is bound to be an up-hill job.* But in these and many other instances disaster can scarcely be ascribed to over-expansion alone. Internal financial weakness was too often also to blame. The primary principles of effective mihtary campaigning were neglected; such as the provision and protection of a secure base of supphes, even under the worse possible contingencies; and the thorough and intensive occupation of one territory before engaging in the invasion of another. 1 Swain, op. eit., p. 83, gives many examples. 2 Chap. XVI, infra. ' Chap. XV, infra. * P. 49, supra. 380 RAILROADS The second cause of railroad failure — still unattended by fraudulent practices — is over-capitalization or an ill- balanced financial structure. The Rock Island reorganization of 1880 was not due to lack of traffic or earnings. The road had not suffered from over-expansion or excessive competition. Ways and means for conceaUng or getting rid of earnings without arousing public hostihty were sought. Subsidiary Unes were absorbed, and such an exchange of seciuities effected as to double the capital stock and appreciably to increase the fimded obhgations. It was this process of stock-watering, followed in 1902 by a repetition of the same offence, which finally brought this fine property to its present state of prostra- tion. The East Tennessee, Virginia & Georgia programme of 1884^'86, by which a gigantic merger of most of the discon- nected railroads in the southern states was attempted, also came to a, bad end through over-capitalization. Within eight years the stocks and bonds were run up from $23,000 to $80,000 per mile of hne.^ Net income was entirely absorbed in meeting fixed charges. And then the ever-recurring troubles on the Erie may be cited. Starting wrong in hfe, robbed by those who should have been its guardians, repeatedly committing the financial crime of borrowing anew in order to pay interest upon an already excessive indebtedness, is it any wonder that this tr unk fine should imtil lately have been a byword among money lenders the world over? ^ Equally unfortunate as to its past was the Wabash, also so loaded down with fixed obliga- tions that no margin whatever for development remained.' The present difficulties of the Cincinnati, Hamilton & Dayton, hkewise, all date from 1904, when within the short space of two years its bonded indebtedness ran up from $12,000,000 to $48,000,000 and its floating debt from $200,000 to $10,000,000.^ It is the over-weight of bonds, of course, rather than of total capitalization alone, which is at fault in most of these cases. 1 Daggett, p. 157. ' P. 85, supra. " Daggett, pp. 36-58. * P. 214, supra. BANKRUPTCY 381 But there can be little doubt that an excessive aggregate of securities so closes all possible channels of financial aid that a property is bound to drift into rough water in face of competi- tion from more conservatively handled roads. Soundly financed, a company may weather a period of rapid or even dangerous expansion; and conversely, a prudent policy of cultivating a given field intensively may offset a poorly devised financial structure; but the combination of both over- expansion and stock-watering is irresistible. Thus was the Union Pacific reorganization of 1893 rendered necessary. Jay Gould had unloaded upon it all of his worthless branch Unes. Its indebtedness to the United States had been mis- managed; and yet all the time it had pursued a policy of wide extension. All experience from this exaggerated instance, and of the others above mentioned, goes to reinforce the princi- ple that a wide margin between fixed charges and minimum earnings is an essential both for present safety and for such promise of improvements and development as shall minimize costs of operation and keep step with the march of events. Many a well-operated railroad has been brought to reor- ganization through speculation or manipulation for the in- terest of insiders in the management. As good an example as those already cited in our treatment of the subject,* is the Richmond & West Point Terminal failure of 1891. This led through reorganization to the creation of the present Southern Railway system. The events contributing to this failure in all their ramifications read Hke corporate melodrama.^ Three principal companies played a part: the Richmond & Danville, lying lengthwise of the Piedmont shelf on the Atlantic side of the Appalachian Mountains; the East Tennessee, Virginia & Georgia, west of the mountains and reaching around the southern end across Georgia to the sea; and the Richmond & West Point Terminal, merely a holding company organized 1 Chap. VI, supra. 2 Details in Daggett, pp. 146-199. 382 RAILROADS in 1881 by the first road above mentioned, for the purpose of acquiring stocks and bonds of subsidiary Unes. The first of these three had been heavily financed by Virginia. Tennessee had been foster-mother to the second. The third, although finally dominating everything, had no such respectable antece- dents. Officially, it was an orphan, a waif. The tale opens with a forgotten chapter in Pennsylvania Railroad history, which left it in the early '70s owning a majority of stock through the Southern Railway Security Company in both of the afore- mentioned railroads, east and west of the AUeghanies. On its abandonment of this southern extension policy, its concen- trated holdings were shuffled from one rival syndicate to another, each taking a profit on the way.^ The early '80s witnessed control of the two actual railroads, respectively east and west of the mountains, lodged once more in the same hands. But in the meantime the East Tennessee had been over-extended, extravagantly financed and inadequately maintained even to the point of bankruptcy by 1884. TJie Richmond & Danville, not much better off, in search of means for reducing expenses, at this jimcture picked up the Richmond Terminal holding company which had been cut loose from its parent road. It was thereupon bereft of 1,500 out of its 1,800 odd miles of line; and its stock was dumped upon investors who knew nothing of its poverty of assets. Fortunately for the Richmond Terminal Company, certain of its stockholders were resourceful enough promptly to turn the tables upon its enemies. A control of the stock of the railroad which had just taken away most of its assets was promptly picked up; and, even more than that, the East Tennessee system was also brought into the combination for the third time, at first by lease ^ and subsequently by purchase of a majority of its capital stock. Next in these kaleidoscopic ' Cf. the C, H. & D. syndicates, p. 216, supra. ' So questionable as being entirely in the interest of first preferred stockholders that it was promptly cancelled by judicial order. RECEIVERSHIP 383 changes, came the purchase of the Central Railroad of Georgia, on terms which permitted large speculative profits to insiders on both boards of directors, although at heavy annual loss to the Richmond Terminal itself. A few minor additions brought the system in 1890 to a magnitude of 8,500 miles of line. A year later the inflated bubble burst and all the speculative machination came to light. Its most patent manifestation was the immense over-capitahzation of all the roads concerned. No salvation except through drastic reorganization was possible. Downright fraud as a cause of bankruptcy is evidenced in practically every railroad with which Jay Gould ever had anything to do.^ Dishonesty also undoubtedly played a con- siderable r61e in the involved connection with the Wisconsin Central which culminated in receivership for the Northern Pacific in 1893. And then, 20 years later, the "Frisco," like the Richmond Terminal and the Northern Pacific, wrecked through over-expansion, was undoubtedly brought to a sad end through acts of insiders grossly tinted with favoritism, if not dishonesty.^ Internal dissension, last in our series of causes, is not infre- quently provocative of receivership. Other issues than finance, that is to say, may bring about judicial intervention. Disputes over the terms of leases, dissatisfied minority interests' and even controversy between opposing reorganization committees, as on the Northern Pacific in 1893, may any of them precipitate receivership and lead up to reorganization.* The first indication of trouble is the taking over of the property from the stockholders by the appointment of a re- > Cf. the Kansas Pacific, p. 249, supra; the Erie, p. 157, supra; the Missouri, Kansas & Texas and the Texas & Pacific. (Cleveland, p. 249.) 2 P. 41 mpra. Add also the C, H. & D. affairs of 1904-'06, p. 216, supra. ' P. 445, infra. * Swain, op, cit., p. 93; Crnn. & Fin. Chron., vol. XLIII, pp. 23 and 515; Cleveland, p. 234; and Daggett, p. 288. 384 RAILROADS ceiver.i The function of this agent of the court, originally confined merely to closing out the affairs of the corporation for the benefit of creditors, has gradually expanded into a multi- plicity of activities, often actually constructive and intended to conserve the interest of all parties concerned. The rights of creditors to satisfaction of their claims, of stockholders to pres- ervation of their equity and of the public to uninterrupted service must all be safeguarded. Receivership, contrary to popular impression, has thus come to be quite as often a reprieve as a death sentence. It may be the first step toward rehabilita- tion. The office gradually developed out of ordinary trustee- ship, especially during the late '70s, when it was ascertained that trustees of a mortgage oftentimes possessed powers neither sufficient to overcome obstacles to foreclosure nor broad enough to continue operation and to safeguard the stockholders' equity. For, as will be recalled from our discussion of bonds,^ the real security of creditors and stockholders alike is not dead assets, but property productive of earnings through con- tinued use. As for the inunediate occasion for the appoint- ment of a receiver, it is most commonly impending or actual default in interest or principal of a debt. But such obligations need not be long-standing funded ones alone. Quite as often a property goes into receivership upon the application of note holders, contractors, supply men or even employees, seeking satisfaction of their respective claims. Sometimes, even, the road may be quite solvent. The court, nevertheless, assmnes custody pending the settlement of some dispute.' But what- ever the immediate occasion, the receiver upon taking charge supplants all others in authority. ' On receivership consult Swain, American Economic Association, Studies, vol. Ill, 1898, p. 161; Crowell, Yale Review, vol. VII, 1898, pp. 319-330; Cleveland and Powell, Railroad Finance, 1912, pp. 227-247; and legal treatises, such as Beach, Alderson, High, Smith and EUiot. Cf. also American Law Review, vol. XXIII, p. 56; vol. XVII, p. 481; and vol. XXX, pp. 161, 259 and 520. 2 P. 126, supra. ' Swain, op. cit., p. 93. RECEIVERSHIP 385 The fxinctions and powers of receivers are multifarious and conaplex. The primary office is to continue operation of the road. This is usually in bad condition, due to postponement of necessary maintenance as a measure of forced economy. Cancellation of onerous leases and contracts is a second detail of the receiver's task. Had the Boston & Maine been thrown into receivership in 1914, the burdensome leases of subsidiary lines, as well as the American Express Company and Pullman contracts, might have been promptly annulled. Car-trust agreements also may be terminated or modified. But perma- nent contracts in substitution, usually require a special judicial order for validation. Whether interest payments will be continued or not also lies at the discretion of the court. Re- ceivers may sometimes exercise positively constructive powers. They may overhaul and upbuild the plant and restore its working efficiency. Construction under way may be com- pleted; and even entirely new mileage may be undertaken, if it be necessary to the end in view. In short, receivers have come to exercise most of the functions of stockholders, provided the urgency be sufficiently great. The length of term under American practice somewhat explains this situation. Many receiverships have extended over periods of from five to ten years.i The Vermont Central was thus held for 29 years. On the whole, the average duration has been from two to three years; that being a sufficient period to determine whether the property can be saved as it stands, or must pass on through foreclosure and reorganization. Owing to the commonly depreciated condition of a property on going into receivership, the first duty of the new manage- ment is to raise cash at once. All sorts of claims are pressing for settlement. The credit of the road is exhausted. And every step toward rehabilitation calls for extraordinary outlay. In order to meet this situation, emergency methods for raising funds through the issue of so-called receivers' certificates » CroweU, p. 102. VOL. 11 — 25 386 RAILROADS gradually came into vogue. They were first used in the southern states about the time of the panic of 1873. The courts originally permitted such loans only in cases of extreme necessity and for specifically defined purposes. But it speedily developed that in order to obtain additional capital these certificates must take precedence even over the first-mortgage bonds, as a prior lien both on assets and earnings. The Wabash receivership of 1884 contributed to the development of this type of emergency financing. The court, despite protest from the bondholders against a large issue of certificates being placed ahead of their claims, still recognized their validity, inasmuch as they were intended for the settlement of back claims against the property as a whole. Little by little the same superiority in lien over outstanding bonds has become attached to the issue of certificates for a number of general purposes.! At first allowed only to pay claims for wages and supplies or past advances of interest by bankers, certificates have been permitted for construction of additional mileage, the purchase of new rolling stock, for general betterment or the redemption of pledged seciuities. Undue liberality in the issue of emergency certificates has not infrequently obtained, whereby even solvent roads, thrown into receivership because of some other cause than bankruptcy, have finally succumbed to an overload of fixed charges of this sort. And yet how insistent the need for funds under such circimistances may be, was well exemplified in the case of the recent "Frisco" failure in 1913. The receivers endeavored strenuously to avoid the issuance of certificates, on the ground that it would defeat the prime purpose of the receivership which was to reduce fixed charges. But after a delay of several months, they were compelled to follow the customary procedure, in an application for authority to issue $10,000,000 of certifi- cates. On the Wabash since the receivership in 1911, over $14,000,000 have already been issued. The salability of ' Cf. Cleveland and Powell, p. 244, for instances. RECEIVERSHIP 387 securities of this sort has heretofore depended entirely upon their priority of lien over all pre-existmg obligations. But somewhat of a shock to the established practice was afforded in 1913, when the Atlanta, Birmingham & Atlantic actually defaulted on its receivers' certificates. This was, to be sure, an exaggerated case of such financing; inasmuch as fixed charges had always been excessive, rolling stock was controlled by equipment trust note holders, and necessary terminals were independently owned.i There is certainly danger to investors as well as to the railroad of an excessive issue of securities of this type. Various abuses in connection with receivership gradually developed in the course of time. Much of the practice evolved in absence of statutory enactment.^ The original rule was that the receiver should be a disinterested person; but the necessity of technical training and of famiharity with the property soon led to the continuation of control under receiver- ship by the same persons responsible for the failure. Swain, for example, found that in 80 out of 150 cases within a genera- tion, the former president of the road was appointed receiver; while in 58 other instances higher officers of the company served in this capacity. It was inevitable, perhaps, that the stockholders should be unduly represented in absence of any formal organization of the creditors' interest.' But the anom- aly of rehabilitation intrusted to the very same persons who had brought about the failure, is difficult to defend. Frequent petitions for the removal of such receivers led to their discharge; as, for example, in the "Frisco" case of 1913. This difficulty was sometimes avoided by the appointment of two receivers, one technically familiar with the property, the other repre- senting the creditors. A cognate abuse has had to do with secret and preferential arrangements. The Atchison receiver- ship in 1894 was of this sort. Out of such conditions also ' P. 27, supra. ' Economist, vol. LII, 1894, p. 140. 2 Swain, op. dt., p. 57. 388 RAILROADS arose the peculiarly American practice of the so-called "friendly- receiver"; for which a precedent was set in 1884, when the [old] Wabash itself apphed for a receiver in order to forestall dismemberment by foreclosure. Neither bondholders nor general creditors were represented in these proceedings.' And then again, serious difficulty, verging upon scandal, appeared in connection with conflicts of jurisdiction in the courts. Tangles of this sort often became extremely involved. On the Northern Pacific in 1895 three separate sets of receivers in as many different groups of states, finally compelled the Supreme Court of the United States to intervene.^ Remedial legislation by the Federal government has at various times been pro- posed.' But, on the whole, an enlightened public opinion and a higher type of judiciary has tended of late to bring about a considerable improvement in practice. Receivership is terminated by judicial order, either upon settlement of the controversy, whatever it may be, or upon abandonment of the property to the creditors through fore- closure sale. If this latter course be unnecessary to reorgani- zation, the receiver is dismissed and the property is restored to the control of the stockholders. Whenever such fore- closure occurs, however, it is customary for the court to name a minimum price. Then upon the completion of a reorganiza- tion plan, the various transactions are confirmed by judicial order. And the receivership ends upon the delivery of the property to those duly authorized to succeed in management. In financial reorganization, as distinct from receivership, the most striking feature at the outset is the flat conflict of interests involved. Rival claims of every conceivable sort ' Swain, op. dt., p. 91, traces the development of friendly receivership; Presidential Address, American Bar Association, 1896; Harvard Law Re- view, vol. X, p. 189. ^ Daggett, op. dt., p. 301; Cleveland, p. 238. « Ann. Rep., I. C. C, 1900, p 83; on the Cullom-Straus bill, Bradr streets, vol. XX, p. 564; and T\e Forum, vol. XVII, pp. 19 and 676. FINANCIAL REORGANIZATIO;S[ 389 press for settlement. The variety of these types of obligations has already been emphasized in our earlier chapters upon stocks and bonds. In the Wabash reorganization of 1884, no fewer than 38 distinct mortgages were lined up for con- sideration; on the Atchison, five years later, there were 41 issues of bonds alone. Over and above these, perhaps, are representatives in order of precedence; of liens for wages, receivers' certificates, short-term notes and floating debt. As for the priority of due bills constituting the floating debt, this depends largely upon their character. All of these claimants stand at last face to face. But the necessity for immediate satisfaction of employees' liens and receivers' certificates soon leads to their elimination. Some of the general creditors may also be paid off. Owners of receivers' certificates occupy, as we have seen, an impregnable position; and holders of equip- ment trust notes must be satisfied, imder penalty of with- drawal of the mortgaged rolling stock.^ This would cripple the property too seriously to be permitted. For the long pull, therefore, negotiations over the reorganization plan, narrow down practically to the three groups of senior bondholders, owners of junior securities and stockholders. The various interests concerned in reorganization com- monly crystallize into a number of more or less self-constituted bodies for purposes of negotiation. In a diflicult situation, as on the Union Pacific in 1893, no fewer than fifteen such committees arose, fourteen of them representing not over two classes of bonds each. In the Reading reorganization of 1884r-'86, two committees of bondholders and seven reorgani- zation trustees representing the foreign creditors, the first mortgage and the income and junior bonds as well as the stock, were confronted by a general opposition committee, critical and suspicious. The pending "Frisco" reorganization lately took place under negotiations between nine distinct commit- tees. Such bodies under reorganization proceedings seldom ' P. 171, supra. 390 RAILROADS include representation of the stockholders who are more apt to organize separately in case of receivership. ^ Yet occa- sionally, as in the Texas & Pacific reorganization of 1886, an unfair assessment on the stock may be substantially reduced through such a committee. The more general its composition, the greater the influence which may be exerted by organized effort on the course of affairs. Usually, however, the old management, particularly when held responsible for the failure, is excluded. On the Wabash in 1914, the bondholders took charge in place of the stockholders, through election of their representatives as the executive committee of the board, as an alternative for receivership and foreclosure. The Atchison reorganization of 1889 was a marked exception, in that the reorganization was proposed by the former directors, certainly tainted by self-interest, and had to be all done over a few years later. Aside from the bankers, necessarily interested as underwriters of the new securities, these committees may contain representatives of other and competing railroads. Thus the Kansas City, Mexico & Orient reorganization at the present time^ will doubtless be influenced by committee mem- bers either seeking to get control for the Southern Pacific, or contrariwise, holding in contemplation the continuance of an independent property affording connections into the south- west for all those roads from the northeast which would other- wise be bottled up at Kansas City. In such manner does railroad strategy enter into the deliberations of what might otherwise seem to be purely financial bodies. The inevitable outcome of it all is compromise. An adjustment is reached, partly on the basis of the constructive power of the majority, and partly through the weight of obstructive tactics at the hands of the minority. Senior bondholders with a lien on the main stem or property essential for operation, such as terminals, naturally occupy the strongest position. Their claims may conceivably be 1 Economist, vol. LII, 1894, p. 140. ^ P. 48, mpra. FINANCIAL REORGANIZATION 391 satisfied by immediate foreclosure, in which case they would be favored through the right to turn in their bonds in part payment of the purchase price. A veritable bargain might be had imder such circimistances. And yet the fact that few railroads would realize at forced sale even the face value of their first mortgages, predisposes even the senior bondholders to caution. As for the owners of junior bonds and securities, foreclosure sale would be even more prejudicial to their interest than to senior claimants. They may not wish to bid in the property and yet may conceivably find it necessary to do so. The anomaly of their status is evident in the practice, once common, of treating them like stockholders, that is to say, partners in the equity, through subjecting them to an assess- ment. More logically, nowadays, they are considered as having the right to treatment similar to that of the senior bondholders. An alternative would be to induce senior bond- holders to postpone foreclosure upon guarantee of payment of their interest due. Most vulnerable of all are the stock- holders. As representing only the equity over and above indebtedness, they usually have little voice in reorganization plans. They must often submit to the most onerous condi- tions, inasmuch as foreclosure would wipe out their investment entirely. On equitable grounds, it should be remembered that the stockholder's right to consideration is by no means repre- sented by the face value of his holdings. Concessions must be made by all; but in fairness they should be proportioned to the actual original investment. Most stocks in roads of the class subject to reorganization have been avowedly specu- lative in character, were bought as such at low market prices owing to the risks involved, and must submit without murmur to the fortunes of war. Yet occasionally stockholders are strongly represented and are able to extort unduly favorable treatment. The first plan more often favors them, as on the Richmond Terminal in 1891 and the Erie two years later; ^ 1 Daggett, op. cit., pp. 173 and 63. 392 RAILROADS but such an outcome as the Atchison '89 affair, which left the control of the road entirely in a valueless capital stock, is fortunately infrequent.^ The necessities of an insolvent property naturally subdivide into two groups: those, namely, which are immediate, as distinct from those which are merely prospective. First of all among the former, the floating debt must be cared for: while among the prospective needs the main items are; provision for working capital and betterment, permanent reduction of fixed charges, and the removal of hampering restrictions. Immediate settlement of the floating debt is imperative. It is this last straw, probably, which breaks the camel's back. Loans of all sorts are based upon collateral which can be saved from sacrifice at forced sale only by prompt payment of the principal. Refusal of bankers to renew short-term notes at a critical time has often precipitated receivership. We have seen how the Erie was barely saved in 1908; and how in 1914 the New England roads escaped with difficulty upon maturity of their notes.^ The floating debt of an embarrassed property has almost always acquired large' proportions. The Northern Pacific in 1893 owed $15,000,000; the Reading m 1895 abnost as much; the Atchison in 1893 had accmnulated a floating debt of $16,000,000; and the Baltunore & Ohio by 1896 had to have $36,000,000 at once.' Such obligations are naturally carried at excessive rates of interest. The Atchison for five years paid over $1,000,000 in discounts and commissions for the renewal of $9,000,000 in notes. It is evident that default in interest or principal upon obligations of this class immedi- ately precipitates trouble. This can be averted only by the prompt provision of large sums in cash to clear away the ac- cumulated rubbish. Next in order, after the provision of cash under reorganiza- tion for the immediate settlement of floating indebtedness, 1 Railroad Gazette, 1895, p. 252. 2 P. 169, supra. ' Daggett, p. 348; Meade, p. 207. FINANCIAL REORGANIZATION 393 comes the fiscal necessity of supplying working capital, together with such new moneys for betterment as shall bring about more economical operation in future. For, in all probabihty, a high operating cost due to inadequate facilities, themselves in turn a product of exhausted credit, contributed materially to the d6bdcle. Every reorganization, consequently, has as one of its most important details, the provision of ample funds for this purpose. But, so far as betterment is concerned, the programme differs from settlement of the floating debt in that the burden may be spread over a considerable period of time ahead. Proceedings now on foot illustrate the importance of this feature. For working capital and betterment alone, the latest Wabash plan calls for $30,000,000; the "Frisco" $60,- 000,000; the Rock Island $30,000,000 and the Missouri Pacific $35,000,000-150,000,000.1 Any plan which is deficient in this regard is as surely foredoomed to failure as if it had not even taken care of the floating debt. Thus, for example, partly because of this defect, did the Atchison reorganization of '89 have to be all done over again flve years later.^ Such expendi- St. Joseph & Grand Island; Central of Georgia; Chicago & Eastern Illinois; cited in detail, p. 140, supra. As to minority rights in reorganiza- tion, p. 390, supra; and among preferred shareholders, p. 103, supra. 2 The Keene Southern Pacific Pool: Quarterly Journal of Economics, vol. XXV, 1911, p. 205, p. 217, supra. MINORITY RIGHTS 449 the pathway of its actual merger with the New York Central at this time, affords an instance of the conflicting iaterests involved. The New York Central has for years managed the Lake Shore primarily in its own interest, even to the extent of using it as its fiscal agent in controlHng the Reading and other subordinate roads in Trunk Line territory. Nice questions of confhcting rights between majority and minority interests have naturally arisen all along the Hne.^ Assuredly no undue obstacle should be placed by law in the way of a straightforward movement toward combination of connecting, non-competing railroad companies. All such movements make for better service, simpler financing and more economical management. But there is a wide difference between buying the property, — e.g., the entire capital stock of a company — and merely acquiring 51 per cent, of its shares. It is this latter practice which should be regulated. The propositions and debates in Congress dealt with the matter at length, following out the plans in the President's message of 1910; but unfortunately the Mann-EDdns Act did not cover the point at all. The matter has, however, been revived by the wise recommendations of the Railroad Securities Com- mission authorized imder that lafW. These recommendations may best be stated by the following excerpt from its report. "Any company, or group of companies, which has purchased a majority of the stock of any existing road may properly be required to buy the minority stock at the same price as that paid for the ma- jority stock where the price has been uniform. If the price has not been uniform, the purchase should be either at the average price paid for such holdings or at a price to be fixed by appraisal, at the option of the minority stockholders. "If a company has acquired control of the common stock of another, but not of its preferred, it should be required either to buy the preferred stock or to make the preference cumulative. For the continued existence of a non-cumulative preference under such con- ditions will offer constant temptations to unfair dealing, if not to actual fraud. ' P. 416, Merger, supra. VOL. n — 29 450 RAILROADS "In order to avoid vexatious opposition to consolidation by a minority it should be possible, after such an offer had been fairly made, to convey the property by three-fourths vote of the share- holders and dissolve the corporation. The purchase of less than a majority of the stock of one line by another (except as one of a group of railroads jointly holding the stock of some connecting company) should be discoimtenanced and as far as possible prohibited." The difficulty of direct prohibitive legislation, as proposed by the Federal Securities Commission, is well illustrated by two related events in 1912, which gave rise to discussion as to the rights of minority stockholders. These matters came before the New York Public Service Commission (up-state) in 1912 on petition, respectively, of the New Haven road to be permitted to sell its majority holding of stock in the New York, Ontario & Western road to the New York Central; and, contrariwise, of the New York Central to effect a transfer of its majority stockholding in the Rutland Railroad to the New Haven system. In the first instance the Ontario line, it was alleged, would give the New York Central an entrance to the hard-coal fields of Pennsylvania as well as to improve its terminal facilities at New York. In the other case it was urged that the Rutland Railroad with its connections length- wise of Vermont would afford a valuable outlet to the north- west for the New Haven-Boston & Maine railway system of New England. Financially, the questions raised in these two petitions were quite similar. The selling price for the majority shares in each instance was substantially higher than the market quotations, which latter, of course, ruled for the stock of the minority shareholders. And in both cases these minority shareholders protested vigorously that, in consonance with the first recommendation of the Federal Securities Com- mission above cited, each railroad purchasing a majority of stock in another company should be required to extend the same offer to the holders of the minority shares. Answer to this contention was made by the petitioners that, while such an agreement might properly hold where the transaction MINORITY RIGHTS 451 created a new relation between the controlling interest and the remainder, in these instances no real change in this regard would ensue. For, obviously, the minority interest in the hands of one parent company would be no more powerless than in the hands of the other. Moreover, as the New Haven contended, if it was compelled to make a imiform price for all the shares of the Ontario road rather than merely a majority — making a difference of about $13,000,000 in the cost of the transaction, — it would not consider it financially advisable to make the sale. The New York commission in these cases dechned, on the one hand, to permit the sale of the Ontario & Western to the New York Central; but, on the other, disregarded the pro- testing minority and gave its assent to the purchase of the Rutland road by the New Haven at a price for the majority shares distinctly higher than the market quotations.' In differentiating the two cases the reasoning of the Securities Commission was carried a step farther, in emphasizing the traffic considerations instead of confining its attention to the mere difference in purchase price between the two classes of holders. The possible oppression of the minority by con- trolUng interests was fully recognized; but it was pointed out that in this regard the two cases were quite dissimilar. For, whereas the Rutland Railroad for many years within the New York Central system had been competitive with other lines of that company, and consequently might have been, as it was alleged, starved through diversion of traffic elsewhere; on becoming an extension of the existing fines of the New Haven system to the northwest, its foster-parent would most naturally prosper by its own development and utiHzation to the full. The two principal means by which a controlled property might be starved are either through diversion of traffic from its fines or else through shrinkages of its proportion I 3 P. S. C, 2nd D. (N. Y.), 261, etc. Cf. facts cited in U. S. Bill of Complaint in the New Haven dissolution suit, July, 1914, p. 52. 452 RAILROADS of joint through rates. Within the New York Central system, the Rutland might conceivably suffer in both of these ways. As an extension of the New Haven system, only the latter pohey might in any case be adopted to its disadvantage. Con- sequently, the minority shareholders would presumably be benefited by the transfer even if they were denied the ad- vantage of sharing in the favorable purchase price for the minority holdings. On the other hand, in the case of the Ontario, Western transaction, the above-stated considerations did not apply. As before, the minority interest by itself would be as powerless in one control as in the other. But in this case the minor company traversed directly the heart of New York Central territory; so that the possibiUty of its practical retirement as a complete through line from New York city to the Lakes was imminent. It was held, moreover, that the ener- gies, credit and resources of the larger company should properly be directed to the solution of its other pressing problems. Whatever legislation occurs in future, whether by the states or the Federal government, should clearly make pro- vision for the protection of minority shareholders.^ Mere cumulative voting for directors on the principle of certain proposed reforms in the laws respecting the suffrage, in order to curb the tyranny of political majorities, might do some- thing. But there should also be limitations upon intercor- porate shareholdings, at the discretion of the regulative body, not calculated to interfere with the pubhc interest but rather to bring about a complete disclosure of the manner in which the public interest requires a sacrifice, if any, of the rights of the minority. Any general plan for Federal incorporation of railroads ought certainly to contain provisions of this sort. What statutory regulation may properly be applied in the matter of intercorporate stock holdings? All authorities are ' Cf. dissenting report to Draft Bill for Regulation of Public Utilities, National Civic Federation, October 23, 1914. C/. Cong. Record, XL, 1910, p. 6159 #. INTERCORPORATE RELATIONS 453 agreed upon the need of full publicity. All the financial de- tails of every act on the part of carriers should become a matter of pubUc record. The Federal Securities Commission of 1911 wisely emphasized the vital need of such revelation. Holding companies, particularly, which have sought to evade the enlarged powers over accounting of the Interstate Commerce Commission since 1906 should be promptly brought to book.^ Somewhat more debatable is the proposition to forbid all intercorporate stock holdings. The Attorney-General of Ohio in 1907, since followed by other eminent authorities, has stoutly urged legislation of this sort. But it appears as if such a prohibition, apphed to common carriers, might be too drastic.^ Were it indeed to force a substitution of indissoluble mergers for looser forms of combination, real evil might result. On the other hand Federal incorporation, carrying the right to construct and operate across state hues, free from interference by local authority, might, perhaps, ehminate one of the strongest reasons for the existence of compHcated intercorporate relation- ships. Too much must not be expected of any prohibitory — that is to say negative, — enactments. Experience with the so-called Commodities Clause of the Act of 1906, pro- hibiting railroads from engaging in any other business than transportation, has certainly been disappointing. For, as already hberally construed by the courts, this does not seem to exclude, but rather to invite, intercorporate stock holdings.' Complete subjection of all rights of carriers to emit securities to the authority of the Interstate Commerce Commission also involves many difiicult questions of detail, particularly in view of the present chaotic legal situation, the conflict of state • C/. the dissenting view in the National Civic Federation Draft Bill, October 23, 1914. 2 Many state laws already prohibit stock ownership in competing lines. The Administration bill in 1910 originally allowed a raikoad ah-eady owning a majority of stock in another to acquire it aU. 3 Effects described in om' Railroads: Rates and Regulation, p. 552 efseq. Later experience in Eliot Jones, op. cit., p. 187 ff. 454 RAILROADS laws with one another and with the Federal statutes. On the whole, one finds most comfort in the proposition of the Federal Securities Coromission of 1911, recommending im- reserved publicity. Its due enforcement would imdoubtedly thwart the purposes of the dishonest promoter or speculative management, without occasioning serious embarrassment to straightforward financing. The Chicago & Alton and some of the Union Pacific episodes would never have occurred; while constructive poUcies might freely have been pursued. Some measure of private gain might have been cut off; but the gen- eral stockholders and the pubhc would have been far better off. Since writing the above, the Democratic majority in Con- gress has enacted an important measure amending the Anti- Trust law at many points.'^ Although primarily directed to the regulation of trusts it contains a niunber of provisions dealing with the corporate relations of railways. As originally introduced, interlocking directorships were absolutely prohib- ited in every form. ^ But fortimately this absurd and drastic measure was toned down considerably. For connnon carriers as in other fines of business, no person, under the law as en- acted, may at the same time serve in any responsible position including the directorate, who has at the same time any direct or indirect interest in any other connection which may conflict therewith to the amount of more than $50,000' in any one year; unless all such deafings shall be by competitive bidding after due pubfic notice including full details as to the per- sonaUty of those jointly concerned.' Banking institutions, originally included in this section, were subsequently stricken out. Whether private banking houses which are just as truly supply men as those who sell rails or coal are also prohibited '■ Based upon the Report of the Senate (Clayton) Judiciary Committee Report; 63rd Cong., 2nd sess., H. R. Rep. no. 627. Outlined as to rail- roads in Qvarterly Journal of Economics, vol. XXIX, 1914, p. 81 et seq.; and Amer. Economic Review, March, 1915. ^ Cf. F. H. Dixon in Journal of Political Economy, XXII, 1914, pp. 937-955. ' Cf. 31 I. C. C. Rep., 61, for the New Haven. INTERCORPORATE RELATIONS 455 from duplicate service is not perfectly clear.i Full reports are required in all such connections to the Interstate Commerce Commission. Intercorporate stock ownership is also regulated, although less drastically than in the case of trusts. Raiboads are specifically allowed either to control, or to aid in the con- struction of, subsidiary lines wherever no substantial competi- tion exists. The Interstate Commerce Commission itself, in connection with this legislation of 1914, submitted to Congress the text of a bill making it unlawful for any common carrier to acquire an interest in another transportation company by any means whatsoever without prior administrative approval. It expressed a preference for such legislation over a statute conferring general authority in the matter of security issues. But no action along this fine has yet been taken by Congress. The final provisions of the Clayton Act, which affect rail- roads, taking a lesson from the corrupt chapters of New Haven and Rock Island finance, had to do with the individual Ha- bihty of responsible officers or directors. Whether it is possible to add force to the prevailing common and statutory law, and particularly whether the abuse of inert directorship can be bettered by such means, is not yet clear. ^ The fact remains that however violative of freedom and independence, and however contrary to both law and equity, interlocking direc- torates and stock ownership may be, relief must ultimately come from an aroused pubhc sentiment, coupled with extreme vigilance on the part of the administration. Conceivably the enforcement of personal habihty of directors might even add to the prevalence of dummies. The greatest hope for the future must be the force of public opinion as stimulated and rendered effective by entire pubhcity in every domain of the business. 1 Cf. Pujo Report, 62nd. Cong., 3rd sess., H. R. rep. no. 1593, p. 55 et seq. 2 Cf. especially Harvard Law Review, vol. XXVI, 1913, pp. 467-492. The outcome of criminal suits against the New Haven directors, instituted in November, 1914, in view of President Roosevelt's express approval of its merger policy, may not yet be predicted. CHAPTER XIV COMBINATION: EASTERN AND SOUTHERN SYSTEMS Progress of combination historically, 456. — Steady enlargement of oper- ating units, 457. — Effect of the depression of 1893-'97, 458. — The strategy of the decade to 1910, 459. — The subsequent marked qui- escence, 461. The transportation problem in New England, 462. — Relations with out- side roads, and intricate and retail traffic, 463. — Results of traffic density, 465. — The first phase of combination, followed by consoli- dation to the second power in 1907, 466. — Monopoly of water trans- portation, 469. — The political and legal struggle, 470. — Why did monopoly fail? 471. — Financial, pohtical and moral offences, 472. Combination in Trunk Line territory, 473. — Rise of the Vanderbilt system, 474. — The Pennsylvania described, 476. — Secondary roads, a menace to stabiKty, 479. — Control of the lesser trunk lines and coal carriers, 480. — Financial disentanglement after 1906, 480. — The fiscal outcome of inter-raUway investment, 483. — Latest tendencies in this field, 485. Combination in the southeastern quarter of the United States, 486. — The economic and historical background, 487. — The Louisville & Nashville-Atlantic Coast Line transaction, 489. — • Competition now financially circumscribed, 489. RiiLROAD combination in the United States down to the present time may be roughly divided into four periods. In the first, — that is to say down to 1870 — 100 miles in length constituted the maximimi for efficient operation. The Illinois Central, with 700 miles of line, was long considered one of the greatest railroads in the world. Until after the Civil War there was only one road with a length aggregating more than 1,000 miles. This growth began early in the '50s, at which time the Pennsylvania system first surpassed 600 miles in length; and in 1853 to 1858, when the New York Central nucleus was formed by the consolidation of some sixteen independent corporations. In the territory beyond Chicago, the Chicago & Northwestern road operated but 119 miles in 1859, a figure which rose to COMBINATION IN GENERAL 457 upward of 500 in 1866. The inconvenience, both for freight and passenger traffic, incident to these small systems was quite obvious. It is stated that, for instance, a journey from New York to the Mississippi in the '50s involved not less than seven bodily transfers from one car to another. The twenty years down to 1890, at which time 5,000 miles was about the maximum length of a single railroad, cover the second period in the development of the larger transportation units. The Pennsylvania first attained the length of about 4,000 miles in 1880. Two years later the Lake Shore & Michi- gan Southern absorbed its parallel line, the "Nickel Plate" road. Then, when in 1885 the New York Central picked up the West Shore, the Vanderbilt system under common control first attained sizable proportions. Even west of Chicago, the Vanderbilt interest was already strong in the Chicago & North- western, which by 1886 had about 3,500 miles of line. Some 1,500 miles more were soon added in subsidiary properties. By 1889 the Union Pacific owned 2,000 miles of line and con- trolled nearly 4,000 more. Whether the Act to Regulate Commerce of 1887 appreciably affected the growth of large imits or not is entirely obscured in face of the more important direct effects of general prosperity or stagnation. Single systems comprising as much as 10,000 miles of line appeared for the first time after 1890. The Pennsylvania rapidly increased in size to a mileage greater than 7,000. And the interchange of business attendant upon close working agreements and community of ownership between the trunk lines and roads west of Chicago, foreshadowed even closer relationship in future. The changes down to the present time are shown by the following table. The results cannot be given by official data except for what is now a relatively small unit of operation, 1,000 miles of line. But the figures are significant. A steady increase in the proportion of roads of a greater length than this is apparent decade by decade. According to the table, the greatest change ensued in the '80s. 458 RAILROADS But a similar table constructed for operating units exceeding 5,000 or even 10,000 miles in length would imdoubtedly throw the tendencies during the next decade into high relief. The Roads over 1000 Miles Long Number Per cent, of U. S. Mileage 1867 1 7 1877 11 20 1887 28 44 1896 44 57 1900 48 60 1910 54 67 spread of consolidation, especially since 1900, has been so marked that there has been an actual decrease in the number of independent operating roads. During the decade to 1910, 300 more railroads came into being; but the number inde- pendently operated fell from 847 to 829. The period of depression of 1893-'97 retarded for some time the growth of railroad systems. In fact, dismemberment of a number of important properties took place in connection with bankruptcy and reorganization. The Atchison lost the "Frisco"; and the Union Pacific was bereft of the Oregon Short Line. This second system, in fact, was entirely dismembered. The Erie was about the only important property which under- went reorganization, and at the same time successfully resisted the disrupting tendency of financial readjustment.^ Low- water mark in consolidation occurred in 1898 when only 174 miles of line changed hands. It was during these years of depression that the rubbish was cleared away for the con- structive work of consolidation which characterized the ensuing decade. A striking example is the Southern Railway, which already in 1900 aggregated almost 40 smaller railroads in a system comprising about 7,000 miles of line. Preliminary to ' P. 405, supra. COMBINATION IN GENERAL 459 this work, however, was a complete break-up and reconstruc- tion of the Richmond and West Point terminal. Such occur- rences are tj^iical of the decade of the '90s. The working out of the higher strategy in railroad consoli- dation was the most significant feature of American transporta- tion history in the decade to 1910. Within this brief period what now promise to become more or less permanent financial and operating groups, evolved out of the competitive chaos of the period of depression of 1893-'97. Nor was the growth of large units confined to railroading alone. In fact, the rapid rise of great banking units undoubtedly had much to do with the activity in this direction in the railroad field. All the various events of the period naturally dovetail together. Rising freight and passenger rates; growing interest in govern- mental control; hostility to continued favoritism and personal discrimination; the growth of the trusts; it is difficult to determine the order of causation. Combination in every de- partment of commerce was in the air. It was the spirit of the time. But undoubtedly the intimate association of railroads with great banking houses in New York favored, if it did not actually bring about, many of the great combinations. More- over, the return of railroad securities in large volume from Europe as a result of the panic of 1893, afforded a unique opportunity to great financiers to acquire control of properties and thereafter to shift them bodily from hand to hand as inclina- tion and opportunity dictated. Speculation in earlier years was more largely confined to sales of stocks and bonds; now it became common to buy and sell entire railroads through transfer at one time of controlling portions of their shares. As one witness in an important transaction put it, — "We bought the Louisville & Nashville just as you would buy a box of candy. It was wrapped up and delivered to us, and we paid $50,000,000 for it. That was all there was to it." Popular attention was to some degree focussed upon the course of consolidation by reason of this highly accentuated control by bankers or stock- 460 RAILROADS exchange houses, with the attendant speculative activity on a large scale to which attention has already been called.^ The course of consolidation during the last twenty years for the whole country is exhibited by the following diagram, based upon data of the Interstate Commerce Commission. The solid black line indicates the mileage annually merged or consolidated in terms of the left-hand scale. The right- hand scale shows by the dots the companies whose identity — MERGER AND CONSOUDATION 18SZ- JDflD ■t3 1 \ Z 6000 7000 / \ / ? P / \ / a, ? a / \, / 1 6000 3 / \ 1 / i a- t /,/ \ v / 3000 t> s \ '/ •. / *-. \ ^ s / / \ \ — ; '■' V y / ■■:} y' <^- \ -_ •• / 1695 1900 190S 1910 Solid line indicates mileage. Dotted line shows number of companies was affected by such transactions. Both curves emphasize the prominence of railroad combination from and after 1899. Within four years, that is to say down to the panic of 1903, 410 railroads aggregating about 32,000 miles of line owned, were thus merged and consohdated. But even these figures fail to show the extent of the movement. The chart is useful as exhibiting fluctuations year by year. But it does not include the large number of combinations which took the common form of mere purchase of capital stock without actual merger. And, as we have already seen, most of the great systems came to be articulated in this way. Thus, the earlier ^ Chap. VI, supra. On banking affiliations, c/. p. 424, supra. COMBINATION IN GENERAL 461 systems which during the '90s rose to a maximum of 10,000 miles of line, were superseded by financial groups controlling from 15,000 to 20,000 miles of line apiece. The suddenness of the outbreak of combination with the return of prosperity about 1898 may be judged from the state- ment of the Interstate Commerce Commission that "disregard- ing mere rumors and taking account of well-authenticated statements, there were absorbed in various ways between July 1, 1899, and November 1, 1900, 25,311 miles of railroad. There are in the whole United States something less than 200,000 miles of road; more than one-eighth of this entire mileage was, within the above period, brought in one way and another under the control of other Imes." The Rock Island was a leading instance. With 3,800 miles of line in 1901, its length rose within less than five years to a total in excess of 15,000. The highest flight of railroad combination occurred, as we shall soon see in detail, in the final exploits of the late E. H. Harriman in 1906, in investing the proceeds of his specu- lative operations with Union Pacific funds in the stocks of other railroads all over the United States. Absolutely control- ling nearly 25,000 miles of line, the Union Pacific stock holdings powerfully influenced over 30,000 miles in addition; while other Harriman alliances indirectly affected some 16,000 miles over and above this. A stupendous and top-heavy pyra- mid was thus erected comprising perhaps one-third of the railway net of the United States. The death of Harriman in 1909 put an end to this dangerous tendency toward combina- tion which seemed to have no limits at the time. There is every indication that the combination movement was brought to a close by a process of financial exhaustion. In how far the size of the resultant unit conformed to the demands of operating efficiency seems open to question. For a time it seemed as if the railroad groups were so firmly estab- lished and well-defined by mutual agreements of the parties in interest, that they might be regarded as more or less perma- 462 RAILROADS nent. Even the new and undeveloped territory appeared to be partitioned off by treaty and alliance. The shifting panorama of years of struggle for supremacy promised to be succeeded by a sort of stable equilibriiun. Something akin to the balance of power in Europe was indicated; whereby any wholesale readjustment of relationships within a single system might entail too great results upon other financial or operating groups to be permitted to occur. But prophecies to this effect failed to reckon with two human and political certainties. Foremost among these was the frailty of man's existence. The deaths of Harriman in 1909 and of Morgan three years later removed the main-springs of constructive effort in the direction of consolidation. And the rising hostility of the public to monopoly was exemplified in increasing pressure by public authority under the Sherman Anti-Trust Act. And then again, all of the financial excesses of the frenzied years of speculation came home to roost along about 1910. In response to all of these influences certain of the great consolidations, as we shall see, began to go to pieces. The Gould system died of inanition; the Rock Island, of internal corruption; and the Union Pacific and New England monopolies by man- date of the Federal Department of Justice. How far back the pendulum will swing in the direction of dissolution it is difiicult to foresee. But a cycle of development of extraordi- nary interest to the economic student in all its interesting details bears every indication of approaching completion. The transportation problem of New England is .unique.' As an economic unit it is on the far outskirts of the central commercial territory of the United States, for many years debarred by a high protective tariff from intimate trade rela- 1 Among the ofBcial sources for New England the following are to be noted: 27 I. C. C. Rep., 560; 31 id«ra, 31; Original Petition, U. S. v. N. Y., N. H. &. H. R. R., District Court U. S. So. Dist. N. Y., pp. 104 with maps; Review of the New England Traffic Situation, Boston Chamber of Commerce, 1913. Cf. also references pp. 251 and 442, supra. NEW ENGLAND MONOPOLY 463 tions with the neighboring background of Canada. Highly developed industrially, it is nevertheless divided from the great non-manufacturing and consuming regions of the West and South by the competing manufacturing states of New- York and Pennsylvania. Remote also from coal and iron deposits, its industrial activities must be confined to the less bulky, highly speciaHzed forms of manufacture, in which the element of labor cost outweighs that of mere raw material or cost of transportation. It is densely populated, its main asset being its ample supply of high-grade labor. Thickly dotted with large cities and towns, passenger business is of equal importance to its railroads with the carriage of freight. The main problem of its railroads, viewed broadly, therefore, must ever be to foster these manufacturing industries in two ways: first, by provision for the cheapest possible carriage of raw ma- terials, coal, cotton, iron and steel; and secondly, by ensuring a relatively low cost of living by low freight rates upon food- stuffs. With these two essentials, prosperous industrial condi- tions promised to yield an ample return to the New England railroads in the most profitable business of distributing high- grade New England products all over the United States. The old-fashioned policy used to be to charge all that all the traflSc would bear, whether coal, and steel bars or cotton cloth and hardware. Such a policy accentuated the geographical isola- tion of the region; and rendered it increasingly difficult to maintain competition with the rest of the country. Cotton mills sprang up in the South; shoe factories in the Middle West; and many of its iron manufactures disappeared entirely. A far-sighted policy would make the furnishing of cheap food- stuffs and raw materials almost a charge upon the carriers; for the sake of stimulating the production of those high-grade manufactiu-es which yield most profitable traffic in return. The first essential, theoretically, in carrying out 'the pro- gramme outlined above, would be to create transportation agencies in New England, large enough and powerful enough 464 RAILROADS to deal with other connecting railroads on even terms. Form- erly, with disjointed and independent railroads outside of New England imder conditions of keen competition one with another, foreign negotiations and alliances were not disad- vantageously conducted. If the New York Central refused to concede fair proportions of a joint through rate, it was possible to turn to the Erie or the Pennsylvania. But with the forma- tion of great systems after 1900, and especially with the disap- pearance of competition among carriers throughout trunk-line territory, the small New England roads found themselves greatly handicapped in protecting the interests of their clients. It seemed essential that all the weight of a united New England system should be massed, in order that its special territorial transportation rights should be safeguarded. Such was cer- tainly a strong incentive toward combination of all the New England railroads under one powerful leadership. Another equally powerful factor in bargaining with connections, west and south, was the independent possession of alternative routes to important interior points. Not alone a substantial monopoly within the home territory, but the actual control of such independent lines to the coal fields, to the Great Lakes and the Saint Lawrence, as should insure respect and fair treatment, seemed essential to the success of a broad progressive policy. Another peculiarity of New England, from a transportation point of view, is the intricate and retail character of much of its commerce. Its highly specialized manufacturing centres demand free and easy communication in every direction for their fullest development. Not great shipments of staple commodities over long distances, east and west or north and south; but convenient and efficient articulation of related manufacturing centres is needed. Prompt delivery of shoe machinery from Beverly in Brockton, or of hardware from Worcester in Lynn, was essential. Interlacing cross routes, a multiplicity of junction joints, combined with the retail char- acter of much of the traffic, were naturally productive of delay, NEW ENGLAND MONOPOLY 465 inconvenience and a high cost of operation, not alone for the railroads but for manufacturers as well. Yet general and orderly routing of freight was diflSicult under separate and often competitive railroad administrations. And bodily transfer both of freight and passengers at Bdston, the meeting point of all lines, was an insuperable obstacle to promptitude and efficiency. Consolidation of lines radiating from this centre to all parts of New England, with every facility for direct physical connection, avoiding the necessity of congestion at this point by means of the establishment of handy junction points outside, promised, theoretically, abounding and valuable results. The very density of traffic, particularly of passengers, in New England territory constituted in itself a certain menace to the steam railroads. With the growth of inter-urban trolley lines, the railroads were threatened with the loss, not only of much of their local passenger business but of their high-grade and lucrative less-than-carload traffic as well. Many of these local enterprises sprang up all over New England after the middle of the '90s; and then, a decade thereafter, began to artic- ulate into formidable competitors with the railroads even for considerable distances. These trolley lines seldom cost $15,000 a mile to build, whereas the railroads were capitalized, — and honestly so — anyivhere from three to ten or more times as much per mile of line. These street railroads, of course, could not furnish through passenger service, nor could they carry bulk freight; but, on the other hand, they threatened to capture much of the express service, the light freight business and local passengers, by rates prohibitively low to the steam roads. The trolley competition became increasingly keener with the passage of time. Numerous connections were thrown out to the back doors of factories; and the transportation of workmen to or from these establishments was captured. Much of the highly specialized manufacture going out in small package shipments, roads like the New Haven were soon left with the unenviable burden of supplying coal to the factory at six mills per ton VOL. II — 30 466 RAILROADS mile, — an unremunerative rate — and then of taking what bulk freight the shippers found it inconvenient to turn over to the trolleys. Two remedies for this situation were at hand. One was to meet this competition by a quick appreciation of the demand for prompt and cheap service, and thereby forestall rivalry by the very excellence of the steam railroad facilities offered. Such is the policy characteristic of the British rail- ways in supplying the local needs of a densely populated ter- ritory. The alternative was to attempt to throttle this competition or to keep it within bounds by the acquisition or financial control of the light railways, as fast as they appeared upon the scene. In yet another way the wealth of trafiic proved an embarrassment. Freight trains were continually in the way of the frequent passenger service. To transport heavy bulk freight in such a manner as to keep the rails clear for express traffic, necessarily entailed great expense. Many of the economies realized by slow low-grade freight movements in the West were entirely impossible. And, finally, it was urged by the advocates of consolidation, the upbuilding of New England demanded such powerful rail- road combinations as should be able successfully to demand a fair share of the export business of the United States for New England ports, not alone for the profit thereof, but also because without such flourishing export traffic, first-class steamship service for the sake of imports and passenger business would be impossible. Mere export business in itself is of secondary importance, except as it contributes to this end. In short, financial power and the highest operating efficiency, it was said, all depended upon combination carried to the point of com- plete territorial monopoly. The history of the transformation of the old-fashioned and disjointed railroads of New Englai^d into a single monopoly is comparatively recent. Prior to 1900 a most significant feature was the division of the field north and south of Boston between two companies, each of which agreed to respect rigidly the NEW ENGLAND MONOPOLY 467 territory of the other.i The thin line of the Boston & Albany running due west across Massachusetts marked the boiurdary line between the two. On the south during the '90s the New Haven company aggressively picked up all of its competitors as well as all the local disconnected lines. Among the most important of these was the lease of the Old Colony, covering southeastern Massachusetts and including the important Fall River boat line to New York. The next important acqui- sition was the purchase under foreclosure proceedings of the old New England Railroad which operated an air Une between Boston and New York; but which for years had dragged out a miserable existence by reason of the lack of terminal facihties at the southwestern end. Some of the details as to the acquisi- tion of the property afford interesting reading. The methods employed to exclude this direct line from participation in through business were quite discreditable. Among other details may be mentioned an agreement by the New Haven to pay the New York Central $5,000 in ten annual installments, added to the rental of the Grand Central Station, on condition that the New York Central acquire the Housatonic Company which operated a hne of car floats into New York. Thereafter it was part of the plan to close this outlet to the New England line. Progressively during the '90s all of the little properties through Connecticut and Rhode Island were merged in the New Haven monopoly. At the same time in the northern field, the Boston & Maine was actively forging a system of its own, mainly by means of long-time leases gaining a dominant ownership throughout its territory. The Concord & Montreal system, leased in 1895, was among the most important acquisi- tions; but within a few years all of the smaller properties were picked up. The final step was the acquisition in 1900 of the Fitchburg competitive through route to the West along the northern border of Massachusetts. 1 The text of this agreement is in the Original Petition of the U. S. above named, p. 103. 468 RAILROADS A second phase of consolidation in New England began with the twentieth century in consonance with the general move- ment in that direction all over the country. The New York Central extended its lines to Boston in 1900 by a long-time lease of the Boston & Albany. Removal of this independent road left transportation about evenly divided, otherwise, between two great territorial monopolies, each with somewhat over 2,000 miles of Une ramifying out from Boston. Renewed active expansion of the New Haven started in the following year, the first event being the acquisition of the New York, Ontario & Western road. This not only gave direct access to and ownership in the Pennsylvania hard-coal fields, but also, in connection with purchase of the Central New England road, of an independent Une to the Great Lakes and a new trade route across the Hudson river. The acquisition within three years of almost all competing or connecting electric trolley Hnes throughout Connecticut, Rhode Island and Western Massachusetts was next in order.^ This step was followed in 1907 by the most important act of all, the purchase through exchange of stock of a practically controlling interest in the Boston & Maine road. Thus the two territorial monopolies were welded into one, the only remaining independent line into Boston being the Albany-New York Central line. In 1911, by a co-operative arrangement whereby profits or losses of the Albany road were to be shared ahke between the New Haven and the New York Central, this fine was also brought within the combination; and at the same time by purchase of the Rutland Railroad, the New Haven gained an outlet both to Lake Ontario and Montreal. This route, with the Ontario & Western, it was alleged, guaranteed an independence of other connections of great importance as a factor in sub- sequent strategy. In this cormection, it should be added, a New Haven alliance with the great Pennsylvania system, particularly in view of an approaching physical connection ' On the financial methods employed, vide p. 251, supra. NEW ENGLAND MONOPOLY 469 by tunnel under New York, was believed by many to be imminent. » The creation of a transportation monopoly in a territory geographically circumstanced Uke New England, necessitated the control of steamship lines as well as railroads.' In 1893 New England water transportation was done by twenty boat hues operated by seventeen companies. Most of these were independent, ranging all the way from local enterprises on Long Island sound to companies operated to the Provinces on the north and as far as Virginia and Georgia on the south. After 1893 nine new boat Unes were established; but as a result of the aggressive poUcy of the New Haven company twenty-two of these were bought up within a very few years. Some of these were acquired fairly and openly in the public market. Others were bludgeoned into parting with their properties by the most unfair sorts of competition. All of the efforts of the Boston Chamber of Commerce to secure the estab- lishment of lines to Texas and elsewhere were blocked by the steady opposition of the railroad monopoly, which sought thereby in the interest of New York or of its connections to throttle such independent enterprises. And, on top of it all, in order to close the way forever to the development of coastwise transportation, the New Haven company by all sorts of devious means bought up and controlled all of the available water front, not only in Boston but all along the seaboard of New England. The result was within a few years to bring about an absolute control of approximately 90 per cent, of the water transportation to, from and among the New England states. The rapid and widespread progress of consohdation above described, naturally occasioned the utmost concern to shippers 1 Best outlined in Original Petition U. S. v. N. Y., N. H. & H. R. R., District Court U. S., So. Dist. N. Y., pp. 59-76; a Review of the New England Traffic Situation, 1913, Report by D. O. Ives to the Chamber of Commerce, Boston. The U. S. Bureau of Corporations on Transportation by Water, pt. 4, 1913; 21 I. C. C. Rep., 560, 31 idem, 31; Boston Tram- script, May 16, 1914. 470 RAILROADS and the general public. A bitter political struggle ensued, in the coiu'se of which almost a legal deadlock- was reached. Deli- cate questions of state regulative rights were raised between Connecticut and Massachusetts; and even the Federal author- ities intervened by proceedings to compel dissolution under the Sherman Act.' For years it had been contrary to the established policy of Massachusetts to allow steam railroads to own trolley lines or, for that matter, to permit one steam railroad to control another. The pursuance of the New Haven policy of street railroad control, first begun in Connecticut, was speedily brought to a test judicially when extended over into Massachusetts territory. And a decree was entered in 1908 by the Supreme Court, enjoining the New Haven from further acquisitions or from continuing to hold such stocks after July 1, 1909.^ This promptly brought the- New Haven to terms, and a working compromise resulted in the following year. Massachusetts gave its consent to the continued control of the Boston & Maine, but required the intervention of a Massachusetts holding corporation, subject to the regula- tive power of the state, to serve as a financial nexus between the two great territorial monopolies lying to the north and south.^ The New Haven, on its part, promised substantial improvements in service and ostensibly acceded to the popular demand for abstention from political activities. Its Boston & Maine holdings, deceitfully sequestrated for a time* in private hands, were transferred to the newly approved holding company. Its finances were officially investigated and ap- proved by a so-called validation commission.^ The way, as it appeared, was thus paved for the introduction of such econ- omies in management and betterment of service as should promote the welfare of all parties concerned. Efficient monop- > Well outlined in Boston Transcript, June 18, 1910. Cf. p. 571, infra. " Att'y-Gen'l, etc., v. New Haven, etc., 198 Mass., 413. ' Financial details at p. 415, supra. « P. 255, supra. ' Of. p. 358, supra. NEW ENGLAND MONOPOLY 471 oly, instead of wasteful competition, was oflBcially recognized' as a public policy for the future. Only one detail was lacking for a well-rounded programme. This was the important corollary to acceptance of the monopoly principle, that it should be accompanied by the fullest exercise of powers of regulation and supervision by the state. This did not come until 1913, in the creation of a new pubUc service commission, after another bitter political campaign in which every agency of corruption was employed by the New Haven, then tottering to its fall, to thwart the will of the people.^ In view of the foregoing theoretical advantages of trans- portation monopoly, why did the New England experiment so completely fail in practice? Was it due to the inherent defectiveness of the monopoly poUcy, in and of itself, or to the means which were employed to put it into effect? Why, superficially promising so fair, did a few years' experience result in a catastrophe of the first order? Losses on every side occurred. Both principal and income were lost to stock- holders, and all adequate service to the commimity as well. The outcome is bound to be of far-reaching effect upon the future pohcy of the state respecting competition among carriers. The projected New Haven combination broke down utterly because it was an attempt to create a monopoly regardless of cost. The financial plans were not only reckless in the ex- treme, but in many respects dishonest as well. It is the same old tale, repeated time after time, of the bankruptcy which is bound to follow improvident financial management. It is one thing to acquire competitors in the interest of the economies attendant upon monopoly at fair and legitimate prices. It is quite another matter to purchase them, as the management was aptly described by an observant banker as doing, "like a drunken miUionaire," regardless of first cost and reckless as ' Report, Mass. Commission on Commerce and Industry, March 18, 1908. 2 P. 300, supra. 472 RAILROADS to the fixed charges or the effect upon free income available for the development of public service. Both the financial and operating management of the New Haven under the Mellen- Morgan rSgime was more than xmwise; it was corrupt.^ Nor did this corruption stop at secret profits to insiders. Despite the fairest promises of abstention from politics, every principle of political decency w;as violated down to the last moment of control. Wholesale bribery, veiled in various ways, of members of the legislature, of the press and of in- fluential citizens, was resorted to, in a vain endeavor to "jam through" legislation and stem the rising tide of outraged public opinion. Corporate accounts were falsified; unearned dividends were declared; solemn engagements of every sort were broken; and, to cap the cHmax, the chief offender, devoid even of a sense of honor among rascals sought personal immu- nity from Federal prosecution by "peaching upon his pals." Lasting obloquy should attach to the name and reputation of every one, from the president down, responsible for this great financial catastrophe. One of the most depressing aspects of the New Haven collapse was the entire absence of a sense of accoimtability on the part of the administration, either to the public on one side for transportation service, or to the shareholders on the other for protection of their investment. No obligation of trustee- ship is apparent either in the financial or operating department. The local constituency, whether of merchants or travellers, was persistently offended by blimdering attempts to sacrifice the interest of New England to those of New York. The axiom that you cannot operate a line in an enemy's country was entirely disregarded. It seems to have been believed that a campaign of falsification, and subornation of perjury, coupled with a dash of bluff and bluster, could be relied upon to deceive the intelligent pubfic, in the face of a complete break-down of service and an obvious and growing financial strain. Whether 1 For details, cf. pp. 251, 442, etc., supra. TRUNK LINE COMBINATION 473 it is fair to judge of monopoly, as to its possible advantages in an operating way, by this unhappy affair is beside the main point. Certainly, in absence of competition, no wholesome rivalry productive of adequate service can be expected with- out either an exalted sense of responsibihty and trusteeship on the part of the management or vigilant and effective public supervision. Absolutism, even if the autocrat be well-wishing, is at variance with the spirit of American institutions. The New Haven disaster goes far to justify the popular distrust of any imdue concentration of power, even if, for the time being, the promised results did fail to follow. Once and for all in New England the question seems to be settled that even an honest transportation monopoly is inimical to the best public interest. A clear comprehension of the recent progress of consolida- tion in Trunk Line territory, — that is to say in the populous states east of the Mississippi and north of the Ohio, — requires that it be considered in three parts.^ Two great companies, rooted respectively in the states whose names they bear, — the New York Central and the Pennsylvania railroads, — covered this territory in 1900 with a net-work of interlacing branches.^ Of these, as widely extended systems, the Pennsylvania was the older. Its principal outlines dated back to the '70s; whereas the New York Central with its main stem and many of its present lines equally old, was not financially co-ordinated imtil about 1900. Each of these two companies is in its internal development a study by itself. The third and perhaps the most interesting phase of trunk line consoUdation consists of the mode in which these two great rivals, having each built up a great system of its own, undertook to co-operate for the 1 Only two official references exist: The Special I. C. C. Report on Intercorporate Relations of Railways, 1908; and 59th Cong., 1st sess., H. R. Doc. no. 475. For the rest one must glean from the technical rail- way and financial journals. 2 Cf. maps at pp. 475 and 477 respectively. 474 RAILROADS practical elimination of all competition from the host of other and lesser railroads within this area. For these other roads reached out from New York and Philadelphia toward the west and continually threatened the stability both of rate and financial structures in the entire district. It was regarded as essential that they be brought under common control. The New York Central system remained imtil 1898 an end-to-end consolidation of many small connecting roads between New York and Buffalo. (Map opposite.) These followed the only water-grade line between the seaboard and the interior, closely paralleling the Hudson river and its main western tributary, the Mohawk. It was controlled by and largely administered in the particular interest of the Vanderbilt family. It was heavily capitalized and most conservatively operated. Such relations as it had with connecting hues beyond New York state were conditioned by the dominant position of its wealthy owners in the affairs of other railroads. The initial, and by far the most important, change occurred in 1898, — an event which laid the foundation for much of the subsequent expansion. This was the purchase of the Lake Shore & Michigan Southern Railway, extending from Buffalo to Chicago south of Lake Ontario. It also, incidentally, created a second direct Hne to Chicago, inasmuch as the Lake Shore already owned the so-called Nickel Plate line and the New York Central had already for many years leased the West Shore road, — both of these having been built about 1882 closely parallehng the then-existing lines. An offer to exchange New York Central 3§ per cent, bonds for stock of the Lake Shore road at $200 per share, was widely accepted; and subse- quent purchases of the still outstanding Lake Shore stock have rendered the stock ownership almost complete.' The opera- tion was financially simple and set a pattern for much subse- quent consolidation all over the country. The New York Central bonds were of thef collateral trust variety, secured by ' Pp. 146 and 416, supra. TRUNK LINE COMBmATION 475 476 RAILROADS the deposit with trustees of the acquired Lake Shore stock. The funds for this expansion thus cost 7 per cent.; so that any returns on the purchased stock above this figure would accrue as profit to the New York Central company. So successful was the first exchange of stock for New York Central bonds, that the Michigan Central railroad was taken over, thus providing a third direct line to Chicago, north of Lake Ontario. Thereafter it was important to reach St. Louis and the intervening territory of Ohio, Indiana and Ilfinois. This was effected by the acquisition in 1900-'01 of the Big Four road and the Lake Erie & Western. But it is significant of the relative financial looseness of the system, and of its dependence upon the Vanderbilt family, that the Lake Shore road for many years, at least, held only approximately 40 per cent, of the common stock of the Big Four road. At about the same time the Pittsburg & Lake Erie and the Boston & Albany railroads were added. In this mamier a company controlhng about 3,000 miles of Une was within a very short time expanded to approximately four times that figure. Offi- cially this was the extent of the New York Central system; but practically it derived greatly added strength from the control by the aid of the Vanderbilt family of the great Chicago & Northwestern road. This property gridironed the territory north and west of Chicago, extending out to the Rocky Moun- tains. It also possessed the most direct Hne to Omaha, giving the best connection with the Union Pacific for San Francisco. Thus adding some 9,000 more mileage, an aggregate resulted for the Vanderbilt system of about 22,000 miles of hne. By contrast with its great rival, above described, the Penn- sylvania system is both financially and territorially more compact. (Map opposite.) It has no afiiUations beyond the Mississippi; and actually owns instead of leasing a larger part of its operated property. Pennsylvania expansion was marked in 1900. First came the absorption of the Erie & Western Transportation Company, giving greatly enlarged facilities TRUNK LINE COMBINATION 477 -i—^i^ 478 RAILROADS upon the Great Lakes. This was followed by the acquisition of the Western New York & Pennsylvania, which, by the con- trol of a majority of the stock, gave an independent outlet to the Great Lakes at Buffalo. Two months later the Allegheny VaUey Railway was taken in, adding 820 miles of line to its holdings. In the spring of the same year a majority of stock of the Long Island Railroad was purchased; and far-reaching plans were made for improvement of terminal facihties at New York. In 1901, also, came absorption of the railway hues to Washington and Richmond. Yet even with all these additions, the total mileage is scarcely more than half that of the Vanderbilt group. The striking feature of the Pennsylvania system is the concentrated nature of its traffic. Traversing a populous manufacturing section, its mainstay is an enormous coal, and steel and iron toimage. The New York Central is more de- pendent upon the great staple agricultural products of the West. While the Vanderbilt system was expanding widely, the Pennsylvania to a greater degree concentrated attention upon the costly problem of terminals at New York and of closer connection with the rich New England territory. Com- pactness; provision for such adequate service within its own domestic territory that rivals might not hope to gain foothold; and careful safeguarding of its dividend position were the main features of its policy. In one regard the corporate organiza- tion apparently served as a model for the Vanderbilt lines. For many years it has maintained a dual corporate existence. The ownership of all its properties west of Pittsburg is vested in the Pennsylvania Company, all the stock of which is owned by the Pennsylvania Railroad. This dual form was practically adopted by the New York Central with the acquisition of the Lake Shore road. For that company served its largest stock- holder as a convenient repository for most of the investments of the systefti in subsidiary hnes west of Buffalo. The con- venience of this plan of organization for subsequent develop- ment was soon demonstrated. TRUNK LINE COMBINATION 479 Stability of traffic conditions in Trunk Line territory used to be at all times endangered by the competition, real or poten- tial, of the lesser independent trunk lines and the hard and soft coal roads. There were three through routes to the west to be considered: The Erie, the Baltimore & Ohio and the Chesapeake & Ohio, naming them in order from north to south. The location of the Baltimore and the Chesapeake lines is shown upon the map of the Peimsylvania system, pier- cing the Appalachian highlands by lines directly west from the northern and southern ends, respectively, of Chesapeake Bay. The Erie and the Baltimore & Ohio, until reorganized after the depression of 1893-'97, were in a state of chronic indigence. Having little to lose, they had everything to gain from rate cutting, which of course immediately forced the two great companies to follow suit. Five or six coal roads, located as shown by the map at p. 535, were also highly disturbing fac- tors, partly for the same reason. But certain of these roads were troublesome also, because, while supported mainly by their coal earnings, they could continually reach out for addi- tional trunk-line business at rates ruinous to competitors dependent mainly upon that traffic. Nor was the power thus to disturb trunk-line rates confined to the lines north of Balti- more. Traffic from the seaboard to Chicago might move by round-about routes as far south as Asheville, North Carolina.^ Both the Chesapeake & Ohio and the Norfolk & Western roads were necessarily comprehended within any plan aiming at stability of tnmk-Une rates as well as of enhanced prices for coal. And up to the north as well, other independent roads Uke the Ontario & Western, or Delaware & Hudson, were always open to arrangements for devious through routing from the west by way of the Canadian connections. More- over, it was also clear in 1898, that great economies and profits might result from the creation of a tight transportation monop- oly in this field. With hard-coal prices maintained by a firm 1 Railroads: Rates and Regulations, chap. VIII. 480 RAILROADS hand, and modem methods of transport adopted, these com- panies might be extricated from a financial slough. Subsequent events have amply justified this belief; but it seems probable that the decision of the two great companies to control their lesser rivals was mainly due to a desire to regulate the trunk- line rate situation. Control of hard and soft coal prices fol- lowed, rather as an after-thought and a rich by-product than as a primary motive. The plan for controlling the lesser roads assumed the form of a secret Vanderbilt-Pennsylvania compact. It was carried into effect during the five years after 1900. By this agreement the New York Central, through its agent the Lake Shore road, was to protect the anthracite coal situation; while the Penn- sylvania on its part was to attend to the soft-coal roads. In either case, it was important to avoid the express prohibitions of law as to the merger of parallel or competing lines. This was done by adopting the western portion of the dual New York Central organization as a financial agent; while the Pennsylvania made use of another subsidiary. The Penn- sylvania road took the initiative, and first made substantial investments in the Baltimore & Ohio, Chesapeake & Ohio and Norfolk & Western roads, — all soft-coal properties. Then in 1903 the Baltimore & Ohio, in turn, was caused to invest heavily in the dominant hard-coal road, the Reading. These holdings it proceeded to share with the Lake Shore as agent of the New York Central. The resulting interlocked situation is graphically represented by the accompanying diagram.' The process of absorption, above described, was in full swing, when within two years after 1903, there followed in quick succession the Northern Securities decision of the Supreme Court setting bounds to the use of holding companies, searching investigations by committees of Congress and the Interstate Commerce Commission, and finally the campaign of President Roosevelt for effective legislation to control railroads, ending 1 Details in table on p. 150, supra. Cf also Eliot Jones, op. cit., p. 61. TRUNK LINE COMBINATION 481 in the through amendment in 1906-'10 of the Act to Regulate Commerce.! The situation at that time is concisely described in a special report on the subject.^ NEW YORK CENTRAL & HUD5DN RIVER R.RID. OWNS 3o.B%^r sracK ap LAKESHDREaMlCHIEAN SOUTHERN RY. ED. PENNSYLVANIA 5Y5TEM BALTIMDRE &DH1D R.RID. PHIL READ A& PHILADELP ED EDAL READING ED STDEKSl4aDDaDDD "The Pennsylvania system on June 30, 1906, held $73,040,960, or 37.7 per cent., of the stock of the Baltimore & Ohio Railroad Company, and $34,230,000, or 39 per cent., of the stock of the Norfolk & Western Railway Company. This same system shared with the New York Central system a virtual control of the Chesapeake & Ohio Railway Company, the Pennsylvania system owning $15,630,000, or about 25 per cent., and the New York Central system $12,500,000, or about 20 per cent., of the stock. These two great systems extended their sway stUl further and exercised a very potent influence in the Reading company, through the ownership by the Lake Shore & Michigan South- ern Railway Company and the Baltimore & Ohio Raihoad Company of $30,332,500 each of Reading company stock, or a total of 43.3 per cent. It will be recalled from the discussion of holding companies that control of the Reading company carries with it the control of the 1 FuUy detailed in Railroads: Rates and Regulation, Chapter XV, et 2 Intercorporate Relations of Railways; Int. Com. Com., Special Report, 1908. For actual investments and paper profits, mde p. 140, sa-pra. VOL. II — 31 seq^ 482 RAILROADS Philadelphia & Reading Railway Company and the Central Raiboad Company of New Jersey, over whose tracks the Baltimore & Ohio RaUroad Company makes its entry into New York City. The Lehigh VaUey Railroad Company is brought into the circle of interest through holdings of its stock by the Erie Raih-oad Company, the Lake Shore & Michigan Southern Railway Company, the Reading company, the Central Railroad Company of New Jersey, and the Delaware, Lackawanna & Western Railroad Company, the latter a railway closely affiliated with the New York Central system. A majority of the common stock of the Hocking Valley Railway Company, an amount which insures practical control, is held by the Pennsylvania system through the Pittsburg, Cincinnati, Chicago & St. Louis Railway Com- pany, the New York Central system through the Lake Shore & Michi- gan Southern Railway Company, the Erie Railroad Company, and the Baltimore & Ohio Railroad Company." . . "In addition to the minority holdings just described the close affiliation of the principal eastern railways can be still further illus- trated. . . . The stock of the Lehigh & Hudson River Railway Com- pany is jointly held by the Erie RaUroad Company, the Lehigh Valley Railroad Company, the Delaware, Lackawanna & Western Railroad Company, the Central RaUroad Company of New Jersey, and the Pennsylvania RaUroad Company. The Little Kanawha Sjnadicate, which holds the stock of a niunber of West Virginia and Ohio raUways, partly under construction and aggregating about 80 mUes of line, is controlled by the Baltimore & Ohio Railroad Company, the Penn- sylvania RaUroad Company, and the New York Central system through the Pittsbiu'g & Lake Erie RaUroad Company. FinaUy, a coimection is made with the southern group of raUways through the joint ownerstip of the Richmond- Washington Company, a holding company for the stock of the Richmond, Fredericksburg & Potomac RaUroad Company and the Washington Southern RaUway Company, by the Atlantic Coast Line RaUroad Company, the Baltimore & Ohio RaUroad Company, the Chesapeake & Ohio RaUway Company, the Pennsylvania Railroad Company, the Southern RaUway Company, and the Seaboard Air Line RaUway. "The extraordinary concentration of raUway interests shown in the situation on the Middle Atlantic seaboard would lead to the con- clusion that, so far as this group of raUways is concerned, competition has been practicaUy eliminated; for the motive that would lead to the fostering of such a policy has disappeared." I In response to the pressure of law and of aroused public opinion about 1906, the two main trunk lines soon proceeded to lessen their investments. This they were also pleased to do because of the large profits at which they could close out their TRUNK LINE COMBINATION 483 purchases. But in many cases they retained substantial minority holdings, — large enough, it was assumed, to prevent disturbance of the established harmony. In September, 1906, the Penn- sylvania disposed of all of its Chesapeake & Ohio stock, and reduced its investments in Baltimore & Ohio and Norfolk & Western. A purchaser for the Baltimore & Ohio was found in the Union Pacific system; which, as we shall see, was reinvesting the profits of certain speculative operations in Northern Pacific at about this time. The New York Central disposed of its in- vestments in rival hues somewhat later. It did not cause the Lake Shore, as its financial agent, to sell its Reading & Lehigh Valley holdings until 1908; and it did so then, apparently, only because of its own urgent need for funds for improvements on its own lines. Legally, the Lake Shore's position in owning stocks of coal roads and lesser trunk lines east of Buffalo, seemed to be stronger than that of the Pennsylvania. For the latter, in controlling its neighbors, especially the Baltimore & Ohio, was certainly violating the state's interdiction of combination of competing lines. But financially the Pennsylvania road seemed to be in better shape, although it also was sadly cramped in construction of its New York terminals by this diversion of vast simis into investment in other roads. One contrast between the two great systems may be noted at this point. The Penn- sylvania seems to have avoided tying up its hands for the future by refraining from the issue of collateral trust bonds as a means of financing these operations. Selling stock or bonds convertible into stock, it might the more freely dispose of its investments as occasion offered, and at the same time keep the way open for sale of ordinary bonds in case of need. The New York Central financing seems to have been much less scientific both in plan and execution. So far as the fiscal outcome of all these investments was concerned the two great systems were certainly fortunate. They not only enjoyed a substantial rate of return while these stocks were carried in their treasuries, but they were able also 484 RAILROADS to sell them ultimately at much higher prices than they cost. Paper profits at the height of the boom prior to the panics of 1903 and 1907 were in fact enormous.^ But the losses under the low quotations of the periods of depression would also have been considerable. Actually, most of the stocks were closed out at substantial profits. Pennsylvania purchases of Chesa- peake & Ohio stock for example were made in 1899 between $24 and $41 per share and were sold at above $60, — the aggregate profit being about $4,500,000. The Lake Shore paid for Reading stock about $80. It sold 100,000 shares at one time for $110. These are only samples of the fortunate outcome of these in- vestments. They are not cited, however, as an extenuation in any degree of what must be regarded as a most dangerous tendency of the time, — a tendency most extraordinarily exemplified in Union Pacific financing of the period. Happily rate harmony in trunk-line territory having been achieved, partly as a result of this community of interest plan, and in part also because of the vigorous exercise of regulative power by the Federal government, the financial interlocking above described seems now to be considerably disentangled. The Pennsylvania, to be sure, in 1909 repurchased a part of its Norfolk & Western stock; but, on the other hand, the effects of the extraordinary partition of upwards of 25 per cent, of Lehigh Valley stock among its natural competitors in 1906, as revealed in the foregoing quotation, have been distinctly lessened by the subsequent sale in 1907-08 both by the Erie and the Lake Shore of their Lehigh Valley holdings. There is no doubt that the financial solidarity of the entire body of trunk-line roads is as marked today as it was in 1906. But the relation seems to be considerably more personal, through great bankers or banking houses rather than by direct investment by one road in shares of its competitors. For a time unquestionably the dominant influence, especially in the anthracite coal lines, was that of J. P. Morgan and of the powerful New York banks and » P. 150 supra. TRUNK LINE COMBINATION 485 insurance companies which were also within his control. But after his death and with the retirement, official at least, of his successors from the directorates of many of these roads, the semblance of independence became more marked. Whether it is real or not remains in the womb of the future.^ A later phase of consolidation in trunk line territory seems to be associated with the southerly drift of coast-to-coast and long-distance traffic. Geographically, the southern seaports, notably Charleston, are nearer the Middle West than those of the North Atlantic. Baltimore, as so often emphasized in the Port Differential cases,^ is considerably nearer Chicago than is New York. Consequently, outlets and connections by the northern trunk lines toward the south have been sought of late. The New York Central in 1912 by means of a traffic agreement with the Western Maryland, together with a short piece of construction, gained access to Baltimore. And the re- newed investment of the Pennsylvania in the Norfolk & Western may, perhaps, have been influenced by considerations of the same sort. Several independent &nd troublesome roads south of the Great Lakes have also been picked up latterly by the southern trunk lines in order to make water connections to the north. The Chesapeake & Ohio after 1909 constructed a line to Chicago, and at the same time invested heavily in the Hocking Valley and the Kanawha & Michigan,' thus reaching Lake Erie at Toledo. And the Baltimore & Ohio, evidently in pur- suance of the same end, was persuaded to take over the Cin- cinnati, Hamilton & Dayton. Repeated attempts had been made by banking houses for a number of years to unload this decrepit property upon a succession of stronger companies.'* The Erie barely escaped. But it finally found lodgment with the Baltimore & Ohio in 1909; greatly, as might have been fore- seen, to its new sponsor's loss. Thus did the last independent 1 Cf chapter XIII, swpra on interlocking directorates. 2 Railroads: Rates and Regulation, p. 404. ' P.424, supra. * P. 216, supra. 486 RAILROADS cross road in trunk line territory lose its identity, — the so- called "Clover Leaf" (Toledo, St. Louis & Western) having tied itself up in 1907 to the Chicago & Alton. Before leaving the trimk-line situation one important point also remains to be noted; viz., the manner in which, all smaller independent roads now being controlled in the interests of harmony, the incursion of troublesome competition from abroad has been forestalled. The Grand Trunk road, for example, formerly enjoyed an inde- pendent avenue of approach from Canada to New York City, by way of the Rome, Watertown & Ogdensburg and the Ontario & Western. Of these, the former is now in the Vanderbilt fold, while the latter has been absorbed by the great New England system. And control of all the smaller coal roads which might be bought up, is safely lodged, so far as their stocks are con- cerned, in safety vaults in New York City. It is difficult to conceive of any serious disturbance of the present equilibrium. A permanent condition of monopoly has taken the place of unregulated and often destructive competition. The next great territory in which actual financial consoli- dation has since 1900 taken the place of unregulated, or at best imperfectly controlled, competition is that of the southern states east of the Mississippi. The complexity of the rate situation has always been great.' This is due to several causes. The interlacing net-work of poorly constructed roads serving a very sparsely settled region, was largely dependent upon particular crops, notably cotton. Many distributing centres of about the same size were keen rivals for trade. And the entire territory was open to water competition from the ocean on two sides: the Mississippi and its tributaries on the west; and the deeply penetrating coastal rivers from the south and east. The im- perative need of some restraint upon competition led to the formation and successful conduct for many years of the most ' Fully outlined with map in Railroads: Rates and Regulation, p. 380. COMBINATION IN THE SOUTH 487 powerful railway pool in the United States.^ But the Federal prohibition of pooling in 1887 caused it to be dissolved. There followed a long period of bitter competition, from which, how- ever, there gradually emerged before 1890 a system comprising nearly 9,000 miles of line, known as the Richmond Terminal Company. Its only formidable competitor was the Louisville & Nashville with a mileage of less than 2,500. Bearing in mind, however, that there was a total of more than 50,000 miles of railway line in the entire territory at this time, it is evident that the small independent roads were still overwhelmingly in the majority. And the Richmond Terminal Company was poorly built, weakly and improperly co-ordinated and perilously financed. Its affairs drifted from bad to worse until in 1893 it was taken in hand by the banking house of J. P. Morgan & Co.^ There then emerged, in the following year, the most important railroad in the region, known as the Southern Railway. Be- ginning with 4,600 miles of line, it grew steadily until in 1908 it had attained more than twice that size. As the accompanying map shows, this Southern system reaches every important point between New Orleans and Richmond, and as far up as the Ohio river. And what was of especial importance, it controlled lines running to the north, on both sides of the Appalachian moun- tain chain. Formerly it was the competition of these two dis- tinct sets of lines, one seeking to supply the South from eastern centres and the other from the Middle West, which was the most formidable obstacle to stability of rates.' The Southern Railway by no means enjoyed monopolistic power over rates prior to 1900. Its lines were paralleled by formidable competitors to the north, both east and west of the mountams. There were several roads parallehng the Atlantic seaboard; and, as affording connection with St. Louis and Chi- cago, there were two great companies, the Illinois Central and » C/. p. 584, infra. ^ Its financial experience in detail at p. 381, supra. ' This is the kernel of the great Cincinnati Freight Bureau case; Ripley, Raiboads: Rates and Regulation, index. 488 RAILROADS COMBINATION IN THE SOUTH 489 the Louisville & Nashville. Of these the former was mainly a trunk line direct to New Orleans. But the Louisville & Nash- ville, from its base at the Ohio river cities, radiated out all over the western half of these southeastern states. The broken lines on the map show its present extent. Without power to make enforcible traffic agreements, competition under such circum- stances was bound to be keen. Moreover, this Louisville & Nashville system was prosperous, and was rapidly expanding toward the south and east. Its great opportunity arose in 1902 as the result of what at first threatened to be a calamity. The affair was somewhat complicated as we have already seen.^ Suffice it here to state that, as a result of a speculative raid, control of the Louisville & Nashville was finally turned over to the most important railroad paralleling the eastern seaboard. The Atlantic Coast Line extended down from Richmond and reached inland as far as Augusta and Montgomery, its location being shown upon our map, also, by broken lines. The relation between the two companies, thus combined in 1902, may be compared with two arms, reaching down each side of the mountains, and touching one another about their southern end with extended finger tips. There is no direct connection between the two northern ends. These two railroads, when combined, covered most of the territory of the Southern system and com- peted with it at every strategic point. A few independent local lines still remained; but for all practical purposes the transporta- tion business of the South was now in two powerful hands. The trunk line of the Illinois Central, closely paralleling the Missis- sippi, has since then been extended to the Atlantic seaboard through the acquisition of the Central of Georgia (map p. 500, infra); and the Atlanta, Birmingham & Atlantic has been constructed across the same field.^ But entire harmony still seems to prevail. The complex inter-relations of the two great systems, and their affiliations even with the other two, above-mentioned, are ' Pp. 144 and 218. supra. " P. 27, supra. 490 RAILROADS concisely set forth in the Report on Intercorporate Relations of 1908. "The Southern Railw;ay Company, as will be recalled., is jointly interested with the Louisville & Nashville RaUroad Company in the Chicago, IndianapoUs & Louisville Railway Company. This estab- hshes a working aUiance between the Southern and Atlantic Coast Line systems. But the relations between these systems are made still closer by the fact that the Southern Railway Company owns $550,000 of the stock of the Atlantic Coast Line RaUroad Company; jointly with the LouisviUe & Nashville Railroad Company owns the Birming- ham Southern RaUroad Company; and jointly with the Atlantic Coast Line RaUroad Company and the Central of Georgia Rail- way Company owns the Augusta & SummervUle RaUroad Company. Again, the Atlantic Coast Line RaUroad Company, the LouisvUle & NashviUe RaUroad Company, and the Central of Georgia Railway Company jointly control the Western RaUway of Alabama; and the Central of Georgia RaUway Company and the LouisvUle & Nash- vUle RaUroad Company, directly and through the Georgia RaUroad, own large interests in the Atlanta & West Point RaUroad Company. The Atlantic Coast Line RaUroad Company and the Seaboard Air Line RaUway hold large interests in the Columbia, Newberry & Laurens Raihoad Company. The joint ownership in the Richmond- Washington Company has aheady been described. Finally, it is of interest to observe that the majority of the stock of the Old Dominion Steamship Company is owned by the Norfolk & Western RaUway Company, the Chesapeake & Ohio RaUway Company, the Atlantic Coast Line RaUroad Company, the Seaboard Air Line RaUway, and the Southern RaUway Company." It is thus evident that since 1900 this entire southeastern quarter of the United States has been consolidated to a standstill. CHAPTER XV RAILROAD COMBINATION IN THE WEST The Hill-Morgan group, 491. — Northern Pacific-Great Northern re- lations before 1900, 492. — The Burlington acquired, 494. — Strug- gle with Harriman for the Northern Pacific, 495. — The Northern Securities Company, 497. — Its dissolution by Federal decree, 498. The Harriman Union Pacific group, 499. — Foreclosure, reorganiza- tion and reconstruction, 501. — The Southern Pacific acquisition, 504. — Financing the Northern Pacific investment, 506. — Profits invested all over the country, 508. — The situation, strategically, 509. — Harriman's death a turning point, 510. — Five principles of Union Pacific finance, 511. — Bold borrowing, 512. — Powerful and con- centrated financial support and control, 513. — Scientific operation and territorial monopoly, 514. — Speculative aspects of Harriman management, 515. The Gould system, 516. — Jay Gould's properties in 1892, 518. — Trans- continental plans in 1901, east and west, 618. — The Wabash-Pitts- burg extension, 620. — Structural and financial weakness, 623. — CoUapse and dismemberment since 1907, 523. The Rock Island group, an example of financial weakness and corrup- tion, 524. — Formation of the Rook Island Company, 625. — Expan- sion south and west, 529. — The inevitable disintegration, 630. Membra disjecta in the so-called Hawley system, 632. — The three great independent companies, 533. The transcontinental railroads of the United States fall naturally into three more or less distinct groups. The Union Pacific and, since 1909, the Western Pacific run directly across to San Francisco. The southern group comprises the Atchi- son and Southern Pacific roads, both reaching the same ter- minal by way of southern California. [Cf. maps, pp. 477 and 500.] The third group includes the Northern Pacific, the Great Northern and, since 1909, the St. Paul, all three of these penetrating the Northwest to the coast at Seattle. Substan- tial monopoly among these transcontinental roads was built up by a series of events beginning about 1900. It was weak- 492 RAILROADS ened only in part by the opening in 1909 of the two independent railways above named. Up to this time these transcontinental lines, however, while geographically in three groups, were financially divided into only two. Until then, two great personalities, James J. Hill of the Great Northern, and E. H. Harriman of the Union Pacific, absolutely controlled the situa- tion between them. Hill, to be sure, was supported by the house of J. P. Morgan; but he was evidently the real dominat- ing railroad factor. The history of the decade is unique and momentous. It is a record of the personal achievements of these two men.' The Northern Pacific railroad from St. Paul to the Pacific was opened as a through line in 1883. It was carried through only by the aid of heavy subsidies from the Federal govern- ment; and until the late '90s had a checkered financial career.^ Closely paralleling it on the north, along the Canadian border, the Great Northern Railway, having the same terminal points, was put through without public assistance a few years later. Conservatively financed, it was successful from the outset, in striking contrast to its older rival which had been a specula- tive football for years. These two roads lived in compara- tive peace with one another for some twenty years; when, about the opening of the century, a combination of personal and economic motives led to a project for their combination. A powerful group of stockholders had attained an age when, contemplating retirement, they desired to perpetuate their joint control of the road. Important developments in the opening up of Oriental markets, with the need of guaranteeing traffic for steamship lines, made greater permanency of rela- tionship desirable. For traflSc agreements with Chicago con- ' The fugitive sources are very abundant. The Library of Congress has published a bibliography of the subject. But practicaUy all the im- portant details wiU be found in B. H. Meyer, History of the Northern Securities Case. Bull. University of Wisconsin, no. 142, July, 1906. The most important chapter is reprinted in Ripley, Railway Problems (rev. ed.), pp. 553-567. ' On its reorganization in the '90s, consult chapter XII, supra. NORTHERN SECURITIES COMPANY 493 ."^ ^ V V ^^- \x\_^ v^ r^^^ff^^ s ^mXX '''V„-'-~4 ^ '; ' '"-^ ^^^^^^ ri, >ci ', r-W ^ j^\s I-/ a, ID ' o? V^^'- 494 RAILROADS nections were always subject to change or abrogation. And undoubtedly, also, it was clear that the revival of prosperity after 1898 must be accompanied by a great increase of traffic in this undeveloped territory; so that large profits would accrue to both roads could rates be maintained or perhaps even raised all along the line. The primary need for both companies was an independent entrance into Chicago; and it was plain that a single road would amply suffice for the two. From among several possi- bilities, the Burlington system was finally selected. For it not only afforded the necessary Chicago connection; but it also gridironed a rich and populous territory of its own. It tapped the great live-stock, coal and mineral areas of the Middle West as well. Negotiations for purchase were hast- ened by a sudden resolution of the rival Harriman or Union Pacific forces in 1900-'01 to obtain possession of it. For the Union Pacific, terminating at the Missouri river, also might make use of the Burlington in order to reach Chicago. The dominant stockholders of the Burlington were approached; and finally agreed to a sale of the property to the two northern roads as joint purchasers. The agreement assumed the famil- iar form used in the New York Central — Lake Shore and Louis- ville & Nashville-Atlantic Coast Line transactions. The Northern Pacific and Great Northern were each to receive one-half of the $108,000,000 of Burlington stock; and were to pay for it in joint long-time collateral trust bonds. About 97 per cent, of the stock was thus purchased, and deposited in trust as security for the new bonds. There were no cash requirements at all, it will be observed, for the passing of control. The foregoing transaction was bitterly opposed by the Harriman-Union Pacific forces, who saw in it a menace to their plans for a monopoly of the transcontinental situation; they having already, as will soon appear,' endeavored to secure 1 P. 503, infra. NORTHERN SECURITIES COMPANY 495 a share in the Northern Pacific purchase. Consequently they set about an attempt at its control by bidding for stock in the open market. The stock market panic of May 9, 1901, was the result.^ As prices soared in the competitive bidding, hosts of brokers sold Northern Pacific stock short, not being aware that all purchases were for actual delivery and not for mere speculation. A corner ensued, in the course of which for a brief period, Northern Pacific stock sold at $1,000 per share. The outcome is so admirably and concisely told by Prof. B. H. Meyer, ^ that it can best be quoted directly: "During the very days when the Burlington transaction was being perfected, the men who had been refused what they regarded an equi- table share in'that purchase elaborated plans which were calculated to vanquish their enemies and elevate the Union Pacific interests to a position of supremacy in trans-continental traffic. These stirring events led a cosmopoUtan editor to invent a parable of fishes in which the bass had swallowed the minnow, and the pike swallowed the bass. In this instance, however, the bass, armed with retirement fins, com- pelled the pike to spew him out. "The total outstanding capital stock of the Northern Pacific was 1155,000,000, of which $80,000,000 was common and $75,000,000 preferred. During April and early in May, 1901, the Union Pacific interests acqmred $78,000,000 of this stock, — $41,000,000 preferred and $37,000,000 common — with the view of controlling the Northern Pacific railway, with its haK interest in the BurUngton system. Such a moverhent appears to have been anticipated. 'It was a common story at one time.' Individuals representing the Great Northern and Northern Pacific interests, becoming apprehensive, increased their holdings in the Northern Pacific by pinchasing about $15,000,000 of common stock in the market. Short selling of Northern Pacific stock and the scramble to cover, when it was discovered that only a limited supply was to be had, drove the price of Northern Pacific common stock up to about $1,000 per share. This was the chmax of a series of events which culminated in the stock-exchange crisis of May 9, 1901. 'The markets of the world were convulsed, the equihbrium of the financial world shaken, and many speculative interests in a critical condition.' On May 1, 1901, when the so-called 'raid' upon Northern Pacific stock became known, J. J. Hill and his associates, who had been in possession > P. 200, supra- * Now a member of the Interstate Commerce Commission. In BuU. University of Wisconsin, no. 142, 1906. 496 RAILROADS of large blocks of Northern Pacific stock from the time of the reorgani- zation of the company, were holding from $18,000,000 to $20,000,000, par value, of common stock; and J. P. Morgan & Co. were holding some $7,000,000 or $8,000,000. Together, May 1, 1901, these individ- uals lacked the dramatic $15,000,000 of common stock, which, when they had acquired it, gave them a majority of some $3,000,000 par value, of the $80,000,000 of common stock, when the 'show down of hands' occurred after May 9. Although the Union Pacific interests represented by E. H. Harriman and Winslow S. Pearce, as trustees for the Oregon Short Line, held a majority of $1,000,000 of the total amount of stock, their majority lay in the preferred shares which could be retired on any 1st of January prior to 1917, — that is, before the present owners could get an opportunity of exercising the authority which was assumed to reside in them, and which would give them the coveted control. This is why the pike did not swallow the bass. To the country at large and to Wall Street these events appeared like a duel between giants, but one who appears to have been a leading parti- cipant in the duel, on the losing side, asserted that he never was in a contest, nor did he and his associates lose money. "According to the by-laws of the Northern Pacific Company, the annual election of its board of directors by the stockholders occurs in October, and under the distribution of stock existing after May 9, 1901, the Union Pacific interests could have controlled this election, and thus prevented the retirement of the preferred stock on January 1, 1902, which would legislate them out of control. Both the preferred and the common stock could vote under the conditions existing on May 9, 1901. A postponement of the annual meeting from October till after January 1, 1902, was frequently thought of and advised by counsel. It could have been done. This potential power of retiring the Northern Pacific preferred stock before the same could be voted, residing in the Northern Pacific Board of Directors, appears to have generated a concihatory attitude on the part of the representatives of Union Pacific interests, and negotiations for the purchase of such shares were successfully carried through by J. P. Morgan & Co. Direct testi- mony admitting this causal connection does not exist, but the admitted facts make it appear highly probable. To be sure, the retirement of the preferred stock had been thought of long before, and the right to do so on any 1st of January between 1896 and 1917 was expressly re- served; yet up to 1901, when this plan was finally consummated, no plan had been devised for the retirement of that stock. The inter- ested parties agreed not to wait until October, but to act at once; in order to establish permanent peace and 'to show that there was no hostility.' In order to prevent the recurrence of such disorder, the Northern Securities Company was planned and soon after incorporated. Probably also an incentive toward the formation of this finance com- pany, was the opportunity which it would afford to the Morgan-Hill NORTHERN SECURITIES COMPANY 497 party to resell a part of their stock without losing control. For after the exchange of securities provided for, the Harriman party would hold less than a quarter of Northern Securities stock. A considerable hghtening of the financial burden would therefore be feasible." The Northern Securities Company, incorporated in Novem- ber, 1901 imder the laws of New Jersey, was a holding or finance company, pure and simple. It was in no sense to be concerned with operation; ^but was created in order to indis- solubly bind the two great transcontinental roads together. The capitalization of $400,000,000 was intended to cover the market value of the shares of both roads and to constitute in itself so huge a total that there could be little hope of outside interests stealing control from the Hill-Morgan party. About 76 per cent, of the Northern Pacific's stock was taken over at $115 per share; and approximately 96 per cent, of the Great Northern at $180. But a special bonus appears to have been extorted by the Harriman party for its large holdings of Northern Pacific stock, — a premium which with other items played an important part in subsequent Union Pacific finance. In the meantime, so far as operation, rate-making and financing were concerned, it was apparent that an abso- lute monopoly had been created. Three formerly independent roads were now firmly united; and many economies, not for- merly practicable, were put into effect. Traffic between the two transcontinental lines seems to have been divided on a basis proportionate to the freight received by the Burlington from each, unless otherwise routed by special agreement. But whatever friendly rivalry there might have been in service, all actual competition in rates, so far as the public was con- cerned, was at an end. The later history of the Northern Securities Company is largely legal; but may best be outlined in this place in order to round out the record. State and Federal authority was promptly invoked to declare it an illegal monopoly in restraint of trade. The United States Supreme Court in March, 1904, VOL. n — 32 498 RAILROADS in a momentous decision did, in fact, so declare it in violation of the Sherman Anti-Trust law; although by a bare majority opinion.! It condemned the holding company device; and forbade the company either to vote its railway stocks held, or to collect dividends thereon. The response of the company was prompt. It reduced its capital stock by 99 per cent, and took steps to distribute its holdings among the original owners. But at this point an interesting controversy arose, which re- quired a second decision of the Supreme Court in 1905 for its settlement. For the distribution of assets reopened the old contest for control between the Harriman-Union Pacific and the Morgan-Hill parties. The latter, controlling the Northern Securities Company, naturally desired to perpetuate their ascendency. This they proceeded to do by offering to divide the Northern Securities Company's stocks of both Northern Pacific and Great Northern proportionately among all their own stockholders. For each share of holding company stock, there was to be given $39.27 in Northern Pacific stock and $30.17 in Great Northern scrip. To this the Harriman party vigorously objected; because, as will be recalled, they once actually held a majority of the total capital stock, common and preferred, of the Northern Pacific road. They had failed of control only because of a slight minority of the common stock, which had power to retire the preferred shares. Could they recover the shares actually turned in to the holding company, now that the retirement period for the preferred stock had passed, the Northern Pacific would at last be theirs. To make a long story short, the Supreme Court decided against this contention.^ Distribution took place; and the Hill-Morgan party remained in control of both roads and consequently also of the Burlington system as well. The only assets of the Northern Securities Company, since reduction of its capital stock, have been certain shares of the Burlington road and of the Crow's Neck Pass Coal Company. ' C/. p. 555, inpa. « 228 U. S., 482. THE UNION PACIFIC COMBINATION 499 Since the legal dissolution of the northern transcontinental monopoly in 1905, no outward change, so far as the public is concerned, is apparent. Harmony in rate policy has been un- broken; and in all subsequent changes of rates, all roads have acted practically as a unit. This is undoubtedly because substantial blocks of the stocks of both main lines are still lodged in the same hands. At all events, everything except competition in facilities has ceased. And both roads con- tinue in control of one-half each of the Burlington system. Nor has the latter ceased to expand, in the interest of its joint owners. The most important event was its acquisition in 1908 of the Colorado & Southern road, which afforded, as our map shows, an independent outlet for the affiliated systems upon the Gulf of Mexico at Galveston. The problem of meeting the competition of the Panama Canal in due time was thus met. And the addition of a mileage of 2,500, brought the size of the entire transportation group to the formidable total in 1909 of 25,000 miles of hne. The phenomenal growth of the Union Pacific system within the short period from its sale under foreclosure in 1897 to the death of E. H. Harriman in 1909 has perhaps no parallel in transportation history.^ Omitting all mileage of other roads in part owned through minority stock holdings, the Union Pacific system during this time rose from 1,800 to more than 23 000 miles of line. The total capitalization — stock and bonds — in 1898 was $226,000,000. Ten years later it was only $518,000,000. And yet it threatened to dominate the management of more than 25,000 miles of line outside its own 1 On the Union Pacific the following general references are best: 12 I C C Rep 319; Quarterly Journal of Economics, vol. XXI, 1907, pp 569^12; idem, vol. XXVII, 1913, pp. 295-328; idem, vol. XXVIII, 1914 pp 772-794; also the complete record in the Union Pacific- Southern' Pacific Dissolution case, p. 561, infra. McClure's Magazine, October 1909 pp. 641-659, and January, 1911, pp. 334-348, gives a popular' account. The Boston Transcript, Sept. 10, 1909, also reviews Harriman's career comprehensively. 500 RAILROADS system, capitalized for more than $2,600,000,000, including the entire Vanderbilt group and comprising several through i ^' 60^, 1 -s &s WA^' n^-~. S_L' k -IV y^ \ y ^^ 2j ^e^^L^ _\ 2 ^#1^ ^p^?r^ z ^/or*'^'''" ) i i' i ; S Ms J-- t r""^ r^ y\\ r' ? * h ! K Hv- ' "^ '^■~' ' / 1 ■>i\ ' s / , ! ftiV 1 // ^ ./ y^^ ^/ ' us. 8! 1^ t- /U _-i -\*5 ' > -] ^7 ; If-^ y^' 2 ' 3J r !<^ J ; V "- /?^' ~~^?ir~ •*..-•""» (^ vfW» ( /;N r--H ^ lines from the Atlantic to the Pacific. Given the Harriman financial formula, soon to be described, skilfully applied to this end, and it would be difiicult to set limits to the consolida- THE UNION PACIFIC COMBINATION 501 tion which might have ensued, had not the guiding hand either been removed by death or restrained by law. The chapter is indeed one of the most remarkable and significant in our industrial history. This brief chronicle naturally divides itself into three dis- tinct periods. Internal improvements and financial rehabili- tation during the first few years were most important. The five years following 1901 were largely concerned with the Northern Securities Company struggle and the strengthening of the transcontinental monopoly. And the period subsequent to 1906 witnessed the great expansion through investment in stocks of other railroads all over the United States. These three periods are quite distinct in character, although following one another logically. After the death of Mr. Harriman in 1909, the company most wisely reverted to a more normal course of development, not meriting further special consideration. The claim of the United States in 1897 against the old Union Pacific Railroad, for aid in its construction and for unpaid interest, amounted to $58,400,000.1 "phe property was in a pitiable plight. All its feeders, as well as its through con- nection to the Pacific, had been cut off dm-ing the fom- years of depression and receivership since 1893. It had thus lost 5,800 miles of line. Less than a quarter of its main stem mUeage was even graded and ballasted. Everything was in a state of extreme dilapidation. The opportunity for develop- ment, nevertheless, was so plain to Harriman, that he raised enough cash to bid in the road under foreclosure proceedings for the full face of the government's claim. The history dur- ing the next two years is merely one of remarkable prosperity, utilized to the full in upbuilding the company's credit and in regaining possession of its lost feeders and connections. The most important re-acquisition was the Oregon Short Line, giving an outlet to the Northwest. This was acquired in ' A detailed account of the foreclosure proceedings is in Quarterly Journal of Economics, vol. XIII, 1899, pp. 427-^44. 502 RAILROADS 1899 by an exchange of stock; and has since been distinct only as a fiscal unit, serving as a sort of treasury agent for the deposit of purchased securities. Other branches were speedily taken back; so that by 1901 the system had grown from 1,850 to 5,628 miles of line. At the same time these early years were devoted to an entire rebuilding of the road from end to end. Fortime fa- vored the enterprise from the start. An unusual rainfall in the semi-arid belt brought heavy crops and prosperity at a crucial time. For this all occurred, it should be noted, before the days of dry farming and extensive irrigation in the Far West. The annexation of the Philippine Islands also largely stimulated transcontinental and Oriental business. Gross earnings increased rapidly. Dividends began. And sub- stantial surpluses over and above these were turned back into the property for every form of permanent improvement, which would reduce costs of operation. The construction of the Lucin cut-off at the Great Salt Lake was a first-rate achieve- ment. The initial appropriation for this great work was $10,000,000; but it shortened the line from 147 to 103 miles, saved 1,500 feet vertically of grade, and cut out about ten complete circles of curvature. The mere operating savings for the first year on this account were nearly one million dol- lars. Double tracks were laid, solid embankments took the place of trestles and curves were eliminated wherever possible all along the line. The result was a heavy decline in the operating ratio. ^ This was 62 per cent, in 1896. Within six years operating expenses were below 53 per cent, of revenue from operation. Train loads rapidly increased, so that the greatly expanding business was yielding more than propor- tionate net returns. Within three years, both gross and net revenues more than doubled. By 1901, therefore, the com- pany was in prime financial condition, with strong credit and unsurpassed banking connections. ' P. 22, supra, and Appendix II, infra. THE UNION PACIFIC COMBINATION 503 Two distinct events opened the second five-year period of Union Pacific finance down to 1906. These were the ac- quisition of the Southern Pacific Railroad; and the bitter struggle with the Morgan-Hill party for the control of the Northern Pacific. But the guiding principle of the whole five years was really the creation of an absolute monopoly of all transcontinental business. Leaving aside the northern lines, it may fairly be said that California territory up to 1901 was served by at least five distinct routes or "lanes" of trafiic^ These had evolved gradually during a half-century; and some of them at least were openly in competition with one another. Measured by volume of traffic the "Sunset Route," consisting of steamship lines from Atlantic seaports to New Orleans owned by and operating with the Southern Pacific Railroad, was by far the most important. Nearly three-fourths of the transcontinental business used to move over this line. Next in importance was the Union Pacific, which was^the short line; but which was forced to depend upon the Southern Pacific for its last fink from Ogden, Utah, west to the sea. This same connection, known as the Central Pacific, was also essen- tial to the third transcontinental line over the Gould roads, as will shortly appear. The links in this chain were the Mis- souri Pacific and its controlled road, the Denver & Rio Grande. But these Gould lines, like the Union Pacific, had no independ- ent western outlet. Not so, the fourth transcontinental route, the Atchison system. ' This alone had rails into both Chicago and San Francisco. And finally, there was the Panama route, made up of two steamship companies with a short connecting link of rail over the isthmus. Having completed its internal reconstruction, the second great task before the Union Pacific was to eliminate competition between as many of these lines as possible. Contemporaneously, also, as a part of this same plan, there was the unsuccessful struggle for control of the northern lines.^ This episode was of more importance in the > Maps on pp. 493 and 500, supra. ' Details at p. 494, supra. 504 RAILROADS later financial development of the Union Pacific, as will appear in due time. It is possible that failure to control ia this direc- tion, only whetted the ambition to put an end to competition between the remaining lines. The first competing road to be absorbed was the Southern Pacific. This was bought outright in. 1901, by the purchase of $75,000,000 par value of stock, originally owned by the Crocker, Stanford and Himtington estates. In the following year enough more stock was bought to give absolute control through a majority of its capital stock. This transaction was financed by a large issue of convertible bonds of the Union Pacific Company.! Thus over 9,500 miles of line was added to the system. A very extensive betterment policy for the newly acquired road was at once adopted. Within four years $33,000,000 was expended for this purpose alone.^ The line was rebuilt from end to end; and in the meantime prospered greatly from an enormous growth of business. But to all intents and purposes, competition with the Union Pacific was at an end. Next in order, of combination during the years 1902-'04, the Atchison was taken into partnership. This road had lately become aggressive, and in 1902 began to extend its lines both ia Arizona and into Northern California. A bitter struggle ensued, ending in 1904 with a heavy purchase of Atchison stock and the election of Union Pacific men to its directorate. Several new lines were thereafter jointly owned; the highly important citrus fruit business was pooled; ^ and rivalry from this source was at an end. The Atchison stock was speedily resold; but temporary ownership served its purpose. Then came the elimination of the Gould lines, which, as has been said, only came as far west as Ogden, Utah. The refusal of the Central Pacific longer to join in through rates and ship- ments after the purchase of the Southern Pacific, was the act which finally compelled this rival system to enter upon the » P. 158, supra. « Cf. p. 217, supra. ' P. 596, infra. THE UNION PACIFIC COMBINATION 505 construction of a new line, known as the Western Pacific. This is described in connection with our account of the Gould sys- tem. Until it was opened, the Denver & Rio Grande route shared not at all in the great growth of California business during the decade. It was practically elimuiated from compe- tition. Last of all, there remained the Panama route to be dealt with. This was controlled through ownership of the Pacific Mail steamers. But a poHcy of discouragement of shipments by this route seems to have been adopted. In 1907 less than one-third of the tonnage of 1901 was carried. It was even said that Panama Canal supplies for a time came from California largely by way of New York; instead of by the direct route as before. ^ In order to round out this chronicle, it may also be added that a one-half interest in a new line from Salt Lake City to Los Angeles was in 1904 the outcome of a protracted struggle to prevent its construction at all. The monopoly of transcontinental business seems to have been pretty effectually obtained. Operating efficiency having been brought to the highest point of perfection, as well in respect of direct operating expenses as of economic routing of traffic, and freight rates west-bound having also been largely increased since 1897, as could now readily be done under the conditions of monopoly just de- scribed; an enormously enhanced revenue was the necessary result. Gross receipts from operation rose from $19,000,000 at the start to $76,308,000 in 1907; while net revenue increased even more rapidly. Nevertheless, with the growing share capital, much of it consisting of bonds now converted into capital stock, these expanding profits might easily have been distributed as dividends. But the unforeseen outcome of the Northern Securities affair in 1906, rendered possible a more 1 Much of this data, it may be added, is to be found in the evidence taken on the subject by the Interstate Commerce Commission in 1907; and in connection with the prosecution of the Federal suit against the Union Pacific company in the years thereafter described in Chapter XVII, infra. 506 RAILROADS ambitious programme of expansion; that one, in fact, which characterizes the third period in the company's history, to which we shall soon turn. But meanwhile it remains to trace certain fiscal results of the struggle for control of the Northern Pacific road, heretofore described in connection with the Hill- Morgan group. The 781,080 shares of Northern Pacific stock, bought in the open market by Harriman in the spring of 1901, were financed by means of the issue of $100,000,000 of convertible bonds issued by the Union Pacific company. About $40,000,000 of these were used for the acquisition of the Southern Pacific. The balance, together with heavy loans from the New York banks, provided the $79,459,000 which this investment seems to have cost originally. This sum was reduced somewhat later by sale of Northern Pacific preferred shares, to about $73,159,000; and then increased again by subsequent sub- scription to new Great Northern shares; so that the final net cost of its Northern Pacific venture was $76,900,000. These securities, however, during the speculative boom of 1906,' rose to such extravagant quotations that the rate of return, measured by dividends paid, was less than 3 per cent. To sell the Northern Pacific and Great Northern shares which were returned to them in place of their original Northern Pacific stock, on the distribution of assets of the Northern Securities Company, was obviously a plain business proposi- tion. This was promptly done. And the Union Pacific realized in cash, and held for shares still unsold, the sum of about $159,848,000. The profit in hand and on paper of this extraordinary venture was therefore approximately $82,943,- 000, or 113 per cent, on the cost. This outcome accounts for the policy of the third period in the company's history, to which we may now turn. Up to 1906 the Union Pacific seems not to have invested largely in other independent companies except the Northern ' Chaps. V and VI, supra. THE UNION PACIFIC COMBINATION 507 Pacific. Temporarily, to be sure, it had picked up several hundred thousand shares of Atchison in 1904; and in order to secure an independent entrance into Chicago, it had bought Chicago & Alton shares m the following year.^ In the main it had attended strictly to trans-Mississippi affairs. But now the company's treasury was literally bursting with free assets. Its revenues from operation were enormous; its repayments of advances to subsidiary companies, like the Southern Pacific, were steadily increasing; these companies, likewise, were paying larger dividends; and, on top of it all, came the huge profits of the Northern Securities venture. The Union Pacific was apparently loaning in 1906 some $34,- 000,000 in Wall Street. But now came a sudden change of policy. When the Interstate Commerce Commission inves- tigated the subject a year later, the following investments in roads all over the country had been made within eight months from July 1, 1906, at a cost of over $130,000,000.^ Cost op Union Pacific-Oregon Short Line Investments' Atchison, Topeka & Santa F4, preferred stock $10,395,000 Baltimore & Ohio, preferred stock 6,665,920 Baltimore & Ohio, common stock 38,801,040 Chicago, Milwaukee & St. Paul, common stock 5,997,750 Chicago & Northwestern, common stock 5,303,673 Fresno City Railway stock 106,410 Illinois Central stock 41,442,028 New York Central, etc., stock 19,634,324 St. Joseph & Grand Island stock 2,022,540 $130,368,688 By this good stroke of business the Union Pacific's income from investments was enhanced by more than 50 per cent. Such income had in fact risen from less than $3,000,000 in 1900 to $6,497,000 in 1905. Now it jumped to $10,330,000 — a sum greater than all the Union Pacific dividend disbursement in the preceding year. The time had come for freer distribution. But, unfortunately, the manner • P. 265, supra. ^ 12 I. C. C. Rep., 20. ' Minor items omitted. 608 RAILROADS in which this change was announced in August, 1906, led to grave charges of bad faith against the management. The matter really belongs to the study of speculation in railroad seciu-ities, and is described elsewhere under that heading.^ Suffice it to say that the announcement of an increase in the dividend rate to 10 per cent, annually, — six to be paid from operation and the balance from outside investments, — was delayed for two full days after being voted by the board of directors. It was a time of extraordinary speculative activity. The stock market was at the boiling point. And the oppor- tunity afforded to insiders and their friends to make use of this privileged information was too valuable to suppose for a moment that it failed to be utilized. But leaving this ques- tion aside, the Union Pacific company had now reached a point where it could completely abandon operation as a rail- road and still have sufficient income from investments to pay all fixed charges and the customary four per cent, dividend on its preferred stock. The aggregate cost of these securities purchased within a few months was, as we have seen, over $130,000,000. As a reinvestment of surplus funds the list speaks for itself. The next question is as to their strategic importance for purposes of transportation. Absolute majority control of none of these properties was secured. Less than one-third of Illinois Cen- tral; one-fifth of Baltimore & Ohio; only about 8 per cent, of New York Central, with perhaps as much more in friendly individual hands; and even smaller percentages of the share capital of the granger roads, — was all that was held. But there can be no doubt that such substantial fractions could exercise a powerful influence upon the traffic policy of the properties concerned. And considered in their entirety, they made up a net-work of lines reaching every part of the United States. Most directly valuable, probably, was the Illinois Central, as giving both the Southern Pacific at New Orleans ' P. 209, supra. THE UNION PACIFIC COMBINATION 509 and the Union Pacific at the Missouri river, direct access to Chicago. And with the acquisition of the Central of Georgia in 1907, as the map on p. 500 shows, a through line from the south Atlantic ports to the West was afforded. The important coal and iron and cotton manufacturing districts of the South were given their first through routing to important inland and Oriental markets over a single system. And of course, con- trariwise, the Illinois Central gave opportunity for participa- tion in the large grain export business through the GuK ports; ^ as well as ready access to the new trade routes to be opened up by the Panama Canal. Incidentally, it may be noted that the distance to Chicago from the Atlantic seaboard was, by comparison with the northern trunk lines, shortened by about one-sixth by this new southeastern through trade route. The Union Pacific now also enjoyed part control of two great Atlantic trunk lines. The New York Central with its trans-Mississippi extension, the Chicago & Northwestern, had long made up with the Union Pacific the shortest and probably the best ocean-to-ocean line. And the Baltimore & Ohio shares, being one-half of the Pennsylvania's former holdings,^ gave access to the remaining North Atlantic seaports; as well as amounting, in connection with powerful joint directors in the Union Pacific and Pennsylvania boards, to a sort of part- nership with this most powerful company. As for the St. Paul road, was that not an important rival in a rich western territory? And even more important, was it not at this very time, announcing a Pacific coast extension which should give entry to the North Pacific ports, served by the rival Morgan- Hill properties? Add to all this vast net-work, the important extensions of the Southern Pacific in northwest Mexico; the participation of Harriman in 1908 in the affairs of the Wheel- ing & Lake Erie, and even of the old Erie trunk line as well,^ to say nothing of activities in the great New York life insur- 1 C/. our Railroads: Rates and Regulation, p. 437. 2 P. 481, supra. ' P, 169, supra. 510 RAILROADS ance companies; and it appears as if a dream of universal dominion were indeed about to come true. The supposition of Justice Brewer in the Northern Securities decision, of a multiplication of powers of control, by the expedient of inter- corporate investment to the point of final amalgamation of all the railroads in the Union States in a single group, was made to appear even possible.^ But the Napoleonic plans were halted in 1909 by the hand of death. The Union Pacific com- pany, in safer because less all-ambitious management, re- turned more nearly to the status of a transportation company. Furthermore, an aroused public opinion had been moved to institute over the railways a real system of Federal publicity and control, which should render a repetition of these exploits impossible in future. In fact, it was probably the extraordinary career of this individual, Harriman, which largely contributed to the final success of the government in the protracted strug- gle over regulation of the carriers by public authority.^ A unique chapter in our industrial history was abruptly closed. The subsequent history of the Union Pacific may be briefly told. It promptly retired from Wall Street. And a poUcy of concentration of investment in roads physically allied to the parent company was inaugm-ated. More Illinois Central stock was purchased. On the other hand, the legally doubt- ful policy of investment in even remotely competing trans- continental roads was abandoned. The St. Paul and Atchison stocks were wisely sold. But those which strengthened direct through connections to the East, as in the Vanderbilt or Balti- more & Ohio systems, continued to be held. Two matters of primary importance were left unsettled at the time of Harri- man's death. Some mode of distributing the great surplus, consisting of stocks of other transportation companies, had to be found. This was necessary in order to allay the popular distrust against a continuance of the ten per cent, dividend 1 Outlined in Railroads: Rates and Regulation, chap. XV, et seq. ^ Cf. colloquy in idem, p. 491. THE UNION PACIFIC COMBINATION 511 rate, even although this were manifestly compounded of 6 per cent, from operation and 4 per cent, from profitable outside investments. The second difficulty consisted of the vulnerability of the intercorporate relationships between the Union Pacific and its subsidiary roads imder the anti-monop- olistic provisions of the Sherman Act. The company actually seemed, in a way, to be endangered by reason of its extra- ordinary good fortune m the past. Yet the highly involved intercorporate relationships of the system rendered any segre- gation or dissolution plan extremely difiicult. Many of the securities in the treasury were not free assets; but, as in the case of Southern Pacific stock, served as collateral for bonds issued by the Oregon Short Line. Nor was this all. For the conflicting rights of preferred and common shareholders, to say nothing- of bondholders armed with conversion privi- leges, promised to block the way to* a peaceful solution. The clever way in which these embarrassments were at last dis- posed of, largely in connection with the Union-Southern Pacific dissolution by order of the Supreme Court of the United States, will be related in a subsequent chapter. Reviewing this remarkable history, it appears that the cardinal principles of Harriman finance were five : bold borrow- ing; powerful and concentrated financial control; high operat- ing efficiency; monopolistic rates for service; and corporate stock speculation. As for the first of these, a most daring use of credit was characteristic from the first. To borrow freely at low rates in order to devote the funds to more produc- tive use is of course good business. But the risk incident to heavy mortgage indebtedness, based upon the possible growth of earnings in future, is often a powerful deterrent. Harri- man corporations, however, never hesitated to borrow. The Chicago & Alton financing is a good, or rather an infamous, example of this.^ The Union Pacific borrowings were at all times heavy. Twice at least within this short period of twelve 1 P. 262, supra. 512 RAILROADS years, mortgage loans of $100,000,000 were authorized; the first in 1901 to acquire the Southern Pacific and to fight for the Northern Pacific; and the second through the Oregon Short Line in 1905 "for other corporate purposes." Nor was there hesitancy in contracting the heaviest short-time loans, carried as floating debt. A good part of the $80,000,000 required for the Northern Pacific struggle was thus borrowed. In 1901 the Union Pacific increased its floating debt by $30,000,000; and its loan account for several years thereafter was almost as large. Surveyed broadly, the extraordinary financial status of the Union Pacific was due quite as much to borrowing in order to purchase the stocks of other roads, as to borrowing for the benefit of the Union Pacific property itself. Practically every- thing hinges upon that first great loan of $100,000,000 in 1901, the entire proceeds of which went to the acquisition of South- ern and Northern Pacific stocks. Of course it was essential that these heavy loans should be contracted at the lowest possible interest rates. Years of Harriman experience with the Illinois Central had inculcated this principle. Sound credit was the first essential. But novelty lay in the success- ful appeal to the speculatively inclined capitalist. Plain bonds in Harriman finance were relatively scarce. These large mortgages were either convertible into Union Pacific stock on favorable terms; or else contained "participating" interest in future profits, as of the Oregon Short Line, in case its Northern Securities venture should prove highly profit- able.i Remarkably clever appeal to the speculatively inclined investing class was an essential part of the general scheme. It should, however, be added, that ultimately the outcome of these heavy issues of low-rate convertible bonds was highly favorable to the companies concerned. For as the road pros- pered, the bonds were rapidly converted into stock; thereby freeing the line from an overload of mortgage debt and strength- ening greatly its credit in case of future borrowings. Without 1 P. 164, supra. THE UNION PACIFIC COMBINATION 513 a positive genius for corporate finance, the Union Pacific's tangled intercorporate accounts could never have been blessed with so favorable an ultimate issue. Safeguarding a financial base of supplies was a second essential factor in Harriman success. The most powerful banking support and personal alliances obtainable were cul- tivated, in and out of season.^ The significance of this appears most strongly by contrast with the financing of the Gould system. This came to grief in some considerable measure through the attempt to keep transportation and banking opera- tions entirely distinct. The personal side of Union Pacific affairs is too complicated to follow in detail. It began in 1877 with partnership in the powerful banking house of Kuhn, Loeb & Co., and affiliation with the National City Bank, the largest institution of its kind in America. To these was added after 1902, personal alliance with two of the wealthiest Stand- ard Oil directors and with powerful leaders in the United States Steel Corporation. These last seem to have come into closer alliance in connection with the upheavals in the great New York life insurance companies in 1905. All were directors of the New York Mutual Company and were deeply concerned in the general fracas which culminated in Harriman's with- drawal from the Equitable Life Assiu-ance Company, as well as in finally securing control of the Illinois Central. The great idle funds of the insurance companies were most service- able as participants in the wholesale borrowings of the Union Pacific company.^ And then in addition to the members of these inside groups, the active interest of a large number of very wealthy New York families was sedulously cultivated. The re- sult was an almost unequalled financial and personal backing. Fortunately the record in the Federal investigation of 1906-'07, enables us to follow the personal participation of these various individuals, including Mr. Harriman, in the 1 Pp. 425 and 545, supra, on interlocking directorates, etc. 2 P. 138, supra. VOL. II — 33 614 RAILROADS ownership of the various roads concerned. And the most surprising feature is the extremely small percentage of owner- ship which accompanied their control. This personal ownership may be purely individual, pooled jointly, or it merely may be syndicated through banking connections. But all of these forms of ownership together amounted in September, 1900, to only 0.88 per cent, of the share capital of the Union Pacific. This proportion rose to 3.96 per cent, in 1901; to 8.78 per cent, in 1902; to 17.31 per cent, in 1903; to 21.67 per cent, in 1905; and culminated in 1906 at 23.38 per cent. Thus when the first great loan of $100,000,000 was contracted, less than four per cent, of Union Pacific stock, and only 0.15 per cent, of the Southern Pacific shares, was concentratedly owned. Of course, with control of the parent company, which in turn absolutely controlled the subsidiary ones, these personal hold- ings outside the Union Pacific were of less importance. But occasionally, as in the temporary control of the Atchison in 1905, the outside ownership of 7^ per cent, of its stock, power- fully reinforced the Union Pacific company itself as against other rivals in the field. Of the remaining essential features of the Harriman financial plan, both the genius for scientific operation and the set pur- pose to create an absolute monopoly of transcontinental busi- ness have already been discussed. The fact that for years the expenditures annually for maintenance of way were often 50 per cent, greater per mile than for other properties in the same territory, is in itself eloquent testimony to the thorough- ness of the physical side of the work. It only remains to treat of the final and in some respects the most critical feat- ure of the Harriman administration; namely, its highly specu- lative stock market character. Throughout the entire period under review the Union Pacific railroad was, as has elsewhere been shown in detail,^ the very pith and marrow of the cor- porate and individual speculation of the time. Its financial 1 P. 201, supra. THE UNION PACIFIC COMBINATION 515 operations were always calculated rather with an eye to the Wall Street situation than to the welfare of the general body of stockholders. And rigidly scrutinized, the whole chapter of investment in other companies, except perhaps the Southern Pacific, is merely one of corporate speculation. The original $100,000,000 loan of 1901 and many of the succeeding mort- gages, were largely devoted to investment in other roads. Money, -in short, was borrowed on mortgage in order to buy shares in Wall Street. Moreover, when the shares were sold, as they happened by good luck to be at a great profit in the Northern Securities affair, the receipts from sales, instead of being devoted to cancellation of the original debt, were at once reinvested elsewhere. And even more was then borrowed, both on short-time notes and by mortgages of subsidiary com- panies, in order to carry the operations yet farther. It was a real case of pyramiding profits. Nor does it alter the situation, that much of the indebtedness created was apparently can- celled in due season through conversion of the mortgage bonds into capital stock. Suppose the first stock market plunge in Northern Pacific had resulted in loss instead of profit; as in fact on paper, the purchases of 1906 at inflated prices turned out for a time to be. Had the company been forced to sell these in 1907, there would have been a loss of about $50,000,- 000. The liability would have been none the less because to its own shareholders, instead of to bondholders outside. The original stockholders, would then have suffered by just the amount of the loss. The fact remains that many of these operations were entirely foreign to the business of transporta- tion. And enormous risks were assumed with funds belonging to an unknowing body of stockholders, — innocent as well as unknowing necessarily because profoimd secrecy and a general air of mystery always surrounded Union Pacific financial opera- tions. The pubhshed statements, even, did not help to dispel this mystery; as witness the report of 1910, with its sudden disclosure of unsuspected indebtedness of the Oregon Short 516 RAILROADS Line to the Union Pacific of $71,600,000. These speciilative plunges of the Union Pacific might, of course, have been made on margin, as the Reading acquired the Boston & Maine or as the Pearson-Farquhar syndicate in 1909-'10 endeavored to piece together a new transcontinental system. But the Union Pacific operations succeeded, as in fact either of these others might have done imder similar favoring circvmistances, had they occurred in a long-continued period of rising stock market prices. That was the only real difference. For all alike were based upon borrowed money. At all events the prompt return to safer, if less alluring, paths of corporate finance since 1909, could not but be matter for congratulation. The so-called Gould system of railroads,^ after 1901 reached a maximum length within five years of about 19,000 miles of line, stretching almost from ocean to ocean, only to be as rapidly dismembered after the panic of 1907. The nucleus was formed by the properties, mainly reaching southwest from St. Louis as far as the Mexican boimdary, left by Jay Gould at his death in 1892. The principal one, destined to form the parent con- cern in the new system, was the Missouri Pacific. Jay Gould had in 1891 entered into a compact with the Southern Pacific for a division of the field in Texas by which the latter was to confine its activities to the western half of the state. The east- ern half, together with territory up to St. Louis and Kansas City, was occupied by five separate roads all controlled by the Gould family.^ Besides the Missouri Pacific, which extended west to Colorado, the Iron Mountain road and the St. Louis Southwestern lay close along the Mississippi; while the Texas & Pacific and the International & Great Northern ' In addition to the standard financial periodicals and annual re- ports of the companies, the following references are serviceable: Railway Age Gazette, especially vols. XXXIV and XXXV: Philadelphia Saturday Evening Post, Jan. 16, Feb. 16 and March 5, 1904; Boston Transcript, Feb. 18, 1911; and McClure's Magazine, vol. XXXVIII, 1912, pp. 483-501, * Cf. diagram on p. 519, infra. THE GOULD SYSTEM 517 . \ . n ■* ^-■^ ^ / >s» ^, ^>^ f \>s ""^ r'-' \ -% — ^ \ \ \ \ \ "Ww^ ...^-^ va 1? ^ ^'->xi\\/ V ? ^s^N \ r W ■? ^ \y A ^^Ir-'^^^^ ^SiRl:^ 's.^Jj// 518 RAILROADS reached farther down across Texas. The only line east of the Mississippi was the Wabash, extending to Toledo with lake connections thence to Buffalo. All the southwestern lines were weak roads, poorly constructed and worse main- tained, operating in sparsely populated and little developed country. They were all greatly over-capitalized; and suffered from all the financial ■ excesses associated with the career of Jay Gould. It has been truly said of him that he made his great fortune out of railroads, not in them. These properties were certainly no exception. It is important to emphasize this point, inasmuch as a part of the blame for the ultimate break- down of the great plan for an ocean-to-ocean system is assign- able to this cause. Too high a price had been paid for some of these roads, notably the Missouri Pacific; and they had for the most part long been in a state of chronic bankruptcy. Every available cent had been squeezed out in dividends, if indeed any net earnings were possible; and there was no credit to permit of further borrowing for purposes of improve- ment. Re-creation from within might have taken place through a drastic policy of retrenchment; but this course was not adopted, unfortunately, as an essential feature of the policy of expansion. The same old inefficient methods were applied to a great modern system which had for so many years characterized the policy of the separate lines. The contrast with the constructive Harriman programme is nowhere more striking than in this respect. The far-reaching plan for expansion of the Gould roads was evidently formulated in 1901. This consisted of two entirely distinct parts; for extension of the lines of the Missouri Pacific, east to the Atlantic seaboard and west to the Pacific Ocean, respectively. The first step toward the latter end was the acquisition of about one-quarter of the capital stock of the Denver & Rio Grande road. This carried the system as far as Ogden, Utah, where, together with the Union Pacific, connection was made with the Central Pacific on to the coast. THE GOULD SYSTEM 519 ii ■sss 520 RAILROADS This first purchase was financed by a large issue of new stock by the Missouri Pacific, which was at the time in a relatively prosperous condition; and which promptly proceeded to ini- tiate dividends on its largely increased capital stock instead of upbuilding its plant out of earnings. This invasion of far western territory brought the Gould roads into immediate conflict with the then rapidly unfolding plans for a Pacific coast monopoly of the Union Pacific system, already outlined. And no sooner was the Southern Pacific, carrying control of the Central Pacific, purchased in 1901 by Harriman than the Denver & Rio Grande was denied further participation in through rates and facilities beyond its western terminus. Had the Interstate Commerce Commission then had the plenary power over joint rates which it now enjoys, the remedy would have been simple. But, under the circumstances, only one course was open, namely to construct an independent line on to San Francisco. This was incorporated as the Western Pacific Railway. It was financed by a public offering of bonds; but a majority of the capital stock was held by the Denver & Rio Grande. At the same time this latter road, then fairly prosperous, undertook to guarantee the payment of interest on the entire indebtedness of the new Western Pacific road. All might have been well had the original estimates both as to the cost and the length of time requisite for construction of this final liuk, not proven entirely inadequate. ^ The line was at last completed and formally opened for traffic in 1908. Bufr as will shortly appear, the financial burden of so great an undertaking was too heavy for the remainder of the Gould system to support. As for the plans for easterly extension, it is important to note the corporate connection between the Wabash and the Missouri Pacific. As indicated by the accompanying diagram on page 519, the principal nexus was through the large per- 1 Quarterly Journal of Economics, vol. XXVIII, 1914, p. 781, on terminal troubles at San Francisco. THE GOULD SYSTEM 521 sonal holdings of the Gould estate in both roads. But in addi- tion to this, the Missouri Pacific and its subsidiary, the Iron Moimtain road, held stock as well as bonds of the Wabash. These holdings were considerably increased about 1904. A substantial and probably a controlling interest in the Wabash line was thus assured. This road in the meantime had been extended east as far as Buffalo. The next step was taken in 1901, when the Wheeling & Lake Erie, a single-track coal road only about two years old, was acquired through purchase of a majority of its capital stock. This brought the Gould system down to Wheeling, W. Va., within 60 miles of Pitts- burg. The Pittsburg district is one of the most important traflac centres in the United States. Its freight tonnage of coal, ore and iron is said to exceed that of any other three cities in the United States; and to be more lucrative as traffic than the movement of the entire cotton crop. But this prize had long been enjoyed by the powerful Pennsylvania railroad, almost as a complete monopoly. Even as the western exten- sion brought the Gould system into conflict with the Harri- man forces; so also did this eastern expansion arouse the most bitter antagonisms among powerful transportation and allied banking interests. In the meantime, while the plans for reach- ing Pittsburg were in the making, arrangements for still further extension to the Atlantic Coast were being made. This was brought about through the acquisition in 1902 of the Western Maryland Railroad, a small property reaching inland from tide- water at Baltimore. Control of this was purchased from the municipality which had largely financed its construction. This too was a weak road, running up a tree at its western terminus. The plan was to carry it up to meet the Wabash extension at Pittsburg. This would complete the transcontinental system. It will now be observed that all three of the gaps to be filled by new construction, lay in difficult and mountainous territory, calling for enormous expenditures of capital. But by far the most stupendous undertaking was the short stretch 622 RAILROADS of sixty miles between the Wheeling & Lake Erie and the city of Pittsburg. Not only does the city itself lie between two deep rivers with very high bluffs; but the entire district is also extremely rugged. This piece of road, therefore, proved to be one of the most expensive to construct in the United States. It is said that more than half of its length consists either of bridges or timnels. Nor could it be cheaply built if it was to compete for the heavy low-grade traffic in coal and iron with the Pennsylvania road. The work physically was thoroughly done. Grades and curves were eliminated at any cost; and the many bridges were fashioned to carry the heaviest modern train loads. But much of the enormous cost of building this Pittsburg connection was not due to the physical obstacles. The legal and political difficulties to be overcome were even more formidable. The charter to bridge the Monon- gahela river, to be sure, was cleverly secured. It took the form of revival of a right once granted by Congress for con- struction of a railroad bridge into Pittsburg; but it was sought and granted ostensibly in the interest of a suburban trolley line. The right to construct elsewhere was simple enough under the lax provisions of Pennsylvania law. The real politi- cal difficulty lay in securing franchises from the city authorities for the construction of terminals, and especially of connections to the great outlying steel plants. Terminal sites alone merely called for large siuns of money; but franchises had to be granted for all these spurs and feeders. And in face of the political control of the district by the Pennsylvania railroad, these franchises might never have been obtainable. Fortimately the imprecedented prosperity of the coimtry in 1901-02, so congested all the railroads of the country, the tnmk lines included, that local public opinion finally in 1903 compelled the city authorities to grant the desired rights of entry in some measure. But the war between the Gould and Pennsyl- vania forces was not ended by truce until 1904. In the mean- time, it had been extended to include all the other Gould THE GOULD SYSTEM 523 properties, notably the Western Union Telegraph Company. The Pennsylvania railroad for example at one time retaliated upon its rival, by ordering the complete removal of all the Western Union poles along its right of way, then giving the franchise to a rival concern, the Postal Telegraph Company. But at last the hne was built, and all the properties were in 1904 consolidated as the Wabash-Pittsburg Terminal Company. Whether under normal conditions of business, the far- reaching plans for creation of a transcontinental Gould system could ever have been successfully realized or not, will never be known. A chain is no stronger than its weakest link, and none of these links were over-strong. Moreover, until the connections were actually completed, the burden of interest on the excessive mortgage indebtedness could not be sup- ported by augmented earnings. And the great cost of all the new construction had piled up a huge mass of obligations. The Wabash-Pittsburg Terminal Company, for example, had out- standing in 1906, about $54,000,000 of bonds covering its sixty miles of line. The enterprise is said to have cost more than $45,000,000. And as yet it had no adequate freight yards or terminal facilities; nor had it equipment of any sort. It had most valuable traflSc contracts, with the Carnegie Company for instance, but it was as yet unable to make use of them because of the lack of physical connection with the plants. The Western Pacific work was also proceeding slowly. And all the other older companies had been under heavy strain for improvements to keep pace with the growth of business. At this most unfortimate juncture, came the sharp panic of 1906-'07. It was a shock too severe to withstand, and the entire system began to go to pieces. The first link in the long chain to snap was the Western Maryland, which went into the hands of a receiver in 1908. The International & Great Northern, — a personal possession of the Gould family, — promptly followed suit; while the other Texas properties either defaulted on their bond interest 524 RAILROADS or reduced their dividends. Then came a receivership for the Wabash-Pittsburg Terminal Company, the stock of which was all owned by the Wabash; while a majority of the Wheel- ing & Lake Erie shares were held by the Pittsburg Terminal Company.! g^t the Wabash had only been loosely held by a syndicate. Strenuous efforts were made to hold the system together. Other property was sacrificed to this end. In 1909 the control of the Western Union Telegraph Company was sold. But all the strain from both ends of the line ran back to the Missouri Pacific at the middle. This company was forced to suspend dividends; and finally in 1911 was formally yielded up to great international banking interests, formerly closely identified with the Harriman system. In fact before his death, Harriman himself had already personally intervened on behalf of the Wheeling & Lake Erie road. And in 1910 with the collapse of the Pearson-Farquhar syndicate,^ impor- tant holdings in the Wabash had gone to Union Pacific bankers. The Missouri Pacific was the keystone of the whole financial arch. With its loss the entire Gould domination came to an end. Moreover, with all the western lines, — rivals of the Union Pacific group for transcontinental business — passed over to the hands of Harriman bankers, the rate policy of the two was far more likely to be harmonious. And the long- standing needs of the companies for an efficient constructive management, aiming at internal reconstruction rather than territorial expansion, promised to be gratified. Some of these properties, notably the Denver & Rio Grande and the Missoiu-i Pacific itself, ought to prosper under more favorable conditions. Whether they will yet do so must depend to some extent upon the industrial prosperity of the coimtry as a whole. The sudden rise and subsequent dismemberment of the so-called Rock Island system within eight years prior to 1911, ' On the Wabash reorganization, chapter XII, supra. 2 P. 221, supra. THE ROCK ISLAND SYSTEM 525 are of interest as illustrations of irregular financial method attendant upon almost exclusively banker management, rather than as an elucidation of any principles, economic or operating, having to do with consolidation. In fact it is clear that personal greed rather than constructive impulses have been the leading features in its management. Such being the case, the practical failure of the undertaking through loss of public confidence and internal dissension is matter for congratu- lation. The Rock Island consolidation was handicapped by at least four primary financial vices. It was grossly over- capitalized. It was organized solely for the benefit of a few "insiders." The general investing public was rigidly denied all information as to the real status of affairs. Its securities at all times constituted a blind pool of a highly speculative sort. And there is little evidence of any real constructive transporta- tion policy, which by upbuilding either the property or the territory served, might in the course of time overcome or counterbalance its fiuaancial weakness, — little evidence, in other words, of the upbuilding genius which in a measure palliated some of the offences of the Harriman administration of the Union Pacific. The kernel of the Rock Island system, which within a few months attained a total length of nearly 15,000 miles of line, was the old Chicago, Rock Island & Pacific Railway Company. Up to 1901 this was a prosperous, modestly capitalized and reputable granger road about 4,000 miles long, serving a well- settled territory between Chicago and Denver, with feeders nmning off toward the Southwest. A syndicate of bold specu- lators, — since known as the Moore-Reid party — then re- cently enriched by successful operations in the line of consolida- tions of steel properties, purchased control of it in 1901-'02. This was a costly affair. For in those "boom" times Rock Island stock, — and there was $50,000,000 of it — sold above $200 per share. But the necessary funds were temporarily seciu-ed by the familiar processes of pyramiding loans from 526 RAILROADS THE ROCK ISLAND SYSTEM 527 the New York banks. The primary purpose of the plan of corporate organization adopted was to enable continued control of the property while lessening the burden of these extensive borrowings; or, in other words, to enjoy the fruits of manage- ment of the road without actually owning any considerable fraction of it. The first step toward this end was to increase the share capital of the origmal Railway Company to $75,000,- 000. The second, to recall the details of our earlier treatment of the subject, 1 was the chartering in Iowa of a purely financial corporation, the Chicago, Rock Island & Pacific Railroad Company, capitalized at $145,000,000. And then again in the state of New Jersey, still another financial corporation, the Rock Island Company, was chartered, this time with a capital stock of about $139,000,000. These two latter con- cerns — the Rock Island Company and the Railroad Company — then in substance exchanged shares with one another, no cash being necessary to the transaction. This left the Rock Island Company as sole stockholder of the Railroad Company; while this latter corporation was in possession of most of the share capital of the Railway Company. Thus far all was on paper. Now followed the first real transfer of property. The Railroad Company, standing between the other two, as shown by the diagram on p. 153, offered to purchase their holdings from the stockholders of the original operating Railway com- pany, — the only one, be it observed, which had any real possessions to sell. Specifically, this Railroad company offered for each $100 share of old Railway stock, an equal amount of its own Railroad collateral trust bonds, to be secured by the Railway shares thus acquired; and in addition $70 in preferred shares and $100 in common shares of the Rock Island Company, — these having been acquired by the prior exchange of secu- rities above-mentioned. This inextricably bound all three corporations together. The offer, made primarily to them- selves, as they had already bought up nearly all of the old Pp. 153 and 205, supra. 528 RAILROADS Railway shares in the open market, was promptly accepted by themselves, despite the vigorous protest of outside minority interests. About 93 per cent, of the Railway stock was thus exchanged, which at the prevailing market prices showed a substantial paper profit to those who accepted the offer and could forthwith sell their new securities. On this basis the gist of the plan was by marketing the new collateral trust bonds, to reimburse the managers for their original outlay in buying up the old company. The attractiveness of the plan to those who chose to keep all their securities was that it gave what appeared to be as much certain income yield as before, with a bonus of new stocks which might some day become valuable. Such was the apparent result. But there was another feature not so evident at once to the general public and yet of far greater importance to those immediately concerned. The significant feature of this reorganization, apart from the mere multiplication of holding companies, was the practical vesting of control of the Rock Island Company in its relatively small amount of preferred stock. For the right to elect five of the nine directors was lodged in its possible $52,500,000 of preferred shares, to the exclusion of all common stockholders. Moreover, this sole power of electing directors could not be surrendered without consent of two-thirds of the preferred shareholders; nor could the amount of such stock be increased without afiirmative vote of two-thirds of both classes of shares alike. By this means, supposing all the old railway share- holders were to effect the exchange, the possession of 262,501 shares of preferred stock would permanently intrench a manage- ment in control. Not all the old shares were actually ex- changed; so that only about $48,000,000 of preferred stock had to be issued. And of course, it will be observed that while at par this would require an investment of less than $25,000,000; the enormous increase in the total capitalization of the system, especially swollen in later years by largely increased mortgage THE ROCK ISLAND SYSTEM 529 indebtedness of the several operating railroads controlled, progressively lowered the market price of this preferred stock. It was evidently expected that this mode of finance would substantially lower quotations all round; and hence render control comparatively cheap. Yet it is improbable that so serious a decline was contemplated, as in fact actually occurred. By 1908 the preferred shares dropped from 86 to less than one-quarter of that figure. Six years later they reached a quotation of if. At this latest figure $300,000 worth of pre- ferred stock would control the entire Rock Island Company; leaving it in turn to control all those below it in series. But it is only fair to base the calculation upon prices prevalent when the combination was at flood tide. In 1908 a little over $5,000,- 000 worth of this regnant preferred stock kept the banker management in the saddle. When it is considered that the aggregate stock and funded obligations both of the 15,000 miles of railroad and of the two holding companies was at par $1,500,000,000 the preposterous and top-heavy character of the whole organization is plain. The wonder is that the project could ever have succeeded at all. That it did so, is a striking commentary upon the speculative furor of the time.^ Having completed its financial organization as above described, and with an investing public ready and even eager to purchase collateral trust bonds based upon railroad stocks deposited as collateral, it was now a relatively simple matter to expand the Rock Island railway net. This took place in two directions; first toward the south and west and later into trunk line territory. Further financial details are not neces- sary. Most of the purchases were effected by the issue of collateral trust bonds of the intermediate holding company, the so-called Railroad company. No cash was therefore required. In 1902 the Choctaw, Oklahoma & Gulf, from Memphis due west into Texas, was acquired. And the next » Railroad collateral trust bondholders successfully foreclosed and took the Railway stock in January, 1915. VOL. H — 34. 530 RAILROADS year the lines were extended to the most important Gulf ports, New Orleans and Galveston; and the rich Alabama iron and steel region at Birmingham was tapped by purchase of the St. Louis & San Francisco. Thus the entire region from St. Paul to the Gulf of Mexico and from the Mississippi to the Rocky Mountains was well covered, — possibly too well covered in places. For the original Rock Island and "Frisco" roads were clearly competitive rather than complementary at many points. Given this wide territorial expansion, it was next in order to procure eastern connections. This was done in 1903 by absorption of the Chicago & Eastern Illinois, thus giving a direct line from the southwest into Chicago, besides by means of the Evansville & Terre Haute, traversing the entire length of Illinois, cross-cutting every possible outlet to the east. Then the Chicago & Alton was taken on, at first for alter- nate years with the Union Pacific road, but finally in toto. It seemed, indeed, as if both tnmk and branches were so arranged as to promote the utmost growth of traffic in future. Even more comprehensive plans for expansion seem to have been for a time entertained. As late as 1908 a Rock Island syndicate acquired a one-quarter interest in the Lehigh Valley Railroad, which would have given access to the Atlantic seaboard, pro- vided some connecting link like the Wabash could be brought into line. But in the meantime, internal dissension seems to have arisen which finally led to a partial disruption of the system. The fruits of irregular financing soon began to be apparent. Public confidence in all Rock Island securities speedily de- clined. Despite rapid increases in gross earnings, the necessary funds for improvement could not be raised through the sale of bonds. And this of course meant inadequate facilities and imperfect maintenance, hence abnormally high operating expenses. Under such circumstances net earnings responded but feebly to growth of mileage. Such borrowing as was effected was at ruinous rates. During the five years to 1907, THE ROCK ISLAND SYSTEM 531 the operating Railway company doubled both its net earnings and its funded debt; but its fixed charges increased nearly threefold. So severely was public confidence shaken, that the New York Savings Bank Association finally disallowed the collateral trust bonds for institutional investment. The old Railway stock once commanding a price of over $200 per share, was by 1914 represented by a set of securities worth in the aggregate at public sale only about $18. Rock Island Company common stock practically dropped out of sight. And much the same thing was true of the securities of the other absorbed roads. The later disintegration of the Rock Island is a matter of recent history. In how far this was due to financial necessity, to appreciation of the fact that many parts of the system were unduly competitive with one another, or to the activity of the Federal government in enforcing the Sherman Anti-Trust Act, cannot well be ascertained. In 1907 the Chicago & Alton — a scuttled hull — was sold, its stock being exchanged for bonds of one of the so-called Hawley roads. Two years later, the "Frisco" company with its 6,500 miles of line was set off through retirement of the collateral trust bonds based upon deposit of its stock.^ This was a serious loss in itself; especially as it carried all the lines east of the Mississippi, including the then Lehigh Valley share holdings. Practically, it left two great competitive systems, not widely different in mileage, each with branches spread through the Southwest and with stems reaching Chicago. And of the two the "Frisco" was the more homogenous and compact. For the Rock Island in its lay-out manifests a disposition to sprawl out rather loosely over the map. The important lesson that any road with so huge a burden of securities that they of necessity command very low prices, is bound to become a prey to stock market manipulation, both from within and without, is well inculcated by Rock Island ' P. 155, supra. 532 RAILROADS experience. From the beginning a mere football of speculation/ its annual reports worse than an enigma, its career has been of little consequence to the investing public. In 1909-'10 it was seized upon by an Enghsh syndicate which aimed to create a new transcontinental system out of various properties of much the same sort.'' With the collapse of this speculative affair, some forty per cent, of Rock Island preferred stock was taken over in block by new banking interests. Whether the original promoters still control the necessary 51 per cent, of the pre- ferred shares remains to be seen. In most companies whose shares command public respect, practical control of a railroad is accompanied by the ownership of at least one-quarter of its capital stock. The question is merely of academic interest in view of the impending reorganization of the entire property, which, as we have already seen,' seems likely to be accomplished through the elimination of the superfluous holding companies alike. An entirely secondary aggregation of nine or ten low-grade and detached railroads may be dismissed in a word. This is the so-called Hawley group, bearing the name of its main promoter. For a time, beginning with the acquisition of the Minneapolis & St. Louis in 1895, with the later additions of the decrepit Iowa Central, the "Clover Leaf," the "Katey" and the ill-famed Alton, it seemed as if an important transporta- tion combination might result. This seemed especially likely when the Chesapeake & Ohio was taken over from the trunk- line systems, which, as we have seen, were induced to part with it through the legal activities of the Federal government. But the inferior quality of these properties, calling for vast sums in the way of betterment in their severally detached locations, stood in the way of any comprehensive operating » P. 205, m'ln-a. 2 P. 221, supra. ' Chapter XII, supra. By foreclosure the Rock Island collateral trust bondholders in December, 1914, have at last secured possession of the old Railway stock. THE HAWLEY ROADS 533 plan. At all events the death of Edwin H. Hawley seems at this writing to have put an end to further progress along this line. Having thus passed in review the remarkable tendency toward combination up to about 1907, it remains only to note the very small number of important companies which still deserve the name of independent roads. The Pennsylvania by itself is sufficiently great to stand alone as a system. All the others were in one way or another linked up in series; with the exception of two transcontinental roads, the St. Paul and the Atchison, Topeka & Santa F6. (Map, p. 477.) It has often been prophesied that the latter will some day mate with the Pennsylvania to form an ocean-to-ocean system. The fact seems to be that each is so prosperous, so strongly backed financially and, moreover, has so large a proportion of small stockholders, that it would be almost impossible to wrest con- trol from the present managements. Some railroad groups are powerful geographical monopolies, as in the coal fields, in New England (once) and in the southern states. Some are prosperous because of their well-ordered lay-out and their efficient management upon great through routes of trade. Such are the Hill and Harriman systems. But the Pennsyl- vania, the St. Paul and the Atchison roads, each offer so strong a combination of strategic location, financial power and able administration, as to promise continuance as sole survivors of a time now apparently passed into history. If, however, they were to be brought into a close alliance with one another, what an invincible combination they would make! The Federal law could not lay hands upon them as team mates; for their lines are nowhere competitive. They supplement one another at every point. And as a matter of commercial strategy, such an aggregation of transportation units would reach almost every trade portal of the United States, and, with the exception of the cotton crop, would tap every great field of our agricultural and industrial production. CHAPTER XVI THE ANTHRACITE COAL ARRANGEMENT i Nature and location of the anthracite deposits, 534. — Every invitation to monopoly offered, 536. — Predominant and increasing railroad ownership, 637. — Early attempts to maintain prices, alike unsuc- cessful, 639. — Pecuharities of the business responsible, 640. — After 1898, conditions ripe for real monopoly, 641. — Three features of the new plan, 641. — Non-railroad operators eliminated by increased percentage allowances, 542. — Two projected independent raUroads throttled, 643. — Actual corporate consoUdation, 644. — Inter-rail- way relationships tightened, 544. — Proof of monopohstic combinar tion, circumstantial if not documentary, 545. — Remedial action, 647. The anthracite coal measures of northeastern Pennsylvania are irregularly distributed over an area of less than 600 square miles of territory, — only 22 miles square, in all. The location appears upon the accompanying map on the next page. These deposits lie scattered over four distinct areas, known respectively as the Northern or Wyoming field, extending, as our map shows, from Carbondale south by Scranton and Wilkes- barre; the Southern or Schuylkill field, lying east and west of Pottsville; and two smaller intermediate fields known respec- tively as the Eastern Middle or Lehigh region about Hazelton, and the Western Middle or Mahanoy and Shamokin basins. The character of the deposits in these several fields is somewhat different. The Northern field has been worked for a much longer time, and the danger, difficulty, and cost of mining are ' This brief summary is based upon my Report of 1901 to the U. S. Industrial Commission, vol. XIX, pp. 444-466. The entire subject has been authoritatively treated by Dr. Eliot Jones, The Anthracite Coal Combination in the United States, pp. 1-250; Harvard Economic Studies, 1914. Complete bibhographical data are included. From this source my own report has been brought down to date. THE ANTHRACITE ARRANGEMENT 535 considerably less than in the remaining territory. This is largely because the Wyoming coal measures lie in a broad shallow fold not more than 1,000 to 1,200 feet below the surface; although between Wilkesbarre and Nanticoke, where a large part of the supply now remains, the measures extend as deep as 1,800 feet. In the Western Middle field, where the folds are 536 RAILROADS much sharper, the depth of the deposits is considerable. The Mammoth beds, 40 feet or more in thickness, lie here as low as 2,000 feet imder the groimd. In the Southern field, which must of necessity constitute the bulk of the supply for the country in future years, the general depth is very great. It is estimated that fully one-half of the unmined coal is in these measures, not less than three-quarters of a mile below ground. Here are principally the enormous reserves of the Reading and the Central of New Jersey,^ which await development after the relatively accessible beds further north have been worked out. Every essential for one of the most perfect natural monop- olies in the world is possessed by these anthracite deposits. The product is an article of prime necessity. As a fuel, it is a natural coke, far superior to soft coal because the undesirable soot and gas have been removed by the heat and pressure associated with the upheaval of the Appalachian highlands. Thus there is no good substitute for it. The demand, further- more, is remarkably constant. For the "prepared sizes" are utiUzed almost exclusively for domestic purposes. Hence the consumption is far less susceptible to the ups and downs of business than that of soft coal. The market is a highly de- pendable one. The possible profitableness of the business, too, is greatly enhanced by convenience of location, midway between the greatest population and industrial centres of the United States. With a well-nigh indispensable commodity, a stable demand for it, and ready access to a great market; what more could potential monopoly ask, save that the supply should be limited, and hence capable of being garnered under one control! The sharp geological definition of the hard coal deposits upon the map throws the last essential to perfect natural monopoly, a restricted supply, into high relief. The actual amount of coal unmined has been ascertained to be approxi- ' Cf. my map, U. S. Industrial Commission, 1901, vol. XIX, p. 462. THE ANTHRACITE ARRANGEMENT 537 mately 6,000,000,000 tons of marketable anthracite, allowing for the high proportion of waste in mining.' At the present accelerating rate of shipment this aggregate points to a prob- able exhaustion of the supply in about one hundred and fifteen years. More uncertain is the up-grade of consumption year by year, than the actual mass of coal below ground, so pre- cisely measurable are the beds. It is doubtless this contrast between the strictly limited supply of anthracite and the practically inexhaustible deposits of soft coal, imderlying the entire Middle West, which accoimts for the pertinacious assiduity with which the railroads have sought to hold and tighten their grip upon the business. The inevitable rise in the price of hard coal, until, indeed, the name of black dia- mond becomes truly apposite, promises richly to reward a successful combination.^ The present control of the coal fields by the railroads has been a long, slow process. As far back as 1834 the danger of a union of transportation and mining was officially reported to the legislature of Pennsylvania. But as late as the '50s the Schuylkill region, which was principally worked at that time, was still mainly served by canals. With the advent of rail facilities during the decade, development spread up into the Wyoming territory, with a consequent steady increase in railroad ownership. First in the field in 1851 was the Lacka- wanna, followed four years later by the Lehigh Valley. Prog- ress was for a time impeded by the absence of legal authority to exercise mining privileges. And, oddly enough, the Reading, now the acknowledged leader, until 1869 stood as a dog ia the manger opposing all grants of mining privileges to railroad corporations. For nearly a generation after 1842, it seems to have confined itself almost exclusively to transportation. The turning point in pubhc poKcy came in 1868-'69, when the 1 21 I. C. C. Rep., 152; also Jones, op. ait. 2 C/. chapter II and p. 231, supra, on net earnings of the hard coal roads. 538 RAILROADS Pennsylvania legislature threw wide open the doors for the railroads "to aid corporations ... to develop the material interests of the commonwealth." Railroad ownership of coal lands and mining companies was immensely stimulated at once, both at the hands of the two companies already in the field and of other newcomers who stood waiting outside. Fore- most was the Philadelphia & Reading, which within a few years bought up approximately one-third of the coal lands of the whole anthracite basin, principally in the Schuylkill field. The Central of New Jersey also came in at this late day; but it, too, pressed forward so vigorously that it was soon a close second to the Reading in coal possessions. A feeble protest against the prevailing tendency was embodied in the Penn- sylvania constitution of 1874, prohibiting common carriers from engaging in the mining business. But no more attention seems to have been paid to it than to most other legislation in the interest of the people against corporations in Pennsylvania, either before or since. The result of the foregoing development was that, at least until 1913 when the Pennsylvania Railroad announced its withdrawal, the hard coal fields were predominantly in the hands of the eight railroads . depicted upon our map. Little mining was done directly; most of it was carried on through the medium of coal-mining companies.' In 1900 these eight railroads produced about 62 per cent, of the total output; and as a result of the aggressive campaign soon to be described, raised the marketed proportion to about nine-tenths within a few years. Only about three-quarters of the total shipments, even then, were actually mined by railroad coal companies. But the balance of the nine-tenths controlled, was tied up by perpetual contracts with the independent mine operators. This predominant mastery, furthermore, must inevitably strengthen with the passage of time; inasmuch as the still ' Jones, op. dt., pp. 113-131; Railroads: Rates and Regulation, p. 552, tor details of intercorporate relations. THE ANTHRACITE ARRANGEMENT 539 independent mining is mainly confined to the Wyoming field, now approaching exhaustion.^ The last "submerged tenth" of individual production outside of railroad control promises to be eliminated automatically as early as 1933. There are only four railroads, indeed, which have enough coal unmined for more than fifty years; and only three which can outlast a century. Although the anthracite coal deposits theoretically con- stitute so perfect a natural monopoly, experience has dis- covered a munber of difficulties in the way of accomplishment. These obstacles cropped out in the successive attempts which for a generation down to 1900 were unsuccessfully made to control the output, and thereby the price of the product, by concerted action of the mine operators, that is to say of the railroads. The first project, in 1872, took the form of a rail- road pool; but it proved ineffective owing to inability to keep the members within- their allotment of tonnage. After a disastrous interregnum, the arrangement was renewed six years later, and worked well enough in good times. A "friendly understanding" preserved the peace during the prosperous years to 1884; but the panic soon caused the bottom to drop out of the market thereafter. The agreement was revamped in 1886, for the first time taking in the Pennsylvania Railroad, and imposing a penalty for exceeding the apportioned tonnage. Once again the results fell short of expectation. Furthermore, after 1887 the prohibition of pooHng stood in the way of any- thing like a formal understanding. Stricter control of the trade in the early '90s was then attempted through corporate combination of the competing roads. The Philadelphia & Reading took the lead both in the purchase of competitors and in promoting inter-relation through community of interest.^ But everything naturally went to pieces again with the bank- 1 Cf. the detailed maps of railroad and independent holdings in our U. S. Industrial Report, 1901, vol. XIX, at p. 448. 2 The U. S. Industrial Commission of 1900 offers much evidence as to this experience. 540 RAILROADS ruptcy of this company in 1893. During the ensuing hard times the old allotment plan was revived and for a time was efficacious. But it, too, soon went the way of its unlucky predecessors, proving powerless to support the market. None of the plans accomplished more than a temporary sustentation of prices which yielded at once under the slightest falling off in the demand. The failure of the persistently renewed attempts at control was due to certain peculiarities of the hard coal business. Probably the most important was the wide variability of demand from one season of the year to another. Anthracite of the so-called "prepared sizes" is primarily used for domestic purposes; in consequence of which the demand, imlike that for manufacturing, although constant year after year, fluctuates widely both according to the season and the weather. The short-sightedness of householders postpones the filling of bins until the first touch of frost, when the demand comes with a rush. There is thus an alternation of stagnation and activity in the collieries which must, nevertheless, maintain sufficiently large plants to meet the maximum demand when it occurs. Nor can this peak of the demand be anticipated, practically, for a number of reasons. Interest charges accumulate; storage costs and double handling are expensive, and the product rusts on continued exposure to the weather. Normally, therefore, expensive plants must lie idle in part throughout much of the year in order that the maximum demand may be promptly met when it arises. Certain expedients such as enticing discounts for early purchase during the spring and summer, and improvements in the method of handling the product, were good as far as they went. But, on the whole, the tempta- tion was continuing and irresistible for each operator to more nearly work his plant to its full capacity all the time, even al- though that had to be done by shading the price.' ^ The parallel with the potash Kartell in Germany is almost perfect. Quarterly Journal of Economics, vol. XXVIII, 1913, p. 140 et seq. THE ANTHRACITE ARRANGEMENT 541 The mere bigness of the project of monopolizing the an- thracite coal business was an obstacle even more formidable than the operating difficulties above described. It called for more than the mere control of shipments. Acquisition of all the reserves of unmined coal was also necessary. This, in turn, entailed an accumulation of fixed charges for indebtedness incurred in buying up these reserves under ground, which must be borne by the profits of immediate operation. No success could reasonably be anticipated in this direction until the consumption had so far increased that it was able to bear the bm-den of the unmined supply upon its shoulders, aided in so doing by 'power to raise the price. The Reading had repeatedly gone bankrupt in the past by attempting to carry the load alone. The time was first ripe for achievement in this direction with the advent of prosperity in 1898. Thenceforth, combina- tion among the anthracite coal roads became part and parcel of the great movement toward consolidation of common carriers in other fields which has already been described. The ultimately successful campaign against competition after 1898 developed along three independent lines of attack. The first two, namely, actual corporate consolidation and community of interest, were prosecuted in a manner not essen- tially different from that pursued by the carriers elsewhere. It was the third, the attempted elimination of the independent operators, which was peculiar to the anthracite coal fields. The relation of the shipper of coal to the railroads in an- thracite territory has always been unhke that which prevailed elsewhere. Instead of charging so much per hundred pounds for carriage, the hard coal railroads allowed the operators a certain percentage of the market price, whatever that might be. The usual percentage of the tide-water price for the larger sizes of coal gradually increased with the progress of time from 40 per cent, in the early '80s to a standard of 60 per cent, ten years later. Such allowances were fixed by means of contracts entered into for a term of years. Nor did it affect 542 RAILROADS the system whether the coal mines were owned by the railroads through subsidiary corporations or were independent; except that in the former case the carriers were making engagements between their own right and left hands. The percentage of the tide-water price allowed at the mine mouth was to them a matter of indifference, or rather merely of bookkeeping. Not so the independents. For they could not recoup themselves for losses in coal mining by gains in transportation, as did the railroad companies. The bone of contention, then, worried over for years, was the fixing of this percentage allotment, which was of importance, however, only to the small body of independents, mostly in the Northern field, who stUl xemaiaed free to ship and market their coal as they chose. With them the struggle settled down to the determination of a fair per- centage rate. Their lives depended upon it. To the railroad, on the other hand, the most important feature of these per- centage contracts was a clause which should tie up the mines indissolubly to one or another of the carriers to which they had access. The widespread dissatisfaction among the independent mine operators in the late '90s, with an arrangement which left them but 60 per cent, of the tide-water price, was dealt with by the railroads in two ways. The smaller ones were quieted by granting them an increased proportion of the market price. The more powerful ones, who were capable of making trouble, had to be purchased outright. As for the former, the increase in their percentage allowances took place in connection with the great coal strike of 1900. The RepubUcan party, fearing lest the election of McKinley be endangered, persuaded the operators to concede an advance in wages of 10 per cent. Many of the independents hung back, hoping to recoup them- selves for this wage increase by a reduction in freight rates. After extended conferences a new standard arrangement be- tween the mine operators and the railroads was agreed upon. The three significant features were: an increase of the per- THE ANTHEACITE ARRANGEMENT 543 centage allowance to 65; a supply of cars guaranteed to the operators in such quantities "as in its [the railroad's] judg- ment, the requirements of the market will permit"; and a contract in perpetuity. ' Thus did the mine owners, in con- sideration of a surrender of their independence forever, receive assurance of a better price and adequate facilities for reaching the market. But the determination of their share in the total production was committed irrevocably to the railroads. The threat of the larger and more aggressive independent operators to kick over the traces, finally inducing the railroads to buy their mines outright, took shape in two projects for the construction of independent railroads from the coal fields to tide water. The first, in 1898, proposed to build the New York, Wyoming & Western as an outlet for the Lackawanna region. Several million tons yearly were pledged to it, the largest individual firm promising well over one million tons. This enterprise was brought to an untimely end through the agency of the Temple Iron Company, a holding corporation already described.^ This excellent corporate instrument was employed by President Baer of the Reading to prevent these troublesome independents from becoming "Ishmaelites in the field." As a holding company it bought out the independents, and to it were transferred a number of outlying concerns.' Its capital stock was apportioned among seven of the anthracite coal roads, — all except the Pennsylvania, in fact; and its tonnage, as acquired, was distributed among them in proportion to their several mining capacities. The second proposition for an "Ishmaelite" railroad was fathered by the Pennsylvania Coal Company, the largest of all the independent operators, which produced in 1899 some two million tons of coal. An abandoned canal was actually purchased for the road-bed, and terminal facilities on the Hudson river were acquired. This railroad promised like the other to advance the allowance of the opera- 1 Jones, op. cit., p. 91. ^ P. 437, supra. " Complicated transactions described by Jones, op. cit., p. 78 ff. 544 RAILROADS tors to 65 per cent. But the project was frustrated in 1899, as in the former case, by the Erie, which with great difficulty succeeded in picking up a majority of the coal copipany shares from scattered holders throughout Pennsylvania. Actual railroad consolidation, as a means of tying up the hard coal situation, was also actively pushed after 1898. The Erie first purchased the New York, Susquehanna & Western, upon its threat to become an independent carrier to tide water. This was succeeded by the purchase of a controlUng interest in the Central Railroad of New Jersey by the Reading in 1901. ^ This second transaction brought together the two railroads controlling the largest reserves of unmined coal in the field, — about 63 per cent, of the existing supply altogether. It also gave the Reading a direct line to tide water at New York, relieving it of the necessity of a round-about haul by way of Philadelphia. Three years later, the New Haven took over the New York, Ontario & Western which up to that time had been something of a free lance. And in the same year several other small railroads in the Lehigh field were also brought within the railroad fold.^ While the foregoing corporate combinations were taking place, rapid progress was being made toward monopoly by means of inter-railway stock ownership and interlocking directorates. Among the former, the most important single transaction was the joint purchase by several of the coal roads under the leadership of the trunk lines, of nearly 30 per cent, of the capital stock of the Lehigh Valley. The presidents or leading directors of the other coal roads promptly entering its directorate, the Lehigh Valley was and still is virtually brought into assured harmony with all of its natural competitors. These events, it should be noted, were taking place concomi- tantly with the concerted activity to eliminate competition from the trunk line territory.^ The final result was an extraordi- nary interweaving of stock ownership and directoral repre- ' P. 66, supra. ^ Jones, op. cit., p. 65. ' P. 480, supra. THE ANTHRACITE ARRANGEMENT 545 sentation. The same individuals or banking interests appear repeatedly upon the boards of this entire group of companies. The complexity has abated somewhat of late, in response to the pressure of public opinion and law; but still, to all intents and purposes, these anthracite coal roads conduct their affairs as a imit.i If further proof of the existence of combination than the inter-railway relationships already described were needed, it would appear as if the evidence, statistical if not legal, were convincing enough. Formal or other docmnentary record has been most ingeniously avoided.^ But the slightest evidence of corporate independence has been promptly smothered by the appUcation of forceful banking and railroad pressure.' Furthermore, it is inconceivable that the allotment of tonnage between the different carriers should have been maintained ' Jones, op. cit., p. 71, describes the situation in 1903 as follows: "Four out of the nine directors of the Reading Company constituted four of the nine directors of the Central of New Jersey. Six out of the thirteen direc- tors of the Lehigh Valley were directors either of the Reading Company or of the Central of New Jersey. Four out of the fourteen directors of the Lackawanna were directors of the Reading Company or of the Central of New Jersey, three of whom were directors of the Lehigh Valley also. Three of the directors of the Erie were directors of the Reading Company, three were directors of the Central of New Jersey, three of the Lehigh Valley, and one was a director of the Delaware & Hudson. One of the directors of the Delaware & Hudson was, therefore, a director of the Erie, and another was a director of the Ontario, and also of the New York Central, and of the Lake Shore. After the New York Central and the Pennsylvania obtained practical control of the Reading, and large interests in other roads, the ramifications became still greater. Three of the New York Central directors, and three of the Lake Shore directors, were then directors of the Lackawanna, one of the directors of the New York Central was a director of the Reading Company and of the Lehigh Valley, and another was a director of the Delaware & Hudson and of the Ontario. The Pennsylvania, through the Baltimore & Ohio, was represented by one director in the Reading Company and in the Central of New Jersey, and by two in the Lehigh Valley and two in the Erie. In addition, Mr. Morgan, a director of the New York Central, and of the Lake Shore, had very large holdings in the anthracite coal roads." 2 Cf. 52nd Cong., 2nd sess.. House Rep. no. 2278, vol. I; and p. 570, infra. ' Jones, op. cit., p. 146, cites the leading case of the Ontario & Western In 1906. Cf. especially the correspondence reprinted in Appendix. VOL. II — 35 546 RAILROADS so unchangingly without an "understanding," by telephone, telepathy or otherwise. No matter how widely the total ship- ments have fluctuated year by year, nor how great the increase from one decade to another, each railroad has as unfailingly adhered to its percentage allowance as have the planets fol- lowed their courses in the heavens. This constancy is exhibited by means of the diagram following. Comparison of the first 1890 1900 1910 1913 and last years covered by this chart with the abnormal situa- tion at the time of the great strike in 1902, brings out the extraordinary persistence of a well-defined division of traffic. Thus, the Reading handled the following percentages of the THE ANTHRACITE ARRANGEMENT 547 total anthracite shipments: in 1890, 20.97; in 1900, 20.70; in 1912, 20.21. Even under the abnormal strike conditions of 1902 when the total shipments were almost cut in halves, its proportion still "happened" to be 18.94 per cent. Viewed in a large way, the allotments of the original participants slightly declined during twenty years, probably because of the aggres- siveness of independent intruders; but since 1900, so firmly was restraint applied all along the line, that the deviation from standard was almost negligible. The medium of control seems to have been the Temple Iron Company which acted as a clearing-house for assuring to each railroad its "normal" share of the business; while at the same time appljdng the brakes against any over-production which might tend to break the "standard" price. What is there to do about it? Is there no hope of escape from monopoly? There are only three instrumentalities which promise relief. These are now in the hands of the Federal goverrunent. The Interstate Commerce Commission seems, on the whole, to have made little headway. '^ The com- modity clause of the Act of 1910, seeking to compel the rail- roads to divest themselves of mining properties, has already brought about a considerable corporate readjustment; but it cannot be afl&rmed that much real progress has resulted.^ As for the Anti-Trust law, as will be seen in the next chapter, the government is in the mid-stream of effort at this present writing. Thus far it has succeeded only in nullifying the percentage contracts which tied up the individual operators, and in com- pelling the dissolution of the Temple Iron Company as a holding concern. Not merely the protection of the rear-guard of individual operators is the task in hand, — necessary as that 1 Jones, op. cit., p. 180 ff. The important Pennsylvania Public Ser- vice Commission decision of December, 1914, reducing coal rates to Philadelphia by 40 cents a ton is a hopeful sign; but then there is the usual force in Pennsylvania, of power in the county courts to reverse the commission on appeal. 2 Raih-oads: Rates and Regulation, p. 552; Quarterly Journal o/ Economics, vol. XXVII, 1913, pp. 579-615; or Jones, op. dt., p. 187 ff. 548 RAILROADS is in the interests of fair dealing. The problem is bigger than that of the reasonableness of rates for the carriage of coal. Final success will be achieved only when the market price of anthracite, mining included with transportation, is brought definitively under government control. CHAPTER XVII DISSOLUTION UNDER THE ANTI-TRUST LAW Circumstances attending its passage, 549. — Congressional intent to in- clude common carriers uncertain, 650. — Text of the Act, 551. — Its uneven enforcement by different Administrations, 552. — First in- voked against pooling in 1897-'98, 553. — Revivification under Presi- dent Roosevelt, 554. — Holding companies condemned by the Northern Securities decision in 1904, 555. — Broad constitutional principles settled, 656. — No distinction between due and undue restraint, 657. — Final construction by the rule of reason, 558. — First applied in the St. Louis Terminal case in 1912, 669. — Constructive reUef replaces mere condemnation, 660. — The Union Pacific-Southern Pacific dis- solution proceedings, 1912, 661. — Was there competition prior to the merger in 1901? 562. — • Did the combination lessen rivalry? 664. — And if so, was it unreasonable? 565. — Careful attention to the dissolu- tion decree, 566. — The several plans outlined, 667. — Renewal of proceedings to set off the Central Pacific, 569. — The Anthracite Coal Trust decision, 1912, 670. — The agreement for undoing the New Haven merger in 1914, 571. — Present conditions summarized, 573. No piece of legislation can be understood, much less appre- ciated, except in the light of the circumstances attending its enactment. This is particularly true of the Sherman Anti- Trust law as applied to transportation. Prior to 1887, indus- trial combination in the United States had scarcely passed the stage of incubation. Something was evidently doing within; but the outer shell had not yet been broken wide open. Cer- tain combinations, notably the Standard Oil Company, had already, to be sure, grossly outraged pubhc opinion. And it is indubitable that its offences against commercial decency were among the causes contributing to the passage of the Act to Regulate Commerce in 1887.' But the real outbreak of indus- trial combination over a wider field did not occur for some time thereafter. The later years of the decade of the '80s were associated with active investigation of industrial affairs, with » Ripley, Railroads: Rates and Regulation, p. 445. 550 RAILROADS the tariff looming large in the background behind the issue of monopoly. A number of anti-trust laws were passed about this period, along with the far-reaching New Jersey statute of 1889, which empowered its corporations to hold stocks in other companies anywhere. It was undoubtedly the public feeling productive of these investigations and bits of state legislation, which also induced Congress to place the Sherman Act upon the statute books in 1890. This statute, succeeding the Act to Regulate Commerce after an interval of three years, seems to have been introduced primarily as a remedy for ptu-ely indus- trial evils, unassociated with railroading as such. For the Interstate Commerce Act was at the time regarded as adequate for dealing with the existing transportation abuses. The Congressional history of the Sherman Act is important in its bearings upon the question as to the intent to bring com- mon carriers within the prohibitions of the statute.^ As early as 1888 Senator Sherman of Ohio introduced a bill declaring all combinations, conspiracies and agreements in restraint of trade unlawful. This died in committee. An identical bill, except for the elimination of "conspiracy" and "restraint of trade" was re-introduced in the following year. The first de- cisive step was taken in 1890, when the Committee on Judiciary reported to the Senate, recommending that everything except the enacting clause in the latest Sherman bill should be stricken out, and that an entirely new measure drafted by Senator Hoar of Massachusetts be substituted.^ It was this bill which sub- sequently became the Sherman Act, so-called as Senator Hoar somewhat tartly observes "only because Sherman had nothing whatever to do with it." It is uncertain whether it was originally intended to include railroads imder the Anti-Trust law. The indetermination of the Congressional mind is clearly brought out in the divided 1 Most conveniently traceable in Bills and Debates in Congress Relating to Trusts, 57th Cong., 2nd sess., Senate Doc. no. 147, I, 1903; Autobiography, by Hon. G. F. Hoar, vol. II, p. 362 et seq. 2 21 Cong. Record, pp. 2901 and 4089. ANTI-TRUST DISSOLUTIONS 551 opinion of the Supreme Court of the United States in the Trans-Missouri Freight Association case.^ Five justices de- clared that it was "impossible to say what were the views of a majority of the members of each house," as well as "that the debates in Congress are not appropriate sources of information for this purpose." Not satisfied with this disposition of the matter, four justices in the dissenting opinion reviewed in detail the Congressional history of the bill. Evidence was found to their satisfaction that a determined effort was made, by means of amendments proposed, to include transportation contracts or agreements, but that the effort was unsuccessful. According to this interpretation there was no purpose to interfere with the Interstate Commerce Act. These dissidents, consequently, held that all activities of common carriers should be adjudged according to the provisions of the Act to Regulate Commerce of 1887 and not by the Sherman Act at all. It is rather sig- nificant in view of this closely divided opinion, that the statute has subsequently been so broadly applied to the common car- riers of the country in the series of decisions henceforward to be reviewed. The text of the Sherman Act "To protect trade and com- merce against imlawful restraints and monopoHes" in the first section declares illegal: "Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several states, or with foreign nations." The second section turns from restraint of trade to monopoly. "Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopo- lize any part of the trade or commerce among the several states, or with foreign nations," commits a misdeameanor, punishable by fine and imprison- ment. By the third section of the Act, the same prohibitions are made applicable to the territories as well as to the states. 1 166 U. S., 317 and 359. 552 RAILROADS The remaining clauses are unimportant for our purpose save, perhaps, the sixth which declares any proscribed property in the course of interstate transportation forfeit and defines the word "person" as including corporations. The law was indeed quite brief by comparison with the extended and elaborate Interstate Commerce Act. As a background for the examination of the application of the Sherman Act to railroads, attention should be directed to the extreme unevenness with which that statute has been enforced by Federal executive authority. Only thus does it become apparent why combination among railroads was en- abled to attain so considerable a momentum before the inhibi- tions of the Act were brought into play at all. The record of the different presidential administrations is illimiinating. As Professor Seager observes,^ it will now scarcely be denied that three successive presidents and five successive attorneys-general were seriously remiss in their duty. Under the administration of President Harrison to March 1893, only four bills in equity were filed, and but three indictments were returned. The succeeding term of President Cleveland, to 1897, witnessed the same number of bills with only two indictments. The dis- appointing outcome of the first prosecutions attempted, prob- ably accounts in a measure for this lack of interest; although the affirmed illegality of railroad pooling somewhat relieved the monotony. The low water mark of enforcement of the Anti- Trust law was touched under President McKinley, during the four years 1897-'01. The statute was practically a dead letter so far as either railroads or industrial combinations were con- cerned. The artillery of the Department of Justice was, to be sure, trained upon one petty live stock combination and certain agreements among local coal dealers. But the attention of the country seems to have been fixed rather upon sowing the ' Political Science Quarterly, vol. XXVI, 1911, p. 584. The pamphlet summary of Anti-Trust Decisions, published by the Department of Jus- tice annually, contains the record. ANTI-TRUST DISSOLUTIONS 553 seeds of monopoly than upon any attempt to prepare the soil for a more healthy industrial crop. During this long dull period, while the existence of "teeth" in the Sherman Act was so wholly unsuspected, it is not sur- prising that its judicial interpretation as applied to railroads occurred only in connection with pooling. As a matter of fact the great railroad combination movement did not get under way imtil somewhat later. Hence the distinction of applying almost the first test was reserved for the Trans- Missouri Freight Association in 1897.^ The structure and func- tioning of organizations of this sort will be considered in the next chapter; ^ but, inasmuch as this first railroad decision really turned upon the question of monopoly rather than of pooling per se as defined in the Act of 1887, its legality may be considered as a thing quite separate and apart from its econo- mic serviceableness. This is particularly true since the latest turn of interpretation, awaiting our analysis, which holds that legality is to be adjudged in the light of reason and not accord- ing to any absolute and arbitrary standard. As for the Trans- Missouri Freight Association proceedings, both of the lower Federal courts held that the Sherman Act had not been violated; and the Supreme Court decision, reversing these judgments, was, as we have already seen, rendered by a bare majority, four justices out of nine dissenting. The first aspect of the matter, namely as to whether the Anti-Trust law comprehended com- mon carriers by rail, has already been touched upon; especially the strong dissenting view that in the absence of a definite application of the Anti-Trust law to railroads, inasmuch as the statute was expressed in general terms while the Act to Regulate Commerce antedating it by three years was specific, the latter exempted the carriers entirely from the drastic pro- hibitions against monopolistic combination. 1 166 U. S., 290; reprinted as 55th Cong., 1st sess., Senate Doc. no. 12; cf. also Harvard Law Review, vol. XI, 1897, pp. 80-94. » Especially p. 588. 554 RAILROADS The second judicial construction of the Sherman Act for common carriers within a few months reinforced the first. The Joint Traffic Association, an agreement entered into in 1895 by thirty-two railroads operating east of Chicago, was declared unlawful in 1898.^ This pool was attacked not only as violating the Anti-Trust law, as in the Trans-Missouri case, but also as being contrary to the Act to Regulate Commerce. An attempt was made to distinguish between this and the Trans-Missouri Freight Association case, on the ground that the latter association actually conferred power to fix rates, whereas the Joint Traffic Association merely provided for the adoption jointly of such rates as were in force. Both of the lower Federal courts once more held that such agreements were not repugnant to the provisions of the Interstate Commerce Act. But the force of the argument in the Supreme Court was directed entirely to the interpretation of the Anti-Trust law; and it was finally decided, as in the preceding case, that the agreement was in contravention of that statute. Between the pooling decisions in 1897 and the suggested reorganization of the St. Louis Terminal Company fifteen years thereafter, despite the extraordinary activity in the field of railroad consolidation described in the preceding chapters, the Supreme Court only once passed upon the validity of attempts to substitute monopoly for competition in railroading. The one interrupting opinion is of great importance; but, before proceeding to its examination, it may not be out of place to inquire still further as to the reasons for the prolonged judicial quiescence. It is the more striking in view of the new life infused into the Sherman Act under the administration of President Roosevelt in 1901-'09. No fewer than twenty-five indictments and eighteen bills in equity were returned, by way of contrast with only five indictments and ten bills in equity during the entire three preceding presidential terms. But even greater assiduity was to characterize the administration ' 171 U. S., 505. Economic details, p. 689, infra. ANTI-TRUST DISSOLUTIONS 555 of President Taft to 1913. Within a period scarcely half the length of Roosevelt's term, twenty indictments and seventeen bills attended the vigorous initiative of the Federal Depart- ment of Justice. Quite apparently it was only after the more impressive and convincing manifestations of the evil of monop- oly in trade and manufacture had been disposed of, that the attorney-general was able to re-direct attention to the common carriers. It is probable, also, that the Northern Securities deci- sion, which alone broke the long period of immunity from prosecution of the railroads, was in itself of such compelling importance that much was accompHshed informally in the way of admonition and repression. The fact also deserves considera- tion that the peculiar interpretation placed upon the Sherman Act by President Roosevelt, inducing him to stay the original proceedings instituted in 1908 against the New Haven combina- tion,^ undoubtedly operated to discourage a more searching test of the law as applied to common carriers at the time. Narrowly viewed, the Northern Securities decision in 1904 ^ is significant as abruptly putting an end to the holding com- pany as a legal instnunentality for the attairmient of monopoly, and as coincidently displaying cautionary signals with regard to the possible misuse of intercorporate stock ownership. The facts in the case have already been spread upon our pages in various other connections and do not call for restatement.^ The condemnation was explicit. "If Congress has not, by the words used in the (Sherman) Act, described this and like cases, it would, we apprehend, be impossible to find words that would describe them." For without such judicial construction "then the efforts of the national government to preserve to the people the benefits of free competition among carriers engaged in inter- state commerce will be wholly unavailing, and all transcon- tinental lines, indeed the entire railway systems of the coimtry, may be absorbed, merged and consoHdated, thus placing the public at the absolute mercy of the holding corporation." The . p. 571. 2 193 U. S., 197. ' P. 497, snjLpra. 556 RAILEOADS objection was swept aside that the prohibition of unrestricted intercorporate stock holding would be an unconstitutional in- fringement upon the right to do as one wills with one's property. The immediate and direct result of the decision, then, was to relegate the holding company along with the "trust" to harm- less disuse. But the importance of the Northern Securities opinion does not stop here. It is even more commanding upon broad constitutional grounds. Two separate questions were treated and settled at one and the same time. The first apper- tained to the competing ^nd conflicting powers of the different states with one another. The second confronted the sover- eignty of the several states with that of the Federal government. It was the mere ownership by one corporation of the capital stock of another which started the trouble, to be sure; but from this kernel the controversy grew and spread until the ultimate principles of our framework of government became involved. As to the conflicting authority of state with state, in the matter of railroad stock holdings, our preceding review of the material facts is almost self-explanatory. The state of New Jersey through its license by charter to the Northern Securities Company to hold railway stocks without let or hindrance, ex- cept for the obligation to pay taxes into the state treasury, empowered it to commit acts within the jurisdiction of a sister state which were repugnant to the laws thereof — as well as to the Federal Anti-Trust law, after which most of the state statutes were fashioned. For, in consequence of the deeply aroused public opinion throughout the Northwest, the Northern Securities Company had already been put to the test, as well in the highest state coiu'ts as in the Supreme Court of the United States, under the provisions of the Anti-Trust law of Miime- sota; and the device of the holding company had thus been found to be in contravention of the terms and intent of that state statute.! ^^y gtate, as the opinion ran, did it so choose, 1 PearsaLl v. Qreat Northern,, etc., 161 U. S., 646. ANTI-TRUST DISSOLUTIONS 557 might submit to the existence of combination within its own limits that restrained its internal trade; but beyond that frontier it might not "project its authority into other states and across the continent." No longer could immunity by a New Jersey corporation be successfully maintained within the territory of Minnesota against the expressed will of the people of that commonwealth. The soundness of this general rule is above dispute. Equally plain was the purport of the Northern Securities decision in its affirmation of the paramount authority of the Federal government over the several states; even in such matters of seemingly private finance as the charter right to hold stocks in their own corporations. Much depended at this point upon the nature of stock ownership, that is to say, as to whether interstate stock ownership was in reality interstate commerce. No difference of opinion is evident upon the pro- posal that Congress should stay its hands "to the detriment of the public because, forsooth, the corporations concerned or some of them are state corporations. . . . No such view can be entertained for a moment." But serious dissent was registered against the affirmation that stock ownership and interstate commerce were indistinguishable at law. Yet, not- withstanding the vigorous dissenting view that Congress was void of power to regulate or control the acquisition and owner- ship of railway stocks by the Northern Securities Company, the majority opinion to the contrary prevailed, and thus became law. Pecuhar signfficance in a large way also attaches to the Northern Securities decision as foreshadowing an about-face on the part of the Supreme Court in the general interpretation of the Sherman Act. Perhaps the most puzzling feature of this brief and seemingly drastic statute, as judicially construed, presents itself in this connection. Are all arrangements or practices without exception or limitation of any sort forbidden; or was it the intention merely to prohibit those which poten- 658 RAILROADS tially or actually were unreasonable? Is competition to be perpetuated regardless of results; or shall a sound public policy permit a distinction between those acts provocative of economy and efficiency and those others which are necessarily and always inimical to the common welfare? Throughout the extended series of decisions applying the Anti-Trust law under all sorts of circumstances and conditions, the notable change in opinion is, oddly enough, in view of the fact that this statute was originally intended to deal with business rather than transpor- tation, most clearly discernible in the great railroad cases. As we have already seen, in the test applied in the pooling cases in 1897-'98, the Court by a bare majority held that the statute forbade all combinations of whatever sort, reasonable and unreasonable alike.^ In the Northern Securities case, the majority of the Court after the lapse of seven years still adhered to its original con- struction as to reasonableness; but Justice Brewer, in what is possibly the most significant portion of the entire decision, an- nounced his conversion to the belief that the ruling, not only in this but in the pooling cases as well, should have condemned the arrangements at bar because they were restraints upon trade which were unreasonable -per se, and not merely because they operated to interfere somehow or other with the free exer- cise of competition. The dissenting opinion of Justice Holmes also coincided with this view of the matter. The prohibitions of the law "certainly do not require all existing competitions to be kept on foot. ... I am happy to know that only a minor- ity of my brethren adopt an interpretation of the law which in my opinion would make eternal the helium omnium contra omnes and disintegrate society so far as it could into individual atoms. If that were its intent I should regard calling such a law a regulation of commerce as a mere pretence. It would be an 1 This development is most clearly traceable in the Standard Oil opinion of 1911, 221 U. S., 63; to which should be added the concurring opinion of Justice Brewer in the Northern Securities case, 193 U. S., 361; and the dissenting opinion, idem, 407 £F. ANTI-TRUST DISSOLUTIONS 559 attempt to reconstruct society." It only remained for the con- version of the remaining justices totake place m the next great case. Out of the confusing fogs of legal doctrine and the dis- turbed cross currents of interpretation of economic history, the Supreme Court at last emerged upon the broad and open sea in the great Standard Oil Company decision of 191 1.^ Dissent almost vanished. "With substantial unanimity it was held unequivocally that the Anti-Trust Act was to be construed "in the light of reason." All but one member of the Court agreed that the prohibition applied only to such contracts and combinations as amounted to an unreasonable or undue restraint. All other arrangements which conduced to a smoother and more efficient conduct of business were declared lawful. Merely to prove monopolistic intent or attainment, irre- spective of its nature or quahty, under all the complicated cir- cumstances of modern industrial life, is at best a difficult task. But it is far easier than to attempt to draw the line between "good" and "bad" monopoly, actual or potential. Yet such was the obligation imposed upon itself by the Supreme Court through its new construction of the statute. The first occasion in the field of transportation was offered in complaint against the St. Louis Terminal Railroad Association. The opinion ^ clearly exhibits the advantages which may be expected to flow from an interpretation of the Anti-Trust law according to the rule of reason laid down in the Standard Oil case. For the first time one might entertain hope of constructive results to flow from the differentiation of concerted acts inimical to the pubhc interest, from those which, rightly applied, would con- tribute to the public advantage. The facts were as follows: Although twenty-four railroad lines converged at St. Louis, not a single one passed through the city. About one-half of them terminated on the east bank of the river, which, once the location of a great trade by water, had now become an obstacle in the way of free intercourse by rail. The volume of traffic ' 221 U. S., 1. 2 224 U. S., 383; decided AprU 22, 1912. 560 RAILROADS at this point was enormous. It was impracticable that each separate road should have its own Mississippi bridge. The cost was prohibitive. And ample facilities could be provided, as in fact they were, only by associated action. Besides the river as an obstacle to passage, the location of the city upon hills approaching close to the river bank, made it impossible to enter the municipal limits by rail from the west except along certain well-defined approaches. In order to cope with these physical obstacles at St. Louis, two separate bridge corporations and a ferry line cared for the necessary passage over the Mis- sissippi; while certain other transfer and terminal companies came into being in order to provide the necessary connections into town. All of these instrumentalities in the course of time were taken over by the Terminal Railroad Association, organ- ized in 1889. This corporation, in turn, was not independent. It was itself controlled by a nicely balanced and evenly divided stock ownership among fifteen trunk lines. The cause of com- plaint was the alleged inability of remaining carriers, notably the Rock Island, to obtain the most-favored-nation treatment as to rates and facilities. Admission by new-comers was ren- dered difficult by the charter requirement of a imanimous con- sent of the associated lines. It was complained that this entire arrangement was in violation of the Anti-Trust law, and in its effect was contrary to the public interest. The Supreme Court found that the St. Louis Terminal com- pany was in violation of the law; and undoubtedly under the earlier interpretation of the statute, as apphed in the pooling cases, matters would necessarily have rested at that point. No alternative but dissolution would have remained. But a great advance is marked in the added qualification that "the violation of the statute grows out of administrative conditions which may be eliminated and the obvious advantage of uni- fication preserved," in such a manner "as will amply vindicate the wise purpose of the statute and will preserve to the public a system of great public advantage." In other words, the ANTI-TRUST DISSOLUTIONS 561 Supreme Court of the United States, noting the economic waste and thelexpense and inconvenience to the public which would result from a disruption of this co-operative arrangement, tempered its findings in such a way as to make the decision in reality a victory at once for the terminal association, the rail- ways and the people. Certain modifications of organization and practice were prescribed, as conditions necessary for the continued lawfulness of the terminal association. Among these requirements was one caUing for the admission of any existing or futm-e railways to joint ownership and control; another extended the facilities of the terminals under reasonable terms to any carriers not electing to become joint owners in the association; and a third abrogated the existing restriction of the proprietary companies to the use of the terminal company's lines. Over and above these, the Supreme Court called for the discontinuance of certain practices of charging an "arbitrary" for trans-Mississippi traffic originating w\thin one hundred miles. These conditions, however, are merely matters of detail. Considerable dispute ensued as to particulars. For our purposes they simply serve to illustrate the maimer in which a penetrating discermnent may reconcile the financial and oper- ating necessitites of the railroads with the interest of the pubhc, in the perpetuation of such competition in service as shall make for efficiency. Appraised both by the financial magnitude and the geo- graphical extent of the interests concerned, the proceedings to bring about the dissolution of the Union Pacific-Southern Pacific merger probably outrank any other test hkely to be apphed to railroads under the Sherman Act. This combina- tion stood for monopoly to the third power. It was the logical climax of a tendency, stayed at its height by the stern hand of the law. A repetition of the facts is unnecessary in view of their extended statement heretofore.' Official proceedings 1 Especially p. 499, supra. vol. II. — 36 562 RAILROADS began with the original report of the Interstate Commerce Commission in 1906. The dissolution suit, prosecuted for five years, resulted imexpectedly enough in an opinion by the Circuit Court unqualifiedly adverse to the government. Two justices held that the Union- Pacific and the Southern Pacific were connecting, and only incidentally, competing lines. The third judge dissented from this view. The case then went on appeal to the Supreme Court. The final opinion,^ considering the volmninous record, was surprisingly brief. Nor did it differ from other recent pronouncements, in confining attention largely to economic fact in preference to legal doctrine. For the occasion called merely for the apphcation of pre-determined law to an elaborate set of material circmnstances. Three questions called for answer, (l) Was there competition be- tween the constituent railroads in the Harriman system prior to its formation? (2) Did the merger eliminate such competi- tion, assuming that it had existed? (3) If there had been competition, and it had ceased, was its suppression brought about by imlawful means? An afl&rmative answer to these three queries was essentia,l to the government's success.^ More clearly elucidated were the subtleties of competition in railroad- ing than in connection with any other single public proceeding in our history. It will be worth while to review them briefly in order. The accompanying map will facilitate a clear under- standing of the situation. As to competition between the transcontinental lines iu the Harriman system prior to 1900, the competitive situation dif- fered according to the route. The Southern Pacific partici- pated unavoidably in all coast-to-coast business, whether it went direct or by way of New Orleans. Inasmuch as it held a monopoly of the entire California field, San Francisco could be reached only over its own rails. But it was evidently not 1 226 U. S., 61; decided Dec. 2, 1912. ' These details are admirably reviewed by Daggett in the Quarterly Journal of Economics, vol. XXVII, 1913, pp. 295-328, reprinted in our Railway Problems (rev. ed.), chap. XXII. ANTI-TRUST DISSOLUTIONS 563 564 RAILROADS a matter of indifference whether this traffic moved one way or the other, in view of the fact that it had but 30.1 per cent, of the total revenue from transcontinental freight via Ogden, whereas by the Sunset Route via the Gulf ports no division whatever with connecting lines was necessary. Active solici- tation had ruled in consequence. Nor was the Union Pacific entirely neutral in its attitude toward coast-to-coast business, because of the choice offered at its western terminus (Ogden) of routing traffic to the northwest over its own Oregon Short Line, or of turning it over to the Central Pacific — a Southern Pacific subsidiary. Not quite so keen in the old days was the competition for traffic between interior points of the United States and the Pacific slope; but solicitation upon the basis of quality of the service and even of rates was in evidence. Space does not permit an exhaustive statement of many of the data of this sort. It may be concluded with one sigmficant example. A triangle will be noted upon the railroad map, with its base on the Pacific slope and its apex at Ogden. Traffic from the northwestern angle at Portland to points in Utah and Colorado had formerly moved either directly southwest or else around the remaining two sides of the triangle, both of which were in Southern Pacific hands. Reduced to equivalents in straight level haul, the direct route was 3,498 miles as compared with the round-about one aggregating 6,164 miles. This disability to the contrary notwithstanding, prior to the merger in 1901, traffic, especially lumber, had thus moved around Robin Hood's bam.^ This could not have occurred in absence of keen rivalry. Other data of the same sort in the voluminous record established the existence of active competition at all points. The force of this showing was somewhat weakened although not squarely met, by proof that the triangular lay-out above described, had never been utilized for working business into or from California via the Portland gate-way and water lines to San Francisco. '■ Cf. Railroads: Rates and Regulation, chap. VIII. ANTI-TRUST DISSOLUTIONS 565 The Union Pacific had been less prodigal of motive power than its rival in this regard. For the Oregon Short Line seems to have refrained entirely from transcontinental business, thereby- compelling the Union Pacific at all times to interchange with a direct competitor at Ogden; although it had a possible round- about way of its own to destination. The second essential in the government's case was proof that the Harriman merger had lessened the competition which formerly obtained. It was shown that soliciting agencies had been discontinued; operating officials consoUdated; traffic diverted over new routes; competition, as of the new San Pedro short-cut from Ogden direct to Los Angeles, throttled by traffic agreements; competitive construction with the Santa -F6 in northern California stopped; and citrus fruit traffic from south- ern California pooled. Nor was this evidence controverted by proof of the greatly increased traffic facilities which, in the aggre- gate, had been added. For even $374,000,000, expended for betterment and addition within eight years, need not neces- sarily improve service or lower rates. As for the argument in rebuttal, that minority stock holding in the Southern Pacific by the parent company was not actual control, it deserved and was accorded little weight. The government's case concluded with the third contention that the suppression of competition above described had been brought about by unlawful means which violated the Sherman Act. Thus far matters had been relatively simple. But at this point the Court was confronted with the obhgation of drawing the nice distinction between due and undue, reasonable and unreasonable restraint. One was lawful; the other was not. The issue as to the effect of an adverse decision upon what, as the carriers contended, was a fundamental right freely to buy and sell property, was dis- missed rather abruptly, that point having been settled in the Northern Securities case. The Court found no difference in this regard between a holding company and direct intercorpo- rate stock ownership. Domination, control and the power to 566 RAILROADS suppress competition, with the resulting mischief, was held to be as characteristic of one as of the other. A notable feature of the Union Pacific dissolution, which marks a distinct advance over its predecessors, was the care bestowed upon the segregation of the great properties concerned. The government had not been altogether successful in its mandates heretofore. The Northern Securities dissolution was merely formal.^ The Standard Oil proceedings were entirely farcical. Some improvement marks the Tobacco Trust segre- gation, inasmuch as its complex organization forbade so naive a decree in relief. The remedy prescribed in the St. Louis Terminal case was for the first time really constructive. The delicacy of adjustment requisite in the Union Pacific affair is exhibited by the comphcations which attended the various plans worked out in this instance. There were no less than four of these.^ The first dissolution plan proposed to distribute the Union Pacific's entire holdings of 1,266,500 shares of Southern Pacific common stock among its own shareholders gratis. This was vetoed by the Supreme Court, on the very proper ground that it would leave control in exactly the same hands as before, except that such control would be exercised through the mediimi of private persons, — dominant stockholders of the Union Pacific' This was precisely what happened with the Standard Oil Company. The second plan likewise came to grief. It proposed: first, a sale of Southern Pacific stock, under privi- leged conditions, to all shareholders both of the Union Pa- cific and Southern Pacific companies, except, of course, to the Union Pacific corporation or the Oregon Short Line company; and secondly, with funds thus acquired, an outright pur- chase by the Union Pacific from the Southern Pacific of the Central Pacific link. A number of obstacles speedily developed. ' Condemned by the dissenting opinion, 193 U. S., 373. ' Quarterly Journal of Economics, vol. XXVIII, 1914, pp. 772-794. ' 226 U. S., 470. ANTI-TRUST DISSOLUTIONS 567 Conflicting stipulations in the indenture of bond issues stood in the way. An almost hopeless physical entanglement of the two properties had grown up in the course of time. Thus, on San Francisco bay one company owned the piers, another the approaches and a third the ferry. But the greatest objection came from the aroused public sentiment of California, which through its railroad commission insisted upon the continuance of actual competition at all points. Thus the advantage of this plan to the Union Pacific, in that it would give the long desired access over its own rails to the coast — its alleged motive for originally taking over the Southern Pacific, be it remembered — was denied. A third scheme was then evolved, quite different in principle. All the Southern Pacific shares were to be distributed jyro rata among the Union Pacific stockholders, as by the first plan, but such disposition was to be coupled with disfranchisement for all purposes of control, of all holders of 1,000 shares or over. A trustee was to issue certificates of interest upon deposit of all Southern Pacific shares held by the Union Pacific, which were to carry no voting rights while so held, and which should be exchangeable for actual Southern Pacific shares only on affidavit that the applicant for exchange held less than 1,000 shares. This plan would exclude 368 selected private share- holders from further increase of their holdings, and would thus appear to have been of doubtful legality. The final plan adopted in July was entirely different in many ways. It aimed to dissolve another similar control by the Pennsylvania Railroad of a competing line, by substituting in each case control or at least a dominant interest in merely a connecting line. The Pennsylvania exchanged 212,737 pre- ferred shares at $80 and 212,736 common shares at par of the Baltimore & Ohio Railroad with the Union Pacific system for its 382,924 shares of the Southern Pacific at par. This left the Union Pacific with a balance of 883,576 shares of Southern Pacific stock, which balance it was authorized by the Court to 568 RAILROADS distribute to the extent of 27 per cent, of their then holdings among the other general shareholders of its own company. The expedient of issuance of certificates of interest by a trustee to be exchanged for actual stock upon affidavit that purchase was made in good faith on his own behalf, independently of the Union Pacific interests, was borrowed from the preceding plan. The price of such privileged subscription was made so favorable that the certificates when offered were subscribed for two and one-half times over. The final step was the distribution of the Baltimore & Ohio stock as a dividend to Union Pacific shareholders. Disregarding details, this amoimted to about $89,000,000, the greater part of which was the profit made by fortunate investments as described heretofore.* This last plan, it will be observed, differed from the first two, in that it left the Central Pacific link to the coast still in the hands of the Southern Pacific. But this feature, held by the outgoing Administration as essential, was not emphasized by the new Democratic attorney-general; and as for the Union Pacific, it was deemed that a traffic alliance with the Central Pacific providing for a through route and most-favored treatment as to facilities for interchange — guaranteed in any event by the significant clause upon the subject in the Hepburn law of 1906 — would in some ways be preferable to ownership. It would be more elastic and would, moreover, as a detail of interstate commerce, be free from interference by the railroad commis- sions of the states concerned. Such a traffic agreement would also insure to the Union Pacific a due share of east-bound busi- ness, which otherwise, had it purchased the Central Pacific, the Southern Pacific might choose to route entirely over its own long line. Thus was the dissolution brought at last to a successful termination. The arrangement resulting from the dissolution of the Harriman system, as ultimately put through, was defective in its failure to fulfil the original intention of Congress to en- ' Chap. XV, supra. ANTI-TRUST DISSOLUTIONS 569 courage by liberal land grants and subsidies the construction of the first transcontinental railroad. For by the acts of 1862- '64 it was provided that "the whole line of said railroad . . . shall be operated and used for all purposes of communication ... so far as the public and Government are concerned, as one connected continuous line." (Our italics.) So long as the Central Pacific link remained in the hands of the Southern Pacific, therefore, the primary purpose of this historic legisla- tion was thwarted. Reconsideration and conviction upon this point led to the institution of another suit in 1914 by the De- partment of Justice, this time to compel the Southern Pacific to terminate its control of the Central Pacific.^ The logic and facts of the situation reinforced the contention of the govern- ment that the public interest, particularly of the Pacific slope, would be promoted by this means. Competition in trans- portation with the outside world is and has always been the supreme need of California. Yet, as we have already seen, so long as the Southern Pacific owned a continuous water and rail transcontinental line, the entire earnings of which it re- tained without pro-rating division, whereas on all traffic by the alternative direct route over the Central Pacific it must be contented with but a fraction of the joint through rate, just so long was it bound to encourage the southern or Sunset Route at the expense of the other. For many years, to be sure, it exchanged much business with the Union Pacific, being im- pelled thereto by the desire to secure reciprocal advantages; but the record in the original Harriman dissolution proceedings contains much evidence of a denial of the equal advantages and facilities called for by the Act of 1864 and even of actual dis- crimination against its own hnk in the direct route to the East. Were the Central Pacific to be set free, as pointed out in the government's petition, it might also, by recourse to but little new construction, create a truly competitive line between San Francisco and Portland, Oregon. Yet once again the pending 1 Original Petition, U. S. v. So. Pac.; U. S. Dist. Court, Utah, etc. 670 RAILROADS attempt of the government to secure for the Pacific slope the great commercial advantage of "one connected continuous line" was opposed by certain California shippers. They pre- dicted that the loss of the Central Pacific would so weaken the Sunset Route as to unfit it for effective competition in future. In gaining a better direct line they feared crippling the round- about one. The advent of the Panama Canal naturally had to - be reckoned with. In the past the Southern Pacific had im- doubtedly been restrained somewhat from whole-hearted com- petition with the all-water lines, lest it might prejudice thereby its considerable investment in the direct route via Ogden. Nevertheless, were this investment to be closed out, was it not equally possible that more, rather than less, vigorous efforts might be made to tempt traffic from the sea routes to the all-rail line? All things considered, both domestic and Oriental busi- ness alike, it would appear as if the probable splitting up of the Southern Pacific monopoly, followed perhaps by closer rela- tions between the two connecting railroads which meet at Ogden, might bring to pass at last, after the lapse of half a cen- tury, a direct connected continuous line between East and West which woiild more closely bind California to the rest of the United States. Close upon the heels of the decree calling for the dissolution of the Harriman system followed the opinion of the Supreme Court with reference to the so-called Anthracite Coal Trust.^ As to the charge that a general combination existed, the Court held xmanimously that the case was "barren of documentary evidence of solidarity." The Court declined, in other words, to base an opinion upon inference which, as it would appear, was sufficiently plain; but it insisted upon the proof of specific acts or transactions in pursuance of monopolistic intent. Yet the conclusion of the protracted suits was not entirely disap- 1 226 U. S., 324; decided Jan. 16, 1912. EUot Jones, op. cU., p. 212 et seq., outlines the course of this Utigation. The material facts are given in chap. XVI, supra. ANTI-TRUST DISSOLUTIONS 571 pointing. For a second time did the holding company come under the ban of the law. The Temple Iron Company ^ was adjudged to be an unlawful combination, whereby an inde- pendent railroad had been "strangled." The Court also di- rected a cancellation of all of the so-called percentage contracts, ^ by means of which the allied coal roads had sought to tie the hands of independent producers in perpetuity. No opinion was expressed regarding the legahty of the control of the Central of New Jersey by the Reading, or of various other similar transactions. Some advance was undoubtedly made in the direction of liberating the people of the United States from unjust extortion; and the institution of additional suits, still pending, holds out the hope that more may yet be accom- plished in due time. Whether or not the existing informal understanding, based upon the mutual self-interest of the great coal roads concerned, may serve as effectively as formal or contractual arrangements, which are clearly ruled out, may not yet be predicted with certainty. A satisfactory solution of the anthracite coal problem is by no means yet in sight. Our record under the Sherman Act concludes with the dis- solution of the great New England transportation monopoly, heretofore described.' The best evidence that this statute is now recognized as a vital piece of legislation is afforded by the fact that in this instance protracted and expensive suits were avoided by a dissolution agreement, reached in conference between the New Haven and the Federal Department of Jus- tice. Strong pressmre undoubtedly was brought to bear. And the company yielded, not because the illegahty of its com- bination was conceded, but only because it was feared that prolonged litigation might precipitate a receivership. It will be recalled that in 1908 the Roosevelt administration had instituted proceedings,* which were afterward discontinued by a formal agreement between the President and the New Haven 1 P. 437, supra. ^ P- 570, supra. " P. 462, supra. * P. 470, supra. 572 RA.ILROADS management that the latter would thereafter be a "good" monopoly. How faithfully this promise was kept has already been recited. A second bill of complaint praying for dissolu- tion brought matters to a head in 1914, only to be withdrawn upon a formal agreement providing for the resolution of the system into its component parts. The dissolution plan was officially summarized as follows: "First. The Boston Railroad Holding Company ^ is a Massachu- setts corporation holding a majority of the' stock of the Boston & Maine Railroad, and 90 per cent, of the former's stock in turn is owned by the New Haven railroad. The charter of the holding company prohibits it from disposing of the Boston & Maine stock. The legis- lature of Massachusetts wiU be asked to reniove this prohibition, and if this is done the stock of the holding company will be transferred at once to five trustees, and, after arrangements have been made to protect the minority stock of the holding company, they shall sell the Boston & Maine stock prior to January 1, 1917. "Second. The stocks of the companies which control the Con- necticut and Rhode Island trolleys wiU be placed in the hands of trus- tees — five for each State — and shall be sold within five years from July 1, 1914. "Third. The majority stock of the Merchants & Miners Trans- portation Company, now held by the New Haven, will be placed in the hands of three trustees and shall be sold within three years from July 1, 1914. "Fourth. The minority stock in the Eastern Steamship Cor- poration, held by the New Haven, shall be sold within three years from July 1, 1914, and in the meantine shall be deprived of voting power. "Fifth. Whether the New Haven railroad shall be permitted to retain the sound lines will be submitted to the Interstate Commerce Commission for determination under the provisions of the Panama Canal act. "Sixth. The Berkshire trolleys shall be sold within five years from July 1, 1914." The financial magnitude of this operation is exhibited by the following table of the book value of the various investments of the New Haven system. The principal lesson to be deduced from this case is the force of public opinion acting through law to bring a once insolent and corruptly powerful corporation ' P. 415, supra. ANTI-TRUST DISSOLUTIONS 573 imder restraint. The obligation henceforth rests upon the people to exercise this power constructively in the interest of all parties concerned. It is by no means certain that all, or even As carried on books of New Haven New England company Navigation Company Boston Railroad Holding Company $29,371,165.97 Boston & Maine R.R. subsidiary lines. . . . 1,417,216.95 The Connecticut Company 2,125,000.00 $40,000,000.00 The Rhode Island Company . , 27,852,336.41 1,266,379.37 Berkshire Street Railway Company 9,809,395.58 The Vermont Company 1,477,164.31 Eastern Steamship Company 4,200,000.00 New York & Stamford Railway 1,396,523.40 The Westchester Street Railroad 1,152,150.84 Shore Line Electric Railroad 117,000.00 New England Investment and Security Company 13,631,750.00 $74,599,953.46 $69,215,129.37 many of the units in the New Haven system were really compet- ing rather than merely supplementary lines; still less that the welfare of New England will be promoted by a rigid insistence upon corporate disruption. Could the matter have been brought to a test as to its legality, as would surely have hap- pened under more auspicious financial circumstances, some very pretty transportation problems would have come to light. The true purpose of a statute is not punishment but the prevention of evil. When the force of a law has become so fully recognized that voluntary submission to it replaces re- calcitrancy, its main purpose has been accomphshed. Action in other parts of the country bears witness to conviction upon this point. The Missouri, Kansas & Texas in I9I4, like the' New Haven, came to an agreement under which a suit imder the Anti-Trust law of Texas was withdrawn under promise of good behavior. This paved the way for the railroad to reha- bilitate and even to consolidate its properties lawfully. The 574 RAILROADS withdrawal from the anthracite coal combination of the Penn- sylvania Railroad; its disposition of investments in competing trunk lines; the consolidation policy of the New York Central; ^ the close scrutiny to which intercorporate relations are every- where else being subjected; all alike demonstrate that the avowed purpose of the people to perpetuate railroad competi- tion is accepted as an established fact. It is next incumbent upon us to subject this policy to examination in the few pages which remain. ' P. 416, supra. CHAPTER XVIII POOLING AND INTER-RAILWAY AGREEMENTS Pooling defined, 575. — The physical apportionment of traffic, 577. — ■ Money pools, 578. — Division of the field, 579. — Agreements merely to maintain rates, 580. — Concrete illustrations of procedure, 580. — Early agreements among water hnes, 582. — The first railway pools, 583. — The Southern Railway and Steamship Association, 584. — Its various functions, 585. — Division of business, 686. — As modified after 1887, 587. — The Trunk Line pools, 588. — Conditions west of Chicago, 590. The legal problem, 593. — Pooling under the Common Law, 593. — Pro- hibition by the Act to Regulate Commerce, 593. — The Trans-Mis- som-i Freight Association case, 592. — The Joint Traffic Association decision, 590. — Other legislation proposed, 594. — Traffic agreements since 1898, 596. — British experience, 597. — The Parliamentary com- mittee of 1909, 598. — Its significance for us, 598. — The pros and cons of pooling, 599. — The objection of increased rates, 599. — Ser- vice under comphcated traffic conditions, 600. — The southern cotton pools, 601. — Promotion of more economical operation, 603. — Equip- ment pools proposed, 604. — Agreements and railroad consolidation, 606. Although for almost a generation, pooling among rail- roads has been prohibited by act of Congress, the reiteration by the people and by the courts interpreting their will, of the principle that competition must be maintained at all hazards as a safeguard of popular rights, warrants discussion of what might otherwise, perhaps, be regarded as an obsolete topic. The enforced dissolution of the great railway combinations which, whatever their faults, have certainly contributed ma- terially to aid the government in the enforcement of equal and stable rates, can have but one result; namely, that com- petition will be keener in future than in the recent past. That it will take place under goverimiental scrutiny and supervision does not alter this plain fact. The course of interpretation of the Anti-Trust Act, trending to the acceptance of the view, not that all contracts in restraint of trade but only those which 576 RAILROADS are unreasonable are prohibited, may conceivably open the way to judicial approval of the right sort of traffic arrange- ments. But, after all, such action would be negative. A con- structive policy, safe enough now that Federal administrative control is indubitably assined, might better be fashioned after the Enghsh plan, whereby agreements between carriers are actually enforceable at law, subject always to the sanction of the proper administrative authority. Any contract, agreement or combination between different and competing railroads through which competition is sup- pressed either in rates or service constitutes a pool.^ The means or agency is immaterial whereby the result of destroying such rivalry as would otherwise exist between the carriers is brought about. In other words, it is unimportant: whether this be done by joint action of an association or committee representing the roads in interest; whether such power, — in the matter of routing for example, — be absolutely and un- qualifiedly left to the will of an initial carrier; whether the agreement divides the traffic quantitively; or whether, even, the competitive business is apportioned territorially or according to its nature. Etjually without significance, especially in the eye of the law, is the purpose or intent of the agreement. It may be made solely with reference to the maintenance of equal and stable rates; or it may contemplate an actual increase ^ On pooling consult the following: 1876, Report on Internal Com- merce of the United States, 44th Cong., 2nd sess., H. R. Exec. Doc. no. 46, pt. 2: 1886, Senate (CuEom) Committee Report, Testimony: 1890, Report, Transportation Interests of United States and Canada, 51st Cong., 1st sess., Senate rep. no. 847: 1892, 6th Ann. Rep., I. C. C., pp. 215-265: 1897-98, Joint Traffic Association, 55th Cong., 1st sess.. Senate Doc. no. 39, 55th Cong., 2nd sess., Senate Doc. no. 133; and U. S. Supreme Court records 171 U. S., 505, aild 166 U. S. 290. The file of I. C. C. Annual Reports, especially 1897-'98, as also those on Internal Commerce; and the numerous pamphlets of Albert Fink and G. R. Blanchard, mainly included in the Catalogue of the Bureau of Railway Economics, abound in concrete data, as well as discussion. Certain parts, elaborated and brought down to date, of my report on the subject for the U. S. Industrial Commission, vol. XIX, 1902, pp. 329-350, have also been incorporated herein. POOLING 577 therein. The law has pronounced such differences immaterial; inasmuch as it is the existence and not the actual exercise of power which transgresses the limits of lawfulness. It is im- portant to keep these distinctions clearly in mind in drawing the line between such concerted activities as seek to apply the poohng principle, and the many other functions performed by car-service and traffic associations. Agreements concerning the formation of through lines, interchange of business, the use of cars, mutual accounts and classification, and rules for the handling of traffic; none of these are pools in any sense. Many services of this sort have been at times rendered by associations which were at the same time engaged in pooling traffic; but they belong in an entirely different category in the contemplation of the law. Agreements for the elimination of competition, that is to say pools, are of four sorts. The simplest is a straight-away physical division of business. This is known as a traffic pool. Under such an arrangement one road is guaranteed, let us say, a certain percentage of business. If the percentage for any reason falls below this allotment, enough tonnage is diverted from other roads which enjoy an excess over thek proper share. The principal objection to this form in the old days was that it necessitated the diversion of freight from one road to another, thereby often running counter to the wish of the shipper. The provision of the Act of 1910 permitting the shipper to name his route ^ definitely closed the door to further arrange- ments of this sort. But, in any event, experience shows that the amount of such variation from the customary percentages is usually very small; and that there is generally enough foot- loose freight to obviate this difficulty.^ Nevertheless, the railroads in practice generally found it better to organize upon another basis. 1 Railroads: Rates and Regulation, p. 572. _ 2 Cf. the Senate Report on Pools, 1897, p. 39, and Testunony of Fink, CuUom Committee, p. 119. voii. n — 37 578 RAILROADS A money pool, the second type of agreement for division of business, proceeded upon the basis of a mutual guarantee to each railroad of a certain percentage of the total revenue accruing, either in gross or in net, from the transaction of the business. Under this plan either gross or net earnings, as the case might be, were divided in certain shares, entirely irrespec- tive of the amount of business which happened to pass over the lines concerned. This, of course, would be unfair unless some allowance were made for the actual expense of conducting transportation, when the traffic over a particular road happened to be greater than was its particular allotment of earnings. Consequently, it was often customary to allow each road to handle all the traffic which came to it naturally; but to provide that after the deduction of a certain proportion, usually 40 or 50 per cent, for actual outlay, the remainder in excess of its accrued proportion should be paid over to other roads whose proportion of business carried during the period happened to fall below their allotment. In order to accomplish this result without friction, the roads sometimes deposited a certain sum of money with the chairman, subject to his draft. If from his periodical reports he found that the percentages allotted varied somewhat from the actual percentages which happened to go by the different routes at that time, he made good the difference by check. Of course it was important, in making the allowance out of the income for an abnormal proportion of business, to see to it that the percentage allowed for conducting transportation should not be large enough to offer any possible inducement to an unscrupulous road to carry this extra business for even the moiety of rate which might remain. In the old Southern Railway and Steamship Association, for instance, at one time only 20 per cent, of the gross receipts was allowed for hauling an excess over the allotted amount, for the expense of hauling. The remaining 80 per cent, was to be turned into a pool, to be divided among the roads which had received more than their fair share. POOLING 579 The particular difficiilty with money pools exists in the dis- inclination of the roads to pay over money which, in a sense, it seems as if each had earned, having actually transported the freight. The deposit of a certain balance in advance, how- ever, as above described, has, in experience, helped to mitigate this defect. Experience seems to show that when percentages are agreed upon for a definite period there is always a tempta- tion for each road to endeavor to increase that percentage of its traffic actually carried, in order to prove its competence for a larger share in subsequent apportionments, when the existing agreement shall expire. In other words, rate cutting, special favors and concessions may still exist, not for the sake of their immediate advantage but in order to affect the division in future agreements. Moreover, money pools are liable to a very peculiar abuse, which, from a public point of view, renders them far less desirable than traffic pools. It is always possible that money payments may degenerate into a mere subsidy to weak roads, or a premium for virtuous conduct to unscrupulous ones. As instances of this possible abuse, the payment of almost $900,000 to the Panama Railroad prior to 1892, and also the pajTnent of $500,000 annually which was made for some years to the Erie Railroad, may be mentioned. In each of these cases the expressed purpose of the subsidy or "space rental" was practically to induce those carriers to refrain from soliciting business actively — action which, on the part of circuitous or irresponsible carriers, almost always means, in practice, to abandon that business. ' A third type of pool is either a division of the field or of the business according to its nature. Such an agreement differs, however, from the foregoing ones in the absence of any continuing agency or machinery for putting it into effect. The negative act of abstention from construction or soHcitation 1 Proc. Board of Arbitration on Canadian Pacific Differentials, Oct. 12, 1898, pp. 31 and 164; alao 51st Cong., 1st eess.. Senate rep. 847, pp. 44, 74, 121 and 216. 580 RAILROADS of traffic of a certain kind, is relied upon to put an end to such rivalry as might otherwise exist. The experience of Texas and Colorado in the early '80s will soon be given in our histori- cal review.! The attempt to create a monopoly of the New England field in recent years has also led to similar agreements for partition of the field. In essence there is no substantial difference between the Gould-Huntington arrangements a generation ago and the Boston & Maine-New Haven contract of 1893 to divide this rich territory.^ Nor did this differ from the 100-year traffic agreement of 1902 between the Los Angeles & San Pedro and the Southern Pacific or the other monopolistic acts of the Harriman system.^ FoiU" varieties of pools have been mentioned. The last would be constituted by a mere agreement of the parties in interest to maintain the established rates. Such a promise is characteristic of most of the foregoing plans. It is, perhaps, rather a statement of purpose than anything else. But it might become the decisive factor in a community-of-interest plan or other arrangement of the sort. The pooling principle in action may be best illustrated by means of a concrete example. The opposite table shows the niunber of tons of dead freight forwarded from Chicago during a certain period over eight different trunk lines. Con- sideration of these statistics shows that within variations of a few per cent, the proportions of freight carried by the differ- ent roads remain fairly constant.* At this particular time, to be sure, the charge was freely current that the Chicago & Grand Trunk was increasing its percentage at the expense of some of the more direct lines; but, taking a series of years and under normal conditions, such percentages do not vary ' P. 584, infra. 2 Text in Bill in Equity, Original Petition of the U. S. in the New Haven Dissolution Suit of 1914, pp. 31 and 103. ^ Quarterly Journal of Economics, vol. XXVII, 1913, pp. 302 and 305; 12 I. C. C. Rep., 329. Cf. also the New York Central-Pennsylvania agreement to control the subordinate trunk hne roads. P. 481, supra. * Cf. the anthracite percentages, p. 546, supra. POOLING 581 East-bound Dead-peeight Tonnage Forwarded from Chicago, etc. [Report Transportation Interests of the United States and Canada, 51st Cong., 1st sess., Senate rep. no. 847, p. 588.] First half of 18S9 Chicago and Grand Trunk, . Michigan Central Lake Shore and Michigan Southern Pittsburg, Fort Wayne and Chicago Chicago, St. lx)uis and Pa- cific Baltimore and Ohio New York, Chicago and St. Louis Cincinnati, Indlanapoli8,St. Louis, and Chicago 7bn». 242,901.59 308,688.60 816,620.90 369,920.77 229,778.25 166,929.14 169,647.68 19,001.17 Total.. 1,872,387.90 I'.cL 12.9 19.7 16.9 19.7 12.3 8.9 8.5 1.1 Tonf. 301,895.13 363,862.93 360,«96.22 480,022.18 226,935.85 238,894.16 201,149.07 36,387.19 P. d. 14.0 16.4 16.3 2L7 10.2 10.7 9.1 1.6 400,651.37 377,107.72 399,035.98 448,578.28 218,345.33 283,964.05 222,655.18 16,650.89 P. c(. 16.9 16.9 16.9 18.9 9.2 11.9 9.6 0.7 Tora. 214,462.00 186,324.00 162,461.00 295,278.00 93,197.00 136,916.00 109,880.00 1,635.00 100.01,111,153.00 100.0 P. a. 19.3 16.8 14.7 18.6 8.4 12.3 9.» O.t greatly. They are determined by fixed conditions, such as the general reputation of the road for promptness and dispatch, its fairness in adjusting damages, etc. In other words, business has become distributed, as between these lines, to a large degree in a definite proportion. This fact may be further emphasized by comparing the table above with the table at page 591, showing the apportionment of similar tonnage in 1896. Assuming, then, that there is a certain natural division of tonnage on the basis of facilities and reputation, it is obvious that the granting of special rebates and favors by any one of the roads might temporarily increase its proportion of the traffic; just as the Grand Trunk seems to have increased its proportion during these 3i years from about six per cent. Such an increase, disproportioned to any development in the facilities of the road itself during this short period, would probably mean the prevalence of special rebates and favors in order to divert trafiic over that particular line. The incen- tive was naturally strong on the part of freight agents, each of whom is seeking to establish a record; and, of course, the shippers were always on the lookout for traffic officials whom they could induce to help them privately. In the absence of any agreement among the roads themselves, it is apparent that competition, as between these eight trunk lines, might 682 RAILROADS easily result in an entire disorganization of any established rate basis. The more nearly bankrupt and consequently desperate, or the weakest and most circuitous, route was enabled by cutting rates upon its small proportion of traffic to inflict enormous damage upon the standard, first-class lines. A railroad pool, under such circumstances, is nothing more nor less than an agreement among the several parties concerned, that each will accept a certain percentage of the entire traffic, which shall be guaranteed to it by the other roads. This guarantee obviates at once the necessity for urgently soliciting business by cutting rates; and at the same time it nullifies the threat of the large shipper to divert his tonnage from a road which refuses to grant him such con- cessions as he sees fit to ask. Such, in essence, is the nature of a pooling contract. It has absolutely nothing to do, in itself, with the establishment of rates. To be sure, the purpose of the agreement is to maintain rates at a definite figure; but the amoimt of those rates, as thus fixed, may be determined by other causes, such as water or foreign competition, which are entirely beyond the control of the roads themselves. In fine, the purpose of a pool need by no means be protection against the public. The prime motive in the old days was protection of one railroad against one another. Historically, pooling seems to have been not imcommon between water lines in the early days. The court records as early as 1847 bring to light a number of such agreements. Thus in 1842 the canal-boat lines in New Jersey formed an association, fixed rates and divided earnings and made deposits to cover balances due. This was evidently a strict money pool. One year later 35 lines, owning 400 canal boats, entered into contracts concerning rates which came before the courts in 1848. Steamship lines in New York, forbidden to combine under a statute of 1854, resorted to pooling for the elimination of competition. The Hudson river boats in 1876 were thus POOLING 583 operated under a joint committee providing for a division of gross earnings. Steamship pools on the Kentucky river and between the hnes to Cuba existed in 1885-'86. Such agree- ments were doubtless the outcome of the same necessity which still makes such contracts so prevalent among steamship companies the world over.' The earliest railroad pools, tentative in character, were fashioned to cope with relatively simple traffic conditions. One of the earliest was organized in 1870 in order to arrange for a division of their Chicago-Omaha business between the three principal granger roads. Each agreed to limit its partici- pation to one-third of the tonnage. I^ese percentages were maintained throughout the agitated period of the '70s and undoubtedly conduced materially thereby to stability of rates. From this simple agreement afterward developed the Western Freight Association in 1884. The Boston-Portland business seems to have been apportioned in 1874, 40 per cent, of earn- ings being divided equally, with retention of the balance. This was ended by a New Hampshire statute three years later. In 1879 the lines from Boston to New York entered into a 99-year pool. Probably the earliest persistent attempt to fix rates upon a monopolistic basis was the combination of the anthracite carriers with respect to tidewater business in 1873.2 This agreement lasted for three years, being made effective under penalty of withholding rolling stock. For two years after 1876 the pool lapsed; but it was renewed in 1878 for a year, only to be succeeded thereafter by four years of relatively open market. A definite pool was once more set up in 1884 and lasted with varying success for about seven years, despite the legislative prohibition of the Act of 1887. Stability of charges between Chicago and St. Louis was also promoted after 1876 for a few years by the Southwestern 1 Huebner on Steamship Agreements, etc., Rep. House Com. on Merchant Marine, etc., in Investigation of Shipping combinations under H. Res. 587, pp. 459, 1914, leaves Uttle to be desired. 2 Full details in Eliot Jones, op. cit.; cf. chap. XVI, supra- 584 RAILROADS Railway Rate Association. In the early '80s, also, two some- what difEerent attempts to eliminate competition were made in the western and southern fields. Colorado was partitioned by a tripartite agreement between the three principal railroads, local and also Missouri river business being apportioned. ^ The territory of Texas was allotted in sections one year later, — the northern half to the Gould roads and the southern to the Himtington system.^ These agreements, together with the Ohio river pool in 1883,' comprehend most of the earlier experimentation in this line, with the exception of the great co-operative movement in the South. The most efficient railroad pool in the United States, largely owing to the genius of Albert Fink as manager, pre- vailed in the southern states during the period between 1874 and the enactment of the Interstate Commerce law in 1887.^ Linking up the through routes to the Middle West entirely changed the nature of competition. Up to 1860 each road had kept its equipment upon its own lines, all traffic being transferred at termini. When through lines were opened, each road began to work for the whole haul of which it formed a part. But this condition arose much later in the southern states than elsewhere. Sharp competition first appeared after prostration by the Civil War, when it was soon discovered that there were more roads than available traffic. Agree- ments to restore and maintain charges alternated for a time with the most destructive rate wars. It has been estimated that gross earnings were oftentimes but little more than half what the published rates should have yielded. Bankruptcy and ruin in railroad affairs were wide-spread. Permanent 1 University of Colorado Studies, vol. V, 1908, p. 137. Cf. RaU- roads: Rates and Regulation, p. 447. ' Potte, Railroad Transportation in Texas, 1909, p. 73. ' Record, Cincinnati Freight Bureau case, U. S. Supreme Court, p. 687 et seq. ^ Quarterly Journal of Economics, vol. V, 1890, pp. 70-94, gives a complete history; at p. 115 is the agreement in fuU. Reprinted in Ripley, Railway Problems, pp. 128-153. SOUTHERN RAILWAY POOL 585 success was finally wrought out of such chaos by the first General Commissioner, who perfected an agreement in 1875 which proved lasting. At first an annual convention was held, to which each rail- road in the southern states sent a representative. But after 1883 it was found more effective to concentrate power in the hands of an executive committee made up of the managers of the principal lines concerned. The active administrative head, however, was known as the Commissioner, who kept in touch with constituent companies by means of printed letters of instruction. This file constitutes the permanent record of the association's activities."^ The first task was to bring about a permanent division of business at the most competitive points. Atlanta, Augusta and Macon were first chosen in 1875. Each road was expected to conform to its agreed proportion; but where deviation occurred, one-half cent per ton mile was allowed for any excess. This was supposed to cover the bare expense of carriage; but not to yield a profit. Everything over and above this amount was transferred through the Commissioner to the credit of other roads carrying less than their agreed proportions. The greatest difficulty was in securing settlement of these balances. But it was finally arranged to make a deposit in proportion to the amount of business. This seems to have worked fairly well. At the outset, the Southern Railway and Steamship Associa- tion included only eastern tonnage; and it was not until 1886 that traffic with the western states was brought under control. The plan until 1886, moreover, was confined to freight traffic alone. The first business was to keep a strict accoimt of the nature of the business. This service was performed by an auditor. Tables were circulated monthly, showing the exact division of tonnage to all of the important points and for differ- ent classes of commodities. Full details as to weight, gross and 1 Known as Circular Letters, S. R. and S. A., 1875. 586 RAILROADS net revenue, and the agreed and actual percentages were fully- set forth. Each manager from this data was thus in a position to see just how much business there was moving and what the status of his own railroad was. The central office also acted as a clearing-house for the settlement of accounts. An elabo- rate system of deposits came to be arranged, which in the main covered all balances due. In addition the Commissioner was given the right to examine the books of the constituent railways. In a number of instances breaches of good faith were detected and penalized. The primary office of the association was to maintain rates. An important function in this connection was the detection of irregular practices in classification, weighing, etc. In one period of seven months, for example, upwards of 10,000 shipments were corrected, resulting in a substantial increase in revenue. But even more important was the fact that the presence of inspectors discouraged such frauds by all parties concerned. The most difficult task, one which was referred to the so- called Rate Committee, was the division of business. This, of coiurse, had to be readjusted from time to time. As new roads were built or old lines offered greater facilities, the situa- tion had to be gone over in detail. The Rate Committee was also charged with matters of classification and the fixing of differentials between neighboring cities. The object in making these last was, of course, to place all cities similarly situated on a parity. The principal southern towns were and still are grouped as respects rates from outside territory. Determina- tion and readjustment of these groups was a very important matter. The Rate Committee also had to make arrange- ments with lines outside the southern states. Those of them which refused to work in harmony were in practice boycotted. Even more troublesome was the competition of river steam- boats. Differentials between neighboring cities might be wide enough apart to allow these lines to cut rates. Next to the SOUTHERN RAILWAY POOL 587 work of the general Commissioner and the Rate Conunittee, the Board of Arbitration deserves mention. The primary- function of this agency was to pass upon disputes as to the division of competitive business. When the Rate Committee could not settle an affair, it had to go over to this judicial body. Questions, also, relating to rates, and differentials often had to be referred to the Arbitration Board. Originally these matters were settled by an outside referee, but gradually the practice of choosing three arbitrators was adopted. Many matters now settled by the Interstate Commerce Commission, such as the definition of initial and terminal roads or matters of classification, were dealt with. After 1887, with the prohibition of pooling, the Southern Railway and Steamship Association was considerably modified in form. All division of traffic was stopped, as well as the practice of deposits for settlement of accounts. But daily and monthly reports of business were continued. The associa- tion was recognized by the Interstate Commerce Commission and appeared officially before it in a number of instances. So far as it might, its main object remained the saving of reve- nue by maintenance of rates. The association undoubtedly greatly benefited the railways of the South. It probably was more serviceable to the weak than the strong fines. This is always the case. From the public point of view the greatest advantage was the stability of rates and the detection of rebating. It certainly does not appear that the effect of the association was to prevent general reductions, for the down- ward trend of charges was notable throughout the life of the association. Most important of all, as bearing upon the policy of the future, seems to be the fact that this association main- tained rather than suppressed competition. It did, indeed, limit competition; but restricted it to a healthy and normal sort. Each road still attempted to get as much business as could be obtained openly and fairly at the established rates. In this regard the Southern Railway and Steamship Association 688 RAILROADS certainly performed a great public service under the most trsdng circumstances. As an efficient regulator of rates, the association was greatly weakened by the prohibition of pooling in 1887, although for a few years it discouraged rate wars in a halting way by the imposition of fines. But the depression of 1893, with its incident temptation to rate cutting, proved too discouraging for it to withstand, so that dissolution then ensued. There still exist in the southern states a number of rate associations of one sort and another. But none of them attempt anything like an actual pooling of traffic. The northern trunk-line pool had its origin in the railroad presidents' Saratoga compact of 1876.^ This resulted from the panic of 1873 and the other attendant circumstances lead- ing up to the rate wars of the latter half of the '70s.^ The first actual agreement to pool rates was entered into in 1877. It was distinctively a traffic pool, confined to west-bound business, with diversion of freight in order to make good the allotted percentages. Two years later, the steadying results of this organization led to the establishment of the Joint Execu- tive Committee of 1879. With varying fortunes, determined as well by bad faith on the part of the railroads as by popular hostility, the trunk-line pools lasted under various forms until 1887, when they disappeared from public view under the ban of the Interstate Commerce law. This trunk-line organi- zation, as managed by Albert Fink, reached a high standard of efficiency, based upon the experience of the preceding decade both here and in the South'. It was a money pool, involving monthly settlements and deposits as a guarantee for good faith. An immediate readjustment to suit the changed conditions was necessitated by the enactment in 1887 of the law pro- ' 1st Ann. Rep. on Internal Commerce 1876 and subsequent ffle, p. 61; N. Y. Hepburn Committee Report. Also CuUom Committee Report, 1886, for statistical data; and Rep. Trans. Interests U. S. and Canada, 1890. ^ Railroads; Rates and Regulation, p. 22. Also Daggett, Railroad Reorganization, index. SOUTHERN RAILWAY POOL 589 hibiting pooling contracts between conamon carriers.^ The trunk lines immediately acquiesced in the provisions of the Interstate Commerce Act by entering into new articles of association on the 7th of April, 1887. They seem to have adopted, in place of the old division of traffic or earnings, a system of differentials, by which the weaker roads were enabled to secure their proportion of business by making a fixed con- cession in rates. The Grand Trunk Railway of Canada was not a party to this agreement. It immediately proceeded to take advantage of the relaxation of joint control, by cutting rates upon dressed-beef traffic from Chicago east. This action was immediately met by the standard all-rail lines; and a serious rate war resulted, which entirely disorganized the sit- uation for some months. For a part of this time the Grand Trunk road seems to have carried in 1887, about 47 per cent, of all the dressed beef transported. The outcome of this ruinous contest was a new agreement in 1889, to which the Grand Trunk Railway became a party. This pool, being more comprehensive, seems to have conduced to stability in rates, so that for two or three years conditions were fairly satisfactory. The agreement seems to have entailed the payment of a practical subsidy to such roads as the Erie, which in two years from April, 1889, received about $530,000 per RTmum as a premium for virtue. This actual money payment seems to have taken the place of an earlier agreement by which tonnage was actually diverted to this road. Both forms of gross and net money pools were in fact tried. The regulation of roads in trunk-line territory was intrusted to two subsidiary associations, known as the Trunk Line and the Central Traffic associations, with headquarters, respectively, in New York and Chicago. The former had supervision of rates in the eastern section; while the latter supervised rate adjustment on east-bound shipments from Chicago. Various 1 Cf. 55th Cong., 1st sess., Senate Doc. no. 39; 55th Cong., 2nd sess., Senate Doc. no. 133; I. C. C. Ann. Rep. 1897-'98; on this period. 590 RAILROADS attempts were made to consolidate the work of these two associations — in November of 1892 and again in 1894. In the latter year, particularly, a traffic pool of east-bound business, which has always been more difficult to handle, owing to the multiplicity of points of initial shipment, was practically arranged. It seems to have been an attempt to regulate rates by imposing a fine of $10,000 for each infraction of the agree- ment, this arrangement having worked satisfactorily in the South under similar circumstances. Finally, in January of 1896, the entire business of the trunk lines was intrusted to the so-called Joint Traffic Association. The control of traffic division was vested in a permanent board, representing each of the nine leading trunk lines. Its recommendations were to be enforced by the imposition of a fine of $5,000. As indica- tive of the apportionment of east-bound business made imder an award of arbitrators, the opposite table is of interest. Comparison of this with the preceding table, giving the appor- tionment ten years earlier, shows that the balance of power between the trunk lines had become very little altered. ^ This seems to have been an actual traffic pool, with diver- sion of freight to secure the allotted percentages. Its efficiency, however, never received a fair test, inasmuch as action was immediately brought at the instigation of the Interstate Com- merce Commission to declare the contract illegal imder the Act to Regulate Commerce. Yet in spite of the decision of 1898,^ rendered by the Supreme Court of the United States, which declared this association illegal, it continued to perform many functions of a co-operative character, and has not occasioned serious complaint on the part of shippers. There seems to be some sort of an understanding between the lines by which harmony is engendered.' In the territory west of Chicago, the prohibition of pooling in 1887 produced wide-spread demorahzation. The old agree- ments were dissolved; and as a result, during 1888, there were ' See page 581. ^ p_ 554^ supra. ' P. 480, supra. POOLING 591 Apportionment of East-bound Shipments prom Chicago, 1896 [U. S. Supreme Covirt, October term, 1896-97. United States v. Joint Traffic Association, No. 341. Brief for United States, p. 50.] Baltimore and Ohio Railroad Cleveland, Cincinnati, Chicago and St. Louis Railway Chicago and Erie Raiboad Chicago and Grand Trunk Railway Lake Shore and Michigan Southern Railway . . Michigan Central Railroad New York, Chicago and St. Louis Railroad. . . . Pittsburg, Cincinnati, Chicago and St. Louis Railway Pittsburg, Fort Wayne and Chicago Railway . . Wabash Railroad Total 100 Live stock and dressed meats Dead freight Per cent. Per cent. 4.5 8 1.1 5.8 9.4 11.2 13.2 11 19.8 14.2 16.1 13.6 11.3 8.2 10.7 7 8.7 14.2 5.2 6.6 100 disastrous rate wars throughout the West. Early in 1889 the presidents of the roads concerned, met and organized the Inter- state Commerce Railway Association, which was intended to exercise control throughout the territory west of Chicago, with the exception of the transcontinental and international railways. It was general in its scope, having for an object merely to maintain rates and to enforce the law. Provision was made for a guarantee fund, for statistical reports to secure publicity, and for the pajnuent of penalties. This association was intrusted to the management of the Hon. Aldace F. Walker, who had formerly been a member of the Interstate Commerce Commission. It went to pieces, however, within a year. In a few months another presidents' agreement was entered into, which in turn resulted, in January of 1891, in the organization of the Western Traffic Association. This was less centralized than its predecessor, and was rather in the nature of a federa- tion. Under it there were to be organized more highly special- ized associations, to deal with traffic in particular territories, 592 RAILROADS such as the Gulf, trans-Missouri, and transcontinental business. Private traffic agreements were not prohibited, as in its predeces- sor; but provision was made that they must be filed and made open to inspection. Soon after this time — in 1892 — the United States filed a bill against the most efficient of the sub- sidiary organizations under this Western Traffic Association, known as the Trans-Missouri Freight Association. This had been in existence since early in 1889, a committee represent- ing the various roads concerned, having power to enforce agreed rates under penalty of a fine. This organization, which seems to have successfully performed many of the functions of a traffic pool, was upheld in the United States circuit court, but in 1897 it was held by a majority of the United States Supreme Court to be in violation of the anti- trust law of 1890.1 The only group remaining, that of the Pacific roads, had a checkered history in respect to pooling after 1887. The roads concerned organized in 1888 the Transcontinental Association. This, like the trunk-line pools, endeavored to secure an equitable division of business, by allowing a differential to the Canadian Pacific; and in the following year this differential was increased in order to prevent ruinous rate cutting by this extraterritorial competitor. Objection from the Southern Pacific Company, however, led to constant discussion and dissatisfaction, so that in 1892 the Transcontinental Association was dissolved. Since 1892 the Canadian Pacific has not been a party to any transcontinental agreement, but has simply proceeded to take a differential of 10 per cent, under the rates allowed by the other lines. The California roads organized a Transcontinental Freight Rate Committee in 1893. This was dissolved in 1897 and replaced by the Transcontinental Bureau, which included the Northern Pacific and the Great Northern. This organization has endeavored to harmonize action between the lines with indifferent success until recently, when the ^ P. 553, supra. POOLING 593 great movements toward consolidation brought about a con- certed action in all matters of traffic policy. As to the legal status of pooling in the United States, a distinction must be clearly made between the common law and the Sherman Anti-Trust Act. In his brief for the United States in the Joint Traffic Association case/ the Solicitor- General declared that pooHng contracts under the former have ahnost without exception been held illegal.^ Thus even without the specific prohibition of section 5 of the Act to Regulate Commerce, the unanimity of these decisions would probably have inhibited the continuance of pooling contracts. Both the legislature and the courts in the United States have evidently been in accord in their insistence upon competition as a safeguard of the pubUc interest.^ The legislative prohibition of poohng by section 5 of the Act to Regulate Commerce of 1887 begins with the report of the Cullom Committee. This report stated that it "does not deem it prudent to recommend the prohibition of pooling," adding that "the ostensible object of pooling is in harmony with the spirit of regulative legislation. . . . The majority of the Committee are not disposed to endanger the success of the methods of regulation proposed for the prevention of unjust discrimination by recommending the prohibition of pooling, but prefer to leave that subject for investigation by the Com- mission, when the effects of legislation herein suggested shall have been tested and made apparent." This opinion was undoubtedly influenced by the fact that only about one-third of the witnesses interrogated were opposed to such concerted action for the maintenance of rates. The Senate bill, based upon the Cullom Committee Report, was originally adopted 1 Oral Argument in Reply. Supreme Court, U. S., October Term 1897; U. S. V. Joint Traffic Association, no. 341, p. 49. 2 Cf. the Closser case, 126 Ind., 348; as also 30 Fed. Rep., 2; 61 idem, 998; T. M. Cooley, Popular and Legal Views of Traffic Pooling, reprinted from the Railway Review, especially the Central Trust Company case of 1888 enforcing a pooling contract under certain circumstances. 3 Chapter XVII, supra. VOL. n — 38 594 RAILROADS without this provision. Its preceding clauses were all based upon concrete experience as crystallized in the existing laws of Massachusetts and Great Britain. The prohibition of pools by section 5, on the other hand, was a leap in the dark, due to the stubborn insistence of Judge Reagan of Texas, then Chair- man of the Committee on Commerce of the House of Repre- sentatives. Not until the last moment in conference was this prohibition inserted after considerable opposition by the Senate conferees. Added importance attaches to this action by the Federal Congress because of its influence upon the sub- sequent policy of different states. Within four years traffic agreements between parallel roads were forbidden by no less than fourteen commonwealths. The rate demoralization engendered by the dissolution of the traffic associations by the Supreme Court of the United States, through its interpretation of the Sherman Anti-Trust law, led to a number of proposals for legislation in 1897. A bill to rehabilitate pooling had already as a matter of fact passed the lower house in 1894. Three distinct policies were indicated in the bills presented. One, fathered by pro-railroad senators, merely sought to repeal the prohibitory fifth section of the Act of 1887. No legal status was conferred. Railroad agreements would then stand or fall by the common law. The other extreme was represented by bills specifically authoriz- ing inter-railway agreements respecting competitive traffic. Subject to approval by the Interstate Commerce Commission, a bill of a third type, in the nature of a compromise, received the official sanction of the carriers. Supervision by the Inter- state Commerce Commission was conceded, but its decision was to be subject to revision by the courts. The need of action was evident, but nothing resulted.^ The obstacle to legis- ^ 12 Ann. Rep., I. C. C, 32. The following references to the Con- gressional Record may also be useful for consultation: — 53rd Cong., 3rd sess., vol. XXVII, pt. 1, 1894, pp. 62-70, favoring pools; ibid., pp. 87-95, against; ibid., pp. 95 et seq., favoring pools; ibid., pp. 101-105, against; ibid., pp. 135 et seq., favoring pools; ibid., pp. 143 et seq., favoring RAILWAY AGREEMENTS 595 lation at this time seems to have been the unwillingness of the Interstate Commerce Commission to agree to any legis- lation which did not specifically enlarge its power over rate- making.i The railroads ardently desired, not only the rehab- ilitation but the actual legal sanction of pooling contracts. Legislation to this end could not be had without specific approval by the Interstate Commerce Commission, which sought to make use of this need as a lever to enforce its authority in the matter of rates. Individual members of the Commission, particularly the Chairman, specifically stated that the anti-pooling clause was "irreconcilable "with the general spirit of the Act of 1887. The majority of the Commission, in fact, seems to have been convinced in 1897 of the expediency of actual legalizing pooling contracts under suitable safeguards. After the immediate confusion engendered by the traffic association decisions of the late '90s, legislative interest in the subject of pooling waned completely.^ Attention was focussed upon more important aspects of governmental control. Never- theless, high authority still favored the granting of a definite legal status to inter-railway agreements. A clause to this effect formed a part of the Taft Administration bill of 1910, but the Progressive coalition succeeded in striking it out;' it was strongly urged that the present prohibitive act provoked its own violation. Self-help on the part of the railrpads, it was argued, for the limitation of competition within reasonable limits was essential to the prevention of grave abuses. The point seems to have been well taken. Congress insisted that competition should be kept alive. The courts had fully ac- pools; ibid., pp. 220 et seq., favoring pools; ibid., pp. 226, the Patterson bill as passed by the House; ibid., pt. 2, pp. 1479 and 2627, against; ibid., pt. 3, pp. 2208 et seq., against. 1 The situation is described in Railroads: Rates and Regulation, chap. XIV. 2 Except Hearings before Senate Int. Com. Com. on the Cullom bill, 1900; and idem on the Nelson bill, 1902. ' Railroads: Rates and Regulation, p. 560. The elaborate plea by Senator Root on April 1, 1910 (Cong. Record), deals fully with the subject. 596 RAILROADS quiesced in this policy, but it was and is obvious that such competition must be tempered by arbitration or agreement. A return to the imrestrained rivalry of the early days would be disastrous. Not even the vigilance' of the state could hope to secure the best results without encouragement and susten- tation of some measure of concerted action by the carriers themselves. The persistence of pooling agreements, not only after the prohibition of the Act of 1887 but even after the adverse de- cisions of the Supreme Court in the late '90s, goes far to estab- lish the positive need of some sort of an understanding in order to promote stability of rates. That an actual division of tonnage took place under the Joint Traffic Association as late as 1894 is proven by our table on page 591. During the late '90s a number of proceedings against the cotton pools in the southern states are on record, as has already appeared in our historical review. The aid, even, of the courts was as late as 1894 invoked to compel the payment of allotted earnings between carriers in other parts of the country although the action failed. ' In 1900 the Buffalo grain pool was also in active operation.^ Four years later in connection with the Orange Routing cases in California it appeared that an appor- tionment of this traffic had been systematically arranged between the Atchison and the Southern Pacific' In 1905 proceedings were directed against a similar immigrant pool of the Western Passenger Association, by which all business was to be equally divided among the carriers concerned. The scene shifted in 1907 to a number of associations in the soft-coal field, which sought to eliminate competition by agreement; followed a year later by similar arrangements covering the transfer of sugar on the Atlantic Seaboard.* It is clear enough 1 61 Fed. Rep., p. 998. 2 P. 600, infra. ' Railroads: Rates and Regulation, p. 546; 132 Fed. Rep., 829; 10 I. C. C. Rep., 611. * I. C. C. investigation of eastern bituminous coal situation, Jan. 25, 1907, p. 30 el seq.; 14 I. C. C. Rep., 619. As also 6 idem, 142. RAILWAY AGREEMENTS 597 from such evidence that nothing but the continued vigilance of the government held pooling agreements in abeyance, despite the emphatic prohibition of the Supreme Court of the United States. The experience of Great Britain at this particular jimcture in our railroad affairs is illimiinating. The state policy respect- ing pooling agreements is diametrically the opposite of our own. As early as 1867 a Royal Commission on Railways recommended that companies should be allowed to enter into valid working and traffic agreements, without authorization either from Parliament or from the Board of Trade. More- over, in the absence of specific legislation to the contrary, the English courts have sustained such concerted action for the circumscription of competition; '■ although the lawfulness of joint-purse contracts on non-competitive business is still open to question. In practice, a large number of such agreements are in effect at the present time.^ Some of them date as far back as 1862. A typical arrangement is the present division of the beer traffic between Burton and London, entered into between three companies in self-defence against the big brewers. Even broader arrangements are concluded, covering all com- petitive traffic of whatever sort. Thus there is the 90-year pool formed in 1909 between the London & Northwestern Railroad and three of its competitors. This last example is peculiarly significant for us, as it was an alternative for a much closer combination for which Parliamentary sanction had been actively sought. These English pools are of the net-money type. That is to say, twenty per cent, is first deducted from gross receipts to cover working expenses, before the residue is apportioned among the members. 1 Notably Hare v. London, etc., Railway Company, 1861. Many- citations in Noyes On Intercorporate Relations, p. 524. Cf. on the other hand, Robertson, op. cit., p. 46. 2 Knoop, Outlines of Railway Economies, 1913, p. 105, and Robertson, (yp. cit., cite several. 598 RAILROADS British interest of late in the subject of railway combina- tion found expression in the report of a Departmental Com- mittee of the Board of Trade in 1909.i This body renewed the recommendation of 1867, that encouragement should be afforded to binding agreements for amalgamation, division of territory or pooling of traffic. These, however, it was added, should be public as to their terms. The committee unanimously agreed, — and it is not without significance that six of the ten members were without corporate affiliations, three were lawyers with experience in railway matters and one was a representative trader — that the balance of advantage, not only to the rail- ways but also to the public, would be found to attach to a properly regulated extension of co-operation rather than over- stimulated competition. They reached the conclusion, already clear to discerning students in the United States, that however effective market rivalry may still be, direct competition of railway routes one with another, — water competition aside — is dead or dying.^ Certain of the past effects of competition persist, but may not safely be relied upon for the protection of the public in future. In one respect, however, this report condemned American practice, through disapproval of a proposed administrative sanction for such contracts as seemed desirable. The committee preferred new legislation which should provide legal remedies in the form of damages for such evils as might arise from concerted action. The foregoing official reconomendations, taken as a whole, seem to indicate a rejection of further reliance in England upon competition. They point possibly to something like the French system, which avoids useless duplication of lines or service by a territorial apportionment between different com- panies. But the Parliamentary committee, in declining to 1 British Documents, 1911, Cd. 5631. " Cf. the admirable discussion with diagrams in Amer. Economic Review, IV, 1914, pp. 771-792. RAILWAY AGREEMENTS 599 recommend such positive govermnental supervision as now obtains in the United States, while at the same time sanctioning a limitation of competition, would seem to be opening the way for British railways to go to sleep with impunity. Without constant and persistent state intervention, it is at least open to question, once competition is circumscribed, whether an adequate pubhc service will continue to be rendered. Either one or the other safeguards must be provided. Without either of them, stagnation would seem to be invited. For the United States, on the other hand, where such administrative authority already exists in ample measure, it appears as if the encouragement of co-operation, or even of concerted action, might safely take place. Discussion of the economic serviceableness of railway agree- ments in the public interest may be revived at the present time upon an entirely different plane from that which marked the debates twenty years ago. Three events of profoimd signifi- cance have entirely transformed the background in the mean- time. For adequate control over rate-making has been conferred upon the Interstate Commerce Commission by the Act of 1910; rebates and personal favoritism have been to all intents and purposes eliminated by the Elkins and subsequent laws; and combination among the carriers, with an attendant harmonious conduct of business, now fully recognizes the steadying influence of the other two. Nevertheless, bearing these considerations in mind, it may be worth while to review the situation as it at present stands. The primary objection on the part of the public to railroad agreements used to be based upon the idea that somehow they were necessarily intended to increase rates. And despite the solemn asseveration of pool managers — naturally not always to be taken too seriously — that their functions were intended less to make rates than to provide for the maintenance of rates already agreed upon, this mistrust was in all probability well founded. The danger was well illustrated in the base of the 600 RAILROADS Buffalo ex.-Lake Grain Pool of 1900.^ This sought to divide the grain traffic between the four lines from Buffalo to the seaboard. It was clearly shown that, by agreement upon certain percentages at an established rate, it would have been entirely possible to maintain substantially higher charges than in the absence of such an understanding. But, on the other hand, it was equally clear that such a contract operated to steady an otherwise imcertain and difficult traffic situation. The existing power of the Interstate Commerce Commission over freight rates, automatically and entirely disposes of this objection; but, even without it, the fact that rates are so largely made by conditions beyond the power of the participants to control in most instances, would effectually dispose of this argument. A more serious objection is that the limitation of competition by inter-raUway agreements tends to stagnation, to just the degree that it lessens that keenness of rivalry upon which the public has learned to depend for prompt and ade- quate service. And it is at the present time upon just such competition in facilities, and not at all in the matter of rates that rehance must be placed for progress in future.'' Whether such rivalry can be maintained by other means, such as a greater control administratively over operation, is yet to be established. On the whole, railway agreements have in the past favored the weak lines as against the strong. It has been the longer, lame or round-about routes which under the old money pools had to be subsidized in order to keep their competi- tion within bounds.^ And it has always been the strong lines, fully able to protect themselves at all points, which have been content with the prohibition of such agreements, as it exists at present. Two substantial arguments in favor both of the repeal of the present prohibition of pooling and of the substitution of 1 14th Ann. Rep., I. C. C, 21; 15 idem, 16, 55th Cong., 2nd sess., Senate Doc. no. 133, pp. 19, 23, 34, 74, 97 and 108. " P. 281, supra. ' P. 589, supra. RAILWAY AGREEMENTS 601 a positive legal sanction, under supervision by the Interstate Commerce Commission have already been given. The first of these is that by such means, judging by experience, unusually difficult and complicated traffic situations may be steadied and controlled. The mechanism operated for many years in the southern states for the harmonious division of cotton business demonstrates the force of this contention. Such pools existed for years at a number of points throughout the South. The situation at Memphis is entirely typical. Cotton comes in from all the territory round about, as well as from remote sections of the South; and six railroads compete for its transpor- tation. A large amount of this cotton is destined for export, and the remainder is in the main subject to a long haul to New England. Rates by water for export are, by the nature of the case, highly fluctuating in amount. They vary from day to day, imlike rail rates, according to the number and character of vessels which may be awaiting a cargo. This cotton is exported from the United States by any one of a nimiber of ports, no less than thirteen, in fact, between New Orleans and Boston. Each railroad rimning into Memphis makes coimec- tion with a different port or group of ports. Long experience has shown that, without some definite agreement or imder- standing, a large number of different rates on cotton to Liverpool or Hamburg may be quoted on the same day, according as the freight goes out by Baltimore, Charleston, or New Orleans, etc. The annoyance and uncertainty to the shipper incident to such diversity of rates is plainly apparent. Such a situation offers every incentive to rate cutting and personal discrimination of the most pernicious kind. At Montgomery, Shreveport and a number of other points besides Memphis, where the situation is as above described, actual traffic pools have been instituted and still exist. Their vahdity was, in fact, upheld by the supreme court of Tennessee in 1899.^ The procedure was as follows: Each day a designated ' 19 Pickle (Tenn.), 197; 52 S. W. Rep., 301; 16th Ann. Rep., I. C. C, 43. 602 RAILROADS official, acting for all the roads jointly, received by telegram from every port of export in the United States, a dispatch stating the prevailing rate of freight on that day. Each of the carriers serving these ports had a regular rate on cotton which it accepted for domestic traffic. The chairman of the Cotton Committee issued a bulletin each day, stating the domestic rate from Memphis to each port, and also the ocean rate prevailing on that day from that port to destination in foreign ports. The lowest combination of any of these rates from any port was accepted, on the basis of this showing, by all the roads concerned. Thus, for example, it might appear that on a certain day the combination of ocean and rail rates was such to Liverpool that; via the lUinpis Central to New Orleans they amounted to 60 cents a hundred pounds; via the Southern Railway through Brunswick, 72 cents; via the Nash- ville, Chattanooga & St. Louis, through Savannah, 70 cents, and via the Southern Railway through Norfolk, 62 cents. The lowest joint rail-and-water rate prevailing for that day to Liverpool, on the basis of this showing, was the rate via New Orleans, namely, 60 cents. In the absence of any agreement between the roads, under these conditions, all the cotton on that day would go out with a rush towards New Orleans. On the following day it might happen that the lowest combination was via Savannah, and all the cotton would consequently go by that route. The result would be great congestion of traffic, alternating with periods of entire inactivity on the different roads. By the simple device of an agreement of all the roads affected to accept the lowest rate by any route on all traffic which went out, and to accept it on the basis of an agreed per- centage, all this inconvenience and imcertainty, both to the shipper and to the railroad, was obviated. The cotton moved smoothly and freely, and it is difficult to see how the public interest was in the least jeopardized. The second manifest service of railway agreements, es- pecially if our existing great railway systems are to remain RAILWAY AGREEMENTS 603 dismembered under the Sherman Act, is that by them alone the most economical routing and handling of freight may be had. In our eariier volume/ the great waste incident to imrestricted railway competition was fully discussed; and one of the remedies proposed for minimizing these wastes was the grant of legal sanction to such imderstandings as tended to promote their elimination. The disadvantage of useless duplication of service by competing lines is well appreciated.'' Between Chicago and St. Louis, four trunk lines at one time operated as many passenger trains each way on practically identical schedules; when ten or twelve trains, at the most, would have carried the traffic just as well. In freight schedules between New York and Chicago, five competing routes recently maintained a 60-hour schedule, although a much slower one would have answered all the requirements of most shippers, is made with regularity and certainty. Yet no single road dared cut down its facilities; nor could piecemeal action have had any other result than to embarrass the public. The carriers cer- tainly ought to be able to act co-operatively, in such a way as still to render an abimdance of the best service, without, as at present, giving a superfluity of it.^ On the other hand, a complication, particularly in agree- ments as to routing, is now introduced in the provision of the Act of 1910 permitting the shipper to prescribe the line of carriage. Assuredly the discontinuance of certain routes within the great railroad systems may at times embarrass the public. Thus the Southern Pacific arbitrarily withdrew its Ogden- Portland hues entirely from certain classes of business, forcing all of it, formerly competitive as to service, over the Oregon Short Line.* Yet undoubtedly much better service, together * Railroads: Rates and Regulation, chap. VIII. 2 Railway Age Gazette, vol. LI, 1911, p. 1096; and idem, vol. LVII, 1914, p. 795. ' Cf. Railway Age Gazette, vol. LVI, 1914, p. 1327. « Appellant's Brief of Facts, U. S. v. U. P. RR. Co., U. S. Supreme Court, October term, 1911, p. 213. 604 RAILROADS with manifest economy in operation, might conceivably result from a better division of labor among American railroads. The English carriers have devoted special attention to the con- centration of traffic between given points over the shortest avail- able routes.^ Therein, also, lies a great advantage imder the completely unified governmental systems of Europe, particu- larly of Germany.^ Should oiu: American roads each specialize in the business for which it was best adapted, mutually respect- ing one another's rights, many wastes might be eliminated in future; and such economies in service as circimistances permit might be introduced without the least detriment to the shipper. An instance of the possible advantage of co-operative action by railways is afforded by the present situation respect- ing the ownership and use of equipment. The main reason for the surprising success of the private car companies has been their ability to keep their rolling stock in almost continual use, by shifting it according to seasonal needs from one part of the country to another.' The disadvantage under which the single railway operates in this regard is pronounced, particularly under the present conditions of financial strain. The stronger roads with a varied traffic are able to care for their own equip- ment needs; but those with poor credit, as well as those which rely upon irregular and seasonal business, have been greatly embarrassed by the expenses entailed by equipment insuffi- ciently employed to pay returns upon its cost. The improve- ment incident to payment for equipment by the day instead of by mileage, as contributing to keep rolling stock constantly in motion, has been considerable. But it is evident that some service, co-operatively financed and managed by the railroads, is needed, which shall free them from dependence upon the private car companies. Several plans for joint purchase have ' Robertson, op. cit. " National Railways of Mexico, unified, in 1913 abandoned almost 300 miles of useless duplication. ' Cf. Railroads: Rates and Regulation, p. 192; and p. 428, supra. RAILWAY AGREEMENTS 605 been proposed of late.' One would finance the acquisition of equipment through an association supported co-operatively by the railways of the country, with liberal resort to the issue of equipment trust securities. Another proposes that the Federal government should purchase the equipment and lease it to the railroads. There is evidently great need of improve- ment along this line; but efforts thus far have been blocked by those carriers owning many cars, which insist upon retaining their control, together with those other roads which profit by the indigence of their neighbors. It would seem as if some concerted action, short of actual joint purchase, might be de- vised, were it possible under the law. In how far the great railway combinations already described, which sprang up after the resumption of prosperity in 1898, were an outcome of the drastic repression of pooling is some- what open to question. The complacency with which the public, and particularly the press, viewed the great consolida- tions of 1900-'10 is especially peculiar in view of the. popular hostility to pooling. Hence it is not without interest to con- sider in how far opportunity favoring legislation might have discouraged the growth of the great systems in the subsequent years. Certain differences as to results between pooling and consoUdation may be noted. One is that corporate combina- tion is far more comprehensive in scope. Agreements for the division of traffic constitute but a small part of the mere ma- chinery of rate-making. A railroad may readily preserve a large part of its identity, even to the extent of reserving power to make rates independently, under a traffic agreement, without thereby entirely nullifying the steadying influence of the pool. The economies and inhibitions attendant upon actual com- bination are more far-reaching. This is well shown by the effect of the Harriman mergers upon traffic conditions in the Far West. The government maintained that three results 1 Railway Age Gazette, vol. LV, 1913, pp. 414, 941 and 957; Journal of Political Economy, vol. VIII, 1899, p. 347. 606 RAILROADS flowed directly from these combinations; namely, that rates were grossly increased, the construction of new lines into competitive territory was prevented, and that the service instead of being bettered sensibly deteriorated.^ Far more rivalry might have continued under a pooling agreement, each party being still desirous of maintaining, or even of increasing, its percentage status in the periodic division. Consolidation may also operate to reduce facilities; while pooling need necessarily in no wise contribute to this result. Healthful and reasonable rivalry may persist, stripped of the ruinous aspects of competition. Reference has elsewhere been made to the possible advantages of co-operation in unifying and distributing passenger traffic.^ Instead of useless duplication of service, traffic agreement may bring about appreciable economies, Avith- out the downright sacrifice of service which a powerful com- bination, like that of the New Haven in recent years, might impose upon a suffering public. Traffic agreements enjoy an advantage over combination in the matter of scope in another way. No consolidation can aspire to include all competitors; but a pool may readily enough comprehend all the rivals within a given field. More- over, all of the abuses of excessive or uneconomical competition may just as well arise between two great systems, each repre- senting the ultimate stage of consolidation, as between a dozen less powerful companies. It is certainly not without significance that a considerable modification of opinion on the part of representatives of the public, formerly hostile to trafiic agreements, has supervened of late. The state railroad com- missioners in convention assembled have formerly approved such legislation. The leading freight associations about 1900 indorsed a bill to repeal the existing prohibition. It is con- ceivable that conditions have so far improved, in respect of 1 Appellant's Brief of Facts, U. S. v. U. P., etc., U. S. Supreme Court, October term, 1911, p. 19 et seq. Also p. 561, supra. ' P. 603, supra. RAILWAY AGREEMENTS 607 the general attitude toward competition, that no legislation is necessary. Especially is this possible under the latest liberal construction, which, as we have seen, has been placed upon the Anti-Trust law by the Supreme Coin-t of the United States. But with or without such enactment, it is evident that many economies in operation, particularly in routing,^ might be introduced, were agreements of this sort to be set free from the express inhibition of the Act to Regulate Commerce. 1 C/. the famous " equalizing circular " under the Northern Securities Company, to bring about economical routing over the shortest line. P. 427, supra; and B. H. Meyer, op. cit., p. 249. APPENDIX I A matter of extraordinary difficulty has been the treatment of corporations "held jointly" by several different systems. These are usually terminal companies in the larger cities. The Chicago & Western Indiana Railroad Company, for instance, operates some 48 miles of hne and is capitalized at $33,750,000. It is owned jointly by the Atlantic Coast Line, the Erie, the Wabash, the Grand Trunk and the Rock Island. It would seem as if properly the proportionate share of its total capital- ization held by each participating road should be an allowable deduction from the total outstanding securities of that road in determining net capitaUzation. The data for doing this, how- ever, aside from the statistical labor involved, are not avail- able in many cases. And what, from the point of view of principle, is even more important, if this were done the pro- portionate division of income to each participant would need to be Ukewise made. Inasmuch, however, as the earnings of these companies, thus jointly held, are not usually included in the statements of individual systems, it seems fairer to elimi- nate them entirely. Otherwise, at a later point in our calcula- tions, as will appear, we should be taking account of their capital issues, while still neglecting to include their earnings. There- fore, in the case of all these jointly held companies — such again as the St. Louis Terminal Association and the Richmond- Washington Company — their mileage roughly totalized, and the aggregate of their security issues (given separately in a column in our table) have in each case been eliminated entirely. This procedure is radically different from the method properly adopted in the Report on Intercorporate Relations, which, as vol-. II — 39 610 APPENDIX I has been said, sought to determine, not the particular, but the general capitaUzation of the entire railway net. The deduction of the total rather than the proportionate capitalization of these jointly held companies from the total outstanding capi- talization of each participating system, in order to ascertain net capitalization, obviously over-corrects the error. It weighs the results on the side of conservatism, making the capitalization of each participating road appear less than it should be. Strong companies which own all their own termi- nals, instead of dividing ownership with other roads, are made to appear more heavily capitahzed by comparison than they should. And, from the operating point of view, it is absurd, of course, to ehminate these terminal companies at all. Where would the New Haven and Boston & Albany- roads be without the Boston terminal station? Yet the capital of $14,500,000 representing it has been eliminated from our calculations altogether; and, worse than that, this total capitaUzation has been deducted from each participant. The main plea in extenu- ation, however, is that greater error would result from any other course. What shall be said of this procedure, as appUed to other jointly held companies than mere terminal associations? The Chicago, IndianapoHs & Louisville (Monon) is jointly owned by the Louisville & Nashville and the Southern Railway. At the date of our calculations the Chicago & Alton was jointly held by the Union Pacific and the Rock Island. Other notable in- stances of roads in this class are the San Pedro, Los Angeles & Salt Lake and the Colorado Midland. The maximmn of be- wildering complexity in ownership appears in the Little Kana- wha Syndicate or the Southwestern Construction Company.' A nmnber of different roads are interested in the former, but the Southern Railway owns about 40 per cent, of its capital stock. In this case, as in many others in this class, such substantial investments appear in our tables and are duly accoimted for ' C/. p. 444, supra. APPENDIX I 611 under the head of "Minority Holdings" or investments "Out- side the System." To deduct them again from gross capital- ization, as jointly held companies, is undoubtedly duplication. Yet how can it be avoided; and if it could be, would it materi- ally affect our conclusions? The answer is positive. The exclusion of such jointly held companies makes little difference in the final result for most railways. This is particularly true of the Union Pacific and the New York Central. For others, like the Reading and the Atchison, the net capitaUzation is actually increased by ehmination of jointly held corporations. For some few roads, notably the weaker companies, this factor is of greater moment. The net capitaUzation per mile of the Wabash company was brought down by eliminating jointly- held companies from $119,000 to $92,000 per mile. The lUinois Central's capitalization came down from $52,000 to $39,400 per mile. There can be no doubt that in any detailed computation, ownership of the jointly-held companies should be apportioned and allowance for it made. In this case, how- ever, it seemed fairer to the few companies detrimentally affected to rule them out. And this, at a considerable expendi- ture of statistical labor, has been done in order to be on the safe side. APPENDIX II The operating ratio is a criterion of financial success in management of substantial worth when critically and care- fully used; but it is at the same time likely to be most misleading in inexpert hands.^ This is a figure giving the per- centage of gross earnings from operation required for operating expenses. A high or rising percentage, therefore, apparently denotes expensive or wasteful management. A low operating ratio, contrariwise, seems to afford evidence of efficient or prudent administration. This figure varies in practice between wide limits. For individual companies, exposed to pecuhar conditions, it may range above 90. Conceivably, when a property is operated at a positive loss it will rise above 100. It may in extraordinary instances, such as ore roads, or with manipulated accounts fall as low as 40.^ But normally it lies between 50 and 75. In other words, for most railroads any- where from one-half to two-thirds of the income from operation is required to meet operating expenses. The balance, after the payment of fixed charges, remains for dividends or surplus. For the railway net of the United States as a whole, this figure reflects the rising cost of operation in recent years, as shown by the accompanying diagram. From a low point of 64.6 in 1900 it has gradually risen to almost 72 in 1913. For the large roads in trunk-line territory, the operating ratio in 1911 was 1 The classic discussion of this question is by Albert Fink in the Louisville & Nashville annual report of 1873-04. J. S. Eaton, Raihoad Corporations, 1900, is a standard. U. S. Statistics of Railways give results annually for all companies. ^ For deceptive construction accounts see p. 20, supra. APPENDIX II 613 Operating Ratio, 1900-'13. 70.35. The operating ratio for typical railroads in 1911 is shown by the following figvires. Operating Ratio, 1911 Carolina, Clinchfield & Ohio (coal) (1913) 17 Virginian Railway (coal) (1913). 23 Duluth & Iron Range (ore) ... 42 Pittsburg & Lake Erie (ore, steel) 49 Union Pacific 53 Southern Pacific 57 Central of New Jersey 57 Great Northern 61 Atchison, etc 63 Norfolk & Western 64 Southern Railway 68 Chicago & Northwestern ... 70 Pennsylvania 72 Wabash 74 Boston & Maine 78 Colorado Midland 87 Missoiiri Pacific 94 Kansas City, Mex. & Orient 97.6 P6re Marquette (1913) 106 The defectiveness or inadequacy of the operating ratio, as a moment's consideration will show, is due primarily to its entire dependence upon the system of accounting in force. Given entire uniformity as to financial policy in such matters as maintenance and improvement, as treated in the capital and income account, comparisons between different roads or be- tween results for the same road through a series of years are valid. But otherwise they are apt to be entirely misleadmg. If in one instance taxes are included in operating expenses or improvements, and betterments are charged to operating expenses instead of capital account, while in others a different 614 APPENDIX II policy is adopted, the operating ratio is utterly worthless for purpose of comparison of one property with the other. This figure being* a ratio between two variables, anything which affects earnings as treated in the accounts also upsets compari- sons. The Union Pacific, for example, in 1905 is said to have reported the extraordinarily low operating ratio of 48, by unduly increasing its gross receipts by additions from other sources than earnings.^ The stock market value of an operat- ing ratio of 48 instead of 56 is too obvious to require explanation. The fluctuating and uncertain policy of American railroads in the past, in these respects, has rendered the use of the operat- ing ratio in the hands of others than experts highly dangerous. The financial results of roads that are being "skinned" or "fattened" for speculative purposes could never rightly be interpreted in terms of the operating ratio. The receiver of the Pere Marquette in 1913, by including an overload of expen- ditures for new equipment in operating expenses actually brought the ratio to 106. But since the rigid standardization of accovmts under the Federal laws since 1906, a new value or significance, nominally at least, attaches to this figure. Even with standardization of accoimts the operating ratio still requires expert interpretation. Eaton well characterizes it as affording a convenient and quick summary of results. But he adds that the operating ratio shows merely the actual profit, without giving any idea of possible profit. In other words, it shows nothing as to the potential earning power of the invested capital. Nor does it show whether the fault, if fault there be, lies in the expensiveness of operation or in the dearth of business. No indication as to causes is afforded. The operating ratio may point to the existence of disease; but it is no further help in diagnosis. Referring to the table of operating ratios for individual roads as given above, the Great Northern, for example, may conceivably have a low operating ratio because of its successful policy in increasing train loads. 1 New York Evening Post, Dec. 16, 1905. APPENDIX II 615 But similar results, "reflected in a low operating ratio, might flow from a large proportion of high-grade or other profitable traffic; or in another case, it might be affected either by the proportion of freight and passenger business, or of local and through traffic. Differences in the average length of haul are also important. Or from year to year, as a result of mere changes in the volume of business the operating ratio might fluctuate widely.^ The most extraordinary results, appearing in case of the two coal roads at the head of our table of operat- ing ratios, show what may be done with the most complete plants, specially built for a purpose, and efficiently operated from the start. ' Cf. Railroads: Rates and Regulation, chaps. II and III, especially p. 73. APPENDIX III The construction company at its worst is exemplified by the experience of the Credit Mobilier in building the Union Pacific Railroad.' The first attempts at raising funds for construction by subscription to the capital stock proved abor- tive. A small sum thus raised hardly permitted a beginning to be made. Even after the Congressional Act of 1864 which doubled the land grant and bonds per mile, friends of the enterprise were doubtful as to its success. The prime mover in the enterprise was Thomas C. Durant who seems to have been interested rather in the profit on construction than in the subsequent operation of the property. The first contracts for construction half-way across Nebraska west from Omaha, were made with dummies who were subsequently to make assignment of them to such persons as might be designated by Durant. At this juncture new financial allies were secured in the persons of Oakes and Oliver Ames of Massachusetts, through whose personal and financial influence, both in and out of Congress, it was hoped that the success of the road might be insured. From this time forth the expedient of an inde- pendent construction company, separate and distinct from the Union Pacific, was adopted. A charter conferring the necessary powers at law was picked up in Pennsylvania. The Permsylvania Fiscal Agency, empowered to build railways in the South and West, was purchased; and the name was changed to the Credit Mobiher of America. The advantage of limited liability as a protection to subscribers in such a risky enterprise over any partnership ' Pp. 17 and 35, supra. APPENDIX III 617 arrangement was clear. Funds necessary for a resumption of construction were quickly obtained. This corporation was to all intents and purposes identical in personnel with the controlling interests in the railway to be built. Subscriptions to rights in the earher contracts were transferred to the new corporation, which was thus placed in possession of a consider- able working capital. Unfortimately, however, no sooner were arrangements thus made, than decided friction between two factions headed by Ames and Durant developed. Neither seems to have considered the welfare of the railroad; both alike sought to make use of the construction company for their own private enrichment. The controversy turned merely upon the means which should in either case be adopted to this end. After several futile attempts to raise funds by subscriptions to the capital stock of both road and construction company, matters were finally placed upon a firm footing in 1867. A tacit agreement was reached that, whatever the means adopted, the Credit Mobilier stockholders should have the profits result- ing from construction. The final terms on which the remain- ing six himdred sixty-seven miles of line were to be built, included an agreement by Ames that in case bonds should not sufl&ce to complete the work, he would subscribe for enough railroad stock to make up the balance. A complicated trip- artite agreement was thereupon drawn up, by which Ames transferred his contracts to trustees representing the Credit Mobilier. From 1868 on, no further difficulties in securing capital were encoimtered. Numberless obstacles were over- come; and the work was completed well within the tune limit set by Congress. But, financially, the operations were dis- tinguished by an entire disregard of the obligations of the directors of the road, as trustees acting on behalf of its stock- holders. The contracts made by these persons in a dual capacity, controlling both the railroad and the construction company, fully merited the popular condemnation which 618 APPENDIX III Congressional investigation brought about. Ames, while, per- haps, no more guilty than his associates was expelled from Congress for his connection with the affair. Estimates of the secret profits made by the Credit Mobilier at the expense of the Union Pacific varied greatly. The Con- gressional Committee of 1888 estimated these at $43,900,000, on an actual cost of $50,000,000.^ This clearly excessive profit has been considerably scaled down by subsequent analyses. When account is taken of the considerable discount on sale of bonds, the rate of return seems to be but slightly over 25 per cent, which in view of all the circumstances does not seem immoderate. 1 " It appears, then, speaking in round numbers, that the cost of the road was $50,000,000, which cost was wholly reimbursed from the pro- ceeds of the Government bonds and first-mortgage bonds; and that from the stock, the income bonds, and land-grant bonds, the builders received in cash value at least $23,000,000 as profit, being a percentage of about forty-eight per cent, on the entire cost." — Report of the Wilson Commit- tee on the Credit Mobilier; 42nd Cong., 3rd sess., H. R. Rep. no. 78, p. xiv. APPENDIX IV The distribution of ownership of railway securities is a matter of great public importance. It concerns a multitude of investors individually; and indirectly, through the medium of beneficial corporations, touches the welfare of a still greater number. As for the first class, the individual investors, it is impossible to ascertain the distribution of unregistered certifi- cates of indebtedness; but accurate data concerning the num- ber of shareholders has been compiled. The extravagant estimate of the late George R. Blanchard in 1897, that there were 950,000 stockholders and 300,000 bondholders in the United States was certainly wide of the mark. By direction of Congress in 1904, the Interstate Commerce Commission reported 327,851 as the niunber of shareholders of record. This figure, however, did not take account of duplications due to ownership in several different roads by the same person, nor did it analyze with any care the holdings of trustees and banking houses. As for the magnitude of holdings by bene- ficial corporations, it has been estimated by competent author- ity that railway securities constitute not less than one-fifth of the investments of savings banks, about one-third of those of colleges and other educational institutions, and approxi- mately 30 per cent, of the reserves of the substantial fire and life insurance companies. Through these agencies, the number of persons indirectly interested in the welfare of the railways is greatly increased. By this same authority it was estimated that in 1905, about one-seventh of the stock and bond issues of transportation companies was thus lodged in the hands of semi-pubHc institutions of this class. 620 APPENDIX IV The wide dissemiaation of railway securities is of interest because of its bearing upon the question of concentration of ownership or control withia relatively few hands, especially as incidental to the growth of great railway systems. Scattered holdings are in this regard, a source both of strength and of weakness. Certainly a road like the Pennsylvania company with upwards of 50,000 shareholders — is too large an enterprise to be readily passed about from hand to hand. Mere size thus carries an implication of stability. In this regard, the differ- ence between the Pennsylvania and the New York Central is significant. The latter road has only about one-fourth as many separate shareholders of record. Despite their equality in size, the ease with which the late Mr. Harriman in 1908 secured a substantial proportion of New York Central shares, could not conceivably take place on the other road. Yet on the other hand, scattered holdings in the case of smaller com- panies render continued control relatively easy in normal times, because of the uiertia and lack of interest of the small investor. The greater the concentration of investment, the greater is the need of actual majority ownership of stock in order to insure control. Roads of a speculative sort not on a permanent dividend basis, like the Erie, the Southern Railway or the Wabash, are peculiarly exposed to centralization of control. Their securities sell for a low price, and the market is always an open one. Transfer of a considerable number of shares in such roads would not attract attention, and thereby defeat the purpose of those interested in seeming control. Indications are not wanting that the general public is more alert than formerly, as to opportunities for investment in times of sudden depression. Both the panics of 1903 and of 1907 have witnessed large increases m the number of small investors. Roads like the Atchison and the Union Pacific gained more than a thousand shareholders apiece within the short period of six months to August, 1903. The Pennsylvania added 15,000 new shareholders — an increment two and one-half APPENDIX IV 621 times greater than for the four preceding years. It was not until the next period of low prices in 1907, that the nvunber of stockholders attained so large a total gain. A goodly part of the gain in 1903-'04 was from European sources, from causes already explained. The increase in the number of share- holders in 1907 was pronounced. The total for 25 large companies rose by upwards of 41,000 within the year — an augmentation of almost one-fifth. The Great Northern more than doubled its quota; the Southern Pacific increased by nearly one-half, and the Union Pacific by almost one-third. A peculiarity of these recent rapid expansions of railway owner- ship in periods of financial depression has been their permanent character. Such purchases are usually made for investment and may become a source of great financial strength to the companies concerned. And it is not unlikely that such invest- ments in small lots by a wider, and especially a local constitu- ency, may become a factor of some moment politically. INDEX Abandonment of property, 235, 348 Accounts, construction, 20; capital or income, 21; manipulation of St. Paul, 23; of securities held, 65; manipulation and speculation, 212, 213, 233; stock issue below par, 274; bond discounts, 278; secrecy, and holding companies, 440; involved New Haven, 441 Act to Regulate Commerce, and Sherman Law, 549, 554; prohibi- tion of pooling, 553, 587, 690, 593 Adams, H. C, 363 Adaptation, and sohdification, 358 Agreements (See contents of chap- ters XVII and XVIII, as also Pooling), as means of combina- tion, 427; the Vanderbilt-Penn- sylvania compact, 480; steamship, 583; legislation proposed, 594; economic serviceableness, 599; for use of equipment, 603 Allegheny Valley, 478 Allison, J. E., 356 AUocation, 322, 341 Allotment, of coal (diagram), 546; Trunk Line, 581, 591; of cotton, 601 Alton [Chicago & Alton] (See con- tents of chapter VIII), "skinned," 77; low rate bonds for high, 112; reorganization by Harriman, 262; alternate operation, 429; sale by the Rock Island, 531 Amendments, Clajrton, 454 Amortization, 130, 292 Anthracite roads (See contents of chapter XVI), extra dividends, 231; the deposits described (map), 534; railroad ownership, 537; attempts to pool, 541 pecuUarity of the business, 540 last attempt successful, 541 independent roads projected, 543 interlocking directorships, 545 tonnage allotments, 547; the Supreme Court opinion, 570 Anti-stock watering (See Stock- Watering), law in Massachu- setts, 298 Anti-Trust law {See contents of chapter XVII), amendment in 1914, 454; its passage, 549; Con- gressional intent, 550; text, 551; uneven enforcement, 552; the pooling cases, 553; and holding companies, 555; new construc- tion, 557; dissolution plans, 666; and common law, 593 Apportionment (See also Allot- ment), in valuation work, 322, 341; of tonnage, 581, 591 Aroostook Construction Company, 28 Assessment, 396 Assets (See also Capital, etc.), and capital stock, 13, 64; disputes among stockholders over, 101 Atchison [Atchison, Topeka & Santa F6], early financing, 11; con- struction practice, 32; low capi- talization, 70, 81; dividend scan- dal of 1887, 210; falsified ac- 624 INDEX counts in 1893, 213; Pecos Valley capitalization, 305; reor- ganization, 378, 387, 392, 393, 401, 408; partnership with Union Pacific, 504, 565; Union Pacific purchases, 607; as an indepen- dent property, 533 Atlanta, Birmingham & Atlantic, 27, 47, 387 Atlantic & Birmingham Construc- tion Company, 27 Atlantic Coast Line, map, 488; and Louisville & Nashville, 144, 219, 459, 489; the Holding Co. (dia- gram), 434; franchise value, 369 B Balance sheet (See also Accounts, etc.), "cost' of road," 21, 37, 53, 238; evils of consoUdated, 223 Baltimore & Ohio, early financing, 10; bonds in '80s, 107; falsified accounts in 1896, 213; takes the Cincinnati, Hamilton & Dajrton, 216, 424; reorganization, 392, 396, 398, 401; Pennsylvania pur- chases, 480; Union Pacific pur- chases, 507; Union Pacific disso- lution, 101, 567 Bankers (See Interlocking Direc- tors), Preface vii; underwrit- ing, 135; commissions, 170; in combinations, 423, 459; use of holding companies, 438; the Clayton biU, 454; support in reorganization, 377; Harriman policy, 513 Bankruptcy (See Receivership, Reorganization, etc.) Baring failure, 5 Bemis, E. W., 356 Betterments (See also Mainte- nance, etc.), and speculation, 211; new capital for, 267; penal- ized in Texas, 304 "Big Four" [Cleveland, Cincin- nati, Chicago & St. Louis], 476 Billard Company, 255, 416, 423, 470 Billard, J. L., 255, 423 Blackmailing suits, 448 "Bue-Sky" laws, 285 Board of Trade, British pooling report, 698 Bondholders (See Bonds, etc.,) foreign in 1914, 9; plight under bankruptcy, 20 Bonds (See contents of chapter rV, also Indebtedness, Con- vertible Bonds, Debentures, Income Bonds, Collateral Thust Bonds, Mortgages, etc.), discount on, 30, 39, 280; and stock on the Northwestern, 30; legal proportion of, 90; and preferred stock, 99; and pro- portion of stock, 105; table, 111; heavy iucrease since 1897, 109; price and term, 129; par- ticipating, 130, 164; provision for calling, 131; how marketed, 135; income, 139, 141; sign of strength or weakness, 142; prices (diagram), 191; specula^ tion in, 204; regulation of con- vertible, 276; issue below par, 277; senior, under reorganiza- tion, 390; assessment on junior, 400; reduction under reorganiza- tion, 401; imder holding com- panies, 441 Book value (See also Property Accounts, Assets, etc.), 21, 37, 53, 228, 238, 265, 292, 317, 347 Borrowing, Harriman policy, 611 Boston, Chamber of Commerce, 462, 469 Boston & Albany, 10, 467 Boston & Lowell, 10 Boston & Maine, and Hampden construction, 25; capitaJization of leased Unes, 73; notes in 1913, 170; taken by the Reading, 220; Connecticut River lease, 229; imperfect replacement policy, 237; the New Haven purchase, 255; stock above par, 298; leases and express contracts, 394; the dissolution agreement, 571; the INDEX 625 Massachusetts Holding Co., 416; its structure defective, 420; com- bination development, 467 Boston & Providence, 10 Boston Railroad Holding Company, 416, 470, 572 Branch hnes, financing, 20; under reorganizations, 405 Brewer, Justice, 510, 558 Brooklyn Rapid Transit, 422 Brownsville, 19, 42 Buffalo grain pool, 596, 600 Burlington [Chicago, Burhngton & Quincy], map, 493; 32, taken by transcontinental lines, 494 California, gold discovery in, 4; financial regulation, 308; rail- road lines, 503; railroad competi- tioij, 562 Camden & Anaboy, 3 Canada, railway scandal, 44 Capital (See also Assets), scarcity in United States, 2; foreign sources in United States, 3; foreign investments, 1899 (table), 6; foreign interest after 1904, 8; defined, 54; provision of new, 267 Capital account (See Accounts, Maintenance, etc.), v. income account, 234 Capital stock (See contents of chapters II and III, as also Stock), disadvantages of alone, 11; below par in construction, 13; representing ownership, 89; legal proportion of, 90, 116; habihty under fraud, 91; pre- ferred shares, 95; proportion to bonds, 105; table. 111; subscrip- tion to subsidiary stock, 114; fixing issue price, 297; position under reorganization, 391; assess- ments under reorganization, 396 Capitalization (See contents of chapter II), defined, 54; gross and net distinguished, 61; table of United States net, 63; net VOL. II. — 40 increased since 1905, 64, 65; table for selected roads, 69; net retiirn upon, 79; of European systems, 80; heavily capitahzed roads, 84; matter of relativity; 86; U. S. railways, (table), 109, of surplus, 239; Massachusetts and Connecticut compared, 296; xmder Texas regulation, 303; and valuation, 344; increased under reorganization, 406 Car hnes, private, 604 Carolina, Chnchfield & Ohio, 26 Car trust certificates, 171 Cash, dividends, 229; requirements under reorganization, 407 Cedar Rapids Gas, case, 321 Central of Georgia, income bond controversy, 140, 383; map, 500, 609 Central Pacific (See Southern Pacific, Union Pacific, etc.), maps, 501, 563; construction, 36, 41; the Lucin cut-off, 235; lease by Southern Pacific, 419, 564, 566, 668-569 Central Railroad of New Jersey (See Reading, Anthracite, etc.), 66; purchase by the Reading, 66, 437; enters coal fields, 538 Central Traffic association, 589 Certificate of participation, 93 Certificates, car trust, 171; re- ceiver's, 386 Chesapeake & Ohio, 65, 480, 484 Chicago & Alton (See Alton) Chicago, Burhngton & Quincy (See Burlington) Chicago Great Western, 8, 141, 375 Chicago, Milwaukee & St. Paul (See St. Paul) Chicago & Northwestern (See Northwestern) Choctaw, Oklahoma & Gulf, 529 Cincinnati, Columbus & Hocking Valley (See Hocking Valley) Cincinnati, Hamilton & Dayton, collateral gold notes, 147; pur- chase by Erie, 163; speculative managements, 214, 373; bonded 626 INDEX debt increase, 113, 380, 409; purcliase by Baltimore & Ohio, 424, 480 Clayton Bill, committee, 426; amendments, 454 Cleveland and Powell, cited Preface x; 121, 371 Cleveland, President, 413, 552 Coal (See Anthracite Roads) Coal rates, 329 Colorado & Southern, map, 493, 499 Colorado-Utah, Construction Co., 15 Collateral trust bonds, 143; as dupUcating capitalization, 61; historical development, 145; in consolidations, 146; as inviting speculation, 149; for fimding floating debt, 151; danger from manipulation, 152; for evading state regulation, 156; impairment of security of, 239; under New York Central merger, 417; the Lake Shore purchase, 474; the Burlington Joint 451, 494; the Atlantic Coast Line, 144, 219, 459, 489 Combination (See contents of chap- ters XIII, XIV, XV, etc.), histori- cally considered, 456; diagram, 460; and speculation, 459; and the Northern Securities decision, 555; British report on, 598; and pooling, 605 Commercial valuation, 338; and rates, 360 Commission, United States Securi- ties, 92, 104, 273, 277, 280, 284, 289, 310 Commissions, bankers, 170 Commodity Clause, 453 Commodity prices (diagram), 191 Community of interest (See also Interlocking Directorships), 424 Competition, as cause of failure, 378; in the Union Pacific dissolu- tion case, 562 Complimentary directors, 425 Connecticut River Railroad, stock dividend, 229, 298 Connecticut trolleys, the New Haven, 252; Massachusetts and Connecticut compared, 296 Consolidated Gas Company case 321, 353 Consolidation (See contents of chap- ter XIII, as also Combination), and increased bonded debt, 113; and market prices, 177; and stock-watering, 248; in Texas, 251; regulation in New York, 288, 414; progress of (diagram), 460 Conspiracy, 550 Construction (See contents of chap- ter I), low standard of, 45, 233; regulation in New York, 288; regulation East and West, 308; original cost of, 347; and holding companies, 437 Construction accounts, 20; St. Paul manipulated, 23; the Alton affair, 264 Construction company (See con- tents of chapter I), financial office of, 14; normal operation, 14; wind-up, 15, 18; described by Forbes, 24; the Hampden case, 25; Atlantic & Birmingham, 27; Aroostook, 28; Southwest- em, 29, 444; Tidewater, 29; Virginian, 29; North River, 35; residue of railroad control, 40; the Colorado-Utah, 40; false security under, 47; present pUght, 50 Construction cost, Europe and America compared, 46; and traf- fic, 47; piecemeal, 359 Contract and Finance Company, 16,35 Control (See contents of chapter XIII), divorced from ownership, 41; of subsidiary roads, 111; concentration by holding com- panies, 438 Convertible bonds, 138; historical development, 157; as stimulat- INDEX 627 ing investment, 158; other rea- sons for, 159; for reducing fixed charges, 160; disadvantages, 161; convertible below par, 163; and state regulation, 276 Cooke, Jay, 43, 106, 165 Co-operation {See Pooling), 428 Comer, Northern Pacific, 495 Cost of property, 21, 37, 53, 228, 238, 265, 292, 317; Antigo, theory in Wisconsin, 347 Cotton pools, 601 Cotting v. etc. case, 323 Covington Turnpike case, 316 Credit, failure to utiUze, 12; use by Harriman, 512 Credit MobiUer, bibliography, 17, 35, 616 Crow's Neck Pass Coal Company, 498 Current liabilities, 60 Cycle, financial, of development, 118 D Daggett, S., 562 Debenture, 141 Debt (See Bonds, etc.) Deferred shares, 95 Delaware & Eastern Railway, 294 Delaware & Hudson (See aho chap- ter XVI), 289 Delaware, Lackawanna & Western (See also chapter XVI), early financing, 10; its extra dividends, 230; dividend, capital or income, 276; valuation, 335 Density of traffic, 75; and mainte- nance, 77; financial advantage, 84; in the New England situation, 465 Denver & Rio Grande, 33; map, 517 Depreciation, reserves for, 131; two kinds, 234; Minnesota rate case, 322; and valuation, 341, 357, 358; intangible values, 363 Development, capitalization of eX' penses, 308, 350, 359 Differentials, 586 Directors, compUmentary, 424; Ua- biUty of, 455 Discount, on bonds, 71, 277, 280, 292; on stock (See Par, etc.) Dismemberment, 458 Dissolution (See contents of chapter XVII) Dividend (See also Stock Divi- dend), policy and preferred stock, 103; examples of stock, 228; extra cash, 229; D. L. & W. ex- ample, 231; Boston & Maine policy, 237; the Alton affair, 264; from capital in New York, 290 Division, of assets, 103; of territory, 428, 579 Dixon, F. H., 412, 430, 433 E Earnings (See also Subpltjs, etc.), " net compared with capitalization, 77; "ploughing-in," 241; con- tingent under reorganization, 402 East Tennessee, Virginia & Georgia, 380 Elasticity of poUcy, 48 England, capitaUzation and earn- ings, 80; preference stock, 95; stock- watering in, 272; pooling policy, 597 Equipment, table of maintenance of, 78; on the Rock Island, 236; pooling of, 604 Equipment securities, 171, 307 Erie, map 488; construction ac- count, 22; bonds in 1851, 106; nomenclature of mortgages, 125; use of convertible bonds, 157; saved by Harriman in 1908, 169; and the C. H. &. D., 216, 485; bond discounts, 278, 288; scrip dividend, 290; reorganization, 375, 391, 403 Erie & Western Transportation Co.j 476 Europe, land dear, labor cheap, 2; wars, 9; construction standards, 628 INDEX 46; capitalization and earnings, 80 Expense, preliminary in construc- tion, 13 Export rates, 466, 601 Failure (See Receivi!RShip, Re- organization, etc.), (diagram), 375; causes of, 378 "Fair Value " (See contents of chap- ter X), 318, 356, 361 FaU River Gas Co., 291 Federal control (See Interstate Commerce Commission) Feeders, independent construction of, 33 Finance company (See Consteuo TioN Company) Financial regulation (See contents of chapter IX) Fink, Albert, 684 Fitchburg road, 467 Fixed charges, tables for individual roads, 81; effect of heavy, 82; reduced in 1893, 108; and con- vertible bonds, 160; the Alton affair, 266; reduced imder reor- ganization, 400, 409 Floating debt, under Texas regula- tion, 304; under reorganization, 392 Forbes, John M., 4, 24, 45 Foreclosure, difficult but forces reorganization, 127, 373; dia- gram, 375; the Union Pacific proceedings, 501 Foreign bond holdings, 9; other capital, 5 Fourteenth Amendment (See Rba- soNABiiE Rates) France, capital in United States, 8; capitaUzation and earnings, 80; division of the field, 598 Franchise value (See contents of chapter XI), 321, 365, 368 Fraud (See chapters VI, VII and XII), over-valuation in promo- tion, 91; as cause of failure, 383 Freight density, 75 Friendly receivership, 387 "Frisco" (See St. Loins & San Francisco) Functional depreciation, 234 G Gates, J. G., 219 Georgia Company, 434 Germany, capital in America, 6; capitalization and earnings, 80; unified service, 604 Gerrymander, financial, 248 Goiug value, 341, 345, 366 Gold, effect of discovery, 4 Good-will, 366 Gould, Jay, 22, 106, 249, 383, 423; estate (diagram), 519 Gould system (See also Denver & Rio Grande, Missouri Pacific, Wabash, etc.), reorganization, 33, 375; cut oflE from Pacific business, 504; map, 517; con- flict with Union Pacific, 520; with Pennsylvania, 521; dis- memberment, 523; division of the field, 580, 584 Grand Trunk Railway, 44, 486, 580, 589 Granger cases, 314 Great Britain (See England) Great Northern, map 493; ore land transactions, 19; construc- tion, 32, 492; all preferred stock, 97; original nucleus, 107; valua- tion cases, 355; and mergers of 1907, 415; bonds and stock, 441; profits to Union Pacific, 506; the Pearsall case, 556 Guarantee, 350 H Hampden Railroad, 25 Harlem Railroad, 417 Harriman, E. H. (See also Union Pacific), underwriting syndi- cates, 138; saves the Erie, 1908, 169; speculation, 202; the Alton scandal, 262; and progress of combination, 461; and the North- em Pacific, 494; his death, 202, INDEX 629 511; five principles of finance, 611; personal investments, 514; map, 563 Harrison, President, 652 Haverhill Gas case, 245 Hawley system, 216 Hepbm'n law, 668 HiU, J. J. (See Great Northern), 492 HiU-Morgan Group, map 493 Hocking Coal, speculative pool, 207 Hocking Valley, promotion, 91; and Kanawha & Michigan, 447; control by trunk lines, 482; bought by Chesapeake & Ohio, 485 Holding company (See contents of chapter XIII), the West Point Terminal, 381; early examples, 434; various reasons for, 437; the Rock Island, 527; the Boston Co., 672 Holmes, Justice, 558 Housatonic Company, 467 Houston & Texas Central, 303 Hudson Companies, 100, 438 Huebner, G. G., 683 Hughes, Governor, 287 Interborough-Metropohtan Com- pany, 260 Intercorporate relations (See con- tents of chapter XIII), among Trunk Lines, 481; in the South, 490; among anthracite roads, 644 Interest, 133 Interlocking directorships, 426, 464, 545 Intermountain Rate cases, 329 International Construction Com- pany, 17, 48 Interstate Commerce Commission, the Alton investigation, 262; balance sheet rules, 274; account- ing for bond discounts, 280; and financial regulation, 311; valua- tion work, 336; commercial valu- ation, 339; and directors' Uabil- ity, 425; the New Haven investi- gation, 442; and holding com- panies, 453; proposed legislation in 1914, 455; and combinations, 461; trunk Mne investigation, 480; Union Pacific investigation, 607; anthracite proceedings, 647; and pooUng, 696 Investment and prices, 194 Illinois Central, map 563; 4, 5, 67, 456; modest capitalization, 81; land values, 351; the Missis- sippi Valley Co., 440; Union Pacific purchases, 607 Income accounts (See Accounts), St. Paul manipulation, 23; v. capital account, 234 Income bonds, 139 Indebtedness (See ako Bonds, etc.), funded, highly localized, 122; simplification by refunding, 134 Independents, roads in Trunk Line territory, 479; railroad systems, 51, 533, coal operators, 542; Index numbers (See Prices) Insurance companies (See Life Insurance) Intangible values, statistics, 345; defined, 361; how calculated, 362 Joint ownership, 429, 608 Joint through rates, 464 Joint TraflSc Association, 654, 591 Jones, Eliot, 670 K Kanawha & Michigan, 447 Kanawha Syndicate, 429 Kansas, valuation results, 342 Kansas City, Fort Scott & Mem- phis, 260 Kansas City, Mexico & Orient, 16, 48, 165 Kansas City Southern, Supreme Court case, 23, 234 Kansas City Stock Yards case, 323, 326 Kansas Pacific, Union Pacific mer- ger, 249; map, 500 630 INDEX Keene, pool in Southern Pacific, 217 Knoxville Water case, 320 Kuhn, Loeb & Co., 513 Lackawanna (See Delawaee, Lack- awanna & Western) La Follette, Senator, 336, 368 Lake Shore {See New York Cen- tral), investments in Reading, 150; the New York Central merger, 417, 448; and New York Central, 474 Lake Superior Company, 440 Lake Superior & Mississippi River, 99 Lake Superior ore-land certificates, 230 Land, speculation in construction, 18, 432; and surplus, 243; treat- ment in valuations, 321, 334, 341, 351 Leases, release under reorganiza^ tion, 394; term of, 418; coupled with stock control, 419; no new financing required, 421; difiicult details, 422; joint, 429 Legislation, Federal financial regu- lation, 309; concerning minority rights, 449; concerning pooling, 604 Lehigh VaJIey, replacement and speculation, 211; valuation, 335; ownership by trunk line, 484, 544 Life insxirance companies, and un- derwriting, 138, 438; and Har- riman finance, 513 Loan capital (See Boiros) Loans, construction company, 15; short time, 164; Harriman pohcy, 511 Long Island Railroad, 478 Los Angeles & Salt Lake (See San Pedro, etc.) Louisville & Nashville, map 488; and Atlantic Coast Line, 144, 489; speculative raid, 219; fran- chise value, 369; intercorporate relations (diagram), 435; bought Uke candy, 459 Lucin cut-off, 235, 502 M Maintenance, manipulation of ac- count, 21; the Alton "skinned," 77; and density of traffic, 77; table for selected roads, 78; in- sufficient Rock Islandj 236; and over capitalization, 282; and valuation, 358 Majority rights, 446 Manipulation (See Accotints) Margin of safety (See also Fixed Charges), 87, 119, 417 Marketing bonds, 135 Market prices (See Prices), after reorganization, 399; Rock Island securities, 529 Market value, 317, 360 Massachusetts, loans, 106; gas company pohcy, 244; anti-stock watering, 271; stock below par, 273; bond discounts, 279; com- mittee on corporation laws, 285; and New York regulation com- pared, 292; pubhc service regular tion, 296; New Pubhc Service Commission, 300; Commission on Commerce and Industry, 415; Validation Commission, 252, 335, 343, 358, 470; intervention in New Haven affairs, 470; the Boston Railroad Holding Co., 416, 470, 572 Massachusetts Electric Companies, 275 Massachusetts Pubhc Service Commission, the Hampden case, 26; convertibles in 1913, 276; its creation, 300 Maximum Rate case, 318 McKinley, President, 552 McLeod, 220 Meade, E. S., 121, 413 Mellen, C. S., 26, 255 Merger (See contents of chapter XIII), the St. Paul, 34; super- vision in Texas, 251; under New INDEX 631 York regulation, 291; merits and defects, 413; public aspect, 415; progress of (diagram), 460 Metropolitan Street Railway, 283, 287 Meyer, B. H., 415, 492; quoted, 495 Mexico, Union Pacific lines, 509 Michigan, financial regulation, 309; valuation, 333; valuation results, 342; intangible values, 363 Michigan Securities Company, 443 Millbrook Company, 16, 19, 257 Minnesota, valuation results, 342; Rate cases, 314, 321, 355; the Anti-Trust law, 566 Minnesota Rate cases, 277; of 1890, 314; of 1913, 321, 332; rate regulation, 334, 352 Minority holdings, 68, 431; Union Pacific investments, 508, 514; rights of stockholders, 446 Mississippi Valley Company, 440 Missouri, 309 Missouri, Kansas & Texas, 532, 573 Missouri Pacific, map 617; 33, 503 Money, changes and prices, 193 Money pool, 578 Monon [Chicago, Indianapolis & Louisville], 610 Monopoly {See contents of chapter XVII), recognized in New Jersey, 308; failure in New England, 471; the Harriman policy, 514; anthracite, 536 Moore-Reid party, 525 Morgan, J. P. & Co., New Haven underwriting, 137; retire from directorship, 426; in the South, 487; group of roads, map 488; Morgan-Hill group, map 493 Mortgage bonds {See contents' of chapter IV, as also Bonds, In- debtedness, etc.), few in early days, 10; priority of liens, 124; ' ' af ter-acqmred ' ' property clauses, 126; not really secured by specific liens, 126; foreclosure difficult, 127; blanket, 132 Multipliers, 334, 363 Mumm V. Illinois, 314 N National City Bank, 513 Nebraska, financial regulation, 308; Maximum'Rate decision, 318, 326; valuation results, 342; land valu- ation, 354 Net return, upon capitaUzation modest, 79 New England {See contents of chap- ter XIV), the railroad problem, 462; the dissolution agreements, 571 New England Navigation Com- pany, 442 New England Steamship Company, 442 New England Telephone Company, 338 New Hampshire, valuation, 347 New Haven [New York, New Haven & Hartford], its net capitalization, 64; stock hold- ings, 67; underwriting, 137; notes ia 1913, 169; downfall in 1912, 252; losses under Mellen- Morgan management, 257; the convertible bond case, 276; trolley purchases, 290; valuation, 335; the Boston Holding Co., 416; the BiUard Company, 423; and Boston Herald, 433; involved accounts imder holding com- panies, 441; the Ontario & West- em sale, 450; the Rutland pur- chase case, 451; the transporta- tion problem unique, 462; pur- chase of trolleys, 252, 253, 468; acquires boat lines, 469; why it failed, 471; development of com- bination, 466; agreement with New York Central, 467; the dis- solution agreement, 571; book value of properties, 573; division of the field, 580, 584 New Jersey, evasion of dividend limitation, 232; J bond discounts, 279; financial regulation, 307; valuation results, 342; valuation, 353; gas case, 361; intangible 632 INDEX values, 363; the Northern Se- curities Co., 656 New Jersey RaUroad, 10 New York, abolition of par value, 93; bond conversion below par, 163; public service regulation, 286; and Massachusetts regula- tion compared, 292; legislation vs court control, 293; veto of two- cent fare law, 328; land valuation policy, 353; life insurance com- panies, 138, 438, 513 New York Central (See contents of chapter XIV), map, 475; stock holdings in trunk-line roads, 150 dividend scandal of 1868, 210 Commutation Rate case, 294 merger in 1914, 416; interlocking directorships, 426; the New York & Northern case, 446; the Ontario & Western case, 450; the Rutland case, 451; the Housatonic iacident, 467; lease of the Boston & Albany, 468; de- velopment described, 473; com- parison with the Pennsylvania, 478; the Lake Shore purchase, 474; the Western Maryland out- let, 485; Union Pacific purchases, 507 New York Loan and Improvement Company, 16 New York, New Haven & Hartford (See New Haven) New York & Northern Railroad, 446 New York, Ontario & Western, map 535; projected New York Central purchase, 450; purchase by the New Haven, 468; as a coal road, 546 New York Pubhc Service Com- missions (See contents of chapter IX), securities approved, 116 3rd Ave. reorganization, 261 Erie convertibles below par, 277 treatment of discounts, 132, 280 their work reviewed, 287; land valuation practice, 353; the On- tario & Western and Rutland cases, 450 New York street railways, 16, 250, 260, 283, 287-288 New York, Westchester & Boston (See also New Haven, etc.), 255, 257 Norfolk & Western, 397, 480, 484, 485 Northern Pacific, map 493; Dutch capital in, 4; early prohibition of bonds, 11; land operations of, 19, 43; securities held, 65; notes in 1872, 165; panic. May 9, 1901, 200, 492; extra cash dividend, 230; bond discounts, 277; the Spokane case, 329; valuation, 348; intangible values, 363; re- organization, 379, 383, 388, 392, 395, 401, 403; construction, 492; profits to Union Pacific, 506 Northern Securities Company (See contents of chapter XV), the dispute over control, 103; partici- pating bonds, 164; its formation, 497; profits to Union Pacific, 506 Northern Securities decision, and combination, 555; and state powers, 556; affirms Federal supremacy, 557; construction of the Anti-Trust law, 555 Northwestern [Chicago & North- western], map 475; financial his- tory, 4, 29; low capitaUzation, 70, 81; comparison with Union Pacific, 77; Union Pacific pur- chases, 507; in Vanderbilt sys- tem, 456 Northwestern Improvement Com- pany, 433 Northwestern Pacific, 308 Notes (See contents of chapter IV), historical development, 165; to finance terminals, 166; extent of borrowing, 165, 167 O Obsolescence (See also Maiktb- nancb), 234, 357 Ohio, valuation results, 342 Operating ratio, 21, 612; diagram, 613 INDEX 633 Operation, enlargement of units, 457 Orange Routing cases, 696 Oregon Short Line (See also Union Pacific), map 563; financial use, 149; participating bonds, 164; as a holding company, 432; investments for Union Pacific, 149, 507, 566 Over capitalization (See also Stock- Wateeing), table of roads, 85; the public injury in, 281; as causing failure, 380 Pacific Railroad Commission, 36 Panama route, 503, 505 Panic, of 1873, 5, 107; of 1884, 375; of 1893, 6, 108, 458 Par (See also contents of chapters III, VIII and IX), stock below, in construction, 13; and capitahza- tion, 56; inter-railway state- ments, 67; proposed abolition of, 89, 128; bond conversion below, 163; stock issue below, 272; stock subscriptions above, 274; bond issues below, 277; Massa- chusetts policy, 297; under reor- ganization, 401 Paralleling, 427 Participating, stock, 99; bonds, 130, 131, 164, 205 Pearson-Farquharsyndicate,221,524 Pennsylvania Coal Company, 543 Pennsylvania railroad (See also contents of chapter XIV), map 477; construction practice, 32; and net capitahzation, 66; stock holdings, 67; physically, 70; imderwriting experience, 136; stock holdings in trunk-Una roads, 150; financing terminals, 166; premiums on new stock, 275; early stock holdings, 430; growth, 456, 457; comparison with New York Central, 476; lessens its stock holdings, 483; and Union Pacific dissolution, 567; stock distribution, 619 P6re Marquette, 215, 309 Persons, as intercorporate ties, 423 Physical valuation (See VALtrATioN) Piecemeal construction, 359 Pittsburg, the Wabash into, 521 Pooling (See contents of chapter XVIII), anthracite, 539; the Supreme Court decisions, 551; defined, 575; varieties, 577; function illustrated, 580; histori- cally considered, 582; southern, 580; trunk line, 588; western, 590; transcontinental, 592; legal status, 593; legislative proposals, 594; British experience, 597 Pools, in speculation, 207; Union Pacific, 565 Portland Union Station Company, 256 Preferred stock (See also Capital Stock), 94; and dividend policy, 97; for raising new capital, 98; in reorganization, 98, 402; and bond issues, 99; in consolida- tions, 100; to hold control, 100; disadvantages, 101; declining, 105; and income bonds, 141; and minority rights, 449; to control the Rock Island Co., 528 Premium (See Par, etc.), at issue in accounts, 55; on stock above par, 275; on shares, 299 Present value, 358 Prices (See contents of chapter V) 174; diagram 1884-1906, 175 and industrial combination, 178 diagram to 1914, 178; net in- come and, 180; and operating ex- penses, 181; and enlarged capi- tahzation, 183; and unproductive outlays, 184; and competing securities, 186; as a barometer, 188; seasonal movement, 189; of bonds, 190; compared with com- modities (diagram), 191; inter- national comparisons (diagrams), 196; and valuation, 349 Profits, of promotion, 12; of pro- moters in "Frisco," 42; from trunk-hne operations, 484 Promotion, profits, 12; often devoid 634 INDEX of capital, 16; outline of, 18; stock for promoter's control, 40; Hocking Valley, 91 Property account (See also Ac- counts, etc.), 54, 182, 238 Prouty, Charles A., 337 Providence Securities Company, 254 Prussia (See Germany) Publicity (See Accounts, Inter- state Commerce Commission, etc.), 59; preventing financial abuse, 284 Puget Sound Extension (See St. Paul), 23, 34, 58 Pujo, committee report, 426, 455 Queen & Crescent, 72; structure (diagram), 443 R Railroad Securities Commission, 92, 104, 246, 273, 277, 280, 284, 289, 310, 450, 453 Railroad Securities Company, 441 Rate Advance case, 246, 329, 351 Rates (See oZso Reason abIiE Rates), and refunding, 133; ultimate limitation of, 326; joint, to New England, 464; and pooling, 686, 699 Rea, Samuel, 136 Reading (See also contents of chap- ter XVI), map 636; Central of New Jersey purchase, 66, 644; speculation in, 206; acquisition of Boston & Maine, 220; reor- ganization, 376, 379, 392; control by trunk lines (diagram), 160, 481; enters coal business, 538 Readjustment, of debt, 130 Reagan, Judge, 594 Reasonable rates (See contents of chapter X), and over capitaliza- tion, 281 Receivership (See contents of chap- ter XII), "and bondholders, 18; appointment, 383; powers, 386; issue of certificates, 386; abuse, 387; termination, 388 Refunding, 130, 132, 247, 293, 418 Regulation (See contents of chapter IX), holding companies to evade, 446 Rentals, 76 Reorganization (See contents of chapter XII), and preferred stock, 98, 402; disputes over assets, 101; foreclosure in, 127; and over capitalization, 259; under New York regulation, 291; conflicts of interest, 389 Replacement, manipulation of ac- counts, 21; and stock-watering, 233; regulation in New York, 288; in Massachusetts, 299 Replacement cost, in valuation, 354 Responsibility, fixed by stock hold- ings, 11 Restraint of trade (See contents of chapter XVU), 550 Rhode Island, troUeys in the New Haven, 253 Rhode Island Company, 263 Richmond & West Point Terminal Company, 381, 391, 441, 487 Rights ((See contents of chapter VIII), stockholders' subscription, 268; how computed, 269; ex- amples, 270; at law in. Massa- chusetts, 275 Robinson, M. H., 413 Rock Island (See contents of chap- ter XV), map 626; over capi- talized, 85; separation from the "Frisco," 148; diagram of sys- tem, 163; the "Frisco" invest- ment, 154; speculation, 205, 221; defective maintenance, 236; the Alton purchase, 266; and the Alton, 282; reorganization, 378, 380, 393, 398; increasing in- debtedness, 394; and Choctaw, etc. road, 446; purchase of the old railway, 625; financing the new structure, 627; disintegra- tion, 531 Roosevelt, President, 564 INDEX 635 Routing, wasteful, 564; Hepburn provisions, 568; the Orange case, 596; and railway agreements, 603, 607 Rutland Railroad, 450, 468 St. Joseph & Grand Island, 141 St. Louis, 338, 559 St. Loms & San Francisco (See also "Frisco"), construction evils, 19; scandal in 1914, 41 ; mortgag- ing a traffic contract, 123; under- writing commissions, 139; sepa^ ration from- Rock Island, 148, 530; involved Rock Island financ- ing, 154; bond discounts, 278; under Texas regulation, 304; reorganization, 393, 398 St. Louis Terminal Railroad Asso- ciation, 559, 608 St. Paul [Chicago, Milwaukee & St. Paul] (See also Puget Sound Extension), manipulation of ac- counts, 23, 34, 214; Puget Sound Extension, 37, 58; low capitaliza- tion, 70, 81; Union Pacific pur- chases, 507 San Diego Land Co. cases, 320, 349 San Francisco, 567 San Pedro, Los Angeles & Salt Lake, map 563, 565, 580 Santa F6 (See Atchison, Topeka & Santa Fii) Saratoga compact, 588 •Schuylkill coal field, 534 Seaboard Air Line, 69, 75, 78 , 84, 280 Seager, H. R., 552 Secrecy (See also Accounts, etc.), 440; the Harriman poUcy, 515 Securities (See Bonds, Stocks, etc.), owned, 62; distribution of owner- ship, 619 Securities Commission, United States Raikoad, 92, 104, 246, 273, 284, 289, 310, 450, 453 Service, and valuation, 357 Shareholders (See also Capital Stock), as responsible managers, 59; privileged subscriptions, 267 Shares of interest, 93 Sherman Act (See contents of chap- ter XVII, also Anti-Teust Law), amendment in 1914, 454 Short-term loans (See Notes) Shreveport cases, 322 Sinking fund, 131 Sliding scale, 327 Smythe v. Ames, 318 South Dakota, valuation results, 342 Southern Pacific (See also Union Pacific), speculative pool in, 207; Keene pool in, 217; and North Calif omia lines, 308; lease of Central Pacific, 419; purchased by Union Pacific, 503; Union Pacific dissolution case, 561 Southern Railroad, overcapitalized, 69, 75, 85; reorganization, 381; map, 488; its origin and lay-out, 487 Southern Railway and Steamship Association, 584 Southern territory (See contents of chapter XIV), combination in (map), 486; pools described, 584; cotton pools, 601 Southwestern Construction Com- pany, 443 Speculation (See contents of chap- ter VI), in l^nd, 18; and par value, 94; and prices, 176; in bonds, 204; in Rock Island, 205, 221; in Reading, 206; pooling contrast, 209; by insiders, 208; by outsiders, 217; Louisville & Nashville affairs, 219; remedies, 223; aa causing failure, 381; and combination, 459; the Harriman policy, 514; Rock Island experi- ence, 531 "Sphtting" securities, 248 Spokane case, 246, 329 Standard Oil decision, 558, 559, 566 State commissions (See contents of chapter IX), 285 Statistics, of capitalization, mileage, etc., 63, 69, 75; of density of traffic, 75; of maintenance ex- 636 INDEX penditures, 78; of European sys- tems, 80; capitalization, net earnings and fixed charges, 81, 83, 84; of outstanding bonds, 139; stock exchange sales, 201; valuation by states, 342; of individual roads, 345; of receiver- ship, 377 Stock (See aho Capital Stock, Holding Companies, etc.), inter- raUway holdings, 66; ownership, 430; and bonds under holding companies, 441 Stock and Bond law, of Texas, 301 Stock exchange {See contents of chapters V and VI),y sales on (diagram), 199, 203 Stockholders, rights, 267 Stock-watering {See contents of chapters VII and VIII, and also Overcapitalization), and con- struction finance, 35; on the St. Paiil extension, 58; in construc- tion, 233; for replacement, 233; in refunding, 247; under con- soHdation, 248; and provision of new capital, 268; Texas policy, 302 Stockyards case, 324 Strategy, and major groupings, 459 Structure, simple on Northwestern, 31; as affecting capitaHzation, 72 ] Sunset Route (See also Southben Pacific), 503, 564 Supplies, accounting in construc- tion, 21 Supreme Court (See chapters X and XVII) Surplus, in accounts, 57; unsub- stantial nature, 238; American policy conservative, 240; whose is it?, 241; and land values, 243; Massachusetts gas pohcy, 244; in Spokane case, 246; treatment of the Alton's, 264; capitalization above valuation, 344 Swayze, F. J., 313, 314, 321, 361 Syndicate, in Cincinnati, Hamilton & Dayton, 216; the Pearson- Farquhar, 223 Taft, President, 595 Taxation, valuation, 331, 369 "Teazers," 349 Temple Iron Company, 437, 543, 547; adjudged vmlawful, 571 Terminals, New York Central diffi- culties, 416; hard to finance, 423; joint ownership, 429; the Wabash- Pittsburgh, 523; the St. Louis Supreme Court case, 559 Texas, regulation law evaded, 156; refunding operations in, 247; supervision of mergers, 251; fi- nancial regulation, 301; capitah- zation-rates case, 328; valuation, 333, 342; "teazers," 349; ap- portionment between systems, 516; division of territory, 580, 684 Texas & Pacific, 45, 390 Texas Railroad Commission case, 315, 316 Third Avenue Street RaUroad {See also New York Street Rail- ways), reorganization, 260 Toledo, St. Louis & Western, 155, 532 Trackage agreements, 427 Traffic pool, 427, 577 Transcontinental Association, 592 Transcontinental railroads, grouped, 491 Trans-Missouri Freight Associa- tion, 551, 553, 554, 592 Trolley fines (See also New York Street Railways), use of hold- ing companies, 439; competition in New England, 465; purchase by New Haven, 252, 253, 468; the New Haven dissolution, 572 Trunk Line Association, 589 Trunk lines, control of coal roads, 149, 545; interlocking director- ships, 426; combination, 473; independent roads, 479; control (diagram), 480; southerly outlets, 485; pooMng arrangements, 588 Trustees, 424 INDEX 637 u Underwriting, 135, 170 Unearned increment, 334 Union Construction Company, 16 Union Pacific (See contents of chapters XV and XVII), maps 500, 563; branch line finance, 20, 431; early operating ratio, 22; construction practice,' 31; stock holdings, 67; dissolution, 101; and St. Joseph & Grand Island, 141; purchase of lUinois Central, 147; segregation of assets, 148; Northern Pacific profits, 149; speculation in, 200; dividend scandal, 209; the South- ern Pacific pool, 217; merger with Kansas Pacific, 249; the Alton purchase, 265; truce in the Northwest, 427; opposition to HiU-Morgan plans, 494; settle- ment of United States claims, 501 ; betterment work, 502; acquisi- tion of the Southern Pacific, 504; the Atchison partnership, 504; large revenues, 505; Northern Pacific profits, 506; other invest- ments everywhere, 507; lessen stock holdings, 510; five princi- ples of finance, 511; the Supreme Court dissolution, 561 Unit cost, 359 United Gas Improvement Com- pany, 253 United States, valuation law, 336 Validation Report, Massachusetts, 252, 255, 335, 343, 358, 470 Valuation {See contents of chapters X and XI), in Texas, 302, 305; statistical results, 342, 345; origi- nal cost, basis, 347; replacement cost, 354; present value, 358; market value, 360; intangibles, 362 Vanderbilt system (See New Yoek Central) Vermont Central, 385 Virginia, 10 Virginian Railway, 26, 47, 447 Voting power, as between classes of stock, 102 Voting trust, as protection against speculation, 221; after reorgani- zation, 403 W Wabash (See contents of chapter XV), map 517; income bonds, 140; reorganization, 310, 386, 388, 390, 393, 398, 400, 402; the Pittsburg extension, 485, 522 War of 1812, 3 Wash sales, 205 Washington, St. Paul financing and law, 37; valuation, 334, 347, 360, 363; valuation results, 342; land valuation, 354 Waste (See also Routing), in dupU- cate service, 603 Water transportation, involved New Haven accounts, 441; in New England, 469 Way, table of maintenance of, 78 Western Maryland, 398, 408, 521 Western Pacific (See also Gould System), map 517; 33, 59, 505, 520 Western Passenger Association, 596 Western Traffic Association, 591 Western Union Telegraph Co., 523 West Point Terminal Company (See Richmond & West Point Terminal) West Shore Raihoad, 35, 419 West Virginia, 273 Westchester Road (See New York, Westchester & Boston), 20, 255, 573 Wheehng & Lake Erie, 509 Whitten, R. H. (See chapters X and XI), quoted, 242 Wisconsin, early stock issues, 36; financial regulation, 306; two- cent fare case, 328; valuation 638 INDEX results, 342; Antigo theory of, 347; land valuation, 354; and Northwestern merger, 414 Wisconsin Central, 379, 383 Working capital, under reorganiza- tion, 393 Working expenses, 299 Woronoco Construction Company, 25 Wyoming coal field, 534 Yazoo & Mississippi Valley, 67 Yoakum, B. P., 42, 43 THB- PLIMPTON- PRESS NORWOOD* MASS* U'S'A, KF 2301 R58 Author Vol. Ripley, William Zebina Title Copy Railroads; finance & organization Date Borrower's Name