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http://www.archive.org/details/cu31924013778414

CORPORATION

FINANCE

CORPORATION

FINANCE

BY

EDWARD SHERWOOD MEAD, Ph.D.

WHARTON SCHOOL OF FIHAKCE AND COMUZSCE,
UNIVERSITY OF PENNSYLVANIA
AUTHOR OF "trust FINANCE"

REVISED EDITION

NEW YORK AND LONDON

D. APPLETON AND COMPANY

1920

HI

CoPYBiaHT, 1910, 1912, 1315, 1920, BY
D. APPLETON AND COMPAlTr

(3 l^bJ>(>

Printed in the United States of America

TO

J. LAURENCE LAUGHLIN

PREFACE

A RECENT computation showed $34,763,000,000 par value
of securities issued by American railway and industrial cor-
porations and now outstanding. These securities have been
originally employed in obtaining capital for enterprises or-
ganized under the corporate form, or in enabling the owners
of properties, or the promoters and financiers of new projects
to realize their profits, or to distribute to the owners of cor-
porations the accumulated profits of the past, or in exchange
for other securities which it was found necessary to retire.
The amount of income which these corporations receive is
estimated at $4,572,000,000, An increasing share of Ameri-
can property is represented by stocks and bonds. An ia-
creasing proportion of American income is taking the form
of interest and dividends.

The enormous and increasing values and profits repre-
sented by American business corporations have attracted gen-
eral attention to corporate activities. The problem of cor-
poration regulation is perhaps the leading issue of the day.
Each of the leading political parties is committed to pro-
grams of corporation control, particularly in the field of pub-
lic-service corporations. Many laws have been passed to
supervise the activities of corporations, to control the admin-
istration of corporate income and expenses, and to limit capi-
talization. - One of the most important elements of our eco-

viii PEEPACE

nomic life, the business corporation, is being' taken under the
direct supervision of the Government.

" Corporation Finance " aims to explain and illustrate the
methods employed in the promotion, capitalization, financial
management, consolidation, and reorganization of business
corporations. Of necessity, the treatment of this extensive
subject can, in no part, be exhaustive. A volume as large as
this could be, and I hope will be, written by iuvestigators upon
the subject outlined in each chapter. Neither have I at-
tempted to deduce from the facts of Corporation Pinance any
new laws or principres. All that I have tried to do is to de-
scribe in as much detail as the subject permits, the methods
employed! in Corporation Finance, to indicate the working
rules of procedure and management which govern these meth-
ods, and to show some of the dangers which lie in ignorant and
careless financial management.

The treatment of the subject follows the natural line of
corporation development. We begin with the investigation of
a business proposition. Control of this proposition is secured
by a promoter, a financial plan prepared, the cooperation of
bankers secured, and the securities are sold. The next group
of problems encountered relate to the management of the cor-
porate income in order that a regular rate of distribution of
profits may be made by the directors to the stockholders. The
methods of obtaining new capital, directly by the sale of
securities and indirectly by consolidation with other com-
panies, are then examined. The last part of the book deals
with the procedure in corporation bankruptcy, and with the
reorganiza;tion of the capital accounts of both solvent and in-
solvent corporations.

The material of the book has been mainly taken from the

PREFACE ix

Commercial and Financial Chronicle. Much of the mate-
rial has' been included in the text in its original form. I have
reproduced three chapters from my " Trust Finance " entire,
and have made large use of the lectures on Corporation Pi-
nance delivered in the Harvard School of Business Adminis-
tration in 1908-1909. I have to especially acknowledge my
indebtedness to my friend Dr. Thomas Conway, Jr., of the
Wharton School staff, who has rendered to me valuable as-
sistance throughout the preparation of this book, of which I
desire to record my grateful appreciation. I wish also to
■shank Mr. H. Edgar Barnes, of the Philadelphia Bar; Mr.
Ben Loeb, of Sutro Brothers and Company, New York; Mr.
Milton W. Lipper, of Arthur Lipper and Company, New
York; Mr. Poland L. Taylor, of the Philadelphia Trust, Safe
Deposit and Insurance Company; and Mr. George Stevenson,
of Sailer and Stevenson, Philadelphia, for advice, suggestions,
and assistance. I wish that space permitted me to record the
names of a large number of my friends and acquaintances who
have placed their time at my disposal. Mr. Albert Hill and
Mr. A. W. Taylor have greatly helped me in the work of
revision and proofreading.

I have inscribed this book to Professor J. Laurence Laugh-
lin, of the University of Chicago, as a tribute of my appre-
ciation of his work as a teacher.

B. S. M.

PREFACE TO SECOND EDITION

In the second edition of Corporation Finance a place has
been made for a discussion of the problem of Capitalization,
the chapter on Holding Companies has been rewritten in the
light of the recent decisions by the Supreme Court by which
the Oil and Tobacco combinations have been dissolved, and
additional material on Sinking Funds has been included.

E. S* Mead.

PREFACE TO THIRD EDITION

In the third edition of Corporation Finance in place of
the discussion of the Promotion of the Trust has been inserted
a brief summary of the nature and the structure of. the busi-
ness corporation. Chapters IV and V on the Materials of the
Financial Plan, have also been enlarged and in Chapter XXIX
the discussion of the financial development of the holding
company and the methods of its regulation has been amplified.

E. S. Mead,

PEEFACE TO FOURTH EDITION

In the fourth edition of Corporation Finance, a place
has been made for a more extended discussion of preferred
stock, and of stock without par value. The place of bank
loans in corporation finance has been more fully developed,
also the subject of sinking funds and serial bonds. In con-
nection with the sale of speculative securities, there is a dis-
cussion of "blue-sky" legislation and of the activities of
the Post Office Department in checking the sale of fraudu-
lent securities. Under the head of the "Distribution of
Surplus," a synopsis of the decision of the United States
Supreme Court in the Stock Dividend case is given. A
summary of the Boyd case, which has seriously modified the
treatment of unsecured creditors in reorganization, is in-
serted as an appendix.

B. S. Mead.

CONTENTS

CHAPTER Page

I.— Intboductiok' 1

II.— The Work of the Promoteh .... 14

III.— The Business Corporation 25

IV.— Materials of the Financial Plan— Stock . 44

v.— Materials of the Financial Plan— Bonds . 63

VI. — Terms and Conditions of Bond Issues . . 72

VII. — Provision foe the Repayment of Bonds . . 87

VIII.— Methods of Paying for Stock .... 99

IX.— The Sale of Securities 114

X.— The Sale op Speculative Securities . . 127
XI.— Public Protection against Fraudulent

Security Issues 135

XII.— The Capitalization of Corporations . . 142

XIII. — Underwriting 156

XIV.— The DetIbrmination of Profits .... 168

XV.— The Determination of Profits- Depreciation 187

XVT.— The Management of the Corporate Income . 207
XVII.— FrsiNG THE Proportion of Profits to be Paid

Out in Dividends 225

XVIIL— The Methods of Distributing the Surplus . 238

XIX.— The Provision of New Capital .... 253

XX.— The Methods of Providing New Capital . 267

XXI.— The Issue of Stock 277

XXII.— The Borrowing of Money by Corporations . 291

XXIII.— Long Term Bonds 304

XXIV.— Mortgage Bonds and Corporate Endowments

AND Guarantees 312

xiii

xiv CONTENTS

CHAPTEB PAGB

XXV.— The Collateral Trust Bond .... 323

XXVI.— Bonds Secured bt the Assignment op a Lease 330

XXVIIJ— Consolidation op Corporation .... 336

XXVlil.— The Holding Company 346

XXIX.— The Lease 373

XXX.— Ebadjustment op the Capital Account . ., 383

XXXI.— Receiverships 404

XXXII.— The Reorganization op Bankrupt Corpora-
tions 425

Supplementary Note 459

Index 463

CORPORATION FINANCE

CHAPTER I

INTRODUCTION

Every day of the year numerous opportunities for the
production of wealth are being brought forward, deposits
of minerals are discovered, franchises obtained, patents
granted. Railway extensions are constantly bringing new
land, timber, and coal into the market. Increasing popu-
lation offers a basis for water, light, and transportation
plants. New inventions stimulate new wants, and these
wants in their turn produce new means of satisfaction.
The automobile, sanitary plumbing, tropical fruits, electri-
cal household appliances, the delicatessen, the multiplica-
tion of outer garments and footwear, the popular magazine,
the movies, the resort hotel, Chautauqua, are only a few of
the modern innovations which are now regarded as necessi-
ties to decent existence. Human wants are indefinitely
extensible. The luxuries of one generation become the
necessities of the next, and upon their heels come crowding
a host of new luxuries destined in their turn to rise to the
rank of necessities.

Population is also rapidly increasing by immigration.
This increase in population is gathered into cities and towns,
requiring the provision of elaborate and costly transporta-
tion systems, and making increasing demands upon the
productive power of the nation to feed, clothe and house
them. In so-called "good" times and in bad, the increas-
ing pressure of human desire is operating to call into being
new industries and to enlarge the old. At the basis of all
industry lies the production of power and in this field we

1

2 CORPORATION FINANCE

find abundant illustration of the multiplication of oppor-
tunity for the production of wealth. We have the mechani-
cal fo]*ced draft and the mechanical stoker, the use of
pulverized fuel; to burn a low grade fuel, we have im-
proved boiler and grate construction; elaborate apparatus
for testing the efficiency of fuels and boilers and various
compounds designed to purify the water used for the pro-
duction of steam. An examination of recent security offer-
ings in the Commercial and Financial Chronicle shows the
great diversity of industrial development and the present
direction of industrial interest. Here we find automobile
manufactures; automobile parts and bodies; wire prod-
ucts; shipbuilding; syrups; electrical appliances; soft
drinks; sugar; chewing gum; phonographs; men's cloth-
ing; agricultural machinery; fertilizers; fisheries; retail
"chain" grocery stores; wholesale distributing of coal;
musical instruments; rubber goods; railroads; railway
equipment ; electric light and power plants ; municipal im-
provements; woolen goods; electric traction; gold and
platinum mining, and urban and farm land development.
Bach of these issues was designed to raise money for some
form of productive enterprise; to supply some new want
or to increase the means of satisfying old wants.

We have an illustration in a railroad replacing a wooden
trestle with a steel bridge. Over this bridge it can run a
heavier train load, which it obtains by the lower rate which
the decrease in operating cost resulting from the heavier
train load makes possible. The lower rate enables the
farmer to turn a part of his grazing land into wheat, and
so eventually the $50,000 invested in the railway bonds
has increased the supply of wheat on the world's market.
This increased production of wealth was made possible by
the purchase of the bonds which the investor bought be-
cause, out of their increased earnings, the railroad could
pay him four per cent interest. Without investment in-
creased production would be impossible. Upon the in-
vestor rests the responsibility of adding to the wealth of

INTRODUCTION 3

the world. As he directs his funds to railroads, cotton
mills, irrigation, or shipbuilding, the productive energy of
society is exerted in this or that field of enterprise.

This office of investment is variously performed. Men
may invest or capitalize their own savings. The farmer
devotes one thousand dollars, half the proceeds of his last
wheat crop, to the purchase of nitrate fertilizer. The New
England cotton manufacturer invests his surplus earnings
in a South Carolina mill where cheap power, labor, and ma-
terial invite development. The Bessemer steel maker adds
an open hearth furnace to his equipment and takes ad-
vantage of a local supply of scrap. The Pennsylvania coal
operator or lumberman buys the cheap coal and timber
land of the South. Every successful producer is continually
devoting his surplus funds to enlarge his enterprise along
lines with which he is familiar as competition compels or
as opportunity presents for greater profits. The producer
often branches out into other fields, as when the farmers
of a locality erect a flour mill or a sawmill, or open a stone
quarry, or a carriage maker engages in the manufacture of
automobiles, or a railroad spends a portion of its surplus
in purchasing a coal property on its line. By such invest-
ments producers extend their business out of their profits
and with their own funds.

Every industry is constantly growing from within — as
the bioldgists say, by intussusception— out of the profits of
the past, and individual producers are making ventures of
their money into untried fields in enterprises where they
alone stand to win or to lose, and where they act from per-
sonal knowledge of the opportunity.

There is a second class of investors which may include
some of the first class but whose members are actuated by
different motives and who act in a different way. These
persons are also in possession of surplus funds from the
employment of which they wish to obtain a profit, and they
are ready to buy the stock of any corporation which gives
them the assurance of satisfactory returns. They are in

2

4 CORPORATION FINANCE

the market for any securities which they consider to be
safe and profitable investments. The members of this class
are not, as a rule, in close touch with the industries whose
securities they buy. A leather merchant invests in steel,
a banker in railroads, a retail dealer in mining stock, not
because he desires to identify himself with the business in
which he invests, so far as to give it his close personal
attention and to assist in its management, but solely that
Jie may share in its profits. Included in this class are in-
vestment institutions and managers of trust funds, who
take no active part in the numerous enterprises whose
securities they hold and who may know, indeed, little or
nothing about the business.

The importance of this vicarious interest in industry is
steadily increasing. Production is each year being carried
on on a larger scale, and it becomes increasingly difficult
for a few men to combine a sufficient amount of capital for
the inauguration of a new enterprise or the development of
.an enterprise already established. Twenty years ago a few
thousand dollars would build a sawmill. A half dozen
farmers, by combining their savings, could start in the
lumber business. To-day a well-equipped sawmill may cost
$100,000, and added to this may be the expense of per-
haps twenty miles of railroad to reach the timber. The
-assistance of outside capital is becoming every year more
essential to the development of any industry or the ex-
ploitation of any resource.

A very good example is this: The Pennsylvania Rail-
road Company owns a majority of the stock of the Long
Island Railroad Company which completely dominates
Long Island. Long Island is largely vacant territory.
With Long Island brought into direct contact with Man-
hattan, it could reasonably be expected that a large number
of people would move from Manhattan into Long Island
increasing the population of the towns of Long Island'
manufacturing enterprises would spring up along the
lines of the Long Island Railroad, and a dense population

INTRODUCTION 5

would eventually be settled in the eastern end of the
- Island. The Long Island Railroad would naturally supply
the means of transportation to this population, and the
Pennsylvania would profit from the dividends on its inter-
est in the Long Island Railroad Company, and also to the
Pennsylvania would come the transportation of most of
the freight which that large population would use. There
has been some advantage, though very slight, from the
passenger traffic west-bound from Long* Island, and also
a certain advertising value connected with the building
of a beautiful terminal in the center of Manhattan. This
was a very large enterprise. While its outlines were clear
and its success seemed assured, it could not be carried
through out of the profits of the Pennsylvania' Railroad.
For the completion of the work, which cost over one hun-
dred million dollars, the Pennsylvania Railroad Company
has raised a large amount of money through the sale of
stocks and bonds, besides appropriating considerable sums
out of its surplus. In order to get money together for
large undertakings of this character, it is necessary to draw
upon the funds of a large number of investors, and espe-
cially upon financial institutions: trust companies, insur-
ance companies, and savings banks, which are great reser-
voirs of investment funds. ,
The investor is appealed to to furnish funds for two
classes of enterprises : those which are already in existence,
and new enterprises which are to come into existence
through the money he advances. The investor will not
look up new schemes of investment for himself. He will,
however, buy securities which are offered to him when they
are properly presented, for the purpose of increasing his
interest on his capital. The proprietors of this outside
capital know little about the technical aspects of the in-
dustries into which they put their money. They are ac-
quainted with these industries merely as sources of profit.
If they can be given satisfactory assurances that profits
will be forthcoming from a proposed development, they are

6 CORPORATION FINANCE

willing to invest money to that end. They will not, how-
ever, devote themselves to searching out and preparing
the propositions into which, when once discovered and pre-
pared, they are willing to put their money.

This attitude of the general investor brings forward the
promoter whose function in industry is that of discovering
investment opportunities, forming companies to develop
these opportunities, and selling the securities of those com-
panies to obtain funds for development. The function of
promotion involves three stages : first, the discovery of the
proposition ; second, the assembling of the proposition and
third, the presentation of the proposition.

The work of the promoter may be explained by describ-
ing the promotion of two enterprises : a small coal company
in Western Pennsylvania, and the industrial combinations,
commonly known as "trusts," which have now absorbed a
large portion of our productive industry.

"Western Pennsylvania is underlaid with great sheets of
bituminous coal. It contains one of the most important
fuel reserves of the United States. The coal is generally
of good quality, and it is accessible to the largest markets
in the country. A large number of mining propositions,
most of which have, since their inauguration, been consoli-
dated under the ownership of a few corporations, have
been developed in this region. The law gives the owner
of land the right to all the minerals which may be found
beneath its surface. The land under which this coal lies
is poor farming land, situated usually in narrow valleys
intersected by streams which have excavated deep channels
offering easy access to coal seams whose outcroppings are
exposed on the banks and hillsides. This land is owned in
tracts varying from ten acres up to three hundred acres.
Many of the farmers mine coal for their own use and for
local sale. A large number of "country banks" are found
where, with primitive appliances, g. considerable amount
of coal is extracted- The sale of this coal is restricted to
the immediate neighborhood since, in the absence of a

INTRODUCTION 7

largfe mining development, railway facilities would not be
provided.

Such a region may attract the attention of bankers or
capitalists who are interested in the development of coal
properties, and they will organize a Syndicate for its de-
velopment. The syndicate will be organized, in much the
same manner as a partnership association, under the terms
of a syndicate agreement, whereby the subscribers asso-
ciate themselves into an organization which it is agreed
shall be managed by one or more of their number known
as "Syndicate Managers," and agree to pay into a common
fund a certain amount of money to be used in the develop-
ment of a certain enterprise. Some part of this money
may be borrowed by the syndicate; a larger amount is
usually borrowed by the members. "We shall, in a later
chapter, consider the organization and administration of
syndicates in detail; for our present purpose, this brief
description will suffice. The syndicate having been organ-
ized, a call is made upon the members for a small per-
centage of their subscriptions for preliminary expenses.
The syndicate is now ready for operation.

Some of their number will have received a considerable
amount of information concerning the possibilities of the
coal mining development under consideration, either from
a local promoter or from some other source. The local
promoter is usually a small lawyer or rural capitalist whose
ambition outruns his means, and who may have spent some
money in preliminary surveys and examinations, the re-
sults of which are communicated to some banker or m,in-
ing official who has command of the necessary capital, and
who can, with his associates, develop the possibilities of
the proposition. At this point, the promoter, usually so-
called, namely the local man who has introduced the propo-
sition to the capitalist, passes out of the narrative. He
may be paid a certain amount of cash for the work he has
done, or may be allotted a small interest in the syndicate,
which secures him in the possession of a small amount of

8 CORPORATION FINANCE

the stock which the company to be organized may issue.
He is not apt to be a very important factor in the future
development of the proposition.

Starting vpith this preliminary information, the syndi-
cate now has a thorough examination made of the property
which they propose to develop. Engineers are sent into
the field to furnish the necessary technical information
upon which the proposition must be based. From the
reports of these engineers, it will be determined whether
the coal seam is regular, or faulted and broken, requiring
a large amount of expensive rock excavation for large
development, also if the proposed mining operation will be
self -draining, or if pumping machinery must be installed;
the percentage of sulphur and silicon which the coal con-
tains, its properties as a coking coal out of which a coke
can be made which will stand up under heavy burdens in
the blast furnace. Surveys will also be made of the pro-
posed railroad without which commercial coal production
is impossible. The cost of mining development and of
railway construction will be determined as accurately as
possible. At a cost of perhaps $5,000, the syndicate can
gain approximately exact information concerning the
physical features of the proposition.

In addition to the information received from technical
experts, although engineers usually assume to work in this
field also, the financial aspect of the proposition is care-
fully considered. In a thorough investigation of a coal
mining proposition, the price per acre at which the land
can be purchased, the rate of freight charged by the con-
necting railroads, and the prices which can be obtained for
this grade o'f coal in the different markets must be deter-
mined. Other considerations to be taken account of in-
clude the labor situation of the region, especially the
strength of labor organizations, the laws of the State regu-
lating the company store ; and the attitude of the railroads
toward a new mining enterprise— whether they will be
helpful or indifferent.

INTRODUCTION 9

After all this data has been gathered and collated, a de-
cision may be reached to go forward, or the proposition
may be abandoned because of the disclosure of unfavorable
factors not revealed by the preliminary investigation on
the basis of which the syndicate was organized. This ini-
tial investigation of a proposition, the disclosure of all
the factors, favorable and unfavorable, affecting its ulti^
mate success, must be thoroughly carried through or the
enterprise is doomed to failure.

The countless disappointments in the development of
new enterprises! of all kinds are due, not so much to abuses
of management or mistakes in capitalization, as to imper-
fect investigation reaching wrong conclusions as to busi-
ness possibilities. So-called investigations made by local
promoters are in most cases worthless. Their interests are
so deeply involved in putting the best face possible on a
scheme that both their observations and their deductions
are of little value. Even the investigations of so-called
"experts" are open to serious question. The expert's
views are also colored by his interests since he is often,
apparently, employed not so much to keep his principal
out of an investment as to confirm his principal's judg-
ment that the enterprise will be successful.

There is in the neighborhood of a large Eastern city a
suburban railroad running out about twelve miles from a
terminal station at the end of a city transportation line
through a number of fashionable suburban towns, parallel-
ing throughout its entire distance the main line of a large
and well managed steam railway company. The fate of
the company which constructed this line furnishes an ex-
cellent illustration of the blunders into which supposedly
competent investigators are likely to fall in examining a
business proposition. The syndicate which promoted this
enterprise and which completed it with its own money, no
securities being offered to the public, employed engineers
of high reputation to examine into the cost and traffic of
the enterprise. The line was accurately surveyed, esti-

10 CORPORATION FINANCE

mates were made of the cost of obtaining ground for a
private right of way, and options were secured on a large
amount of real estate for the development of suburban
towns.

The engineers also addressed themselves to the possi-
bilities of traffic for the new line based on the population
then in existence. The experience of interurban railroads
in the "West, where the experience of these experts had
been gained, has been that a high-speed interurban line
divides traffic with the steam line. It is usually assumed .
that, from an estimate of the traffic on the steam line, it
will be possible to approximate the number of passengers,
which will be drawn away to the electric road. The en-
gineers in this case followed this method. They made
careful computations of the traffic at each one of the sta-
tions on the line of railroad which their line was to parallel,
and on the basis of this traffic they made an estimate of
the traffic to be gained by the suburban line. Their esti-
mates were accepted and the line was built, about three
and a half million dollars being provided by the sjmdicate.

No sooner was the new line put into operation than it
was discovered that the engineers had made serious blun-
ders in their calculations. The people of the towns through
which the new line ran were entirely satisfied with the
service furnished them by the steam line which landed
them in the heart Of the city. The new suburban line, on
the other hand, would only give them a connection with a
city line, necessitating a change of cars at considerable
inconvenience. The class of people who were expected to
patronize the new road are well-to-do. To them, the ad-
vantages of saving a few cents in fare, and the more fre-
quent service offered by the electric line were of no con-
sequence. The traffic of the new road proved a sore dis-
appointment to its promoters. It failed from the begin-
ning to pay its fixed charges, and for a time even its oper-
ating expenses were not earned. In 1908 its net deficit
was $176,194. It was eventually sold at less than one third

INTRODUCTION 11

of the amount of money invested in its construction; an
expensive extension was built to make it profitable. Its
original projectors, who blundered, have not participated
in its success.

The difficulty in obtaining accurate information con-
cerning the merits of the propositions which are brought
to the attention and which arouse the interest of active men
of affairs, has led to the development of a new type of
promoter whom we will call, for lack of a better term, the
promoting engineer. The promoting engineer is a firm or
corporation engaged in the business of building trolley
roads, power plants, railroads ; doing all kinds of engineer-
ing and construction work within a certain field. They
have a certain capital — the capital of some engineering
firms runs into the millions — and they can borrow several
times the amount from banks. They build up a permanent
organization of engineers, chemists, accountants, and, in
some cases, lawyers.

The engineering concern wishes to keep its organization
constantly employed. Among its clients are bankers and
capitalists who seek their advice on the merits of proposi-
tions. If their opinion is favorable, they are likely to ob-
tain the engineering work. Usually, in such a case, they
include the fee for investigation in their engineering com-
mission. As a result of these inquir^ies and employments,
the engineering concern in time advances to the investiga-
tion and presentation of propositions of their own. They
have no lack of opportunities for independent effort of
this kind. Large numbers of propositions are thrust upon
them from which they can choose those which seem prom-
ising. If, after a preliminary investigation of a project,
the engineers consider it worth undertaking, they secure
the necessary options, and present the scheme to bankers
and capitalists with whom they are connected.

A proposition submitted by an engineering concern of
repute and authority in their chosen field will receive re-

12 CORPORATION FINANCE

spectful attention from the banker who recognizes that the
engineer's interest is not primarily to take part in the pro-
motion, but to secure employment for himself and his or-
ganization, and to make his regular engineering profits.
The engineer may also, in order finally to convince the
banker, take part in the financing of the enterprise. He
may acquire an interest in the syndicate which he proposes
should be organized for its development. This interest the
engineer will dispose of, should opportunity offer, even if
he has to sell it at cost, either to the members of the syndi-
cate, or to outside interests with the consent of the mem-
bers of the syndicate. The engineer is not in the banking
business, save incidentally and to obtain new business for
himself. A usual condition of his participation in the
flotation is that he should be given the supervision of the
constructionr The engineer may go a step farther and
supervise the operations of the electric railway or gas
plant during its initial stages. He assumes these duties,
as a rule, with the cordial approval of the bankers. They
are glad to secure, in this manner, an assurance of re-
sponsibility and competent management which the engi-
neer is qualified to furnish.

The promoting engineer possesses advantages over any
other kind of investigator, from the standpoint of the
banker who advances the funds to make new enterprises
possible, in that the engineer's interest is on the side of
thorough investigation, economical construction, and care-
ful management. Especially when the engineer shares the
risks of the undertaking, is the banker glad to defer to his
judgment and to invest money in the projects which the
engineer indorses. There are a large number of engineer-
ing concerns of this character in the United States. One
of the largest, the Stone & Webster Corporation of Boston,
has gone so far as to develop a banking department in
connection with its engineering work, through which it
sells the securities of its own enterprises. The importance

INTRODUCTION 13

of thorough investigation is now so generally recognized
that alliances of this character between engineers and
bankers may be expected to become general. They are
usually found more satisfactory than when the engineer
is employed by the banker in an expert capacity.

CHAPTEK II

THE WORK OF THE PROMOTER

After the investigation is completed, if it is decided to
proceed-, the next step is to assemble the proposition. By
assembling is meant the securing of control of the property
or rights upon which the proposition must be based. There
are two methods of getting a property under control. The
first is to buy it and the second is to buy the right to buy
it, in other words, to secure an option upon it. Outright
purchase is for the promoter usually impossible, especially in
the case of new enterprises which are to be financed by the
sale of securities to investors. The money to develop the
enterprise must first be obtained from bankers who will
reimburse themselves by selling the securities to their cus-
tomers. Bankers will not undertake to advance large amounts
of money for the development of a scheme until there is a
definite proposition put before them. They will not, for
example, set aside $1,000,000 of their funds to develop a
water power proposition until all the lands adjacent to the
water power, and which are necessary for its development,
have been secured. A part of this money the bankers may
have to borrow. They will not undertake these responsibil-
ities merely to encourage the promoters to make an earnest
effort to get the proposition together. The promoters must
give them definite assurances that all the property necessary
is under their control before the bankers will tell them
whether they are prepared to advance the necessary funds.
As for the promoters themselves to purchase the property,
even if they have the money, they cannot afford to risk it in
14

THE WOEK OF THE PKOMOTEE 15

the purchase of resources whose development they may not be
able to finance.

For example, in the coal land proposition which we have
considered, to buy the 5,000 acres which is necessary, at $20
an acre, would require $100,000. Suppose this initial outlay
to be made, and that the promoters find that, owing to the
adverse conditions of the money market, or to some hitherto
undiscovered imperfection in the project, bankers refuse to
advance the necessary funds. They have $100,000 locked up
in undeveloped property, which represents $6,000 a year in
interest, a large part of which may have been borrowed, and
they may be seriously embarrassed before they succeed, if
indeed they ever succeed, in securing the funds for its
development. . Outright purchase of properties for the devel-
opment of business propositions is not merely undesirable
but unnecessary. The same result as purchase, so far as the
promoters are concerned, can be reached by buying the right
to purchase, in other words, by obtaining an option on the
property which they desire.

An option is a privilege existing in one person, for which
he has paid, giving him the right to buy certain realty,
merchandise, or securities from another person within a cer-
tain time at a fixed price, or to sell such property to such
other person at an agreed price or time. An option is, there-
fore, an unaccepted offer which runs for a deiinite time. It
states the terms and conditions on which the owner is willing
to sell or lease his property if the offeree elects to accept
them within the time named in the option. If the holder
of the option, known as the optionee, elects to accept the
offer of the optionor, he must give notice to the optionor
and the accepted offer thereupon becomes a binding contract.
If an acceptance is not given within the time specified, the
owner is no longer bound by his offer and the option is at
an end. In effect, a man who grants an option on his prop-
erty binds himself to make a contract to sell that property
at a future time and to convey a good title. An option con-
tract, like any other contract, is based upon a consideration.

16 COKPOEATION FINANCE

This may be small; one dollar is a binding consideration.
It is usual, if a substantial payment is made, to apply this
on the purchase price if the ofEer of the optionor is eventually
accepted.

The rights of the optionee in the property are those
expressly named in the contract of option, and those which
are implied from the terms of the contract. It is usual to
give the optionee some right to enter upon and examine and
sometimes even to take temporary charge of the property
which he proposes to purchase. For example, in 1905, the
Southern Eailway Company and the Illinois Central Eailway
Company entered into a contract by which they purchased
the prior lien bonds of the Tennessee Central and obtained
options for three years upon the general mortgage bonds of.
the Tennessee Central, the bonds of the National Terminal
Company and practically all the capital stock of this com-
pany except that held by counties and municipalities. Pend-
ing the acceptance or surrender of the option, they paid
interest on the securities and operated the company under
an agreement to keep it free from debt. The option expired
July 1, 1908. The operation of the property had not been
profitable, and the railroads surrendered their rights.

A privilege commonly given to the optionee, in the case
of purchase of a going concern, is to have an exhaustive audit
made of the books of the company to determine its profits
for a term of years. For the protection of the optionee, it
may be provided that the owner of the property shall do
nothing which might impair its value, for example, that he
must keep up the insurance, discharge all taxes, interest and
mechanics lien obligations, and, in general, maintain the
property in the condition which would render it available
for the uses to which the optionee intends to put it in case
he decides to exercise his rights under the option.

A valuable right connected with an option contract, from
the standpoint of the optionee, is the right to assign the
option. This is not implied but must be set forth in the
option contract. If the right to assign exists, then the pro-

THE WORK or THE PEOMOTEE 17

inoter is in a position to deal to advantage vdth the proposed
corporation. He can either obtain from the company the
funds with which to purchase the property which he has
under option, afterwards transferring it to the company in
return for his agreed compensation, or he can assign his
rights under the option contract to the company which can
then take them up direct.

The remedy of the optionee, in case the optionor refuses
to carry out his agreement to sell the property, on being
notified by the optionee that he is prepared to take it, and
after the purchase price has been tendered, varies according
to the ownership of the property at the time. When the
property remains in the possession of the optionor, the op-
tionee's remedy is to go into a court of equity and ask for
a bill of specific performance which the court, on proper
showing being made, will issue, requiring the optionor to
transfer the property. When the property has passed into
the hands of an innocent third party, however, the only
remedy of the optionee is a suit for damages. The measure
of the damages may be the margiu between the price named
in the option and the present market value of the property.
It is easy, however, to block such conversions by recording
the option at the time it is created. The purchaser of the
property is then chargeable with notice that certain rights
against this property have been created in the option con-
tract, and he takes it subject to a liability to have a bill
for specific performance issued against him. The form of
the option contract conforms with the requirements of any
contract as to form and consideration; capacity of parties;
and legality of object.

Having decided to option 5,000 acres of coal land owned
by perhaps one hundred farmers, the syndicate sends an agent
into the district, and visits these farmers at their homes. He
explains his purpose to them, assures them that he will be
able to raise the money to develop his proposition, and asks
them, for the sake of their mutual interest, and for a nominal
consideration in hand paid, to sell him an option to purchase

18 COKPOKATION FINANCE

their property at any time within six months, at a price of,
say, $30 per acre.

Various arguments may be employed to influence a gen-
eral assent to this proposition. The landowners may be
shown that the value of the surface soil, which will remain
in their possession after the transfer of the coal, will be in-
creased by the demands which a coal mining community will
make for the produce of their farms. They may be offered
the advantage of a railway which the opening of coal mines
will bring. The hopelessness of developing their own prop-
erty may be pointed out to them, and, as a last resort, the
promoter may threaten to "sew them up" by refusing to
transport their coal over his road. By employing such argu-
ments, the promoter persuades the farmers to option or
" lease " their land.

As far as possible, he keeps each owner in ignorance of
the terms offered to his neighbors, for a general diffusion
of such information would cause a general raising of prices.
In dealing with the well-to-do and intelligent farmers, he
must often pay a high price for the option, and the price
named in their instrument is, also high. The promoter sub-
mits to these onerous terms not merely because he wants the
land of these hard bargainers who know just how indispens-
able their coal is to him, but also, and chiefly, because he
desires to use their names and influence with other owners.
These higher prices are recovered in dealing with the more
ignorant landowners, who are greatly impressed with the
representations of the promoter, and also by the fact that
their richer neighbors have joined the scheme. It may even
be necessary for the promoter to employ coercion through an
alliance with the general storekeeper who may hold chattel
mortgages and judgment notes against the recalcitrants —
powerful arguments when skillfully employed.

The proposition has now been assembled; the owners have

obligated themselves to sell to the syndicate at a certain

price until the expiration of the period named in the option.

.It is known How much the land and development will cost

THE WORK OF THE PROMOTEE 19

and the land is under the syndicate's control. The next step
is to finance the enterprise. At this point, a corporation
is usually formed to take over the options. The bonds or
stock of this corporation are taken by the syndicate whose
members are now called upon to pay a substantial portion
of their subscriptions. A portion of the necessary funds may
also be borrowed, the securities being deposited as collateral
for loans. With the money raised in this manner, the cor-
poration, all of whose stock is owned by the syndicate, pur-
chases the coal land, makes the development necessary, and
starts the company as a going concern. After a record of
earnings has been established, the securities of the company
are usually offered for sale. If the enterprise has been wisely
planned and economically developed, these securities may ba
sold at prices which will restore the syndicate's original in-
vestment, and either leave them in control of the stock of
the company or enable them to sell out all their holdings
of its securities at a profit.

This represents a typical promotion. Similar enterprises
are constantly being promoted throughout the country, not
only on mines, but on real estate, manufacturing enterprises,
railroads, water powers, irrigation and timber projects. The
details of each may vary from the form presented, but the
essential principles are the same: (1) The securing of a right
to purchase an opportunity to make money; (2) the capital-
ization of that opportunity at a higher figure than the price
to be paid the original owner plus the funds required for
development; and (3) the sale of the certificates of this cap-
italization to the investor, either directly or through the
agency of middlemen, for a sum of money exceeding the
amount necessary to purchase and develop the resource which
it is intended to exploit. The difference represents the pro-
moter's profit, a characteristic feature of corporation finan-
ciering.

What have the promoters done to entitle them to this
large profit? They have produced no coal; that is done by
the comnany to which they turn over their options. Nor

20 COEPOEATION FrKTANCE

have they risked an amount of money in any way comparable
to the profit which they have made. To obtain fifty options
under the circumstances described may not have required
an outlay of more than $5,000. Judged by the canons of
what is generally considered to be legitimate money making,
the promoters have done nothing to entitle them to the
$70,000 profit which, out of a flotation of this importance,
they frequently take. And yet the profits of the promoter
are as legitimate, as are the profits of any of the more familiar
professions.

The promoter is a crea,tor of value. He brings into ex-
istence a means of producing wealth which did not before
exist. By combining the control of a number of separate
pieces of coal property into a fully equipped coal-mining
enterprise, he is able to offer to the investor an opportunity
to earn say twenty per cent net on his money; in other
words, to sell to the investor $500,000 worth of stock which
can be depended on to pay dividends of ten per cent, for
$250,000.

Without this combination, in the hands of individual
owners, without transportation facilities, and without equip-
ment, the value of this coal, based on its earning power
from the small mines which produce for the local trade, did
not exceed $20 per acre. Combined under one ownership,
connected with a trunk line railroad, and equipped for large
operations, a value of $100 per acre is not excessive. This
increase in value of $80 per acre is the result of the invest-
ment of $35 per acre — $20 in the purchase of the coal and
$15 in its development. Deducting the $35 which must be
spent to put the coal on the market, there remains $65 per
acre as the promoter's profit, which he may share with the
banker and investor, a profit differing in no essential feature
from the gains of the manufacturer who contracts ahead
for his material and takes advantage of a rise in the market
price of his product.

But, it may be objected, why should the promoter be
allowed to make this large profit? Why should it not be

THE woek: of the PKOMOTEE 21

divided between the farmer who owns the land and the
investor who furnishes the money? What is the justification
for the promoter's profit? .The answer to these qijestions
lies in the nature of the transaction. Neither the owner nor
the investor can do the work of the promoter, and they have,
therefore, no claim to his profits. The farmers, save in ex-
ceptional instances, could not even organize their own propo-
sition, much less fibaance it. Mutual jealousies, local feuds,
and overmuch information about the character and financial
standing of local individuals who might undertake this work
interfere with any general agreement. It would be found
next to impossible to agree upon the proper price for differ-
ent prices of coal land. Farmer A, whose land lies near the
creek, would insist upon a higher value for his property
than farmer B, whose coal is less accessible;, while B on his
part might cite as a reason for disputing the justice of A's
claim, the fact that his coal had been opened in several
places while nobody knew that A had any coal on his prop-
erty. Farmer C, who owned land across the right of way
of the proposed railroad, and who therefore considered his
cooperation indispensable, might insist upon a price of $150
per acre, which would probably disgruntle his less favored
and jealous neighbors, and so defeat the scheme. The Brown
family might refuse to go into any agreement with the
Jones family, with whom one of the chiefs of the Brown
clan may have had a lawsuit of some years' standing. Any-
one of a number of similar causes which might be cited
would be suifieient to prevent the concentration of control
of these separate properties, which are of small value unless
combined.

Some one interest acting exclusively for its own ad-
vantage, and dealing independently with each owner, is es-
sential to the assembling of such a proposition. This inter-
est may be local, and, as already noted, by means of local
alliances the task of the promoter is made easier; but in
most cases, the successful assembler of a proposition is the
outsider who can pose as the man of wealth and connection,

22 COEPORATION FINANCE

and can reap his harvest of options during the pleasant
weather of a first impression. It is the experience of pro-
moters that an outsider of imposing personalily, pleasing
address, and experience in handling men has usually much
greater success in securing options than even a local
"squire" or other celebrity whose standing in the com-
munity may be of the best, but who is too well known to
be allowed by his neighbors to make any large amount of
money out of their property.

Even if the farmers succeeded in getting their proposi-
tion together in the control of a selected committee or in-
dividual, they would have great difficulty in securing a
financial connection. They would have to provide for expert
reports on the property, and then to open negotiations with
some financial interests with whom none of their members
would probably be personally acquainted. After securing an
introduction, they would present their proposition, probably
in a lame and halting manner, which would not show that
they possessed a comprehensive knowledge of the importance
of the property in question to the general coal market or of
the cost and conditions of its development.

Since they would have no connection with the investing
public, if the banker to whom they would naturally apply
for the funds was sufficiently interested to examine the prop-
osition and to determine its value, he might take one of
two ways to further his own advantage. He would either
prolong the negotiations until the local contingent lost heart
and withdrew, trusting. to his own ability to obtain the options
for himself, or he would compel the representatives of the
owners, if they desired his assistance, to accept a price not
greatly exceeding the face of their options; in which event
the financier would be the promoter one stage removed, and
acting by deputy. It is evident,' therefore, that the larger
part of the promoters' profits on such propositions cannot
ordinarily be saved by the original owners of the coal.

The proprietor of an undeveloped opportunity is seldom
in a position to bargain to advantage for its sale. His best

THE WOKK OF THE PROMOTEE 23

course is to put his property in the control of some promoter
at a fixed price and for a definite time, contenting himself
with effecting a sale, not at the price which he thinks the
property is worth, but at a price which will represent a fair
return on his investment of brains or money. Any attempt
on his part to promote his own scheme is likely to end in
failure. The failure of inventors to make more money out
of the sale of patents which have merit is probably due, more
than to any other cause, to the fact that they insist upon
an excessive interest themselves, and are unwilling to offer
sufficient inducements to those who might otherwise promote
the scheme.

It is equally impossible for the investor to secure the
promoters' profits. The investor is looking for a security
which will produce as large an income as is consistent with
the safety of his principal. He is not likely to concern him- ,
self with the active management of these industries into
which he puts his money. How much less likely is he, there-
fore, to abandon his regular business or profession and roam
about the country in search of resources to develop. The
investor, of necessity, assumes a receptive attitude. He is
the customer to whom the promoter and financier offer their
wares. He buys on his judgment, not so much of the merits
of the proposition, as of the reputation of those who offer
it for sale.

We must conclude, therefore, that the promoter performs
an indispensable function in the community by discovering,
formulating, and assembling the business propositions by
whose development the wealth of society is increased. He
acts as the middleman or intermediary between the man with
money to invest in securities and the man with undeveloped
property to sell for money. In the present scheme of produc-
tion, the resource and the money are useless apart. Let them
be brought together and wealth is the result. The unassisted
coincidence of investment funds with investment opportu-
nities, however, is uncertain. The investor and the land or
patent or mine owner have few things in common. Left

24 COEPOEATION FUSTANCE

to themselves they might never meet. But the promoter
brings these necessary elements together, and in this way
is the means of creating a value which did not before exist,
and which is none the less a social gain because much of it
is absorbed in the first iostance by the promoter and the
financier.

Our promoter has now proceeded in the flotation of his
enterprise as far as he can go without assistance. He must
now obtain money to take up hig options, build his factory or
railroad, and inaugurate his enterprise. He may obtain
this money from the investing public to whom his appeal
may be made directly, by published advertising, circular
letters and agents. If the nature of his proposition per-
mits, he will present it to bankers and ask them to pur-
chase, or to agree to purchase, a sufficient amount of the
securities of his new company to provide it with the money
which it requires. In the United States it is a safe con-
clusion that in nearly all cases where the character of the
proposition is such as to appeal eventually to the conser-
vative investor, the promoter will approach bankers and en-
deavor to secure from them the funds which the new com-
pany requires. The bankers will purchase the securities with
the expectation of selling them to the public, but, for the
time being, the dealings are between the promoter and the
banker.

A company has been incorporated which will hold title
to the property with whose acquisition the promoter has
occupied himself. This corporation will issue certain secur-
ities. These securities will be sold to the investor who will,
in this way, furnish the money for the development of the
enterprise.

CHAPTER III
THE BUSINESS CORPOEATION

Fkom this point we have to do with the corpora,tion as an
agency for the conduct of business enterprise. A comparison
of the two forms of association effort, the partnership and the
corporation, will show the advantages of the corporation.

The partnership is a voluntary contract between two or
more persons by which they combine their property, skill and
labor, ia the transaction of business for their common profit.
The corporation is an association of individuals authorized
by the state, under an instrument called the charter or cer-
tificate of incorporation, to transact a particular kind of busi-
ness, together with all kinds of business collateral or inci-
dental to the main line of activity, and, in the transaction of
this business, to buy, sell, lease, mortgage, employ, borrow,
and lend, and in all respects, for the transaction of business, to
act as a natural person.

The partnership being a contract between individuals, does
not merge the identity of these individuals in the association.
The corporation, on the other hand, is an association with a
life, a personality, a will, and a reputation of its own, alto-
gether apart from those of its members.

From this broad distinction arise a number of important
differences between the corporation and the partnership as
forms of working business organization.

First, as to the liability of the members. The partner-
ship, "Jones, Brown and Eobinson, Provision Dealers," con-
sists of these three men, in their own proper persons, joined
in a business relationship. The debts of the partnership
are, therefore, the debts of each member of the partner-

25

26 COKPOEATION- FINANCE

ship up to the full extent of his resources, all of which,
not merely his share of the partnership property, but his out-
side property as well, may be seized in execution and sold
for the payment of partnership obligations. The "Jones,
Brown, Eobinson Company, Successor to Jones, Brown &
Eobinson," although its members are the same as the members
of the partnership which it succeeds, stands between its own
creditors and the outside resources of its members. These
creditors, having dealt with and trusted the Company must
look to the Company for payment. Since the company
creditor does not recognize the individual members in the
incurring of the debt, so he cannot leap over the company in
the collection of the debt, and seize the houses, lands, or per-
sonal property of the members of the company, which they
hold apart from their interest in the company itself. All that
belongs to the company the creditor can seize and sell. Its
members may lose every dollar they have put into the enter-
prise, but the remainder of their property they cannot lose,
hecause of the business misfortunes of their company.

This is the "limited liability" of the corporation, which
so strongly recommends this form of organization to the
investor who looks for income with the minimum of respon-
sibility. In a partnership, the investor must be always oil
guard lest some careless op fraudulent act of a fellow partner
or trusted employee might involve the business in ruin, the
efEects of which might spread to his private resources. In
the corporation, on the other hand, while the consequences of
failure to stockholders are no doubt serious enough, yet these
consequences do not overflow the boundaries of the company's
assets. In some cases, as for example, National Banking
Corporations, liability additional to the stockholders' interest
in the company, is imposed upon them, but even here the
amount of the liability is fixed and known, and the National
Bank stockholder can estimate with exactness the extent of
his liability in holding a form of investment which for this
reason, however, is by no means highly regarded.

The second point of advantage of the corporation over

THE BUSINESS COKPOEATION 27

the partnership, is the respective lives of the two organi-
zations. The partnership, being a group of men, Jones,
Brown and Robinson, doing business as a group, can en-
dure only so long as all of its members are alive, and so
long only as each one remains solvent and willing to continue
in business relations with his partners. The death of Jones,
the bankruptcy of Brown, or the invalidism and consequent
withdrawal of Eobinson, each will operate to dissolve the
partnership and conceivably to dissolve the business. It is
true that enterprises have been conducted iinder the partner-
ship form for many years, leaving, in the case of the Baldwin
Locomotive Works, for example, four generations of partners,
hut this was due to the co-operation of several favorable fac-
tors, not always met with; prosperous business, harmonious
relations between the partners, which resulted in provisions
being made for the valuation and transfer of the interests of
deceased partners, and the admission of valued employees into
the partnership succession. The Baldwin Locomotive Works
continued under the partnership form in spite of the disad-
vantages thereunto attaching. In 1909, moreover, the Bald-
win Locomotive Works was incorporated.

In the absence of a similar conjunction of favorable cir-
cumstances, any business conducted by a partnership is liable
to extinction. The heirs of a deceased partner, the creditors
of a bankrupt partner, or one of the partners dissatisfied with
his associates, may force, by legal proceedings, not merely a
dissolution of the partnership but the sale of all the partner-
ship assets even though the entire good will and most of the
value of the unsold assets should be destroyed.

No such difficulty need be anticipated with the corporation.
The life of the corporation, a life wholly separate from the
lives of its members, can be projected by the terms of its
charter, into perpetuity. No matter what may happen to the
members, the life of the company goes on and on. Every
member may die, every member may become individually in-
solvent, every member may withdraw from the association,
and yet the life of the company will continue.

28 COKPOEATION FINANCE

Sir William Blaekstone, in his "Commentaries" has de-
scribed the immortality of the corporation in a passage of
singular force and beauty.

"In order to facilitate business and to increase production
of wealth, there have been created by acts of the public power^
running back to remote antiquity, associations for business,
religious, governmental, and charitable purposes known as
corporations. These artificial, persons are called bodies
politic, bodies corporate, or corporations, of which there is a
great variety subsisting, for the advancement of rights and
immunities, which, if they were granted only to those in-
dividuals of which the body corporate is composed, would
upon their death be utterly lost and extinct. To show the
advantages of these incorporations, let us consider the case
of a college in either of our universities, founded for the
encouragement and support of religious learning. If this
were a mere voluntary assembly, the individuals which com-
pose it might indeed read, pray, study and perform scholastic
exercises together, so long as they could agree to do so : but
they could neither frame, nor receive, any laws or rules of
their conduct; none, at least, which would have any binding
force for want of a coercive power to create a sufficient
obligation. Neither could they be capable of retaining any
privileges or immunities: for, if such privileges be attacked,
which of all this unconnected assembly has the right, or
ability, to defend them? And, when they are dispersed by
death or otherwise, how shall they transfer these advantages
to another set of students, equally unconnected as themselves ?
So also, with regard to holding estates or other property, if
land be granted for the purposes of religious learning to
twenty individuals, not incorporated, there is no legal way
of continuing the property to any other persons for the same
purposes, but by endless conveyances from one to the other,
as often as the hands are changed. But when they are con-
solidated and united into a corporation, they and their suc-
cessors are then considered as one person in law: as one per-
son, they have one will, which is collected from the sense of

THE BUSINESS COEPOEATION 29

the majority of the individuals: this one will may establish
rules and orders for the regulation of the whole, which are a
sort of municipal laws of this little republic; or rules and
statutes may be prescribed to it at its creation, which are
then in the place of natural laws : the privileges and immuni-
ties, the estate and possessions, of the corporation, when once
vested in them, will forever be vested, without any new
conveyance to new successions; for all the individual mem-
bers that have existed from the foundation to the present
time, or that shall hereafter exist, are but one person in law,
a person that never dies : in like manner as the river Thames
is still the same river, though the parts which compose it are
changing every instant."

The perpetual existence of the corporation gives it great
advantages over the partnership. The corporation can enter
into contracts, such as franchises or mortgages extending over
many years. It can undertake programs .of construction
which may require a quarter century for their completion. It
can offer to the investor a permanent as well as a safe
resting place for his income seeking funds.

Connected with the advantage of perpetual succession
which the corporation enjoys over the partnership is the
advantage of transferability of interest. Any partner can
force his way out of the association without the consent of
his fellow partners, usually at the expiration of any year, or,
at best, at the end of a short term of years, but no outsider
can force his way in to replace the one who withdraws, with-
out the consent of each one of the remaining partners. The
partnership relation is so intimate, so personal, the partners
are joined so closely together in their duties and responsibili-
ties, that unanimous consent is rightly considered to be neces-
sary before new members are admitted. This fact makes
partnership interests generally unavailable for investment
purposes. Even if the investor could get his money into
the partnership, which is not, unfortunately, as difficult in
many cases as it should be, he will find it far more difficult
to get it out again. With the rapid growth in the scale on

30 • CORPORATION FINANCE

which husiness is conducted and the consequent necessity of
drawing money from more people for its capital equip-
ment, this difficulty o£ transferring interests counts
strongly against the partnership form of organization.

The stock of a coi^poration, however, is divided into
shares and these shares are the personal property of those
who hold them free from any limitation or restriction on
the right of transfer in the absence of a special agreement
to sgU to the company or the remaining stockholders. Any
stockholder may sell his stock to anyone, and all of his
fellow stockholders acting together, are powerless to pre-
vent the admission into the association of the new member
thus created. The way is thus opened for the free circula-
tion of the investor's money from one corporation to an-
other by the process of buying and selling stock interests.

The final advantage possessed by the corporation over the
partnership is the advantage of representative government.
In a partnership, each member of the firm is the agent of all
the others. Each member can bind the firm. The partners
are presumed by law to trust each other absolutely in the
conduct of the business so that the words and acts of each
partner have equal force with the words and acts of any
other. This fact makes membership in a partnership, for
any investor who is not in a position to give his personal
attention to the business, extremely hazardous, since his
entire fortune may be swept away by an ill advised or
fraudulent course of action taken by the other partners with-
out his knowledge. Personal attention to the affairs of a
partnership by each of the partners is therefore essential, and,
though this makes for the highest business eflfieiency where
the partnership is harmonious and well organized, since the
"eye of the master" is on every part of the business, yet it
closely limits the number of members and therefore, the
amount of money which can be placed at the company's dis-
posal. In the nature of things, few can give their time and
close personal attention to the»conduct of a business.

In the corporation, on the other hand, we have a perfect

THE BUSINESS COEPOEATION 31

system of representative government. A group of individuals
come together under the powers given them by the corpora-
tion law of the state and draw a- certificate of incorporation.
This instrument gives the name of the corporation, its objects,
the amount of capital it is authorized to raise, the location
of its principal office, the period of its duration, the names
and post office addresses of the original subscribers and
the amount of their several subscriptions, and any provision
for the regulation and conduct of the affairs of the corpora-
tion. This instrument is recorded and filed with some state
officer — in New Jersey, the Secretary of State — and the sub-
scribers thereupon become a corporation.

The corporation now proceeds to organize by setting up
its government which shall regulate its afEairs. Immediately
the principle of representation is applied. The stockholders
select from their number certain directors or trustees to
manage the business. This the law requires. There may be
in time many thousand stockholders scattered all over the
world, but few of these" stockholders know anything about
the business owned by the corporation of which they are the
owners, save as they may, in time, receive dividend checks
or when their voting proxies are solicited. It is impossible,
even if it were desirable, that these stockholders should come
together at frequent intervals to give their attention to the
management of their business. So they delegate directors to
represent them. The stockholders, both in the certificate of
incorporation or charter, and in the by-laws or regulations
supplementary to the charter, can lay down the fundamental
laws by which they wish the business of the company to be
governed ; just as the sovereign people in their constitutional
convention, change and add to the fundamental laws of the
state by which the legality of every statute passed by the
legislature must be tested. But having passed these laws,
both people and stockholders, except on such matters they
leave reserved for their own decisions, such for example, as
the borrowing of money by the state; or the mortgaging of
property to creditors, or the creation of new stock having

32 CORPOEATION" FINANCE

priority as to dividends over existing issues, by the private
corporation; must leave the decision of questions of public
or corporate policy to their elected representatives.

And even the directors are not supposed as directors to
manage the routine of the business. For example, the Gen-
eral Corporation Act of New Jersey in section 12, provides
that "the business of every corporation shall be managed by
its directgrs who shall respectively be shareholders therein,
they shall not be less than three in number, and except as
hereafter provided, they shall be chosen annually by the
stockholders, at the time and place provided in the by-laws,
and shall hold office for one year and until others are chosen
and qualified in their stead."

However, it is further provided that "every corporation
organized under this act shall have a president, secretary and
treasurer, who shall be chosen either by the directors or stock-
holders, as the by-laws direct, and shall hold their offices until
others are qualified in their stead."

These officers and others who may be provided for in the
charter or by-laws, manage the business of the company under
the general supervision of the directors, who even though
they may hold weekly meetings, can do little more, in refer-
ence to the routine management of the business, than to pass
upon the reports of the managers.

In this universal application of the principle of represen-
tative government to corporation management, lies another
safeguard for the investor. He cannot manage the business
himself. He must turn it over to others to manage. These
delegated representatives, however, are, in the fullest sense
of the word, his trustees. The rules under which the trust
is to be administered, are set down in the law of the state
and in the charter and by-laws of the company, and for any
deviation from these rules the directors are liable to the stock-
holders. The law requires corporation directors to give, and
the vast number of prosperous corporations now in existence
proves that directors do give to stockholders the benefits of
honest, careful and diligent supervision of their affairs. In

THE BUSINESS COEPOEATION 33

the same way, directors receive from tlie administrative offi-
cers of the company, to whom they must delegate not only
the routine of management but the initiation and carrying out
of important policies of construction, consolidation, and ex-
pansion; faithful and intelligent service.

As the directors represent the stockholders and administer
the affairs of the company in accordance with the constitution
of the corporation, so the officers, as the executives, represent
the directors. Both officers and directors have their spheres
of activity exactly defined in the charter and by-laws supple-
menting the corporation law of the state, just as the public
law lays down in minute detail the rules by which public
officials must conduct the affairs of the state. And further-
more, just as the public legislators must go back at frequent
intervals to the electors to give an account of their steward-
syp, so the corporation directors must obtain from their con-
stituencies, the stockholders, at intervals of even greater fre-
quency, approval of what they have done, and the right to
continue in their positions of trust and responsibility.

The principles and methods of representative government
as applied to corporation management are so flexible that they
can be expanded to unite into the vast organization of the
United States Steel Corporation, which has more than 110,000
stockholders, owning among them $868,000,000 of pre-
ferred and common stock of a corporation, which in 1913
mined 28,738,451 tons of coke, manufactured 14,087,730 tons
of pig iron and 16,656,361 tons of steel ingots, whose total
sales, in 1913, reached $796,894,299 and which employed
228,906 men receiving $207,206,176 in wages. This great
corporation, with assets valued at $1,792,233,492, and with
over three hundred thousand persons directly interested in its
management either as stockholders or employees, is managed
by a board of twenty-one directors, who are elected for three-
year terms by the stockholders, and who in their turn elect the
administrative officers of the United States Steel Corporation
and the directors and officers of its subsidiary companies.

No matter how large the United States Steel Corporation

34 COEPOKATION FINANCE

may grow, the representative form of government, extending
through the directors and officers of the parent company
down through the directorates and administration boards of
the principal subsidiary companies and of the subsidiaries of
these subsidiaries, can expand with the growth of the busi-
ness. The Steel Corporation can indefinitely increase the
number of its stockholders and the amount of the aggregate
contributions to its capital, without impairing the efficiency
of its organization.

It has been already shown that corporations are organized
by incorporators under the provisions of a general corporation
act, which states the procedure in organization and lays down
in general the powers of the corporation, the rights of its
members, and the powers and obligations of its directors and
administrative officers. The corporation is in general author-
ized to act as a natural person for the transaction of the
particular kind of business which it sets forth in its certificate
of incorporation that it proposes to carry on. For the purposes
of this business, including not merely the primary business
such as, for example, steel-making, but any business contribu-
tory thereto, such as transportation or water supply, every
corporation has, quoting from the New Jersey law, which
closely resembles the corporation laws of other states, the
following powers :

1. "To have succession, by its corporate name, for the
period limited in its charter or certificate of incorporation and
when no period is limited, perpetually.

2. "To sue or be sued in any court of law or equity.

3. "To make and use a common seal and alter the same
at pleasure.

4. "To hold, purchase and convey such real and personal
estate as the purposes of the corporation shall require, and all
other real estate which shall have been bona fide conveyed or
mortgaged to the said corporation by way of security, or in
satisfaction of debts, or purchased at sales upon judgment
or decree obtained for such debts ; and to mortgage any such
repl or personal estate with its franchise; the power to hold

THE BUSINESS COEPORATION 35

real and personal estate shall include the power to take same
by devise or bequest.

5. "To appoint such officers and agents as the business
of the corporation shall require, and to allow them suitable
compensation.

. 6. "To make by-laws fixing and altering the number of
its directors, and providing for the management of its prop-
erty, the regulation and government of its affairs, and the
transfer of its stock, with penalties for breach thereof not
exceeding twenty dollars.

7. "To wind up and dissolve or be wound up and dissolved
in manner hereafter mentioned."

In the remainder of this chapter the provisions of the
corporation law will be briefly eslplained. Certain points,
however, will be reserved for an extended discussion in the
chapters folloiving.

We have already discussed the perpetual existence of the
corporation which is described in the foregoing enumeration
of powers, as the right to have succession. The presumption,
as the text of the law shows, is in favor of perpetual suc-
cession. Only when a definite number of years is named in
the charter or in the law is any limitation placed on the
life of the company.

Succession is by the corporate name. A corporation has
the right to select any name with the exception that it must
not use a name so similar to that chosen by another cor-
poration of the same state as to create confusion. It must
not call itself, for example, Peck Bros. Co., when Peek Bros.
& Co. are in the same line of business. This is appropria-
tion of the good will of the second corporation. Good will
is defined as trade reputation which is identified with a
certain name. When a company has built up, through ad-
vertising and attention to the details of its product, a repu-
tation in its field, the law protects it in that reputation. If
a new company, selling the same goods, attempts to select &
name closely resembling the name already connected in the
public mind with the goods it offers for sale, the new com-
4

36 COEPOEATION FINANCE

pany will gain an unfair advantage of its predecessor and
competitor.

The right to sue on behalf of the corporation is usually
exercised by the directors and officers. The stockholders may,
however, be granted this right but only in such cases when
the directors have been appealed to in vain to sue in protection
of the company's interest, or where the directors' interests in
the matter in question are opposed to the interests, of the cor-
poration so that even if they did sue they would be suing
themselves. The courts have always taken the position that
the only way for a stockholder to act is through his repre-
sentatives, the directors.

In connection with this right to sue and be sued, we come
upon the personality of the corporation. The old theory of
the corporation describes it as invisible, intangible, and exist-
ing only in contemplation of law. The modem theory looks
upon the corporation as an association of individuals. The
association, it is true, acts as a body but nevertheless consists
of individuals, and retains the personality of the individuals.
This element of personality appears in connection with the
corporation's position in court. In contemplation of law, the
corporation has a mind which it exercises with every corporate
act, and that mind can direct the agents of the corporation
to commit acts which may result injuriously to others. Al-
though the acts are the acts of the agents, yet the corporation
must answer for thenl, and if the acts are of a criminal nature
the corporation must answer directly to the criminal law. The
corporation is authorized by the law to act as a natural per-
son. It is given the power of a natural person, and power
cannot be separated from responsibility. The corporation
also has a business reputation which may be injured
by false statements, and for these statements the offender
may be sued by the company and made to pay damages. In
order to recover damages for alleged libel, the corporation
must prove that its business reputation was damaged. It has
no reputation apart from its business to be affected by libel.

In fixing the responsibility of the corporation for injuri-

THE BUSINESS COEPOEATION 37

ous acts, the courts have frequently encountered the defense
that the acts complained of are in excess of the corporation's
power, and that, in doing these acts which the law had not
allowed it to do, the corporation had no existence and was not
visible to the law. This defense, however, has always been
overthrown by reference to the legal maxim that as a man
cannot plead his own wrong-doing in his own defense, neither
can a corporation escape liability from the acts of its agents by
proving that it had specially forbidden its agents to commit
those actions.

The use of the corporate seal is restricted to those con-
tracts, mainly relating to the transfer of real estate, where
it would be essential for an individual to use a seal. Under
the old law, the corporation could act only xmder seal, but this
no longer prevails.

The fourth power of the corporation is the right to hold
real and personal estate and to mortgage such property. As a
general rule, the power of a corporation to mortgage its
property for the security of its debts is unrestricted. The
method by which this is accomplished is indicated in detail
in later chapters. The consent of the stockholders is ordi-
narily required. It is also unusual to find any prohibition in
the right of the corporation to incur debt, secured or unse-
cured, and the promissory notes of the corporation, issued "
under the power of the corporation to incur debt, are protected
by all the safeguards surrounding a negotiable instrimient.
The innocent holder for value of a corporation note, which
on its face appears to be legal, will be protected against the
corporation, even though the company receive no benefit by
the issuance of the note, and although neither the corporation
law nor the charter authorizes the company to borrow money.

The fifth general power of the corporation is the power
to appoint agents. This power ordinarily rests with the
directors but they may delegate it to the ofiicers. The trading
or manufacturing corporation has the same right as an in-
dividual trader or manufacturer to select its agents and im-
pose conditions upon them.

38 COEPOEATION FINANCE

The sixth power possessed by all corporations is the power
to make by-laws. By-laws are rules of self-goyernment which
have already been compared to the constitution of the state.
They are adopted by the stockholders of the corporation, who
may, however, confer this power upon the directors. An
example of an ordinary by-law:

"The treasurer shall keep full and accurate account of all
receipts and disbursements on books belonging to the com-
pany and shall deposit all money and checks in the name and
to the credit of the company, in such depositories as may be
designated by the board of directors. - He shall disburse the
funds of the company as may be ordered by the board and
receive vouchers for same. He shall render to the president
and directors at the regular meetings of the board and when-
ever they may request, account of all his transactions. He
shall, together with the president, sign all certificates of stock."

By-laws are constantly being changed and new ones added,
with the development of the business. These alterations are
usually made by the directors. A by-law relates to the
relations between the members of the corporation. It has
no reference to the corporation's relation to third parties
who are usually, although Pennsylvania is an exception,
not charged with knowledge of a by-law unless they have
■ been notified. For example, if the by-laws of a corpora-
tion provide that the treasurer alone can borrow money,
and the president, contrary to the provisions of this by-law,
signs and negotiates a note of the company, the corporation
can not escape the obligation to pay the note by pleading
the absence of authority of its president to sign it.

A by-law, adopted at the time of the organization of the
company, has equal force with the provisions of the charter.
As a contract between the corporation and its stockholders,
it can not be altered except by the same vote of the stock-
holders required to make an amendment to the charter.

The seventh corporate power is the power to wind up
and dissolve. Under the laws of New Jersey the following
methods are available for the dissolution of a corporation.

THE BUSINESS COEPOEATION 39

First: Limitation in the certificate of incorporation.

Second: Dissolution by the incorporators before the pay-
ment of capital.

Third : Voluntary dissolution by directors and stockholders
or by unanimous consent of the stockholders.

Fourth: By an act of legislature.

Fifth: By decree of the court in insolvency proceedings,
and for failure to obey the court's order to bring the books
' into the state.

Sixth : By proclamation of the governor for failure to pay
taxes.

The fourth method of dissolution requires some com-
ment. Section four of the Corporation Law of New Jersey
is as follows : "The charter of every corporation or any sup-
plement thereto or amendment thereof, shall be subject to
alteration, suspension and repeal, in the discretion of the
legislature, and the legislature may at pleasure dissolve any
corporation." A similar provision is found in the corporation
acts of every state of the Union. It is intended to assert the
supreme control of the state over the corporations which are
the creatures of the state. Before the passage of the general
corporation law, it bad been held by the Supreme Court of the
United States in the Dartmouth College case that a corpora-
tion's charter is an irrevocable contract between the state
and the corporation.

The right of suspension, alteration, or repeal of the char-
ter of the corporation is exercised only in the public interest
and it is subject to certain limitations, for example: The
legislature can not so modify a charter to annul contracts made
with third parties; neither can it so modify a charter as to
take away property without compensation.

We see now the seven general powers which the corporation
possesses. In addition to these powers, the corporation clothes
itself in its charter by permission of law, with the powers
necessary to carry out the special objects of its foundation,
and if it does not enumerate all the powers necessary to
achieve this object, the law allows it to exercise additional pow-

40 COEPOKATION FINANCE

ers, "so far as the same are necessary or convenient to the at-
tainment of the object set forth in such charter or certificate
of incorporation." It is unusual, however, for a corporation
to rely upon this power given to it by the corporation act to
exercise additional or implied powers. Corporation attor-
neys have worked out formal statements of expressed pow-
ers of organization for all kinds of business. The claims
of these powers are made in special object clauses which
set forth in detail the different things which the corporation
claims the right to do. Special object clauses are so drawn
as to empower the corporation to carry on certain primary
lines of business, also to do those things which may be neces-
sary or convenient to further the main object of the corpora-,
tion. For example, the Kankakee Packing Company is
authorized by its charter,

"To buy and otherwise acquire, sell and otherwise dispose
of, deal in and with and to slaughter hogs, cattle, sheep and
other live stock;

To acquire by purchase or otherwise, preserve, pack,
manufacture, cure, deal in and with all kinds of ham,
sausages, meats, beef, pork, bacon, lard, fat, tallow, fer-
tilizer and provisions, and all or any products of live stock of
every nature and kind ;

To carry on the< business of cold storage and warehousing
and all or any business necessary or impliedly incidental
thereto ;

To operate and maintain a packing house for preserving
and packing meats and provisions of all kinds, and to produce,
buy or otherwise acquire, sell or otherwise dispose of, deal in
and with, the products of the same."

The foregoing are the express powers of the Kankakee
Packing Company. In carrying out these express powers,
it may be necessary for the company to engage in a variety
of other lines of business and so the charter empowers it "To
conduct a general trading, commission and storage business ;"
to buy and rent or otherwise acquire conveyances for the
transportation, in cold storage or otherwise, of live stock.

THE BUSINESS COEPOKATION 41

and, as incidental to the cold-storage business to manufacture
. ice and cooling compounds. The charter also authorized the
company to own, lease, operate and control all kinds of trans-
portation undertakings both in New Jersey and other states,
by direct ownership or the ownership of stock in these com-
panies, and even beyond this the charter authorizes the com-
pany "to manufacture, prodiice, buy or otherwise acquire,
sell or otherwise dispose of and generally deal in or with all
kinds of goods, wares, merchandise and materials, raw as well as
finished;" and further "to acquire the good will, business rights
and property of any person, firm, association or corporation."

These sweeping provisions, however, are not intended to
enlarge the power of the company beyond the limits of the
packing business, but were granted in order that the corpora-
tion may achieve the greatest possible success. Under these
powers, the packing company can do anything which con-
tributes directly or indirectly to the packing business. Out-
side of this, however, it can not go, and if the directors of
the company should use the company's funds for any enter-
prise not directly connected with the packing business, at the
instance of a stockholder, they could be stopped.

We have already seen how flexible is the organization of
the business corporation and we now understand how com-
plete are the powers of this association to transact business
as a natural person. We have also seen how vastly superior is
the corporate form of organization to that offered by the
partnership. . It is no cause of surprise, therefore, to find
that the business corporation is the accepted form of busi-
ness organization. When men come together for the prosecu-
tion of any joint enterprise it is unusual for them to organize
, under the partnership form. Even in those states where laws
provide for limited partnership, wherein the liability of the
partner may be confined to the specific amount he invests in
the business, or where, as a special partner, he takes no active
part in the management of the business, the corporation form
is the one which prevails.

The first step, therefore, in the flotation of a proposition

42 COEPOEATION FINANCE

is the organization of a corporation to conduct the business.
The corporation laws of the states differ in many respects
and the first problem confronting the incorporators is the
selection of a state whose corporation laws will enable them
to accomplish the objects of their business in the methods
which they prefer to use. The problem before the incor-
porators was thus stated by former Attorney-General Wicker-
sham in a lecture delivered at Harvard University :

"In a large number, perhaps a majority of cases, the or-
ganizers of a corporation enterprise are free to select from
among several, at least, of these states, the one in which to
incorporate. No large business is confined to the limits of
one state, although natural conditions may determine the
place where mining, manufacturing or some strictly local
business is to be carried on.

"What has been termed 'the legislative competition for
capital' has led states like New Jersey, West Virginia, Maine
and Delaware, which are not naturally great industrial and
commercial commonwealths, to enact most liberal corporation
laws, which have been availed of by a vast number of asso-
ciations, which, in the ordinary and natural course of events
would not have resorted to those states for a charter."

In Pennsylvania or Ohio a company can be organized for
only one purpose, which must be stated in the certificate of
incorporation. If several lines of business are to be carried
on, even though these activities are directly related, it is
diificult to accomplish this purpose in a state like Pennsyl-
vania or Ohio without forming separate corporations. The
amount of capital which must be paid in at the organization
of the corporation also differs between the different states.
The liability of stockholders ds another consideration. In
New Hampshire, for example, stockholders are made jointly
and severally liable for all the corporate debts until the whole
capital is paid in. They are individually liable for the wages
of employees in a number of states. Some states also re-
quire that directors' meetings should be held and the books
of the company kept within the state. The corporation laws

THE BUSINESS COEPOEATION 43

of some states, such as Pennsylvaiiia, have provisions in-
tended to secure representation by the board for the minority
stockholders. It is customary, therefore, for the incorpora-
tors to select a state which gives them the greatest privileges,
no matter if that state- may he located three thousand miles
away from the place ia which they may do business.

In such a case, instead of doing business as a domestic
corporation, they come into their state as a foreign corpora-
tion. The transaction of business in every state in the Union
by a foreign corporation is now permitted by local laws.
These foreign corporations must subject themselves to the
same regulations as those passed for domestic corporations
and in some cases special regulations ; they must pay a license
and furnish information to the state authorities for purposes
of taxation. If they conform to these regulations, however,
they are given the same freedom of action as that possessed
by domestic corporations. In certain cases, it is true, even
the most liberal states require certain kinds of business to be
carried on by their own corporations. In New Jersey, for
. example, railroad, street and steam, gas and electric light,
telephone and telegraph companies, banking institutions, and,
in general, all corporations with the proper conduct of whose
business, the general public, as distinct from a limited num-
ber of customers, is concerned, and all of whose operations
should be under the direct control of the state authorities,
must be in(3orporated under New Jersey laws. All other
kinds of business, trading, manufacturing, mining, lumber
and agricultural may be carried on in any state by corpora-
tions organized in any other state.

Having selected the state whose corporation law seems
best adapted to their purposes, the incorporators proceed to
work out in their charter and by-laws a financial plan, which,
when carried out, wiU place at the disposal of the new com-
pany the money or property which it requires and which
shall give suitable recognition, in the distribution of profits
and the right to vote for directors and on other matters, to
those who contribute this capital.

CHAPTER IV

MATERIALS OF THE FINANCIAIi PLAN—STOCK

A CORPORATION has been deiiiied as an association of
individuals authorized to own property, to contract debts,
to appoint officers and agents and to manage its busi-
ness within the limit of its formal grant of authority by the
state known as its certificate of incorporation or charter; in
all respects to act as a natural person. The association, it
will be remarked, owns the property; the stockholders own
the association. The stockholders are represented in the man-
agement of the business of the association by trustees known
as directors. These directors, while transacting the most
important business themselves, appoint administrative officers
who carry on most of the work of the business management.

The ownership or property interest in this corporation is
called the stock of the corporation, and this stock, for pur-
poses of convenience in distributing, is divided into shares.
It has long been the custom to represent this stock owner-
ship in the corporation by a certain sum, such as $500,000
or $1,000,000 or in the case of the United States Steel
Corporation, $1,100,000,000. This sum is presumed to be the
amount of capital, i.e. property or money, which has been
contributed to the corporation to equip it for the transaction
of business. This capitalization, as the expression of owner-
ship in the company, is divided into shares each of which, be-
ing a proportionate part of the total capitalization, repre-
sents an assumed sum of money. This assumed sum is
known as the par value. If the capital stock of the com-
pany, for example, is $100,000 and is divided into 1,000
44

MATERIALS OF THE FINANCIAL PLAN 45

shares, then the assumed or par value of each share is $100.
If the capitalization is divided into 1,000 shares the par
value of each share is $10 and if, as sometimes happens,
1,000,000 shares, the par value is $.10. Since it is in this
form the ownership of the corporation is usually expressed,
the first step in the preparation of the financial plan is to
fix upon a certain capital which shall represent the owner-
ship in the company. The considerations affecting the
amount of this capitalization will presently appear.

It is not necessary that shares of stock shall have any
par value. Ten states, including Pennsylvania, New York,
Illinois, and Ohio, authorize the issue of shares without par
value. When this method of issuing shares is used, instead
of setting forth that the capital stock is $100,000 divided
into 1,000 shares of $100 each, the offering is made of capi-
tal stock, divided into 1,000 shares. The value of stock
without par value may be settled by a resolution of the
board of directors or by the subscription price. In some
states, a minimum amount of cash must be paid for each
share, in New York, five dollars. Par value stock is of no
benefit except as the purchaser of such shares may identify
the figures on the stock certificate with the value of the
shares. There is no necessary connection between these two
facts. The value of the shares depends upon the earning
power of the company, and this earning power, while de-
pendent upon the amount of money or property contrib-
uted, primarily depends upon the ability with which this
property is administered by the directors and officers of
the company. It is also influenced by the general business
conditions of the country, and those affecting the particular
industry in which the company operates. For all practical
purposes, a share of stock without par value serves as well
as the more familiar type of share. The holder can re-
ceive dividends at the rate of a certain number of dollars
per share, the percentage form in which announcement
of a dividend is usually made being of no practical conse-
quence. The holders of such shares can vote and partici-

46 CORPORATION FINANCE

pate in the proceeds of liquidation. All the rights of stock-
holders are theirs. If they desire to offer their stock for
sale, their shares will be valued exactly as any other kind',
on the basis of profits and dividends.

These shares of stock or ownership may be sold to pro-
vide funds for the company. In private corporations, such as
manufacturing and trading companies and financial insti-
tutions, this is the usual method. The company is capitalized
for the amount of money which is immediately required, and
those who desire to partake in the enterprise purchase vary-
ing amounts of stoqk. The method is to circulate a sub-
scription agreement, by which the subscribers bind them-
selves to purchase certain numbers of shares. This agree-
ment can be enforced against delinquent subscribers by the
usual processes of debt collection.

The rights of holders of these shares are as follows : First
to vote for the directors of the company and on all propo-
sitions which the charter or laws of the state declare shall be
submitted to a vote of the stockholders — for example, the
sale of the property of the company, the issue of a special class
of stock, the placing of a mortgage on the property of the
company, or the dissolution of the corporation. In large
public corporations, the stockholders are so widely scattered
that it is usually not convenient for them to attend meetings
of the corporation. Provision is, however, made in the law
for them to vote even though absent. The political elector
must go personally to the polls to deposit his ballot. The
stockholder, however, by signing a written power of attorney,
called a proxy, may authorize anyone designated in the power
to cast the number of ballots to which the number of shares
which he owns entitles him. The proxy need not be in any
prescribed form. A telegram has been held to be sufficient
proxy. It may convey to the attorney a general power to
vote the number of shares in the proxy or it may designate
the person or the measure for which the holder of the stock
desired his vote to be cast. A proxy may be revoked at any
time before the election and a new proxy issued to another

MATEEIALS OP THE FINANCIAL PLAN 47

attorney or the stockholder himself may appear in person
and cast his vote as he pleases.

The general rule is that the ownership of one share of
stock entitles the holder to one vote, but this rule can be
modified in any way that the incorporators may desire. They
may provide, for example, that one share equals one vote
up to 100 shares; from 100 to 200 shares, two shares equals
one vote; and from 200 to 500 shares, three shares equals one
vote, the purpose being to reduce the voting weight of large
stockholders. Such provisions are to be found in the cor-
poration laws of some states.

In the absence of special provisions to the contrary, in cor-
poration elections just as in political elections, the majority
rules and this majority, since it is a majority of stock and
not of individual votes, may consist of one man. This stock-
holder may be arrayed against 100,000 other men who, be-
cause their collective stock holdings are one share less than
half of the total number of shares, are powerless to influence
the policies of the corporation by their vote at stockholders'
meetings. It is to prevent such exercise of authority by a
few stockholders over a large number of individuals holding
a minority of shares that provisions as just indicated have
been devised.

A more familiar restriction on the power of ]bhe holders
of the majority stock, however, regulates their right to con-
trol the affairs of the corporation by undertaking to secure
for the holders of the minority of stock a sufficient repre-
sentation on the board of directors to enable them to know
what is going on and thus to act promptly if their interests
are endangered by any act of the majority directors. This
method of protecting the rights of the minority is known
as cumulative voting. It is thus described in section 35a
of the Corporation Act of New Jersey.

"The certificate of incorporation, original or amended,
of any corporation now or hereafter organized under the
laws of this state and thereunder issuing or authorized to
issue shares of its capital stock, may provide that at all

48 COEPOKATIOlSr FINANCE

elections of directors, managers or trustees, each stockholder
shall be entitled to as many votes as shall equal the number
of his shares of stock multiplied by the number of directors,
managers or trustees to be elected, and that he may cast all
of such votes for a single director, manager or trustee or
may distribute them among the number to be voted for, or
any two or more of them as he may see fit, which right, when
exercised, shall be termed cumulative voting."

Suppose, for example, that there are 100 shares of stock
outstanding and five directors to be elected. The holder of
twenty shares of stock may vote as follows when cumulative
voting is provided: He may cast twenty shares of stock for
directors A, B, C, D and E, or, ia case he finds himself in
the minority, and desires to secure the election of at least
one director who will represent his interests and keep him
posted, he may elect to cast 100 votes, which equals the num-
ber of shares he owns times the number of directors to be
elected, for director E or he may cast 50 votes for E and 50
votes for C. When cumulative voting is provided, it is im-
possible for a stockholder owning one-fifth of the stock of a
company having five directors, to be denied representation on
the board. He is certain to provide a clear majority for
his candidate.

Stockholders have the right to be faithfully represented
by directors. Directors must not speculate with the funds
or credit of the company ; they must not, without the consent
of the stockholder, express or implied, be parties' to any con-
tract with the corporation, and they must exercise good
faith to the stockholders in all their dealings. Directors must
answer to stockholders, not only for acts of commission, but
for negligence in caring for the interests committed to their
charge. Directors of American corporations usually serve
without compensation other than a small fee for attending
meetings. There is no legal prohibition agaiust paying them
stated or contingent salaries.

Stockholders have, finally, the right to participate in the
profits of the company, when the directors decide that these

MATEEIALS OF THE FINANCIAL PLAN 49

profits have been earned, and that it is expedient to dis-
tribute them; and to share in the proceeds of the assets of
the company in. ease of dissolution or liquidation. These
rights of the stockholder are set down in detail in the cer-
tificate of incorporation or charter. The incorporators them-
selves draw up this certificate undei* the general incorporation
law of the State. When duly authenticated, recorded and
filed with the proper official, it becomes the charter of the
company, the evidence of its right to be a corporation, the
fundamental contract between the State and the corporation,
between the corporation and its stockholders, and between
the stockholders themselves, a contract which cannot be
changed without the unanimous consent of every stockholder.
In but few cases can a public business corporation be
financed in such a simple manner. When the appeal is made
to the public to supply funds, a more elaborate financial
plan must be devised, dividing the stock into two classes,
preferred stock and common stock, or as the English describe
it, ordinary stock. Preferred stock has preference in the dis-
tribution of profits, and, if provided in the charter, preference
in any distribution of the assets of the company to stock-
holders. If a company issues 50,000 shares, the owner of
5,000 shares is the proprietor of one-tenth of the corporation.
In the absence of some special provision to the contrary, he
can exercise one-tenth of the voting power. If the directors
declare a dividend out of the profits of the company, this
distribution is made to the stockholders on the basis of the
number of shares held by each. For example, if the sum
distributed is $50,000, the holder of 5,000 shares would
receive $5,000. If the company is dissolved and its assets
bring $500,000, the holder of 5,000 shares would receive $50,-
000. This would apply, no matter what the capitalization of
the company might be, or into how many shares it might
be divided. Whether the capitalization is $5,000,000, or $50,-
000, or the par value $100, or $1, the position of the stock-
holder in participation in dividends and in assets is the
same.

50 COEPOEATION FINANCE

This holds true if only one class of stock is issued. If
preferred stock is issued, two classes of owners are created:
First, preference shareholders, who receive a certain rate of
dividends, usually seven per cent on the par value of their
shares, which must be paid them out of the profits distributed
before the holders of any of the common stock can receive
anything; second, common stockholders, who take what is
left after the claims of preferred stockholders have been satis-
fied. The advantages of the preferred stockholder is that
he has a prior claim upon the profits of the company, a claim
inferior, it is true, to that of the creditor, but which takes
precedence of the common stockholder. If the profits of the
company are only sufficient to pay seven per cent on the par
value of the shares, if this amount is called for in his pre-
ferred stock contract with the corporation, and in case the
directors decide to distribute these profits, the preferred
stockholder will receive his seven per cent, while the common
stockholder will receive nothing. It may also be provided
in the contract between the corporation and the preferred
stockholder that he shall participate equally with the common
stockholder in any distribution of profits, until a certain
additional amount of return on the preferred stock has been
paid ; or this participation with the common stock may begin
after a certain dividend has been paid on the stock, after
which both classes of stock share equally in profits; or the
participation of the preferred stock may be unlimited from
the beginning.

Preferred stock may be classified into cumulative and
non-cumulative preferred stock. In the charters of com-
panies issuing preferred stock, the following provision is
usually found: "The dividends upon the preferred stock:
shall be cumulative so that if, in any year, the dividends
amounting to seven per cent per annum, are not paid on the
preferred stock, the deficiency is payable subsequently before
any dividends are set apart or paid on the common stock."^
If the earnings of a corporation in a certain year are only
sufficient xor the distribution of $1,500,000, while the divi-

MATERIALS OF THE FINANCIAL PLAN 51

dend of seven per cent on the preferred stock calls for a
distribution of $2,000,000 in the following year, the pre-
ferred stockholders, in addition to their regular dividends
of $2,000,000, must receive the $500,000 of dividends which
they failed to get in the preceding year before the common
stock can receive any dividend. No matter to what sum
these unpaid dividends on the preferred stock may amount,
all these back dividends must be paid in some form to the
preferred stockholder before the common stockholders re-
ceive anything. Preferred stock may be divided into series,
according to the order of preference, as first, second and
third preferred.

Owing to the provision in the income tax law applying
to corporations which refuses them permission to include
money or property borrowed in their invested capital on
which the amount of their exemption from the tax on ex-
cess profits is computed, preferred stock has come into high
favor and is now generally issued even when, under other
circumstances, the issue of bonds might have been pre-
ferred. It is important, therefore, to consider the various
charter provisions which may be included for the protec-
tion of the preferred stockholder. The following list of
such provisions includes substantially all the protective de-
vices available to the preferred stockholder. They assume
that his position is that of a passive recipient of dividends,
and they aim to make sure that the business of the com-
pany is managed with proper regard for his interests.

1. Preferred and Cumulative:

The holders of the preferred stock shall be entitled to
receive, when and so declared, from the surplus or net
profits of the company, dividends at the rate of six per
centum (6%) per annum, but no more, except as herein-
after otherwise provided, payable quarterly on the first
days of January, April, July and October in each year,
or at such other quarterly dates as the by-laws of the
company may hereafter provide. Said dividends on the
preferred stock shall be cumulative and shall be payable
before any dividends on the common stock shall be paid

52 COBPORATION FINANCE

or set apart so that if in any year dividends amounting
to six per centum (6%) shall not be paid thereon, the
deficiency shall be payable before any dividends shall be
paid upon or set apart for the common stock.

2. Participating Preferred:

The company may declare additional dividends from
its remaining undivided profits or from any surplus from

time to time in excess of dollars, as the board of

directors, in its discretion, may determine; but such ad-
ditional dividends shall be payable to the holders of pre-
ferred and common stock equally without priority or
discrimination; provided that all dividends for previous
years, both upon the preferred and common stock, at
not less than .... per centum per annum, shall have been
paid or declared, and a sum sufficient for the payment
thereof shall have been set aside for that purpose.

Reference to this provision has also been made in a
preceding paragraph. As there stated, the plan of partici-
pation is subject to indefinite variation according to the
requirements of the particular situation. If properly set
forth in the charter any of these provisions are legal.

3. Preferred as to Assets in Dissolution, Liquidation
or Winding Up. Also: Participating with common stock
in such distribution of assets.

In the event of the liquidation or dissolution, or wind-
ing up (whether voluntary or involuntary, or by the ex-
piration of the period of corporate existence) of the
company, the holders of the preferred stock shall be en-
titled to be paid in full all dividends theretofore unpaid,
and the par value of such preferred stock; and after
.such payments shall have been made the common stock,
to the extent of its par value, plus all dividends, if any,
to the extent of .... per centum per annum, which the
.company theretofore may have failed to declare and pay,
;shall be paid in full from such assets as remain ; and any

surplus then remaining to the amount of dollars

■shall be distributed among the holders of said stock ; and
all surplus, if any, remaining thereafter, in excess of said
amount shall be distributed among the holders of the pre-
ferred and common stock, share and share alike.

MATERIALS OF THE FINANCIAL PLAN 53

This provision is intended to guard against the danger
involved in the following situation. A company, largely
in arrears in its preferred dividends, and with its common
stock selling at a low figure, may be favored by a large
increase in the value of its properties. If the preferred
stock is not preferred as to assets, the holders of the com-
mon stock may buy enough of the preferred to give them
the majority necessary to dissolve the corporation and dis-
tribute the assets. The outcome of this transaction might
be that the common stockholders would make a large profit
at the expense of the preferred stockholders. Such a specu-
lation is made impossible by a provision such as the above.

4. Payment of Dividends on Common Stock:

Whenever all cumulative dividends on the preferred
stock for all previous years shall have been declared and
shall have become payable, and the accrued quarterly in-
stallments for the current year shall have been declared',
and the company shall have paid such cumulative divi-
dends for previous years and such accrued quarterly
installments, or shall have set aside from its surplus or
net profits a sum sufficient for the payment thereof, and
shall have made such deductions and reservations from
profits as are hereinafter set forth, the board of di-
rectors, in its discretion, may declare dividends on the
common stock, payable then or thereafter, out of any re-
maining surplus or net profits.

This clause is a restatement of the rights of the pre-
ferred stockholder in terms of the right of the corporation
to pay dividends on the common stock.

5. Sijiking Fund for Retirement of Preferred Stock:

The company will create a cumulative first preferred
stock sinking fund for the redemption or purchase of
preferred stock, and for that purpose will set aside out
of net profits remaining after the payment of full divi-
dends (with all arrearages) upon the first preferred stock

and second preferred stock, $ within days

after in the year and $ within

days after in each thereafter; the sinking fund to

be'appUed to the purchase of first preferred stock at the

54 CORrUKATlON FINANCE

lowest price obtainable, not exceeding 115% of the par
value and accrued dividends, or, if not purchasable at
said price, to the redemption of the first preferred stock

at % of par plus accrued dividends. Moneys

credited to the sinking fund will be required to be with-
drawn from the business and kept available for sinking
fund purposes.

In case in any year dividends in excess of 5% shall
be paid upon the common stock, the next succeeding first
preferred stock sinking fund payment shall be increased -
by a sum equal to the amount of dividends in excess of
.... % so paid upon the common stock.

The sinking fund provisions in preferred stock con-
tracts, of which the above is a good example, are now al-
most universal. This provision does not, it will be ob-
served, compel the corporation to set aside and pay a
certain annual sum to the holders of the preferred stock.
Such payments are contingent upon profits. Assuming,
however, that profits are earned, the obligation to redeem
a portion of the stock is unconditional.

6. Surplus to be Maintained:

The corporation shall not at any time pay dividends
upon the common stock which will reduce the surplus of
unappropriated profits below and no divi-
dends upon the common stock shall be paid until the

surplus of unappropriated profits shall amount to

net current assets maintained at stipulated amount.

7. The Net Current Assets

of the company : cash, materials, supplies, etc., good ac-
counts and notes receivable, less all liabilities maturing
in less than one year— shall at no time fall below an
amount equal to the first preferred stock then outstand-
ing or ... . No dividends shall be paid on any class
of stock until this requirement is complied with.

These two restrictions aim, first, to insure the preferred
stockholder against a dividend policy too liberal to the
common stock, and, second, to guard the preferred stock-
holder against all over-investment of profits in plant and

MATERIALS OF THE FINANCIAL PLAN 55

equipment by which the liquid assets of the company would
be so much reduced as to force the directors to borrow too
large an amount of working capital. Observe that until
this second requirement has been met, no dividends shall
be paid upon any class of stock. The operation of this
clause will result in an accumulation of dividends on the
preferred stock.

8. Special Voting Powers of Preferred Stock :

The holders of the first preferred stock shall elect one-
third of the board of directors and shall have in addition
full voting rights on all matters by the charter reserved
for the determination of the stockholders. The remainder
of the directors shall be elected by the holders of the sec-
ond preferred stock and common stock.

9. Restrictions on Directors:

Without the consent expressed in writing of three-
fourths of the holders of both classes of preferred stock,
the corporation shall not (a) create any lien or mortgage
upon any of the real or personal property of the com-
pany; (b) make any change in the voting powers of any
class of stock; (c) sell all or substantially all of the prop-
erty of the company; (d) sell any part of the real estate
or securities of the company without investing the pro-
ceeds in new property of a similar character, acceptable
to . . . .; (e) make any increase in the authorized
amount of either class of preferred stock, or create any
stock issue priority to the first preferred stock; (f) au-
thorize the increase of either class of preferred stock,
and even with the consent of the holders of three-fourths
of each class of preferred stock authorize any increase in
such issue unless the earnings for the preceding fiscal
year are . . . .; also unless all arrearages of divi-
dends on the class of preferred stock that it is proposed
to increase shall have first been discharged; (g) issue
any bonds or notes maturing more than one year from
the date of issue; (h) change the voting power of either
class of preferred stock.

The purpose of these restrictions is to secure to the pre-
ferred stockholders adequate representation on the board
of directors and to give them a veto on any acts of the
corporation which they may consider injurious to their

56 CORPORATION FINANCE

interests. The three-fonrths percentage is that usually
selected. A larger amount would open the door to ob-
structive, blackmailing tactics by a small minority. A bare
majority might act unfairly to a large minority. What-
ever course of action meets the approval of three-fourths
of the preferred stock will usually be wise and fair.

10. Supplementary : Veto powers :

The aggregate compensation of the administrative
officers of the company shall not exceed . . . . , until the
gross sales of the company reach . . . . , and shall not
be increased thereafter, unless with the consent of three-
fourths of the holders of both classes of preferred stock,
by an amount greater than .... or one per cent of the
increased sales.

The limitation of salaries prevents the controlling
holders of common stock from exploiting the company by
paying themselves excessive compensation, a common prac-
tice especially since the passage of the Excess Profits Tax
Law.

11. Security for Loans:

The corporation agrees with the holders of the pre-
ferred stock not to pledge as security for loans any of its
quick assets or personal property without the consent of
three-fourths of the holders of the preferred stock ex-
cept as it may discount its bills and notes receivable.

This aims to force the company to care and conserva-
tism in the matter of incurring bank loans. It is, however,
of doubtful value since the directors, unable to borrow on
their current assets, may be forced to sell them on un-
favorable terms in order to meet pressing demands for cash.

12. Leases:

The company agrees that without the consent of the
holders of three-fourths of the preferred stock it will not
lease any of its property.

This wise restriction is intended to prevent the con-
veyance of property which has suddenly become valuable,

MATERIALS OF THE FINANCIAL PLAN 57

by the method of lease, and the diversion of a large por-
tion of the profits, by this method, away from the treasury
of the owning company.

13. Use of Credit :

The company agrees that without the consent of
... it will not lend its credit by way of endorse-
ment, guarantee or surety to any other person, firm or
corporation, except by endorsement of notes receivable
for discount.

This is aimed to guard against a practice which has
involved many corporations, once prosperous, in serious
embarrassment. The contingent liability of the guarantor
comes before the preferred stock, whose interests are pro-
tected by the grant of this right of veto.

14. Classes of Directors:

The directors of the company shall be divided into
three classes. The directors of the first class numbering
one-third of the total number of directors shall be elected
for a term of five years by the holders of the first pre-
ferred stock. The directors of the second class, also one-
third of the total number, shall be elected for a term of
two years by the holders of the second preferred stock.
The remaining directors of the company, composing the
third class, shall be elected for a term of one year by the
holders of the common stock.

15. Breach of Covenants:

In case of a breach of any of the foregoing cove-
nants by the corporation, it is agreed with the holders of
the preferred stock that at the next election all the votes
for directors whose terms then expire shall be cast by the
holders of the first preferred stock ; and that at the second
election next succeeding such breach of covenant and re-
striction, all the votes for directors whose terms shall then
expire shall be cast by the holders of the first preferred
stock so that after the second annual election all the
directors of the company shall have been chosen by the
holders of the first preferred stock. And it is further
agreed that the terms of such directors shall be equal to
the terms of the directors by the preceding section re-
quired to be elected by the holders of the first preferred

58 , CORPORATION FINANCE

stock, so that in case any of the foregoing restrictions
or covenants shall be violated within one year there-
after, the entire board of directors shall be chosen by the
holders of the first preferred stock.

And it is further agreed that the exclusive voting
power, not only for directors, but on all other matters by
law reserved to the stockholders, so long as the above
mentioned breach of covenant may continue and for one
year thereafter, shall reside and be vested in the said
holders of first preferred stock, and it is further agreed
that the report of the auditors of the company as to
the observance of all of the above described covenants
and conditions shall be conclusive as to the fact of
their breach or observance.

16. Injunctions:

In case any holder of the first preferred stock of
this company shall petition any court of competent juris-
diction for relief or an injunction restraining the oflScers
and directors from doing or continuing to do any act
which would result in a breach of any of the foregoing
covenants and agreements, the company agrees that it
will not interpose any defense to such proceeding.

When the method of issuing shares without par value
is used instead of setting forth that the capital stock is
$100,000,000, divided into 100,000 shares of $100 each, the
representation is made that the capital stock is divided
into 100 shares. The value of property represented by
stock without par value may be settled by resolution of the
board of directors or the value of the stock may correspond
to the subscription price. In some states, for example,
New York, a known amount of stock must be paid' for
each share. For all practical purposes a share of stock
without par value serves as well as the more general type
of share. The holder can receive dividends, the rate stated
in the number of dollars per share, the percentage form
made in the newspapers being of no practical consequence.
As a matter of fact, the official resolutions of corporations
declaring dividends frequently recite that a dividend of a
certain number of dollars a share is to be paid. The
holders of stock without par value can vote and participate

MATERIALS OF THE FINANCIAL PLAN 59

in the proceeds of liquidation. All rights of stockholders
are theirs. If they desire to offer their stock for sale their
shares will be valued on the basis of the earning power
of the company which depends, not merely upon the
amount of property or money contributed, which stock
with par value is supposed to represent, but primarily
upon the ability with which this property is administered
by the officers and directors of the company and also by
general business conditions of the country and those affect-
ing the particular industry in which the company operates.
Ten states now authorize the issue of common stock
without par value and two, Pennsylvania and New Hamp-
shire, authorize the issue of preferred stock without the
dollar mark. The argument for the development of this
kind of stock is contained in the report of the Committee
on Corporation Laws of the New York State Bar Associa-
tion, presented in January, 1909, composed of Mr. Francis
Lynde Stetson, Mr. Edward M. Shepard, and Mr. Victor
Morawetz. The reasons influencing the recommendation
were stated in the report of the committee as follows:

Perhaps the very strongest impression today of un-
fair corporate organization has arisen from so-called
'over-capitalization.' About this it has been felt that
there has been, or, at least, seemed to be, an element of
misrepresentation or even deceit. Sales on the stock ex-
change or other market of common shares immediately
after the companies have been launched made at a small
percentage of nominal par ^( and theoretically real) value,
have afforded or, at least, have seemed to afford, some
reason for this wide-spread belief, even though the de-
ception or misleading of investors by stock-watering may
have been greatly exaggerated. This popular verdict,
whatever its justification, is injurious to corporations
and investors and to legitimate business interests.

The abolition of the money denomination of shares
would, we believe, deprive those who promote corpora-
tions of the advantages, real or seeming, of that ex-
aggerated capitalization, which undoubtedly is possible,
tinder the existing laws of every or nearly every Ameri-
can State; and at the same time, it would compel in-
vestors to fix their attention upon actual value, free of

60 CORPORATION FINANCE

' the influence of what, as overwhelming experience shows,

tends to become nominal or symbolic valuation. We
would have the truth recognized, without the misleading
effect of such valuations, that a common share of stock
of a corporation represents neither more nor less than a
certain aliquot part, a one-thousandth or one-millionth
or other fraction, according to the number of common
shares of the net value of the enterprise over and above
all debts and stock preferences. If promoters or di-
rectors wish to assert a money valuation for their shares,
this amendment would not prevent them from doing so in
such manner as would secure the confidence of their
creditors; but, they ought to be compelled to do that di-
rectly, and thereafter be rigorously held to make their
representations good.

The report of the Railroad Securities Commission trans-
mitted to Congress in 1911 presents the argument in favor
of stock without par value in great length, as follows:

We do not believe that the retention of the hundred
dollar mark, or any other dollar mark, upon the face of
the share of stock is of essential importance. We are
ready to recommend that the law should encourage the
creation of companies whose shares have no par value and
permit existing companies to change their stock into
shares without par value whenever their convenience re-
quires it. After such conversion any new shares could be
sold at such price as was deemed desirable by the board
of directors, with the requirement of publicity as to the
proceeds of the sale of such shares and as to the
disposition thereof ; giving to the old shareholders, except
in some cases of reorganization or consolidation, prior
rights to subscribe pro rata, if they so desired, in pro-
portion to the amount of their holdings.

As between the two alternatives of permitting the is-
sue of stock below par or authorizing the creation of
shares without par value, the latter seems to this com-
mission the preferable one. It is true that it will be less
easy to introduce than the other because it is less in ac-
cord with existing ^business habits and usages; but it has
the cardinal merit 'of accuracy. It makes no claims that
the share thus issued is anything more than a participa-
tion certificate.

The objections to the creation of shares without par
value are two in number: first, that their issue will per-

MATERIALS OF THE FINANCIAL PLAN 61

mit inflation, by making it easy to create an excessive
number of shares; and, second, that it will produce a
division of roads into two classes, those whose shares
have a par value and those whose shares have not. The
second of these objections does not appear to be a very
serious one. There are listed on the stock exchanges
today, side by side with one another, shares of the par
value of one hundred dollars, shares of the par value of
fifty dollars, shares with very much smaller par value,
and a few, like the Great Northern Ore certificates, with
no par value at all. The share sells in each case simply
for what the public supposes it to be worth as a share.
The danger of inflation deserves more serious considera-
tion. We believe, however, that it is more apparent than
real, because shareholders will be jealous of permitting
other shareholders to acquire shares in the association
except at full market value, and will not permit the is-
sue of such shares to themselves at prices so low as seri-
ously to impair the market or other value of their hold-
ings. Shares either with or without par value, and
whether sold at par or above par or below it, should, ex-
cept in cases of consolidation and reorganization, be
offered in the first instance to existing shareholders pro
rata.

The issue of stock without par value offers special
facilities for consolidation and reorganization.

Where two roads have consolidated, whose shares
have different market values, it has been the custom to
equalize the difference by the issue of extra shares of the
consoKdated company to the owners of the higher priced
stock. This practice has always tended to produce in-
crease of capital issues, and may readily cause the new
stock to be issued for a consideration less than its par
valuef The only alternative was to scale down some of
the old stocks ; and this often involved serious difficulties,
both of business policy and of law. By the simple ex-
pedient of omitting the dollar mark from the new shares,
the number can be adjusted to the demands of financial
convenience, without danger of misrepresentation or sus-
picion of unfairness to anyone.

In the case of reorganization, the advantage of shares
without par value is even more obvious. It is here that
the necessity and justice of getting money from stock-
holders is greatest. It is here that the impossibility of
getting them to pay par for new shares is most con-
spicuous. We believe that in such cases the public inter-
est would be subserved and the speedy rehabilitation of

62 CORPORATION FINANCE

the roads promoted by requiring the conversion of the
common stock and encouraging the conversion of the pre-
ferred stock into shares without par value; the certifi-
cates simply indicating the proportionate or preferential
claims of the holders upon assets and upon such profits
as might from time to time be earned.

All of these considerations seem to apply with equal
force to the securities of railroads under state incorpora-
tions, and we believe the laws of the several states could
with advantage be modified so as to provide for the is-
suance of stock without par value.

CHAPTER V

MATEBIALS OF THE [FINANCIAL PLAN— BONDS

Corporation bonds are promissory notes, usually in
denominations of $500 or $1,000, and as evidences of the
same debt, $1,000,000, $50,000,000, or $300,000,000, as the
case may be. The evidences of these large debts are issued
in a number of notes, in order that they may be readily
marketed. A corporation wishing to borrow $1,000,000
for thirty years on the best security, would have great
difficulty in placing the entire loan with a single investor.
No matter how good the security might be, few investors
have sufficient funds to make a loan of this amount. By
issuing, instead of one note for $1,000,000, one thousand
notes of $1,000 each, the corporation is able to draw upon
the funds of a large number of investors who may buy its
thirty-year notes, in lots of one, five or fifty.

The division of the debt into a large number of "pieces"
necessitates the intervention of a "trustee" who will repre-
sent the owners of the bonds in all negotiations with the
debtor company, wherever the borrower gives "security"
for his debt. The "trustee" takes the place for the bond-
holders that the company organization holds for the stock-
holders. "Without this representation, it would be necessary
for the bondholders to maintain a regular organization to
elect directors, who would elect officers to represent the
body of creditors. All these arrangements are made un-
necessary by the election of a trust company to act for the
bondholders as their permanent representative.

These notes are usually secured as an entirety, by a
mortgage, the relation of each to the security being the

63

64 CORPORATION FINANCE

same as every other. A mortgage is a written instrument
for the conveyance of real or personal property by a debtor
to the creditor or his representative to insure the per-
formance by the debtor of his promise to pay interest and
principal. But the possession of the property may remain
with the debtor, and this is the rule when real property
is pledged. When personal property, however, such as
shares of stock is pledged as security for a loan, the actual
property is usually turned over to the lender's representa-
tive or trustee, usually a trust company.
The form of a bond is as follows :

(Form of Coupon Bond.)

UNITED STATES OF AMERICA.

State of New York.
No. 100. $500.00.

THE LONG ISLAND RAILROAD COMPANY.

EoTir Per Cent Refunding Mortgage Gold Bond,
Due March 1, 1949.

THE LONG ISLAND RAELROAD COMPANY,
a corporation organized and existing under and pur-
suant to the laws of the State of New York, for
value received, hereby promises to pay to the bearer,
or, if this bond be registered, then to the registered
owner hereof, at its financial agency in the Borough
of Manhattan, in the City and State of New York,
500 dollars in gold coin of the United States of Amer-
ica, of or equal to the present standard of weight and
fineness, on the first day of March in the year nine-
teen hundred and forty-nine, and to pay interest
thereon at the rate of four per cent per annum, from
the first day of September, nineteen hundred and
three, in like gold coin, semi-annually, on the first
days of March and September in each year, upon
presentation and surrender at its agency aforesaid
of the coupons hereto annexed as they severally be-
come due and until said principal sum is paid.
Both the principal and interest of this bond are pay-
able without deduction for any tax or taxes which
the Railroad Company may be required to pay or re-

MATEEIALS OF THE FINANCIAL PLAN 65

tain therefrom under any present or future law of
the United States or of the State of New York.

This bond is one of a series of bonds of like date
and tenor, of the denomination of five hundred dol-
lars or multiples thereof, known as Four Per Cent
Eefunding Mortgage Gold Bonds, issued and to be
issued to an amount not exceeding in the aggregate
the principal sum of forty-five million dollars at any
one time outstanding, all of which bonds are issued
and to be issued under and equally secured by a
mortgage and deed of trust dated September 1, 1903,
executed by THE LONG ISLAND EAILROAD
COMPANY to THE EQUITABLE TEUST COM-
PANY OF NEW YOEK as Trustee, to which mort-
gage and deed of trust reference is made for a de-
scription of the properties and franchises mortgaged,
the nature and extent of the security, the rights of
the holders of bonds under the same, and the terms
and conditions upon which the bonds are issued and
secured.

IN WITNESS WHEEEOF, The Long Island
Eailroad Company has caused its corporate seal to be
hereunto affixed and attested by its Secretary or As-
sistant Secretary, and this bond to be signed in its
corporate name by its President or Vice-President,
and has also caused the signature of its Treasurer to
be engravei upon the annexed coupons, as of the
first day of September, in the year one thousand nine
hundred and three.

THE LONG ISLAND EAILEOAD COMPANY,

By President.

Attest :

Secretary.

(Form of Coupon.)

No. 100. $10.00.

THE LONG ISLAND EAILEOAD COMPANY
will pay to the bearer at its financial agency in the
City of New York, on the first day of March, ten dol-
lars ($10.00) in gold coin, being six months' interest
then due on its Four Per Cent Eefunding Mortgage
Gold Bond Number 100.

Treasurer.

66 COEPOEATION PINANCE

This bond or promissory note refers to a certain mort-
gage executed to the Equitable Trust Company of New York
by the borrowing company, for the equal securing of all the
bonds, ninety thousand in number, into which this loan is
divided. This mortgage describes in detail the property of
the company set aside for the securing of its bonds, and trans-
fers it to the trustee, in the following granting clause :^

That in order to secure the payment of the princi-
pal and interest of all said bonds at any time issued
and outstanding under this indenture, according to
their tenor, purport and effect, and to secure the per-
formance and observance of all the covenants and
conditions herein contained, and to declare the terms
and conditions upon which said bonds are issued, re-
ceived and held, and for and in consideration of the
premises and of the acceptance or purchase cf said
bonds by the holders thereof, and of the sum of one
hundred dollars, lawful money of the United States of
America, to it fully paid by the Trustee on or before
the ensealing and delivery of these presents, the re-
ceipt whereof is hereby acknowledged. The Long
Island Eailroad Company, the party of the first part,
has granted, bargained, sold, aliened, released, con-
veyed, assigned, transferred and set over, and by these
presents does grant, hargain, sell, alien, release, con-
vey, assign, transfer and set over unto the said Trus-
tee and its successors in the trust hereby created, all
and singular the railroad and ferry property, and other
property, real and personal, used in connection with
such railroad and ferry property, and franchises of
every kind relating thereto or exercisable in connec-
tion therewith, of the Eailroad Company, including
the following, to wit : ^

(A detailed description of the property follows.)
This grant, however, is not absolute, but conditional. If
the borrowing company performs its obligations to pay prin-
cipal and interest, and, as we shall show hereafter, to con-

' Detailed provisions for registration omitted.
2 Italics are the author's.

MATEEIALS OP THE FINANCIAL PLAN 67

serve the security of the bonds, then the grant lapses. It is
made for a specific purpose, namely the securing of the bonds,
and when the bonds have been paid, the purpose has been
accomplished, and the title to the pledged property reverts
to its owner who is, moreover, so long as he lives up to his
obligations, allowed to remain in undisturbed possession. The
clauses of the mortgage governing these matters are as
follows: First, the "Habendum" clause:

TO HAVE AND TO HOLD all and singular
the above mentioned and described railroads, rail-
road property, ferries, ferry property, franchises, real
estate and personal property unto the said The Equi-
table Trust Company of New York, as Trustee, its
successors and assigns forever.

BUT IN TEUST, NEVERTHELESS, for the
equal and proportionate benefit and security of all
holders of the bonds and coupons issued and to be
issued under and secured by this indenture, and for
the enforcement of the payment of said bonds and in-
terest, when payable, according to the tenor, purpose
and effect of such bonds and coupons, and to secure
the performance and observance of and compliance
with the covenants and conditions of this indenture,
without preference, priority or distinction, as to Hen
or otherwise, of one bond over any other bond by or
by reason of the purpose of its issue, so that each and
every bond issued or to be issued hereunder shall have
the same right, lien and privilege under and by vir-
tue of this indenture, and so that the principal and
interest of every such bond shall, subject to the terms
hereof, be equally and proportionately secured hereby
as if all had been duly issued, sold and negotiated
simultaneously with the execution and delivery here-
of.i

• The right of the railway company to remain in possession of the
property is not expressly stated in this mortgage but is implied from
numerous clauses. This conveyance of its property by a company to
the trustee is not in perpetuity. When the obligations of the bonds
are discharged the property reverts to the company.

68 COEPOEATION FINANCE

AETICLE SEVENTEENTH.— If, when the
bonds hereby secured shall have become due and pay-
able, the Eailroad Company shall well and truly pay
or cause to be paid the whole amount of the principal
and interest due upon all of the bo^ids hereby secured
then outstanding, or shall provide for such payment
by depositing with the Trustee hereunder, for the
payment of such bonds and interest thereon, the en-
tire amount due or to become due for principal and
interest, and shall also pay or cause to be paid all
other sums payable hereunder by the Eailroad Com-
pany and shall well and truly keep, perform and ob-
serve all the things herein required to be kept, per-
formed and observed by it according to the true in-
tent and meaning of this indenture, then and in that
case the premises and all properties, rights and in-
terests hereby conveyed shall revert to the Eailroad
Company and at its cost and expense, enter satisfac-
tion and discharge of this indenture upon the rec-
ords; otherwise, the same shall be, continue and re-
main in full force and virtue.

In addition to promising to pay the principal and inter-
est, the railway company enters into a number of agreements
which are designed to maintain the security of the bonds in-
tact. Some of these covenants are as follows : to pay taxes, to
keep the property in repair, and to perform all the obliga-
tions of the franchises and leases under which the lines of
the system are operated. Failure to perform any of these
covenants would evidently impair the value of the security
underlying the bonds.

In case the railway company defaults in the payment of
principal or interest, or fails to perform any of the covenants
into which it has entered for the protection of the bond-
holder, the mortgage provides that the Trustee may either
enter upon the property and operate it for the benefit of
creditors, or sell the property and apply the proceeds of the
sale to the payment of the company's debts, returning any
balance which may remain to the company, or apply for a
receiver to administer, and if deemed wise, sell the property

MATEEIALS OP THE FINANCIAL PLAN 69

for the benefit of creditors. The company agrees not to
interpose any obstacle or objection to the enforcement of the
bondholders' rights by the Trustee.

The purpose and effect of this mortgage is to set apart
certain property of the company for the protection of its
creditors should it default on any of its obligations, and to
provide a method by which the representatives of the
creditors may take possession of this property when default
occurs, and apply its income or the proceeds of its sale to
the payment of the company's debts. The company, in effect,
says to its creditors : "We appoint you or your representative,
our trustee, to pay our debts in the event that we are unable
to pay them. In order that you may discharge your trust,
we place in your hands certain property with the stipulation
that as long as we perform our obligations we may be allowed
to use the property as our own. Should we fail, however,
in the performance of any of these obligations, then you,
our trustee, are to sell the property and so discharge the
obligation of your trust."

These mortgages may be of various grades, first, second,
and third mortgages, all resting upon the same property,
differing from each other in the relative superiority of their
liens. Thus the bonds secured by the lien of a second mort-
gage, if the company defaults on their interest, cannot en-
force their claim by seizing and selling its property, until
they have first satisfied the claim of the holders of the first
mortgage bonds, or, if they sell the property, they must sell
it subject to this first mortgage lien. Except during a receiv-
ership, as will be explained hereafter, as long as the bonds
which the first mortgage secures are in existence, the prop-
erty of the company can in no way be separated from the
lien of the first mortgage. In the same way, the lien of the
third mortgage is inferior to that of a second mortgage.

The nature of a mortgage as a conveyance of property
appears more clearly in a collateral trust mortgage, where
the security of the bonds consists of the stocks or bonds of
other corporations. Under these mortgages, not merely the

70 COEPOEATION" FINANCE

title, but the physical possession of the property passes to
the Trustee. For example, the Trust Indenture securing the
bonds issued jointly in 1901 by the Great Northern and the
Northern 'Pacific Railroad Companies, secured by the stock
of the Chicago, Burlington & Quincy, provides:

That, in order to secure the payment of the prin-
cipal and interest of all such bonds at any time is-
sued and outstanding under this indenture, and the
performance of all the covenants and conditions here-
in contained, and in consideration of the premises
and of the purchase and acceptance of such bonds by
the holders hereof, and of the sum of one dollar
to each of them duly paid by the Trustee at the en-
sealing and delivery of these presents, the receipt
■whereof is hereby acknowledged, the Railway Com-
panies, parties of the first part, have assigned and
transferred, and by these presents do assign and trans-
fer unto the Trustee, party of the second part, its
successors and assigns, one million and sixty-six thou-
sand and six hundred (1,066,600) shares of the capi-
tal stock of the Chicago, Burlington & Quincy Rail-
road Company, the certificates for which have been
delivered to the Trustee, and all additional shares of
the capital stock of said Company in exchange for
which bonds hereby secured shall be certified and de-
livered hereunder.

TO HAVE AND TO HOLD the said shares of
capital stock, and all additional property that herer
after shall become subject to this indenture unto the
Trustee and its successors and assigns, in trust for
the equal and proportionate security of all present and
future holders of bonds and interest obligations is-
sued, and to be issued, under and secured by this in-
denture, and for the enforcement of the payment of
said bonds and interest obligations when payable, and
the performance of and compliance with the covenants
and conditions of this indenture, without preference,
priority or distinction as to lien or otherwise of any
one bond over any other bond by reason of priority in
the issue or negotiation thereof.

MATEEIALS OF THE FINANCIAL PLAN 71i

If any default should occur on the part of the borrowing
companies, the Trustee is authorized to sell the shares of
stock securing the bonds, and to proceed against the Great
Northern and the Northern Pacific for the recovery of any
balance which may remain after the Trustee applies the pro-
ceeds of the sale to the payment of the bonds. As long, how-
ever, as the borrowing companies carry out the condition^
and covenants of the mortgage, the Trustee empowers the
company issuing the stock which he holds in pledge, the
Chicago, Burlington & Quincy, to pay to the owners of the
stock, the Great Northern and the Northern Pacific, the
dividends on the stock, and issues to them his power of
attorney, or proxy, which will authorize them to vote the
stock as though the certificates representing it were in their
possession, and they appeared as the registered owners of
the stock on the books of the Chicago, Burlington & Quincy.
In case of any default, however, the Trustee immediately re-
sumes these delegated rights of ownership, and the two
borrowers lose their right to vote the Burlington stock and
to receive dividends.

NOTE : In later chapters, when dealing with the methods of pi'O-
viding new capital, further material relating to the mortgage bond
and the collateral trust bond will be presented.

CHAPTER VI

TEEMS AND CONDITIONS OF BOND ISSUES

We have now described the ordinary securities which
our new company may issue to obtain the money required
to construct its plant. Our next topic is the methods by
which these securities are prepared and included in a plan
of capitalization, for sale to bankers or to the public.

In taking up the considerations which the banker and
promoter must have in mind in preparing a financial plan,
we note first that their chief concern is to obtain the neces-
sary money on the easiest terms. Up to the point of pro-
viding the money, their interests are united. It is only
when the division of the profits is reached that they part
company. We have now to consider the choice of securi-
ties of which the capitalization of the new company is to
consist. These are, as we have seen, stock of various kinds,
and bonds with various kinds of security.

As a rule, whenever the enterprise admits, the financial
plan" will call for the issue of bonds, and if that fails,
for the issue of preferred stock. The reason for preferring
this method of borrowing lies in the nature of a bond. The
purchaser of a corporation bond, in return for what he
considers to be sufficient security of income and principal,
surrenders his right to participate in the profits of the
company above the rate of interest named in his bond, six,
seven or eight per cent. With the preferred stockholder,
the situation is the same. In return for a preferred claim
to a fixed rate of dividend, the preferred stockholder, un-
less his stock is participating, surrenders the remainder of
the dividends to the common stock. If, therefore, in the
financial plan, all, or a large part of the money necessary,
72

THE ISSUING OF SECURITIES 73

can be secured by selling bonds or preferred stock, and if
the expectations of the promoters that large profits will be
earned are realized, it is more profitable to employ this
method.

Suppose, for example, that $1,000,000 is required to
carry through the consolidation, or build the plant, or con-
struct the railroad, and that the earnings of the enterprise
wiU be at the rate of twelve per cent or $120,000 annually.
Suppose, further, that this money can be raised either by
the sale of bonds, or by the sale of stock, or that both
methods can be used in combination. If $1,000,000 can be
provided by the sale of bonds bearing six per cent interest,"
the promoters and bankers will have common stock which
can share surplus earnings of $60,000 a year, and for this
stock they may have paid nothing, except the cost of secur-
ing the options and selling the securities. Although they
may have to surrender part of this common stock in con-
nection with the sale of bonds, they can usually retain a
sufficient amount to. control the company. If they are
obliged to sell common stock to obtain this $1,000,000, they
must admit each share of stock to participation in their
earnings at a higher rate than that which bonds usually
carry, and it will be difficult for them to obtain any sub-
stantial interest unless they pay for it. Furthermore,
when the security is good, bonds or preferred stock can be
more readily sold, and at proportionately higher prices,
than any other issue. From the standpoint of the banker
and promoter, bonds or preferred stock are preferred
whenever the nature of the business admits of their issue.

We now take up the classification of industries into
those which furnish satisfactory security for the issue of
bonds and those which do not. In the discussion of the
mortgage as security, we have seen what great attention is
paid to the enumeration of the items of property of a cor-
poration, how carefully this property is segregated to pro-
tect the holders of the bonds. When this property is non-
specialized, that is when it can be put to a variety of uses,

74 CORPORATION FINANCE

so that it can readily find a purchaser, for example, real
estate, or stocks of finished goods, or materials, then the
property itself furnishes the security for the loan. "When,
however, the property of the company is specialized to
the use of a particular business, such as a railroad or manu-
facturing plant, where the business must be carried on
in a certain place and by people who are skilled in its man-
agement, and where the property, once devoted to a particular
use, can be turned to no other use, the real security of the
creditor is not the property but the earnings of the property.
With a mortgage on centrally located real estate, the selling
value of the real estate can be easily realized, and a loan
can be made without reference to the profitableness of the
business which is to be carried on in the property. One million
dollars, however, may be iavested in the property of a manu-
facturing company which could not be sold for any other
use than the one to which it is specifically devoted, for more
than $100,000. The security of the creditors is here the
profitableness of the business which - is carried on in the
factory.

Furthermore, a 'business is not an aggregate of physical
property but consists of physical property — buildings, boilers,
machine tools — plus an industrial opportunity, plus the or-
ganization and ability to operate the business. The corpora-
tion owning this business borrows the money, and the value
of the business is based upon its earnings. The physical
property, which is set aside with such a profusion of formal-
ity in the mortgage, is merely the visible symbol of its earn-
ing capacity. Without the plant, it is true, earnings would
be impossible, but the plant has little value unless the spirit
of profitable life is breathed into it by an intelligently
managed organization. In estimating the stability of differ-
ent classes of enterprises to furnish security for bond issues,
we must take account first of this factor of earnings.

Since the bondholder is solely interested in the security
of his principal, and regular payment of his interest, and
since both security and interest depend upon the permanence

THE ISSUING OF SECUKITIES 75

of inccme, other things being equal the companies with the
most stable earnings or a market for their products at all
times reasonably satisfactory furnish the best security for
bonds. Stability of earnings depends upon (1) the possession
of a monopoly; (2) good management; and (3) the charac-
ter of the business.

Monopoly is exclusive or dominant control over a market.
The more complete this control, the more valuable is the
monopoly. The advantage of monopoly lies in the fact
that the prices of services or commodities are controlled by
the producer rather than by the consumer. In the long run,
the returns in profits from monopoly are greater than when
the consumer is able to play ofE one seller against another,
and so secure concessions in prices. Monopolies are of va-
rious origins. The most familiar are (1) franchises, the right
to use public property for private purposes, for example, the
furnishing of light, water and transportation, (8) control of
sources of raw material supply such, for example, as that which
the United "States Steel Corporation exercises over the Lake
Superior ore deposits, (3) patents, which give the exclusive
right to manufacture an article for seventeen years; and
(4) high cost of duplicating plant, which secures the rail-
roads in thickly settled territory, where land values are high,
and where terminal sites are especially costly, against com-
petition from the duplication of their facilities. Of these
forms of monopoly, those conferred by franchises and by high
costs of duplication are most valuable from the standpoint
of bond security. Next comes possession of supplies of raw
material, and last patent monopoly.

Stability of earnings also depends upon good manage-
ment. This means not merely economical operation but culti-
vation of new business. Stability of earnings depends finally
upon the breadth of the demand. In manufacturing Indus-'
tries, for example, those enterprises which produce raw ma-
terials and the necessities of life have a more stable demand
than those which produce highly finished articles and luxuries.

We may classify enterprises according to the quality of

76 COEPOEATION FINANCE

the security which they offer for an issue of bonds. Mining
enterprises — coal, iron, copper, lead — furnish a basis for
bond issues only when the extent of the resource is known.
When a bed of coal or a deposit of ore has been sur-
veyed and its contents estimated, it furnishes a basis for
a bond issue up to a moderate percentage of its market
value. Industrial enterprises are mortgaged, as a rule,
only when possessed of mineral properties or real estate.
The limit of bond issues in these cases is narrow, and it has
a close relation to the"selling value of the property. Public
Service Corporations, operating under franchises liberal in
terms, furnish excellent security for bond issues. The mo-
nopoly of street railway or gas companies, which may have
the exclusive right to serve the consumer for a term of years
at prices which leave a large margin over the cost of produc-
tion, is so perfect that the bondholder runs little risk of
lending to a high percentage of the cost of the property.
Eailroads furnish perhaps the best basis of bond issue be-
cause of the stability of the demand for the transportation
service which is rendered to every industry, and because of
the high cost of duplicating the railroad plant, which secures
existing lines in the possession of valuable territories, and,
within the limits imposed by law, enables them to fix their
rates on freight and passenger traffic. Most of the bonds
which are outstanding in the United States are based on
railroad property.

We now take up the amount of bonds which can be issued.
The amount of bonds should not be so great as to impose
upon the corporation a burden of interest charges which is
above, or even equal to, a conservative estimate of the earning
power of the company under the worst conditions which it
is likely to meet. If a corporation does not pay its interest,
and is put into bankruptcy, its affairs are thrown into con-
fusion. Even though it is relieved from bankruptcy without
reorganization by an improvement in its business, serious
damage will always be found to have resulted. In issuing
bonds, therefore, conservative financiers keep in mind the

THE ISSUING or SECUEITIES 77

danger of bankruptcy to result from business depression or
other unforeseen contingencies, and regulate the amount of •
debt to guard against any such untoward event.

The considerations which relate to the stability of differ-
ent enterprises as security for bonds can also be employed
to determine the percentage of income which can safely be
represented by interest on bonds. A railroad company can
safely assume interest payments which bear a much higher
proportion to its income than a manufacturing company
whose earnings fluctuate within much wider limits. In most
cases, no more than twenty per cent of the gross earnings
of a railroad company should be represented by interest
charges. This standard is established in one of the most
stable of industries. It furnishes a limit above which, speak-
ing generally, no company should go in pledging its earn-
ings for the payment of interest charges.

In fixing the amount of bonds to be issued, provision
should be made for future issues of capital. Under normal
conditions, every corporation, if well managed, will expand
its operations and will largely increase its initial capital in
handling the increased volume of business which the growth
of the country and the energy of its management will bring
to it. If the capital of the company was originally obtained
by an issue of bonds, it will again resort to its credit to pro-
vide funds for the enlargement of its plant. The corporate
mortgage, however, is an obstacle to the subsequent sale of
new bonds. When a mortgage authorizes $5,000,000, this
amount cannot be increased without the consent of the
bondholder, which is seldom obtained. The corporation is
not likely to be in a position to offer inducements suffi-
cient to persuade the bondholder to relax the obligation of
his mortgage, and permit an increase in the amount of
debt which it secures. Failing this provision, the natural
method for the company to adopt in raising money for ex-
tensions will be to mortgage these extensions, either directly,
or by organizing separate companies to issue their mortgage
bonds. When the company is very strong in earnings, and

78 OOKPOEATION TINANCE

its first mortgage debt is small, it may also raise monej by
a second or general mortgage.

These methods, however, while available and desirable
in some cases, are not so effective as a first mortgage on the
entire property of the company in satisfying the demands
of the investor that the bonds which he purchases should be
properly secured. Take, for example, the case of a railroad
building a line from Kansas City to Galveston. Upon this
line is placed a first mortgage, securing an issue of bonds
sufficient to pay the cost of construction. The railroad pros-
pers, and, within a few years, the necessity arises for a large
amount of branch line mileage. If the first mortgage does
not contain the provision, which is usual in the older mort-
gages, that the lien of the indenture should include all prop-
erty owned or thereafter acquired, it would be possible for
the company to issue bonds secured by a first mortgage upon
the branches and a second mortgage upon the maia line.
These bonds would be inferior to the bonds secured by .the
first mortgage upon the main line, because the branches are
not indispensable to the main line, while the main line is
indispensable to the branches. The holders of bonds secured
by a first mortgage upon branch lines, in case of default and
foreclosure proceedings, come into possession of property
which depends upon other property for its value. On the
other hand, foreclosure of a mortgage upon the main line
would briag into the possession of the bondholders property
which could stand upon its own feet, which would not depend
wholly or mainly upon the branches for its traflBc, and to
whose earning power the possession of branches would not
be essential.

The best security for bonds issued by such a corporation
is the lien of a first mortgage upon the entire property of
a company, a lien protecting not merely the bonds first
issued, but all later issues, so that every bond may be secured
by the lien upon the entire system. In case of default,
holders of bonds secured by such a mortgage come into the
possession of the property as a whole. Their owners need

THE ISSUING OF SECUEITIES 79

not make concessions to the holders of securities protected
by first mortgages on certain parts of the system. Eecent
financial plans, • recognizing the value of the best security
in securing a ready market and a high price for bonds,
authorize amounts of first mortgage bonds which shall be
sufficient to provide, not merely for the original construction
of the property, but for all additions and improvements. An
example of such an issue is furnished by the Chicago Bell
Telephone Company which, in 1908, authorized an issue of
$50,000,000 of first mortgage bonds of which '$3,000,000 were
to be issued immediately, and the remainder over a period
of years as required.

At this point, however, we meet an objection. One of
the chief advantages, from the standpoint of security, of a
mortgage bond over any kind of stock, is the limitation of
its issue. The buyer of a mortgage bond knows exactly what
his security is in relation to the obligations outstanding
against it. If $5,000,000 of first molrtgage bonds are sold
the investor knows that this amount can never be increased
without his consent. If, however, he bought preferred or.
common stock, in the absence of special restrictions, there
would be no limit to the increase in the number of shares.
It is necessary, therefore, in providing for a large bond
reserve in a financial plan, to satisfy the investor that the
large amount of bonds held in reserve to be issued from time
to time as the company's business expands, does not weaken
the security of the bonds which he is asked to purchase.

The bondholder should have no objection to the unlimited
issue of bonds secured by the same mortgage which protects
his own holdings, provided that the additional proceeds of
the additional issues could be invested to produce an income
as great or greater than that earned by the initial investment.
Indeed, from one point of view, the sale of addition^ bonds
and their investment to yield to the business more than their
interest, strengthens the position of all the bonds, especially
if any large part of these excess profits are left in the busi-
ness. The earnings over interest charges are the protection

80 COEPORATION PINANCE

of the bondholder's interest. The surplus of assets over bond
liabilities may be considered as an insurance reserve against
such an impairment of the assets of the business as might
threaten the security of the bonds. If a company is well
managed, and if its improvements and extensions are conser-
vatively made, the bondholder should have no objection to
an increase of the amount of the debt secured by the same
mortgage which protects his own bonds. It is, however, dif-
ficult to give him such assurances, and to satisfy him that,
without specific safeguards in the mortgage, his earnings will
not be jeopardized by additional issues. A bond reserve is,
therefore, usually included in the financial plan with such
stipulations that the investor knows in advance the condi-
tions imder which the various installments of bonds author-
ized can be sold.

A company, arranging for a large bond reserve, must
provide safeguards in the mortgage, which will assure the
investor that the proceeds of the issues of bonds which ma^
follow those which he buys will be so invested as to strengthen
his security. The first of these safeguards is a limitation
on the amount of bonds to be issued in any one year. A
company with $50,000,000 of bonds authorized, which pro-
poses to issue $20,000,000 or $30,000,000 within a short time
after the first issue of $5,000,000, might weaken the con-
fidence of the investor in the security of his bonds. The
investor could not be made to understand why such a large
investment would be necessary. He is assured on this point
by such a restriction on the amount to be annually issued as
appears in the mortgage of the Bell Telephone Company
already referred to, which provides that no bonds in addition
to the $5,000,000 sold on that date, could be issued until
after December 1, 1909, and, thereafter, the trustee is per-
mitted to certify bonds not exceeding $5,000,000 per annum.

We have already seen that, if the same earnings are ob-
tained on the investment of the proceeds of successive bond
issues, as were shown on the first expenditure, the position
of the bondholder would not be weakened. There is, how-

THE ISSUING or SECUEITIES 81

ever, always danger that this rate of earnings may not be
realized. In order to insure the bondholder that there will
always be a wide margin of safety in the cost of any property
acquired with the proceeds of subsequent issues of bonds,
provision is made, again quoting from the restrictions in
the mortgage of the Chicago (Bell) Telephone Company,
that the "total amount of bonds issued shall at no time
exceed fifty per cent of the value of the property as repre-
sented by its total assets, nor more than sixty per cent of
the real estate and construction account." This protects the
bondholders against an overestimate by the directors of the
earnings from the new property by providing an ample mar-
gin in the value of the property of the company above the
mortgage obligations.

Such restrictions, however, are unusual. As a rule, the
bondholder will be satisfied if a limitation is made similar
to the following in the mortgage securing the bonds of the
Pacific Telephone & Telegraph Company : " Of the first mort-
gage and collateral trust bonds authorized, $13,000,000 may
be issued for extensions, additions, etc., but only up to 66f
per cent of the cost thereof." The Pacific Telephone & Tele-
graph Company is more liberal. The trust deed of this
company provides that " of the remaining $85,000,000 bonds
over the $3,000,000 first issued, $22,000,000 shall be issuable
only to cover actual expenses on plant and improvements,
but at no time shall the amount of bonds issued exceed an
amount equal to eighty-five per cent of such expenditures,
nor shall they be issued to provide for repairs."

Another form of restriction makes additional bond issues
depend upon earnings. A common provision is that inserted
in the mortgage of the TJtica & Mohawk Valley Eailroad
Company where the bonds reserved " could be issued for sev-
enty-five per cent of the actual cash cost of additions and
improvements, but not until the net earnings for the preced-
ing twelve months are equal to or exceed double the interest
charge on the total amount of bonds outstanding, including
those to be issued." It is better, from the standpoint of the

82 CORPORATION FINANCE

holder, to limit the' issue of new bonds with reference to
the amount of surplus earnings of the company than by
any other standard, although the provision that bonds can
be issued only up to a reasonable percentage of the cash cost
of improvements is also desirable.

A common stipulation for the protection of the bond-
holder, whether bonds are reserved or not, with a company
whose business is subject to wide fluctuations, provides that a
certain surplus of quick assets over liabilities should be main-
tained at all times. A large amount of convertible assets in
proportion to its liabilities insures a company against financial
embarrassment. It was a lack of quick assets that carried
down the Westinghouse Electric and Manufacturing Com-
pany in 1907. In the mortgage securing the $10,000,000 of
five per cent gold bonds issued by the Republic Iron & Steel
Company the following provision appears :

The net cash and quick assets over and above lia-
bilities, other than the $10,000,000 of bonds and the
interest thereon, shall never be less than $6,500,000
while any of the said issue of bonds remains out-
standing, until the total amount of such issue of
$10,000,000 not canceled, shall be less than $6,500,000,
and thereafter shall never be less than the amount of
such $10,000,000 of bonds at any time uncanceled.
By the phrase " cash and quick assets " is meant cash
in bank, good accounts and bills and notes receivable,
contract notes, or similar or other securities received
on the sale of products of the Republic Company,
raw material, manufactured products (it being un-
derstood that the material shall be figured at actual
cost without interest if cost is below the market
value thereof at the time of the valuation thereof
hereunder, but at market value if at such time below
cost thereof). It is expressly understood and agreed
that in the term raw material no ore or coal shall
be included except such as has actually been mined
and is then on the surface at the mines available for
shipment by rail or in transit or at upper or lower
lake docks, or at works.

THE ISSUING OP SECURITIES 83

This requirement resulted, in 1907, in the suspension by
the Eepublic Iron & Steel Company of dividends on its pre-
ferred stock, all the cash assets of the company being neces-
sary to preserve the stipulated ;margin of quick assets above
liabilities.

We may summarize the restrictions upon the issue of
bonds reserved to be sold under first mortgage as follows:

(1) A limitation on the amoimt vrhich can be sold in
any one year ;

(3) Each installment to be restricted to a certain per-
centage of the cost of additions or improvements upon which
the proceeds of the bonds are expended, the percentage vary-
ing with the type of property and the permanence of the
business.

(3) That the earnings of the company shall show a sub-
stantial margin over its interest or fixed charges, including
the interest charges on the new bonds ;

(4) In special cases, a provision that a surplus of quick
assets shall always be maintained for the protection of the
bondholder.

If these restrictions are included in the mortgage, the
existence of a large bond reserve need cause no apprehension,
to the holders of bonds already issued under the same mort-
gage. The company, for its part, is enabled to raise money
on the most favorable terms and each succeeding capital
expenditure, on account of the margin required in the cost
of the property, increases the security of the bonds already
outstanding.

The Terms and Rates of Interest on Bonds. — A new
company must usually sell its bonds at lower prices than
after it has become established. After its success has
been determined, the bonds of the company can be sold at
higher prices or can be refunded at lower rates. Although,
therefore, the investor usually prefers a long term bond of
an established company, a new company usually issues a
short term bond, not exceeding twenty or thirty years, ex-
pecting that when it matures, instead of selling on a five or

84 CORPORATION FINANCE

five and a half per cent basis, its bonds will sell to yield
four or four and a half per cent. It then sells a new issue
on more favorable terms and retires the bonds originally is-
sued. In order to provide for refunding the bonds at. lower
rates of interest, should the opportunity offer, provision is
frequently made in recent mortgages for retiring the entire
issue at a premium often of five per cent, a premium low
enough not to prove burdensome to a company wishing to
pay off a six-per-cent loan by making another loan at five
per cent, and yet a premium which amply compensates the
holder of the six-per-cent bonds for any inconvenience he
may suffer because he is forced to change his investment.
Our next question concerns the rate of interest to be
fixed on the bonds. Corporations engaged in different
enterprises pay different rates of interest, depending upon
what inyestors in that particular class of bonds are accus-
tomed to receive. The rate of interest also varies, to some
extent, with the location of the enterprise. Certain con-
ventional rates of interest may be indicated, varying with
the class of enterprise in which the corporation is engaged.
Railroad companies in good credit can usually borrow on
first mortgage security at five to six per cent. Public
service corporations pay six to seven per cent; bonds of
manufacturing, mining, lumber companies, etc., seven to
nine.^ The explanation of these differences we find in the
varying demand for different classes of bonds. The in-
vestor prefers railroad bonds since, as a class, these give
him the best security. "When corporations engaged in
enterprises which, from the standpoint of stability and
security are, in the mind of the investor, inferior to the
railway industry, apply for funds, the demand for their
bonds is weaker than the demand for railroad bonds, and,
consequently, a higher rate of interest must be paid.

1 These rates of interest have been largely increased since 1916.
With the recession of prices which will eventually come, they may be
expected to decline. Over extended periods, interest rates move with
commodity prices.

THE ISSUING OF SECURITIES 85

A new enterprise must, as a rule, either sell its bonds
at a discount or give a bonus in stock. Take, for example,
an industrial corporation which has excellent prospects,
and to which the creditor is willing to lend money. The
company wishes to borrow at six per cent, and approaches
a representative of the investor for a loan. The answer is
that money can be loaned on security of this class to es-
tablished companies with a record of earnings, interest pay-
ments, and dividends, and that if the new company wishes
funds it must offer suitable inducements. These induce-
ments can take various forms. A higher interest rate
might be suggested, but this would create an unfavorable
impression as to the security which the company offered.

Another method is to offer the bonds at a discount,
which is equivalent to placing a higher rate of interest
upon them. A six-per-cent bond, for example, which
might be sold at par by an established company, might
be offered by a new company at 80. This is equivalent to
paying a higher rate of interest than six per cent. The
corporation sells to the investor for $800 the right to receive
six per cent on $1,000, and the further right, at the end
of thirty years, to be repaid $1,000. In selling bonds at a
discount a corporation is not merely paying six per cent
on a larger amount of money than it receives, but is also
obligating itself to pay back a larger amount than it re-
ceived. The sale of bonds at a discount is, therefore, less
advantageous from the standpoint of the company than to
offer the investor a higher rate of interest, although in
practice it is more often resorted to.

It is unusual, however, to find corporations paying more
than the conventional rates of interest. The sale of bonds
at a discount is more common. The reason is that investors
grow suspicious when unusual rates of interest are offered,
while they will very gladly buy bonds at a discount which
represent, on their face, a moderate rate to the corpora-
tion.

Another method, less frequently employed than before

86 CORPORATION FINANCE

the days of careful regulation of capital issues, in selling
the bonds of a new company, is to make the creditor, in a
sense, a partner in the concern, by giving him with his
bond one or more shares of stock, and selling him the bond
at or near par. In this way, the corporation receives a
larger amount of money, and the creditor is admitted to
share in the profits of the concern, a fact which may recon-
cile him to advancing money to new enterprises at no
greater rates of interest than he could obtain from estab-
lished corporations. The estimates of the earning power
of the new company are usually so liberal as to permit a
sufficiently large issue of stock to pay the bonus on bond
sales, and still leave an ample supply in the hands of the
projectors of the enterprise.

Another method employed to give the bondholder more
than the legal rate of interest is to grant him a participa-
tion in earnings. This method is legal and a few cases
have been noted where it has been employed. The agree-
ment is inserted in the bond that, in addition to interest,
the holder shall have a share— twenty to twenty-five per
cent has been given— of the net earnings over interest. If
this method could be combined with a representation of
bondholders in the directorate, expressing the wishes of a
bondholders' organization, an extremely attractive security
can be furnished, combining the safety of the bond with
the profit possibilities of stock.

VII
PEOVISION rOK THE EBPATMENT OF BONDS

The corporation bond is a promissory note. It differs
from a bank loan only in the fact that it matures in twenty,
fifty, or one hundred years, instead of in three months.
When a promissory note matures, it must be paid, either in
money or by a new note. With short-time obligations, such
as are given in exchange for bank loans, payment of a
substantial part if not all the debt is expected. With
corporation bonds, however, the custom has been to extend
all or the greater part of the debt, exchanging new bonds
for maturing bonds, keeping the security intact, and if
possible improving it. If any holder of a bond at its
maturity wishes cash for his obligation, the money is ob-
tained by selling new bonds.

The reasons for this practice of refunding instead of
paying corporate debts, lie in the relation of the bond-
holder to the corporation. Bonds are sold to investors who
wish to secure a return on their money, with the guarantee
that the principal sum will also be secured. These invest-
ments are regarded as permanent. The investor does not
often desire the return of his money. He wishes the con-
tinuance of interest payments. If the principal of his
bond is paid at maturity, he is obliged to look about for
some other equally satisfactory investment, and this, at
the time, it may be hard to find. Should the bondholder
wish to convert his bonds into cash at any time, if the

87

88 CORPORATION FINANCE

interest has been regularly paid and the margin of net
earnings over interest has been increased, he can usually
find a market for his bond, usually at a price equal to or
greater than the price he paid, — not always but usually at
small reduction. When its bonds mature, it is not difSeult
for the corporation to offer a new issue to take the place of
maturing bonds, and secured by a first lien upon the same
property. Those of the old holders who desire to continue
the investment may take the new bonds, while the means
of redeeming those bonds whose holders want their money
can be obtained by selling the equivalent in the new bonds
to new investors. While the conditions of security are met,
the bondholder is indifferent to the repayment of his prin-
cipal. At maturity, or before maturity if he desires, he
can obtain his money. ' The bond investor is one who con-
tributes capital to a company in return for a fixed and
secured amount of its earnings. All that he asks of the
corporation is that this income and the security of his prin-
cipal shall not be jeopardized.

The full payment of bonds at maturity is also appar-
ently opposed to the interest of the corporation. The
method by which provision for repayment is usually made
is to devote a portion of the profits to the periodical retire-
ment of portions of the debt, the company saving the in-
terest on the bonds retired. The argument against ac-
cumulating a fund for the repayment of debt is similar
to the argument for incurring the debt in the first place.
If a company can make ten per cent on its investment it
can safely sell bonds bearing six per cent interest. If,
therefore, it is wise to incur an obligation to pay $1,200
in interest on a twenty-year bond and also to agree to
repay the principal at maturity in return for $1,000 in
cash paid to the corporation, because twelve per cent can be
earned on the $1,000, it is wise to invest $50 per year in the
business of the company on which a return of twelve per
cent can be made, rather than to use this $50 to retire the

THE REPAYMENT OF BONDS 83

$1,000 of debt over twenty years. On the other hand, there
is no assurance that the sinking fund appropriation will
be invested in improvements nor can any guaranty be
given that if these are made, they will yield an, average
return of double the interest charge. "With a sinking fund,
a certain positive return is made each year— $50 saves
$3. If invested in the business, $50 might make $6, if the
stockholders did not get the money and if the expenditure
was well planned. The better plan, that followed by well
managed companies whose business is permanent, is to
make provision out of earnings to retire a certain amount,
one-third or one-half of their bonds, before maturity, leav-
ing the rest to be refunded into bonds of a new issue.

Certain classes of business, moreover, require that
bonds issued on the security of their property shall be
entirely paid off by maturity. The first class of com-
panies which should maintain sinking funds are those
whose tonds are secured by a mortgage on property which
is exhausted by the operations of the business. A rail-
road property may be expected to last forever. It is true
that repairs and replacements are always going on, paid
for out of earnings, and charged to operating expenses or
depreciation. The property is preserved and built up by
these outlays. At the end of the term of the bonds, their
security is generally much larger, as a result of the ex-
penditures upon its replacement and repair. When, how-
ever, bonds are secured by a mortgage on seams of coal
or on standing timber, or on land which is to be broken
up into small tracts and sold, the security of the bonds is
exhausted by the operations of the business. Every ton of
coal mined and sold, every thousand feet of timber cut
down and sent to market, lessens by just so much the
security of the bonds which have been issued on this prop-
erty. When bonds are issued by companies operating in
such industries, special provision must be made out of
earnings for paying the bonds, either by installments or

90 CORPORATION FINANCE

when they mature. The company must preserve the rela-
tion between its debt and the security for that debt, either
by reducing the amount of the debt, as the value of the
security falls, or by replacing the coal or lumber sold, by
other property purchased out of its income.

The nature of sinking funds against bonds secured by
so-called "wasting" assets is seen in the following state-
ment of the safeguards of bonds offered by a lumber com-
pany:

The mortgage requires the deposit with the trustee
of $5 per 1,000 feet, mill run, on all timber cut. It
also requires the company to cut and manufacture
exclusively from 15,920 acres containing 146,000,000
feet of timber, holding the remaining 38,000 acres,
containing 232,000,000 feet, as a reserve, which can-
not be cut during the life of this mortgage. This
sinking fund should retire over $500,000 of this loan
before maturity; the unpaid balance $300,000 will
ihen have for security the remaining 38,000 acres.

Similar plans of keeping up the sinking fund are
usually followed by all companies of this character. A coal
mining company will set aside three or five cents for each
ton mined to make good the loss in its coal. A land com-
pany will make certain payments for each acre sold, into
the hands of a trustee.

Sinking funds are also needful when bonds are issued
by companies whose business is not plainly of an enduring
character. Existing railroad bonds usually carry no sink-
ing funds although later issues usually have this protec-
tion. The bonds secured by companies operating interur-
ban electriclines carry sinking funds. Power companies,
real estate companies, and manufacturing companies can
offer to the investor no positive assurance that thirty years
from the time he buys their bonds the original value of his
property will be intact, and their business will be pros-
perous. Such companies, in order to sell their bonds, must
provide for payments to a trustee from their annual earn-

THE REPAYMENT OP BONDS 91

ings of an amount sufficient to pay all or the greater part
of their mortgage debts at maturity.

Sinking funds are divided into two classes : first, where
the company makes annual payments to a trustee ; and the
second where bonds are issued under the serial plan so
that a certain part of the principal matures each year
until the entire amount is repaid within the term named
in the mortgage. When the first plan is adopted the ques-
tion arises, What shall tlie trustee do with the money
■which is paid to him? Several methods of disposing of
■these funds are available. The mortgage may provide that
a certain number of bonds may be drawn by lot foi; re-
tirement at a fixed price, notice being given by advertise-
ment of the bonds so drawn, or provision may be made that
an annual cash sinking fund of, say, two and one-half per
cent of the original issue, shall be paid to the trustee, and
shall be applied to the purchase and cancellation of these
bonds at a named maximum price : or if not to be bought at
that price, redeemed by lot at the same price. In some
cases, also, the interest on the bonds purchased is added
to the amount set aside for bond purchases so that the
sinking fund increases each year by a fixed amount.

The method of drawing bonds by lot for retirement at
a fixed price is objectionable to the investor because he
must be on the lookout for the announcement of the draw-
ing of bonds for retirement, and frequently be put to the
trouble of finding another investment for the money which
the corporation may at any time return to him. These
drawings of bonds, however, are often for payment at a
good premium over the price paid, and this premium offsets
any trouble to which the investor may be put because a
part of his bonds are paid to him before maturity.

The plan of purchasing bonds in the open market is,
from the investor's standpoint, better than the method of
drawing bonds. The bond market is less active than the
stock market. Bonds are usually bought for permanent
investment. They come on the market but seldom as com-

92 , CORPORATION FINANCE

pared with stocks, and in smaller amounts. The taking of
this small floating supply, by the purchases of the sinking
fund trustee, operates to maintain a market price higher
than could be. had without such a regular demand. From
the standpoint of the corporation, however, aside from the
fact that the buyers of these bonds are apt to be well satis-
fied with their investment, and open to new offerings of
the same kind, if the company must retire a certain par
value of the bonds in each year by purchasing at the
market price, it may sometimes suffer a loss, because of the
artificially high price resulting from the trustee 's pur-
chases.

This objection is met by provisions similar to those
given abovCj whereby the trustee is obliged to spend $200,-
000 or $300,000 each year in the purchase of bonds in
the open market if these can be had at or below a certain
price — say 105 or 106. If enough bonds are not forth-
coming at this price, then the trustee may draw a sufficient
number of bonds at the price stated in the mortgage to
expend the money in the sinking fund. This provision
tends to keep down the market price to the figure at which
the bonds can be drawn.

A second alternative might be offered to the trustee in
case he was not able to buy bonds at the price named in
the mortgage. He might be allowed to buy other securities
with the sinking fund. Some of the Burlington sinking
fund mortgages contain this provision. This method, how-
ever, brings into the sinking fund an element of chance.
The bonds bought for the sinking fund may rise in price,
in which ease the security of the bondholders will improve,
or their price may fall, and the objects of the sinking fund,
to the amount of the fall, will not be achieved. If bonds
are bought at par for the sinking fund, to offset a debt
when it comes due, and if in the meantime the price of the
bonds falls to 90, the sinking fund lacks ten per cent of
the sum needed to pay the bonds. It is better, if any bonds
are to be bought for the sinking fund, that they should

THE REPAYMENT OF BONDS 93

be the bonds of the company which is building up the
fund, so that the reduction of its debt may be certain.

Another method of using money is to invest the fund,
either by absolute stipulation, or in case the trustee fails
to buy bonds at a reasonable price, in improvements and
additions. An example of this method is furnished by
the following extract from the trust indenture securing the
first mortgage bonds of the San Diego Consolidated Gas
and Electric Company:

Article Three. Section 1. The company cove-
nants and agrees that it will deposit with the Harris
Trust and Savings Bank, Trustee, in a Depreciation
and Renewal Fund the following amounts annually:
On the first day of June in each of the years 1910
to 1914, inclusive, a sum equal to three per cent (3%),
and on the first day of June in each of the years 1915
to 1938, inclusive, a sum equal to five per cent (5%)
of the amount, in par value, of bonds outstanding
hereunder on the first day of October next preceding
each such respective deposit.

Section 2. The Depreciation and Renewal Fund
shall be held by the Harris Trust and Savings Bank,
Trustee, as a special trust fund, and the company shall
be entitled to withdraw therefrom, upon certificates
satisfactory to said Trustee, the aggregate amount of
the actual and reasonable cash expenditures made by
the company subsequent to April 1, 1909, for renewals
and replacements of its plant, properties, and equip-
ment now owned or hereafter acquired, exclusive of
customary expenditures for current repairs and cur-
rent maintenance ordinarily chargeable to operating
expenses.

Section 3. At the option of the company any part
of said Depreciation and Renewal Fund may be with-
drawn, upon certificates to the Harris Trust and Sav-
ings Bank, Trustee, to reimburse the company (a)
for its actual and reasonable cash expenditures for
permanent extensions and additions of and to 'its
plants, properties, and equipment . . . provided such
expenditures shall not have been previously made
the basis for the issuance of bonds hereby secured;
or (b) for its expenditures made in the purchase or
redemption of bonds at not exceeding par, accrued in-
terest, and five per cent upon the principal thereof.

94 CORPORATION FINANCE

Here is a sinking fund provision, under another name,
which gives the company the option of either buying its
bonds at 105 and accrued interest, or of spending a certain
amount upon its plant. When the business of the borrow-
ing company is secure, as in this case, and if the trustee
is vigilant in supervising the expenditure of the sinking
fund, the security of the bonds can be conserved by the
investment of the sinking fund on the improvement of the
property. The value of the security will be increased at
a more rapid rate under this method than the rate at
which the liabilities of the company will be decreased by
its purchases of its own bonds. This method does not
apply to companies with wasting assets nor to those whose
future is uncertain.

The methods of disposing of bonds bought by the trus-
tee for the sinking fund are as follows: (1) they may be
canceled as purchased and delivered by the trustee to the
company — the usual plan; (2) they may be kept in the
sinking fund as an obligation of the company, and the inter-
est paid into the sinking fund as an addition to the regular
sinking fund appropriations — the retirement of the bonds
proceeding at an increasing rate because of 'the addition
of the interest on the bonds in the sinking fund to the
appropriations from income for the benefit of the fund;
and (3) the bonds held in the sinking fund may be sold
for the benefit of the company.

The use of the third method is shown by the trust in-
denture of the San Diego Consolidated Gas and Electric
Company, already referred to, which states that ' ' said trus-
tee upon the written request of the company shall hold un-
canceled in said Depreciation and Renewal Fund any
bonds so purchased, and the company may with the ap-
proval of said trustee sell any or all such bonds so held,
in which ease the proceeds shall be held and applied."

The serial plan of bond issue is illustrated by the follow-
ing offering of the 7 per cent bonds of the Monsanto Chemi-
cal "Works :

THE REPAYMENT OP BONDS

95

Maturities and Prices

$100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
100.000
100,000

ipo,ooo

100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000

due Mar.

due Sept.
due Mar.
due Sept.
due Mar.
due Sept.
due Mar.
due Sept.
due Mar.
due Sept.
due Mar.
due Sept.
due Mar.
due Sept.
due Mar.
due Sept.
due Mar.
due Sept.
due Mar.
due Sept.

1921,
1921,
1922,
1922,
1923,
1923,
1924,
1924,
1925,
1925,
1926,
1926,
1927,
1927,
1928,
1928,
1929,
1929,
1930,
1930,

at 99.76
at 99.65
at 99.54
at 99.44
at 99.34
at 99.24
at 99.15
at 99.05
at 98.97
at 98.88
at 98.80
at 98.72
at 98.65
at 98.57
at 98.50
at 98.43
at 98.37
at 98.30
at 98.24
at 98.18

These bonds ara offered at prices which represent a uni-
form yield of 7.25 per cent for all maturities.

These bonds offer important advantages from the sell-
ing standpoint. The short maturities are usually sold to
banks, while the longer maturities appeal to the investor,
individual or institutional. American banks and trust
companies have always been large buyers of bonds. The
purchase of long term bonds with the money of depositors
is, however, no better than a speculation. The price of
these promises to pay money at dates lying far in the
future fluctuates according to the movement of prices, ris-
ing as they advance, and falling as they decline. It is true
that commercial banks need not sustain heavy losses from
declines in bond values. If the market goes against them
they can get out of the holdings at small sacrifices, and
when bond prices are advancing they often make fine
profits. All this, however, is not banking, but trading.
It involves the taking of unnecessary risks, and is to be
avoided by well-managed banking institutions. On the

96 CORPORATION FINANCE

other hand, the banker may be unable to lend his funds to
his depositors, or to purchase satisfactory commercial
paper. He is forced to buy some form of corporate obliga-
tion. Short Inaturity serial bonds are exactly suited to
his requirements. They promise to pay a definite sum
within one or two years and their security is, generally
speaking, superior to that of the short term notes, with
which they compete.

Serial bonds may be and generally should be coupled
with other forms of sinking funds. For example, when
issued by a coal company it is desirable to "provide for the
payment of a fixed sum per ton of coal extracted into the
hands of the trustee of the mortgage securing the serials.
If the sum so accumulated between serial payment dates
exceeds the amount of the next payment, the surplus can
be held by the trustee against subsequent payments. If the
current accumulations on a tonnage basis are insufficient
the company must find the money elsewhere. It is also
not unusual to find a certain percentage of the net earn-
ings of a company paid into the trustee of a serial bond
mortgage. So that if the company is exceptionally fortu-
nate its obligations may be provided for in advance of
their maturity.

The serial bond plan is that of an exaggerated sinking
fund. It is a radical departure from the method formerly
universal, of making no provision whatever for the pay-
ment of debt, relying on the value of the property and its
earnings to furnish a basis for a new bond issue to take
the place of the old. Under the serial plan, the entire bond
issue, every dollar of it, will be paid at definite dates, the
principal of the debt steadily and rapidly diminishing,
while the security remains the same. There is no way for
the corporation to postpone or evade its obligations. Every
year $100,000, or $250,000, or $500,000 must be found, in
addition to the interest on the remainder. With a sinking
fund iDased on business done,— tonnage extracted, or tim-
ber shipped, — or a sinking fund based on net earnings, or

THE REPAYMENT OF BONDS 97

even a sinking fund representing a percentage of the bonds
outstanding, there is some measure of latitude for the
company. With the serial plan, however, there is no re-
spite. Bach year brings its installment, which it is some-
times extremely inconvenient and very costly to meet. The
imminence of these short maturities also operates to
limit closely a company's credit. Its bonds consist of a
succession of annual or semi-annual installments of bills
payable. The banker to whom a company in this situation
applies for a commercial loan will be very cautious, and
will probably demand special security.

On the other hand, the company which has borrowed
to the limit of its resources on the serial plan has set its
feet on the path that leads to solvency and prosperity. Its
affairs must be managed with economy and caution. High
dividends and high salaries to stockholding officials are
not to be thought of. Capital expenditures must be care-
fully considered, and the mistakes of commission, which
always attend a large and unallotted cash balance, will
be few. The pressure of urgent necessity is constantly
bearing upon the managers. They walk always in the
shadow of apprehension, and are less likely to be taken
unawares by some unforeseen development.

One qualification must be made to the foregoing ad-
vocacy of high sinking funds, which might otherwise be
justly regarded by those who are familiar with the difficul-
ties of financial management as too sweeping. A sinking
fund represents an unconditional promise to pay a sub-
stantial amount of the principal of a debt at a definite
date. Some catastrophe, such as a financial panic, or a
nation-wide strike, may befall to make this payment im-
possible. Shall the company, normally solvent, able to
meet every obligation, be forced into bankruptcy because
of such an untoward event? Manifestly, some relaxation
of the rigid requirements of an unconditional obligation
is demanded. Sinking funds are frequently arranged on a
graduated ascending scale, beginning, e.g., two years after

98 CORPORATION FINANCE

the date of issuing the bonds. Serial payments are often
arranged on a small scale at first, rising to the full amount
necessary to extinguish the total debt at the end of a
period. For example, a ten-year bond can be arranged
to mature in nine installments, the first due date being
two years from the date of issue. Sinking funds may also
be made cumulative in whole or in part, and for a limited
time cause the corporation no more embarrassment than
that caused by failure to pay dividends on preferred stock.

CHAPTER VIII
METHODS OF PAYING FOB STOCK

We take up next the methods of paying for stock. We
shall first consider the cases in which the stock is paid for
in whole or in part by cash. Stock sold bv the corporation
for cash is of two classes, assessable or full paid, according
as the payment is full or partial. Full paid stock may be
paid for at one time or in installments. When stock is issued
for work of construction, such as the building of a new line
of railroad or the erection of a mill, the companjr's payments
are protracted over a considerable period. There is no pur-
pose, therefore, in securing the full amount of the subscrip-
tion at one time. The money is arranged to be paid as it
is needed, the payments sometimes being extended over a year
or even longer. The practice in such cases is not to pay
dividends on the new stock until the entire amount has been
paid up, but to allow the subscribers interest on their install-
ments as these are paid into the treasury of the corporation.

Assessable stock is of a different character. Here the
payment is made in cash and in promises to pay cash.
The subscription to $10,000 of stock, par value $100, "ten
per cent paid," will be $1,000 in cash, and $9,000 in a promise
to pay that amount when called for by the board of directors.
*Ihe advantages of this form of stock, viewed from the stand-
point of the corporation, are considerable. In the first place,
the issue of assessable stock makes it possible for a company
embarking in a new enterprise to guard against underestimates
of the cost of construction. If, for example, an interurban
railroad is estimated to cost $500,000, and subscriptions to

100 CORPORATION FINANCE

$500,000 are secured, and supposing, as frequently hap-
pens, that the cost is raised by unforeseen circumstances to
$750,000, it then becomes necessary for the officers of the
company to apply to the stockholders for additional sub-
scriptio;ns which they can usually obtain only by issuing
preferred stock which may not have been contemplated in
the original plan. Under such circumstances, however, it
is practically impossible to persuade stockholders to sub-
scribe to an additional amount of common stock. They
are apt to lose confidence in the managers of the enter-
prise whom they hold responsible for the mistakes in the
estimates of construction cost, and may even oust the di-
rectors from office and put in a new control. The writer
heard a banker who had been interested in promoting an
iron furnace enterprise in Eastern Pennsylvania, say that
it was easier to procure $2,000,000 at the outset than to
secure $200,000 after $1,000,000 had been represented as
all that would be necessary. If the method of assessable
stock is adopted, stock can be issued to the amount of
$1,000,000, with an understanding, which is not, of course,
a part of the subscription contract, that only $500,000
need be called. If, then, it is found necessary to call $250,-
000 more, this can be secured without difficulty since the
stockholders will not wish to see their original investment
forfeited by a sale of their stock by the company to pay up
the assessment.

Assessable stock can be issued to capitalize future
profits when it is not deemed prudent to pay too large 'a
dividend. If a street railway consolidation required $15,-
000,000 cash, and if public sentiment would not tolerate
more than six per cent in dividends, it might issue $45,000,-
000 of stock, calling one-third of the amount with the bal-
ance as a liability. Six per cent dividend on $45,000,000
would be eighl^per cent on the amount paid in. This method
was employed in the street railway consolidation of Phila-
delphia. As a means of evading regulation of rates by pub-
lic service commissions, however, it will no longer serve.

METHODS OP PAYING FOE STOCK 101

Assessable stock is not a popular form of security. The
unpaid portion of such stock operates to depress its value.
Investors can never be certain when the directors will call
assessments. When a call is made, those holders who are
unable to respond must throw a portion of their stock on
the market to obtain sufficient funds to pay the assessments
on the remainder. These sales not only make the value of
partly paid shares irregular, but open the way to unscru-
pulous directors to enrich themselves at the expense of the
stockholders by buying the stock on the decline and selling
at the advance which, since the real value of the stock has
been increased by the assessment, is likely to follow its pay-
ment.

The investor has a rooted objection to purchasing assess-
able 'stock because of the uncertainty as to the amount he will
be called upon to pay, and because of a well grounded dis-
trust of the danger of manipulation by directors who are in
a position to control the times and amounts of the calls.
When stock, therefore, is to be sold to investors, it is necessary
to make it full paid. This can be done, either by paying
for the stock in cash, or by issuing it in exchange for prop-
erty or services. The only way in which promoters can make
a profit on stock which has been paid up in cash is to sell this
stock at a premium. Since we are dealing here, it will be
remembered, with new enterprises, whose earning power is
. yet ,to be demonstrated, and which must ofEer inducements
to investors to secure funds, this method is impossible. In
Germany, where the law forbids the stock of any new enter-
prise to be listed for sale until the company has been in
operation for a year, and where the amount of capital is
strictly limited, it has frequently happened that a large
premium could be secured, and a considerable profit real-
ized. In Great Britain, where founder's shares, entitling
their holder to a disproportionately large share of profits,
are used to compensate promoters, these shares frequently
sell at a high premium. In the United States, how-
ever, where the law allows listing at once, and founder's

102 COEPOEATION FESTANOE

shares are not as yet employed, the risks of new enterprises
are so great and the demand for banke'-'s capital so heavy,
that very little time is allowed to elapse between the com-
pletion of the construction or consolidation and the sale of
its securities. This unwillingness of the investor to buy se-
curities of new enterprises, except on very favorable terms,
extends to its bonds. To sell bonds, it is sometimes necessary
to give a bonus in stock from which the corporation will re-
ceive no cash whatever. This stock, to be attractive to the
investor, must be full paid.

Prom these several considerations, it is evident that some
method must be devised of making stock full paid, which will
not require the payment of its par value in cash. This
method is the issuing of stock for property or services. The
laws of every State permit the directors of corporations to
purchase such property as it may need by issuing its stock.
Corporations are also allowed to make contracts for construc-
tion work, payment for which is to be made in bonds and
stocks. One of the most liberal statutes permitting the pur-
chase of properiy with stock is that of New Jersey. Section
49 of the General Corporation Act of New Jersey is as
follows :

Any corporation formed under this act may pur-
chase mines, manufactories, or other property neces-
sary for its business, or the stock of any company or
companies owning, mining, manufacturing, or pro-
ducing materials, or other property necessary for its
business, and issue stock to the amount of the value
thereof in payment therefor, and the stock so issued
shall be full paid stock and not liable to any further
call, neither shall the holder thereof be liable for any
further payment under any of the provisions of this
act ; and in the absence of actual fraud in the transac-
tion, the judgment of the directors as to the value of
the property purchased shall be conclusive, and in all
statements and reports of the corporation to be pub-
lished or filed this stock shall not be stated or reported
as being issued for cash paid to the corporation, but
shall be reported in this respect according to the fact.

METHODS OF PAYING FOE STOCK 103

The New Jersey Corporation Law also authorizes the is-
suance of stock and bonds for services rendered in the follow-
ing section :

Corporations having for their object the building,
constructing, or repairing of railroads, water, gas, or
electric works, tunnels, bridges, viaducts, canals, hotels,
wharves, piers, or any like works of internal improve-
ment or public use or utility, may subscribe for, take,
pay for, hold, use, and dispose of stock or bonds in any
corporation formed for the purpose of constructing,
maintaining, and operating any such public works,
and the directors of any such corporation formed for
the purpose of constructing, maintaining, and oper-
ating any public work of the description aforesaid,
may accept in payment of any such subscription, or
purchase, real or personal property, necessary for the
purpose of such corporation, or work, labor, and serv-
ices performed or materials furnished to or for such
corporations to the amount of the value thereof, and
from time to time issue upon any such subscription
or purchase, in such installments or proportions as
such directors may agree upon, full paid stock in full
or partial performance of the whole or any part of
such subscription or purchase, and the stock so issued
shall be full paid and not liable to any further call.

The method described in this section is that usually fol-
lowed for making stock full paid. After the corporation is
organized, the first meeting of the stockholders held, and the
directors elected, a proposition is made to the directors to
sell to the corporation certain property — patents, mining
property, factory property, railroads or stocks and bonds, for
all or part of the securities of the new corporation. The
only limit in most States to the amount of bonds which may
be issued under these circumstances is the conclusion of the
directors as to their need of capital and their ability to sell
these bonds. The law does, however, limit the stock " to the
judgment of the directors as to the value of the property
purchased." As long as this judgment is an honest judgment.

104 CORPORATION FINANCE

and there is no suspicion of fraud in the transaction, it will
be held to be final, and cannot be questioned in subsequent
proceedings against the corporation.

In fixing a value upon the property purchased, or upon
work which is to be done for the company, the directors
itre not to be limited to the sum for which the propertj'
would sell for cash, or to the amount for which the services
could be purchased for cash. The payments are not made
in cash, but in evidences of debt, and in certificates of
rights to participate in profits. The ability of the corpora-
tion to pay interest on these bonds is yet to be demon-
strated. The profits, in which the holders of these shares
of stock are to participate, are yet to be realized. Anyone
who transfers property, or contracts to perform services
for a company, in exchange for securities, can properly
charge much higher prices than if he is to receive cash for
his property or services. The corporation, for its part, is
warranted in paying a much higher price for property
or services expressed in terms of securities. When the
vendors or contractors will agree to accept, instead of cash,
which the corporation might have great difficulty in secur-
ing, its bonds and stock, making it unnecessary for the
corporation itself to raise more than a mpderate amount of
money for working capital, they are entitled to liberal
terms. The valuation placed upon property or services by
directors is generally accepted by the courts.

The only risk attaching to the overvaluation of prop-
erty, when purchased with stock, arises in the subsequent
bankruptcy of the company issuing the stock. If creditors
of the corporation prove that stock was fraudulently is-
sued, and if they find this stock in the possession of the
original incorporators, or those for whom these incorpora-
tors were acting, the receiver of the corporation, acting
for the creditors, can recover such part of the difference
between the par value of the stock and what the court
considers a fair value for the property, as will make up
the difference between the company's assets and the credi-

METHODS OF PAYING FOR STOCK 105

tors' claims. The so-called full paid stock of the company,
issued to an excessive amount, is considered assessable
stock, the corporation not having received full value, and
those who have received the stock are liable for the differ-
ence between true value and par value of the stock, solvent
delinquents being compelled to assume the shares of the
insolvent.

The theory of law under which liability attaches, is
that the capital' of the corporation takes the place of the
individual liability of the partners, so far as the creditors
are concerned, who have the right to assume that the capi-
tal of the company has been paid, either with cash or with
property and services taken at a fair value. When, there-
fore, the company fails, and the creditors prove that the
stock was issued for property and services at excessive
values, it is held that they can recover through the cor-
poration from the original subscribers if they find the stock
in their hands. This liability does not attach to innocent
holders for value, and it is a question whether the original
subscribers may not divest themselves of all liability by
transferring their stock on the books of the company.

Here again appears the advantage of issuing stock with-
out par value. No implied representations as to values are
made by the statement that the stock of the company is
divided into so many shares. No creditor can claim that
he has been deceived and no recovery by a receiver can be
had. Even if the directors by resolution state that the
stock as represented by property has a certain value and
that value proves excessive, no fraud can be imputed to
the stockholders, who have received the stock before this
misrepresentation was made.

The purchase of property with stock of a corporation
directly from the owner presents no difficulty. When
services are to be performed, in order to make the stock
full paid, it is necessary to interpose between the final
purchaser of the stock and the corporation an agency
known as the Construction Company, which exchanges its

106 . CORPORATION FINANCE

contract for services for the stock and bonds of the com-
pany in whose interest the work is to be done. A con-
struction company is not often what its name implies. As
a rule, it does not expect to carry on any work of construc-
tion. It has no force of engineers at its disposal. It ex-
pects to let the contracts connected with the work to others.
It is merely a device to make stock full paid so that it can
be sold to the investor without any liability attaching.

A typical construction company transaction is outlined
in the following:

OFFERING OF BONDS AND STOCK

OP

THE DENVER NORTHWESTERN & PACIFIC
RAILWAY COMPANY

Payments to be Made in Instalments or at Once at
Subscriber's Option.

Denver, Col., October 21, 1902.
' The Colorado-Utah Construction Company has con-
tracted with the Denver Northwestern & Pacific Rail-
way Company to build and equip, approximately, 500
miles of its railroad between Denver, Col., and Salt
Lake City, Utah. The contract provides for a sub-
stantial roadbed, steel rails eighty pounds per yard,
and a modern standard passenger and freight rolling
stock equipment. Payments under this contract are
to be made in the bonds and stock of the Railway Com-
pany which are now offered for subscription.

Under the provisions of the construction contract,
there will be issued by the Railway Company to the
Construction Company $40,000, and no more, of the
first mortgage four-per-cent bonds of the Railway
Company and $20,000, par value, of its full paid pre-
ferred stock and $20,000, par value, of its full paid
common stock for each mile of main track of railroad
as it is built, equipped, and turned over to the Rail-
way Company for operation.

The authorized capital stock of the Railway Com-
pany is $20,000,000, of which $10,000,000 is five-per-
cent non-cumulative preferred stock and $10,000,000 is
common stock.

METHODS OF PAYING FOR STOCK 107

The first mortgage of the Railway Company to The
Mercantile Trust Company, oi New York, provides
for an issue of not exceeding $22,500,000 of Fifty-
Year Four-Per-Cent Gold Bonds, of which issue the
balance of $2,500,000 remaining after the payments
to be made under the construction contract will be held
in reserve by the Railway Company.

The Colorado-Utah Construction Company will re-
ceive, through its designated depositaries, applications
for subscriptions in $1,000, and multiples of $1,000,
to the bonds and stock of the Denver Northwestern &
Pacific Railway Company above mentioned until Novem-
ber 16, 1902, after which no further applications will
be received.

The Colorado-Utah Construction Company reserves
the right to scale down or to reject any and all appli-
cations.

The terms of the subscription agreement, which is to
be :signed by the parties whose applications shall be
accepted by the undersigned, provide that payment shall
be called in as money is required by the Construction
Company for the purpose of fulfilling its contract with
the Railroad Company, but that in no event shall the
subscribers be required to pay more than ten per cent
of their subscriptions in any one month; but that each
subscriber shall have the option to pay the whole amount
subscribed at once. Each subscriber will receive, as
provided in the subscription agreement, for each $950
paid:

$1,000 f our-per-cent fifty-year First Mortgage Gold

Bonds of the Railway Company,
$250 par value of the Non-Cumulative Preferred

Stock, and
$250 par value of the Common Stock of the Rail-
way Company.

Until the bonds and stock of the Railway Company
are engraved, executed, and received by the Construc-
tion Company under the terms of its contract with the
Railway Company, the Construction Company will is-
sue to the subscribers, as any payment is made upon
their subscriptions, its receipt providing for the pay-
ment of interest from 'the date of such payment at the
rate of four per cent per annum until the bonds and
stock subscribed for are ready for delivery to the sub-
scribers, subject to adjustment to be made as to any
interest then accrued upon such bonds.

108 CORPORATION FINANCE

The one half of the eommon and preferred stock of
the Railway Company not offered for subscription will
be owned by the Construction Company.

, The above offer is made upon the terms above stated,
subject to advance or withdrawal without notice, and
the vmdersigned recommends the bonds and stock of the
Denver Northwestern & Pacific Railway Company as a
safe and profitable investment.

THE COLOEADO-UTAH CONSTRUCTION
COMPANY,
By Sylvester T. Smith, President.

The foregoing shows very clearly the service which the
construction company performs. The Denver Northwest-
ern & Pacific Railway property, at the time this offer was
made, was not yet built. The public was expected to fur-
nish a large part of the funds necessary for the work.
Since the enterprise was not yet in being, it was necessary
to offer special inducements to the subscribers to the bonds
in the shape of bonus in stock. This stock bonus could not
be legally offered by the railway company. The construc-
tion company was therefore employed to contract with the
railroad company to build its line in return for securities.
These securities the construction company forthwith of-
fered to the public on the terms set forth in the advertise-
ment.

The foregoing represents a public offering of construc-
tion securities under favorable conditions of the security
market. Such offerings may succeed. Bankers, however,
dislike to handle any other securities than those issued by
going concerns. It is usually necessary, therefore, for a
considerable amount of capital to be raised by the con-
struction company, with which it margins loans made with
financial institutions on the security of the stock and bonds
which it receives from the railway company as the work
progresses. The following is a detailed description of a
typical operation of this character:

METHODS OP PAYING FOE STOCK 109

A eonstmction company is organized for the purpose of
building a line of railroad. The shares of the construction
company are offered for subscription to obtain working
capital. Simultaneously with the organization of the con-
struction company, a railroad company is incorporated.
An agreement is now made between the railroad company
and the construction company for the building of a rail-
road, and for supplying a certain amount of equipment for
its operation after completion. The construction company
agrees to secure the necessary rights of way, and to con-
struct or procure for the railroad company, upon such
routes as it may select for the purpose, a certain line of
railroad. It is stipulated that the work to be performed by
the construction company shall be in accordance with stand-
ard specifications, and under the supervision and conti'ol
of the chief engineer of the railroad company. All the
contracts for the grading, rails, equipment, and all other
necessary work for the completion of the railroad, will be
let by 'the construction company.

For the service performed in constructing the railroad
and furnishing a certain amount of equipment, the railroad
company agrees to deliver to the construction company its
full authorized capital stock at a certain rate per mile of
railroad constructed, and also bonds for each mile so con-
structed. The bonds issued shall be a first lien on the prop-
erty, and before any shall be delivered by the railroad com-
pany to the construction company, the trustee under the
mortgage shall be furnished with a certificate of the com-
pleted mileage by the chief engineer of the railroad com-
pany. The construction company, upon the completion of
its contract, becomes the owner of all the stock and bonds of
the railroad company, except that stock which was sub-
scribed for at the time of the incorporation of the railroad
company, and that necessary for the qualification of the di-
rectors.

The method of financing the construction of the railroad
involves the joint use of the credit of both the railroad and

110 COEPORATION FINANCE

the construction company. At the outset, the railroad com-
pany has no property and therefore it has no credit. The
construction company has a cash capital and by the use of
this capital of the construction company, the railroad com-
pany gradually comes into possession of railroad property
represented by securities which form a basis for loans. An
illustration of this follows.

"A construction company is formed with a capital of
$2,500,000. Out of this capital, it purchased mining inter-
ests which cost $500,000. In order to develop this opera-
tion, a railroad company is formed, and on the strength of
the balance of the capital of the construction company,
contracts are let and work begins. The mileage to be con-
structed is 200 miles, on which stock at the rate of $16,500
per mile, and bonds at the same rate can be issued. Bach
mile of railroad constructed and with the equipment fur-
nished, costs the construction company $18,000 per mile.
On a mileage of 200 miles, the cost would be, approximately,
$3,600,000.

"Under the terms of the agreement of the construction
company with the railroad company, as the work progresses
in sections of so many miles, the construction company be-
comes entitled to bonds at $16,500 for each mile so con-
structed upon delivery of the certificates of the chief engi-
neer of the railroad company certifying to such completed
mileage, to the trustees under the mortgage.

"After paying for its coal estate the construction com-
pany's available capital would be $2,000,000. Upon the
basis of a cost of $18,000 per mile, with this capital, it can
construct approximately 110 miles, under which it becomes
entitled to receive bonds to the amount of $1,815,000. This
will use all the available funds of the construction com-
pany. With the bonds thus received (which would be in
the form of temporary certificates) it now seeks loans from
financial sources, pledging these certificates as collateral, on
the basis of sixty per cent of their face value. Assuming
that the loan can be made with this collateral on this mar-

METHODS OF PAYING FOR STOCK 111

gin, the construction company will obtain funds for the fur-
ther construction to the extent of $1,089,000, which will
complete an additional sixty miles, upon completion of
which the construction company will be entitled to receive
bonds at the rate of $16,500 per mile, or $990,000 of bonds.
To complete the remaining thirty miles under contract, the
construction company will require an aWitional loan of
$540,000, and if the same method of borrowing on the
pledged collateral is pursued, it will require $900,000 of the
$990,000 bonds received for the former sixty miles com-
pleted, which will leave in the hands of the construction
company $90,000 of bonds, plus those issued for the last
thirty miles ($495,000) or a total of $585,000 of bonds
with all the capital stock, amounting to $3,300,000, and the
coal estate costing $500,000, as assets, and with liabilities of
loans to the amount of $1,629,000 and capital stock of $2,-
500,000.

"The property of the railroad is then put into opera-
^;ion. The receipts and expenses are such that its earning
power will be sufficient to meet the interest on the bonds,
which will tend to increase their value. A syndicate, is now
formed to take the bonds at ninety. The $2,715,000 of
bonds held as collateral are sold, realizing in cash $2,443,-
500. From this sum, the loans amounting to $1,629,000
with interest are paid off, realizing approximately $800,000
in cash. The $585,000 bonds among the assets of the con-
struction company are sold at ninety, realizing in cash
$526,500 which, with the $800,000 remaining from the
loans, furnishes $1,326,500 of cash. With this cash the con-
struction company's capital stock, amounting to $2,500,000,
could be proportionately paid off, thus reducing it to $1,-
173,500 with the $3,300,000 capital stock of the railroad
company and the coal estate of $500,000 as remaining as-
sets.

"In order to wind up the affairs of the company, and to
distribute the stock of the railroad company to the construc-
tion company stockholders, it may be estimated that the

112 CORPORATION FINANCE

stock is worth $25 per share (par value $50). For the
66,000 shares, $1,650,000 could be realized, which would be
distributed to the stockholders oiit of the proceeds of the
sale, amounting to $1,173,500, leaving a credit balance of
$476,500 with the coal estate. It has been assumed that all
the securities would be sold for cash. The various securities
can be distribute'd among the stockholders of the construc-
tion company. The stockholders might also become mem-
bers of the underwriting syndicate to take bonds at
ninety."^

One more problem arises in connection with the issuing
of stock for property or services. Every new enterprise
needs working capital, and the financial plan must provide
for this. A portion of the proceeds of the securities of the
new company must be put into the treasury to serve the
current needs of the corporation. The stock of the new
company cannot be sold at par. It must either be sold at a
discount, or given away as a bonus with bonds sold. The
latter method is generally forbidden the corporation by
law. The stock can be made full paid by transferring it
for property or services, and then can come into possession
of the corporation by gift. The company can sell this stock
or give it as a bonus with the sale of bonds as it sees fit.
The ordinary method of accomplishing this result is for
the vendors of property, or the construction company, after
the stock has been made full paid, to donate to the company
a certain portion of what they have received, to be placed
in the treasury and sold to provide working capital. Here,
again, it has been held, in the event of bankruptcy, that the
fact that stock was given away by the incorporators was
proof positive that the stock was overvalued.

It may be argued for the construction company that with-
out this agency whose subscribed capital guarantees the
loans made on the security of bonds, enterprises would have

1 This account of the operations of a construction company was
obtained from a confidential source, on the promise that no names
were to be mentioned.

METHODS OP PAYING FOR STOCK 113

great difficulty in raising money for construction. In-
vestors are wary of new concerns which are not on a going
basis. Investment bankers usually demand a showing of
earnings before risking any money in such securities. The
construction company, in return for the opportunity of
large profit which its dealings with the railroad company
presents, is willing to take risks with new enterprises, and
to co-operate with financial institutions in furnishing money
for construction, on the security of the bonds of the new
company.

A potent reason for the use of the construction company,
aside from the evident advantages to the corporation which
have been enumerated, is the fact that this is the only way
in which the promoters of an enterprise which does not
require the purchase of property, but, instead, involves the
building of a trolley line or railroad, to bring into existence
property which did not exist before, can make any money
for themselves out of the scheme. Even if the law permits
the railroad company to sell its stock as a bonus with bonds,
and supposing a railroad company sells these securities di-
rect and the money is placed in its treasury, these funds
must be spent for the benefit of the corporation. There is
no way in which the promoters can make any profit from
them except by subscribing to the stock and holding it for
an indefinite period until it shows some value. By utilizing
the construction company, however, they can make a con-
tract with the railroad company, which will involve the
payment' to them of a sufficiently large aihount of securities
to reimburse their expenses, and, at the same time, give
them an immediate profit in case their calculations have
been wisely made.

CHAPTER IX
THE SALE OF SECDBITIES

We have now reached, in the development of our corpora-
tion, the time when it is necessary to arrange for its perma-
nent financing. Up to this point, the money which has been
put into the enterprise has been advanced by members of the
promoting sjoidicate. These advances are intended to be
temporary. Both the members of the syndicate and the banks
from which they have borrowed expect to be repaid when the
securities are finally sold. Although the construction period
may be prolonged for several years, either because of unfore-
seen difficulties, or because it is deemed essential that the
enterprise should make a fair showing of earnings before its
securities are offered for sale, the promoters wish to make this
period of development as brief as possible. As soon as the
company is in a position to make an attractive offer of stocks
or bonds, the securities are sold.

There are two methods of selling securities; either to the
public direct or to investment bankers. The security business
is organized along lines generally similar to the business of
producing and selling commodities. The corporation cor-
responds to the manufacturer, the investor to the consumer.
Between the manufacturer and the consumer, stands the dis-
tributer. The wholesaler^ in the field of commodities, and
the banker, in the field of securities, occupy similar positions.
The business of the private banker has assumed great im-
portance in recent years. At one time it was thought that
the function of distributing securities to the public might be
taken over by the commercial banker who would buy from
114

THE SALE OF SECUEITIES 115

the corporation and sell to his own depositors. A number of
the larger banks and trust companies ha:ve gone so far as to
establish bond departments. But while there is a certain
amount sold by commercial banks to depositors, for the most
part through their bond departments, as a rule banks dispose
of such bonds as they may purchase, in the general investment
market, making no special effort to interest their depositors,
on whose funds they can make a larger profit by lending
them in the ordinary course than by using them in the pur-
<hase of bonds. It is now admitted that the bond business,
as a branch of mercantile industry, does not belong to the
commercial bank, and it is properly left to a special kind
of financial institution.

The investment banker on his part, however, may advan-
tageously carry on certain departments of the business of the
commercial bank. The investment banker offers investment
securities suitable to the needs of various classes of investors,
furnishes to investors free of charge accurate information on
securities, receives accounts subject to check, and allows inter-
est on daily balances, collects and remits dividends and inter-
est; negotiates collateral loans for various classes of borrow-
ers, executes orders for the purchase, sale, or exchange of
securities on the stock exchanges; and, in some cases, carries
on the business of foreign exchange. The investment business
is, however, the primary function of the private banker. To
this all his other activities are subordinated.

The private banker organizes his business on the lines of
a jobbing house. He has a large number of present, prospec-
tive or potential customers on his list sometimes running into
the thousands. He circularizes these customers at intervals
with letters and circulars, follows up all inquiries with at-
tractive prospectuses, and also brings the merits of his wares
to the attention of the buyer by means of public advertise-
ments. The investment banker enjoys special advantages for
the financing of his business. So far as possible, he aims
to make his sales and purchases coincide. In an active bond
market, it is not unusual that a large issue should be sold

116 COEPOEATION riNANCE

before the banker is obliged to make his final payment.
When a stock of securities is to be carried, however, the
investment banker employs his established lines of credit with
banks and trust companies, pledging the securities which he
is holding as collateral for loans on various margins of secur-
ity, depending on the quality of the bond or stock pledged
and the conditions of the loan market. By the liberal em-
ployment of his credit, he is able to do a large business with
a comparatively small capital. A bond house with a capital
of $500,000 is a very substantial institution of its class.

These investment bankers stand ready to purchase the
securities of corporations for cash. The prices which they
will offer are, of course, below those which they expect to
receive, the margin of profit demanded depending on the
salability of the security, and the salability usually depend-
ing on the quality determined from an investment standpoint.
The question now arises, shall the promoters of the new cor-
poration sell the securities to bankers, or shall they offer
them direct to the public? This question can be answered,
without serious qualification, and with few exceptions,' in
favor of dealing with the banker.

There are great advantages to a corporation in placing
its securities with investment bankers. The cost of obtain-
ing the required capital is definitely determined in the bank-
er's contract. If the bonds are to be sold at $85, or $90, or
$93^, the exact amount of money which will be received from
these bonds is known. The money, moreover, will be paid
at a definite date, so that the syndicate need have no uncer-
tainty about recovering their advances and repaying their
loans. The cost to the corporation of selling securities to
bankers is also much less than if sales are made direct to-
the public, and the certainty of return is far greater. The
banker, as we have seen, has a permanent organization and
an established clientele of customers. This organization is
constantly employed in marketing securities. Established
banking houses of good reputation have a large number of
customers who will buy from no one else. They can count

THE SALE OF SECUEITIES 117

on a certain amount of money from .these customers at reg-
ular intervals, which will be spent on the securities which
they offer. They are also able to make a market for new
securities, for which the demand may be weak at the outset,
by exchanging these new bonds on a favorable basis for sea-
soned bonds of long standing, which their regular customers
have purchased in the past, and for which a ready market
exists. With a large number of satisfied customers with
whom the banker is in constant touch, new issues of secur-
ities can be quickly sold by exchange, when direct sale would
be impossible. Bankers, moreover, are not obliged to force
a market for the securities which they purchase. They can
utilize their credit to carry stocks and bonds until a favor-
able season arrives for selling them.

A corporation engaged in the mining of coal or the opera-
tion of an interurban electric railway has none of the equip-
ment for selling securities. If it desires to sell bonds direct
to the public, it will be necessary for the company to con-
struct a selling machine for the express purpose, and since
it cannot keep this organization together after the necessity
out of which it originated has passed, its cost will be excessive.
It must rely on newspaper advertising to discover its custom-
ers, and newspaper advertising is an expensive method 6f
selling securities. The corporation, while it might have a
good credit for the purposes of its own business, would have
great diflSculty in establishing a credit with whidiTi. to finance
its venture into the security business. The same banker
might look with favor on a proposition coming from an in-
vestment banker to lend money on the securities of a cor-
poration, which that investment banker had purchased for
sale, and might look with extreme disfavor upon a proposition
to lend on the same securities offered by the corporation
direct.

There is no certainty, when the securities are offered direct
by the corporation, as to the cost of selling. The usual method
will be to turn the work over to some advertising agency
which would undertake, without any guarantee of results, to

118 COKPOEATION TINANCE

sell the securities on the basis of a certain percentage of the
proceeds. In some cases, this percentage would run as high
as forty per cent, and the selling campaign might, at that,
have to be abandoned before half of the securities were dis-
posed of. From every standpoint, the attempt of a company
to market its securities direct will be likely to prove unsatis-
factory and unsuccessful. The cost will be excessive, the
results uncertain, and the risks great.

But while sale to a banker is advantageous to the com-
pany, bankers will not purchase every kind of security. They
sell to investors, and the securities which they offer must be
such as will appeal to their customers. We may distinguish
between investment securities and speculative securities. Both
the investor and the speculator are so called because they
buy stock or bonds of companies which are the owners of
productive properties. By means of the corporation which
divides its stock or debt into shares or notes of $50, $100, or
$1,000 each, and which is managed by ofiBcers elected by
trustees whom the stockholders select, an individual can be-
come a part owner, or a part creditor, of as large a number
of corporations as his capital will allow, without identifying
himself in any way with the management of any of these
corporations. He has no concern in their affairs, save to
receive out of their earflings his dividends or interest, or to
increase his capital by selling his stocks or bonds should their
price be advanced. Broadly speaking, there are two kinds
of enterprises, and two kinds of securities which these enter-
prises may issue: Those which have been in existence a suf-
ficient time to enable their earning power to be conclusively
demonstrated; and those which have not yet demonstrated
their earning power, either because they exist only on paper,
or because their operations have, as yet, been unsuccessful.

Examples of investment stocks are furnished by such com-
panies as the Pennsylvania Eailroad, the Chicago and North-
western, the Norfolk and Western, among railroads; the
Cambria Steel Company, the Standard Oil Company of New
Jersey and the General Electric Company, among indus-

THE SALE OF SECURITIES 119

trials ; the Boston Elevated and the Chicago City Railway
Company, among street railways; the Calumet and Hecla
among mines. An examination of these stocks shows the
following characteristics : Each of these companies operates
an established business, supplying articles or service for
which there is a steady demand, and where the processes of
the industry are standardized and thoroughly understood.
Each one of these companies is efficiently managed. Their
costs of production are low, their selling methods are et
ficient, and their financial management conservative. Each
one of these corporations has been profitable for many
years. In good times, as well as in periods of depression,
their net profits have been far more than sufficient to pay
their operating expenses and their fixed charges. Each one
of these companies has a record of dividend payments. The
directors have dealt fairly with the stockholders in paying
to them such part of the profits as could be safely distrib-
uted. Anyone who buys the stocks of these companies
knows that profits will be earned, and that he will receive
as large a part of these profits as can be prudently paid.

We have here the requisites of an investment security:
an established business, efiicient management, assured profits
and a conservative distribution of profits to stockholders.
If any of these characteristics are absent from a security, it
is not entitled to be called an investment, because there is
no guarantee to the investor that the income, on the basis
of which he buys the stock or bond, will be permanent.

A speculation is illustrated by the stock of The Consoli-
dated Oil Company. This company controls 130 acres of
land in the Coalinga district of Southern California, touch-
ing so-called "proven land," that is land in which paying
oil wells are in operation. This company ofEers a portion of
its capital stock for sale at one third of its par value. " With
the proceeds it is proposed to drill a well and it is practically
a certainty that we will have at least a 500 barrel well within
a few months. If you have carefully read this book you will
understand that the profits from this one well should drill

120 COEPOEATION FINANCE

two more and leave some money over for dividends. Then
these three should produce enough to drill sis more, and so
on up to about twenty wells, which the company should have
in two years. These twenty wells, remember, will be drilled
with profits after the first one, and should make the company
over $1,000,000 profits per year." The directors and pro-
moters of this company are not known as men who have been
successful in the oil business, and no representations of their
previous experience are made in the prospectus. That their
means are limited, is shown by the fact that, instead of tak-
ing advantage of this golden opportunity themselves, they are
forced to appeal to the public to supply the means of develop-
ing their proposition. Here are all the elements of a specu-
lation, an enterprise which may or may not be successful.
Oil is being produced in California at a profit. The property
of this company, if its representations are to be believed, is
near the oil reservoir. If oil is discovered, it is probable that
it can be produced at a profit. So much can be said in
favor of the proposition. On the other hand, there are several
unfavorable considerations. Oil may riot be found, or if it
is discovered, the flow may cease after a short time. The
company may not be able to store or transport this oil. The
officers, even though honest, having had no previous experi-
ence, may prove incompetent. They may involve the com-
pany in obligations whose maturity may destroy the value
of its stock, or they may fritter away its funds. The Con-
solidated Oil Company is an illustration of a type of specu-
lation where the company has not yet come into existence,
where its future is wholly problematical.

The AUis-Chalmers Manufacturing Company was in-
corporated in 1901, as a consolidation of companies manu-
facturing heavy engines, mining and other machinery. This
company has $26,000,000 of common stock and $16,500,000
of preferred stock. On the preferred stock seven per cent
was paid from July, 1901, to February, 1904. Suspended
dividends were resumed in 1917. No dividends have been
paid on the common stock from the beginning. Here, the

THE SALE OF SECURITIES 12]

separate concerns which were mergecj into this company
were profitable, and they have continued to be profitable.
The anticipated increase in profits, as a result of the combi-
nation, was not, however, sufiScient to permit the directors
to pay regular dividends on the' stock, which represented a
large increase over the combined stock of the merged com-
panies. The AUis-Chalmers Manufacturing Company may
some time prove to be an investment, but the earnings up
to the present time have not been sufScient to warrant the
maintenance of regular dividends on its preferred stock,
and the common stock is apparently a long way off from a
dividend. The stock of the AUis-Chalmers Manufacturing
Company illustrates a type of security in which the busi-
ness has not been as profitable as was anticipated, and
where dividends could not, therefore, be maintained.

The stock of the Westinghouse Electric & Manufactur-
ing Company is issued by a company which, while profit-
able, and while paying dividends for many years, was yet
so badly managed as to be forced into bankruptcy. The
stock of this company cannot, therefore, be considered as
an investment. Although the management was changed, a
long period of successful and conservative operation must
elapse before the company is completely reinstated in the
confidence of the investor, when its securities will be fully
acceptable.

The Anaconda Copper Company and the American
Smelting & Refining Company are corporations which have
paid out the greater part of their earnings to their stock-
holders. In times of prosperity, these stocks sell at high
values because of this policy of liberal distribution. During
a period of depression, dividend payments are greatly re-
duced. These stocks are, therefore, regarded as speculations.

"We see from a comparison of these illustrations, that the
characteristics of a speculative security are the exact oppo-
sites of the distinguishing features of an investment. If a
company is a new enterprise, or if the efficiency of its man-
agement is doubtful, or if it has not yet come into a stage of

122 COEPOKATION FINANCE

profitable operation, or if, as happens in rare instances, it
has made profits and has not distributed them to the stock-
holders, or finally, if it has paid out too large a percentage
of profits so that it has been obliged to suspend dividends
when earnings declined, its stock must be regarded as specu-
lative.

Between the best class of stock investments, of which the
stock of the Pennsylvania Eailroad is an illustration, and
the stock of The Consolidated Oil Company which stands
at the bottom of the list, there are degrees of difference,
and it is difficult to sharply divide the sheep from the
goats. For our present purpose, however, which is to examine
the different methods of selling investment and speculative
securities, it is sufficient to characterize as investments those
enterprises which have already succeeded, or whose success
can be confidently predicted from the experiences of similar
enterprises operating under conditions generally identical,
as for example the introduction of a street railway in a town
of 50,000 people, and to distinguish from these, as specula-
tive securities, stocks and bonds of enterprises whose success
lies in the future. The distinguishing characteristic of a
speculation is the fact that its value depends upon circum-
stances which cannot be known because the future is needed
to reveal them. An investment on the other hand contains
no "ifs" or "provideds" or "believes," its value is founded
upon certainty. The value of a speculative security is built
upon the unstable foundations of probabilities and sup-
positions.

These two classes of securities correspond broadly to the
characters of the people who buy them. The stocks and
bonds of established companies, where success is certain, are
purchased by investors, speculative securities by speculators.
The investor will not buy a security whose value is in any
way doubtful. He demands in a stock or bond, before any-
thing else, the virtue of stable value. He must be reasonably
certain that his principal is safe, that he can, at any time
in the future, disregarding the occasional fluctuations of the

THE SALE or SEOUEITIES 123

market, sell his stocks or bonds at or near the price he paid
for them. If this assurance of safety of principal and cer-
tainty of income can be given him, he is satisfied with a
moderate return.

The most important investors in the United States are
the financial institutions, insurance companies, trust com-
panies, banks and large estates. These institutions demand
safety before every other consideration. They are vrilling
to pay high prices for stocks and bonds where the assurance
of safety can be given. Besides these institutions, the char-
acter of whose investments is determined not merely by
prudence but by law, there are a great majority of the
wealthy and well-to-do people of the country in the invest-
ing class. Their chief concern is to keep what they have.
They demand of the securities, into which they put their sur-
plus income, the highest degree of safety and stability, the
most complete guarantee of security.

The investor will buy government bonds, well-secured rail-
road bonds or guaranteed stocks of railroads, municipal bonds,
bonds of street railways, electric light or gas companies in
large cities, and the best grade of railroad, street railway or
gas stocks. Of later years, with much diffidence and hesita-
tion, he has gone into industrials. The preferred stocks of
some of the large concerns are now extensively held by con-
servative investors. The stocks of new industrials, and of
oil and mining companies he usually lets alone. This invest-
ment demand, concentrated upon a portion of the securities
offered for sale, fixes the value of every investment, no matter
how high may be the return upon its face value, at a figure
which will allow to the purchaser only a small return upon
the money invested. There are few safe investments offered for
sale on the New York Stock Exchange whose price when com-
pared with their yield in interest or dividends, shows a return
of more than six per cent.

When the investment banker is approached by the pro-
moters of a new enterprise, and asked to assist in the flota-
tion, he examines carefully the character of the scheme. The

124 COEPOEATION FINANCE

first thing lie demands of the securities which are offered to
him, is that they shall be salable. Unless he can sell them
at a profit, he will have nothing to do with the scheme.
Assuming that the securities are salable, the next question
is, can he recommend them to his own customers? It must
be remembered that the relation of the investment banker
to his customers is a fiduciary relation. He is a wholesaler
of securities. By an extensive organization, covering some-
times many states, he keeps in touch with funds offered for
investment. He has classified in his catalogues the names,
sometimes, of many thousands of people who buy securities;
he knows how much money they have to invest and when
this money will be available. He has an organization of
salesmen who make regular visits to his customers, and he
carries on an extensive correspondence with them to influence
their purchases. This business the investment banker expects
to be permanent. If he sells a bond, matiiring in ten years,
he has a record of that sale, and when the bond is paid off,
he expects to be on hand with a new bond to take the place
of the old one. He aims to cultivate, therefore, by every
means in his power, the good will of his customers. The
basis of that good will, the foundation upon which his busi-
ness must rest, is the investment quality of the securities
which he offers for sale. In his literature and through his
salesmen, the banker lays primary emphasis upon the safety
of the securities which he offers. He recommends them to
his customers, and ordinarily he has bought them himself,
before he offers them for sale. His constant endeavor is to
protect his customers against loss. He will carry these ef-
forts, in some cases, so far as to repurchase bonds concerning
whose security there may be a doubt, or to undertake at con-
siderable expense and trouble, the work of reorganizing bank-
rupt companies whose bonds he has sold, so that they may
again be put upon a solvent basis.

A man in such a business as this cannot recommend specu-
lative bonds or stocks to his clients. He might indeed sell
a large amount of doubtful securities during a period of

THE SALE OF SECUEITIES 125

good times which would be bought from him by his clients
because of their confidence in him, but when depression over-
took these shaky enterprises they would go down, and witly
them would go the good will of the banker's business. A
long record of successful flotations is not sufficient to protect
a banking house against the discredit of offering and recom-
mending securities which are not good, and whose quality
could have been revealed by an investigation.

An illustration of the caution displayed by reputable
financial institutions in standing sponsor for new and untried
companies, so far as to recommend their securities, is fur-
nished by the following letter received in answer to an inquiry
concerning the merits of a Mexican mining proposition which
had announced that subscriptions to its bonds would be re-
ceived at a prominent trust company, large use being made
of the trust company's name in the advertisements. The
inquiry addressed to the trust company was as follows :

Dear Sirs : I have received certain information on

the proposition offered by the . These

reports are extremely interesting, and I have given
them careful attention. I should like, however, to
have your own opinion of the merits of the debenture
bonds as a safe investment.

The Corporation , by its Vice-President, Mr.

, has heartily recommended them, and I presume

you will have no hesitation in confirming his state-
ment that he believes them to be a safe and profitable
investment.

The reply of the trust company is as follows :

Dear Sir : We have your favor of the 18th inst. In
reply thereto would say that following our invariable
policy, we regret our inability to advise you in the
matter of the investment referred to. Our duty is
merely to receive such subscriptions as may be ten-
dered on behalf of the , and

we have been selected to countersign the bonds. The
parties interested in the matter have come to us prop-
erly recommended.

126 COEPOEATION FINANCE

The statements contained in the advertisement and

circulars are the statements of the and not

of this Company.

Yours very truly,

(Signed) ,

Second Vice President.

If the securities of the new company are of a speculative
character, it is evident that the banker cannot purchase them
directly and offer them as his own property to his customers.
He can, however, insure or guarantee their sale. The trust
company just mentioned could have been interested in these
bonds at its own risk, or by lending to officers and directors
on the security of the bonds, without openly indorsing them,
unless the use of its name as the depositary of the mining
company may be regarded as an indorsement.

CHAPTER X

THE SALE OF SPECULATIVE SECURITIES

If the securities of a new eorpoiation cannot be sold to
the banker for resale to the investor, they must be sold di-
rect to the speculative public. This is composed of persons
of moderate or small means who are willing to buy the
shares of new companies at low prices, trusting in the repre-
sentations of those who have stocks to sell, that these stocks
will pay large dividends and eventually increase in value.
The speculative buyer has usually no knowledge of finance.
He does not understand the nature of an investment judg-
ment. He thinks of a stock as $100 and regards its divi-
dends as certain and permanent. He has no skill in offset-
ting advantages with disadvantages. "With him a security is
either good or bad. There is no halfway point. If the syn-
dicate manager had set before him all the materials for an
investment judgment of the trust proposition, he could not
have made such a judgment. If, moreover, the difficulties
and uncertainties which deter the investor from buying
trust stocks had been presented to the speculative buyer, he
would have been frightened away. If these negative con-
siderations are not presented, however, he will not ask for
them nor will he suspect their existence. Great care must
therefore be taken to give him only the most simple and
favorable information concerning the stock which it is de-
signed that he should buy. The "public" asks few ques-
tions— save as to the standing of the officers and directors
of the new company, for they naturally do not want to be
robbed, and the amount of dividends which is promised to
its stockholders. It is from this class of buyers that a por-

127

128 CORPORATION FINANCE

tion of the funds which are to reimburse the advances of
the underwriter are to come.

The first step in the process of selling stock to a specula-
tive buyer is to excite his imagination. There must be
placed before him a picture of enormous wealth in which he
is invited to share. In actual existence as yet there is noth-
ing save a flat plain, a precipitous mountain, or a prospect
of monopoly profits. The speculator must furnish the
money to ascertain what lies below the surface, and if there
is anything found, to develop it. But in order that the
speculator shall advance these funds, he must be made to
disregard the present and project his gaze into the future.
He must behold, as does one in a vision, a fully equipped
mining property or oil well, and he must see himself as part
owner of this valuable property. In view of this necessity,
the general arrangement of a prospectus, no matter of what
enterprise it treats, is always the same. The project con-
tains some new feature— a new resource, a new invention, a
new form of industrial organization, oil lands in California,
copper land in Arizona, real estate on the frontier of Brook-
lyn, or options on competing plants. The development of
these resources and opportunities is to be followed by large
earnings.

The reasons for this belief are forcibly set forth in a
prospectus. The mine is either directly adjoining a fully
developed property which is paying large dividends, or the
geological indications point unmistakably to the existence of
a resource of great value. Similar enterprises in other parts
of the country have prov^ enormously profitable. The
present scheme is fundamentally identical with these enter-
prises. Therefore, the present scheme will be equally suc-
cessful.

A mass of expert testimony of this or that "professor,"
whose wealth of technical detail is most convincing, is usu-
ally added. Note, for example, the following extract from
an expert's opinion of the Monterey district: "... The
geological formation of the oil-bearing strata and extensive

SALE OP SPECULATIVE SECURITIES 129

, ( surface indications of petroleum seem to indicate the cer-
tainty of there being productive resources of oil below.
Sandstone and shale of a bituminous character seem to be
the general surface indications of petroleum. There are
apparently three anticlinal ridges extending through this
range which the oil belts seem to follow. Judging from the
croppings, the west side of the Salinas Valley contains a
vast oil reservoir. I have formed this conclusion on account
of the immense depth and thickness of the oil-bearing sands
and also the immense beds of bituminous shale." Perhaps
the "professor" has a record of success to enforce his state-
ments. He may "stake his reputation" on the success of
this last project which he indorses, and which he believes to
be "far richer than United Verde," a mine which paid
$2,924,000 in dividends in one year.

Accompanying the expert's reports will be maps and
charts showing the exact location of the property, if the
proposition is for a mining or oil enterprise, in relation to
producing mines or wells, these latter being always in the
immediate neighborhood of the land of the new company
or else "the geological formation on this claim is identical
with that found on the largest dividend paying properties
in the districts." The National and State Geographical
Surveys are dragged in to support the expert testimony.

Newspaper accounts of the "fabulous richness of the
Eootenay country," or ""Wonderful Tonppah, a Desert
Camp of Fabulous Richness, ' ' written for local newspapers,
or the more sober narratives of the metropolitan journals,
also excite the imagination of the speculator. Such news
items as the following appear in metropolitan journals:
"Nevada, January 27th — At the Tonopah camp the most
impressive things are the huge stacks of ore awaiting ship-
ment. Henry Cutting, who came into the camp early last
year with only $2.50 in his pocket, has one stack which is
estimated to be worth ,$500,000. Another man who has
been very lucky is Frank Golden, who has a great stack
of sacks of ore like a fort, which is worth $700,000."

130 CORPORATION FINANCE

*

Strongly worded testimonials may be added to the
schedule of evidence. The project is backed by substan-
tial business men, often by men of national reputation —
won in some other field — who publicly advise their friends,
as did an ex-governor of a "Western State, to "provide for
the children" by investing a few dollars in rubber certifi-
cates. The best of bank references are also given.

All this mass of skillfully arranged data leading the
mind almost imperceptibly from the known to the un-
known, emphasizing advantages to the point of exaggera-
tion, glossing over difficulties or preferably remaining
silent about them, marshaling history, science, and repu-
tation to the support of prophecy — all these specious and
forceful arguments are directed to the end of creating in
the mind of the prospective buyer a vision of enormous
wealth. It is but seldom that they fail to accomplish the
result. If it were possible, a sympathetic examination of
their literature would deceive the very elect.

Cupidity is the next passion to which the promoter ap-
peals. The stock in these companies whose prospects of
large profits are so well assured, is offered at a low price,
50 cents, $1 or $2.50, per share, some indeed as low as five
cents a share. The company issuing the stock, it is stated,
is in possession of a resource of enormous value. Only a
small amount of money is needed to develop the mine or
drill the well— "in order to facilitate the development of
the valuable lands of this company, the directors have
placed on the market a limited amount of its treasury stock
to be sold at the special introductory price of twenty cents
per share, and the company reserves"— mark this, oppor-
tunity knocks only once — "the right to advance the price
of the same without notice. ' ' After the initial expenditure,,
it is claimed, the enterprise will grow out of its own
earnings.

And its assured dividends. "Marvelous and mon-
strous" is the only phrase that adequately describes them.
It is a poor company that cannot assure the investor twenty

SALE OP SPECULATIVE SECURITIES 131

per cent on his money. Note, for example, the following:
"The value of this stock as an investment may readily be
seen when it is understood that one well producing 100
barrels of oil daily will earn four per cent on the entire
capitalization, or twenty per cent on the present selling
price of the stock." The company in question had room
for 150 wells on its property and the inference of the
prospectus is that dividends of 1,000 per cent on the in-
vestment are by no means out of the question.

If the speculator asks for conclusive evidence that these
huge dividends will be paid— let him look to the record of
other enterprises which had at the outset no better pros-
pects than that into which he is asked to put his money.
"In one instance, about one and one half years ago, $1,200
was invested in three sections of oil land in one oil dis-
trict. To-day these same lands are worth $5,000,000. In
another instance $3,200 was invested in two sections. To-
day these two sections are worth $6,000,000." Specimen
advances in oil stocks are given— for example: "The New
York Oil Company sold at fifty cents per share, present
market price $200"; or "the Home Oil Company sold at
$10 per share, present market price $5,000." Or, if the
proposition is in gold or copper mining, figures like these
are given: "United Verde once sold for fifty cents a share
and is now paying nearly 8,700 per cent on that price.
The LeRoi Mine was sold entire in 1890 for $12.50 ; it now
has a market value of $10,000,000— $100 invested in LeRoi
a few years ago is now worth $250,000 and has paid $35,-
000 in dividends. Alaska Treadwell has paid $5,000,000
in dividends and its stock has advanced 3,200 per cent,"
etc., etc. 'Evidence of this character is abundant and
effective.

If doubt is expressed as to the future demand for these
products even should they be successfully produced, the
prospectus is ready with assurance that ""the development
of California will demand all the oil that can be produced"
or "the electrical industry will continue to exhaust the

132 CORPORATION FINANCE

supply of copper. ' ' Nothing is left uncovered. Every de-
tail is attended to. A chance to draw a valuable prize is
offered at a low price.

The whole argument is summed up with convincing
brevity by a copper prospectus. "Bell telephone was given
away for board bills, yet has paid over $36,000,000 in
dividends. Calumet and Hecla went begging not so many
years ago ; its total dividends to date are over $60,000,000.
It would take a day to enumerate the instances where prop-
erties rich and great to-day were offered for a song. The
people who did buy them are rich now, and why ? Not be-
cause they were 'lucky,' but because they investigated
promptly, judged the merit of, the proposition, and acted
"while there was time. If they had waited until to-day to
buy the shares of these enterprises they would get perhaps
five per cent on their money, possibly eight, but no more.
But" buying when they did, they got all the way from fifty
per cent up to 500 per cent because they had both the
judgment to recognize the worth of the opportunity and
the courage to seize it. A thorough examination of the
details of the Arizona Copper Syndicate will satisfy any
man of judgment as to its merits. It is one of the greatest
opportunities ever given investors. Investigate it now
while the price is low."

Here are the principal inducements offered to the specu-
lator in every new enterprise. Other men have made
money in similar enterprises. "Why should not he be
equally fortunate ? He is not asked to gamble, but merely
to investigate an industrial opportunity and act as his
judgment directs. He is carried away by the prevailing
optimism of the time, and he is ready to listen to the ad-
vocates of new schemes for getting rich. Other people are
making money fast, and he is certain of his ability to do
as well as they. The appeal to his "judgment" and his
"courage" is the bit of flattery which is often decisive,
and the final outcome is that the man of small means invests
$100, $200, or $5,000 in the stock of a new company in

SALE OP SPECULATIVE SECURITIES 133

the confident expectation that from this, small investment
he will one day reap a fortune.

When once embarked on a doubtful enterprise, the
speculator is impelled by sentiment and interest to draw
others along with him. The speculator is by instinct a
promoter. He is zealous in advocacy of this project to
which he has committed his money. He urges upon his
friends the merits of the new scheme. His enthusiasm is
infectious. Others are drawn into the net by his represen-
tations, and they in turn compass sea and land to make one
proselyte. In this way the wave of speculation is set going
and sweeps through all classes of society, turning the .ac-
cumulations of years of effort into the treasuries of the
new companies.

The situation is universally familiar. A minister or a
physician has a few thousands laid by ; a woman has either
saved or inherited a small amount ; a workman or a farmer
has managed to scrape together something for a rainy day.
Such people are found by the thousands in every part of
the country. From their accumulations they draw a small
rate of return, often so small that they are constrained to
add it to the principal and do not venture to apply it to
expenditures. Four or five per cent clear gain is about
all that can be expected. Their lives are hard, monotonous,
and barren. Before their eyes is constantly flaunted the
luxurious extravagance of the wealthy leisure class. To
such people the prospectus of a new enterprise is wonder-
fully attractive. . In exchange for a few thousand it offers
them a fortune. The offer dazzles them. Their desires
benumb their judgment. The risk of the undertaking is
forgotten. Few of those who put their money into a
speculative scheme enter it with the thought of risk. The
calm balancing of chances is the exercise of a superior
order of mind. The speculator does not buy a chance, he
buys what he thinks is a fortune. He has had a vision of
a vein of ore or a great reservoir of oil. He has seen a
populous town arise around the factory in which he has

134 COEPORATION FINANCE

invested. He has forsaken the difficult paths of reason for
the flowery fields of imagination and conjecture.

The line of speculators is very ancient. In 1720 there
was printed for W. Bonham, in London, "an argument
proving that the South Sea Company is able to make a
dividend of thirty-eight per cent for twelve years, fitted to
the meanest capacities." This was one of the first pros-
pectuses ever issued, and the succession has been worthy
of its ancestor : Spanish Jackass Company, Louisiana Bub-
ble, South American Bonds, American Improvement Bonds,
English Railways, American Railways, American Mines,
South American Railways, Australian Railways, Rand
Mines, American Industrials — John Law, Hudson, Bar-
nato, Hooley, Gates, and Lawson. The line runs true.
The Jackass Company still lives.

The foregoing presents in brief outline the methods of
selling stock in an enterprise which is, on its face, so
dangerously risky as to require the most spectacular rep-
resentations and the most fiamboyant promises in order to
work the speculator up to the point of shutting his eyes
to the risk and going in on faith alone. Hundreds of these
companies are floated every year, and their promoters often
find good markets for their wares. Most of these promoters
are honest. They expect to spend a large part of the
funds intrusted to their care in the exploitation of the
resource or opportunity which they control. A minority
are fraudulent. But, one and all, they must, in order to
float their schemes, appeal to the imagination and the
cupidity, and blindfold the judgment of the people who
buy their shares. All that they can properly offer is a
chance in a lottery in which there are few prizes and many
blanks.

CHAPTER XI

PUBLIC PROTECTION AGAINST FRAUDULENT
SECURITY ISSUES

Recognizing the heavy losses inflicted upon the com-
munity by the activities of the promoters of "wild cat"
companies, a determined effort has been made by the legis-
lators of various states to abolish or abate this evil. These
efforts have taken the form of "Blue Sky Laws," so called
because of the reputed habit of the speculative promoter in
capitalizing the sky above him.

The first of these laws was passed by Kansas in 1911.
The object of the law was to guard the investor against the
numerous companies selling stocks and securities of little
or no value. The law compels all companies, persons, or
agents who desire to sell any stock, bonds, or other securi-
ties in the State to submit information to the banking de-
partment which wiU enable the department to determine
the bona fide of their investment — this includes full details
of the business basis of the proposition, a copy of all con-
tracts, bonds or instruments to be made or sold, the name
and location of the investment company, and an itemized
account of its actual financial condition, the amount of its
assets and liabilities, together with such other information
as the bank commissioner may require. Foreign corpora-
tions must file consent that actions may be commenced
against them in the proper court of any county by the ser-
vice of process on the Secretary of State, and that such ser-
vice shall be as binding as if commenced against the com-
pany itself. It is the duty of the bank commissioner to
examine all statements filed, "and if he find such company
solvent and that the proposed plan and contracts provide

135

136 CORPOEATION FINANCE

for fair, just and equitable transaction of business, and in
his judgment, promises a fair return on the stocks, bonds, '
and other securities by it offered for sale, ' ' he shall issue a
statement declaring that the said company has complied
with the act and is entitled to do business in the state.
Without the approval of the Commissioner an investment
company cannot do business in the state of Kansas and a
violation of this law is considered a misdemeanor, punish-
able by fine or imprisonment, or both. The investment com-
pany is also compelled to file with the commissioner semi-
annual statements of financial condition and such other
statements as he requires, and if they fail to do so they may
be denied the right to do business within the state. This
law has been sharply criticized and vigorously attacked by
investment bankers who considered that it placed an intol-
erable burden upon their business. In an address delivered
by W. S. Hayden, Hayden, Miller & Co., Cleveland, Ohio,
the principal objection to the law is summarized as follows :

"I thought I knew what the Kansas Law meant; but
wishing to he sure, I sent to Topeka a typical general cir-
cular of an old line bond house, and asked whether the
bonds described therein were within the purview of the
Blue Sky Law. The circular exhibited only good bonds
made up of obligations of large cities and municipalities of
moderate size and issues of highly respectable public utility
corporations. The banking department replied that these
securities could not lawfully be sold in Kansas without the
Department's advance approval. I also asked whether, in
case of such bonds as the circular described, more would be
required before approval than presentation of a copy of the
face of the bond — that being the 'contract proposed to be
sold.' To this the Department responded that the Depart-
ment must be satisfied that each security is all right, and
this necessitates submission of all the statements called for
by the law.

' ' Some houses customarily have as much as two hundred
issues represented on their lists— very many have upwards

PROTECTION AGAINST FRAUDULENT ISSUES 137

of fifty. As to each of these issues, except domestic muni-
cipals, advance submission of data and approval thereof
would be necessary. If in a list of fifty items five new lots
were acquired every day, the correspondence of a single
house with the Department would be rather heavy. If
many other States adopted the Kansas plan, the burden
would be multiplied by the number of such states. The
factor of delay must be considered. If the Department
acted very promptly, and in the ordinary ease approval re-
quired but three or four days, there would be that interval
in many cases which now require only an instant for the
transaction 'both ways.' Such a state of affairs would be
intolerable, not only to the bond house but to the investing
public. The bond house might care primarily about its own
loss or profit, but the public would be concerned about the
loss of service. As usual, the consumer would pay — the
annoyance never stops with the middleman. I have no
doubt all this is appreciated in Kansas, and I do not believe
that the technical requirements of the statute are fully en-
forced against the small number of well-established bond
houses which have Kansas customers. Such a situation
would show the common sense of the Bank Commissioner,
but could hardly be considered evidence that the law itself
is judicious. Assuming the strict enforcement of the law,
it might appear that its effect would be to turn the bond
businessr over to the banks.' However, it is safe to assume
that any house doing a legitimate business with a large
clientele will not find its business destroyed."

These Blue Sky laws were passed in a large number of
states, modeled, for the most part, on the Kansas Act. They
were promptly attacked in the United States District
Courts, and the attacks were generally successful. The
lower courts held in a number of cases that Blue Sky legis-
lation was unconstitutional, because (a) corporate securities
are subjects of interstate commerce; (b) Blue Sky legisla-
tion imposes a burden Upon interstate commerce; (c) such
legislation, since it does not lie within the powers of the

138 CORPOEATION FINANCE

individual states to pass regulations bearing upon interstate
commerce, is contrary to the Fourteenth Amendment of the
United States Constitution, being a deprivation of liberty
or property without due process of law. Therefore the gen-
eral opinion of the legal profession was that when appeals
were taken from the above cases and from several others of
a similar character to the United States Supreme Court,
the chances were ,greatly in favor of the highest Court in
the land deciding that Blue Sky laws, even as passed in
their amended forms, were unconstitutional legislation.

Two successive waves of Blue Sky legislation had rolled
up against the United States District Courts and each time
those courts had been almost a unit in holding such laws
unconstitutional. It was therefore confidently expected
that the position of so many United States judges would be
affirmed by the United States Supreme Court when these
cases were finally presented to them. The matter came be-
fore the United States Supreme Court in three cases which
were all argued in the Fall of 1916 and decided in January,
1917. These cases, although coming from various parts of
the country and involving many different phases of Blue
Sky legislation, were all considered together and the opin-
ions in all of them were written by Justice McKenna, one
of the oldest and most experienced of the Supreme Court
Judges.^ To the general surprise the Supreme Court con-
firmed the constitutionality of the Blue Sky legislation in
all of the cases, dealing with almost every conceivable
branch of the subject. The Supreme Court .took the position,
in brief, that it was not their duty to pass upon the wisdom

1 The oases in question were : Hall vs. (Jeiger- Jones Co., Hall vs.
Coultrap, Hall vs. Rose, 37 Supreme Court Reporter, page 217 (Ap-
peal from the United States District Court for the Southern District
of Ohio) (1916); Caldwell vs. Sioux Falls Stockyards Co., 37 Su-
preme Court Reporter, 224 (1916) (Appeal from District Court of the
United States for the District of South Dakota) ; Merrick vs. N. W.
Halsey & Co., 37 Supreme Court Reporter, page 227 (1916) (Appeal
from the United States District Court for the Eastern District oi
Michigan).

PROTECTION AGAINST FRAUDULENT ISSUES 139

of legislation of this character in view of the fact that
twenty-six states had decided this question in the affirma-
tive ; that the only thing which they had to do was to decide
whether the method adopted to enforce the purpose of such
legislation was constitutional or not. They decided that
such legislation was not contrary to the Fourteenth Amend-
ment, for while no person under that amendment may be
deprived of life, liberty or property without due process of
law, nevertheless the acquisition, disposition and enjoyment
of property is always subject to the regulatory powers of
the state.

Speaking of such regulation, Justice McKenna said : "It
will be observed, therefore, that the law as a regulation of
business constrains conduct only to that end, the purpose
being to protect the public against the imposition of unsub-
stantial schemes and the securities based upon them. What-
ever prohibition there is, is a means to the same purpose,
made necessary, it may be supposed, by the persistence of
evil and its insidious forms and the experience of the in-
adequacy of penalties or other repressive measures."

Another feature connected with illegitimate promotion,
which is of great interest and importance, is the system
adopted by the United States for preventing and punishing
improper, fraudulent and criminal promotion. The Fed-
eral Government is able to attack fraudulent stock selling
schemes because in almost every instance where promotion
is wrongfully carried on on a large scale the mails are mis-
used by the promoters.

Criminal operations of this kind are covered by an act
of Congress passed March 4, 1909, which is recited at length
in section 1707 of the Postal Laws and Regulations of the.
United States of America, edition of 1913. This act makes
it a crime for one who has devised, or intended to devise,
any scheme or artifice to defraud, or for obtaining money
or property by means of false or fraudulent pretenses,
representations or promises ; to place, or cause to be placed
for the purpose of executing such scheme or artifice, any

140 CORPORATION FINANCE

letter or other kind of mail liiatter, in any post-office of the
United States. The punishment therefor is a fine of not
more than $1,000, or imprisonment for not more than five
years, or both.

Very efficient machinery is provided for the enforce-
ment of the law above mentioned. There is a corps of of-
ficials, known as the United States postal inspectors, who
are charged with the duty of investigating and assisting in
the prosecution of infractions of the postal laws. These
inspectors work directly under the Postmaster General, who
is a chief inspector stationed at Washington. The country
is subdivided into nine districts for purposes of enforcing
the law, each district being in charge of a deputy chief in-
spector, while each deputy has a force of inspectors directly
under him. ' In the district in which Philadelphia is situ-
ated, which includes the states of Pennsylvania and New
Jersey, there are at present 40 postal inspectors. Bach
inspector must report daily to the deputy chief inspector,
who is his immediate superior, and in this way the depart-
ment is kept in constant touch with the work of all of its
subordinates.

When a complaint comes to the postal department that
an investor has been defrauded by means of unscrupulous
promoters, the investor is asked to furnish evidence of the
fraudulent treatment which he has received. If he satisfies
the deputy inspector that he has grounds for his complaint,
one or more inspectors are appointed to investigate the
matter, and, at the same time, the chief inspector at Wash-
ington is notified that a new complaint is pending. If; after
^ careful investigation, the department believes that the
complaint is well founded, that the' mails have been mis-
used, and that a crime has been committed, the evidence
collected by the department is submitted to the United
States District Attorney, and, at the same time, the evi-
dence is forwarded to Washington with the request that a
"fraud order" be issued against the accused promoter.

PROTECTION AGAINST FRAUDULENT ISSUES 141

The "fraud order" is one of the most potent means of
protecting the public from the speculative promoter. It
prevents the accused from receiving mail of any kind what-
ever, until it is rescinded, and this protects the public long
before the conviction of the accused promoters, if they are
eventually convicted. It should be said, in justice to, the
post-office department, that there have been few cases in the
history of the department where accusations of this kind,
when seriously made, have not been fully sustained there-
after by the action of the courts.

"With all these legal and administrative safeguards, the
work of the speculative promoter goes on. The past year,
so it is claimed by investment bankers, has witnessed the
greatest amount of "wild-catting" ever known in our finan-
cial history. The universal desire to get much for little, to
grow rich quick, and the exorbitant profits and wages
which have resulted from war-time inflation have united
to turn over to the promoters of new companies amounts of
money which run into the hundreds of millions. "It was
ever thus," and thus, so far as we can judge from the
observed facts of human nature, it will continue to be as
long as men are allowed the unrestrained control of prop-
erty and income. Legislation and efficient administration
may check obvious frauds, but they are powerless against
the colossal tribute paid by honest imagination.

CHAPTER XII
THE CAPITALIZATION OF COEPOEATIONS

The capitalization of a company is the face or par value
of its stocks and bonds. The theory of the law is that the
capital liabilities of a company equal the contributions by
stockholders and creditors.,

The considerations of practical expediency which deter-
mine the amount of preferred and common stocks and
bonds in the original plan of capitalization have been pre-
viously considered. We are here concerned with the rela-
tion of capitalization to the public welfare. There is a
general belief that many of the most serious evils of our
economic life are traceable to the excessive capitalization
of corporations, and that some plan should be devised by
which the evil of overcapitalization may be eliminated.
Senate' Bill No. 2941, introduced July 5, 1911, by Senator
Newlands of Nevada, aimed to provide for the registration
under federal authority of corporations engaged in inter-
state commerce, gives, in Section 10, a definition of over-
capitalization as follows :

The Commission . . . may revoke the registration of
any such corporation upon the ground of overcapital-
ization; that is to say upon the ground that the par
value of the total securities, including shares of stock

and all obligations running for a term of years or

more, of such corporations, issued and outstanding at
any time clearly exceeds the true value of the property
of the corporation at that time. In determining such
true value the said Commission shall consider the orig-
inal cost of such property, its present replacement cost,
its present market value, including the good will of the
corporation's business, and the fair value of the services
rendered in the organization of such corporation . . .

This definition is that currently accepted. If the face or
par value of the shares of stock and the bonds issued by a
142

THE CAPITALIZATION OF CORPORATIONS 143

corporation exceed the fair value of its property, including
good wiU, patents, franchises, and other forms of intangi-
ble wealth, that corporation is said to be overcapitalized.

Various methods are available for 'determining this fair
value. If we look on a corporation as a going concern,
operated for profit, its value can be exp'ressed as a certain
number of years' purchase of its average profits. If, for
example, a company earns an amount of $50,000 a year
for five years, and if it is operating in a business of a
temporary or extra hazardous character, such as the ex-
ploitation of a patent or a publishing business, it may not
be worth more than two or three years' purchase of its
profits, $100,000 to $150,000. A railroad company, on the
other hand, with the same profits, might sell for twenty
years' purchase, or $1,000,000.

Corporations are seldom sold for cash. The usual
method of disposing of them is to sell their stock, both
their assets and the debts secured by those assets being
taken over by the purchaser. The current or market meas-
ure of the value of a corporation is, therefore, the amount
for which its stock can be sold. If its bonds are worth
par, and its stock is sold for one half of its par value, or
$50 a share, then assuming that the capital is equally
divided between stock and bonds, the company is twenty-
five per cent overcapitalized. Its capitalization is $2,000,-
000, let us say, but the selling value of the evidences of
debt and shares of stock, the tokens and symbols of its
capitalization, is only $1,500,000. On the other hand, a
condition of undercapitalization would be revealed by a
price of $200 for the stock. A par value of $2,000,000
would, in this event, be worth $3,000,000, an undercapitali-
zation of 50 per cent. If we accept this standard of capi-
talization, the use of the terms "over" and "under" im-
plies that a company is only "properly" capitalized when
the par value of its securities outstanding equals their
market value.

144 CORPORATION FINANCE

An acceptance of this definition compels us to go 'fur-
ther and approve the practice known as "stock watering"
or more euphoniously "the capitalization of earnings." A
company pays twenty-four per cent on its stock. As a re-
sult of thesie large dividends the stock sells at a high
premium, say $350 a share on a par of $100. This com-
pany is "undercapitalized." That its stock capital may
be reduced to a "proper" basis, the number of shares
must be raised from 10,000, on which twenty-four per cent
is paid, to 40,000 on which the dividend will be six per
cent, and which, if the business is reasonably secure, may
be expected to sell around par, a "proper" capitalization.
If, therefore, we attempt to limit the capitalization of
corporations to the "fair" value of their business, and
accept the standard of selling value or market price to
determine that value, we might indeed prevent many ex-
travagant and outrageous abuses of capitalization, a result
which would be most desirable, but we should, at the same
time, sanction the practice of stock watering, the multipli-
cation of shares of stock as earnings and profits increase.

The treatment of stock watering as a method of dis-
tributing the accumulated surplus of a corporation is re-
served for a later chapter. At this point, I wish to con-
sider briefly the alleged necessity of strict regulation of
the capitalization of corporations in the interest of the
public welfare. It has been often charged that the increase
of capital without the addition of new funds is opposed
to the interests of the community for the following reasons :

(1) The corporation is obliged to pay dividends on this
extra, or "watered" stock, which results in higher prices of
product to the public than the prices which would suffice
to pay dividends on an "honest" capitalization.

(2) The payment of dividends on a capital larger than
the cost of duplicating the corporation's equipment is an
indneement to competition, which results in an unnecessary
duplication of railroads and mills.

(3) The issue of securities for which no cash equivalent

THE CAPITALIZATION OF CORPORATIONS 145

has been received, often results in the sale of large amounts
of worthless stocks and bonds to the uninstructed public.
These arguments refer to matters of great importance and
merit a careful consideration.

Every business concern, no matter on what basis it has
been capitalized, fixes its prices at the point of largest
return. A corporation is not in business for the benefit
of its customers, but for its own benefit. Its prices are not
graduated according to what the buyer would prefer to
pay, but are based upon what he can be made to pay. If
a corporation has a monopoly of a particular line, it will
fix its price at the point of maximum net return, i.e., at
that point where, account being taken of the larger con-
sumption at low prices and the decreased cost of production
with large profit, and, on the other hand, of the decreased
cost of distributing a smaller output, the net return on the
sale will be the largest. If the corporation has competi-
tors, its prices will be influenced by the quotations of its
rivals. In no case will lower prices be charged than the
self-interest of the seller directs.

The fallacy that the natural tendency of business men
is to charge a "proper price" has dominated the argu-
ment against railway corporations. They have been
charged with maintaining exorbitant rates in order to pay
dividends on watered stock although they have always, in
so far as public opinion would allow them, determined
their charges by the exigencies of competition, and by the
principle of charging what the traffic will bear. The pres-
sure for dividends has sometimes influenced a board of
directors to take undue advantage of a temporary oppor-
tunity to exact high prices or high rates; but if prices or
rates were higher than the traffic would bear, the effect of
such extortion was to reduce the profits of the corpora-
tion below the figure at which wise management would
have placed them. Railroad corporations have sometimes
been able to prevent a reduction of rates by railroad com-
missions, by making it appear that the proposed schedules

146 CORPORATION FINANCE

of rates would render impossible the payment of interest
or dividends on issues of bonds or stocks which bore no
reference to the capital invested in the road, but which
were looked upon by the courts as constituting a vested in-
terest in the hands of innocent holders whose rights must
be protected.

But although the watering of stocks and bonds may thus
have been made, at times, a means of securing a corporation
in the revenues of monopoly, by interposing an innocent
third party, the investor, between the corporation and the
public power; from the company's standpoint, it has noth-
ing to do with fixing the schedule of charges upon which the
revenues depend. The number of pieces of paper repre-
senting the ownership of a steel corporation, and which en-
title their holders to share pro rata in any disbursements
of profits which the directors may make, has no more to do
with the price of steel rails or steel billets than the number
of persons among whom those pieces of paper may be di-
vided. Both steel and oil are sold for the prices which will
produce the maximum profit, and there is no more reason
why that price should advance because the capital is in-
creased than that the capital should decrease because the
price is reduced. The same charge is made against the ex-
cess profits tax, — that the producer or dealer is forced to
add the amount of the tax to his price, thus shifting its
burden to the consumer. On the contrary, the seller charges
the most profitable price he can obtain, tax or no tax.

The claim that the existence of watered stock stimulates
competition has stronger authority to support it. Thus the
Wall Street Journal says :

Any plant which is overcapitalized and- which pays
dividends on overcapitalization, invites competition by
announcing that a competitor capitalizing his plant at
its true value can earn dividends. If there is overcapi-
talization, there is certain to be competition. ... It is
an economic law that profits in any line of business will
not continue to exceed a fair return on the capital in-
vested in the plant.

THE CAPITALIZATION OF CORPORATIONS 147

In other words, it is claimed that the competitors of the
United States Steel Corporation, for example, are encouraged
to ,press forward, by the belief that the sum of the figures set
out on the faces of the shares and bonds of that company
represents an amount in excess of its investment value.

Within limits, this opinion is well founded. An exces-
sive capitalization on which dividends are being paid is cer-
tainly a protection to outside companies. Upon this subject,
some remarks of the Iron Age on the occasion of the forma-
tion of the Steel Trust are of interest :

Probably none have greater occasion to rejoice at the
turn which affairs have taken than the outside interests.
The majority of the latter express themselves as well
pleased with the formation of the great consolidation.
Above all, they hold that a less aggressive policy will be
pursued than has characterized some of the constituent
interests, and that they will be gainers from the greater
steadiness which is sure to characterize the markets.
They frankly admit, too, that they see increased safety
to their own interests in the fact that the corporation
must provide for large fixed charges and will probably
make efforts to earn a good return on that part of their
capital which they pronounce " water." That means
that living prices must be maintained — ^prices which.
wiU give them an opportunity to make a profit on their
own investments.

In other words, the large capital of the Steel Trust would,
in the opinion of its competitors, influence its managers to
a more pacific and conciliatory policy than that formerly pur-
sued, for example, by the Carnegie Company, and would
render thera less ready to resent outside invasion of their terri-
tory. The policy of the corporation shows that this expecta-
tion was well founded, and has probably influenced the com-
petitors of the steel corporation to increase their productive
capacity more rapidly than they would otherwise have done.

Indications have not been lacking of more sinister in-
fluences of overcapitalization. In an endeavor to market
their stock, the interests temporarily in control of certain

148 CORPOKATION FINANCE

corporations have marked up prices to exorbitant figures, and
have given large encouragement to competitors. Charges have
also been made that many plants have been built for the sole
purpose of selling them out to some company which was en-
deavoring to retain control of a particular industry. These
two variants from established business practice may perhaps
be cited as further evidence that overcapitalization stimulates
competition.

But while so much may be conceded' to the theory that
overcapitalization stimulates competition, on the general prop-
osition, denial must be made. A man engages in a business
because he sees an opportunity to make a profit by produc-
ing or buying commodities at one price, and selling them at
a higher price. He does not look to the capitalization or the
dividends of his competitqrs when forniing a final judgment
as to the profit of an enterprise. Large dividends on large
capital may call his attention to the profits of an industry,
but the factors determining a change in his investment are
the conditions of the industry and the prospects of the market.

A group of men proposing to engage in the manufacture
of steel rails, for example, would take into account the follow-
ing factors: (1) The supply of raw material; (2) the labor
and superintending force; (3) the transportation facilities;
and (4) the prospective demand for steel rails. They would
next turn their attention to the position of the manufacturers
already in the field, and here the capitalization of competitors
would be considered. But the main considerations which
enter into any scheme for building competing plants — are the
factors affecting the cost of production and the demand for
the product. The dividends of competitors are not to be re-
lied on as a guide to profits. They may be concealed or
exaggerated. The foundation of conservative judgment con-
sists of the known facts of the industry.

The third objection to the method of capitalizing a cor-
poration on the basis of value instead of investment or cost
of replacement, is founded on the claim that such capitaliza-
tion leads to the issue of large amounts of worthless securities.

THE CAPITALIZATION OP CORPORATIONS 149

We may admit that the method of capitalizing earnings gen-
erally employed in the United States has often resulted in
deluging the speculative public with the stocks and bonds of
new enterprises whose prospective earnings are seldom real-
ized. The evils resulting from these practices are generally
deplored. It must be admitted also, that the enforcement
of a law which would limit the issue of capital to the amount
actually invested in an enterprise, would have the effect of
banishing from the stock exchanges the low-priced, speculative
securities whose number is a standing reproach to our finan-
cial methods.

Suppose, for example, that the original capital of the
United States Steel Corporation had been limited to the
amount of money which represented the value of the various
properties of that corporation, and which has been estimated
by the Commissioner of Corporations at $630,000,000. Sup-
pose, now, that the capital had been divided into $315,000,000
of seven per cent cumulative preferred stock and $315,000,000
of common stock. After such a readjustment, the value of
the preferred stock would be considered safe and it would
probably sell, under normal conditions of interest rates,
around 130. The common stock would, on this basis of
capitalization, ^how average earnings of more than $100,-
000,000, out of which a 20 per cent, dividend could safely
be paid out of the profits of the current year. On the basis
of those industrial stocks which represent a conservative
capitalization, United States Steel common would sell
around 200. The effect of enforcing upon the promoters
of companies such a rule as the one suggested would place
the securities of these companies, if their management were
only ordinarily successful, upon an investment basis. Such
a result, few will deny, would be desirable.

The expediency of instituting such a drastic change in
corporation regulations, however, may be seriously ques-
tioned. In point of security. Standard Oil at 800 was not
as safe as Pennsylvania at 130. During the second six
months of 1908, for example, the price of the former fell

,150 CORPORATION FINANCE

from 710 to 449, not as a result of any lack of confidence in
the company, but because of the limited floating supply of
the stock, and the narrow restriction of its holdings. Penn-
sylvania stock, on the other hand, equally secure in its
earnings, fluctuated only 7^ points during the same period.
It is, to repeat, a question whether any great benefit is
gained by so limiting capitalization as to make shares of
stock sell at 600 per cent premium. Nothing is gained in
security. The investment interest in the company, owing to
the high price of shares, is likely to be less widely distrib-
uted, and the fluctuations in value of these high-priced
stocks are sudden and of great extent.

It is in the field of public service corporations, railroads,
street railroads, gas and water companies, that the alleged
evils of overcapitalization are most serious. We hear much of
the watered stock of our railroads, of the overcapitalization
tax of our municipal monopolies. The organs and instruc-
tors of the public have labored diligently to fix in the minds
of the voters the conviction that the overcapitalization of a
public service corporation results in a tax upon the patrons
of the monopoly to pay interest and dividends on the watered
capital. Even if the advocates of this view admit that a rail-
road or a street railroad company, no matter what its capital-
ization, will make all they can out of their business, and will
only regard their debt or the number of shares of their capital
stock when they come to divide their gains, the critics of
overcapitalization will still contend that by multiplying
bonds and stocks, these companies are able to conceal their
earnings, to keep the public in ignorance of what they
are making, and in this way to safeguard their ill-gotten
gains.

This opinion is erroneous. It is true that in many in-
stances the stock or bonds of a company have been increased
in order to keep a more or less supposititious " public " in ig-
norance of its real earnings; or to invoke the aid of the law
against proposed reductions of rates of charge, on the ground,
already mentioned, that the enforcement of the new tariffs

THE CAPITALIZATION OP CORPORATIONS 151

would result in injury to the innocent investor. This has
been particularly true of street railway and gas companies,
where a uniform charge invites a reduction of rates by act
of the legislature. This is, at best, however, a recourse of
doubtful value. If, in the opinion of the court, the public
policy demands a reduction of charges, the chances are that
the bondholder will have to take the consequences.

A holder of stock in the American Sugar Refining Com-
pany could not successfully plead his "vested interest" in
opposition to a proposal to remove the differential on refined
sugar; nor could a holder of People's Gas or Interborough
Company, have much hope of success in a plea against a reduc-
tion of his dividends by some act of the municipal legislature.
As a rule, the public policy will prevail with the court, and
while care will always be taken to allow a fair return to capi-
tal, and while the court will be especially careful not to force a
company into bankruptcy by approving a reduction in rates
which would make the payment of interest impossible, if it
came to an issue between public interest and private property,
the latter must give way. Although such appeals for the
protection of vested interests have been successfully made, no
well-informed investor would pay for the bonds — for example,
of a gas company, where the charges were threatened with a
reduction by act of the legislature — a price which would ex-
press his conviction that a court would be influenced by some
such argument as that described, to declare the reduction
unconstitutional. Stock watering is no reliable defense
against legislative attack.

The question of the reasonableness of rates, from the point
of view of the investor's interest, has been frequently raised
in suits brought to restrain the reduction of rates by railroad
commissions. The United States Supreme Court, while ad-
mitting that the investor's rights should be considered, has
gone on record as upholding the interests of the public to
be paramount to any other interest. The most forcible ex-
pression of this view is contained in the opinion in the Ne
braska Maximum Freight Rate case :

152 COEPOEATION FINANCE

The rights of the public, said the court, would -
be ignored^ if rates for the transportation of persons or
property on a rkilroad are exacted without reference to
the fair value of the, property used for the public, or
the fair value of the services rendered, but in order sim-
ply that the corporation may meet operating expenses,
pay the interest on its obligations, and declare a divi-
dend to stockholders.

The principles underlying the regulation of the rates and
prices of Public Service Corporations have been finally settled
by a line of decisions in the Federal courts. These com-
panies are entitled, irrespective of the amount of their debt or
the number of shares into which their capital stock may be
divided to a " reasonable return " on the " fair value " of their
property. The leading recent case which illustrates and eon-
firms this principle is that of William E. Willcox, et al, consti-
tuting the Public Service Commission, etc., of New York, vs.
The Consolidated Gas Company of New York. This case was
decided by the United States Supreme Court on January
4, 1909.

The New York legislature and the Gas Commission of
New York had ordered that after May 1, 1906, eighty cents
per thousand feet should be the maximum price charged for
gas in New York City. The Consolidated Gas Company had
resisted the order, and had obtained from the United States
Circuit Court for the Southern District of New York, an in-
junction restraining the defendants, who had succeeded to
the Gas Commission, from enforcing the provisions of the
act on the ground that the eighty cent rate would not yield
the Consolidated Gas Company a fair return on the value of
its property, and that the act establishing that rate was, there-
fore, in violation of the Federal constitution. It was not con-
tended that the new rate would reduce the company's dividend
rate, but the objection was that the " net income " would be
reduced below what was "reasonable." The method em-
ployed by the Master in Chancery, to whom the ease was re-
ferred for ascertaining the "fair value" of the property of

THE CAPITALIZATION OF CORPORATIONS 153

the Consolidated Gas Company, was to End the cost of repro-
ducing its physical plant $47,000,000, and to add to this sum
$12,000,000 as the value of its franchises, its right to do
business in New York City. This value of franchises was ar-
rived at by adding to $7,781,000, which the defendant cor-
poration had paid for these franchises in 1884, the same pro-
portionate increase that the value of the tangible property
in 1905 showed over the value in 1884.

The Supreme Court rejected this method of valuation.
It accepted the original franchise value of $7,781,000 since
the Consolidated Gas Company had taken them over at that
figure. It accepted also the value of $47,000,000 for the
tangible assets which had been taken by the lower court-.
The Supreme Court, however, rejected the increase in franchise
value as entitled to any consideration, taking the position that
the increase in the value of the franchise was due to the high
rates which had been charged, and that the Company had no
right to presume that it would be left free to charge these rates
in the future. The Supreme Court has declared that the
property of a corporation on which it is entitled to charge rates
which will yield it a reasonable return, includes its physical
property at the reproduction value, plus any franchises which
it may have purchased. It is impossible, in the light of this
decision, for a stockholder to set up the plea of vested interest
against a reduction of the rates charged by the company in
which he has purchased stock. All that the investor can
be assured of is a reasonable return on the "fair value" of
the property which his company owns. The Supreme Court,
in the same decision, has established a fair rate of return on
the property of the Consolidated Gas Company. Owing to
the security of earnings offered by this monopoly, this " fair
rate " was declared to be six per cent. Applying the six per
cent rate to the ascertained value of the "tangible property" in
which the Supreme Court made a slight reduction, and allow-
ing for the increased consumption due to the lower price of
gas, the eighty cent rate, it was found, would yield a net rev-
enue of at least six per cent on the fair value of the property.

154 CORPORATION FINANCE

In the Minnesota" Rate Cases, the Circuit Court accepted
the cost of reproduction as the method of determining the
fair value of the property, and applied to this a seven per
cent rate as that to which an investor in the railway busi-
ness.—more hazardous than the business of supplying gas
in a large city— was properly entitled.

In neither case were the rights of the stockholders to
receive a given rate of dividends on their stock regarded by
the court. The stockholder has no right to dividends which
can be pleaded against the public interest. The corporation,
as distinct from its creditors and stockholders, has a right to
a reasonable return on the fair value of its property em-
ployed in the public service. The income which represents
this reasonable return the company can divide according to
its pleasure. If, for example, the fair value of a railroad
company's property is $100,000,000, a reasonable return
would be $7,000,000. Assuming an equal division of the
capitalization between stock and bonds, and that the bonds
bear four and one half per cent interest, $2,250,000 would
be devoted to interest and $4,750,000 to dividends, or at
the rate of 9.5 per cent on the stock. Now, the company
might double its stock capital, raising it to $100,000,000
and on this it could pay 4.25 per cent, or it might cut its
stock capital in two, reducing it to $25,000,000, on which
the dividend would be nineteen per cent. This apportion-
ment of the company's income would be no concern of the
courts, although the Public Service Commission of a state
might exercise authority over it, as in New York and "Wis-
consin, or the Interstate Commerce Commission under the
Esch-Cummins Act, by which issues of capital are closely
restricted. All that the Federal courts are concerned to
do, however, is to protect the public against exorbitant
charges, to limit the income of public service corporations
to what is fair and reasonable Questions of capitalization,
over or under, as the case may be, do not concern them.

Public opinion will not permit stock watering by public ser-
vice corporations. The report of the Hadley Commission con-

THE CAPITALIZATION OF CORPORATIONS 155

tains the following statement of principle which, however we
may individually dissent from it, we must recognize is, in fact,
almost the law of the land, so firmly is it bedded in public
opinion.^

Scrip, bond and stock dividends should be pro-
hibited. They are commonly justified on the theory
that the company has in times past put earnings into
the property which it. might have divided among the
stockholders, and that the scrip dividend merely reim-
burses the stockholders for what they have put into the
road. But these sums were put in, either to make de-
preciation and obsolescence good, or as actual additions
to the property. In the former case the capital account
ought not to be increased. In the latter case any such
increase gives color to the claim that the shippers have
been taxed to pay for the improvement of the prop-
erty, and that the stockholders have appropriated the
result. . . it is far better to let the increased value be
shown by a higher rate of dividends on the existing
shares of stock, instead of by-an addition to their nom-
inal amount.

Thig conclusion, as we shall see in a subsequent chapter,
is not only sound public policy, but it is sound finance. The
best companies in every line have largely abandoned the prac-
tice of stock watering. It is fraught with danger to the com-
pany, and if the practice is applied to the stock of a large
corporation prominently before the public, a stock or scrip
dividend is likely to excite unfavorable comment. As we shall
see, there are other methods, until now not subject to criti-
cism, of favoring the stockholders in the issue of new shares
of capital stock.

' Report of the Railroad Securities Commission, December 8, 1911,

p.ao.

CHAPTEE XIII
UNDERWRITING

Feaelt all public flotations require the aid of the un-
derwriter. The underwriter, as his name implies, insures or
guarantees the sale of securities within a certain time at a
price sufficiently below the anticipated market price to insure
a profit to the guarantor, it is a matter of indifference to
the corporation whether its securities are sold outright or
whether a responsible syndicate guarantees the sale. In either
case, the money necessary is provided at once by the bankers,
who mu,st look to the sale of the securities which they have
undei'WTitten or purchased, for their reimbursement.

In underwriting the securities of a new company, or in
purchasing them outright, the banker who undertakes the
responsibility of the transaction usually associates with him-
self a number of other individuals and banking houses in an
organization known as an underwriting or subscription syn-
dicate. The difference between underwriting and subscrip-
tion is that in underwriting the securities underwritten by
the banker are offered for sale by the corporation through
the banker, and in subscription, the securities are purchased
by the banker and offered by him to his o^\ti customers as
sound investments. In either case, the association which is
formed to assist him in carrying out his contract with the
corporation is substantially identical, and the two forms of
syndicate underwriting and subscription can be considered
together.

The underwriting syndicate is a voluntary and temporary
association of individuals or firms or corporations which is
156

UNDERWRITING 157

formed by a syndicate manager, usually a banking firm, to
assist them in guaranteeing the sale of, or in purchasing an
issue of stocks or bonds. The steps in the organization of
the syndicate are as follows :

The original contract is made between the banker and
the corporation, by which the banker agrees to either pur-
chase certain securities at a price, or to guarantee their sale
within a certain time, at a certain price. The corporation
usually knows no one but the syndicate manager in the trans-
action, and looks only to him for the fulfillment of the agree-
ment. The fact that the banker associates others with him-
self in the transaction, in an underwriting syndicate, is a
matter of no concern to the corporation, although the mem-
bers of the syndicate may be asked, with the consent of the
corporation, to directly assume a share of the syndicate man-
ager's liabilities.

While the syndicate manager may be a very strong bank-
ing firm, such as J. P. Morgan & Company; Kuhn, Loeb &
Company, and may be able to guarantee the flotation of a
very large issue of securities, it is usually advantageous to
organize a syndicate. Most banking houses have a definite
policy which regulates the amount of capital which they will
allot to a particular enterprise. The house, for example,
with a capital of $10,000,000 may have a rule that it will
not invest more than $1,000,000 in any one undertaking, so
that any losses which it may sustain by unsuccessful invest-
ments may be offset by the profits of those which have been
profitable. When, therefore, this banking house makes an
agreement to underwrite $10,000,000 of bonds or preferred
stock, unless it departs from its established policy of dividing
its risks, it must add to its capital the capital of its friends.

By admitting other bankers with wide connections and
large numbers of clients to share in the profits of its sub-
scription, a banking house obtains a broad market for the
securities which it has for sale and by adopting this policy
in all its undertakings it makes sure of quicker returns.
The necessity of securing a broad market for bonds or stocks

158 COKPOEATION FINANCE

is sometimes recognized in the original contract between the
corporation and the bankers by a joint agreement between
several banking houses so situated as to command invest-
ment funds in different parts of the country. A recent bond
issue of the American Telephone Company, for example, was
taken by J. P. Morgan & Company ; Kuhn, Loeb & Company ;
Kidder, Peabody & Company, of New York, and Baring
Brothers, of London. Ordinarily, the subscription would
have been offered to a New England banking house, but the
New England market was unable to absorb more telephone
securities and a broader market was required, to obtain which
the cooperation of New York and London houses was enlisted.
An Eastern house, undertaking the underwriting or pur-
chase of bonds of a Western enterprise, associates with itself,
if possible, Western bankers whose clients are likely to be
familiar with the enterprise. The syndicate is organized as fol-
lows : A contract is made between the Pennsylvania Eailroad
Company and Speyer & Company. The head of the banking
house communicates with a number of firms and individuals
with whom they have cooperated in the past. If, as in the
case cited, Speyer & Company have agreed to guarantee the
sale of $75,000,000 of stock of the Pennsylvania Eailroad
Company at 120 in return for a commission of $3,250,000,
they will recite these facts in their communications to those
whom they wish to join in the syndicate, and they will ask
each one to indicate by return mail or telegraph, the amount
of participation in the syndicate, which Speyer & Company
state they propose to form, which he desires. One house
will ask for $1,000,000, another house for $5,000,000, an-
other house for $500,000, and so on. Very few will decline
because, to refuse to participate in a syndicate when re-
quested by a house of the standing of Speyer & Company,
may result in excluding the banker from participation in
any new syndicate, and may also cost him the cooperation
of Speyer & Company in his own undertakings. After the
replies have all been received, the amounts are summed up
and either one of two xesults may be disclosed. The applica-

UNDERWRITING 159

tions for participation in the syndicate may exceed the
amount of securities which have been underwritten or pur-
chased, and they may be below the required amount. In the
second place, unless the deficiency is considerable, the plans
of the syndicate manager are not disarranged, since he ex-
pected to take a certain amount of participation in the
syndicate himself. It may also be necessary, in case his
request for applications does not meet with a cordial response,
for him to assume a much larger part of the responsibility
than he originally intended. For the most part, however,
this contingency is guarded against by offering participations
in the syndicate to such a large number of important houses
and financiers as to make it unlikely that the combined sub-
scriptions will be below the amount which the syndicate
manager considers necessary. In most cases the amount
will be largely oversubscribed. He may require only $75,-
000,000, and the sum of his applications to participate in
the syndicate may be $150,000,000.

It is now necessary for the syndicate manager to allot
these subscriptions. Since this is an association somewhat
resembling the corporation, in which the liability of the par-
ticipants is limited to the amounts of their subscriptions, it
might be supposed that everyone would stand on the same
footing, just as when subscriptions to the stock of a corpo-
ration are made. In this case, if the subscriptions are twice
the amount necessary, each subscriber will expect to receive
one half of the amount subscribed for.

With the underwriting or subscription syndicate, how-
ever, the procedure is different. This voluntary association
or temporary corporation, which is in process of organization
by the syndicate manager, is for his individual benefit. It
is a business enterprise which he is promoting. While he
requires the members of his syndicate to indicate how much
of a participation they desire, he does not guarantee to give
them all they ask for. He makes his allotment according to
his understanding of his own advantage, and he considers
nothing but his ovra interest, and the interest of the corpora-

160 COEPOKATION FINANCE

tion for whose financial affairs he is temporarily responsible.
He may assign one applicant 100 per cent of his application,
another fifty per cent, another ten per cent, and another five
per cent. No member of the syndicate is likely to be in-
formed by the syndicate manager, although he may easily
learn from members direct, how much allotment another
member has received.

The principles which govern this allotment, looking at
it from the standpoint of the syndicate manager, are as fol-
lows : In the first place, he wishes the flotation to be a success,
and he makes his allotment with this object principally in
view. A particular kind of securities will, in his judgment,
find a ready market in Cleveland. He will allot the full
amount of their applications to Cleveland bankers. If a flota-
tion of a similar character has failed in Baltimore, Balti-
more bankers will have to be content with a small share of
their applications.

On the other hand, individual financiers who were not
able to assist in marketing the bonds, or applicants for
small amounts may receive only small percentages of allot-
ment. The syndicate manager expects to be in business for
many years; he wishes to participate in underwriting syndi-
cates managed by other bankers. When he receives an
application from a banker who is himself a manager of syn-
dicates, he will give that banker what he asks for, since other-
wise he might himself be cut off from some profitable par-
ticipation in the future. Participations in syndicates, in
other words, are allotted for the sake of securing participa-
tions in other syndicates. A banker makes his allotments to
cultivate business good-will with the banks and trust com-
panies from which , he may wish to borrow money, and in
every way possible to strengthen his position and influence
by the disposition of the allotments which are entirely in his
hands.

After the syndicate manager has decided upon the allot-
ments, he sends to each subscriber a copy of the syndicate
agreement which the subscriber signs, and opposite to his
12

UNDERWRITING 161

name places the amount of his allotment. The subscriber is
then bound by the conditions of the agreement, up to, but
no further than the amount for which he has subscribed.
Provisions usually found in underwriting agreements are as
follows :

First, the subscriber agrees to take and pay for the amount
of securities for which he has subscribed when called upon by
the syndicate manager, and this agreement may be enforced
against him in the usual manner by a suit at law.

Second, he agrees that the syndicate manager shall have
entire charge of the marketing of the bonds or stock, that
he may make any and all contracts and incur any expenses
necessary to secure their sale, and that all these charges and
expenses shall be a first claim upon the profits of the syn-
dicate. An illustration of the large discretion given to the
syndicate manager is taken from the agreement between
Speyer & Company and the members of the syndicate which
underwrote the $75,000,000 stock issue of the Pennsylvania.
This agreement provided in p^rt as follows:

The managers may from time to time in their dis-
cretion purchase upon the markets shares of stock of
the railroad, or rights to subscribe for stock, and in
case of any such purchases the syndicate obligation
shall be increased by the amount thereof, and the
obligation of each subscriber shall be increased pro-
\,portionately, provided, however, that the aggregate
syndicate obligation shall not at any time be increased
by such purchases by an amount exceeding ten per
cent of the aggregate subscription price of the stock
offered to the stockholders.

The syndicate subscribers appoint the syndicate
managers their agents and attorneys, with full power
to do any and all acts expedient to perform the agree-
ment, including the repurchase and resale from time
to time for the account of the syndicate of any stock
or rights which may have been sold for account of the
syndicate, and generally such transactions in shares
and rights as they may deem best.

The syndicate is to continue in force until January

162 COEPOEATION FINANCE

1, 1904, but the managers may terminate it at any
time on notice.

Any shares or subscription rights received by the
managers may from time to time be sold at public
or private sale at such prices as the managers may
deem proper.

In case the managers shall distribute among the
subscribers any stock or rights during the existence of
the syndicate, it shall be held by the respective sub-
scribers subject to the delivery to the syndicate man-
agers upon demand, and no subscriber shall prior to
the termination of the syndicate sell or contract for
the sale of any of the syndicate stock or rights.

Third, it is usually, although not invariably, agreed that
the syndicate manager shall assign to the members of the
syndicate a certain percentage of the profits on. the trans-
action. The remainder, sometimes one fifth, sometimes a
smaller amount, is reserved as his own profit.

Fourth, the syndicate manager also reserves the right to
participate, up to the amount of his reservation for himself,
as a regular member of the syndicate.

Fifth, any member of the syndicate may, at any time
during its life, withdraw any of the securities at the price
named in his subscription.

Sixth, it may be provided that he may assign a portion
or all of his responsibility to the syndicate manager or others,
and that, with the consent of the syndicate manager, he may,
in this manner, be relieved of his responsibility.

Seventh, it may be provided that the members of the
s3Tidicate are to cooperate with the syndicate manager in bor-
rowing a portion of the price of the securities underwritten or
subscribed for, from banks, in which case their participation
may be put in the form of a negotiable instrument so that the
syndicate manager can assign it as additional security.

Eighth, the syndicate manager agrees to be responsible
for good faith in the management of the syndicate, and in
the distribution of profits, and for nothing else.

The terms of the underwriting agreement carry out the

UNDERWRITING 163

idea that this is the private enterprise of the syndicate man-
ager, which the members enter on the terms which he pre-
scribes, and which leaves him absolute control of all the
transactions necessary to carry out the purposes of the syndi-
cate. His associates in the syndicate place the whole manage-
ment in his hands. He may make or modify contracts in
the interest of the syndicate; he may incur such expenses as
he deems necessary; he may buy or sell the securities on the
market, and he is frequently authorized to hypothecate the
subscriptions of the members to provide the funds nec-
essary for his advances to the company.

A common feature of large syndicate transactions is the
organization of sub-syndicates. These differ in no essential
respect from the ordinary syndicate. They are divisions of the
responsibility apportioned by members of the syndicate among
their own friends on much the same terms and conditions
as those to which they have subscribed in the original syndi-
cate agreement. It often happens that a man will request a
larger amount of participation in a syndicate than he expects
to carry, so that he may admit some of his friends to share
in his expected profits, or he may become doubtful of the
outcome of the syndicate, and may wish to dispose of a part
or all of his responsibility to others. As a rule, the syndicate
manager does not know the members of the sub-syndicate
any more than the corporation knows the members of the
original syndicate. The ramifications of these sub-syndicates
may be very extensive. The first United States Steel Under-
writing Syndicate, which involved $200,000,000, for example,
it was understood, was shared in by almost every financier
of any importance in the United States.

After the syndicate has been organized, the syndicate
manager usually makes a call upo;i the members for a certain
percentage, often twenty-five per cent of their subscriptions.
This must be paid in cash. With these subscriptions as a
basis, he borrows the balance of the amount necessary from
banks and trust companies which may themselves be inter-
ested in the syndicate, and therefore disposed to assist him.

164 COEPOEATION FINANCE

These loans lie may make on his own security, with the
pledge of the bonds or stocks which he has underwritten or
purchased, on the certificates representing these securities,
or he may, as above described, pledge in addition the respon-
sibility of the members of his syndicate. He then sells the
stocks or bonds by the ordinary methods employed in market-
ing securities, direct to the investor, indirectly through fiscal
agents, and also by utilizing the various stock exchanges on
which the securities are listed. The members of the syndicate
may act as his agents and sell on commission.

The syndicate is organized for a certain term. At the
end of that term, if the securities are not sold, two alter-
natives are open, either the syndicate can be extended, in
which case the securities remain in the hands of the syndicate
manager, and the loans which he has made to supply the
cash to the corporation are renewed, or the syndicate is dis-
solved. The proceeds of the securities which have been sold
are then applied to paying any loans which may have been
incurred, and the unsold securities are distributed to the
members of the syndicate, according to their several partici-
pations, payment being made in cash. It is customary to
make at least one extension of a syndicate which has not
been successful during its original term, and in some cases
syndicates have been extended several times.

The method of dissolving a syndicate is illustrated by
the following letter, addressed by J. P. Morgan & Company,
managers of the S3mdicate which guaranteed the preferred
stock conversion plan of the United States Steel Corporation,
to the syndicate members.

PEEFEEEED STOCK EETIEEMENT
SYNDICATE— PINAL NOTICE

Dear Sir: Eeferring to our circular letter of Sept.
14, 1903, we beg to inform you that We shall be pre-
pared to close the syndicate account on May 17, 1904.
Tour subscription to the syndicate was for $3,750
bonds, of which amount 80 per cent was payable in

UNDERWRITING 165

preferred stock and 20 per cent in cash at par and
interest.

Having delivered to you on Oct. 1, 1903, a portion
of the bonds payable in preferred stock, there remains
still to be delivered to you the balance of such bonds,
amounting to $1,000 bonds, ex-matured coupons, ac-
counted for below :

On Oct. 1, 1903, we called from you 25
per cent of your cash subscription,
leaving still due from you 75 per
cent of such cash subscription,
which, with accrued interest to May
17, amounts to $564.18

Your share of the amount standing to
the credit of the sjnadicate on May
17, 1904, including interest at 5
per cent per annum on the portion
of cash subscription paid Oct. 1,
1903, will be $325.50

To which is added the amount of cou-
pons due Nov. 1, 1903 (7 months),
and May 1, 1904, on the undelivered
portion of bonds payable in pre-
ferred stock mentioned above.... 54.18 379.68

This leaves a balance due from you in

final settlement of $184.50

for which kindly hand us your check on Tuesday,
May 17, 1904, upon receipt of which and upon sur-
render of your certificate of participation, properly
indorsed, we shall be prepared to deliver to you all
the bonds subscribed for by you in cash, together with
the balance of the bonds payable in preferred stock,
as stated above, making total delivery to you at that
time of $1,750 bonds. Fractional amounts of bonds
will be adjusted in cash.

(Signed) J. P. Morgan & Co.

The syndicate manager may not have chosen to carry on
the operation with the proceeds of loans, and may have called
upon the members of the syndicate to pay up the full amount

166 COEPOKATION FINANCE

of their participations before the term of the syndicate has
expired. In this case, since they have all paid for the secur-
ities, the dissolution of the syndicate involves merely the
distribution of the unsold securities among the members.

In settling the affairs of an underwriting syndicate, the
syndicate manager renders no accounting to the members,
nor is any accounting asked for. The transaction is based
upon good faith, and legal guarantees are not required.
There is no instance on record where a banking house of
good reputation was sued for an accounting by members of
a syndicate which it had organized. If crookedness or sharp
dealing were attempted by a syndicate manager, even though
he renders no accounting, the fact would soon become known,
and would make it impossible for him to secure participa-
tion in future syndicates. Thus the accounting is really not
necessary in order to insure fair dealing. Furthermore, if
any member of a syndicate fails to pay for his bonds as
requested, no proceedings are instituted against him by the
syndicate manager. He is simply dropped from the man-
ager's list, and it may be difiBcult for him to obtain financial
assistance or an opportunity to participate in profitable finan-
cial operations in the future. Instances of such failure are,
however, rare. The consequences to a man's reputation are
serious, and syndicate members will strain every resource,
and will dispose of their participations even at a heavy sacri-
fice, in order to make good their word to the syndicate
manager.

Participations in underwriting and subscription syndi-
cates are sometimes very profitable. If market conditions are
auspicious, it frequently happens that the entire issue of se-
curities may be sold to the public before any calls are made
upon the subscriber. Usually, however, a portion of the
subscription is called, but if the syndicate is successful, only
one call is likely to be made. The syndicate which subscribed
$200,000,000 to assist in the fiotation of the United States
Steel Corporation, paid in $25,000,000 and received back
$65,000,000. On the other hand, the security markets may

UNDERWRITING 167

be unfavorable, owing to stringent money markets, or to
distrust of some classes of investments, and syndicates may
be left with large amounts on their hands which their
members must carry, sometimes for years, before they can
dispose of them at a profit.^

1 Underwriting is not limited to the purchase of securities. Any
financial transaction may be underwritten or insured. For example,
an exchange of bonds for stock, or stock for bonds, or the payment
of an assessment on stock or bonds in reorganizations.

CHAPTER XIV

THE DETERMINATION OF PROFITS

The financing of the new corporation has now been
finished. The money for the construction of its plant and
its working capital has been paid in. Its plant has been
completed; its organization assembled; and it is a -'going''
concern. We have now to consider the methods by which
its profits are determined. The Corporation Income and
Excess Profits Tax make it necessary for every business,
no matter under what form it may be conducted, to deter-
mine its profits. Failure to make proper returns subjects
the delinquent to severe penalties.

Of special importance, however, to the corporation is
the accurate determination of profits from the standpoint
of financial management. The partnership, or the private
corporation whose owners are in close touch with its affairs,
may tolerate a degree of laxity in the determination of
profits. If profits are overestimated and the business is
too rapidly expanded, it may be possible, by economizing
and contracting the scale of operations, to regain a firm
position. Private corporations and partnerships, more-
over, grow out of earnings. They do not appeal to the
body of investors, as the public corporation is forced
to do, for funds with which to enlarge their business.
Their stocks and bonds are not dealt in on the public
exchanges.

168

THE DETERMINATION OF PROFITS 169

, The stocks and bonds of public corporations which ap-
peal to the investor to provide them capital, are widely-
held by institutions and individuals who draw income
from these securities. This interest should be regularly
paid, and dividends should be distributed without serious
and sudden changes in their rates. These regular pay-
ments can only be counted on if the fund out of which
they are to be made is exactly determined. The securities
of public corporations, moreover, are usually listed on the
exchanges, and are bought and sold every day. A free
market for their securities is of great importance to cor-
porations. They are enabled, by this means, to obtain,
from time to time, additional sums of money for the en-
largement of their business. A primary essential to a free
market is accurate information concerning the financial
status of the companies issuing these securities. Corpora-
tion stocks and bonds are deposited in enormous amounts
with banks and trust companies as collateral for loans, and
the bank cannot lend intelligently, unless it is placed in
the possession of all essential information concerning the
affairs of the enterprise.

It is not merely necessary that their profits should be
accurately determined by public corporations, but it is
equally essential that they should be stated in simple and
intelligible form, so that the investor and the banker can,
without difficulty, reach an accurate conclusion as to their
earning power and financial condition. For a long time,
American railway companies did not recognize the neces-
sity of making such statements of assets and earnings, and
their stocks were the objects of speculation which always
thrives upon uncertainty. This condition has long since
passed away. The reports of our railroad companies, even
before the law compelled them to make an accurate deter-
mination of their profits and a full statement of their

170 CORPORATION FINANCE

financial condition, leave little to be desired. The indus-
trial corporations are more remiss in making statements
of their condition. Until the United States Steel Corpora-
tion set the example by publishing what is, probably, the
most satisfactory report of any of the large industrials,
officials of these corporations generally refused to give in-
formation, on the ground that disclosure of the condition
of their business would give an advantage to their competi-
tors. In time, however, this aversion to revealing the con-
dition of their affairs was worn away by the necessity of
obtaining a broad market for their securities, which could
not be had without some information upon which the in-
vestor could base his judgment. The reports of industrial
corporations are still, as a class, far from being as complete
as the reports of the railroads. Street railway and public
service corporations generally give even more meager in-
formation than do the industrials. Steady improvement
in the direction of publicity is, however, everywhere evi-
dent. Even if the laws do not intervene to compel full
statements of income and expenditures, assets and liabili-
ties, the force of financial opinion may be relied upon to
accomplish this result. >

It is not necessary, as corporation officials have feared,
that the amount of information which is necessary to ac-
quaint the investor with the financial condition of the
property in which he is interested should involve the dis-
closure of the secrets of the business. This may be illus-
trated by an instance related by a public accountant,
which shows the possibility of harmonizing publicity for
the investor with secrecy as to essential details with which
the investor had no legitimate concern. The accountant
was engaged to make a report on a newspaper property
which was about to be sold by order of the court. The
report was especially full and detailed, but not sufficiently

THE DETERMINATION OF PROFITS 171

explicit to suit certain persons, who requested information
as to the returns from advertising and the amount paid
for salaries. The Master in Chancery refused ^o allow this
information to be given on the ground that the competitors
would discover the secrets of the business. The accountant
pointed out, however, that by presenting merely the totals,
without mentioning individual items, this danger could be
avoided, and at the same time the investor could be fully
informed. The competitors of this paper could not have
profited from information as to the aggregate salaries paid
or the total amount of advertising receipts. What they
were concerned to discover, was the amount paid to certain
individuals on the staff, and the terms of particular adver-
tising contracts. This information, however, would have
been of no assistance to the investor, and could easily have
been dispensed with.

Recognizing the necessity, from the standpoint of the
public corporation, that its profits should be exactly ascer-
tained, and that clear and intelligible statements of its con-
dition should be made, we proceed to consider the methods
by which the determination of profits is accomplished. The
profits of a corporation may be defined as the increase in
the net worth of a corporation over a given period. The
net or present worth of a business consists of the difference
between assets and liabilities. In a manufacturing concern,
the statement of assets and liabilities of a given year might
be as follows on January 1st:

Assets Liabilities

Plant $1,000,000 Capital stock $100,000

Aeeoimts receivable . . . 500,000 Bonds secured by mort-

Materials and supplies 300,000 gage 500,000

Cash 250,000 Pay-rolls, vouchers, etc. . 200,000

Surplus 1,250,000

$2,050,000 $2,050,000

172 CORPORATION FINANCE

On December 31st of the same year, if the business had
been prosperously conducted, and no withdrawals had been
made, the statement might |be as follows:

Assets Liabilities

Plant $1,250,000 Capital stock $200,000

Accounts receivable . . . 600,000 Bonds 500,000

Materials and supplies 400,000 Pay-rolls, vouchers, etc. . 350,000

Cash 350,000 Net present worth 1,550,000

$2,600,000 $2,600,000

The results of this comparison would show in the fol-
lowing table of differences:

Net present worth, January 1st $1,250,000

December 31st 1,550,000

Increase $300,000

It appears that the net present worth, the difference be-
tween assets and liabilities, usually called the "surplus,"
has increased $300,000 during the year. The company has
succeeded in increasing its assets over the increase in its
liabilities by this amount. During the year, however, vari-
ous payments will have usually been made on account of
interest and dividends. The amount of these payments
must be added to the increase in surplus in order to ascer-
tain the profits of the year.

The profits of a business are expressed in the following
form which is used by the International Harvester Com-
pany to express the results of its business during 1908 :

1908

Total sales $72,541,771

Manufacturing and distributing cost 59,615,222

Net earnings from operation $12,926,549

Miscellaneous income 524,598

THE DETERMINATION OF PROFITS 173

Total income $13,451,147

Administrative and general expenses 520,769

Net income $12,930,378

Charges :

Total deductions $4,044,695

Net profits $8,885,683

Dividends ■ 4,200,000

UudiTided profits $4,685,683

Previous surplus 12,006,306

This form, with unimportant modifications, is used by
every corporation which makes any report of its condition.
We start with gross earnings, the product of sales or com-
modities, services or contracts, according as the business is
a manufacturing or jobbing company or a bank or insur-
ance company. From the gross earnings of the Interna-
tional Harvester Company for 1908 these sales were $72,-
541,771. From these gross earnings are deducted the cost
of running the business, maintaining the plant, and selling
the product. For the International Harvester Company,
this amount was $59,615,222. The difference between the
receipts and the payments represents the net earnings from
operation, in the above statement, $12,926,549. To this
amount must be added items grouped under the head of
the product. For the International Harvester Company,
this "other income" was comparatively small, only $524,t
598, leaving total income at $13,451,147. This company
next deducts administrative and general expenses before
arriving at the balance of net income. It is a common
practice to include administrative and general expenses
with operating expenses. Making this last deduction, we
arrive at the total net income of the International Har-
vester Company — $12,930,378. This represents the com-

174 CORPORATION FINANCE

bined earnings and income of the business during the
calendar year ending December 31, 1908.

Various claimants now appear to this income. First
comes the state which receives taxes ; then the creditor with
his demand for interest and sinking funds; then the cor-
poration demanding that its plant shall be fully main-
tained, and that provision shall be made against the day
when it is worn out; also asking money for insurance and
losses incident to the conduct of the business. There is also
the claim of the owner of property which the corporation
holds under lease, known as rentals. These deductions,
added together, make the "total deductions" by the Inter-
national Harvester Company from income, before the
owners can draw anything from the business, $4,044,695.
Deducting this amount from the net income, there was a
balance available for distribution to stockholders of $8,885,-
683. This company had $120,000,000 of capital stock
equally divided between preferred and common stock.
The preferred stock paid seven per cent dividends and
the dividend was cumulative. It is necessary, if the profits
permit, that dividends on the preferred stock should be
paid. Seven per cent on $60,000,000 of preferred stock
calls for a distribution of $4,200,000, leaving $4,685,683
for the common stock. The directors of the International
Harvester Company had recently declared a dividend on
the common stock. At the date of this report, however,
the business needed money for its development; it was not
deemed wise to pay any common dividend, and the un-
divided profits, amounting to $4,685,683, were retained in
the business. This amount was now transferred from the
income account to the surplus account, increasing the ex-
cess of assets over liabilities from $12,006,306 to $16,-
691,989.

This addition to the surplus was accomplished by an
increase in certain assets of the company and a decrease in
certain liabilities which appear in the following table:

THE DETERMINATION OF PROFITS 175

Assets

1908

Property account

Deferred charges to operations

Insurance fund assets

Finished products, raw material, etc

Material, purchased for current season . . .

Farmers' and agents' notes

Accounts receivable less contingent reserve

Oash

Total

Liabilities

Preferred stock

Common stock

Purchase money obligations ■

Bills payable

Audited vouchers, accrued interest, taxes,

etc

Preferred dividend payable

Eeserves

Surplus

Total ^

$63,680,776

189,683

400,832

33,854,933

13,832,123

25,471,132

10,840,098

9,339,055

$157,608,632

$60,000,000
60,000,000

8,286,664

4,729,387

1,050,000

6,850,540

16,692,041

$157,608,632

1907

$62,844,136
285,288

35,140,416
15,147,210
26,583,001
12,708,509

3,573,894

$156,282,454

$60,000,000

60,000,000

3,450,195

10,465,775

4,543,443

1,050,000

4,766,734

12,006,307

$156,282,454

The ]j)alanee sheet surplus represents the accumulations of
undistributed profits over a series of years. It may, in
turn, be distributed by a readjustment of the capitalization
according to methods which will be discussed in a later
chapter.

Having now defined the surplus of a corporation, we
have next to examine the sources from which these profits
are derived. We find these to be as follows:

First, income arising directly from the company's busi-
ness.

Second, premiums on the sale of stocks and bonds of
the company. *

Third, profits arising from the sale of other assets of the
company no longer needed for its business.

Fourth, profits arising from a revaluation of the com-
pany's property.

176 COEPOEATION E'INANCB

We have now to consider these sources of profits from
the standpoint of an accurate determination of their sev-
eral accounts. Gross earnings represent the receipts from
the sale of services, contracts, or commodities. These re-
ceipts are in the form either of cash or of promises to pay
cash. In ascertaining their amount, it is necessary to ex-
clude all items such as rebates to customers and cash, dis-
counts. When the business is carried on among several
departments or sub-companies, all sales between depart-
ments or subsidiary companies should also be excluded. It
is also necessary to exclude all bad or doubtful debts and
accounts.

Operating expenses are divided into two general classes :
expenses incurred in operating the plant ; and expenses in-
curred in keeping the plant in good condition. A railroad
company divides its operating expenses into five classes,
namely, maintenance of way and structures; maintenance
of equipment; conducting transportation, traffic, and gen-
eral expenses. The nature of these expenses may be under-
stood from some of the items under each classification. The
largest items under maintenance of way and structure are
track maintenance, road cleaning and ballasting, rails, ties,
buildings and grounds and track material. Under main-
tenance of equipment, the largest items are repairs of
locomotives, repairs of passenger and freight cars, and
repairs of tools and machinery. Under conducting trans-
portation, we find the following principal items:

Station service,

Road men.

Road enginemen and firemen,

Fuel for locomotives,

Engine house men,

Trainmen,

Telephone and telegraph.

The general expenses and the traffic expenses consist mainly
of salaries paid to employees and officials.

We have here illustrated the essential distinction be-
tween the cost of running the road and the cost of main-

THE DETERMINATION OF PROFITS 177

taining it. All those expenses involved in obtaining freight
and passengers, in receiving and earing for them, in trans-
porting and delivering them in safety to their destination,
are classed under the head of traffic and conducting trans-
portation. Those expenses, on the other hand, which result
in keeping the plant of the railway, its track, bridges,
stations, cars, locomotives, round houses, repair shops, in
good condition and in efficient working order, are classed
under maintenance expenses, and, for purposes of con-
venience in railway accounting, are divided into Main-
tenance of "Way and Structure, and Maintenance of Equip-
ment.

The cost of operation— in the railway field, the cost of
conducting transportation — need not further concern us.
Its principles vary with every industry, and have no spe-
cial significance for the subject of corporation finance.
The cost of maintenance, however, is a division of operating
expenses in which rules and principles have been devel-
oped of general application, and of peculiar importance,
in interpreting the financial operations of public corpora-
tions.

The maintenance of physical property involves the fol-
lowing: First, the establishment of certain standards of
physical condition which may be either printed in books of
rules or may exist only in the minds of foremen and super-
intendents ; second, the expenditure of money on labor, ap-
pliances and materials in order to keep the property in a
condition corresponding to this standard. A standard, for
example, for a railway track is a description of the track
and roadway as it ought to be, in other words, an ideal
which the Maintenance of Way Department is constantly
striving to attain, but which, while they may never fall
far below, they never quite reach. The accompanying dia-
gram gives in cross section the standard roadbed adopted
by the Pennsylvania Railroad. This diagram represents
the condition of the roadbed as it should be if it is to be
preserved at its highest efficiency. This diagram is supple-

THE DETERMINATION OF PROFITS 179

mented and explained by specifications which furnish de-
tailed direction to the Maintenance of Way Department as
to the methods which must be fpllowed in keeping the
track in repair. Some typical specifications are as follows :

1. Roadbed. The surface of the roadbed should be
graded to a regular and uniform subgrade, sloping
gradually from the centre toward the ditches.

2. Ballast. There shall be a uniform depth of six
(6) to twelve (12) inches of well-broken stone, or
gravel, cleaned from dust, by passing over a screen of
one-quarter-inch mesh, spread over the roadbed, and
surfaced to a true grade, upon which the ties are to
be laid. After the ties and rails have been properly
laid and surfaced, the ballast must be filled up as
shown on standard plan; and also between the main
tracks and sidings where stone ballast is used. All
stone ballast to be of uniform size; the stone used
must be of an approved quality, broken uniform-
ly, not larger than a cube that will pass through a
two-inch ring. On embankments that are not well
settled, the surface of the roadbed shall be brought
up with cinder, gravel, or some other suitable material.

3. Cross-ties. The ties are to be regularly placed
upon the ballast. They must be properly and evenly
placed, with ten (10) inches between the edges of bear-
ing surfaces at joints, with intermediate ties evenly
spaced; and the ends on the outside on double track,
and on the right-hand side going north or west on
single track, lined up parallel with the rails. The
ties must not be notched under any circumstances;
but, should they be twisted, they must be made true
with the adze, that the rails may have an even bear-
ing over the whole breadth of the tie. Tor all tracks
on main line and branch roads, the rules governing
the use of cross-ties shall be as follows :

a. First-class cross-ties shall be used in tracks where
passenger and freight trains run at full speed.

b. For tracks where the trains run at low

new second-class ties shall be used. For all tracks
in yards, or temporary tracks laid for construction
purposes or otherwise, second-class and cull ties, or
good second-hand ties taken out of a main track shall
be used.

Specification for Cross-ties, Revised March 24, 1902.

180 CORPORATION FINANCE

Kind of Timber.— The approved timber for cross-ties
shall be White Oak, Rock Oak, Burr Oak, Post Oak,
Locust, "Walnut, Yellow Pine or Chestnut. Other
kinds of wood will not be accepted, unless regularly
ordered and specified.

Quality and Manufacture.— The timber should be
cut in the fall and winter, say from September 1st to
March 1st. All ties must be cut from good sound liv-
ing timber, well manufactured to size and length,
straight, free from large, loose or decayed knots, splits,
shakes or any other defects that may impair the
strength and durability Of the timber for the purpose
intended; pole ties must have two parallel face sides,
hewn or sawed with the grain of the wood out of wind
or twist, and stripped of bark; square-sawed ties must
be sawed with the grain of the wood; square-hewed ties
may be made of split timber, but must be straight and
out of wind or twist. Yellow pine must be long leaf,
grown in the interior belt of Georgia, Florida, Ala-
bama or Mississippi. Yellow^ pine ties must be square,
and may be hewed or sawed; the heart should be in the
center and not more than one inch of sap, measured on
the face or side, will be allowed on each comer. All
ties must be sawed off square at the ends.

P6le ties less than six inch face, square sawed or
square-hewed ties less than seven inch face, and Yel-
low Pine ties less than eight . inch face, will be
classed as culls, and will not be accepted unless spe-
cially ordered.

c. On all running tracks where the weight of rail is
seventy pounds per yard or over, fourteen ties shall be
used to each thirty feet of track, and for all tracks in
yards and for temporary use, not more than twelve ties
shall be used for each thirty feet of track.

Line and Surface. — The track shall be laid in true
line and surface; the rails are to be laid and spiked
after the ties have been bedded in the ballast; and on
curves, the proper elevation must be given to the outer
rail and carried uniformly around the curve. This eleva-
tion should be commenced from fifty (50) to three hun-
dred (300) feet back of the point of curvature, depend-
ing on the degree of the curve and speed of trains, and
increased uniformly to the latter points where the full
elevation is attained. The same method should be
adopted in leaving the curve.

THE DETERMINATION OF PROFITS 181

d. In removing cross-ties from the main tracks, they
shall be taken out only as they become unfitted for
service, in the manner generally known as "spotting
ties," and not by entire renewals in continuous sec-
tions, and Subdivision Foremen will be held responsible
for the proper observance of this rule. It shall be the
duty of the Supervisor or his assistant to walk over the
track with the roreman and personally inspect the ties
to be renewed before he authorizes the same to be taken
out and replaced with the new ones.

Ditches.— The cross-section of ditches at the highest
point must be the width and depth as shown on the
standard drawing, and graded parallel with the track, so
as to pass water freely during heavy rains and thor-
oughly drain the ballast and roadbed. The line of the
bottom of the ditch must be made parallel with the rails,
and well and neatly defined, at the standard distance
from the outside rail. All necessary cross drains must
be put in at proper intervals. Earth taken from ditches
or elsewhere must not be left at or near the ends of the
ties, thrown up on the slopes of cuts, nor on the ballast,
but must be deposited over the sides of embankments.
Berm ditches shall be provided to protect the slopes of
cuts, where necessary. The channels of streams for a
considerable distance above the road should be exam-
ined, and brush, drift and other obstructions removed.
Ditches, culverts and box drains should be cleared of all
obstructions, and the outlets and inlets of the same kept
open to allow a free flow of water at all times.

Similar standard specifications exist for every part of
the railroad's property. It is the duty of the Maintenance
Departments to see that the property is always kept in this
condition. A variety of agencies are constantly at work to
lower these standards. The pounding of heavy trains
throws the track out of alignment, grinds the ballast to
powder, wears the rails, especially on the curves, and
loosens the spikes and fish plates. And while the locomo-
tives and ears are destroying the track they are constantly
destroying themselves. "Wheels become worn, frames loose,
paint wears off, glass is broken, boiler tubes are filled with
scale, furniture and fittings become dirty and dingy.

182 CORPORATION FINANCE

While the running of the trains is doing all this dam-
age, the agencies of nature are ceaselessly at work upon
the roadway. Rain, sun, frost and running water are
constantly wearing away the roadway. "Water seeps into
the ties around tjie spikes, carrying in bacteria and fungi,
and in time the wood decays. In the spring, when the
ground thaws, the track is lifted and wrenched out of line
and surface ; erosion is constantly filling up the ditches and
damming up water which settles around the ballast and
helps on the disintegration of the roadbed. The ballast,
from its own weight and that of the track and trains,
settles into the ground. Sunshine, wind and rain unite to
destroy paint and timbers. Frost makes rails and fasten-
ings brittle. All these manifold agencies of destruction
are incessantly at work to pull down the road below its
established standard.

The property of the railroad is also subjected to occa-
sional accidents, sometimes rising to the dignity of catas-
trophes. Streams may flood and wash away large sections
of track and numerous bridges, railway terminals may be
destroyed by fire, numerous train wrecks from collisions or
derailments are constantly occurring, destroying large
amounts of property. It is the business of the Maintenance
Department to combat these forces of destruction, and to
repair the damage which is incessantly being inflicted upon
the property of the company. The track and equipment
of a railway are the subject of constant inspection and
close scrutiny.

The work of the Maintenance Department of a corpora-
tion may be illustrated from the Maintenance and Repair
Shop Practice of the Interborough Rapid Transit Company
described in the Street Railway Journal for April 25
and May 23, 1908. This department has charge of keeping
in good condition all the cars on the elevated and subway
lines on Manhattan Island. The work is done in two shops,
one at Ninety-eighth Street and Third Avenue, and the
other at 148th Street and Lenox Avenue. These shops are

THE DETERMINATION OP PROFITS 183

equipped with machine tools, electric hoists and cranes, and
the Ninety-eighth Street shop contains in addition a brass
foundry and a paint shop. When a car needs any over-
hauling or repairs it is put into the shop, the elevated cars
at Ninety-eighth Street and the subway cars at 148th Street.
The selection of cars for overhauling is made on the basis
of mileage. For the elevated roads, it is assumed that a car
will run 65,000 miles before it needs attention. This stand-
ard has been modified for the subway cars so that each
piece of equipment in the car, and the car itself, has a
predetermined mileage which it is supposed to run before
needing attention. As fast as this mileage is reached, the
car is put into the shop and that particular part is over-
hauled. By this method the entire ear does not need atten-
tion every time it reaches the shop. In the case of acci-
dents to ears, general overhauling and complete repair may
be necessary before the standard mileage has been reached.

The nature of the work done in these shops may be
illustrated from the practice followed in painting the cars.
Painting records and records of inspection for painting
show the date the car was last in the shop, the date last
inspected, the date it should be sent to the shop, and the
class of painting for which it is due. The ears are graded
in four classes with regard to the condition of the paint:
Class A, to be burned off and repainted from the wood
up. B, to be scraped thoroughly, cut in, lettering and
striping touched up and varnished. C, sash to be removed,
burned off and painted ; otherwise same as Class B. D, car
to be scrubbed and varnished.

Inspection of cars is made on the road from time to
time, and the cars are brought in on predetermined dates
as required. When they come into the shop they are classi-
fied; their trucks are taken off to be taken to the truck
repair shop; any required carpenter work is done on the
car, all trimmings are stripped off and the sash and doors
are removed; sashes needing repairs are taken to the mill
and afterwards painted. The cars are now haulfed on the

184 COEPORATION FINANCE

shop trucks to the paint shop. "When the painting is com-
pleted they are returned to the repair shop and mounted
on their regular trucks which, in the meantime, have been
overhauled and repaired. Every large corporation follows
some such system in maintaining its plant and equipment,
although the system is not always so well worked out as by
the Interboroiigh. Every manufacturing business, no mat-
ter how small, would profit, by an imitation of the practice
adopted by these large companies in the up-keep of their
plant and equipment.

It is the custom of those corporations, whose accounting
methods are constructed along conservative lines, to charge
to maintenance not merely the cost of repairing the prop-
erty, but also the cost of all renewals due to breakages or
failures in service, and of replacements due to the substitu-
tion of some improved appliance. If the maintenance ac-
count were strictly interpreted, the difference between the
cost of new rails or ties substituted for rails or ties which
are either worn out or inadequate to carry the strain of
heavier cars or engines, might be a charge to capital ac-
count. The usual practice, however, is to call all such
expenditures betterments, and either to charge them direct
to maintenance or into some account, such as extraordinary
expenditure, created for the purpose. Such expenditures
should not be charged to capital.

A betterment expense is one wliich raises the standard
of construction. Examples of such expenditures, taking
our illustration from the railroads, are the substitution of
stone for gravel ballast, and of masonry embankments or
steel structures for wooden trestles, replacing light rail
with heavy rail, lining tunnels with brick or concrete, sub-
stituting ties treated with some preservative to prolong life
for untreated ties, fencing right of way, elevating tracks
in cities, and such like expenditures whose object is to
raise the physical standard of the property. When this
new standard has been established, it is the duty of the

THE DBTBKMINATION OF PROFITS 185

IMaintenanee of "Way Department to maintain it in the
same manner as the lower standard which it succeeds.

These betterment expenses, although they represent an
increase in the cost of the property, should not, in the
opinion of most accounting officers of corporations, figure
on the balance sheet as an addition to any asset account.
It is true that they may reduce the cost of operation. They
may even enable the company to handle a larger business,
or to handle its existing business more expeditiously and
economically. On the other hand, they may do no more
than maintain the earnings of the company at their former
level. A railroad company has always to meet competition
which may force it to reduce its rates, or to improve the
quality and cost of its service. The rates and prices of all
public service corporations are also liable to reduction by
action of the legislature or some public service commission,
and the improvements and economies resulting from better-
ment expenses may be no more than sufficient to offset the
increased cost in operation, due to higher prices or higher
wages.

The Interstate Commerce Commission and, following its
lead, the State Public Service Commissions, as they have
come into control of accounting matters, have insisted upon
the capitalization not only of additions to property but
also of all betterments, irrespective of the contributions
which these expenditures may have made to earnings. The
increase in the cost of say rails, or ties, or concrete work
over the depreciated value of what this new material re-
places must be charged, under the rules of the Commission,
to the appropriate asset account. The Commission's rule,
put into effect in 1907, related only to the asset accounts.
The companies are left undisturbed as to the rearrange-
ment of their liability accounts. Assuming, for example,
a betterment charge of $1,000,000 road and equipment
must be increased by that amount. So much the law re-
quires. On the liability side of the balance sheet, how-
ever, the amount may be added to a special account, such

186 CORPORATION FINANCE

as "Additions to property since 1907," or it may be
credited to surplus, or profit and loss. This regulation un-
doubtedly leads to an inflation of assets. No harm can re-
sult if the additions are expressed in normal form, and
the possible dariger of a corresponding inflation of stock
or bond capitalization, at least of interstate railroads, has
been removed by the control over security issues, conferred
upon the Interstate Commerce Commission by the Esch-
Cummins bill. Many state commissions have long since
possessed absolute power over security issues of corpora-
tions subject to their jurisdiction. While, therefore, noth-
ing is to be gained by the requirement that the full cost
of all betterments must be capitalized, and while the regu-
lation may result in many cases in inflating profits and in
unduly increasing tax burdens, and incidentally rates and
charges, which are based on valuation, on the other hand
the danger of inflating capital accounts by adding the full
cost of betterments is imaginary.

CHAPTBE XV
THE DETERMINATION OF PROFITS— DEPRECIATION

"Well-managed business enterprises, and especially pub-
lic corporations to whose standing and reputation, as already
explained, an accurate determination of their profits is es-
sential, make provision out of their income for impairment
in the value of their physical assets which is known as
depreciation. The life of every tool, building, machine or
structure which a company may own, with the possible ex-
ception of permanent structures, such as concrete bridges,
wharves, permanent roadway, etc., is limited. No matter how
carefully a machine may be repaired, no matter how attentive
the Equipment Department may be to painting cars and
rewinding armatures, the time finally comes when the ma-
chine, or car, or locomotive, or building is no longer fit for
use. Every piece of productive property, like every normal
individual, has a period of mature and vigorous life when
repairs are at a minimum and work at a maximum, and a
period of old age, finally ending in dissolution. This period
of useful service, in a machine as in an individual, may be
lengthened by proper care. If the individual does not ob-
serve the laws of health, if he works under unsanitary con-
ditions, or is subjected to excessive labor, his working life
is shortened. In the same way unless the machine is re-
paired when out of order, is sheltered from the weather, and
is saved from undue stresses and strains, the term of its
active life is reduced.

The termination of the active life of a machine may also
be due to the discovery of some better machine for doing the

187

188 COEPORATION FINANCE

same work. Competition forces progressive business con-
cerns to keep their plants up to date so that they can produce
articles of good quality at as low costs as their competitors.
A good illustration of this class of depreciation which is
called " Depreciation due to Obsolescence " is seen in the
rapid increase in the size of railway cars. Within the last
thirty years, these have increased from a capacity of from
fifteen to twenty-five tons to a maximum load of seventy
tons, due largely to the substitution of steel for wood in con-
struction. This increase in the size of railway ears has
rendered a large number of cars obsolete before the normal
term of their working life has expired. The increase in the
size and operative power of the locomotive has had the same
result. Numbers of engines are now doing good service on '
logging railroads and local lines which, without the improve-
ment in locomotive construction, would still be running on
the leading trunk lines.

The third cause of depreciation is changes in business
conditions which may seriously impair of entirely destroy
the productive value of properties in perfect physical con-
dition. A marked reduction in the tariff on the finer grades
of textiles, for example, would throw out of use a large
amount of serviceable machinery, and a street railway
operating under a limited term franchise which it carries on
its balance sheet as an asset, may find, as in the cities of
Cleveland and Chicago, that the value of this asset is de-
sttoyed or greatly impaired by a change in public sentiment
imposing additional burdens and restrictions upon streetrrail-
way companies.

Understanding now the regular and inevitable, as well
as the accidental and contingent reductions in the ' value of
a company's productive property, we can recognize the neces-
sity of providing in advance for its replacement. In so far
as these losses can be estimated with approximate exactness,
an accurate provision can be made. Contingent and extra-
ordinary losses, however, can only be anticipated by provid-
ing such sums as experience shows will probably be sufiicient

THE DETERMINATION OF PROFITS 189

to offset these losses, and there still remain the losses due to
such causes as change in fashion or in the tariff, against which
no foresight can provide because there is no method of prede-
termining the amount of the damage.

The losses due to depreciation, if provision is not made
to apportion them over a series of years, may fall upon a
business with such force as to annihilate it. When a plant
is new, repairs are light and replacements are not necessary.
This condition may persist for several years. In the mean-
time the management, not convinced of the necessity of mak-
ing provision against the day when their plant shall be worn
out, may have paid out all their earnings to their stopk-
holders. At the end of the fifth or sixth year extensive
renewals become necessary, machines are worn out or become
obsolete; and a reconstruction, a rearrangement, or a reloca-
tion of the plant may be necessary. If money is not avail-
able for these purposes, all that the management can do is
to issue stock or bonds and spend the proceeds, not in increas-
ing the value of their property, but merely in maintaiaing it
at its, original figure.

An illustration on a small scale will serve: A man ob-
tained a pumping contract from a railroad. The contract
ran for ten years and called for a payment of $3,000 a year.
The cost of the pump and other machinery was $5,000 and
the operating expenses $1,000 each year. The owner gave
but nominal supervision to the plant, which indeed was all
that it required, and estimated his profits at $1,000 a year
or $10,000 during the life of the contract. At the end of
the time, however, when the contract came to be renewed,
it was found that the pump was worn out, the $5,000 invested
had been lost, and it was necessary for the contractor to
raise another $5,000 for the purchase of new apparatus. In-
stead of a profit of $10,000 during the ten years, the actual
profits of the business were only $5,000. A correct account-
ing system would have required the setting aside of $5,000
in such a form as to be available at the end of ten years for
the purchase of a new pump.

190 CORPOKATION FINANCE

The accounting for depreciation is managed by building
up in the assets of the business an amount of value. Provi-
sion for depreciation is made as follows: A deduction is
made from income of the amount estimated to be necessary
in that year to provide for depreciation. This amount is
kept in the business, either being held as a bank deposit,
invested in securities, or spent in such a way as to increase
the value of the company's property, for example, upon a
new mill or a new piece of machinery. If an expenditure
is made, cash is credited, and niachinery or plant account,
or the materials or securities purchased is debited. Then
Profit and Loss is debited and depreciation reserve, appear-
ing as a liability on the balance sheet, is credited. This plan
is followed year by year, until a depreciation reserve of large
amount may be built up as a liability to the business, balanced
by various assets on which a certain amount of the income
of the company has been spent.

Now suppose that, after a term of years, since deprecia-
tion does not usually count in the early stages of a company's
operations, new equipment is necessary to replace that which
is unfit for service, or that a complete overhauling, a reloca-
tion, or a reconstruction of the plant is necessary, including
a general replacement of its machinery with machinery of
new and improved design. The cost of the reconstruction
or replacement is provided either out of the income of the
company or by an increase of its bonds or stock. The entries
are as follows: in case provision is made out of the cur-
rent income of the year for necessary depreciation; cash
is credited and the plant account concerned is debited;
then depreciation reserve is debited and plant account is
credited for the equipment thrown out. If the old ma-
chinery can be sold, cash is debited and the depreciation
reserve is credited. If the cost of replacement is too large
to be thrown upon the income of a single year, provision
for the expense is made in the following manner: The
company, we will suppose, presents the following balance
sheet:

THE DETERMINATION OP PROFITS 191

Assets Liabilities

PlanTand Equipment. .$2,000,000 Stocks $1,000,000

Cash and current as- Bonds 500,000

s«ts 500,000 Depreciation reserve .. . 500,000

Surplus 500,000

$2,500,000 $2,500,000

Suppose that $500,000 is required for extensive re-
placements and reeonstruetion, and that only $200,000 of
this amount can be provided out of the income of that
year. Resort is now had to the depreciation reserve, the
accumulations of past investment for the benefit of the
depreciation fund. The Company issues $300,000 of bonds,
increasing its debt to $800,000, and reducing the deprecia-
tion reserve by a corresponding amount. The proceeds of
the bonds together with the $200,000 taken from income,
are spent in renewing the plant. The entries are as fol-
lows: When the bonds are sold, bond account is credited
and cash debited. Then plant account is credited and
depreciation reserve is debited. Finally, the replacement
is made, plant account being debited and cash credited.
What has been done is to substitute on the balance sheet
one kind of liability for another, reducing the depreciation
reserve and increasing the amount of bonds, leaving the
surplus, the difference between assets and liabilities, at its
former figure. If the depreciation reserve is insufficient,
a part or all of the surplus may be drawn upon.

The accumulated reservations for depreciation may be
disposed of in two ways : First, they may be handled as a
fund and kept in assets which are either specifically set
aside for the purpose of making renewals, when these shall
become necessary, or kept in the current assets of the busi-
ness immediately available for use. This is the method
adopted by the United States Steel Corporation. The
balances to the credit of sinking, reserve and depreciation
funds, which are treated alike, on December 31, 1919, were

192 COEPORATION FINANCE

included in the assets of the company in the following
accounts :

Sinking and Reseeve Fund Assets

Cash resources held by lYustees account of

Bond Sinking Fund • $1,662,732.22

(In addition Trustees hold $128,710,000
of . redeemed bonds, which are not
treated as an asset.)
Contingent Fund and Miscellaneous Assets.. 10,983,420.48
Deposits with Trustees of Mortgages (pro-
ceeds from sale of property) 93,296.79

Insurance and Depreciation Fund Assets and
purchased bonds available for future bond
sinking fund requirements, viz. :

Securities $52,714,162.91

Cash 5,965,996.39

$58,680,159.30
Less, Amount of foregoing
represented by obliga-
tions of Subsidiary Com-
panies issued for capital
expenditures made .... 16,655,475.00

42,024,684.30

$54,764,133.79

The United States Steel Corporation keeps its deprecia-
tion and other funds in a form readily available for use,
invested in the current assets of its business as a part of
its working capital. If the directors should conclude that
a more definite separation of the assets representing these
various funds should be made, they could make a special
deposit of all the money, or invest it in securities which
could be used for nothing else than to provide means for
the replacement and renewals as required.

The International Harvester Company handles its de-
■ preeiation account in a different manner. The accumula-
tions in the plant depreciation and extinguishment funds
of this company on December 31, 1908, amounted to $5,-
009,844. This amount appears on the balance sheet as a
liability item under the head of "Provisional and Con-
tingent Reserves." The total amount of these reserves at
this date was $6,850,590.37. In addition, the company had
a surplus of $16,691,989.61; the two amounts together be-
ing $23,542,579.98. This sum represented the difference
between assets and liabilities accumulated out of the profits
of the business from the date of its organization. This

THE DBTEEMINATION OF PROFITS 193

accumulation was in part the result of increase in property
account, in part the result of the payment of liabilities of
which $3,173,398.21 under the head of "Purchase money
obligations" were discharged in 1908, and in part of an
increase in current assets. There is no attempt made by
this company, so far as appears in its report, to keep its
depreciation fund in any particular form of assets. As the
money is reserved, it is apparently put to the most ad-
vantageous use, either in increasing the bank balances of
■the company or its stocks of railway materials, or in paying
its debts, or in additions and improvements to its plant.
The depreciation fund of the International Harvester Com-
pany is represented by amounts invested in different pro-
ductive assets of the company without special segregation.

This method is the one ordinarily followed. Its gen-
eral adoption by those companies which maintain depre-
ciation funds has given rise to the statement often heard,
that a depreciation reserve is only a bookkeeping item
without special significance. There is no fundamental dis-
tinction between the surplus appearing on the balance sheet
and the -depreciation reserve also appearing as a liability.
Added together, they represent the total accumulations
out of income which are held in the business for the benefit
of the business. The only difference between the surplus
and the depreciation reserve lies in the fact that the former
is usually regarded as the property of the stockholders to
"be distributed to them, from time to time, by various ad-
justments of capitalization, which will be considered in
detail in a later chapter, while the depreciation reserve is
regarded as something belonging to the business, which is
-to be withheld from the stockholders to make good any
extraordinary replacements or renewals for which the cur-
rent reservations from income for the purposes of depre-
ciation will not prove adequate.

There is, of course, a limit beyond which it is unprofit-
able for a company to accumulate a fund of this character.
"When the amount of the depreciation reserve fund has

194 CORPORATION FINANCE

reached beyond the figure which in the judgment of the
directors is necessary to protect the business against ex-
traordinary accidents, it can then be treated as a part of
the surplus and distributed to the stockholders. As an
example of such a distribution, the stock dividend of the
Pullman Company, voted on February 10, 1910, was ex-
plained by the directors in part as follows: "There were
certain reserve accounts in the manufacturing department
which had hitherto been held in abeyance to meet contin-
gencies which were possible to arise (fire insurance), but
which present conditions render improbable. These items,
together with the existing surplus as shown in the pub-
lished statement of the last fiscal year and the current
results of operation, are regarded by the board as a justifi-
cation for making this recommendation." The Pullman
Company, in making these dividends, transferred certain
of its reserve to its surplus account, and then substituted
for a portion of the surplus an equal amount of capital
stock.

The balance sheets of conservatively managed com-
panies may show reserves in addition to the depreciation
reserve. Thus the International Harvester Company main-
tains a reserve for collection expenses and receivables to
provide for losses which may ultimately be sustained in
the realization of bills and accounts receivable, and a cash
reserve when it is deemed wise for a company to carry its
own insurance. A company may also maintain a dividend
reserve fund to make good any temporary shortages in
income available for distribution to stockholders. These
reserves are built up out of the unexpended balances of
the annual appropriations to these several purposes. For
example, the International Harvester Company provided
for contingent losses on receivables in 1908, $650,000. The
debts which were charged off as uncoUectable during 1908
amounted to only $228,048.15, so that there was an addi-
tion to the reserve for contingent losses on receivables dur-

THE DETERMINATION OF PROFITS 195

ing the year of $421,951.85. The efforts of this company
are constantly directed toward reducing the losses to pro-
vide against which these reserves are established. It has
spent large sums to equip its works and other buildings
with automatic sprinkling systems and the latest devices
for protection against fire, and it carries on continually a
systematic investigation into the financial responsibility of
prospective customers who give notes for purchases. This
insures to the company a high grade of notes and ac-
counts. These precautions, and the care taken to reduce
losses, tend to increase the balances annually added to
these various funds which may in time be carried to such
a height that a portion of them can be distributed to stock-
holders.

These reserves are handled in the same manner as the
reserve for plant depreciation, with the exception that the
insurance reserves and the dividend reserves, in order to be
immediately available for use, should be invested in good
securities set aside for the purposes of these funds. As an
illustration of this segregation, we find that the balance in
the fire insurance reserve of the International Harvester
Company of December 31, 1908, was $671,093.23, of which
$400,832.20 had been invested in income-bearing securities
on that date. Since that date the balance of the fund has
also been invested in income-bearing securities.

In calculating depreciation, the first step is to deter-
mine the amount necessary. This is figured as a percentage
of the cost of property to be depreciated. The percentage
is obtained by estimating, sometimes in great detail, the
active life of different kinds of equipment and dividing the
result into 100 to obtain the annual rate of depreciation.
By the method ordinarily followed, no account is taken of
compound interest. If a business or property is estimated
to last for twenty years, five per cent of this cost is assumed
to be reserved out of income in each year in order to make
good the annual depreciation. The Chicago Union Trac-

196 CORPOEATION FINANCE

tion Company, for example, has adopted the following
rates for its power-plant equipment :

Life Bate

Track, ties, bonding, etc 12.85 years; 7.75%

Paving and grading: '

Granite block 16 " 6.6%

Cobblestbnes 25 " 4%

Electric equipment of cars 12-15 " 8.5% to 6%%

Iron poles 20 " 5%

Power-plant equipment 15 " 6.66%

Shop tools and machinery 20 " 5%

Buildings and improvements 50 " 2%

These various percentages are applied to the costs of the
equipment, and the results added together are assumed to
give the annual requirement for depreciation for that
year.

These rates, however, are subject to wide variations un-
der different conditions. Mr. C. I. Sturgis'- explains these
variations in relation to railway equipment as follows:

On a railroad, the life of ties varies with soil and
climate ; the life of bridges depends on the weight of loco-
motives running over them; the life of locomotives de-
pends on the quality of water and coal with which they
are fed, and there is hardly a railroad tool or machine
the life of which does not depend on local conditions,
and even if, in determining depreciation, we could ap-
proximately estimate such variable factors as these, we
would still have to consider what in the end will be the
cost of the new articles to replace the old, and with
markets ever fluctuating that is impossible definitely to
determine. Furthermore, prosperous roads, in main-
taining high standards, consider equipment is worn out
when, on poorer roads, it would be considered still good
for many years of service.

"While admitting the influence of local conditions upon
assumed rates of depreciation, it is possible to give proper
weight to these influences on the basis of experience in that

1 Slectrio Sailway Journal, December. 18, 1909..

THE DETERMINATION OF PROFITS 197

locality, and to ascertain, with a degree of accuracy, the
life of the company's property. It is also possible to ascer-
tain, as we have explained in our discussion of main-
tenance, the effect of high and low standards of mainte-
nance on depreciation. Property which is well maintained
will last much longer, and give more effective service dur-
ing its life, than where maintenance is neglected. We may
conclude, therefore, that depreciation due to wear and
tear and to natural decay can be closely approximated.

Depreciation due to obsolescence and extraordinary
accidents involving extensive expenditures upon the plant
cannot be estimated even approximately. A case came re-
cently to the writer's notice where the owner of a textile
mill had imported an expensive machine from England
and estimated that it would last only five years. He there-
fore assigned to it a depreciation rate of twenty per cent.
Within two years, however, this machine was displaced by
a better one, so that the correct rate should have been fifty
per cent. Other illustrations are the passage of city ordi-
nances requiring large expenditures on track elevation or
an electrification to abolish the smoke nuisance. Such
changes as this cannot be foreseen. It is impossible to
provide against them. Partial provision, it is true, may be
made in the manner already indicated by establishing vari-
ous rates of depreciation and, by improving the business
methods of the concern, accumulating reserves against
various contingencies. These reserves are available for
emergencies. But even the most conservative company
cannot make suitable provision out of its income accounts
to protect it against any contingency which might arise.
For example, depreciation on telephone equipment can be
figured at ten per cent per annum. This will provide for
the replacement of the plant at the end of ten years. But
suppose the town is visited by a hurricane and most of
the plant is destroyed. This would be a contingency
against which no foresight consistent with ordinary busi-
ness practice would provide. All that can be done in the

198 COEPORATION FINANCE

event of such a catastrophe is for the owners of the business
to take their loss and build anew, increasing their toll rates,
if need be, in order to regain the money spent for the
reconstruction of the plant.

As an offset to this sort of depreciation, several account-
ants and engineers have urged the natural appreciation in
the value of the property due to the development of its
business.

It is claimed that "the depreciation due to the dimin-
ished value of equipment, track, bridges, structures of
all kinds, shops and shop tools is limited and is, further-
more, more than counterbalanced by the appreciation due
to the fact that the railroad has an established business
which amounts to more in the case of a railroad than does
'good will' in the case of a mercantile corporation. In-
dustries, mines, and factories are established along its
lines with switches and side-track facilities, towns grow
up, and a certain amount of business becomes assured
which requires time, money and energy to develop — all of
which is charged into current operating expenses, and
should be considered as an offset to any depreciation of the
property.

"Besides the appreciation due to the cause there is
also physical enhancement of value due to the solidification
of the roadbed and embankments, the establishment of
water-courses and the replacement of the original struc-
tures with others of a more permanent character, without
any addition to capital account; thus, wooden trestles,
bridges, culverts, etc., have been filled with earth or re-
placed by steel or iron, stone or concrete.

"No estimate can be made, moreover, of the enhanced
value of the right of way and terminals due to the growing
values of land, even though the existence of the railroad
may have contributed largely to the development of the
country through which it runs. The railroad corporation
suffers from this increased value if it is compelled to pur-
chase any property as well as in the increase in its taxes;

THE DETERMINATION OP PROFITS 199

but it has not been usual to make any allowance for this.
Railway men generally believe that the appreciation of the
property above described more than balances the deprecia-
tion ; especially when it is remembered that the total physi-
cal depreciation under proper maintenance rules is limited
to half the first cost of the property. ' ' ^ The considerations
advanced by Mr. Delano should be kept in mind in fixing
depreciation rates. In the writer's opinion, however, it is
unsafe to go as far as he does in claiming that apprecia-
tion offsets depreciation. This increase in the value of a
business is dependent to a large extent upon the conditions
of trade. Certainly, from 1892 to 1897, there was no ap-
preciation in the value of railway property in the United
States. At this time a large amount of railway mileage
was in the hands of receivers, and railway earnings were
greatly depressed.

There is only one safe rule to follow in the determina-
tion of questions of this character — to take the side of
conservatism in the disbursement of earnings. As between
deducting too much for depreciation and taking too little,
the first course is usually to be preferred. Excessive de-
preciation means that money which would otherwise be
available for dividends is retained in the business, covered
up and concealed from the clutching hands of stockholders,
but eventually appearing on the right side of the income
account. No one can be injured by conservatism in these
matters, and the hazards of business are so great that any
doubt as to the propriety of such deductions is always to be
resolved in favor of the conservative course.

In final summary of the rules of depreciation the fol-
lowing may be taken as conservative: First, charge to
maintenance the cost of minor replacements, even if the
cost of the property substituted for that worn out or dis-
placed by a better machine is greater than that originally

1 Condensed from an article by Frederic Delano, formerly President
of the Wabash Railroad Company, in the Railway Age Gazette, March
27, 1908.

200 CORPORATION FINANCE

purchased; second, maintain depreciation rates based on
standards established by engineers familiar with the busi-
ness in which the corporation is engaged, and after mak-
ing due allowance for special and local conditions; third,
provide additional reserves for special classes of losses not
covered by outside insurance.

Our final topic for discussion under the head of depre-
ciation concerns the comparison between sinking funds
and depreciation. There is substantial identity between
these two classes of deductions from income. The sinking
fund, whether maintained against so-called "wasting"
assets— that is, coal or ore— or against the plant of an
electric railway, or the terminable franchise of a public
service corporation, up tb the percentage of the total cost
of the company 's assets which is represented by its bonds,
and up to the percentage of the cost of the property which
is represented by the sum of annual appropriations for the
sinking fund, is usually regarded as the identical equiva-
lent of a depreciation charge. If the cost of the entire
property of a company is represented by its bonds, which
often happens, and if its. life is twenty years, a sinking
fund of five per cent on the bonds is the same as a depre-
ciation of five per cent on the cost of the property. At
the end of the twenty years, the plant is worn out, the
bonds are paid, and the company is back where it started,
with the addition of the good will and prestige which it has
accumulated. It can then incur a new deblj for the originaf
amount, probably at a lower r|,te of interest, rebuild its
plant, and maintain its surplus intact.

The identity of the sinking fund and the depreciation
charge may be admitted, however, only with important
qualifications. The depreciation fund should be available
for replacements when these are required. "When a sinking
fund is invested in bonds, whether these are canceled or
held, it is not available for current replacements, but only
for extinguishment of the company's debt. Th'e latter
forms of sinking fund, however, contain, as noted in a

THE DETERMINATION OF PROFITS 201

former chapter, certain provisions which remove the fore-
going objection to identifying a sinking fund with a de-
preciation charge. If the bonds purchased for the sinking
fund can be reissued to provide funds for improvements and
extensions, or if the sinking fund can be invested in the
plant at the option of the trustee, the sinking fund and
the depreciation charges are in all particulars the same,
and the amount of the sinking fund established should be
deducted from the assumed rate of depreciation. If the
company maintains a sinking fund against its debt, and
also allows rates of depreciation on ^the cost of its physical
property, it is, to the extent of the sinking fund, dupli-
cating its depreciation charge, and accumulating reserves
in its asset accounts which will eventually come to the
stockholders, or which may be drawn out in case of emer-
gency.

After ascertaining the total income of the company,
consisting of net earnings from operation plus other in-
come, certain deductions must be made known as fixed
charges, which include taxes, interest, and rental. The
only question which may arise concerning these payments
is the treatment of interest paid on bonds during the con-
struction period. It is customary to include this in the
construction cost, issuing enough securities not only to
provide for the cost of the plant, but to pay interest on
the bonds while the plant is building. As long as no secret
is made of the matter, and it is well understood, there can
be no reasonable objection to the practice. All that could
be required is for the stockholders to advance the money
necessary to pay interest on bonds during the construction
period.

The final item of charges consists of such miscellaneous
items as commissions on sales of securities and other ex-
penses which are chargeable against income, but which
cannot properly be classified either as operating expenses
or as fixed charges. Companies often include as "other
charges" the cost of betterments and additions which, in

202 CORPORATION FINANCE

the judgment of the directors, are wot properly chargeable
to capital account. This has been discussed in connection
with depreciation. Such expenditures should be charged
to operating expense rather than to fixed charges. The
balance remaining after these charges have been paid is
the surplus earned for the stock during the year, out of
which dividends may be paid. Another source of surplus
consists of profits from premiums on the sales of securities
issued by the company. Discounts on all sales of securities
are to be considered as losses and charged against the in-
come of the year. For the same reason, premiums received
are to be regarded as profit. '

The next item in the income account is income from
other sources. This is made up as follows :

Interest received on bonds of other companies;

Dividends on stocks of other companies;

Rentals of property owned by the company and leased
to outsiders;

Interest on the company's bank deposits or on any
loans in which it may invest its cash balance.

These receipts are usually incidental to the main opera-
tions of the company.

Business corporations are not primarily investment
companies. They are organized to transact a railroad or
manufacturing or trading business; and, although they
may acquire securities in the course of their regular busi-
ness, these securities are usually acquired for other pur-
poses than to obtain revenue. A railroad corporation, for
example, may purchase an interest in the stock of another
company with which it exchanges a large amount of trafSc,
and may receive a dividend on this stock. The principal
advantage of the purchase is not, however, to receive the
dividend, but to obtain a favorable traffic agreement.

Again, railroad companies may build new mileage
through subsidiary companies to which they advance
money, taking the bonds and stocks of the subsidiary com-
panies as payment and holding these in their treasury.

THE DETERMINATION OP PROFITS 203

In this ease, instead of treating the operations of all the
companies under their control as a unit, we have the dis-
tinction between lines directly operated and lines con-
trolled. In reality, however, the returns on the stocks and
bonds of the subsidiary, while in the treasury of the parent
company, represent merely a part of the operating income
of the entire system.

The item of interest on bank deposits figures largely in
the accounts of profitable corporations during periods when
they are not expanding their operations, especially when
their receipts are evenly distributed throughout the year,
and their dividend and interest payments are made at
periodical intervals. Under these circumstances, there is
necessarily a considerable accumulation of money to the
credit of the company, and this money they may either
leave or deposit, receiving the bank rate of interest, or
they may lend it out at a higher return than the banks
will pay. During periods of great business activity, how-
ever, this source of income is ordinarily not available, since
the corporation needs all of its money to conduct its regu-
lar operations, and is usually a heavy borrower besides.

Profits from premiums on securities sold are essentially
different from profits or losses derived from income ac-
count. "When securities of a company are sold at a pre-
mium, the usual practice is to show in the balance sheet
as a capital liability only the par value of the security
sold, and to credit to surplus, or profit and loss account,
the premium received above the par value. Profits derived
from the sale of capital obligations should be reserved as
capital, unless the company is dissolved, and should be
separately stated, else dividends may be paid while money
is being lost in operation.

In practice, this separate statement of premiums on
sales of securities is rarely made. The consequence is that
directors may get a wrong idea of the profits of the busi-
ness, and may pay dividends which are not warranted by
the earnings from operation. The practice of investing

204 CORPORATION FINANCE

these premiums in productive assets is, however, so well
established that the danger of basing dividends upon them
is remote. A similar disposition is usually made of profits
received from the sale of unpledged treasury assets, usually
consisting of securities. Unless the total proceeds are dis-
tribute,d to stockholders as a special dividend, the practice
is to invest the entire proceeds in the improvements in
capital assets. Such a disposition was made by the Penn-
sylvania of the proceeds of the coal stocks following the
passage of the Hepburn Law in 1906. A large profit was
shown, but the proceeds were invested in the property.

Discounts on securities sold are treated as losses. If
small in amount, they are charged against the income' of
the year. Discounts on bonds or stock sold for original
construction are usually included in the cost of construc-
tion. In calculating income for taxation, the deduction of
discounts is not allowed.

The third source of surplus is "profits and losses from
the sale of assets." A company may have operated a fac-
tory situated in a large city where land values were ap-
preciating. In time, the growth of the company's opera-
tions makes a country location desirable. The city real
estate then comes up to be sold, and it is found that its
value is greatly increased over its cost. This increase in
value is to be taken as a profit, but since the profit was
not earned during a single year, but represented the ap-
preciation in value over thirty years, it will be improper
to count this in the surplus available for distribution to
stockholders except as a special dividend. It will be treated
in the same manner as profits from premiums on the sale
of securities. In cases, however, where the company pur- ,
chases and sells property in the same year and shows a
profit, this profit may be included in the annual profits of
the company upon which the distribution of profits is to
be based.

Profits arising from the revaluation of assets are doubt-
ful. It is frequently necessary, when the property of a

THE DETERMINATION OP PROFITS 205

business has been subjected to some unusual damage which
is too great to be covered by the ordinary rate of deprecia-
tion, for example, the discovery of new and richer deposits
of iron ore which will reduce the valuation to be legiti-
mately placed upon a company's iron-ore deposits, to write
down the book value of assets in the form of a loss on the
single year's operation, or, if the depreciation is excessive,
to spread this loss over a series of years. On the other
hand, it has been urged that the writing up of assets where
property has appreciated in value is equally legitimate.
This can be admitted only within narrow limits. It is
entirely proper in the case of securities owned where the
market value can be ascertained, and where the increased
income corresponds to the increased price. Beyond this,
however, the "writing up" of assets is of doubtful pro-
priety. It is safer to maintain a book value of securities
based upon cost, less depreciation, and to leave the surplus
account undisturbed by any appreciation in their market
value.

The danger of thus appreciating assets may be seen by
an illustration. The property on which the Broad Street
Terminal of the Pennsylvania Railroad Station stands has
increased over 400 per cent since purchase. If this piece of
real estate was to be revalued, its original cost to the com-
pany would be quadrupled. Broad Street Station is, how-
ever, not to be sold. It will for many years continue to be
used for the purpose of the company. It is altogether
probable that the contribution of this terminal location to
the profits of the Pennsylvania Railroad has not increased
as rapidly as its value as real estate. At the same time,
it is impossible to ascertain how much is this increase in
the contribution of Broad Street Station to the net profits
of the Pennsylvania. The only basis on which its value
could be written up on the books of the company would
be by comparing it with the value of real estate in the
vicinity. This would result in an exaggeration of its value
as a piece of property producing revenue for the Penn-

206 CORPORATION FINANCE

sylvania Railroad. The New York, New Haven & Hartford
has a three-fourths interest in the South Station, Boston,
which cost $15,000,000 to build. The loss on the operation
of this station, however, which is maintained largely for
public convenience has been as high as $500,000 in a single
year. As a piece of real estate this property is very valu-
able. As a piece of railroad property, however, it is a
source of loss.

The only practical reason for increasing the value of
railroad terminal property would be when it is desired to
make this the basis for an issue of terminal bonds. In such
a case, however, the lenders will make their own estimates
as to the value of the real estate in question as security
for the loan asked, and the corporation need not adopt the
expedient of writing up the value of the property on its
books. All things considered, the method of carrying the
property of the company at its original cost, and main-
taining that cost intact by proper rates of depreciation
is best.

CHAPTEE XVI
THE MANAGEMENT OF THE CORPORATE INCOME

CoEPOEATioNS exist and do business to produce dividends
for their owners. A company which has no prospect of
paying dividends should be either dissolved, or, according
to methods which we shall have later occasion to explain,
reorganized down to a dividend basis. After making the
various deductions which have been indicated, the surplus
profits belong to the stockholders, and if the company is suc-
cessfully managed under conditions of ordinary good fortune,
the stockholders will in time receive these surplus profits,
directly or indirectly, either in the form of cash or dividends.
A dividend is a payment of the profits of the company to
its stockholders expressed in the form of a certain rate per
cent on the par value of the stock. The dividend of the
Pennsylvania Eailroad Company is $3 — six per cent on
10,000,000 shares, amount of capital stock $499,296,400;
that of the United States Steel Corporation seven per cent
on 3,602,811 shares of preferred stock, and $5 on 5,083,025
shares of common stock. The General Electric Company
pays $8 per share on 1,181,920 shares; the Union Pacific
Railroad Company pays $10 on 2,722,916 shares of com-
mon stock.

There are two steps in the process of distributing profits
to stockholders: First, the directors by a formal resolution
declare that profits have been earned. As a preliminary
to the declaration of a dividend, the directors consider the
following: (1) the cash or liquid assets of the company

207

208 COEPOEATION FINANCE

at that time from which the dividends must be taken; (2)
the prospect of business for the early future; (3) thp abil-
ity of the company to obtain any funds which may be neces-
sary for new construction by the sale of new stock or bonds.
A company may be exceptionally prosperous without being
able, on account of the rapid growth in its business which has
locked up its cash assets in the form of accounts receivable,
materials, etc., to pay out any portion of these profits in
dividends. A declaration of a dividend, under these circum-
stances, could be made only by selling stock or notes to
obtain the money, and while this is sometimes done, as a
common practice it is to be avoided. Again, the business
of the company, at the time when the matter of paying a
dividend is considered, may be exceptionally prosperous, but
the outlook for the future may be in doubt. At a time, for
example, when a revision of the tariff is in progress, the
companies whose earnings will be affected by any changes
under consideration are inclined to husband their resources
and prepare for a possible shrinkage in earnings. A com-
pany whose business is rapidly expanding may require large
amounts of new capital. It may not be desirable to raise
this money by increasing capital stock. Any money required
must come out of profits. The directors, under such condi-
tions, would be cautious in paying dividends.

The law provides that the declaration of dividends is
optional with the directors. They have authority to fix the
amount of working capital which, in their judgment, the
business of the corporation requires, and until they declare
a dividend by resolution, there is no way in which the stock-
holder, except by his vote to displace one or more directors,
can control their action. The directors are the trustees for
the stockholders. They are given full power to dispose of
the funds of the corporation as their best judgment may
direct. No matter how large are the profits of the company,
there is no way in which they can be compelled to declare
a dividend. The stockholders can only participate in profits
through the channel provided by law. Various attempts have

MANAGEMENT OF CORPORATE INCOME 209

been made to force a declaration of dividends, especially on
preferred stock, on the ground that large profits had been
earned, and that the stockholders were entitled to share in
these profits. These attempts have been generally unsuc-
cessful. The stockholder can invoke the aid of the courts
to prevent the diversion of the company's funds to unlawful
objects ; he can restrain the officers and directors from paying
to themselves exorbitant salaries; and he can prevent any
improper use of the company's profits. As long, however,
as the directors elect to leave the company's profits in the
treasury, until they decide that a dividend shall be paid, the
stockholder can obtain no share of these profits. His only
remedy, in case he is dissatisfied with the management of
the company, is to elect new directors or sell his stock and
withdraw from the company. When a dividend has been
declared, however, it becomes an obligation of the company,
enforcable as any other debt.

The object which an honest and conservative board of
directors set before them is to establish a dividend rate
which can be maintained under all conditions of earnings.
The interests of the stockholder and the corporation unite
in the demand that a rate of dividend once established shall
be maintained. The stockholder desires a stable dividend
because the value of a stock whose dividends, for example,
run six, six, two, two, and four, averaging four per cent for
the five years, but irregularly distributed, will command a
lower price than stock on which four per cent is paid every
year. Investors, as distinct from speculators, although both
elements are present in the minds of both purchasers of stock,
desire stability in the income from their investments. The
dividends which they receive go into their personal income
accounts; their expenditures and appropriations are adjusted
to these receipts; a reduction or the passing of a dividend
disturbs their calculations and unsettles their confidence in
the company. As a result of this preference of the investor
for stocks with a regular rate of distribution, the payinent
of fegular dividends produces a higher and more stable valua

210 CORPOEATION FINANCE

for such stocks. Stocks with regular dividends are worth
more to sell and are also more valuable as collateral securiiy.
A stable rate of dividend with its resulting higher and
more permanent value is of great advantage to the company.
Many corporations, especially those whose receipts are not
evenly distributed throughout the year, have occasion to
borrow money in anticipation of income to meet obligations
which mature before that income is received. Wages, inter-
est, and taxes must be paid and supplies purchased often
before the proceeds of sales are received. In order that a
corporation should retain a strong position with the banks,
it is important that its stock should be maintained at a good
figure. A high and sustained value for the stock of a com-
pany is ordinarily taken by the bank as evidence of its high
credit. Of course, if this value is merely a recent marking up
of stock-exchange quotations, it may not have much weight
with the bank oflBcers, but if it is a steadily maintained
quotation, and represents what investors really regard as .
the value of the stock, the banker considers it good evidence
of the financial standing of the company applying for a
loan. On the other hand, the fact that a stock sells at a
low price is usually a warning to the banker to discriminate
against the paper of the corporation issuing the stock, unless
the notes are well secured by indorsement or collateral.

A settled investment value for its securities, which can
be obtained only by the stability of its dividend rate, also
benefits the corporation because it makes it possible for it to
procure money for improvements and extensions on favorable
terms. A prosperous company is a growing company, and is
under frequent necessity of selling stock or bonds to obtain
new capital. The prices obtained for the new securities will
depend to a large extent upon the prices of those already out-
standing. If the company issues bonds, a high value for
the stock indicates that the interest on these bonds is amply
secured by surplus earnings. If, however, the stock is selling
at a low figure, the investor knows that the company which
proposes to increase its debt has little security to offer its

MANAGEMENT OF CORPORATE INCOME 211

creditors aside from the property which the proceeds of the
new bonds are to purchase. A low price of the stock in-
dicates that the judgment of market observers is unfavor-
able to the company. The investor properly regards the past
achievements of the corporation as the best assurances of its
future prosperity. No matter how large the net earnings of
a company may be at the time an increase of stock or bonds
is made, the low market value of this stock resulting from
an irregular dividend policy would be a warning to anyone
investigating its credit that there was good reason for be-
lieving that these large earnings would not be permanent.
Under these circumstances, it might be difficult to obtain
high prices for these securities.

So important is an even distribution of corporate profits
considered, that even when increasing earnings enable the
corporation to raise the rate of dividend, care is usually
taken to avoid any oflBcial statement, or even any implication
from a statement, that the higher dividend rate is to be per-
manent. The method employed in such cases is to declare
the " regular " dividend and then an " extra " dividend in
addition. The increase is made in the form of the " extra "
dividend as an intimation to the stockholder that the di-
rectors are not yet fully convinced that they can add the
amount of the " extra " to the regular rate, and that they
prefer to wait developments before establishing the regular
rate at the higher figures. After the extra dividend has
been paid for several years, and if profits are maintained,
the rate will be made regular. In order to maintain an even
rate of distribution on its stock, the directors of well-man-
aged companies are governed by the following rules :

First, to pay no dividends for a considerable period after
the company begins operation.

Second, to manage the expense accounts of the company
in such a way as to reduce the fluctuations in surplus profits
to the minimum.

Third, to pay out, in any one year, only a portion of
these profits in dividends.

212 COEPOEATION FINANCE

Every new corporation is, in some degree, an experiment.
Even though it operates in an industry where the machinery,
the methods of administration, and the product are standard-
ized, and where the management have nothing more to do
than to follow established models, the degree of its success
cannot be accurately predicted. The number of unknown
factors in every business situation is large; new laws to
reduce profits, increases in taxation, unusual burdens im-
posed by the municipality in the way of public improvements,
the incursions of competitors, changes in the tariff, dangers
of industrial depression, encroachments of organized labor,
substitutions of new products or the invention of machinery
to produce at lower cost — these influences may enter to dis-
appoint the calculations of the directors. Furthermore, in
most public flotations, there is some overvaluation of the
property purchased or constructed, and a corresponding
element of inflation in the capitalization of the company.
Even with the most painstaking care, mistakes of construc-
tion, location, or anticipation of demand may have been made.
If the company is prosperous, these mistakes can be rectified,
but the money with which these replacement and insurance
funds are built up comes from the profits of the company.
Conservative directors will, therefore, usually refuse to pay
out profits until the company has demonstrated its ability
to earn its fixed charges, and to produce a surplus out of
which dividends can be paid.

The issue of cumulative preferred stock seriously inter-
feres with a conservative management of the company's in-
come. When dividends are carried over and accumulated
to the prejudice of the common stockholder, fairness to him,
as well as the usual necessity that a market should be made
for new securities as quickly as possible, influences the di-
rectors to promptly begin the payment of dividends upon the
preferred stock. In some cases, notably that of the United
States Steel Corporation, the stock-market situation influ-
enced the directors to immediately begin payment of divi'
dends on the common stock as well as on the preferred. For

MANAGEMENT OF CORPORATE INCOME 213

this, hoTfever, they were severely criticised. The position of
the company during the early period of its existence was
weakened by a policy of dividend payment which was gen-
erally believed to be unduly liberal. In December, 1903,
the depressed condition of the steel trade led to the suspension
of dividends on the common stock of the United States
Steel Corporation. The directors quickly took advantage of
the opportunity to adopt a conservative dividend policy.
Although the depression in the steel trade was only tem-
porary, conditions approaching normal in the following year,
the policy of investing large sums in plant and equipment
which the directors would probably have been glad to follow
from the first, had stock-market considerations not proved
controlling, was steadily adherred to. No dividends were
paid on steel common until 1906, when a two-per-cent rate
was established, raised a year later first to three and then
to four per cent. Not until the autumn of 1909, was the rate
advanced to five per cent. During this period from 1903
to 1909, the company earned $300,044,000 on its common
stock and paid only $63,537,813 in dividends, the balance
being invested in various reserves, and in building up a sur-
plus on the balance sheet which, at the date of the last annual
report, stood at $151,354,538. As a result of this policy of
investing profits in improvements, instead of paying them out
in dividends, the United States Steel Corporation has elimi-
nated much of the "water" in its original capitalization,
and has placed itself in a strong position.

In 1914, however, evidencing the continuance of a con-
servative policy, a sharp reduction in profits influenced the
directors to suspend common stock dividends.

The later policy of the United States Steel Corporation
in sacrificing its dividends to its surplus indicates the policy
which every company whose financial situation permits should
follow. In no other way can a corporation whose capital is
excessive, and whose earning power is in any way doubtful,
so certainly reach an investment position as by adherence
to the policy of accumulating a large reserve out of income.

214 COEPORATION FINANCE

The more doubtful the success of the company, and the
greater the number of dangers and risks to which it is
subjected, the more important it is that dividends should
be withheld until a strong financial position is attained.

Having fulfilled the initial requirement of accumulating
an adequate reserve to offset the blunders of omission and
commission which characterize the beginning of every new
enterprise, the next problem confronting the directors of a
company, anxious to place their stock upon a dividend paying
basis, is the management of the expense accounts in such a
maniler as to reduce to a minimum the fluctuations in the
income available for distribution to stockholders. A large
part of the expense of operating any business varies with the
volume of business done. An increase in the traffic of a
railroad means more trains, and more employees to run the
trains and to keep them in repair. A falling off in business
results in a corresponding reduction in the cost of conducting
transportation. The same is true of all other industries.
The cost of operating the plant, as distinct from the cost
of maintaining it, fluctuates with the amount of business
done. There are, of course, in every business certain fixed
expenses connected with the operation and selling which can-
not be adjusted to changes in business, and which result in
increased cost when earnings are reduced. Broadly speak-
ing, however, the cost of running the plant, of manufactur-
ing the goods, or transporting the freight and passengers,
changes with the volume of business transacted. There is
little opportunity, therefore, in the cost of operation, to ad-
just expenditure to fluctuations of income so as to minimize
the changes in the balance of income available for distribu-
tion to stockholders.

In the maintenance- and replacement items of operating
expenses, however, a certain amount of adjustment and varia-
tion is possible. Maintenance charges, as we have seen, con-
tain two items : the cost of up-keep and repairs, and the cost
of betterments calculated to raise the standard of construction
and decrease the cost of maintenance or operation. The

MANAGEMENT OF CORPORATE INCOME 215

rule which governs the management of the first class of
maintenance expenses is that, so far as possible, without dam-
aging the credit of the company, standards of maintenance
once established should be rigidly adherred to. Maintenance,
in other words, should be a comparatively fixed expense, vary-
ing only as the influences which affect the wear and destruc-
tion of the property are modified.

Rigid adherence to this rule admits of a considerable
amount of fluctuation in the amount of annual appropriations
for the up-keep of the property. The cost of railway main-
tenance of way, for example, is increased by an open winter,
which results in greater damage to the track and roadway.
It is increased by the high cost of labor and material incident
to business prosperity, and also by the heavy traffic which
results from large production. Maintenance cost, on the
«ther hand, is naturally reduced, without injury to the prop-
erty, during periods of depression. When traffic is light, the
wear upon the track is reduced, the amount paid out in
wages is lessened. The efficiency of labor is also increased
at auch a time, not merely because of the greater desirability
of steady employment during a dull season, which can only
be secured at such a time by diligence and faithful service,
but also because track work is not so much interfered with
by passing trains. The cost of materials is also reduced
during periods of depression. The maintenance of plant or
equipment not directly affected by weather conditions can
also be reduced during the period of depression without
injury to the property. The Pennsylvania railroad, for ex-
ample, made a heavy reduction in the cost of maintaining
equipment during 1908, amounting to $6,864,347. This was
due to the fact that a large portion of its equipment was not
in service, and consequently was not subjected to the wear
and tear of operation. A large amount of substitution of
parts, such as air-brake hose, belting, etc., can be made dur-
ing a dull season, when only a portion of the plant or equip-
ment is in operation, thus reducing the cost of maintenance.
A case in point is a factory manufacturing leather goods

216 COEPORATION FINANCE'

which had four floors in operation during 1907. In 190S
business fell ofiE so that only the machinery on the one floor
was used. As fast as the belting wore out on the lower
floor, belts were transferred from idle machines, where they
would naturally deteriorate, and put into use. Such econ-
omies of maintenance do not involve any lowering of the
standard of the plant, although the cost of maintenance may
be greatly increased to restore the equipment used up in this
manner when the entire plant again comes into operation.

With this exception, however, the safe rule to follow in
maintaining the standard once established for a plant is
that a " stitch in time saves nine." Neglect of maintenance,
for any reason, is likely to be followed by the most serious
consequences. The operating efiQeiency of a plant is so closely
related to its physical condition, the success of its business
is so dependent upon its efiiciency of operation, that serious
and permanent damage may be inflicted upon a company by
failure to maintain the standards of its plant. A good illus-
tration of the consequences of neglecting maintenance is fur-
nished by the fifth annual report of the Kansas City South-
ern Eailway Company for the fiscal year ending Jtme 30,
1905. The capital stock of this company was originally vested
in a voting trust for five years from April 1, 1900. This
voting trust expired by limitation on April 1, 1905, when
the stockholders came into possession of their property and
elected a new board of directors.

They found the road in such a condition as to be prac-
tically unfit to carry on the business of transportation ; twenty-
five per cent of the engines were in bad order, sixty-five per
cent of the freight equipment was unfit for use in the trans-
portation of grain, merchandise and other freight demanding
dry cars; fifty-five of the sixty-five per cent required heavy
repairs, enough ties had not been renewed, ditches had not
been cleaned, sufficient ballasting had not been done and suf-
ficient rail had not been laid. The condition of the ties
and wooden structures and track, as a result of the neglect
of maintenance, was so bad that it was impossible to move

MANAGEMENT OF CORPORATE INCOME 217

trains at ordinary speed. During the six months from Jan-
uary 7th to June 30, 1905, as a result of the impaired con-
dition of the property due to the neglect of its maintenance,
there were 715 wrecks and derailments reported, " each of
which was of sufficient magnitude to require a Special report
and therefore cause serious loss and delay. Such a great
number of accidents could not fail to cause serious loss of
confidence and good will of the public and consequent diver-
sion of traffic, also destruction and damage to property, delay
to trains, and resulting wasteful expense for extra fuel and
overtime of employees." ^ Duriilg the month of May, 1905,
overtime paid engine and train crews amounted to $8,311.38,
although the average of overtime for the three years preced-
ing, before the property had reached its worst condition,
was $5,990.88. In addition large amounts were paid each
month for labor in rerailing cars and engines, and for re-
pairing track and equipment, as a result of derailment due
to defective tracks. Large amounts were paid for loss and
damage to freight due to such derailments. Finally, the
company suffered severely in competition for business be-
cause of its inability to take all the traffic which might have
been obtained, and also because the traffic which it did move
was often seriously delayed in delivery and arrived, in bad
condition.

We see illustrated, in the case of the Kansas City South-
ern, the • effect of the neglect of maintenance upon opera-
ting efficiency, and the effect of decreased operating effi-
ciency upon traffic and earnings. While this is an extreme
case, it illustrates a principle which is of invariable applica-
tion. To allow a property to run down is to impair the
property's efficiency and to inflict serious injury upon the
operating company.

It is possible, however, and this is the practice of many
corporations, especially those which have not yet reached a
position where they can show large surpluses over the amount

1 Fifth annual report of The Kansas City Southern Railway
Company, fiscal year ended June 30, 1905.

218 COEPOEATION FINANCE

required for their dividends, to vary their appropriations for
maintenance according to their earnings, never allowing the
condition of the property to deteriorate so far as to interfere
with its eflBciency, but postponing, on occasion, all but the
most necessary replacements and repairs until earnings have
improved. Such a policy may be justified by extreme finan-
cial necessity. When a reduction in the dividend of a com-
pany will impair the company's credit, or defeat the con-
summation of projects for raising large amounts of capital,
the skimping of maintenance cost may be pardoned. A board
of directors are always reluctant to reduce the dividend rate.
Such action inflicts serious damage upon the stockholders,
and is likely to lead to unforeseen criticisms. When com-
panies are running on a narrow margin of earnings, their
usual disposition, when conditions of reduced earnings are
encountered, is to save at the expense of the plant. It is
going too far to say that such a policy is never justifiable.
Bach case must be determined on its own merits, with refer-
ence to the peculiar circumstances in which the directors of
the company find themselves. It is, however, well established
that the policy of so-called " concentration " of maintenance
expenses into years of large earnings is costly, in that it
results in a higher average of expenses over a series of years
in keeping the plant in condition, than would be necessary
if fixed repairs were made.

This subject was investigated in 1908 by a committee of
the American Street Eailway Association. In their report
they present the detailed figures of maintaining car bodies
over ten years, first, when the car is put in the shop each
year, and second, when it is shopped bi-yearly. The com-
parison of the cost of maintaining car bodies under the
yearly and bi-yearly systems of shopping is shown in the
table on the following page.

To the cost of the yearly maintenance over the ten years,
should be added an estimated item of $44.40 on account of
the additional equipment made necessary because of four
days loss of time on each car while in the shop, and an item

MANAGEMENT OF CORPORATE INCOME 219

Cost

Shopped Yearly

Shopped
Bi-Yeablt

829.18
61.49
54.94
60.99
60.44
59.99
54.94
67.74
55.44
79.99

2d "

$86.46

3d "

4th "

97.46

5th "

6th "

111.46

7th "

8th "

115.96

9th "

10th "

143 . 15

Total. . .

8585.14

8554.45

of $10.40 on account of increased shoproom made necessary
by the yearly maintenance, making a total of $639.85 as the
cost of maintaining the cars when shopped yearly as com-
pared with $554.45, the cost of bi-yearly repairs. This com-
parison, however, does not indicate the merits of the respec-
tive policies. The objects of car maintenance as stated by
the committee are as follows:

First, to prevent accidents due to defective equipment.

Second, to prevent failure of service due to defective
equipment.

Third, to prevent excessive depreciation of equipment.

Fourth, to maintain equipment comfortable and attractive
to patrons and public.

The committee finds a marked saving under each one of
these items as result of shopping the cars every year. First,
less liability to accidents. "When a car is thoroughly over-
hauled each year, there is less liability of accidents due to
defective flooring, straps, windows, door and seat mechan-
ism than where such overhauling is done every second year.
If such accident claims are made, the fact that the car had
been carefully " overhauled inside of a year would greatly
improve the ralilway company's case in court, and it would
seem that two cents per car per day would be a conservative

220 CORPORATION TINANCE

estimate of its value." The liability to failure in service was
also decreased by frequent overhauling. The life of the car
body is also increased when the cars are put into the shop
every year. " Very few electric car bodies have been aban-
doned on account of deterioration. Many have been retired
on account of being obsolete and unprofitable to operate.
Therefore, the proper value for ordinary depreciation is hard
to determine, but it is a well-known fact that where wood is
exposed to moisture it will deteriorate rapidly, that paint
and varnish will crack at joints if they are not kept well
covered and the varnish elastic, and that floors and sills will
rot if they are not kept well painted. Therefore, it is safe
to estimate that the life of a car body which has received
proper attention each year will be ten per cent greater than
one receiving attention every second year.

This conclusion of the committee is abundantly borne
out by examination of the detailed figures of maintenance
of cars under the two systems, which are given in the report.
For example, the item of general woodwork repairs and
tightening up frames, under the system of yearly shopping,
cost the company in the eighth year $15 and in the tenth
year $15.50. When the car has been shopped bi-yearly, how-
ever, this item cost $45 for the eighth year and $60 for the
tenth year. The cost of varnishing and cleaning and reno-
vating upholstery and curtains is also much greater for the
later years of the period than on cars which have been
shopped yearly. The committee estimates that the life of
a car body which has received attention every year is ten
per cent greater than one receiving attention every second
year.

There is also a great advantage in yearly maintenance of
equipment in reduced cost of car cleaning and in greater
attractiveness leading to an increase in revenue. " It will
also be conceded," says the committee, " that a car which is
kept well varnished can be kept clean with less labor than
is the case where the luster is gone and the paint exposed.
This would amount to at least ten per cent of the cost of

MANAGEMENT OF COEPORATE INCOME 221

keeping the woodwork clean, but as it would not afEect the
sweeping, dusting and cleaning of glass, five per cent of the
total car cleaning is taken as a fair value.

" A clean car excites pride in the car crews, tends to make
them more attentive to their personal appearance, their
work more pleasant, and, in consequence, they will render
better service to the company. An attractive and comfortable
car goes a long way toward making a satisfied passenger and
a well-disposed public."

,The committee estimates the gain under this head result^
ing from yearly maintenance at ten cents per car per day.
The final comparison of the results of yearly and bi-yearly
maintenance is presented in the following table of costs and
credits :

SuMMABT OP Costs and Credits

Cabs Shopped Ybably

Cass
Shopped

Costs

Credits

Car body maintenance (for 10
years)

$585.14

44.40
10.40

$36.50
84.65

182.50
61.50

Interest, depreciation, taxes and
insurance (for 10 years) on addi-
tional equipment on account of
being in shops four days per
year more than when shopped
hi-vparlv

Interest, etc., on increased shop

Reduced liability of accidents for
five years at two cents per day. . .

Five per cent saving in cost of car
cleaninff for five vears

Value of car being more attractive
and comfortable to passengers
(at ten cents per day for five

Decreased depreciation on longer
life of car body (ten per cent.) . . .

Tntala for ten vears

$639.94
63.99

$365.15
36.51

$554.49

55.44

222 COEPOKATION FINANCE

The claim of regular maintenance could not be more
clearly presented than in the final results of this comparison,
showing an advantage of $27.96 for the method of yearly
shopping. Prom every standpoint except that of immediate
saving, the policy of postponing maintenance is to be con-
demned, not merely because of its effect upon the property
maintained, but also because of the impaired operating effi-
ciency which neglect of maintenance always brings in its
train.

Having established our rules for the financing of main-
tenance, we have next to consider the financing of deprecia-
tion. Shall the depreciation charges be annually deducted
from income as are maintenance charges and sinking funds,
or shall the directors be given a certain amount of liberty
in concentrating these charges upon years of large earnings?
The various public service commissions which have passed
rules on the subject and the Interstate Commerce Commission
are inclined to the opinion that depreciation should be a fixed
rule. The Wisconsin commission, for example, provides that :

Every electric railway shall carry a proper and ade-
quate depreciation reserve to cover the full replace- '
ment of all tangible capital in service. There shall
be' opened a depreciation account, to which shall be
charged monthly, crediting the depreciation reserve, an
amount equal to one twelfth of the estimated annual
depreciation of the tangible capital in service of the
railway, or as near that amount as the finances of the
property will permit.

On the other hand, the practical view of this subject is
expressed by Mr. Prank E. Pord, of Pord, Bacon & Davis,
electrical railway engineers, in a paper presented at the mid-
year meeting of the American Street & Interurban Eailway
Association on January 28, 1910:

The depreciation fund is essentially a financial prob-
lem, the solution of wnich is apparently by law left
to the directors of the corporation as they are em-

MANAGEMENT OP CORPORATE INCOME 223

powered to determine the amount of current income to
be set aside for working capital and the amount of divi-
dends to be declared. It is questionable if utilities com-
missions can lawfully impose rules for the charging of
depreciation in cases where the physical property is
fairly maintained and securities properly issued. I be-
lieve that no hard and fast rule can be laid down for
charging a fixed amount to such a fund month by month
or year by year; the proper amount to be charged should
be known, and if in lean years this amount is not laid
aside, in prosperous years the deficiency should be made
up. It might even be necessary to use this fund for
other purposes than renewal of physical property, due
to business contingencies unforeseen.

Mr. Ford's view, while it may be endorsed when viewed
solely from the standpoint of financial administration, must
be considered obsolete in the light of income tax regula-
tions. A tax of 10 per cent on corporation profits, to say
nothing of excess-profits tax deductions at 20 and 40 per
cent rates, make it imperative that every lawful deduction
should be made from the income of each year. The text
of the law and its administration favor large deductions
for depreciation, and, by implication, the building up of
ample reserves, both for depreciation and other contin-
gencies. If a company tries to concentrate its depreciation
appropriations into years of large earnings, in order to
take credit in its tax statements for excess depreciation,
it must convince revenue officials that its allowances in
former years were not sufficient, and this may be difficult
to do mor^ than once. It is far better to deduct the full
amount allowed by law each year, and also to put as much
as possible of these reserves into special funds immediately
available for replacements. By holding replacement funds
in liquid form, a company will not merely be able to make
its renewals at the time when costs of construction are
lowest, but if these funds are continually being expended,
at the time and in the manner indicated, earning power
will steadily increase by the substitution of superior de-
vices which may cost no more than those which they dis-

224 CORPORATION FINANCE

place. A most salutary and commendable feature of the
income tax law has been this encouragement which it offers
to the building up and utilization of large reserves.

CHAPTEK ,XVII

FIXING THE PROPORTION OF PROFITS TO BE PAID OUT
IN DIVIDENDS

The third rule or principle which we find to govern the
dividend policy of well-managed companies is to pay out in
cash dividends only a portion of the balance of income re-
maining in any year available for distribution to stockholders.
Even after a large surplus has been accumulated to safeguard
the dividend rate, and with the most careful management of
the depreciation and renewal accounts, the amount of this
"balance for dividends" is subject to wide fluctuations,
which, in view of the desirability of maintaining a fixed
rate of dividend, makes the distribution of the entire amount
in any year unwise.

The earnings of a corporation are the resultant of three
factors: (1) The volume of traffic or sales; (2) the rate
or price at which the business is done; (3) the cost of opera-
tion or production. A steel manufacturing company, for
example, buys coke, pig iron and limestone and converts
these products first into iron, and then into steel rails by
purchasing the services of a number of employees, and fimally
sells the product to the consumer. The formula for calculat-
ing the profits of this company is as follows : (Eeceipts from
sales) — (cost of materials) -{- (wages, salaries and general
expenses) -|- (interest, rentals and taxes) -(- (cost of ma-
terials, machinery for replacements and new construction
charged to depreciation). A variation in any of the items
of expenses, unless accompanied by corresponding variation
of receipts, will result in a fluctuation of profits.
225

226 COEPOEATION riliTANCE

Stability of profits, under these circumstances, is an im-
possibility. The price of the product changes with the period-
ical fluctuations of demand. The growing power of organ-
ized labor as well as the inefiBciency of labor when employment
is plentiful, makes labor cost uncertain. New inventions
and improvements may require the company to discard large
amounts of machinery. Only the items of general expense
and interest charges can be regarded as factors of expense
which can be reckoned with certainty. On the other hand,
the receipts from sales are even more uncertain. In Sep-
tember, 1907, for example, few anticipated that within three
months the leading manufacturing plants of the country
would be operating at one half of their normal capacity.
The regular alternations of prosperity and depression, to
say nothing of general breakdowns, such as befell the steel
industry in 1908, or difficulties with organized labor, or
advances of freight rates or tariff changes, any one of these
uncertainties may come in to make a marked change, both
in prices and the volume of sales. Here are two sets of profit
variables, , one disturbing calculations of expense, the other
calculations of income. As a result of their interaction,
every industry is subject to excessive variations of profits.

We may illustrate from reports of the Baltimore & Ohio.
The gross earnings of this company increased from 67.6
millions in 1905 to 82.2 millions in 1907. Then came the
panic and the depression, which reduced gross earnings to
73.6 millions. Operating expenses, from 1905 to 1907, in-
creased only ten millions. As a result, the net earnings of
the company, the difference between gross earnings and oper-
ating expenses, increased nearly five million dollars. On
the other hand, from 1907 to 1908, operating expenses were
hardly reduced at all, standing at fifty-four millions each
year. Fet earnings from operation of the Baltimore & Ohio
declined from twenty-seven millions to nineteen millions, the
exact amount of the decrease in gross earnings, in con-
sequence.

FIXING PROPORTION OP PROFITS 227

These fluctuations in profits are even more serious in the
case of industrial corporations. For example, the American
Smelting & Refining Company reported gross earnings of
13.2 millions in 1907, and 9.4 millions in 1908, and the
net earnings from operation of the United States Steel Cor-
poration which were 161 millions in 1907 to which figure
they had increased from 119.7 millions in 1905, suffered a
decline of approximately forty per cent during 1908, falling
to 91.8 millions. This fluctuation of profits is not the same
for all industries, nor is the rate of change the same for
every corporation in each industry. The distinction between
industries, in respect to the relative stability of their profits,
we shall have present occasion to examine. For the time
being, it is sufiBcient to note that these profit fluctuations do
exist, and that they must be reconciled with the necessity of
paying the regular dividend.

In view of these irregular earnings, it is impossible for
corporation directors to pay out all their earnings to stock-
holders without making dividends unstable and damaging
the financial standing of the company. To reconcile the
necessity for stable dividends with the fact of unstable profits,
the directors must pay out only such a percentage of profits
as will leave a margin over the dividend requirements, assum-
ing profits to fall to the lowest point which, in all reason-
able probability, will be reached. A corporation should ascer-
tain from its own experience, and from the experience of
other companies similarly situated, what are likely to be the
lowest earnings under the most unfavorable circumstances
which it is likely to encounter, and then fix its dividend rate
well below that point. In order to maintain a stable rate of
dividend, a corporation should have its maximum dividend
requirement always fall below its smallest earnings. If the
opposite policy is adopted, large dividends will be paid out
of large profits, small dividends out of small profits, and
the value of the stock, as already explained, will be low and
uncertain.

Our next question concerns the percentage of profits

228 C0EP0EATI02T FINANCE

which directors, having regard to the desirability of a stable
■dividend rate, can safely pay out to stockholders. The deter-
mination of this proportion is a matter for the judgment of
directors in each case to determine, having regard to the
peculiar circumstances of their own company. There are,
however, certain broad considerations on the basis of which
a classification of companies, with reference to the proportion
of surplus earnings which should be paid to stockholders,
can be made.

The percentage of average profits which can safely be
paid out to stockholders varies with the regularity of its
profits. To illustrate: a corporation, the difference between
whose maximum and minimum profits over a period of years
is fifty per cent, should pay out only half the proportion of
annual earnings which can be safely distributed by another
.corporation whose earnings fluctuate only twenty-five per
.cent.

The stability of the earnings of a corporation depends
primarily upon the steadiness of the demand for the product
or service which it supplies. In manufacturing industry, this
stability of demand is greatest in those corporations which
produce the necessaries of life, such as sugar, oil and flour, and
it declines as the article becomes less indispensable to the con-
sumer. The percentage of average earnings which a lace
■or glove manufacturing company, for example, can safely
pay to its stockholders is far less than that which a sugar
,.or oil company prioduces. The fluctuations in the demand
for all goods used in production, including machinery and
materials, are also great. Iron and steel products, for ex-
ample, are purchased that the buyer may make a profit
by using these commodities in further production. Such
articles as lathe, steel rails and structural steel are usually
bought by producers who expect to make a profit by using
them or reselling, them. The strength of the. demand for
iron and steel depends, therefore, upon the movement of
■profits.

As a genera:l principle, rising prices always mean advanc-

FIXING PROPORTION OF PROFITS 229

ing profits to the industries concerned, and falling prices
mean declining profits. The reason for this is that costs of
production move more slowly than prices of the product,
since they contain certain elements such as wages and inter-
est, which change very slowly. Industries are, moreover, so
closely joined together in the relations of producer and con-
sumer that an increase in the prices and profits of one
industry is quickly passed to the others. When the price of
wheat, for example, is rising, the farmer's profits go up, and
with them his demand for agricultural implements, barbed
wire, and nails. When the price of wheat falls, these pur-
chases are postponed to a more convenient season. Rising
prices increase the volume of traffic, the earnings of the rail-
roads, and the prices of their securities, enabling them to
raise money for extensions and improvements, which improves
the demand for a great variety of articles entering into the
con^ruction and equipment of railroads. On the other hand,
when prices are falling, and the volume of business shrinks,
railway earnings decline, the security market will take only
high-grade bonds, and these only at low prices, the railroads
have no margin in their earnings to make improvements,
and their securities cannot be sold to advantage. It is then
necessary to stop their extension and improvement work, and
to curtail their expenditures for materials. The same in-
fluence determines the demand for the products of all the
metal industries, and also the demand for such articles as
coal and lumber which are purchased for profit and not for
the personal consumption of the buyer. The demand for
these articles fluctuates widely and often wildly, correspond-
ing to the alternations of business prosperity and business
depression. Industries which produce production goods, there-
fore, if properly managed, will be very conservative in their
distribution of profits to stockholders.

There is a wide difference between the profits of railway
transportation companies and manufacturing companies, the
instability of whose profits we hkve just been considering.
The demand for the products of a single industry is limited

230 COEPOEATIOiSF FINANCE

to a small portion of the total number of commodities pro-
duced. The demand for railway transportation, on the other
hand, is represented by every commodity of commerce. The
demand for transportation corresponds to the supply of com-
modities. The broader is the demand for the products or
service of an industry, the more stable are its earnings. A
large and diversified demand is but slightly aifected by any
influence, but if this influence is left to operate by itself
upon the price of a commodity or service, it produces wide
fluctuations. The withdrawal of ten thousand gallons from
a standpipe appreciably affects the level of water in the pipe.
Withdraw the same amount from the reservoir, and the water
level is scarcely affected. This analogy may be applied to
explain the stability of the demand for railway transporta-
tion as compared with the demand for coal, sugar, or iron.
The railroad company is patronized by the producers of every
commodity. What it loses in freight earnings from a decline
in price or supply of one group of products, is often more
than regained by advances in others. The manufacturing
company, on the other hand, by producing, at the most, only
a small number of products, has usually less compensation
for a decrease in demand. Its earnings usually, therefore,
show a larger effect from a fall in prices.

The classified freight trafiBc of the Pennsylvania Eailroad,
for example, includes thirty-six general classes of freight,
some of which comprise thousands of individual articles, and
each one of which contributes to the $153,564,528 of gross
earnings which the company earned in 1909. Each one of
these commodities is acted on by a variety of influences which
affect its demand or supply, and which, through these factors,
influence the profits of its producers. The production of
anthracite coal is reduced by a strike. As a result the de-
mand for bituminous coal is increased. A failure of the corn
crop reduces the profits of the farmer and rancher. A cut
in duties decreases the profits of the manufacturer, and a
change in internal revenue duties affects the profits of the
grower and distiller. Prices and profits are in a state of con-

FIXING PROPORTION OF PROFITS 231

Bta^it change. No manufacturing industry can be certain of
its earnings a year hence.

From these disturbing influences, however, the railway
company is, to a large extent, protected. The great variety
of its traflBc prevents rapid changes in the gross amount.
What is lost on one commodity is often regained on another,
and the total toimage is not reduced. This is well illustrated
by a comparison of the gross earnings of the Pennsylvania
Railroad with those of the United States Steel Corporation.
The one is the largest railroad system in the United States
and one of the best managed, and the other is the largest and
one of the best-managed and best-orgaiiized industrials. The
steel corporation, moreover, manufactures a great variety of
products, so that its demand would naturally be more stable
than those of steel manufacturing companies whose profits
are more narrowly specialized. It has also been able to main-
tain for long periods stable prices for most of its products,
and its supremacy in the steel trade since its organization
has only recently been challenged. Competition, until the
winter of 1909, has very slightly disturbed it, and yet the
fluctuation of its gross earnings, compared with the Pennsyl-
vania Railroad, which appears in the following table, where
the figures are stated in millions of dollars, is extreme. The
figures for the Pennsylvania Railroad are as follows, stated in
millions of dollars:

1902 112

1903 122

1904 118

1905 133

1906 148

1907 164

1908 136

and for the United States Steel Corporation as follows :

1902 500

1903 536

1904 444

1905 585

1906 696

1907 757

1908 482

232

COEPOEATION FINANCE

Tlie percentages of fluctuation from one year to another in
the two companies are as follows :

Pennsylvania
Raileoad.

United States
Steel Cor-
pobation.

1902

15.15
8.93
3.28
12.71
11.28
10.81
17.08

1903 .

7.20

1904

17.16

1905 .

31.76

1906

18.97

1907

8.76

1908

36.33

Broadly speaking, the distinction which has been indi-
cated between railway and manufacturing industries holds
good wherever it is applied. The demand for the transporta-
tion services offered by some railways, especially those which
depend exclusively upon iron and steel or kindred industries,
is more irregular than those of some manufacturing compa-
nies— for example, gas or electric lighting companies or com-
panies supplying certain food products which are regarded as
necessaries of life. But as between the two classes of cor-
porations, railroads and industrials, the comparison of sta-
bility of demand favors the railroad, primarily because of the
breadth of the demand for its products.

The distinction between transportation and manufactur-
ing industry, on the basis of the respective stability of their
profits, is explained, not merely by varying conditions of de-
mand, but by their respective liability to competition. A
business in which competition prevails is certain to be a busi-
ness of fluctuating prices. When demand is slack, the sell-
ers, in their struggle to keep their plants in operation and
their organizations employed, give the buyer concession after
concession, which he very well knows how to extract by play-
ing one seller against another. Then, when business revives,
the producer, who has usually lost money during the depres-
sion, takes immediate and full advantage of the opportunity
to charge the highest price which the trafiic will bear. These

FIXING PROPORTION OF PROFITS 233

high prices, as soon as the low-price contracts with which
large consumers have protected themselves expire, lead to the
curtailment of demand and to another outbreak of competi-
tion. When the steel industry, for example, was a competi-
tive business, prices were highly irregular. In fact, for a
long period there were no fixed prices on account of the
rebates and discriminations; everything was uncertain, irreg-
ular, and unstable. Under such conditions profits were not
only reduced in the aggregate, but their fluctuations were
enormous. From 1901 to 1909, however, under the domi-
nance of the United States Steel Corporation, which has
controlled about sixty per cent of the production of finished
material, and of whose power the smaller producers have
stood in awe, stable prices have been maintained. The cor-
poration has neither raised prices during periods of active
demand — for example, in 1904, 1905, 1906, and 1907, when
they could have materially advanced quotations — nor when
business declined have they attempted the futile experiment
of persuading the manufacturer half of whose plant is idle,
or a railroad with one third of its equipment on the sidings,
to invest large sums in steel products for extensions and im-
provements by making concessions in price. By maintaining
prices they have earned a larger margin of profits on a re-
duced tonnage, and have protected their interest and pre-
ferred dividends.

From the influence of competition, the profits of the rail-
way industry are almost fully protected. The railway com-
pany enjoys a natural monopoly. After the territory through
which its lines pass has been fully settled, and the local dona-
tions of land and cash, upon which most American railways
originally depended for their construction, have ceased, the
building of competing lines becomes very difiicult. An im-
portant deterrent to new railroad construction is the increas-
ing cost of terminals. A recent illustration of this fact is the
enormous expenditures of the Gould interests to put a line
into Pittsburg, which it is claimed cost them $30,000,000,
and which, because of their inability to connect with the lead-

234 COKPOEATION FINANCE

ing industries of that city, and also because of the absence of
an Eastern outlet which would enable them to compete for the
bulk of the tonnage, has never been successful. Even where
competition exists between the larger cities, the local traffic
is generally free from this influence, and competition for
through business, while eiieetive in maintaining lower rates
between competitive points, is nevertheless well regulated by
uniform agreements, which are well observed, presumably
because the decline of traffic during periods of depression is
not so severe as to incite a struggle for existence between
railroads, and also because all forms of secret rate cutting,
rebating, and discriminations are now prohibited by a Fed-
eral criminal statute, which has been rigidly enforced in
recent years.

A few years ago the attempt was made to permanently
eliminate competition in the railway field by a system of
community of interest by which one road purchased control,
although not always a majority interest, in the stocks of its
competitors. This system has been broken up by the enforce-
ment of the Shernian Antitrust Law, but it lasted long
enough to enforce upon the railroads the necessity of agree-
ment upon rates. While railway competition, so far as it re-
lates to speed and character of service, still exists, competi-
tion in rates has practically disappeared.

The elimination of competition from manufacturing in-
dustry, however, is exceedingly difficult. To return again to
the United States Steel Corporation, which offered the best
promise of accomplishing this result, we find that, during the
winter of 1909, this attempt to control prices, although it
was for the manifest interest of the trade, was completely
broken down. The steel corporation at no time controlled
two thirds of the steel production of the United States, but
relied upon its control of raw materials and the influence
which the dominant factor in the trade usually has upon
the weaker members, to secure adherence to a policy of fixed
prices. By uniting upon this policy, the small amount of
business which was to be had was handled at remunerative

FIXING PROPORTION OF PROFITS 235

prices, and th6 profits of all steel producers were much larger
than they would have been had they surrendered to the con-
teumer it the outset of the depression. Little by little, how-
ever, \mder the pressure of necessity, the independents broke
away from the agreement, and cut prices in order to secure a
larger share of the limited business available than they would
have obtained had they followed the policy of the steel cor-
poration in maintaining prices. At last this price cutting
was seen to threaten the steel corporation with the loss of
most of its business for the coming year. In self-defense it
was compelled to announce an open market for steel. With
this declaration, a portion of the benefits of combination, so
far as these relate to the control of prices, were surrendered to
the consumer.

The failure of the attempt of the United States Steel
Corporation to control prices, an attempt made under the
most favorable auspices, with the strongest leadership, and
apparently with the cordial cooperation of all members of the
trade, shows that the maintenance of, stable prices in the field
of production goods, unless the ownership of an entire in-
dustry can be secured by one producer, is difficult. Single
ownership the Federal and State laws, as at present inter-
preted, will not permit.

In the field of consumption goods, where commodities ^re
purchased directly by the consumer, monopoly is even more
difficult to secure. The concentration of manufacture under
the control of large corporations has worked for a larger
measure of stability than was possible when an industry was
carried on by a large number of productive units, but com-
bination has thus far done no more than to mitigate the
severity of competition. It has not been able to do away
with competition.

These general difEerences between industries, however, do
no more than furnish the starting point for the determina-
tion of the percentage of profits which a given corporation
can carry. Within each industry, a great diversity of condi-
tions as to the strength of demand, costs of production, con-

236 COEPOEATION FUSTANCE

trbl of raw materials, location in reference to markets, and
a variety of other considerations are encountered. The "exist-
ence of these differences in conditions makes it impossible,
without reference to the circumstances of the corporation in
question, to determine the proportion of average proiits which
can safely be distributed to stockholders.

Even within the industry whose profits are more stable
than any other, the business of railway transportation, we
find wide differences between the stability of profits of differ-
ent railroads. The N'ew England railroads — for example,,
the New York, New Haven & Hartford and the Boston &
Maine— have a large percentage of passenger traffic which
fluctuates little, and a high-class traffic of manufacturing
goods and merchandise, which produces a stable revenue. In-
dustrial conditions in this territory are very stable. The peo-
ple, as a community, are well-to-do, and the New England
States are affected in a much smaller degree by an industrial
depression than are many other communities. As a result of
these conditions, the traffic and earnings of the New York,
New Haven & Hartford and the Boston & Maine are subject
to relatively slight fluctuations. Until these companies were
forced by unwise management to suspend dividends in order
to recuperate, they were able, with safety, to pay out much
larger percentages of their relatively stable profits, than would
have been safe for companies depending largely on coal or
iron and steel traffic, or on grain and lumber traffic.

But while it is impossible, for the reasons stated, to indi-
cate, as between different industries, the percentages of prof-
its which can be safely distributed in dividends, we may an-
swer the question as to the proper amount of earnings which
should be _ reserved for the protection of the dividend rate
by reference to the practice of the most conservative railway
and industrial companies. The Pennsylvania Eailroad, for
example, on an average of many years, has made it a rule
that for every dollar paid out in dividends another djollar
shall be put into the property. The Chicago & Northwestern
has distributed about three fourths of its profits; the Great

FIXING PROPORTION OP PROFITS 237

N'orthern, a somewhat smaller percentage. The earnings of
the railway business, with the possible exception of public
service corporations located in a few of the larger cities, are,
as we have seen, more permanent and stable than those of any
other leading industry. In fixing the percentage of reserve
required for corporations operating in industries where the
stability of profits is less than in the railway industry, it is
safe to require at least as large a proportion as that reserved
by the strongest railway companies, since the nature of the
railway business renders the earnings of long-established rail-
way companies far more stable than the profits of even those
manufacturing companies which are most firmly intrenched
in the control of raw materials and in a stable demand for
their product.

On the basis of this principle, we may assume that no
railroad company, outside of corporations so exceptionally
situated as are the railroads in Southern New England, can
safely pay out in dividends, on an average of ten years, more
than three fourths of its profits, and that the percentage of
cash distributed by industrial corporations should not be more
than fifty per cent of the average profits. The implication of
this rule is, of course, that during periods of large profits a
much higher percentage than fifty per cent must be reserved
for the stock. As a general proposition, a corporation which
follows the rule of a dollar for the company and a dollar for
the stockholder is on the way to an investment position for
its stock. In cases where the industry is exposed to excep-
tionally wide fluctuations of profits even a larger percentage
must be reserved. The balance reserved for the company is
invested for its benefit, the accumulation of this annual in-
vestment raising the earning capacity of the company so that
a higher dividend rate can eventually be paid. As the divi-
dends increase, however, the surplus should also increase,
both dividends and surplus, with ordinary good management,
moving upward, and the stockholders profiting, not merely
from the Increase in dividends, but from their greater se-
curity in any rate of dividend once attained.

CHAPTEE XVIII
THE METHODS OF DISTRIBUTING THE SURPLUS

What now is the relation of this surplus appearing on the
balance sheet to the rate of dividend ? May it be drawn upon
in case of emergency to make up a deficit in income? May
it be distributed in large amounts as special dividends to
stockholders, or can the stockholders hope for no greater ben-
efit from this accumulation out of profits than their propor-
tion of the addition which will be made to the income of the
company as a result of the investment of its profits? In the
majority of companies the only service 'which the surplus
accumulated out of profits renders to the dividend rate is to
increase the amount of annual profits, which furnishes the
basis for the amount of dividends declared. It may, how-
ever, in some cases serve as a fund out of which deficits in
the amount necessary to pay the regular dividend may be
made up, either by direct withdrawal or by borrowing. The '
surplus may also, from time to time, be directly distributed
to stockholders, in a lump sum, as a special dividend. These
various methods of utilizing the surplus we have now to ex-
amine.

The surplus of. a corporation may be used as a source of
dividends to its stockholders, aside from its service in increas-
ing the net earnings of the business, in the following ways:
The company may, during a season of depression, draw down
its surplus by reducing its cash working capital for the pur-
pose of making up a temporary deficiency in revenue. It may
accomplish the same result by negotiating a temporary loan,
which will be returned out of the income of a later period of

238

METHODS OF DISTRIBUTING SURPLUS 239

the year. This method of. borrowing money to meet divi-
dends, when receipts are irregularly distributed throughout
the year, is very common. It is a legitimate practice. If
the revenues are in sight, a bank will lend money to a cor-
poration to anticipate those revenues, no matter if the pro-
ceeds of the loan are to be immediately distributed to the
stockholders in the form of a dividend.

The second method of distributing surplus directly to the
stockholders is employed when a company may have acquired
in the course of its business certain assets with which it can
readUy dispense, such, for example, as coal-mining or express
companies, or land companies. The stocks representing these
concerns may be held in the treasury of the parent company,
and the dividends received on these stocks may be added to
the other income of the parent company, and merged into its
general surplus available for distribution. In case it is expe-
dient or convenient for the corporation to divest itself of the
control of these properties, the stocks or bonds issued by the
subsidiary companies may be distributed to the stockholders
of the parent company as a special dividend.

An illustration of this method is furnished by the
distribution of the Great Northern Ore Certificates to the
stockholders of the Great Northern Railway Company. Cer-
tain iron-ore lands in Minnesota had been acquired in the
interest of the Great Northern Railway by Mr. James J. Hill,
then its president, and his associates. These properties, ag-
gregating about '60,000 acres, were located in the Missabe dis-
trict of Minnesota. They were controlled by the corporation
known as the Lake Superior Company, Ltd., controlled by
the Great Northern Railway. The properties were trans-
ferred in the autumn of 1906 to Mr. James J. Hill, Louis W.
Hill, and E. T. Nichols, as trustees, and 1,500,000 shares of
permanent beneficial interest in the trust were issued in De-
cember, 1906, to the Great Northern stockholders. In Au-
gust, 1906, a lease was executed to the Great Western Mining
Company, guaranteed by the United States Steel Corpora-
tion, covering 39,295 acres of this land. The Great Western

240 COEPOEATION FINANCE

Mining Company agreed to extract 750,000 tons of ore in
1907, with an iaerease of 750,000 tons annually, until a max-
imum annual extraction of 8,250,000 tons was reached in
1917. The least fixed the net royalty for each ton of ore deliv-
ered at the dock by the Great Northern at $.85, and, after
deducting eighty cents per ton as freight to the railroad com-
pany for transporting the ore, the balance is distributed to
the holders of trust certificates at least once a year. These
certificates were immediately distributed by the trustees to
the Great Northerh stockholders as a special dividend. This
lease has since been terminated.

It has long been the policy of the Great Northern to keep
its dividend at seven per cent. Had these ore certificates been
placed and held in its treasury and added to the regular
dividends, this rate would have been exceeded. The lease pro-
tected the railway company in the transportation of the ore
to be mined under the lease. It could, therefore, without
danger of losing control of this traffic, distribute the certifi-
cates of beneficial interest in the lease as a special dividend to
the stockholders. This would have been a direct distribution
of its surplus by the Great Northern Eailroad Company.

A portion of the surplus may be put into a dividend reserve
fund, withdrawn from the working capital of the business, and
so invested that it cannot be drawn upon without impair-
ing the efficiency of the corporation. Unless the dividend
reserve fund is so built up, the assets of the company can-
not be directly utilized to make up a deficiency in earnings.
A railroad company, for example, has invested its surplus
in equipment, or in improvements to its line, or in securi-
ties of corporations. It also carries a certain cash balance.
It cannot sell any of these properties or assets without im-
pairing its efficiency. The investment of surplus funds in
the business of the corporation merges and identifies them
with the general assets of the company, which are used for its
general corporate purposes, and which, unless the stockholder
decides to wind up its affairs and to pay its debts and divide
the balance, are not available for distribution. If, however,

METHODS OP DISTRIBUTING SURPLUS 241

a company adopts the policy of maintaining a dividend re-
serve fund, it may utilize its surplus directly to make up
deficiencies in revenue.

When a dividend reserve fund is established, an amount
is withdrawn each year from the working capital of the busi-
ness, and invested in securities which are held merely as in-
vestments, and which do not represent the control of the prop-
erties necessary to the business of the company. In a year
of small profits, a portion of these securities can be sold, or
they can be hypothecated for a loan, and the regular dividend
can thus be paid. This plan is in effect the averaging of
payments out of surplus over a period of years — the same
principle as that followed by many companies in insuring
their own plants.

An illustration is furnished by the Cunard Company,
which, over the twenty years ending 1903, out of £4,650,380
of profits earned, paid only 18.8 per cent to the owners of
the company and added 81.2 per cent to the various reserves
which the company maintained. A large amount of 'this
money withheld from the stockholders was invested in good
securities, and during four bad years, from 1892 to 1895,
these reserves were dravm upon for dividends. Of the
£64,000 which was paid out to stockholders during these
years, £55,000 came from the reserves. The maintenance of
a dividend reserve fund is justifiable for corporations, such
as ocean transportation companies, whose profits are subject
to wide fluctuations. As a general proposition, however, the
maintenance of these funds cannot be approved. The reason
is the same as that which can be urged against maintenance
of sinking funds — the fact that money invested in securities
can earn at the best 4| or 5 per cent, while if invested in the
business its earnings are much larger. A growing company
has always need of new capital to expand its business, and
save in exceptional cases such as the one just described, it is
bad policy to maintain any portion of its surplus in a form
from which it can be directly distributed to the stockhold-
ers. It is better that the annual reservations from profits

242 CORPORATION FINANCE

should be merged into the General assets of the company,
since in this way they will contribute to the increase of its
profits and property.

With the exception of the three methods described —
temporary reduction of working capital; distribution of
assets f pr which the corporation has no further use, and
payment of dividends out of a dividend reserve fu^nd —
direct distribution of the accumulations of the surplus of a
corporation is not possible. The surplus has become an
integral part of the property of the company, merged into
general assets, increasing in time the annual profits iii
which stockholders participate, but not available as a fund
of assets for immediate distribution to stockholders. The
company cannot sell any part of its plant to pay a divi-
dend or dispose of any securities held in order to control
corporations which these securities represent, nor impair
its working capital, to make a distribution to stockholders.
The distribution of the surplus must usually be made, if at
all, by increasing liabilities rather than by reducing assets, '
by the indirect rather than the direct method.

We have described the surplus as the difference between
assets and liabilities, which appears on the liability side of
the balance sheet This surplus can be reduced, not dis-
tributed, either by reducing the assets or by increasing lia-
bilities. In either case, the difference between assets and
liabilities is reduced, and if the corporation issues stock or
bonds directly to stockholders, or sells these securities and
pays out the proceeds as special dividends, it may, without
impairing its general assets or crippling in any way the
efficiency of its plant, distribute its surplus to its stock-
holders.

The usual method of distributing the surplus — although
if we understand the surplus as consisting of assets it is
really no distribution, but merely a reduction— is to de-
clare a stock dividend. The method of doing this, and the
reason for doing it are both shown in the following resolu-
tion of the directors of the American Tobacco Company :

METHODS OF DISTRIBUTING SURPLUS 243

Whereas, in the judgment of this board, it is to the
interest of this Company to capitalize a substantial
amount of its surplus so that it may permanently remain
invested in the business, to accomplish which purpose the
most convenient method is by the distribution of a stock
' dividend among its stockholders out of the authorized
and unissued Common Stock "B" of the Company.

Therefore Be It Resolved (1) That there be and hereby
is declared a stock dividend on the Common Stock and
Common Stock "B" of this Company of 75%, payable in
Common Stock "B" at par on August 1, to holders of
record July 15.

(2) That on August 1 there be transferred from sur-
plus to capital account an amount equal to 75% of the
total par value of Common Stock and Common Stock
"B" outstanding July 15, 1920, and certificates of Com-
mon Stock "B" equalling at par said 75% or warrants
therefor,, shall on August 1 be distributed pro rata
among the holders of record July 15 of said Common
Stock and Common Stock "B."

The business reason in most cases of stock dividends is
the desire of the directors to retain cash in the business
for purposes of its development. If they distribute a cash
dividend and simultaneously offer to their stockholders an
amount :of stock equal to the dividend, it is by no means
certain that all the stock will be taken. If, on the other
hand, the directors hold their cash, and distribute stock,
they are in the same position as if all the stockholders
under the first supposition had received their cash divi-
dend and had immediately endorsed the checks over to the
corporation in payment for stock.

Another, and at present a controlling reason, is the
bearing of the stock dividend upon the sur-tax upon in-
dividual incomes. Out of the heavy business of the last
five years, corporations, with few exceptions, have taken
enormous profits; and these profits are in many cases in
liquid form, available for immediate distribution. Before
the imposition of heavy income taxes, large cash disburse-
ments out of these profits would have been made. These
corporations, however, are for the most part controlled by
rich men. To men in this position the payment of a large

244 COEPORATION FINANCE

cash dividend, which is added to their taxable income, is a
calamity. Suppose, for example, that a man has $60,000
income derived from $500,000 of stock paying 6 per cent
.dividends, plus a salary of $20,000. In addition to the nor-
mal tax of 4 per cent on the first $4,000 of taxable income,
and 8 per cent on the excess over that amount, paid on the
420,000 salary, the stockholder pays a sur-tax of $8,110.
Now assume that the corporation has a large cash surplus
which it desires to distribute. Our stockholder's share will
be $40,000 in addition to the $40,000 which he is now
receiving, making his total income $100,000. On this
amount his total sur-tax will be $23,510. In other words,
over $15,000 of the $40,000 of the special dividend will
be paid out in sur-tax.

Now suppose that instead of paying out '$40,000 cash
i,o the stockholder, the corporation issues to him $40,000
of 6 per cent stock. His income is increased by only $2,400, the
standard rate return on $40,000, and his sur-tax is only in-
creased to $9,900. In other words, by the first method he has
-only $24,600 to invest, which at 6 per cent will bring him in
$1,476 per year, while from the return on his stock dividend
he will receive $2,400, gaining $924 in annual income by
.substituting the stock dividend for the cash dividend.

With men of great wealth, who are in receipt of enor-,
mous taxable incomes, and whose sur-taxes run to 65 per
.cent, large cash distributions are out of the question. In-
deed, it is a striking tribute to their honesty and fairness to
the stockholders of the companies which they control that
their dividends are not reduced, or indefinitely deferred.

The exclusion of stock dividends from incomes by the
recent decision of the Supreme Court was rightly con-
.sidered a most valuable concession to the men of large in-
comes, although, of course, no such consideration influenced
the minds of the majority. The essential parts of this
opinion are as follows:^

1 Eisner v. Maoomber— No. 318. Decided, March 8. 1920,

METHODS OF DISTRIBUTING SURPLUS 245

On January 1, 1916, the Standard Oil Company of
California, a corporation of that Statei, out of an authorized
capital stock of $100,000,000, had shares of stock outstand-
ing, par value $100 each, amounting in round figures to
$50,000,000. In addition, it had surplus and undivided
profits, amounting to about $45,000,000, of which about
$20,000,000 had been earned prior to March 1, 1913. In
January, 1916, the directors decided to issue shares suffi-
cient for a stock dividend of 50 per cent of the stock, and
to transfer from surplus account an amount equivalent to
such issue.

Myrtle Macomber, being the owner of 2,200 shares of
the old stock, received certificates for 1,100 additional
shares, of which 18.07 per cent, or 198.77 shares, par value
$19,877, were treated as representing surplus earned be-
tween March 1, 1913, and January 1, 1916. She was
forced to pay, under protest, a tax imposed under the
Revenue Act of 1916, based upon a supposed income of
$19,877 because of the new shares; and she brought action
against the Collector to recover the tax. In her complaint
she contended that in imposing such a tax the Revenue
Act of 1916 violated those sections of the Constitution of
the United States requiring direct taxes to be apportioned
according to population, and that the stock dividend was
not income within the meaning of the Sixteenth Amend-
ment. The Supreme Court decided against the Collector
of Internal Revenue.

"We are constrained to hold that the judgment of the
District Court must be affirmed because a reexamination of
the question, with the additional light thrown upon it by
elaborate arguments, has confirmed the view that the under-
lying ground of that decision^ is sound, that it disposes

1 Towne v. Eisner, 245 U. S. 418, where it was held that a stock divi-
dend made against surplus earned prior to January 1, 1913, was not
taxable as income.

246 COEPORATION FINANCE

of the question here presented and that other fundamental
considerations lead to the same result.

"The fundamental relation of 'capital' to 'income'
has been much discussed by economists, the former being
likened to the tree or the land, the latter to the fruit or
the crop ; the former depicted as a reservoir supplied from
springs, the latter as the outlet stream, to be measured by
its flow during a period of time. For the present purpose
we require only a clear definition of the term 'income,'
as used in common speech, in order to determine its mean-
ing in the Amendment; and, having formed also a correct
judgment as to the nature of a stock dividend, we shall
find it easy to decide the matter at issue. . . . ' Income may
be defined as the gain derived from capital, from labor,
or from both combined, provided it be understood to in-
clude profit gained through a sale or conversion of capital
assets. ' . . . Brief as it is, it indicates the characteristic and
distinguishing attribute of income essential for a correct
solution of the present controversy. The Grovernment, al-
though basing its argument upon the definition as quoted,
placed chief emphasis upon the word 'gain,' which was
extended to include a variety of meanings ; while the signifi-
cance of the next three words was either overlooked or
misconceived. 'Derived — frotn — capital'; — 'the gain — de-
rived— from — capital,' etc. Here we have the essential
matter: not a gain accruing to capital, not a growth or
increment of value in the investment ; but a gain, a profit,
something of exchangeable value proceeding from the
property, severed from the capital however invested or
employed, and coming in, being 'derived,' that is, re-
ceived or drawn by the recipient (the taxpayer) for his
separate use, benefit and disposal; — that is income derived
from property. Nothing else answers the description.

"The same fundamental conception is clearly set forth
in the Sixteenth Amendment — 'incomes, from whatever
source derived'— the essential thought being expressed

METHODS OF DISTRIBUTING SURPLUS 247

with, a 'Conciseness and lucidity entirely in harmony with
the form and style of the Constitution.

"Can a stock dividend, considering its essential char-
acter, be brought within the definition? To answer this,
regard must be had to the nature of a corporation and the
stockholder's relation to it. We refer, of course, to a
corporation such as the one in the case at bar, organized
for profit, and having a capital stock divided into shares
to which a nominal or par value is attributed.

"Certainly the interest of the stockholder is a capital
iiiterest, and his certificates of stock are but the evidence
of it. They state the number of shares to which he is
entitled and indicate their par value and how the stock
may be transferred. They show that he or his assignors,
immediate or remote, have contributed capital to the enter-
prise, that he is entitled to a corresponding interest pro-
portionate to the whole, entitled to have the property and
business of the company devoted during the corporate
existence to attainment of the common objects, entitled
to vote at stockholders' meetings, to receive dividends out
of the corporation's profits if and when declared, and, in
the event of liquidation, to receive a proportionate share
of the net assets, if any, remaining after paying creditors.
Short of liquidation, or until dividend declared, he has no
right to withdraw any part of either capital or profits,
from the common enterprise; on the contrary, his interest
pertains not to any part, divisible or indivisible, but to the
entire assets, business, and affairs of the company. Nor
is it the interest of an owner, since the corporation has
full title, legal and equitable, to the whole. The stock-
holder has the right to have the assets employed in the
enterprise, with the incidental rights mentioned; but, as
stockholder, he has no right to withdraw, only the right
to persist, subject to the risks of the enterprise, and look-
ing only to dividends for his return. If he desires to
dissociate himself from the company he can do so only by
disposing of his stock

248 CORPORATION FINANCE

"In the present case, the corporation had surplus and
undivided profits invested in plant, property, and business,
and required for the purposes of the corporation, amount-
ing to about $45,000,000, in addition to outstanding capi-
tal stock of $50,000,000. In this the case is not extraordi-
nary. The profits of a corporation, as they appear upon
the balance sheet at the end of the year, need not be in
the form of money on hand in excess of what is required
to meet current liabilities and finance current operations
of the company. Often, especially in a growing business,
only a part, sometimes a small part, of the year's profits
is in property capable of division; the remainder having
been absorbed in the acquisition of increased plant, equip-
ment, stock in trade, or accounts receivable, or in decrease
of outstanding liabilities. When only a part is available
for dividends, the balance of the year's profits is carried to
the credit of undivided profits, or surplus, or some other
account having like significance. If thereafter the com-
pany finds itself in funds beyond current needs it may
declare dividends out of such surplus of undivided profits ;
otherwise it may go on for years conducting a successful
business, but requiring more and more working capital
because of the extension of its operations, and therefore
unable to declare dividends approximating the amount of
its profits. Thus the surplus may increase until it equals
or even exceeds the par value of the outstanding capital
stock. This may be adjusted upon the books in the mode
adopted in the case at bar — ^by declaring a 'stock divi-
dend.' This, however, is no more than a book adjustment,
in essence not a dividend but rather the opposite; no part
of the assets of the company is separated from the com-
mon fund, nothing distributed except paper certificates
that evidence- an antecedent increase in the value of the
stockholder's capital interest resulting from an accumula-
tion of profits by the company, but profits so far absorbed
in the business as to render it impracticable to separate

METHODS OF DISTRIBUTING stlRPLUS 249

them for withdrawal and distribution. In order to make
the adjustment, a charge is made against surplus account
with corresponding credit to capital stock account, equal
to the proposed 'dividend'; the new stock is issued
against this and the certificates delivered to the existing
stockholders in proportion to their previous holdings. This,
however, is merely bookkeeping that does not affect the
aggregate assets of the corporation or its outstanding lia-
bilities; it affects only the form, not the essence, of the
'liability' acknowledged by the corporation to its own
shareholders, and this through a readjustment of accounts
on one side of the balance sheet only, increasing 'capital
stock' at the expense of 'surplus'; it does not alter the
preexisting proportionate interest of any stockholder gr
increase the intrinsic value of his holding or of the aggre-
gate holdings of the other stockholders as they stood be-
fore. The new certificates simply increase the number of
the shares, with consequent dilution of the value of each
share.

"A 'stock dividend' shows that the company's accumu-
lated profits have been capitalized, instead of distributed
to the stockholders or retained as surplus available for
distribution in money or in kind should opportunity offer.
Far from being a realization of profits of the stockholder,
it tends rather to postpone such realization, in that the
fund represented by the new stock has been transferred
from surplus to capital, and no longer is available for
actual distribution.

"The essential and controlling fact is that the stock-
holder has received nothing out of the company's assets
for his separate use and benefit; on the contrary, every
dollar of his original investment, together with whatever
aecre+ions and accumulations have resulted from employ-
ment of his money and that of the other stockholders in
the business of the company, still remains the property of
the company, and subject to business risks which may result
in wiping out the entire investment. Having regard to the

250 CORPORATION FINANCE

very truth of the matter, to substance and not to form, he
has received nothing that answers the definition of income
within the meaning of the Sixteenth Amendment.

"It is said that a stockholder may sell the new shares
acquired in the stock dividend; and so he may, if he can
find a buyer. It is equally true that if he does sell, and
in doing so realizes a profit, such profit, like any other, is
inconie, and so far as it may have arisen since the Six-
teenth Amendment is taxable by Congress without appor-
tionment. The same would be true were he to sell some of
his original shares at a profit. But if a shareholder sells
dividend stock he necessarily disposes of a part of his
capital interest, just as if he should sell a part of his old
stock, either before or after the dividend. What he retains
no longer entitles him to the same proportion of future
dividends as before the sale. His part in the control of
'the company likewise is diminished. Thus, if one holding
$60,000 out of a total $100,000 of the capital stock of a
corporation should receive in common with other stock-
holders a 50 per cent stock dividend, and should sell his
part, he thereby would be reduced from a majority to a
minority stockholder, having six-fifteenths instead of six-
tenths of the total stock outstanding. A corresponding
and proportionate decrease in capital interest and in vot-
ing power would befall a minority holder should he sell
dividend stock; it being in the nature of things impossible
for one to dispose of any part of such an issue without a
proportionate disturbance of the distribution of the entire
capital stock, and a like diminution of the seller's com-
parative voting power — that 'right preservative of rights'
in the control of a corporation. Yet, without selling, the
shareholder, unless possessed of other resources, has not
the wherewithal to pay an income tax upon the dividend
stock. Nothing could more clearly show that to tax a
stock dividend is to tax a capital increase, and not income,

METHODS OF DISTRIBUTING SURPLUS 251

than this demonstration that in the nature of things it
requires conversion qf capital in order to pay the tax.

"Throughout the argument of the Government, in a
variety of forms, runs the fundamental error already men-
tioned—a failure to appraise correctly the force of the
term 'income' as used in the Sixteenth Amendment, or
at least to give practical effect to it. Thus, the Govern-
ment contends that the tax 'is levied on income derived
from corporate earnings,' when in truth the stockholder
has 'derived' nothing except paper certificates which, so
far as they have any effect, deny him present participation
in such earnings. It contends that the tax may be laid
when earnings 'are received by the stockholder,' whereas
he has received none; that the profits are 'distributed by
means of a stock dividend,' although a stock dividend dis-
tributes no profits; that under the Act of 1916 'the tax
is on the stockholder's share in corporate earnings,' when
in truth a stockholder has no such share, and receives none
in a stock dividend; that 'the profits are segregated from
his former capital, and he has a separate certificate repre-
senting his invested profits or gains,' whereas there has
been no segregation of profits, nor has he any separate
certificate representing a personal gain, since the certifi-
cates, new and old, are alike in what they represent — a
capital interest in the entire concerns of the corporation.

' ' "We have no doubt of the power or duty of a court to
look through the form of the corporation and determine
the question of the stockholder's right, in order to ascer-
tain whether he has received income taxable by Congress
without apportionment. But, looking through the form,
we cannot disregard the essential truth disclosed; ignore
the substantial difference between corporation and stock-
holder; treat the entire organization as unreal; look upon
stockholders as partners, when they are not such; treat
them as having in equity a right to a partition of the cor-
porate assets, when they have none ; and indulge the fiction
that they have received and realized a share of the profits

252 CORPOEATION FINANCE

of the company which in truth they have neither received
nor realized. We must treat the corporation as a substan-
tial entity separate from the stockholdei^ not only because
such is the practical fact but because it is only by recog-
nizing such separateness that any dividend— even one paid
in money or property — can be regarded as income of the
stockholder. Did we regard corporation and stockholders
as altogether identical, there would be no income except
as the corporation acquired it; and while this would be
taxable against the corporation as income under appro-
priate provisions of law, the individual, stockholders could
not be separately and additionally taxed with respect to
their several shares even when divided, since if there were
entire identity between them and the company they could
not be regarded as receiving anything from it, any more
than if one's money were to be removed from one pocket
to another."

CHAPTBE XIX

THE PROVISION OF NEW CAPITAL

EvEET prosperous corporation is continually adding to its
plant in order to increase its profits. The extent of these
additions to plant may be seen by comparison of the item
" cost of plant " in the case of a number of our leading cor-
porations over a period of years. Such a comparison appears
in the following table :

1900

1907

Pennsylvania Railroad

Baltimore & Ohio

Chicago, Milwaukee & St. Paul .

Union Pacific

General Electric

United States Steel Corporation

1901

Republic Iron & Steel Co

$125,789,918.95

125,969,036.90

218,302,680.50

130,520,818.00

3,400,002.00

1,232,585,197.10
41,142,251.00

$291,061,204.00

165,066,928.00

259,148,727.00

373,951,998.00

9,000,000.00

1,435,540,068.00
63,592,166.00

Taking all the railroads of the United States, we find
that their cost of road and equipment increased from 1900
to 1907, inclusive, $2,879,800,000. Every prosperous corpo-
ration, whether the fact appears in its balance sheet or not,
has followed a similar line of development. Its productive
assets are steadily growing, more rapidly during some periods
than at others, but increasing to some extent in every year
of its existence.

The distinction between an expenditure which should be
charged to operating expense, and an expenditure which
should be charged to capital and appear as an increase ia

253

254 OOEPOKATION FINAJJCE

some asset account, is found in the fact that an expenditure,
to be properly capitalized, should result in a certain and ap-
proximately definite increase in the profits of the company,
an increase which is more than sufficient to pay interest or
dividends, at the rate paid by the company on its existing
liabilities, on the amount necessary to make the iniprove-
ment. From the class _ of expenditures which can be prop-
erly capitalized, on the basis of this definition, the so-called
betterment expenditures should be excluded. While better-
ments may result in decreasing the operating expenses of a
company, the amount of the increase is usually uncertain,
and, as has already been shown, the necessities of competi-
tion and the demands of the public and of the consumer
for improved service and better products, make it prudent
and even necessary for a well-managed company to charge
into their current operating expenses large amounts ■repre-
senting the cost of raising their property to higher standards.
An expenditure is capitalized when it is added to some asset
account, appearing also on the liability side of the balance
sheet either as an addition to stocks, bonds, unfunded debt,
surplus, or some one of the reserves which may be carried.
Capitalized expenditures should result in positive additions to
the business of the company. The construction, for example,
of a new mill, or the purchase of railway equipment, or the
construction of lines into new territory, are examples of ex-
penditures which could be properly capitalized. On the other
hand, under ordinary conditions, such expenditures as the sub-
stitution of heavy rail for light rail, the rebuilding of locomo-
tives, the elevation of tracks to increase the speed and safety
of passenger traffic, the improvement of passenger stations,
the substitution for out-of-date machine tools of new shop
equipment, are properly betterments, and their cost should
be clearly segregated in the asset accounts.

The influence which is most effective in forcing a cor-
poration into the policy of expanding its plant is the neces-
sity of guarding against the encroachment of competitors by
occupying the territory bordering the business on which

THE PEOVISION OF NEW CAPITAL 255

these competitors would thrive. If the demand for its prod-
ucts or services increases, the corporation must enlarge its
facilities to supply the demand; if it does not, and competi-
tors are permitted to occupy the new territory without a
struggle, there is danger that they may foUow up this eon-
quest by an approach to closer quarters. A forcible illustra-
tion of the reasons for providing additional capital funds is ,
given in a circular letter of the president of the Central
Union (Bell) Telephone Company to the stockholders in
1901, at the time when, the Bell company, was embarking on
its policy of expansion :

"After two months' investigation I find it imperatively
necessary that at least $3,000,000 be provided without delay.
The people of the states of Illinois, Indiana, Ohio, and iowa
want telephone service. Will you supply it, or must some
one else ? Are you doing it with fewer than 70,000 stations ?
ITo. When you have 300,000 exchange stations, then you
have a good start, not before. When you have 150,000 ex-
change stations, at proper rates, you will have a plant upon
which you can earn something with which to build up th&
second 150,000. With your present 70,000 stations, you can-
not build up anything except opposition. You are not sat-
isfying the public, because your system does not reach far
enough. There are scores of villages and small towns, taken
as a whole, that should have 50,000 telephones, and in which
the company has not one single instrument. What you want
done must be done now. Later on, and a very little later at
that, will be too late."

A recent illustration of the truth of the observations con-
tained in this circular came under the writer's observation
in Hammonton, IST. J., a town of about 4,000 people. The
Bell Telephone Company had exclusive possession of the field;
there were only about twenty-five stations in the town; thv
instruments were antiquated, the service wretched, the rat«s
high. Since the Bell company showed no disposition to im-

256 COKPOKATION FINANCE

prove matters, the citizens of the town organized a company,
raised $20,000, and installed an exchange, which now serves
300 subscribers and which furnishes a considerable amount
of long-distance business to the competitor of the Bell com-
pany. The Bell company could easily have had these 300 sub-
scribers if they had shown proper enterprise. As it is, the
business of this community is practically lost to them.

Closely allied to considerations of necessity are the con-
siderations of financial advantage which are offered to every
prosperous corporation in the enlargement of its plant or the
extension of its control over other corporations. These ad-
vantages are as follows: First, the restriction or regulation
of competition, by which rates or prices may be increased;
second, the enlargement and improvement of the plant to
handle increasing business at a lower cost; third, the ex-
penditure of money to develop the territory and to enlarge
the sales of the company. The policy of the Pennsylvania
Eailroad since 1900 furnishes illustrations of the realization
of each of these advantages by a progressive corporation. In
1900 the capital liabilities of the Pennsylvania Eailroad in-
creased $72,838,475 ; in 1901, $31,379,637; in 1902, $52,829,-
284; in 1903, $125,973,000— a total increase of $283,020,396
in the assets of the company within four years. This was
followed in 1904, 1905, and 1906 by further increases of $136,-
217,897. The money which the Pennsylvania Eailroad re-
ceived and spent from 1900 to 1906 was sufficient to build and
fully equip, at $60,000 per mile, a trunk line railway of 6,987
miles in extent. It is an amount far greater than the capital
liabilities of most of the larger railroad companies in the
United States.

When this increase of the Pennsylvania's capital is ana-
lyzed, and when the purposes to which the funds were applied
are understood, this large increase of capital is seen to have
been not merely warranted by the earniag power of the com-
pany's property, but imperatively demanded by the competi-
tive situation in the trunk line territory and by the growth
of the traffic which was pressing for immediate shipment.

THE PKOVISION OF NEW CAPITAL 257

The purposes for which the funds obtained by this increase
of capital were devoted were three: (1) the purchase of a
dominant interest in the stocks of the Baltimore & Ohio, the
Norfolk & Western, the Chesapeake & J)hio, the Western
New York & Pennsylvania, and the Long Island railroads;
(2) the improvement and enlargement of the physical prop-
erty of the Pennsylvania Eailroad Company; (3) the building
of extensive terminal improvements in New York City, in-
volving the construction of a tunnel passing under Manhattan
Island and connecting New Jersey with Long Island, and a
large passenger station on Manhattan Island.

The inauguration of the policy of purchasing securities
of competing lines was foreshadowed in the report of 1899:

" While the growth of your traflSc and its successful move-
ment are subjects for congratulation, your board has to
report a further reduction in the average ton mile rate.
Por years, the compensation of the trunk lines for moving
freight traflBc has steadily decreased. As may be supposed,
railway managers have not seen this reduction without seri-
ous concern, or without making strenuous efforts to check the
downward movement. These efforts have met with but little
■success. Had the railway companies not been able to meet
the diminution in the ton mile rate by a corresponding re-
duction in expenses, disastrous results must have followed.
But there is a limit, and it cannot be far off, to the possible
lessening of the cost of movement. The only alternative is
to arrest the reduction in revenue, which has been largely
hrought about by apparently uncontrollable conflicts between
the railway companies, and between rival communities. The
problems involved are not incapable of solution, and it is
believed, that by earnest and united effort the difiBculties in
ihe way may be met and overcome. With this end in view,
it has seemed wise to your board to acquire an interest in
sorae of the railway? reaching the seaboard and to unite
with the other shareholders who control these properties in
.supporting a conservative policy. This will, it is hoped,
IS

,258 OOKPOEATION FINANCE

result in securing reasonable and stable rates and do away
with unjust discrimination."

These observations of President Cassatt referred to the
inauguration of a program of purchasing stock interests in
competing lines which was carried on until the Pennsylvania
had acquired a dominant, although not a majority, stock inter-
est in its three southern competitors in the soft coal traffic, and
was able to influence their policy. Beneficial results were
immediately apparent. Soft coal rates, which had been utterly
demoralized, and in which the grossest and, most burdensome
discriminations had long existed, were immediately advanced
to a profitable basis, and imposed upon all shippers alike.
The most important item of the Pennsylvania traflBc, in
which there had hitherto been small profit, was turned into
a valuable source of revenue. Although in the succeeding
four years the freight traffic of the Pennsylvania increased
only 9,625,000 tons, or 9.6 per cent, the gross earnings from
freight traffic increased from $51,395,733 to $73,899,939, a
conclusive proof of the beneficial results of the application
of the principle of community of interest to the solution of
the problem of soft coal rates with which the Pennsylvania was
confronted in 1899. The profitableness of the freight traffic
of the Pennsylvania during this period increased nearly five
times as rapidly as the amount of the tonnage moved. These
investments in the stocks of the bituminous coal carriers were
profitable, not because of dividends received by the corpora-
tion which did not quite equal the interest paid on the pur-
chase money obligations, but because of the higher rates on
Coal which these purchases, representing control of compet-
ing lines, made possible, and which amounted to consider-
ably more than the interest on the bonds. Since the passage
of the Hepburn Law in 1906, the Pennsylvania Railroad
Company has disposed of a large part of these securities and
has definitely abandoned the attempt to influence its com-
petitors by a large representation on their directorates. The
necessity for these holdings no longer existed owing to the

THE PROVISION OF NEW CAPITAL 259

disappearance of the distrust and uneasiness which formerly
characterized the relations of the trunk line executives.
Furthermore, the Interstate Commerce law has now been so
strengthened that secret rate cutting is a thing of the past.
It should be remarked that the Pennsylvania Eailroad, in
addition to the dividends which it received on the stocks of
the soft coal carriers, made a profit of over thirteen million
dollars on such of them as it sold.^

The second object of the Pennsylvania's expansion of its
capital during this period was the improvement of its physical
property. The equivalent of a double track railroad has been
built from New York to Pittsburg and equipped with rolling
stock and yard and terminal facilities. As a result of this ex-
penditure the company now has a four-track road between
Pittsburg and Philadelphia, and six tracks between Harris-
burg and New York. By making large expenditures on
equipment the company has also increased the tractive power
of its locomotives and the capacity of its freight cars. Large
sums have also been spent upon supplementary improvements^
such as stations, expansion of yards and track elevation, all
of which increased the capacity of the road.

In the face of enormous expenditures, and in spite of
the notable gains in operating efiBciency which they brought
about, the facilities of the Pennsylvania proved inadequate
to the demands of this period. As President Cassatt re-
marked in his report for 1903:

"The remarkable development of business, particularly
in the sections served by your lines, created a demand for
transportation which could not be supplied. For, although
the trafiic carried over the roads comprising your system
east and west of Pittsburg aggregated nearly 2'i'0,000,000
tons, being an increase of 36,000,000 tons, or more than ten
per cent over the previous year, the necessities of the indus-
tries dependent upon your lines demanded a much larger

' In 1909 a large interest in the Norfolk & Western was acquired by
the Pennsylvania, whose control of the company is again effective.

260 COEPOKATION PINANCE

movement. The inability 'to accommodate these industries
was due mainly to lack of track and yard facilities. It has
been the policy of your management for years past to con-
tinually increase these facilities so as to keep them up to
the demands of the trafiBe; but although heavier expenditures
have been made for this purpose since the beginning of the
present period of business activity than ever before in the
same time, the exceptional growth of the tonnage has out-
stripped the facilities that it was practicable to create."

Primarily as a result of these large expenditures, result-
ing in an increase of capacity of its plant, the tonnage carried
by the Pennsylvania increased from 133,433,845 tons in 1903
to 323,810,040 tons in 1907, an increase of 90,376,195 tons,
which represented the total tonnage of the entire system
twenty-one years before. Without this expenditure, this traf-
fic could not have been handled, and the increase in operating
earnings from 1903 to 1907, which amounted to $32,051,553,
could not have beei^ realized.

The final field of the Pennsylvania Eailroad's expansion
policy was the New York terminal project. This will re-
quire, when completed, an expenditure of about $150,000,000.
The traffic situation in New York is peculiar. The total
area of Manhattan Island, excluding Central Park, is 20.6
square miles. Upon this small spot of ground is concentrated
a population exceeding 3,000,000. In the census year of 1900,
New York had a population of 89,805 to the square mile, as
compared with 9,951 for Philadelphia, 13,044 for Boston, and
8,939 for Chicago. These figures indicate the extreme con-
gestion of population which is due to the fact that the city
is located upon an island. If communication with the sur-
rounding country could be established, the population would
spread into the suburbs, a movement similar to that which
has followed the growth of other large cities. To the resi-
dent of New York, however, immigration to the suburbs is,
denied. East, on Long Island, are large territories, almost
unoccupied, offering desirable places of residence, but from

THE PKOVISION OF NEW CAPITAL 261

these opportunities of suburban residence the resident of Man-
hattan is cut off by the barrier of the East Eiver. If easy
communication with Long Island were to be established, there
could be no doubt that a vast exodus of population from Man-
hattan would result. As the matter stood, however, the large
number of hardy commuters who were willing to run chances
of missed boats and trains is a small fraction of the number
who will move into the suburbs when these obstacles are
eliminated.

This task of eliminating the river problem from the
transportation situation in New York has been left for the
Pennsylvania Eailroad to undertake. The Interhorough Com-
pany and the Hudson companies, which have also carried
tunnel projects to completion, followed the lead of the Penn-
sylvania. The Pennsylvania Eailroad has completed two
tunnels between New Jersey and its new terminal at Thirty-
fourth Street and Seventh Avenue, and four tunnels from
this point to its Long Island terminal at Long Island City.
These tunnel improvements will bring Manhattan into imme-
diate connection with the mainland and with Long Island, and
will result in a large migration from Manhattan Island to
places of more desirable residence. In Long Island particu-
larly, the largest and most desirable residential territory which
is tributary to any city in the United States, will be opened
by these improvements, which will practically insure, within
the next decade, an immense population throughout the east-
ern part of the island.

The advantages of these improvements to the Pennsylvania
lies in the fact that this corporation owns a majority of the
stock of the Long Island Eailroad Company which controls
the Long Island territory. It is true that the connection
with the mainland will increase the share of the Pennsyl-
vania in the competitive passenger business to the south and
west, making the Pennsylvania route quite as convenient as
the New York Central from its Forty-second Street terminal.
It will also develop the passenger business between Washington
and New York, already largely controlled by the Pennsyl-

262 COEPOEATION FINAlSrCE

vania, and will throw to the Pennsylvania lines a large part
of the through passenger business which originates in Brook-
lyn and along the lines of the Long Island Eailroad.

These gains are, however, unimportant compared with the
opportunities offered by the development of Long Island
territory. In Long Island, the terminal improvements will
build up a large and permanent suburban trafiBc for the
Long Island Eailroad. With the completion of the tunnel
project, the Long Island Eailroad Company will be able to
carry passengers from Thirty-fourth Street thirty miles into
the country in less time than the Manhattan Elevated Eailroad
now requires to take them from the Battery to 135th Street,
offering them, moreover, not merely a quicker passage, but a
more comfortable journey.

Of far greater importance, however, than the increase of
passenger business which wUl follow the completion of the
tunnel project, is the growth in the freight traffic. The
receipts from freight trafiBc on the Long Island have been
far below the returns from passenger traffic. This company
has been mainly dependent upon summer resort travel. It
usually fails to earn its interest charges during the winter
months. On the New Haven & Hartford, on the other hand,
the returns from freight and passenger traffic are about
equal. The reason for this discrepancy in the division of
receipts is that Long Island, up to the present time, has been
practically vacant territory. Only in the summer is its
population large. In 1900 its entire population, outside of
Brooklyn, was only 286,000. With Long Island brought into
communication with the mainland, the shifting of popula-
tion, it is expected, will build up a large city in the eastern
part of the island. This population will not only demand
a large amount of merchandise for direct consumption, but
the development of a variety of manufacturing interests will
follow its growth. All these developments mean, moreover,
a large amount of freight over the Long Island Eailroad, and
will give the Pennsylvania a long haul for a large amount
of traffic.

THE PEOVISION OF NEW CAPITAL 263

'New capital may also be required in the form of cash
and cash assets as working funds to handle an increased
amount of business. If a company makes large additions to
its plant, or if the business of its existing plant shows a
considerable increase, in case it does not make correspond-
ing additions to its working capital, it is quickly forced to
become a heavy borrower, and while this position causes little
inconvenience when rates of interest are low and money easily
obtained, should a financial stringency occur, bankruptcy
may be the result. Even under ordinary conditions, an
inadequate working capital may be the cause of heavy expense
to the corporation. The experience of the Pressed Steel
Car Company is in point. The report of the president for
the year ending December 31, 1901, contains the following:

" Since the incorporation of the company the profits have
aggregated $4,313,385. Out of these profits has been paid
$2,625,000 in dividends. The McKees Eocks plant cost
$1,581,580, and additions and improvements to original
plants, amounting to $555,702, have been taken out of the
initial working capital and earnings. Prom this it will be
seen that the actual cash working capital has been somewhat
encroached upon, but the plants and capacity have been more
than doubled, and the monthly production increased from
$1,000,000 to upward of $2,000,000, the full operation of
the plants.

" It is necessary to carry between $4,000,000 and $5,000,-
000 worth of material on hand, and for this purpose the
company has been compelled to be an extensive borrower.
During the year it was thought prudent to fund this in-
debtedness. Therefore, a mortgage for $5,000,000 was made
to secure five per cent notes maturing at the rate of $500,000
each y6ar, with the right to anticipate payment of all or part.
These notes have been disposed of on terms advantageous
to the company. By this means the company secures extra
working capital, and its interest charges are limited to not
to exceed $250,000 the first year, and $25,000 less every

264 OOEPOEATION TINANCE

year thereafter. There was disbursed last year for interest
and borrowed money $315,821, which was charged off to
operating expenses, and we believe that more than the differ-
ence appearing between this amount and $250,000 can be
saved in extra discounts on materials purchased."

The Pressed Steel Car Company, in funding its large
floating debt, not only made the economies indicated in the
president's statement, but also removed a serious danger of
financial embarrassment which might have resulted from
failure to renew these loans. The receivership of the West-
inghouse Electric & Manufacturing Company, in 1907, was
due, in large part, to inadequate working capital, and to
the efforts of the company to supply this deficiency by con-
tracting heavy bank loans, and by piling up large obligations
to merchandise creditors. Working capital is properly re-
garded, not merely as essential to the safety and prosperity
of a company, but as perhaps the most profitable part of its
equipment for business. It enables the company to carry
large bank balances on the strength of which, with the com-
pany's good credit, heavy loans can be made on occasion, to
take advantage of favorable opportunities for the purchase of
materials and to discount bills, while, at the same time, it
makes unnecessary the resort to the banks for more than tem-
porary and occasional accommodation.

New capital may be finally required for the reconstruc-
tion of a plant where a profitable business has been sacrificed
because the physical condition of the property has been neg-
lected. A case in point is that of the Kansas City Southern
Eailway Company when taken over by the new management.
Here was a road operating in a territory rich in traffic possi-
bilities, and carrying a sufficient amount of traffic to pay its
interest charges, in spite of its impaired physical condition.
It was estimated that, to put the property in a suitable con-
dition for handling present and prospective traffic, and to ex-
pand the business of the company to its proper proportions,
the following expenditures would be necessary:

THE PEOVISION OF NEW CAPITAL 265

Repairs and improvements to track $2,983,856 . 00

Reinforcements and reconstruction of bridges 510,000 . 00

Repairs and improvements to equipment 540,000 . 00

New tracks 388,000.00

New freight depot facilities 125,000.00

New water stations 65,000 . 00

New shop facilities 435,000.00

New telegraph 34,000.00

New fencing 180,000.00

Work at Port Arthur, Texas 50,000.00

New equipment 1,604,749.50

Total $6,915,605.50

Practically all of these expenditures, with the exception of
the equipment • purchaseSj should have been spread over a
period of years, and charged to operating expenses, not to
capital. Over $5,000,000 of the amount which was deemed
necessary to be spent on the property represented deferred
charges to maintenance and betterments. The company should
not, in a narrow view of the situation, have received any capi-
tal for the reconstruction of its plant, but should have de-
voted its surplus income to the purpose. Under the conditions
confronting the management, however, there was no surplus
income. At the same time, the expenditure of this large
amount of money, no matter how provided, would put the
company into position to make large earnings. Said President
Edson :

" Your officers are convinced that with the improvements
and additions which have been set forth, which will require
two or three years to complete, and which will enable the road
to handle expeditiously and economically all traffic which may
be offered, the gross earnings will show an increase, of from
twenty to twenty-five per cent over the gross earnings for
the year ending June 30, 1905, and that, with the economies
which the additional facilities will make possible, the ratio
of operating expenses, including taxes, to gross earnings, will
not exceed seventy per cent.

" Taking as a basis the minimum of tweiity per cent in-
crease in gross earnings, the following results may be con-
fidently expected under existing commercial conditions :

.266 CORPOEATION FINANOE

Groas earnings .■ $8,272,387.54

Operating expenses and taxes 5,790,671 '. 28

Net earnings 2,481,716.26

Interest on bonds owned 32,501 .00

Total income $2,514,217.26

Interest on bonds '900,000.00

Ne^ annual surplus from income $1,614,217 . 26

Prom which must be paid, of course, the interest on such
funds as may be borrowed for improvement.

" Prom this it seems certain that, unless overtaken by
some unforeseen and general commercial disaster, the earn-
ing capacity of the property amply justified the capitaliza-
tion of the amount necessary for improvements and exten-
sions."

The surplus for the period to which this report refers
was only $610,191.80. This income was in danger of dis-
appearing, owing to the inability of the company to handle
the business offered. The expenditure of approximately
$7,000,000 would show earnings of 14.28 per cent on this
amount. The conclusion that the cost of rehabilitating the
Kansas City Southern Eailway Company should be defrayed
out of new capital provided for the purpose, and charged to
the capital, instead of to operating expenses or depreciation,
was evidently correct. Acting upon this advice, the stock-
holders authorized an issue of $10,000,000 4^ per cent second
mortgage bonds, pledging them as collateral for $5,100,000
negotiable gold notes. Most of the proceeds were spent in
making good the omissions of the past for the sake of obtain-
ing the profits of the future.

' Not all deductions are given.

CHAPTEK XX
THE METHODS OF PROVIDING NEW CAPITAL

OuE next inquiry is concerning the methods by which
the necessary extension of plant and enlargement of corpo-
rate power and influence is to be accomplished. A company
may either raise money to be invested in the improvement
and extension of its plant, or it may acquire interests in
other corporations which possess the necessary assets. These
interests it may acquire either directly by the exchange of
securities, or through the medium of a holding company, or
by selling its own securities to the investor, expending the
proceeds upon the securities desired, or by some form of
lease of the desired property, or by a working agreement by
which the use of the desired facilities is obtained. The first
plan is the direct method of providing capital out of in-
come or by the sale of securities; and the second, the indirect
provision of capital by various methods which come under
the head of consolidation.

Capital funds may be directly provided for the corpora-
tion by one or more of the following methods: (1) The
money required may be appropriated out of profits; (2)
stock may be issued; (3) the corporation may borrow
money either on short time notes or by the sale of long term
bonds. In Chapter XVII we have discussed the necessity
that a properly managed corporation should never pay out
all its earnings to stockholders. Conservatism demands that
a certain balance should be reserved and invested in the busi-
ness. The purpose of this reservation is to make sure that
a dividend rate, once established, may be maintained. The

267

268 COKPOEATION FINANCE

investment of these funds reserved from earnings, if wisely
made, will increase the earnings of the company, and should
appear as additions to its assets.

There is much to be said in favor of a policy of making
extensions out of profits. A growth which is, made out of
earnings, without increase of stock or debt, is a natural
growth; it is made gradually and cautiously, and therefore
safely. The histories of the largest business concerns in the
country show that even the largest possibilities can be
reached by' the investment of profits in the extension of
plant. The growth of the Carnegie Steel Company from an
insignificant beginning to the gigantic size it had attained
when it was taken over by the United States Steel Corpora-
tion, is an illustration of the possibilities of the investment
of profits. The growth of the Baldwin Locomotive Works,
and of John Wanamaker's, and Marshall Field's retail estab-
lishments are familiar illustrations of the same fact. Indeed,
most large business enterprises in this country which are
still controlled by partnerships or private corporations, rep-
iresent growth out of profits.

If directors follow a conservative policy in the adminis-
tration of the income account of their company, they will
make large investments out of revenues in working capital,
plant and equipment. They will raise the standard of the
property by betterment appropriations, charged either to ad-
ditions or, preferably, to maintenance. They should also
maintain a number of reserves for depreciation and renewal
of plant, for bad debts, for insurance, for the extinguishment
of the loss sustained by the sale of bonds at a discount, if
this loss is not to be taken in the year in which it occurs.
They may be required to set aside out of their income a
sinking fund appropriation, and it may be provided that
the amount of the sinking fund appropriation can be in-
vested in the plant. Finally, in order to maintain an even
rate of dividends, the directors are obliged to reserve a por-
tion of each year's profits, which is also put into the business,
and which, in time, may amount to a large sum. Shall the

METHODS OFPEOVIDING NEW CAPITAL 269

directors go farther than these requirements of safety and
stability in reserving profits from stockholders? Shall they
treat the profits as their first resource when in need of
money, and comfort the stockholders, as did C. P. Huntington,
who, on one occasion, remarked to the stockholders of the
Pacific Mail Steamship Company, that it made no difference
whether they received their dividends in money or in ships?
Their dividends were only deferred.

It. is improper for the directors of a public corporation
to pursue this policy. The company has applied to the
investor to furnish funds for their enterprise. The money
has been contributed with the understanding that if profits
were earned they would be distributed in dividends, so far
as a distribution could safely be made. Beyond the main-
tenance of proper reserves, and the investment of surplus
earnings over a conservative dividend rate, the directors of
a public corporation cannot, as a rule, therefore, with entire
good faith to their stockholders, withhold profits for invest-
ment in plant. If the business is profitable, and demands new
capital, the stockholders have the right to demand that the
capitalization of the company shall be increased in order to
obtain this new capital, and that they shall not be kept out of
their dividends for an indefinite period in order that a
so-called conservative policy should be pursued. If the com-
pany needs new money, the stockholders are usually quite
willing to furnish it, in ease they have been liberally treated,
and fairly dealt with.

There are other objections to the plan of exclusive de-
pendence on profits as a source of capital funds. Profits are
very irregular, and it is difiBcult to carry out a consistent
plan of improvement while depending solely upon the busi-
ness to furnish the funds for these improvements. Further-
more, the exigencies of the corporate situation sometimes
demand that extensive schemes of improvement should be
put through within a short time; for example, the extension
of the Chicago, Milwaukee & St. Paul to the Pacific Coast;
the construction of the Western Pacific from Salt Lake City

270 COEPOEATION riNANCE

to San Francisco ; and the New York Terminal improvements
' of the Pennsylvania. Such gigantic works of construction
may in some cases be provided out of earnings ; for example,
the new plant of the .United States Steel Corporation at
Gary has been built out of profits. As a rule, however, earn-
ings are Hot sufficient for extensive additions.

Assuming a definite opportunity for the profitable invest-
ment of capital, it is to the interest of stockholders that this
opportunity should be developed with the greatest expedition,
and that the construction work should be carried through
within the shortest possible time. Tf the improvement is
to depend solely upon earnings for its completion, it may
be unduly prolonged if the earnings are not forthcoming.
The profits of the company over a period of years may be
much less than if stock had been sold or money borrowed,
and the work crowded through as rapidly as possible to the
point of producing revenue.

The withholding of dividends from stockholders at the
instance of the majority control also creates a bad im-
pression, since it is often alleged, under these circumstances,
that the majority interests who usually occupy important and
lucrative positions in the service of the company, and who
are not infrequently in the receipt of secondary and indirect
emoluments as a result of their positions are unfairly, dis-
criminating against the minority stockholders. It may be
charged that they are, in effect, pursuing a policy which,
while increasing the value of the company's property, is
depreciating the value of the stock which represents the
ownership of the corporation owning the property. Such
charges were forcibly made against the Southern Pacific
management in 1903 by Mr. James E. Keene, who alleged
that the Southern Pacific revenues were not only being with-
held from the stockholders of that company, but that they
were being devoted to improvements for the benefit of the
Union Pacific which owned nearly half the stock of the
Southern Pacific. Although the interests back of this at-
tempt to force dividends on Southern Pacific stock were

METHODS OF PROVIDING NEW CAPITAL 271

discredited because of their obvious connection with a large
speculative pool operating for an advance in the stock,
based on the alleged promise of a dividend, yet their con-
tentions attracted wide attention, and brought out un-
favorable criticism against the directors.

Especial conservatism in the distribution of profits is
usually desirable during the early stages of an enterprise,
a large part of whose stock, as we have already seen, is
usually issued against anticipated earnings. With these
exceptions, however, it seems best that a public corporation
sbould not rely mainly upon its earnings to obtain funds
for extensions and improvements, but when it has reached
a position of assured strength and standing, it should take
advantage of that position to provide funds for the en-
largement of its plant by the expansion of its capital,
allowing its stockholders to share in its profits, so far as
the distribution of these profits is consistent with the main-
tenance of a regular rate of dividend.

Public corporations, with whose methods our study is
mainly concerned, if they go beyond the resources of their
income and propose to issue stocks or bonds, must usually
obtain the authorization of the Public Service Commission.
These commissions are found in almost every State. In
only a few of the larger States, however, have the commis-
sions been clothed with sufficient powers to make their
work really effective. In Massachusetts, New York, Mary-
land, Wisconsin, and Kansas the powers of the Public Ser-
vice Commissions are sweeping. The New York Commis-
sions, for example, are given supreme control over all kinds
of public service corporations, including railroads, street
railroads, lighting and gas and telephone and telegraph
companies. The supervisory and regulative powers of the
commissions extend to character of service, to rates and
fares, and to the approval of the issue of stocks, bonds, and
other forms of indebtedness. In this last power, the in-
vestor finds a considerable safeguard against the improper
issue of securities.

272 CORPORATION FINANCE

The nature of this power over security issues is indi-
cated by the following extract from Section 55 of the Act
Creating the Public Service Commissions of New York:

Any common carrier, railroad corporation or street
railroad ' corporation organized under the laws of the
State of New Yopk, may issue stocks, bonds, notes or
other evidences of indebtedness payable at periods of
more than twelve months after the date thereof, when
necessary for the acquisition of property, the construc-
tion, completion, extension or improvement of its facili-
ties, or for the discharge or lawful refunding of its
obligations, provided and not otherwise that there shall
have been secured from the proper commission an order
authorizing such issue, and the amount thereof, and stat-
ing that, in the opinion of the commission, the use of the
capital to be secured by the issue of such stock, bonds,
notes, or other evidences of indebtedness is reasonably
required for the said purpose of the corporation. For
the purpose of enabling it to determine whether it should
issue such an order, the commission shall make such
, inquiry or investigation, hold such hearings and examine
such witnesses, books, papers, documents or contracts
as it may deem of importance in enabling it to reach a
determination.

Under this power, every corporation proposing to issue
or authorize new securities must apply to the Public Ser-
vice Commission for authority, and the authority will not
be given until a thorough investigation has been made into
the security back of the bonds and the purposes for which
the money is to be spent.

The primary purpose of giving the commissions power
over issues of securities was to protect the public against
excessive issues of capital by public service corporations
on the ground that an excessive capitalization might be
used to defend rates or prices which were excessive. In
the exercise of this power, however, the commissions have
gone much farther and have undertaken the task of pro-
tecting the investor against unwise capital expenditures.
The Commission of the Second District of New York has

METHODS OF PROVIDING NEW CAPITAL 273

outlined its method of procedure in eases involving the
authorization of bond issues as follows:

"In passing upon the application for leave to issue ad-
ditional capital stock, the Commission will consider:

"Whether there is reasonable prospect of fair return
upon the investment proposed, to the end that securities
having apparent worth but actually little or no value may
not be issued with our sanction.

"We think that to a reasonable extent the interests of
the investing public should be considered by us in passing
upon these applications.

"The Commission should satisfy itself that, in a gen-
eral way, the venture will be likely to prove commercially
feasible, but it should not undertake to reach and announce
a definite conclusion that the new construction or improve-
ment actually constitutes a safe or attractive basis for
investment. Commercial enterprises depend for their suc-
cess upon so many conditions which cannot be foreseen or
reckoned with in advance, that the duty of the Commis-
sion is discharged as to applications of this character when
it has satisfied itself that the contemplated purpose is a
fair business proposition."

In practice, however, the commission has made such
careful investigation as to warrant the inference, which
has been generally drawn by the investing public, that for
them to authorize a bond issue is equal to their guarantee
that the issue is good. In the case of the Rochester, Cor-
ning, and Elmira Traction Company decided March .31,
1908, the commission outlined in detail the methods of
investigation which it proposed to follow in determiniag
the amount of bonds which could be safely issued by a
newly organized enterprise as follows:

An estimate will be made from a consideration of the
results of operation of existing roads of the .probable
gross earnings.

An estimate will be made in like manner of the prob-
able operating expenses, taxes, and depreciation charges.

274 CORPORATION FINANCE

The excess of earnings over the disbursements which
must be made before fixed charges can be met represents
the sum which is applicable to fixed charges.

The maximum bond issue which will be allowed must
be determined by the sum thus ascertained to be appli-
cable to the payment of the interest charge.

No bond issue should be permitted creating an interest
charge beyond an amount which it is reasonably certain
can be met from the net earnings.

Stock representing a cash investment should be re-
quired to an amount sufficient to afford a moral guar-
antee that in the judgment of those investing the enter-
prise is likely to prove commercially successful.

The order authorizing such stock and bond issues will
contain approximate provisions designed to secure the
construction of the road in accordance with the plans and
specifications upon which the authorization was made
and not in excess of the actual requirements.

If the allowance proves inadequate for the required
purposes, an application for further capitalization may
be made, upon which application the expenditure of the
proceeds of stock and bonds already authorized must be
shown in detail.

After an issue of bonds has passed this searching scru-
tiny, the investor need have little fear concerning the
safety of his bonds, whether a bond reserve many times
the amount of the initial issue has been created or not.
Indeed, in one notable instance, th^ first mortgage bonds
of the Chicago Railways Company, which are issued under
restrictions similar to those which have been outlined, such
confidence has been placed in the efficacy of the precautions
taken to guard against overissue, that bonds may be issued
without limit under a so-called "open-end mortgage,"
every bond, no matter to what amount these may be issued,
being equally secured as every other bond, by a first lien
upon the property of the company. There is no essential
difference between a large bond reserve and an open-end
mortgage. The open-end mortgage, however, on account
of the uncertainty as to the amount of bonds which may,
at some time in the future, be issued, is inferior, in the
opinion of most investors, to a large bond , reserve. It is,

METHODS OF PROVIDING NEW CAPITAL 275

moreover, in practice, no more effective in providing for
the future capital needs of the corporation.

When a Public Service Commission has authorized the
issue of securities, it is by implication bound to protect the
company whose application it has authorized, not merely
against the ill-advised action of its directors in using the
credit of the company for improper purposes, but also
against competing enterprises for which there is no public
necessity and which would not, therefore, prove profitable.
The New York Public Service Commission for the Second
District, for example, in 1908, refused the application of
the Buffalo, Rochester & Eastern Railroad Company for
authority to issue securities for the construction of a line
of railroad from Buffalo to Albany, paralleling the line of
the New York Central, on the ground that the new enter-
prise would not prove profitable, and the New York Cen-
tral would be injured without any public benefit resulting.
The new line proposed to intercnange traffic at Albany
with lines traversing New England, but the commission
pointed out that the New England lines were not able to
handle the traffic already delivered to them at Albany.
This was sufficient reason for refusing to authorize the
construction of another line which would make the con-
gestion at the Hudson River even more acute.

At the time the New York Public Service Commissions
were instituted, serious apprehensions were expressed by
financial interests lest the new laws, because they took away
from the directors or stockholders of corporations so much
of the control which they had previously exercised over
the issues of new capital, would seriously interfere with
the efforts of companies to provide funds for development.
Indeed, the passage of the New York law produced a feel-
ing of consternation among bankers and investors. As the
commissions have progressed with their work, however,
they have been forced into the position of virtually guar-
anteeing every security whose issue they approve. So well
organized and so favorably regarded are the Public Service

276 CORPORATION FINANCE

Commissions by the investor, as a result of the interpreta-
tion which they have placed upon their powers, that the
bond salesman offering a security whose issue they have
approved has his work of persuasion largely accomplished.
In one case the issue of bonds by a Massachusetts company
secured by the stocks of two other companies, and with
its own stock owned by a fourth, presenting a situation
almost incomprehensible, were readily sold, in the main
for no other reason than that they were issued under the
authority of the Massachusetts Commission. Bond dealers
and large investors, with few exceptions, cordially indorse
the control of security issues by public service commis-
sions, because of the assurance which this control gives to
the investor that his interest will be safeguarded.

The principle of supervision and authentication ,of rail-
road securities by the Interstate Commerce Commission
has been included in the Esch-Cummins bill, by which the
powers of the State Commissions are curtailed. The Inter-
state Commerce Commission will now pass upon the pur-
poses of the issue, the security offered, and the terms of
sale. The position of railway securities will be greatly
improved by this act, since not only will existing lines be
protected against competitive construction, but the Com-
mission may be expected to assume some responsibility for
allowing rates adequate to protect interest and dividends
on the securities which it has authorized.

CHAPTEE XXI
THE ISSUE OF STOCK

Assuming now that funds are to be raised for extensions
by the sale of securities, the first question concerns the class
of securities to be sold. Shall the corporation increase its
stock or shall it borrow the money needed?

The capital stock of a company represents its ownership.
This ownership is divided into shares. An increase of the
amount of stock, therefore, increases the number of shares.
If there is to be only one kind of stock, the shareholders have
two alternatives when it is proposed to increase the capital.
They may take the new stock themselves, in which case their
respective shares of participation in the company's profits
remain unchanged, or they may offer it for general subscrip-
tion. If a corporation has $10,000,000 of capital and pro-
poses to add $1,000,000, each stockholder of record would
have the right, under the law, to participate in the increase,
if the stock was to be sold for money, and not exchanged
for some form of property. The holder of one hundred
shares* of stock, for example, would be allowed to subscribe
to ten shares of the new stock, which would give him the
same proportion of interest in the corporation that he had
before. It frequently happens, however, that existing stock-
holders do not care to take the entire issue. Stock must then
be sold to outsiders, who are admitted to participation in
the earnings, and to share in the control of the company
on equal terms with the existing stockholders.

To the controlling interest of the company, the admission
of new stockholders is often a matter of great concern.

277

278 COEPOEATION mSTANCE

New stock coming upon the market may be absorbed by
those who desire to wrest control from those who now hold
it. And if, as usually happens, the control represents no
more than a strong minority, this may be the outcome of
an increase in the capital stock. A celebrated instance of
this result is the ousting of Mr. August Belmont and his asso-
ciates from the directorate of the LouisvUle & Nashville in
1908. Early in that year the directors of the Louisville &
Nashville, in order to finance some extensions, authorized the
sale of 50,000 shares of stock. Under the rule of the New
York Stock Exchange, shares are not deliverable on contracts
until thirty days after they have been issued. Funds were
needed immediately, however, and in order to obtain them the
chairman, Mr. Belmont, was instructed by the Board to sell
50,000 shares " short " — that is to say, he sold stock which he
did not own, borrowed the stock to deliver what he had sold,
and expected to take up the loan out of the new shares when
these should have become deliverable. At the same time, how-
ever, unknown to- the Belmont interests, a syndicate, headed
by Mr. John W. Gates, was engaged in a campaign to purchase
control of the company, and, in the course of their operations,
they developed a short interest estimated at 130,000 shares,
including the 50,000 shares sold by Mr. Belmont.

The directors of the Louisville & Nashville had, in other
words, sold more shares than they owned, and they could ob-
tain the stock to make their deliveries only from the syndicate
whose advantage it was to bring about this situation. ■ On
April 14, 1903, it was discovered that a corner existed in
Louisville & Nashville; the price of stock on this date touched
133 and a repetition of the May panic of 1901, which was
brought about by a similar operation in Northern Pacific
stock, seemed imminent. Serious trouble was averted, how-
ever, by the recognition that Mr. Gates controlled the Louis-
ville & Nashville, and by the taking over of a majority
interest in that company by the Atlantic Coast Line Eail-
road at a figure which rendered a large profit to the John W.
Gates syndicate. \

THE ISSUE OF STOCK 279

On account of the fear of such operations as that which
has been described, every effort is made, when new stock
is issued, to induce the existing stockholders to increase
their holdings, or, failing in this, to obtain assurance that'
the new interest shall not only be such as will strengthen
the position of the company, but will not be unfriendly
to those in control. The strongest inducement which can
be offered to the stockholders is to sell them a safe invest-
ment at a low price, and the lowest price for par value
stock which the law allows is par, the figure at which
stock is usually offered to stockholders. This prohibition
against the sale of stock below par (unless such a step
is necessary to save the company from embarrassment),
limits the opportunity to raise capital by the sale of com-
mon stock to companies whose profits and dividends are
so large that their stocks sell under normal conditions
above par. Here again appears an important advantage
of stock without par value. With par value stock a pre-
mium sale is possible only when dividends and pros-
pects are so large and rosy as to raise the price of the
stock substantially above par, and to hold it there in the
face of an increased supply of stock. With stock of no
par value, however, on the basis of any market value
whatever, even $1 per share, a privilege can be offered to
the holders.

The existence of these premiums, which reflect high
dividends and assured earning power, make possible the
plan of financing the capital requirements of such strong
companies by the issue of common stock on such terms as
to induce stockholders to enlarge their holdings. This plan
is known as the sale of privileged subscriptions. Under
the law, the stock of a corporation must first be offered to
the existing stockholders. Only in case they are unwilling
to buy can stock be opened to general subscription. Stock
can, of course, be issued in exchange for property without
reference to stockholders. When stock sells at a premium,
new issues may be offered at a price above par. In case

280 CORPOKATION FINANCE

the market value of the stock is realized by offering stock
at a premium, a smaller number of shares need be sold to
obtain a given amount of capital than if stock is sold at
par. Suppose, for example, that $1,000,000 is required by
a company whose stock can be sold at 150, paying eight
per cent dividends. If the stock is sold at market value,
6,666 shares will be needed to obtain the $1,000,000 necessary.
If it is sold at par, however, 10,000 shares will be required.
The amount necessary td pay the eight per cent dividend
on 6,666 shares is $53,328, while on 10,000 shares $80,000
would be required. If the stock is sold at a premium, $27,-
672 of annual dividends, assuming that the eight-per-cent
rate is continued, can be saved for the company, over the
disbursements which must be made if the stock is sold at
par. As a result, the rate of dividend can perhaps be in-
creased, and the price of the stock advanced on the strength
of its larger dividend returns.

In view of these facts, the directors may insist that they
should make the best bargain possible for the company, that
the stockholder shall derive no special or exceptional ad-
vantage from his position as part owner of the corporation;
that he should be treated in the same way as any investor.
^Furthermore, under the plan of selling stock at a premium,
the dividends paid by the company, and the price of the
stock will show its true earning power. No more stock will
have been issued than is necessary to provide the amount of
.money required for the desired improvements. The higher
the price of the stock ascends, borne up on the rising tide
of dividends, the smaller will be the number of shares to be
sold to obtain the same amount of money. The Pennsylvania
Eailroad Company, for example, has received large sums as
premiums on stocks sold. Without these premiums, which
were invested in the business, the outstanding stock of the
Pennsylvania might have been materially greater than it
now is.

On the other hand, if stock is sold at par, or at less than
market price, the corporation must issue a larger number of

THE ISSUE OF STOCK 281

shares than may conceivably be required. It may be impos-
sible, on account of the issue of this extra stock, to do more
than maintain the regular dividend, and the price of the stock,
therefore, may not advance to the point which it would reach
did the directors refuse to sell more shares of ownership than
are necessary to obtain the money required.

In the case of Public Service corporations, the principle
has been conclusively established in most of the leading states
that they shall not be allowed to earn more than a fair return
on the value of their property, and it has also been considered
important in some states that a corporation should not in-
crease its capital stock beyond the amount actually necessary
to secure funds for capital expenditures. In Massachusetts,
for example, the issue of all bonds and of any increase of
stock in excess of the original capital is limited to such
amount as the railroad commissioners shall, after a public
hearing, determine will realize the sum which has been prop-
erly expended, or will be reasonably required by the corpora-
tion for corporate purposes. As a rule, however, a company
whose stock sells at a premium does not attempt to obtain
any part of the premium by a public offering, but offers its
stock to its owners at par. Such a sale is called the offer
of a privileged subscription.

The stockholder receiving the privilege can avail himself
of it either by selling his right to subscribe to the stock,
which is made assignable for the purpose, or by selling a
certain portion of his existing holdings after he receives the
evidence of his right to subscribe, at the existing market price,
replacing these shares at par out of the new issue, or he can
retain his stock and take the new shares as well. In the
first two cases mentioned — namely, the sale of the assignable
right to subscribe, or the sale at the market price of an
amount of stock equal to that to which the stockholder is
entitled to subscribe at par — he makes a profit which approx-
imates the market premium of the stock, times the number
of shajes which he sells. Since the right will only be pur-
chased by some one desirous of becoming a subscriber to the

282; COEPOEATION TINANCE

stock, its price is usually less than the difference between
par and market value. Unless the intending subscriber can
obtain his new stock at a lower price by purchasing a right,
he will prefer to buy the stock direct.

The value of some of these privileges has been very great.
In an article in the Quarterly Journal of Economics foE Febru-
ary, 1905, entitled " Stockholders' Profits from Privileged
Subscriptions," Dr. T. W. Mitchell has computed the profits
which could have been realized by stockholders of the lead-
ing railroad companies which have issued privileged sub-
scriptions. .Dr. Mitchell finds that if a stockholder of the
Illinois Central had purchased 100 shares at a price of 135
per share in 1887, he would have received between that date
and 1903 eight privileges- If he had sold the number of
shares to which he was entitled to subscribe immediately after
receiving his privilege and had invested the proceeds. Dr.
Mitchell finds that, from 1887 to 1903, he would have re-
ceived from all of his eight privileges a total, principal and
interest, of $5,740. This is equivalent to a return of $222
a year during the seventeen years of his investment, or 1.64
per cent which would have been added to the regular divi-
dends on this stock. A man making a similar purchase in
1895, would have received from his five privileges a total
of $2,953, which is equivalent to $265, or 2.73 per cent, a
year. Stockholders who made their investments in 1900,
1901 and 1902 respectively have made, according to Dr.
Mitchell, from privileges alone, 4f to 5J per annum on their
investment, and that, too, when their original purchases were
made at high premiums. The Great Northern has also been
very liberal to its stockholders. Since 1893 the stock of this
company has sold above par. All the stock issues of the
company after the first, with one exception, have been dis-
tributed, pro rata, among the stockholders of the road ,at
par. The market value of the stock at the time these various
issues were distributed ranged from $140 to $264 per share.
The stockholder could, therefore, have paid $100 per share for
his new stock, and could at once have sold it upon the

THE ISSUE OF STOCK 283

market for a much higher price, realizing from the trans-
action from $40 to $164 per share.

If the stockholder does not care to sell his right to sub-
scribe, or to part with any of his stock, the privilege gives
him an opportunity to increase the return he receives on
his investment. Suppose he has purchased the stock of a
company paying six per cent dividends for $150. His return
is four per cent. The company, within five years after he
has purchased the stock, offers to stockholders the privilege
of subscribing to new stock at par to an amount equal to
eighty per cent of their holdings. This stockholder, instead
of selling the right to the stock, prefers to increase his invest-
ment on the favorable terms offered. At the end of five
years, he owns 180 shares on which the annual return is $6
per share, or $1,080, on an investment of $23,000, or 4.7
per cent. There is little doubt that this is the course fol-
lowed by the majority of stockholders when privileges are
offered to them. By the correct method of computing the
yield on investments, the return on a stock should be obtained
by dividing into the rate of dividends, not the cost price, but
the market price. An investor who takes advantage of a
privilege to buy a six per cent stock for $100 per share which
is selling on the exchange at $150, has only a four per cent
investment, since a share of stock represents to him $150 of
capital and $6 of income. The investor, however, estimates
the return by comparing the cost of the stock with the rate of
dividend, and this belief influences him to hold fast to stock,
new issues of which are occasionally sold at less than market
value. In no other way could the failure of shares to show
heavy declines after the announcement of privileges be ex-
plained. Some decline is usually experienced following the
announcement of a privilege, but it is seldom sufficient to war-
rant the conclusion that a large number of stockholders are
disposing of their shares. There is no reason for them to do
so if they have confidence in the value of the stock, since they
can take their profit at any time by selling at a premium stock
which they purchased at par.

284 COEPOEATION FINANCE

When a corporation increases its issue of stock, it must
keep in mind not merely the amount of money which the
new stock will bring, but the efEect of the issue upon the
composition of the stockholding constituency; the necessity
that the subscription should be a success and that the money
should be promptly forthcoming; the desirability of being
able to receive new capital from the stockholders when re-
quired, no matter what the condition of the money market
and to any amount that may be necessary; the justice and
expediency of extending to stockholders more liberal treat-
ment in the matter of subscription than they extend to out-
siders; and, finally, the fact that the sale of a privilege is
equivalent to an increase in the rate of dividends.

Let us take up these considerations in order. The sale
of stock at a high premium means that new interests are
brought into a company, and that its stockholders are con-
tinually changing. Existing stockholders, many of whom
will have purchased the stock at much lower prices than
those prevailing at the time an attempt is made to secure a
premium from a new issue, will have no inducement, other
than their general confidence in the company, to increase
their holdings on less favorable terms than those which they
previously secured. Under these circumstances, therefore,
while a large amount of the new stock may be taken by exist-
ing stockholders, it is fairly certain that much of it will be
sold to outsiders. These new interests may have their own
preferences for directors and officers, and their influence may
be sufficient to disturb the management and control. When,
however, stock is sold at par with a valuable privilege at-
tached, based on the existence of a high premium in the
market, the stock is very closely held for investment. Little
stock is offered for sale, since the stockholder of record knows
that, from time to time, in addition to the yield on the stock
represented by a comparison between the purchase price and
the dividend paid, he will have an opportunity to increasa
his investment on more favorable terms than if he desires
to gain an immediate profit in one of the ways described.

THE ISSUE OF STOCK 285

The election of such a course of action by the stockholder
is the more certain when it is remembered that the values of
stock privileges are not, as a rule, fully capitalized in the
value of the stock. If a corporation would announce that
on January 1st of each year its stock would be increased
ten per cent, and that stockholders of record would have the
privilege of subscribing to the new Stock at par, then the
value of the privilege would be expressed in the market value
of the stock, which would "be" established on a permanently
higher level. No such assurance can, however, be given to
the stockholders. The directors will follow the policy which
seems best at the time. They cannot limit themselves in
the methods which they will employ for raising new, capital.
It is impossible, therefore, that these privileges should be
counted upon at any particular time and to any particular
amount. They are incidental and fortuitous gains to the
stockholder, gains which he has every reason to believe he
will receive in the future as he has received them in the past,
but which will not be fully reflected in the higher market
value of the stock. To gain these privileges, therefore, the
stockholder must retain his shares. It is well known that
those corporations, such as the Illinois Central; Chicago,
Milwaukee & St. Paul; Great ;N"orthern; United Gas Im-
provement Company; and New York, New Haven & Hart-
ford Company, which have granted valuable privileges, have
a body of stockholders whose composition changes slowly.

Directors place a high value upon permanence in their
stockholding body. Stockholders of long standing can be
counted on to support the management. In the unlikely
event of a contest for proxies, the limited supply of such a
stock makes it very difficult and expensive for an outside
interest to buy control. One of the most serious difficulties ex-
perienced by Mr. E. H. Harriman in his contest for the con-
trol of the Illinois Central in 1907, was the firmness with
which most of the individual stockholders supported Mr. Stuy-
vesant Fish's administration.

Another argument in favor of selling stock at par is that

'286 COEPOEATION riNANOE

the securing ol a premium on the sale of a large amount
of stock is an uncertain matter, depetiding on the condition,
of the stock market, which may change overnight. In order
to guarantee that a premium will be secured, unless the sub-
scription price is placed so far below the market price that
it amounts, in effect, to a privilege to stockholders of record,
the services of an underwriting syndicate must be employed.
The Pennsylvania Eailroad, for example, in 1903 offered
$75,000,000 of stock to holders of record at $130 a share.
The stock was at that time selling above 150. 'No difficulty
was anticipated in disposing of the stock as offered in the
subscription. A general decline in stock values, however, set
in which carried down the value of the Pennsylvania stock
with it. It was feared that the stock might fall below the
subscription price by the date when the subscriptions were
to be made. In this event the credit of the company would
hav^ been seriously damaged, since the subscription offer
would have to be withdrawn. To guaTd against such a con-
tingency, an underwriting syndicate was formed, headed by
Sp^yer & Company, which, in return for a commission of
$2,250,000, agreed to take from the company any of the
$75,000,000 of stock at the subscription price of 120 a share,
which the stockholders should not take. The announcement
of the formation of this syndicate steadied the price which
had at one time fallen to 114^, and the syndicate had to
assume only a small part of its obligation, making a large
profit on the transaction. The Pennsylvania Eailroad is
probably the strongest railroad corporation in the world, and
its stock is highly esteemed by investors. On this occasion
the stock was offered far below the market price, and yet the
securing of a premium was only made possible by the inter-
vention, of an underwriting syndicate.

On the other hand, a corporation whose stock sells at a
high premium, and which offers new issues to stockholders at
par, is never at a loss to obtain new capital funds. Dur-
ing 1906, when the bond market was seriously depressed, and
when the strongest railroad and industrial corporations, rather

THE ISSUE OF STOCK 287

than sell long term bonds on a five per cent basis, were
resorting to the expedient of short term notes paying five
and six per cent interest, four of the largest railroad com-
panies— the Great Northern, the Northern Pacific, the Chi-
cago, Milwaukee & St. Paul, and the Chicago & Northwest-
ern— raised, among them, about $300,000,000 from their
stockholders, by the sale of stock at par. If they had gone
into the bond market, it would have been difficult for them
to obtain this amount of money. They might have had to
pay for three years an interest rate of at least six per cent on
notes issued in anticipation of the sale of the bonds.

There is this further to be said in favor of the sale of
stock on a privileged basis to holders of record, that it is
fair t6 the stockholder who does not care to increase his
investment, and who would not be able to participate in any
of the benefits of the new issue, if it were offered at a
premium. Such stockholders receive their rights to subscribe
which they can sell in the manner already explained, and in
this way participate, although to a less extent than the stock-
holders who hold their stock, in the benefits of the new stock
Issue.

The issue of premium stock at par to stockholders is an
indirect method of distributing the company's surplus in the
sense that a larger disbursement must be made on the stock
than if this has been sold at a premium. A corporation
which obtains $1,000,000 by selling 10,000 shares of stock
at par, when it could have obtained the same money by the
sale of 6,666 shares at 150, is assuming a larger burden than
is necessary to obtain the money. Its stock capital is 3,333
shares larger than it would have been had the full market
price been obtained. The dividend rate cannot be increased
so rapidly as though a smaller number of shares had been
sold to obtain the amount required. For this reason, the
sale of privileged subscriptions by public service corpora-
tions has been severely criticised. There is a strong tendency
in public sentiment to compel these companies to sell their
stock to realize the highest market price obtainable, and

288 CORPORATION PINAlSrCE

not to favor stockholders by the sale of stock on preferential
terms.

The law usually does not take cognizance of the market
value of stock. It merely requires that the par value should be
paid in cash, and in the absence of a special statute or ruling
to the contrary, the corporation has authority to sell its stock
at par. Furthermore, market value, as already shown, is un-
stable and uncertain. The realization of a given profit by the
sale of a privilege, which, as we have seen, is a course adopted
by only a portion of the stockholders to whom privileges are
offered, is a doubtful matter. The Interstate Commerce Com-
mission in the ease of the City of Spokane vs. Northern
Pacific Railway Company, considered this question of the
return from privileged subscriptions, in reaching a conclu-
sion as to the earnings of the Northern Pacific. The com-
plainants in this case asserted that the Great Northern, one
of the defendants in the case, had distributed its stock, from
time to time, in such a manner as to give its stockholders
large profits in addition to their dividends, and insisted
"that this manner of selling stock is vicious and unlawful,
and that, in determining the return to these stockholders, we
must have in mind the benefit conferred upon those stock-
holders by this operation."

The commission, however, rejected this view as follows:
"Assuming, without deciding, that the complainant is
right in its position that this practice is both unlawful and
unwise, how can we, in this proceeding, take any practical
note of what has been done? This stock is selling to-day,
January, 1908, upon the market at something less than $130
per share. If the original stockholder has retained and now
owns his stock, he paid $100 in the beginning, has received
a regular dividend, and now owns his stock at the above ad-
vance. While the profit to him has been a handsome one,
there is certainly nothing here which would call for a penal-
izing of the stockholder. Suppose, now, that, instead of
retaining the stock, the stockholder sold the same to some
innocent purchaser who paid the market price, and who has

THE ISSUE OP STOCK 289

continued to own the stock from then until now. This
present stockholder paid perhaps $264 a share for his stock.
He has lost $144 per share. Should we, for that reason,
compel him to sustain a further loss 1 The manner in which
this stock has been manipulated may furnish a strong argu-
ment against the propriety of permitting the sale of new
stock in this manner, but so far as this particular company
and the stock already issued are concerned, the transaction
is ended, and can be given no practical consideration in
determining what rates shall be charged by the Great North-
ern Eailway Company. ' '

The practice of issuing privileged subscriptions, without
restrictions, will not, in all probability, be continued by the
public service corporation. At present the question is not
at issue, owing to the severe depreciation in all securities
dependent for dividends upon fixed rates and fares. This
condition will not, however, be permanent. Eventually,
public service stocks will advance and these companies will
again have to go to stock-holding bodies for new capital.
With the more rigid control now exercised by public service
commissions, including the Inter-state Commerce Commis-
sion, over security issues, however, directors will probably
be required, when selling new stock, to obtain the highest
possible price. This does not, however, mean that stock-
holders will no longer be favored with opportunities to sub-
scribe on preferential terms, but merely that the value of
the preference may be reduced. If a public service commis-
sion is required to authorize an issue of stock selling at a
premium, and to name a price at which the stock can be
sold, unless they wish to take the responsibility for a pos-
sible failure of the subscription, they will not insist that the
corporation should attempt to obtain the full premium rul-
ing at the time the offer is made. Some lower figure will be
named, and at" this figure the stockholders of record, to

290 CORPORATION FINANCE

whom the stock must first be offered, will usually take a
considerable amount of the new issues, especially if the pre-
mium is guaranteed by an underwriting syndicate.

CHAPTER XXII
THE BOKEOWING OF MONEY BY CORPORATIONS

In chapter four the restrictions included in the pre-
ferred stock contract for the protection of stockholders
were enumerated and described. In early days these re-
strictions were made more rigid when preferred stock was
issued to obtain new capital than in original issues. Many
of the old preferred stock issues were those used in re-
organization in exchange for bonds whose interest the earn-
ings of the company were insufficient to meet. Under such
circumstances the bondholders could count themselves for-
tunate if they received anything in the reorganization and
were in no position to insist on measures of protection.
"With the growing use of preferred stock this difference
in the number and severity of their restrictions between
original issues and issues made after the formation of the
company has largely disappeared and all preferred stock
has, no matter when issued, equal protection. "We may pass,
therefore, in our discussion of the method of obtaining
new capital from preferred stock to other means of cor-
porate financing.

The natural place of resort of anyone who wishes to
borrow money is a bank. Corporations consider banks as
places where they can obtain funds for any proper purpose.
The National Bank Law has authorized the purchase of
promissory notes by banks, and this has been stretched to
sanction the purchase of bonds sometimes maturing fifty
years from the date of purchase. Banks are the largest

291

292 CORPORATION FINANCE

laond buyers. Even when the bank is not able to purchase
the security outright it usually will make a loan, using
the security as collateral.

Corporations resort to banks for a variety of purposes :
to pay dividends in part or in whole, when cash is not
immediately available; to purchase materials, or to carry
materials already purchased; to convert purchases into
■cash; to make additions and betterments. In brief, when-
ever money is needed the bank is expected to furnish it,
.and when the security is satisfactory and the corporation
borrowing has carried a satisfactory balance at the bank,
the bank generally does advance the funds needed.

A brief statement of the nature of the deposits out of
Tvhich these loans are made will show that the indiscrimi-
Jiate lending which has characterized relations between the
corporations and the banks, the purchase of corporate
bonds, loans on corporate securities, are by no means to be
approved, and that with the growth of knowledge in this
field these advances to corporations will be greatly cur-
tailed.

A bank deposit is a promise issued by the bank to the
depositor to pay him money on demand. This promise
the bank must at all times be in a position immediately to
redeem. The depositor receives evidence of the promise
in his pass-book and forthwith proceeds to put this credit
in circulation by issuing checks against it. "With these
checks he makes all the payments which the necessities of
his business require. Occasionally he will cash a check, as,
for example, when he needs the money for a payroll, but
-for the most part he employs the deposit or check cur-
rency as a means of payment. It has been estimated that
over 95 per cent of the business of the country is done by
checks drawn against deposits and deposited by those who
receive them. These checks are seldom turned into money.
When there is any doubt in the receiver's mind whether
a check is good at time received, he insists upon certiflca-
-tion, by which the bank, on the check itself, evidences its

BORROWING OF MONEY 293

obligation to pay the money. Checks are, however, as a
rule, neither turned into money nor certified. As fast as
they are received they are deposited for collection: collec-
tions offset each other, through the processes of clearing and
collection, with the result that the banker is able to keep
outstanding, with the aid of his inactive accounts and the
balance which his borrowing depositors carry, an amount
of promises to pay money on demand — deposits, that is
to say— many times greater than the amount of actual
money which he has in his vaults to meet these promises.
The banking laws of the United States specifically rec-
ognize this nature of banking deposits, that they are de-
signed to multiply many times the efficiency of each dollar
of gold.

The foundation of our monetary system consists of
gold coin. This is merely a commodity adopted as a stand-
ard of value by all countries, manufactured into pieces of
definite weight and fineness by the mint and accepted
everywhere without question. In addition to gold the
United States has issued large amounts of token money
which consists of promises to pay gold, on demand. The
national banks have also issued their bank notes, the Fed-
eral reserve banks have issued over three billion dollars
of Federal reserve notes, and banks and trust companies
have issued over thirty billion dollars of deposit liabilities.
Under the National Bank Act as recently amended a coun-
try bank is required to carry no more than 3 per cent of its
demand deposits in the form of gold: the rest of its re-
serve can be deposited with the Federal reserve bank and
the Federal reserve bank can in turn lend 65 per cent
out of every dollar of its deposits to its members. The
result is, as we have seen, that the business of the United
fStates is done with these proraises to pay money on de-
mand and is backed up by a comparatively small amount
of the thing which is promised, namely, gold. Gold is
the foundation, and credit is the superstructure of the
medium of exchange.

294 CORPORATION FINANCE

This system works satisfactorily under ordinary con-
ditions. As long as no one raises the question whether
a bank can redeem all of its deposits, the bank can continue
to issue these promises to pay on demand in return for
promises to pay at some future time, or on demand, and
can charge much bigger interest than it pays on its promis-
sory notes of borrowers. A bank will pay three per cent
on time deposits and two per cent on checking accounts,
while lending its funds at six to ten per cent. It is this
differential, between what it pays and what it receives,
which constitutes the profits of banks — and profits of banks
are very large. The working of this system depends, how-
ever, upon the banks' ability to satisfy, in case they are
called upon to do so, their deposit liabilities in accordance
with the terms of their promises. The theory underlying
the Federal Reserve Act is that, if all the depositors of a
bank should form in line and demand actual money for
all deposits standing to their credit, the bank should be
able to meet these demands. The nearest Federal reserve
bank would be appealed to; bills receivable of the bank
would be turned over either by rediseounting or hypothe-
cating; and the bank would receive Federal reserve notes
to meet every claim of its depositors.

Now it is evident, in order for this system to work
in such an emergency, that bank deposits should be in-
vested only in self -liquidating paper or notes issued against
the maturity of profitable business transactions. A bank
lends its demand obligations, and it must stand ready to
redeem these at any time. If it exchanges them for bonds
maturing in thirty years, or for notes of its customers se-
cured by inactive stocks and bonds, for which it could not
find a market except at a heavy discount, by immobilizing
its obligations, the bank is placing itself in a position
where, if trouble arises, it might have serious difficulty
even in meeting the demands of depositors. The aid of
the Federal reserve bank would be available in ease the
amount of requests would not exhaust the note issue power ;

BORROWING OF MONE\ 295

that is, so long as a 40 per cent gold reserve could be
kept against note issues. But it would be impossible for
the Federal Reserve System to meet an emergency such
as was presented in 1907 when the entire country sus-
pended payment because of the enormous demands for cash.

The only way in which the banker can be certain of main-
taining his solvency at all times is to exchange his demand
obligations for promissory notes, drafts, and bills of ex-
change which will be paid out of the proceeds of maturing
transactions. The ideal loan for a bank to make is the pur-
chase of an accepted draft representing the sale of goods or
their performance of service to or for a solvent customer,
drawn upon that customer, endorsed by the drawer, and
sold to the bank. When the bank has the security of two-
name paper for a transaction which evidently shows a
profit, an unconditional obligation arising out of the pur-
chase of goods, with additional security of the seller, —
when the bank's funds are invested in paper of this char-
acter it is, in the language of the fraternity, a "sound"
bank. When, however, the bank exchanges its deposit lia-
bilities for corporate bonds or for promissory notes secured
by bonds or stock, or for the notes of a corporation or
individual, issued to obtain funds for construction pur-
poses, where the borrower expects to renew indefinitely,
making small reductions from time to time, — under any of
these conditions the banker is violating the canons of sound
banking and is running a risk of being unable to meet the
calls of his depositors.

This principle of sound banking was clearly recognized
by the framers of the Federal Reserve Act in that notes
should not be available for discount which represented
transactions in stocks and bonds. No notes secured by
collateral should be available for discount. The thought
underlyling this provision of the Act was that the Federal
Reserve System should facilitate movement of commodities
froni producer to consumer, that the paper which the Fed-
eral Reserve B.mk should take over should be self-liqui-

296 CORPORATION FINANCE

dating paper and that the maturity of the contract would
furnish the borrower with means of refunding the loan.

If a bank applies this test of self -liquidation to every
loan it will never be embarrassed. In case its depositors
press for money, all that is needed is for the bank to stop
lending, and within four months all of its paper will auto-
matically convert itself into money which can be paid out
to depositors in literal redemption of bank paper.

By this test the legitimacy of all corporate loans is to
be judged — whether they anticipate the proceeds of busi-
ness transactions which will mature in the near future.
It is unsafe for a bank to invest money which is to be put
into any form of fixed capital which will do no more than
return a safe margin over the interest on the loan. Bank
loans must be either paid when due, principal and interest,
or materially reduced. Experience shows that permanent
capital cannot be obtained from the commercial bank.
■Most bank failures which do not result from dishonesty
of bank officials have been caused by locking up of banks'
obligations in securities which could not be quickly con-
verted into money. The business of the bank is to supply
the temporary needs of business for working capital.
Nearly every business is, to some extent, seasonal in char-
acter. The agricultural implement dealer, who sells to
the farmer, may deliver machinery in the spring and wait
until after harvest for payment. In the fall, when he
has collected for the season's sales, and has only begun to
manufacture for next season, there will be no need for the
implement manufacturer to borrow largely from the banks.
The amount of capital locked up in machinery sold, will,
however, steadily increase as the season advances, until,
before harvest, he will have a large temporary investment
in notes and accounts. It is not considered economical
that the manufacturer should have invested sufficient capi-
tal to carry his business for the entire year without resort
to the banks. If such a policy be decided on, for a part
of the year, the manufacturer would have on hand a large

BORROWING OF MONEY 297'

amount of capital on which he might be paying six per cent-
dividends while receiving only three per cent for it from
the banks.

The manufacturer of agricultural implements obtains
notes from his customers, and these notes are used as col-
lateral for his own notes, which are sold to banks. When
the notes mature they are paid out of the proceeds of
collections. This illustration shows the principal contribu-
tion of the banks to the working capital of industry. Banks
sometimes extend permanent credit to concerns which are
' growing rapidly and require an increasing working capital,
but the banks' contribution should be only a portion of the
working capital of the business. It is better that a com-
pany should provide for the normal amount of working
capital, resorting to the banks to supply the seasonal de-
mands for capital, and, also, any extraordinary demands
to meet which permanent provision cannot be made.

We may now summarize the classes of loans to corpora-
tions which may be safely made by commercial banks.

i^irs^— Discounting of trade acceptances.

Second — Loans against stock assessments where
the stockholders have already paid in a sufficient
amount to make it certain that they will meet the
call or where they are known to be solvent.

Third — Loans against stock or bond sales se-
cured by underwriting or subscription commit-
ments. These are, although not recognized by
the Federal Reserve Act, essentially the same as
loans made to facilitate the movement of grain
from producer to consumer. The investment
banker is the middleman here, the same as the
wholesaler who sells commodities ; for as the whole-
saler passes goods on to the retailer, and the re-
tailer on to the consumer, so does the investment
banker pass his wares to the investment houses,
and they in turn on to the individual purchaser.

298 CORPORATION FINANCE

It is entirely proper for the commercial banker
to lend large amounts to the investment banker
since the investment banker is incessantly at work
to dispose of such securities and since he is as
certain to do so as the salesman of any other kind
of merchandise.

Fourth— hoana for extensions of new construc-
tions or for working capital, the purpose of which
is to complete profitable construction already in
hand. It is a common thing, for example, for a
shipbuilding company to make large loans from
banks to complete construction of this nature.
The loans are safe because when the ship is com-
pleted money is available to pay the loan. The
same thing is true of any construction the com-
pletion of which can be iixed at a definite time and
where the payment of money is properly secured.

Fifth — Loans to cover variation in seasonal re-
ceipts of money. These have already been de- ,
scribed. This money may properly be used for
such purposes as payment of interest or divi-
dends, if only the amount of the loan is clearly
in sight on basis of business done.

Sixth — Loans on short term notes secured by
collateral of recognized value.

We can pass now from this analysis of the place of the
commercial bank or trust company in corporation finance
to the consideration of short term notes, the last class of
loans which can properly be made to a corporation.

Bank loans are not available as a source of permanent
capital, although they may furnish a portion of the capital
which a corporation requires. In some cases, however, a
special form of obligation, either secured or unsecured, is
favored by corporations, and largely sold to banks as well
as to investors. This is known as the short term note.
Such obligations run for one, two, or three years, and pay

BORROWING OP MONEY 299

a high rate of interest— five or six per cent. This form
of obligation is usually resorted to during periods of strin-
gency in the money market, when long term bonds cannot
be sold except on the basis of a high interest yield.

A first-class railroad corporation expects, undef normal
conditions of demand, to sell its first mortgage five per
cent bonds at par. The money market may, however, get
into such a condition that a five per cent bond of this class
cannot be sold except at a price to yield six per cent to
the investor. Suppose the corporation wishes to issue a
thirty-year bond. If it makes the issue at such a time, it
will have to pay the one per cent extra for thirty years,
or thirty per cent on the entire amount of the issue. Look-
ing at the proposition solely from the standpoint of in-
come, and assuming that an improvement in the bond
market will, within two or three years, make it possible to
again sell four per cent bonds at par, it is advantageous
for a company, in the circumstances described, to borrow
the amount required for, say, three years, paying seven
per cent interest, and trusting to its ability to refund the
obligation at maturity on a four per cent basis. Instead of
paying thirty per cent premium, therefore, the company
which makes an issue of two-year seven per cent notes,
and refunds these on a four per cent basis, will pay only
four per cent premium for the money over the entire
period.

The conditions under which the issue of short term
notes is advantageous are illustrated by the situation of
the American money market in 1906. During this year,
the bond market had been extremely dull. Prices gen-
erally declined; issues yielding less than four and a half
per cent gained little attention. The explanation was
found in the high rates for money. The largest bond
buyers are the financial institutions, banks, savings banks,
trust companies, and insurance companies. During 1906,
these large bond buyers were able to lend their funds on
call through the banks, or to purchase commercial paper

300 CORPOEATION FINANCE

at very high rates of interest, and with perfect security.
As a result, they reduced their bond purchases. As an
illusttation of the stringency of money prevailing during
this year, may be cited the ease of one of the largest
manufacturing concerns in Philadelphia, and one of the
foremost enterprises in its field, which was obliged to sell
its paper on an eight per cent basis. Individual bond
buyers, large merchants and manufacturers who are, to an
increasing extent, investing a portion of their profits in
negotiable securities, had their funds so fully employed in
their business that no surplus remained for investment.
Railroad and industrial corporations were at this time
heavily committed to new undertakings. To obtain the
money for these extensions and improvements, rather than
burden themselves with high rates of interest during the
life of long term bonds, they preferred to sell short time
notes, generally paying six per cent interest, which would
be taken by banks and private investors on account of the
security offered and the high rates of interest, approxi-
mating those which could be obtained in the loan market.
The amount of notes put out by the principal railroads
and industrial corporations during this year was very
large. The corporations making these issues preferred to "
pay higher rates for one, two, or three years in the belief
that when the date of maturity arrived, the condition of
the bond market would have so much improved as to per-
mit the retirement of these short term obligations with
bonds at lower rates of interest.

An illustration of the use of short term obligations was
the $15,000,000 of six per cent gold notes issued by the
Southern Railway on May 1, 1908. The bond market at
this time was so greatly depressed that none but issues of
the strongest corporations would be taken. The Southern
Railway was not in this class. Its credit was considered
so doubtful that it was not expedient to attempt to market
its bonds. These notes were offered at 983^ and accrued
interest and were payable on or before May 1, 1911.

BORROWING OF MONEY 301

Short term notes may be either secured or unsecured.
If unsecured, their value rests upon the general credit of
the company which dependg primarily upon -its surplus
earnings over charges. The security of notes is also in-
creased by the fact that, in most cases, their proceeds are
invested in the improvement of the property. For ex-
ample, in the case of the Southern Railway notes, it was
proposed to apply the proceeds of the notes substantially
as follows:

"First, to provide capital for obligations accrued and
to accrue, representing generally the retirement of equip-
ment obligations, the purchase of steel rails, construction
now under contract, and additional betterments and im-
provements to the properties covered by the development
and general mortgage, say $8,500,000; to provide for the
redemption of the sterling notes which will mature on
June 1st and July 2d next, say $3,000,000. The balance
to be used to reimburse the treasury to that extent for
moneys heretofore expended for construction and capital^
account, say $3,500,000:"

Out of $15,000,000 of notes, the proceeds of $8,500,000
would go to improvements which might reasonably be sup-
posed to produce revenue equal to the interest on the notes,
and which increased, to that extent, the value of the prop-
erty which secured the notes. Only $3,000,000 were pro-
vided to fund other notes. Short term notes are better
secured when the proceeds of the sale are to be spent for
the benefit of the company than when they merely take the
place of other maturing obligations. The sale of these
notes for refunding purposes is much more difficult than
when at least the major portion of their proceeds is to be
spent upon the property.

Short term notes are usually secured. In cases where
they have been issued on account of the present unsala-
bility at attractive prices of mortgage bonds already au-
thorized, it is customary to pledge collateral as additional
security for the notes. The $15,000,000 of Southern Rail-

302 CORPORATION FINANCE

way notes, for example, were secured by $20,000,000 of
Southern Railway development and general mortgage four
per cent bonds, Series "A," by $2,500,000 of Tennessee
Central Railroad prior lien mortgage four per cent bonds,
and by $2,000,000 Virginia & Southwestern Railway first
consolidated mortgage five per cent bonds. Earlier in
1908, the Hudson Company, of New York City, sold $15,-
000,000 of six per cent notes, secured by the deposit of
$22,500,000 of the first mortgage 4% per cent bonds of the
Hudson & Manhattan Railroad Company which owns the
tunnels between New York, Jersey City and Hoboken. In-
deed, the securing of these short term obligations by col-
lateral is so commor. that the giving of such security may
now be considered obligatory. Even a strong company
like the Pennsylvania Railroad Company, or its subsidiary,
the Pennsylvania Company, secures its short term obliga-
tions by ample collateral.

Since these notes are sold on a banking basis, and are
secured by collateral, it is fair to the company that they
should have the same liberty of reducing their loans which
is allowed to the ordinary borrower on collateral. This
provision is usually made. The Hudson Company's notes,
for example, were issued subject to the right of redemption
on any interest date, upon thirty days' notice, at par and
interest, plus a premium of one per cent per annum upon
the principal from date of redemption to maturity.

If at any time during the life of the short term obliga-
tion, a favorable opportunity arises to sell the collateral,
it is usual to provide that this can be done. Thus, in the
issue above described it is provided that:

"The Southern Railway is to have the right at any time
to withdraw by payment therefor in cash at the following
prices: Development and general mortgage four per cent
bonds. Series 'A,' at the same price and for the same
periods as provided above for the conversion of the notes;
Tennessee Central prior lien mortgage four per cent bonds
at not less than 85 per cent ; Virginia & Southwestern first

BORROWING OF MONEY 303

consolidated mortgage five per cent bonds at not less than
ninety per cent, with accriied interest in each case. Such
cash is to be applied by the trustee to the purchase or
redemption of the notes as provided in the trust inden-
ture."

The use of notes is merely a temporary expedient to
bridge over a period when bonds cannot be sold. Although
they may be sometimes funded into other notes of the same
kind, it is not possible for this process to be continued
indefinitely, and refunding usually requires higher interest
or better security on the new notes. These notes must, in
other words, be paid, principal and interest,' within a short
time. On this account, large reliance upon this means of
obtaining new capital is, for a weak corporation, consid-
ered unsafe. Although it is expected that the bond market
may improve to admit of the collateral back of the notes
being sold at good prices, yet this improvement cannot be
guaranteed, and it has frequently happened that short
term obligations came due at a time when it was most
inconvenient for the company to pay them. With a strong
corporation, in such an event, no difficulty is to be ex-
pected, but if the maturity of the notes coincides with a
period of business depression, when the net earnings of the
issuing company are below even their normal level, and
when the bond buyer is unusually critical concerning the
securities offered him, the company which, for the sake of
saving interest, has burdened itself with the obligation to
repay a large sum of money at such an inopportune time,
may run great danger of bankruptcy. The difficulty ex-
perienced by the Wheeling & Lake Erie, and the Erie Rail-
road Companies in refunding their notes maturing in 1908,
illustrates the danger in this method of procuring funds.
The first company was forced into bankruptcy by the ma-
turity of a note issue, and the Erie was saved only by the in-
tervention of Mr. B. H. Harriman. For any but the strong-
est companies, the provision of new capital by the issue of
short term notes is to be entered upon with great caution.

CHAPTER XXIII

LONG TEEM BONDS

Long term bonds are of two kinds — those without spe-
cial security, known as debentures, and those with special
security, such as mortgage bonds, collateral trust bonds,
and car trust certificates.

A debenture is a certificate of debt issued by a corpora-
tion without mortgage or collateral security. An illustra-
tion of a debenture is an issue by the New York, New
Haven & Hartford in 1904, which is, in substance, as
follows :

Fifty years after date, the New York, New Haven
& Hartford Railroad Company promises to pay . . .. .
or order, $1,000 at the office of its Treasurer, in 'the
(iity of New Haven, Connecticut, and to pay interest
thereon from date at the rate of 3i per cent per an-
num.

The security offered to the debenture holder is the right of
action against the company in default of their payment of
principal or interest. In this respect, debentures are su-
perior to preferred stock which they resemble in having
a prior claim to earnings, a claim, however, which is en-
forceable by legal action.

• The measure of the value of the debenture bonds is the
surplus earnings of the corporation over the prior fixed
charges. They are, in no respect save in name, different
from junior mortgage bonds, and they usually bear a
higher rate of interest than first mortgage bonds. Deben-
tures differ radically from income bonds. An income bond
is a bond whose interest is payable if it has been earned,
but whose principal, like that of any other bond, is payable
304

LONG TERM BONDS 305

at a definite date, and may also be secured by mortgage.
It is necessary, from the standpoint of the purchasers of
these bonds, that the income out of which their interest is
payable should be precisely defined. The borrowing com-
pany should be allowed full operating expenses, but from
maintenance charges all betterment expenses should be
carefully excluded. Depreciation on the capital contrib-
uted by the income bond buyer should not be allowed. In
its place an adequate sinking fund, perhaps conditioned on
earnings, in which case it should be cumulative, should be
provided. Interest on income bonds should in all cases be
cumulative. If not earned in one year, it should be carried
over as an absolute claim on any future accumulation of
earnings. When these precautions are taken, an income
mortgage bond gives the holder all the protection which
can be afforded by the earnings.

Returning now to the consideration of debentures, we
find that the contracts with the debenture holders may
contain certain special securities which go far to compen-
sate for the absence of mortgage security. It may be
provided that no mortgage shall be placed upon the prop-
erty unless the debentures are included in the lien of the
mortgage. Thus, for example, in the offer of the deben-
tures of the New York, New Haven & Hartford appears
the following:

These debentures will also provide, as far as lawfully
may be, that if this company shall thereafter create any
mortgage upon its now existing main lines of railroad
between Woodlawn in the City and State of New York,
and Springfield in the Commonwealth of Massachusetts,
or its now existing main lines between New Haven in the
State of Connecticut, and Providence in the State of
Ehode Island, such debentures shall, without further act,
be entitled to share in the security of such mortgage
pro rata with any other obligations that may be se-
cured thereby, and that any such mortgage shall ex-
pressly so provide.

It may be provided that, as long as the debentures are
outstanding, the debt of the company shall not be increased.

306 CORPORATION FINANCE

The agreement with the debenture bond-holders of the Colo-
rado Fuel & Iron Company provides that:

So long as any of said debentures or the interest war-
rants annexed thereto, shall be unpaid, no mortgage or
other encumbrance shall be placed upon any of the
property of the Iron Company, nor shall any other de-
bentures be authorized or issued, nor a,ny other bonds,
except those provided for in the mortgages or deeds of
trust outstanding July 1, 1901, and except bonds and
mortgages to be authorized and issued to replace the
bonds provided for in such mortgages or deeds of trust,
in case the Iron Company may desire to refund the same
or any of them, but in no event shall the par value of
its said refunding bonds exceed the par value of the
bonds which they shall be issued to replace, nor shall
the rate of interest on any of such refunding bonds ex-
ceed the rate of interest upon the bonds which they shall
be issued to replace, it being the meaning of this agree-
ment that neither the total amount of bonds at any time
outstanding nor the rate of interest thereon, so long as
any of said debentures or the interest warrants annexed
thereto shall be unpaid, shall be increased ; nor shall any
notes be issued or indebtedness authorized or created
for any other purpose than the ordinary running ex-
penses of the Iron Company.

The precautions indicated in the foregoing extract are
highly desirable from the standpoint of the debenture
bondholder.

A corporation which has issued debenture bonds may
have retained the right to issue bonds under its various
mortgages, by which the security of a debenture which
can be satisfied only after the prior claims of mortgage
bonds, would be seriously impaired. By inserting in the
contract with the debenture bondholder such a provision
as the foregoing, a corporation, so long as the debentures
were outstanding, would be unable to issue any other form
of debt than short term notes or an inferior g-rade of de-
bentures.

It may also be provided for the protection of the de-
benture bondholders that the proceeds of these bonds shall
be expended in a specified manner for the benefit of the

LONG TERM BONDS 307

property. To quote again from the agreement of the
Colorado Fuel & Iron Company:

The Iron Company agrees that the proceeds of the
initial $10,000,000 of said debentures shall be used
only for additions and improvements to the plant of
the company, and for working capital and other cor-
porate purposes^ and that the proceeds of the remain-
ing $5,000,000 of said debentures shall be used only
for the acquisition of additional property.

It would be impossible, in view of this clause in the con-
tract, for the proceeds of the debentures to be used to retire
outstanding indebtedness of the company, or as a means of
providing funds for the distribution of a portion of the
company's surplus to stockholders. The provision stipulates
that all the money which the purchasers of the debenture
bonds pay into the treasury of the company shall be expended
in such a manner as to increase the value of the company's
property, and the net earnings upon which the debenture
bondholders must rely for their interest. With these safe-
guards thrown about him, the position of the debenture bond-
holder is not greatly inferior to that of the holder of a
second mortgage bond.

In order to make debenture bonds more attractive, and
to sell them at higher prices, many corporations have adopted
the plan of making these bonds convertible into stock at a
certain figure. The issue of debentures with the convertible
feature is rapidly growing in favor, and several of the strong-
est railroads in the country — ^the Union Pacific, the Atchison,
and the New York, New Haven & Hartford — ^have adopted
this plan of financing their capital requirements. These con-
vertible debentures are direct obligations of the issuing com-
pany, although they are unsecured by mortgage. They carry
a fixed rate of interest and are payable at a definite date.
In addition, the holders of the bonds are given the privilege
of converting them into stock, usually common stock, at a
certain figure, either up to a certain date or after a certain
date. For example, the ten-year five per cent convertible

308 COEPOKATION FINANCE

gold bonds of the Atchison, Topeka & Santa Fe are convert-
■ ible into common stock prior to June 1, 1913, at the option
of the holder, on the basis of ten shares' oi- common stock, par
value 100, for each $1,000 bond; and the Delaware & Hudson
Company, in 1006, issued ten-year debenture four per cent
convertible bonds, convertible into the common stock of the
company prior to June 15, 1912, on the basis of five shares
,of stock for each $1,000 bond. The conversion privilege on
some convertible bonds does not begin for a number of years,
,as, for example, the six per cent debenture bonds of the New
York, New Haven & Hartford are convertible between 1923
^nd 1948, at par into the common stock of the company. As
fi rule, however, the conversion privilege is immediate. The
conversion price is usually fixed at a figure considerably above
the market price of the stock when the bonds are issued.

The advantages offered by these bonds to the investor
,are evident. Convertible bonds, considered as obligations of
■the company, rank with junior lien bonds. A company which
has a long dividend record is reasonably certain to pay inter-
jest and principal of its junior mortgage bonds. The stock
fii the corporation represents the residuary claim to the in-
<crease in its profits and values. If the business of the com-
pany is w.ell conducted, its stock may go to a high figure.
■The holder of the convertible bond can then make a large
profit by exchanging his bonds for stock.

A feature connected with convertible bonds which makes
them especi,ally attractive to the speculative element always
to be attentively considered in any sale of securities, is the
movement pf their value as compared with the movement
.of stock values. Since the convertible debenture is a
bond, an unconditional obligation of the corporation to pay
money, it wjll be valued as a bond by its holders, and
there will be a certain point below which it will not fall.
The purchaser of five per cent debenture bonds of a strong
railroad company at, say, 96, can be reasonably certain that,
no matter how unfavorable the financial situation may be, the
price of his security will not fall much below 90. The stock

LONG TEEM BONDS 309

of the same company, although it may pay a higher dividend
than the rate of interest on the bond, may easily fall to 75.
On the other hand, when the price of the stock advances, the
convertible bonds, since they are exchangeable for the stock,
also rise more rapidly than other junior lien bonds which do
not have the conversion privilege. The Atchison, Topeka &
Santa Pe has outstanding a large issue of convertible four
,per cent bonds as well as a second mortgage four per cent
bond, known as Adjustment Mortgage four per cent. Dur-
ing the panic of 1907, the adjustment mortgage 4s fell
to 77^ and the convertible 4s to 80. With the revival of
business, the stock of the Atchison rapidly advanced, and
the convertible bonds rose. On November 24, 1909, the con-
vertible 4s sold at 119 J while the adjustment mortgage 4s
had only recovered to 94J.

Up to and beyond the conversion figure, as long as any
of the convertible bonds remain outstanding, the price of the
bonds and of the stock into which the bonds are convertible
will move together. The price of the convertible bond will
usually be lower than the price of the stock for which it is
exchangeable, since a large part of the demand for convertible
bonds, which have risen to high figures because of this ex-
change privilege, will come from investors who choose this
method to acquire the stock at less than market figures. Con-
vertibles sell at a lower price than the stock for which they
are exchangeable, for the same reason that rights to subscribe
to stock at par sell for smaller sums than the amounts repre-
sented by the differences between par and market price on
any given date. The correspondence, however, between the
price movements of convertible bonds and stock is suflBciently
close to make these bonds very attractive to a large class of
investors who are not averse to taking a speculative profit if
this can be done with moderate risk.

Convertible bonds are also bought largely by speculators
as a protection against short sales. Suppose, for example,
a speculator desires to sell Atchison stock short around par.
He begins his operations by buying ten of the convertible

310 COEPOEATION FINANCE

bonds which will be selling around 98|. He then sells 100
shares of Atchison short, borrows the stock from some one
who has it to lend, and deposits his bonds as the principal
security for the loan, receiving $10,000 for the stock, less
his commissions,' with which he can pay for his bonds and
have a small profit remaining, subject to the risks of his
contract to deliver 100 shares of stock whenever. called upon
by the lender. Suppose, now, that his calculations are cor-
rect, and that Atchison falls to 90. His convertible bonds
may decline, although this is not necessarily involved in a
situation which would produce a fall in the price of the stock.
He might, however, lose three points on his bonds. At the
same time, however, he would make $10, a share on his trans-
action in the stock, since he could purchase 100 shares for
$9,000, and deliver the stock to the one from whom he
borrowed it, receiving back his convertible bonds. In the
event of the speculator's calculations proving erroneous, and
if Atchison stock advanced ten points to 110, he would lose
$10 a share on his stock, or $1,000. His convertible bonds,-
however, would probably advance to 105, so that his net loss
would be only $350. Furthermore, in the unlikely event of
the stock being cornered, the holder of convertible debentures
can protect himself by exchanging his bonds for stock which
the company holds in its treasury available for the conversion
from the date the bonds are issued. Owing in part to these
speculative advantages possessed by convertible debenture
bonds, they are in large demand, and their prices are often
far above their investment values.

"Whatever may be said of the debenture bond from the
standpoint of the investor — and it must be admitted that the
position of most debenture bondholders as unsecured cred-
itors is, from an investor's standpoint, not especially attrac-
tive— there can be no question that they offer to a corporation
whose stock is selling so close to par that it cannot count on
disposing of any large amount at that figure, and which is not
in a position to issue first mortgage bonds, an opportunity
to obtain money on favorable terms by combining the doubt-

LONG TERM BONDS 311

ful investment quality of debentures with the speculative pos-
sibilities involved in the conversion privilege. From the com-
pany's standpoint, the sale of convertible debentures is merely
a deferred sale of the stock for which the convertibles are
to be exchanged. This deferred sale of stock is often made,
through conversion, at a high premium, a much higher
premium than could be obtained by selling the stock direct.
The use of convertible debentures has been criticised on the
ground that a company by resorting to this form of security
will spoil the market for its prior lien bonds. As a rule, how-
ever, debentures are not resorted to as long as first-class bonds
under prior lien mortgages are available for sale.

CHAPTER XXIV

MORTGAGE BONDS AND COEPOKATE ENDOWMENTS
AND GUAEANTEES

We next take up long term obligations with mortgage, col-
lateral, or lease security. American financiers are committed
to the idea of specific security. Until recent years, it has
been very difficult to sell debenture bonds at values com-
mensurate with their real security. Laws regulating the
investment of the funds of savings banks and trust funds
usually stipulate first mortgage bonds. In Great Britain, on
the other hand, bonds without specific lien security are more
common.

Eecognizing the preference of the American investor for
mortgage bonds, corporation directors, in formulating a plan
for provision of new capital, must keep in view, in selecting
a type of obligation, the following objects: First, they must
secure for the corporation the money required; second, they
must procure this money at a reasonable cost; third, they
should provide, if possible, in a mortgage whose bonds are
readily taken by investors, for subsequent issues of bonds.
The directors come next to the consideration that the in-
vestor will pay a higher price for first mortgage bonds than
for any junior security. Of two bonds of equal security, so
far as earnings are concerned, one secured by a first and iihe
other by a second mortgage on the same property, the first
mortgage bond will always be preferred. This preference
is easily explained. In case of bankruptcy and reorganiza-
tion, the first mortgage bonds are in a position of gteat ad-
vantage. Up to the earning power of the property set aside
to secure them, they must be protected. Before the holder of
312

MOETGAGE BONDS 313'

second mortgage bonds can enforce the lien of their security,
they must satisfy all the claims of the first mortgage. The
investor's first concern is the safety of his principal. He
wishes the utmost protection. This protection the first mort-
gage, as distinct from any junior lien, gives him.^

Next in order to first mortgage bonds, in grading secured
issues, the investor will rank collateral trust bonds where the
security consists of other bonds or dividend-paying stock, and
where the borrowing company can pay the interest, if need
be, without depending upon the income produced by the col-
lateral. Finally, he will put bonds secured by leases, such
as car trust certificates. Two problems then confront the
directors of corporations proposing to issue bonds. They
must give the bonds, if' possible, the security of a first mort-
gage, and, if this cannot be done, they must adopt some form
of obligation which will give the bonds issued a first lien on
either securities owned or on rights under leases. In case
neither method is available, and also as additional security
in all eases, the corporation may assume the indirect or con-
ditional obligation of a guarantor or indorser of bonds which
are sold for its benefit.

In giving bonds first mortgage security, it is necessary
to deal with two types of existing mortgages. First, those
which stipulate that all property subsequently acquired by
the corporation shall come under the existing mortgages, and
second, those which set aside specific property as security,
leaving subsequently acquired property to be pledged as se-
curity for additional loans. Under the first classification we

' Many exceptions can be cited to this rule. Some of the best
bonds are secured by general mortgages — that is, second and third
mortgages. The Erie prior lien bonds, for example, are secured by
a sixth mortgage on its main line. In these cases, however, the first
mortgages are usually for small amounts calling for such moderate
payments in relation to the surplus earnings of the company that
the investor disregards the prior liens. A tendency is visible, however,
in recent yeairs, among railroad financiers, to retire, as far as possible,
these underlying liens in order to bring the mortgages seciuing the
large issues of general mortgage bonds nearer the property. ,

314 COEPOEATION FINANCE

find two types of mortgages — the open-end mortgage, and the
closed mortgage. Under the open-end mortgage bonds may
either be issued to any amount without limit, or a bond reserve
large enough to provide for all future needs of the company
is authorized,^ the bonds being protected, however, by the
requirement that the money shall be invested in a specified
way for the benefit of the company, or that their issue shall
be controlled and approved by some disinterested authority.
Bonds are issued under a closed mortgage when the
amount of bonds to be issued under the mortgage is limited.
Closed mortgages are of two kinds : First, where the property
subsequently acquired by the corporation is included under
the lien of the mortgage; and second, where the lien is lim-
ited to the property enumerated in the instrument. The
first may be called an inclusive and the second an exclusive
closed mortgage. Closed mortgages have the following form
of enumeration of property transferred :

Together with all the branches, extensions and sid-
ings thereof and therefrom, and all the lands and
rights of way used and occupied, or surveyed, laid out,
or intended to be used and occupied for the said rail-
roads, branches, extensions and sidings, with all the
railroad tracks, buildings and improvements thereon,
and all and singular the lands, bridges, trestle works,
wharves, shops, stations, depots, engine houses, en-
gines, cars, rolling stock, furniture, equipments, and
generally all and singular the estate, real and per-
sonal, of the said . . . Railway Company, whatsoever
and wheresoever^ now owned or hereafter to he ac-
quired hy it^

An illustration of the exclusive closed mortgage where
the lien of the mortgage is limited to specified property,
and does not include any property which may be hereafter
acquired, is furnished by the mortgage securing the first lien

' The true open-end mortgage is rare. For practical purposes a
bond reserve several times the amount of the initial issue is equivalent
to the authorization of unlimited issue.

^ Italics are the author's.

MOETGAGE BONDS 315

convertible four per cent gold bonds of the TJnion Pacific
Railroad Company, due May 1, 1911, which assigns to the
trustee :

All and singular the several lines of railroad, prop-
erty, and premises belonging to the Kailroiad Com-
pany which are particularly described as follows. . .
Together with all additions, lands, terminals, yards,
bridges, tracks, rights of way, trackage rights, build-
ings, telegraphs, shops, elevators, and other structures
and fixtures, easements and leaseholds, corporate rights
and franchises, now held or acquired or hereafter held
or acquired for use in connection with the said lines
of railroad, specifically above described; and also the
earnings and profits thereof, also the following de-
scribed bonds and stocks, namely: . . . Together with
any and all shares of stock or bonds of any other cor-
poration which the Eailroad Company may hereafter
deposit and pledge hereunder by way of substitution
or otherwise.'

Under this mortgage, the security of the bonds is specific-
ally restricted to the property enumerated in the mortgage,
and there is no obligation on the part of the company, al-
though it may do so, if it desires, to add to this security.

First mortgage bonds can be issued under inclusive closed
mortgages only if a portion of the bonds authorized has been
reserved to provide for the future needs of the company. Un-
der most of the closed mortgages issued by the large railroad
companies, only small amounts can still be issued. Tor ex-
ample, the offering by the Guarantee Trust Company of
$3,072,000 prior lien 3J per cent gold bonds of the Baltimore
& Ohio Eailroad Company in July, 1908, contained the fol-
lowing :

With the above offering the mortgage is closed, and
in consequence this is probably the last opportunity
to obtain a round amount of these bonds at a satis-
factory price. The general inability of the railroads

> Italics are the author's.

316 COKPOEATION TINANCE

»
to create in the future new bonds which will compare
in point of security with first mortgages of this class
renders this an opportunity which should be em-
braced.

If the authorization of bonds under a closed first mortgage
has been exhausted by issue, the only recourse of the directors
desiring to give to the investor bonds secured by a prior lien,
is to the issue of bonds by a subsidiary company organized
for that purpose, and guaranteed by the parent company;
or to a collateral trust issue, if ' the first mortgage of the
parent company does not include all securities owned in its
schedule of property " to be hereafter acquired " ; or to a
combination of the two methods. These methods of raising
capital we shall take up in detail in their proper places. If
the closed mortgage does not include " all property to be
hereafter acquired," so that the company can subject some
of its property to the lien of a first mortgage, then it is usual
to execute a general refunding first mortgage, or a con-
solidated first mortgage which will become a first mortgage
on all the property of the company when the underlying
bonds mature. Provision is made for a sufiicient issue of
bonds under the consolidated mortgage to retire the prior
lien, bonds, and the general effect and impression is that of
a first mortgage bond. Eeferring again for illustration to
the issue of bonds by the Union Pacific above noted, we find
the following description of the security in a letter from
President B. H. Harriman, under date of June 8, 1908 :

" Eeferring to the ' first lien and refunding mortgage foui
per cent bonds ' of this company, I beg to state that thesp
bonds are to be secured by a first mortgage on l,!??.?! miles
main track and 146.63 miles other track of owned railroad
lines. The lines mortgaged are valuable and important parts
of this company's system. . . . The amount of bonds which
may be issued at present on the security above stated is $50,-
000,000, and no further amount can be issued in addition
thereto until the security of the mortgage be extended to cover

MOETGAGE BONDS 317

^subject only to the first mortgage of this company, dated
July 1, 1897) all the lines covered by said first mortgage . . .
the entire railroad mileage of the Union Pacific Eailroad
Company. When the lien of this mortgage is extended to cover
all of the present railroad mileage of the Union Pacific Eail-
road Company, the total authorized amount of bonds which
may be issued thereunder, including the above $50,000,000,
will be $300,000,000, of which $100,000,000 are to be reserved
to refund the first mortgage four per cent bonds, due July
1, 1947, for a like face amount, which first mortgage bonds
shall not be extended when due, so that the 'first lien and
refunding mortgage shall ultimately become the sole first
mortgage upon the entire present railroad property of the
company, and upon any additional property hereafter ac-
quired or constructed with the proceeds of bonds of this
issue.' ^ The remaining $50,000,000 bonds are to be reserved
to be issued only for the construction or acquisition of addi-
tional lines of railroad, connecting with the lines then sub-
ject to the mortgage, and for the acquisition of other property
for use on or in connection with the mortgaged lines and
for improvements thereon, as specified in the mortgage, and
all of which shall then pass under the lien securing the en-
tire issue of these bonds."

The Union Pacific, it appears from this statement, took
advantage of the fact that its first mortgage is not inclusive
of all property which it may hereafter acquire, to pledge
certain lines which had been built or purchased since the
first mortgage was executed, under the lien of this first con-
solidated mortgage. This is, therefore, a first mortgage on
some lines, and a second mortgage on others. It is also here
provided, which is usual in this type of security, that eventu-
ally this first and refunding mortgage shall become an abso-
lute first mortgage on all the property of the system.

Here again we find the precaution taken that the com-
pany should have available first mortgage bonds, in 'the pro-

' The italics are the author's.

318 COEPOEATION FINANCE

vision that $50,000,000 are to be reserved for subsequent
issue. Great care is taken in drawing refunding mortgages
to provide that the maturing bonds should be retired, either
by payment or conversion, as fast as they mature, so that the
priority of the lien of the refunding mortgage shall be ex-
tended as rapidly as possible.

Bonds are not often issued imder second and third mort-
gages except in reorganizations. So strong is the .prejudice
against them, that even here they have fallen into disuse.
There are exceptions to this rule, but, generally speaking,
second mortgage bonds cannot be sold to advantage.

CORPOKATE INDORSEMENTS AND GUARANTEES

When first mortgage bonds cannot be sold, resort may
be had to several methods of securing the obligations vpith
which the desired capital is to be obtained. The purpose of
each of these methods is to approximate as closely as possible
the security of a first mortgage. The first of these methods
is to organize subsidiary companies in the interest of the
company which desires to provide the new capital. These
companies issue to the parent company their bonds secured
by a first lien on the property purchased o"! constructed, and
also secured by the indorsement of the parent company. The
parent company can either sell the subsidiary company's
bonds direct, or can deposit them as collateral security for
an issue of its debentures, unless compelled by the terms of
its prior lien mortgages to deliver them to the trustees of its
existing obligations. A large amount of railway mileage has
been built in this manner through subsidiary companies,
either because the parent company was limited in its borrow-
ing by the terms of its mortgages, or because the laws of the
State where the new lines were located required ownership by
a local company. This form of financing new construction
is not so common as formerly.

The use of the indorsement is still general. One of the
most common uses of this method in recent years is the in-

MOETGAGE BONDS 319

dorsement of bonds of terminal companies by the various rail-
way corporations which make use of the facilities thus pro-
vided. A number of issues of bonds have been made by new or
weak companies in recent years secured by the indorsement
of certain prominent and wealthy individuals or firms. Th^
most conspicuous illustration of this use of individual credit
to bolster up the credit of weak companies was furnished
by Mr. H. H. Eogers in his guarantee of the bonds of the
Virginian Eailway, and by Mr. Henry M. Flagler, on the
strength of whose personal guarantee a large amount of
notes were sold by th^ Florida & Bast Coast Eailway Com-
pany. Another use of the guarantee is the sale of equip-
ment notes given to such companies as the American Loco-
motive Company or the American Car & Foundry Company
by weak railway companies, and which are sold with the
indorsement of the equipment companies.

An indorsement of a corporate bond has, of course, the
same form and significance as an indorsement on a promis-
sory note. By indorsing a note, a person or corporation alike
agree that in case the maker does not pay the note at matu-
rity the indorser will pay it. Corporate guarantees are of
two kinds: First, strong guarantees, and second, weak guar-
antees. An example of a weak guarantee is as follows :

For value received the Great Western Power Co.
hereby guarantees to the holder of the within bond
the prompt and punctual payment, according to the
terms thereof, of the principal of, and interest upon,
the within bond, and further guarantees to the said
holder that the sinking fund installments in respect
to Series " A " bonds provided in the mortgage and
deed of trust and in said bond referred to shall he
made in ' the manner and to the extent therein pro-
vided.

This guarantee is weak in the sense that it merely stipu-
lates that the holders of the bonds of the California Eleetrio
Generating Company to which the guarantee referred, will

> Italics are the •author's.

320 COEPOEATION FINANCE

receive their interest and principal and will be protected in
accordance with the terms of the mortgage. The Great
Western Power Company does not itself formally assume
the obligation, but merely agrees to assume it in case the
California Electric Generating Company, which issues the
bonds, fails to carry out its agreement. An example of a
strong guarantee is as follows:

For value received the St. Louis Southwestern Rail-
way Company hereby unconditionally guarantees to
the owner of the within bond the payment of the
principal thereof and the interest thereon as the same
matures and falls due, and hereby agrees' itself to
pay the said principal and interest if default in the
payment thereof be made by the Terminal Company.

Here is an unconditional assumption of debt by the guar-
antor, and this form is preferred to that first given. An even
stronger form is the following guarantee indorsed upon bonds
of the New York^ & Westchester Lighting Company, a sub-
sidiary of the Consolidated Gas Company of New York :

For value received, the Consolidated Gas Co. of
New York hereby assumes and agrees to pay the prin-
cipal and interest of the within bond as the same shall
respectively become payable.

Here is the strongest form of guarantee, the assumption by
the guarantor of the obligation of paying interest and pria-
cipal, assuming itself the risk of reimbursement from the
treasury of the subsidiary company. Another form of guar-
antee provides that the guarantor shall deposit within a cer-
tain time before each interest date, with the trustee of the
bonds, the amount required for the payment of that install- ,
ment of interest. As a rule, the guarantee is preferred in
proportion as the guarantor assumes an unconditional obliga-
tion under his indorsement. Another common form of guar-
anteed security is stock on which a certain rate of dividend
has been guaranteed by another company. This method is
mainly employed in connection with leases.

MOETGAGE B0OT5S 321

The remedy of the holders of guaranteed bonds or stock
is the same as the remedy of the holder of an indorsed note,
namely, a suit against the indorser for the amount remain-
ing unpaid. The objections to this form of security are,
therefore, the ordinary objections to indorsement security,
namely, the necessity of suing the indorser, unless it is to
his interest to protect his obligations, and the f adt that there
may be no limit to the amount of contingent liability which
may be assumed. In case of strong companies, which have
guaranteed bonds secured by mortgages on integral portions
of their system, covering property which is essential to their
business, guarantees are regarded as of great value. Such
bonds are often sold on no other security than the indorse-
ment, no attention being paid to the earnings of the com-
pany actually issuing the bonds.

The second objection to the guarantee as compared with
the mortgage security, is more serious. When bonds are is-
sued, secured by a mortgage, certain property is conveyed
to the trustee. The purchaser of the bonds knows that when
the issue authorized by that mortgage has been exhausted,
no further bonds can be issued on the security of that prop-
erty, unless they follow the first mortgage bonds. The whole
transaction is a matter of record. The creditor knows ex-
actly what the value of the security is. On the other hand,
a company with a surplus of $1,000,000 over interest charges
may place its indorsement on a series of bonds issued by other
companies whose stock it has acquired. These guarantees,
if the borrowing companies do not prosper, may steadily
shrink in value, as the margin between the amount which the
guarantor may be obliged to pay under its indorsement, and
its surplus income from the stocks of its subsidiaries, is re-
duced. The company with a surplus of $1,000,000 may
assume the contingent liability of a guarantor up to $100,000
a year, and the bonds will be good aside from the earning
power of the property which directly secures them. When,
however, these guarantees aggregate $600,000 or $700,000 a
year, the investor must look more closely into the condition
22

322 COEPOEATION FINANCE

of the borrowing companies, and must place correspondingly
less reliance upon the security offered by the indorsement.
There are some companies, such as the American Water
Works Company, which have indorsed enormous amounts of
bonds, and which are continually offering additional issues
with the argument that they are also secured by indorsement.
So far as the value of the guarantee extends, however, it is
a question- whether this unlimited indorsement is not a source
of weakness rather than strength.

This objection to the security of a guarantee can be easily
met, however, by including in the indorsement an obligation
of the guarantor to limit his contingent liability. If, for
example, his surplus earnings are $500,000 a year and he
assumes a contingent liability to pay $250,000, it may be
provided in the indorsement that no additional guarantees
will be assumed by the indorser until the surplus earnings
have reached $1,000,000. By preserving a safe margin be-
tween the payments which may be required by the contingent
liability, and the surplus earnings out of which these pay-
ments must be made, the security of a guarantee may closely
approa,ch the security of a mortgage.

Note. — Since the above was written in 1910 the danger of relying^
upon the guarantee has been illustrated by the failure of the American
Water Works and Guaranty Company, a failure due to the extension of
the Company's operations by guaranteeing the bonds of certain irriga-
tion companies which proved unprofitable, and forced the guarantor
company into bankruptcy.

CHAPTER XXV
THE COLLATERAL TRUST BOND

The method of financing new construction by the sale
of bonds of subsidiary companies guaranteed by the parent
company is advantageous only for strong corporations.
Small issues of subsidiary company bonds with the addi-
tional security of a guarantee, when the guarantor is not
abundantly able to meet all these contingent obligations with-
out calling upon the issuer of the guaranteed securities, are
not popular. One of the main reasons for issuing first and
refunding or first and general lien bonds is to ofEer the in-
vestor a large issue and a direct obligation. It is increas-
ingly difiicult to sell the bonds issued by small companies.

When it is impossible or inexpedient for a company to is-
sue first mortgage bonds, and unless it is of the first rank,
BO that its guarantee carries conviction, its best method of
obtaining new funds is to issue its own debenture bonds
secured by the deposit of stocks and bonds of subsidiary com-
panies to which it makes advances for construction pur-
poses. These bonds have already been described as collateral
trust bonds. The value and the salability of these bonds
depends not so much upon the earnings of the subsidiary
company whose securities are pledged, as upon the solvency
of the company which issues the obligation. It is not usual
to issue collateral trust bonds secured only by the stocks and
bonds of a single company. A number of issues of subsidiary
companies are usually combined to furnish security for a
large issue of the parent company's bonds.

One of the first cases where this method was employed

323

324 COKPOEATION FINANCE

was by the Union Pacific in 1879. In 1873, in order to pro-
tect the second mortgage lien of the government to secure
these advances in aid of construction, a law was passed pro-
hibiting the Union Pacific from increasing its bonded debt.
Any additional property which it might acquire must come
under the lien of this second mortgage. As a result, the
Union Pacific could build no branch lines nor extensions.
It was necessary to build this additional mileage through
subsidiary companies. The Union Pacific advanced the
money for construction out of its current earnings, receiv-
ing the capital stock and first mortgage seven per cent bonds
of the construction companies. To reimburse its treasury
for these advances, the Union Pacific pledged these first
mortgage bonds as collateral security for an issue of $7,-
000,000 of six per cent bonds.^ In 1882, a second collateral
trust issue was made by the Union Pacific for a similar pur-
pose. Other railway companies which have made large use
of the collateral trust bond in aid of construction are the
Missouri Pacific, the Eock Island, and the Louisville &
Nashville. A collateral trust bond secured by a lien upon
the first mortgage bonds of subsidiary companies gives
greater security than the contingent liability of a guarantee,
since it is a direct obligation of the parent company. It is,
iowever, inferior to the lien of a first mortgage, since a
ioreclosure of the collateral trust mortgage places the cred-
itor in possession of other bonds, which necessitates addi-
iional foreclosure proceedings before he can get at the prop-
erty which is the object of his search.

Collateral trust mortgages contain a number of safe-
guards designed to preserve the value of the collateral.
When the security consists of bonds, it is stipulated that
no more bonds of equal rank shall be issued by the subsidiary
company, even though the subsidiary company's mortgage
.authorizes additional issues. To this end, the company
owning the stock of the subsidiary company is required

' Thomas Warner Mitchell in the Quarterly Journal of Economics,
vol. XX, 1905-06, p. 443.

THE COLLATEEAL TEUST BOND 325.

to deposit this stock, or a controlling interest therein, with
the trustee to make sure that the directors of the sub-
sidiary company will not exercise their right to increase the
issues of the bonds, and so weaken the value of the collateral
trust bonds. This precaution may be considered unnecessary
when, as is usually the case, whole or controlling interests in
the stocks of the subsidiary companies are owned by the
parent company, but it must be remembered that such safe-
guards are designed primarily for the protection of the bond-
holder whose interests might be jeopardized if the directors
of the parent company should hypothecate treasury assets for
some temporary emergency.

Greater care is taken in the framing of collateral trust
indentures to protect the value of stock collateral than is
necessary in ease of bond collateral. The trust indenture
securing the Northern Pacific-Great Northern-Chicago, Bur-
lington & Quincy Collateral-Trust Bonds, contains a num-
ber of precautions of this character. The railway, companies
which acquired by the issue of these bonds about ninety-eight
per cent of the stock of the Burlington, agree with the trus-
tee that, in case there shall be issued any additional shares of
the Burlington stock, except only treasury stock reserved
for bond conversion, then the railway companies will assign
to the trustee ninety-eight per cent of such additional capital
stock. They bind themselves not to distribute any part of
the surplus of the Burlington existing on July 1, 1901, since
such a distribution would weaken the value of the stock. They
agree also that they will cause all necessary repairs, renewals,
and replacements to be made out of the earnings of the Bur-
lington lines; that they will not permit the execution by the
Burlington of any lease of any of the railways in its system
unless such lease shall be made subject to termination by the
Burlington, if the shares of the stock held by the trustee shall
be sold in case of any default; and finally that they will not
permit the sale of any part of the property of the Burlington,
unless ninety-eight per cent of the proceeds of the sale is de-
posited with the trustee as security for the bonds.

326 COKPOKATION FINANCE

Collateral trust bonds differ from call loans with col-
lateral security in that they usually contain no provision for
the substitution of collateral. "We have seen that mortgages
securing bonds by liens on real property allow directors, with
the consent of the trustee, to seU any part of the property
for which they have no further use, provided only that the
proceeds of this sale be reinvested in place of the property
withdrawn. The security of stock or bond collateral is, how-
ever, by no means so substantial as that furnished by the
pledge of real property. Especially when the bonds run for
a long term, the substitution of other collateral for that origi-
nally deposited is usually considered to give too much latitude
to the borrowing company.

It is, however, possible to include the privilege of sub-
stituting collateral under adequate safeguards. An illustra-
tion of this method is furnished by the mortgage securing
the four per cent refunding twenty-five-year gold bonds of
the Oregon Short Line Railroad Company dated December
1, 1904. These bonds were secured by the capital stock of the
Northern Securities Company, the Southern Pacific Company,
and the Oregon Eailroad and Navigation Company. Article
6 of the indenture allows withdrawal of the pledged securities
and the substitution of collateral. Withdrawal may be made
up to eighty per cent of the value of these securities ascer-
tained by appraisement at the time of their delivery to the
trustee. Section 2 authorizes the substitution of the stocks of
securities of railroad, steamship, or terminal companies for
collateral placed under the mortgage to a value equal to the
value of the securities withdrawn. The method of appraise-
ment is for two appraisers to be appointed representing the
railroad company and the trustee, respectively, and for these
appraisers to choose a third whose judgment as to the value
of collateral is to be final.

The collateral trust bond is employed for a variety of
purposes in addition to the financing of construction by sub-
sidiary companies. A company whose only property con-
sists of the stocks and bonds of other companies is usually

THE COLLATEEAL TEUST BOND 327

limited to the collateral trust bond. The bonds issued by the
large industrial corporations organized in the form of hold-
ing companies, whose chief assets consist of the stocks of
a number of subsidiaries, furnish numerous illustrations
of this method. In such indentures, either the stocks of
subsidiary companies can be pledged under the mortgage,
or the subsidiary companies themselves, in return for funds
advanced to them by the parent company, can execute their
own mortgage bonds, and turn these over to the parent com-
pany to be deposited under the collateral trust indenture.
The precaution usually taken is to have all- the securities,
both stocks and bonds, of the subsidiary companies de-
posited under the indenture, and to provide in the mort-
gage that the parent company, in return for any advances
which it may make to the subsidiary companies out of the
proceeds of the collateral trust bonds, shall obtain from the
subsidiary companies, and shall deliver to the trustee suit-
able evidences of indebtedness to furnish additional security
under the collateral trust mortgage. Should default occur,
the holder of the collateral trust bonds comes into the posses-
sion of bonds or notes of the subsidiary companies secured by
direct liens on their property.

The collateral trust bond is also employed by corporations
to acquire the stock of some other company which, when
pledged as security for an issue of collateral trust bonds,
furnishes the means for its own purchase without seriously
taxing the credit of the purchasing company. Collateral
trust bonds are, as already explained, plain obligations of
the issuing company. They are promissory notes which,
when issued by a solvent corporation, have a value apart
from any special security which may be deposited. In or-
der to give them greater currency and value, however, the
stock of a company which has been purchased may be de-
posited as collateral security, in this manner providing the
funds for its own purchase. Familiar examples of this use
of the collateral trust bond are furnished by the Great North-
ern-Northern Pacific, Burlington Joint 4s already referred

328 COEPOEATION FINANCE

to ; also by the issue of collateral trust three and a half per
cent bonds by the New York Central, in 1897 to purchase the
stock of the Lake Shore & Michigan Southern, and Michigan
Central Eailroad Companies.

In each of these cases, the stock security placed undei
the collateral trust bonds of the purchasing company has
produced a revenue at least equal to the interest on the
bonds, so that the income accounts of the parent companies
have not been drawn upon, save temporarily, to pay interest
on the collateral trust bonds. The credit of the parent com-
pany is, therefore, kept intact for the issue of other deben-
tures for other purposes. With bonds amply secured by stock
collateral, the investor does not consider the obligation as a
burden upon the finances of the parent company. At the
same time, however, the surplus earnings of the parent com-
pany stand back of the bonds to reassure any holder who
may be uncertain of the value of the collateral security. For
example, the Great Northern-Northern Pacific, Burling-
ton Joint 4s have an interest charge of $8,000,000. The
Burlington pays each year $8,000,000 in dividends, and
earns far more than this amount, producing a consider-
able surplus over all interest charges. Besides this', how-
ever, the two purchasing companies had surplus earnings in
their last fiscal year over their fixed charges amounting to
$37,800,000, nearly five times the interest charges on the
joint 4s.

When collateral trust bonds are issued by companies
whose principal assets consist of the securities pledged under
the lien of the collateral trust indenture, then the investor
looks mainly to the value of the collateral, and the price of
the bond fluctuates with the fortunes of the company whose
stock furnishes its sole security. An illustration of a bond
with no other security than stock is furnished by the col-
lateral trust 4s issued by the Chicago, Eock Island, Pacific
Eailroad Company of Iowa, a company whose sole assets
consist of the stock of the Chicago, Eock Island, Pacific Eail-
way Company of Iowa. During 1909, the price of the bonds

THE COLLATEEAL TRUST BOND 321)

showed an extreme fluctuation of nine and one half per cent.
The bonds are highly speculative, since their interest must
come solely from the dividends paid by the Chicago, Eock
Island and Pacific Hailway Company* During the same year,
however, the Burlington Joint 4s, whose interest absorbs
a much greater proportion of the dividends on the Burling-
ton stock than that proportion of the Eock Island Eailway
dividends which is required to pay interest on the collateral
trust bonds which its stock secures, fluctuated only four
per cent. The smaller fluctuations of the Burlington Joint
4s as compared with the Eock Island bonds show the high
standing which collateral trust bonds issued by strong com-
panies possess. At the same time, as already shown, unless
the company issuing the collateral trust bonds secured by
dividend-paying stock is obliged to make up the difference
between the interest on the bonds and the dividends on the
stock securing them, its credit is not seriously weakened by
the issue of collateral trust bonds.

When such advances have to be made, however, as for
a time was necessary in the case of the Atlantic Coast Line
— ^Louisville & Nashville collateral 5s — ^the attention of
the investor is directed to the nature of the collateral trust
bonds, the direct obligation of the issuing conjpany, alto-
gether apart from the stock security underlying it. The
existence of collateral trust bonds in such an event operates
to subtract from the borrowing power of the issuing com-
pany, perhaps more than might be expected from the extent
of this deficit between the dividends on the collateral stock
and the interest on the bonds. The liability of the issuing
company is then regarded in much the same light as the con-
tingent liability of a guarantee when the borrowing company
is not earning its interest and must call upon the indorser of
its bonds to make up the deficit.

1 The Chicago, Bock Island and Pacific Eailway was in 1915
placed in the hands of receivers and later reorganized, the intercom-
pany relationship above described disappearing in this process.

CHAPTEE XXVI
BONDS SECURED BY THE ASSIGNMENT OF A LEASE

Another method of securing capital in the face of a
closed first mortgage is by the use of the lease as security.
The detailed discussion of the lease is postponed to a later
chapter. At this point it is sufficient to define the lease as
a contract by which the possession of property is transferred
by the owner, known as the lessor, to some other person or
corporation, known as the lessee, the title of the property re-
maining in the lessor but the lessee being allowed its pos-
session and use ilnder certain conditions set down ' in the
lease.

The lease is largely used by railroad companies to borrow
money for the purchase of equipment under a form of obli-
gation, known as the car trust certificate, by which the prop-
erty acquired serves as the security for the bonds, and which
are also the direct obligations of the railroad company. This
method of borrowing may be illustrated by the issue of the
Lehigh Valley Car Trust Certificates, Series G. A syndicate,
headed by E. T. Stotesbury, a leading Philadelphia banker,
was organized to purchase and pay for a large number of pas-
senger and freight cars. E. T. Stotesbury then executed an
agreement whereby, in return for certain payments, and on
the basis of certain covenants and stipulations, he leased to the
railroad company from October 35, 1902, to August 1, 1910,
the equipment which he had purchased, and which is carefully
enumerated and described. The Lehigh Valley Eailroad
Company, for its part, in return for being allowed the use of
the cars, agreed to pay $203,398.80 before the equipment was
330

BONDS SECUEED BY ASSIGNMENT OF LEASE 331

delivered to them and half yearly the following sums : First,
a sum equal to 2| per cent on $800,000 to be reduced from
time to time by 2^ per cent on money paid by the railroad
company in reduction of $800,000. Second, a sum equal to
all expenses incurred by the lessor in enforcing the covenants
and terms of the lease. Third, a sum equal to the taxes
which the lessor might be liable to pay. Fourth, yearly the
sum of $100,000, making in' all eight annual payments of
$100,000 each.

The deferred payments were evidenced by equipment
notes the substance of which is as follows: '

The Lehigh Valley Railroad Company hereby ac-
knowledges itself to be indebted to the bearer, or regis-
tered owner hereof, in the sum of $1,000 with inter-
est at the rate of 4J per cent per annum. This cer-
tificate is one of a series of 800 for $1,000 each issued
under the terms of a lease bearing date of the 25th
^ day of October, 1902, between E. T. Stotesbury and
the Lehigh Valley Railroad Company.^

In addition to these payments, the railroad company
agrees with the lessor to keep the cars in good repair, to re-
place any which may be destroyed from any cause, to mark
the name of the owner plainly upon the cars, and to furnish
him each year a list of the equipment, not to sublet the
equipment, and, in case of default under any of the provi-
sions of the lease, to deliver to the lessor the equipment to
which the lease relates. The lessor on his part agtees that
after the payments have been completed, he will upon the
payment by the railroad company of the additional sum of
one dollar, transfer to the railroad company, as its absolute
property, all the railroad cars held under the lease. The
rental referred to in this agreement consists of three parts:
First, a sum of cash which is usually considered to repre-
sent the expenses and profits of the syndicate acquiring the
equipment; second, a sum which represents the purchase

' Only the essential portions of the Car Trust Certificate are given.

332 COEPOEATION FINANCE

price of the equipment payable in installments; and third,
interest on the unpaid installments of the purchase price.
E. T, Stotesbury, having now purchased the equipment,
and having leased it to ,the Lehigh Valley, assigns the agree-
ment as security for the certificates evidencing the deferred
payments under the lease, to the Girard Trust Company sub-
stantially as follows:

First, that the said E. T. Stotesbury hereby assigns
unto the Girard Trust Company as trustee for the
holders of the certificates hereinafter set forth, all the
right, title and interest of said E. T. Stotesbury in
and to a certain indenture of lease bearing even date
herewith made by the said E. T. Stotesbury to the
Lehigh Valley Railroad Company.

Second, the said trustee covenants and agrees that
it will certify and deliver to Drexel & Company
(Jor whom Stotesbury is actingY for distribution to the
several subscribers to the said Lehigh Valley Car
Trust Fund eight hundred certificates in the following
form {given above) ^ which certificates shall be de-
livered in amounts and at times corresponding to the
value and the time of delivery of the various lots of
said railroad cars by the said E. T. Stotesbury to the
Lehigh Valley Railroad Company. All of which cer-
tificates, when and as issued, shall be entitled to the
security of all such railroad cars previously and sub-
sequently delivered by said Edward T. Stotesbury to
the Railroad Corppany under the terms of said in-
denture of lease of even date herewith.

These certificates were numbered consecutively from one
to eight hundred and were payable < in eight installments be-
ginning August 1, 1903.

The agreement for assignment of lease, to which the
Lehigh Valley Railroad Company is made a party, provides
in detail for the protection of the holders of these certificates
by the trustee. In case of any default in the payments under
the lease, or the breach of any other covenant by the railroad

* Italics are the author's.

BONDS SEOUEED BY ASSIGNMENT OE LEASE 333

company, the trustee is authorized to retake possession of the
cars, and to hold, or lease, or to otherwise dispose of all or
any part of the equipment in such manner as it may deem
beneficial, and also to recover from the company, for future
accruing rent, any deficit which may remain after the sale
or lease of the equipment, and the application of the proceeds
to the claims of the certificate holders.

Prom the foregoing, the strong position of equipment
trust obligations is evident. They are, in fact, debenture
bonds of the railroad, with the additional security of a title
to railway equipment. They have the further advantage,
explained in a former chapter in connection with the dis-
cussion of serial bonds— that their margin of security con-
stantly increases, since the equipment is in existence at
the time the last bond matures. Equipment trust obliga-
tions usually bear higher rates of interest than first mort-
gage bonds issued for long terms. They also yield higher
returns to the investor than first mortgage bonds, while the
security which they offer is practically perfect.

The Guarantee Trust Company of New York, in a cir-
cular dealing with the advantages of the equipment trust
securities, summarizes these advantages as follows:

" The equipment of a railroad corporation is essential to
its operation. It is the tool with which the railroad handles
its business. If an individual mechanic becomes bankrupt,
his tools are ordinarily exempt from seizure on the ground
that possession of the tools is necessary for the mechanic to
obtain his livelihood and ultimately satisfy his creditors. In
the same way the courts, both State and Federal, have ruled
that the necessary equipment of a railroad must be preserved
for the Eeceiver of a bankrupt railroad in order to enable
him to operate the railroad; and have generally placed the
charges of principal and interest of equipment obligations
upon an equality with charges for wages, materials and other
operating expenses, and in priority to interest of even first
mortgage bonds."

334 COKPOKATION FINANCE

The record of equipment obligations issued by railroad
companies which have subsequently gone into bankruptcy
confirms this favorable judgment. With few exceptions the
principal and interest on equipment bonds have been paid in
full even by companies where all other bonds were reduced
in interest or principal. This strong position of equipment
bonds in bankruptcy is due to the fact that their security is
not the property of the bankrupt corporation. The cars and
locomotives which they represent are the property of another
who has leased his equipment to the railroad company on cer-
tain definite conditions. Unless these conditions are met, the
equipment can be hauled off the company's lines and sold.
Property which is owned by the company can, as we shall see
in a later chapter, be put out of reach of creditors, within the
protection of the court. The eolirt, however, can have no
jurisdiction over property not belonging to the bankrupt cor-
poration. The receiver, no matter if he defaults on the first
mortgage bonds, must pay the interest on the equipment trust
obligations.

The iaquipment trust bond represents the most familiar
use of the lease as a means of obtaining new capital. An-
other method often employed is to organize a subsidiary com-
pany in the interest of a company desiring to obtain capital.
This subsidiary company constructs or purchases the equip-
ment or other property needed by the parent company, issu-
ing for the purpose its own first mortgage bonds which may
be guaranteed by the parent company. The property is then
leased to the parent company for a rental sufficient to pay
the interest on the bonds and to retire their principal after
a term of years. In some cases, the rental is made sufiBcient
to pay dividends on the stock of the subsidiary company.
After the bonds of the subsidiary company have been retired,
the property, upon the payment of a nominal sum, passes
to the parent company. For the greater protection of bond-
holders, it is customary for the subsidiary company, in such
a case, to assign the lease, out of which the money to pay the
interest on the bond must come, to the trustee. If the rental

BONDS SEOUEED BT ASSIGNMENT OF LEASE 335

is not paid, then the interest cannot be paid, the bonds are
in default} and their holders can bring foreclosure proceed-
ings. The trustee can sue the lessee company either upon
its obligation of guarantee, in case it has indorsed the bonds
of the subsidiary company, or under its contract of lease.

A third use of the lease as security is by the lessee com-
pany. The lease, being a contract for the use of certain
property on the payment of certain stipulated sums, may be
expected to show a surplus over the amount of the rentals.
This surplus makes the leasehold interest, the value of the
annual profits of the lessee, a valuable right which can be
pledged by the lessee like any other thing of value as secur-
ity for bonds. This form of security was employed by the
Interborough Company which pledged its 999 year lease of
the Manhattan Eailway and its subway lease from New York
City as the main security of $55,000,000 of mortgage bonds
dated November 1, 1907. The Interborough, from the op-
eration of these leased lines, in 1909 showed a large surplus
over rentals, so that its leasehold interest represented a valu-
able property, furnishing ample security for a bond issue.
It is unusual, however, to find leases showing such large
earnings. While the leasehold interests are frequently con-
veyed as supplementary security to trustees, they are not
often given a prominent position as a basis of bond issues.

Note. — An exception to the rule that equipment obligations have
been cared for in receiverships is furnished by the Detroit, Toledo and
Ironton. In April, 1909, the equipment covered by the $1,656,000
Equipment Trust 4^8 of 1905 was surrendered to the tnistee and sold
at auction for Sl,200,000, the holders of the bonds becoming the owners-

CHAPTEE XXVII
CONSOLIDATION OF CORPORATIONS

The consolidation of corporations offers a means of ob-
taining new capital without the necessity of providing funds
for construction or purchase. It also enables companies to
abolish or restrict competition and in this way to increase
profits. In 1901, the Eeading Company desired to obtain
permanent possession of sufficient terminal facilities in New
York. The Central Eailroad of New Jersey possessed these
facilities. The consolidation of the two companies gave the
Eeading the use of the valuable terminals of the Central
Eailroad of New Jersey in perpetuity. Numerous illustra-
tions of the advantages of consolidation in restricting compe-
tition are furnished by the industrial trusts. These advan-
tages have been fully discussed in a preceding chapter.

The methods of uniting corporations by consolidation are
three: First, the merger; second, the purchase by one com-
pany of a controlling stock interest in another; third, the
lease.

When a merger of corporations is accomplished, one or
more of the companies concerned loses its identity in an-
other. Suppose the case of two gas companies — A and B —
competing for the business of the same town. A sufficient
amount of the stock of B has been acquired in the interest
of A, to control the sale of its assets and its dissolution.
Two methods are available for merging B with A. A may
offer its stock or bonds or cash in exchange for the stock of
B, having acquired the amount of stock which by the laws of
the state or the charter of B is necessary to assent to the

CONSOLIDATION OP CORPORATIONS 337

disposition of B's assets. The directors of B now sell the
property of that company to A. If all the stock of B has been
acquired, the consideration need be only nominal. A now con-
trols all the stock of B, and secures the dissolution of B, in
the manner provided by law. The second method is for A to
purchase the property of B, at its market value in securities
or cash. B has then in its treasury the proceeds of the sale.
B is then dissolved and the directors distribute its assets to
its stockholders.

The method of merger is seldom adopted. There is usu-
ally some advantage to a company acquiring control of an-
other company, in continuing the corporate existence of its
subsidiary. Companies which have been in existence a suf-
ficient length of time to establish a reputation have a certain
good-will value in connection with their name which would
terminate if their corporate existence were ended. Valuable
privileges may also be lost if the method of merger is adopted.
For example, the Boston Consolidated Gas Company, where
the price of gas is fixed by law at eighty cents per thou-
sand feet, owns stock of the Quincy Gas Light Company,
the Chelsea Gas Light Company, and the East Boston Gas
Light Company. In Chelsea and East Boston, where the
population is not so dense as in Boston, the iegal price of gas
is $1 per thousand feet. In Boston the cost of distributing
gas is less and the profit even at the lower price is greater.
If the large lighting companies were merged with the con-
solidated company, the eighty cent rate would apply through-
out the consolidated property. It is desirable, therefore, to
maintain the corporate existence of these outside companies
in order to secure the $1 rate in the suburbs. In consolida-
tions of street railway companies possessing perpetual fran-
chises, care is taken to preserve the corporate existence of the
companies owning these valuable franchises.^ There is no
serious disadvantage in maintaining separate existences for
corporations controlled by other companies. The salary ac-

' Lecture by P. E. Snow to Harvard School of Business Administra-
tion, Jan. 15, 1909.
2S

338 COEPOEATION FINANCE

counts of the subsidiary companies are nominal and the opera-
tion of their property can be merged if desired by leasing their
property to the main system, or by operating them as divisions
or departments of the parent company.

The second method of consolidation is that of stock own-
ership. One operating company can purchase the stock of
another, giving in exchange cash or securities, or a company
can be organized for the purpose of holding the stocks of other
companies which by this device are brought under central-
ized control. How much stock is it necessary for a company
to acquire to control another? The rule of law is that, in
the absence of a provision allowing stockholders to accumu-
late their votes on one or two directors, thus insuring to the
minority representation on the board, a bare majority of the
stock can elect, if the owners wish, all the directors. While the
rights of the majority are seldom pushed to this extreme,
yet the holders of a majority of the stock always demand,
with propriety, a substantial majority of the board of di-
rectors. There is no general reason, therefore, for acquiring
ing all the stock of a corporation in order to control it.

Where the interest of the parent company may be op-
posed to the interest of the subsidiary company, there is" no
alternative, if it is desired to maintain the identity of the
subsidiary, save for the parent company to acquire all of its
stock, or to see that its control is held in the parent com-
pany's interest. Many of the consolidations of manufactur-
ing concerns have resulted in the closing of badlj^ located
or otherwise unprofitable mills in order to concentrate the
production in plants which are better equipped or more
favorably situated. This policy makes for the interest of
the parent company. It is, however, directly opposed to the
interests of minority stockholders of the corporations owning
the plants whose operation is discontinued. If their business
were to be closed up in this manner, the minority stockhold-
ers would undoubtedly appeal to the courts which would give
them effective protection against the depreciation in the
value of their shares which would follow the suspension of

CONSOLIDATION OF COEPOEATIONS 339

dividends on their stocks. To avoid trouble of this character,
it is usual to secure all the stock of the company to be con-
solidated, in case this can be purchased at reasonable figures.

If all the stock cannot be acquired, and in case the
subsidiary company is to be exploited for the benefit of the
interests which control it, the method vrhich has been em-
ployed in some cases is to guarantee a dividend on the
minority stock of the subsidiary. This plan was followed
by the Carnegie Steel Company in 1901 in guaranteeing four
per cent on the minority stock of the Pittsburg, Bessemer
& Lake Erie Railroad Company, whose principal freight,
since its organization in 1897, had been ore destined for
the Carnegie furnaces. The minority stockholders of the rail-
road company complained that their failure to receive divi-
dends was due to the fact that the owners of the majority of
their stock of the Carnegie Steel Company received such low
rates on its ore that the railroad company was unable to make
a profit. In order to quiet this criticism, the Carnegie Steel
Company, through a subsidiary company, the Bessemer and
Lake Erie, guaranteed a dividend on the stock, leaving itself
free to fix rates as low as it thought best.

An exception to the rule that all the stock of a company,
control of which is desired by another company, should be
acquired, is furnished by large public corporations, such as
railroad companies, where the object of the consolidation is
merely to secure uniformity in rates or to arrange inter-
changes of traffic which will be mutually profitable. Here
there is no temptation to the exploitation of one company by
another, and the minority stockholders have no reason to feel
aggrieved. Where the stock of a company is widely scattered,
moreover, a controlling interest may be much less than a
majority. The Pennsylvania Eailroad Company for seven
years exercised a potent influence in the directorates of the
Baltimore & Ohio, the Chesapeake & Ohio, and the Norfolk
& Western. At no time, however, did it own a majority of
the stock of any -of these companies. Any contest for con-
trol, however, during the period of the Pennsylvania's in^

340 COEPOEATION mSTANOE

fluence, would have been hopeless, owing to the control of
the administrative machinery of these companies in the inter-
est of their principal stockholder, and to the advantage which
this control would have been given these officers in soliciting
voting proxies.

' Having settled upon the amount of stock required for
control, our next question concerns the method by which

, this stock can be acquired. Stock may be purchased for
cash, or with the stock or bonds of the purchasing company,
or with stock trust certificates on which dividends are guar-
anteed by the company acquiring the stock. The considera-
tion which, will be offered and accepted in the acquisition
of a stock control can be viewed from the standpoint of the
purchasing company, and also from the standpoint of the
individual stockholder. A purchasing company, if its surplus .
over its regular disbursements is substantial, can safely offer
bonds or their cash equivalent to holders of stock which it
desires to purchase. Other things being equal, an offer of
bonds is desirable. If- there is no identical interest repre-
sented in both companies to be considered, if the purchaser
is in a strong financial position, and especially if there is
a prospect that the stock purchased will become much more
valuable in the hands of the purchaser, the method of pur-
chase by bonds is likely to be adopted. The stockholders
who receive bonds for their holdings surrender all right to
future participation in the profits of their company over the
amount guaranteed on their bonds. The purchasing com-
pany, by giving them a secured claim, succeeds to their
right to the increase in profits over the amount paid in in-
terest.

In some cases these purchases of stock with bonds have
proven immensely profitable. In 1898 the New York Central
purchased $45,000,000 out of $50,000,000 of the capital stock
of the Lake Shore, Michigan & Southern, giving in exchange
its 3^ per cent bonds at the rate of $300 in bonds for $100
in stock. The seven per cent dividends on the Lake Shore
stock represented the equivalent of the interest paid on the

CONSOLIDATION OF COEPOEATIONS 341

bonds issued in payment. From 1899 to 1903, the Lake
Shore paid seven per cent, from 1904 to 1906 inclusive, eight
per cent, in 1907 twelve per cent, in 1908 fourteen per cent,
and in 1909 twelve per cent. The purchase of the Lake
Shore stock has proven most fortunate for the New York
Central. Indeed, had it not been for the large profits made
on this purchase, the Central would have had much difficulty
in maintaining its five per cent dividends during 1^09. The
joint purchase of the Burlington by the Great Northern and
the Northern Pacific has also been profitable, although the
purchasing companies have not as yet taken any direct
profit into their income accounts out of the large surplus
earnings which the Burlington is showing over the dividends
necessary to pay interest on the bonds issued to purchase
this stock. There is the more reason to adopt the method of
purchasing stock with the bonds of the purchaser, if the
stock desired is a dividend payer, since then a substantial
portion of the interest on the bonds can be provided out
of the stock purchased.

When any doubt exists, however, concerning the ability
of the purchasing company to meet the interest on a suf-
ficient bond issue to buy the stock which it desires, prudence
demands that stock be employed. Cumulative preferred
stock gives almost the security of bonds, with the added
advantage of a higher return. At the same time, the failure
to pay dividends on such stock does not work the bankruptcy
of the company. The United States Rubber Company in a
circular to its stockholders recommending the purchase of
stock of the Eubber Goods Manufacturing Company, stated
the argument against bonds and in favor of preferred stock
as follows :

" If no better means were provided, it might be advisable
to make such purchase by the use of collateral trust notes,
but it occurred to the management that rather than subject
their stock to the prior fixed charges of such collateral trust
notes, the stockholders might prefer to provide the means

342 COEPOEATIQN riNANCE

of purchase by an increased issue of stock, the preferred
stock of the Eubber Goods Manufacturing Company to be
acquired by an issue of new first preferred stock of the
United States Company in amount equal to that of the
Manufacturing Company, and with dividends limited to eight
per cent annually."

Even where bonds can safely be employed, the importance
placed upon preserving the credit of the purchasing company
influences the use of its stock to acquire other stock. The
'New York, New Haven & Hartford, for example, at the time
of its acquisition of the Boston & Maine, could undoubtedly
have purchased this stock with bonds. The Boston & Maine
stockholders had been in receipt of a seven per cent dividend
for many years, and had no reasonable expectation of any
higher return. It is not to be doubted that they would have
accepted the debenture bonds of the New York, New Haven
& Hartford secured by their ovm stock quite as readily as
they received the stock of the purchasing company. By ac-
quiring the Boston & Maine stock with its stock, however, the
New Haven & Hartford maintained its credit unimpaired.
Any mistake in its calculations as to the increased value which
association with the Boston & Maine would confer upon that
company's stock, would not damage the credit of the purchas-
ing company, but would fall upon its stockholders.

From the standpoint of the stockholder, the acceptance
of an offer for his stock may be influenced by various con-
siderations. If he is not satisfied with the prospects of his
own investment, ' there is little trouble in inducing him to
accept a fair offer. For example, at the time of the forma-
tion of the United States Steel Corporation, the Carnegie
Steel Company threatened with its competition every one
of the large industrials whose stockholders were asked to
exchange their holdings for United States Steel stock. The
advantages of eliminating this competition, and of being
associated in the same company with the strong Carnegie
Steel Company, were sufficient to induce a practically unani-

CONSOLIDATION OF COEPOEATIONS 343

mous acceptance of the offer of the United States Steel
Corporation to the stockholders of the separate companies.

If, however, the stoqkholder is receiving good dividends
and is not apprehensive of their discontinuance, strong in-
ducements are usually required to persuade, him to sell. In-
stances are not lacking where stockholders have given up
dividend paying stock in return for stock which paid them
nothing. A case in point is that of the Atlantic Transport
Company, whose stockholders went into the International
Mercantile Marine Company, exchanging their stock, on which
they had been receiving regular dividends, for the stock of a
large company on which they received nothing for many
years. With a weak company or a new company offering
to purchase, and especially when a corporation is organized
with the sole purpose of acquiring the stocks of other com-
panies, unless there are strong reasons urging consolida-
tion, and unless bonds are not available, stock will not, as a
rule, prove attractive. The stockholders demand either col-
lateral trust bonds secured by the stock purchased, and
with the provision in the indenture that in case of default
the bonds can be employed to purchase the stock, or they
demand cumulative preferred stock bearing a high rate of
dividend. An additional bonus of common stock was usu-
ally demanded by stockholders of strong companies.

As a compromise between the stock and the bond, a"
company purchasing stock may employ the stock trust certifi-
cate. In 1909, for example, the Minneapolis, St. Paul &
Sault Ste. Marie Eailroad Company acquired most of the pre-
ferred stock of the Wisconsin Central with its leased line
stock certificates secured by a deposit of the stock purchased,
on which four per cent is guaranteed for ninety-nine years.
These stock certificates do not differ essentially from a collat-
eral trust bond. In case of default, the holders of the certifi-
cates receive back the stock from the trustee and can sue for
unpaid dividends. The obligation of the certificate is, how-
ever, a contingent obligation, and on that account is more
acceptable to the stockholders of the purchasing company.

344 COEPOEATION FESTANOE

No matter what form of consideration is offered for th^
stock, the acceptance of the offer is not certain. Some stock-
holders will always be found to demand cash for their
holdings, and some there are who will not sell at any price.
This situation necessitates the usual employment of the
underwriting syndicate in such transactions, which guarantees
the provision of the cash required, and, in some eases,
guarantees the delivery of the amount of stock necessary.
The official circular announcing the joint offer of the Great
Northern and the Northern Pacific to purchase the stock of
the Chicago, Burlington & Quincy stated that " The pur-
chasers will pay cash instead of bonds to an amount not
exceeding in the aggregate $50,000,000 to those shareholders
who shall prefer to receive payment partly in cash; and J. P.
Morgan & Company, as managers of a syndicate, have under-
taken to provide such cash, and to take therefor such bonds
at par and accrued interest. You are accordingly offered the
privilege of selling your stock at $300 per share, payable
wholly in the four per cents described above, or in bonds to
the, amount of $160 and cash to the amount 9f $40."

Another precaution usually in such offers is to make the
offer contingent upon its acceptance by a certain percentage
of the stockholders to whom it is made. The offer just
referred to was for not less than two thirds of the stock of
the Burlington. When the syndicate guarantees the delivery
of a certain amount of stock, a buying campaign is usually
the preliminary feature of the transaction. Preceding the
purchase of the Burlington stock, and also preceding the
Eock Island consolidation, the stocks of these companies
showed a large increase in value, owing, it was believed, to
the operations of the syndicates interested in promoting the
consolidation. The purchasing company can, of course, take
no official part in this buying campaign, however essential
though it may be to the execution of its designs. The com-
pany would not be justified in using its funds in buying
stock for which it might have no use. The profits of syndi-
cates under these circumstances, although severely criticised.

CONSOLIDATION OF COEPOKATIONS 345

have been defended on the ground that in no other way could
the delivery of the amount of stock required be insured than
by allowing the syndicate to make what profit they could in
purchasing the stock below the figure at which, as they are
informed, the company for which they are acting is prepared
to purchase it.

CHAPTER XXVIII
THE HOLDING COMPANY

The holding company is a corporation organized for the
purpose of acquiring the stocks and other securities of other
corporations. These securities are acquired either by direct
exchange of its own stocks and bonds, or by their sale for cash
•which is used to purchase the securities desired. The owner-
ship of the stocks of various companies gives to the holding
company the right to elect their boards of directors and to
completely dominate their policy, thus accomplishing a com-
bination between them which is as perfect as though the dif-
ferent corporations had merged their existence in that of
the company which has acquired a controlling interest in
their stocks.

Holding companies are formed both for legal and finan-
cial reasons. The primary purpose of forming a holding
company is to effect a combination of allied enterprises which
cannot be accomplished by the use of any one of the corpora-
tions which it is intended to include. The legalization of
consolidation has, in most states, been deferred until recent
years. If corporations are organized under the laws of dif-
ferent states, there is no method by which they can be
directly consolidated. We have already referred to the for-
mation of the trusts. These companies have been generally
organized by means of holding companies formed under the
laws of the State of New Jersey. The conditions out of
which this device for consolidating competing enterprises
developed will show in detail the principal legal reason for
the use of the holding company.
346

THE HOLDING COMPANY 347

Many attempts had been made before i898 to lessen the
recognized evils of competition. These attempts had usually
taken the form of pools, many of which, especially in the iron
and stee^ trades, were organized during the last industrial
depression. A pool is a voluntary association of sellers who
place the marketing of their product under some central con-
trol or general restriction. The primary object of such agree-
ments is to secure profitable prices, either directly or by means
of payments from a central treasury, to the members of the
association. The methods by which these profitable prices
have been secured are in general as follows: (1) The output
of the mills included in the association is restricted, so that
prices can be advanced by the limitation of supply; and (8)
the buyer is held to the regular quotations, and is unable,
by playing off one competitor against another, to obtain
special concessions. The pool may go further than the regu-
lation of prices and output; it may secure favorable terms
on material purchased; it may deal as an association with
railroads to obtain such concessions as are granted to large
shippers, and it may assist its members in dealing with or-
ganized labor. As a general proposition, however, the pur-
pose of a pool is to regulate production and control prices,
leaving the details of management to the separate companies.

The pool is usually organized with a central governing
or advisory body which conducts all routine business, and re-
ceives and distributes the funds of the organization. A mat-
ter of such importance as a change in prices would generally
be decided at a meeting of all the members of the association,
or by some executive committee composed of the larger manu-
facturers. Within these lines, the pool has assumed a variety
of forms.

The Bessemer Steel Pool, which was organized in 1896,
furnishes an illustration. This organization- included the
majority of the producers of crude steel and finished material
in the Central West. Every mill was given a percentage
allotment which it was allowed to sell — say, 500,000 tons, or
one seventh of the total estimated output of the association.

348 OORPOEATION FINANCE

At the end of ^ch month the shipments from all the mills
"were reported to the officers of the pool. If any mill was
found to have exceeded its percentage allotment, it was
required to pay into the pool treasury $3 per ton of such
excess^ while an equivalent was paid out of the treasury to
those who did not ship their allotment. For example, if the
mill which was allotted 500,000 tons sold 700,000 tons, while
the sales of another mill fell 200,000 tons short of its allot-
ment, it would receive out of the pool treasury 'the amount
which Mill No. 1 would pay in— viz., $400,000. The ex-
istence of this penalty operated to prevent price cutting
among the members of the pool. In the Wire Nail Asso-
ciation, which held control of the nail market during 1895
and 1896, the central office fixed prices and assigned to each
producer his share of the output, which it was believed could
be marketed at the price agreed upon. It often happened
in the management of a pool that the output of the associa-
tion would be produced by a few of the best-equipped or
best-situated plants, the owners of the idle plants being paid
a certain rental to keep out of business.

The essential weakness of this form of organization is its
inability to enforce its agreements. The necessity of volun-
tary assent on the part of every member of the association,
the liberty of each to withdraw on short notice, and the diffi-
culty of establishing relations of mutual confidence among
competitors, all unite to emphasize this defect. The mem-
bers of a pool have long since formed the habit of closely
scrutinizing the moves of those in the same business, and
even a small misunderstanding often creates a feeling of mu-
tual distrust and apprehension which work the destruction
of harmony and the final dissolution of the organization.

The successful management of a pool is peculiarly diffi-
cult during a period of business depression, when business
at remunerative prices is hard to get. Strong producers at
such a time are suspected of attempts to obtain more than
their allotted share of orders by methods which are contrary
to the spirit, if not the letter, of the pool agreement. For

THE HOLDING COMPANY 349

example, the Bessemer Steel Pool, above referred to, origi-
nally applied only to the tonnage of steel billets, ingots,
bars, or slabs. The steel which was rolled into merchantable
shapes did not count in the allotment. Some of the large
producers took advantage of this fact to market as much as
possible of their output in the form of finished material, by
this method of indirection far exceeding the limits of their
allotment, and they could not be penalized for so doing.
Such offenses against the pool agreements made their per-
manent continuance impossible.

The following quotation from the Iron Age of December
10, 1896, shows the usual fate of these associations and the
results which follow their dissolution : " The Billet Pool, or
Bessemer Steel Association of the United States ... is now
in session. . . . The meeting promises to be a stormy one,
as there is considerable ill feeling against certain concerns
who are charged with having violated the pool agreement.
The pool was practically dissolved as soon as the resignation
of the Bellaire Steel Company was in the hands of the sec-
retary. There has been an open market on Billets, Sheet
and Tin-plate Bars since Saturday morning, and a scramble
for business on the part of some mills. Probably 25,000 tons
of Sheet Bars have been sold this week at very low prices,
the deliveries running up to the close of 1897. There have
also been considerable sales of Billets and Tin-plate Bars at
low prices."

The prices which follow the dissolution of a pool, when
confidence has been destroyed, and when manufacturers are
making concessions to secure business, are often even lower
than the low prices which had brought the producers to-
gether. Before the dissolution of a rail pool, in February,
1897, the price of steel rails at Chicago was $37.50 per ton.
Owing to the dissatisfaction of the Lackawanna Iron and
Steel Company with its allotment of seventeen per cent of the
total output, and its consequent withdrawal from the asso-
ciation, and owing to the demand of the Illinois Steel Com-
pany for all territory west of Pittsburg, the pool was dis-

350 COEPOEATION TINANCE

rupted. Steel rails were immediately offered by the Car-
negie Company for delivery at Chicago at $17 per ton, a
reduction of $10.50 from the pool price. In 1895, for six
months before the organization of this pool, the price of
rails averaged $21 per ton. After the dissolution of the pool,
the price did not again reach this figure until January, 1899.
The breakdowns of pooling agreements in the steel trade
during the period 1892-98 occurred with such periodical
regularity that large buyers were accustomed to wait for
the dissolution before making their purchases. After the
break in the rail pool in February, 1897, the Eastern sales
resulting from the reduction in price amounted to 200,000
tons. The Illinois Steel Company in the West booked or-
ders amounting to $5,000,000. The railroads hastened to
load up the rail mills with large orders, often for delivery
eighteen months in the future.

Not only were the pool agreements unstable, but their
regulation of prices was frequently very foolish. The de-
termination of the policy of a pool is, in most cases, a ques-
tion of majority rule, and the majority of producers in any
trade are unlikely to be possessed of a broad grasp of business
situations, or to be able to see further than the immediate
future. When they found themselves in control of the sjip-
ply, the various associations frequently raised prices to fig-
ures which seriously interfered with demand and which stim-
ulated immediate and general competition. The policy of
the nail pool above referred to offers a good illustration of
this tendency to extortion. In the face of a general decline
in prices, and a severe depression affecting every important
industry, the price of a keg of wire nails was increased from
87 cents to $2.55, a rise of almost 200 per cent, and this
high price was maintained for six months.

The Iron Age characterized this policy as follows :

"Looking at the matter even from the manufacturer's

standpoint, it would seem the part of wisdom to have put

the price of nails at a reasonable figure rather than attempt

to maintain a price which in the very nature of things must

THE HOLDING COMPANY 351'

be temporary, and may, perhaps, end in disaster. Only
those in close touch with the trade are aware of the influence
which the policy of the association has in encouraging the
establishment' of new plants, whose competition must be
troublesome, while at the same time it invites the impor-
tation of foreign nails. . . . The trade are aware that the
present price of nails is abnormally high as a result of agree-
ment between the manufacturers — so high, in fact, that it is
constantly under suspicion. The trade will doubtless con-
tinue to' limit their purchases to their imperative require-
ments so long as nails are held at their present iigures."

Pooling agreements among manufacturing competitors
are inherently defective. They have no firm basis in mutual
confidence. They usually result in such an unreasonable in-
crease of prices as to check consumption and stimulate com-
petition. In few cases have they been productive of more
than a temporary advantage in profits to their members.

The " Trust " movement of the eighties promised a more
satisfactory restriction of competition. In this form of or-
ganization, agreement among manufacturers as to prices and
output was secured by depositing the stocks of the constitu-
ent companies with trustees in exchange for trust certificates.
These entitled the holders to such di|p.dends as might be
declared on the stocks, and also empowered them to vote
for the trustees in the same manner as the stockholders of
a corporation elect their directors. The trust certificates,
moreover, could be dealt in on the stock exchanges in the
same way as the certificates issued by the voting trust of a
corporation. The trustees, being in control of the stock of
the several corporations included in the trust, directed the
management of these companies, and secured a uniform pol-
icy upon prices and output. Permanence of control was
secured by making the transfer of stock io the trustees,
except by the formal dissolution of the trust, as provided for
in the articles of association, irrevocable.

The trust, so far as it included former competitors, fur-
nished a more satisfactory restriction of competition than

352 COEPOEATION FINANCE

the pool. It was open to fewer objections; its organization
was permanent; its government was centralized, responsible,
and representative. The control of the constituent corpora-
tions by the central organization — ^the trustees — was complete,
for the, trustees elected the board of directors of each of the
coiastituent companies. Because it was permanent and cen-
tralized, the trust pursued a more enlightened policy as to
prices than the pool. The Standard Oil Trust made a con-
siderable reduction in the price of refined petroleum, and
the Sugar Trust, although for some years in practical con-
trol of the market, did no more than to restore i>rices to a
living basis. The Whisky Trust attempted to charge exces-
sive prices, but the complete failure of its attempt, owing
to the growth of competition, justified the wisdom of the
more conservatively managed organizations. The Cotton Oil,
Linseed Oil, and Lead Trust showed no disposition to prac-
tice extortion upon the consumers of these products. The
trust, as a device for the control of competition, was satis-
factory. Its legal position, however, was inherently de-
fective.

Beginning with the Granger agitation against the rail-
roads in 1870, there had grown up throughout the United
States a pronounce^ sentiment against monopoly, under-
standing by monopoly any attempt on the part of a railroad
or manufacturing corporation to increase rates or prices by
reason of its control of a particular market. The laws of most
of the states forbid monopoly. Many state constitutions con-
tain similar provisions. In 1890, sixteen states, either in
their constitutions or by statute, prohibited any combination
in restraint of trade; and the common law, which was gen-
erally applicable throughout the states, also forbade any com-
bination of this nature. The antitrust law of Missouri, for
example, prohibited any " pool, trust, agreement, combina-
tion, confederation, or understanding with any other corpo-
ration, partnership, individual, or any other person or asso-
ciation of persons, to regulate or fix the price of any article
of manufacture." In 1890, Congress passed the Sherman

THE HOLDING COMPANY 353

AntitruBt Act, which declared that "every contract, combi-
nation in the form of trust, or otherwise, or conspiracy in
restraint of trade or commerce among the several states
or with foreign nations, is hereby declared to be illegal."
This legislation was backed up by a vigilant public opinion
rancorously hostile to large corporations. It was not to be
expected that the trusts would long survive in such an un-
friendly atmosphere.

The pool was also specifically designated by most of these
statutes as an unlawful combination, but the pool was a secret
agreement whose details were not a matter of record and
against which it was difficult to secure evidence. The Addy-
stone Pipe and Tube Company is the most conspicuous case
of the dissolution of a pool by legal process, and here the
evidence against the organization was only secured through
information given by a disaffected stenographer. That such
pools existed was common knowledge, but to obtain conclu-
sive evidence was difficult. *

The trust, however, which was a permanent pool, and
which was expected to realize the benefits of the pool while
avoiding its mistakes, lay open to attack. The trust agree-
ments were matters of record. Their organizations were
made under the usual legal forms, and the details of these
organizations could not be concealed. The trustees could
not refuse to disclose their authority for issuing the trust
certificates which were dealt in on the exchanges. Any
stockholder could enforce his right to examine the consti-
tution and working of the trust which held his property.
Neither could the fact be concealed that these corporations,
whose identity and active life had been preserved, were,
under the trust agreement, no longer masters of their own
actions. They had surrendered their delegated powers to
the trustees. A perfect " combination in restraint of trade "
had been effected, and in view of the manifold statutes pro-
hibiting these self-evident combinations, the dissolution of
euch combinations waited only for an attack upon their

right to exist.
S4

354 COKPOEATION FINANCE

The attack came in 1890, when the Attorney- General of
New York brought suit against the North Eiver Sugar Ee-
fining Company under the common law. The case was de-
cided against the company, not only on the ground as stated
in the opinion of the Circuit Court, that the North Eiver
Sugar Eefining Company was a combination ..." the tend-
ency of which is to prevent competition in its broad and gen-
eral sense and to control, and thus at will enhance, prices
to the detriment of the public, . . . but because the corpora-
tion, entering the trust, had exceeded the powers of its
charter. The defendant had disabled itself from exercising
its functions and employing its franchise as it was intended
it should by the act under which it was incorporated, and
had, by the action which was taken, placed itself in complete
subordination to another and different organization to be
used for an unlawful purpose, detrimental and injuri^as
to the public. This was a subversion of the object for
which the company was created, and it authorized the Attor-
ney-General to maintain and prosecute this action to vacate
and annul its charter." The Standard Oil Trust was also
declared illegal on similar grounds by the Supreme Court
of Ohio in 1893.

The result of these suits showed that even without the
new menace of the Federal antitrust law the legal position
of the trust had become impossible. The states had pro-
hibited all combinations in restraint of trade. The corpo-
ration is the creation of the state, and the state can revoke
the powers which it has granted when these powers are ex-
ceeded or unlawfully exercised. Certain corporations had
combined into trusts in order to limit competition — e. g.,
to restrain trade. These corporations had exceeded their
powers, they had violated the laws of the states which had
created them, and their charters were therefor forfeited.
Unless some new device could be discovered by which the
hardships of competition could be alleviated, the pool whose
existence, though illegal, could be partially concealed, and
which was ordinarily safe from legaJ attack, whenever refiru-

THE HOLDING COMPANY 355

lation was required, must still be employed. Its defects were
generally admitted, and it often aggravated the very evils
which it was designed to cure; but if the trust was to be
forbidden,' the pool seenjed to be the only form of combina-
tion possible.

In 1893 the Standard Oil Trust solved the problem
presented by the illegality of the trust agreements by the
application of the principle of community of interest to
the managment of its various constituent companies. This
trust was dissolved, and the stock was returned to the hold-
ers of the trust certificates, which were then canceled.
A majority of the stock of each company, however, was re-
tained by nine men who had been prominent in the affairs
of the trust, and unanimity of action was in this way se-
cured. Such an arrangement is always open to objection.
It depends for its success upon the maintenance of harmony
among the members of a group of individuals, and upon
the tensile strength of the ties of self-interest supplemented
by the bonds of friendly association and personal regard.
The control of the various Standard Oil companies was held
by the members of a single family and their close personal
associates. These men had long been identified with a single
interest, and the feuds of the competitive struggle had not
divided them. The principle of community of interest proved
to be, in this case, a working substitute for permanent or-
ganization.

Generally speaking, however, mutual self-interest backed
by the friendship of members of a group of business men
is a precarious foundation for stability of prices or rates.
Self-interest may lead men one day together and the next
day it may lead them apart, and when the paths of self-
interest diverge, friendship is usually powerless to prevent
a break. Community of interest, as applied to railroads on
May 9, 1901, did not solve the difficulty. Yet the threat-
ened catastrophe of renewed competition among the members
of the trust must be prevented, not only to secure the ad-
vance toward stability of prices, which had already been

356 COEPOEATION FINANCE

rtnade, but to furnish similar solutions for other vexing prob-
lems of competition.

Before 1889, when the corporation law of New Jersey-
was revised, the laws of no state authorized the chartering
of a corporation for the general purpose of owning the stocks
.or property of other corporations. Consolidation of corpora-
tions was more generally permitted, but the purchase of stocks
.of other corporations by a holding company was not consid-
■ered to fall within the field of corporate privilege. There
were but few exceptions to the general rule that a corporation
ishould be organized for a specific purpose or for closely
:allied purposes. Pennsylvania had gone so far as to pro-
hibit incorporation for more than one purpose.

In 188® 'New Jersey revised its corporation act to permit
icorporations organized thereunder to acquire securities issued
by corporations of other states and also as New Jersey Cor-
porations to transact business in other states. Under this law,
following the decisions against the American Sugar Eefining
Company in New York in 1890 and the Standard Oil Com-
pany in Ohio in 1893, the trusts proceeded to reorganize as
New Jersey Holding Companies. The same control over the
policies and actions of the constituent companies which had,
under the "Trust" form of organization been exercised by
the trustees, was now transferred to the directors of the hold-
ing company. The changes in organization were as follows :

(1) To substitute for the certificates of the trust the

shares of the new corporation, which were issued
in exchange for the trust certificates.

(2) To substitute for a board of trustees elected by the

holders of trust certificates, a board of directors
elected by the stockholders of the New Jersey hold-
ing eompany.

The assets of this New Jersey corporation consisted of
the stocks and bonds of other corporations, each of these sub-
sidiary companies being in full possession of its corporate
faculties and exercising all of its lawful activities.

THE HOLDING COMPANY

357

The difference between the old-time trust and the trust
as we know it to-day, and the nature of the change in
combination-organization which has taken place, may be
illustrated by the accompanying table, which shows the meta-
morphosis of the Sugar Trust in 1891.

STOCK OF CONSTITUENT COMPANIES IN HANDS OF
TRUSTEES— TRUST CERTIFICATES OUTSTANDING

THE AMERICAN SUGAR REFINING CO.

Capital
Stock

Capital

Assets

Capital
Stock

1. The Havemeyer & Elder

Sugar Refining Co

2. The Dick & Meyer Co

3. The DeCastro & Donner
1 Sugar Refining Co

4. The MoUer & Sierck Co.. . .

5. The Oxnard Brothers Co. . .

6. The P. 0. Matthiessen &
; Wirchers Sugar Refining

Co

$500,000
200,000

350,000
210,000
100,000

400,000
300,000

1,000,000
300,000
650,000

1,000,000
225,000
755,000
450,000
250,000

$500,000
200,000

350,000
210,000
100,000

400,000
300,000

1,000,000
300,000
650,000

1,000,000
225,000
755,000
450,000
250,000

7. The Brooklyn Sugar Re-
fining Co

8. The Havemeyer Sugar Re-

9. The Forest City Sugar Re-

10. The Boston Sugar Refining
Co

11. The Standard Sugar Re-

12. The Bay State Sugar Re-
fining Co

13. The St. Louis Sugar Re-
finine Co..

14. The Louisiana Sugar Re-
fining Co

15. The Planters' Sugar Re-
fining Co

$6,690,000
Valuation

$6,690,000
$50,000,000

$50,000,000

For all practical purposes the two organizations are iden-
tical. Under the " Trust " the control of each company was

358 COEPOEATION FINANCE

vested in a board of trustees, who issued trust certificates
against the shares which they held. Under the "Holding
Company " the control of each company was located in the
company which held its stock, not as trustee, but as owner.
In place of a board of trustees came a board of directors; in
place of a distribution of dividends collected by trustees to
holders of trust certificates, a distribution of dividends re-
ceived by the holding company as declared by the subsidiaries
to the holders of its own stocks. The parallel is almost exact.

The desired result of restricting competition by a per-
manent organization appeared now to be accomplished. It
is true, that the state authorities could, as Missouri did,
expel domestic corporations on the ground that by allowing
their stocks to pass into the possession of the Standard Oil
Company of 'New Jersey they had disabled themselves from
obeying the anti-combination laws of their state. Of such
interference, however, the New Jersey holding companies
were not afraid. The field was vast and the difficulty of
arousing state authorities to action was great.

A more serious menace was the Federal Anti-Trust Law,
passed in 1890, known as the Sherman Law. The impor-
tant sections of this statute are as follows :

Section 1. 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, is hereby declared to be illegal.

Every person who shall make any such contract or
engage in any such combination or conspiracy, shaQ
be deemed guilty of a misdemeanor, and on convic-
tion thereof, shall be punished by fine not exceeding
five thousand dollars, or by imprisonment not exceed-
ing one year, or by both said punishments, in the
discretion of the court.

Section 2. Every person who shall monopolize, or
attempt to monopolize or combine or conspire with
any other person or persons, to monopolize any part of
the trade or commerce among the several States, or
with foreign nations, shall be deemed guilty of a mis-
demeanor, and, on conviction thereof, shall be pun-

THE HOLDING COMPANY 359

ished by fine not exceeding five thousand dollars, or
by imprisonment not exceeding one year, or by both
said punishments, in the discretion of the court.

The law, however, was quickly declared inoperative against
the New Jersey holding companies by a decision of the Su-
preme Court in the case of the United States vs. the E. C.
Knight Company. The American Sugar Eefining Company
had purchased four refineries located in Philadelphia and
suit was brought by the Department of Justice to enjoin
one of the purchases on the groimd that it was a violation of
the Sherman Law. The court, though by a divided vote,
held that the combination, assuming that its purchase re-
sulted in forming a combination, related primarily, to manu-
facturing, that any commerce resulting from manufacturing
was merely incidental thereto, and that Congress had no
authority under the Commerce Clause of the Constitution,
over any transaction which did not primarily relate to inter-
state commerce.

Freed by this decision from apprehension as to the legal-
ity of their course, promoters and bankers in 1898, launched
the trust movement which within fiye years brought under
the control of New Jersey Holding Companies large sections
of the principal manufacturing industries of the country.
Coal, heavy iron and steel, lumber, railway equipment, liquor,
worsted cloth, crackers and biscuits, smelting, harvesting ma-
chinery, com products, rubber goods, explosives, ship build-
ing, tobacco, in addition to oil and sugar, to mention only
the most important of the industries whose ownership was
in large part consolidated under the New Jersey Corporation
Act were all brought under the control of holding companies.
In each case the method was the same, the exchange of stock
or bonds of a holding company for the stocks of companies
which it was desired to unite.

In 1901 the movement spread to the railroads. In order
to compose the differences arising out of the contest for con-
trol of the Northern Pacific Railroad Company, the Northern
Securities Company of New Jersey was formed to exchange

360 COEPOEATIOK FINANCE

its stock for the stock of the Great Northern and the North-
ern Pacific, parallel and competing lines of railway extend-
ing from Lake Superior to Puget Sound. Eumors were
also current of a Southern Securities Company and a South-
western Securities Company, while in the eastern field the
Pennsylvania Kailroad Company had already acquired con-
trol of its principal competitors in the soft coal carrying
trade and the Beading Company in this same year, 1901, had
purchased a controlling interest in the Central Kailroad of
New Jersey. The industries of the United States seemed to
be rapidly drifting toward complete consolidation when the
Department of Justice again intervened.

Attorney General Knox, in February, 1903, filed a peti-
tion against the Northern Securities Company praying that
it be enjoined from voting the stocks of the two railroad
companies which it held, and also that it be enjoined from
receiving dividends on these stocks. The claim of the gov-
ernment was (1) that a controlliiig stock interest in these
, two parallel and competing railways systems was held by the
Northern Securities Company, (3) that it was manifestly to
the interest of this majority stockholder that competition
should be suppressed between these companies, and (3) that
it should be presumed that this dominant voting power would
be so exercised as to restrict and limit competition, and there-
fore, (4) that the stockholding body which had the power
and the incentive to violate the law should be permanently
enjoined from exercising those corporate functions of voting
and receiving dividends through which the law might be vio-
lated, and the profits of violation might be obtained.

This argument which, in the writer's opinion, is the most
forcible presentation of the cases against the holding com-
pany as successor to the trust, was answered by the attor-
neys for the Northern Securities Company, in substance as
follows :

" The Northern Securities Company is an investor in
railway stocks. It was formed not to restrain trade, but to
promote trade. It claims the right of any individual in-

THE HOLDING COMPANY 361

vestor of any financial institution, of any trustee, to exercise
all the rights incidental to stock ownership. The Northern
Securities Company exercises these rights by virtue of
power conferred upon it by the State of New Jersey. Con-
gress has no power under the Constitution to override the
right of the States to charter corporations for lawful pur-
poses, and the holding of securities is a lawful purpose."

In this case, it appears that the holding company as a
device to override the laws against unlawful combination in
restraint of trade, was on trial, and it is therefore surprising
to find that the government won by a divided vote. The
Supreme Court, by a bare majority, held that the Northern
Securities Company, as then constituted, was a combination
in restraint of trade, because its stockholdings in the Great
Northern and Northern Pacific Railroad Companies gave it
the power to restrain interstate commerce, and because it
would be to its advantage to exercise such restraint by limit-
ing the competition and increasing the profits of the com-
panies which it controlled.

While this decision struck at the holding company as a
device for defeating a federal statute under the protection
of a State law, it did not finally settle the question of the
legality of a combination of manufacturing companies, which,
had been definitely taken out of the scope of the federal power
by the B. C. Knight decision in 1895.

The suits against the Standard Oil Company and the
American Tobacco Company, however, struck directly at the
industrial combinations. The Circuit Court, in deciding
against the American Tobacco Company, brushed aside the
technicality of the Knight decision, assumed that a corpora-
tion controlling other corporations engaged in trade through-
out the United States, was engaged in interstate commerce,
and declared that "the Sherman Act must "he construed
as prohibiting any contract or combination whose direct effect
is to prevent the free play of competition and thus tend to
deprive the country of the services of any number of inde-
pendent dealers however small. . . . Two individuals who have

362 CORPORATION FINANCE

been driving rival express wagons between villages in two
contiguous states who enter into a combination to join
forces and operate a single line, restrain an existing com-
bination, and it would seem to make very little difference
whether they make such combination more effective by
forming a partnership or not."

The Circuit Court, with the best intentions, no doubt, at-
tempted, in placing such a strained construction upon the
language of the act, to draw off all its force and vitality.
If the Supreme Court had accepted this interpretation it
might have been necessary for the President to summon
Congress in special session to repeal the Sherman law.

The Supreme Court, however, by a vote of eight to
one. Associate Justice Harlan- dissenting, in declaring the
Standard Oil Company of New Jersey an unlawful com-
bination, laid down the principle that the Sherman law
does not prohibit every contract restraining trade, but
merely those contracts and combinations which result in
undue and harmful restraints of trade. Chief Justice
"White stated that the law made a comprehensive enumera-
tion of every contract, combination in the form of trust or
otherwise, or conspiracy, in order to make sure that no
form of combination by which an undue restraint of inter-
state or foreign commerce might be effected, would escape
the prohibitions of the Act.

To decide what are undue restraints of trade, the Court
refers to the standard of reason which had ieen applied
at the common law, and applies this rule of reason to deter-
mine whether a given combination is a violator of the Sher-
man law. The Court further declared that the meaning of
the Act is clarified by the second section which declares
"the attempt to monopolize" as a crime punishable by fine
and imprisonment. In both the Oil and Tobacco cases the
Court discovered abundant evidence that these companies
had been organized "with an intent to monopolize" and
that they were, therefore, unlawful and must be dissolved.

The now famous "Rule of Reason" removes the hold-

THE HOLDING COMPANY 363

ing company, as sueh, from the prohibitions of the Sher-
man Act. If such companies attempt to establish monopo-
lies, they may be dissolved, but the fact that they represent
a combination of previously competing companies will not
condemn them without proof of specific wrong-doing.

Since the Oil and Tobacco decisions a number of anti-
trust suits have been decided, some criminal, against indi-
viduals and others based on petitions for the dissolution of
holding companies. Criminal juries are not inclined to
convict for the crime of combination which, in the view of
most men, is no crime at all. The government has, how-
ever, won a few cases where secret^ pooling agreements
have been brought to light.

Civil proceedings have had Isetter success. The Powder
combination has been dissolved, a portion of the assets of
the parent company being divided between two other com-
panies in no way connected with the parent company. The
International Harvester Company has transferred its
foreign business to a separate corporation. The Corn
Products Refining Company has also accepted a decree of
dissolution. On the other hand, the government has been
defeated in its attempt to dissolve the United Shoe Ma-
chinery Company, and also in its attack upon the United
States Steel Corporation. The decision in the Steel Cor-
poration case was, however, noteworthy in that, while al-
lowing the corporation to continue, it declared that the
practice of reaching informal agreements and understand-
ings with its competitors by which prices were made uni-
form in certain lines was unlawful. The Court pointed
out certain errors of the corporation, without enforcing
the extreme penalty. In each case the Court held that
neither the existence of a monopoly nor of an attempt to
monopolize had been proven. The legality of the United
States Steel Corporation has been finally upheld by the
Supreme Court on the ground that mere size, the implied
power to do evil, is no sign of sin, especially since, for
many years, the corporation had carefully refrained from

364 CORPORATION FINANCE

practices which would indicate its intention either to ex-
tend its control or to exclude others from entering the
industry.

A recent addition to the machinery of enforcing the
anti-trust law and a strengthening of the law itself, was
the passage in 1914 of two statutes, the first known as the
Federal Trade Commission Law, which created a board of
service members known as the Federal Trade Commission,
and the second as the Clayton Law.

The Federal Trade Commission is in many respects
similar to the Inter-state Commerce Commission and is
given like powers. Its duties are first, to investigate cor-
porations engaged in interstate and foreign commerce,
with the exception of banks and common carriers, to detect
any violations of the statutes relating to commercial methods
and practices, and its second function is to determine,
after hearing on complaint filed by the commission, whether
particular persons, partnerships, or corporations have vio-
lated any of the provisions of the laws relating to the
matter placed under its care. The commission is also
charged with the duty of issuing orders where violations
of the law are discovered, and it can appeal to the courts
to enforce these orders. All of the proceedings of the
commission are subject to review by the courts, but its
business is given precedence, and is to be expedited. The
Trade Commission Law also established a new standard by
which the legality of certain practices can be determined,
by declaring that unfair methods of competition in com-
merce are declared unlawful. It will be for the courts
finally to determine what these unfair methods are.

The Clayton Law goes much further than the Trade
Commission Law in enumerating certain business practices
which are declared to be unlawful. These unlawful prac-
tices are as follows:

1. Price discrimination when the object is to create a
monopoly.

2. Tying contracts, by which the sellers or lessors of

THE HOLDING COMPANY 365

goods attempt to prevent buyers or lessees from buying or
leasing the goods of others, the object being to create a monop-
oly.

3. Prohibition against the ownership of stocks in com-
peting corporations by a third corporation unless the purpose
is for investment.

4. Prohibition on inter-locking directorates by which is
meant the holding of directors' positions in two or more large
banking institutions in large cities, or large corporations of
any kind.

Assuming that business is in need of such drastic regu-
lation, the Federal Trade Commission is probably an improve-
ment over the working of the Department of Justice in en-
forcing the Anti-Trust Law. All of the. orders of the Com-
mission must come before the courts. The authority of the
Commission, and the respect in which it is held, will depend
upon the final disposition of its orders.

Holding companies are not formed solely for legal reasons.
Important considerations of financial expediency favor the
use of this device when it is desired to bring under single
control within a short time a number of properties in the
same line of business. When it is desired to form a, combi-
nation, for example, of a number of steel manufacturing
concerns, one of the operating companies can be used as a
holding company, or a new company can be formed. Even
if no legal obstacles intervened, however, the holding com-
pany will be the device usually selected.

Mr. Eobert F. Herrick, in a paper entitled "Holding
Companies," has summarized the situation as follows :

"The natural purpose, then, of a holding company and
the one for which it is used is the combination of allied
and generally though not necessarily competing enterprises.
Theoretically, such a combination or purchase could be
effected by any one person or group of persons with sufficient
capital. Further, it could be effected by the purchase out-
right, either by private individuals or a corporation, of the
various properties or business. Practically, however, a great

366 COKPOEATION FINANCE

many combinations would never be brought about except for
the holding company, and practically all of the great recent
consolidations, such as the United States Steel Company,
the Amalgamated Copper Company, and others, have been
holding companies. It would have been practically impos-
sible for the United States Steel Corporation to have been
formed in any other way. It is necessary in the getting
together of such a group of properties to act quickly and at
a favorable time. It is necessary, so far as possible, to get
along without new cash. The amount of cash necessary to
buy the properties consolidated into the United States Steel
Corporation would have been impracticable to raise. It is
necessary, further, as much as possible to retain the interest
of a large number of stockholders in the older companies in
the new consolidated company. It is necessary to provide
a practical working method of bringing them all together,
and particularly necessary to provide for the contingency
that it may be impossible or impracticable to actually sell
the property of one of these corporations to the consolidated
company, or that it may be impossible to get the consent of
certain of thdse interested in the selling company to the con-
solidation.

"The stockholders act naturally like a flock of sheep.
In the main they follow the lead of the directors, and if the
details of carrying the plan through are so arranged that the
stock in the new company has an apparent money value
greater than the stock of the old company for which it is
offered, the exchange once started takes place generally, and
when a majority of the stock in the companies is exchanged
practically the consolidation is effected. The difBeulty in
bringing enterprises together in any other way can be realized
when you appreciate that in many states it is impossible for
a corporation, even a private manufacturing corporation, to
sell out its entire property, including franchises and good-
will. It has been held in some jurisdictions that such a
sale is foreign to the whole purpose for which the corporation
was formed and that when the time for such a sale comes.

THE HOLDING COMPANY 367

it means the dissolution of the corporation and a final dis-
position of its assets among its stockholders. There is further
in certain states the absolute prohibition for a corporation of
greater than a limited amount of capital to do business in the
state. This alone would prevent the amalgamation of a num-
ber of properties into one great corporation directly owning
all the properties."

Another reason for choosing the holding company for the
consolidation is that to employ an operating company as the
purchaser of the stocks .of other corporations, would require a
large increase in the stock of this company, and this increase
might, under the laws of the state or the charter of the corpo-
ration, require the consent of three fourths or even a larger
proportion of the stock. Stockholders of the proposed holding
company might object to this reorganization of the capital
account for a purpose of which they might not approve, and
the combination might be halted at its outset by embarrassing
litigation resulting from the efforts of minority stockholders
to protect what they considered to be their rights whatever
the motives back of the litigation.

A holding company has various other uses in addition to
that of accomplishing a combination. It is largely employed
as a finance company. One of the best illustrations of hold-
ing companies organized for this purpose is furnished by the
corporations manufacturing electrical apparatus and appli-
ances. The products of the General Electric Company, for
example, are purchased by corporations engaged in the opera-
tion of electric railroads, power and lighting companies.
When these companies are started, their promoters usually
welcome assistance in providing the funds for construction.
They are willing not merely to make liberal arrangements
in the way of stock bonuses, but also to give to the con-
sthiction companies affiliated with the banking or financial
concerns which give them assistance in putting through their
project, exclusive contracts, not merely for construction, but
also for all materials and appliances which may be needed

^68 COEPOEATION FINANCE

for a long time to come in the maintenance and extension of
the plant.

,The companies manufacturing electrical appliances have,
therefore, placed themselves in a position to render financial
assistance to new companies in order to secure a market for
their machinery. The General Electric Company owns the
entire capital stocks of the Electrical Securities Corporation
and the Electric Bond & Share Company. Both of these
companies are finance companies; they take part in the
underwriting of securities of electric companies of various
kinds, and also purchase the bonds of such companies, some-
times taking with the bonds a bonus of stock. They obtain
the funds for these purchases, not merely because of the
high credit which the backing of the General Electric Com-
pany gives them, but also by selling their own bonds secured
by the stocks and bonds which they purchase. The Elec-
trical Securities Corporation, for example, in 1904 offered
$500,000 out of $1,000,000 collateral trust five per cent bonds
secured by $1,350,000 par value of "first mortgage bonds of nine
electric railway, power and traction companies located in dif-
ferent parts of the United States. These companies earned
a surplus over fixed charges, and the Electrical Securities
Corporation was required to keep the principal acquired out
of its interest-paying bonds under pledge equal at all times
to at least 125 per cent of the principal of thfe collateral trust
bonds outstanding. When a favorable opportunity occurs,
bonds may be withdrawn and sold, a corresponding amount
of the collateral trust bonds being paid off. In other cases,
the substitution of collateral, according to the method already
explained in the discussion of the collateral trust bonds, is
permitted.

By pledging the bonds which it purchases as collateral
for loans, a corporation of this character is able to free its
capital for new employment without selling unseasoned bonds
at the low prices which such securities bring. The bonds can
be put away under the collateral trust mortgage until the com-
panies issuing them have reached an assured position, when

THE HOLDING COMPANY 369

they can be sold at a substantial advance over the price paid.
Bonds purchased by such corporations, moreover, often carry
a bonus of stock, and the stock can either be held for dividends
or sold as soon as it reaches a proper figure.

A limit is usually placed upon the amount of collateral
trust bonds which such a corporation can issue. In the case
of the Electrical Securities Company, for example, the " total
indebtedness of the corporation, secured and unsecured,
direct and contingent, shall never in the aggregate exceed
four times the amount of its paid-up and unimpaired out-
standing capital stock and surplus." Bonds of such a
corporation, issued under these restrictions, furnish very
good security. The fact that the collateral pledged represents
the bonds of a number of different enterprises adds to the
safety of these obligations.

The object of the Electrical Securities Corporation and
the Bond and Share Company is to assist the owner of their
stock, the General Electric Company, in pushing its business.
It is not their object to retain permanently the bonds which
they purchase. As fast as these show a substantial profit,
they are sold and the proceeds reinvested in other securities.
Other companies have been organized on this model for the
purpose of permanent income to be derived from the
•securities yielding the high rate of return purchased with
iheir own bonds at a lower rate. The Mortgage Bond Com-
pany of New York, for example, owns first mortgages in a
large number of cities, and from time to time issues bonds
secured by these mortgages with the proceeds of which
'Other mortgages are purchased. The bonds of this company
must at all times be secured by deposit with the trustee of
first mortgages equal in face value to the value of the bonds
outstanding on improved real estate in cities having a popu-
lation not less than 40,000, subject to the right of the com-
ya.nj temporarily to deposit cash. Government bonds, or New
York City bonds at a valuation of five per cent below the mar-
ket value thereof. All the mortgages used as collateral are
'limited to one half of the value of the mortgaged property as
ae

370 COEPOEATION FINANCE

appraised for the company. With cities having a population
of 300,000 or over, such mortgages may equal three fifths of
the value of the property, and in New York City, tv?o thirds
of the value. These bonds are issued at low rates of interest,
and their proceeds can be loaned at rates which show a sub-
stantial margin of profit for the stock. The mortgage bond
indebtedness of the company is limited to fifteen times the
capital stock, outstanding at the time of issue. Other illustra-
tions of holding companies organized for permanent control
of properties are the American Water Works Company, the
American Pipe Manufacturing Company, the American Gas
Company, the American Light & Traction Company, and the
United Gas Improvement Company.

The finance holding companies which have been described
are similar to the organization of the investment trusts which
are numerous in Great Britain. These corporations are or-
ganized to make available to the general investor the stocks
and bonds of other companies, thereby relieving him of the
task of finding safe investments for his money. Invest-
ment Trusts issue shares or debentures bonds to the investor,
and with the funds obtained, they purchase large blocks of
securities in various companies, many of them located outside
of England. It is not regarded essential that these interests
should be controlling interests. In some cases, new flotations
can get their capital from such investment trusts. The pur-
pose of these investment holding companies is indicated in
the prospectus of the General Investors & Trustees, Limiffed,
which says :

This company has been formed to conduct the
business of a trust and investment company. . . . The
directors believe that the present is a favorable time
for engaging in such an enterprise, securities being
generally free from inflation, and the conditions of
trade throughout the world being of a satisfactory
character. It has been shown by experience that a
well-managed investment company enjoys many ad-
vantages which are not usually within the reach of a
private individual, who cannot generally exercise that

THE HOLDING COMPANY 371

vigilance essential to successful results. The former
is in a position, while as a rule a private investor is
not, to make the investigations necessary to ascertain
the real position and intrinsic value and prospects of
the undertakings in which it contemplates investing
its capital. The information now required to be given
by companies under recent legislation in conjunction
with their annual reports and accounts, provides a
useful index to their merit, and furnishes an invalu-
able aid to the operations of a trust and investment
company. The business of participating in the un-
derwriting of new issues of Home, Foreign, and
Colonial Loans, and of bonds, debentures and deben-
ture stocks, and shares and stocks of approved com-
panies, will form a prominent feature of the com-
pany's operations.

The advantages of such a company are many. In the
first place, it can act as an underwriter in taking over the
stocks and bonds of new corporations in which it has confi-
dence at very low prices, receiving occasional bonuses of
stock, and selling its own shares or debenture bonds on an
investment basis. This is essentially the same plan as that
followed by railroad companies which build branch lines
through subsidiary companies, and then sell securities of
these companies in the form of their own collateral trust
bonds to the public. The Investment Trust Company has
also an advantage over the investment banker in that the
latter is compelled to turn over its capital quickly, and is
forced, in order to market securities purchased, to give the
purchaser lower prices than those which could be obtained
for these securities if they were held until the company had
fully demonstrated its earning power. The English invest-
ment trust, moreover, may retain its purchases, or may sell
these securities when they appreciate in value as result of in-
creased earnings. In either case, its shareholders obtain the
full benefit of appreciating value which the American banker
is forced to divide with his customers. The second point in
favor of the investment holding company is that it spreads its

372 COEPOEATION ITNANCE

investments over a wide field, by which it can;. in the same
manner as life insurance companies, reduce the risk of loss to
a minimum. The investor in its debentures or ,shares can also
be safeguarded by reserve funds built up out of the dividends
and interest which it receives.

CHAPTER XXIX
THE LEASE

The lease has already been defined as a contract by which
possession of certain property is transferred from the owner
known as the lessor to some other person or corporation
known as the lessee. Corporate leases contain the following
provisions : '

First, a description of the property, usually in the form
of a complete inventory, which must be kept up to date, since
the nature of corporate property is likely to be constantly
changing. For example, the property of a street railway
company, where the motive power is in turn changed from
horse power to cable, then to the overhead trolley, and finally
to the underground trolley, may be entirely different at the
end of a ten-year period from what it was at the beginning.
If this property is to be leased to another company, it is im-
portant that the inventory be revised at regular intervals.

Second, the length of the lease. It is usual to make
corporate leases for long terms, ninety-nine years being
common, and 999 years not unusual. When leases are made
for shorter periods, options of renewal on certain terms are
usually inserted.

Third, payments under the lease. With hardly an excep-
tion, corporate leases provide that taxes, insurance, interest,
and expenses of maintaining the organization of the lessor
shall be paid by the lessee.. In addition, the payment for
the lease to the lessor is usually made in the form of a divi-
dend upon the capital stock of the lessor as then outstanding.
It may also be provided that the lessee shall pay as rental

373

374 COEPOEATION FINANCE

for the property a certain proportionate part of the gross
earnings or of the net earnings. This method places no
limit^to the participation of the owner in the profits of the
property. These payments are frequently made on a sliding
scale so as to permit the stockholders to share in th§ expected
increase in profits.

Corporate leases provide, in even greater detail than
private leases, for the maintenance of the properiy. This
point needs to be far more carefully guarded in short term
leases than when, for example, ninety-nine year leases are
made. If the maintenance of leased property is not care-
fully looked after, as the date when the lease expires ap-
proaches, the lessee, unless he expects to renew the lease, will
allow the condition of the property to deteriorate, making as
much money as possible during the last year or two of his
occupancy. In order to protect the lessor against such an
abuse of his rights by the lessee, there may be reserved to
the lessor the privilege of examining its physical condition.
A typical provision for maintenance is the following, taken
from the lease of the property of the Manhattan Eailway
Company to the Interborough Eapid Transit Company :

The lessee covenants and agrees, at its own proper
cost and expense, to maintain, operate and run the
demised railroads and property during the said term
in the same manner as the lessor is now or shall at
any time hereafter be required or authorized by law
to do; and shall and will keep all insurable property
insured in reasonable amounts and rebuild all build-
ings and replace all property destroyed or deterio-
rated by fire or otherwise, to such an extent as to be
unfit fpr use; and shall and will maintain, preserve
and keep the railways and property hereby demised,
including all property hereafter acquired, and every
part thereof, in thorough repair, working order and safe
and efiicient condition, and supplied with rolling stock
and equipment, so that the business of the said de-
mised railways shall be preserved, encouraged and de-
veloped, the business thereof be done with safety and
expedition, the public be accoromodated in respect

THE LEASE 375

thereto, with all practicable convenience and facilities,
and the future growth of such business as the same
may arise or be reasonably anticipated be fully pro-
vided for and secured.

The lessee further covenants and agrees, at the ex-
piration or termination of this lease for any cause,
to return and deliver the said railroad and railroads,
real estate, and properties by this lease demised, in-
cluding, among other things, all property, additions,
improvements and equipments which shall be fur-
nished, constructed or completed out of the proceeds
of sale of the stock, bonds or property of the lessor, to
the lessor in as good order, condition and repair as
they were at the date this lease takes efiect, or at the
date when the same came into the possession of the
lessee, and to surrender said franchises, rights and
privileges, easements and properties unim||aired by
any act of the lessee; excepting, however, alj property
of the lessor sold pursuant to the terms hereof, the
proceeds of which shall have been applied as herein
provided. ^•

The lessee further covenants and agrees that it will,
at all times during the continuance of this lease,
at its own expense, keep the said rolling stock, and
tools, equipment, machinery and implements necessary
for the operation of the road, in good order, condition
and repair, and will, as the same shall be worn out
and rendered unserviceable, replace the same at its
own expense, so that the said railroad and railroads
shall always be kept, maintained and equipped in good
and safe condition and effective working order.

The lessee further covenants and agrees that it will
at all times during the continuance of this lease, at
its own expense, comply with all lawful requirements
with respect to the construction, maintenance and
operation of said railroads, extensions or branches
thereof.

In corporate leases, when the instrument covers, for
example, a large and complex street railway system, it fre-
quently happens that some portion of the property of the
lessor is no longer of use to the lessee. It is for the interest

376 COEPOEATIOK FINANCE

of both parties that this property Should be sold. Provision.
is usually made, therefore, for the sale of such pr&perty, with
or without the consent of the lessor, but invariably with the
stipulation that the proceeds of the sale are to be invested in
improvements upon the lessor's property. In other respects
the language and form of a corporate lease closely follows
the corporate mortgage, the main objects being to preserve
the physical condition of the property and to protect the
lessor against any claims or charges arising from the non-
fulfillment of any obligation connected with the property
released. If the property is mortgaged, such a stipulation is,
of course, necessary, and the consent of the trustee of the
mortgage must be obtained.

A proposition made by a strong company to stockholders
of another corporation to lease their property at a rental
corresponding to the dividends which they are then receiving
or of which there is an immediate prospect, is very attrac-
tive, and it is not so essential to make sure of their acceptance
by purchasing enough stock to control the board of directors
of the lessor company, as when a proposition is made to pur-
chase the stock. A typical proposition of this character is
indicated in the following offer :

The Indianapolis Terminal and Traction Company
offers to lease the property of the Indianapolis Street
Railway Company, guaranteeing the payment of inter-
est, taxes, etc., and also dividends on the street railway
stock of one per cent on January 1 ; next, and there-
after- semiannually 3 per cent for the first year, 4 per
cent for the second year, 5 per cent for the third year,
and from July, 1908, 6 per cent. The term of the lease
is for thirty years, which is the unexpired life of the
Indianapolis Company's franchise from the city.

The advantages of the lease, from the standpoint of the
lessee, are equally evident. The lessee company obtains the
control of property without the outlay of any money, and
usually on terms which leave them a margin of profit after
making the payments required by the lease. If property is

THE LEASE 377

to be built a large amount of financing is necessary. Bonds
or stock must be sold, and extensive construction operations
entered into. If, however, the property desired can be rented
from its owners, the lessee company comes immediately into
the possession of a fully completed property, manned by an
operating organization and on a profitable basis. The same
result, from the standpoint of control, may be reached by
purchases of the stock of the company owning the desired
property, which can be pledged under an issue of collateral
trust bonds. This method has already been explained. Here,
however, the question of financing arises, the bonds must be
sold, or a sufficient sale must be insured by a syndicate to
purchase the amount of stock desired. The question of stock,
moreover, as we have seen, usually involves the entire issue
of the company which owns the desired property, and the
financing may be extensive. To acquire control by the
method of lease, however, involves no more than dealing with
the board of directors, and the submission by. them of a
proposition to the stockholders. If the offer is advantageous,
and with the prestige of the directors behind it, it is likely to
be unanimously accepted.

Leased property has objections from the point of view
of the lessee. It is not available as security for loans to pay
for improvements which may increase its value. While the
property of a street railway system is in the' possession of
the lessee company, and while its operation is entirely con-
trolled by the lessee, title to the property remains in the
lessor. In the natural course of improvement, with a steady
growth of population, large extensions and additions, and a
considerable amount of reconstruction of the property, are
reasonably certain. The progress of invention has completely
revolutionized the methods and mechanism of street railway
corporations. The motive power, types of cars, the methods
of generating power and the types of track, have been greatly
improved. The cost of all these improvements and exten-
sions which are made upon the property of the lessor, in the
absence of special provisions in the lease, must be borne by

378 COEPOKATION FINANCE

the lessee company.. With a short term lease, the improve-
ment of the lessor's property may be the ground for a
successful demand for higher rental from the lessee, and
improvements are likely to be deferred or abandoned on this
account. With a long term lease, the only objection to im-
proving the lessor's property is the difiBeulty of financing
the cost of these improvements. In such cases, the only
property right' held by the lessee is the lessor's interest
obtained by capitalizing the profits of the lease. This right
may in some cases be very valuable. We have already seen
that it was one of the assets pledged by the Interurban Eapid
Transit Company as security for a recent issue of bonds. In
few cases, however, are the profits so large as to make the
lessor's interest of great value, and great difficulty may be
experienced in financing improvements which are absolutely
essential to the development of the system, and which may,
in fact, be demanded by the public authorities.

A recent illustration of the difficulty experienced by the
lessee company under these circumstances is furnished by
the Philadelphia Eapid Transit Company which holds under
lease the street railway property of the Union Traction Com-
pany which preceded it in control of the street railway
system of Philadelphia. In September, 1908, the Eapid
Transit Company sent a letter to the shareholders of the
Union Traction Company which is as follows :

" On July 1, 1902, you turned over to this company
your property on a rental basis. You had acquired this
property seven years before, had expended your money in
the development of it, and while in later years you had
shown a surplus from operation, that surplus had not, up
to that time, been sufficient to justify the payment of a
dividend.

"This company, by the terms of the lease, undertook to
pay you a dividend from the start, equal to the largest
earnings which you had shown up to that time, and in-
creasing until they should reach, as they now have, double

THE LEASE 379

that amount. In the past six years we have spent approxi-
mately $20,000,000 in building the new elevated and subway
railway and $20,000,000 upon improvements and extensions
of the system which you turned over to us. This company
has been subject to severe criticism for having assumed to
pay a dividend upon the par value of your stock, only thirty-
five per cent of which has been paid in, but the answer is
that we have (in effect) spent upon this system not only the
19^ millions remaining unpaid upon your capital stock but
10^ millions additional, with respect to which $30,000,000 no
fixed charge has been assumed and no return has been paid.

" The increased cost of operation, the recent depression in
business and unavoidable delays in the completion of the
subway have necessarily upset, to a certain extent, the cal-
culations upon which the rental obligations were based.
These conditions, however, have merely postponed the fulfill-
ment of our expectations, and the management has full con-
fidence in its ability to place the property upon a substantial
paying basis, provided it is able to do the financing always
necessary for a growing property.

" Since we took over this property we have secured a
contract with the city in which the Eapid Transit Company
has given up valuable privileges for the purpose of securing
to your company immunity from the threat of hostile legis-
lation. This contract is of the very greatest benefit to the
Union Traction Company and its underlying lines.

" As already stated, nearly half of the $40,000,000 capital
raised by this company has been expended directly upon the
surface system. Several millions of dollars went to the
building of what are practically new lines, although they
have been built under extensions of your old charters, princi-
pally the Twenty-second Street and Allegheny Avenue Pas-
senger Eailway Company in which you own every share of
stock, and the West Philadelphia Passenger Eailway Com-
pany (under which new lines have been built on 52d, 58th,
and 60th streets) in which your company oa^tis a controlling
interest.

380 COEPOEATION FINANCE

" The Eapid Transit Company has now made the final
call upon its capital stock and this has been practically ex-
hausted by the expenditures already detailed. It is now nec-
essary to relay many miles of surface track and to add equip-
ment of a more modern character calculated to serve the
public better, and to collect a much greater percentaige of
the fares. These expenditures will be made directly upon
your property, rendering the security of your lease that much
better, both as to the value of the property and its earning
power."

It appears from this letter that, unless the Eapid Transit
Company could make use of the credit of the Union Traction
Company, the financing of necessary improvements would
be impossible. A proposition was, therefore, made to the
stockholders of the Union Traction Company to permit
the former to use a large number of valuable securities
enumerated in the list and intrusted to the Eapid Transit
Company as collateral security for an issue of $5,000,000 of
collateral trust bonds. The proposition was accepted by the
Union Traction Company, and thfe funds provided. Evi-
dently, however, the lessee company cannot always count
upon the acquiescence of stockholders of lessor companies
in placing encumbrances upon their property for the benefit
of that property. In recent leases, provisions have been
inserted whereby the lessor company is obliged, under cer-
tain conditions, to finance improvements upon its own
property.

One of the most carefully drawn leases ever executed is
that which gave to the Boston Elevated Eailway Company
the control of the West End Street Railway. The lease
bound the Boston Elevated to pay seven per cent per annum
on the common and eight per cent on the preferred stock
directly to the stockholders without any reduction, the lease
stating that these dividends were to be " net " amounts. The
lease further explicitly provided that the Elevated Company
should pay all damages to persons or property j all sums due

THE LEASE 381

for taxes— federal, state or municipal— upon the lessor's
property, franchise or capital stock; and all sums "by law
required to be deducted from any amounts payable upon
the lessor's stock." The lease, on the other hand, stipu-
lated that all saving from refunding of the West End
Company's bonds should accrue to the lessee, the Boston
Elevated Company. The lessee also assunjed definitely
the interest on the bonds of the "West End Company, and
on the existing indebtedness of any street railway which
the West End Company was under obligations to pay. It
also assumed all liabilities under the contract with the city
of Boston touching the subway.

The provisions in this lease regarding the right of the
lessee to issue stock or bonds of the West End Company for
improvements, particularly deserve attention. The West
End Company was required to issue stock or bonds, from
time to time, at the request of the lessee, in order to meet
the .cost of improvements and additions to the lessor's prop-
erty. The West End Company must "be informed of the
purposes for which it is proposed to issue the securities,
and if it dissent from the expediency of the expenditure,
and withholds its consent to the issue, a board of arbitrators
must pass upon the matter. If the arbitrators, by a ma-
jority opinion, do not approve the same, the lessee cannot
insist upon the issue being made. One arbitrator is to be
chosen by each of the parties to the lease, and the third by
the two so chosen, or by the State Board of Railroad Com-
missioners, or by the Chief Justice of the Supreme Court
of Massachusetts. The lessee company has the right to
decide whether the issue of security by the lessor shall be
stock or bonds, and it may fix the rate of interest which
the bonds shall bear, but it is provided that "no bond shall
be issued in excess of the outstanding capital stock" of
the lessor. Provision must, of course, be made, in case
bonds are issued by the lessor for the improvement of
leased property, for an increase in the rental to provide
for interest and sinking fund on the new bonds.

382 CORPORATION FINANCE

In order to protect the lessor company against im-
proper use of its credit by the lessee, there is set down in
detail in the lease the expenditures which the lessee can
capitalize for the account of the "West End Street Railway.
These are especially limited to the following permanent
additions and improvements:

1. The abolition of grade crossings.

2. Additional rolling stock and equipment.

3. Additional track ihileage and its equipment.

4. Additional real estate.

5. Additional stations, power and car houses.

6. Additional buildings, bridges and other structures.

7. Renewals of or substitutes for stations, bridges,
buildings and other structures, track and equipment, "so
far as the cost of such renewals and substitutes exceeds the
cost, when new, of the things received or the things re-
placed."

The provision just described is now often included in
leases of properties where it is necessary to provide for
capital expenditureis. Another method sometimes em-
ployed, and which a proper organization of the capital
account makes possible, is for the lessee, when it takes over
the property of the lessor and assumes the obligation to
pay interest on its bonds, to take over also any unissued
bonds authorized under existing mortgages, and to issue
these at will subject to the restrictions of the mortgage.
This method is preferable to that employed in the Boston
lease which is apt to lead to endless discussions and bicker-
ing over the propriety of particular expenditures. If the
restrictions in the mortgage are carefully drawn, the lessee
can, without danger to the lessor's property, and in fact
with great benefit to the lessor, freely employ the credit
arranged for in the mortgage for the benefit of the lessor's
property. In this manner provision can be made for the
expansion of the business carried on with the leased prop-
erty.

CHAPTEE XXX
KEADJUSTMENT OF THE CAPITAL ACCOUNT

The capital account of a corporation has been described
as a statement of assets and liabilities. From time to time,
it becomes necessary or advantageous for a company to re-
adjust its capital account, changing the form of assets,
exchanging assets for liabilities, distributing assets or evi-
dences of liabilities to stockholders, or changing the form of
liabilities. The methods employed in making these read-
justments can be grouped under the general title of read-
justment of the capital account.

Eeorganization of the capital account is usually required
in the event of bankruptcy, if the business is to be contin-
ued. This form of reorganization will be considered in a
later chapter. We are here concerned with the reorganiza-
tion of the capital accounts of solvent companies.

Eeorganization may relate either to assets or liabilities.
The first condition under which reorganization may be nec-
essary is when it is desired to change the form of assets.
The property of a corporation is constantly changing. A
railroad company, for example, may wish to sell a part of
its equipment which is no longer suited to its purposes, or
certain real estate put out of use by the rearrangement of
a terminal. Similar occasions are constantly arising when
it is desirable for a corporation to dispose of certain of its
property. When securities are owned, and when the control
over the companies which have issued these securities is no
longer important to the corporation which owns them, op-
portunity sometimes arises to sell these securities, and to
reinvest the proceeds^ either in improvements or in other

383

384 COEPOEATION FINANCE

securities showing higher rates of return. The testimony
of Mr. E. H. Harriman before the Interstate Commerce Com-
mission in its investigation of the alleged illegal combination
between the Pacific companies in 1907, explained a transac-
tion of this character as follows:

" We had, as the result of the Northern Pacific purchase,
$82,000,000 of Northern Securities stock, at a cost of about
$79,000,000. Then we were forced by the decision of the
Supreme Court to take Great Northern, which we did not
want, and a lesser amount of Northern Pacific than we had
deposited with the Northern Securities Company. At the
time the Great Northern and Northern Pacific was forced
upon us, it had a market value of about $100,000,000. . . .
Instead of disposing of it at that time, we held it until
the market price increased in value to somewhere near
$145,000,000 to $150,000,000. We sold some of it grad-
ually as it went up, but at that value the returns from the
Northern Pacific and Great Northern were less than three
per cent on the stock that we held. Therefore we concluded
that it was better to sell those stocks and invest the same
money in other securities that would give us greater returns.
So that, following out that line, we have sold enough of
those stocks to realize $116,000,000."

Mr. Harriman further stated that the income from the
securities purchased was approximately $5,500,000, instead of
$3,250,000 on the Great Northern and Northern Pacific
stock.

The working capital of a company, its cash, materials,
and bills receivable, varies with the volume of its business.
It is offset, in part, by current liabilities. With a falling off
in business, a part of this working capital becomes unneces-
sary. It may then be employed to pay off the current debts
of the company.

In some cases corporations may be unable to meet short
term indebtedness at maturity, and may be obliged to sacri-

READJUSTMENT OF CAPITAL ACCOUNT 385

fice some of their property to take up their loans. The Colo-
rado Fuel and Iron Company, in 1903, "found it necessary,
in order to meet its obligations under contracts previously
made, and for the extensive work of construction and bet-
terments upon which the company entered a year or two ago,
and also for its general corporate purposes, to raise money
from persons interested either as stockholders or directors,
or both, by means of loans and sales (the sales, however, being
subject to a contract permitting repurchase by the Fuel Com-
pany within a specified time)." This property was after-
wards repurchased by the corporation at an advance in price,
the stockholders being allowed to participate in the profits of
the repurchase.

The disposition of assets by the various methods above
indicated presents no difiBculty if the assets are not pledged
as security for some loan. In case they are pledged, how-
ever, it becomes necessary to obtain the consent of the trus-
tee, whose duty it is to make sure that the proceeds of the
sale are used, either to reduce the amount of bonds secured
by the mortgage under which the property sold was pledged,
or reinvested for the protection of the bonds.

Taking up next the readjustment of liabilities, we come
first upon the capital stock. The increase of capital stock
as a means of distributing the surplus has already been re-
ferred to in Chapter XVIII. We are concerned with the con-
ditions under which the amount of capital stock may be re-
duced. When the company has outstanding an amount of
stock so great as to make it improbable that its earnings will
ever reach a point where dividends can be safely paid, and
especially when there has been such an accumulation of unpaid
dividends on preferred stock as to make payment of dividends
on common stock highly impracticable, the question arises.
Shall the capital stock be reduced to a dividend paying basis ?
When the value of the stock, because of the , remoteness of
dividend payment, has fallen to a nominal figure, this ques-
tion should be answered in the affirmative,

A company, for example, with $500,000 of surplus earn-
?6

386 COEPORATION FINANCE

ings applicable to dividends cannot, as a rule, safely pay out
more than $300,000. If $250,000 of this $300,000 is re-
quired to pay preferred dividends, and if the amount of
common stock is $10,000,000, the $50,000 remaining equals
only one half of one per cent on the total common stock.
There may also be accumulated dividends on the preferred
stock, making the payment of dividends on the common stock
even more improbable. Common stock, under these circum-
stances, will usually sell for a nominal figure, under $5 a
share. Very little of it can be sold at any price. If, how-
ever, the $10,000,000 of common stock could be reduced to
$1,000,000, and the accumulated dividends on the preferred
stock adjusted, the company would have enough surplus
earnings to pay five per cent on its common stock, which
might be expected to sell at from $50 to $60 a share. The
proposition made to the common stockholders to exchange,
say, ten shares of the old stock for one share of the new
stock should be aceptable, since they obtain an income at
once, and also a free market for their securities. In case
the increased earnings of the company eventually make it
possible to pay a high dividend on this reduced capital stock,
the stock retired may be returned to the stockholders in the
form of stock dividends,' maintaining a dividend rate at a
reasonable figure, and placing them again in their original
position so far as concerns the par value of their holdings.
This method was employed by the General Electric Company,
which in 1898 reduced its stock 40 per cent in 1902 return-
ing the amount to its stockholders in a special dividend. Sev-
eral corporations which were grossly overcapitalized at the
outset have reduced their capital stocks to a dividend paying
basis. The American Malting Company and the Distillers'
Securities Company, among others, have made such reduction.
Eeduction of capital stock to place it upon a dividend
paying basis can only be accomplished, unless the company
is to be dissolved and its property taken over by a new cor-
poration, by unanimous consent of the stockholders. This
unanimous consent is comparatively easy to obtain when the

EEADJUSTMENT OF CAPITAX ACCOUNT 387

stock has only a nominal value, and where the directors are
able to point out an immediate gain to the stockholder in
taking the new securities. When, however, the stock, even
though nondividend paying, has a speculative value and a
free market, due to the prevalence of rumors concerning its
prospects and earnings, or to reports that a contest for its
control will be waged, or that it is to be consolidated with
another corporation, it is then practically impossible to ob-
tain the consent of the stockholders to reduce the value of
their holdings sufficiently to enable the immediate payment
of dividends.

Take, for example, the Erie. This company has out-
standing $112,378,900 of common stock. The present com-
pany is now over twenty-five years old, and the common
stock has received no dividends. The surplus over fixed
charges has been barely sufficient to pay four per cent on
the $63,892,400 of preferred stock, which, however, has re-
ceived nothing since 1908. The preceding year showed a
surplus of only $540,110. In order to place the Erie upon
a dividend-paying basis, even making allowance for the
expected improvement in its earnings due to the recon-
struction of its property which has been in progress for
some years, it would require a reduction of the common
stock to about one-fifth of its present amount, to enable the
payment of a moderate dividend within the near future.
And yet the market price of the Erie is to-day (Aug. 1,
1920) $25% a share, and even in 1908, when its fortunes
were at the lowest ebb, and when a receivership was antici-
pated, the lowest figure reached by the common stock was
$12 a share. To reduce the common stock of the Erie from
$112,000,000 to $30,000,000, placing it upon a four per
cent basis, might result in a market price of' $40 a share.
A proposition to reduce this stock to a dividend-paying
basis would, therefore, be equivalent to asking the stock-
holders of the Erie to surrender about $20 worth of market
value with a fair prospect of higher prices in the future,
in return for four per cent stock which might be sold for

388 CORPORATION FINANCE

$40 a share. If the Erie stock were held by investors, this
proposition might be acceptable, but since such stocks are
held either for control or for speculation, it would be im-
possible to secure unanimous consent to a proposition to
reduce this amount.

A reduction of the capital stocL of small corporations
whose securities have no speculative value to a dividend
basis is feasible and desirable since it stops the accumula-
tipn of interest on the cost of the original stock to its
holders. With large public corporations, however, whose
stock contains an element of speculative value, this method
is not often available. '

An easier method of favoring the common stock in a re-
organization is to fund accumulative dividends on pre-
ferred stock. These dividends are only contingent claims.
They do not appear on the balance sheet as liabilities.
There is no valid claim against the corporation, on their ac-
count, and yet the moral obligation to pay these dividends
in some form is clear, and is generally recognized. Consid-
erations of expediency also influence a settlement. Suppose
a case like the following : A company issues $5,000,000 of
preferred stock and $2,500,000 of common stock. The pre-
ferred stock carries seven per cent of cumulative dividends,
and thirty-five per cent of unpaid dividends stand against
the common stock. The company earns $500,000 a year net
over charges, sufficient to pay the current dividends on the
preferred, and leave $150,000 to be applied to the accumu-
lated dividends. At this rate it will require eleven years to
pay the accumulated dividends, during which time the com-
mon stock will receive nothing. A proposition is made to the
preferred and common stockholders that the company shall
issue five per cent debenture bonds or five per cent second
preferred stock in exchange for these back dividends which
amount, as already stated, to about $1,750,000 on $5,000,000.
The debentures should sell, on the company's showing of
surplus earnings, at about 80. The fixed charges of the cor-
poration would be increased by the issue, $87,500 per year.

EEADJUSTMENT OF CAPITAL ACCOUNT 389

This proposition would appeal to the two classes of stock-
holders as follows: The preferred stockholder receives, in-
stead of a contingent right to $1,750,000 of dividends, that
amount par value of debenture bonds with a market value
of $1,400,000. There is little doubt that the preferred stock-
holder would accept a proposition so favorable. The com-
mon stockholder is equally advantaged by such a plan. The
earnings available for the common stock, after adding $87,-
500 to the fixed charges of the company, are $63,50,0, or
two and one half per cent on the par value of the stock,
on which one per cent can be safely paid. Without any
reduction of the pax value of his security, the common stock-
holder at once receives an income. Such a case as this is^
however, seldom encountered. Preferred dividends, when
cumulative, are usually paid, even at the sacrifice of the
permanent interest of the corporation. There are few cases
of accumulation so great as to seriously depreciate the value
of the common stock, and when this has occurred, as in the
Republic Iron and Steel Company, and the Crucible Steel'
Company, earnings have usually recovered so as to permit the
discharge of these back dividends without any scheme of re-
organization. Wherever preferred dividends are allowed
to accumulate to unmanageable proportions, however, the
method above outlined will be found in most cases desir-
able.

Stock may also be reduced by exchanging into bonds with
the consent of the statutory proportion of the stock. This
method is applicable to seven and eight per cent preferred
stocks issued by companies which are later able to place
junior issues of .bonds at fair prices. The most notable in-
stance of such a conversion is that of the United States Steel
Corporations bond conversion in 1902. On April 17, 1902,
the president of the United States Steel Corporation issued
a circular to the stockholders, which invited their coopera-
tion in a plan to raise $50,000,000 of new capital. Half of
this amount was to repay loans incurred by the constituent
companies for construction work which was, in part, ren-

390 COEPOEATION FINANCE

dered unnecessary by the ' merger, but which, owing to ad-
vance commitments, could not be suspended. In addition,
$35,000,000 was required for improvements, which, it was
stated, would effect an annual saving of at least $10,000,000.
The plan proposed to the stockholders for raising this money
was "to rearrange your corporation's capitalization (which,
in round numbers, now consists of $300,000,000 of bonds,
$500,000,000 of preferred stock, and $500,000,000 of com-
mon stock) by substituting for $200,000,000 of the preferred
stock, $200,000,000 of sinking fund sixty-year flve-per-cent
mortgage gold bonds, and by selling $50,000,000 of addi-
tional bonds of such issue for cash. As the preferred car-
ries seven per cent dividends, while the bonds would bear
but five per cent interest, the $50,000,000 desired could, in
this way, be added to the corporate resources, and the aggre-
gate of the annual charges for interest and dividends, in-
stead of being increased $2,500,000, would be decreased $1,-
500,000 as compared with the present sum total of these two
requirements."

The plan offered to each preferred stockholder the right
to subscribe to the new bonds to the extent of one half his
holdings of preferred stock, forty per cent of each subscrip-
tion to be payable in preferred stock, and ten per cent in
cash, or the subscription could be limited to forty per cent,
in which event no cash payment was required. This transac-
tion was assailed in the courts, and was delayed for a long
period by injunctions. It was finally abandoned after $150,-
000,000 of preferred stock had been converted. Conversion
of stock into bonds such as this plan provided, can only be
justified when the company making the conversion is so
strong in surplus earnings that the issue of the new bonds
will not jeopardize its solvency. Given this assurance, the
advantage to the common stockholder is in the reduction of
the payments which must precede his dividends, from the
rate on the preferred stock to the rate of interest on the
bonds issued in exchange.

We next take up the readjustment of the debt liabilities

KEADJUSTMENT ,0F CAPITAL ACCOUNT 391

of the company, dividing these into current liabilities, short
term notes, and long term bonds. Current liabilities, when
they exceed the normal amount in a particular industry,
must be paid, either by the sale of some of the assets,
or by the sale of bonds or notes. The methods of hand-
ling short term notes have already been discussed in Chap-
ter XXIII.

When these are issued on the security of collateral, if a
favorable opportunity arises to sell the collateral, provision is
usually made for its retirement before maturity. When
they mature, the method employed is either to sell the bond
collateral and so obtain the means of payment, or to extend
the notes, or to issue a new series of notes, or to take up
the notes with an issue of stock. In most extension agree-
ments, inducements are offered, usually in the form of higher
rates of interest, or better security on the new issue. A
syndicate may be organized to purchase the securities which
are to be issued to take up those maturing, and then to offer
to the holders of the maturing obligations the right to take
the new securities on a favorable basis. The ordinary induce-
ment is a cash premium.

The method of carrying through such a transaction is
shown by the refunding of the $6,000,000 of four and one half
per cent collateral trust notes issued by the Chicago, Eock
Island & Pacific Eailway Company in 1906. When these ma-
tured in April, 1908, the bond market was not in a condition
to justify the offering of a long term security. The company,
therefore, notified the note holders that it had arranged with
Speyer & Company for the extension of these notes for one
year, with interest at six per cent, subject to redemption at
the option of the company on sixty days' notice. It was stated
that " Holders who desire to extend their notes must present
them, the April 1st coupon, at the office of Speyer & Company,
on or before March 23d. A cash payment of $5 on each $1,000
note extended will be made to the holders availing themselves
of this offer. Holders who do not desire to extend will receive
par for their notes on April 1."

392 COEPOEATION FINANCE

Speyer & Company had arranged with the Railway Com-
pany to purchase such an amount of the new notes as were
not taken by the holders. The six per cent notes were of-
fered at 99.5, yielding 6J per cent per annum, so it is fair
to presume that Speyer & Company did not pay over 95 or
96. The more advantageous the extension offer is made, the
easier will be the terms that can be arranged with the syndi-
cate, since every note replaced with a new note lessens the
financial liability of the bankers.

A special method of funding floating debt, which has
been used for the relief of embarrassed companies, is the
funding or deposit of interest coupons. This may be ac-
complished by several methods: arrangements may be made
with a syndicate to purchase the amount of coupons which
it may be impossible for the corporation to pay, taking the
corporation's bonds as security, or the bondholders may be
asked to take stock or bonds in lieu of their coupons, or
they may be asked to deposit their coupons with some des-
ignated agent or trustee, foregoing their claim for inter-
est during the period. The first plan of funding cou-
pons is illustrated by the following announcement to cer-
tain bondholders of the Erie by President Underwood on
June 11, 1908:

To the Holders of Prior Lien Bonds and General Lien Bonds
Under the First Consolidated Mortgage:

" The extraordinary business depression, which has
seriously affected all the railroads throughout the United
States, has so reduced the net earnings of the Erie Eailroad
that there will be a deficit below the amount necessary to
meet fixed charges for the current fiscal year ending June
30, 1908. While it is confidently expected that with any
return to normal business conditions' this deficit will
promptly be made good, it is necessary for the company
temporarily to obtain the amount from other sources.

"To this end, among other things, it has been arranged
that the coupon for interest falling due at any time prior

EEADJUSTMENT OF CAPITAL ACCOUNT 393

to July 1, 1909, may be purchased for cash and, with unim-
paired lien, deposited and pledged under the collateral in-
denture of April 8, 1908, as additional security for the six
per cent collateral gold notes issued and to be issued there-
under, thus making the notes more available to the company
as a means of obtaining further cash if required, such notes
to be accepted at par by the purchasers of the coupons for the
amounts advanced for such purchase. While such temporary
relief will probably suffice for the maintenance and opera-
tion of the property during the current calendar year, it will
not be sufficient for the completion of the improvements be-
gun two years ago, but which have not yet reached a condition
where they are available for producing additional revenue
for the company.

" It was anticipated that the funds for such improve-
ments could be provided from the sale of your company's
general mortgage bonds, but, principally owing to the injury
done to your company's credit by the falling off in earnings
during the existing business depression, such bonds are not
now salable, except at prohibitive prices.

"As these improvements all serve to strengthen the
security of the prior lien and the general mortgage bonds,
it is expected that a plan will shortly be prepared for fund-
ing the coupons maturing on these bonds for a period suf-
ficiently long to enable the company, out of its current
funds, to complete the improvememts now under way,
and thus get the benefit of the large expenditures al-
ready made, but which, as above stated, remain as yet un-
productive.

"You are therefore notified that your coupons, falling
due July 1, 1908, will be purchased at par for cash by J. P.
Morgan & Company, upon presentation and surrender
thereof, on or before June 30, 1908, at their office. No. 23
Wall Street, New York."

The foregoing plan involved the sale to a syndicate of a
Bufficient amount of the collateral trust notes of the company

394 COKPOEATION FINANCE

to take up maturing coupons. The coupons so purchased,
aggregating $3,160,480, were to he pledged under the inden-
ture of the collateral trust notes, and the bankers accepted
for their advances an equal face value out of $4,500,000 of
the $15,000,000 note issue of 1908 which had been reserved.
When these notes were paid, the liability of the company, on
account of these coupons, lapsed.

This relief to the finances of the Erie was not considered
sufficient, and a further proposition was made to the bond-
holders, that they should accept bonds of the company,
instead of cash, for the coupons. This proposition, as finally
approved by the Public Service Commission for the Second
District of New York, was as follows: The company was
to issue $30,000,000 par value of collateral trust thirty year
five per cent bonds secured by general mortgage bonds which
had been authorized but which, as the statement of Presi-
dent Underwood shows, could not be sold at reasonable prices.
These bonds were to be exchanged for coupons on the gen-
eral lien and convertible four per cent bonds up to the
amount of $11,380,000, on the basis of par value of bonds for
the face value of the coupons. The company, on its part,
agreed to expend from income every six months, for im-
provements and additions to the property, an amount
equal to the interest so funded which had accrued during
the six months, this arrangement to continue for the five
years during which the funding of coupons was to go for-
ward. The advantages of this arrangement to the company
and to the holders of these junior mortgage bonds were as
follows :

The company was relieved of the necessity of paying
interest, which at that time was not being earned, and was
assured of $11,380,000 of new capital within five years on
which it paid five per cent interest. The refunding scheme
did not relieve it from the obligation of providing the money
necessary to pay the interest on these junior lien bonds, but
enabled it to apply this money to the improvement of the
property. To the bondholder the advantages of the reorgani-

EEADJUSTMENT OF CAPITAL ACCOUNT 395

zation were even more apparent. They wete set forth in a
statement issued on behalf of the company as follows :

"We have put into the property in the last few years
upward of $16,000,000 that has not been capitalized —
$8,154,381 charged against income and $8,345,829 charged
to capital account, and not yet represented by any bonds. In
seeking to capitalize these expenditures, we are asking the
assistance of our bondholders instead of outside investors, be-
lieving that we can get such assistance from the bondholders
on much more favorable terms. As you will notice, the
coupons are to be exchanged for the new bonds at par, where-
as on the balance of the issue not consumed by the funding
of the coupons or the refunding of the three year notes, the
Public Service Commission fixes a net price to the company
of 871

" We have, awaiting completion, on the Erie & Jersey
Eailroad and the Genesee Eiver Eailroad lines and others,
important improvements in the shape of cut-ofE and low-grade
lines into which we have put millions of money. We are not
yet in a position to reap the benefit of these improvements
because it will require several millions to complete them, and
we do not feel that we can take the amount necessary to
complete them from operating income. Therefore we are
undertaking to defer the interest on the general lien and the
convertible four per cent bonds and to put the equivalent
amount into the completion of the improvements in question,
so that at the end of the five years, the road will be in a
position to take up all its obligations and operate at a
profit.

" There is hardly any question as to our ability to do this.
In every year from the reorganization until last year the
Erie showed a surplus, including coal properties, of from $4,-
000,000 to $7,000,000 over its fixed charges. Last year, on
account of the extraordinary conditions, there was a deficit,
but the first six months of the current fiscal year show a
surplus from operation, and when the revenues from its coal

396 COKPOEATION FINANCE

are taken in, .there is a surplus of $3,000,000 for' the six
months. This is after all the interest has been paid, includ-
ing that which it is now proposed to defer, so that I do not
think there is any reasonable possibility of our being unable
to put the required amount into the property out of income
from year to year."

If the Erie did not obtain new capital, it must abandon
improvements on which a large amount of money had already
been expended and which were as yet unproductive. Un-
less this work could be carried through, the prospects of
the, compaiiy were gloomy. With the new capital, however,
there was every reason to believe that the Erie could be
placed on a basis of assured solvency, and that no such des-
perate remedies as that explained in the announcement of
President Underwood would in fact be necessary. The bond-
holders were not asked to forego their interest. They were
merely invited to invest their interest in the five per cent
bonds of the company, which would be well secured and
marketable at a price near par. The plan of the Erie for the
funding of coupons was unusually favorable to the bondhold-
ers. They were to receive their interest in the form of salable
bonds, but were assured that the amount of the interest
would be invested in the property. It was not found nec-
essary to put this plan into operation, owing to the im-
provement in the bond market, which enabled the Erie to
obtain the necessary money by selling its bonds as originally
contemplated. '

In most cases, the bondholders do not receive so much
consideration, the alternative being presented to them of
either depositing their coupons and foregoing, for a time,
their claim to interest, or taking the chances of bankruptcy.
In return for the deposited coupons, the company may issue
negotiable receipts. The usual method, however, is a simple
postponing of interest without equivalent. The first method
is illustrated by the plan for funding the coupons due from
August 1, 1908, to February 1, 1912, on the first mortgage
bonds of the Hudson Eiver Electric Power Company. This

EEADJUSTMENT OF CAPITAL ACCOTJNT ,397

contemplates the issue of $4,000,000 collateral coupon notes
in exchange for the coupons dollar for dollar : " In case of
default for thirty days in payment of interest, then so much
of the principal of the notes as is represented by deposited
coupons whose dates of maturity shall have been reached,
shall, at the election of the trustee, upon the request of the
holders of sixty per cent of the outstanding notes, become
immediately due and payable. And in case of thirty days
default in the payment of any portion of the principal of
the notes, the trustee shall, upon demand, restore to the re-
spective holders the coupons uncanceled." The deposit of
coupons without a return from the company is illustrated by
the action of the bondholders of the Deschutes (Oregon)
Irrigation Company who unanimously agreed on February
10, 1908, to surrender to a committee of the bondholders
the coupon due March 1, 1908, and also, if the committee
so requested, the coupon due September 1, 1908. The com-
pany was expected eventually to pay these coupons with inter-
est at six per cent, but in the failure to do so, or in the
event of a receivership, the bonds themselv-es were to be de-
posited with the committee. Here is a postponement of
interest for the benefit of a temporarily embarrassed cor-
poration. Action such as the foregoing is prudent. The
bondholders do not care to take over the property with the
responsibilities of its management. The expenses of receiver-
ship and reorganization might subject them to heavy losses.
When they can be readily reached, and the proposition
clearly presented to them, it should not be difficult to per-
suade bondholders to defer their demands for interest, in
order that the company may bridge over a temporary em-
barrassment.

Taking up now the readjustment of long term bonds, we
have, first, the conversion of bonds into stock; this has been
already fully discussed under the head of convertible bonds.
In Chapter XXIV it was shown that the advantage to the
company in using convertible bonds which were eventually
exchanged for etock was, in effect, the sale of stock at a

398 COKPOEATION FINANCE

higher price than could have been obtained fpr the stock in
the market and also, upon conversion, a reduction of its fixed
charges and a resulting improvement of its credit. The ad-
vantage to the stockholder is an opportunity for a speculative
pro^t, or to exchahge his four or five per cent security, for
a stock whose dividends may rise to such an amount as to show
him a large yield on his investment.

The usual adjustment necessary in long term bonds is
the conversion of one issue Into another. "We have already
discussed at some length (in Chapter VII) the general in-
expediency of providing for the payment in cash of bonds
at maturity. Such provision can only be made by the ac-
cumulation of a fund in interest-bearing securities, or to pay
off the debt, during its life, by installments, out of the in-
come. Since a growing corporation is continually in need
of money for improvements, and since the return on such
expenditures is usually far greater than the return on any
securities which could be purchased for the sinking fund,
it is for the interest of the company, instead of accumulat-
ing a sinking fund in bonds, to spend the equivalent of the
sinking fund on its property. Such a policy, however, makes
no special provision for the repayment of bonds at maturity.
Its object is to make the corporation so strong in assets and
earnings that when its bonds mature, there will be no dif-
ficulty in placing a new issue which can either be exchanged
directly for the maturing bonds, or can be sold for cash for
an amount sufiicient to pay off those bonds whose holders
wish to change their investment. ,

An additional reason for refunding bonds, instead of
accumulating a sinking fund to pay them, is found in the
fact that new enterprises usually pay high rates of interest,
owing to the limited demand for such unseasoned secur-
ities. If the corporation succeeds, its credit will im-
prove to the point of placing bonds at much lower rates.
When bonds mature, a considerable saving can therefore
be made by taking them up with other bonds bearing low
rates.

EEADJUSTMENT OF CAPITAL ACCOUNT 399

Eefunding of bonds may take place either before the
bonds mature, or at maturity. If bonds are issued subject
to call at a fixed price, no difficulty is presented in retiring
them. If, for example, a corporation issues $1,000,000 of
six per cent bonds at 90, callable at 105 after three years,
and if its credit improves to the point of selling a five per
cent bond at 95, it is profitable for the company to call the
six per cent bonds, replacing them with an issue of 5s. The
economy of the transaction can be represented as follows:

Amount of five per cent bonds at ninety-five re-
quired to produce $1,050,000 $1,105,262

Interest at five per cent on these bonds 55,263

Interest on the six per cent bonds which are retired, 60,000
Annual saving 4,737

Conversion before maturity is sometimes made in order
to provide for new financing with first mortgage bonds with-
out the provision in the mortgage that these bonds can be
issued for securities purchased. The opportunity may arise
for acquiring control of desired properties, by exchanging
bonds which carry stock control with them. The bonds out-
standing under the first mortgage, however, present an ob-
stacle to this transaction. In such a case, the bonds could
be called and replaced with a new issue secured by a mortgage
containing the desired provision. When such a conversion
is contemplated, the cost can be greatly reduced if a large
amount of the bonds, whose holders are not entitled to infor-
mation concerning the intention of the buyers, can be pur-
chased at the regular market price. The five per cent bonds,
for example, which might be callable at 105 would not sell
for more than 95. In anticipation of the conversion, ar-
rangements could be made with the house which placed the
bonds to accumulate as many as possible, in the interest of
the corporation, at the market price. In this way, the pre-
mium need only be paid on those bonds which it is impossible
to secure.

When bonds are not callable before maturity, and if they
cannot be purchased at reasonable prices in the interest of

400 COEPOEATION FINANCE

the company, certain inducements must be offered to the
holder. These may take the form either of better security
on the new bonds, or a higher market value in the new bonds
than those which are retired, or a. bonus of cash or stock.
An illustration of the method of accomplishing such a refund-
ing is furnished by the readjustment of the bonded debt of
the St. Louis & San Francisco in 1901. It was proposed to
take up thirteen underlying issues secured, for the mosl^
part, by first mortgages on certain portions of the company's
property, by issuing a refunding fifty-ryear mortgage bond,
of which $63,500,000 were reserved for refunding purposes.
By unifying the indebtedness of the sytem, the company not
only reduced interest charges, but was also enabled to finance
additions by selling bonds having an estahlished market
value. A syndicate was formed under the management of
J. & W. Seligman, which agreed to purchase for refunding
purposes $30,000,000 face value of the refunding mortgage
bonds. The syndicate then made the following offer to the
holders of the underlying bonds:

" To Holders of the Following Underlying Bonds :

" As Syndicate Managers of a syndicate formed under an
agreement dated April 4, 1901, we have arranged with the
St. Louis & San Francisco Eailroad Company to purchase,
for refunding purposes, $30,000,000, face value of its pro-
posed Eefunding Mortgage Gold Bonds, to bear interest at
the rate of four per cent per annum, and hereby offer to
exchange such refunding bonds (to the extent to which they
may be so issued and acquired by the syndicate), for under-
lying bonds of the railroad company's system, on the fol-
lowing basis:

EEADJUSTMENT OF CAPITAL ACCOUNT 401

Fob E.icH $1,000 Faou Valtib of

THE FOLLOWINQ OttTSTANDINQ

Bonds

In Refund-
INO Bonds,
Face ■
Val0E

Cash

Market

Price
(Added)

1. 6% Second Mortgage A,

B and C Bonds

2. 6% Missouri & Western

Division First Mort-
gage Bonds

$1,166.66

1,282.05
1,282.05

1,369.23

1,194.87
1,179.49

1131 and int.

125 " "
125 " "

133§ " "

116i " "
115 " "

Range on
June 8, 1901

112-1144

3. 6% Trust Bonds of 1880 . .

4. 6% General Mortgage

Bonds

134-135i

5. 5% General Mortgage
Bonds

118-118i

6. 5% Trust Bonds of 1887. .

7. 6% St. Louis, Wichita &

Western Fi^t Mort-

102J-112

gage Redeemable
3onds

1,179.49

1,128.20
1,025.64
1,051.28
1,000.00
876.93

1,051.28

974.35
1,025.64

115 " "

110 " "

100 " "

1021 " ",

97i " "

85J " "

im " "

95 " "
100 " "

8. 6% Fort Smith & Van
Buren Bridge First
Mortgage bonds (re-
deemable)

9. 5% Southwestern Division
Bonds (redeemable) .

10. 4% Central Division

Bonds (redeemable) . . .

11. 4% Kansas City Division

Bonds (redeemable) . . .

12. 3% Kansas City Division

Bonds' (redeemable) . . .

13. 4% Northwestern Divi-

sion Bonds (redeem-

14. 4% Red River Division
Bonds

15. 4% Consolidated Bonds. .

" At the time of deposit, holders of underlying bonds will
receive payment in cash of the unmatured interest accrued
and accruing upon their deposited bonds to July 1, 1901,
from which date the refunding bonds are to bear interest."

A comparison of these two tables with the third, giving
the current market quotation of the more important of these
underlying bonds, sh»ws the advantage to the holders of ac-
cepting the syndicate's offer. The price offered was, in every
27

402 COEPOKATION FINANCE

case, higher than the current market quotation. Further-
more, the bondholders received in exchange for bonds in-
. eluded in various small issues, the bonds of a large issue which
they could readily market, and which would be accepted by
banks as collateral security to a high percentage of their par
value. These bonds were offered on an exchange basis, at
prices which were, on the whole, more favorable than could
have been secured in the market. The offer in cash was
slightly below the offer in bonds, and the only question which
could arise in the minds of the holders concerning the ac-
ceptance of the bond offered, was whether the new four per
cent bond would sell at par. At the time, there was every
indication that the new bonds would sell at a high price.
For the nine months ending March 31, 1901, the St. Louis
& San Francisco had shown surplus earnings over fixed
charges of $1,451,817, and it was estimated that, for the
year, these surplus earnings would be $1,725,000. The direct
saving in interest by the refunding, in case all the bonds were
got in, was $70,000. In addition, it was expected that earn-
ings would be largely increased as a result of capital ex-
penditures then in progress. The sequel proved, however,
that of the holders of the underlying bonds, those who ac-
cepted the cash offer chose the better part. The general
four per cent bonds have sold below par ever since that date.
The offer by the syndicate of these favorable terms was
intended to reduce the amount of cash required. If all
the bonds could be called in and exchanged, the syndicate
could pay for the $30,000,000 of refunding bonds with the
old bonds, advancing only a small amount of money, and
retaining the surplus amount of bonds for sale.

When bonds are called at maturity, they may be taken
up with stock or with new bonds or with notes, or the old
bonds may be extended. The methods of accomplishing these
various fo^rms of refunding have already been considered in
connection with the handling of maturing note issues and
require no extended discussion here. "The usual method is to
employ the bonds of an issue previously authorized for tha

EEADJUSTMENT OF CAPITAL ACCOUNT 403

purpose of refunding. Careful provision is made in the
mortgage for satisfying the claims of all maturing bonds,
and for releasing the property from the underlying mortgages
in order that it may come directly under the security of the
general mortgage. When the bond market is unfavorable,
notes may be employed to fund maturing bonds, or the bonds
may be extended. In the latter case, extra inducements must
be offered to the holders of maturing bonds to induce them
to defer their claims.

CHAPTEE X

RECEIVERSHIPS

IiT our study of the corporate mortgage we have seen how
large and sweeping are the powers of the trustee in refer-
ence to the disposition of the corporate property in the
event of bankruptcy. The trustee has the authority to enter
upon the property of the corporation and to operate it, col-
lecting the receipts. Out of the receipts he is to pay its
debts. He may also proceed against the company, and se-
cure a sale of the property under the mortgage, applying the
proceeds to the liquidation of its indebtedness. The theory
of the mortgage, therefore, is that the property of a cor-
poration which fails to pay its debts is to be seized by the
trustee and sold, the proceeds being applied in satisfaction
of its obligations. The powers of the trustee of a corporate
mortgage have been taken over from the language of real
estate mortgages. It is the custom, in case of default of in-
terest or principal on debts secured by real estate mortgage,
for the creditor to realize on the property of the bankrupt
by having it forthwith sold under the authority of the court,
compelling the owner to either bid enough at the sale to pay
off the indebtedness or to forfeit possession of it. It is also
customary in the settlement of the affairs of mercantile
houses which become insolvent that the creditors should
seize their stocks of merchandise and forthwith have them
sold by the court for their benefit. While similar remedies
are apparently preserved to the creditor of a corporation in
the terms of the mortgage by which his bonds are secured,
404

EECEIVEESHIPS 405

the theory of the corporation mortgage cannot, in many
cases, be carried out.

Most business corporations are organized in the field of
manufacturing, mining, or transportation. They conduct
their busiuess with properties, which, unlike real estate or
merchandise, are highly specialized to some particular use,
and can be used for no other purpose. Take, for example,
the property of a railroad. It consists of terminals, on which
stand certain buildings which can be used for nothing else
than the purposes of the railroad, of certain real estate in
the form of strips of land 100 feet wide and thousands of
miles in length, between which runs the track, consisting of
rails, spikes, fish plates and ties, and laid in ballast. Over
this track runs the railroad equipment consisting of cars and
locomotives. We have here a different kind of property from
a store building or a farm. The property of the railroad can
be used for no other purpose than the transportation of
passengers and commodities. If sold, it must be sold to an"
other railroad company.

' Furthermore, a railroad property is a unit. To the suc-
cessful operation of a railroad, all the items above enumerated
are essential. A railroad must have main liues and it must
have branch lines. In many cases it must control coal min-
ing companies which furnish it traffic. It must own large
amounts of real estate at its terminal points, and must have
the necessary number of cars and locomotives, a stock of ma-
terials and a cash balance. All of this property is neces-
sary to the operation of the road. No part of it can be sep-
arated from the others and sold without destroying a large
part of its value. Furthermore, a railroad company may
have valuable charter and franchise privileges, without which
its operations could not be conducted. It has built up over
a number of years a wide-spreading business organization
by means of which it obtains traffic. The value of this prop-
erty depends on the income which can be obtained from its
use. If we look on the value of the company's property as
the capitalization of the net earnings accruing from the

406 COEPOEATION FINANCE

operation of that property, we must admit that, to the earn-
ing of these profits, not merely a physical property but fran-
chises and business organization are indispensable.

It follows, therefore, that if the creditors of the company
should enforce the liens of their mortgages, and should take
the property away from the company, especially in those
cases where the different mortgages cover different portions
of the property, in which event the enforcement of their
liens will break the property to pieces, a large part of the
value of this property will be immediately destroyed. In
this value of the property, based upon its earning power,
consists the security of creditors and the equity of stock-
holders. If, however, the creditors' claims are allowed to
take their natural course of suit, judgment, attachment, and
execution, the property of the company will be broken up,
its working capital seized, the equipment haided off its lines,
its terminals taken from it, its organization destroyed, the
franchises are perhaps lost and its earning power reduced to
nothing. The effect is generally to make it impossible for
ihe stockholders to recover any value from the wreckage, and
to seriously jeopardize the security of even underlying mort-
gage bonds supposed to be fully protected by surplus earn-
ings.

When a corporation approaches, bankruptcy, it usually
occurs that different portions of its property have been
pledged as security for various issues of bonds. If the com-
pany is operating a railroad, for example, there are several
first mortgages covering the different divisions of the main
line of the railroad. Then over these is probably spread the
lien of a general or blanket mortgage. Tributary to the
main line of the railroad are a number of branch lines, and
each one of these may carry mortgages to secure issues of
bonds. These bonds have probably been delivered to the
parent company in repayment of advances to the subsidiar}'
company. The parent company may have pledged the bonds
as security for an issue of collateral trust bonds. The equip-
ment of the company may be covered by the lien of a car

EECEIVERSHIPS 407

trust lease. The company perhaps operates coal-mining com-
panies which have bonds outstanding against them. The
terminal properties may also be pledged as security for sep-
arate mortgages. In addition to all these complexities of
obligations, there may be unsecured debentures outstanding,
issues of short-time notes and bank loans, money due em-
ployes and to concerns which have furnished supplies and
materials to the railroad. Suppose, now, each one of these
creditors should undertake to enforce his claim against the
company, which he has the undoubted right to do. Is it not
evident that the property would be completely disintegrated
in the contest of creditors? Each set of creditors would
make off with a piece of the corpus, and the value of the
property, after it had been torn to pieces by the creditors,
would have little relation to its value as a going concern.
The organization of the business would be broken up, its
markets destroyed, its good will extinguished.

It is manifestly the concern of all parties that the credi-
tors should be prevented from exercising their rights under
their various mortgages and liens, and that the property of
the company should be placed beyond their reach so that the
continuity of its operations may be undisturbed, and its
earnings may continue to accrue until such settlement of
its affairs can be made as will preserve the value of the
property. The unsecured creditors, if they obtain judgment
and levy execution, can usually find some property to at-
tach, some cash or materials which have not been pledged
as security for any loan, but if they laid their hands upon
the working capital of the company, they may compel it to
cease operations, thereby reducing their chances of recov-
ering anything more than what they have seized to zero. As
for the secured creditors, if they sit passive and allow
the merchandise and bank creditors to prey upon the com-
pany, they may find their own security rapidly disappear-
ing. But if they enforce their rights, then neither stock-
holders nor unsecured creditors are likely to receive any-
thing.

408 COEPOEATION FINANCE

A typical situation ' resulting in an application for a re-
ceivership is described in a letter of President Bush, of the
Western Maryland Eailroad Company to the directors of
that company in March, 1908, in which he sets forth the
reasons leading to the receivership:

"The gross revenues of the railvray for the six months
ended December 31, 1907, increased $540,735, or 20.333 per
cent, and the net revenues increased $350,176, or 30.324 per
cent over those of the corresponding period of the last fiscal
year, vrith a resulting surplus over all fixed charges, includ-
ing the abnormally high cost of temporary loans and re-
newals.

" The company is not confronted with any failure of its
revenues to cover its full fixed charges, and its business has
maintained a steady growth with unmistakable assurance of
continued development. It has, however, maturing obliga-
tions, arising out of its temporary provisions for capital ex-
penditures, and it must at an early date encounter the
problem presented by the commodity clause of the Federal
rate law.

" As you are aware, this company has outstanding loans
maturing April 1, 1908, to the amount of $3,776,750, se-
cured by pledge of $5,037,000 of its first mortgage bonds.
The market price of these bonds — originally in considerable
excess over the loans, has, notwithstanding substantial in-
crease in gross and net revenues, shrunk to a level below the
face of the loans.

" It has now become apparent that the company will be
unable to meet these loans or to provide additional collateral
to secure their extension. In this situation, the company
itself will, of course, be unable to borrow the money neces-
sary to meet mortgage interest falling due on the first of
April next."

It may be possible, in rare instances, to secure the coop-
eration of all creditors in deferring the enforcement of their

EECEIVEESHIPS 409

claims, and to give the company an opportunity to recover
itself without the expense of a receivership. When there
are only bondholders to consider, in case the holders, of the
number of bonds without which the trustee cannot be forced
to act, can cooperate with the trustee in protecting the com-
pany, the necessary relief can be afforded without a receiver-
ship. Sometimes bondholders' committees will advance
funds to meet pressing claims. As a general rule, however,
creditors cannot be brought together, and the property must
be protected against their assaults.

The property can be placed beyond the reach of the cred-
itors by invoking the aid of a court of equity, the direct rep-
resentative of the sovereign power of the state which cre-
ated the corporation, one of whose recognized duties is to
take charge of the estates of bankrupt individuals, firms, or
corporations, and to preserve this property until the creditors
can make a settlement with the bankrupt, or until a sale can
be made of the property on more favorable terms than can
be obtained by the creditors acting each for himself. The
court takes charge of the estate of a bankrupt corporation
through its agent, who is known as a receiver. The receiver
is an ofiBcer of the court to whose charge is intrusted the
estate of the bankrupt corporation. The judge, in placing
the property of the company in the hands of a receiver, takes
it away from the corporation, puts it out of reach of the
creditors, and places it in a position to be secured, both from
the mismanagement of officers and directors and the attacks
of its creditors.

The reason for the appointment of a receiver has al-
ready been indicated, namely, to conserve the value of the
company's property. He is often appointed at the instance
of the directors who see long before any creditor the impend-
ing insolvency of the company, and who, at the first threat
of disaster, fly to the shelter of a court of equity. The situ-
ation is something as follows : A federal judge is approached
by directors of some corporation which is in difficulty, either
in his court room or privately. Accompanying the directors

410 COKPOEATION FINANCE

' is a creditor of the company. The attorney of the company
informs the judge, to whom in most cases he is well and fa-
vorably known, that his client, the A. B. Corporation, is in-
solvent and he produces a creditor as evidence of the fact.
The creditor states that the company owes him certain money,
ahd the officials of the company are there present to confirm
that the debt is due, and that the company is unable to pay
it. In the interest of all parties concerned, therefore, the
court is asked to appoint a receiver to take charge of the
property until a settlement pi its affairs can be obtained.
The plea is forcibly made that unless the court intervenes,
by appointing a receiver, the creditors of the company will
seize upon its property and will render it unable to perform
its functions. It may be represented that the embarrass-
ment of the company is due to special and exceptional causes,
and that, if the court takes its property under its protection,
a few months will suffice to extricate the company from its
difficulties. This procedure is known as making out a prima
facie case for the appointment of a receiver.

• If the judge suspects no fraud in the matter, he forthwith
appoints a receiver, first temporarily, until the other parties
in interest can have an opportunity to be heard, and after-
wards, unless good reason appears for discharging the re-
ceiver, the receivership is made permanent. "While most bank-
rupt companies do not present such a complex situation as
we have supposed, there are usually at least three conflicting
interests to be considered : secured creditors, unsecured credi-
tors, and stockholders. The stockholders, it is true, have no
claim against the company for money loaned, but they have
an interest in the company which will be sacrificed if its prop-
erty is torn from it. It may happen, for example, that the
embarrassment has been caused by the maturing of a note
issue which, owing to the condition of the bond market, can-
not be funded at that time. Otherwise, the company may be
libundantly able to meet its obligations. The stockholders
have here an interest which deserves recognition and pro-
tection.

EECEIVEKSHIPS 411

The receiver whom the judge appoints is usually an offi-
cial of the bankrupt corporation, often its chief counsel.
The reason for making such an appointment is that the
judge, not being familiar with the operation of a railroad or
manufacturing concern, wishes to install one conversant with
the business and who can carry it on successfully. If he
appointed a stranger to the property, it might suffer injury.
When a receiver is shown unfit to hold this position, or if it
can be made to appear to the court that with a particular
receiver in control of the property, bankers will not come to
its assistance, the receiver may be removed. When large pub-
lic companies apply for the appointment of a receiver, the
court is usually careful that the appointment is acceptable
to all interests concerned. President Bush, of the Western
Maryland Eailroad Company, for example, was appointed re-
ceiver of the property of that company. On the other hand,
in 1893, President McLeod, of the Philadelphia & Eeading
Eailroad Company, who was at first appointed receiver, was
later forced to resign, owing to the opposition of banking in-
terests who held him responsible for the failure of the com-
pany.

Immediately following his appointment, the receiver as-
sumes possession of the property of the company under the
authority of an order of the appointing court, which usually
authorizes the receiver:

(1) To take possession of the property of the corpora-
tion; to keep this property in good condition and repair, and
to operate the property just as the corporation operated it;

(3) to receive the income from the property and to ap-
ply this income under the, direction of the court to the pay-
ment of operating expenses and fixed charges;

(3) to collect all debts due the company, and to defend
all suits to which it may be defendant.

In the performance of these functions, the receiver may
employ such counsel or agents as he may deem necessary.

412 COEPOKATION FINANCE

He must ascertain as accurately as possible the status of
the corporation, and make a report to the court. He must
also make further reports from time to time, and must ob-
tain express authoriiy for any extraordinary action, such as
the discontinuance of interest on bonds or the sale of cer-
tain property.

, In carrying out his duties, it is necessary for the re-
ceiver to provide money. When he takes charge, he usually
finds a large amount of wages and audited vouchers due and
unpaid. The property of the company has usually been
allowed to deteriorate, no money being spent out while the
directors were endeavoring to tide over their period of trial.
He also finds various issues of bonds whose holders set up a
claim to the earnings accruing from the operation of the
business. There are also claimants imder the lease of prop-
erty which it is necessary for the company to retain. This
situation requires that the receiver should provide a large
amount of money at once to liquidate the more pressing claims
against the company. He must then take up the question of
dealing with the various creditors who may in the meantime
have brought suit, usually in the court which has taken charge
of the property, to establish their various claims. In carrying
out these duties, the receiver must raise a considerable amount
of money. He has three sources to rely upon. First, such ,
part of the income of the company as is not required to pay
operating expenses, interest, and rentals ; second, the interest
and rentals themselves ; and third, the use of a form of obliga-
tion known as the receiver's certificate. ■

The receivership may have been caused by the inability of
the company to fund or extend an issue of short-time notes.
Aside from this, the company may be solvent, able to pay all
interest claims. If the property is earning more than enough
to pay the fixed charges of the company from which it has
been taken by the court, and in case the receiver elects to
pay those fixed charges, he can use the surplus income in his
hands to defray any proper expenses of the company. In
but few cases, however, is this surplus income sufficient for

EECEIVEESHIPS 413

the receiver's needs. He must obtain additional funds.
These he gets, in the first instance, by reducing the fixed
charges of the company, by simply declining to pay certain
amounts of interest and rentals. The creditors are power-
less. The property ■which secures their obligations is in the
receiver's hands, they can obtain their interest only by an
order of the court. If, in the opinion of the receiver, whom
the judge usually supports, the needs of the property re-
quire such action, he need pay no interest, and may apply
all of the money which would otherwise go to the creditors,
to pay the pressing obligations of the company. As a rule,
however, whan interest has been earned, it is paid by the
receiver.

The owners of leased property need not submit, unless
they desire, to the forfeiture of the rentals. The receiver
has no title to their property; his possession of it depends
upon his carrying out the covenants of the lease under which
the corporation secured it. The lessor company, in case he
fails to pay their rental, may, at any time, resume possession
of the leased property, and may sue as general creditors for
any unpaid balance on the rental or for any other damage
which they may have sustained. When leases are profitable
to the lessee, there is no danger that the receiver will run any
risk of losing control of the property. With unprofitable
leases, however, this method of refusing to pay rentals which
have not been earned has been largely employed. Stock-
holders in the lessor company, in such a case, are deterred
from acting in defense of their rights by the practical impos-
sibility of making an advantageous arrangement for the dis-
position of their property elsewhere. In few instances, how-
ever, does the receiver carry his powers to this extreme. He
is usually satisfied to pay interest and rentals where interest
and rentals have been earned, and to refuse to pay only in
those cases where the property has not produced a suflScient
revenue to meet the specific charges upon it.

The disbursement of the revenues coming into the re-
ceiver's hands is made under the supervision of the court

414 COEPORATION FINANCE

appointing him. An illustration of the method usually fol-
lowed is furnished by the following quotation from a:^ order
issued by Judge Lacombe, making permanent the receiver-
ship of the New York City Eailway :

" In the matter of improvements the receivers are for-
tunately relieved, at least in part, from the burden of de-
vising improvements in the systenf by the existence of the
Public Service Commission.

"The receipts from car service will be devoted first to
maintenance, including all necessary repairs and replace-
ments. Next in order are certain fixed charges in the na-
ture of rentals and interest falling due on various mortgage
bonds of such roads, which by the terms of the leases, the
New York City Eailway Company has covenanted to pay.
It would seem to be to the public interest, because of facility
of transfer, that the roads which were being run by the City
Eailway when receivers were appointed, should be operated
as a unit. Por the present, therefore, the receivers will con-
tinue to pay such rentals and mortgage interest.

" This will not include the rental in the Third Avenue
Eailroad which will fall due the last of this month. A
clause in the lease of that road provides that default in the
payment of any installment of that rental cannot be availed
of for six months. Long before that time sufficient informa-
tion can be gathered (and made public) by the receivers to
give such enlightenment as to the whole situation as will en-
able the court to deal understandingly will all questions as
to payment of all these items of rent and mortgage interest.
"Before default is made in any case (except the one
above referred to and the rental due October 15 to the Met-
ropolitan Street Eailway) petition will be filed setting forth
alll the facts bearing on the question and asking instructions,
and a day will be fixed on which not only the parties to the
suit, but all in any way interested (including the Public
Service Commission) will be heard as to the most equitable
and wisest course to pursue.

" Fntil further order, the receivers will also, if the other

RECEIVEESHIPS 415

parties to such arrangements consent, carry out the arrange-
ments by which the New York City Eailway Company op-
erates certain railroads not under lease, such as the Dry Dock
East Broadway & Battery Eailroad and the Union Eailway."

To obtain the money required, the receiver usually re-
sorts to the use of receiver's certificates. A receiver's certifi-
cate is, in effect, a short-term note secured by a first mort-
gage upon all the property in the receiver's hands. It is
true that when the property was in the possession of the
company the title to the property may have been vested in
trust for the payment of bonds with a trustee. By the ap-
pointment of a receiver, however, the court takes into its
own possession the title to the property, and, like any other
owner, can pledge any of its possessions as security for a
loan. These certificates may be either without date, or they
may run for a definite period. An illustration of the first
kind of receiver's certificate is the following, issued in 1880
by the receivers of the Philadelphia & Beading Eailroad
Company :

Eeceivers' Office, Philadelphia & Keading Eailroad

Company.
Philadelphia, May 24, 1880.

This is to certify that there is due to or order

from Edwin M. Lewis, Franklin B. Gowen and
Stephen A. Caldwell, receivers of the Philadelphia
& Eeading Eailroad Company (and not individually)
one thousand dollars, on account of money borrowed by
said receivers, under order of court, for payment of
wages and interest upon certain mortgage indebted-
ness of said company.

This certificate is transferable by indorsement, and
redeemable after ten days' notice by advertisement in
one or more daily papers of the City of Philadelphia,
of the readiness of the receivers to make payment
at the expiration of which notice interest thereon shall
cease. Eeceivers,

(Signed) W. McKenna,

Circuit Judge.

416 COEPOEATION FINANCE

The later form of certificate is illustrated by those is-
sued in 1910 by the receivers of the Illinois Tunnel Com-
pany :

This is to certify that for value received Charles
G. Dav?es and David E. Forgan, as receivers of the
Illinois Tunnel Company, and not individually, are in-
debted to the bearer hereof in the sum of one thous-
and dollars ($1,000), payable at the National City
Bank of New York, in the City of Nev? York, or, at
the option of the holder hereof, at the Continental
National Bank, in the City of Chicago, two years from
the date hereof, in gold coin of the United States of
America of the present standard of weight and fine-
ness, with interest thereon at the rate of six per
cent (6%) per annum, payable semiannually, in
like gold coin, on the first days of October and April,
upon presentation and surrender, at one of the places
therein specified, of the coupons for said interest as
they severally mature.

This certificate is part of an issue of certificates of
like tenor and date not exceeding in the aggregate the
principal sum of three million five hundred thou-
sand dollars ($3,500,000) at any one time outstanding,
authorized by an order of the Circuit Court of the
United States for the Northern District of Illinois,
Eastern Division, dated the 16th day of March, 1910,
and on said day filed in the office of the clerk of said
court, entitled in two certain actions pending in said
court and consolidated under the title of The Cor-
poration Trust Company against Illinois Tunnel Com-
pany and Central Trust Company of Illinois, as Trus-
tee, against the Illinois Tunnel Company, and others.
This certificate is issued pursuant to and is entitled
to the benefits and security specified in the foregoing
order, subject to all the terms and provisions whereof
this certificate is issued and held. Among other
things it is provided in said order that:

" Said certificates of indebtedness to the amount of
the principal and interest thereof shall constitute a
lien upon all the property of every nature and descrip-
tion of the defendant Illinois Tunnel Company, and
upon the telephone system which may be constructed

EECEIVEESHIPS 417

by the said receivers, and upon all equipment and
other property that may be acquired or provided by
means of the said certificates or the proceeds thereof,
and upon all net earnings and income which may here-
after result from the operation of the property in
charge of the said receivers, which lien shall be prior
to the lien of the judgment received in this court
by the Corpor?,tion Trust Company against the Illinois
Tunnel Company on December 1, 1909, for $1,129,-
428.64 and prior to the lien of the First Mortgage or
Deed of Trust, dated December 1, 1903, made by the
Illinois Tunnel Company to the Equitable Trust Com-
pany, Chicago as Trustee (under which indenture the
Central Trust Company of Illinois is now the duly
constituted and acting successor Trustee), and prior
to the rights of the holders of any and all bonds is-
sued under the said First Mortgage or Deed of Trust."

These obligations are managed like short-term notes.
They may be issued to consolidate other issues of the same
kind; they may be called at any time; or they may be ex-
tended at maturity.

Money is provided by receivers' certificates for various
purposes. These obligations are usually issued in small ,
amounts, soon after the receiver takes charge, to pay pressing
claims, e. g., for wages and supplies. Larger issues may pro-
vide for repairs which are necessary to the operation of the
property. As a rule, a receiver will go no further than this
in asking authority to issue receivers' certificates. Bond-
holders can have no objection to the provision of money for
tlie purposes indicated. It is true that the lien of the cer-
tificates precedes that of the first mortgage, but if the re-
ceiver did not provide the money, the property could not be
operated economically 'and its value would dwindle to the
injury of its creditors. Eeceiver Frederick W. Whitridge,
who took possession of the Third Avenue Eailroad on Janu-
ary 12, 1908, on May 9th, reported to the Chairman of the
Bondholders' Committee, showing the situation arising out
of tne previous neglect of the property with which the re-

418 COEPOKATION rrNAJ>fCE

ceiver must promptly deal, if he is to maintain and increase
its earnings. This portion of his report is, in part, as fol-
lows:

"Physical Condition. — The general conditions of the
Third Avenue Kailroad were very bad; there were no offices,
no supplies, or material- on hand; the shops had been ne-
glected; the track was and is in very bad shape; the cars in
need of extensive repairs. The power house alone was in
good condition.

" The supplies and material immediately necessary, most
of which has been received, amounted to $50,000. Sprink-
ling apparatus in all of the barns and the cost of the various
other fire apparatus essential to secure new insurance, the
old policies, after the repeated fires in the New York City
Eailway barns, having been nearly canceled, amounted to
$135,000; I hope presently that the property upon the sys-
tem will meet the requirements of the most exigent under-
writers.

, " Car Repairs. — Of the 567 cars delivered to me by the
New York City Eailway Company receivers, there was not
one on which some work was not immediately necessary. I
ordered a sufficient number of n^w motors and controllers
(50) to fully equip every car in the system. I estimate the
total cost of putting all the cars in order, including the new
motors and other electrical equipment, to be approximately
$300,000.

" Repair to Track. — In many places on the main line of
the Third Avenue track the contact rail is completely worn
away, the slot rail very thin, and the car rail worn to the
breaking point. Paving of the tracks, in accordance with
the city ordinance, with Belgian blocks, will save $5,000 or
$6,000 a year in maintenance. Under a temporary arrange-
ment with the New York City Eailway receivers, we are to
repair the crossings on joint account. Altogether there will
be needed for the track this year about $436,000 and there-
after, with a liberal Allowance for maintenance, I think

EECEIYEKSHIPS . 419

no further expenditure will be necessary for some years to
come.

"Buildings. — The building at Sixty-fifth Street and
Third Avenue needs extensive repairs to the roof, and in or-
der to enable the shops to do their work certain other struc-
tural alterations are required, bringing up the total cost to
about $151,000 for $14,821 of which amount I have let con-
tracts.

" At 129th Street and Third Avenue there is, in front of
the car bam, a building used as a hotel and several tumble-
down stores or saloons. I propose to clean out the main
building and construct therein proper offices for the Third
Avenue and other lines; also accommodations for a club for
the employees, which are much needed. The whole improve-
ment will cost nearly $106,000."

To meet the cost of these and other improvements and
payments, the receiver stated:

" I intend to ask the court for authority to issue $3,500,-
000 of receivers' certificates, payable within one year and
bearing interest at the rate of six per cent. With those and
the earnings from the property I think I can do all of the
work and make all the payments which I have herein enu-
merated. It may be desirable to issue a certain number of
certificates of the Union Railway, to an amount necessary to
pay for the car barns, the Bronx & Pelham Parkway construc-
tion, and for the power station, not exceeding in all, however,
$750,000, which could later be taken up by the Third Avenue
certificates ; or it may be desirable, while having authority, to
issue certificates for the Union Eailway, as above mentioned,
as I already have authority to issue certificates for the Forty-
second Street and the Dry Dock railways of which I have not
availed myself, to issue Third Avenue certificates for the whole
amount of $2,500,000 directly, as the bankers may prefer those
to certificates of the other roads. If the certificates of those
Gubordinate lines could be used permanently, the Third Ave-
nue certificates should be diminished pro tanto, but in any case

420 COEPOEATION FINANCE

only certificates for $2,500,000 for one year will be out-
standing."

Cases may arise, however, when receivers must go much
further in the issue of these obligations than the payment of
accrued wages and the making of necessary repairs. The
property of the company, as wiih the Illinois Tunnel Com-
pany, may be only in part completed. Unless it is finished
at once, it may not be possible to secure profitable business.
For example, in anticipation of the construction of a power
plant, contracts with consumers may have been signed whose
binding force depends upon "the delivery of power before a
certain date. The company may have failed, leaving the
plant half finished, and a receiver takes charge of the prop-
erty. He finds a rival concern ready to run lines into this
section and seize the market for power. The receiver, under
these conditions, may have no choice but to mortgage the
property to obtain funds for its completion in order to de-
liver power and secure the benefit of the contracts. He takes
this action as much in the interest of the creditors as of the'
stockholders. Unless receivers' certificates were issued, the
power plant when finished would find its market absorbed
by its rivals.

Existing creditors of the company are violently opposed to
the issue of receivers' certificates of large amount and often
appeal to the court not to allow the receiver to place this
new encumbrance ahead of the lien on their security. Their
pleas are, however, usually disregarded. The court stands
by its own appointee, the receiver, and is usually guided, as
to the necessity of the issue of certificates, by the receiver's
recommendations. The amount of money which the re-
ceiver will spend upon the property depends on his concep-
tion of his duties. If he looks upon his obligation as merely
' to preserve the business, as it were, in a state of suspended ani-
mation, doing as little as possible to repair or improve the
property, merely protecting it from the onslaught of creditors
until the different interests can be adjusted and the receiver

EECEIVEESHIPS 421

discharged, he is not apt to issue more certificates than are nec-
essary to pay the claims which press upon him in the form
of unpaid wages, etc., when he takes charge of the property.
If, however, he interprets the word conservation in its broad
sense, he may conceive it to be his duty not only to preserve
the property, but also to do all things necessary to increase
its e£Bciency. In carrying out this obligation he may bor-
row large sums of money, and he may do a considerable
amount of important work and even neyr construction. An
illustration of this conception of the receiver's duties is fur-
nished by the receivership of the Baltimore & Ohio Eailroad
Company.

The receivers appointed for the Baltimore & Ohio in
1896 were Mr. John K. Cowen and Mr. Oscar G. Murray.
They were confronted with a difficult situation. The prop-
erty of the companyiL'^^s in need of entire reconstruction.
Ties, roadbed, rails, bridges, piers, cars, and locomotives
were sadly in need of replacement or repair. The equipment
of the company was particularly defective, a large number
of freight cars and locomotives being out of service, and the
equipment available for use being entirely insufficient to take
care of the traffic offering. Moreover, the competitive situa-
tion of the Baltimore & Ohio was at this time peculiarly
unfortunate. To the north lay the Pennsylvania, equipped
to handle traffic at the lowest cost. On the south the Chesa-
peake & Ohio was a vigorous competitor, both for through
traffic from the West and for the rapidly growing coal traf-
fic out of West Virginia. Unless the Baltimore & Ohio was
to abandon the field to its competitors, it must be placed in
a position to carry traffic at the lowest possible cost. In other
words, the Baltimore & Ohio must be entirely reconstructed.

Should the receivers reconstruct the road, obtaining
funds by the issue of their certificates, or should they con-
tent themselves with keeping the system together and in pas-
sable running order, leaving the work of rebuilding to the
officers of the company after it had been provided with funds
in a reorganization? The receivers wisely chose the first

422 COEPOEATION FINANCE

alternative, notwithstanding powerful opposition and a vig-
orous controversy between their friends and men who as-
serted that they were exceeding their authority as receivers.
New capital had to be issued eventually. To delay the work
of improvement meant at least temporary abandonment of
the competitive field, and the loss of advantages which
might never be regained. Mr. Cowen and Mr. Murray faced
the issue squarely. As receivers of the Baltimore & Ohio
they issued within two years $10,742,000 of receivers' cer-
tificates, in addition to a large amount of car-trust obliga-
tions. A portion of these certificates were exchanged for
other evidences of indebtedness which had to be taken care
of, but for the most part they were issued for new equipment,
rails, and ties. ,

Immediately after taking charge of the property, in May,
1896, the receivers obtained authority Jto purchase five thou-
sand new freight cars and seventy-five Tocomotives. In Feb-
ruary, 1897, a thousand additional box cars were purchased,
and in May of the same year five thousand one hundred and
fifty more cars were acquired. During this year two thou-
sand one hundred and fifty cars were obtained from coal
companies on mileage contracts, and three thousand ears
were leased from the Pullman Company. Besides these
heavy purchases of equipment, during the first year of the
receivers' administration two hundred and twenty freight
engines, some of which had not turned a wheel for months,
were sent through the shops and put into service. Special
attention was also paid to the way and structure. The track
from Baltimore to Pittsburg and Wheeling was practically
all relaid with new and heavier rails and new ties. Bridges
on the system, many of which were unable to bear the weight
of heavy trains, were generally replaced; and large sums
were spent on the construction of yards and sidings. Tak-
ing advantage of depressed times, one of the features of the
receivership was the placing of an order for forty thousand
tons of eighty-five-pound rail, said to have been the largest
order ever placed for rails up to that time. The price was

EECEIVEESHIPS 423

seventeen dollars a ton. Not all the funds for these im-
provements were raised by the issue of receivers' and car-
trust certificates. Earnings were heavily drawn upon, and
in many instances bondholders were forced to wait until the
property on which they had a lien was put into condition to
earn the interest. In a word, the Baltimore & Ohio re-
ceivers rebuilt the road from end to end, and turned a new
road over to the stockholders when the reorganization was
completed.

This work, as intimated above, was not carried through
without severe opposition. Suit after suit was brought by
security holders to restrain the receivers from increasing the
burdens of the property. It was urged that they were de-
stroying the value of first mortgage bonds by their reckless
issue of certificates, and they were advised that if new equip-
ment was needed, it should be borrowed and not purchased.
Their policy was denounced as a gross usurpation of power
because, as it was charged, they ran counter to every prece-
dent which should regulate the conduct of receivers. To
this the answer was made that precedents were indeed vio-
lated, but that the situation with which the receivers had to
deal was itself unprecedented. The receivers contended, and
in this they were sustained by the court, that their policy was
conceived in the interest of the bondholders, and they insisted
that it be carried through to completion.

The policy of the receivers of the Baltimore & Ohio was
abundantly Justified during their term of ofiBce. During a
period when the gross earnings of its competitors declined
the earnings of the Baltimore & Ohio, as the direct result
of its larger equipment and lower operating cost, materially
increased. In 1896, gross earnings were $25,582,000 and
in 1898, after the reconstruction of the property had been
practically completed, they increased more than $2,000,000
in spite of a steady fall in rates. The contribution of reduced
operating expenses to the result is seen in the increase of the
operating ratio from 69.26 in 1895, a ratio which directly re-
flected the inefficiency of the property, to 78.23 per cent'in

424 COEPOEATION FINANCE

1898, which represented the expenditure of a large amount
of earnings upon itnproTements. The effect of these im-
provements upon the operating efficiency of the road is seen
in a decline in the operating ratio from 76.70 per cent in
1899 to 65.63 in 1900. The Baltimore & Ohio receivers took
great risks. They applied a desperate remedy to a desperate
situation. Their success on this account was all the more con-
spicuous and brilliant.

A receivership is an extraordinary remedy for an extraor-
dinary situation. Like a surgical operation, although it may
save the life of a distressed corporation, it usually leaves the
patient in a weakened condition from which his recovery is
slow. And for the same reason that intelligent physicians
only resort to the knife after all milder measures of treat-
ment have failed, so the owners and creditors of a corpora-
tion which has got into difficulties, consult their best interests,
when they unite to tide over the crisis without resorting to
the protection of the courts. As yet, however, such a de-
gree of cooperation cannot be expected, and it is fortunate
for the investor that the courts have generally shown wis-
dom and foresight in the administration of properties in-
trusted temporarily to their keeping.

CHAPTBE XXXII
THE EEORGANIZATION OF. BANKRUPT CORPORATIONS

The reorganization of a bankrupt corporation is a set-
tlement 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.

As soon as possible after the receivers have been ap-
pointed, efforts are set in motion looking to the rehabilita-
tion of the bankrupt corporation. The interests of all con-
cerned point to a speedy settlement of its difficulties. As
long as a corporation remains in the hands of the receiver,
the values of its securities are low, owing to its uncertain
future. Those persons whose capital is invested in these
bonds and stocks are unable to find purchasers for their in-
vestments at fair prices, or to make loans upon these secur-
ities with financial institutions. Banks and trust companies
which have taken these securities as collateral are, for the
same reason, unable to dispose of the collateral except at a
loss, even if they consider it expedient to further complicate
an already diflBcult situation by such a drastic action. All
interests are, therefore, equally concerned to reach a speedy
reorganization of a bankrupt company. Unless an attempt
is made to treat some interest unfairly, the operation is
quickly concluded and a settlement is reached which preserves
the integrity of the business, and equitably apportions among
the different claimants the losses which have been sustained.
The courts have also assumed the necessity of speedy reorgan-
ization, and have sometimes gone so far as to recommend to
creditors and stockholders that they hasten to arrive at a

425

426 COEPOEATION FINANCE

settlement of their difiBculties in order that the receivers may
he discharged.

The objects of the reorganization are as follows :

1. To pay off or fund the floating debt.

2. To provide funds for betterments and working capital
and to arrange for future capital.

3. To reduce fixed charges within a conservative estimate
of net earnings.

Eeorganization, in almost all cases, requires that a large
amount of cash should be provided. This money is required
to pay certain kinds of current debt, to complete an un-
finished plant, or for the reconstruction and repair of prop-
erty whose physical condition has been allowed to deteriorate.
Taking up first the floating debt which must be provided for,
we find this usually divided into receiver's certificates and
secured loans. The receiver's certificates, as already ex-
plained, constitute prior liens on the property, and must be
paid in cash when due. We have also seen in the discussion
of the issue of short term obligations that these are now
almost invariably secured by a large margin of collateral.
These notes have been usually taken by banks, trust com-
panies or large individual capitalists. The collateral back
of them consists either of bonds authorized under existing
mortgages, or of securities owned by the corporation repre-
senting the control of properties which are indispensable to
it. The holders of such notes are in a position to demand
payment in full. Unless paid, they can sell their collateral
and seriously embarrass those who are endeavoring to re-
organize the company.

The physical condition of a bankrupt property is usually
bad. In some cases the original financial plan has not pro-
vided sufficient funds to complete the plant which must be
finished before it is of any value, and the property of going
concerns has often suffered severely before receivers were
appointed. The receiver, as we have seen, may do much to
improve the physical condition of the property, but he is not
likely to provide all the money necessary.

EEOEGANIZATION OF COEPOKATIONS 427

The reorganization, plan should provide that the net earn-
ings of the company, on a minimum estimate, should insure
a safe margin above fixed charges. If the receivership has
been due to the maturity of debt at a time when financing
was not possible, a reduction of fixed charges may not be
necessary. In the great majority of eases, however, adversity
has disclosed the fact that fixed charges are too heavy for
the earnings of the company, and opportunity is taken in the
reorganization to reduce them. Unless this is done, at the
next season of trial, net earnings may again fall below
charges, and another surgical operation on the capitalization
of the company will become necessary. It is seldom provided
that fixed charges in the reorganization plan should be so
much reduced that an estimate of net earnings based on
present conditions will insure immediate payment of divi-
dends. Such a course would be unfair to creditors. If re-
viving business increases earnings after the reorganization,
to the point of dividend payment, that is the good fortune
of the stockholders ; but the creditors cannot be asked to sub-
mit to a greater reduction in their claims for interest and
rentals than is sufficient to enable the company out of its
net earnings to pay interest and provide for working capital,
renewals and betterments. The information upon which any
plan of reorganization must be based is usually supplied by
the receivers who make for the court an exhaustive analysis
of the situation of the company, its past earning power, the
causes of failure, a schedule of its assets and liabilities, and
an estimate of its cash requirements.

We see the objects of reorganization. How are these
objects to be realized? The first step in carrying through
a reorganization plan is usually the formation of committees
to represent the owners of different classes of bonds. In some
cases also committees are formed to represent stockholders.
The purpose of forming committees is to secure united action
on behalf of each interest concerned in the reorganization,
and also to keep the various bonds and notes of the company
from being thrown on the market and sacrificed. The forma-

428 COEPOEATION FINANCE

tion of committees may not, it is true, be necessary. The
receivers or the directors may themselves formulate a plan
of reorganization, or they may appoint a committee to for-
mulate such a plan to which they may afterwards invite the
consent of the security holders. If the plan proves satisfac-
tory, it may at once be put into effect. It is seldom, how-
ever, that such a quick method of settlement can be adopted.
Holders of different classes of securities are unlikely to con-
sent to any plan which they have had no hand in formu-
lating.

' The, method usually employed in the formation of these
committees is for individual bondholders to constitute them-
selves or their representatives a committee to take charge of
the, particular class of securities, and to invite the creditors or
stockholders to signify their consent to this arrangement by
depositing their securities with some disinterested agent, a
trust company or bank. If a majority of the securities are
thus deposited, the self-constituted committee becomes rep-
resentative, and is recognized as such by the courts. The
powers of these committees are very broad. The committee
is vested with the legal title to all securities deposited with
them, and is authorized to act in all respects in behalf of
the depositors as though they "were directors of a corporation
elected for the purpose. The committee has all the powers
of owners of the securities, and full discretion as to the meth-
ods of carrying out the agreement. The committee is author-
ized to institute suits or to intervene in suits, to sell the
deposited securities under certain conditions, to employ
agents, attorneys and counsel, to purchase property at fore-
closure sale, to borrow money on the security of the bonds
or stocks deposited with them, and also, usually, to prepare
a plan of reorganization which, after reasonable notice has
been given to the depositors under the agreement with the
committee, and failing objection on their part signified by
the withdrawal of their securities, is held to be binding upon
all. The depositors are held to be liable for the necessary'
expenses of the committee up to a certain percentage on the

EEOEGAJSriZATION" OF COEPOEATIONS 429

amount of securities deposited. It is usually provided that
the committee may at any time terminate the agreement, and
also to allow the bondholders to terminate it by a certain
vote. The effect of the deposit of securities is to constitute
the members of the committee trustees for the depositors, to
form, as it were, a temporary corporation for the attainment
of certain objects.

The committee, after conference with bankers, whose
assistance is indispensable to the consummation of a plan
of reorganization, after examining the condition of the
property, its assets and liabilities, its record of earnings,
and also after conferring with large shareholders and cred-
itors, announce a plan of reorganization. This plan they may
either announce on behalf of themselves or through bankers
or individuals whom they may designate as reorganization
managers. For example, J. P. Morgan & Company on June
1, 1909, made the following announcement to the holders
of debenture stock. Preferred stock A, Preferred stock B,
and Common stock of the Chicago, Great Western Eailway
Company :

" At the request of the London Committee for Debenture
Stock of the New York Committee for Debenture Stock, and.
of the New York Committee for Preferred Stock A, Pre-
ferred Stock B, and Common Stock, the undersigned have
consented to act as Eeorganization Managers in carrying out
a Plan for the Eeorganization of the Chicago Great "Western
Eailway Company."

So far as the securities affected by the plan have been
lodged with a committee, the assent of the committee to the
plan is held to be binding on the depositing bond* or stock-
holders unless they signify their dissent within the time named
in the agreement with the committee, by withdrawing their
securities. Holders of securities which have not been deposited
are given a certain time to consent to the plan. This time
limit is often extended, but unless the deposits are made

430 COEPOEATIOlsr FINANCE

within the time stipulated by the committee, nonassenting
bond or stockholders are held to be excluded from the benefits
of the plan and must take their chances like anyone else in
a foreclosure sale.

Coming now to the consideration of the reorganization
plan, we find that the property may be either returned to its
former owner, or it may be transferred under foreclosure
sale to a new company. It sometimes happens that there are
distinct advantages in reorganization without foreclosure sale,
employing the same company which controlled the property
before the default. Companies may have valuable privileges
in the form of exemption from taxation, or' authorization
from the state to engage in enterprises such as the carrying on
of coal mining and railroad operations under the same organ-
ization, which may have been forbidden to corporations since
a particular charter was granted. In such cases, the reorgan-
ization plan usually contemplates the return of the prop-
erty to the existing company. The Philadelphia & Reading
Eailroad Company, for example, went through two reorgan-
izations because its charter privileges were too valuable to be
surrendered.

The usual method is, however, to organize a new company
in which is vested after foreclosure sale such portions of
the property of the old company as it is thought wise to
retain, and which either assumes the obligations of the old
company in their original form, or secures such modifications
and reductions in their amount as are necessary to the suc-
cess of the new company. The advantage of this method is
that, by the foreclosure sale, all the rights of nonassenting
security holders are extinguished, and the new company is
placed in complete control of the property which it desires.
It is customary, even when a new company is employed, to
use a name closely resembling that of the old company. A
railroad company, for example, will be succeeded by a rail-
way/ company, and vice versa.

After the new company is organized, it authorizes the
issue of certain securities. The Chicago & Great Western

EEOKGANIZATION OF COEPOEATIONS 431

'Railway ^ Company, the successor of the Chicago & Great
Western 'Railroad ^ Company, authorized $28,000,000 of first
mortgage, fifty year four per cent bonds, $50,000,000 of
four per cent preferred stock, and $46,000,000 of common
stock. The Western Maryland was reorganized by the for-
mation of a new company which took over the property of
the old company subject to its first mortgage and its under-
lying and divisional bonds, and which authorized $10,000,000
of noncumulative four per cent preferred stock, and $60,-
000,000 of common stock. The securities of this new com-
pany are now offered for subscription. The subscriptions are
paid either in cash, or with the securities of the old company,
or, in rare instances, with the guarantee of another corpora-
tion. In the fulfillment of the conditions of subscription, the
objects of reorganization are accomplished.

Advantage is usually taken of this opportunity to simplify
the capitalization of the company. Especially has this been
done in reorganizations of large railway companies. The
formation of a new company which issues its bonds and stock
in exchange for those of the old, makes possible the concen-
tration and simplification of the capitalization. It unites
branch line and terminal certificates, car trust certificates,
equipment bonds and other obligations under single issues
which are more easily managed, better secured and of higher
values than those which they displace. The property of the
irorthern Pacific Eailway Company, for example, before its
last reorganization, was owned by fifty-four corporations
which had issued ,$380,000,000 of stocks and bonds. The
circular of the reorganization committee described the old
plan of capitalization as follows :

"As it now stands, the system, in its form of incorpora-
tion and capitalization, is a development without method or
adequate preparation for growth. Scarce any single security
is complete in itself. The main line mortgage covers neither
feeders nor terminals. The terminal mortgages may be be-

* Italics are the author's.

432 COKPOEATION FINANCE

reft of their main line support. The branch line bonds are
dependent upon the main line for interchange of business,
and the main line owes a large part of its business to the
branch lines."

The plan of reorganization of this company reduced the
number of these obligations, and greatly simplified the cap-
italization of the company by subjecting the entire system to
the lien of two bond issues, one following the other. Sink-
ing fund provisions, which have proven embarrassing to the
corporation, may also be eliminated. An adequate bond re-
serve may be provided under which, with proper restrictions,
future issues of bonds for the capital needs of the company
may be made. The company may also save in the exchange
of securities by retiring high interest bonds issued on branch
lines where the security is not perfect, with lower interest
bonds secured by mortgage upon the entire property. All
these methods of reorganizing the capital account have been
fully explained in Chapter XXI. They are freely employed
in the reorganization of bankrupt corporations, because the
transfer of the property from one company to another fur-
nishes an excellent opportunity for such readjustments.

A more important use is found for the securities of the
new company in providing the cash required in the reorgan-
ization, and making the necessary reduction in fixed charges.
In most reorganizations, as already observed, a large 'amount
of cash must be provided. The cash requirements of the
Baltiraore & Ohio reorganization plan, for example, in 1896,
amounted to $36,092,000. The reorganization managers of
the Erie had to provide $19,344,000. More recently, the
Chicago Great Western, a comparatively small coinpany, pro-
vided $34,893,2'i'4 in its reorganization. This cash is ob-
tained by subscription to the boiids and stock of the new
company.

Efforts are first made to interest the stockholders who
are invited to participate in the reorganization. To the com-
mittee in charge of the reorganization is presented this

EEOEGANIZATION OF COKPOEATIONS 433

problem : " If we take over the property at a foreclosure sale,
and exclude the former stockholders, it will be necessary
for us to provide the cash required. The money can prob-
ably be raised, it is true, by the sale of first, or first and
refunding mortgage bonds, but since one object of reorganiza-
tion is to reduce rather than increase the debt of the com-
pany, it is desirable to keep down the new bonds issued to
the lowest possible figure. The only practical alternative, is
to induce the stockholders of the bankrupt company to fur-
nish the funds required."

The offer to subscribe to the securities of the new com-
pany is made to the stockholders in one of two forms. They
may be told that their company has failed; it is unable to
pay its debts, its creditors have liens upon all its properties.
Unless the stockholders are prepared to furnish the money
necessary to, pay these debts, the property must be sold by the
court and the stockholders will lose all chance to recover
their loss. In the foreclosure sale, the various evidences of
debt, no matter how much their interest may be in default,
or how worthless they may be in the market, will count, as
against any inferior lien, at 100 cents on the dollar. There-
fore, if the stockholders desired to compete at the sale, they
would be at a hopeless disadvantage, since it would be neces-
sary for them to match, dollar for dollar, with cash, the vari-
ous bonds which will be presented as a means of payment by
the creditors. The creditors, therefore, control the situation.
They propose to organize a new company to take over the
property of the bankrupt corporation, since they realize the
necessity of keeping the property together.

The creditors, however, do not desire to take undue ad-
vantage of their position. They will give to the stock-
holders the privilege of joining with them in this new com-
pany. They make to the stockholders the following offer:
to sell them preferred stock in the new company for, say,
$20 per share, and common stock for $10 a share. " We
have every reason," they say, "to believe that with the in-
debtedness paid, funded or reduced within a conservative
30

434 COKPOEATION FINANCE

estimate of earnings, and with good management, the new
company will be more successful than the old. We are con-
fident that if you purchase stock in the new company on
the basis proposed, you will have no reason to regret your
action."

This was the proposition which, in substance, was made
to the stockholders of the Westinghouse Electric & Manu-
facturing Company, on April 8, 1908. The stockholders com-
mittee of this company sent out a circular letter outlining
a plan of reorganization in substance as follows: Certain
bonds of the company were to remain undisturbed. The
floating debt was in part to be converted into stock and in
part funded into bonds and notes. The stockholders were
to subscribe at par for $6,000,000 of new stock. The propo-
sition to the stockholders was as follows:

" The chief difiBculty with the company and the principal
cause of the receivership are found in the fact that, as the
result of the rapid expansion of its business, too large a
proportion of its investment is represented by debt. If a
substantial reduction can be made in the debt by the sale
of additional stock, it is believed that the receivership can
be promptly terminated with every prospect of the company
entering upon a career of renewed prosperity. On this point
the committee, of which Mr. Jarvie is chairman, in their
circular of April 2, 1908, say:

" ' The committee believe that if the conduct of the busi-
ness can promptly be restored to the stockholders under the
direction of a strong board of directors, the company wiU
continue to make substantial earnings. On the other hand,
there. can be no doubt that a continuation of the receivership
for a considerable time, and a forced liquidation of the as-
sets, would be disastrous to the creditors as well as to the
stockholders.'

"The Merchandise Creditors' Committee have shown
their confidence in the company and its future by under-
taking to secure the exchange of, at least, $4,000,000 of the

EEOEGANIZATION OF COEPORATIONS 435

company's floating debt for ' assenting stock/ at par. They,
however, impose the condition that the remaining $6,000,000
of the $10,000,000 of subscriptions required to terminate the
receivership and place the company in a safe position shall
be furnished by the stockholders. It is for the purpose of
securing from stockholders subscription to this $6,000,000
of stock that the undersigned committee has been formed.
"The holders of the preferred and common stock of the
company are, therefore, asked to subscribe for 'assenting
stock' of the company at par, at the rate of at least one
share of new stock for every four shares (or fraction thereof)
of existing stock. Such subscriptions are to be payable in
the following installments:

25 per cent on May 25, 1908,
20 " " « August 1, 1908,
20 " " " November, 1, 1908,
20 " " " January 1, 1909,
15 " " " April 1, 1909.

The deferred payments are to bear interest at the rate of
six per cent per annum, with the privilege to subscribers to
pay their subscriptions in full at any time.

" The Merchandise Creditors' plan cannot be carried into
efEect unless the stockholders protect themselves by subscrib-
ing pro rata for their shares of this new stock. If these sub-
scriptions are not forthcoming, the inevitable result will be
that the Readjustment Committee, which was organized for
the protection of creditors, will be forced to reduce the debt
of the company to judgment, bring about a forced sale of
the property and its acquisition by a new corporation or-
ganized in the interest of creditors. Such a course would
result in enormous loss which would fall chiefly upon the
stockholders of the company. That loss can be avoided only
by the cooperation of stockholders in promptly subscribing
for a sufficient amount of new stock to insure an early ter-
mination of the receivership.

436 COEPOEATION FINANCE

" The committee wish to lay special emphasis upon the
fact that the success of this plan for saving the company for
its stockholders requires the unanimous compliance of stock-
holders, however small their holdings, with this request for
subscriptions. The ownership of the stock of the company
is divided among about 4,000 stockholders, the average hold-
ing (excluding the holdings of the Security Investment Com-
pany and its president) being only about eighty-three shares
(par value, $50). Most of the stock owned by the Security
Investment Company has been pledged as collateral in com-
paratively small amounts with a large number of banks
which are being asked to subscribe to the new stock in propor-
tion to their respective holdings."

Subscriptions to the stock of the "Westinghouse Electric
& Manufacturing Company were largely influenced by this
express threat that failure to procure the required amount
would subject the stockholders to the danger of foreclosure
sale.

The situation of the "Westinghouse Electric & Manufac-
turing Company is, however, different from that of most bank-
rupt corporations. With this company, the trouble was chiefly
due to inadequate working capital which resulted in an exces-
sive amount of funded debt calling for the payment of both
principal and interest at a time when financing could not be
done. The reorganization of the "Westinghouse Company re-
quired nothing more than the funding of this current debt on
which the company was abundantly able to pay interest. The
stockholders' interest in the property was plain. Even dur-
ing the receivership, the stock never fell below $8.75, (par
$50) which indicated a considerable margin of value after
the debts were paid.

In most eases, however, bankruptcy has been due to the
failure of the company to earn interest on its funded debt.
If the company cannot earn enough to pay interest on its
bonds, then its property is not worth the amount of its debts,
.and there is nothing left for the stockholders. Their in-

EEORGANIZATION OF COEPORATIONS 437

terest in the property has, long before the reorganization,
entirely disappeared. They have already been "wipeid out."
To stockholders in this situation a proposition that they
should subscribe to stock in a new company at the rate of
$10, $15, or $20 per share might be iinattractive. The re-
sponse of many stockholders to such a proposition would be
an emphatic negative. They would inform the reorganiza-
tion committee that they did not propose to throw good
money after bad; that they did not care to make a new in-
vestment in the company with which they had fared so badly ;
that, although the claims of the reorganization committee
as to the future of the company might be borne out by re-
sults, for their part, they would prefer to await the mate-
rialization of those results, rather than risk any more of
their money in a venture which had proven so disastrous.

When money is to be raised from stockholders where
there is no equity in the property which they would naturally,
desire to retain, the proposition has frequently been , pre-
sented to them in a different form. Instead of being invited
to subscribe to stock of a new company, the offer takes the
form of a proposition that they should pay an " assessment "
upon their stock, "go through the reorganization," and re-
cover, in the increasing profits of the company, the losses
which they have sustained. In the Chicago & Great West-
ern reorganization plan, for example, the conditions of par-
ticipation in the plan were set forth to the stockholders as
follows :

" Participation under the plan by holders of the several
classes of stock is dependent on the deposit of the stock cer-
tificates with the undersigned, within the period limited there-
for. The plan embraces only the stocks so deposited. No cer-
tificate for any stock of any class will be received on deposit
unless in negotiable form.

"Debenture Stock and Preferred Stock A are to be re-
ceived without payment as stated in the Plan.

"Depositors of Preferred Stock B must pay $15 in re-
spect of each share of such Preferred Stock B so deposited,

438 COEPOEATION FINANCE

and will be entitled to obtain from the Syndicate mentioned
in the Plan, Preferred Stock voting trust certificates of the
New Company when issued, equal at par to such payment,
and also Common Stock voting trust certificates of the New
Company, when issued, to an aggregate amount,at par equal
to sixty per cent of the par value of their present Preferred
Stock B so deposited.

" Depositors of Common Stock must pay $15 in respect
of each share of such Common Stock so deposited, and will
be entitled to obtain from the Syndicate, hereinafter men-
tioned. Preferred Stock voting trust certificates of the New
Company, when issued, equal at par to such payment, and
also Common Stock voting trust certificates of the new
Company, when issued, to an aggregate amount at par equal
to forty per cent of the par value of their present Common
Stock so deposited."

A careful examination of this statement will show the
difference in form, although not, as we shall see, in sub-
stance, between the proposition of an assessment and the
proposition of a new subscription. The payments of cash
are to be made in respect of and in connection with the de-
posit of common and preferred stock under the plan. The
stockholder is informed that, if he will make a contribution
on account of his present stockholdings, he will be allowed
to receive stock in the new company. He does not, on the
face of things, pay for the stock in the new company — that
is given him in exchange for his old stock. He pays an
" assessment " on his old stock, and, on account of this " as-
sessment," he becomes entitled to receive new stock.

The proposition to the stockholders of the old company
that they should subscribe to stock of the new company is put
something as follows when a subscription is styled an assess-
ment : " Your company is bankrupt ; its creditors are in
position to take the property, and they will take the property
unless a certain amount of cash is raised. The creditors do
not, hoTivever, desire to exclude stockholders from participa-

EEOEGANIZATION OF COEPOKATIONS 439

tion in the reorganization, but they must look to the
stockholders to furnish the necessary money by paying a
small assessment on the par value of their present holdings.
If you will pay this assessment, you will be allowed to ex-
change your certificates of stock in the old company for a
certain number of shares in the new company, and you will
receive stock in addition to the amount of the assessment."

This proposition, it is evident, is precisely similar to the
one first mentioned. It is an offer of stock in a new company.
But, while many stockholders in a bankrupt and discredited
corporation will not accept a proposition when presented
to them as a subscription, when designated as an " assess-
ment" on the stock which they already own, they have very
generally accepted the proposition of reorganization com-
mittees, have paid their assessments, and received stock in
the new concern. The second form of the subscription
proposition appeals to the stockholders while the first does
not. The "assessment" proposition presents to the stook-
holder the idea of an unfinished transaction. He hopes
that, with one more effort, the payment of $10 or $15 per
share, he can recover from the company the money which
he has lost. The "assessment" proposition offers him ap-
parently the opportunity to recoup himself, to justify to
himself his judgment of the value of the stock in which, up
to the present time, he has been so grievously disappointed.
By employing this method of calling a subscription to stock
in a new company an "assessment" on stock in an old
company, reorganization committees have been able to obtain
large amounts of money from stockholders, whereas if they
had asked the stockholders to subscribe to stock in a new
company, they would probably have been much less successful.

The assessments of stockholders are usually underwritten,
a syndicate being organized to pay the "assessments," and
to take the stock of those holders who do not participate in
the plan. The commission paid to this syndicate varies, of
course, with the risk which they assume, but the existence
of the syndicate brings pressure to bear upon the stockholder

440 COEPORATIOiS FINANCE

by assuring him that others stand ready to accept apparently
the same terms which are offered to him. In 1895, for
example, the final Atchison reorganization plan announced
the following:

" A contract has been made with a syndicate to> furnish
an amount of money equal to the assessments of nonassenting
or defaulting stockholders, and such syndicate, by such pay-
ment, shall take the place of the nonassenting or defaulting
stockholders, and shall be entitled to receive the new common
and preferred stock, which nonassenting or defaulting stock-
holders Would have been entitled to receive if they had de-
posited their stock and paid their assessment in full." The
syndicate may actually purchase the new stock and ofEer it
to those stockholders who pay their assessments, thus making
an exceptionally forcible appeal. By employing this method
of approach, reorganization managers, especially in railway
reorganizations, have been remarkably successful in paying
off most of the floating debt without resorting to the sale
of bonds.

The difference between a reorganization " assessment " and
a subscription to new stock is only in form; in substance
they are the same thing. When stock is full paid, it is not
liable to any assessment. A stockholder may have only paid
$20 a share for his full paid stock, but the corporation has
no right to demand any more from him. Any further pay-
ments to the company are at his own pleasure. And yet,
BO imperfect is the knowledge possessed by the average
stockholder of his rights and obligations, that he is apt to
feel, when an assessment proposition is made to him, that
there • is an obligation to pay the assessment and take the
new stock. A reorganization assessment is looked upon as
compulsory. Stockholders are informed that if they refuse
to pay they are " debarred from all participation in the
reorganization," that they "lose all chance to recoup their
loss from their share in subsequent profits."

An examination of a large number of reorganization
* Italics are the author's.

EEOEGANIZATION OF COEPOEATIONS 441

plans recently promulgated, however, shows that "assess-
ments " are now being stated in their true light as
subscriptions. For example, the reorganization plan of the
Kewhouse Mines & Smelters under date of June 1, 1909,
states that:

"In order to furnish the necessary working capital for
development, payment of debts, expenses of foreclosure,
reorganization and underwriting, the Stpckholders will be
required to subscribe to the capital stock of the new company
and to pay one dollar for every share so subscribed. Every
Stockholder so subscribing will receive one share of common
stock of the New Company for each share now held by him."

It is impossible to approve the indirect method of raising
money from stockholders, which is only recently being aban-
doned. The stockholder owes nothing to the reorganization
managers, or to the creditors. If they secure his participation
.in the new company, they should make him an offer of a
more attractive investment than he can obtain elsewhere.
Unless the payment of an assessment on stock of a bankrupt
corporation gives the stockholder, who desires to continue his
interest in the company, the new stock at a lower figure than
that at which he can purchase it in the open market, he
should allow the creditors to advance the money necessary,
and buy the stock after the reorganization has been com-
pleted. While by adopting such a course he may be "de-
barred from all participation in the reorganization," he does
not "lose all chance to recoup his losses from his share in
the subsequent prosperity." Dr. Stuart Daggett, in his book
" Eailroad Eeorganization," ^ gives a list of eight reorganiza-
tions in which the common stock was assessed, together with
the price of the stock one month after reorganization, and
six months after reorganization. In every case the stock
could have been purchased in the open market directly after
the reorganization at a lower price than it was purchased
from the reorganization managers. It is desirable that stock-
holders should cooperate in making the reorganization plan

' P. 353.

442 COEPOEATION FINANCE

a success, but the proposition should be presented to them
in its true light, and not under the guise of an obligation or
a necessity.

The offer to stockholders if foreclosure is not involved in
the reorganization plan is usually more liberal thdn when
the threat of foreclosure can be issued to induce subscrip-
tions. If the method of foreclosure is not to be employed, then
the stockholders must be persuaded iuto the ' subscription by
an attractive offer. The adjustment plan of the Seaboard
Air Line Eailway, which was carried through without fore-
closure, provided the cash required by the sale of $18,000,000
of par value of cumulative five per cent income bonds, called
adjustment bonds. These were offered for subscription at
seventy per cent of their par value to the extent of thirty
per cent of the par value of their existing holdings. A syn-
dicate was organized which, for a commission of five per cent
on the par value of $18,000,000 of bonds, offered to the stock-
holders, guaranteed to purchase at this price any bonds that
might not be subscribed and paid for by the stockholders.
In this case there was no pressure put upon the stockholders
to furnish any capital to the company. An attractive offer
was made to -them, and their acceptance of the offer was
guaranteed by responsible bankers. Whether they subscribed
or not, so far as the provision of cash was concerned, the
success of the plan was assured.

If, or to the extent that stockholders will not advance
money, the creditors must provide the funds required by sub-
scribing to the securities of the new company. The creditors
of a bankrupt company are potentially in the position of own-
ers. They can obtain the property at a foreclosure sale, and
if they cannot persuade or coerce the stockholders into ad-
vancing the money necessary for its rehabilitation, they will
be obliged to take over the property, and themselves provide
the necessary funds. Eliminating the stockholders, we have
now to consider the methods by which creditors finance the
cash requirements of a reorganization. Several conditions
may be presented. There may be only one class of creditors.

EEORGANIZATION OF COKPOEATIONS 443

the holders of mortgage bonds. The company issuing these
bonds has defaulted, and receivers have been appointed.
These receivers have made certain expenditures for the benefit
of the property, and certain other expenditures are necessary.
The stockholders will advance no more money. As the re-
organization committee of the Arnold Print Works stated
in their announcement of a plan of reorganization :

" Eeorganization with fresh capital contributed by the
present stockholders is impracticable, as nearly all the stock
is owned by Messrs. Houghton & Gallup, and apart from
their interest in this stock they are now without substantial
means."

The creditors in such a situation must depend upon them
selves. They organize a new company to take over the prop-
erty, thereby extinguishing all rights of stockholders and
any minor claims of current indebtedness which may be out-
standing. They capitalize this new company according to
the exigencies of the situation. They may subject its prop-
erty to the lien of a first mortgage bond which they may
either take themselves or sell to bankers, obtaining in this
manner all necessary funds, or they may subscribe to the
stock of a new company, placing no funded debt upon it.
The property is at their disposal ; they can use it to support
the credit of the company as it may be necessary. If they
advance the required funds themselves, they may arrange the
capitalization of the new company in any way they see fit.
If, however, they sell the securities to outsiders they must
consult the wishes of the subscribers.

A case in point came recently under the writer's observa-
tion. A water-power company had underestimated the cost
of a power and transmission plant. When the plant was
little more than half completed, funds were exhausted. Ee-
ceivers were appointed and the bondholders eventually bought
in the plant at a foreclosure sale, eliminating the stock in-
terest. It was now necessary to provide funds to complete
the plant. The following plan, after prolonged negotiations,
was presented to the bondholders. A new company should be

444 COEPOKATION FINANCE

organized to take over the plant. This company was to issue
first mortgage five per cent bonds to an amount sufficient to
complete the plant, and certain of the bonds were to be held
in reserve for extensions. The old bondholders were to re-
ceive noncumulative preferred stock for their bonds, and the
new bonds were to carry with them all the common stock of
the company as a bonus. The owners of the plant were
offered the privilege of subscribing to the new bonds, and
receiving their pro rata share of the common stock. The
subscriptions to the bonds were guaranteed by a finance com-
pany, which undertook, for a commission, to take the bonds
of nonsubscribing owners, and receive their share of the
bonus of common stock.

Another condition may arise; there may be secured cred-
itors and unsecured creditors, commonly known as floating
debt creditors. We have already seen that when floating
debt is amply secured by collateral, the reorganization plan
must provide for its payment. It frequently happens, how-
ever, that the floating debt is unsecured. The Westinghouse
Electric & Manufacturing Company at the time of its fail-
ure owed $5,000,000 for merchandise, and $8,000,000 to
banks, for all of which there was no special security. In
such a case, the holders of the floating debt, if the amount
is large, in order to save something from the wreck, must
advance the money required to put the company on its feet.
They cannot ask the, bondholders to make sacrifices, because,
if the bondholders advance the necessary money, they may
insist on retaining the stock of the new company. As for
their own claims, the floating debt creditors, in case they
manage the reorganization and provide the necessary funds,
and in case, also, they do not disturb the position of the bond-
holders and safeguard the bondholders' interests in the re-
organization, may arrange the capitalization of the new com-
pany as they please. In the Westinghouse reorganization,
for example, already referred to, where the stockholders ad-
vanced the necessary funds, the holders of the company's
notes, for fifty per cent of their claims, received convertible

EEOEGANIZATION OF COEPOKATIONS 445

five per cent debenture bonds of the company which were in
its treasury, and for the other fifty per cent of their claims,
fifteen-year five per cent notes of the company bearing five
per cent interest. As for the banks, if they objected to wait-
ing so long for repayment, they were offered the privilege of
taking amounts equal to thirty per cent of their claims in
serial bonds due in four, five, and six years, on condition
that, for the balance of the fifty per cent, they should accept
stock of the company at par. In this case the floating debt
creditors were able to negotiate successfully with the stock-
holders, on account of the large equity iu the property. If,
however, the stockholders had not advanced the necessary
funds, it would have been necessary for the holders of the
floating debt to themselves subscribe to a sufficient amount
of stock in the new company to provide the cash required,
taking in addition stock for their own claims, and diminat-
ing the stockholders.

Occasions may arise where the bondholders and the float-
ing debt creditors, when no money can be obtained from
stockholders, divide the burdens of the reorganization be-
tween them, and partition the stock of the company in return
for their cash advances. Even if the bondholders are obliged
to take charge of the reorganization, and arrange for the
financing, they may not eliminate the floating debt creditors,
on account of special reasons. It may be possible, for ex-
ample, to arrange with some outside company to guarantee
an issue of second mortgage bonds in return for the com-
mon stock. In such a case there would probably be no
objection to the floating debt creditors receiving preferred
stock in the reorganization plan without cash advances. As
a rule, however, if the general creditors do not subscribe, and
if suitable arrangements cannot be made with outside inter-
ests, then the bondholders must provide the money. They
will usually take the stock of the new company, eliminating
general creditors of the old company along with its stock-
holders.

A further complication enters when there are several

446 COEPOEATION riNANCE

classes of bondholders, as well as different floating debt in-
terests, and stockholders. Suppose stockholders will not ad-
vance money, that the general creditors are also unwilling
to invest in the securities of th^ new company, that there are
first mortgage bonds upon the property whose interest has
been fully earned and paid by the receiver, but that, in addi-
tion to the first mortgage bonds, there are first and refunding
bonds — that is, second mortgage bonds. There may be also
debenture bonds and car trust certificates. In such a situa-
tion the underlying bonds and the car trust certificates can-
not be disturbed. Their security is ample, and there is no
way in which the reorganization committee can get at them.
If any attempt is made to impose upon them the burden of
providing the money required, they will assert their rights
at foreclosure sale, taking away the security and eliminating
all junior securities. The holders of car trust certificates
are also in an exceptionally strong position; they cannot be
asked to furnish any money. The holders of the junior bonds,
with or without the participation! of the stockholders, must
here provide the necessary funds.

A ease in point is that of the reorganization of the West-
ern Maryland. In this reorganization plan, securities ag-
gregating $50,951,950 remained undisturbed. Their owners
were not called upon to provide any new money. The $8,374,-
160 of cash required for the payment of maturing obligations
and for improvements and betterments was raised by the sale
of $20,685,400 of the common stock of the company to a bank-
ers' syndicate which offered this stock to the general lien and
convertible holders and to the stockholders. The junior bond-
holders were offered the new stock at forty per cent, up to fifty
per cent of their holdings, and the holders of the common
stock were offered the new common stock at the same price, up
to 100 per cent of their holdings. The undisturbed securities,
in this case, included the first mortgage bonds, $43,518,000;
divisional bonds, $6,200,000; leased line bonds, $1,659,300,
and leased line guaranteed stock, $574,650. Interest on the
first mortgage bonds had been fully earned, and there was no

KEOEGANIZATION OF COKPOEATIONS 447

reason for asking them to make sacrifices. The divisional and
leased line bonds and guaranteed stock were so secured that an
assertion by their holders of their rights under the contracts
with the Western Maryland Eailroad Company might haye
resulted in the disruption of the system. It was necessary,
therefore, to appeal to the junior securities, and, in this case,
the reorganization managers were fortunate in securing the
cooperation of the stockholders. If the stockholders had
not been able to respond, however, then it might have been
necessary for the holders of the first mortgage bonds to have
taken a part of the new stock, securing the cooperation of
the general lien bondholders, if only to a partial extent, by
allowing them to share in the new securities.

I have suggested only a few of the complications which
may arise. A reorganization committee may be confronted
with a great variety of situations. Its task is to obtain the
money on the best terms possible with due regard to the
legal rights of all interests concerned. The only rule which
seems established in the preparation of this portion of a re-
organization plan is first to impose the burden upon the stock-
holders if they can be induced to assume it, next in order
to approach holders of unsecured floating debts, next the
junior bondholders, and finally the holders of underlying
securities. The appeal in each case is strengthened by the
implied or express threat of complete loss to follow the fore-
closure sale which would be controlled by the holders of the
prior claims.

Finalljf, if money is to be raised from bankers or out-
side investors, a proposition must be made which is attrac-
tive to them. For example, if there are first mortgage bonds
which cannot be disturbed, and if it is proposed to obtain the
necessary funds without "compulsory" subscription by any
of the old interests, by the sale of first and refunding mort-
gage bonds to a bankers' syndicate, the syndicate may insist
upon a certain amount of stock. They may also insist that
this stock shall be given special preference. In such a case,
the new company would issue preferred stock A to bankers.

448 COEPOKATION FINANCE

and the other interests would take B preferred and common
stock.

We have already observed in the consideration of these
several cases that the underwriting syndicate is a necessary
feature in every reorganization plan. The commission paid
to the syndicate will vary. In some cases it may be large.
The Western Maryland Syndicate, we have seen, was to re-
ceive a commission of five per cent. In the reorganization
plan of the United States Shipbuilding Company, the com-
mittee announced that it had entered into an agreement with
the Morton Trust Company and Thomas F. Eyan for the
purchase and sale of the entire issue of $3,000,000 collateral
trust sinking fund six per cent bonds at a price of 87^, so
as to guarantee the cash requirements of the plant. These
bonds were ofEered by the syndicate to the holders of the
existing bonds. The low price offered the chance of a large
profit to the syndicate.

The needs of the present have now been provided for,
current indebtedness has been paid, and provision has been
made for sufficient capital to bring up the plant to a condi-
tion of efficiency. The committee on reorganization now
addresses itself to the task of reducing fixed charges so that
they will come well within conservative_ estimate of the net
earnings. We have already discussed the method by which
the limit of fixed charges in the new company is to be fixed.
This limit is, as already pointed out, the minimum net earn-
ings of the company. The amount is usually based on the
experience of the receiver, although some allowance may be
made for an anticipated improvement in earnings. For ex-
ample, in the Atchison reorganization of 1894 it was esti-
mated that the minimum earnings of the property from 1891
to 1894 were $5,204,880, and the fixed charges proposed for
the new company were $4,528,547. The lowest net earnings
which the Union Pacific had ever reported had been $4,315,-
077. The interest on the bonds issued by the new company
which took over the property in 1897, was placed at $4,000,-
000; the net earnings for the Northern Pacific in 1895, the

EEOEGANIZATION OF COEPORATIONS 449

smallest earnings for eight years, were $6,053,660; the fixed
charges of its successor were placed at $6,015,846. Dr. Dag-
gett,^ in his summary of the results of a number of railroad
reorganizations, states that the fixed charges in seven large
reorganizations from 1893 to 1898 were reduced from $65,-
984,319 to $45,576,984. It is now well recognized that un-
less this principle of reducing fixed charges below the lowest
point to which net earnings have ever fallen is followed,
there is danger that the work will, at some later period of
depression, have to be done over again. This principle was
not recognized in many of the reorganizations prior to 1893.
Since that time, however, it has been generally accepted and
may now be taken as an almost invariable rule.

The fixed charges of a corporation may be divided into
rental charges and interest charges. The charges for rentals
can be more easily reduced than the charges for interest.
As long as a company is solvent it must live up to its rental
contracts. The contract is, however, made with the old com-
pany, and constitutes no lien upon its property. That is
segregated for the protection of other creditors. The lesso?
is an unsecured creditor, and can be dealt with as such. The
company which takes over the property at a foreclosure sale
is entirely free from all the lease obligations of its pre-
decessor. Bankruptcy has wiped out the score. The new
company need assume only such contracts as its reorganizers
consider to be necessary to its success. The receiver has
usually terminated or modified unprofitable lease contracts,
and the reorganization committee has only to follow in his
footsteps. If a leased line has proven unprofitable, the re-
organization committee can either dispense with it, or, if it
is retained, its rental can be reduced. The reorganization
committee has a free hand. They cannot be held to old agree-
ments. Old contracts have lapsed and must be renewed by
the new company before they can become binding upon it.

The history of railroad reorganization contains notable
examples of the termination of lease contracts. The reorgan-

' " Railroad Reorganization," Stuart Daggett, p. 357.
30

450 COEPOEATION FINANCE

ization of the Wabash in 1886 resulted in a rediletion of 1,5-11
miles of leased lines, and the Eichmond & West Point Ter-
niinal reorganization lopped off 4,479 miles. A more com-
mon method than the reduction of mileage is, however, the
reduction of rentals. In the railway field, the owners of
leased lines have usually no choice but to accede to any rea-
sonable proposition of the reorganization committee for a re-
duction in their rentals. Their property is usually of little
value outside of a large railway system, and, as a rule, the
system with which it is most valuable is that with which it
is already connected. From 1892 to 1898, the net reduction
in lease rentals for American railways was $24,527,000, a
large part of this representing reductions in reorganizations.
A portion also represented the acquisition of leased lines, and
the consequent conversion of rentals into interest.

We come now to the reduction of interest. Just as
holders of some of the bonds may have been obliged to make
sacrifices by subscribing to new securities, so they may also
be required to sacrifice some of their claims for interest in
order that the solvency of the new company may be secured.
This reduction of interest is accomplished in the exchange
of the securities of the old company for the securities of the
new company. The methods by which such an exchange is
accomplished have been already suggested. The new com-
pany offers its securities for subscription, in part in cash,
and in part in the securities of the old company. If the
old company has not been able to pay interest on $10,000,-
000 of second mortgage bonds, and if it is desired to elimi-
nate this interest charge from the income account of the
new company, the new company may offer the holders of
the second mortgage bonds, $10,000,000 of preferred stock to
be paid for with their bonds.

Some of the creditors of the old company must make
sacrifices. Some of its bonds must be disturbed. Which
bonds shall be disturbed? How shall their claims be modi-
fied and what compensation shall they be given for their
sacrifices? Let us reverse the inquiry and ask what are the

EEOEGANIZATION OF COKPOEATIONS 451

bonds which are not disturbed in a reorganization? In
every reorganization we find some of these bonds. ' Take the
Erie, for example; it has five divisional mortgages ranging
from first to fifth on portions of the line which lie within
the State of New York. These mortgages have survived
three reorganizations, not being disturbed by any of them.
In the same way, the Norfolk & Western Eailroad, the Bead-
ing, the Baltimore & Ohio, have carried through their re-
organizations certain issues of bonds, without, in any way,
disturbing them save, in some cases, to consolidate them by
making attractive conversion offers into large issues. These
bonds are safe from the reorganization committee for the
reason that their interest, even in the worst years, has been
fully earned. Even the receivers have recognized their claims
and have paid their interest. Bonds secured by mortgages
upon important branch roads, terminal property or equip-
ment, do not suffer in a reorganization for the reason that
there is no way to get at them. The property which secures
them is indispensable to the company. Unless the rights
of these holders are properly recognized they may inflict se-
rious damage upon the system by seizing the property which
secures their bonds.

It may, however, be necessary for the holders of first
mortgage bonds, even though their interest has been fully
earned, to subordiaate their lien to the lien of a new first
mortgage, without which the necessary money cannot be se-
cured. Along with this sacrifice may also go a reduction
in their interest claims. Speaking generally, however, the
holders of first mortgage bonds whose interest has been
earned, are not called upon to sacrifice their interest in re-
organizations. In companies which present a complication
of securities; first mortgages, divisional mortgages, general
mortgages, debentures, etc., the sacrifices in interest are usu-
ally apportioned according to the extent to which the differ-
ent bonds have participated in the net earnings of the com-
pany. The net earnings of the company are taken as the
basis of the new fixed charges, and the reorganization com-

452 COEPOKATION FI3MANCE

mittee apportions the net earnings among the various dis-
turbed securities according to the amount which the property
back of each security has contributed to the total. In so far
as the interest on a bond has been earned, this absolute lien,
as a rule, has been retained. In so far as its interest has not
been earned, the bond is reduced to its true position as pre-
ferred stock, a form of security whose return is not guaran-
teed, but is conditioned on the future earnings of the company.
The method employed in this reduction is illustrated by a
statement made by the reorganization committee of the Atchi-
son in the reorganization of 1895 with reference to the posi-
tion of the general mortgage bonds in the reorganization :

" After making a careful estimate as to how much of the
existing lines, if retained in the system, could, under the
circumstances, be avoided, or if these liaes be left out, what
amount the Atchison system would be able to earn without
the auxiliary lines, the committee has arrived at the con-
clusion that it would not be safe to place upon the property
a fixed charge of more than four per cent upon seventy-fi.ve
per cent of the principal of the present general mortgage
bonds."

The situation of holders of general mortgage bonds whose
interest has not been earned is here exactly stated. Since
the company cannot earn their interest, they cannot, in
reason, refuse to consent to a reduction of fixed income.
Suppose they should refuse, what can they do? The only
alternative is to foreclose the mortgage. To do this, they
must raise enough cash to pay off all the prior liens, for their
mortgage is spread over and is subordinate to the claims
superior to their own. This is practically impossible, so
their, only course is to submit, after holding out, as long as
possible, for better terms. It is true that there is always the
final resort to the courts, who may, at any time before the
recording of the new securities, hold up the whole proceeding
by injunction. This will be done, if it can be shown to the

REORGANIZATION OF COEPOEATIONS 453

satisfaction of the court that any interest is being unjustly
treated. Such interference, however^ cannot, unless in cases
of the most flagrant injustice, be secured by a minority. If
a large majority of the bonds are deposited, the courts will
usually refuse to interfere, holding that the consent of the
majority should be binding upon all. The contest over the
Erie reorganization in 1895 offers an illustration. A plan
had been proposed which seemed unfair to the second mort-
gage bondholders. Nevertheless eighty per cent of these bonds
had been deposited, when a suit was brought in the New
York Superior Court to enjoin the company from recording
the mortgage. The court refused to grant the injunction
on the ground that the consent of so large a majority of the
parties in interest had made the plan already operative, and
as minority should not interfere.

The nature of preferred stock has already been fully
explained. Dividends on the preferred stock are payable out
of net earnings after the expenses of operation, repair and
betterments, interest on the funded debt, rentals and taxes,
the necessary cost of operating the business and keeping it
out of the hands of the receiver, have been paid. The fixed
charge of a mortgage bond whose interest must be paid, or
foreclosure results, but which the company cannot earn in jus-
tice to its physical condition and under the circumstances of
its business, is converted into a claim whose payment is con-
ditioned upon the net earnings of the company. In the ex-
change of bonds on which interest is not earned, for preferred
stock in the reorganized company, the relation of the former
creditors to the property is defined precisely. The element
of risk which they assumed when they purchased the junior
lien bonds is exactly expressed in the contract which sets forth
the relation of the preferred stockholder to the company.

The position of the junior bondholder is improved by the
conversion of his bonds into preferred stock. Before the eon-
version, he is occasionally exposed to the risk of receivership
which would depress the value of his securities, and cut off his
income. By converting his jimior lien bond into preferred

454

COEPOEATION FINANCE

stock, he enables the company to preserve its solvency and im-
prove its credit, and he places it in a position where it cannot
only earn interest but pay him his preferred dividends. With
the two exceptions of the Southern and the Erie, and these are
only partial exceptions, the preferred stocks issued in the re-
organiza^tions referred to in the following table have paid
dividends for many years. If they retain these stocks, the
former bondholders have fully recovered the losses caused by
the defaults which led to these reorganizations.

The extent to which the conversion of junior bonds into
preferred stock was employed during the great railway reor-
ganizations following the panic of 1893 is shown in the follow-
ing table :

Amounts of PBBrEBKED Stock Isstjed

NamS of Road

For Old
Bonds

For Stock

For As-
sessments

Miscel-
laneous

»96,740,000

27,146,000

7,271,000

22,833,000

54,880,000

9,290,000
7,184,000

40,286,000
8,214,000
8,214,000

32,887,000

$13,717,000

]::::::::::

$9,200,000

w-;« i First preferred. . .
^™ 1 Second preferred

■ $8,537,000

2,854,000
192,000

167,000

Northern Pacific

17,620,000

2,500,000

Oregon Railway and Navigation

1,440,000

270,000

R-ding jgSfnS'^Sfe^d

20,816,000

1,714,000

St. Louis and f First preferred .

1,150,000

3,850,000

7,786,000

8,799,000

7,814,000

4,800,000

Totals

{314,945,000

$34,956,000

$24,121,000

$54,149,000

The bondholders may also be required to accept a lower
rate of interest, or to postpone their interest altogether for
a series of years, or to take a low rate of interest with a gradu-
ally ascending rate, or to receive a portion of their principal in
mortgage bonds and the balance in some junior security.
In most cases, the reorganization committee, as an induce-
ment to security holders to accept a reduction in their claim
for fixed interest, offers them a bonus in some other security.
If general mortgage bondholders, for example, are asked
to receive one half of the principal in first mortgage bonds

REORGANIZATION OF CORPORATIONS 455

of the new company, and preferred stock for the balance,
they may be given $500 in new first mortgage bonds and
$750 or $1,000 in new preferred stock.' The principal
amount of their securities is, by this operation, increased.
If the prospects of reviving business materialize, and the
new management is efficient, the reorganization may prove
to them to have been a blessing in disguise. An increase
of capitalization is a feature which usually accompanies a
reduction of fixed charges in the reorganization.

In concluding the discussion of the exchange of securities,
two illustrations may be given, showing the distribution of
the securities of the Northern Pacific and the Norfolk and
Western in their respective reorganizations, both of which
were accomplished in 1896.

An examination of these tables shows that so far as the
specific security of the property back of each bond had con-
tributed the amount of the interest on the bonds to the net
earnings of the system, to that extent it was exchanged for

I. BASIS OF EXCHANGE OF THE SECURITIES OF THE

NORFOLK & WESTERN RAILWAY IN THE

REORGANIZATION OF 1896

Old Comfant

New CoMPAirr

Name of Secubtft

Adjustment mortgage, seven per cent bonds

One hundred year mortgage bonds

Maryland and Washington Division bonds

Chester Valley Division bonds

Equipment mortgage bonds, 18S8

Five hundred and mnety debentures of 1S92

Roanoke and Southern Railway bonds

Lynchburg and Durham Railway bonds

Norfolk and Western common']
Norfolk and Western preferred I Assessment S12.50
Roanoke and Southern- Stock C per share
Lynchburg and Durham Stock j

a

6

o * t*

130

62M

70

SO
100

"ss"

35

S

20
75
67H
70
48
100
65
65

Sg

r

I

75

112J5

75

.75

456

CORPOKATION FINANCE

II. BASIS OF EXCHANGE OF THE SECURITIES OP THE
NORTHERN PACIFIC IN THE REORGANIZATION
OF 1896
Old Compant New Company

Name of Secxtbitt

, 6

■k.
if

I"
fie

Common Stock

Trust CDrtificatea.

Per Cent.

General first mortgage bondi

3
4
3
3

135

ioo"

66^

'so"

50
50

20
50

J '

General third mortgage bonds

Collateral trust notes

Northwest equipment stock . . . ^

Depositors of preferred stock on payment

100

SO

Depositors of common stock on payment
of S15 per share

100

new mortgage bonds. In so far as its interest liad not been
earned, preferred stock was given, usually to an amount
greater than the par value of the securities which it displaced.
The principle of apportionment is especially well illustrated
in the Norfolk & Western reorganization. The bonds of four
branch roads were disturbed. Of these, the Maryland and
Washington, and Eoanoke, and Southern had earned more
than the other two, and their greater earning ability was rec-
ognized in larger proportions of preferred stock. The 100-
year mortgage bonds also, whose interest had not been fully
earned, were cut down 25 per cent, but 55 per cent in first
preferred stock was given in exchange, so that in the long run
the bondholders were no losers, the preferred stock in 1898
having sold for 63 J. In the same way, the holders of the con-
solidated mortgage bonds of the Northern Pacific received 62J
per cent in new prior lien bonds, and 62J per cent in preferred
stock. In 1895, before the reorganization, the consolidated
bonds did not rise above 36, while in December, 1898, two
years after the reorganization, the prior lien bonds sold for

EEOEGANIZATION OF COEPOEATIONS 457

93, and the preferred stock for 78. In exchange for a bond
worth $360, the Northern Pacific bondholders received an-
other bond worth, two years later, $642, besides $780 in pre-
ferred stock.

One more feature of reorganization plans demands atten-
tion. The bondholders have controlled the reorganization
and have made sacrifices in order that the plan might be
successful. They insist, as a condition of their participation,
that they should receive some guarantee of the quality of
the management. The stock of the new company, if placed
upon the market, will command a low figure. It may fall
into the hands of speculators who may exploit the property
for their own benefit. The bondholders fear that they may
have another default to suffer, another floating debt to take
care of. To guard against this danger, it is almost invari-
ably provided that the stock of the reorganized company
shall be placed for a series of years in the hands of trus-
tees who will issue to the holders securities of beneficial
interest in any dividends which may be paid on the stock,
the voting power, however, remaining with the trustees.

The nature of a voting trust provision is indicated by
the following extract from the reorganization plan of the
Pope Manufacturing Company:

"All of the stock of the new company except directors'
qualifying shares will be issued to voting trustees, who shall
issue to the various persons entitled to receive said stock
suitable certificates containing an agreement to deliver said
stock on or after August 1, 1911, or sooner if the voting
trustees shall so determine, and in the meantime to pay to
such persons an amount equal to any sums received as divi-
dends upon said shares of stock. During the continuance
of the aforesaid voting trust (1) no mortgage shall be put
upon the property (other than the mortgage herein referred
to) except with the consent of the holders of two thirds in
amount of each class of stock; (3) the amount of preferred
stock shall not be increased except with the consent of the

458 , COEPOEATION TINANCE

holders of three fourths in amount of the certificates rep-
resenting preferred stock and the holders of two thirds in
amount of certificates representing common stock; (3) the
amount of common stock shall not be increased except with
the consent of the holders of two thirds in amount of the
certificates representing preferred stock and the holders of
two thirds in amount of the certificates representing com-
mon stock."

By this provision, not only were the interests of creditors
safeguarded by the placing of control for a period of three
years in the hands of trustees, but the stockholders were as-
sured against any abuse of their power by the voting trustees.

These voting trust certificates, when issued on behalf of
large public corporations, are listed on the public exchanges,
and are dealt in exactly as are shares of stock. The voting
trustees are usually named by the banking firm which car-
ries through the reorganization. They represent primarily
the creditors' interest. Their administration has been gen ■
erally successful and they have materially assisted in restor-
ing to public confidence the corporations for whose man-
agement they have been made responsible.

SUPPLEMENTARY NOTE

The powers of bondholders to deal with stockholders
and unsecured creditors in reorganizations has been very
seriously curtailed by the decision of the Supreme Court
in the case of Northern Pacific Railroad Company v. Boyd,
known as the Boyd Case.^ The Northern Pacific Railway
Company was reorganized in 1896. The reorganization
was controlled by the bondholders and was accomplished
by a foreclosure. The property was bought in by the bond-
holders' committee for $61,500,000, an amount $86,000,000
less than the secured debts. It was transferred to a new
corporation, which issued $345,000,000 of securities. The
old preferred stockholders received 50 per cent of their
holdings in new preferred stock and 50 per cent in new
common stock on paying an assessment of $10 a share,
while the old common stock in return for an assessment
of $5.00 a share received 100 per cent in new common
stock. Unsecured creditors sought to resist the carrying
out of the plan on the ground that it turned over a valu-
able equity in the property to the stockholders of the old
company to the prejudice of unsecured creditors. The
Circuit Court, however, held that there was no equity in
the property out of which these creditors could be paid
and that the mortgage bondholders in purchasing the prop-
erty at foreclosure sale could make any arrangement they
chose with the stockholders of the old company.

The new company prospered exceedingly and its stock
rose to a high figure. Boyd, the owner of a judgment
against the old company, brought suit against both com-
panies, attempting to recover the amount of his judgment
out of the property, alleging that the foreclosure sale was

1 228 U. 8. 482—1913.

459

460 CORPORATION FINANCE

invalid because it was made in pursuance of a Plan of
Reorganization which excluded the unsecured creditors,
although the stockholders were allowed to retain their in-
terest. The lower court sustained this contention, and,
on appealy the Supreme Court, by a vote of five to four,
upheld the lower court:

"The opinion of the majority of the Court proceeds
upon the theory that while the bondholders might have
lawfully bought in the property covered by the mortgage
and kept it for themselves to the exclusion of both the
unsecured debt and the stockholders, the moment they pro-
vided for participation in the new company by the stock-
holders, even at the price of paying a heavy assessment,
the obligation arose to make provision for the. unsecured
debt which would recognize the priority to the interest of
the stockholders."

The prevailing opinion says (p. 504) :

The property was a trust fund charged primarily
with the payment of corporate liabilities. Any device,
whether by private contract or judicial sale under con-
sent decree, whereby stockholders were preferred before
the creditor, was invalid. Being bound for the debts,
the purchase of their property, by their new company,
for their benefit, put the stockholders in the position of
a mortgagor buying at his own sale. . . . That such a
sale would be void, even in the absence of fraud in the
decree, appears from the reasoning in Louisville Trust
Company v. LouisMle By., 174 U. S. 674, 683, 684 (the
Monon ease), where, "assuming that foreclosure proceed-
ings may be carried on to some extent at least in the in-
terests and for the benefit of both mortgagee and mort-
gagor (that is, bondholder and stockholder)," the court
said that "no such proceedings can be rightfully carried
to consummation which recognize and preserve any in-
terest in the stockholders without also recognizing and
preserving the interests, not merely of the mortgagee,
but of every creditor of the corporation. . . . Any ar-
rangement of the parties by which the subordinate rights
and interests of the stockholders are attempted to be
secured at the expense of the prior rights of either class
of creditors comes within judicial denunciation."

/ SUPPLEMENTARY NOTE 461

The Coairt then says (p. 507) :

The invalidity of the sale flowed from the character
of the reorganization agreement regardless Of the value
of the property, for in cases like this, the question must
be decided according to a fixed principle, not leaving the
rights of the creditors to depend upon the balancing
of evidence as to whether on the day of sale the prop-
erty was insufficient to pay prior encumbrances.

The Court continues (p. 508) :

This conclusion does not, as claimed, require the im-
possible and make it necessary to pay an unsecured cred-
itor in cash as a condition of stockholders retaining an
interest in the reorganized company. His interest can
be preserved by the issuance, on equitable terms, of in-
come bonds or preferred stock. If he declines a fair
offer, he is left to protect himself as any other creditor
of a judgment debtor, and, having refused to come into
a just reorganization, could not thereafter be heard in
a court of equity to attack it.

In the face of this opinion it is impossible legally to
exclude any creditor from the benefits of the reorganiza-
tion if the stockholders are allowed to participate. The
unsecured creditors must be offered some form of security
and thfey cannot be forced to pay any assessment as a
condition of receiving these securities.^

1 Reorganization of Corporations, by Paul Cravath, in Some Legal
Phases of Corporate Financing.

INDEX

Accountant, work of, 170.

Addystone Pipe and Tube Com-
pany, case of, 353.

Advertising by corporation, 35.

AlUs-Chalmers Company, as ex-
ample, 120; stock of, 121.

Allotments of stock in syndicates,
160.

Amalgamated Copper Company,
stock of, 366.

American Car and Foundry Com-
pany, equipment notes of, 319.

American Gas Company, 370.

American Light and Traction
Company, 370.

American Locomotive Company,
equipment notes of, 319.

American Malt Company, stock
reduction, 386.

American Pipe Manufacturing
Company, 370.

American Smelting and Eeflning
Company, as example, 227;
stock of, 121.

American Street and Interurban
Railway Association, paper
on depreciation, 222.

American Street Railway Asso-
ciation, report of, 218.

American Sugar Refining Com-
pany, decision against, 356.

American Telephone Company,
158.

American Tobacco Company, case
of, 261; resolutions, 242.

American Water Works Com-
pany, as holding company,

370; guarantee of bonds,
322.

Anti-trust laws, 352, 354, 358,
364, 366.

Appraisers, of collateral, 326.

Arnold Print Works, plan of,
443.

Assessable stock, character of,
99.

Assessment, discussed, 438; in a
reorganization, 440.

Assets, disposition of, 385; pre-
ferred stock cumulative as to,
52 ; sinking fund, 192 ; wasting,
90; writing up of, 204.

Assets and Liabilities, statement
of, 174, 175, 191.

Atchison R. R., debenture bonds,
308, 309; preferred, 454; stock,
in relation to convertible
bonds, 310.

Atchison reorganization, as ex-
ample, 448, 452.

Atlantic Coast Line, in relation
to Louisville and Nashville,
278, 329.

Balance sheet, and depreciation,
193 ; items, 253 ; of a conserva-
tive company, 194, 254; rail-
road, 253.

Baldwin Locomotive Works, 27;
as illustration, 268.

Baltimore & Ohio, as example,
226; bonds of, 315; cash re-
quired in reorganization, 432;
policy of receiver, 423, 424;
463

464

INDEX

problem of, 421, 422; stocks
purchased by Pennsylvania,
257 J reorganization, 451.

Bank deposits, 292; failures, 296.

Banker, attitude toward new en-
terprises, 123; attitude of,
toward promoter, 14; and pro-
moting engineer, 12; business
of private, 114; commercial,
298; investment, 115, 298;
methods in promoting, 22; re-
lation to customers, 124.

Banking house, as underwriter,
156; policy of, 157.

Bank loans, corporate, 297 ; ideal,
295; reason for making, 299;
sound banking, 295 ; when paid,
300.

Bankrupt corporations, reorgani-
zation of, 425.

Bankruptcy, causes of, 436, 437;
effect of, 406.

Banks, bond department, 115;
bond offer, 445; extension of
credit of, 300; plan made
attractive for, 447.

Baring Brothers, take bonds, 158.

Bellaire Steel Company, 349.

Bell Telephone Company, Chicago,
79, 80; circular letter, 255.

Belmont, Mr. August, ease of,
278.

Bessemer Steel Pool, 347, 349.

Betterments, charges, 201, 254;
expenses of, 184, 254.

Blackstone, Sir William, quoted,
28.

Blue Sky laws,' case, 138; Kan-
sas, 135.

Bondholders, advantage for Erie,
in reorganization, 395, 396; in-
terest of, 74; in water power
company, 443; in West Mary-
land reorganization, 446; posi-
tion of, 79 ; position of holders
of general mortgage, 452; rep-

resented, 86; sacrifices of, 454;
take charge of reorganization,
445.

Bondholders' Committee, 427-
432, 459.

Bond issues, basis of, 74, 78; by
. construction company, 110 ; de-
termining the expediency of,
90; restrictions of, 83.

Bonds, advantages of, 73; advan-
tages of debentures, 310;
amount of, which can be is-
sued, 76-79; bonus in stock,
85; bought for sinking fund,
92; business, 115; buyer, 299;
collateral trust, 315; conver-
sion of, into stock, 389; con-
vertible, 308, 311, 397; coupons,
64; debentures, 306-309; de-
ferred interest, 396; defined,
63, 87; drawings of, 91; form
of, 64; income, 304; indorse-
ment of, 319; inducements to
refund, 400; in purchasing
control, 340; interest in pro-
portion to income, 77; methods
of disposing of, 94; preference
for mortgage, 312; provision
for repayment of, 87; rate of
interest to be fixed on, 84; re-
funding of Erie, 392; refund-
ing, 398; remedy for holders
of, 321; repayment of, at ma-
turity, 88; reserve for, 80-83;
railroad security tor, 78; re-
St]|ictions on issue, 83; safe-
guards for, 89; sale of, at a
discount, 85; second and third
mortgage, 318; serial, 94; sink- '
ing fund, 94; term of, 83; use
of, 368.

Bonus, by contracting company,
112; common stock as, 85, 102,
113.

Boston & Maine Bailroad, as ex-
ample, 342; fluctuations in
earnings of, 236.

INDEX

465

Boston Consolidated Gas Com-
pany, as example, 337.

Boston Elevated Railway Com-
pany, provisions of lease, 381.

Boyd case, 459.

Buffalo, Eochester & Eastern
Railroad, 275.

Burlington stock, as example,
325.

Bush, President, quoted, 408; as
receiver, 411.

Business, a, defined, 74.

By-laws, 38.

Caldwell, Stephen A., 415.

California Electric Generating
Company, as example, 319.

Call loans, compared to collat-
eral trust bonds, 326.

Calumet &, Heckla, as example,
132; as investment, 119.

Cambria Steel Company, as in-
vestment, 118.

Capital account, readjustment of ,
385; table of, 401.

Capital stock, discussion of, 246;
decrease of, 387; defined, 44;
in new enterprises, 4, 99 ; meth-
ods of providing, 267; of the
promoting engineer, 7; profits
as a source of new, 269 ; reduc-
tion, gf; 388.

Capitalization, excessive, 142,
150; of expenditures, 254; over
capitalization, 59 ; proper, 143 ;
reasons for restrictions, 144;
stock watering, 144-146.

Car trusts, 431.

Oamegie Steel Company, growth
of, 268; guaranteed dividend,
339; pool dissolution, 350;
policy of, 147; .threatens com-
petition, 342. . .

Cassatt, President, quflted, 258,
259. J. '

Central Railroad "ofi.^ew, Jersey,
320. ■■ '■

Central Union Telephone Com-
pany, as illustration, 255.

Charter, 25, 31, 33; Dartmouth
College case, 39; defined, 44,
49 ; Kankakee Packing Co., 40 ;
preferred stock on, 50; special
object clause, 40.

Chelsea Gas Light Company, 339.

Chesapeake & Ohio Railroad,
stock purchased, 259, 339.

Chicago, Burlington & Quincy
Railroad, joint 4s, 327, 328;
stock, 70, 71.

Chicago & Northwestern, divi-
dend policy, 236; stock of, as
investment, 118; sale of stock,
287.

Chicago & Great Western, as ex-
ample, 429, 431; cash in reor-
ganization, 432; plan set forth
to stockholders, 439, 440; state-
ment of, 438.

Chicago Bell Telephone Company,
as example, 79, 81.

Chicago City Railway Company,
■ as investment, 119.

Chicago, Milwaukee & St. Paul,
sale of stock, 287.

Chicago Railways Company, as
example, 274.

Chicago, Rock Island & Pacific,
as example, 328, 391.

Chicago Union Traction Com-
pany, rates for equipment of,
196.

Classification of industries, 73,
75.

Clayton law, 364.

Closed mortgages, form used by,
314.

Goal company, in western Penn-
sylvania, 6.

Coal land proposition, as illus-
tration, 6, 15, 17,, 21.

Collateral, selling of, 391.

466

INDEX

Collateral trust bond, explained,
313; of finance companies,
368; of Erie, 394; purpose of,
326; security of, 324; use of,
110; value of, 325.

Collateral trust indenture, fram-
ing of, 325; provisions in case
of default, 345.

Collateral trust mortgages, na-
ture of, 69; safeguards of, 324.

Colorado Fuel & Iron Company,
agreement of, 306; sale of
property to meet loans, 385.

Colorado Utah Construction
Company, 106.

Commercial and Financial Chron-
icle, quoted, 2.

Committee for reorganization,
method of forming, 428.

Common stock, as bonus, 85, 113 ;
defined, 49; discussed, 44; divi-
dends on, 45, 53; bow sold,
386; in reorganization, 441;
premiums, 279, 284 ; prices, 149,
152; purch£|,sing with stock,
343 ; reduction of, 386 ; sale of,
279; without par value, 59.

Common stockholders, receipts
of, 50; position of, 72.

Community of interests, 355.

Competition, and prices, 145;
and watered stock, 146; at-
tempt to eliminate, 234; forces
expansion, 254, 256.

Conducting transportation, items
of, 177.

Consideration, defined, 15.

Consolidated Gas Company of
New York, 152; guarantee of,
320.

Consolidated Oil Company, as ex-
ample, 119.

Consolidation by stock owner-
ship, 338.

Construction companies, descrip-
tion of operation of, 109-113;
reason for, 113.

Convertible bonds, 307-310; de-
bentures, use of, 311.

Corn Products Eefining Co., 313.

Corporate bonds, endorsement of,
319.

Corporate leases, provisions of,
375.

Corporation, advantages of, 26-
31; compared to partnership,
25, 41; defined, 25, 28, 44;
issuing stock, 30.

Corporation law of Germany,
101.

Corporation laws of Great Brit-
ain, 101.

Corporation laws of New Jersey,
31, 32, 102.

Corporations, advantages of en-
largement, 256 ; bankruptcy of,
406; bill to control capitaliza-
tion, 142; consolidation of,
338; determining values of,
143 ; dissolution of, 38 ; express
powers, 46; factors in earn-
ings of, 225; foreign, 43; gov-
ernment of, 31; legal position
of, 354; loans, legitimacy of,
296; name, 35; majority rule,
47; New Jersey laws relating
to, 31, 32, 102 ; personality of,
36; powers of, 34-41; profits
determined, 172 ; regulating
capitalization, 144; relation of
stock to prices, 145; source of
profits, 172; sue and be sued,
36; where organized, 405.

Coupons, refunded, 392, 396;
form of, 64.

Cowan, John K., 421.

Cravath, Paul D., quoted, 461.

Creditors, floating debt, 443; op-
position of, 420; position of,
442, 443; relation of, to rail-
road, 406; sacrificing of, 450;
secured, 407.

Crucible Steel Company, divi-
dends, 389.

INDEX

467

Cumulative preferred stock, as to
assets, 52; defined, 50; poUcy
concerning, 51; security of,
341; relation to dividend
poUey, 51.
.Cunard Company, as illustration,
241.

Dagget, Dr. Stuart, 441, 449.

Dartmouth College case, 39.

Debenture bond, attractive fea-
tures of, 307; defined, 304; in
Great Britain, 312.

Debt liabilities, readjustment of,
390.

Debts, of partners, 25 ; of corpor-
ation, 26.

Delano, Dr. Fred. A., discussion
by, 199.

Delaware law, 42.

Delaware & Hudson, debentures,
308.

. Denver, Northwestern & Pacific
Bailway Company, 106.

Depreciation, accounting for,
190-197; calculation of, 195;
causes of, 187; defined, 187;
illustration of, 189, 190, 191;
due to, 188; sinking fund com-
pared with, 200; summary of,
199 ; Wisconsin Commission,
provision for, 222.

Depreciation Beserve, how made,
191-192; for shortage, 194;
surplus and, 193.

Deschutes Irrigation Company,
399.

Directors, Board of, classes of,
57; control of depreciation
fund, 222; declaration of divi-
dends, 209, 211, 227; elected by
preferred stock, 55, 157; in-
terest in stockholders, 285; de-
fined, 31; new stock, 280-285;
of speculative corporations,
120; poUcy of, 268; powers,

32, 42, 44, 48, 55'; United
States Steel, 33, 213.

Dissolution of corporation, 38.

Dividends, advantage of stable,
211; and capitalization, 146,
147 ; cumulative preferred,
eftect of, 212; defined, 207;
moral obligation of, 388; of
different corporations, 207; of
safe investments, 123, 237; of
trusts, 120, 121; on preferred
stock, 51; on speculative stock,-
130; policy regulating, 269;
prohibition of scrip, 155; re-
duction of, 218, 385; reserve
for, 241; s^fe for railroads,
237; stock dividend, 242; Uni-
ted States Steel, 212; with-
holding of, 270.

Drexel & Company, 332.

Earnings, for extension, 268;

railroad, 236; stability of, 75,

228.
Edson, President, quoted, 265,

266.
Eisner v. Macomber, 244.
Electric Bond & Share Company,

owned by General Electric,

365.
Electric Railway Journal, quoted,

196.
Electric Securities Corporation,

owned by General Electric, 368.
Engineers, method used by, 8, 9;

mistakes of, 10, 11; promoting,

10.
Equipment Notes, 319, 333.
Equipment Trust Bonds, use of,

334.
Equitable Trust Company of

New York, 66.
Erie & Jersey Railroad, 395.
Erie Railroad, cash in reorgani-
zation, 432; common stock,

387 ; divisional mortgages, 451 ;

468

INDEX

prior lien bonds, 315; reor-
ganization, 303, 453, 454.

Erie bondholders, proposition to,
394; statement to, 395.

Esch-Gummins Bill, 154, 276.

Excess profits tax, 56, 146, 168.

Expenditures discussed, 253.

Expert testimony, 9, 128.

Palling prices, effect of, 229.

Farmers, and a promotion, 21.

Federal Anti-Trust Law, 358,
365; Federal Trade Commis-
sion Law, 364.

Federal Reserve Act, 295.

Federal Eeserve Bank, 292.

Federal Eeserve System, 295.

Fields, Marshall, as illustration,
268.

Finance Holding Company, col-
lateral trust bonds of, 369; ex-
amples of, 368; purposes of,
370.

Financial plan, 72.

Fish, Mr. Stuyvesant, support of,
285.

Fixed charges, reduction of, 448,
449.

Flagler, Henry M., 319.

Floating debt, creditors, 444;
funding, 392; of Pressed Steel
Car Company, 264.

Florida & East Coast Railway
Company, notes guaranteed by
Mr. Flagler, 319.

Ford, Mr. Frank E., quoted, 222,
223.

Form of coupon bond, 64.

Fourteenth Amendment, 138, 139.

Funding of floating debt, method
of, 392.

Gates, John W., campaign of,
278.

General Corporation Act of New
Jersey, section of, 106, 107.

General Electric Company, busi-
ness of, 367; dividends of,

207; relation to finance com-
panies, 368; stock as invest-
ment, 118.

General mortgage bonds, posi-
tion of holders, 452.

Genesee Eiver Eailroad, 395.

Germany, laws regulating the
sale of stock, 101.

Girard Trust Company, in Le-
high Valley car trust, 332.

Good will, 35.

Gould interests, 233.

Gowen, Franklin B., 415.

Great Britain, debenture bonds,
312; investment trusts, 370;
laws regulating sale of stock,
101.

Great Northern Eailroad, ex-
change of stock, 360 ; ore lands,
239; price of stock, 282; privi-
leges to stockholders, 287, 289 ;
surplus distributed, 239, 240;
trust indentures, 70.

Great Northern, Northern Pa-
cific, and Chicago, Burlington
& . Quiney, transaction, 328,
344.

Great "Western Power Company,
example of weak' guarantee,
319.

Gross Earnings, defiiied, 176.

Guarantee, objections to, 322;
strong, 320; use of, 319.

Guarantee Trust Company of
New Tork, as example, 315;
circular quoted, 333.

Hadley Commission, report of,
154.

Harlan, Asso. Justice, 362.

Harriman, E. H., aid of, to the
Erie, 303; description of secu-
rity by, 316; difficulty ex-
perienced by, 285 ; testimony
of, 384.

Harvard University lecture, 42.

Hayden, W. S., address, 136.

INDEX

469

Hepburn Law, and Pennsylvania
Railroad, 258.

Herrick, Robert F., quoted, 365.

Hill, J. J., and ore lands, 239.

Holding companies, advantages
of, 367; defined, 346; exam-
ples of, 368; investment hold-
ing of Great Britain, 370;
methods of forming, 367; of
New Jersey, 356, 359; purpose
of, 367, 369; why formed, 346.

Home Oil Company, 131.

Houghton & Gallup, owning
stock, 443.

Hudson & Manhattan Railroad
Company, 302.

Hudson River Electric Power
Company, funding coupons,
396.

Illinois Central Railroad, contest
for proxies, 287; option by,
16; privileges for stockholders,
282; stockholders of, 285.

Illinois, laws, 45.

Illinois Steel Company, relation
to pool, 350.

Illinois Tunnel Company, prop-
erty unfinished, 420; receivers'
certificates of, 416.

Income account, 202; discussed,
251; in reports, 173.

Income Tax Law, 51, 243.

Indianapolis Street Railway Com-
pany, leased, 376.

Indianapolis Terminal & Traction
Company, offer, 376.

Industries, classification of, 73,
75; how influenced by prod-
ucts, 230.

Industry, growth of, 2.

Injunction, 58.

Interborough Rapid Transit Com-
pany, surplus, 335; work of
maintenance department, 182,
376.

Interest, higher when bonds sold
at discount, 88; paid on
bonds, 84; reduction of, 450.

International Harvester Company
case, 363; depreciation ac-
count, 192; dividend, 174;
form used by, 172-174; re-
serves, 194, 195.

International Mercantile Marine
Company, stock taken in ex-
change, 343.

Interstate Commerce Commission,
cases, 185, 276.

Investigation, by promoting en-
gineer, 11, 12; of a property,
8, 9.

Investment, relation to produc-
tion of wealth, 3.

Investment banker, function of,
115, 116; work of, 123.

Investment stocks, characteristics
of, 119, 122; examples of, 118;
safe, 123.

Investment trusts, advantages of,
371; of Great Britain, 370.

Investor, and assessable stock,
101; and watered stock, 146;
attitude of, 5, 23, 87; charac-
ter of, 122; classes of, 3; de-
mands reports, 169; preference
for security, 312; privileges of,
283; relation to promoter's
profits, 23; rights to profits,
269; safeguards, 32; trust stock
not popular, 127; what will
buy, 123 ; wishes stability, 209 ;
why so named, 118.

Investors, most important, 123.

Iron Age, quoted, 147, 349, 350.

Jarvie, Mr., chairman, 434.
Junior bondholder, position of,

453.
Junior bonds, table of, 454.

470

INDEX

Kankakee Packing Company, 40.

Kansas plan, Blue Sky laws, 136.

Kansas City Southern Railway
Company, as illustration, 216,
217; expenditures necessary
for expansion, 264.

Keene, James B., charges made
by, 270.

Knight, E. C, Sugar Eefining
Company, 359, 361.

Knox, Attorney General, 360.

Kuhn, Loeb & Company, as ex-
ample, 157, 158.

Lackawanna Iron & Steel Com-
pany, in pool, 349.

Lacombe, Judge, quoted, 414.

Lake Shore & Michigan Southern,
collateral trust bonds, 328; ex-
change of stock, 340.

Lake Superior ore deposits, 75.

Lease, and (preferred) stockhold-
ers, 56; advantage of, 376;
bonds secured by assignment
of, 330; corporate, 374; defini-
tion of, 373; disadvantage of,
377; of Boston Elevated, 380;
of Philadelphia Bapid Transit
Company, 380; restrictions by
preferred stock, 56; typical
proposition, 376; use of, 330.

Lehigh Valley Car Trust Certifi-
cates, 330.

LeBoi Mine, 131.

Lessor, agreement of, 331; power
of, 415.

Liabilities, limited liability, 2?;
of National Banks, 26; of cor-
poration, 105; of partnership,
25; readjustment of, 385, 391.

Loans, classes of, 297; security
for, 56.

Long Island Bailroad, 4, 64, 260.

Louisville Trust Co. v. Louisville,
460.

Louisville & Nashville Railroad,
collateral trust bonds, 278, 329.

McLeod, President, 411.

Macomber, Myrtle, 245.

Maine law, 42.

Maintenance, American Street
Railway Association Beport on,
218; charges, how made, 184;
departments, duty of, 177, 182,
188; illustration of work of
maintenance department, 182;
items of charges, 214; neglect
of, 216; objects of car, 219;
skimping, 219.

Maintenance of equipment, 176.

Maintenance of way and struc-
ture, 177.
' Manhattan Eailway Company,
provision for maintenance,
374; lease, 335.

Maryland and Washington, 456.

Massachusetts Public Service
Commission, authorized bond
issue, 276.

Mercantile Trust Company of
New Tork, 107.

Merchandise Creditors' Commit-
tee of Westinghouse reorgani-
zation, 434.

Merger, explained, 336; method
of, 337.

Mexican mining proposition, 125.

Michigan Central Bailroad, 328.

Mining enterprises, as basis for
bond issue, 76.

Minneapolis, St. Paul & Sault
Ste. Marie, acquired Wiscon-
sin Central, 343.

Minnesota rate case, 154.

Minority protection, 47.

Missouri anti-combination laws,
358.

Missouri Pacific Bailroad, 324.

Mitchell, Dr. T. W., work of, 282,
324.

Money market in 1906, 299.

Monopoly, defined, 75; feeling
against, 352; origin of, 75;

INDEX

471

railroad, 233; when difficult,
235.

Morawitz, Victor, 59.

Morgan, J. P., & Company, an-
nouncement of, 429; as exam-
ple, 157; as syndicate mana-
gers, 344; letter of, 164; re-
funding coupons, 393 ; takes
bonds, 158.

Mortgage, clause of, 55; col-
lateral trust, 69; defined, 64;
example of, 66; first consoli-
dated of Erie, 392; form of
closed, 314; "open end," 274;
safeguards, 80, 83, 90; sub-
sidiary companies used, 318;
types of, 313.

Mortgage bond, advantage of, 79,
312.

Mortgage Bond Company of
New York, bonds and mort-
gages of, 369.

Morton Trust Company, 448.

Murray, Oscar G., 421.

National Banking Corporation,
26.

National Bank Law, 291.

National Geological Survey, 129.

National Terminal Company,
bonds, 16.

Nebraska Maximum Freight Bate
Case, 151.

New Hampshire law, 42, 59.

Newhouse Mines & Smelters, re-
organization plan of, 441.

New Jersey, general corporation
act of, 32, 106; laws of, 31, 34,
38, 39, 41, 42, 43, 47, 356, 358,
359.

Newlands, Senator, bill of, 142.

New York & Westchester Light-
ing Company, as example, 320.

New York Bar Association Ee-
port, 59.

New York Central, competition

prevented, 275; purchasing
control, 328, 340.

New York City Eailway Com-
pany, 414.

New York law, 45, 59, 154.

New York, New Haven & Hart-
ford, as example, 236, 262,
342 ; debenture bonds, 304, 305,
307; privileges of stockhold-
ers, 285.

New York Stock Exchange, safe
investments, 123; rules of, 278.

Norfolk & Western, and Pennsyl-
vania, 257, 259, 339; reorgani-
zations, 451, 454, 455.

Northern Pacific Railroad Com-
pany, and C, B. & Q. transac-
tion, 70, 325, 329, 341, 384;
contest for, 359, 361; ex-
change of stock, 455 ; net earn-
ings, 448; panic, 278; old plan
of capitalization, 431; reor-
ganization of, 456; sale of
stock, 287.

Northern Securities Company,
326, 359, 360, 361, 384.

Northern Sugar Eefining Com-
pany, 354.

Notes, short term, 298, 300.

Ohio law, 42.

Open end mortgage, 314.

Operating expenses, classes, and
items, 176.

Option, definition of, 15; exam-
ple of, 17.

Optionee, examples of, 16; rights
of, 16, 17.

Oregon Eailroad & Navigation
Company, as security for
bonds, 326; in reorganization,
454.

Oregon Short Line Eailroad, re-
funding, 326.

Overcapitalization, 59.

472

INDEX

Partnership, definition, 25; com-
pared to corporation, 25, 41;
disadvantages of, 26-31.

Par value, 45, 58, 60, 143.

Pennsylvania law of corpora-
tions, 38, 43, 45, 59, 356.

Pennsylvania Railroad Company,
and the Baltimore & Ohio,
339; classified freight, 230;
control of competitor, 360 ; cost
of maintenance, 215; divi-
dends, 207; gains of, 261;
gross earnings, 231, 232; policy
of, 236, 256; report of, for
1899, 257; short term notes,
302; specifications of, 179;
stock as investment, 122; stock
premiums, 280, 286; terminal
improvements, 260, 270; ton-
nage, 260.

Pennsylvania tunnel extension,
money raised for, 5; object of,
5, 260.

People's Gas Company, 151.

Personality of corporations, 36.

Philadelphia Eapid Transit Com-
pany, as illustration, 378-380.

Philadelphia & Reading Railroad
Company, in reorganization,
430, 451; receivership, 411,
415.

Pittsburg, Bessemer & Lake Erie
Railroad, stock guaranteed by
Carnegie Co., 339.

Pool, dissolution of, 349; organi-
zation of Bessemer Steel 1*001,
347, 349; prices, 350; trust as,
353.

Pooling agreements, 351.

Pope Manufacturing Company,
reorganization plan, 457.

Postal laws, 139.

Preferred stock, advantages of,
50 ; and directors, 55, 57 ; as to
assets, 52; attempt to force
dividends, 209; breach of con-
tract, 57; charter provisions.

51; classification of, 50;
cumulative, 50; defined, 49;
dividends on, 51, 72, 453; di-
vision of, into series, 51;
funding cumulative dividend,
388; in dissolution, 52; injunc-
tion, 58 ; in reorganization, 454 ;
issues of, 50; issue of United
States Steel, 164; participation
in extra dividends, 52 ; profits
from premiums, 203 ; protection
of, 51-58; rate of dividend of,
50; sinking fund, 53; veto
powers, 56; voting powers,
55, 58; whom used by, 51;
without par value, 59.

Preferred stockholder, demands
of, 51; position of, 50, 51, 72.

Premium stock, issue of, 287;
stock, 279, 284.

Pressed Steel Car Company, re-
port of President of, 263;
funding of floating debt, 262.

Prices, attitude of federal courts
151, 152;' how fixed, 146; in
pools, 350; of trusts, 352;
under United States Steel, 233,
235.

Private banker, function of, 115.

Privileged subscription, 281, 284,
285.

Producer, as investor, 3.

Production, capital necessary for,
4; of wealth,, opportunities
for, 2.

Profits, definition of, 171; dis-
posal of, 50; fluctuation in,
225, 229, 235, 236; how dis-
tributed, 207; illustration of,
228; increase by extension,
253; interest of investor in, 4;
making extensions out of, 268;
obtaining new capital for, 269 ;
percentage of, paid to stock-
holders, 228 ; policy of rail-
roads, 236; policy of United

INDEX

473

States Steel, 213 5 principles of
making, 168; railroad versus
manufacturing, 229 ; sources
of, 175; stability of, 226.

Profit and loss account, 190.

Promissory note, defined, 87.

Promoter, arguments used by,
18 ; basis of Ms profits, 20, 23 ;
function of, 6; justification of
his profits, 6; local, 7; pros-
pectus of, 128; work of, 6.

Promoting engineer, advantages

. of, 11, 12.

Promotion, assembling of propo-
sition, 14 ; function of, 6 ;
principles of typical, 19.

Property, non-specialized, 73 ;
specialized, 74.

Prospectus, character of, 128; in
copper, 132.

Proxies, 285; form of, 46.

Public Service Commission, and
Public Service Corporation,
271; in receiverships, 414;
New York, 152, 154; Erie bond
dssue, 394, 395; power of, 272;
of Wisconsin, 154.

Public Service Corporation, and
capitalization, 185; as bpild
security, 76; case of, 152;
dividend allowed, 281; in Mas-
sachusetts, 271, 281; rate of
interest, 84.

Pullman Company, cars leased
from, 422 ; stock dividends, 194.

Quarterly Journal of Economics,

quoted, 282, 324.
Quick Assets, 82.

Railroad, and construction com-
panies, 109; as monopoly, 233;
basis of bonds, 76; character
of property, 405; community
of interest, 234; consolidation
of, 359; earnings, 229, 231;
effect of bankruptcy, 406;

equipment trust obligations,
333; mortgage, 299; rentals,
450; safe development, 237;
short term notes, 302; use of
lease, 330; use of subsidiary
companies, 318.

Railroad expenses, two classes of,
176.

Railroad Securities Commission
Report, 60, 155.

Railway and manufacturing in-
dustries, distinction between,
232.

Railway Gazette, quoted, 199.

Railway profits, protection of,
233; stability of, 236.

Reading R. R. Co., 451, 454.

Receiver, authority of, 411; cer-
tificates of, 415, 420; duties
of, 411, 412; form of certifi-
cates of, 416; reason for ap-
pointing, 409, 411; report of,
417.

Receiver's certificates, allowed by
court, 420; form of, 415.

Receiversljip, cause of, 412; de-
fined, 409, 424; reasons lead-
ing to, 408.

Refunding, methods of, 402.

Refunding bonds, economy of,
399; reason for, 87, 398.

Reorganization, cash required,
426, 432; defined, 425; North-
ern Pacific, 460; of capital ac-
count, 383; plan of, 430; re-
ducing fixed charges, 448 ; ob-
jects of, 426, 427; stock with-
out par value, 61.

Reorganization plans, feature of,
457.

Reports, form of, 173; import-
ance of, 169; what included,
170.

Republic Iron & Steel Company,
provision of mortgage of, 82;
recovery of, 389; suspension of
dividends, 83.

474

INDEX

Eeserves, how handled, 195.

Revenues, disbursement of, 413.

Richmond & West Point Termi-
nal, reorganization, 450

Right to sue, 34, 36.

Rising prices, effect of, 229.

Roadbed of Pennsylvania Rail-
road, cross-section of, 178;
specifications of, 179-181.

Roanoke and Southern, 456.

Rochester, Corning, & Elmira
Traction Company, as exam-
ple, 273.

Rock Island Company, collateral
trust bond, 324, 329.

Rogers, H. H., use of his credit,
319.

Rubber Goods Manufacturing
Company, 342.

Rule of reason, 362.

Ryan, Thomas ¥., 448,

St. Louis & San Francisco Rail-
road Company, refunding, 400,
454; surplus, 402.

St. Louis & Southwestern Rail-
way, 320.

San Diego Consolidated Gas &
Electric Company, as example,
93.

Seaboard Air Line, adjustment
plan of, 442.

Second mortgage holder, 453.

Security Investment Co., 436.

Securities, and fluctuating pro-
fits, 227; broad market for,
157; prices, 210; sale of, 114;
to bankers, 116; two kinds of,
118.

Security issues, kinds banks will
buy, 118; sale of industrials,
127.

Self -liquidating paper, 296.

Seligman, J. & W., syndicate of,
400.

Serial bonds, advantage of, 94,
95.

Share, defined, 30, 44.
Shareholders, rights of, 46, 4&.
Shepard, Edward M., 59.
Sherman Anti-trust law, 234,
353, 358, 362, 367; illustration
of, 234, 361.
Short term notes, security of,
303; when advantageous, 301,
302.
Sinking fund, assets, 192 ; classes
of, 89; comparison between de-
preciation and, 200; disposing
of bonds, ~ 94 ; investing the
fund, 93 ; method of managing,
90-94 ; refunding and, 398 ; use
of preferred stock, 53; use of
serial bond, 94; when needful,
89.
Snow, F. E., quoted, 337.
Southern Pacific Railroad, 270,

326.
Southern Railway Company, in re-
organization, 454 ; mortgage,
301; notes, 300; purchase of
Tennessee Central, 16; short
term notes, 300-303.
South Sea Company, 134.
Southern Securities Company,

•360.
Southwestern Securities Com-
pany, 360.
Specifications, of Pennsylvania,

179.
Speculation, elements of, 120,
122; illustrated, 119; trust as,
121.
Speculative securities, sale of,

127.
Speculator, and trust stocks,
127; as promoter, 133; char-
acter of, 122; inducements to,
127, 130, 131; interest in con-
vertible bonds, 308, 309; line
of, 134; why so named, 122.
Speyer & Company, as syndicate
managers, 158, 161, 286; plan
of, 391.

INDEX

475

Standard Oil Company, 149, 356,
358, 361; stock, 118.

Standard Oil Trust, efEect of,
352; declared illegal, 354;
prices of stock, 149; problem
solved by, 355.

Stetson, Francis Lynde, 59.

Stock, as collateral, 325-328;
assessable, 99 ; assessment
loans, 297; character of indus-
trials, 127; character of public
corporations, 169; classes of,
49; changes to bonds, 389;
common in reorganization, 454 ;
convertible, 307, 309; defined,
44; distribution of, 111; divi-
dend, 243; fraudulent, 139;
guaranteed, 321; how reduced,
389; increase of amount of^
279; in place of bonds, 289;
issue of, 91, 279; method by
which acquired, 340 ; method of
consolidating by, 366; method
of selling, 127; of Erie, 387;
par value, 45, 58; premium,
280, 287; prices of common,
149; prices dependent on divi-
dends, 211; privileged sub-
scriptions, 281-283; purchasing
control, 240, 258; right of
holder^ 46, 49; sale of, in
Europe, 101; selling at par,
279, 287; speculative, 121, 123;
stock ownership, 338; treasury,
112; watered, 49, 143-155;
voting powers of, 47.

Stock trust certificate, 343.

Stockholder, liability of, 42,
105; ownership, 44; privileges
of, 281; rights of, 58, 59;
standpoint of, 342-344, 368;
value of privileges, 282, 289.

Stockholders, approval of, 33;
classes of, 50; control of
proxies of Illinois Central, 285 ;
distributing profits to, 207;

effect of sales of new stock on
old, 279, 284; in Seaboard,
442 ; position in reorganization,
433, 437; powers of, Zl, 36;
proposition made to, 342, 378;
public and, 154; speculative
profit of, 398 ; U. S. steel, 33.

Stocks, investment, 118, 123.

Stocks and bonds, by whom held,
169.

Stone & Webster Corporation,

. banking department of, 12.

Stotesbury, E. T., agreement of,
332. '

Street Eailway Journal, quoted,
182.

Stringency of money, illustrated,
300.

Sturgis, C. I., quoted, 196.

Sub-syndicates, 163.

Suburban railroad, failure as
financial proposition, 9.

Sugar Trust, 352, 357, 359.

Surplus, and collateral trust
bonds, 368; and depreciation
reserve, 193; as reserve, 241;
defined, 172, 174, 242; illus-
tration of, 239; of C, B. & Q.,
325; of Erie, 395; policy of
United States Steel, 213.

Surtax, 243.

Syndicate, assessment in reorgan-
ization, 439; for construction
company, 111; for St. Louis
& San Erancisco, 400; in coal
land proposition, 7, 18; in re-
funding, 393, 394; Lehigh Val-
ley Car Trust, 330; necessity
of, in reorganization, 448;
organization of, 19, 157, 158;
Seaboard, 442; suburban rail-
road, 9; underwriting, 156,
159; Western Maryland, 448.

Syndicate agreement, 161.

Syndicate dissolution, illustrated,
164-166.

476

INDEX

Syndicate Managers, allotment
of subscriptions, 159; charac-
ter or transaction, 163 ; who
is, 157; work of, 7, 8, 9, 159.

Syndicate transactions, feature
of, 163.

Tennessee Central Railroad, as
security, 302; bonds, 302; op-
tion, 16.

Third Avenue 'Eailroad, 417.

Towne v. Eisner, case, 245.

Treadwell Mine of Alaska, as
example, 131.

Treasury stock, 102, 112, 239.

Trust certificates, how dealt in,
351, 357.

Trust Company, attitude toward
speculation, 125 ; represent
creditors, 63.

Trust Indenture, 70, 93.

Trustees, authority of, 404; in
case of default, 68, 70, 71;
need of, 63; of sinking fund,
90-93; transfer to, 66; work
of, 351.

Trusts, Allis-Chalmers, 120; at-
tack on, 353, 354; changes in,
356; character of securities,"
122 ; competition eliminated,
351; dividends of, 120, 121;
legal position, 354, 362; rail-
roads, 359; results of attack
on, 354; sale of securities, 127;
Sugar Refining Company, case,
359; weakness of, 353.

Typical promotion, principles of,
19.

Underwood, President, announce-
ment of, 392.

Underwriting, by banks, 158.

Underwriter's Syndicate, allot-
ment of, 159; definition, 156,
167; for Pennsylvania Bail-
road, 286; how organized, 158;
provisions of agreement, 161;
profits, 344.

United Gas Improvement Com-
pany, 285.

Union Pacific Eailroad Company,
and Southern Pacific, 270;
debentures, 307 ; dividends,
207; mortgage of, 315-317; net
earnings, 448; prohibited from
increasing debt, 324.

Union Traction Company, leased,
378; proposition made to, 380.

United States Rubber Company,
argument of, 342.

United States Shipbuilding Com-
pany, as example, 448.

United States Shoe Machinery
Company, case, 363,

United States Steel Corporation,
and Sherman Law, 366; as

, example, 149; bond conver-
sion, 391; capitalization, 33,
44; Carnegie threatens compe-
tition, 342; case decided, 363;
competition eliminated, result-
• ing policy, 147 ; control of raw;
material, 75; depreciation ac-
count, 191; dividends, 207,
212, 213 ; dividend policy, 213 ;
extent of monopoly, 234; fail-
ure of, regarding prices, 235;
Gary plant, 270; gross earn-
ings, 231; guarantee of lease,
239; holding company, 366; re-
port of, 169, 170; stabiUty of
prices, 233; stock conversion,
164; stockholders, 33, 34; syn-
dicate, 163.

United States v. E. C. Knight &
Company, 361.

United Verde' Mine, dividends of,
129.

Utica & Mohawk Valley Rail-
road, mortgage of, 81.

Vested interests, 153.

Voting Trust, Kansas City
Southern, 216; Pope Manufac-
turing Co., 457.

Voting Trust Certificates, 458.

INDEX

477

Wabash Eailroad, reorganization
of, 450.

Wall Street Journal, quoted,
146.

Wanamaker, John, as illustra-
tion, 268.

Wasting assets, 90.

West End Street Eailway, lease,
380.

Western Maryland, as example,
486 ; receivership, 408 ; reor-
ganization, 448; stock at dis-
count, 431.

Westinghouse Electric & Manu-
facturing Company, as exam-
ple, 82, 444; cause of receiver-

ship of, 264; proposition of, to

stockholders, 434, 436; stock

of, 121.
West Virginia, 42.
Wheeling & Lake Erie, 303.
Whiskey Trust, failure of, 352.
Whitridge, Frederick W., report

of, 417.
Wickersham, Attorney General,

quoted, 42.
Willcox, Wm. K., et at, 152.
Wire Nail Association, 348.
Wisconsin Central, 343.
Wisconsin law, 154.
Working Capital, 112, 263, 264,

384, 396, 397.

(15)

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