Stuart Daggett

“ Its chief disadvantage is that the sale is apt to be made at a time when the level of general prosperity is not high, and the price obtained is therefore apt to be low. But the question is quite different when the securities are those of the embarrassed or bankrupt road itself. In this case the credit of the company and the price of its securities are sure to be at a low ebb. The initial sacrifice entailed is necessarily great; while if the securities sold are bonds, as they are almost sure to be, the company increases its annual interest charge without receiving an equivalent value in return. ”

“ The second fundamental cause of railroad distress has been competition. If unrestricted capitalization has increased the load which the railroads have had to bear, unrestricted competition has impaired their ability to support any load at all. The forms which this competition has taken have been mainly two: first, the cutting of rates, either openly or by secret concessions; second, reckless extensions of line, generally followed by rate-cutting. The cutting of railroad rates is now a subject familiar to all. Illustrations may be found in the history of any great railroad system. ”

“ In its handling of the floating debt, the plan was a second edition of Mr. Jones’s stock-selling scheme, with all the good points left out. What justification there could have been for calling securities, such as the deferred incomes, “bonds,” which were to be issued for no definite time, ranked even after the common stock for dividends, and were of such doubtful character that Mr. Gowen himself proposed to sell them for one-third of their face value, does not appear; unless it be that the lack of voting power, itself a disadvantage, entitled them to the more respected name. ”

“ The exchange of new securities for old on a large scale usually takes place when a railroad is unable to meet maturing obligations.337 Of 18 reorganizations and 42 plans, 15 reorganizations and 39 plans have had to do with the extrication of companies from financial embarrassment. But though impending insolvency is the usual occasion it is not the only one. Reorganization sometimes occurs when prosperity is too great as well as when it is too little. Or a management may desire to get rid of hampering restrictions, or it may desire to manipulate the conditions of control. ”

“ Is it strange that the troubles of the road came from too great earnings rather than from too small, and that instead of striving to maintain solvency the directors had to seek ways and means for concealing or getting rid of earnings without arousing the hostility of legislators to whom 10 per cent dividends seemed high, and anything over 10 per cent proof of extortion? Between 1866 and 1876 four cash distributions of 10 per cent were made to stockholders, five of 8 per cent, one of 81⁄2 per cent, and one of 71⁄2 per cent. ”

“ If an increased capitalization has been obtained without an increase in charges, owing to the lowering of the rates of bond interest and to the liberal use of stocks or income bonds, what has been the effect on the market value of the securities concerned? Is the aggregate value of the new securities less or greater than the aggregate value of the securities which they have replaced? ”

“ In some respects the history of each road considered is peculiar unto itself. The Reading had coal to sell, the Atchison did not. The Southern ran through a sparsely settled country, the Baltimore & Ohio through a thickly settled one. The Erie has never recovered from the campaigns of Gould, Drew, and Fisk from 1864–72, the Northern Pacific was not opened until 1883. In other respects, however, the roads have had much in common. Excepting only the Rock Island, each of them has found itself at one time or another unable to pay its debts, and has had to seek measures of relief. ”

“ All mortgage bonds possess by law a lien upon the property pledged to secure them. Upon default in repayment of principal, and usually also upon default in payment of regular interest, their owners have the right to sell the pledged property at auction and to recoup themselves from the proceeds. After the underlying bonds have been satisfied the selling price is applied as far as it will go to the settlement in full of mortgages in the order of their issue; while the stock, representing the owners of the property, takes what is left. ”

“ Stockholders in a reorganization have little voice. They are the owners, and all that the corporation has is subject first to the bondholders from whom it has borrowed money. Occasionally they seem to make their influence felt. In 1880 the Reading actually attempted to pay off its floating debt by bonds with a lien inferior to the common stock; and in 1892 the Olcott plan for the reorganization of the Richmond Terminal Company strongly favored the junior securities. But as a rule stockholders must accept, and rightly, about what the creditors desire. ”

“ A Finance Committee might be appointed from and by the directors which should have such powers as the directors and stockholders should choose to give it, and which should have all the powers of the directors when the board was not in session. The directors might accumulate working capital, but no reservation for working capital should be made in any year out of the surplus or net profits of such year until after the payments for such year of the dividends on the preferred stock of the company. ”

“ The East Tennessee, Virginia & Georgia, for instance, leased the Memphis & Charleston in 1877 for a yearly payment of $297,750; while the Southern Railway Security Company a few years before had agreed to pay $318,763.50 annually for the same property. And it is a fact that both consolidation and direct agreement have been the occasion of considerable reductions in the payments for the control of subsidiary lines. There is no reason why leased lines which have not earned their rentals should not suffer as much as portions of the main system which have not earned interest on their bonds. ”

“ The reorganization committee of the Atchison stated in 1895 that during the five years preceding, the road had paid over $1,100,000 in discounts and commissions to secure the renewal of $9,000,000 of guarantee fund notes. And floating indebtedness is by far the most dangerous as well as the easiest sort of obligation to incur. It represents a possible demand for large sums of cash on short notice which even a solvent company may find it impossible to meet;—a demand, moreover, which is likely to be made at a moment of stringency in the money market. ”

“ Some provision for regular increments of new capital, without the need of stockholders’ approval in each case, is highly advisable, and implies no lack of conservatism. In fact, some such provision is often forced upon a railroad. Take the case of the successive reorganizations of the Atchison properties. In 1889 no new bonds were to be allowed to be inserted between the income and the mortgage issues, but it was left optional with the management to deduct all improvements before estimating the earnings applicable to dividends on the former bonds. ”

“ Four per cent is now being paid upon all classes of stock.
Large amounts of Reading stock are held by the Baltimore & Ohio and by the Lake Shore. The Reading has again bought control of the Central of New Jersey, and owns besides a steamship line and something under 500 miles in other subsidiary roads. Its large earnings, its troubles with its mine employees, its influence over the supply of a necessity of life, and the possibility of discrimination which its control of both railroad and coal properties affords, have made it a target for legislative attack from state and national governments. ”

“ In the first place, if earnings are below fixed charges, or are constantly tending to fall282 below, sums put into the property merely assist the company to keep its head above water, and are not a sound basis for an increase in indebtedness; and in the second place expenditures which serve to preserve earnings may not be charged to capital account, even when the method of preservation is the construction of branch lines, and still less when the method is the improvement of the existing plant. ”

“ An increase in the dividend rate is too important to be justified by anything but earnings actually in hand. Moreover, the conditions which the directors held responsible for the decline in Atchison earnings were either well known at the time when the dividend was declared, or could easily have been anticipated. It was even alleged that the decrease in business which the annual report for 1888 disclosed was due to lessened carriage of company material to the West for construction of new track, and not to crop failure or other decline in general business. ”

“ Reorganizations concerned with manipulation of control are therefore closely allied with reorganizations due to too great prosperity. These latter may, however, take place independently, and are likely to occur whenever profits are extraordinarily large, and a simple stock dividend is deemed inadvisable. An example was the reorganization of the Chicago, Rock Island & Pacific in 1880, when the formation of a new company and the exchange of new stock for old was deemed wise, in view of the large earnings which were to be distributed. ”

“ On the whole, during the Civil War and for a whole year afterwards, the Reading was able to carry without difficulty the burden of an enormous capitalization. What increase in capital occurred at this time was in stock, and did not add to the load, although the desire to pay dividends on the increased stock led to the piling up of new issues.
In 1869 an entirely new departure in Reading policy occurred. Whereas the road had previously owned no coal lands, with the advent of Mr. F. B. Gowen to the presidency it began to purchase on an enormous scale. ”

“ In prosperous years series B might receive more than 3 per cent: thus the mortgage provided that from current net revenue applicable to dividends it should get 11⁄2 per cent additional interest before any dividend should be paid on the stock of the company; after that 3 per cent might be paid on the capital stock, and then 11⁄2 per cent additional might be paid on series B; it being understood that the interest in excess of 3 per cent should not be cumulative, but was to be paid only from current net revenues of the company otherwise applicable to dividends. ”

“ The Northern Pacific issued one 100-year mortgage in the course of its troubles in 1889, and two mortgages for 101 and 150 years respectively in its reorganization of 1896. The reason for long terms has been the wish to make new mortgages attractive. Reorganization mortgages, as has just been said, tend to be large mortgages, at a lessened rate of interest. They are also blanket mortgages with an inferior lien. Some inducement besides the compulsion of necessity is useful in securing the assent of old bondholders to the proposed exchanges of these bonds for outstanding securities. ”

“ If it does not, the city which they serve will temporarily eject all others from common market, and may obtain so firm a footing that a permanent increase in business will result. All of the railroads which have been studied, in fact, have suffered more or less from rate-cutting. Repeated attempts at pooling and agreements to maintain rates have improved conditions only during the short periods in which the agreements have been of effect. In the South there have been scarcely more successful attempts to secure harmony by community of stock control. ”

“ The use of voting trusts has therefore become more general, denoting a realization of the dangers of fluctuating and speculative control at critical periods in a railroad’s history. This desire to secure conditions of stable control has been the dominant one in the cases under consideration. “In order to establish such control of the reorganized company for a series of years,” said the reorganization plan of the Baltimore & Ohio in 1898, “both classes of stock of the new company shall be vested in ... five voting trustees.” ”