Definition of railroad reorganization—Causes of the financial difficulties of railroads—Unrestricted capitalization and unrestricted competition—Problem of cash requirements—Problem of fixed charges—Distribution of losses—Capitalization before and after—Value of securities before and after—Provision for future capital requirements—Voting trusts—Summary.
A general survey of railroad reorganizations may now be attempted. Eighteen different ones and no less than forty-two reorganization plans have been examined in detail. In their seemingly infinite variety may not some guiding principles be found which will assist both in interpreting the past and in directing the future?680
It is apparent that a readjustment of a railroad’s affairs is more335 difficult than the readjustment of those of an individual. A railroad is a complex financial, as well as a complex operating machine. Especially when it has been built up by the union of numerous small properties, each of which has been allowed to retain a certain individuality of its own, are the relations between the different parts intricate and involved. The obligations which have been incurred in the course of its career, and the kinds of paper which represent these obligations, disclose a variety which the debts of an individual seldom or never present. This complexity in railroad capitalization inevitably leads to clashes in interest between different classes of securityholders. Divergencies in interest seem to appear even while a road is solvent. If classes of securities exist upon which payment of interest is optional, it is to the advantage of the junior issues to prevent payment of interest or dividends upon others until earnings are such that payment may be made upon all. If common stockholders can reinvest in the property sums which normally would be paid in dividends on the preferred stock, they advance the day upon which they can secure dividends for themselves at the expense of their seniors. The same situation may also arise as between the preferred stock and the income bonds. Or, again, it may be to the advantage of speculative stockholders to pay dividends to themselves by means of the accumulation of a floating debt, and to sell out at top quotations, leaving the floating debt to take precedence even of mortgage bonds.681 Both this and the preceding operation are facilitated by the control which the least valuable portion of the capital, the common stock, usually has over the policy of the entire company. But it is when a reorganization becomes necessary that these conflicts in interest become most apparent, and it is as a compromise between contending forces that a reorganization plan must take its shape.
The term “reorganization” is used in this study to denote the exchange of new securities for the principal of outstanding, unmatured, general mortgage bonds, or for at least 50 per cent of the unmatured junior mortgages of any company, or for the whole of the capital stock. These exchanges have been the essential features of336 the operations which have been described. This exchange of securities must take place upon a considerable scale. Small readjustments may involve valuations of specific bits of property, but they do not require that comprehensive survey of the relations of all parts of the system to each other which distinguishes the general reorganization. In fact, the small adjustments are at once more simple and more difficult than the larger kind. More simple because they involve less change; more difficult because the same pressure cannot often be brought to bear. It is useful to mark a dividing-line between the small and the large. No such line can be defended as exact; but the one chosen seems to include a tolerably homogeneous group, and will lend a convenient definiteness to the discussion.
As thus defined, a reorganization may be, and generally is, accompanied by other operations essential to its success. If a large floating debt has been accumulated, provision for the cancellation of this debt must be made;682 if unprofitable leases have been entered into, these must be abolished;683 or if the system has been unduly hampered by inability to issue new capital, appropriate relief must be afforded. But none of these are determining features. They are means to an end, as is the exchange of new securities for old, and they may have their effect just as the economical management of the union Pacific under Charles Francis Adams had its effect in the years prior to 1890; but they are not essential parts of that group of operations which have been characterized as reorganizations.
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. This last named cause—the desire to manipulate conditions of control—has been fortunately an infrequent cause of reorganization. An example is, however, afforded by the Rock Island reorganization of 1902. It will be remembered that the Chicago, Rock Island & Pacific Railway had long been a prosperous road in the Middle West, and that its control had required the ownership of between 40 and 50 per cent of $75,000,000 of common stock, quoted at over 160 in the early part of 1902. By the issue of new bonds, new preferred and new common stock to a total of $270 for every $100 of old common stock, and by giving to the preferred stockholders the right to elect a majority of the directors, the owners of the property were able to part with a large portion of their holdings and yet retain absolute control. A somewhat similar case was that of the Chicago & Alton. This road had been a conservatively capitalized enterprise, doing a large business between Chicago, St. Louis, and Kansas City. It had paid 7 per cent or better on its two classes of stock for eighteen years without a break, and had accumulated in that time an uncapitalized construction expenditure of $12,444,178. In 1899 a syndicate of Eastern capitalists bought control, and the following year reorganized the property by forming a holding company, which issued $22,000,000 in 3? per cent bonds, $19,489,000 in preferred and $19,542,800 in common stock to exchange for the $22,230,600 old common and preferred shares outstanding. At current prices on January 3, 1899, a majority of both the old issues would have cost $19,030,048; on January 4, 1901, however, a majority of both of the new issues represented an investment of $10,729,437; and this investment it would have been possible to reduce to $2,241,377 by the sale of the new bonds received, without in any way endangering control.684
338 It is evident that both the Rock Island and the Chicago & Alton reorganizations were influenced by the very great prosperity of the companies concerned. It was desired to reap a profit by the sale of new securities as well as to lessen the investment required for control; although it may be remarked that the advantage of retaining control depended on the future prosperity of the roads. 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.
The desire to eliminate hampering restrictions is seldom the sole cause for a reorganization, but frequently it is a contributing one. When, for instance, the managers of the union Pacific wished to extend their system in the years following 1880, they were forced to establish a separate organization for each branch line. By the terms of the charter nothing could be consolidated with the main stem except the Kansas Pacific and the Denver Pacific, the consolidation with which was provided for in the original acts.685 This obviously prevented considerable economies, and could be remedied only by a new incorporation. The Northern Pacific was hampered in yet another way because the consent of three-fourths of the preferred stock was required by the terms of the reorganization of 1875 to the imposition of new mortgages;686 and similarly the Atchison, after 1889, found it extremely difficult to issue new bonds because of the position of the outstanding income bonds. In this last case the restriction was the sole cause of the reorganization which followed. It should be remarked that the cancellation of such provisions sometimes works339 considerable injustice. Restrictions on future increases in capital, for instance, may have facilitated the issue of bonds in the past, and in this case have formed part of the consideration given for subscriptions. The readjustment is defended on the ground of the need of the corporation, or is so accomplished as not to lessen the value of the creditors’ holdings.687
The typical railroad reorganization, as has been said, occurs when a road ceases to be able to pay interest on its outstanding obligations. Whether because of excessive capitalization or because of unexpectedly low earnings, or owing to an accumulation of floating debt which ties up all current resources, the reorganizing railroad finds itself incapable of meeting payments falling due. For this, experience shows that two deep-seated causes have generally been responsible. First, there is the almost entire freedom in matters of capitalization which railroads have enjoyed. Far from the recommendation of Secretary Taft that no railroad company engaged in interstate commerce be permitted to issue stock or bonds and put them on sale in the market except after a certificate by the Interstate Commerce Commission that the securities are issued with the approval of the Commission for a legitimate railroad purpose,688 American railroads have in the past been practically unrestricted. It was open to the Erie to increase its capitalization per mile from $81,068 in 1864 to $117,760 in 1872, with no corresponding addition to its property; it was open to the union Pacific to create a capitalization of $104,561 per mile by 1870, of which about one-quarter was in the form of government bonds; and it was possible for the Atchison to issue $129,162,350 in new bonds and stocks between 1884 and 1889 while its net earnings seriously decreased. Had there been a supervision of new issues, or had even a certain percentage of stocks to bonds in those instances been required, failures would have been less frequent and reorganizations less common. New construction would probably have been less rapid, but not so much so as is often asserted. A smaller number of new enterprises might have yielded340 larger profits; the chances for land speculation might have tempted many, and liberal regulations might have allowed a generous profit while at the same time eliminating all inflation due to fraud. Unfortunately railroad-hungry communities seldom stopped to count the cost. West, South, North, and East, privileges were offered to railroads, donations of land and money were made, and exemptions from taxation were conferred.
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. President Hadley has made classical the theory that roads will take business until rates fall below the specific cost of hauling a given shipment; that is, below the additional cost which the articles in question impose. Even this limitation is often non-existent. Railroads which serve different cities will take freight when a war is in progress whether or not the rate repays the specific cost of hauling. If their rival imitates them they hope to wear it out by their superior ability to stand the loss. 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. Competition by means of extensions has been also vigorously practised. The reader will recall the growth of the Atchison from 1884 to 1889. It was after the dissolution of the Southern Railway Security Company that the East Tennessee entered upon its policy of purchase and of new construction. The entrance of the Reading into New England was341 the direct cause of its failure in 1893; and that of the Baltimore & Ohio into New York largely contributed to its difficulties in 1887. Sometimes such extension is into territory where there is no business to justify it. Sometimes the business is there, but has to be divided among too many rivals. Sometimes the new lines are so poorly built as to be unduly expensive to work, and not infrequently they are so good that the resources of the expanding road are strained in acquiring them. In any one of these four cases new extension causes a drain upon the parent road which may readily bring about its failure.
Other conditions may lead to railroad failure. Simon Sterne alleges the following causes to be often responsible:689
1. The control of railroads by stock which represents little or no original cash investment.
2. The development of the territory served by individual railroads at a slower rate than is anticipated, and the influence of competition in reducing profits when the territory has developed.
3. The undertaking of railway construction when there is considerable activity in the money market, and when capital commands a high rate of interest.
4. The circumstance that railways, lacking reserve capital, can never avail themselves of a cheap market for labor or supplies, but must always buy when everything is inflated, because then only can they float their loans and borrow capital.
5. The necessity of complete reconstruction within a brief period of most railroads built through new territory, and the increase in funded and in floating debt involved.
7. The growth of railroads beyond the ability to handle them.
8. The steadily increasing expenditures required by law to accommodate the public.
9. The abuse of their position by directors and trustees.
10. The irresponsibility of railway accounts.
And it may be added that the control of American railways by foreign investors who apportion charges between operating and capital accounts in a way unsuited to American conditions has been upon occasion a cause of disaster. Unlimited freedom in matters342 of capitalization and unrestricted competition have nevertheless been the fundamental causes of bankruptcy.
It is interesting to observe that the majority of the principal railroads which failed in the nineties had taxed their resources nearly to the point of exhaustion before the panic of 1893 finally drove them to the wall. For every $100 received in 1892 the Richmond & Danville and East Tennessee systems were paying out $68.79 for operating expenses and $31.15 for interest on bonds, rentals, etc., leaving only 6 cents for dividends, necessary improvements, and the like. For every $100 received the Erie paid out the same year $66.46 for operating expenses and $31.85 for interest and other fixed charges, leaving only $1.68 as a surplus to ensure solvency in case of a decline in earnings. In 1893 the Atchison, the Northern Pacific, the Reading, and the union Pacific had no surplus at all, but rather a deficit. The following table shows similar figures for all of our reorganized roads:
Percentage to Gross Income
Operating
Expenses 1893
Fixed
Charges Surplus Operating
Expenses 1892
Fixed
Charges Surplus ?
B. & O. 66.89 24.27 8.83 67.68 24.55 ?7.76 ?
Erie 64.91 32.12 2.96 66.46 31.85 ?1.68 ?
N. Pac. 59.25 43.55 53.71 36.34 ?9.94 ?
Reading 57.04 45.41 52.64 33.91 13.44 ?
Rich. & Danv. and E. Tenn. 73.49 25.63 ?.12 68.79 31.15 ?
U. Pac. 59.66 43.18 51.91 36.42 11.66 ?
Atchison 77.47 24.96 77.16 21.59 ?1.24690 ?
With these figures may be compared statistics for seven roads which went through the depression of 1893–7 without failure. These roads had a more extensive margin which could be cut off before interest on their bonds should be endangered. Furthermore, this margin was secured, not by low operating expenses, but by low fixed charges, including interest on bonds. Operating expenses averaged higher than for the preceding group, fixed charges averaged343 much lower. In the first group but one road had charges in 1893 which were less than 25 per cent of gross income; in the second group but two roads had charges which were greater. The condition of the roads of the second group referred to was as follows:
Percentage to Gross Income
Operating
Expenses 1893
Fixed
Charges Surplus Operating
Expenses 1892
Fixed
Charges Surplus ?
C., B. & Q. 64.46 23.12 12.41 65.17 20.86 13.96 ?
C., M. & St. P. 65.95 20.78 13.26 64.00 22.36 13.63 ?
C., R. I. & P. 71.72 13.31 14.96 69.88 19.83 10.28 ?
Great No. 50.44 34.54 15.01 52.66 32.98 14.34 ?
Ill. Cen. 61.92 25.84 12.23 64.58 23.99 11.12 ?
N. Y., N. H. & H. 72.31 16.07 16.36 73.36 ?8.77 17.86 ?
N. Y. C. 68.79 20.84 10.36 68.46 21.53 ?9.96 ?
The causes which lead to railroad failure have now been mentioned. When bankruptcy has at last occurred, three groups of interests take part in the reorganization which must ensue. These are the creditors, who find interest and perhaps principal of their bonds in default; the stockholders; and the bankers and financiers who advance ready money and subscribe to necessary guarantees. Of these the creditors and the stockholders are widely scattered, and are quite unable to protect themselves by individual action. Their first impulse is, therefore, either to elect committees to represent them, or to authorize self-appointed committees of well-known men to look after their interests. 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.
The creditors, then, are the most important factors, and they, like the stockholders, act through committees. There may be a committee for every class of bonds, or one or more classes may join together. The union Pacific, in 1893, had committees for the consolidated344 first mortgage, the collateral trust 5s, the Oregon Railway & Navigation consols, the Dutch bondholders, and certain branch lines; and in 1894 for the collateral trust 4?s and the Kansas Pacific consols. As the financial situation grew worse the interest on senior mortgages became imperilled, and even the union Pacific first mortgage bondholders deemed it wise to elect a committee; while a second committee arose for the Kansas Pacific consols, and a new committee for the Denver Extension mortgage. By April, 1895, at least fifteen committees were in active operation, of which fourteen represented not more than two classes of bonds each. The Reading reorganization of 1884 to 1886 was largely shaped by two committees representing the general mortgage bondholders; seven reorganization trustees representing the foreign creditors, the general, income, junior securities, and stockholders; and an opposition committee known as the Lockwood Committee. Within four months after the failure of the Erie in 1875 the English bondholders and stockholders each had elected a committee, and had urged all securityholders to join; a meeting of bondholders had elected Mr. John Hooper chairman of a committee in New York; and another meeting had elected Mr. N. B. Lord chairman of another committee in that city.691 The more general a committee the greater the influence which it seems able to exert on reorganization, and the greater the likelihood that the plan which it approves may be accepted. The fact that a scheme has to meet the criticism of opposing interests during its formation renders it less likely to contain any injustice which conditions make it possible to avoid; and the endorsement of their representatives makes all classes of bondholders more ready to accord it temperate consideration. Among the numerous union Pacific committees it was the joint committee, representing the foreign holders, the Denver & Rio Grande, the Oregon Railway & Navigation,345 and other interests that took the leading part. In the case of the Reading from 1884 to 1886 the seven reorganization trustees outweighed any other representatives of the creditors; in that of the Northern Pacific the Adams Committee succeeded in becoming a general reorganization committee, and took the leading part; and the Atchison reorganization was accomplished only by the union into a joint executive reorganization committee of three of the previously existing bodies.692
The situation which bankers and financiers occupy in relation to a bankrupt road is almost equally important. Their aid is essential to a reorganization while that of the officers and receivers of the company is not. And they are not subject to the pressure of imminent financial loss which forces creditors and stockholders to accept plans of which they do not altogether approve. It is true that these bankers may have money invested in the securities of the road. It may even happen that they have been formerly in control. In this case a certain pressure does exist. But as bankers their function is to do one or both of two things; namely, to advance cash to keep the railroad system together pending reorganization, and to underwrite assessments or the sale of securities. Either one of these involves them in new risks, and in undertaking either they will be only indirectly affected by investments which they may previously have346 made. Their influence on reorganization is strong because they are necessary, and because they are free to participate or not to participate according to their opinion of the precise reorganization plan proposed. For much the same reason their influence is a wholesome one. We shall see that the primary conflict which takes place in any reorganization is between the interests of the corporation which needs a lessening of its burdens, and the interests of the securityholders which is opposed to any reduction in their claims.693 The degree to which the former interest prevails determines the strength of the reorganized company. In this conflict the bankers naturally take the side of the company. As bankers, who advance cash, and who usually receive their pay in securities, they wish to make the corporation prosperous, and to raise the quotations of its securities to a high figure. An important factor also is that as reputable banking firms they wish the future career of corporations which they have handled to reflect credit upon themselves.
An example of the influence of bankers and financiers appears in347 the case of the union Pacific. A committee comprising General Louis Fitzgerald, Jacob Schiff, T. J. Coolidge, Oliver Ames, and two railway presidents took the road out of receivers’ hands, cut charges per mile by over one-half, and paid the Government’s claim in full. The Reading reorganization of 1886 to 1887 was the work of a syndicate which took hold after interests closely connected with the properties had failed to produce a satisfactory plan. The result was the best plan ever applied to the Reading Railroad. The Richmond Terminal Company was reorganized by a single banking firm. In this case the operation cut charges less than could have been desired, though the other parts of the plan were well-advised. The intervention of a syndicate has fortunately been usual of late years. And it is doubtful if the compensation accorded has been exorbitant, even for the direct services rendered. In 1886 the Reading agreed to pay a syndicate 5 per cent upon $15,000,000 of subscribed capital, plus 6 per cent on all money advanced. The Richmond Terminal paid Drexel, Morgan & Co. $100,000 in cash to cover their office expenses and $750,000 in common stock at $15 per share694 for their work of co?peration and supervision. The union Pacific paid the syndicate which financed its reorganization $5,000,000 in preferred stock quoted at 59, or 19 per cent at current prices on a subscribed capital of $15,000,000. All three syndicates, however, ran the risk of depreciation in the value of the stock given them, and all three rendered great service in providing large sums of cash at a time when capital was not readily to be obtained.
Payments to bankers or trust companies receiving deposits of bonds and stocks and undertaking the clerical work of a reorganization, should be sharply distinguished from those made to underwriting syndicates above described. Depositaries assume no risk, and are paid a definite sum for definite services performed. In 1895 the Erie set the compensation of Messrs. J. P. Morgan & Co. and J. S. Morgan & Co., for their services as depositaries and in carrying out the plan of reorganization, at $500,000 in addition to all expenses incurred; and the same year the union Pacific allowed $1,000,000 in preferred stock to the bankers who managed its underwriting syndicate, as against $5,000,000 to the syndicate itself.348 It should be said that the compensation to depositaries is in part payment for the use of the name of the firms employed as well as in part payment for clerical work performed. Bondholders are more ready to deposit their securities with a well-known house than with an obscure one; and are to some extent influenced by the implied approval of the reorganization plan which acceptance of deposits by such houses involves.
At the beginning of the ordinary reorganization, then, creditors, stockholders, syndicate, and corporation find themselves face to face. The interests of the syndicate and of the corporation most nearly coincide except in so far as the syndicate is an owner of stocks or bonds. The syndicate desires a radical reorganization,—the corporation requires it. But as between stock- and bondholders and the corporation; between the stockholders and the bondholders; or between the junior and the senior bondholders; there is well-nigh complete antagonism. The corporation, to repeat, needs a reduction in the fixed charges which it has to pay. The securityholders wish to lose as little as possible. The stockholders hope to force sacrifices from the bondholders, and the bondholders to levy a heavy assessment upon the stock. The junior bondholders call upon their seniors to bear their part; and the seniors reply that they are well secured and that the juniors and the stock must take care of themselves.
The first question which arises is that of the cash requirements. How much cash must be raised to pay off the floating debt, and how much working cash capital will the new corporation require? It is almost always true that a large floating debt has accumulated prior to reorganization. The Northern Pacific in 1893 had a gross debt of no less than $15,000,000; the Reading in 1895 one of $13,800,000; the Baltimore & Ohio in 1896 one of $13,000,000; the Atchison in 1893 one of $16,000,000. In part this means simply the accumulation of unpaid bills. In part, however, it represents promissory notes or other short time paper which the corporation has issued, generally to pay current indebtedness, but occasionally for financing somewhat extensive operations. Thus Mr. McLeod carried his purchases of New England railroad stock by means of advances from brokers, and the Government Directors of the union Pacific reported that $15,000,000 out of $21,400,000 of floating debt of349 that road in 1891 were the result of expenditure and advances in the construction of branch or tributary lines. The cost of carrying such indebtedness is naturally high. Mr. McLeod is reported to have paid an average of 9 per cent for his loans. 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. For this reason, and on account of the high interest demanded, corporations endeavor to fund their floating debts when these reach unwieldy proportions. In 1891 the union Pacific authorized three-year 6 per cent notes to the amount of $24,000,000 to be used in taking up its floating debt. In 1893 the Northern Pacific authorized $15,000,000 collateral five-year 6 per cent notes for the same purpose. In each case it was hoped to refund these short time issues with bonds of longer term when the date of their maturity should arrive. After a company has been in receivers’ hands, issues of receivers’ certificates are pretty sure to swell the current liabilities. These, again, may be issued to pay current bills, or to maintain or to improve the railroad when other resources prove insufficient. For whatever reason incurred, it is plain that the problem of the floating debt is a serious one for the creditors and owners of a bankrupt road to meet. If the provision which they make is insufficient their company will not regain a safe financial footing. And if, in addition to cancelling the debt outstanding, they do not provide a margin for working capital, the company will be forced to incur new floating debt and their work will have to be done over again.
In general there are two ways by which cash for floating debt and working capital can be raised:
(1) By assessment on securityholders. (2) By the sale of securities.
Sales of securities may comprise the sale of securities of the bankrupt, or of other corporations held in that company’s treasury, or350 they may be sales of part of new bond or stock issues reserved for that purpose. In 1898 the Baltimore & Ohio sold among other things $3,800,000 of Western union Telegraph stock held in its treasury since 1887; while in 1889 the Atchison issued and sold $12,500,000 general mortgage 4s and $1,250,000 income 5s. When outside securities are sold the value of which is in no way dependent upon the prosperity of the road which sells them; and which are such, moreover, as the selling road can readily spare, this method of raising capital is open to few objections. 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. If, on the other hand, the railroad endeavors to prevent a rise in charges by the use of income bonds or stock, the gain is usually neutralized by the extremely low price obtained.695 In general we may say that sale of a railroad’s securities in time of general depression is impossible except at a ruinous sacrifice; that sales should not be resorted to at all except when the road’s difficulties are acute rather than chronic, as in the case of the Reading in 1896; and that when securities are to be sold the best of the available bond issues should be used and not the worst.
The case of an assessment is very different. Securities may be sold to outsiders or to present securityholders. In the one event no pressure at all can be brought to bear; in the other only that of the indirect loss which the difficulties of the reorganizing company would involve.696 An assessment, on the other hand, is levied solely351 on securityholders and is compulsory. Stockholders or bondholders who refuse to pay are ordinarily debarred from all participation in the reorganization, and lose all chance to recoup their losses from their share in subsequent prosperity. In return for the assessment some security is usually given, so that from one point of view an assessment and a sale resemble each other. But the element of compulsion appears in this: namely, that in the case of a sale the new securities are taken at the buyers’ valuation; but in the case of an assessment the company determines what it shall give for the cash paid in. Hence the usual compensation for an assessment is an equal nominal amount of preferred stock;—while that for the purchase money in a sale is a greater nominal amount in bonds. Either an assessment or a sale of securities may be fortified by a syndicate guarantee. In the one case the syndicate agrees to substitute itself for all non-assenting or defaulting stock- or junior bondholders; in the other it engages to take and dispose of the new securities offered, or such part of them as the company is unable to sell. The advantages of syndicate assistance we have already discussed.
It will be recalled that both assessments and sales of securities have been freely employed in the reorganizations which have been considered, and that syndicate guarantees have been of ordinary occurrence. Out of eighteen reorganizations, fourteen were forced to pay attention to the raising of cash; the four which did not consisting of the consolidation of the union Pacific with the Kansas Pacific and of the Chicago, Rock Island & Pacific with its branch lines in 1880, the income conversion reorganization of the Atchison in 1892, and the Rock Island reorganization of 1902,—each a reorganization of a more or less peculiar nature. Of the fourteen remaining, four provided cash by assessment, three by the issue of securities, and five by a combination of both methods. Adding to this the Northern Pacific reorganization of 1896 and that of the Erie in 1859, which combined an assessment with funding provisions, we have eleven reorganizations which relied on assessments in whole or in part. This preponderance is, however, due to the extensive use of assessments from 1893 to 1898; since the earlier reorganizations show assessments in only about one-half of the cases. This does not mean that the value of an assessment was not understood before352 1893. For the reorganization of the Northern Pacific in 1895 was otherwise so radical that an assessment was less necessary; and that of the Atchison in 1889 took place at a time when business conditions were not in general depressed. The effect of widespread depression on the means employed for raising cash is, however, perfectly clear.697
Of the reorganizations of 1893 to 1898, to repeat, there was none which we have considered which did not make use of assessments. The following table shows the amount and distribution thereof:
Assessments, 1893–8
Common
Stock 1st
Preferred 2d
Preferred Junior Securities ?
Atchison $10 $20 4 per cent on 2d mortgage and income ?
B. & O. ?20 $2 ?
Erie ?12 ?8 ?
N. Pac. ?15 10 ?
Richm. Term. ?10 ?
E. Tenn. ????7.20 ?3 ??6 ?
Reading ?20 20 per cent on 1, 2, and 3 incomes ?
?4 per cent on deferred incomes ?
U. Pac. ?15 ?
It thus appears that the assessments varied from $7.20 on the East Tennessee to $20 on Reading common, with less sums on the preferred stock and the junior securities.698 The real sacrifice demanded of the stockholders is ascertained by deducting from the above the value of securities given for assessments whenever such were allowed. Taking for the purpose the market quotations of these securities six months after actual reorganization, that is, after the sale of the road, or the putting into effect of the plan proposed, it appears that the common stock of the Atchison received $1.90; that of the Baltimore & Ohio $15.20; that of the Richmond Terminal $5.02; that of the East Tennessee $3.55; and that of the union Pacific $8.10. The Erie, the Northern Pacific, and the Reading gave nothing353 for assessments in the nineties.699 Preferred stock, whenever assessed, received the same relative amount and kind of securities for assessment as did the common stock, and the same is true of the junior securities. Since, however, these new securities had but a prospective value at the time of the issue of the various reorganization plans, it is advisable to make no attempt to determine precisely the net assessment, and to call attention to their allowance merely as a fact on which the stockholders could rely as they could count on a future rise in the value of their shares. With this qualification the relative height of assessments and stock quotations one month after the publication of each reorganization plan, and six months after the completion of each reorganization may be given.
Six Reorganizations, 1893–8 ?
Common Stock Preferred Stock ?
Assessments Price
1 month
after plan Price
6 months
after
reorganization Assessments Price
1 month
after plan Price
6 months
after
reorganization ?
Atchison $10 $?5? $13? ?
B. & O. ?20 ?12? ?56? $20 $114? ?
Erie ?12 ??8? ?14? ??8 $22 ??36? ?
N. Pac. ?15 ??1? ?13? ?10 ?10 ??26? ?
Reading ?20 ??2? ?22? ?
Richm. Term. ?10 ??2? ?11? ?
E. Tenn. ???? 7.20 ???? ??6? ??3 ?10 ??13? ?
U. Pac. ?15 ?10? 20 ?
Four Reorganizations before 1893 ?
E. Tenn., ’86 ??6 ??2? ??5? ?
Erie, ’59 ??? 2? ???2? ?
Erie, ’77 ??4 ?18? ??2 ??29? ?
Reading, ’86 ?10 ?38? 58 ?10 53?700 ?
354 In every case during the nineties the amount of assessment exceeded the sum for which common shareholders could have sold their stock one month after the publication of the reorganization plan. The difference ranged from $3.50 for the Erie to $17? for the Reading; in other words the assessments wiped out the whole value remaining to common stockholders, and exacted an additional contribution as the price of participation in any future prosperity. In the case of the preferred stock, where values were greater and assessments less heavy, the results were not the same; but even here the proportional demand was large, and amounted to 100 per cent of current quotations in the case of the Northern Pacific. Before 1893 assessments were fewer in number and not so great in amount. It is to the subsequent rise in stock quotations to which we must turn for an explanation of the willingness of stockholders to contribute such heavy sums. The assessments, we find, did not come out of the stockholders’ pockets in the end; for their payment, in connection with other features of reorganization, so enhanced the value of shares that only six months after reorganization the price of stocks in all cases was nearly equal to the assessment plus the previous market quotation. In some instances, such as the Baltimore & Ohio, the sum amounted to much more than this total.701 Refusal to pay would have wiped out the stockholder’s interest and have kept him from benefiting from the rise. It is needless to add that quotations to-day are many times the amount of the assessments. The increase in value has occurred alike for common and preferred stock, even in times of severe depression. On the whole, it has abundantly justified the payments which stockholders were asked to make.
The use of assessments alone represents the most radical and the soundest method of raising cash. It disposes of the accumulated quick liabilities once and for all; and involves no subsequent increase355 in interest charges. It was the method of the Atchison and the union Pacific after 1893, of the Reading from 1883–6, and of the Erie from 1875–7. It was furthermore the method of the Western, New York & Pennsylvania in 1893,702 of the Norfolk & Western in 1896,703 and of other railroads which might be named. Probably its most drastic application was in the case of the Houston & Texas Central in 1887, where an assessment of 73 per cent was found necessary to discharge the floating debt and to provide cash payments for interest and bonus to first mortgage bondholders, and to pay the charges, expenses, and other liabilities made or incurred by the Trust Company.704
The sale of securities also has been relied upon for the production of cash. The most striking example of the use of securities alone is afforded by the Reading reorganization of 1883, which at the same time illustrates the possible unsoundness of the method. The floating debt of the Reading companies amounted in June, 1880, to $12,155,248, the bulk having been incurred in attempts to maintain solvency. To cover this Mr. Gowen proposed an issue of $34,300,000 deferred income bonds,705 to be sold at 30 per cent of their par value, and to be entitled to dividends after 6 per cent had been paid on the common stock. These securities were practically worthless, and had to be set aside in favor, first, of new general mortgage bonds, and then of old unissued general mortgage 7 per cent bonds which the company happened to have in its treasury. So ineffective was even this expedient that in October, 1884, the floating debt amounted to a sum nearly one-third greater than that reported in 1880. Another example was the Erie scheme of 1886, which was not, however, a reorganization, according to our definition. The floating debt of the Erie in September, 1884, amounted to $5,455,338, of which $1,007,922 consisted of unpaid coupons. On the suggestion of English securityholders these coupons were funded; and the balance was raised by a new terminal mortgage issued and disposed of by a subsidiary terminal corporation known as the Long Dock Company. The result was an increase in fixed charges, which contributed to the356 final failure in 1893. The history of the Southern Railway affords a third example. At the end of 1888 the Richmond & West Point Terminal Railway & Warehouse Company found itself with a floating debt of $5,000,000, and proceeded to authorize an issue of $24,300,000 5 per cent 25-year collateral trust bonds, of which $5,000,000 were to be sold to cancel this indebtedness. In subsequent years the current liabilities again increased, and for this and other reasons a general reorganization became necessary, in which both an assessment and a sale of securities were required. On the whole the result of experience bears out the statement as to the unsoundness of reliance on the issue of securities for cash even when the sale of the securities is guaranteed.
Yet another method of raising cash has been the combination of assessments with the sale of bonds or stock or both. In 1898 the Baltimore & Ohio disposed of $3,800,000 Western union Telegraph stock. It also provided a total of $37,900,000 prior lien and first mortgage bonds and preferred stock, which was in part given for assessments, and in part turned over to a syndicate in return for cash. The Erie, in 1895, besides its assessment sold $15,000,000 in prior lien bonds; while the Reading sold $4,000,000 in new general mortgage bonds and $8,000,000 in new first preferred stock. In each case the success of the sale was ensured by a syndicate agreement. In 1886, to go outside of the reorganizations which have been particularly described, the Texas & Pacific provided funds with which to cancel a part of its floating debt by an assessment of $10 and an issue of $6,500,000 common stock. Three years later, the St. Louis, Arkansas & Texas assessed its second mortgage bondholders 5 per cent and its stock 10 per cent and sold securities to the par value of $4,490,880 to cover $3,400,000 of cash requirements.706 In 1894 the New York & New England issued $4,355,000 in securities and levied $20 and $25 respectively upon its common and preferred shares.707 In 1896 the St. Louis & San Francisco planned to raise $821,410 by assessment and $5,500,000 by sale of securities. Such examples might be multiplied indefinitely.708
357 The problem of cash requirements must be met and solved before the parties interested can consider the fixed charges. It is the reduction in charges, nevertheless, which is usually of the more fundamental importance. A floating debt accumulated through inability to pay current expenses is the direct result of excessive charges, and a settlement which did not lower these, as well as pay off the debt, could give but temporary relief. Only when failure has been due to special causes can a decrease in the annual burden be even a matter for debate. The following tables show the absolute changes brought about by those of the reorganizations earlier considered for which precise figures are available:
FIXED CHARGES
Seven Reorganizations, 1893–8 ?
Road Before After Per cent
decrease Per cent
increase ?
Atchison ?$9,423,160 ?$6,486,842 31.16 ?
B.& O. ??7,202,855 ??6,359,896 11.70 ?
Erie ??8,637,700 ??8,126,283 ?5.92 ?
N. Pac. ?13,813,945 ??6,761,960 51.04 ?
Reading ?11,422,054 ??9,043,944709 20.81 ?
Richm. Term. system ??7,498,584 ??4,195,925 44.04 ?
U. Pac. ??7,985,921 ??4,502,134 43.62 ?
$65,984,219 $45,576,984 30.92 ?
Seven Reorganizations before 1893 ?
Atchison, ’89 $11,157,770 ?$7,256,054 34.9? ?
Atchison, ’92 ??7,189,199 ??9,423,160 31.0 ?
E. Tenn. ’86 ??1,742,495 ??1,167,000 33.0? ?
Erie, ’75 ??4,697,802 ??5,215,146 11.0 ?
Reading, ’80 ??7,734,031 ?11,535,078 49.1 ?
Reading, ’83 ??8,235,047 ??7,581,032 7.9 ?
Rk. I. ’80 ??1,508,989 ??1,271,836 16.3? ?
$43,276,372 $43,449,306 ?? .53 ?
One Reorganization, 1902 ?
Rk. I. ’02 ??$4,780,649 $10,485,882 119.3710? ?
358 From these tables, it appears that each of the reorganizations from 1893–8 occasioned an absolute reduction in fixed charges which varied from 5.92 per cent in the case of the Erie to 51.04 per cent in that of the Northern Pacific. On the other hand the reductions in the earlier reorganizations were more irregular and were exceeded by the increases.711 Absolute figures, however, reveal little. Charges may be reduced and the road be worse off than before because of more than proportional reductions in mileage or in earnings. The preceding table must therefore be supplemented by one showing the changes in charges per mile of road and changes in the relations of charges to earnings.
FIXED CHARGES
Seven Reorganizations, 1893–8 ?
Charges per mile Per cent of charges to net income ?
Before After Before After ?
Atchison $1415 $1001 110.5 ?80.9 ?
B.& O. ?3438 ?3107 ?98.2 ?86.3 ?
Erie ?4116 ?3824 114.7 ?95.8 ?
N. Pac. ?2630 ?1494 106.8 ?50.2 ?
Reading ?9856 ?6611 111.3 ?82.1 ?
Southern ?1553 ??955 105.1 ?81.5 ?
U. Pac. ?4381 ?1859 105.7 ?40.6 ?
Seven Reorganizations before 1893 ?
Atchison, ’89 $1603 $1064 ?
Atchison, ’92 ?1079 ?1415 ?85.8 110.5 ?
E. Tenn. ’86 ?1578 ?1083 134.3 ?79.5 ?
Erie, ’75 ?4984 ?5619 ?93.9 ?91.1 ?
Reading, ’80 ?9138 ?7287 ?98.1 ?83.0 ?
Reading, ’83 ?8760 ?7185 ?78.3 ?77.0 ?
Rk. I., ’80 ?1200 ??952 ?13.2 ?10.2 ?
One Reorganization, 1902 ?
Rk. I. ’02 ?1231 ?1448 ?39.8 ?59.0712 ?
359 A summary of the preceding tables is as follows:
FIXED CHARGES BEFORE AND AFTER REORGANIZATION
Seven Reorganizations, 1893–8 ?
Per cent Decrease Per cent Increase ?
Absolute
Charges Charges to
Income Charges
per mile Absolute
Charges Charges to
Income Charges
per mile ?
Atchison 31.1 26.7 29.2 ?
B. & O. 11.7 12.1 ?9.6 ?
Erie ?5.9 16.4 ?7.0 ?
N. Pac. 51.0 53.0 43.0 ?
Reading 20.8 26.2 32.9 ?
Southern 44.0 22.4 37.7 ?
U. Pac. 43.6 61.5 57.5 ?
30.9 31.2 31.2 ?
Seven Reorganizations before 1893 ?
Atchison, ’89 34.9 33.6 ?
Atchison, ’92 ?31.0 28.5 31.1 ?
E. Tenn. ’86 33.0 40.8 31.3 ?
Erie, ’75 ?2.9 ?11.0 12.7 ?
Reading, ’80 15.3 20.2 ?49.1 ?
Reading, ’83 ?7.9 ?2.2 17.9 ?
Rk. I. ’80 16.3 22.7 20.6 ?
10.3 13.1 ??? .53 ??? ??? ?
One Reorganization, 1902 ?
Rk. I. ’02 119.3 48.2 17.6713 ?
360 These tables show plainly that substantial reduction in fixed charges was the rule in the reorganizations of 1893–8, though less universal and less important in the reorganizations before that date. Even before 1893, however, the fact that reductions must be made was apparent. Three reorganizations increased absolute charges instead of decreasing them. Of these the Atchison reorganization of 1892 was not due to lack of prosperity, and the Erie reorganization was a failure. The Reading reorganization of 1880 increased absolute charges, increased mileage more than correspondingly, but was also a failure. And it is significant that only those roads which generously reduced charges regained even a temporary prosperity.
The distribution of losses which a reduction in fixed charges requires can best be made by a comprehensive redistribution of securities. All the bonds and stocks which are to suffer must be called in; and varying amounts of new securities must be given in their place. Among the important considerations to those who fix the rates for exchanges are these:
(1) Maximum charges under the new régime should approximate minimum net earnings under the old.
(2) As large a proportion of the charges as possible should consist of the one item of interest on bonds.
(3) Losses should fall most heavily on the junior securityholders.
(4) The nominal value of outstanding securities should be reduced as little as possible.
(5) Bondholders whose claims have been cut down should be afforded some chance to participate in future increased earnings of the property.
These rules may be considered in turn. The point to which the best practice should reduce fixed charges is readily understood. Nothing less than solvency under the least favorable conditions is the goal toward which a reorganization plan should strive. It appears, accordingly, that the minimum earnings of the Atchison property from 1891–4 had been $5,204,880; while the fixed charges proposed for it were $4,528,547. The lowest net earnings which the union Pacific had ever recorded had been $4,315,077. The interest on its new bonded indebtedness was placed at $4,000,000. The net earnings for the Northern Pacific in 1895 were $6,052,660, which was the361 least that the road had earned for eight years. The new fixed charges were estimated at $6,015,846. The minimum net earnings of the Baltimore & Ohio from 1887 to 1898 had been $6,610,774. The fixed charges of the plan of 1898 were set at $6,252,351.
In order to simplify the charges, as well as for other reasons, it is desirable to have the item of interest bear a large proportion to the whole. The fixed charges of six of our seven reorganizations from 1893–8 amounted together to $54,562,165. Of this sum, interest on bonds comprised $35,239,146 or some 64 per cent. The charges of the same railroads after reorganization amounted to $36,533,040, of which sum interest on bonds comprised $30,926,638 or 84 per cent.
The distribution of losses should bear most heavily on the junior securities. The simplest readjustment would seem at first sight to demand a proportionate concession from all creditors. But this would be both unjust and impossible. In no sense do all bond- and stockholders stand upon an equal footing. In the first place, the cost at which senior bondholders have acquired their claims has much exceeded the cost at which junior bondholders and stockholders have acquired securities of equal nominal amount. Apparently equal claims represent very unequal investment. In the second place this increased cost has been due to certain legal provisions touching security which become prominent during reorganization. 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 i............