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THE FINANCIAL POLICYOF CORPORATIONSAssistant Professor of Economics, Harvard University; author of Corporate Promotions and Reorganizations, History of the

National Cordage Company, etc.

IN FIVE VOLUMES

VOLUME ICORPORATE SECURITIES

Second Printing

NEW YORKTHE RONALD PRESS COMPANY1921


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Copyright, 1919, byTHE RONALD PRESS COMPANY

Copyright, 1920, byTHE RONALD PRESS COMPANY

All Rights Reserved


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TOWILLIAM Z. RIPLEY


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PREFACEThis book is a study of the financial structure and the

financial problems of large business corporations. The cor-poration has been gradually called upon to assume the opera-tion of those business enterprises which require considerablecapital and skill of management but which are not compre-hensive enough for governmental operation. To this concep-tual creature of the law modern society has delegated some ofthe most important functions of its economic life. And to en-able its many members to co-operate with each other andderive the benefits of each other's capital, the fascinating realmof corporation finance has been gradually built up.The problems connected with this highly artificial realmof corporation finance are intimately connected with greatand far-reaching economic and social questions. In the easewith which they effect the transfer of property, corporationsecurities are a substantial bulwark of an economic democ-racy ; in the ease with which they perpetuate the form withoutthe substance of property ownership, they jeopardize the veryexistence of an economic democracy. It is such contradic-tions as this that give to the financial problems of corporationsan importance far beyond mere descriptive economics.

It is perhaps not too much to hope that this study will beof value to two groups of persons. There are many businessmen and bankers who are concerned with finance as a meansto a purely practical end namely that of administering theirparticular businesses wisely and with broad judgment. If thisstudy helps them to accomplish this practical purpose and tosee their daily problems in a wider perspective, it will haveserved a good end.

It is my hope, too, that this study will help to strengthencollege teaching in contemporary economic problems. Ameri-


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VI PREFACEcan students are turning, in increasing numbers, to contempor-ary social and economic courses of study. Those educated inthe older humanitarian moulds of thought may regret thischange in the students' point of view. Nevertheless, it ispresent. It cannot be stifled, nor circumvented by the substi-tution of the study of other peoples and other times. Thealert undergraduate of vigorous, virile personality, the bestfoundation for the making of American men, wants to knowhow banks are organized, how railways are run, and how theaverage man one meets on the street is getting a living. Thesemay be very prosaic questions, but they are very vital ones.And the college undergraduate demands I know this froman intimate teaching acquaintance with many young men intwo of our universities that his college course shall givehim a direct and sympathetic appreciation of the foundationupon which rest those great social and economic questionswhich present themselves in any direction he turns the news-paper, the periodical, politics, even the banter of the dilet-tante in social reform.

I have a strong belief that there is no opposition betweenthe theory and the practice of sound finance. As in all otherspheres of social activity, good practice is based on soundtheory and sound theory has its constant pragmatic justifica-tion in successful practice. In their mutual desire to strengthenour economic fabric the practical business man turns moreand more to the economist, and the economist feels an increas-ing sympathy and a greater respect for the constructive geniusof modern business activity.A small, temporary imprint of Volumes I and II was firstprinted in 1919 and these volumes are now reprinted withunimportant changes. The last volumes were finished in 1920.ARTHUR S. DEWING.Cambridge, Massachusetts.

October 15, 1920.


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INTRODUCTIONFinance is the science of money. As the value of money

lies in the value of other things for which it is exchanged, anytransaction in which goods or services are given for money,might be called a financial operation. The term finance,however, broad as would be its most general definition, is or-dinarily narrowed to embrace only a study of the principlesand the methods of obtaining control of money from thosewho have saved it, and of administering it by those intowhose control it passes. The term is employed usually inconnection with relatively large transactions, in which theremay have been difficulty in bringing together the requisiteamount of money, or in which a number of different partiesare concerned. Regarded, indeed, as a science or a body ofscientifically related facts, finance has come to refer to largecapitalistic undertakings whether conducted by a governmentor its political subdivision, or by an individual or group of in-dividuals.

The science of finance may be conveniently divided intopublic finance and private finance. The former deals with themethods of securing money for the conduct of governmentand the administration of the public funds; the latter withthe methods of securing money for private, usually gainful,enterprises and the administration of this money by individ-uals, corporations, and voluntary associations. The two fieldsare distinct. In the former, money is spent so that it mayyield, ostensibly, the greatest value for the members of thecommunity; while in the latter the money is spent so that itwill yield, ostensibly too, the greatest ultimate profit to thosewho contributed it. The point of view is different throughout,although there is this in common, that in each case the ulti-mate economic sanction is the largest value with the least

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viii INTRODUCTIONwaste, and the ultimate ethical sanction is justice to all con-cerned.

Private finance in its turn may be further subdivided intovarious departments, such as personal finance, partnershipfinance, and corporation finance. From another point of viewit may be subdivided according to the kind of industry forwhich the money is gathered banking finance, railroadfinance, public utility finance, industrial finance, or miningfinance. The present book is concerned wholly with privatefinance, and especially with those financial operations carriedon by the modern economic unit known as the business cor-poration.The primary purpose of the present work is to describethe financial processes of corporations. Without attemptingto formulate a legal or historical definition, a corporation maybe described as an organization sanctioned by government tocarry on some specific and clearly defined undertaking. Thecorporation is considered as separate from its members; it iscapable of expressing purposes and ideals of its own, of own-ing property, of contracting debts, of suing and being suedall in its own name without in any way involving its incorpora-tors, officers, directors, or shareholders. In these respectscorporations are to be distinguished from partnerships andpurely voluntary associations involving the individual respon-sibility of their members.

Speaking in general terms, corporations may be dividedaccording to their main purpose into those existing for analtruistic or ideal purpose, such as churches, colleges, andscientific societies; and those existing for an economic pur-pose, the business corporations, such as railroads, banks, andgas works. The term corporation finance includes, specifi-cally, the financial transactions of the latter group.

Corporation finance deals with both fact and policy. It isconcerned with fact, in so far as it describes the prevailing


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INTRODUCTION ixcustoms and methods which are employed in the financial ad-ministration of the modern corporation; it deals with policy,in so far as it succeeds in formulating principles or rules ofexpediency which may serve as guides to sound financial pro-cedure. The two should be distinguished. For example,that short-term notes have been issued extensively by rail-roads since 1910 as a means of securing money from in-vestors, is a plain fact about which there can be no dispute.That such a course has been inexpedient and should not be con-tinued, is a judgment of policy over which there may be adispute. One is a clear statement of empirical fact, and theother a statement of financial policy. Both kinds of state-ment find places in a science of finance. Yet care must be ex-ercised to distinguish between them, for the former is ob-jectively true, while the latter is significant only as the productof mature generalizations, based on grounds of economic ex-pediency. As in all other branches of the social sciences, whatpurports on its face to be an inductive principle, turns out onanalysis to represent merely a summary statement of a limited,though extensive, area of experience.The assumption that business corporations as a class areorganized and conducted primarily for profit, does not ob-scure the still more important fact that in receiving a profit,all private corporations must serve a public end. The rail-roads were built originally by money collected from men whohoped to obtain large profit through their operation. Never-theless the railroad has wrought a veritable social and eco-nomic revolution, welding into a coherent industrial unity thepeoples of widely separated geographical regions. Built byprivate means, and administered by private agencies, the rail-roads, the electric light companies, the gas works, were con-ceived primarily to yield a profit ; yet this profit was possibleonly so long as they served real human need. This is thepresupposition of the social justice of private property.


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x INTRODUCTIONEmpirical facts and theoretical psychology both substan-

tiate the belief that individual initiative, personal ambition,and even the primitive passion of conquest, are forces whichare necessary to produce the greatest efficiency of economicproduction with the least waste of social capital. The diffi-culty about the modern practice of this theory lies in the in-adequacy of the quantity of capital that can be devoted by asingle individual or group of individuals to a single enterprise.Yet economic progress, since the industrial revolution, has de-pended more and more on increasing the quantity of capitalat the command of a single enterprise. The capitalization ofthe Pennsylvania railway system is close to a billion dollars;that of the New York Central system is the same an amountof capital inconceivable for a private enterprise to commanda century or even half a century ago. The all-important eco-nomic problem of the last hundred years has been to securethe initiative and coherence, the force of individual ambitionwith its attendant responsibility, that goes with the privateconduct of enterprise, and at the same time secure to theprivate managers the necessary capital to carry on vast andexpensive undertakings. In brief, it has been the problemof retaining the force and responsibility of private businesswithout the limitations of private capital.The problem has been solved by the corporation.1 Theofficers and directors of the corporation retain the responsi-bility of private effort, the stockholders furnish the capital inunlimited amounts. Although merely an immaterial form,it has nevertheless wielded an economic and social influencegreater than any other purely conceptual entity of the lastcentury.

The contribution of the corporation to the evolu-1 The b9olcs and monographs on the development and economic significance ofthe corporation have been legion. See particularly for legal aspects Baldwin, S. E.,in Two Centuries' Growth of American Law (Yale Bicentennial Series [1901], andfor brief account of early American corporations, Davis, J. S., Charters for Ameri-can Business Corporations in the Eighteenth Century. 15 Jour. Am. Stat. Assn. 426

(1916).


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INTRODUCTION xition of the form of modern industry has been no less potentthan that of machinery to its technique.

Aside from the form of the corporation itself, as a con-ceptual entity, three wide-spread influences have tended to ac-centuate the importance of corporation finance. These arethe broader distribution of wealth among small capitalists,the increasing public responsibilities which private corporationsassume as they increase in size and influence, and lastly thewidening breach between the persons who save capital, that isto say, the capitalistic forces of society, and the managers ofbusiness enterprise, that is to say, the entrepreneurs.The extent to which the Fourth Liberty Loan was sub-scribed throughout the country was a revelation to most econo-mists of the potential saving power of the workers, the smallfarmers, the shopkeepers, in fact the great body of Americanmen and women whose individual margin between receipts andexpenditures is ordinarily small. True, the Great War hasvery much increased the margin of the ordinary worker,farmer, and small entrepreneur, nevertheless the latent powerof saving has been present to a far larger and wider extentthan anybody realized, even the observant student of con-temporary economic conditions. Much of this vast fund ofthe small savers has been finding its way into the economiccurrent through the instrumentality of co-operative banks,savings banks, and life insurance companies, so that the ulti-mate origin of the savings has not been at first sight clear.Statistics show, however, that the real owners of the railroadsof this country are the life insurance companies and the smallnational, state, and savings banks; and the real owners ofthese institutions are the thrifty wage earners, shopkeepers,farmers, and country merchants.The means of the economic development in this countryhave come, as in England, France, and Holland, from thewide-spread thrifty, industrial, middle class. The United


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xii INTRODUCTIONStates Steel Corporation has over a hundred thousand indi-vidual stockholders, the Pennsylvania Railroad and the Amer-ican Telephone and Telegraph have fifty thousand each; be-yond this number there are the millions of creditors of thelife insurance companies and savings banks whose contribu-tions have made possible the enormous bonded issues of thosecorporations. Sporadic cases exist of large capitalists. Thelarge merchants and large banks use their own resources.But the resources of even such concerns are insignificant com-pared with the aggregate of the small savers of the countryto whom the accumulation of capital is merely incidental tothe every-day planning of life. This fact explains why thereis no capitalist class, for the great industries of this countryare owned by the people. It explains, also, why our unstableeconomic life produces so little of individual permanencyand yet so great permanency of our fundamental

economicinstitutions. All this is possible because wealth has assumedthe form of corporation securities instead of titles to land.

Another cause for the increasing importance of corpora-tion finance lies in the influence wielded by the great privatecorporations in our economic and social organization. Soonafter the United States entered the Great War it was realizedthat one of the essential elements to our success was an effi-cient transportation system. Because of the narrow visionand still narrower understanding of men who composed theInterstate Commerce Commission, the railroads had not beenallowed to increase their rates in proportion to the costs ofoperation. Consequently, their earnings had declined and withtheir earnings their credit. As a result, the railroads hadbeen unable to improve their plants in proportion to thedemands of our widening economic activities, so that whenthe crucial test of the war came, the railroads were quite asdisastrously as the various departments of the governmentunprepared for the test.


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INTRODUCTION xiiiThe railroads are by no means the only great corporations

essential to our national life. When the Westinghouse Elec-tric and Manufacturing Company failed in 1907, creditors,co-operating with the receivers who acted under instructionsfrom the court, sought every means to rehabilitate the cor-poration. The business interests of the country required theactive existence of this concern, because it was then the secondlargest manufacturer of electric equipment in the country.The ideas of eminent domain, of the inviolability of franchisecontracts, of regulated monopoly as applied to public serviceenterprises all testify to the important place which theseenterprises occupy in our modern life. The telephone system,the gas works, the electric light and power company, and thestreet railroad, are all private corporations of varying sizewhose activities are indissolubly bound up with the industriallife of their communities.

These two aspects the widening ownership of the cor-poration and the widening public concern in its success havedeveloped together. The success or failure of a business con-ducted by a single individual or a group of individuals is notof wide public interest. Thousands of small businesses failevery year without the fact being noted except in the tablesof the credit statistician. The big businesses, with their le-gions of stockholders, are big because of wide-spread owner-ship, and of the public concern which such business activityentails. It is this interaction between increasing size with itsincreasing number of stock- and bondholders and an increasingpublic importance, which is one of the most significant ele-ments in contemporary economic history.And these changes have been concurrent with a growingdivergence between the owners and the operators of theselarge corporate enterprises. The economist has long sincedistinguished between the parts which management and capitalplay in industry, though he has failed to recognize the fact that


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xiv INTRODUCTIONthis separation has applied in practice only to large businesses.In small industries the separation is difficult and inexpedient:the farmer is both owner and operator of his farm; the phar-macist owns and operates his corner drug store; the localcountry butcher owns his shop, slaughters his cattle, and sellshis meat. But as enterprises increase in size and scope, theoperators find themselves able to employ profitably more cap-ital than they individually can command. Then they arebacked by others first wealthy friends, then the local com-munity, then the great army of small savers who live on lessthan they produce. In the same way, the first bankers in therich Italian cities of the Po Valley seven centuries ago werebusiness men who participated in the maritime ventures ofothers, and somewhat later the first English banks were thegoldsmith companies which owned and loaned their gold.As wealth increased on the one hand and business specializa-tion on the other, men who had little if any capital, but markedability, were led to assume the management of enterprises builtwith capital furnished by others.Under the simpler economic conditions of earlier times,when the owner and the manager were one, finance was com-paratively simple. But now with a constantly increasingdiversification in the elements of a business, the financialmethods of the proprietor-manager have given place to otherswhich are increasingly complex.The field of corporation finance has been progressivelywidened, following the changes in the form under which in-dustries are conducted. From 1830 to 1890 railroads andbanks were the only great industries requiring the use of largeamounts of capital and hence requiring, of necessity, the cor-porate form of organization. Therefore, the financial terms,methods, and policies connected with the new form becameestablished in railroad finance before they were carried overinto other industries. Just prior to the panic in 1893, however,


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INTRODUCTION xvmanufacturers conceived the idea of organizing their com-petitive businesses into large units for which new capital couldbe secured from public subscribers. Family businesses andpartnerships of several generations were changed into corpora-tions, and these in turn merged into great industrial consolida-tions. And concurrently the financial practices were trans-formed to agree more nearly with the established practices ofrailroad finance. It is this entire body of precedents, prac-tices, policies based on accident, on law, and on past expe-diency, and applying to all kinds of corporations which formsthe substance of corporation finance.

This work is divided into five volumes. The first deals withthe form of securities likely to be issued by a corporation.The second traces the embryonic development of a corporateenterprise through the period of organization, or promotion.A third discusses various problems arising from the financialadministration. A fourth section describes the methods whichmay be pursued in obtaining the money necessary to expanda corporation and the forms which this expansion may take.And the fifth and last section is concerned with the failuresof business enterprises and the various means to be employedto rehabilitate a bankrupt corporation. The volumes are inter-related; no single phase of corporation finance is complete initself.


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CONTENTSVolume I Corporate Securities

CHAPTER PAGEI CAPITALIZATION AND COMMON STOCKS 3

Elemental conceptions of capital, 3; Economic capital,5; Capitalization, 5; Capital stock, 6; Two types of cap-ital stock, 7; Certificates of association, 9; Massachusettstrusts, ii ; Certificates of part ownership, 13; Stock with-out par value, 13; Assessment, 16.

II THE GENERAL FORM OF BONDS 17General definitions, 17; Part of an issue, 18; The

promise to pay, 20; The denomination, 20; The time ofpayment, 21 ; The rate of interest, 22 ; The place of pay-ment, 23; The security, 24; Open and closed mortgagebonds, 24; The maturity of bonds, 27; Redemption ofbonds, 31; Convertibility of bonds, 33; Lack of votingpower, 34; Conditions of enforcement, 35; Investmentstatus of bonds, 36.

III BONDS SECURED BY PLEDGE OF SPECIFIC PROPERTY . . 40The classification of bonds, 40; First mortgage bonds,

41 ; The after-acquired property clause, 44 ; Divisionalbonds, 45; Special direct lien bonds, 46; Second and latermortgage bonds, 48; General and consolidated mortgagebonds, 50; Refunding mortgage bonds, 50; Collateraltrust bonds, 54; Short-term notes, 64.

IV BONDS SECURED BY CREDIT 67Nature of straight credit bonds, 67; Receivers' certifi-

cates, 68 ; Assumed bonds, 69 ; Guaranteed bonds, 71 ;Joint bonds, 74; Debentures, 77; Income bonds, 82; Par-ticipating bonds, 87; Convertible bonds, 87.

V EQUIPMENT OBLIGATIONS 89General definition of equipment obligations, 89 ; History

of their issue, 90; Extent of present use, 92; Chief rea-sons for issue, 94; Economy, 94; Avoid after-acquiredproperty clause, 98; Subordinate reasons, 98; The Phila-delphia plan of issue, 99; Equipment bonds, 101 ; Securitypledged, 103; Treatment in reorganization, 109; Invest-ment strength, 112.

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XV111 CONTENTSCHAPTERVI

PAGEPREFERRED STOCKS 113

Status of preferred stocks, 113; General description,114; Conditions of issue, 115; Lien on assets, 116; Re-demption, 119; Preferred stock dividend rate, 121; Cumu-lative, 124; Participating, 127; Protection of position,128; Protection from note issues, 130; Protection frombond issues, 133; Protection from further issues, 134;Management rights, 134.

VII CONVERTIBLE ISSUES 137General description, 137; Historical uses, 137; Conver-sion security of bonds, 138; Conversion security of pre-

ferred stocks, 140; Conversion ratios, 141; Difficult ratios,143; Convertible short-term notes, 143; Double conver-sions, 144; Periods of conversion, 145; Main purpose ofall convertible issues, 147.

Volume II PromotionI THE PROMOTER 3Stages in promotion, 3; The promoter, 4; Promoter and

inventor, 5 ; The promotion of an invention, 6 ; The workof a promoter in the public service field, 9; The promoterof a new factory in an established industry, 13 ; The pro-moters of industrial combinations, 14; Value of the pro-moter, 17; The promoter's profits, 19; The legal status ofthe promoter, 20.

II THE BANKER'S CONTRIBUTION TO PROMOTION ..... 21The position of the investment banker, 21 ; Contrast be-tween investment banker and institutional banker, 21 ; Con-trast between investment banker and stock-broker, 25;True functions of investment banker, 26; The distributivefunction, 28 ; The selective function, 29 ; Aids to the invest-ment banker's selection, 30; Social and economic service ofselection, 34; The administrative functions, 35.

Ill THE GENERAL PRINCIPLES UNDERLYING THE FINANCIALPLAN 38The nature of the financial plan, 38; Fundamental con-siderations, 40 ; The cost of the property, 41 ; Future earn-ing capacity, 41; Conditions of the investment market, 46;The balance of control, 47.


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CONTENTS XixCHAPTER PAGEIV THE FINANCIAL PLAN OF A NEW MANUFACTURING EN-

TERPRISE 48Invested capital as a basis for estimated earnings in

manufacturing promotions, 48; Value of earnings of othersimilar businesses, 49; Dead reckoning from probabledemand, 50; The value of past earnings in the cases ofindustrial consolidations and reorganizations, 52 ; The in-fluence of investors' prejudices, 56; Financial plan forhighly speculative business, 57; Financial plan for indus-trial consolidation, 58; General summary of principles, 59.

V THE FINANCIAL PLAN OF THE NEW PUBLIC UTILITY . . 61Connection between rates and earnings of a local utility,

61 ; Tests of earning capacity of a new utility, 64; Popula-tion, 64; Wealth, 65; Past and future of locality, 67;Actual and potential competition, 68; Comparative earn-ings, 69; Estimation of earnings of a reorganized utility,69; Money investment required, 72; Form of the financialplan, 75 ; Financial plan of an hydro-electric enterprise, 80 ;Human factors in promotion, 85.

VI THE FINANCIAL PLAN OF A RAILROAD PROMOTION ... 88Kinds of contemporary railway promotion, 88; Early

railroad promotion, 89 ; The construction company, 91 ; Thefinancial plan of the new railroad, 97 ; Illustrative exampleof small contemporary railroad promotion, 99; Promotionof an interurban railway, 101.

VII UNDERWRITING SYNDICATES 104General definition of a syndicate, 104; Types of under-

writing syndicates, 105 ; The guaranteeing syndicate forsale of a large, well-known corporation's securities, 107;Ordinary underwriting syndicates and the function of themanager, no.

VIII MARKETING OF INVESTMENT SECURITIES 129Kinds of investment banking houses, 129; The whole-

sale investment banker, 129; The typical large distributinghouse, 131; The small dealer, 137; The procedure of sell-ing, 138; The various services rendered by the bond house,140; The fallacy of direct selling, 146; The profits of se-curity selling, 148.


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XX CONTENTSCHAPTERIX THE MARKETING OF LOW-GRADE SECURITIES

Risk incident to all promotion, 152; Four methods usedto sell low-grade securities, 154; Appeal to avarice, 157;Appeal to speculative instinct, 159; Appeal to vanity, 164;The sucker lists, 166.

Volume III The Administration of IncomeI THE SIGNIFICANCE OF ACCOUNTING THEORY IN FINANCE

The basis of business policy is the science of account-ancy, 3; Accountancy based on a correspondence betweeneconomic and money values, 4; Balance sheet and incomeaccount contrasted, 5; Net profits deduced by two sepa-rate sets of adjustments, 7.

II THEORY OF COMPENSATION FOR WASTING ASSETS . . .Classifications of adjustments, 9; Repairs, n; Deprecia-

tion, 14; Obsolescence, 21; The important principle of allreserves, 25; Certain objectionable accounting practices, 26.

III THE COST OF BORROWED CAPITAL 29The problem of the use of capital, 29; Classification of

payments for borrowed capital, 30; Cash discounts, 31;Interest on merchandise loans, 31 ; Interest on funded debt,32; Rentals and royalties, 34; The amortization of bonddiscount, 37; Summary statement, 40.

IV MANAGEMENT OF SURPLUS 42Sources of the surplus, 42; Paid-in surplus, 43; Surplus

through the sale of stock at a premium, 44; Surplusthrough sale of capital assets at an advance over bookvalues, 45; Surplus through reorganization, 49; Accumu-lated surplus from earnings, and its investment, 50.

V SPECIAL RESERVES FOR BUSINESS CONTINGENCIES . . .The necessity of special reserves, 54; Classification of

these special reserves, 56 ; Reserves for taxes, 57 ; Reservesfor property destruction, 60; Reserves for public, unre-munerative improvements, 65 ; Reserves for business uncer-tainties, 69.

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xxii CONTENTSCHAPTER PAGE

II THE LAW OF BALANCED RETURN 9Statement of the Problem, 9; Law of diminishing re-turns, 10 ; The scope of the law, 12; Application of dimin-

ishing returns to manufacturing, 13 ; Quantity factors inproduction, 14; Illustrations from shoe industry, 16;Tentative conclusions, 19; The law of balanced returnexpounded, 21 ; Illustrations of the operation of the law, 25.

III INDUSTRIAL COMBINATIONS 33The problem of industrial incorporations, 33; Historical

survey of industrial consolidations, 34; Reasons for cessa-tion of industrial consolidation, 38; The failure of theindustrial consolidation, 41 ; The present-day problem, 52 ;Importance of extremes of ability, 53 ; Four modern suc-cessful types of consolidation, 54; Automatic industrieslikely to succeed in large-scale production, 54; Integratedindustries, 54; Chain stores, 57; Export companies, 64.

IV THE EXPANSION AND CONSOLIDATION OF RAILROADS . .Methods of treating subjects, 69; Analysis of forms, 71;

The lease, 74; Traffic leases, 76; Gross earnings leases, 76;Net earnings leases, 77 ; Fixed rental leases, 79 ; Stock con-trol by purchases, 83 ; Stock control by exchange, 85 ; Stockcontrol by collateral trust bond, 86; Outright purchase,92; Historical period of railway consolidation, 94; Firstperiod of end-to-end consolidations, 96; Second period,100; Third period, 106.V THE PUBLIC UTILITY HOLDING COMPANY 109Means of control over many small companies, 109; Early

history, no; Four advantages, 113; Superior technical effi-ciency, 114; Economy in purchase of equipment, 118; Ad-vantage in business dealings with public, 118; Advantagesin financing, 122; Financial structure of the public utilityholding company, 128; Special types of holding com-pany, 134.

VI THE COMMUNITY OF INTERESTS 137Problem of business organization a balance between

unity and diversity, 137; A balance involving advantagesof each, 139 ; Trade associations, 145 ; District associations,146; Manufacturers' associations, 151; Community of in-terests, 154; Community of interests in production and dis-tribution, 155; Community of interests in stock owner-ship, 157.


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CONTENTS xxiiiCHAPTER PAGEVII THE SOURCES OF CAPITAL AND SHORT-TERM BORROWINGS 168

Problem of new capital, 168; The investment of earn-ings, 168; Growth of short-term corporate borrowings,172; Evils of short-term notes, 174; Distinction betweenself-liquidating and fixed property, 176.

VIII EXPANSION THROUGH THE SALE OF SECURITIES TOBANKERS 180Problems to be considered, 180; Advantages of issues ofbonds rather than stock, 181 ; Advantages of stock issues,

184; Advantages of sales through bankers, 188; Assur-ance of sales, 188; Widening of market for securities, 190;Relative economy, 193; Exchange, 195; Growing use ofstocks rather than bonds, 196; Pretended safeguards frompoint of view of investor, 198.

IX PRIVILEGED SUBSCRIPTIONS 202Conditions of privileged subscription, 202; Terms of

offer, 203; Value of the right, 210; Effect of the privilegedsubscription on the market price of the stock, 213 ; Methodsof taking advantage of privileged subscription, 214; Theprofits from privileged subscription, 217; Underwritingprivileged subscription, 218.

APPENDIX 221Volume V Failure and Reorganization

I THE PROBLEM OF REORGANIZATION 3The problem stated, 3 ; The importance of reorganization,5; Motive, 5; Difficulty of definition, 7; Two stages inreorganization, 8.

II CAUSES OF FAILURE 10Distinction between the fundamental and the superficial

causes of failure, 10; Four fundamental causes of failure,II ; Competition, n; Unprofitable expansion, 14; Cessationof public demand, 21 ; Excess payments of capital charges,22; Superficial signs of failure, 26.

Ill THE PROCEDURE OF REORGANIZATION29Motives governing the procedure of corporate reorgan-

ization, 29; Events immediately preceding failure, 32;Formation of committees, 33 ; Classifications of reorganiza-tions according to legal procedure, 37; The appointmentof a receiver, 40; Investigations succeeding receivership,


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xxiv CONTENTSCHAPTER PAGE

48; The formation of the reorganization plan, 52; Execu-tion of the plan, 55; Adjustment of opposing interests, 60.

IV THE REORGANIZATION OF RAILROADS 66Importance of railway reorganization, 66; Summary of

the intents of railway reorganization, 67; Five periods inthe history of railway reorganization practice, 70; Earliestperiod of railway failures, 72; Second period comprisingreorganizations following the panics of 1857 and 1873, 73;Third period of the later eighties, 77; Fourth period fol-lowing the panic of 1893, 80; Contemporary theory andpractice of railway reorganization, 86; A classification ofrailroad reorganizations, 90.V MONEY REQUIREMENTS AT TIME OF RAILROAD REOR-GANIZATION

Divisions of the subject, 96; The treatment of floatingdebt holders, 97; The issue of receivers' certificates, 102;The uses of new money, 105; The sale of treasury assets,108; Assessment of stockholders, 109; Expediency ofmeeting assessment, 120 ; Reorganization underwriting syn-dicates, 122.

VI THE REDUCTION IN FIXED CHARGES IN CONTEMPORARYRAILROAD REORGANIZATIONS 129

Reorganization plans all modifications of the first type,129; Classes of securities to be dealt with, 130; Treatmentof the underlying bonds, 131 ; Treatment of first generalmortgage bonds, 140; Treatment of junior bonds, 149;Reorganization of Class II, 151 ; Reorganization ofClass III, 153; Cancellation of burdensome leases, 155;Voluntary reorganization, 159; Effect on total capitaliza-tion, 160.

VII INDUSTRIAL REORGANIZATION PLANS 162Causal characteristics of industrial reorganizations, 162;

Chief ends of an industrial reorganization, 166; Simplemeans of obtaining money, 167; Assessment on securityholders, 169; Assessment on outside creditors, 172; Changesin capitalization, 174; Reorganizations to extinguish ac-cumulated preferred stock dividends, 176; Reorganizationsto relieve a burden of floating debt, 181 ; Reorganizationsto reduce fixed charges, 183; Voluntary industrial reor-ganizations, 185.

GENERAL INDEX

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THE FINANCIAL POLICYOF CORPORATIONS

VOLUME ICORPORATE SECURITIES


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CHAPTER ICAPITALIZATION AND COMMON STOCKS

Elemental conceptions of capital, 3 ; Economic capital, 5 ; Capitali-zation, 5 ; Capital stock, 6 ; Two types of capital stock, 7 ; Certifi-cates of association, 9; Massachusetts trusts, n; Certificates of partownership, 13; Stock without par value, 13; Assessment, 16.

The securities which a corporation may issue consist oftwo general types: stocks and bonds. Their characteristics,rules, etc., will be discussed in detail in the succeeding chap-ters of this volume. Here it is advisable to consider first thegeneral subject of capital and capitalization.The elemental conception of finance is capital. The wordcapital has been used, unfortunately, in such a variety ofsenses that it is now meaningless outside of its context. Asa conception of economic theory it has been defined, inter-preted, and reinterpreted according to the training or whimof the economist. As a conception of accounting, it has beenvariously conceived as an asset or a liability, as property ormerely an equity. In our common speech it has come toimply a variety of meanings all vaguely in accord with the va-riety of views current in the business world.From the point of view of the theoretical economist,trained in the positivism of Smith, Mill, and Cairnes, capitalmeans one thing, namely, the material goods created throughthe labor of man which are devoted to the production ofwealth. The term capital designates both material goodsmade by men, and society's instruments of production. Withthis theoretical definition we are not here concerned, except tocomment that all other conceptions of capital are ultimatelybased on this description; all other conceptions presuppose

3


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4 CORPORATE SECURITIESthe three elements labor, material goods, and productiveness

involved in the definition used by the classical economists.We are here concerned with the term capital as used in

business, together with two related terms expressive of dif-ferent aspects of the fundamental idea of property value:namely, capitalization, and capital stock. By capitalis meant in ordinary usage the actual property devoted tosome productive end. 1 It is the substance of the business.In some cases it is convenient to distinguish between grossand net capital, the former referring to the investment of theproprietors plus their borrowed capital and the latter to theproprietors' own capital alone. 2 At all events the word cap-ital must be used to refer to actual physical goods, the muscleand the sinew of economic production.The terms capitalization and capital stock are repre-sentative. They refer not to physical goods, but to the valuesset over against the actual capital of the business. They areof accounting or representative significance; they stand forthe liabilities of a business and not its assets. 3 Capitalizationis the sum of the various values by which the proprietaryinterests of a corporation care to evaluate the actual capital.That portion of the total capitalization of a business whichthey, the proprietors, claim represents their own personal

1 Two modern writers dealing with capital from the same point of view as inthis book have said, Capital assets are all those funds, properties and equipment re-quired for continuous, productive use. Cleveland and Powell, Railroad Finance,322 (1912).2 Ripley uses the term gross capital to refer to an aggregate of funded liabili-ties where there has been no effort made to avoid duplications, and net capital tothe sum of such liabilities where all duplication has been avoided. Ripley, W. Z.,Railroads Finance and Organization, 61 (1915). This distinction is of the utmostimportance in railroad finance, and recent public utility finance.8 A great deal has been written from the different points of view of economictheory, finance, and accounting in the effort to distinguish between and define thedifferent uses of the concept of capital and its derivatives. See particularly Cleve-land and P9well, Railroad Finance, Chap. Ill and XVII (1912); Ripley, W. Z.,Railroads, Finance and Organization, Chap. II (1915). Every treatise on economicsfeels compelled to discuss the question, but few shed much illumination.Among the books on corporation finance, strictly speaking, the most exhaustivediscussions are found in Lyon, W. H., Capitalization (1912), whose main effortsare directed toward clarifying our usage of these words. See also discussion inCooper, F., Financing an Enterprise, Part IV (1915).


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CAPITALIZATION AND COMMON STOCKS 5capital, they call capital stock ; that portion which theyadmit is borrowed from others, they call debt. In briefthen, and as used hereafter in these pages, capital refers tothe actual wealth employed in an undertaking, and capitaliza-tion to the representation of this wealth in terms of purelyartificial and, in the end, fictitious values.4 A part of theserepresentative values, namely those contributed by the pro-prietors, is designated capital stock ; and the other part,that contributed by outsiders, is spoken of as debt.

In a single-proprietor business, or even in a partnership,capital is the total of assets of the business. In concrete casesit is determined from an inventory of the actual propertyowned by the proprietor or the partnership. In businessesconducted by corporations, this simple way of ascertainingcapital cannot be used, owing to the necessity of establishing abalance between the assets and the liabilities. The .capital isnot the aggregate of assets, because the apparent assets aregenerally inflated by fictitious bookkeeping entries, such asbond discount or the various balances from contingent reserveaccounts. It is, on the contrary, the actual or real wealthvalues used by the corporation those which have a positiveand marketable value. That is, it is the amount of economicgoods segregated by the corporation for its own purposes. 5

The term capitalization, or the valuation of the capital,4 Ripley makes the same distinction: The property brought into being ascapital remains forever entirely distinct from its capitalization, albeit linked in acausal relation thereto. Capital is reality. Capitalization is merely a record of

past operation and a bench mark or standard of measurement for the future.Ripley, W. Z., Railroads, Finance and Organization, 55 (1915).

5 There are two distinct uses of the word capital, both accepted by businessmen. One refers to the total property employed in a business, irrespective of itsfinal ownership, and the other to the amount actually owned by the proprietary in-terests. Thus an individual or a corporation takes $100,000 of its own money andborrows $200,000 more, investing the entire amount in a plant, its equipment, and astock of merchandise. It is possible to refer to the capital as either $300,000 or$100,000, according to whether one follows the first or the second usage. In thepresent discussion the first usage is followed as more consonant both with currentbusiness practice and with the idea of capital as expressed by sound economic theorj.


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6 CORPORATE SECURITIESincludes the capital stock and the debt. In individual pro-prietary and partnership businesses the term has no signifi-cance, as there is no occasion to represent the capital of abusiness other than in terms of actual property. But with thecorporation the matter is entirely different. The corporationis conceived to be the recipient of a fixed amount of propertywhich remains constant, no matter what the fortunes of thebusiness. This is the capital stock. In addition, the corpora-tion borrows money from outside sources. The sum of theseamounts represents the securities or the representative valuesissued against the actual capital employed in the business. Ina concrete case it is often difficult to determine the exactamount of capitalization, because much corporate debt repre-sents merely temporary borrowings more or less completelyoffset by an ever-changing volume of current assets. Theidea, however, of capitalization is that it shall represent thecapital stock and the permanent or funded debt. It is thetotal securities or representative values issued by the corpora-tion against its actual property. 6

Capital stock, common stock, or merely stock, representsinvariably the interests of the proprietors in the corporate en-terprise. In no sense can stock represent an outside claim;in no sense can the stockholder regard himself as a creditor.7

6 It is very difficult to determine the capitalization of a railroad. While in asimple case it may be fixed by adding together its capital stocks and its bonds oneis always perplexed by a variety of other liabilities. In some railway systems, likethe Lackawanna, the rentals must be capitalized. In others, like the New Haven,the current debt must be included, as this current debt was incurred in order toconstruct permanent additions to the property of the road. On the other hand, theremust be various adjustments for joint bonds, collateral trust bonds issued on pro-prietary lines, and all contingent liabilities, as in the case of the Great Northern,Northern Pacific collateral trust joint bonds. For example, Ripley questions tothe length of an appendix, the extreme difficulty of proportioning the capitalization ofjointly owned terminal roads. Ripley, W. Z., Railroads, Finance and Organization,609 (1915). In actual practice, great care must be exercised in any given caseand no general rule can be laid down as to what liabilities to include and what notto include in determining the net 'capitalization of any railroad.

7 This distinction is sometimes obscured by such anomalous cases as redeemablestock and participating bonds. Yet, as clearly brought out in the American Maltingand later cases, the distinction is still recognized by the law of corporations and isfundamental to corporation finance.


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CAPITALIZATION AND COMMON STOCKS 7The fundamental idea of stock is that it represents the pro-portionate contribution to the original capital or propertyof the corporation. Stock is the share of interest, the shareof responsibility of management, and the share of profit orloss. 8 So far as the complexity of modern business permits,the stockholder is the business partner of the old-fashionedpartnership, but lacking certain of the legal implications at-tending the position of partner. Unfortunately this originalsimplicity has been modified by the demands of the increas-ingly complex financial organization of business, so that inmany forms of stock this original simplicity of motive isobscured or almost entirely obliterated.

The import of capital stock then, is that it shall stand forthe representative values of the proprietary interests; repre-sentative values which may or may not include the entireassets or actual capital of the corporation.There are two types of capital stock, unlike in the extentof the rights which the ownership implied involves. One typeof capital or common stock stands for the entire capital of thebusiness. The stockholders own everything. There are nopreferred shareholders, no bondholders, no short-term note-holders. The other type represents merely the margin ofassets and earnings after the claims of a host of preferredstocks, bonds, and notes have been satisfied. From every pointof view, except that of legal status, these two types of commoncapital stock must be carefully distinguished.The simpler form of corporation with its single class ofcapital stock was developed logically and historically out ofthe partnership. Capital stock of that first type, representingthe entire business, was therefore prior in point of time as

8 The most exhaustive discussion of capital stock in contrast to the liabilities ofa corporation is Lyon, W. H., Capitalization (1912). The sesond chapter entitledTrading on the Equity is a very able exposition of the economic status of thestockholder.


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8 CORPORATE SECURITIESwell as first from the standpoint of simplicity. It was onlyin later developments of corporate enterprise that bonds, orpreferred stock, or any other form of capitalization than stockalone came into use. The vast majority of all the railroadsof the East promoted prior to 1840 were constructed frommoney subscribed by stockholders, in the same manner asstockholders now furnish the share capital of a bank. With-out exception the main railroads of New England were origi-nally built by the inhabitants along their lines who took ordi-nary common stock. Even today many sections of the NewEngland railroads are unmortgaged, although the great na-tional railways systems, particularly since the year 1900,have paid for most of their extensions through the issue ofbonds.9

Throughout the history of American railroad finance thetendency has been from the simple financial plan to the com-plex, from plain stock to stock and mortgage bonds, then totwo kinds of stock and the wide variety of bonds covering thesimple mortgage and the intricate, non-cumulative incomebond. The financial methods of public service enterpriseshave undergone a parallel development. The first gas worksin the older states were built entirely from stock subscriptionand the old Massachusetts public service corporations stillhave only stock outstanding. But, as in the case of railroads,when extensive enlargements requiring other than local capitalwere necessary, it was found easier to secure money throughthe sale of bonds than through the sale of stock alone. Atthe same time preferred stocks were introduced to meet therequirements of an investing class who were willing to sacri-fice security for high return. The development has movedmore slowly in the case of manufacturing enterprises than

9 For example, note the small bonded debt of the New Haven in 1899. See Poor'sManual. This matter is further discussed by Cleveland and Powell, Railroad Finance,50 (1912). Ripley, W. Z., Railroads, Finance and Organization, 10 (1915). Forspecial studies see Volume II, Chapter VI,


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CAPITALIZATION AND COMMON STOCKS 9with public utilities. Because the large industrial combinationsare still on trial, as it were, before the bar of investment preju-dice and can obtain money only from people directly inter-ested, stocks still predominate in their financial plans. Yetthere is clearly apparent a growing inclination to diverge fromthe original custom of issuing only common stock and createin addition both preferred stocks and bonds. To recapitulatethen, in the wide range of the railroads, the lighting andpower, and the manufacturing businesses, the original formof a common stock, representing the entire business, has beenmore or less superseded by a common stock representingmerely nominal rights in residual equities.Common stocks of the first group representing rights tothe entire property are now restricted to a few small rail-roads, the majority of Massachusetts electric light and gascompanies, most small and medium-sized cotton mills, locallyowned manufacturing companies, banks, insurance companies,and mines. There have been in almost every case some specialreasons tending to hold back these types of industry fromdeveloping the more elaborate form of capitalization. Untilrecently the tax laws in Massachusetts levied a general prop-erty tax on bonds, but not on stocks, so that gas, electric light,and even cotton mills, found a readier sale for their tax-ex-empt stocks among local capitalists. Small manufacturingcompanies everywhere find the banks reluctant to extendcredit to bonded plants; banks and insurance companies areprevented by law from altering the form of their originalstock issues; mines find it impossible to sell bonds. Investorsin any of these stocks are the actual owners of the business,subject only to the claims of the holders of floating debt andthe merchandise creditors.

Analogous to the common stocks of corporations possess-ing the entire rights to the corporate property are the shares


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10 CORPORATE SECURITIESin associations, shares in trusts, and certificates of part owner-ship. Except in the legal obligations taken by their own-ers, which are analogous to those of partners, these anomaliesare common stocks in all but name. The certificates in asso-ciations are, in truth, certificates of partnerships. Owing tothe unlimited liability that attaches itself to such partnershipinterests, these certificates of associations are not in use any-where in the United States, except in the case of the largeexpress companies and certain small New England businesseswhich have maintained a kind of localized partnership char-acter for the last fifty or more years. The Adams and Amer-ican express companies' stocks are the only remaining part-nership shares widely held by the public. These partnershipswere formed some fifty years ago by means of Articles ofAssociation under which the original associates and theirsuccessors agreed to engage in the express business.10 Themanagement was restricted to a small group of officialswhich organized and maintained itself independently of thegreat body of certificate holders or partners. In this mannerthe management of the Association was independent of allregulation either from within or without, and it was not untilthe Federal Government, by the constitutional authority ofthe commerce between the states provision, placed the ex-press companies under the Interstate Commerce Commissionthat any control was exercised over the conduct of their busi-ness. This power of the management to conduct the affairs

10 The certificates of the American Express Company read as follows: AMERI-CAN EXPRESS COMPANY, organized under Articles of Association, dated November 25,1868, in which it is among other things provided: THAT the term of the existenceof said company shall be thirty years from and after the first day of December, 1868.THAT the shares shall be transferable on the books of the company only in personor by Attorney, upon surrender of the script representing the same and the paymentof all calls and assessments unpaid thereon. THAT such transfer is not matter ofright, but is permitted by the Company, in case the Board of Directors shall notelect to purchase said shares for the benefit of the Company at the market valuethereof. THAT the shares are subject to assessment for all losses and damages andother liabilities incurred in the prosecution of the business of the Company. THATthe receipt of this certificate constitutes the person receiving the same, from the datethereof, a member of said Company, entitled to all benefits and subject to all theliabilities of a shareholder therein as fully as signing said Articles of Associationwould do.


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CAPITALIZATION AND COMMON STOCKS nof the express companies without financial responsibility tothe shareholders has worked greatly to the latter' s disad-vantage. 11

Shares of trust, or business associations survive only inMassachusetts. 12 Historically they owe their origin to thefact that corporations cannot hold real estate for investment(mortmain). Title to property, accordingly, is taken by agroup of trustees who issue their certificates of equitable in-terest in the trust property. The trustees derive their au-thority from trust agreements or articles of association, whichdescribe in detail their powers, rights, and exemptions, to-gether with those of the certificate holders. When the trustform of organization was driven out of other states13 it re-mained in Massachusetts because, sanctioned by a century ofusage, a large amount of property had passed under the trustorganization and the persons most concerned exercised astrong influence on the course of legislation.The exact legal status of the Massachusetts VoluntaryAssociation is extremely difficult to determine and has givenrise to much litigation and a good deal of legislation. 14 Ifthe associations are actually express trusts, then the holders ofthe certificates, beneficiaries or cestui que trustent, canhave no voice in the management. If on the other hand, the

11 An illustration of this is afforded by the purchase of a large interest in theWells Fargo Company by the American Express Company at a greatly inflated priceand the retention of its large holdings of New Haven stock, although not operatingover this road. Altogether the management of the American Express Company,especially in the matter of its investments, has been conspicuous for its stupidity.

12 Except elsewhere in a few cases where specifically permitted by law, as inthe case of the Chicago Elevated Railways. See note 29 of this chapter.13 Largely because of the North River Sugar, 121 N. Y. 582 (1890), and theOhio Standard Oil, 49 Ohio 137 (1892) cases.14 There are a number of discussions of the subject, besides the innumerable

legal cases.Lewin, The Law of Trusts, Harvard Law Review, Vols. I, IV, and VII.Sears, J. H., Trust Estates as Business Corporations (1912).Wrightington, S. R., The Law of Unincorporated Associations (1916).12 111. L. Rev. 482 (1918).27 Yale Law Rev. 677 (1918).Two legislative reports contain exhaustive discussions of the subject. Mass.House Doc. No. 1646 (1912); No. 1788 (igi^).


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12 CORPORATE SECURITIESbeneficiaries are given managerial power, then the associationpartakes of the nature of a partnership and the holders ofthe trust certificates become legally bound for the debts of thetrust estate. To secure a kind of control by the shareholders,yet immunity from personal liability, has been the aim of allthese voluntary associations. 15

Such an association, with transferable shares, was decidedto be legal over thirty years ago,16 notwithstanding an oldEnglish statute to the contrary;17 and subsequent decisionshave given the voluntary association a secure position amongMassachusetts business forms. 18 Until recently these volun-tary associations with transferable shares had all the advan-tages of the corporate form of organization, and were freefrom many of the disadvantages. Accordingly, in addition totheir original purpose of holding land for investment, theyhave been formed, extensively, to operate cotton mills inMassachusetts and even in other states, 19 public utilities in210and out of Massachusetts, 21 and other enterprises. But theirprominence led to a number of statutory limitations beginningin 19 1 3 22 which have now placed these associations in prac-tically the same position as corporations. Trust certificatesare bought and sold as are corporate stock certificates and alarge number of those who invest in them are ignorant oftheir true nature.

18 Gerstenberg, C. W., Materials of Corporation Finance, n (1915), givesan excellent example of an agreement under which one of the most important ofthese voluntary associations the Massachusetts Electric Companies was formed.^16 Phillips v. Blatchford, 137 Mass. 510 (1884). An important recent leadingdecision is Hussey v. Arnold, 185 Mass. 202 (1904).17 St. 6, Geo. I, c-i8.18 See among others 140 Mass. 346; 168 Mass. 566; 174 Mass. 491; 185 Mass.202. Exhaustive discussion in legal treatises referred to under note 14 above.19 Amoskeag Manufacturing Company of Manchester, New Hampshire, the largestsingle cotton mill in the United States and possibly in the world.20 Massachusetts Gas Company, Massachusetts Electric Companies, Central Elec-tric Trustees.Texas Southern Electric.22 Act to punish Trustees of Voluntary Associations who do not file reports withCommissioner of Corporations. Gen. Acts Mass. 1913, Chap. 376, and for publishingsuch reports, Ibid. Chap. zoj.


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CAPITALIZATION AND COMMON STOCKS 13Certificates of part ownership based on the direct owner-

ship of property are of rare occurrence except in the coastwiseshipping business. In this business a vessel is bought by agroup of men and the cost divided into tenths, twentieths,or any other convenient fraction. Each member of the groupis then given a certificate representing the fractional part ofthe cost for which he is responsible. Thus one membermay own one-sixtieth of a schooner, another seven-sixtieths,and another ten-sixtieths, according to the original contribu-tion. The profits of each voyage are divided among the groupin proportion to the certificates of ownership. On the otherhand, if the voyage is conducted at a loss, or if the schoonerruns on a shoal and repairs are required, the losses are pro-portioned according to the certificates of ownership.

Capital stock, whether of the type that represents all theassets of the corporation or the type that represents merelythe residual equity after all other claims have been satisfied,involves two distinct ideas a participation in the rights ofownership, and a valuation of this participation. This latteris the par value. It is the less important. The stockholdercan never collect, like the bondholder, the par value of hissecurity from the corporation. Even though paid for in fulland representing for a short time the full and actual value, theequality passes with the first business transaction, for the valueof the property behind the shares changes with every step in thesuccess or failure of the corporation, as new property is addedor old property lost or dissipated. The essential character ofcapital stock that remains permanent whatsoever the fortunesof the actual capital, is that it stands for a definite proportionof the corporate property and earnings. This involves no parvalue. 23 The purpose of stock would therefore be fully ac-

23 G'erstenberg, C. W., Materials of Corporation Finance, 43 (1915), gives an ex-ample of a certificate of incorporation with shares of stock without par value.


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I4 CORPORATE SECURITIEScomplished if the shares were merely proportionate parts of atotal, in other words, shares without par value. 24

There would be, aside from doing away with the meaning-lessness of par value, certain specific advantages. The mostconspicuous is that of truthfulness. Without par value thereis no pretense that the actual property of the corporation isequivalent to the par value of its shares after the liabilities aremet, and there is no insinuation of overcapitalization or under-capitalization. In other words, the capital stock would standmerely for proportionate shares in the earnings of the corpora-tion, and, if the corporation be liquidated, the proportionateshares in the equity remaining after all other claims had beensatisfied. 25 Another cardinal advantage would be that offorcing the prospective investor to examine the real value ofstock, and not be deluded into thinking that there is somenecessary connection between the par value and the real in-trinsic value.26

24 The plan has been widely discussed and vigorously defended on the groundthat, at most, the par value is a fiction. See particularly 26 Harvard Law Review729, and the Report of the Railroad Securities Commission, November i, 1911. It hasbeen vigorously opposed by Ripley, especially with reference to railroads, on theground that it would relieve the stockholders of financial responsibility to the creditorsin case of fraud (Ripley cited at length the famous case of the Cincinnati, Columbusand Hocking Valley Railroad), and would give a kind of legalized sanction to theunrestrained issue of bonus stock at the time of promotion. Ripley, W. Z., Railroads,Rates and Regulation, 575 (1912); Railroads, Finance and Organization, 90 (1915).On the other hand, the policy has been adyocated by the majority of writers on cor-poration finance. A short vigorous defense in Lyon, W. H., Capitalization, 104 (1912).A more elaborate discussion in Cooper, F., Financing an Enterprise, Chaps. XVI andXVII (1915). Perhaps the best discussion recently is that in Ignatius, M. B., TheFinancing of Public Service Corporations, Chap. IV (1918). The writer here con-siders the problem with special reference to the proverbial difficulty of public servicecommissions in dealing with the traditional par value of public service corporationsecurities. See also Lough, W. H., Business Finance z 95 0917); Mead, E. S., Cor-poration Finance 45 (1915); Walker, W. H., Corporation Finance, 201 (1917); Cleve-land and Powell, Railroad Finance, Chap. Ill (1912).

25 A clear statement of this advantage of truthfulness is to be found in theReport of the Railroad Securities Commission appointed by President Taft. We donot 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 torecommend that the law should encourage the creation of companies whose shareshave no par value, and permit existing companies to change their stock into shareswithout par value whenever their convenience requires it ... As between the twoalternatives of permitting the issue of stock below par, or authorizing the creation ofshares without par value, the latter seems to this Commission the preferable one.... It is less in accord with existing business habits and usages; but it has thecardinal merit of accuracy. It makes no claims that the share thus issued is anythingmore than a participation certificate.

26 This has been admirably expressed in one of the early decisions of the LowerNew York Public Service Commission: It may well be considered a matter worthy


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CAPITALIZATION AND COMMON STOCKS 15Numerous cases exist where the common stock has no par

value, although such issue is not permitted by the laws of thegreat majority of states. New York is a conspicuous excep-tion. 27 Under the enabling statutes of the New York corpora-tion law some very important corporations have been charteredwithout a par value for their common shares. The companycontrolling the entire traction system of New York City is acase in point.28 In Chicago a modified plan of shares withoutpar value has been used for the traction system.29 In Massa-chusetts many of the voluntary trusts have no par value what-ever for their shares, while others are represented to have apar value only on liquidation.30 The most recent form of en-terprise to adopt the practice is that of mining. Here, of allindustries, the amount paid in is least indicative of ultimatevalue. 31

of grave reflection whether in the case of at least all corporations hereafter organizeda certificate of stock should have no par value, but should state only that the owneris entitled to a named proportional interest in the corporation. Every prospectivepurchaser would then be required to get a notion of the value of the property froma source other than the sums named on the certificate. The owner could not expector demand returns upon a fictitious basis. The real would supersede the unreal inmost investigations as to corporate values. Re N. Y. C. & H. R. R. R. Co., I Pub.Ser. Rep. (N. Y., 2nd Dist.), 294.

17 The change was made in 1912 after indorsement by the New York Bar Associa-tion. The Act itself is given in Gerstenberg, C. W., Materials of CorporationFinance, 47 (1915).8 The old Interborough-Metropolitan Company was reorganized in 1915 to formthe Interborough Consolidated Corporation which issued $45,740,500 par value of6 per cent non-cumulative preferred stock and 932,626.92 shares of commonstock with no par or nominal value. This is the most important case of no par valuestock thus far issued.29 The Chicago Railways Company, that controls the surface lines, was createdwith a nominal amount of capital stock $100,000 all held under a trust agreement.Against this were issued 265,100 shares. Of this amount 30,800 shares were firstentitled to $8 a year accumulative dividends, then 124,300 shares entitled to the sameamount, then 60,000 shares again entitled to the same amount, and finally the remain-ing 50,000 shares were to participate in any remaining earnings.In the case of the Chicago Elevated Railways, a voluntary association like theMassachusetts trusts, the trustees issued 160,000 shares of preferred stock and 250,000of common stock. The preferred shares were redeemable at $100 and in many respectsthe shares may be considerd as haying a par value of $100 cash, so that the idea of parvalue has not been entirely eliminated.

w Thus the Commonwealth Gas and Electric Company, a Massachusetts voluntaryassociation, has 15,005 shares of preferred stock with a par value of $100 each, and15,005 shares of common stock with no par value. The Central Electric Trustees ofMassachusetts have preferred shares of a par value of $100 each, not limited in num-ber by their Articles of Association, and 50,000 shares of common stock without parvalue.

^ A recent notable example of this is the Kennecott Copper Corporation, organ*ized in 1915.


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16 CORPORATE SECURITIESCapital stock is usually, although not always, full paid,

other words, the corporation subscribes to the legal fiction thatproperty to the full par value of the stock was paid into itstreasury in exchange for the shares. When, as is generally thefact, this is not done in reality, the statutes of the various statesenable the directors to pass a resolution to the effect that, intheir opinion, the property received by the corporation is worththe par value of the shares issued. As directors at the incep-tion of a corporation are almost invariably irresponsible law-yers and clerks, such opinion has no value except that of meet-ing the requirements of the much abused statutes.32 In ratecases, however, the stock is admittedly not full paid. Itis then subject to assessment for the unpaid balance. Thiscustom seems at present to be restricted to Philadelphia com-panies33 and to Boston mining enterprises. It is of advantageto the corporation, because its directors may call for the unpaidassessments at any time, but it interferes with the marketingof the stock for that same reason.

NOTE TO CHAPTER I: It will be noted that two other phases of thesubject sometimes touched upon in works on corporation finance, havebeen entirely omitted from the present discussions. These are the legalquestions involved in the status of the corporation and the issue of itsstock, and the practical expedients of stock issue. For the former seethe exhaustive treatises of Cook, Corporations ; and Machen, Modern Lawof Corporations. For the latter see any of the practical law bookson business corporations. A very valuable collection of actual documentsin connection with the issue of stock is included in Gerstenberg, C. W.,Materials of Corporation Finance.

82 For illustration of this see organization of United States Shipbuilding Company.Documents given in Ripley, W. Z., Trusts, Pools and Corporations, Chap. IX (1916).Also in Dewing, A. S., Corporate Promotions and Reorganizations, Chap. XX (1914).83 Thus the old Asphalt Company of America's stock was only 10 per cent paid.The stock of the Philadelphia Rapid Transit Company was for a considerable periodonly partially paid. Thus, back in 1902 it was only 10 per cent paid; in 1904, 30per cent; in 1905, 40 per cent; in 1906, 50 per cent; 1907, 70 per cent, and later 85per cent; and finally in September, 1908, it became full paid. Assessments werelevied as the business grew, but the earnings failed to keep pace with the assessments.The Philadelphia Electric Company shows a similar record. In 1902 it was 20 percent; in 1903, 30 per cent; in 1904, 40 per cent; in 1908, 54 per cent: in 1910, 60per cent; in 1913, 70 per cent; in 1914, 90 per cent; and finally in 1916 it becamefull paid. In this case the earnings have more than kept pace with the assessments.This is a striking example of the contrast in return on invested capital between anelectric light and a traction enterprise, both operating in the same city.


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CHAPTER IITHE GENERAL FORM OF BONDS

General definitions, 17; Part of an issue, 18; The promise to pay,20; The denomination, 20; The time of payment, 21; The rate ofinterest, 22; The place of payment, 23; The security, 24; Open andclosed mortgage bonds, 24; The maturity of bonds, 27; Redemptionof bonds, 31; Convertibility of bonds, 33; Lack of voting power,34; Conditions of enforcement, 35; Investment status of bonds, 36.

Between the two classes of corporation securities, stocksand bonds, there is a fundamental difference, in spite of manyefforts to create securities which partake of the nature of both.Stocks are evidence of the right to participate in any net profitsresulting from the business. The stockholders are under allcircumstances partners and possess rights to the property andincome of the corporation only after the rights of the bond-holders have been satisfied. Bonds are promises to pay acertain precise sum of money and a certain definite rate ofinterest. The treatment of the general subject of bonds1 isconfused by the variety of forms that have been issued andcertain anomalous cases that resist any reasonable classifica-tion. Owing to this confusion no single statement can be made

1 There are practically no thoroughly scientific studies of corporate bonds, fromthe point of view of corporation finance. For detailed studies the best work availableis the atlas of White and Kemble which covers only railroad mortgage bonds. Theinvestment aspect is fully, although in places superficially, treated in Chamberlain,L., Principles of Bond Investment (1911). Aside from the elaborate treatises on thelaw of bonds and mortgages there is a brief, compact, but dogmatic, statement of thelaw by Heft, L., Holders of Railroad Bonds and Notes; Their Rights and Remedies(1916). For exhaustive study of the legal phases see Jones, L. A., Treatise on theLaw of Corporate Bonds and Mortgages, and Short, E. L., Law of Railway Bondsand Mortgages. The Investment Bankers Association have authorized the issue, undertheir auspices of a little book by Lilly, Wm., Individual and Corporation Mortgages(1918) which gives in a very clear style, the essential legal facts of the moderncorporation mortgage. This book should be referred to in case more detailed informa-tion is wanted regarding the specific clauses and covenants of an indenture than aregiven in the following pages.

17


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jg CORPORATE SECURITIESregarding all bonds as a class2 to which some exceptionnot somehow and somewhere be found. 3 There are, however,certain general characteristics of bonds to which most issuesconform, and which, if absent, lead one to regard the case asan exception. There are other characteristics which may ormay not be present, such as the privileges of redemption andof conversion into stock, which are not sufficiently unusual torender the issue in which they belong an exception, but whichare sufficiently unusual to require special comment. It is thepurpose of the present chapter to describe certain generalcharacteristics of bonds, reserving for the next a descriptionof the varied standard forms.

The bond, the document which is bought and sold by in-vestors, is a right to participate in a certain legal contractwhich the corporation enters into with a trustee. There are,therefore, two parts to each bond issue.

4 There is first thesingle elaborate document issued by the corporation, whichis in the form of a triple agreement between the corporation,a trustee, and the holders of the bonds. 5 There are, secondly,

2 The following strictly formal definition is excellent: To the word 'bond,' cus-tom has given the prerogative of representing all subdivided interest-bearing contractsfor the future payment of money that are drawn with formality, whether they aresecured or unsecured, whether the interest is imperative under all conditions or not.Chamberlain, L., The Principles of the Bond Investment, 73 (1911). This definitionis perhaps too general and it excludes all forms of perpetual certificates of debt.

3 This statement is strictly true. Even if one reduces the definition to merelya promise to pay a specific sum at a. definite time, there would occur to the mindthe perpetual annuities issued by a few corporations which could not, by any twistingof words, be made to comply with the definition. If, on the other hand, the defini-tion of bonds is made to rest on the certainty and the regularity of the interest pay-ments, the ordinary income bond would fall outside of the field. The perpetual cer-tificates of indebtedness and the irredeemable income bond cannot by any subterfugebe included within a single definition.* There are few exceptions. Some bonds are not issued under a mortgage, deedof trust, or indenture of any kind, but are merely long-period promissory notes ofthe corporation. Such issues are now very rare and belong usually to strong corpora-tions whose credit at the time of issue was above reproach. To this class belongnumerous bonds of the Boston and Maine Railroad, sold directly to local savingsbanks; the New York, New Haven and Hartford Convertible 3^'s of 1956 and the

Convertible 6's of 1948. Also some short-time bonds having a very limited marketand issued by companies of poor credit, as the International Steam Pump Company'sConvertible Debenture 6 per cent Notes of 1913.8 For concrete examples the student may secure copies of corporate mortgagesfrom any of the large investment bankers. Gerstenberg, C. W., Materials of Cor-poration Finance (1915), gives an excellent illustration of a corporate mortgage,that of the Jones and Laughlin Steel Company. The most elaborate and exhaustive


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THE GENERAL FORM OF BONDS 19the bonds issued under the agreement, signed in the name ofthe corporation with the certification by the trustee that thebond is covered by the agreement. The agreement specifiesin great detail the obligations of the corporation, the duties ofthe trustees,6 and all the rights and privileges of the bond-holders. The bonds themselves merely state that the corpora-tion promises to pay the bearer or registered holder a sumof money on a certain date with interest in the meantime at aspecified rate, and give a brief recapitulation of certain im-portant promises of the agreement under which the bond isissued. Great care is ordinarily exercised to see that the cor-responding statements in the bond and the agreement shall bethe same in letter as well as import. 7 When a divergence isdiscovered the courts are not agreed as to which takes prece-dence.mortgages are those for the great refunding issues of railroad bonds drawn withinthe last five years.Certain lawyers of New York have acquired a reputation for their skill in draw-ing elaborate corporation mortgages. Francis Lynde Stetson, a master of the art,has written a very illuminating account entitled Preparation of Corporate Bonds,Mortgages, Collateral Trusts and Debenture Indentures Some Legal Phases of Cor-porate Financing, Reorganization and Regulation, Macmillan (1917). This was aseries of lectures delivered by prominent New York lawyers, specialists in their sev-eral subjects, before audiences of practicing lawyers. It will be referred to re-peatedly in these pages.

6 In theory the trustee, formerly one or two individual persons and now in-variably a trust company with or without a cotrustee, holds the -property in trust forthe benefit of the owners of the bonds* In practice, however, the duties of the ^trusteeare merely nominal, consisting at most of receiving from the corporation the intereston the bonds and paying it over to the holders. The trustee does nothing of his owninitiative to protect his trust estate and will not act, even when requested by thebondholders, unless paid liberally for each and every move. (For brief outline ofthe customary duties of the trustee see Stetson, F. L., Some Legal Phases of Cor-porate Financing, Reorganization and Regulation, 52 [1917].) There has been muchdiscussion, fruitful of various suggestions, directed toward increasing the activeresponsibility of trust companies acting as trustees under corporate mortgages. Asevere criticism of present methods is to be found in a recent report of the Com-mittee on Railroad Securities of the Investment Bankers Association. This reportsuggests delegating the supervisory functions of the trusteeship to a committee of thebondholders. The present methods are defended by Walker, R., Railroad MortgageTrusteeship, 25 Trust Companies' Magazine 541 (1917).

7 Sometimes troublesome litigation arises when the two statements do not agree.For example, in a certain income bond issue of the Mount Vernon-Woodberry CottonDuck Corporation, the mortgage specified that the corporation should set aside a re-serve for depreciation, yet in the wording of the bonds such a reserve was omitted.Litigation resulted (Whitridge v. Mount Vernon Company). The courts have main-tained that the agreement shall govern in cases of discrepancy, as this forms thefundamental basis upon which the bonds are issued. Any bondholder could andwould be presumed to refer to this document to ascertain his rights. Yet sometimesand in the Mount Vernon-Woodberry case just cited the court decided that thewording of the bond should control, as this was the form of the contract specificallypurchased by the bondholder.


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20 CORPORATE SECURITIESThe first statement in a bond is the promise to pay a cer-

tain sum of money. This statement, more than any other,distinguishes the bond from the share of stock and indicatesclearly that the bondholder is a creditor and not a partner inthe corporate enterprise. But although the statement itself isimportant from the legal point of view, the details such asgold coin and present weight and fineness have at thepresent time more apparent than real significance, as the presentUnited States laws make all forms of currency redeemableby the government in gold. 8 Yet if, as in Europe after theGreat War, the government should some time authorize a de-based or irredeemable paper currency, the power of the bond-holder to demand payment in gold would assume great impor-tance. Still, too often, the word gold is given undueprominence in bond issues having little security in order toobscure the absence of real elements of security by focusingthe attention on an empty symbol of strength.

The face value of the promise or denomination of the bond,as it is called, was uniformly one thousand dollars in ourAmerican private finance until within the last twenty years.Before that time government bonds had been issued in smalldenominations to meet the demands of small savers, but cor-porations still clung to the tradition that a bond must be ofone thousand dollars in denomination. The practice was bad,since it drove the small investor into the purchase of stocks,the par value of which was usually one hundred dollars, orinto placing most if not all his capital in one bond eithercourse being contrary to sound investment principles. Butduring the last few years some of the strongest corporations,as well as many weak ones, have issued hundred-dollar bondsand in some cases even bonds of a denomination of fifty dol-

Exception, see note 13.


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THE GENERAL FORM OF BONDS 21lars. This practice is growing, so that an investor with a fewhundred dollars may obtain the strength of a mortgage obliga-tion and have an investment fund of ample diversification.Corporations object to the issue of bonds of small de-nomination because of the additional initial expense and thegreater clerical labor in attending to their interest payments.This slight expense is of inconsiderable importance comparedwith the advantage to the corporation of a wide distributionof its securities among small investors. Such distribution notonly insures a wide market in case of the issue of new bonds,but also makes less probable the quick depression of themarket price because of some sudden increase in the floatingsupply. It may be said without hesitancy, that the advantagearising from the higher selling price of the bonds, because oftheir small denominations, many times offsets the increasedinitial cost and that the advantage of a steadier market whichcomes with small holdings again more than offsets the in-creased expense in caring for the interest payments.

Included in the promise to pay there is ordinarily the pre-cise statement of a definite time, the maturity date of thebond. This is the characteristic which distinguishes bondsfrom redeemable preferred stock, although even this may beabrogated at certain times.9 Thus the privilege of paying offan issue of bonds before they are due may be retained by acorporation, 10 and it is quite common to allow a certainlatitude of time during which the corporation managersmay pay the bonds if they see fit to do so. 11 Sometimes, al-though not frequently, the corporation may recognize the

An interesting innovation in government, rather than corporate finance is theunkundbar German war loans. This may be freely translated as loans, the generalterms of the redemption and maturity of which, the government will not now declareitself on. This is a step beyond the second and third Italian loans (5*3 of 1916, s'sof 1917) which have no maturity but which are redeemable at the option of thegovernment after certain specified dates.10 See subject of redemption, discussed later in this chapter.11 Some bonds are referred to by the limiting dates. Thus an issue of bonds


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22 CORPORATE SECURITIESpossibility of some contingency which may lessen the securityor intrinsic value of bonds. As in such an event the bond-holders might well demand the immediate payment of thebond by the corporation, the latter obligates itself inthe bond to the immediate payment of the principal shouldthat contingency arise. In public service obligations, an earlymaturing franchise may introduce just such a contingency.12

Following the promise to pay the principal amount at adefinite time is the statement of the fixed rate of interest tobe paid periodically. 13 In rare instances this varies from timeto time,14 but almost universally the interest rate is fixed andwhich is due in thirty years but payable in ten years in referred to as 10-30 yearbonds.

12 The First Lien Collateral Trust Bonds of the Continental Gas Electric Corpora-tion, due in 1927, contain the following provision: The principal thereof will be-come due on November i, 1924, in the event that certain changes in the franchise ofone of the underlying companies, as stated in the mortgage shall not have becomeeffective prior thereto.13 In very rare cases the rate of interest is not specific. Thus the Chicago, Bur-lington and Quincy Railroad Trust Mortgage of July, 1873, provided that the bondsissued under it should bear interest at the rate of seven (7) per cent per annum,payable semiannually, both principal and interest in currency, or at the rate of six

(6) per cent per annum, payable semi-annually in gold.14 In these rare instances the rate begins small and increases gradually to a maxi-mum. Such bonds, issued with variable increasing interest rates, ordinarily owe their

origin to some period of expansion during which the shares of some poorly payingenterprise were acquired through the issue of bonds. The interest rate on suchbonds was made low at first, as the property acquired had little earning capacity;it was to be increased in accordance with the prospective increase of the acquiredproperty's earnings. Very frequently this prospective increase was not brought aboutand the corporation found itself burdened with an increase of fixed charges withoutany offsetting ad