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Les diegrammes suivants illustrent la mAthode. 1 2 3 1 2 3 4 5 6 MICROCOPY RESOLUTION TEST CHART (ANSI and ISO TEST CHART No 2) 1.0 13.2 136 U 1^ 2.5 1 2.2 2.0 1.8 ^ /APP LIED IIVHGE Inc ^^ ■••b< lost Ma.i Sl'^el r.S ^^.>>ester. Ne* Tofit !460y USA iSg 'lb) 48; - OJOO - PKon» SB '16) 288 - 5989 - fo« Modern Business CANADIAN EDITION A SERIES OF EIGHTEEN TEXTS, ESPECIALLY PREPARED FOR THE ALEXANDER HAMILTON INSTITUTE COURSE IN ACCOUNTS, FINANCE AND MANAGEMENT EDITED BT JOSEPH FRENCH JOHNSON DBAM, raw Toax nfivBRSiTT SCHOOL or comnacs, Accomrn ako miANCB raw TOKK OITV Title Author APPLIED ECONOMICS Jambb Mavob ORGANIZATION AND MANAGEMENT Lee Gaixowat SELLING R. S. Butusb CREDITS Lee Gallowat TRAFFIC S. J. McLean ADVERTISING Lee Gaixowat BUSINESS CORRESPONDENCE . . G. B. Hotchkiss ACCOUNTING PRACTICE . . . . (Jbo Gmsendlingbb IE. W. Wbight CORPORATION FINANCE . . . .(!I^"^1_^"™ V Fbed W. Field MONEY AND BANKING .... { ^ "w^S^^^iT"" BANKING PRACTICE E. L. Stewabt Pattbbbon FOREIGN EXCHANGE (^TSf ^^" V E. L. Stewart Patterson rTnouAB Conwat INVESTMENT AND SPECULATION . | Albert Atwood I Fred W. Field INroHANCE {CT*F^"' J^^A^ {^TVX"" AUDITINQ Sbtiiocb Wamon COST ACCOUNTS Stephen W. Giuian COMMERCIAL LAW Walteb S. Johnbon Corporation Finance AN EXPOSITION OF THE PRINCIPLES AND METHODS GOVERNING THE PRO- MOTION. ORGANIZATION AND MANAGE- MENT OF MODERN CORPORATIONS BY WILUAM H. LOUGH VICE-PRESIDENT. ALEXANDER HAMILTON INSTITUTE: FOR- MERLY PROFESSOR OF FINANCE IN NEW YORK UNIVERSITY SCHOOL OF COMMERCE. ACCOUNTS AND FINANCE IN COLLABORATION WITH FRED W. FIELD EDITOR OF THE "MONETARY TIMES," CANADA Modern Business Canadian Edition Volume VI ALEXANDER HAMILTON iNSmUTE NEW YORK r? -^ -' -7 AWXANDER HAMILTON INSTlTOTK .,_ CofTBioar, 1812 gy ALEXANDER HAMILTON INSTITUTE ALEXANDER HAMILTON INSTITUTE ALEXANDER HAMILTON INSTITUTE TABLE OF CONTENTS INTRODUCTION. CHAPTER I. THE CORPORATE FORM. aacnoN „o, 1. "Non-Stock" Corporations 1 2. " Stock " Corporations I 3. Definitions 2 4. The Fiction of " Corporate Entity " 3 5. Corporations in Aiicient Nations 4 6. Popularity in Modern Times 5 7. Adaptability to Raising Large Amounts of Capitnl . . 5 8. Permanence 8 9. Centralization of Control 9 10. Transferability of Ownership i . . 10 11. Limited Liability 11 IS. Disadvantages of the Corporate Form is CHAPtfeR II. LEGAL STATUS OF THE CORPORATIONi IS. Defining and Controlling Ihstmments l*f 14. Common Law of Corpohitions . . . . ^ ; i . 17 15. The State Constitution 18 16. Method of Creating the Corporation 19 17- Essential Features of the Charter 20 18. A Sample Charter 22 19. The Corporate Naihe 24 20. The Corporate Purposes 24 21. Other Imt>ortant Fe^turei oJf the Charter 28 22. The By-Laws 28 28. Essential Features of the By-LAws B8 via CONTENTS CHAPTER III. 8ECT.o« INTERIOR ORGANIZATION. 24. Rights of Stockholders f*"" 25. The Proxy and its Uses *'' 26. The Right to Dividends »» 27. The Right to Information *^ 28. Liabilities of Stockholders *^ S9. Rights of Creditors • • . . ... 48 SO. "Dummy" Directors ** S2. The Efficiency of Corporate Organisation . .' .' .' ; l^ 8S. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. CHAPTER IV. WHERE AND HOW TO INCORPORATE. A Corporation May be Chartered in Any State and Do Busmess in Other States ° The Regulation of "Foreign" Corporations .' ' ' * T, Choosmg the State of Incorporation . ' ' ' Comparative Charges in Several States ?f Liberality of Corporation Laws in Several States ' ' ,, Permanence of the Laws * ' ^^ Reputation of Va... us States ^® tages of the Important States of Incorporation « The Wide Range of Choice in Incorporation ..''«! Canada's Corporation Laws • • • . 64 Extra-provincial Licensing Acts .* .' .* .' .* .' ' ^'' .V CHAPTER V CORPORATE STOCK. 45. Stock Certificates Not Fully Negotiable . . 46. Par vs. Market Value of Stock • • • . 73 47. Nature of Preferred Stock ^® 79 CONTENTS VL SECTION '*" 48. Uses of Preferred Stock 81 sy. Cumulative Voting ** jU. Voting Trusts ** 51. History of a Large Canadian Holding Company ... 86 CHAPTER VI. TYPES OF BUSINESS CORPORATIONS. 52. Further Classification of Corporations M 53. The "Parent" Company »* 54. Nature of a Holding Company 95 55. The Holding Company as a Means of Organising "Trusts" 9^ 56. Complexity of Holding Companies 100 57. Organisation of the Standard Oil Company ... 101 58. 59 60. 61. 62. 68. 64. 65. 66. 67. 68. CHAPTER VII. THE SOURCES OF CORPORATE FUNDS. Summary of Preceding Chapters 10* Four Sources of Corporate Funds 105 The Investing Public as a Source of Funds . . . 107 Difi'erence Between Investment and Speculation . .108 The Speculative Public as a Source of Funds . . . 109 Desirability of Borrowing Funds HO Distribution of Security Issues H^ Corporation Growth and Bank Loans in Canada . . 118 Attitude of Canadian Bankers 119 How the Canadian Bank Makes Loans to Corpora- tions *** Bank Loans and Credits 128 CHAPTER VIII. SHORT-TIME LOANS. 69. Trade Credit as a Source of Funds .... 70. What Reliance Should be Placed on Bank Loans? 125 127 y * CONTENTS MCTION 71. Notes Sold th^ Public a, a Source of Fnnd. ^ 72. Canada's Short-term Loans • • • 184 73. Canadian Railway Loans ^** 74. Three-year Land Notes *** 75. Problems of Short-term Loans ^" 144 CHAPtER IX. THi: C0R1>0RATE MORTGAGE, re. What Determines the Value of Fixed Assets^ 77. Nature of a Mortgage Bond /'"'^ ^"^t'-' • • . 147 79 rr"!:"' ?''''*"^' °' '^ ^'^^'^ «^ Trust [ ' ' ' ' !?' 79. Classlfic-Uon of Mortgage Deed, of Trust ' * ' * J' CHAPTER X. TYPES OF CORPORATION BONDS. 80. Classification of Bonds 81. Mortgage Bonds "« S2. Sinking Fund Bonds ^*r 88. Collateral Trust Bonds "« 84. Equipment Trust Bonds .161 B5. Five-year Equipment for Canadian Railway; .' : .' ^ CHAPTER XI. -nrPES OP CORPORATION BONDS (conttn.^^ 88. Debenture Bonds .... 87. Income Bonds . '71 88. Other Types of Bonds .* "* 89. Purposes, Manner of Pavment »\>A r "j...* ' * ' '^7 demption of Bonds ' ^""'*'"°"' °^ '**^- »0. Convertible Bonds ^^9 181 CHAPTER XII. CORPORATE PROMOTION-THE NEW ENTERPRISE. 91. The Function of a Promoter 98. "Discoverr of . Proposition *•* 188 COKTlENTS xl turn SECTION . -w 93. "Assembling" a Prdposition *»7 94. Financing a Proposition — The Initial Development 188 95. Foresight in Providing Funds 1^ 96. Advantages of a Wide Distribntioii of Stdck . . . 191 97. "Starting Right" in the Sale of Stock J91 98. A Ckjncrete Illustration *"* 99. ioo. Ibl. 102. lOS. 104. 105. 106. 107. JHAPTER XIIi: THE PROMOTER AND THE CORPORATION. Professional Promoters *^ Lawyers and Bankers as Promoters . . • . *• 1^ Engineering Firms as Promoters 1*9 Secret Profite are Illegal *01 Misleading Statemento Constitute Fraud • . • • «0* Contracts on Behalf of the Corporation and Their Ac- ceptance The Promoter's Pay *0* The Promoter's Riiks and Labors 808 Ii the Promoter Over-Paid? «<>• CHAPTER XIV. CORPORATE PROMOTION— FORMING CONSOLIDATIONS. 108. The Importance of Small Industrial Combinations . 810 109. Difficulties in the Promoter's Task 811 110. "Discovery" of a Small Consolidation 818 111. Basis of Consolidation 8l8 118. The Necessity for Cash 880 118. One Method of Raising Cash 881 114. Problems in Forming a Large Consolidation ... 884 115. Basis of Consolidation 885 116. The Interborough-Meteopolitan Consolidation . . . 886 117. Canada's fixt)terlenfce in FAhnlng ConwUdktlons . . 888 118. Basis of Consolidation 880 119. Dangers of Ovfcf-Capitallsatioil 888 ItO. Reorganisatioli of Industrial Consolldatiohs ... 888 l8l. Most Complicated Merger in Canada's History . . 886 ^' CONTENTS CHAPTER XV. ^^^ THE UNITED STATES STEEI. CORPOBXTION. 128. Preparing the Ground »*« 125. Method of Promotion **> 126. Prospectus of the Corporation .' ." f« 127. Profits of the Promoters «*« 128. Capitalization at the Beginning *** ::• f '^^«- *o the Steel c'orporftio. :;•••• **f 150. Financial Changes *** 151. Basis of Capitalization *" 132. Operating Policy of the Corporation .' .* ' * ' !" ISS. Secunt.es of the Corporation and Their Standing! .* «" I CHAPTER XVI. SELLIKG SEC.aiT,BS-XHE^pHOSP.cx.S A.O T„B BA^KI.O 184. The Four Methods of Selling Securities lie !T"^?r*"^»**^'°^»^-^"~^^ ■ • III 136. A Typical Speculative Prospectus • • • 266 137. A Typical Investment Prospectus f* 1S8. Tne Ideal Prospectus ««« 139. Selling Through Banking House, .* ^ ' ' * ' *!J 140. Requirements of Reputable Banltin- h • • • • «71 '*>. Thd,Me.h«,.ofl„u„^^"„^;;;»'':"- ; : ; ;'^ CHAPTER XVII. SELLING CANADIAN SECURITIES. 142. Markets for Canadian Corporation Securities 43. Canadian P.„,p,,,„, ,,, B^.^^^,, J ««• ' ' ^r. 144. A Typical Canadian Prospectus " ' • • tSO CONTENTS ziu tMIB SECTION 145. Growing United States Market for Canadian Securities 283 Canada's Richest Rural Community and Fox Farm Finance 146. 284* CHAPTER XVIII. SELLING SECURITIES-THE WALL STREET MARKET. 147. The Principal Stock Exchanges of the United States 291 148. Listing Securities 149. The Curb Market *®* 150. Stock Exchange Methods 2®* 151. Importance of Speculative Dealings S^T 152. Buying on Margin . . . *«n 153. Selling Short *^^ 154. Stock Exchange Houses vs. Bucket Shops .... 800 155. The Classes of Wall Street Speculators .... 802 156. A Summary View of the Stock Market 80S 157. Stimulating Speculative Interest *0* 158. Syndicate Operations *05 159. Stock Market Manipulation ^^ CHAPTER XIX. SELLING SECURITIES-THE UNDERWRITING SYNDICATE. 160. Origin of Underwriting '0* 161. Advantages of Underwriting to the Corporation . . 809 162. Advantages to the Buyers of Securities «10 168. When is Underwriting Advisable? 81 J 164. Why Underwriting Syndicates are Formed .... 814 165. Three Types of Syndicates «" 166. A Fourth Type— PooHng the Sale of the Security . 817 167. A Fifth Type— Distributing the Security .... 817 168. The Large Underwriting Houses 819 xit CONTENTS ncrioN 169. 170. 171. 172. 173. 174. CHAPTER XX. MANAGEMENT OP THE UNDERWRITING Informal Agreements . A Formal Syndicate Agreement SYNDICATE. F^r:::'*".."^ '^'-^^ ^^»^^ ions of Dndtrwitiiig Smdicte. A» E«n.pfc of Sp«™lrt,„ Cmienniltag FACE 821 821 829 880 881 882 174. 176. 177. 178. 179. 180. 181. 182. 188. 184. 185. CHAPTER XXI. INVESTMENT OP CAPITAL FUNDS. Importance of Wise Investmfent . ^ne Installment Method «fn«*»- ^ .' * ' ' • **« Other Possible Methods *«« HowMnchShaUbeI„vested'inFi,«lC.Dit.i; * ' *** Forms of Working Capital . "^ ^•P*'*'? • • «40 How Much Working Caoibi! «5i.*ii i ^ ' ' ' • ^*^ ^xt^jT^H ■ ■ ■ •■ •■ - 186. 187. 188. 189. 190. 101. CHAPTER XXII. firtiWiTlON OP GROSS EARNINOa Determination of Income . Honesty in StaUngOtos. £.„,•; «*» What Are Operating Expenses? «« Necessity for Depreciation Reserres* "° Income From Other Soopom -«j r^ j ' ' ' * • **J H«Moc»sunk.?:?."r;::s;t-- • • • ••♦ * * • 905 pr CONTENTS 192. Variability of Profits . . . aoo 193. Regularity of Pividends Desirable «60 194. Prudence in Paying Dividends ? '^^ CHAPTER XXIII. BETTERMENT EXPENSES. 195. Two Classes of Betterments ^^^ 196. Sources of Funds for Betterments '64 197. Appropriations from Earnings '°^ 198. Objections to This Method *^^ 199. The Attitude of Stockholders 866 200. The Case of the Lehigh Valley Railroad .... 868 201. Policy of the Union Bag and Paper Company ... 872 202. Borrowing Funds for Betterment? 873 203. Policy of the Pennsylvania Railroad ..... 974 204. General Conclusions as to the Financing of Better- ments ^''^ CHAPTER XXIV. CREATION AND USE OP A SURPLUS. 80S. Definition 877 206. Four Sources of Surplus 878 207. The Fifth Source— Saving 879 208. Policy of the "Trusts" 881 209. How Should Surplus be Invested? 882 21Q. The Surplus as a "Rainy Day Fund" ..... «82 21 L Putting the Surplus Back Into the Property ... 885 218. SIS. CHAPTER XXV. DISTRIBUTION OF THE SURPLUS. Effect of a Surplus on Assets and Dividendf Distribution Through Stock Watering . . S87 889 xvi SECTION 214. 215. 216. 217. 218. 219. 220. 221. CONTENTS Cashing the P,ivilege-Thec„r ^ J"^««tme„t „ ** ^ "« *>"osequent Sale "-Short Selling .. "~S«Je of Old Stock • • • , rAGi 391 392 393 394 395 395 397 399 222. 223. 224. 225. 226. 227. 228. 229. 230. CHAPTER XXVI Fraudulent Contracts " ' * ' MLe'Tt^r f-«*«"e B-iness Canada Fairl. P-Z "^^e™ Common ? 2«i. cand:F:irr^ "^ • i-airly Free from Manipulation . CHAPTER XXVII. mmPULATION BY DIRECTORS. Usual Methods Fraudulent Contracts " Attitude of the Courts * ' ' " * An Acc„„„,.„,., ob,er,.,i„„, .' ' ' remedies for This lCi»A * », The n-n ? ^'^ Corporation . 40] 401 402 403 404 *D5 407 410 412 418 232. 233. 234. 235. 236. 237. 238. 239. 240. 414 415 418 419 420 423 424 426 428 CONTENTS zvu m 02 OS 04 35 )7 S 8 ■KnOll PACE 241. Form of Annual Stateipents in Canada 481 242. What Should Be InclaJed in the Statement? . . . 482 248. Quarterly Statements 488 CHAPTER XXVIII. MANIPULATION BY AND FOR STOCKHOLDERS. Cheating Creditors 485 The Chicago and Alton Deal 486 Manipulation Through Subsidiary Companies . 488 Central of Georgia Income Account 489 Squeezing the Minority Stockholders 441 A Complicated Real Estate Proposition 448 Robbing a Partnership to Pay a Corporation 445 Remedies for Manipulation 448 244. 245. 246. 247. 248. 249. 250. 251. 252. 258. 254. 255. • 256. 257. 258. 259. 260. 261. CHAPTER XXIX. INSOLVENCY AND RECEIVERSHIPS. Two Types of Insolvency 450 Causes of True Insolvency 451 One Cause of Legal Insolvency — ^"Lack of Capital" 458 The Case of the Detroit, Toledo & Ironton Railway Company 454 Additional Causes of Legal Insolvency 454^ Two Methods of Handling Insolvency — Bankruptcy and Dissolution 457 A Third Method — Appointment of a Receiver . . . 459 Duties of a Receiver 460 Receiver's Powers 462 Business Failures in Canada 468 CHAPTER XXX. PRINCIPLES OF REORGANIZATION. 968. Reasons for Reorganisation 466 268. The Formation of Committees 468 CqitfTENTS SECTION 264. Why Not Foreclose? . 365. Problems Confrontino- «.» d *' m. Necessity for cTs^ ®^'»-""««<"' Commttec . v, III' ff"* ^-"'^ ^3^ Assessments ['■'■• *^ «e8. Reducing Fixed Charges . *' 260. Capitalization of the »»«,» • \ L 47 48: CHAPTER XXXI. ^'^^^ ^^WCAL REORGANIZATIONS. «7»- *"•»* ReorganizaUon of th^ may lay down this generalization, that in almost every great active commercial nation the corporate form of organ- ization has sooner or later come into existence. It must, then, we may be sure, have some clear and important business advantages. 6. Popularity in modern times. — This conclusion is confirmed when we reflect that along with the marvelous business development of the last century there has been apparent a more than proportional increase in the num- ber and importance of corporations. At first only large enterprises, such as railroads, steamship companies and great manufacturing establishments were so organ- ized. Later the smaller factories and wholesale estab- lishmeiits followed the lead of the larger concerns. Finally within the last few years we have witnessed both in Europe and particularly in this country the extension of the movement to small manufacturing and retail establishments. The drift in this direction is so apparent that it need not be dwelt upon at any length. Every reader of this book may look around and see with- in his own circle numerous concerns in corporate form which were conducted a few years ago by individuals or partnerships. Unless this tendency receives some unexpected check it will not be many years before the corporate form will be adopted by almost every business, large and small, in the United States. 7. Adaptability to raising large amounts of capital. — Evidently there must be great advantages in the corpo- rate form; otherwise the landslide toward it would long ago have been stopped. It will be worth while to review briefly some of these advantages. Originally, as has been said, corporations were con- fined almost altogether to large enterprises and were used .^ 6 CORPORATION FINANCE principally because of the facilities which thev afforcle^ ..v«.™ .t >». u,i„ .„'"• ^,;'^ ^«~> »n™i were able indivulnoiNr *■ , i *^" " °"^ <^t these men wealth do not consider it . Jvislble to 1 aU thei ^"'" more tha„"?::;:b:,:r tirr °" '-^ ^^^ -"^ i". to,x t„e ^^"i::tfoT:;r t??'"«- quired for everv n-r^o* * • '-apitai tliat are re- extraordina4"»i„XceTr:^, l™"'^ ^ <«" «ealth, who might coneeivabr^^L"!" °^"™"^".^ partnership a biff railroad nr , i • . *'™". »"'' own in able to lmLnifernX:,*^f^:;tr„t' *™^'' ''^'! to co-operate effipi'pntK • "'"^^^"^es of opinion and '"Story of the ^orM w I„t „o"t «;!,"'''* T"?'"'™'" of. say, a billion or e,-en h tfT^ ' * ^'"«'^ ">»"'"'« a Lundred million-dollars of eapitlTr^''^ T ''"" aifcd under a partnership aK^ment It ' T' rememlwr in this connection ^^T J " "■•■" '" dividual fortunes are ^Jr I , " ^^ «'^»''»' '"- wealth of a TJlTZX^Tt -t^""! *°'" ^ Furthermore, of these individLlf 1 "'^ ^''"<^'- part ordinarilv is freTa „ v onl f"'*Tl""'^ " """" i vested as the ;,„ ner « ill ' ""' *° "* "'"' "' '"" THE CORPORATE FORM The corporate form, on the other hand, has infinite possibihties so far as the raising and managing of capi- tal is concerned. Any number of people, large or small, may contribute funds. The American Tele- phone and Telegraph Company, for example, has over 54,000 stockholders, the Pennsylvania Railroad Company over 84,000, and the United States Steel Corporation not far from 125,000. A large num- ber of owners of a corporation does not tend to break up and render inefficient the management, for the control of whatever capital the owners contribute is kept in the hands of the officers of the corporation. Thus the corporation, without losing in efficiency, may reach out into the highways and by-ways of the land, draw its capital from a thousand or from a hundred thousand individuals and heap up vast aggregations of capital that could not possibly be obtained in any other manner. For this reason it is inevitable that the corporate form should be used in the financing of practically every large enterprise. This advantage of corporations, that they are able to collect and to make use of the small contributions of many individuals, though most prominent in great undertakings, is by no means to be overlooked in the case of smaller enterprises. Frequently an inventor or a retail dealer or any small business man who needs a few hundred or a few thousand dollars, could not uo* tain it from his own immediate relatives and friends. The same man, perhaps, may easily raise the capital he requires by organizing a corporation and selling small interests to a considerable number of people. Many a business man has thus obtained necessary capital which he has made the foundation of a fortune. 8. Permanence, — The second important advantage 8 CORPORATION FINANCE i I of ihe corporate form is permanence.. Wlien an in iv^dual owner of a business die,,, Lis business dierwth him. It may, to I« snre, be carried on bv bis famiWor bought by strangers; on the other hand, t may ™ «.a no praebeable method of disposing of it exi ot at »„ uie mrerest ol tJie deceased partner Tn c« Tf *hJ • ' *^^^ ^^^^*^ '^ not clearly defined o 1 ueceased partner may be denrivprl r.f Heparin, t e";^ -t'"' ""'"''''" «"'^^- managing the bus ne Ti^"^^', ™*'"^^ ^°' becomes bankrunf ;. oil ? ! , ^' ^''''''*^ ""^'^ >* "ic.> uankrupt, is allowed to lapse or i« v«l.,«* -i (bsso ved. Hie dpnfh .^^ ^ ^oiuntardy per cent of tl,t^k„f ,,""'' "'""' '™" '" '" """•' »» «.e eorpora^ont, f ' It' U I™"T«"7 ,""' '"^«' creature „f the law not u ie" to , hf ''"« '">" " human existence If : """J'^'^'. 'o the infirmities of dies or wiH d'ws a f " "''"'"""*' "'"* '^ ""« "««' As the c«:;:^ raTa;"r '"..'""^■'"^ ^'■•'-"• own it and as «>nW ,l7in T m" '^T' '^'"' or withdrawal of an owrtrrt-aTrirtt THE CORPORATE FORM 9 machinery, and the death or withdrawal of an officer means simply that someone else must be found and ap- pointed to the position. 9. Centralization of control— This brings us to the 'third important advantage of the corporate form, namely, its centralization of power and responsibility. In this particular feature it cannot be, of course, supe- rior to individual ownership, but it is far ahead of the partnership. As the law does not recognize in the part- nership anything but a gi-oup or association of individ- uals, it follows that each partner is empowered to conduct the business, to buy and sell the partnership assets, to make binding contracts and incur debts. Ordinarily, to be sure, the partners mutually agree to a fixed division of duties and powers, but this division is not supposed to be known or to be binding on outsiders. Each partner, so far as his dealings with outsiders are con- cerned, is the whole partnership. Obviously, therefore, no partnership should ever be formed except between persons who have entire confidence in each other; and even then a partnership often proves an unsafe and inefficient method of conducting business. Except by mutual agreement binding only on themselves, to repeat, there is no clear-cut division of powers and responsi- bilities. Under the corporate form, on the other hand, busi- ness can be transacted only by the duly appointed officers; no owner, unless he is also an officer — even though he hold almost all the stock— has any authority to transact business for the corporation. Each of the officers of the corporation, as is explained in the chapter on "Interior Organization," has his sphere of duties care- fully defined, l)oth within the corporation and outside. l*er8ons not connected with the corporation are expected 10 CORPORATION FINANCE .1 y to have their dealinffs only with the duly authorized offleers. and if they do not exereise r^asonabk t^"' th,s respect may find whatever agreements or contract by the reader after a study of the chapters on ageney n the ™lume on Commercial Law Furthem^^ the relabons of the corporate officers to each otC are clearly defined and the gradations of authority are^ marked that each one may understand clearly jU how far he is empowered to act on his own judgmen a^d what questions he should refer to his oflicial^;^!:^^ m delegation of power is so obvious that it need not be cam sTit^ a7 '"'^-t ..^ -"—««" -por:«on :n ;id- c- "i^:^ :;r '^ ^-^^ --i -othness JJ'JT"'''''"'''''''' °f ""■'"■'•"'"/'-A fourth advan- tage of the corporate form is the ease with which ite ownership may be transferred. An individuJowne^ who desires to sell his pro,«rty must find a putw^or all of It at one and the same time. A oartiJ X T sires to sell his interest in the firm mustC ma^e ^t ina> oe a difhcult matter, or must find a purchaser who offer, satisfactorj- terms and is personally aeceZbir to dm cult. Altogether the problem of withdrawing funds that have bec-n invested in an individuallyK>wned pr^l erty or m a partnei^hip is almost alwaysT.rd'^Z frequently ii.sohible. Under the corporal f^ the problem is much simpler. The ownership of a^r^ the least with the stabili^^fre:;^- ^^^^^^^ THE CORPORATE FORM 11 of several shares need not, therefore, find any one person to take all his property off his hands; he may sell a few shares to one man, one or two to another, and so on, and thus dispose of his property piecemeal. Furthermore, as the corporation is managed directly by the officers, not by the owners, no consideration ordinarily need be given to the question as to whether or not a prospective buyer is a good business man or is acceptable to the other persons interested in the corporation. Women, old men, administrators and trustees of estates, institutions of all kinds— all are possible purchasers of corporate securities. Thus the owner of corporate shares finds his market much broader and his facilities for selling much better than does the owner of a partnership interest. The se- curities of large corporations are constantly dealt in on the stock exchanges of large cities, and thus a continuous and easily accessible market is afforded to every owner. 11. Limited liahility.—The fifth and last important advantage of the corporate form is the fact that the liability and possible loss of each owner is limited. Gen- erally speaking, the owner of any corporation security is safe in reflecting that, though the security may become worthless and he may lose all that he paid for it, he cannot possibly lose more than that amount. The reader may perhaps think that to the owner of the stock of a failed corporation this statement affords but cold com- fort; but compare his situation with that of a partner in a bankrupt firm. The partner may not only lose all that he invested in the firm, but in addition is personally liable for all the unpaid debts of the firm. As has been explained above, it is possible that these debts may have been foolishly or even fraudulently contracted by some other partner; yet that fact would not relieve any other partner from his personal liability. No doubt most 13 CORPORATION FINANCE f readers of this paragraph will call to mind instances in their own experience of individual owners or of partners in disastrous enterprises who have lost everything thev owned, including even their homes and most of their personal property, by the failure of such enterprises. If a corporation fails, on the other hand, and its debts prove greater than its assets, the creditors have no claim on the property of the stockholders outside the failed business. An important exception to this principle of limited liability exists m the cace of stockholders of national banks. They are individually liable in case of failure not only for their investment but for an additional sum equal to the par value of their holdings of bank stock. A similar rule applies in Minnesota to stockholders of most corporations and there are one cv two other exceptions which are referred to in Chapter IV. Even in such cases, however, though the liability of stock- holders is somewhat greater than with the ordinary cor- poration, it is still strictly limited. xXo doubt this principle of limited liability has been one of the main advantages of corporations that has led to their formation in a great many cases, and especially has encouraged in recent years the widespread move- ment to change partnerships into corporations. No business man, especially one who has considerable per- sonal property and perhaps is advanced in years, hkes to reflect that at any moment, through the fraud or mis- management of some subordinate or partner, or throuifh some unavoidable natural calamity, he may be compelled \^7\l^ 5'' ^''"'' ^""^ P""'^"^^ P^P^^ty '" order to satisfy the demands of business creditors. The corpo- rate form of business relieves him of this haunting THE CORPORATE FORM 13 The prominent advantages of the corporate form, which have brought about its great extension in recent years, may then be summed up as follows: (1) Flexibility. The owners of a corporation may be few or numerous. This makes the corporate form especially well adapted to collecting large amounts of capital by means of small contributions from a great many people. . (2) Permanence. The life of a corporation is not dependent on the life or on the caprice of any individual. (3) Centkalization of control. Under the cor- porate form the officers of the corporation within care- fully defined limits exercise complete control. (4) Transferability of ownership. Corporate shares may be readily sold either in a block or piecemeal and have a wide market. (5) Limited liability. The corporation alone, with certain minor exceptions, is liable for its own debts and the shareholders cannot lose more than their orig- inal investment. . 12. Disadvantages of the corporate form.— In view ot these advantages it may be asked why all kinds of busi- ness without exception are not organized under the cor- porate form. The answer is that certain minor disad- vantages, which in some instances are sufficient to offset the advantages named, are inseparable from corpora- tions. These disadvantages may be briefly summed up as follows: . . (1) Increased expense. All states impose certain incorporation fees, license and franchise *axes on corpo- rations, which taxes are In addition to the ordinary state and local taxes on property. These taxes are, however, uniformlv small. The United States Government also imposts 'a tax on corporate income. In addition, 14 CORPORATION FINANCE legal assistance is almost always nece«flr.r ;,, f • hampered at thn jly KluthoritZ ^ """'"'"'* ations that would be ptoSi^mT tI l"^ "" °^'- «cia, objection S:;t Jd'^ d'^S-^ T..po.tai:f-U™d:^--^^^ (3) Limited cbedit. A lender of money would of fonner ca.e is unlimited, and in the latte^^t ^hL i^lTeSio"""'^"- .^""^ " p"'-hT;:hlt > converted mto a corporation w 11 sometimes be em barrassed more or less by reluctance of its Editors To' ™rlr ™"t« r"" "' ''^^'y - bcforr?^:,;? lersion This objection, which is of importance usiiallv only in the case of a small and closely heW busTess miv be overcome, if desired, by the offion « "<>» "bl^g"! to Tarry out all of the purposes named in the charter; on the oth«- hand, it has no authority to do anythmg which is n:ttnamed or clearly implied. The courts, to ^sure are sencraily liberal in their interpretation of the implied t«wfrs of .iirporations-, but it is better to keep out of r»urts and to take a little care at the beginning so as t^^^rt any future disputes as to whether proposed uctivitls are beyond the purp<»es and powers of the coi'Doration or not. ^r « To illustrate the care with which the PU^P^^-of « larKC company are stated in order to comprehend and Zlc^al authority for any possible future a«'v>ty. he fharter of the United States Steel Corporation, which ts drawn by one of the great -porat'on awyers of the country, the late James B. Dill, of New Jersey, ZlyZ cite'i The section of the charter, m which the purposes of this great corporation are stated, ,s too long o l« quoted in full. Nine paragraphs are devoted to 'describing all the manufacturing, landownmg, mining. tr«ling, «,ntr«c»ing, inventing and patenting, security- buytog selling and holding activities >vbich could be thought of by »U the eminent lawyers and business men who helped Judge Dill to draw the charter. Then ;lw thftwo piagrapl. quoted below, in which. ., \ 26 CORPORATION FINANCE the reader will observe, the incorporators aim to provide for any other possible actiA'ity not already distinctly set forth. Note particularly the italicized clauses. A state- ment somewhat similar to these two paragraphs might be included to advantage in the charters of many much smaller corporations, and perhaps would dispose of otherwise troublesome questions of authority. The business or purpose of the Company is from time to time to do any one or more of the acts and things herein set forth ; and it may conduct its business in other States and in the Terri- tories and in foreign countries, and may have one office or more than one office, and keep the books of the company outside the State of New Jersey, except as otherwise may be provided by law; and may liold, purchase, mortgage and convey real and personal property either in or out of the State of New Jersey. Witliout in any particular limiting any of the objects and powers of the corporation, it is hereby expressly declared and provided that the corporation shall have power to issue bonds and other obligations in payment for property purchased or ac- quired by it, or for any other object in or about its business; to mortgage, or pledge any stocks, bonds, or other obliga- tions, or any property which may be acquired by it, to secure any bonds or other obligations by it issued or incurred; to guar- antee any dividends or bonds or contracts or other obligations; to make and perform contracts of any kind and description ; and in carrying on its business, or for the purpose of attaining or furthering any of its objects, to do any and all other acts, and things, and to exercise any and all other powers which a co- partnership or natural person could do and exercise, and which now or hereafter may he authorized by law. A further illustration of the importance of a clear and full statement in the charter of the purposes for which a corporation is organized is contained in a decision of the New Jersey Court of Errors and Appeals handed doivn March 5, 1909. The case involved the right of a rail- LEGAL STATUS OF THE CORPORATION 27 road company to acquire -d hold the s-J^ckof^ certain trolley companies near Atlantic City. J''l^°^ S this right and said, among other thmgs. Xhe peer to pure„a,e hold, etc stock and^^^^fj^^ e„rp„»«o„s '""'^'^^y^X'^^^LZZ^^y Sec- act is to be exerci^d suHject to the nm ^ f,„„ « of the same act ; that « to say, the po«r ^ vonient to the attainment of the objects »«»«;" ^^^^^ charter or certificate of i-'P""""". ' J "^^^'ey GenenJ to the certi«cate of --7™*'? .^ff ^ ptopi cL readily and other offlcials interested on ^^^alf of^te peop ^^ determine »hat powers have ^2,^^^ti by the state. It .ompany is -7';«/™t:f alS™ th'at investors can « by reference to the a*cks ol _^_^^^^^_^^ .__^__ ,^.^^ r;tt rSta t pCrty rights they are acuiring in .■-•--■"f'tLlorlttenC' stock ownership by on. corn- It must not be f"lf »™ J ^^-^^ the former company pany in another .s ""'^ » """^J "j^t .;„« the second com- ^''"^^"sttiorrw e*n^ L in iU effert) might Ki-e. puny (If Section 51 ""' " ■» ti„„ „ corporation., and wise hold stock m any other ™"Tor«t.o J . "-" -g-t ao *-- 1: rttlnceapartlipation company under such a system woui participation in a in -^ ■'-"tr -''"^f rr:;^:- sti'.'rrL'maiority. "blind pool" subject to the uncon ^ ^. There would be an end at once of aU P»^'f ^;^^„ ,^ ,t.t, trine that '^'-'^"'^^'•1:^:^:^^:^ ^ ^^^^« und the corporation or between tne corp themselves. Evidently the eminent ,awj-er, who d«w up^ d^r, or certificate of incorporation, of the railro«l 28 CORPORATION FINANCE company in this instance were either careless or lacking in foresight. Otherwise, they would have avoided this adverse decision very easily by including among the powers granted by the charter the right to acquire and hold stock. 21. Other important features of the charter, — The amount of capital and the number of shares of a new corporation which are desirable depend on principles of capitalization that are discussed in Chapter VII and which need not be considered at this stage. Most, though not all, of the state laws require that the principal office of the corporation shall be within the state where the charter is secured. Partly for this reason, other things being equal, it is better to secure a charter from that state in which most of the business of a corpo- ration is carried on; but this is by no means an invariable rule, as will be pointed out in Chapter IV. It is also usual, although not universal, to provide that one or more of the incorporators shall be citizens of the state which grants the charter. The minimum number of in- corporators in most states is three. The number of directors of a new corporation is an important point to consider when the charter is obtained. Sometimes the nimiber is stated not in the charter, but in the by-laws and may readily be amended from time to time; but where the number is fixed by the charter it cannot be easily changed. A small board obviously is apt to be more efficient than a large board. This is another question which will come up for fuller discussion in a subsequent chapter. 22. The by-laws. — The by-laws are simply a collec- tion of permanent rules for transacting business adopted by the stockholders or directors. It is not absolutely necessary, though almost always very desirable, that a LEGAL STATUS OF THE CORPORATION 29 corporation should have by-laws. The by-laws usuaUy contain provisions as to: (1) Issue and transfer of stock. 2 Meetings of stockholders and directors. 3 Election of directors and officers. 4 Powers and duties of directors and officers (5) General directions as to the management of the "ri^^Xlfo'f the charter, we will run over hriefly a irsx, iiic *^» , ^ York corporation, «pt of bv-laws, which is used by a iN ew x or^ t- cellent manual, "The Modern Corporation. BY-LAWS OF THE STANDARD BLEACHING COMPANY, NEW YORK CITY Article I. — Stock. 1. Certiflcte. of Stock shaU be i.ued in m.^nc.1 order from urcr and sealed by the Secret , ^^^^j .cord of each -^.S-^V^^ ^1^,":^ „p„n the books of Jc^rana br a ne. eerti«»te U issued the .do. ;. ;7!:dl'::sta:din. sto* of the company J ™^ ^.-Jd "-''-''"»5°™7,V*:~^°" such stock subject to disposal by the uoar ^,>-i 30 CORPORATION FINANCE 1 I w' shall neither vote nor participate in dividends while held by the Company. Article II. — Stockholders. 1. The Annual Meeting of the stockholders of this Company shall be held in the principal office of the Company in New York City at 12 M. on the second Monday in January of each year, if not a legal holiday, but if a legal holiday then on the day following. 2. Special Meetings of the stockholders may be called at the principal office of the Company at any time by resolution of the Board of Directors, or upon written request of stockholders holding one-third of the outstanding stock. 3. Notice of Meetings, written or printed, for every regular or special meeting of the stockholders, shall be prepared and mailed to the last known post-office address of each stockholder not less than ten days before any such meeting, and if for a special meeting, such notice shall state the object or objects thereof. No failure or irregularity of notice of any regular meeting shall invalidate such meeting or any proceeding thereat. 4. A Quorum at any meeting of the stockholders shall con- sist of a majority of the voting stock of the Company, repre- sented in person or by proxy. A majority of such quorum shall decide any question that may come before the meeting. 5. The election of Directors shall be held at the annual meet- ing of stockholders and shall, after the first election, be con- ducted by two inspectors of election appointed by the Presi- dent for that purpose. The election shall be by ballot, and each stockholder of record shall be entitled to cast one vote for each share of stock held by him. 6. The Order of Business at the annual meeting, and, as far as possible, at all other meetings of the stockholders, shall be : 1. Calling of Roll. 2. Proof of due notice of Mcctino-. 3. Reading and disposal of any unapproved Minutes. 4. Annual Reports of Officers and Committees. LEGAL STATUS OF THE CORPORATION 31 5. Election of Directors. 6. Unfinished Business. 7. New Business. 8. Adjournment. Article III.— Directors. 1. The Business and Property of the Company shall be man- aged by a Board of seven Directors, who shall be «tockho ders and who shall be elected annually by ballot by the s ockholaers ZtL term of one year, and shall serve untd the election and eptance of their duly qualified successors. Any —e^ may be filled by the Board for the unexpired term. Directors shall receive no compensation for their services. 8 Th Regular Meetings of the Board of Directors shall be held in the principal office of the Company in New York Tit V at 3 P M on the third Tuesday of each month, if not a W 1 hoi d!y, ut if a legal holiday, then on the day foUowuig^ 3 Special Meetings of the Board of Directors to be held in the p» office o'f the Company in New York City may be Jled at any time by the President, or by any ^^^.^^^^^^^^ the Board, or may be held at any time and place, without notice ly unanimous written consent of all the members, or with the nresence of all members at such mcetmgs. . „ i. T Notices of both regular and special meetmgs sha 1 be mid by the secretary to each member of the Board not les Zn five days before any such meeting, and not.ces of spec,al melngs shall state the purposes thereof. «» -lu- or -gu- Urity of notice of any regular meetmg shaU mval.date such meetinir or any proceeding thereat. 7 A Quorum at any meeting shall consist of » .™aJor,ty ot the entire membership of the Board. A majorrty of sud^ Quorum shall decide any question that may come before the ■"t" Mcers of the Company shall be elected by ballot by the Board of Directors at their first m«ti„g after the ele*on o directors each year. If any offlee becomes '-""'/"""^^ year, the Board of Directors shall fill the same for the unex 32 CORPORATION FINANCE if 1 pircd term. The Board of Directors shall fix the compensa- tion of the officers and agents of the Company. 7. The order of business at any regular or special meeting of the Board of Directors shall be : 1. Reading and disposal of any unapproved Minutes. 2. Reports of Officers and Committeet. 3. Unfinished Business. 4. New Business, 6. Adjournment. Article IV. — Officers. 1. The Officers of the Company shall be a President, a Vice- President, a Secretary and a Treasurer, who shall be elected for one year and shall hold office until their successors are elected and qualify. The positions of Secretary and Treasurer may be united in one person. 2. The President shall preside at all meetings, shall have gen- eral supervision of the affairs of the Company, shall sign or countersign all certificates, contracts and other instruments of the Company as authorized by the Board of Directors; shall make reports to the directors and stockholders and perform all such other duties as are incident to his office or are properly re- quired of him by the Board of Directors. In the absence or disability of the President, the Vice-President shall exercise all his functions. 3. The Secretary shall issue notices for all meetings, shall keep their minutes, shall have charge of the seal and the cor- porate books, shall sign with the President such instruments as require such signature, and shall make such reports and per- form such other duties as are incident to his office, or are prop- erly required of him by the Board of Directors. 4. The Treasurer shall have the custody of all moneys and securities of the Company and shall keep regular books of ac- count and balance the same each month. He shall sign or coun- tersign such instruments as require his signature, shall perform all duties incident to his office or that are properly required of him by the Board, and shall give bond for the faithful perform- LEGAL STATUS OF THE CORPORATION 33 ance of his duties in such sum and with such sureties as may be required by the Board of Directors. Article V. — Dividends and Finance. 1. Dividends shall he declared only from the surplus profits at such times as the Board of Directors shall direct, and no divi- dend shall be declared that will impair the capital of the Com- pany. 2. The moneys of the Company shall be deposited in the name of the Company in such bank or trust company as the Board of Directors shall designate, and shall be drawn out only by check signed by the Treasurer and countersigned by the President. Article VI.— Seal. 1. The Corporate Seal of the Company shall consist of two concentric circles, between which is the name of the Company, and in the centre shall be inscribed "Incorporated 1905, New York," and such seal, as impressed on the margin hereof, is hereby adopted as the Corporate Seal of the Company. Article VII. — Amendments. 1 These By-Laws may be amended, repealed or altered, in whole or in part, by a majority vote of the entire outstandmg stock of the Company, at any regular meeting of the stock- holders, or at any special meeting where such action has been announced in the call and notice of such meeting. 2. The Board of Directors y adopt additional by-laws in harmony therewith, but shall not alter nor repeal any by-laws adopted by the stockholders of the Company. 23. Essential features of the hy-laws.—The sections with regard to stock are usually of a formal character and state simply that the ownership of stock shall be evidenced by the issue of certificates to each stockholder, and that transfers of ownership shall be made only upon the books of the company. The reader should thor- oughly understand this provision, which is prarticaUy universal. Pyrequently the engraved certificate of stock r—vi— 3 34 CORPORATION FINANCE in the possession of a stockholder, which usually reads This is to certify that John Doe is the owner of shares of the capital stock of the John Doe Company* transferable only on the books of the company, etc '' (see page 96) is incorrectly called and mistaken for stock Itself. As a matter of fact, stock is an intangible thing; It is merely a right to a share in the company's assets and earnings. A certificate is only a convenient method of proving that a certain person is the owner of stock. A certificate may be lost or stolen or given away or sold and yet the ownership of the stock will remain unchanged. Only by transfer on the books of the com- pany will a change in ownership be consummated. The usual method of transferring stock is to sign a blank form on the back of each certificate (see page 86) which authorizes the secretary of the corporation or some other agent of the owner to make the transfer. The by-laws almost always specify the time and place of an annual m-eting of stockholders for the transaction of important business. Special meetings may be called trom time to time on request of a certain number of stockholders or in whatever manner the by-laws may lay down. The important point is that to make a special meeting legal every stockholder must have proper notice m writing mailed to his last-known address. Meetings of the directors also are usually re(iuired at stated inter- vals and it is set forth in the by-laws that the directors are to elect the officers of the company and otherwise to manage its affairs. The essential officers of a corporation are the presi- dent, the secretary and the treasurer. The duties of each officer should lie and usually are clearly specified in the by-laws. Ordinarily the president, brieflv stated, IS the chief executive officer; the secretary keeps the LEGAL STAT0S OF THE CORPORATION 35 records of the corporation; the treasurer handles the corporate funds. The reader should clearly understand, however, that this definition of duties is not necessarily or universally followed. The by-laws may make the president the custodian of funds and the treasurer the chief executive officer, or may distribute the duties in any other manner. The law recognizes, however, that an outsider has the right to assume that the man who is given the title of president, treasurer or secretary is given the powers and duties that customarily belong to that position. The by-laws usually declare that dividends shall be paid only out of surplus, not out of the capital of the corp' dtion, although this is simply a formal statement of a principle which could not legally be violated in any case so long as the corporation has creditors. A corporate seal is usually adopted and briefly described in the by-laws. The procedure and necessary percent- age of favorable votes in order to amend the by-laws are usually stated. The board of directors or the stockholders may some- times adopt new rules of action which will be binding until rescinded, without the formality of amending the by-laws, simply by passing a formal resolution. No resolution, it need scarcely be said, will be legally bind- ing if it is contrary to any by-law provision. Resolu- tions are frequently used, however, to supplement and further elucidate the by-laws and to lay down a general permanent policy. We have now covered very briefly the main points that the reader should bear in mind as to the legal status of the corporation and as to the instruments that confer and define that status. All this is rather dry and more or less technical matter; yet it must not be slurred 36 CORPORATION FINANCE over by anyone who desires to acquire that knowledge of the corporate form and understanding of its uses and misuses that is essential to every person successfully concerned with modern business. We cannot afford to forget that the corporation is created and maintained under certain specific provisions of the law to which all its actions must conform. CHAPTER III INTERIOR ORGANIZATION 24. Rights of Stockholders.— In this chapter we shall treat as briefly as the subject will permit the relations to each other of the various groups of individuals who are interested in a corporation. Those groups are: I. Stockholders. II. Creditors. III. Directors. IV. Officers. Every corporation must be so organized that the duties, the liabiUties and the rights of each of these groups are clearly known and may be enforced. The nature of stock— the fact that it is an intangible share in the corporation's assets and earnings— has al- ready been discussed. Each owner of stock becomes to the extent of his holdings an owner of the corporation. His rights fundamentally are the same as the rights of other owners of private property, but the full exercise of these rights is under the corporate form much abridged and modified. To illustrate, the private owner of a piece of property has the right to sell or destroy or give away or use for his personal enjoyment the prop- erty and its earnings. A stockholder, however, cannot sell or destroy or otherwise tamper with his proportion of the corporation's assets, because under the corporate lorm he has committed those assets to the care of other oeople. 87 38 CORPORATION FINANCE The rights of stockholders as a lx)dy are: (1) To elect directors. (2) To amend the charter or by-laws. (3) To sanction or veto the selling or mortgaging of the permanent assets of the corporation. (4) To dissolve the company. The first two rights have been touched upon in the preceding chapter and need not be further considered. The third right is not universal in all states and under all charters, but is generally conceded. In some states the courts assume that the stockliolders, having chosen directors, freely turn over to them the sole and complete management of the business without any reservations whatsoever. Even in such states, however, the directors, in order to avoid any charge of fraud that might be brought against them, generally prefer on such impor- tant actions as the sale of permanent assets to have the officially expressed concurrence of the stockholders. A clause is sometimes placed either in the charter or in the by-laws requiring unanimous consent or the consent of a very large percentage of the stockholders in order to validate a sale or mortgage of permanent assets. The right of dissolution is very seldom exercised inasmuch as an unsuccessful corporation may be very easily aban- doned and its charter allowed to lapse by non-payment of taxes. 25. The proxy and its uses.— The rights of each in- dividual stockholder are four in numl)er, as follows: (1) To receive notice of and to participate in all stockholders' meetings. (2) To share in the assets of the corporation in pro- portion to his stockholdings in case of dissolution. (8) To share in dividends declared by the directors in proportion to his stockholdings. INTERIOR ORGANIZATION 39 (4) To inspect the accounts of the corporation. The first right has already been mentioned. It should be further observed, however, that a stockholder's right to participate in meetings is not confined to personal attendance at the meetings. If he does not go himself he may confer the right to represent him upon some other person. The instrument which confers this right is known as a "proxy" and generally reads somewhat as follows: KNOW ALL MEN BY THESE PRESENTS, that I, the undersigned, do hereby constitute and appoint John Doe my true and legal attorney to represent nic at all meetings of the stockholders of tlie Blank Company and for me and in my name and stead to vote throughout upon the stock standing in my name on the books of said company at the times of said meetings, and I hereby grant my said attorney all the powers that I should possess if personally present. This is a form well adapted to conferring a simple, un- limited right to represent the stockholder who gives it. The proxy may be much more formal and may contain any limitations that the giver chooses to impose ; for in- stance, it may be good only for one meeting or up to a certain time or for a certain purpose, such as giving an affirmative vote on a proposition that is to come before the meeting. The use of proxies in this country is widespread and is an important feature of corporation management. In England stockholders are more likely to appear in person at the annual meetings. By means of proxies American corjx)ration officials are accustomed to hold meetings with no one but themselves actually attending, but with a constructive attendance through their proxies of more than a majority of the outstanding stock. The 40 CORPORATION FINANCE i'l Union Pacific Railroad, for instanc^e, which is incorpc rated m Utah and must hold its annual meetings in that state, whereas its principal office is in New York City every year sends its secretary and a few minor officios from New i ork to Salt Lake City, each official carrying .satchel full of proxies. The annual meeting is then held and the election of directors carried out with all the formality that would characterize a fully attended meet- fi!S tl, rr ^'•^■^•'"W" »''o appears in person wiU find that his presence adds nothing to the effectiveness in tt I^T'ni'^' ""•' 'Z""^" "»' •^^I'onse their character in the least. Of course, m smaller companies the stock- holders are more likely to be present in person, although even Uiere representation by proxy is the estabUshrf the°^tn^'"<>* '*""' ' T^y *'' »'«'"''> ^ '■■"P'^^ed on the mmd of every stockholder is that it is n«-er under any circumstances irrevocable. The courts will not rec- ognize an irrevocable proxy as a valid agreemen" No matter what the wording of the original p™"ymay W^ no matter rf ,t clearly and emphatically sLes thlt it is .mvocable, a stockholder may. as a milter of fac and of law. revoke it at his will. tJ.^ T"^ "*'!*' " '"' "'■•^"'y ^" intimated, is in- frequently of much practical importance 26. The right to dividcmh.—'Fbe third riitht_tn «h.re m dividends-is so often misunderst^ by sLk" J^ trs^r* " "'""'"°"' "«" f "« --fuii/^ireS. In the first place, notice that nothing is said as to earn- nTflf """P"™""" "^y ^ Betting enormous yearly profits and yet an individual stockholder may not draw any dividend, whatever; nor can the stockholder gt.T these earning, until dividends are declare,!. In the second place, it will be pointed out in connection with Z INTERIOR ORGANIZATION 41 powers of directors that directors alone have the right to declare dividends and cannot be compelled by any legal action whatever to grant dividends to the stock- holders until they see fit. A case in point, which at- tracted some attention several years ago, was that of the Midvale Steel Company, a fairly large and now pros- l)erous company, located in a suburb of Philadelphia. The management of the company for the ten years 1887 to 1897 devoted all of its earnings to improvement of the plant, in spite of protests and strenuous efforts on the part of minority stockholders to force the declaration of dividends. The courts will not interfere with the policy of the board of directors in this regard unless fraud or mismanagement can be proved. 27. The right to information. — The fourth right— to inspect the corporate books and accounts — was originally universally admitted and was of considerable impor- tance. Each stockholder could go into the company's office whenever he chose and demand that he be given access to all the books and accounts. Early in the his- tory of business corporations, however, it became evident that the manager of a rival business could buy a single share of stock and thereby obtain trade information that could be used to the detriment of the corporation. Thus the anomaly was presented of a stockholder of a corpo- ration Ixiing able t'^- work against the corporation's in- terests. The couiis, recognizing the situation, have greatly modified and almost nullified this original right. Xo stockholder can now on legal grounds demand that he l)e furnished with information as to the customers of the corporation, the persons from whom supplies are lM)ught and their prices, the corporation's contracts, and other points of similar nature. In most states he gets all the information that rightfully l)elongs to him if he <^ 42 CORPORATION FINANCE i 'Jt obtains simply a summary of the profit and loss account ior the preceding year and of the balance sheet at the end of the corporation's fiscal year. Indeed, he cannot in all states secure cn en this meagre and apparently in- nocuous mformation. The movement in favor of publicity of corporate ac counts however, is now so general and strong, and the force of public opinion behind it is so great, that ahnost all the important corporations voluntarily give to their stockholders and to the public fairly complete amiual reports. Railroads particularly under the Interstate Commerce Act, as amended in 1906. are compelled to render to the Interstate Commerce Commission and through the Commission to the public and to their stock- holders, a very complete and detailed summary of their operations each year. One striking exception among the large corporations to this general tendency toward increased pubhcity is the Standard Oil Company, whose management has never yet given out anything more than a bare statement of the amount of the capitalization and of the dividends declared. Publicity of accounts is not to be confused with the right of the individual stock- holder to have access to the corporation's books, for even the greatest degree of publicity extends only to general financial results of the corporation's activities, not to the corporation s individual purchases, sales and contracts. Ihe right to actual inspection of the books, with few unimportant exceptions, is entirely a theoretical, not a practically important, attribute of stockholders 28 Liabilities of stochhoIders.-The next topic to consider is that of liabilities of stockholders, which may be grouped under the following four heads : (1) Their liability to the corporation or to unsatisfied INTERIOR ORGANIZATION 43 cieditors of the corporation for unpaid installments on part-paid stock. (2) Their liability to unsatisfied creditors of the corporation in case dividends have been paid out of capital assets. (3) In New York State, their liability to employees and servants for wages due by the corporation. (4) In the state of Minnesota, their liability (except manufacturing corporations) to corporate creditors up to an amount equal to the face value of their stock- holdings. In national banks the same rule holds good. (5) In California the unlimited liability of each stockholder for his proportion of unpaid obligations in- curred while he remained a stockholder of record. This liability continues even though he sells his stock. With further reference to the liability first stated in the preceding paragraph, it should be observed that cor- porations frequently do not need at the beginning of their existence all the capital assets that will later be necessary. They therefore ask their stockholders to pay only a certain percentage of their stock subscriptions at the beginning and either set certain dates for the re- maining payments or leave the dates to be fixed later by the directors of the company. In the latter case it sometimes happens that the corporation becomes so pros- perous that the unpaid installments are not called for and in the course of years stockholders may almost forget that they are still unpaid. Then if the corpora- tion later gets into financial difiiculties, the owners of stock at the time mav suddenly find themselves con- fronted by a demand for the immediate payment of un- paid installments. It is a very unpleasant and not especially uncommon situation. Ttuyers of stock should 44 CORPORATION FINANCE i :: therefore be very certain that their certificates are marked "full paid and non-assessable," or else make sure that they can meet whatever installments are un- paid, when called for, without great inconvenience to themselves. The payment of dividends out of capital instead of out of earnmgs is a practice which we shaU have occasion to refer to later in this volume. All that need be said about It here is that it might obviously be used as a means of divertmg to stockholders assets pledged to creditors of the corporation and for that reason is not permis- sible. ^ 29. Rights of creditors.— ThQ creditors of a corpora- tion are of two distinct kinds, secured and unsecured. Ihe secured creditors are those who have had set aside lor them under some form of agreement certain parts of the property of the corporation wliich are to be devoted, in case the corporation fails at the specified time to meet its debt, to paying the creditor in full. Ihe exact procedure will be discussed at some length m connection with corporate notes and bonds. The unsecured creditors hold simply a claim against the general unattached assets of the corporation. Whether the creditors be secured or unsecured, they have no part in the organization or management of the corporation so long as the debts to them are fully and promptly met. Only in case of insolvency or bank- ruptcy may they step in and exercise any rights which may have been conditionally granted t^ them. We wiU therefore defer a study of their place in the corporate organization until we come to the subjects of insolvency bankruptcy and reorganization. 30. "Dummy" directors.— The statutes of nearly all the states require that the directors of a corporation INTERIOR ORGANIZATION 45 shall also be stockholders. In most states the owner- ship of a single share is sufficient to meet this re- (juirement. As an example of the striking difference at times between what the law intends and what it ac- complishes, this requirement deserves special mention. Obviously it is intended to prevent any one man from "packing" the board of directors; In practice it serves to facilitate the creation of and control over "dummy" directors. A dummy director is one who serves the interest of some other person and who votes as he is told. Some- times he is an actual stockholder or is given stock out- right in order to qualify him for his position, and the man who controls him depends on influences outside the corporation to retain his control. When any doubt exists as to that point, however, the "dummy" director usually receives a certificate of stock duly transferred to him on the books of the company — which thus qualifies him to act as director — but is required to endorse the certificate back to the real owner. Thus the owner of the stock always has a string tied to the "dummy" director. If his orders are not followed to his satisfaction, all that he needs to do is to send in the certificate, have the stock transferred back to himself and thereby disqualify the "dummy." Thus a major- ity stockholder may elect a whole board of directors who are absolutely subservient to his orders and repre- sent only his interests. He may not himself be a member of the board at all, and yet may dictate its every action. 31. Potters and liabilities of directors. — In theory, however, even if not in practice, a board of directors is supposed to represent all the stockholders equally. Partly for that reason the board, as has already been 46 CORPORAnON FINAxNCE M' SJ indicated, is given complete control over the corpora- tion s assets and officers. Very seldom, indeed, will the short of selhng or mortgaging the corporation's perma- nent assets unless fraud or wrongdoing is conclusively shown. Their powers are usually more or less modified, however by the corporation's by-laws, and, like othe^ officers, they are not at liberty to transgress or omit any of the duties specifically set forth in the by-laws As a general thing they have power among other things to fill vacancies m their own number until the next annual meeting of the stockholders for the election of directors, to appoint and remove officers of the corpo- ration, and under limitations to modify or enact by-laws Any or all of these powers the board of directors may delegate if they see fit, to a standing committee chosen from their number. Where the board of direct- ors IS so large as to be unwieldy and difficult to assemble at regular intervals, such delegation of powers is cus- tomary^ The board of directors of the United States Steel Corporation, for example, which consists of twenty-four members, delegates a large part of its func tions to a standing committee of eight members known as the finance committee. The finance committee holds trequent meetings and conferences with the chairman of the board of directors, and between meetings of the full board has complete authority to settle most ques- tions. It also handles with full authority such financial questions as m most corporations would be referred to the board of directors. The committee with these func- tions in most corporations is caUed the executive com- mittee. The usual duties of corporation officers have already been treated in the preceding chapter. One officer not INTERIOR ORGANIZATION 47 ntioned there, who is in several large corporations r . .ch importance, is the chairman of the board of (iix^ cors. In the United States Steel Corporation, the New York Central Railroad Company, the National City Bank of New York, and other companies of like magnitude, the chairman of the board of directors is a prominent officer to whom the president of the corporation sometimes reports. It would not be far from wrong to say that the chairman represents the board of directors and the standing committees of the board in the intervals between meetings. To him, in other words, are delegated ad interim many of the powers of the board. Personal liabilities of directors may arise in four ways: (1) By reason of neglect or wrongdoing on their part that results in loss to the company. (2) By issuing stock as full paid that is not actually full paid. (8) By paying dividends out of capital. (4) By doing other acts specifically forbidden by the statutes of the state in which the company is incorpo- rated. These acts, it should be observed, in the eyes of the law are wrong and fraudulent. So long as the direct- ors keep within the law, no liability will .ittach to them in their capacity of directors. 32. The efficiency of corporate organization. — The reader may now see more clearly perhaps why "central- ization of control" was named in the first chapter as one of the important advantages of corporations. He may carry away a more vivid idea of the who'e arrangement if he compares the corporation to a double pyramid, as shown in this diagram: COKl'OUATIOX FINANCE S i ! I CLERKS AND LABORERS The base of one pyramid represents the body of stock- holders or owners of the corporation who delegate their rights as owners to the directors, who in turn transfer all active autliority to the jjresident or other chief execu- tive officer, wlio is at the apex of that pyramid. The other pyramid represents the subordinate officials and employees of the corporation. The chief executive officer is also the apex of this pyramid and transmits his orders through the various grades of subordinates to the clerks and lalxirers at the base of the pyramid. Thus responsibility and authority conferred by the stockholders id exercised over the employees are both centered in this chief executive officer. It is an organ- ization almost ideally adapted, so far us efficiency and ect)nomy go, to the conditions of present-day industry. CHAPTER IV WHERE AND HOW TO INCORPORATE 33. A corporation may he chartered in any state and do business in other states.— The reader is probably well aware that a corporation need not necessarily take out a charter in the state in which it transacts its principal business. In fact, the great majority of the large in- dustrial and raih-oad companies are incorporated in one state and carry on their operations in several states; in many cases none of their permanent assets worth men- tioning are located in the state of incorporation. This anomalous condition is made possible by the peculiar character of our American political system. Each state has the right to create corporations and by custom such corporations are recognized and allowed the usual rights and privileges in all other states. It should l)e noted at this point that such rights and privileges are granted as a matter of custom and of policy, or of "comity," to use the legal term, and not— as is some- times stated even in legal text-books— under that clause of the Constitution of the United States which says that "the citizens of each state shall be entitled to all ])rivileges and immunities of citizens in the several states." A corporation is not a citizen, but an artificial IKTson created by law, which is an entirely different thing. In an early case before the Supreme Court of the IJnited States, The Bank of Augusta vs. Earle, the right of a corporation to make a contract outside the C— VI— 4 4tf 50 CORPORATlOxX FINAxNCE i state of its incorporation was brou^rht into question. The decision of the Court upheld this right as a legal presumption, but stated that the right might be with- drawn by any state legislature. The opinion written I by Chief Justice Taney is so important and informing i that some of the salient paragraphs are quoted below; I ^* '* "^^'y true that a corporation can have no legal existence I out of the boundaries of the sovereignty by which it is created. * It exists only in contemplation of law, and by force of law ; and . whe.-e that law ceases to operate, and is no longer obligatory, the j corporation can have no existence. It must dwell in the place : of its creation and cannot migrate to another sovereignty. But although it must live and have its being in that state alone, yet j it does not by any means follow that its existence there will not ; be recognized in other places; and its reside cr in one state creates no insuperable objection to its power of contracting in another. It is indeed a mere artificial being, invisible and in- tangible; yet it is a person, for certain purposes in contempla- tion of law, and has been recognized as such by the decisions of this court. . . . Now, natural persons, through the in- tervention of agents, arc continually making contracts in coun- tries in which they do not reside ; and where they are not per- sonally present when the contract is made; and nobody has ever doul>ted the validity of these agreements. And what greater objection can there be to the capacity of an artificial person, by its agents, to make a contract within the scope of its limited powers, in a sovereignty in whicli it does not reside; provided such contracts arc pennitted to be made by them by the laws of the place? The corporation must no doubt show tliat the law of its crea- tion gave it authority to make sucli contracts, through such agents. Yet, as in the case of a natural person, it is not neces- sary that it should actually exist in tlie sovereignty in which the contract is made. It is sufficient that its existence as an artificial person, in the state of its creation, is acknowledged and recog- nized by the law of the nation where the dealing takes place; WHERE AND HOW TO INCORPORATE 51 and that it is permitted by the laws of that place to exercise there the powers with which it is endowed. It is nothing more than the admission of the existence of an artificial person created by the law of another state, and clothed with the power of making certain contracts. It is but the usual comity of recognizing the law of another state. We think it is well settled, that by the law of comity among nations, a corporation created by one sovereignty is permitted to make contracts in another, and to sue in its courts ; and that the same law of comity prevails among the several sovereignties of this Union. The public and well-known and long-continued usages of trade ; the general acquiescence of the states ; the par- ticular legislation of some of them, as well as the legislation of Congress ; all concur in proving the truth of this proposition. 84. The regulation of "foreign" corporations. — In the state in which its charter is granted a corporation is called "domestic" ; in other states it is a "foreign" cor- poration. This word "foreign" must not be taken to refer to corporations of other countries than the United States; such corporations are known as "alien." Every state in the Union regulates to a greater or less degree the business carried on within its borders by foreign corporations. In some states it is necessary to procure a license, which may be obtained by deposit- ing with some official a certified copy of the corpora- tion's charter and naming some agent on whom legal papers may be served. In other states it is merely required that the foreign corporation shall maintain an office and have an agent within the state. Some states restrict the power of foreign corporations to hold real ' .tate. These regulations are not intended to apply to corporations which merely solicit orders or execute contracts incidental to their main business, but to those which are permanently established. •52 CORPORATION FINANCE ii I ^'y. Choosing the state of ineorporation.—Vnless there ir jome reason to the contrary, it is generally much better for a corporation to get its charter in the state in which its principal business is located. This remark applies particularly to small companies operating wholly within one state. There are several reasons therefor. One is the fact that a foreign corporation must usually pay incorporation and annual franchise taxes in the state of incorporation and in addition a license fee or some other kind of a tax in the state in which it does business. Another reason is that the courts of each state are inclined to treat domestic corpora- tions with greater considera ,ion than foreign corpora- tions. A third reason is that there is a popular prej- udice, more or less well-founded, against those companies which go to other states for their charter. Creditors and prospective buyers of the corporation's securities are apt to ask embarrassing questions as to why the coT-poration cannot or does not comply with the legal requirements of its own state. A fourth reason is the inconvenience caused by the necessity of filing reports and generally of maintaining a separate office in the state of incorporation. If the managers of a small local concern, therefore, are considering where to in- corporate, the answer will almost always be, "Get your charter in the state where you expect to do most of your business." The answer to a similar question is not so easy, how- ever, where the prospective corporation will be large, or where its business will be widely scattered through many states, or where its managers have in view some purpose or purposes not avored by the laws of the state in which its principal office is to be located. Neither is the answer so easy even for small local con- WHERE AND HOW TO INCORPORATE 53 ccrns in those ultra-conservative states in which the corporation laws are unduly burdensome or corporation taxes unduly expensive. Under all these circumstances, persons who are about to form a new corporation, or who are thinking of giving up their charter in one state, will naturally look about and compare the ad- vantages obtainable under the laws of the various states. There are great variations among the states in regard to taxes, liberality of corporation laws and treatment of foreign corporations, and the problem of weighing all these factors and picking out the most economical and advantageous corporate home is often very difficult. The advice of a thoroughly competent corporation lawyer in all such cases is absolutely essential. Never- tiieless, for his own protection, both in forming and in dealing with corporations, every business man should have a pretty accurate idea of the requirements and prinleges in all the important states. 86. Comparative charges in several states. — The first and most obvious factor to consider in selecting the state of incorporation is the cost. This cost consists of organization fees, annual taxes and counsel fees. The following tables copied from a convenient manual by Thomas Conyngton, of the New York Bar, entitled "Corporate Organization," will give the reader an idea of how these expenses run in the five states which are most commonly used for incorporation by companies that expect to do business in other states: COMPARATIVE TABLE OF ORGANIZATION EXPENSES. Capital Stock of Company. f 1,000 5,000 10.000 (Including all Filing and Incidental Fen.) Jtr$0y. fSA.OO SA.OO 35.00 N0W York. 116.00 17.50 90.00 Dtlavart. i?5.00 95.00 95.00 JitAnt. 197.00 97.00 97.00 South Dakota. 113.00 13.00 13.00 54 CORPORATION FINANCE Capital Stock New Sew South Dakota. of Company. Jer»ey. York. Delaware. Maine, 25,000 35.00 27.50 25.00 67,00 13.00 50,000 35.00 40.00 25.00 67.00 18.00 100,000 35.00 65.00 25.00 67.00 18.00 500,000 110.00 265.00 65.00 67.00 23.00 1,000,000 210.00 515.00 115.00 117.00 33.00 5,000,000 1,010.00 2.515.00 :165.00 517.00 113.00 10,000,000 3,010.00 5,015.00 615.00 1,017.00 133.00 COMPARATIVE TABLE OF ANNUAL FRANCHISE TAXES. 91,000 $1.00 $1.50 $5.00 $5.00 None 5,000 5.00 7.50 5.00 5.00 u 10,000 10.00 15.00 5.00 5.00 u 25,000 25.00 37.50 5.00 5.00 u 50,000 50.00 75.00 10.00 5.00 M 100,000 100.00 150.00 10.00 10.00 « 500,000 500.00 750.00 25.00 50.00 « 1,000,000 1,000.00 1,500.00 50.00 75.00 H 5,000,000 4,000.00 7,500.00 150.00 275.00 M 10,000,000 V50.00 15,000.00 275.00 525.00 « South Dakota and Delaware are fair examples of what are sometimes called the "barifain counter" states, so far as incorporation expenses are concerned. Arizona also belongs in this class, and West Virginia and the District of Columbia might until recently have been included. As an example of the importance of this feature when large companies are formed, it has been estimated that if the United States Steel Corpora- tion had taken out its charter in Pennsylvania, where most of its business is transacted, the organization expenses would have been about $3,500,000, whereas in New Jersey, where the charter was actually obtained, the corresponding expenses were only about $220,000. A great many companies which are organized to exploit mines or new inventions or other highly speculative en- terprises may without impropriety issue very large amounts of stock, although the actual market value of their assets at the time of incorporation may be verj' WHERE AND HOW TO INCORPORATE 55 small; in such cases it is customary and obviously tconomical to secure a "bargain counter" charter. In those states where taxes and initial fees are small the necessary expense for legal assistance is apt to be at a minimum, for two reasons: first, because the state legislatures obviously are making a bid for the cheap incorporation business and will naturally make their forms and the necessary red tape of incorporation as simple as possible; second, because in such states incor- poration agencies which carry on their business on a wholesale scale, are in existence, and high-priced legal talent is hardly necessarj'. In other states competent attorneys should always be secured, and their fees may l)e expected to range from $50 up. In this connection it may be well to remark also that the necessary corpo- rate records, wliich are the secretary's minute book, the stock certificate book and the stockholders' register, may be obtained for from $10 to $500 per set. One of the cheaper sets is all that is necessary for most small companies. The reader now has sufiicient data before him to form a rough estimate of the expense necessarily involved in the process of incorporation. This factor of initial cost, however, in the case of companies which expect permanently to car^' on an established business is, after all, a minor consideration. Among the other important points to bear in mind in selecting a corporate domicile, four stand out most prominently — the liberality of the laws, the permanence of the laws, the liabilities attaching to stockholders and the reputation of the state. 87. Liberality of corporation laws in several states. — The chief respect in which state laws differ, so far as lil)erality is concerned, is in granting or denying the right to buy and sell the securities of other corporations. V" 56 CORPORATION FINANCE In 1889 New Jersey, first of all the states, enacted that corporations formed under its laws might hold the stock of other corporations. This privilege proved of great importance in the financial and industrial development of this country. The Xew Jersey act in this respect was followed by Delaware, Maine and New York. In 1913 however, through the so-called "Seven Sisters Law," New Jersey attempted to define and make illegal and criminal all monopolies and agreements to discriminate, prevent competition, limit production and fix prices. The great industrial trusts, which formerly patronized this state when incorporating new companies, are now obliged to look elsewhere. Another feature in which the various states differ widely with regard to liberahty is the issuance of stock for property. Most corporations as now organized turn over at least part of their stock in exchange for property, not cash. Some of the states make the esti- mate placed by the directors upon the value of the prop- erty so secured conclusive unless fraud is clearly shown. Other states hedge this general principle about with irntatmg and usually unnecessary restrictions. Liber- ality of the state laws as to other less important points will be considered by careful incorporators, but are too technical to be discussed here. 88 Permanence of the lawa.-ln those states in which the general corporation statutes have existed for some years practically unchanged, it is reasonable to ex- pect that they are in fairly permanent form. Moreover m such states the courts have given a large number of decisions on vital points. Both the statutory law and the interpretation of that law, therefore, may be con- s^ered well settled. This is a matter of prime impor- tance to large corporations, which may expect, from the WHERE AND HOW TO INCORPORATE 57 very extent of their business, to be involved in more or less litigation. They want to know where they stand at all times and do not care to be confronted with sudden legislative enactments or with unexpected court de- cisions. For this reason the large corporations which had incorporated in New Jersey were especially hard hit when the "Seven Sisters Amendments" were suddenly enacted. The liabilities imposed upon stockholders have al- ready been treated in the preceding chapter. The states of California, New York and Minnesota, as there noted, impose certain liabilities additional to the usual liability on capital stock. These liabilities are not apt to prove a serious matter. Yet corporations gen- erally look with some alarm at any provisions of this nature. 39. Reputations of various states. — The reputation of the state of incorporation may have considerable effect on the sale of corporate securities. It is so well- known, for instance, that the laws of South Dakota and Arizona are lax that investors look with distrust on any corporation which operates under one of their charters. This statement, although to a much less de- gree, applies to Delaware and to Maine. Delaware is now especially popular, having in part displaced New Jersey after the legislation already referred to. West Virginia and the District of Columbia do not rank nearly so well, on account of their record, although the District of Columbia law in 1905, on the recom- mendation of President Roosevelt, was altered and improved and the West Virginia law also has been changed. Connecticut, :Massachusett8, Pennsylvania and Illinois have reasonably — Massachusetts perhaps unreasonably — strict requirements, and all as states of incorporation are in good repute. Among all the 58 CORPORATION FLVANCE States, New York, under its "Business Corporations l^aw, as amended in recent years, perhaps best com- bines the advantages of hberahty and of high repute. Its laws however, have not been so thoroughly tested and settled by the courts us the corresponding laws of 'New Jersey. 40. Comparative summary of the advantages and disadvantages of the important states.—For the benefit of readers who may desire to form a corporation or who may have occasion to consider the advisability of buying stock of a company incorporated in some other state than the one in which it does business we give below a bnef summary of the ad^antages and disadvantages of several states: ® ASIZONA. Advantaget: 1. Stock may be issued for money, property, or services. JdvanL '*" '''"''* ^''' '''^'''' "^^ ^' ^"^ important 2. Directors' meetings may be held outside of the state. 3. The organization fee is very small. The annual franchise tax IS small. 4. Cumulative voting is permitted. Disadvantages: 1. Stockholders' meetings must be held within the state, unless at first meetmg a by-law provision permitting subsequent meet- mgs outside the state is adopted. 2. The corporation laws are not thoroughly adjudicated. CONNECTICUT. Many promoters do not care to incorporate in Connecticut as they 'rnagine that the advantages are not great. As a matter of fact, the high organization fee is the chief disadvantage. Advantages : 1. Stock may be paid for in either cash or property. The judgment of the directors is final with regard to the value of WHERE AND HOW TO INCORPORATE 59 the property for which stock is issued, except in case of fraud. 2. Incorporators may be non-resident. S. There is no annual franchise tax. 4. Corporations may hold stock in other corporations. Dinadvati^aget : 1. Stockholders' meetings must be held within the state. There is no provision requiring the meetings of the directors to be held within the state, but this may be inferred. fi. There is an inheritanr tax on the stock. 9. The organization f et:^ are comparatively high, from $S6 to $2,510. DELAWAEK. Advantages: 1. Stockholders* and directors' meetings may be held outside of the state, if the by-laws so provide. 2. Stock may be issued for cash, property or services. 3. Incorporators may be non-resident. 4. Corporations may hold stock in other corporations. 5. Provision may be made whereby bondholders will be per- mitted to vote. This provision makes a good market for bonds because bondholders will be assured that they will have a voice in the management of the corporation. 6. Organization fees are not very large, ranging from $30 to $765, including filing fees. Disadvantages : 1. One of the directors must live in Delaware. 2. There is an inheritance tax on stock, applying both to resi- dents and to non-residents. 3. There is an annual franchise tax. BISTKICT OF COLUMBIA. Advantages: 1. Very small cost of incorporation, probably not exceeding $10. it. No franchise or inheritance tax. i i GO CORPORATION FINANCE Disadvantages: 1. A majority of the trustees, (the term trustee corresponds to the term director) must live in the District. 2. Stock cannot be issued for services, only for property or CAsn* 3. 10 per cent of capital stock must be paid in before begin- ning business. New York requires 50 per cent paid in before the end of the first year, but business can be carried on in the meantime. Here, no business can be (lone in the name of the corporation tiU 10 per cent is fully paid in. 4. An annual report of the corporation must be filed and published. This report must include amount of capital stock authorized, amount paid in and amount of existing debts. 5. The corporation cannot own stock in other corporations. 6. Corporation laws are unadjudicated. MAINE. Advantages: 1. Stock may be issued for property, cash or services. The judgment of the dirt tors is conclusive as to value of the prop- erty—always provided there is no evidence of fraud. «. Incorporators and directors may be non-resident 3. Directors' meetings may be held outside of the state. 4. The corporation may acquire stock in other corporations. 6. Low organization fees, ranging from $10 to $617 for a $5,000,000 corporation. Disadiran tages : 1. Stockholders' meetings must be held within the state. 2. There is both an inheritance and an annual franchise tax ; the latter, however, is very small. MASSACHUSETTS. Advantages: 1. Incorporators and directors may be non-resident. 2. Directors' meetings may be held outside of the state. 3. Stock may be issued for cash, property or services. WHERE AND HOW TO INCORPORATE 61 Disadx'aniaget : 1. Stockholders' meetings must be held within the state. 2. It is doubtful whether ordinary corporations can hold stock in other corporations. 3. A detailed annual report must be rendered to the state au- thorities. 4. There is an inheritance tax. 5. The organization fee varies from $26 for a $10,000 cor^ poration to $1,S00 for a $5,000,000 corporation. . J . NEVADA. Advantaget: 1. Incorporators and directors may be non-resident. 2. Stockholders' and directors' meetings may be held outside of the state. 3. Stock may be issued for cash, property or services. The judgment of the directors is conclusive as to value of prop- erty, providing there is no evidence of fraud. 4. Action of the majority of the stockholders or directors may be valid witho''t regular meeting; that is, there may be an informal meeting held, without any notice whatsoever being given. 5. Bondholders may be given the right to vote. 6. Cumulative voting is allowed. 7. No annual franchise tax. 8. The organization fee is comparatively low, ranging from $15 to $700; there are no filing fees except those imposed by counties. Disadvantages: 1. In some cases an annual report must be prepared for the state authorities. 2. The state's reputation as a corporate home is not of the best. .J . NEW JERSEY. Advantages: 1. Corporations may hold stock in other non-compet'tive cor- porations. New Jersey was the first state to authorize the for- mation of holding companies. 62 u I i CORPORATION FINANCE 2. Incorporntors nmy be non-resident. 3 Stock may be issued for property or cash. Ju.lgment of the directors ,s conclusive as to vahie of property. The courts however, have shown a strong tendency to accept circumstantial evidence of fraud. 4. Direct- ' .nectings may be held outride of the sUte. if by-laws so p Je. 5. Cumula. ,. voting is permitted. 6. A voting t.ust, un,ler certain restrictions, may be created 7. Laws are all well adjudicated. Disadvantageg : 1. Stockholders' meetings must be held within the state. 2. One of the directors must live in the state. 3. There is an annual franchise tax ; also an inheritance tax, ^f Ir ir "°* *PP'^ *** non-residents. Fees are from .$25 to $1,000; filing fee $10. NEW YOBK. Advantaget: 1. Stock may be issued for cash, property, or labor. Labor must be distinguished from "services" though there is no de- cision explaining the exact difference. The judgment of the directors is conclusive as to value of property, provided there is no evidence of fraud. 2. Directors' meetings may be hcio outside of the state. 8. Corporations may hold and control the stock of other cor- porations. 4. Cumulative voting is permitted. 6. A voting trust may be created, limited, however, to five years. Ditadvantagea: 1. Stockholders' meetings must be held within the sUte. 2. One incorporator and one director must reside within the state. 3. One-half of the capital stock must be ; aid in within a year from incorfioratinn. 4. Detailed books and account* of the business are r«,uire«l. WHERE AND HOW TO INCORPORATE 68 41. Agreements prior to incorporation. — Sometimes a corporation is formed practically by and for an in- dividual acting alone, who expects to take all the stock except what is necessary to qualify dummy directors and either hold it permanently or dispose of it whenever an opportunity arises later. Frequently, also, it hap- pens that a corporation is organized to take over the business of a pre-existing partnership and the partners have come to an informal understanding as to how much stock shall be issued to each one. Under such circum- stances, of course, no formal agreements previous to incorporation are necessary. In many instances, however, corporations are formed by the harmonious action of a numl)er of men who mutually agree as to the purposes, capitalization and other essential features of the new corporation and who each subscribe for a certain amount of stock. In such cases it is customary to draw up what is known as a "subscription contract" and to leave space at the bottom of this contract for each subscriber to write his name and fill in the number of shares that he agrees to take. The subscription contract should state among other things the par value of each share of stock, the total number of shares to be issued and the total number to l)e subscribed, in order to make the contract binding. Usually the subscription list is accompanied by a pros- pectus (descrilHjd in Chapter XVI) which more fully states what the corporation is expected to accomplish. It i^ould be noted that the subscription contract may be made immediately binding by having the amount of the subscription payable to certain specified trustees; or if not immether state in which thoie ,iuali- ties are pnm.inent in the generd corporati.m law. If the incorporators desire permanence and legal stability above all things, they may go to still another state The range of choiee is wi.le. It takes only a little effort and mgenuity for a capable lawyer to fit out a business en- terpriH. with the exact corporate powers and organiza- tion that will prove most advantageous. WHEKE AND HOW TO INCORPORATE 65 43. Canada's corporation laics.— The advantages, drawbacks and principles of the corporate form, dis- cussed in previous pages, are in a general way applicable to Canada as well as to the United States. Here it is necessary only to examine briefly the corporation laws of the Dominion. Each of the nine provinces of Canada has its own company laws. In addition there is the Com- panies' Act of the Dominion, known commonly as the Federal Act. This act is divided into six parts. The first deals with joint stock companies; the second, with companies' clauses; the third, with the incorporation of loan companies; the fourth, with British loan companies; the fifth, with British and foreign mining companies; and the sixth comprises only two clauses dealing chiefly with the payment of (lel)entures by loan companies. The Secretary of State at Ottawa may grant charters, on certain conditions, to not less than five applicants who must file with him the following information: (a) The proposed corporate name of the company, which shall not be that of any other known company, incorporated or unincorporated, or any name liable to i»e confounded therewith, or otherwise, on public ^M-ounds, objectionable. (1)) The purposes for which the incorporation is sought. (c) The place within Canada which is to be its chief place of business. (d) The pro|K)sed amount of its capital stock. (c) The number of shares a'ul the amount of each share. ( f ) The names in full and the addresses and calling of ciith of the applicants, with special mention of the names of not more than fifteen and not less than three of their ( -VI— 4 ^ A 66 COHPOUATION FINANCE number, who are to be the first or provisional directors oi the company. (g) The amount of stock taken bv each applicant, the amount, if any, paid in upon the str>ck <,1' each applicant. a.id the manner in which the same has been paid, and is held for the company. Existin^r companies may l>e incorporated under this act as may also any company incorporated under anv general or special act of any of the Canadian provinces or under the laws of the United Kingdom or anv foreign country'. There is a tariff oi' fees to be paid on ap- plication for incorporation. This tariff mav l)e varied by the government accordin^r to the nature i)f the com- pany, the amount of capital stock, and the like. A com- pany must not CHimmence it« operations or incur anv lia- bility before 10 per cent of its authori/x-d capital has been subscribed and paid. In order to check traffic in charters, anv charter grant- ed under the Dominion .Vet becomes forfeited in case of non-use by the company, or in case the company does not go into actual operation within three vears after the charter is granted. The Dominion Law particularly emphasizes that the word "Limited" must appear after the company's name. This applies to notices on the crmipanv's oiKces,' their lit- erature, bills of exchange, and other stationery. The habihty of shareholders is limited to the amount unpaid on their respective shares in the capital stock. The ques- tion of liability king an iinp(.rtant one. we may (luote sections 39 to 42 of the Dominic.n Companies' Act on that point: 39. Any «hiirLh..Mir may |il((u| |,v or ill p,irt to miy iutivt-off wliit-li 1 May of (Icfoiro in wliole • r uikKi- III., last j)n<»(|- K> ciui s«» lip uguinst thu WHERE AND HOW TO INCORPORATE 67 ...mpuny, except a claim for unpaid dividends or a salary or allowance, ns a president or a director of the company. K). No person holding stock in the company as an executor, ulinin.strntor, tutor, curator, guardian or trustee of or for any person named in the books of the company as being so .vprosonte.1 by him, shall be personally subject to liability as a shareholder: but the estate and fun.ls i„ the hands of such per- s.m shnll 1,0 hnble in like manner, and to the same extent as the testator or intestate would be if living, or the minor, ward, ... mterduf.l p.rson or the person interested in such trust fm.d would be, ,f cou.petent to act and holding such stock in his own name. n. No person holding such stock ns collateral security shall I- personally subject to such liability, but the person pledging such stock shall Ik. considon.l f„r the purposes of such liability as hold.ng the same and shall be liable as a shareholder ac- •onbngly. 42. Every such executor, n.lministrator, curator, guardian -• rustee shall represent the stock hehl by him, at all meeting, •of the company, and n.ay vote as a sharehohler; and every p. -son who plc..l^.es his stock n.ay represent the same at aU •Muh meetn,gs, and notwithstanding such ple.lge, vote as a shareholder. ^ o , The capital stcK-k of the company must he personal es- tate and tran.sferahle. The directors of a company may nmke by-laws for creating and issuing anv part of the capital st(K.k as preference stock. Several clauses of the act deal with the increase of capital. If authorized by hy-hiw, sanctioned by a vote of not h ss than two-thirds in value of the subs'cribed stock of tin mnpany representeersons who have ceased to be members within the twelve months next preceding, and the number of shares held by each of them. 44. Ejctra-provincial licensing acts. — One of the serious difficulties in company incorporation matters in Canada is the operation and effect of what are known as the extra-provincial licensing acts. These are in force in the various provinces in Canada. Generally speaking, these laws require companies incorporated outside the j)rovince enacting the law, to comply with certain condi- tions and pay certain fees before l>eing allowed to carry on business in the province. Default in these matters is met with penalties. In most of the Canadian provinces, these extra-provincial acts apply not only to companies incorporated under the Dominion Act, but also to those incorporated in other Canadian i)rovinces or in foreign jurisdictions. These conditions naturally complicate the incorjwration of companies in Canada and undoubtedly interfere considerably with the business, trade and com- merce of the Dominion. The question as to the rights f the nine provincial and the Dominion governments in the matter of company control has been before the courts <) 70 CORPORATIOX FINANCE i t of C anada for many years, and there seems little likeli- lio(M of an early deeision l>etueen the two parties. The formalities neeessary to seeure authorization un- der the various aets vary Mith the provinces. In some o the provuiees, the authorization is obtained by a license ; ,n others, it is secured by ''registration." In ail the provu.ces, the administration of the acts is in the hands of the government department that administers the C ompanies' Act, and the procedure is similar to that m issuing a charter. As the corporation laws of Canada stand, it is unwise for company promoters to proceed with the business of promotion and incorporation without the senices of reputable Canadian lawyers, and preferably those who are accustomed to the intricacies of the various acts An exami)le of a Dominion charter is appended The forms of charter of the various provinces are somewhat similar to that of the Dominion AMERICAN KITCHEN PRODUCTS COMPANY OF CAN- ADA, LIMITED Puyic Notice is hereby given that under the First Part of chapter 79 of the Revise.! Statutes „f Canada, 1906, known ".s 1 he C ompanie.' Act," letters patent have heen issued under he S.. of the Secreiary of State of Canada, bearing date of tlie 90tl. chiv of A.gust, 191JJ, incorporating Wilham Jay Seh.effehn an.I Henry Stevenson Livingston, merchants, and Benjannn Jonas Weil, real estate dealer, of the City of New y.rk, ,n the State of New Y«rk, one of the United States of America and David Charies Robertson, King's counsel, and I harles Lovelace Buchanan, accountant, of the City of Mon- treal, ,n the Province of QueWc, for the following purposes. VIZ.:— (a) To manufacture, purchase and sell bouillon cubes WHERE AND HOW TO INCORPORATE 71 and otiior kinds of concentrated food protlucts; (b) To purclinse, iii.'iMiifacture untl sell any raw nmtcrial used for the manufacture of such cuIkjs or food products; (<•) To carry on the huHincss of niercliants or of manufacturers' agents in connection with the purchase or sale of such cuhcs or food products; (rf) To carry on the business of warehousemen f«)r tJie warehousing of tlieir own products or those of others; {c) To apply for, pur- chase or otherwise acquire nny patent of invention or secret process useful for the purposes of any business which the com- j)any is authorized to carry on ; (f) To sell out the undertaking of the company, in whole or in part, for such consideration as the company may deem fit, and in particular for shares, de- luiitures or securities of any other company having objects similar, in whole or in part, to those of this company, notwith- standing the provisions of section 44 of the said Act, and to provide by by-law the manner in which the directors may be iiuthorized to make such a sale; (fr) To acquire the good-will, rights and property of an}' kind, and to acquire and undertake the whole or any part of the assets and liabilities of any person, firm, association or corporation having powers similar to those of this company, and to pay for the same in cash, stock or bonds of this corporotion or otherwise; (h) To amalgamate with any company having powers similar to those of this com- pany, upon such terms and conditions as may be agreed upon ; (J) To acquire by purchase, subscription or otherwise, and to hold, sell or otherwise dispose of shares, stocks, bonds or obli- gations of any company having objects similar, in whole or in part, to those of this company, notwitlistanding the provisions of section 44 of the said Act, and to vote thereon as owners thereof; (j) To invest and deal with the moneys of the company not inntie«liately require> s e E .t; a o ^ o ■a >^ S OS 3; O oj t. *- S e o B ■^ a. « i . « 0> 6(3 U3 u H 8 5 J e o es I s2 S5 u c £ O o « s o o £ I o -J ,s ^ .- 5 p c ,? s -a ^ B 33 n »< v J! s c' B Km 4-t 8 5 B Ecn o « 4> u B CI (« Q •§ o >5 •o s ■S 2 ■■s I •o u I Registered this .. . . day of 19 City Trust Company of New Yorlt, by Secretary. CORPORATE STOCK 79 in practice sknply a right to a certain percentage of the assets and earnings of the issuing corporation? The form of a certificate of stock under the present system is given on page 70. The question before us is whether it would not be better to make the second line of the face of the certificate read instead of "Capital Stock $1,000,- 000," "Number of shares 10,000," and to elimmate the last line, "Shares $100 each," altogether. Logically there could be no objection to the proposal; each share would be just as valuable— no more and no less— after the change as before. The chief advantage gamed would be that misconceptions based on the idea that par value and actual value in some way correspond would no longer be possible. Although this reform would be desirable, and is now legally permissible in New York and in some other states, it is not very seriously advocated and probably will never be adopted simply because the custom of as- signing a nominal money value to each share has become well established and would be very difficult to eradicate. The same object will be attained in time, as people be- come more familiar with corporation practice, by the general recognition of the obvious fact that par value and actual value need not correspond; that the earning power of each share is the real test of value. 47. Nature of preferred stock.-ln most corpora- tions all the stock is of one class and each share has an equal right to its proportion of the assets and earnings. Such stock is called "common" because no share has any privileges which do not attach to all the other shares In general, common stock may be defined as stock which does not possess any special or peculiar rights. Other corporations, however, set aside certam amounts of stock in a separate class and grant to this class spe- 80 CORPORATION FINANCE i: ilii' cific privileges. Such stock is called preferred. The usual preference consists in giving a fixed dividend to the stock preferred before any payment whatever is made to the common stock. This dividend may be "cumulative"; that is, if profits are not enough to pay it in full in one or more years, the unpaid portion re- mains as a claim against earnings that must be settled before any payment is made to the common stock. Or it may be "non-cumulative"; that is, if profits in any year, including usually the accumulated profits of pre- ceding years, are insufficient to cover the preferred stock dividend, the unpaid portion is wholly lost to the pre- ferred stockholders, no matter how large the earnings in succeeding years may be. Let it be kept clearly in mind, however, that preference as to dividends is merely the usual, not the universal, privilege given to preferred stock. When the single statement that stock is "pre- ferred" is made, it is necessary to consult the charter and by-laws of tlie corporation in order to be sure as to the exact nature of the preference. The stock may be preferred as to assets, as well as dividends, or as to both. Furthermore, cumulative preferred stock may get a fixed dividend, and no more, which is the customary arrangement; it may get a fixed dividend and then, after the common stock has secured a fixed dividend, all the rest of the earnings may be divided equally between the two stocks, which is the arrangement presumed by law unless an expressed stip- ulation to the contrary is contained in either the charter or by-laws; or it may get a fixed dividend and the com- mon stock a fixed dividend and all the rest of the earn- ings may then go to the preferred stock, which is a very unusual arrangement. Preferred stock had its origin in railroad reorganiza- CORPORATE STOCK 81 tions. In reorganization after bankruptcy it is neces- sary to cut down the claims of the various bond issues outstanding in order to put the reorganized corpo- ration in a reasonably safe condition. The interest on the first mortgage bonds is usually scaled; some of the junior issues are perhaps turned into income bonds; and in the seventies some bright mind conceived the idea of changing the inferior bond issues into preferred stock. This process will be explained much more fully in our discussion of bankruptcy and reorganization. 48. Uses of preferred stoch— Although preferred stock was originally the offspring of receiverships, it proved to be such a useful instrument for some purposes that it has been retained and is now much used, especially by industrial companies. The railroad companies, for reasons that will be later discussed, are gradually giving it up. Apart from its usefulness already alluded to in cases of reorganization, preferred stock serves four other purposes. First, it may be a convenient means of separating a company's stock into different voting classes. Sometimes the preferred stock has no vote at all; sometimes it elects a limited number of directors. In either case the owners of the majority of the common stock may elect a majority of the board of directors. Therefore, a much smaller interest will control the business than would be necessary if all the stock issued voted alike. Second, preferred stock is often very useful in form- ing industrial consolidations. As we shall see in the study of these consolidations, they are usually capitalized for a great deal more than the combined capitalization of their subsidiary companies. Ordinarily the extra capitalization, which represents prospects, takes the form C— VI— 6 .■/T// 82 CORPORATION FINANCE rf i.ii of common stock, and the present value of the plants and businesses absorbed is represented by bonds and preferred stock. The subsidiary company stockholders are much more inclined to exchange their common stock for preferred stock in the consolidation than they would be to exchange for common stock. If the sub- sidiary businesses have been successful and profitable it is reasonable to expect that dividends on the preferred stock can be paid, whereas nobody can foresee whether common dividends will be paid or not. The third purpose of preferred stock is to facilitate the incorporation of a business which has been conducted as a partnership. In a partnership each partner has as much say with regard to affairs as any other partner, irrespective of the extent of his interest. It is true that in practice the senior partner usually controls, but in law they are all on the same footing. They may desire to preserve the same arrangement in the corporation, in which case they may create a non-voting common stock and assign that stock to each partner in proportion to his interest in the partnership and in addition may make a voting preferred stock, of which each partner receives an equal amount. In this case it is possible that the so- called preferred stock may have preference in nothing except voting power. Fourth, preferred stock obviously may attract con- servative investors who would not care to buy the more speculative common stock of a corporation. Preferred stock, in point of security, ranks between the lower grades of bonds, which are described in succeeding chap- ters, and common stock. The preferred stock of indus- trial corporations, on account of their fluctuating earn- ings, usually sells at much better prices than the common stock of the same corporations, even though the common CORPORATE STOCK »» stock may receive on the average as large or larger dividends. , .„ , . -j^ Sometimes a certain amount of stock will be set aside at the organization of a corporation and given voting power, which right is denied to all the other stock. In such a case the corporation has in existence two classes of stock, "voting" and "non-voting." This is not at all a .ommon arrangement and is rarely, if ever, adopted ex- cept when a partnership business is put into the corpo- rate form. It amounts to the same thing as creating preferred stock with the preference confined to the privi- lege of voting. , 49. Cumulative voting. -OvigmaWy the universal cus- tom as to the voting power of corporate stock was to give ore vote to each share. The custom is still general, at least so far as common stock is concerned but is no longer universal. Certain important modifications of the custom, which have become more and more popular, should be noted. . -u i. •* The chief objection to ths origmal custom is that it puts the control of the corporation absolutely m the hands of the owners of the majority of the stock. Under this custom they elect, not merely the majority, but all of the members of the board of directors. Hence the minority stockholders may find themselves unrepre- Tented and absolutely powerless. This is unfortunately the condition of the minority in almost all American corporations. . In order to provide to some extent against this ac- knowledged evil and the abuses which are likely to fol- low, it is very common in England to restrict the number of ;otes allowed to any one stockholder. Thus a man with ten shares or less may be allowed one vote for each share ; for each additional share up to twenty he may get 84 CORPORATION FINANCE If t, ir. #1! only one-half of a vote ; for each additional share up to forty he may get only one-quarter of a vote, and so on. As each company prescribes in its by-laws its own rules as to voting, there are naturally a great many variations of this arrangement. The object evidently is to give the great body of small stockholders a voice in the manage- ment of the company and to make it impossible for any individual or small clique to gain absolute control with- out owning all or nearly all the capital stock. At first glance this arrangement seems admirable. It would be so easy, however, for a large stockholder to have his stock transferred in small lots to various employees and members of his family, and thus retain full voting power for that stock, that it is certain that the principle could never be made to work effectively under American con- ditions. The only reason that it is moderately success- ful in England is that stock is o i the whole more widely scattered and held in smaller lo':s than in this country. A far more effective method of attaining the same end is "cumulative voting." Under this method each share has as many votes in electing directors as the num- ber of directors to be chosen. These votes may be scattered among the nominees or concentrated on one or two of them as the stockholder sees fit. The eftect is to make it impossible for a majority to elect all the board; the minority at least secures representation. To illustrate the working of this method, take a cor- poration in which tliere are lOOC voting shares and five members of the board of directors to be elected; each share, then, is entitled to five votes. We will suppose that there is an organized majority of 550 shares and an organized minority of 450 shares. Under the usual ar- rangement a majority vote would be cast for five nom- inees, all of which would represent the majority stock- CORPORATE STOCK 85 lioldcs, u Under the cumjJative voting system, however, oaci '-re having five votes, the majority would cast altogether 2,750 votes and the minority 2,250. The majority could safely give 91G 2-3 votes to each of tliree nominees and thus elect a majority of the board, leaving tlie other two directors to be elected by the 2.250 votes of tlie minority. But if the majority should attempt to elect four directors they could give only 6871/2 votes to each of the four, whereas the minority, if well organized, could concentrate their votes on three directors and give each one 750 votes, thereby electing a majority of the board. To make the system and its possibilities per- fectly clear, it would be well for each reader to construct mentally a number of similar hypotl ^tical cases and to observe how readily a minority under this system may secure control of the board of directors, if the majority stockholders are too greedy. Cumulative voting is an ingenious and generally a highly desirable method of conducting corporate elec- tions. As was stated once before, the constitution of Pennsylvania contains a clause requiring that all corpo- rations organized under the laws of that state shall con- duct their elections by the cumulative voting method. Opinions may differ as to the propriety of includmg snnh a provision in a state constitution. There can hardly be a doubt, however, as to the wisdom of putting it into the charters of most corporations. 50. Voting trusts.— Another method of protecting the interests of minority stockholders and of the creditors of a corporation is the formation of a voting trust, i his is an agreement under which a majority of the voting stock of a corporation is placed in the hands of trustees who are authorized to vote it under whatever limitations may be prescribed. The trustees usually issue m return 86 CORPORATION FINANCE if :| I for the stock so deposited "voting trust certificates," which certify that the stock is held in trust by the trus- tees and which may be sold and transferred in the same manner as certificates of stock. As the trustees are usually men of high standing who are under instructions to vote the stock for certain officials or in behalf of cer- tain measures, the minority stockholders may safely feel that so long as the agreement exists no radical change in the policy of the corporation can take place, and the rights of all stockholders alike will be respected. A voting trust agreement which seriously restricts the freedom of the majority stockholders of a corporation is, of course, not likely to be acceptable to those stock- holders. The agreement, therefore, as might be ex- pected, is not often made except under strong pressure. It is most frequently used either when a corporation is first formed and can secure additional capital on no other terms; or when a corporation is in financial difficulties and its creditors are in a position to demand that the management be intrusted to certain men and that a well- defined policy be pursued. 61. History of a large Canadian holding company. — The most notable example of recent years of the forma- tion of a holding company in Canada was that of the Dominion Steel and Coal Corporation, Limited. This concern was incorporated, issued new stock, and them controlled both the Dominion Iron and Steel Company and the Dominion Coal Company, formerly separate corporations. The history of this transaction is interest- ing and illustrates many of the principles enunciated in this volume. It is necessary to consider it briefly, as leading up to the foundation of a holding company to control two corporations which were previously fighting in the law courts. CORrORATE STOCK 87 Dominion Coal Company was incorporated and began ""oSon^irand SUel Company was organi^d i„ mTrny directors being also directors of the coal Teel'company erected works and began to operate '" S Company entered into contract with Coal Com- nanv for supply of coal at $1.20 per ton. ■^ Steel Company took lease of Coal Company m 1902. • ;„,lv rental of $1,600,000 and royalty of lo S^r t^ <-. U ll nJn;d exceeding 8 500,000 tons. "teaCtermTnated in 1903. and Coal Company as- sumed full control of its own property. Ccl Company agreed on October ^O.^^^^J^'^^ nish Steel Company with all coal required at $1.24 per ton, with four cents per ton for use of ca«. Steel Company, having choice, asked tor cod from ^ Tte rZ^nt to Stee. Company and found to conUin too Lh gr^e of sulphur for steel manu acture was r^eafd a^d frequently taken back by Coal Company. St^ Company notified Coal Company that coal was TtS'company agreed to accept without preju^« ,0 rights under contract. 75 tons per day of rejert^ coal. Proposal was agreed to by Coal Company and the ar- ranjtement continued for some months. C»T Company in 1905-6 failed to supply the Ml coal requirements of the Steel Company, except m wm- '"s^fcompany notified Coal Company on March 80 ,905>.tt^«u« of increased work 80,000 tons of coal would be required in April. 1906. 88 CORPOKATIOX FINAxVCE mn Coal Company replied: "We shall endeavor to pre- pare to meet your increased requirements." Steel Company gave notice on April 30, 1906, of 80,000 tons of coal for August, September and October, 1906, respectively. Coal Company supplied only 58,270, 50,525 and 62,- 618 tons respectively. Steel Company was compelled to purchase 19,000 tons elsewhere to operate works. Steel Company having agreed to accept without prejudice to contract rights, slack coal and banked coal, so as to receive sufficient coal, and Coal Company failing to deliver right quantity. Steel Company notified they would not accept any coal except from Phelan seam, which coal was satisfactory. After November 1, 1906, Coal Company's cars sent to Steel Company were labelled "Run of Mine, Phelan Seam," while previously cars were labelled indicating pit from which coal was taken. Steel Company analyst was thus compelled to ana- lyze coal, and found much of it unfit for steel manufac- turing. Sleel Company rejected this coal. Coal Company gave notice of termination of contract on ground that Steel Company had made a breach by refusing the coal. Steel Company closed woi-':s about November 9, 1906, until coal could be procured elsewhere. A temporary contract was made between Steel and Coal Companies for supply of coal at a price much higher than that specified in contract of October 20, 1908. Judge Longley decided dispute in favor of Steel Com- pany on September 10, 1907. Coal Company lodged appeal with Privy Council. CORPORATE STOCK 89 Coal and Steel interests met in Toronto to endeavor to arrange a settlement, April 15, 1908. December 1, consolidated appeal of the Dominion Coal Company opened before judicial committee of Privy Council. Privy Council gave judgment in favor of the Steel Company. The conclusion of the Privy Council's decision reads: Inasmuch, however, as according to their Lordships' view, this is not a contract of which, on the authorities cited, specific performance woiSd be decreed by a court of equity, the plain- tiffs arc entitled, owing to a wrongful repudiation of the con- tract by the defendants, to treat the contract itself as at an end, and recover damages for the loss of it, in addition to damages in respect of those breaches of it which may have been committed before repudiation, namely, to the 31st of October, 1906. A proper reference should, their Lordships think, be directed to ascertain these damages. Their Lordships there- fore humbly advise that the judgment of the Supreme Court be affirmed, and that the case should be remitted to the court to have the damages under the two heads above mentioned assessed in the usual way, the appellants to pay the costs of tlie principal appeal. No order as to costs or the cross appeal. Judge liongley of the Supreme Court of Nova Scotia ruled, it will be remembered, that the old contract was unbroken; that the Coal Company must perform the contract, a referee to be appointed to assess the damages payable by the Coal Company; that the damages should iiidude all the amounts the Steel Company had paid for coal over and above $1.24 a ton: that the coal supplied from No. 6 mine was unfit for the uses of the Steel Com- pany: that if the Coal Company attempted to evade l)crformance of the contract, the court had power to ap- ])oint a receiver. 90 CORPORATION FINANCE 6 i 5J H h: The Steel Company was entitled to damages for the loss of its contract with the Coal Company and to dam- ages for breaches of the contract before repudiation by Coal Company. The Steel Company's claim of dam- ages against the Coal Company up to May 31, 1909, was as follows: Paid for extra cost of coal purchased from l")oininion Coal Company $1,847,550.18 Pav'. for extra cost of coal purchased from others 465,005.76 Damages due to short deliveries in August, September and October, 1906 132,252.75 Damages due to cessation of deliveries in No- vember, 1906 (estimated) 479,000.00 $2,928,808.69 The Privy Council, in London, England, the final court of appeal, in February, 1909, gave judgment in favor of the Steel Company. So far as legal rulings were concerned, the case was at an end. The next thing known to the public was that after this lengthy corporation battle, the two companies pro- posed to unite interests, a very sensible decision. Mr. James Ross, president of the Coal Company, agreed to sell to a syndicate 50,000 shares of Dominion Coal com- mon stock at $95 per share. Thus he made his exit. Other shareholders who desired were given an opportu- nity to sell their coal holdings on the same terms. Of that price, $25 per share was payable in cash within thirty days and ten instalments of $7 each per share at intervals of three months during a period of two and a half years, with interest at the rate of 4V^ per cent, payable quarterly. This paved the way for those share- CORPORATE STOCK 91 liolders who did not desire to remain as shareholders under control of the new holding comptiay. Compara- tively few holders sold their shares. There then remained the question of the union of the companies. After the formation of the Dominion Steel and Coal Corporation, the holding company, it was agreed that Steel and Coal shares should go in on the slnie basis, holders of either having the privilege of ex- changing them for an equal number in the new concern. A payment of $4 in cash was made to the holders of each share, in amounts of $1, payable quarterly, beginnmg July 1, 1910. This payment in cash was equivalent to a dividend of 4 per cent per annum for one year, and while forming part of the purchase price, was in- tended to obviate any call on either company for divi- dends until the coal strike and its effects had passed away, and the new plant of the Steel Company was com- pleted. The surplus earnmgs meantime were used to strengthen the financial position of the two companies and, so far as they were used for permanent improve- ments, lessened the amount of securities they might otherwise issue. So did two warring corporations be- come united in peaceful industry. The total capital of the new company remained the same as the aggregate capital of the two individual com- I)anies. Here is a table showing the amount of the out- standing securities of the two companies as at Decem- l)er 20, 1909: Authorized Common Pfd. 7% Bonds 6% Dominion Iron & Steel .. $20,000,000 $5,000,000 $20,000,000 Dominion Coal Co 13,000,000 3,000,000 7,500,000 Total $85,000,000 $8,000,000 $27,500,000 92 CORPORATION FINANCE Outstanding Securities Dominion Iron & Steel. .$20,000,000 .$5,000,00C $18,000,000 Dominion Coal 15,000,000 3,000,000 6,175,000 Total $35,000^000" $8^00o7)00 $24,429,000 The second mortgage bonds have been retired, and at the beginning of 1910, out of the $8,000,000 authorized issue of first mortgage 5 per cent bonds, only $7,414,- 000 were outstanding. The company had issued $10,- 840,000 of its twenty million authorized consolidated bonds. The official announcement of the arrangement and damage settlement was made in the few words following by Mr. J. H. Plummer, president of the Steel Com- pany, and now president of the holding company, the Dominion Steel and Coal Corporation: In December last your directors found themselves in a posi- tion to acquire at par 50,000 shares of the common stock of the Dominion Coal Company, Limited, under circumstances which in their opinion made their purchase a great advantage to the company. The purchase was accordingly completed, and your directors have agreed to exchange the shares for shares in the Dominion Steel and Coal Corporation, Limited. By the formation of this corporation, the interests of the Coal and Steel Companies are practically merged, to their common advantage. Following on the purchase of the shares, several of your directors joined the board of the Coal Company, and the presi- dent and general manager of this company became president and general manager of the Coal Company as well. The outstanding claim against the Coal Company for dam- ages, on account of which .$2,750,000 was received in March, 1909, has been settled by payment of a further sum of $800,000. This payment covers, in addition to the damages, several other claims which have been in dispute for many years, and operates as a settlement of all outstanding accounts between the two companies. CHAPTER VI TYPES OF BUSINESS CORPORATIONS 52. Further classification of corporations.— So far, our only classification of corporations has been into the two groups, stock and non-stock. The non-stock cor- poration, as has been said, is adapted only for govern- mental, social, eleemosynary, educational or religious in- stitutions, and not to business concerns, the prime reason being that the absence of stock leaves no machinery for obtaining capital, except borrowing, or for distributing profits. We have, therefore, dismissed the non-stock corporations as being altogether outside the scope of this volume. Stock corporations may be further classified as quasi- public and private. Quasi-public corporations are those which perform a service for the whole community for the sake of profits to the owners of the corporation. The most conspicuous examples are steam and electric rail- roads, water companies, gas and electric light companies and telephone and telegraph companies. Quasi-public corporations are granted special franchises and powers, such, for instance, as the right of eminent domain, and, on the other hand, are peculiarly subject to legislative control. Private corporations are those which carry on imy business, such as manufacturing, trading, and so on, without having any special franchise, entirely for the sake of profits to their owners. The great majority of corporations belong in this second classification. We may further classify this last group on the basis 93 94 CORPORATION FINANCE t if of number of owners into "close" and "open" corpora- tions. Close corporations are those in which the shares of stock are held by a very small number of people who do not expect to transfer them. Such corporations are not much in the public eye, since their affairs are of interest to only a few individuals. Frequently a "family business," which has been organized as a kind of loose partnership for many years, is turned into a corporation and none but members of the family are stockholders in the corporation. Sometimes estates are put by execu- tors into the corporate form for ease in transferring in- terests and in making the complicated adjustments at- tendant upon the settlement of a large estate. These are typical instances of the close corporation. By an open corporation is meant one, the shares of which are held by a considerable number of individuals and are traded in more or less. It is called open because anyone who has the money may readDy buy some of its shares. Most business corporations belong in this class. We shall have occasion frequently in this volume to refer to both "large" and "small" corporations. These words, of course, have no absolute meaning; yet in con- nection with corporations a fairly definite distinction between them may be drawn. Generally speaking, when large corporations are mentioned we shall have in mind the companies which operate several different plants or rail lines, particularly the big railroad consolidations and industrial trusts. A corporation which has only one plant, even though it be of considerable importance in its own commimity, for our purpose may be put into the class of small or local corporations. Two types of business corporations that are both prominent and important in present-day mdustry are the parent company and the holding company. These two TYPES OF BUSINESS CORPORATION 95 types are frequently, even usually, confused, although tiie distinction between them should be kept in view. 53. The parent company.^A parent company is one that for some reason does not desire to carry on opera- tions in its own name over the whqje country, and which therefore organizes and holds all or nearly all the stock of one or more subordinate companies. There may be several reasons for so doing. The parent company may wish to operate in other countries than the United States, in which case it will obviously be necessary to form a separate corporation in each country. Several English companies, for instance, have subordinate com- panies in this country and a great many American companies have British subordinate corporations. An- other reason for this method of organization is to avoid excessive local taxation. As the capitalization of each of the subordinate corporations may be low, and as the parent company is not officially known to the authorities of the states in which the sub-companies are located, the taxes paid to these states are by this means much re- duced. Another frequent reason is that it is desirable to have local men in charge of various plants of the corporation and to give these men a stock interest, not in the corporation as a whole, but in the branch under their control. This is best accomplished by the organiza- tion of a subordinate company at each branch. Obvi- ously a parent company is also a holding company in the sense that it owns the stock of other corporations; but these subordinate companies have been created by its officers in its interest, and are in reality simply forms in which sections of its business are organized. 54. Nature of a holding company.— A holding com- pany proper, on the other hand, using the term in a financial, not a legal, sense, comes into existence for the 96 CORPORATION FINANCE i ' f f : i, M if >■■■: purpose of buying control of pre-existing companies. Its ostensible object is the buying of securities of other corporations to be held for whatever revenues they will produce. The real object of its existence, however, is not accomplished unless it holds control of all its sub- sidiary companies and directs their operations. Some- times this control consists in holding a bare majority of the voting stock of the subsidiary; but it is generally advisable to secure as much stock as possible, for the greater the extent of the control, tlie more readily may the holding company carry out its plans to achieve economies and fix prices. As we shall see in our later discussions of industrial combinations, the process of economizing frequently involves loss to one or more of the subsidiary companies; that is to say, production is often concentrated in the best plants and the poor plants are allowed to fall into decay. If there is a considerable minority interest in any of these poorly equipped sub- sidiary companies, there will inevitably be s' g objec- tions and legal obstacles to the plans of . i holding company. It is also to the holding company's interest to own as much as it can get of the stock of those sub- sidiary companies the business and profits of which it intends to expand. Thus a holding company almost always aims to be- come practically the sole stockholder in its subsidiary companies, so that it may operate their properties un- hindered. Although in theory it merely holds securities, in practice it is the virtual owner of the railroads, the mines, the plants and the other property of its subsid- iaries. We see an expression of this dual relation, the nominal and the virtual, in the reports of almost all hold- ing companies. In these reports we almost always find two balance sheets and two income statements. The TYPES OF BUSINESS CORPORATION 97 first balance sheet shows as assets of the holding com- pany simply the securities in its treasury and the first income statement reports merely the dividends and in- terest received on those securities; the second balance sheet— usually called "consolidated" or "general"— shows as assets the physical property of the subsidiary companies and the second income statement shows their combined profits. A lack of knowledge of these simple facts has frequently caused confusion in the minds even of stockholders of holding companies, many of whom do not understand the status of their own company. 55. l^he holding company as a means of organizing "trusts"— The holding company is the method now used ill organizing those vast industrial and railroad consoli- dations that are called trusts. Two former methods of forming such combinations were pools and trusts — ^this word being used in this instance not in its popular, but in its legal sense. The pool is a more or less formal agreement among manufacturers of any given com- modity to limit production and to maintain prices; sometimes this agreement includes the organization of a central selling agency through which all the manufac- turers dispose of their product. Trusts— in the legal sense— worked on a different principle; the holders of the voting securities of competing companies turned over at least a majority interest in each company to one man or a small group of men to hold in trust, and received in return what were known as trust certificates. In other words, a single voting trust for a number of competing companies was formed. The trustees had power to vote all the stock in their possession and thus exercise control over the policies of competing companies. Pools proved to be unworkable and trusts illegal, for reasons which it belongs to the science of economics rather than to corpo- C— VI— 7 98 CORPORATION FINANCE l ! 1 I I fi si i ration finance to discuss, and both have been giv3n up in favor of the modern form of combination, the holding company. The holding company was first made possible in 1889 by an amendment to the corporation law of the State of New Jersey, which reads as follows : Any corporation may purchase, hold, sell, assign, transfer, mortgage, pledge, or otherwise dispose of the shares of the cap- ital stock of, or of any bonds, securities, or evidences of indebt- edness created by any other corporation or corporations of this or any other state, and while owner of said stock may exercise all the rights, powers, and privileges of ownership, including the right to vote thereon. Professor Edward Sherwood Meade, of the Univer- sity of Pennsylvania, includes in his valuable work on Trust Finance some remarks as to the meaning and results of this Act which are of such interest and impor- tance that they are presented below in full : For momentous consequences, this statute of New Jersey is hardly to be equaled in the annals of legislation. Sixteen sovereign states had passed searching and stringent laws in prohibition of any attempt to restrict competition ; laws whose detailed minuteness of specification could hardly be improved upon ; which had been proved effective against the only perma- nent form of competition regulation yet attempted, and which undoubtedly represented the conviction of a majority of the people of the United States — a conviction finding more general and authoritative expression in the Sherman Anti-trust Law, and strengthened by the anti-monopoly provisions of the com- mon law ; a well-nigh unanimous sentiment opposed to any form of trust or pool ; and the little State of New Jersey, containing two per cent of the population and one and three-tenths per cent of the wealth of the United States, by the simple act of amending its corporation law, nullified the anti-trust laws of every state which had passed t em. TYPES OF BUSINESS CORPORATION po A trust could not exist in New York. The courts of New York would not allow the creation of a holding company to perpetuate the trust under another and slightly different form. Here are, say ten corporations, all located in New York, which were formerly engaged in competition, later organized into a trust, and more recently dissolved by the New York courts. Tlie owners of these corporations, having experienced the bene- fits of combination, wish to continue their organization under another form. They apply to the New York Legislature for permission to charter a new company which shall purchase all their stock, and whose officers can thus control their united policy. The Legislature refuses the application on the ground that the new corporation would be the old trust under a new name, and wonld therefore be existing in violation of the same law which had been recently employed against its predecessor. The case of the stockholders seems hopeless. They are citizens of New York. Their corporations are chartered by New York. New York absolutely forbids them to combine in restraint of trade. What are they to do? In despair they turn their eyes southward. There, upon the other side of the North River stands the State of New Jersey, beckoning them with welcoming hands. For a franchise bonus or fee, New Jersey will come to their assistance. New Jersey will authorize them to form a corporation which is empowered to buy the stocks of their ten companies. New Jersey will allow them, as a New Jersey corporation, to perfect the combination in New York — for operation in New York — which the laws of New York absolutely forbid. New Jersey will thus deprive the State of New York of the right to control, in the interests of what her Legislature considers to be public policy, the corpora- tions which New York has created and over which it assumes sovereign power. New Jersey will perform a similar office for any body of individuals who may wish to evade the anti-trust laws of any State in the Union. As a New Jersey corporation, they may combine and coalesce for the operation of any num- ber of competing plants, anywhere in the United States, with none to molest or make them afraid. 100 CORPORATION FINANCE |- This quotation is not intended to give the impression that holding companies are necessarily formed in every instance for unlawful or harmful purposes. On the contrary, the writer wishes to record here his conviction that some form of industrial and railroad combination under present conditions in this country is both inevita- ble and desirable. It is inev itable because by means of combination production as a rule can be carried on more cheaply than would otherwise be possible; it is desirable because through the working of economic forces the advantages gained by this cheapness of production will be distributed in the long run among all classes. To defend and illustrate this proposition would lead us too far away from our main subject. The statement is worth bearing in mind, however, especially by those persons who are prone to join in thoughtless outcry against the "trusts." 56. Complexity of holding companies. — Holding companies may be formed, not only to acquire stock of operating companies, but also to obtain control of other holding companies; then there is no reason, of course, why the stock of the second holding company should not be purchased sooner or later by a third still greater hold- ing company. Thus there may be built up a most intricate and extensive oi ganization, in which so many companies may be involved that it becomes a difficult matter to trace their relations to each other. Many ex- amples, each of which would require considerable expla- nation, might be given. The reader will get a sufficiently clear idea, however, as to how complex organizations of this kind are built up if he will study the accompany- ing chart of the Intcrborough-Metropolitan Company, which was prepared for the Public Service Commission of the First District of the State of New York. The TYPES OF BUSINESS CORPORATION 101 Interborough-lSIetropolitan Company controls all the street car, elevated and subway railway lines in the prin- cipul boroughs of New York City. It was formed, as shown in the chart, by an exchange of its securities for the securities of two formerly competing companies, the Metropolitan Securities Company and the Interborough Kapid Transit Company. The relations of these two companies to each other, to their direct subsidiaries, and to the subsidiaries of their subsidiaries, are as clearly as possible presented in the chart. 57. Organization of the Standard Oil Company. —To illustrate further the extent, as well as the complexity, of the organization of a great holding company, there is presented below the most complete list ever published of the subsidiaries formerly controlled by the Standard Oil Company. The reader will find this list of value, not only for the present purpose, but for future refer- ence The Standard Oil Company of New Jersey was tlie "parent" of something over half of the subsidiaries shown in this list; it was a true holding company, in the sense in which that term has been defined in this chapter. so far as the other subsidiaries named were concerned. I COMPANIES WHOSE STOCK WAS OWNED niHECTLY BY THE STANDARD OIL COMPANY Total Per Ceni Capitnl Owned bji Stock. Standard. AnKlo-Amerionn Oil Co., Ltd ^^ ^^ Atlantic Reflnmg Co. ^^3 Hr-lford Petroleum Co ^^^^ ^^ l,,.rne-Scry.nserO.^^ •••••••• ^^ n,K-keye Pipe Line Co ^^,^^^^ ^^ (.rterOilCo ...^. ^^^ ^^^ (luseLrough Mfg. Co ^^^^^ ^^ i ..ntinrntnl Oa Co •■■ ^^^^^^^^ ^^ I wscent Pipe Line Co 102 CORPORATION' FINANCE Total Per Cent Capital Owned by Name. Stock. Standard. Clarksburg Light & Heat Co $100,000 51 Deutsch-Amcrikanische Petroleum Gesellschaft 2,i250,000 100 Deutsch-Anierikanlst'he Petroleum Gesellschaft (share warrants 5,350,000 99.9 Empire Refining Co 100,000 78.5 Enipreza Industrial de Petroiio 500,000 70 Eureka Pipe Line Co 5,' D,000 100 Forest Oil Co ? ? Gilbert & Barker Mfg. Co 40,000 100 Galena-Signal Oil Co., pfd 3,000,000 74.4 Galena-Signal Oil Co., com 8,000,000 70 Hazelwood Oil Co ? ? Hope Natural Gas Co 500,000 100 Indiana Pipe Line Co 1,000,000 100 Interstate Cooperage Co 300,000 100 Lawrence Natural Gas Co 450,000 100 Mahoning Gas Fuel Co 150,000 99.9 Marion Oil Co 100,000 50 Mountain State Gas Co 500,000 100 National Transit Co 35,455,300 99.9 New York Transit Co 5,000,000 100 Northern Pipe Line Co 4,000,000 100 Northwestern Ohio Natural Gas Co 3,775,350 59.4 Ohio Oil Co 10,000,000 99.9 People's Natural Gas Co 1,000,000 100 Pennsylvania Lubricating Co 50,000 60 Pittsburg Natural Gas Co 310,000 100 Komano-Americana 2,500,000 100 Reserve Gas Jo 3,335,000 60 RafRniTie Franvi; o 80,000 100 River Gas Co 190,000 53.e Solar Refining Co 500,000 99.8 Southern Pipe Line Co 10,000,000 100 South Peiin Oil Co 3,500,000 100 South W^st Pennsylvania Pipe Lines .1,^00,000 100 Standard Oil C«... California 17.000,000 99.9 Standard Oil Co., Indiana 1,000,000 99.9 Standard Oil Co., Iowa 1.000,000 100 Standard Oil Co., Kansas 1.000,000 99.9 Standard Oil Co., Kentucky 1,000,000 99.9 Standard Oil Co., Nebraska 600,000 99.9 Standard Oil Co.. New York 15,000,000 100 Standard Oil Co., Ohio 3,500,000 99.9 Swan & Finch Co 100,000 100 TYPES OF BUSINESS CORPORATION 103 Total Percent Capital Owned by Stock. Standard, yame. ^ 25 000 gg.g imlerhay Oil Co 3,500,000 99.9 inion Tank Line Co 2,500,000 100 Vmiuim Oil Co. ^jjQ,jOO 68.6 UMt.rs-Pierce Oil Co. . .^ ^ ^0 West India Oil Refining Co ^^^^ ^^ West Virginia Oil Co ^^^^ ^^^ West India Oil Co j^^^ 7j ^ Washington Oil Co II COMPANIES WHOSE STOCK WAS OWNED PRIMARILY BY SUBSIDIARY COMPANIES. A merikanische Petroleum Anlagen '^10^ 100 Automaat Co ,^^00 35 1 .schweiler Petroleum Import oooioOO 60 (liient Petroleum Co 'i^'oOO 100 I lollandsche Petroleum Vereemging . ... . . . . . • • • • • • • ' Mannheim Bremer Petroleum Actien Gesellschaft . . . . T50^ 100 ^ IVtrolifere Ghent ^^^',^00 iqo 1 Vtrollf ere Nationale ■■■■—- 3„,000 54.6 IVtroleum Raff, vorm August Korff... ^^^' ^^ Societe AnonymeH. ReithCo... 250 100 lUieinische Petrol. Actien Gesellschal ; ^ A.tien Ge.scllschaft Atlantic -^ ^^ 3 American Petroleum Co ^^ Street Tank Wagon Business-Duren ^♦'^ ^^ Gibraltar Petroleum Co •••-•• ' ^^ Imperial Oil Co., Ltd jJnnn HI 3 net Danske Petroleums Aktieselskab ^^^ * -^ .... 1 r»ii r-^ 20,000,000 »»•» Tidewater Oil Co : ' Qmnon 100 1 ank Storage and Carriage Co., Ltd., pfd 300.000 100 Tank Storage and Carriage Co., Ltd., orclinary «.^ 1^ S..deta Italio- Americana per Petrolio 1.000,000 W Aktieselskabct Ostlandskc Petrol. Cie 16-."00 ».» Krooks Petrol, og Olje Aktiebolag 270.000 10 Skanska Petroleums Aktiebolaget "*•»»» «" Svenska Petroleums Aktiebolaget ^^'"^ 'J Svdsvenska Petroleums Aktiebolaget 9»,M0 *♦.• Wcstkustens Petroleums Aktiebolag "7.W0 i».a Kocnlgsberger Hnndeln Compngnle «"•«» "•" l'.trolcum Import Compngnie • ""'"^ S. h wel«er5schc Petroleum HandeU Gesellschaft 60,000 60 T> i-„i.a 80,000 oo.a Societe Anonyme Petrolea ' Wachs. & Flossner Petrol. Ge9ell»ch.ft 2i.«» 100 104 CORPORATION FINANCE f,: ■J i I • >.; ■ i 1 ! Capital ^ame. Slock. Westphalische Petroleum Gesellschaft $ i?o,000 S. T. Baker Oil Co 50,000 Galena Oil Co.— Soci^t^ Anonyme Fran^aise 40,000 Queen City Oil Co., Ltd 200,000 Connecting Gas Co 8:35,000 Cumberland Pipe Line Co 1,000,000 East Ohio Gas Co «',00o',000 Franklin Pij)e Line Co 50,000 New Domain Oil and Gas Co 1,000,000 Prairie Oil and Gas Co loioOO^OOO St. Paul Petroleum Tank- (Lim.) 250,000 Societa Meridionale per Commercio del Petrolio 120,000 Societa per pli Olii Mineral! 156,000 Soeiet^ Tunsiemie des Petroles 80,000 International Oil Co., Ltd 2,750,000 Vacuum Oil Co., Pro|)rletary Limited .500,000 Vacuum Oil Co., Rcszvenytarsasag 2,100,000 Vacuum Oil Co., Limited 275,000 ^'acuum Oil Co.— .Socictc .\nonyrnc Franvaise 400,000 Deutsch— Vacuum Oil Co ((25,000 Vacuum Oil Co.— Societa .Anonyme Italiana 100.000 Vacuum Oil Co.— .Xktiebolag 27,000 Taylorstown Natural Gas Co 10,000 Totnl $229,963,195 Standard Oil Co. of New .Icrsey 98,.S:W300 Grand Total $328,301,495 Per Cent Owned bii Standard. 100 100 100 87.4 49.9 99.9 100 39 99.!) 100 55 52.1 65 99.4 100 100 99.9 100 100 100 96.(i 70 ii CHAPTER VII SOURCES OF CORPORATE FUNDS .)8. Summary of preceding chapters.— The first six chapters of this book cover those fundamental features „f corporation law which are essential to an understand- in., of the financial organization and management of corporations. We have taken up in turn among other topics: the advantages of corporations over other forms of conducting business; the legal powers of the corpora- tion; the charter; the by-laws; the duties, rights and privileges of stockh Iders; of directors; of officers; the process of incorporation ; tlie factors to consider in select- in.' the state of incorporation; the relative advantages aiul disadvantages of several states; the characteristics of common and preferred stock; the use of cumulative voting and of voting trusts; the nature of a close corpo- ration; of an ordinary operating company; of a parent con.panv; of a holding company. All of this matter, altliougii essential, is intended merely as an introduction to what follows. Our real subject is not the legal, but the financial, side of corporation practice, and this sub- i( ct we are now ready to take up. It must not be for- .„tten at anv stage of thi , study, however, that all finan- , ial measures must comply with and be in harmony with the legal principles that have been discussed. :)0. Four HonrccH of corporate fiintJs.—ln financing a (orporation the managers may go for funds to six dif- 1 1 rent sources, as follows: 105 106 CORPORATION FINANCE a ■ i. 4 H ' : *i ■ \ • *!' 1^- ■ > p (a) Active interests in the business (b) Profits of the business (e) Trade creditors (d) Banks (e) The investing? public ( f ) The speculative public. There is no need of discussing in detail methods of raising funds from peoj)le who are actively engaged in the management of the corporation. Each one presum- ably will be fully informed as to the records and pros- pects of the company and will regulate his investments accordingly. In the case of close corporations the proc- ess of raising funds is simply to allow each person interested to invest as nuich as he can and will on terms that are settled by direct bargaining. Profits that are not paid out from a surplus may be one of the most important soiu-ces of funds. The Carnegie Steel Company, as we shall see later, is a con- spicuous example. This particular topic is fully dis- cussed in later chapters and need only be mentioned here. It may not be plain at first sight that the trade cred- itors of a concern are in reality fimiishing part of the funds necessary to the business; but a moment's reflec- tion makes it evident that a company which continually carries, say, $10,000 of accounts payable, thereby makes that amount available for its business. If the trade cred- itors should demand cash for every purchase, the concern would have to raise the $10,000 from some other source. In some lines of business, especially retail, a very small investment is sufficient to carry on comparatively large operations simply because long-time payments are per- missible. Usually, however, the merchant or manufac- turer who buys on credit also sells on credit, in which SOURCES OF CORPORATE FUNDS 107 case the funds derived from trade creditors are promptly placed at the disposal of trade debtors. Of course, it is possible also that a business may draw its funds from the advance payments of the people who buy its products; but this is so unusual a case that it is hardly worth mentioning. Banks are institutions whose primary function is to furnish funds for commercial enterprises. Without going into the theory of banking, it may be pointed out that banks are dealers in credit. They buy the credit of other people in the form of notes and similar obliga- tions and they sell their own credit principally in the form of deposits. Any reader to whom this statement is not altogether clear may turn to the volume on Money AND Banking for further enlightenment. In order to make its credit good a bank must always be ready to re- deem promptly every check that may be presented to it for payment. Therefore, a well-managed bank will never tie up its assets in permanent investments, but will keep them always "liquid." For that reason the corpo- ration manager can look to banks only for short-time h)ans, usually not longer than ninety days. We will discuss the requirements of banks in detail in the next chapter. It is enough for the present to say that funds secured from banks will almost always be short-time h>ans in strictly limited amoimts backed by unquestion- able security. GO. The investing public as a source of funds. — The fifth source of funds is the investing public. This phrase covers, not only individuals, but institutions. The most important classes of investors are: (a) professional and salaried people who have no business of their own in which to place their savings; (b) women and minors wlio have inherited money; (c) estates held in trust; 108 CORPORATION FINANCE (d) savings institutions; (e) insurance companies, liusiness men are not investors in securities of other cor-, porations than those in which they are directly interested to any great extent, for the obvious reason that they are apt either to put their savings into their own concerns or to seek larger returns than are offered by strictly mvestment securities. One of the great problems of raising funds for many kinds of business is to arouse interest and inspire confi- dence in the investing public. They may be appealed to by advertisements and circular letters — a plan which is seldom successful; or they may be reached — usually with much better results — through bond and brokerage houses whose business it is to retail investment securities to their clients. This is another topic that will come up for later discussion. 61. Difference between investment and speculation. — This is a good place to define the words "investment" and "speculation." The former word, as it is used in a somewhat technical sense by the leading financial pa- pers, refers to a security or other property which is practically certain, so far as human minds can foresee, not to depreciate in value. No security in which the element of risk is prominent can properly be called an investment. If the probabilities are strong, but not con- clusive, that the security or property will not depreciate in value, then the terms semi-investment or semi-specu- lative may be applied. To illustrate, a United States Government bond is certainly an investment, and so is a first mortgage bond (in any of the standard railroads. Most of the industrial bonds, however, even where the earnings are large and the prospects apparently good, would be classed as semi-investments, because there is always danger that competition or some new invention SOURCES OF CORPORATE FUNDS 109 will cut into the business. In the same way high-grade preferred stocks of successful railroads and industrial companies would be called either semi-investment or semi-speculative issues. For our purposes in this book these finer distinctions are not necessary and would per- haps be confusing. We shall, therefore, use the word "investment" in a more popular sense to include the true investment and the semi-investment or semi-speculative securities. We may define it, in its objective sense, as any security or other property the principal of which seems safe and returns on which (interest, dividends or rent) seem certain. The great majority of corporate stocks would be classed as speculative; for no matter how promising they may be, conservative brokers would not in most cases be willing i^ call them safe. Calling a security "specula- tive," the reader should understand, is not necessarily condemning it or objecting to its sale. As a matter of fact, few corporations comparatively have anything but speculative securities to offer. Moreover, it is only by more or less speculative purchases that returns on capital above 5, 6 or 7 per cent may be obtained. Nearly all investment securities have been at one time specula- tive in character. When the terms "highly speculative" or "purely speculative" are used, however, it is generally saf'j to assume that the writer intends to convey the idea that the security in question has a very remote chance of ever getting into the investment class. 62. The speculative public as a source of funds. — The speculative public may be roughly subdivided into three groups: (a) ill-informed people who do not know the (liflPerence between an investment and a speculation and who are continually placing their hard-earned money in the hands of unscrupulous promoters in the blind faith 110 CORPORATION FINANCE 1 MA - ;. J \ ! I III I -I V: II s that they are making an investment; (b) intelligent business and professional men who buy and hold for a rise speculative securities and property in the full knowl- edge that they are taking chances; (c) speculators who buy securities and property "on margin" in the hope of making a quick and large profit. Group (a) may be reached by means of circular letters and advertising; group (b), generally by personal solicitation or through the stock-market; group (c), usually through the stock- market. A detailed discussion of the methods of reach- ing and interesting possible buyers of corporate securi- ties must be deferred. For the present our attention should be confined to the securities themselves. Corporate funds fall into two classes : borrowed funds and owned funds. The borrowed funds are secured through accounts and bills payable, through b^jpik leans or through bonds and mortgages. The owned funds are secured through issues of stock. 63. Desirahility of borroiving funds. — ^Why should a corporation borrow funds at all ? The reader will per- haps answer, as many people do, that it borrows from necessity; that as soon as possible it ought to pay off its debts, just as a man gets rid of the mortgage on his house as soon as he can. The fact is, however, that for a corporation to be out of debt is no credit to it, but rather a sign that it is either in a dangerous position or not intelligently managed. No method of raising funds is cheaper than borrowing, unless we include stealing. Therefore, a corporation should borrow as much as it can within the limits of safetv. To illustrate the desirability of borrowing part of the funds of a corporation : Suppose a manufacturing com- pany needs $100,000 to carry on its business and pro- duces an average net income of $6,000. If it raises the SOURCES OF CORPORATE FUNDS 111 whole $100,000 by stock issues, it will only pay 6 per cent dividends — not enough to compensate for the risks and uncertainties of the business. Now suppose that the company is dissolved and the same business is carried on under a new company which sells $50,000 of 5 per cent bonds, gets additional and larger credits to the extent of $10,000 and borrows $5,000 from bunks at an average rate of 5 per cent. Then, only $35,000 stock need be issued, the income of which, after deducting interest charges o^ $2,750, will be $3,250, or 9.3 per cent, a satisfactory return. Thomas L. Greene, author of "Corporation Finance,'* points out that a few years ago three-quarters of owned to one-quarter of borrowed funds was thought about right, whereas now the proportion in well-managed cor- porations is nearer one-quarter owned to three-quarters borrowed. The result has been to reduce the average rate of returns on capital and thereby to reduce cost of production and prices. In order to make profits at all under present conditions mercantile and manufacturing concerns must borrow heavily. Of course, there are limits to the safety and advantages of borrowing. On the following pages are given five recent balance sheets (Herring-Hall-Marvin Safe Company, Ameri- can Thread Company, Bethlehem Steel Corporation, A. Booth & Company, and Central Leather Company) selected practically at random, which will perhaps make these statements somewhat more vivid and concrete. Assuming that the balance sheet of the first-named concern is based on the actual value of the property (which is, to be sure, a pure assumption) we arrive at the real amount of funds utilized in the business by deducting from the total assets the item of "Pat- ents, good-will, etc., $290,000," leaving approximately h - f II 'i ' I \ I i if- 112 CORPORATION FINANCE HERRING-HALL-MARVIN SAFE CO. Assets: Real estate, plant, equip., &c $531,148 Pateuts, good-will, &c 290,000 Inventory 433,118 Cash, notes & accts. rec 219,617 Advances, prepayments, &c 14,834 Notes rec. discounteti 4,670 ToUl $1,493,387 Liabilities: Preferred stock $400,000 Common stock 700.000 Debenture notes 100,000 Accts. pay. & accrd. accts 60,950 Notes payable 155,949 Notes rec. discounted 4,670 Reserves 34,422 Surplus 37,396 ToUl ; $1,493,387 t i I mi P ill AMERICAN THREAD CO. Assets : Land, water, & steam power, mills, machinery, plant & eflfects $12,694,898 Stooks-in-trade at net cost 4,960,971 Accounts receival)le, net 1,016,445 Cash at bankers & in hand 341,483 Sundry investments 2:?9,840 Advance payments 39^.93 Total $19,281,927 9 Liabilities: . Com. stock ($...50 paid up) .«V1,200,000 6% Pfd. stock (fully paid) 4,890,475 4% 1st mtge. bonds 6,000,000 English Sew. Cot. Co. Ltd 351,164 Accounts payable 770,410 Bond int. accrued ^0,000 CORPORATE FUNDS AND CAPITALIZATION 113 Depreciation fund 9,076^7 Div. on com., payable July 588,000 Profit & loss 344,891 Total $19,28M27 BETHLEHEM STEEL CORPORATION Assets: Property account $72,891,695 Raw materials & supplies 4,919,590 Worked materials and contracts in progress, less bills rendered on acct 5,487,144 Accts. & notes receivable 9,909,956 Miscellaneous investments 865,374 Special funds ■mth trustee 34,464 Cash 1,963,481 Deferred charges to operation 447,800 ToUl $95,589,300 Liabilities: Preferred stock $14,908,000 Common stock 14,864,000 Bonds & notes outstanding. 83,599,033 Notes payable 3,388,509 Accounts payable 6,459,314 Bond interest accrued 448,097 Coupons payable 435,710 Depreciation reserve 9,586,010 Reserves for relining furnaces, &c 390,069 Contingent reserve 4,413,050 Appropriated for additions & working capital 7,500,000 Unappropriated surplus 4,411,517 Total $96,599,300 A. BOOTH & CO. Assets: Cash »510,777 Merchandise 937,976 Accounts receivable 1,556,689 Bills receivable 930,560 Unexpired insurance, R. R. mileage, etc 119,4^'.8 Treasury preferred stock 20,800 Treasury comtnott stock 170,650 Plants, steamboats, real estate, etc 5,510,927 Total $9,757,827 C— VI— 8 t:.<.t!>4 si .; ■i ' lU CORPORATION FINANCE Liabilities : Common stocit $3,000,000 Preferred stocit 2,500,000 Surplus 1,523,700 Undivided profits 203,138 Accounts payable 931,989 Bills payable 1,601,000 Totel ?9,757,827 CENTR VL LEATHER CO. Assets: Property account $63,210,120 Investments 319,987 Leather & other finished products 9,995,527 Hides & leather, raw & iu process, &c 32,463,316 Accounts receivable 7,220,896 Bills receivable 448,747 Call loans & short time investments 5,632,274 Cash 1,777,227 Deferred charges 133,984 ToUl $121,211,078 Liabilities: Preferred stock $33,290,050 Common stock 30,701,030 First mortgage bonds 85,750,150 U. S. Leather debentures 12,000 Real estate mortgages 80,000 Foreign drafts 1,730,070 Accounts payable 1,021,283 Accrued interest 459,552 Ptd. dividend, payable Jan. 2 582,732 Com. dividend, payable Feb. 2 793,000 Reserves 1,333,475 Surplus 6,437,828 Totd $121,21 1.078 CORPORATE FUNDS AND CAPITALIZATION 115 Tlie borrowings including bonds, bills payable and accounts payable, are approximately $317,000, or some- thing over 27 per cent of funds. To arrive at the actual funds utilized in the property „f the American Thread Company we should deduct from the $19,281,000 assets the depreciation fund of s> 076,000. Of the total funds, approximately $17,- •'00,000, about $7,750,000 is borrowed (including bonds. ,kl,ts to stock- and bond-holders and to English Sew- lujy Cotton Co., and accounts payable). The per- centage of borrowing is 45. Deducting reserves for depreciation we find funds of the Bethlehem Steel Company to be approximate y ^80,000,000. Borrowings are about $44,000,000 or 45 per cent. In the case of A. Booth & Company there are funds of about $9,750,000 and borrowings of $2,500,000, or •'-, 6 per cent. As the firm failed in September, 1908, this low percentage of borrowing tends to confirm what has already been said, to the effect that abnormally small borrowings indicate either a weak or a misman- ajjcd company. In estimating funds in the Central Leather Company, it would not be improper to deduct the item of invest- ment, although it is not large enough to make any ma- terial difference. This leaves actual funds of approxi- mately $121,000,000, ar • t borrowings of $20,800,000, about 80 per cent. It goes without saving that this analysis of the five balance sheets is superficial and that the results are merely suggestive. To ascertain the exact proi>ortion of Wowed to owned funds in each case we should have iust to learn the exact, not the nominal, value of the 116 CORPORATION FLNANCE '£■' iff i 11 t| r^i assets, which is an impracticable task. As it is reason- ably certain that the cost in every case is less than the book value of the assets, the true percentages of bor- rowed to owned funds are in all probability greater than the ligures given. Four out of these five corporations no doubt borrow more than half the funds they use. Other well-managed companies follow the same prin- ciple. 64. Distribution of security issues. — The next ques- tion to consider is: What issues of securities or credit instruments should a corporation put out and what pro- portion of its total funds should be obtained by each of these issues? In order to raise fund« from each of the four sources outside the business itself named above, the corporation manager will offer: SOURCES SECURITH (a) To trade creditors Bills and notes p. able (b) To banks Notes payable and en- dorsed notes receivable (c) To the investing pub- Mortgage bonds a» i per- lic haps preferred stock (d) To the speculative public Stock. The amount of each security offered will depend in part on the assets and in part on the earnings of the corpo- ration. Corporate assets in nearly every line of business fall naturally into six groups, as follows: (a) Fixed investments essential to the business, such as real estate, buildings and machinery and, in the case of holding companies, securities of subsidiary corpo- rations. SOURCES OF CORrORATE FUNDS 117 (b) Property that could be sold without breaking up the business, though the sale would probably be at a mavy sacrifice, such as, outlying real estate, securities of other companies control of which is not essential to tlie integrity of the corporation, raw materials, and goods in process. (c) Finished products on hand. (d) Accounts receivable. (e) Cash. (f) Intangible assets, such as good-will, trade marks, etc. To the first five groups roughly correspond obliga- tions for borrowel money, as follows: (a) INIortgages and mortgage bonds obtainable as a rule on good terms up to 60 to 75 per cent of the appraised value of real estate; 50 per cent of build- iii; -: 11, ii communities are drawn to the monetary centers and there used as loans to underwriters, promoters and others engaged in the practice of high finance. But many of the large factories or industries located in suburban districts and country towns could not have been built unless the facilities for financing the under- writing operations had been available. Mr. White's question seemed to indicate that there is some difference of opinion among Canadian bankers as to whether the chartereu banks should engage extensively, in this way, in the promotion of new industrial companies. Wlien a Canadian bank participates in the flotation of a large issue of this kind, and the securities are taken at once by the public, it, in company with the other un- derwriters, receives the prearranged commission, without being under obligation to take up any of the securities. Even in that case the bank will very likely be obliged to make loans to brokers on security of tlie newly issued bonds. If the bank has the account of the promoters of the enterprise, it will probably be required to make ex- tensive loans to them prior to the public flotation. Some part of these loans would remain on the books after the flotation. This is what may be expected even when the flotation is entirely successful. Circumstances are not so comfortable for the bank when the issue is only a par- tial success; and they may be decidedly uncomfortable if the flotation proves to be a flat failure. When the public does not take the securities, the bank, as one of the underwriters, must take its proportion of the unsold securities. It may have to make loans to other under- writers to enable them to take up their loans also. When a broker or other financier enters an underwriting syn- dicate, he does not usually contemplate putting any of his own fimds or capital intr the venture, even if the flo- SOURCES OF CORrORATE FUNDS 121 tation proves to be a failure. He will eount upon bor- 1 owing the requisite amount from his bankers; and he ^^\\\ perhaps expect the bank to carry the loan until the syndicate succeeds in finally disposing of the issue. If tiie securities do not sell rapidly, the bank may have the underwriters' loans on its hands for long terms. They will not, perhaps, offer to reduce the loans— except as the securities are sold— and if the banker suggests re- ductions they may not receive his suggestion kindly. (17. How tJie Canadian hank makes loans to corpora- tions --The supervision of loans and credits by the Ca- nadian banks obviously involves great responsibility. We may explain here the system of one Canadian bank which has been successfully carried on for several years. The borrower is expected to have only one banker, or, if the account is very large and there are two or more hankers, there is a clear agreement as to their respective shares of the bank advances. A bank credit is never established for more than one year, and expires on a particular day. The manager in charge of the account is expected to arrange for its renewal before the date of (xi)iry. If this is not done, the account falls automatic- ally into the irregular class and is under the eye of the s.ij)erintendent's department until the credit is re-estab- lished. A new credit or the renewal of a credit will not Ik considered unless the balance sheet for the year is sub- itted, together with as full a statement of profit and ss as is obtainable. This procedure refers only to (1 edits involving direct advances not secured by securi- ties or by bills of other parties for merchandise sold. Wn^en the practice of demanding a balance sheet from every customer who desired direct loans was put into ..peration, it was said that it would not succeed. But it has been found that, no matter how wealthy the cus- nii los* 122 CORPORATION FINANCE ■ U .i t tomer may be, he can be induced to give his full con- fidence to the banker from whom he is, through his application for credit, asking practically the same thing. In lending funds for the entire requirements of a tim- ber business, for instance, where a large expenditure in the forest precedes extensive milling operations, sums are advanced, sometimes with no other security than the mere obligation of the customer. This would seem dan- gerous even to the conservative English banker. The basis for the credit may be mainly the expenditure of a bank over a series of years, during which every pay- ment out of the business and all receipts for merchan- dise sold pass through the bank account. Each year the balance sheet is presented, and many of its features can be roughly verified by the bank account itself. The branch manager is expected to revalue the items in the balance sheet and to analyze it so as to separate the liquid from the fixed assets. If the liquid capital— that is the surplus of liquid assets over the floating debts — is not sufficient to warrant the belief that once a year the loans will be paid in full, the credit requires, at least, unusual justification. There are some trades in which the payment of ad- vances once a year would not be wise or natural, but the bank authorities have been greatly surprised at the extent to which, in the past five or ten years, they have succeeded in establishing this as a most important factor in credits. 68. Bank loans and credits. — Sir Edmund Walker, president of the Canadian Bank of Commerce, in an address on Banking in Canada, before the London In- stitute of Bankers, said: Apart from the transactions in New YorV or at other points, whciP that portion of our reserves which may safely be placed SOURCES OF CORrORxVTE FUNDS 128 In call or on short loans on securities is carried, the Canadmn banking business is more closely akin to tlie banking of the .,,ai„ary cities, towns and villages in England than to that of London. There are practically no acceptances by other banks or by wealthy merchants, against shipment of merchand.se to Canada, offered for discount. In the main it is a case of establishing a credit for the working of a particular busmess. 1 do not know what may be the opinion of outsiders regardmg the carefulness or otherwise with which the lending operations of Canadian banks are carried on. It is a time of great expan- sion and it might be natural to suppose that the requirements of customers would be vaguely considered and the relations Ixtween banker and customer ill-defined and sometimes beyond the control of the banker. Doubtless, there is a considerable percentage of bad banking in Canada, as in other countries, hut I doubt whether banks in any country are as a rule more explicit in the establishment of credits or do so upon more complete information. We are, fortunately, forbidden from lending on real prop- . rty, although it may be taken as security for an existing debt, and long experience has taught the Canadian banker to beware of advances which rest even partially upon the plant or buUd- i„ffs or any of the fixed assets of the borrower. In other countries such banking may be both safe and wise, but our policy is to lend by established credits only the money neces- sary to produce and carry the merchandise to market. Now, if a customer deals with only one bank, pays for all materials and labor in cash, makes all payments by checks on his bank, exhibits once a year his balance sheet and profits, and at the same time discusses at length the various features of his busi- ness for the purpose of having his credit re-established, it is not .Ufficult to lend him very large sums with safety. In addition to the analysis of the balance sheet, comparisons are made with several previous years, and as all correspondence is conducted on special forms with only one subject on each form, and every- thing is typewritten— the carbon copies of one side of the cor- respondence being filed with the originals of the other side— 124. CORPORATION' FINANCE t * ' - if \ : i i the banker can in a moment have before him in the correspond- ence and the analyzed balance sheet, practically all that he needs to know. All except the quite small credits are discussed with the boards of directors, and the system makes it possible to deal with a large number of credits at each sitting. The growth of the loans of the Canadian banks is shown by the following figures: 1867 $ 55,469,521 1870 78,095,144 1880 125,555,284. 1890 202,518,727 1900 362,004,795 1910 880,857,520 1912 881,331,981 f i CHAPTER VIII SHORT-TIME LOANS 69. Trade credit as a source of funds.— The preceding chapter named, without describing, the three forms m ^^ hich corporations incur short-term or medium-term ob- ligations, namely, trade credit, bank loans and notes sold to the public. We will now take up each of these forms ill turn and see what we can discover as to the principles tliat should govern their use. Readers of this volume who are themselves engaged in an unincorporated busi- ness will perhaps read what is said as to the first two forms named with a more lively interest if they reflect that the principles laid down apply to partnerships or to individual proprietorships as well as to corporations. The funds raised from the trade creditors of a cor- poration are secured simply by buying goods on credit. It is not customary in most lines of business to demand cash immediately on delivery of goods, except from concerns that are considered untrustworthy. Thirty (lavs is usually allowed before trade cr-ditors begm to press for payment and a company whose business is worth having can often considerably lengthen the aver- age time of settlement, if that policy proves desirable. In some lines-especially when the sales are m large lots— sixty to ninety days, or even six months, is the usual allowance. For sixty days or over the debtor company generally gives a formal promissory note or else accepts a time draft which amounts to about the same thing. 125 12G CORPORATION FINANCE ni As was indicated in Chapter VII, it is good business policy for a company to take as much trade credit as it can get on advantageous terms ar.^ with safety. These two qualifications are worth elaborating. A company does not obtain trade credit on advantageous terms: (a) when by so doing it acquires a reputation for "slow pay" which makes dealers imwilling to quote to the company their lowest prices; (b) when by so doing it loses the benefit of cash discounts larger than the pre- vailing discount on bank loans, — provided in this case that the company is not already borrowing as much as it should from banks. A company cannot accept trade credit with safety when by so doing its short-time lia- bilities are brought up nearly equal to its quick assets. Notice that the relation is not between total liabilities and total assets, but between quick liabilities and quick assets. A concern must have cash funds at hand to meet its accounts and bills payable when due and no other assets, no matter how valuable, will serve the pur- pose. A failure to realize just that simple fact has been responsible for many an unnecessary bankruptcy. Taking the five balance sheets previously referred to (see pages 112-114), we find: (1) That on the date of the balance sheet the quick liabilities of the Herring-Hall-Marvin Safe Company were about 100 per cent of quick assets and about 33 per cent of all the current assets, including stocks, work in process and materials. (2) That the corresponding percentages for the American Thread Company were .58 per cent and 18 per cent. (Current liabilities, including debt to English Sewing Cotton Company, in proportion to current assets, including stocks, investments and advance pay- ments.) SHORT-TIME LOANS 127 ( 3 ) That the corresponding percentages for the Beth- lehem Steel Company were 81 per cent and 42 per cent. (4) That the corresponding percentages for A. Booth and Company were 83 per cent and 64 per cent. (.3) That the corresponding percentages for the Central Leather Company were 34 per cent and 6 per cent. We may infer from these five representative balance sheets that a conservative company will not, as a rule, allow its accounts, bills and notes payable to run much ever 7.5 to 80 per cent of its quick assets. This per- centage is, in fact, not far from normal. It would be foolish to try to lay down any absolute rule where so much depends on the custom of each line of busmess, „n the seasons, on the nature of the company's assets, on the ease with which bank credits may be secured, and „n the general commercial outlook. Enough has been said to indicate that trade credit, though a necessity to nearly every successful corporation, may become too extensive. Further discussion of this important phase of corporation finance must be deferred imtil we begm a study of the financial ma gement of corporations. 70 What reliance should he placed on hanh loans?— Bank loans are not usually to be had except on first- class security and for short periods. Perhaps the best method of considering the advantages and disadvan- tages of bank loans will be to run over hastily the de- tailed statements which many conservative banks now require applicants for loans to file with them. A blank form of such statements, adopted by the New York State Bankers' Association, and widely used, is pre- sented on pages *8-lti9. Let us see how criticaUy a hanker will examine one of these statements when pre- sented by a corporation with which he is not thoroughly 128 COUPOUATION FINANCE O *-* H < OS O cu OS o O OS o H M H en •Li bt y a 3 •Z £ a : ."■Q l^^x: o • *C * ** :»5 = ••<» = . A at !» ■a. -=2 •M = c • USug ■ OO " w« ^ "^ •MS o n a -fl o « r « ** £ = §. s Of o n 1. S » M ■"a* - > "a „ ►• MS 02 C » « » ?2 T -r r J?< ■M — H> C3 w^ >> .i^ O m « « 5 5 .• • .• "■ C Q O O V ♦* O 0-5 s5 l s^ u * ? lis £ Eg 9 • • 5i •a e £ B It c t rt a •? : = C V 1 S a 3 Si e » 3 .a n 3 k. Si? a .- :!i * c a» « w — £-= s e B « ," r « a s • ■: £8 * I a « E^= = gc: : » £5 2SJ ;o3 8 SHORT-TIME LOANS 129 < < K K £ U H U M M O •"►•►* , M bi h h o o O O H H t O n Ck a *> la :- •'< 6 5 S « HUH C-VI-0 S 9 t n •a s a a a a ■o a * \ 130 CORPORATION FINANCE ■ I III % I familiar. Wliat is said on this point is largely based on an article by Mr. William Post, Cashier of the Central National Bank of Philadelphia, in The Journal of Accountancy, Volume 1, page 181. Take first the item, "notes receivable.'* In most lines of business notes are little given except by weak concerns, and a large amount of "notes receivable" out- standing, therefore, may indicate that a corporation has been in the habit of granting unsafe credits. Some of the principal lines in which note giving is still common are harvesting machines, plumbers' supplies and electric trolley supplies. Where notes are received to any con- siderable extent they are generally discoimted at once by well-managed corporations. Corporations which show a large figure under this heading of "notes re- ceivable," therefore, would be regarded by the banker with distrust. "Notes >»nd accounts receivable of officers," except in insignificant amounts, would naturally arouse suspi- cion. Ordinarily officers of corporations are expected to keep their personal obligations and the company funds entirely separate. The valuation of merchandise should be made by means of an expert's inventory. In connection with these items a careful banker will take into consideration the possibility of extensive fluctuations in value, partic- ularly in the case of staple articles such as pig iron, cotton, wool and metal. The other assets specified are not of immediate in- terest to the banker, because they will not ordinarily be sold to meet short-time obligations. They may be con- sidered, however, as a final protection to the banker in case the concern should go into bankruptcy. Mr. Post suggests, "that in estimating the value of SHORT-TIME LOANS 131 plants, a sharp distinction should be made between Ixiildings used for manufacturing and for merchandis- ing purposes. A business structure, conveniently lo- cated for trade, is a good asset. It is not adapted specially to any one purpose. Even if the business vliieh now occupies it should be withdrawn, it could be sold and applied to some other use. Its value can be easily appraised. The banker is justified, therefore, in placing a high net value upon such property when well locatetl. With the manufacturing plant, however, the situation is entirely different. The whole building is often specialized to some particular use: if the busi- ness fails, it is very difficult to apply the premises to otlier purposes." Machinery is even less salable, as a rule, than a manufacturing building. In general, a concern that is not making a success of its undertaking ^\ ill very seldom find buyers, except at a very heavy sacrifice, for its fixed assets. Turning to the liabilities, we have already laid down the rule that "notes payable" given for merchandise, except in the few lines of business specified above, are not required from first-class concerns. "The second and third items," says Mr. Post, "are distinguished in ortler to show how much paper a concern may have with its own banks and how much it may have negotiated through a note broker. It is quite important to the hanker to know how much paper a borrower has sold, as the saying is, 'on the street.' If he finds that the horrower is choking his bank account and at the same time putting a large amount of paper out into the open ni;irket, the ])nnker is likely to arrive at the conclusion Ticit the borrower is not keeping available any partic- ular resource or channel which he could utilize in case of a stringency in the money market. It is a fixed rule 132 CORPORATION FINANCE Ill h h .! i % #4 of financial management that a concern should not borrow largely at its bank and at the same time sell large amounts of its paper in the market. If the bank line is full, paper should not be upon the street ; if made largely for the street, then the bank should be kept open." "Accounts payable" is to be considered, of course, in contrast to "accounts receivable" and the propor- tions already mentioned in this chapter should be ob- served. Ordinarily only close corporations would have any deposits made with them by individuals. Wliere there are such deposits they would be regarded as a possible source of danger, since the persons who make them are r.pt to be in close touch with the management and to be informed of any impending trouble in time to protect themselves — possibly at the expense of the other creditors. Bond and mortgage debts should, of course, be pro- portioned to the fixed assets of the corporation. The mortgage should be very carefully examined in order to make sure that it does not cover more than the fixed assets. Sometimes a real estate mortgage will contain a clause making it a first lien also on the chattels or quick assets of the corporation. Chattel mortgages are unusual and do not often exist unless a corporation is already in serious straits. A large amoimt of contingent liabilities would be regarded as a weakness. Especially is this true of the item "other contingent liability," which refers to en- ? lacement by long-term securities bearing a lower rate of interest. Ca- nadian borrowers had shared in this class of financing, but by far the greatest proportion had been done by the United States railroads. It was feared, said Sir Edmund, that it would be some time before the market would be in a position to absorb, on a long-term basis, the huge accumulation which had taken place during the year. Besides the scarcity of money saved by investors, there was another difficulty in the shape of the nature of the security back of the loans. There are some misgiv- ings in the mind of the financial world of London as to the quality of the security. Discussing the problems of short-term loans, a con- tributor in The Financier and liulUonist, London, said that while the Canadian Northern Railway Company might be congratulated on the success of its issue of five per cent, five-year notes (referred to previously), the episode was decidedly significant of the monetary situation and the prospects with regard to future issues on somewhat the same lines. It was not impossible SHORT-TIME LOANS 145 tliat the decision of the Canadian Xorthem management to adopt this means of raising further capital may have been influenced by the example of a great number of railway and other undertakings in Great Britain and in the United States. The writer continues: There is much virtue in the redemption of securities within a moderate period and at a definite dat«, but, of course, short- term notes, as usually understood, are on quite a different plane. The device has to be regarded as appropriate for con- ditions which, though not altogether abnormal, may be said to bo unfavorable for the flotation of an ordinary issue. Indeed, the principal, if not the only reason, for any commercial under- taking resorting to this form of finance, is that capitalization by means of permanent obligation is impracticable or impos- sible. The borrower offers short-term bonds, either because he cannot get money at a profitable rate otherwise, or because he thinks that at the end of the term he would be likely to procure capital on a permanent basis at a lower rate of interest. Now British railway conipanics habitually issue short-term notes to tht ir bankers in connection with dividend payments and other obligations, but it would appear tolerably certain that any British railway company which proposed to adopt such a d. . ree to enable it to, say, build new stations, or provide other betterments to its property, would immediately find » difficulty. pi rhaps a non possumus, in the way. The fact is that banks in general are inclined to regard any such proposal exactly as one trader may regard a proposal bv anotlur who desires to strike a bargain. The very fact ti.at a companv needing money comes forward with a proposal of this sort indicates that there is a difficulty in raising money on permanent stock issued in the usual way. In other words, tli<. companv is in a position which has been brought abou»: partly, iHrh"a])s, by the condition of the money market and the curse of investment, and partly by some more or less obvious weakness In its own position. The proposal is that the bank O— VI— 10 146 CORPORATION FINANCE should advance so much capital at a lower rate than would have to be paid for it if an issue were ma('e to the public. In the case of a quite ephemeral requirement, such as that which arises in connection with dividend distributions, the se- curity which can be offered to the bank is so perfect that low terms are given without demur, but when a company wants capital to enlarge its operations, or to tide it over an awkward time, or to use it, in fact, in any fashion which involves ordi- nary commercial risks, then the bank looks at the whole affair from an entirely different standpoint. In such a case the bank manager may be supposed to say : "\Miy should I advance you this money for three or five y^ ^rs on easier terms than would satisfy the ordinary investor? If I take your notes, what am I to do with them? The ordinary investor would not look at them, and it is highly probable I shall have to either put them in the cellar for the whole term or dispose of them to other financial liouses, who would expect to nmke something out of their compliance. If you want money at this low rate of inter- est I expect very first class security. I see no reason why I should part with my commodity at less than its proper market value." Before the adoption of short-term financing' hy those interested in eorpo rat ions, serious consideration should be given to the need and the advisability therefor. CHAPTER IX THE CORPOUATE MORTGAGE 76. What determines the value of fixed assets? — Now we take up the long-time oMigations — especially mortgages and mortgage bonds — of corporations. Evi- dently they must be based on permanent, or fixed assets, and in amount will correspond roughly to the value of such assets. Here we meet with the difficult and important (jucstion, What determines the value of fixed assets? Most people would be inclined to say that the cost of the assets must determine their value. A moment's reflec- tion, however, shows this statement to be untrue. Sii[)pose, for instance, that a man has put up a plant at an expense of .$100,000 for refining copper, and after- wards discovers that there is no copper within hauling distance. The plant would not be worth the expense of demolishing it. On the other hand, suppose that he does put his plant in a rich copper country and secures such favorable contracts with the mine owners that he makes profits of $100,000 a year and may expect to con- tinue such profits for an indefinite period. His plant, in that case, could be sold for perhaps a million dollars. iM-idently cost of construction would have very little to do with the value of sudi assets. The second opinion is tint the value of fixed assets i^ determined by the expense of duplicating them. It is claimed, for instance, that to arrive at a fair valuation ..f the railroad property »f the United States, all we 147 148 CORPORATION FINANCE need to do is to figure how much it would cost to re- produce this property under present conditions. The illustration already used, however, would apply in criticism of this second opinion as well. The third opinion is that the value of fixed assets is determined by their earning power as in the above illustration. It takes no argument to show that this is actually the case in ordinary business practice. If you were going to buy anything in the nature of a fixed asset, from a university education to a steel mill, your first question as a business man would be. How much will this asset earn for me? Similarly, an investor in buying the securities of a corporation will inquire as to the value of the corporation's fixed assets, and will naturally estimate their value on the basis of earnings — not the present earnings altogether, but probable future earnings as well. Bear in mind that this principle that earnings de- termine value is applicable only to fixed assets. The selling value of floating assets, such as raw material, tools, finished goods on hand, is another matter. That will be determined, normally, as the science of economics explains, by cost of production. The difference arises from the fact that fixed assets — land, buildings, machinery — are not intended for sale, but for use. They generally have little or no value except for the purpose for which they were intended; and their value for their purpose can be determined only by their earn- ing power. We have already intimated without going into details that the amoimt of investors* securities which may be issued by any corporation depends both on the value of its fixed assets and on the amount of its income available for interest charges. There is no contradic- THE COnrORATE MORTGAGE 149 tion between these two considerations. At bottom the important factor on which to base bond issues of a going concern is the amount and stability of income. We bluill elaborate and emphasize this point a little later. 77. Nature of a mortgage bond.— The simplest method and the method most common among small cor- porations of borrowing long-time funds is by direct mortgage on the corporation's real property. An ordinary mortgage conveys "all right, title and interest" in a given piece of property to the mortgagee, with the proviso that the transfer is to become null and void in case principal and interest are paid as promised. Al- tliough the old common-law phrases, which would cause the whole property mortgaged to pass to the mortgagee in case of default, are generally retained in the mort- gage indenture, yet the mortgage is universally re- garded at law as in effect a lien. A simple corporate mortgage is in no important respect different from a mortgage by an individual or firm. Where large sums of money are to be raised by a mortgage, however, the procedure is not quite so simple. In such a case it is customary to offer mortgage bonds in conven-ent denominations to the public. As the property mortgaged is for all practical purposes in- divisible and as there are a large number of secured bondholders, it is impracticable to give a separate mort- gage with each bond. It becomes necessary, therefore, to give the mortgage to some individual or concern, acting as trustee for the bondholders, in which case the mortgage indenture becomes a deed of trust. Each l)ond is a simple promise to pay, its phrasing being more formal, however, than that of a note. It is executed under corporate seal and contains a reference to the indenture between the corporation and the trustee. A 150 CORPORATION FINANCE I I study of the sample mortgage bond printed on page 151, will serve better than a long description to show the reader exactly what is contained in a bond. The varieties of mortgage bonds will be considered later. For the present let us take up the terms of the deed of trust between the corporation and the trustee. 78. Essential features of a deed of trust. — Experi- ence has demonstrated the necessity of making this deed very exact and comprehensive. The indenture of a large railroad mortgage may contain as many as 50,000 to 100,000 words. If printed and bcund it woidd make a good-sized book. Of course, the ordinary industrial corporation would not find so lengthy and involved a description of the property and the terms of the mort- gage necessary. To the lay reader even a comparatively simple indenture is apt to seem a mass of cumbersome and more or less nonsensical legal phraseology; but it must be borne in mind that every such deed is closely scanned by a large number of able and experienced lawyers, who will demand that no possible loophole for evasion or misinterpretation shall be left open. The rights and obligations of each of the three parties to the agreement, the corporation, the bondholder and the trustee, must be fully and explicitly set forth and the mortgaged property nuist be described so exactly that no conflict with other mortgages or obligations can possibly arise. The instruments have now come to follow certain models and are almost always arranged about as follows: First, of course, come the date and the names of the parties to the indenture. Next follows the preamble, in which is a full statement of the legal status of the corporation, including the state in which it is incorpo- rated, the amount of its capital stock and bonds, the THE CORPORATE MORTGAGE 151 152 CORPOR ATIOX FIN ANCE amount and kind of property it ow-ns. The preamble also presents the authority given by the stockholders and directors for the bond issue and the specific purpose of the issue, Then the full texts of the bond, the interest coupon, if it is a coupon bond, and the trustees' cer- tificate of validity, which should appear on each bond (see form on page 151), are given. The granting clause, which transfers the property to the trustee, and a detailed description of the aiort- gaged property follow. The duties of the trustee, in- cluding the statement tnat the property is granted only in trust, and a provision that the trustee shall certify to the validity of each bond are next set fortt. This is followed by the covenant of the corporatiou to pay the interest and principal of the bonds at the time specified. An important section of the mortgage is that which binds the corporation to keep the property insured, pay all taxes, assessments and charges, and in general to preserve the property and keep the lien valid Another section retains for the company complete control of the mortgaged property and enjojinent of all the profits unless and until default is made of principal or interest. Where a corporation has subsidiary companies it may be necessary to include a full statement as :o the status and securities of each of these companies. The sections following deal with defaiit and fore- closures. Exactly what constitutes defajlt must be definitely stated. Usually a short period of grace is allowed after interest payments fall due before the trustee can take action. The percentage of bond- holders at whose request the tnistee shall take active steps is stated, usually 20 or 25 per cent. The per- centage of bondholders who must request foreclosure THE CORPORATE MORTGAGE 158 and sale in order to authorize the trustee to proceed to this extent is also given; usually a majority is re- (luired. The course of action of the trustee in case of foreclosure and sale is prescribed and the proceedings in case of receivership are set forth. The responsibilities, liabilities and compensation of the trustee are presented and provision is made for the resignation of the trus ee, or his removal upon request of a majority of the 1 ndholders, and for the appoint- ment of his successor. It is customary, although seemingly hardly necessary, to absolve the officers and directors of the corporation from any personal liability. In long mortgages there is frequently a separate sec- tion in which terms and phrases used in the indenture and open to possible misinterpretation are exactly defined. At the end appear the signatures and seals of the corporation and of the trustee through their proper officers with formal attestation of the seals. Frequently modifications of the original document are called for by changes in the legal status of the cor- poration or trustee or in the corporate property. Such modifications may take the form either of a supple- mentary indenture or of a supplementary agreement. The latter is less formal and usually relates to compara- tively unimportant matters. Supplementary indentures are most common in case of reorganization. They must he authorized by stockholders and bondholders as well as by the two parties directly concerned. 79. Classification of mortgage deeds of trust.— Mort- sages are conveniently classified as closed, open-end, and limited open-end. A closed mortgage covers a limited amount of bonds all issued at one and the same time and absolutely forbids any additional bonds secured by the 154 CORPORATION FINANCE same mortgage. The open-end mortgage authorizes an indefinite amount of bonds, some of whieh are issued at onee and some, under certain restrictions, in the future. This type has so fur been restricted to railroad com- panies. The usual provision is that a given amount of additional bonds may be issued for each additional mile of track constructed. The limited open-end mortgage, which is the common and for almost all purposes the best type, names a certain maximum amount of l)oii(ls to be based on the mortgage, part of which amount is issued at once. The rest may be sold under certain restrictions as to t'me; usually a given amount may be i)ut out each year. Sometimes there are further restrictions, such as a requirement for the permission of the syndicate which bought the first installment; or the requirement that interest on out- standing bonds be paid for a given period before any new bonds are sold. The merits of this limited open-end mortgage over either of the other two types are obvious. An abso- lutely closed mortgage may make it very difficult for a v rporation to secure additional fimds with which to carry on construction that is essential to its welfare. Possibly the corporation's earnings may thereby be re- stricted so as to invalidate the bondholders' as well as the stockholders' interests. The open-end mortgage, on the other hand, is too indefinite. The corporation may issue so many bonds under the mortgage and may raise its fixed charges to so high a point as to bring risk or even actual loss to the bondholders. We must not for- get in dealing with mortgages and mortgage bonds that in principle the holders of these instruments are sup- posed to be free from even reasonable risk. CHAPTER X TYPES OF CORPORATION BONDS 80. Classification of bonds.— This and the following c hapter are tievoted to enumerating and describing the various types of bonds that are in common use. We Nsonld recommend tliat they be studied with particular (are; for ignorance as to the exact nature and uses of each of the bond types named may very easily prove rostly both to investors and to corporations. An error ;liat is particularly frequent in small manufacturing cor- porations is to create a bond issue of a type that is not at ,11 adapted to the financial status and prospects of the corporation. One attentive reading of these two chap- . rs would have prevented many of these errors. Bonds may be classified with respect to: (a) The security for their payment, (b) Their purposes, (c) The manner of their payment, (d) The conditions of their redemption. As these classifications, which should be kept quite dis- tinct, are frequently confused, the writer has made up ■lie following list of the words commonly used in de- scribing bonds, each word being placed under its proper Leading: \. —Security of Bonds. 1. First Mortgage, 2. Second Mortgage, Third Mortgage, etc. 155 MO C'OUPOUATION FLNAXd; 3. Terminal, Divisional, I^and-Grant, or other Spe- cial Mortgage, 4. Gr»t ral Mortgage, 5. Sii tg-f'und, «. Co., eral Trust, 7. Car (»' K(jiiipn»ent Trust, 8. Debenture, 9. Income, 10. Participating, 11. Profit-Sharing, 12. Joint, 13. Receivers' Certificates. B. — Purposes of Bonds. 1. Unifying, 2. Uefunding, 3. Constniction, 4. Purchase-]Money, .). Improvement, 0. Extension, 7. Adjustment, 8. Consolidated. C. — Manner of Payment. 1. Coupon, 2. Registered, 3. Registered as to principal, hut dividends in T 81. Mortgage bonds.— A bond secured by a first mortgage on all the real property of a corporation- provided the corporation is stable and prosperous and tlie bond issue is not large— is regarded as a highly de- sirable investment. You could infer this from the quo- tations on th; first mortgage bonds of the standard railroads and industrial companies, as shown in the three examples below. It should be noted that none of these three issues is secured by an absolute first mortgage. Such issues are usually small and then prices are hard to determine. At present prices, Baltimore & Ohio first 4's yield ahout 4.0.5 per cent; Western Union first 4's, about U5 per cent; and Union Pacific first 4's, about 4.02 per cent. A debt secured by a bona fide first mortgage cannot be interfered with by any inferior security and, unless the corporation goes into receivers' hands, no security of higher rank can be put out. It is always possible, of course, to place a second mort- jrage on the same property covered by the first mortgage atid to follow the second mortgage by a third, and a fourth, and so on. It is very seldom possible, however, to find buvers for an>'thing junior to a second mortgage l)ond. Although bonds derive their value in large part from income, yet as they are nominally based on property, investors do not like junior bonds. Their dislike is not unreasonable, for in case of reorganization the heaviest loss would necessarily fall on the holders of junior securities. Many large corporations have nmde every effort to give each one of their bond issues, tio matter bow numerous these issues may be. the ap- |).arance of being based on a first mortgage. To this 158 CORPORATION FINANCE end many ingenious expedients and names have been invented. For instance, there are many railroad divisional and terminal first mortgage bonds. Sometimes these bonds are based on property highly valuable in itself. Some- times, however, they are first mortgages on branch lines or on terminal real estate that would be of very little use to any concern except the particular railroad that issues the bonds. In such a case the vaunted priority of the divisional or terminal bond is more or less of a fiction. A railroad could give up the branch line or the terminal real estate far more easily than the bondholders could afford to havo the property separated froui the railroad. Another very conmion practice with both railroads and industrials is t(» have first mortgage bonds issued by subsidiary companies and then have a nominal first mortgage bond issued by tlie holding company. The holding company's bond is in reality based only on its holdings of subsidiary companies' securities and is infe- rior to all the sid)sidiary (•(»uij)auy bonds. Various names are given to these junior issues. Sometimes they are called "first and refunding" mortgage bonds, or "first general" moi tgage bonds, or "first and unifymg." The words "unifying," "consolidated," "refunding," and the like, u.sed in this connection, are intended to signify that the underlying bonds v. ill he retired as they fall due with the proteeds of tin lu « issue, ft would perhaps not be jjist to say that these nauies are intended to mislead; but at least it may be saits in paying eijual periodic installments to the bond- holders, or their trustee, to settle principal and interest n a given number of years. It calls for somewhat 1 iger payments than the second method, inasmuch as it takes care not only of the principal, but of the interest ;is well. A fullei (liseussion of sinking fund methml is unnecessary, as the sul»ject has been covered in the volume on Aicouxtim; Pkaitkk. Tlie sinking fund method of guaranteeing that l)ond issues will be i)aid has \kv\\ much use«l by industrial cor- porations. i)artieularly when the permanence of their l-usiness is somewhat uncertain and investors conse- iientlv are incline*! to l fixid chargt^s. This gain, however, is in reality u loss to the ^tockholdirs. I> the money whi<'h has gone into the sinking fuiul had h. en spL circumstances, it is a good policy to devote all surplus tuials to increasing the earning power of the company, allowing tin debt to run without a special provision for repayment. In otiiir words, by refunding bonds when they mature, and by re- fu>irig to make uny deductions from profits to provide funds for (l.ht payment, a corporation not only pays a larger dividend but iiK reases the value of its productive assets more rapidly than the value of its sinking fund would increase during an equal number of VLurs. To put the matter in still another way, the accumula- tion of a sinking fund by a corporation decreases the propor- tion of debt to value of property less rapidly than when the annual amount of the sinking fund is invested in the equipment.* For the larger corporations the sinking fund is usually in cliarge of a special trustee acting for the bondholders. With smaller corporations, however, it is customary to allow the sinking fund to remain in the custody of the corporation. «;j. Collateral trust bomh.— With the growth of large JK.lding companies a modified form of mortgage bond lias come to be widely used. It is called a "collateral trust" bond because it is based on the securities of other toiiipanies owned by the bond-issuing corporation and deposited with a trustee as collateral security for the liimdholders. The securities are covered by a deed of trust just as in the case of real property offered as s« curity. The securities may consist either of stocks or of bonds of subsidiary comi)anies or of a combination of l>oth. It would seem at first sight that a collateral trust bond would not be worth much, especially when the collateral 'TruHt Fivanrr, pp. 241-243. r— VI— n 162 CORPORATION FINANCE consists of stock. In such a case the collateral trust bond would be junior by several degrees to all underly- ing bonds of the subsidiary companies. In case any of the subsidiary companies go into bankruptcy and force the holding company to default, all that the trustee for the collateral trust bondholders can do is to take the stock posted as collateral. When he gets the stock he still is a long distance from having tangible property with which to satisfy the demands of the bondholders. Even when the collateral consists of bonds they are usually junior issues and the collateral trust bondholders in case of default are very uncertain as to getting pos- session of real property. Nevertheless, collateral trust bonds are sold at high prices. The Northern Pacific-Great Northern collateral trust 4's, which are secured by the deposit of Chicago, Burlington & Quincy Railroad Company stock, have steadily sold close to par. :Many other similar issues are well thought of in the financial district. One reason is that the income, out of which interest on the collateral trust bonds is paid, is derived from the interest and divi- dends on the collateral, and these latter returns are more regular than are railroad or industrial profits. A second reason is that securities, if they are worth anything at all, are almost always readily salable, whereas real property, even if its cost and value are high, is apt to prove im- marketable. Hence, the collateral trust bonds have preat advantages in these respects which in the eyes of the financial public often outweigh their obvious dis- advantages. Strange as it may seem, it is not impossible for a hold- ing company with subsidiaries, whose credit is poor, to take the stocks and bonds of these companies, post them as collateral and sell the collateral trust bonds very TYPES OF CORPORATION BONDS 168 readily. It is not unnatural to feel a passing doubt as to the sanity of the financial world when one discovers that :i premise to pay based on real property is less valuable than a promise to pay based on paper that is itself based „n the same real property. Yet after all there is a sound reason for this apparent absurdity. Real property is hard to sell; paper representatives of property may be easily sold. Collateral trust bonds are therefore fre- (Hiently excellent means of raising funds for subsidiary lompanies without much credit of their own. They are also very useful at times in financing the process of buying control of subsidiary companies. The liolding company borrows money from the banks and hiiys securities; then it issues collateral trust bonds based (.u'tliese securities and with the funds thus obtained pays „rt' the bank loans. Thus it finds itself with very little expenditure of its own funds in full control of the com- pany whose stocks it has bought. Some companies have repeated this simple process time and time again. It is entirely legitimate, though somewhat risky. To protect the bondholders, collateral trust mort- fi'd'^es generally provide against the issue of any securi- ties by subsidiary companies ahead of those deposited as collateral. The mortgages also frequently have clauses to prevent unfavorable leases or other misuse of prop- erty represented by the deposited securities. A further study of this type of bond belongs in the subject of investments rather than here. Enough has heen said to indicate how a holding company may, by means of collateral tnist bonds, borrow funds which it would probably be impossible for the subsidiary com- panies to reach. j 8-4. Equipment trust bonds.— Thh form of bond is extent by other than railroad companies. »t any 164 CORPORATION FINANCE The equipment used as security for a bond issue of this kind does not belong to the railroad company at all. The manufacturers of the equipment usually turn it over to an intermediary company, which in turn leases it to the railroad, generally for a term of ten years or less, and hands over the lease to the trustee of the equipment trust bondholders. The railroad pays to the trustee the purchase price of the equipment in equal installments, together with interest on unpaid installments. When the payment is complete, the lease is cancelled and the title to the equipment passes to the railroad company. In the meantime, in order to pay the manufacturers the intermediary company issues bonds to about 80 or 90 per cent of the cash value of the equipment. The bonds are in serial form so that as fast as purchase money is received from the railroad it may be devoted to their redemption, and the series is so arranged that when the last payment by the railroad is made the last bonds are redeemed. The form of an equipment trust bond Is given on page 187, and the following extract from the prospec- tus of one of the early intermediary companies in this field will further explain the working of this ingenious plan. The business of the Railroad Equipment Company is to lease and conditionally sell on what is known as the Car Trust plan, to railroad and other corporations directly connected there- with, certain needed Rolling Stock. A cash j)aymcnt ranging from 10 per cent to as high even as 50 per cent is made at the outset, and the principal and interest of the balance due, represented by the promissory notes of the Corporation, maturing at fixed intervals over a term of years, is secured by a first Hen or mortgage on the said Rolling Stock, TYPES OF CORPORATION BONDS 165 3 Cl'g to 4< CO •*4 4i .S cn < l^;|li H '''fi-o ^ p I CO I s s I »1 e-. U "slug? S -A <'• C rii 2>3 HSfc^S. !|i: C c CO «: o ^2 ^ o §•0 5 « 2 E'SJH^'Si £ 5 25 •S = «'-5.J^ S€ • f Si's lllr •=3§o 1^ \ ^S\ 111 ^ lis B £ £2 ir,6 CORPORATION FINANCE I ■ the whole of which remaint at tuch security untU the last note is paid. These deferred payments extend over a period ranging from four to ten years, and during such periods and until the final payment is made and all the provisions of the Car Trust Con- tract have been fully complied with, the conditional purchaser uses the Rolling Stock as lessee only, and subject to the legal rights of the lessor, in whom the title to the property remains fixed and inalienable and unaffected by any liens or indebtedness of any kind of the lessee. The lessee is also bound by the contract to keep the Rolling Stock in proper repair, to replace it if destroyed, and to hold it at all times subject to the inspection (it being readily identified, not only by the road numbers, but by the ownership plates invariably attached to each locomotive or car) of the lessor, by whom and for whose benefit it is fully insured. In case of default of any of the payments, or of non- performance of the other provisions of the contract, the lessor has the legal right, not only fully recognized and confirmed by the United States Courts, but also protected by direct legisla- tion in many of the States, to take inunediate possession of the Rolling Stock wherever it may be, or however in use, to i -11 it at public or private sale, and to apply the proceeds to the payment of any indebtedness arising under the contract, whether matured or not, and in cases where a Receiver is appointed, the rule of the Courts is to order him to pay the Car Trust notes as they mature, rather than lose the use of the Rolling Stock and the benefit of the payment already made on it. The securities arising under these Car Trusts are assigned to a Trust Company, and are held by it in trust, as security for certain Bonds of The Railroad Equipment Company issued against the same. The holder of these Bonds has therefore as his security: The direct obligation of the Railroad Equipment Company. The direct obligations maturing at specified dates, generally monthly or quarterly, of the Corporation, the lessee of the Rolling Stock. ^5JSScf TYPES OF CORPORATION BONDS 167 The absolute ownership of such Rolling Stock which is kept in repair, insured, and replaced if destroyed, and the first cost of nhich, already reduced by th? cash payment at the outset, is being steadily still further reduced by the periodical payment niude by the lessee. The security behind bonds of this character is excel- lent. In the first place, no railroad has ever yet de- faulted on an equipment trust bond issue, because to do so would mean a loss of its equipment. All through the railroad receiverships of the 90's the receivers paid the interest and principal on these bonds regularly. In the second place, the railroad merely leases the equipment until the last payment is made and in case of default, therefore, no legal process is necessary in order to enable the trustee to take physical possession of the property. The leases usually provide that the equipment is to be kept in good repair. In effect this form of security is a kind of chattel mortgage. From the railroad corporation standpoint it is open to the usual objection against chattel mort- gages, namely, that it pledges a semi-fixed asset under a short term obligation which must be met at all hazards. It may well happen that the railroad, in order to meet this obligation, will have to part with funds necessary in order to meet other fixed charges. The best managed railroad corporations use these instruments with great caution. One reason for their existence is that many existing first and second mortgages on railroad prop- erty have what is called an "after-a cquired property" clause, which makes the mortgage extend over all the property that the railroad owns at the time of making the mortgage and all that it acquires thereafter. Under this clause a straight mortgage on equipment would not MICROCOPY RESOLUTION TEST CHART lANSI ond ISO TEST CHART No 2i 1.0 ;riii III 1.25 1 1^ 1.4 2.5 2.2 2.0 1.8 1.6 ^ A PPLIED IM /OE_jnc ^B". '*-■'' ro5l Mo.n SltMl ^^ '■'a:. >-.s'.r, Nr, rork ' *609 U'"J» ^^ ■: " 6 1 .8; JOO - P>.on. y 168 CORPORATION FINANCE be a first lien. The lease is the method by which this difficulty is overcome. The market for equipment trust bonds is narrow, partly because the public does i-ot thoroughly under- stand them and partly because Ine issues are relatively small. They are largely bought by banks, insurance companies and other financial institutions desiring to invest their reserve funds to the best advantage. The average yield on equipment trust bonds is considerably better than on ordinary mortgage bonds and their safety is almost perfect. The principle of the equipment trust bonds is not applied to any considerable extent in industrial corpo- rations and with very few exceptions it would be highly inadvisable for such corporations to buy equipment in this manner. 85. Five-year equipment notes for Canadian rati- ways.—Some surprise was created in American and English financial circles in July, 1913, by the issue in London, by the Grand Trunk Railway of Canada, of £1,500,000 five year, five per cent secured notes, dated October 1, 1913, and due October 1, 1918. The notes were to be in denominations of £200 and £100, and could be registered as to principal only. The company re- served the right to redeem the notes at 101 either as a whole, or in amounts of not less than £200,000 by draw- ings on any interest date upon sixty days' notice; and in the event of any notes being redeemed before the date of maturity the trustee would release a proportionate part of the debenture stock deposited with them as secur- ity. The notes were secured by the deposit with the trustee of £2,000,000 Grand Trunk perpetual four per cent consolidated debenture stock. The issue price was 98, payable as follows: TYPES OF CORPORATION BONDS 169 Per Cent £5 £30 £30 £33 On Application Allotment August 30th, 1913 September 30th, 1913 £98 According to a statement in the prospectus by Mr. A. W. Smithers, chairman of the Grand Trunk directorate, the proceeds of the notes were to be "applied in part pay- ment for additional rolling-stock (75 engines and 8,000 freight cars), the contract price for which exceeds £2,- 000,000. This new equipment has become necessary owing to the approaching completion of the Grand Trunk Pacific Railway and to the very large increase in the traffic of the system — including the Grand Trunk Western, Detroit, Grand Haven and Milwaukee, and Canada and Atlantic Railways, but not including the (irand Trunk Pacific Railway." It therefore looked like an issue of equipment notes, hut Canadian financial authorities have not been inclined to class them as such, as the terms of payment and the periods are different from the standard equipment trust hond or note described in previous pages. About the same time the Grand Trunk Railway sold an issue of (•(|nipment notes in the United States. The five-year note issue in London must be considered as an ordinary short-term loan, and as such it created a considerable flutter in financial circles. One objection raised in Lon- don to borrowing on such onerous terms was that it tended to depreciate the value of the company's deben- ture stocks. The company did get the money, as the issue was over- subscribed. 170 CORPORATION FINANCE ,1 A cable message from London stated that the market there objected to the company embarking on a new form of financing by the issue of short-term notes, but that it was being pointed out that many of the first-class roads in the United States, such as the Lake Shore and the New York Central, had been recently doing the same thing and on no better terms than the Grand Trunk was able to obtain; in fact, in most cases the United States lines had to pay considerably higher rates than the Grand Trunk for temporary loans of this nature. The short life of such securities as these Grand Trunk notes recommends them specially to a growing class of investor which confines itself to redeemable securities of this kind. It brings us, however, to the question of short-term loans generally, which is discussed elsewhere. I* CHAPTER XI TYPES OF CORPORATION BONDS (CONTINUED) 86. Debenture bonds. — There are two different uses (if the word debenture which are somewhat confusing. In law any instrument which formally acknowledges a debt and promises payment, including any written bond X secured or unsecured, is a debenture. In finance, how- ever, the term has come to be restricted to a bond which is not secured by a lien upon any specific property. In other words, it is for all practical purposes, simply an unsecured promissory note running for a number of years. Being unsecured, the debenture bond, in case of insolvency, is legally on the same level as the general floating indebtedness of the insolvent corporation. The debenture is much used in the financing of Eng- lish corporations. Indeed, our American mortgage bond, in the case of railroads at least, is there almost imknown. It is used so largely because the English investors realize clearly that the earnings of the railroad after all are their actual security. As has already been pointed out, the holders of a railroad mortgage in case of foreclosure seldom take the physical property which legally belongs to them, because to separate any portion of a railroad's property from the rest is to diminish and ])erhaps destroy its value. Logically, therefore, the English custom is right and the American custom is wrong. In practice, however, it is probable that the -(\merican railroad managers have borrowed more funds on better terms than have the English railroad mana- gers. An English railroad corporation has only one 171 1 ■ 172 CORPORATION FINANCE I ILl kind of bond — the simple debenture — to offer; an American railroad corporation may offer, as we have seen, an indefinite variety of mortgage bonds, each bond being secured by a lien on some part or section of the railroad property. The American junior bond, for that reason, looks better to the average investor than the English junior bond, and is more readily salable. Notice that this statement says "looks better," not "is better." If all American railroad mortgage bonds were to be exchanged for simple debentures arranged in the order of their priority, investors would be as well off as they are now. Under the present system, however, the existing debenture bonds are for the most part far inferior in security and investment standing to mortgage bonds. Indeed, it would hardly be correct to call any of the present railroad debenture bonds, with a few notable exceptions, investments at all in the technical sense of that word, as previously defined. If debenture bonds are so far inferior to mortgage bonds and therefore so much less attractive to investors, why issue them at all? There are several possible reasons. In the first place, a company may have reached its limit, so far as mortgage borrowings are concerned; it may have nothing of any great value left on which first and second mortgages have not already been placed. Third mortgages are so unpopular with investors that a simple debenture may be more easily sold. Sometimes debenture bonds are created when a bank- rupt railroad company is reorganized. The reorgan- izers may desire to lighten the load of mortgages that previously weighed down the company and perhaps caused its bankruptcy. In the general scaling down of TYPES OF CORPORATION BONDS 178 sitler in detail when we take up reorganization — the junior mortgage issues are often replaced by debentures. This is the origin of most of our present railroad de- bentures. A third possible reason may be that a conservative corporation is anxious to reserve some of its resources for future mortgage issues. Suppose a railroad, for instance, already has a first mortgage on all its property and desires to borrow a comparatively small additional Slim. If it places a second mortgage on its property it Mill have used up much of its remaining borrowing capacity. If it issues simple debentures, however, it will still have a second mortgage to fall back upon. Usually debenture bonds issued under such circumstances arc accompanied by an agreement between the corporation and the bondholders to the effect that if any new issue ofmortgage bonds is subsequently put out, the debenture bondholders shall be secured by the same mortgage as the new bondholders. A fourth reason that has at times led to the issue of debenture bonds is that they are intended to be sold to European investors, among whom, as has already been stated, such bonds are highly regarded. In the reor- ^mnization of the Wabash Railroad Company in 1887, for instance, certain issues which are actually secured as to principal by a third mortgage were nevertheless given tlie name of "debenture bonds, Series A," because they were intended for English investors. In this country the most successful railroad debenture bond issues are those of the New England railroads, for the obvious reason that the earnings of these roads are not only large, but particularly stable. The Boston and Maine R. R. Co. has outstanding four mortgage bond issues and seven debenture issues. All of the de- 174 CORPORATION FINANCE in M I i ^>i■ 111 benture bond issues commanded good prices and were considered sound investments. The earnings of this company have averaged six or seven times interest charges. Similarly the New York, New Haven and Hartford R. R. Co. has six issues of debenture bonds outstanding in addition to numerous issues of mortgage bonds of subsidiary companies. The net earnings of this company have been more than three and one-half times the interest charges. The practice of issuing debenture bonds seems to be gradually gaining favor among American railroads, and a number of lines have adopted the policy of replacing mortgage issues when they mature by simple debenture issues. The debenture bond is not much used by industrial corporations, how- ever. These corporations do not usually have the con- fidence of investors and the stability of earning power which are necessary to make debenture bond issues successful. 87. Income bonds. — The income bond is a hybrid, partaking of the nature of both bonds and stock. As the name implies, the payment of interest charges can be demanded only %vhen there is sufficient income for that purpose ; if the interest charges are not earned they need not be paid. The principal, however, is usually secured by a mortgage. If there is no such mortgage, as happens in one or two cases, the word bond is a mis- nomer. For all practical purposes such an "income bond," so-called, is preferred stock without voting power. Income bonds are usually the product of reorganiza- tion and are designed to take the place of junior mort- gage bond issues which it is thought necessary to scale. Their advantage lies in the fact that they do not impose any fixed interest charges on the corporation. How- ever, there is a great disadvantage in the fact that the TYPES OF CORPORATION BONDS 175 principal is secured by mortgage and that therefore new mortgage bond issues in the future are hard to float. Another disadvantage is that there is apt to be dispute between the corporation and the bondholders as to whether the interest charges are actually earned or not. This objection can be obviated in part by inserting in the bond such a detailed statement of the method by which net income is to be determined as is given in the sample income bond shown on pages lie and l47. The new system of railroad accounting under the Interstate Com- merce Commission will probably aid in the settlement of this question in connection with railroad companies. For an example of the difficulties inherent in income i)()nds see the case of the Central of Georgia Railway Company cited in Chapter XXVII. 88. Other types of bonds.— The name of "participat- ing bonds," is almost self-explanatory. A bond of this class usually gets a fixed rate of interest and in addition a share of whatever profits are earned by its underlying security. The best known issue of this kind was the Oregon Short Line participating 4's issued in 1903 and retired the next year, which were secured by all the stock of the Northern Securities Company, amounting to $82,- 491,000 in the Oregon Short Line treasury. These b(inds were to receive not only the regular 4 per cent but whatever dividends over 4 per cent were declared on the collateral stock. Profit-sharing bonds, which are infrequently issued, usually entitle the bondholder to get back his principal with the agreed interest and also to share in whatever increase in the value of the underlying assets may take place before the retirement of the bonds. Joint bonds are direct obligations of two or more cor- i f ii 1 *f r 176 S u o u H <: Q H o o (Li o IS < OS H fa < a < < a o 9 o O f u U s u b o CORPORATION FINANCE o £ S •= o c B >. - tB ». Jj ■= s s s o 5 S *^ S 4) t s c « = S 5 ■5 ^ O O 75 Si .= « .Q H.^ S H 3 -S !i5 ■< a. o U a •< o a « u < en p •«! ■< W H b O H - S «" jB a ca i: 5< i* B <« S o o ■- ' . S £^ V ■ ■ a s 3 — -a fc6 B 3 - B - E £ o 2 .s c .5 ii O o "5 a, at ^ S ^ f* "" 5 .a I = a ii •s c -, o &£.1 = 5 « 3 c. «-■=*; 2 S = 5 § a c c c- £ K sj Im 2 a ■g S 1 u 5 2- R « S -B O ? c t-> u a =; 6h > <« _ j: c § - - i; c II ° .a >> a " j; .- "S - ■■■ •« :§ -5 S- =* a ■at-*' -5 y; ,, t, c X o o .!- 'S 4> 5 = in 4; -3 c £ _ a ? to ? r a o ^ E |=£=^55'oo a ^ r Cfi — C i- B 4< X *" ,— ^ -S a B SB X B _ = C 1-5 3 "O « - - S o so s:< B u bo a B jj '■? -3 2;. a «- JS 3 ? 4- I u - c« M 5 e "O .S c _ 50 ■'' ^ o a ■■« E H - 5 = -^l^g be ^-1 1( r** 4^ -7 Q a,5 c- ?- ^ tt o £ ^ E o "ilp; « = ^ = 2 B B ~ O B W B B 4- c f^ 3 ii 41 " 41 O «M O o g « c 13 'S a a O 60 O CA iC S 1= •B v< *• B -a » S '^ *" B s B ^ Ji. .E ^ « Ml '• c 41 4 — c .a c . a 4< i>- «a CS t. o l-l o - "^ -w B 4i p 4; E C 3 S' a « w to C "S 4i M •" •3 5" 4j ~ r:: '-^ ■. ■#■. 4; U t- »-t .41 ft; 3 a *^ B ^ 4; .E "a I o " o ,° -^ — c S "b' o a g ■& § ■:• "a a ^ _ a S 5 4> 3 'a o • a o r J= -2 l-M TT t^ B ■ 4< S ' a C iJ 3 •s-S o " 2 a G 1 - -c. o g-. .s=-s ?; 60 41 S J3. a 4> -a B a S a a o '^ £• B =8 c ■B * B 44 S E » p. « u o 60 « B 4. •a « 2 § S (A 41 *- 2: B 4) 3 JS o ■ E E .S a o ^ s s 60 <' B« a o j: it *, .5 .£1 '^ CO — •-^ .?r .^ w, ,= -^ = — Ec;=: c C5 £ 15 = ^53 a * ^- « § JS ,r <• B — "^ a :3 ^ so 2. O B to «►" « w 2 e 4J "O j: ^ 60 E B •" i f". 3 B •V a 4* a, ■3 E o « *" ? 6C£ £ < 6C •C 3 4* fc j: c o .«s I,- B ■d c « . (J e £ S. \ 178 CORPORATION FINANCE "I il t I < Pi O < b D a Q < O S H tn H B O u U H U u t: « .s c o o o o O s C9 T3 E o il ° i i S o X *: ii Si « *: be t "S bfc a o ,c c ^. .^ 1 u ~ -:> O E E c iS 3 c o E o C O 4< 3 O E c C M) >. » U £ o 3 _B ** "o Jh a b o k_ _C "3 i £ 4-^ H -a g -a B CS C3 •-5 •s s to B s o £ 1 E > O CO 5? B CB 1 c G :5 es O E 4-« t: o X tfi o *-• V s Cm O ■1-) S o o "* CS o (i^ the more readily the invention may be marketed. The a.noiint of advertising and selling expense called for must also be taken into account. Next, the promoter takes up the cost of manufactur- ing. He finds out whether new and specially con- stmcted machinery is necessary in manufacturing the invention, and whether any especial skUl on the part of laborers is required. He considers the amount of expe- riment that will be necessary in order to perfect the invention and in addition figures a large amount of extra cost for unforeseen contingencies. These are only a few of the factors that the promoter would investigate before taking any further action. Their number is sufficient to indicate, however, that any promoter who has a reputation to make or preserve, can- not afford to jump hastily at whatever proposition is presented to him. The process of discovery may take a long time, perhaps months or even years. The case just cited is comparatively simple. Where a promoter is dealing with such an enterprise as a new railroad or a new mine or with a consolidation of manu- facturing plants, he is confronted by a far more com- plicated situation. If the investigation is thorough and searching, the promoter will be able to give a well- jrrounded and satisfactory answer to every question that ijrospective buyers may raise. 93 "Assembling" a proposition.— By assembling a proposition is meant the process of getting temporary control into the hands of the promoter. If he is dealing with an invention, he assembles the proposition by get- ling an option on the invention or by making an agree- ment with the inventor on a royalty basis. In the case of a consolidation of plants or railroads into a new cor- poration, assembling is frequently much more compli- II !l 188 CORPORATION FINANCE cated and difficult. In such a case the promoter may have to get options or arrange the terms of purchase with every plant and perhaps with all the different classes of security-holders involved. Unless a promoter has these agreements or options in his own hands, it is as a rule foolish for him to go ahead with any further efforts. He might complete his arrangements for put- ting the new corporation on its feet and then find that in the meantime the original owners of the property had sold to other parties or had taken steps that would diminish the value of the property. Or he might find that after forming the corporation and bringing the owners of the funds and the owners of the property together, they would mutually agree to dispense with his services and would leave him, so far as his compen- sation is concerned, out in the cold. 94. Financing a proposition. — The initial develop- ment. — Now we come to the most difficult part of the promoter's work, his financing of the new corporation. No hard and fast rules can be laid down to cover the promoter's procedure. There are some general prin- ciples, however, which apply to all enterprises and which should always be kept in mind. First, it is advisable in practically every case to de- velop the proposition as far as possible with the pro- moter's own resources and those of his immediate friends before it is presented to outsiders. In making this statement it is assumed, of course, that the promoter really has faith in his proposition and is willing to take whatever risk is mvolved in developing it ; otherwise the promoter will naturally spend as little as possible of his own money. In the case of an invention, for instance, which the promoter is trying to finance, it is far better to have the invention actually manufactured and a few CORPORATE PROMOTION 189 of the articles on exhibition before any attempt is made to interest outside capital. If this is impossible, a working model at least should be on hand. The average capitalist is not likely to part with his money unless he sees before him something more tangible and impressive than a verbal description of what the inventor expects his as yet unborn machine to accomplish. If a promoter is financing, let us say, a copper mine, lie should do his utmost to have the ore bodies opened up and mining operations started, even if only on a small scale, before he starts to float his corporation. Where the promoter is consolidating several existing plants he already has some of his exhibits at hand in the form of the going plants and companies that are to be consolidated. Nevertheless, the combination itself is in reality a new enterprise and the promoter should spare no pains to secure some practical demonstration of its profit-making possibilities. Sometimes he may point to the success of previous combinations created under closely similar conditions. If he does not have examples, at least he can get exact figures as to the selling, admmistrative and operating expense under the present arrangement which would be saved if the com- bination were effected. In general the promoter must bear in mind that an enterprise which exists only on paper does not make anything like as powerful an appeal to the buyer of securities as an enterprise which has something tangible to show. It may be that the standing and prospects of ihe enterprise are in reality very little changed simply by producing some tangible results. Xevertheless, the confidence of people with funds is much increased and this, after all, is the promoter's main object. lao CORPORATION FINANCE 95. Foresight in providing funds.- -Second, the pro- moter should take care not to get his enterprise into such a condition that funds must he secured immedi- ately on whatever terms are demanded. This is a situa- tion that is quite apt to confront one who goes ahead with construction and development too rapidly. In his eagerness to make a favorable showing he may perhaps run short of funds, find the obligations of his cor- poration pressing and be compelled to make some very disadvantageous deals or see his corporation go into bankruptcy. Many a meritorious enterprise has suf- fered this fate. To prevent such a catastrophe the promoter should see that his corporation is capitalized for a krger amount than he expects to need ; thus there will always be unused securities which mav be offered for sale with- out involving tedious and unnecessary formalities. It may be well to have this stock actually issued and trans- ferred to the treasurer of the company in the manner which has been previously described. Furthermore, the promoter should endeavor to raise in advance of any expensive construction or develop- ment all the funds that will be recjuired for that purpose. The corporation which has a factory half-built, or min- ing machinery partially installed, or merchandise busi- ness half-stocked, is in an extremely precarious condi- tion. AVithout additional funds it can go neither backward nor forward. It has no valuable assets or established trade on which to borrow funds, it has no trade credit, it has no record of sales and profits to pre- sent to ])ros])ective buyers of securities. It is therefore unable to secure any funds except from some individual or small group who may come to its rescue. The pro- moter mav feel reasonably confident that their assistance CORPORATE PROMOTION 191 will be purchased only with the sacrifice of his own control and probably of most of his profits. 96. Advantages of a wide distribution of stock.— Third, it is usually far better both for himself and for the corporation that the promoter sell his securities to a large number of small buyers rather than to a small number of large buyers. In the former case the stock- holders are scattered and their holdings are too small to induce them to take any active interest in the busmess. Consequently the promoter, even if he fails to retain a majority of the voting stock, is left in absolute control. In the second case, the promoter is watched and perhaps hampered by the large stockholders; even if he holds a majority of the voting stock, he will probably not desire to arouse their objections and will therefore feel obligated to consult them or their representatives. Such an arrangement the promoter who has faith in his own abilities and ideas does not desire. He usually feels that he understands i' ^proposition better than anyone else and that to bin should be left the con- duct of the business until it is well started toward success. From the standpoint of the corporation, u large num- ber of small stockholders is almost always desirable. The wider the distrib\ition of the stock, the more friends the corporation has and the easier, probably, will be the selling of additional securities. Besides, the large capitalists who might be interested in the enterprise, should generally be kept in reserve for such emergencies as have been described. If the corporation does get into difficulties, in spite of all the care that its promoter may take, it can then turn as a last resort to these capitalists instead of drifting helplessly into insolvency 97. "Starting right*' in the sale of stock.— Fourth, if 1! 192 CORPORATION FINANCE the promoter is handling a legitimate small enterprise, he should look for his funds to the people of the locality where the enterprise is started. If the enterprise is too large for them, at least he should accomplish his pre- liminary financing — that is, the raising of sufficient funds to get the enterprise started, although not enough to carry it on to success — among the local people. Con- servative bankers and business men always recognize the superior opportunities for getting exact information of local investors and have considerable confidence in their judgment. It is a great advantage to a promoter in presenting his enterprise to the public to be able to say that a large part of the funds have been subscribed by persons who are on the ground and in close touch with what is actually being accomplished. The same ob- servations apply to people with technical training if the enterprise has many difficult technical features. The promoter of a corporation to manufacture a new elec- trical engine, for instance, ought to have the support of experts in that field — manifested not only in words, but by money — before he starts his campaign for sub- scriptions among outsiders. 98. A concrete illustration. — The practical applica- tion of the principles here laid down in the promotion and financing of interurban electric railroads has been well described in a lectuVe before the students of New York University School of Commerce, Accounts and Finance by Dr. Thomas Conway, Jr., of the University of Pennsylvania. Dr. Conway said: The proposition havinpf been discovered and thoroughly in- vestigated, and the necessary options, for example the rights of way, etc., together with the necessary franchises, having been obtained, the promoter arranges to present the proposition to those who will furnish the money necessary. He accom- CORPORATE PROMOTION 198 panics his statement of anticipated earnings, with a map of the territory showing population adjacent and tributary to his proposed lines and he submits also engineers' estimates of cost of construction and cost of operation based on the amount of traffic, and the grades and curves which will be encountered. He is now ready to arrange for the financmg of his proposition. His first step is to organize a corporation, usually under the laws of a state in which his road expects to operate. This cor- poration will be organized with the minimum capital permitted bv laws of the state in order to save initial taxes payable to the state. It will be organized with a minimum amount of cash payment and, if possible, requirements for actual contributions, will be satisfied by turning in options to the company. The charter of the company contains the authorization of the amount of capital which will be required to finance the enter- prise. This capital consists of bonds, preferred and common stock. It is important that the amount of bonds per mile of road should be kept down to the lowest practicable figure as a large bonded debt immediately arouses a suspicion and suggests the advisability of a more skeptical and scrutinizing investigation of the promoter's representations. The amount usually fixed upon as conservative is $20,000 per mile. This may be exceeded in cases of especially expensive construction where interest on an excessive amount may be offset by lower cost of maintenance. The preferred stock issue is usually for subscription in the immediate locality where interest in the new proposition must be aroused. It is advantageous to secure the largest possible amount in this manner, since it gets down the amount of bonds to be sold and makes their sale correspondingly easy. Two courses of action are now open to the promoter. He may either, after secqring the proper introductions, address himself to a private banker in some financial center and oflTer to him the en- tire bond issue, or he may arrange for the financing of his enter- prise in his own locality, approaching the city banker only after ht has a record of earnings upon which to base his argument. The invest© t& whom these securities must be «old, will not C— VI— 13 194 CORPORATION FlxNANCE I 4 i mm buy the bonds of an enterprise whicli has no recognized status, so long as it remains in formation and in chaotic condition. It is in his eyes a speculation a. id as such he is reluctant to put his money into its securities. If the bonds arc, therefore, sold in the city, to the city banker, he must borrow the money to build the road, and must hold the bonds until at least a year's operation of the new property has been completed. The city banker will demand hard terms as a condition of ad/ancing this money, if indeed one can be found witli sufficient confidence in the new enterprise to risk his capital in its inauguration. It is better, therefore, if possible, that the promoter should arrange for a preliminary financing of his scheme among local interests. This he does in the first place by securing subscrip- tions to preferred stock as already indicated. He also obtains a guarantee of purchase of the bonds of his corporation from local interests, bankers, institutions and capitalists, with whom he is acquainted, the condition of the guarantee being, that W the bonds are not sold within a definite time, sa}' three years, above the price named in the contract of guarantee, the guar- antors will take them at that price. Tiie city banker would usu- ally require that local interests guarantee at least a portion of the bonds, and it is therefore just as well for a promoter if he can accomplish this to secure guarantee of the entire issue. In order to make the stock of his company fully paid a device fre- quently resorted to is that of a construction company organized by the promoter and his friends and associates, who receive all the stock except what preferred stock may be prescribed for bonds of the new company in exchange for an agreement to construct and e(juip its lines in accordance with the plans and specifications of the engineers, which are nuide part of the agreement. At the time this contract is executed, all the common stock and sometimes such a portion of the preferred a» may not have been provided for is turned over to the construc- tion company, togt-tluT with a small amount of the bond*. The remainder of the bonds are issued to a trust company, which acts as trustee for the holders, in installments correspond- CORPORATE PROMOTION 195 iii'i- to the completion of sections of the lines as certified to by thu engineers representing the trust company. The promoter or liis representative, acting for the construction company, uliicli has now come into possession of all the securities of the luw corporation, arranges with some trust company or bank to (ulvance sufficient funds to build and complete the line. The Miurity offered is the bond issue of the railroad company sup- pldiiontcd bv the guarantees above mentioned and by a certain aiiiDunt of the stock. The common stock of the railroad com- [liiiiy, it should be mentioned, is divided up among the guaran- tors of the bonds. The trust company advances the funds, the Iiiiiikcr finally sells the bonds, and what rcma'ns constitutes the jiroiiioter's profit. The amount of common stock, which must lu {riven to each Oiic of those interests, and that can be re- tiiliied by the promoter, varies with circumstances. In return tor making the loan, the trust company usually exacts a com- n.i>>ion of say 2\-i per cent to 5 per cent, resides the regular iiil. rest of 6 per cent or in some cases as high as 8 per cent, the louis running for two years. This money is advanced on serial iiotts of the construction company, corresponding to the com- |)1. tion of different sections of the roud, and secured by the bonds which arc issued to the construction company by their trustee as fast as the road is completed. For example, we will suppose that the total amount of bonds is !^1, 000,000, and that these should be issued in ten installments to the construction company. The first installment of $100,000 is Issued at the time the contract with the railroad company is (NKuted. The construction company takes this note together with the guarantee of the ])urchase of these bonds, and $100,000 of lunids, and borrows from the trust company $100,000. With tlii> .*1 00,000 it pays for the completion of five miles of road. Wlun it is certified to the trustee of the bonds that this mileage 1 l^ been completed, another $100,000 of bonds is issued, an- ;*lu r note negotiated and in this way by serial installments and nol(s, the trust company in time advances all the funds neces- sary to build the line. Prior to the completion of the linei 196 CORPORATION FINANCE ,:^: ii some portion of the interest may be earned by the sections which may be put into operation. It is customary, however, to pro- vide in the original "apital issue sufficient funds for the payment of one or two years' interest. If the calculations of the promoter have been correct, after the company has completed its first full year of operations, little difficulty will be experienced in arranging for an advan- tageous sale of the bonds to the city banker. Some stock may be demanded along with these bonds, but the amount will be small compared with what would have been asked if the banker had been obliged to advance the money for construction. In agreeing to take the bonds of an intcrurban electric railway the banker is running little risk, and is often able to dispose of all the bonds as soon as he has completed his payments for them. These bonds, until the notes which have been sen red have been paid, remain in the custody of the trust company which ad- vances the money to the construction company as fast as the bonds are delivered to the banker. He makes payment for them, and with these funds the notes of the construction company are satisfied and all the bonds have been taken up and paid for; the indebtedness of the co;.struction company is discharged, and there remains in its hands a certain amount of cash and securi- ties which are distributed to its stockholders. The construc- tion company's work having been accomplished, it is then dis- tiolved. lu CHAPTER XIII THE PROMOTER AND THE CORPORATION 99. Professional promoters. — It is time to say some- thing about the promoter, his personality, his duties, his legal responsibilities, the services that he performs and the pay that he receives. Readers who are unfamiliar with the world of finance may have assumed from what has been said that a certain class or group of men make it their sole business to promote enterprises and that no one else ventures into this field. This would be an en- tirely erroneous impression. Anyone who is pushing a money-making scheme is a promoter for the time being, or at least he is performing some of the functions of a promoter. On the other hand, as not everyone by any means is well fitted by temperament, training or practice to make a success of the difficult work of pro- motion, comparatively few men are concerned with such work to any great extent. We may classify the men who spend a considerable amount of their time and energy in promotion into four groups. Let it be clearly understood, however, that this classification does not pretend to be com- plete. First come the professional promoters, the men who really do make it their main, and almost their sole, busi- ness to hunt for enterprises that promise profits and to turn nee those enterprises. This type is common in fic- tion, but rare in real life. So far as the writer recalls, he has met only one man who could be put in this class, 197 M m ! -jj 198 CORPORATION FINANCE m m I* ' I t» a tall, lank, fervent individual with a persuasive air. At the time the writer knew him he was engaged in selling the stock of a IMexican rubber plantation com- pany; he was also interested with others in the de- velopment of a tract of real estate near Xew York City; and he was investigating the possibilities of a copper mine in Xorth Carolina. "So doubt other plans were germinating in his mind. He was of the enthusiastic, visionary type, utterly incompetent to manage an enter- prise but skillful in appealing to the aspirations and emotions of others. On the whole, he was fairly suc- cessful; tnat is to say, he was making enough money on one enterprise to pay his losses on the others and to get a decent living in the bargain. lie was unquestionably honest in his convictions; indeed, it was easy for him to be honest, for he possessed a w.'nd that readily believed whatever he wished to believe. Probably he was used as a tool in many cases, although he never suspected it, by shrewder and less scrupulous men. It might be said that ^Ir. John W. Gates, Judge W. H. Moore, INIr. Daniel G. Rcid, and the others named in Chapter XII, are professional promoters. It would be more nearly correct, however, in the writer's opinion to classify these men as primarily brokers, or lawj'^ers, or bankers, who have won a few great successes in the field of promotion. The man who does nothing, but "promote" is not apt to achieve marked successes, one reason being tliat the really great opportimities are not usually stumbled upon by chance or disclosed to those who seek after them, but are revealed only to those who have an intimate acquaintance with the details of the business to be promoted. The only exception to this statement worth noting is when one who has already achieved success as a promoter is called in by men who PROMOTER AND CORPORATION 199 tlioroughly understand the business to be promoted and who place their knowledge at his disposal. 100. La-wycrs and bankers as promoters. — The second class consist of lawyers and bankers in small commu- nities. Such men have exceptional opportunities to in- form themselves as to local conditions; they frequently take liold of some local enterprise, such as a steam or street railway, secure the assistance of experts for inves- ti«iation and carry through the proposition to success. sun more frequently, however, so far as the writer has observed, such men underestimate the difficulties of the problem; they take it up with enthusiasm but are forced either to drop it or to call in men of wider experi- ence. The men to whom they generally turn constitute the tliird class of promoters, namely the larger bankers and brokers. The amount of promotion work performed by such men is limited and they usually confine their active participation— except for advice— to the financ- ing- of such enterprises as they take up. The late Mr. J.l'ierpont Morgan stood out as the most prominent ex- ample of this class. 101. Engineering frms as promoters.— The fourth class— and this is a recent important development- consist of engineering firms engaged in construction work of various kinds. Certain large engineering con- cerns have established a wide reputation for success in operating street railroads, water works, electric lighting plants, and so on. These firms naturally have built up a large and well-equipped staff of experts in those fields. As the staif is expensive, it becomes a pressing problem to keep them profitably employed all the time. In the effort to solve this problem such firms have drifted into the custom of taking up new enterprises of merit 200 CORPORATIOx\ FINANCE in m ■U-Jfj W and performing the work of promotion themselves. Their prime object in so doing is to employ their own engineering talents and +hc abilities of their staff to the best advantage. Incidentally, of course, they have no objection to securing some of the other returns that naturally follow from successful promotion. These engineering promoters have three great ad- vantages which have told heavily in their favor: (1) They are able to carry on a thorough investiga- tion of any project that is presented to them without much extra expense; and as they are constantly engaged in such investigations, they have developed a body of experts who are able to give the best possible judgment as to the outlook for success in each instance. Conse- quently they seldom go wrong. (2) They are almost invariably big enough and have resources enough to finance the projects which they undertake themselves, if necessary. However, as they are primarily engineers, not financiers, they nearly al- ways prefer to secure the greater part of the funds from other persons. This they accomplish by calling to their assistance some large banking and brokerage house, which will undertake to sell the securities of the corporations organized by the engineering firms. The alliance thus formed is of great advantage to the bank- ing house, inasmuch as it may accept with confidence the results of the investigation carried on by the engi- neering firm's experts. (8) The engineering firm, having a reputation to acquire and sustain, does not desert the new enterprise as soon as financed, as most promoters do, but sticks with it until it is a thor(>ughly established success. The en- gineering firm must have on its staff experts, not only in planning and building the street railroad or power PROMOTER AND CORPORATION 201 plant or whatever the new project may be, but also in operating the enterprise. It is in position, therefore, not merely to put the new corporation on its feet, but to give it a good running start toward success. Fur- thermore, if the corporation later gets into difficulties, the engineering firm may be relied upon to come to its assistance. With these advantages there is no telling how far the tendency toward promotion by engineering firms will go. It would not surprise the writer to see almost all business of this kind except the large projects turned over by common consent within the next few years to the well-established engineering firms. No doubt, as soon as this tei dency becomes well known, cheap imitators of the reliable engineering concerns will come into the field. This difficulty, however, can be o\ercome, and in the end we shall perhaps find the husiness of promotion cleaner, more reputable and con- ducted with greater ability than under present condi- tions. 102. Secret profits are illegal. — No mattter who the promoter of any particular enterprise may be, it is al- ways necessary for him to raise funds from outsiders for his new corporation; and in the process of raising funds he must make representations as to the standing and prospects of the corporation. He also frequently enters into contracts on behalf of the corporation to be. His activities in both directions frequently raise knotty legal questions, which it is important for us to notice. At law a promoter is in an anomalous situation, so far as his relation to his corporation is concerned. He is not, strictly speaking, an agent, because an agent must have a principal and the company promoted can- not be a principal because it is not yet in existence; *|: 202 CORPORATION FINANCE It = yet the courts have held that his activities in many respects are analogous to those of an agent. In addi- tion, a promoter is in a sense a trustee of the interests of the corporation that he is organizing. He is under obligations to do his best for the corporation and to act always in good faith for its benefit. Furthermore, he must disclose all the pertinent facts in connection with the contracts and bargains that he makes for the cor- poration to its officers and stockholders when formed. Generally speaking, secret profits and fraud on the part of the promoter are not merely immoral, but are re- garded by the courts as illegal as well. "Where such transactions are discovered the corporation may bring suit and recover damages. Thus four cases given in abstract below illustrate different phases of this prin- ciple. 1. B agreed to sell land to X and Y, promoters of a corporation, for $12,000. He then associated him- self with them and the three agreed to form a corpo- ration which should buy the land for $40,000, out of which B was to receive tlie $12,000 he had originally de- manded and in addition one-third of the profits of pro- motion. The company was formed, the purchase price of $40,000 paid and the stock of the company sold to outsiders. Subsequently the facts were discovered and the company filed a bill against the administrator of B's estate for the funds which B had received over and above $12,000, the ground of action being that B, as a promoter, was not entitled to make a profit by a sale of his land to the company at a fictitious value. The Supreme Court of Pennsylvania ordered a refund to the company of the amount received above $12,000. 2. B and C with the object of incorporating a mining company purchased oil lands for $10,000, and united PROMOTER AND CORPORATION 203 ill organizing a company to buy the lands for $81,000. It was represented to prospective shareholders that B and C had purchased in the interest of the company and that the price paid by the company was the same as that paid by B and C to the original owners. The cor- poration sued B and C to recover the difference between the price paid in the first instance, and the figure at wliich the property was turned over to the corporation, and the suit was successful. ,3. In a recent New York case it was shown that a promoter joined with the owner of a tract of land in procuring options of doubtful validity on adjoining tracts. The promoter then organized a corporation to purchase the land at an advanced price under an agree- ment with the owner that the profits thus secured were to be shared equally. The promoter bought the land for $66,223, though the deed to him recited $80,000 as tlie purchase price, and conveyed the land to the cor- poration for $80,000 and 400 shares of stock. He sold the stock to other stockholders and kept for himself the $13,777 profit. All of the money paid to the original o^vners of the land belonged to the corporation. It was held that the corporation was entitled to the $13,777 profits. 4. The promoters of a plantation company purchased land in Cuba for $40,000 and secured an option or addi- tional land so drawn that it appeared they paid $20,000 for the option, making the total purchase price appear to be $60,000. Tn fact, nothing had been paid. They organized a corporation and represented to their associa- ates that the plantation cost $60,000. They assigned their option to the corporation, taking $2,000 in stock as their share. Their associates retained the balance of the stock. It was held that the promoters were under a fidu- 204 CORPORATION FINANCE ii ciary relation to the corporation and that the corporation was entitled as against them to the cancellation of the stock so issued to them. It should be imderstood that there would be neither legal nor moral objection to a promoter's sale of prop- erty to his corporation at a higher price than he paid for it. The only obligation resting on him is that he should not conceal his profits. In practice it is very difficult to prevent concealment and the promoter may readily find methods of making sworn statements as to his profits that will be true, so far as they go, but will not be the whole truth. A scheme much used in buying property that is later to be sold to the pro- moter's corporation is to have it passed from the original owners first to another corporation owned by the pro- moter or to a friend of the promoter; then this corpo- ration or friend will sell to the promoter at a price far in advance of what was paid to the original owner and the promoter will be able to assert that he turns it over to the corporation he organizes at cost to himself or at a very small profit. Sometimes the property may be made to pass through two or three intermediate hands in order to make detection more difficult. 103. Misleading statements constitute fraud. — An- other feature of the promoter's work which should be considered relates to his statements with regard to the enterpr' n h tor a certain amount of stock with wliich to buy the plants re- quired and to pay expenses, permitting him to retain the sur- plus for his profits. In the case of the Rubber Goods Manufac- uring Company the syndicate subscribers furnishing cash re- ceived for each $100 paid in $100 in preferred stock and $90 in common stock. The promoters had to purchase the plants and were given the entire issue of preferred and common stock. If they could buy the plants for the proccds of 100 per cent of preferred stock and 90 per cent of common they made the 10 per cent of common stock for their profit; if they had to pay more than that sum their profits were correspondingly lessened ; if they could buy for less, naturally they made more than the 10 per cent of the common stock. They were under the express limitation that no preferred stock was to be issued in excess of tangible assets, and no conunon stock in excess o' an amount determined by the earning capacity of the plants, as shown by previous experience, capitalized on a 7 per cent basis. In the case of the American Smelting and Refining Company, syndicate subscribers for each $100 paid in cash received $100 in preferred stock and $70 in common stock. The promoters received the remaining $30 in common stock, out of which they had to pay the entire evuensos of organization. They retained the remainder for their profits. Speaking generally Mr. Chap- man states that when a financiering syndicate receives for its subscriptions par in preferred stock and sontbthing less than par in common stock the usual custom is for the promoters to receive the remainder of the common stock as pay for their serv- ices and for covering the costs of organization. In most cases their profits will depend upon the rigidity with which they can hold down their expense accounts, and, in many cases, where the purchase of plants is entirely in their hands, upon the skill which they can show in making purchases. Usually, of course, a careful appraisement has boen made of plants beforehand, so that the basis of the stock issue is well known to all parties in- terested in the deal. A certain speculative chance is also often given to the promoters through the fact that it is within their PROMOTER AND CORPORATION 20- (iiscrction to buy for cash or stocks as they can best make agree- iiunts with the vendors. In that case they can sometimes make much better bargains for themselves by paying cash, or, on the otlier hand, by persuading the vendors to take securities, thus lessoning the amount of cash that needs to be paid out. It is n^iilarly the case that the promoter receives his pay in common stock. Within the last two or three years there seems to have been a more conservative tendency shown by the bankers and others interested in financing the industrial combinations. The man who advances money to buj' the various plants is, in many in- stances, taking a considerable risk and expects often to secure , high pay therefor. The extent of his pay is dependent never- theless largely upon his judgment as to the future course of de- v(h)j)iiient of the business of the combination in question. He ]ir,utically buys securities of manufacturing establishments. If thty earn high dividends his earnings will be great, provided he retains the securities ; if he sells them his profits will be de- termined by the market rate of the securities, that being de- pendent again in the long run upon the earning capacity of the establishments. The more usual terms probably, under which within the last two or three years the financial agreements have hcen made, are that for each $100 cash paid in the subscribing iiienibcr of tho finaiicial syndicate receives par in preferred stook with a bonus in common stock equal to the preferred less the amount reserved for the pay of the promoter. This reserve has sometimes been as high as 50 per cent of the common stock, sometimes 30 per cent, and sometimes only 10 per cent. Instead of the plans mentioned above numerous others are of course found, especially where it is more desirable to issue bonds or where for some reason it seems desirable to make special terms, owing to the peculiar situation of some of the members entering into the combination. Promoters sometimes receive specified sums of money for their services ; bankers practically always have to take for their services a r* rcentage of the stock or the surplus left over. I.i 208 CORPORATION FINiVNCE U 106. The promoter's risks and labors. — Enough has been said to indicate tliat the promoter's labors and risks are heavy. If he does his work thoroughly he will probably spend a long time in careful investigation of the enterprise and in examination of all the possible causes of failure before he binds himself in any manner. If he is a man of sound judgment, as he must be in order to be successful, he will probably find serious if not fatal flaws in most of the enterprises that come to his atten- tion. A professional promoter niust expect, therefore, to spend a large amount of time and money in studies and investigations that bring him no return. Unless this part of his work is thoroughly done his efforts are foredoomed to failure. In the process of assembling his proposition, the promoter must always take coniJiderable personal risks. lie buys options, enters into contracts, and perhai)s spends money for further experiment, all of which will he absolutely lott unless his promotion proves sugcessful. In financing the enterprise, the promoter puts in jeopardy not only the time and money previously ex- pended, but his business reputation as well. One notoriously unsuccessful jjromotion will i)robably end a promoter's activities, at least if he is engaged in an entirely legitimate line of business. 107. Is the promoter overpaid? — It is obvious also that the promoter must possess a rare and highly valu- able conjbination of talents. He must be keen, shrewd, a good bargainer, farsighted, prudent, enthusiastic, persuasive, and, above all, he must inspire confidence. With this necessary combination of talents, labnrR and risks, it is not sur^^rising that the promoter should sub- sequently claim exact large profits. It is no doubt PROMOTER AND CORPORATION 209 ^ true that a considerable number of men who have won success in this field have made millions and tens of millions of dollars in a very short time. To the on- looker it sometimes appears that these millions almost came dishonestly, that it is hardly possible that they are legitimate earnings. The average on-looker, how- i \ cr, Ins no conception of the amount or importance of the preliminary work which the promoter performs. .\ either has he any conception of the large number of failures in this field. Probably the losses of promoters, wlio have spent their own time and both their ovm and their friend's money without benefit to themselves, would almost equal or perhaps exceed the total profits of successful promotions. We must not forget to consider also the great im- portance to business and industry of their achievements. They are the men who have found and developed the inventions, the improvements and the better organiza- tion of industry which underlie our modern prosperity. Frequently the inventor complains that he has made kss out of his invention *hat did the business promoter; the manufacturer complains that with all his years of (fl'ort he has made less out of his factory than did the ])r()moter who takes it into a bi^ corporation; the mine owner complains that he has made less out of his land nnd ore than did the promoter who obtained the funds for its developments. All of these complaints are natural enough; yet they all alike fail to take into ae- (oimt the obvious fact that the promoter's efforts have iK.t done them harm, but good. He has performed for each of them a great service; and even if he retains the larger part of the profits, they have no just ground for complaint. C_VI-14 m e i - i 11 m iiW !":ll^ CHAPTER XIV CORPORATE PROMOTION— FORMING CONSOLIDATIONS 108. The importaJH'c of small industrial combinations. — Of late years the most cdiispiciious and i)crhaps the most imi)ortant field for promoters has heen the con- solidation of manufacturing? and railroad companies. The tendency toward consolidation has heen even more widespread in the last few years than has appeared to the casual ohserver. Popular attention has heen directed almost exclusively to what is called the trust movement, that is, the coml)itiati()ns of big companies with a view to controlling prices. Of still greater importance, however, to the average business man has been the tendencv to consolidate small local plants, not for the sake of achieving even a partial monopoly, but for the sake of the economies that result from manufacture on a larger scale than is possible by a small ])artnership or corporation. Among the most important ec( rsuasiveness and business judgment that a promoter may possess. Usually managers and owners of the vari- ous plants to be taken into the proposed consolidation arc so mutually jealous and antagonistic that it is next to impossible for any one of them to effect a friendly combination with all his competitors. Once in a while a successfjil manufacturer may buy outright the securi- tiis, or perhaps the physical assets, of competing plants; init this is an exception. Usually the promoter of a consolidation must come from the outside. He will probably be better off if he has had no connection with the business and therefore has no grudges and no prej- udices to overcome. Sometimes the outside promoter is a lianker friendly with all the interests to be combined; sometimes he is a well-known promoter who has made a name for fair dealing and success; sometimes he is a 212 CORPORATION FINANCE security holder in one or more of the concerns to be con- solidated, who has taken no active part in +heir manage- ment. He will of necessity have constantly at his command the exper' lowledge of men directly con- cerned with the busuiess. For the sake of simplicity we will first consider the process of consolidating two or more small independent partnerships or corporations into a somewhat larger combination of some local importance ; and after that we will consider the still more complicated problems that arise in the process of forming a big "trust" — using that word in the popular sense — a combination of previous consolidations. 110. "Discovery" of a small consolidation. — In organ- izing a small consolidation the promoter's first step, as has already been indicated, must be a thorough inves- tigation of all the concerns which are to be included. Usually the promoter will not have the time or the facilities to undertake such an investigation personally or by means of his own assistants. But he should certainly be imwilling to accept the unsupported state- ments of the manufacturers; he will, therefore, use the services of competent engineers, of expert public accountants and perhaps of lawyers. The accountants' examination should produce the most important and significant results, and on these results the terms of the consolidation will probably be based. The accountant's work in this connection should be even more extensive and searching than in the case of a regular audit. This is particularly true because the managers in the case of an audit presumably desire a correct report; in the case of this special investigation their interests lead them to favor over- valuation of assets, fictitious accounts receivable and a padded in- FORMING CONSOLIDATIONS 213 i 1.1 come statement. The accountant must get an accurate physical inventory of the property, if possible; he must verify the accounts and bills receivable as well as the accounts and bills payable; he should look into all in- direct and contingent liabilities with great care; he must see that sales do not include goods sent out "on con- signment" and "on approval" and that profits are not swelled by sales of what are in reality capital, not current, assets. 111. Basis of consolidation. — The promoter's next step, if he is acting not simply on his own account, but as a sort of arbitrator for the various manufacturers, each one of whom is willing to go into the consolidation on reasonable terms, is to draw up a tentative "basis of consolidation." In an article in The Journal of Accountancy for Xovember, 1908, Mr. F. H. Mc- Pherson, F. C. A., gives in illustration the following informal memorandum of agreement which was used as a basis in a certain consolidation of small companies with which he was concerned. The agreement is typical and is well worth careful reading. It is given in full below: Basis of Consolidation: A corporation to be formed under the laws of the State of Michigan, with a paid-up capital of ten million dollars, to be apportioned into 6 per cent preferred stock and common stock, as the parties interested may hereafter determine. This corporation to purchase all the assets, property, good- will, etc., of all the four companies and to pay therefor in pre- ft rred and common stock and by an assumption of the indebtcd- riLss of each company. The amount of preferred and common stock, to be paid to f nch company, to be determined by the value of the net tangible assets and the valuation placed upon the earning power of each company. 214 CORPORATION FINANCE li In placing a value upon the tangible assets, same to be reached as follows: (1) The land, buildings, machinery, tools, and patterns, to be determined by appraisers, to be chosen by a majority of a committee made up of one appointed by each of the com- panies ; on failure of this conmn'ttee to agree on appraisers the selection to be left to the committee who present these suggestions. (2) Inventories of raw materials, work in progress and manu- factured stock to be taken, and valuations placed thereo bj' the individual companies, and this to be done under the supervision of a disinterested party, to be named by the committee. The inventories are to be made as of the same date, and to be taken at substantially the same time. When completed the inventories are to be passed and agreed upon by a committee consisting of a representative of each of the companies and one to be named by the committee. The decision of these five to be binding. (3) In reaching the value of the earning })ower of the several companies, consideration is to be given to the following de- tails: (a) That profits are incidental to the business and have not been anticipated. (b) To the charging to operating expenses of items, excep- tional or unusual, and which have had the effect of reduc- ing profits below normal. (c) The eflfect upon the earnings of the money paid out as interest upon borrowed capital, in case it be found that the borrowings (loans) made by the several companies are disproportionate to each other. (d) That all charges to operating expenses are proper charges against the business and that they are made for and during the proper period, (c) That proper and reasonable allowances have been made for repairs and renewals and that these have been charged against earnings. FORMING CONSOLIDATIONS 215 ( f ) That charges against earnings for depreciation are ad- justed upon an equitable basis. (IaQt which have been deducted from earnings during said FORMING CONSOLIDATIONS 219 ; m period of five and one-lialf years, and tlic said amounts so as- certained are set forth on the schedules of said vendors. In order to place said vendors on a uniform basis as to the iiiuounts expended, or which ought to have been expended, for repairs, renewals and maintenance of plant and charged against (>r deducted from the earnings during said five and one-half vears or other period, each vendor shall add to saic' earnings ;iny amount actually expended by it for repairs, renewals and maintenance of plant which it has heretofore charged against and deducted from said earnings, and there shall then be charged against and deducted from said earnings of each vendor ascertained as aforesaid, annually a sum pqual to 3 per cent of the schedule value of the plant of said vendor completed prior to the last date of the five and one-half years or other period applicable to said vendor. In the case of those vendors, if any, which shall not have kept a separate repair account the amounts expended by them for repairs, as required by this subdivision, shall be ascertained as n^jarly as possible by the accountants and the committee of ap- praisal from the books of such vendors and from the condition of their plants and otherwise, and in default of information to the contrary it shall be assumed that they have expended in re- pairs a sum equal to 3 per cent of the value of their respective plants. Having by the foregoing methods, ascertained the earnings, there shall thereupon be deducted from the average annual earn- ings of each vendor for said period, a sum equal to 6 per cent (5%) of the value of the land and plant sold and completed prior to the last date of the five and one-half years or other period applicable to such vendor, and the balance of said aver- age annual earnings so ascertained shall be deemed for the pur- poses of this agreement the net profits of the respective vendors to be severally multiplied by ten as aforesaid. Provided, however, that in case it shall be found that the aforesaid multiplier of ten will produce a grand aggregate of common stock greater in amount than the grand aggregate of preferred stock, the Executive Committee shall choose such 220 CORPORATION FINANCE I a ¥ lower multiplier as will limit the grand aggregate of preferred stock. Provided, further, that in the event that the grand aggregate of the average annual net earnings of the vendors, ascertained as aforesaid, shall be found to exceed 12 per cent of the total value of the tangible property, then said Executive Com- mittee in its discretion may choose such multiplier as will fix the i 1 1: volume of common stock as closely as may be at an amount upon which such past net nearnings would show 6 per cent applicable to dividends upon such common stock after providing for the dividend on the preferred stock. And thereupon such newly chosen multiplier (whatever the same may be) shall be the multiplier to be used in the case of each vendor. The agreement that has just been cited in part de- serves careful study. As the extracts given are self- explanatory, however, it will be left to the reader to work out for himself the exact methods employed by the pro- moters, and accepted by the owners of the plants in determining values. The substance of the plan, it will be seen, is that tangible property is to be represented by preferred stock in the consolidation and additional earning power by common stock. This puts the consol- idation, so far as capitalization is concerned, on a con- servative basis. The same plan, slightly modified, is widely used. 112. The necessity for ca*^.— Having investigated and assembled his proposed consolidation, the promoter must next arrange for its financing. It may be said at this point that the basis of consolidation in itself finances the new consolidation, inasmuch as it provides for the :B|^|: exchange of the consolidated company's securities for the subsidary companies* securities. This financing is not sufficient, however, to provide for the needs of the new corporation. Working capital, to a considerable 11 ' FORMING CONSOLIDATIONS 221 amount, must certainly be obtained or the new corpora- tion will plunge at once into banki-uptcy. Further- more, a consolidatio- almost always implies changes in methods of operation. New officers must be appointed, old ones dismissed. Some of the plants perhaps will be dismantled or put on part time; other plants will be remodeled and refitted with expensive modem machin- ery. Frequently the whole arrangement of the plants and processes of manufacture will be reformed in order to introduce the methods that belong to large scale production. All of these changes may be necessary in order to obtain the economies that belong to combina- tions. They may and probably will prove wise and in the end highly profitable. At the moment of forming the consolidation, however, they call for large amounts of new capital funds and bring to the front some of the most difficult problems of financing which a promoter lias to face. 113. One method of raising cash. — Following the basic principles outlined in Chapter XII, the promoter of a small consolidation will endeavor to raise whatever cash is necessary first of all from local bankers and financiers. If he succeeds in obtaining the coopera- tion of these men, he is much more likely to find his proposition regarded favorably by larger banking in- terests. Two courses are now open to him; either he may issue bonds of the new company, which will not be first mortgage, but which he may name "first and refunding" or "first general" or "first consolidated"; or lie may try to sell stock in addition to that which has been given to the owners of the consolidated plants. Either course has its disadvantages. The bond issue probably cannot be sold on advantageous terms because the consolidation must necessarily be an experiment at t ' I eI 'i pi . 1 :: ■ :i m H ^B 1 . In ■r IB 1 11 1 IB IT'' 222 CORPORATION FLXANCE the beginning and even its best securities will have a speculative character. Furthermore, in many cases the promoter will find the property of the subsidiary com- panies already mortgaged so that the bonds of the con- solidated company, whatever title he may pick out for them, will be in reality junior liens. The sale of stock is undesirable because the stock issue in all probability is already large; it has to be large in order to make the terms offered to the owners of the subsidiary plants sufficiently attractive. If still more stock is issued to be sold to the public, it will be very difficult to pay dividends even on the preferred, not to speak of the common. This result, the promoter certainly does not desire. He has promised usually heavy cumulative dividends at once on the preferred stock and has held out hopes of early dividends on the common, and his reputation is staked on the fulfillment of these predic- tions. Moreover, he is himself usually a large holder of the common stock. On balancing these considerations, the promoter usually finds himself strongly inclined to favor the sale of bonds if they can be sold at any reasonable price. His sanguine temperament — for that kind of tempera- ment naturally belongs to a promoter — leads him to minimize the danger of increasing the new corporation's fixed charges and to exaggerate the probable profits. He therefore turT». to local bankers for assistance in borrowing tlic necessary funds. Frequently, as the first step, he has the corporation put out a bond issue under a mortgage of the limited open-end ty]»e. The pro- vision may be. and often is. that of tlic total issue one- half shall be offered for sale in the first year, one-fourth in the second, and one-fo\n*th in third vear: of course, the length of time over which the sale is spread and the FORMING CONSOLIDATIONS 223 corporation's allotment each year may vary indefinitely, depending on the urgency of the company's need for cash. He then obtains a guarantee from local finan- ciers, including perhaps some of the banks, to take the unsold bonds at the end of each period from the corpora- tion at a low price which is specified. By this guarantee the corporation is protected from an absolute failure to secure cash. The guarantors must, of course, be paid, usually by a considerable commission on all the bonds that are sold. This kind of arrangement, which we will consider at greater length later, is known as under- writing. The promoter may now take his bond-issue— or pa.t of it, if he has been able to get the sale of only a part guaranteed — to a friendly bank and secure a short- time loan, using the bonds as collateral security. He lias thus provided for the immediate cash necessities of the new company at the beginning of its existence. As fast as he can sell the be ids, he pays off the bank loans and thus puts the corporation in a stronger financial position. If the issue is entirely successful, the corpo- ration will soon have plenty of cash, obtained by this bond issue, and will be able to carry out the improve- ments in operation which are expected to make the consolidation a profitable venture. The essential feature of this plan, it will be noted, is tlie distribution of the risk among several different parties. The bank is well protected in accepting the bonds as collateral by the guarantee of responsible parties to buy the bonds nt the end of a certain period, if no purchaser willing to pay a higher price is pre- viously found. The guarantors usually take little risk, for the price of the bonds to them is made low enough to be attractive. The corporntitm obtains at enou once what- 224 CORPORATION FINANCE I ri if i ever cash is necessary and its only risk is that it may have to sell its bonds to the guarantors at a low price. Naturally the promoter in the period left to him before the guarantors' option becomes effective does his best to sell the bonds at a good price. The methods which he uses and the agencies through which he works are fully treated in later chapters. 114. Problems in forming a large consolidation.— There is no difference in principle between the pro- moter's functions in forming a small and his functions in forming a large consolidation. He is doing things on a bigger scale, however, and finds necessary several important variations in his methods. In the first place, such a consolidation is almost always too large to be handled by any one man. In order to reach all the parties concerned and to inspire confidence, it is generally desirable for several promoters to work together, each performing a portion of the labor. When the United States Steel Corporation was formed, as described in the following chapter, almost all of the prominent, successful promoters of the country were concerned !n one way or another. Apart from the necessity of dividing the work to be performed, it is very desirable to promote harmony and secure the best solu- tions of the difficult and complicated problems invob'ed in such a consolidation by getting the ideas of a con- siderable number of able and experienced men. In the second place, the promoter or group of pro- moters is dealing with such a large number of security owners of subsidiary companies that lengthy consulta- tion with these owners and bargain-making is out of the question. TTsually the hea\'y stockholders in the subsidiary companies are consulted and frequently they have some part in the scheme of promotion. The great "N>? FORMING CONSOLIDATIONS 225 mass of stockholders, however, are simply notified, when the proper time comes, of what is proposed and are in- vited to accept the oifer which the promoters lay before them. 115. Basis of consolidation. — The amount and char- acter of the security issues of the proposed consolidation, and the terms upon which these securities will be exchanged for the securities of the subsidiary companies, are fixed by the promoters in advance. This does not mean that the terms are unfair to the subsidiary com- panies' stockholders. On the contrary, ihey are usually extremely liberal. It must be remembered that it is very desirable for the holding company to have all the stock — certainly all the voting stock — of each sub- sidiary. The less subsidiary company stock there is left outstanding, the less is the chance of complaint and annoying legal processes on the part of the dissenting stockholders against the actions of the holding company. The promoters, therefore, try to oflPer such terms that all, or almost all, the stock of subsidiary companies will he exchanged for stock of the consolidation. The usual arrangement is to divide the capital stock (tf the consolidation into preferred and common, the amount of the preferred being equivalent to the total market value of all the subsidiary company stock. Practically any amount of common stock may be issued; the promoter usually puts out as much as he thinks can possibly obtain dividends within a reasonable number of years. The stockholders of the subsidiary companies are then off'ered somewhat more than the market value of their stock payable in cash, or consid- t rably more than its market value payable in preferred stock. If they take preferred stock, they will ordinarily receive in addition a substantial bonus of common stock. C— VI— 18 220 CORPORATION FINANCE 11 f: U The first proposition is intended to catch the ultra-con- servative; the second proposition is intended to be even more attractive. The stockholder is to receive in place of his present holding, having a fluctuating and uncer- tain dividend, a more than equal amount of stock preferred as to dividends, and in addition a considerable amount of the new common stock. Very few stock- holders are likely to refuse so attractive an offer. The application of these principles is well illustrated in the promotion of the biggest and one of the most successful consolidations that has yet been fon-ned, the United States Steel Corporation. So important is this great company, not only in connection with our present study of corporation finance, but in its influ- ence on industry in this country, that it has been I bought best to devote a separate chapter to a review of its origin, its promotion, its financial history and its prospects. 116. The Interhorough-MetropoUtan Consolidation. — Another typical consolidation which was formed under very different conditions is the I nterbo rough-Metropol- itan Company, the holding company for the transporta- tion companies of New York City. A chart showing the complicated internal organization of the company has been presented in Chapter VI. The terms of the consolidation are clearly set forth in the following ex- tract from a lecture by Albert W. Atwood, Financial Editor of the New York Press and Lecturer on Invest- ments in New York University. 1 . Companies Taken Over. Metropolitan Steel Railway $ 52,000,000 stock Metropolitan Securities Co. .'J0,000,000 ♦* Intcrborough Rapid Transit Co. ^5,000,000 " $117,000,000 FORMlxNG CONSOLIDATIONS 227 Capitalization of Inter-Met, Bonds Preferred Stock Common Stock Total Deduct $ 70,000,000 55,000,000 100,000,000 $225,000,000 117,000,000 Excess $108,000,000 3. Basis of Exchange. Interborough — one share received $200 bond and $99 common stock in the Intcr-Mct. Metropolitan Street — one share received $100 pre- ferred and $55 common in the Inter-Met. Metropolitan Securities — one share, $75 paid up, re- ceived $93.50 common in the Inter-Met. The Interborough-Metropolitan took over practically all the capital stock of the subsidiary companies. In 1902 the Metro- politan Street Railway, which had been the company which con- trolled and operated the surface lines, ran short of money and a scheme was devised to keep it going by leasing it to the New York City Railway (which had a comparatively small amount of stock) the stock of which was in turn all taken over by the Metropolitan Street Railway shareholders. By getting a large majority of the stocks of the Metropolitan Street Railway and t! Metropolitan Securities Company the Inter-lMetropolitan got control of the entire surface system and by securing the stock of the Interborough Rfti)id Transit it got control of the subway and elevated lines. The total of securities taken over was about $117,000,000 and the new company issued $225,000,- 000 of securities. The excess capitalization was $10C,000,000, which in view of the fact that many believed the surface lines «(re already waterlogged, was a remarkable piece of finance. Tlirce reasons are advanced for the excess capitalization: 1. The promoters say they honestly believed that within two or three years the common stock would be earning 2 per cent. 228 CORPORATION FINANCE il^'i: h; 2. The merger was formed at the height of the business and financial boom of 1906 and at that time the later financial and business reaction was not generally foreseen. 3. The holders of the securities of the old companies had to have an inducement to exchange their securities for the new ones. In other words, they had to be hypnotized into believing that they were getting something for nothing. Much was made of the growth of the passenger trafBc in New York and the official prospectuses declared the common stock of the new combine would certainly be able to pay dividends in time owing to the growth of population. These two illustrations will serve to indicate the gen- eral practice in exchanging a consolidated company's securities for those of the subsidiary companies. It may be observed that the steel consolidation was far more conservative than was the Interborough-Metro- politan consolidation. The second-named company was in a dangerous situation from the very beginning, for it was compelled to pay regular interest on its large bond issue or go into receiver's hands. The steel corporation gave only a small amount of bonds — rela- tWe to its total capitalization — and consequently was not in serious danger of insolvency. Even if it had failed to pay interest on its preferred stock it would not have been forced into a perilous position. The Interborough- Metropolitan financing was on its face so unsound as to arouse the suspicion that this particular consolidation was never intended to succeed. 117. Canada's experience in forming consolidationt. — Canada's experience in industrial consolidations has been confined to recent years, more partictilarly from 1910 to 1918 inclusive. Indeed, it has been a new factor in corporation financing in that country and one which has not proved eminently successful. Generally speak- 1»V FORMING CONSOLIDATIONS 229 ing, the features of the movement have been the large number of consolidations, the heavy capitalization (often proving to be over-capitalization) and the conse- (juent necessity for reorganization. In the volume on Investment and Speculation," figures are cited showing that the number of industrial mergers negotiated in the Dominion from January, 1909, to January, 1913, was 56. The aggregate authorized capitalization (includ- ing bonds) of these mergers was $456,938,266. The 56 amalgamations absorbed 248 individual companies. The aggregate capitalization of 206 of these individual com- panies was approximately $167,289,182, which amount in various ways was increased upon amalgamation. The 40 securities issued to the public, resulting from the amalgamation movement, totalled $57,346,666. With 16 of these, amounting to $16,500,000, an aggregate bonus of $6,750,000 was given. The largest consolida- tion was the Canada Cement Company, which absorbed twelve companies. Its authorized capitalization, in- cluding bonds, amounted to $38,000,000. Amalgamation operations have not been confined to one or a few classes of commodities. Companies hand- ling soap, cereals, asbestos, bread, flour, milk, cars, leather, lumber, cement, dried fish, carriages, bolts and nuts, steel, coal, ice, felts, shoes, furs, crockery, paint and jewelry, have all seen apparent or real gain in a combination of interests. Arrangements have also been made between navigation, light and power, brewery, canning, retail box and numerous other companies. These instances are sufficient to exemplify the wide- spread nature of what is a new feature in Canadian commerce and finance. Among the objects and advantages to be gained by consolidation, the following have been cited by promot- ers in Canada: I I 4 230 CORPORATION FINANCE «s' The standardization of brands. Elimination of needless competition. Securing of further working capital. Prevention of increase in prices to the public. Keeping pace with the growing market demand. Elimination of a large amount of freight charges. Savings from the concentration of the executive force. Economies in the purchasing, manufacturing and sell- ing departments. Ability to establish branches of the one company in various parts of the country. Specialization of various plants, dispensing with un- necessary duplication of output and patterns. Although, naturally enough, the fact that companies have found themselves in a critical condition, is not stated by promoters as a reason for consolidation, this was probably the real cause in some cases. Keen com- petition, bad financing or disaster on the part of one company might be met to some extent by being swal- lowed by a combine. 118. Basis of consolidation. — The basis of consolida- tion is one of the most important considerations for the shareholders of the companies absorbed. The promot- ers of amalgamations in Canada have given little infor- mation to the public on this point. Generally speaking, the companies forming the merger have taken bonds, preferred or common stock in the combine. Supposedly, the individual companies have usually desired a fairly large holding of the amalgamation's bonds. Preferred stock has sometimes been accepted with, in some cases, a bonus of common stock. In the formation of these new companies, it would seem that comparatively little cash has been paid by the consolidation for the proper- ties of individual companies. FORMING CONSOLIDATIONS 881 This exchange of securities might possiblj lead to un- due inflation of capitalization including the bond issue, l)ut there are two counteracting influences: first, the companies entering the trust would naturally wish to obtain a fairly large share of the bond issue, which ranks first in ^he matter of interest payments; second, if the bond issue were made unreasonably large it might prove a difficult task to make the earnings of the amalgama- tion sufficient to pay the interest on the bonds. The average merger bond should prove a safe investment, although in Canada, unfortunately, it has not always done so, owing chiefly to over-capitalization. One of two instances of the basis of consolidation may be cited. In the case of the Steel Company of Canada, the various concerns included agreed to accept the bonds of the amalgamation for two-thirds of the appraised vahie of the properties. They also agreed to accept pre- ferred stock for the remaining one-third of the appraised value plus the liquid assets of the properties, and com- mon stock against the earning capacity as demonstrated by the history of the company. An important provision is that by which the company is prevented from paying dividends on its common stock until such time as, from earnings of the company, there has been placed in the treasury a sufficient amount to pay dividends on the preferred stock for one year in advance. ^Vhen the sale of the Brantford Screw Company to the Canada Bolt and Nut Company was confirmed by the shareholders of the former concern, the following division of stock was agreed upon: holders of Brantford Screw Company preferred were to receive seven per cent cumulative preferred stock in the Canada Bolt Com- pany, at the rate of $145 for every share, and in addition, 282 CORPORATION FINANCE II- a bonus of thirty per cent in the common stock of the new company. Holders of the Brantford Screw Com- pany common stock received $120 in new T,ref erred and thirty per cent in new common. The proceeds realized by the Canadian Pacific Lum- ber Company, Limited, from the sale in July, 1911, of $1,750,000 (approximately) six per cent first mortgage bonds to bearer, less expenses, were to be applied ex- clusively in carrying out the consolidation of the five properties in which it became interested. The proprie- tors relied entirely for their profit on their holdings of shares in the company. Of the $3,650,000 six per cent first mortgage and col- lateral trust bonds of the Canadian Steei Foundries, Limited, issued in March, 1911, $2,900,000 (including a public oflFering in London of $2,000,000) were issued for the purchase or acquirement of control and for the development of the properties of the Montreal Steel Works, Limited, and the Ontario Iron and Steel Company, Limited. The sum of $750,000 was re- tained by the trustee for retiring a similar amount of bonds of the Montreal Steel Works, Limited, then out- standing. 119. Dangers of over-capitalization.— Tae capitaliza- tion, and, in that connection, the issue of securities to the public, is perhaps most liable to abuse by self-in- terested promoters. In most cases the aggregate capi- tal of the mergers is in excess of the total capitalization of the companies absorbed. Good reasons have some- times been advanced to account for that fact, but this is a phase of the amalgamation movement, conceming which by no means sufficient information has been given by the average merger promoter. Making allowance for various considerations, the capitalization of the aver- FORMING CONSOLIDATIONS 23a age consolidation in Canada still appears to be larger than that of the total capital of the contributing corpo- rations. After allowing for money required for extensions, re- organization, new factories, and the like, one must con- dude that a proportion of the securities issued by the mergers has been what is popularly known as "watered stock." Although many companies have not issued se- curities to the limit of authority granted them, their power to place bonds and stocks upon the market in fu- ture may extend far into the next decade. If stock and bond issues of the amalgamations are forced into domes- tic and other markets, with an appetizer in the shape of a bonus, there is likelihood of protest on the part of the public. This is especially so in the London market, where the securities of several Canadian mergers have l)een floated and are likely to be sold in the future. The investor will regard favorably the stocks and bonds of a consolidation conservatively planned and financed without an ill-concealed effort to market practically use- less and valueless securities. Stock watering is usually accomplished with ease, but the public are becoming more accustomed tr analyze the statements of new com- ])anies and to invest accordingly. As has been stated previously, a large number of in- dustrial consolidations in Canada have had to undergo drastic reorganization. 120. Bcorganhation of industrial consolidations. — One of the most notable breakdowns of recent years among the consolidations of Canada was that of the Amalgamated Asbestos Corporation, Limited, in 1912. Action was taken by the directors, and a bondholders' committee was appointed to save the company from com- ]ilete disaster. A new concern, the Asbestos Corpora- 21U CORPOKATIOX FINANCE I } I tion of Canada, was formed, and the old company's properties were purchased. The capital and bonding powers were $7,000,000, divided as follows: First mort- gage forty-year, five per cent bonds, $3,000,000; six per cent preferred participating stock, $4,000,000; common stock, $3,000,000— total, $10,000,000. This compared with a stock and bond capitalization of $2,500,000 of the old company. In submitting their reorganization scheme, the bond- holders' committee pointed out that it was evident from the operation of the company that the original capi- talization, involving a fixed charge of $400,000, was ex- cessive. The average earnings for a period of three and a half years were not less than $250,000, and under nor- mal conditions the company should exceed this. The plan of reorganization suggested was the formation of a new company, with a capitalization of $5,000,000 bonds, of which $2,875,000 were issued at the outset, $4,000,000 of six per cent participating preferred stock, and $2,875,000 common stock. Under this plan the holder of $1,000 par value old bonds received $250 new first-mortgage l)onds, $500 new six per cent preferred stock, and $250 new common stock. To provide work- ing capital, it was proposed to sell $875,000 new first mortgage five per cent bonds. The annual statement for 1911 showed that the profits for the year were only $98,003, against a bond interest of $400,000, unfavor- able conditions in the trade, and the unsatisfactory re- sult of certain contracts telling heavily against the com- pany. The Black Lake Consolidated Asbestos Company was another Canadian concern which encountered financial difficulties, and was reorganized in 1912. A new com- pany, the Black Lake Asbestos and Chrome Company, FORMING CONSOLIDATIONS 'JSo Limited, was formed, with bonding powers and ca il i- zation as follows: Six per cent income bonds (to be issued bond for bond to holders in the old company) $1,250,000 First mortgage 6 per cent bonds (to be held in treasury) 250,000 Preferred stock 1.000,000 Common stock • 8>000,000 $5,500,000 The capital stock and bonds of the old company were as follows: Authorized Issued Ijonds $1,500,000 $1.2:^0,000 Preferred stock 1,000,000 1,000,000 Common stock 3,000.000 3,000,000 $5,500,000 $5,230,000 It is interesting to note that two reorganizations of Canadian industrial consolidations resulted in wiping out stock and bonds, mostly "water," aggregating $19,- 000,000. 121. Most complicated merger in Canada's history. — One of the most important and far-reaching consolida- tions during recent years, in Canada, was the merging of its lake steamship companies. To create this consolidation, a new company was formed called the Canada Transportation Lines, Lim- ited, the authorized capital of which was $25,000,000, divided into 125,000 seven per cent cumulative prefer- ence shares of $100 each and 125,000 ordinary share? of $100 each, and with authority to issue thirty-year first 'jm ( 'ORPOIIATION FINANCE mortgage debenture stock of $8,000,000 bearing interest at five per ce-^ Mi power to increase the amount of such mortga^^ ^.eoenture stock from time to time, pro- vidmg the proceeds were used for the purchase of new boats or other property necessary for the company to acquire, and on terms fully set forth in a mortgage trust The new company will eventually acquire as going concerns, including all their assets, good-will and profits for the current year, the following companies: Richelieu anc Ontario Navigation Company; Inland Lines, Lim- ited; Northern Navigation Company, Limited; Niagara Navigation Company, Limited; St. Lawrence River Steamboat Company, Limited; Richelieu and Ontario Navigation Company of U. S. A.; Quebec Steamship Company, Limited; Canada Interlake Line, Limited- Ontario and Quebec Navigation Company, Limited! Merchants Montreal Line; S. S. Haddington, and the Ihoiisand Island Steamboat Company, Limited. The assets of these companies were appraised and the acrounts audited. The appraisal company's reports and auditors' statement were open to the inspection of the shareholders. The new company had assets, as shown by the statement of the appraisal company, of $33,053,- r)38, in which vessels were valued at $10,806,834; real estate, buildings and dock properties at $5,450,267.99; $061,.531.04 cash on hand, and the sum of $8,694,969.89 represented the value of leases, contracts and good-will acquired by the company and covered by ordinary shares. The company started free from debt over and above the debenture stock issued and current amounts. The net earnings of the consolidated companies for the year ended December 81, 1912, were $1,494,554.48. which showed a margin for the payment of interest on FORMING CONSOLIDATIONS 237 debenture stock and interest on the preferred stock with a fair amount applicable to reserve and ordinary stock. Allowing for the new tonnage not in operation in 1912, on the same basis as earnings on similar tonnage in 1912, the increase in net earnings over the previous year from that source alone was estimated at $263,000. Little information was obtainable as to the terms of exchange for shareholders of the companies entering the consolidation. According to Mr. Jahies Carruthers, president of the Richelieu and Ontario Navigation Com- pany, one of tije largest entering the merger, the im- portant point that the directors had to consider was whether, in their opinion, it was in the interests of the Richelieu shareholders to sell out the assets and under- takings of that company, and if so, whether the Riche- lieu shareholders were, in their opinion, obtaining a fair share of the stock of the new company for the stock which they held. Severe criticism was leveled at the promoters of this navigation consolidation as to what was termed "the dis- appearance" of eight and a half millions of common stock. This eight and a half millions was left over after the purchase of the Richelieu and Ontario Navigation Company's stock. Following this purchase, the Cana- dian Transportation Company had to secure control of the Interlake IJne, the Quebec Steamship Company, the Thousand Island Line and other interests which absorbed in the neighborhood of four and a half millions of the eight and a half millions stock left over. This left in the neighborhood of four niilllion dollars to be divided between the Canadian ]>romoters of the merger and the English houses who financed the project. It is said that the Knglish house which put up the money exacted sti^ terms and secured the major part of the 238 CORPORATION FLNANCE I '• « t four millions of common stock. This left but a little over a million dollars to be divided between the Canadian pro- moters and interests who brought about the consolida- tion which, as a Montreal critic said, "In view of the magnitude of the merger, the amount of time they de- voted to it and, in contrast to some of the gratuities other promoters have secured, is not out of proportion." In financing the merger, it was planned to issue f 7,500,000 five per cent debentures which would retire all outstanding bond issues and permit of but one secu- rity being placed on the market. In some cases it was proposed that the transfer of bonds should be on a basis of earning power whether they were "seasoned" or not. Those who objected to an exchange of bonds would iii all probability be offered a cash price for the holdings. It was believed by the promoters to be in the interests of the water transportation companies of Canada that they should get English capital on a large Fiale inter- ested in this business just as it is to-day interested in the great railroads of the country. The only way this could be accomplished successfully, in their opinion, was to be connected with a new company large enough to command the interest of some of the most important financial houses in London. The $2.5,000,000 author- ized capital of the new company will l)e listed on the London Stock Exchange and a substantial portion of the preferred stock was to be taken at par by strong financial interests in London. x^ CHAPTER XV THE UNITED STATES STEEL CORPORATION 122. Preparing the ground.~lS90 to 1900 is an im- portant decade in the history of the steel business of the United States. Between 1890 and 1893 production was vastly increased, while the demand for iron and steel products practically stood still. As a result, prices were declining and a majority of the steel producers wore in a precarious situaJ.n even before the severe crisis of 1893 began its work of destruction. The crisis Iiit the steel makers especially hard, and wiped out many of the small concerns. In the five years of depression that followed, individuals and partnerships as factors in steel production almost disappeared; their places were taken by comparatively large and strong corporations. These corporations not only managed to live, but even to thrive in a waj% because they were able to buy new plants and enlarge old ones at bargain prices. By the year 1K98 in all branches of the steel industry, including bar iron, rolled iron, steel rails, sheet steel, tin plate, wire and other more highly finished products, a considerable number of fairly efficient and well-managed corpora- tions, which had grown in strength during the depres- sion, were prepared to handle tlie flood of new business that was expected to come with the revival of good times. The floml came and with it such a rise in prices and a 'It luge of profits as would have seemed inconceivable f"o or three years before. Steel, in Andrew Carnegie's picturesque phrase, is either "a prince or a pa»jper." 280 I 24U CORPORATION FINANCE H The reason is that, as large amounts of fixed capital must be invested, the supply of steel products cannot easily be increased or decreased ; whereas, as steel is not a prime necessity, the demand ^uctuates violently. In other words, since supply and demand do not move up and down together, prices and profits jump from one extreme to the other with extraordinary rapidity. 123. The steel consolidations preceding the forma- tion of the United States Steel Corp ition. — In 1908, then, American steel makers had reaoned a higher level of prosperity than ever before and were moving rapidly upward ; the business was carried on by a comparatively few fairly strong corporations in each line; at the same time, public interest in the advantages of industrial com- binations and in their supposed opportunities for great profits was keen and the public appetite for the securi- ties of such combinations, or "trusts," had ben excited. Placing these three factors together, we see why the three years following, 1898-1901, were marked by a remarkable series of steel consolidations. We cannot take time here to tell the stories, interesting though they would be, of these consolidations. For our purpose it will be enough to name the important steel companies in existence in 1000. 1. The Federal Steel Company was formed in Sep- tember, 1908, by combining the Illinois Steel Company, the Minnesota Iron Company, and the Elgin, Joliet and FiBstem Railroad. Its authorized capital was $200,- 000,000 of which, however, only .$99,700,000 was ever issued. 2. The American Steel & Wire Company was organ- ized by John W. Gates in March, 1S98. It was big enough to control virtually the entire production of wire goods. Its capital was $00,000,000. THE UNITED STATES STEEL CORPORATION 241 3. The National Tube Company, formed in Feb- ruary, 1899, included over a dozen companies. It was the largest concern of its kind in the world and at the time the third largest concern in the iron and steel busi- ness, being surpassed only by Carnegie and Krupps, of Germany. 4. The National Steel Company, the American Steel IIoop Company, the American Sheet Steel Company and the American Tin Plate Company were organized in the period from December, 1898, to March, 1900, by Judge W. 71. Moore, his brother, James H. Moore, Daniel G. Reid, William B. Leeds, and others who were later given the titles "Moore Party" and "Rock Island Crowd." Of these concerns the largest was the Tin Plate Company, which was a consolidation of forty companies, embracing about 95 per cent of the total output of tin plate in the United States. .') The biggest and most powerful company of all. The Carnegie Company, was not a consolidation, but a prowth. This great concern had been built up by the consistent policy, extending over many years, of putting most of its earnings into improvements, instead of into dividends. The organizing genius of Carnegie, Frick, Pliipps, and their co-workers, had made its body of workingmen the most efficient and its enormous plant the most economical in the world. Through its control of the II. C. Frick Coke Company, the Oliver Mining Company, the Pittsburg Steamship Company and the Pittsburg, Ressemer & I^ake Erie Railroad, together with its fit. .-year contract with the Rockefeller iron, mining and transportation companies, its supply of raw materials at low cost was assured for many years to come. 124. A condition of unstable equilibrium. — In one of r— VI— ifl ;>»■ 242 CORPORATION FINANCE ' the most brilliant chapters in his well-known volume on "Trust Finance" Professor E. S. Meade has well de- scribed the conditions in the steel business in 1900. In- dustrially the situation might be said to be one of un- stable equilibrium. It might have been expected that all of these consolidations would have been content to enjoy the prosperity, which was being showered upon steel makers, and would have desisted from intense com- petition with each other. Ordinarily competitive strife awakens in periods when business is stagnant and mills idle, while harmony is readily secured so long as orders are outrunning production. This would, in fact, have been the happy situation in the steel trade if it had not been for the appearance of a powerful new factor, the tendency toward integration. "Integration" is the economist's technical word for the control by one concern of the whole process of production from the raw material to the finished product. Ordinarily the manufacture of any finished article, say a tin can, is carried on through several stages, and at each stage passes from one group of producers to another group. In making the tin can iron ore must be mined ; the miner sells his ore to a manu- facturer who transforms it first into iron and next into steel; this manufacturer sells his product to a manufac- turer of sheet steel, who in turn passes it on to the manu- facturer of tin plate; finally the can manufacturer buys the tin plate and forms it into tin cans. At each stage of siich a process there is a sale of the partly finished product and a profit is taken that enters into the final cost of production. Under the pfdicy of integration, according to which all these stages are combined under the control of one great mnnnfaeturing concern, a two- fold advantage is gained; first, the intermediate profits arc all secured ; second, a permanent, dependable supply THE UNITED STATES STEEL CORPORATION 243 of raw materials at lowest costs is assured. This second advantage is even more important than the one iirst named. The Carnegie Company in 1900 up to a certain point was an integrated company; that is, it controlled great quantities of ore and coal, owned its own steamships and raihoads for the transportation of these raw materials to its Pittsburg plants, and at the Pittsburg plants turned out steel rails and a large variety of half-finished products. It was partly for this reason that the com- pany had become so strong and prosperous. Neverthe- less, it was by no means wholly independent, for its chief customers were the other steel companies in the Pitts- burg district which purchased its steel billets, ingots, i)ars, plates and slabs. The Federal Steel Company, also, was "integrated" up to a certain point, but like the Carnegie Steel Company was by no means independent of its large customers. A large part of its business consisted in furnishing wire rods to the American Steel and Wire Company and steel billets to the National Tube and the American Bridge Companies. The Na- tional Steel Company, a much smaller concern, fur- nished part-finished products to the other Moore com- panies, the American Tin Plate, American Sheet Steel, and American Steel Hoop. The group of producers of finished steel products were by no means satisfied with their position. They desired to secure the advantage of integration for them- selves; particularly they were anxious to free themselves frojn the domination of the concerns on which they were dependent for raw materials. Therefore, all of these (oinpanies in 1898, 1899 and 1900 were planning to pur- cliase ore and coal lands, to get control of transportation companies and to construct furnaces and mills for the ^■t 2U CORPORATION FINANCE manufacture of part-finished steel products. The American Steel and Wire Company brought two thou- sand acres of Connellsville coal land and large ore prop- erties. It already had partially under its control a fleet of twelve ore steamers. It now announced its intention to build large steel plants at Milwaukee and Pittsburg. The National Steel Company purchased iron mines and coal land and started to increase its furnace capacity. The National Tube Company began work on a large steel plant at Wheeling, West Virginia. The completion of these projects meant heavy loss to the Carnegie Company and the Federal Steel Company. They were forced to fight back. The Federal Steel Company threatened to build wire mills unless the American Steel and Wire Company should abandon its proposed ^lilwaukee plant, and the threat for the time being proved effective. The Carnegie Company an- noimced that it would construct a large tube mill at Conneaut, Ohio, and let it be understood that it would not hesitate to enter into active competition with all the producers of finished goods. There was no doubt in the minds of those who knew Andrew Carnegie but that these plans would actually be carried out. They re- called that "the wild Scotchman" had been successful in even more daring schemes. The situation was full of dangers. The prosperity of the steel makers could not continue through the bitter competitive war that seemed to be in prospect. The officials of the Carnegie Company apparently were not seriously worried, for they felt confident of the ability of their organization to finance and make highly profit- able in the end whatever new construction might become necessary. Tlie officials of the other great companies, however, were not so complacent. All of the large con- Tin: UxNITED STATES STEEL CORPORATION 245 solidations were capitalized, as we shall see, up to the limit of their earning power, and their stock had been sold on the promise of large and regular dividends. J\Iorcover, large amounts of the stock were still owned by the original promoters and underwriters. The man- agQTs, therefore, were far from eager to enter into a regime of severe competition. Under these conditions the suggestion that an immense holding company, the greatest trust in the world, be formed was favorably received. It furnished the only possible peaceful so- lution of the pend'ng problems. The strongest finan- cial houses, as well as the largest steel companies, were committed in advance to this plan, because it was the only means of protecting them from severe loss. 125. Method of promotion. — The promotion of the United States Steel Corporation was not, for the reasons that have been given, an especially difficult task. The chief obstacle was overcome when men of sufficient breadth, imagination and ability to form a clear con- ception of what was to be done had been found. So stupendous an undertaking could only be carried out by the giants of the financial the industrial and the legal worlds. Fortunately for the project, the right men were at hand and were interested in its success; above all, the active support of Mr. J. P. Morgan, the most forceful personality in Wall Street, did more than anything else to make the plan practicable and ulti- mately successful. The details of the promotion of the United States Steel Corporation have never been disclosed. Long in- vestigation was not as necessary as in most promotions for the reason that the promoters were familiar at first hand with the concerns to be consolidated. The plan at first, it is known, was to combine only the great com- I'. i I 246 COHPORATIOX FINANCE panies; the Carnegie Steel Company, Federal Steel Company Xational Tube Company and the American Steel and Wire Company. The potential competition however, of the four JMoore companies looked so threat' ening that they also were brought into the combination. Certain other large companies, such as :iie Jones and Laughl.n Steel Company, of Pittsburg, were ap- proached, but no terms were agreed upon. The United States Steel Corporation filed its certifi- cate of incorporation in Xew Jorsey on February 23, 1901, showing a capitalization of .$3,000. Under its anriended certificate of April 1, 1901, however, its capi- talization was changed to $1,100,000,000, one-half common and one-half preferred. The charter, it may be noted, gives discretion to the board of directors to increase its capital stock. 126. Prospectus of the corporation.— In the light of the later history of the company and as an example of scientific prospectus-making, some extracts from the prospectus issued by the firm of J. P. Morgan and Company are given below. The reader should note how carefully each positive statement is qualified and how much more is implied as to prospective profits than is actually said. Yet the prospectus cannot be called misleading. If it is read as carefully as it was written, it will be found not only to contain technically accurate statements but to give a correct impression as well. The difficulty comes in the fact that comparatively few persons are capable of giving it a careful reading. The prospectus also contains a sufficient account for our pur- pose of the basis of consolidation. A syndicate, comprising leading financial interests through- out the United States and Europe, of which the undersigned THE UNITED STATES STEEL CORPORATION 24T arc managers, has been formed by subscribers to the amount of $'iOO,000,000 ( including among such subscribers the under- signed and many large stockholders of the several companies), to carry out the arrangement hereinafter stated, and to pro- vide the sum in cash and the financial support required for that purpose. Such syndicte, through the undersigned, has made a contract with the United States Steel Corporation under which the latter Is to issue and deliver its preferred stock, and its common stock, and its 5 per cent gold bonds in consideration for stocks of the above-named companies and bonds and stock of the Carnegie Company and the sum of $25,000,000 in cash. The syndicate has already arranged for the acquisition of substantially all the bonds and stock of the Carnegie Com- pa->v, including Mr. Carnegie's holdings. The bonds of the United States Steel Corporation are to be used only to acquire bonds and 60 per cent of the stock of the Carnegie Company. The syndicate offers for each $100 par value of stock of the class mentioned below, the amount set opposite thereto in preferred stock or common stock of the United States Steel Corporation at par: .,) Name of company and class of stock. Amol'ntofnew stock to be delivered in pab VALUE. Pheferked Stock Common Stock Federal Steel Company: Preferred stock $1 10.00 Common stock 4.00 $107.60 American Steel and Wire Company of New Jersey: Preferred stock 117.60 Common stock 102.60 National Tube Company: Preferred stock 126.00 ...... Common stock 8.80 126.00 1 ii 248 CORPOUA'j'lOA FINANTK National Steel Company: Preferred stock ,25.00 Common stock American Tin Plate Comj)anj : Preferred stock ,25 00 Common stock ' 20 00 American Steel Hoop Company : Preferred stock ^o^^O Common stock American Sheet Steel Company : Preferred stock '. ^^O.OO Common stock 125.00 125.00 100.00 100.00 ^'^l" 'f ''''''' *" *''^' ''^'^t f«"«* companies the ^7^, amount of stocks so to be offered was arranged with the^ pa stockholders of those con.panies, who ha.^- re^uestlh:!- tr,but,on of such amount an.ong the four companies, to be made m the percentage above stated. Statements furnished to us by officers of the several com- pun.es above named and of the Carnegie Company show thatthe aggregate of the net earnings of all the companls for the cal- endar vear 1900 was amply sufficient to pay d.vulends on b^^^ funds and maintenance of properties. It is expected that by the consummation of the proposed arrangement'the n. ...tr ar^ deductions heretofore made on account of expenditures for ™Provements will be avoide proaelung termination of the lease was announced. f^"m,'Z ' 'T' u' "-^P"™""" ""luired about ¥30 000,000. or praefcally all, of the ontstandinR e„„. mon stoc'k of the Tennessee Coal, Iron and Railro^ Conu»„y. The stoek was paid for at the rate of C- 00*-<0 par value of the 10-00 year sinking fund 5 per cent bonds of the steel enrporation for $10,000 par"!^ Tennessee common. Many readers no donht will recall the crcumstances surrounding this deal. It was n,ade possibly by the ability of the Steel Corporation to pu up ready cash in the critical time of the October. ,907 crisis. The cash was used to buy in the Steel Corpora- 1^™ s own bonds with which to pay for Tennessee sLk. The operation thus ha.I a double effect of supplying cash to persons who needed it badly, and of supplving a security, which was acceptable as collateral, in !« "f the unavailable Tennessee stock. The Tennc s^ Company owned 16 blast furnaces, 4,?0,000 acres of coal, ore and limestone and tin.fer lands, large develooed coal mines and a big .steel rail mill at Kus^v, Ilf' Besides these large purchases the steel corporation has also increased its holdings by building o.It of its thoTbT r ^""^^'>- "™ l-l""t- M Gary, Indian., there has been erected a large modem steel rail mill .t m, "'^'IT'T ""'" "■'" '•^«'"' ">-™«""" in «hich 1. «.1 acres arc devoted to the plant. The emt was nearly $80,000,000. This new pl„„t w.,, ealledX I..V the gr^at increase in the western demand f oT t«l THE UNITED STATES STEEL CORPORATION 253 130. Financial changes. — The chief event in the financial history of the Steel Corporation is its much discussed preferred stock conversion of 1902. In April of that year the management issued a circular to stock holders saying that $50,000,000 new capital was needed, one-half for redemption of temporary loans incurred by constituent companies and one-half for improvements. The plan proposed was to create a new issue of $250,- 000,000 5 per cent bonds, of which $200,000,000 was to he exchanged, dollar for dollar, for an equal amount of preferred stock and $50,000,000 was to be sold for cash. Each prci'erred stockholder was offered the right to sub- scribe to the extent of one-half his holdings, paying 40 per cent in stock and 10 per cent in cash, or to the extent of 40 per cent of his holdings, paying in stock alone. The argument urged for this plan was that the $50,000,- 000 would be raised and yet an annual saving in the company's charges of $1,500,000 would be effected. To this plan 99 8-10 per cent of the stock voted at the annual meeting assented. The plan was objectionable, how ever, to certain stock- hohlers for the obvious reason that a new issue was cre- ated superior to their own security without any corre- sponding enhancement in the value of the corporation's assets. The plan was further ol)jectionable in that the i>siie was to be underwritten by a syndicate which in- chided some of the corporation's directors. The syndi- cate agreed to take enough of the bonds to bring the total sale up to $100,000,000.' In return they were to have the privilege of subscribing to any or all of the Inrnds not taken by the stockholders and they were to get a 4 per cent commission on all the l)onds sold to the stockhohc rs or otherwise. It was objected that under ' See a copy of the agrr^mcnt in Chapter ZIX. 254 COHPOKATION FINANCE I this a^^ment tlie syndicate took a very slight risk in 000,000 worth of bonds would be sold, and got an «. cess-ve eomm.ss,o„. The objections on this Lre we« never satisfactorily answered. The opponents of the conversion plan secured a tern- porary mjunetion and brought suit to restrain «,ed" th turtTu"""'"*"' °'" "" P'""- '^'^ <'--- of the court, however, were in favor of the Steel Corpora- t.on management, on the ground that no fraud wl shown .„j t, t a,^ g^^^j ^^ st«.kWders had approved the issue. The danger of disaster to tl« corporation, on account of its great increase in bond^ interest on these smkmg fund .5's must lapse for two rius provision is a safeguard to the corporation, though, ll "!i 'i """'■^ ""' ^ "' «™' ™'"^ ■'" « period o prolonged depression like that from 1893 to 1897 sary f r the corporation to ecnomi^e. Several mills were dismantled and some of the sub-executive offi " were abolished. It Wcame desirable to change somewC 908 t^L -Tr""" '." ""' -'P"™""" In Ma,;; 908 the original Carnegie Company of Pennsylvania, the National Steel Company and the American Stee t arnegie Steel Comnnpy „f x,,„ j„, , , the year the American Sheet Steel Company and ,W •American Tin Plate Company were combin^ed as American .Sheet and Tin Plate Company. Earlv the next year the corporalio„-s search for wi.lcr markeis M '.>|.ort Company, which is the selling agency for all THE UNITED STATES STEEL CORPORATION 255 the foreign business of the corporation. The direct con- trol of this company is in the Federal Steel Company. I.'31. Basis of capitalization. — Is the steel corpora- tion over-capitalized;' It is not worth while to rehash the wordy debate on this question, which has lasted for several years, but a few facts ought to be noted. The a^roregate capitalization of the first ten companies to tnter the corporation was approximately $710,000,000. In exchange for this amount of stock ♦^he corporation issued $868,000,000 stock and $1 U,000,000 bonds, an iutrease of $302,000,000. In addition the promoters of the steel corporation received for their services some- thing over $240,000,000 in stock. Even though we should estimate that all the subsidiary companies' stock represented tangible assets, therefore, we should still have to conclude that $.)42,000,000 of the United States Steel capitalization was water at the start. But what are the facts as to the capitalization of the original companies? Daniel G. Reid, president of the American Tin Plate Comi)any, testified before the In- dustrial Commission that of the $46,000,000 capitaliza- tion of that company, $18,000,000 (preferred stock) was supposed to represent the value of the property and !^28,000,000 (common stock) represented hopes for the future and the pay of the promoter. It is well known that in the capitalization of the National Steel, Ameri- can Steel Hoop and American Sheet Steel companies, ;'ll of which were promoted by the same interests as the American Tin Plate Company, the same principle was rnllowcd. Similarly. ^Slr. ,Tolin W. Gates testified that of the "-^0,000,000 cajjitalization of the American Steel and \\'ire Company, $20,000,000 to $30,000,000 was water. Of the $100,000,000 capitalization of th( Federal Steel 250 CORPORATION FINANCE ^nr$7ooOiH:!. $4-^;000,000 represented tangible assets and $10 000,000 cash assets, vvliile the rest was water .feJlnl "'^"*' ^'^ ^"""^h *« ''n^'cate that of the $710,000,000 capitalization of the original companie^ large share stood for nothing more tangible than goU will and prospects." ** The suits to prevent the carrying out of the preferred stock conversion plan of 1903 brought out some inter- esting statements. One affidavit, by an engineer who was represented as an expert, said that the plants and properties of the corporation could be duplicated for about $200,000,000 and that the total assets, including «^.od will and organization, were not worth $500,000,- 000. Another affidavit stated that the plants of the Carnegie Company, represented 44 per cent of the pro- duct.ve capacity of the steel corporation and that these plants had been valued on March 12, 1900, bv the part- ners of the Carnegie Company in a legal proceeding at $7.,000 000. On the other* hand. Mr.'chrrK Schwab then president of the steel corporation, sub- mitted the following valuation: 1-Iron-oro Properties ^ 700,000.000 2--PIa„ts, M.IIs, Fixtures, Equipments 800,000,000 8-CoaI and coke fields, 87,589 acres 100,000,000 4-Tran,portat,on properties 80,000.000 5-BIast Furnaces 6-Natura Gas Fu-Ms ^0.000,000 I rZ r ?°^''^''" *'000.000 8~Cash and casl, .,,et. 214,278,000 $1,466,278,000 There is not such a great difference between these wo estimates as at first appears. More than one-half the assets, as given by Mr. Schwab, consist of ore and THE UNITED STATES STEEL CORPORATION 257 coal land in which he included unmined ore at a high value. Beyond question, such an estimate is uncertain and speculative. Technical progress may introduce new methods of treating ore which will greatly reduce the value of this large buried mass. Besides, Mr. Schwab had already counted the value of this ore once when he based his estimate of the value of the plants on their low cost of production and, as a factor in that low cost, counted in the cheapness with which they could secure raw materials. In what has been said it has been assumed that the proper way to value a property is to arrive at the prob- able cost of replacing it. But there is another method of valuation which is more popular among business men, and, to the writer's mind, more scientific. This method is to capitalize earning power. The profits of the eight original sub-companies of the Steel Corporation in 1900 were $96,000,000. The record of the Steel Corporation in the first seven years of its history was as follows: Net Earnings 1^2 $188,808,000 1903 109,171,000 1^* 73,176,000 1^5 119,787,000 1906 156,624,000 1907 160,965,000 1908 91,267,000 Average $120,614,000 Now if we assume that 10 per cent is a fair rate on money invested in the steel business and capitalize prof- its on that basis, we get a result not a great deal below the present capital izaticm. r—vi— ir 'r. I 258 CORPORATION FINANCE Our general conclusion on this point must be some- thing like this: If the properties of the Steel Corpo- ration were sold under the hammer, they probably would not fetch one-half or one-third the amount at which the corporation is capitalized. Even if we take into con- sideration good will, organization, financial connections, and so on, we could hardly say that the assets equal or nearly equal the capitalization. But, if we base our valuation on earnings, not assets, we can safeb' say that the over-capitalization is not very great. The Steel Corporation is earning immense sums be- cause it is well managed; because it has prestige; because in some lines it has almost a complete monoply. These things are not tangible assets, but they are sources of income; and income, according to ordinary business us- age may properly be capitalized. Even from the ultra-conservative standpoint, it may be said that the Steel Corporation is rapidly "squeezing out the water" for it has made it its policy to provide from its gross income for depreciation and for improve- ments. The figures following show that about $300,- 000,000 have thus been added to the tangible assets of the corporation since its formation. Sinking Funds, subsidfarv companies $ 9,,367,412 Sinking Funds, U. S. Steel Bonds 25,624,410 New Construction 176,187,166 Increase in surplus 82,223,107 $293,352,095 132. Operating pnlic/;. A carcfiil study of the op- erating policy of the Steel Corporation belongs else- were. Our attention may be turned, however, to a few conspicuous facts. THE UNITED STATES STEEL CORPORATION 259 The corporation's relations with its employes have so far been exceptionally harmonious. There has been 110 strike or serious trouble of any kind. At the end of 11)02 the corporation started its famous profit-sharing plan under which a large amount of preferred stock has been sold to employees. The workers are divided into six classes, according to salary, and each class is allowed to buy a certain proportion of stock each year at a fixed price. The prices named have always been somewhat below the market prices. The corporation gives a bonus of $5 for each share which is held for five years. The result has been to give a considerable number of the 210,000 employees a lively interest in the success of the corporation, and to bind them more closely to the man- ai,'ement. The scheme has proved practicable and has l)cen probably of great benefit in maintaining industrial peace. The corporation is, of course, simply a holding com- pany and has only a general oversight over the sub- eotnpanies. Each subsidiary company manages its own internal affairs and buys and sells from and even com- petes with other sub-companies. Cross shipments, how- ever, are avoided and raw materials are furnished by ffnmon agencies. The idea is to stimulate each com- pany by internal competition and otherwise to the hi<,rj)est pitch of efficiency. The operating ratio or per cent of manufacturing costs to gross business has been \('ry steady with a slight tendency downward since 1902. The ratio has not moved up very high in periods of de- pression, which is considered an indication of econom- ical management. 133. Steel securities. — The securities of the United States Steel Corporation now outstanding are: ■ * M I 260 CORPORATIOX FINANCE 1-UiidcrIying bonds * leo 877 «"7 2-Coll. Tr. Gold 5's. 1901 ' Iwlllm S-^' " Skg. Fd. 5's, 1903 JS;5^ 4 P 7°**^^?""^.' $ 620,601,i^ 4-Prefcrrc^ Stock g^o.^si^joo 5-Comn,on Stock 608.302.500 Total Securities $1,489,084,977 The underlying bond issues are too numerous and too small m volume to be worth discussing here. Most of them are secured by direct first mortgages and are very closely held. ^ The collateral trust gold 5's of 1901, due AprU 1, 1951, are secured by the deposit of all the securities owned by the corporation. A sinking fund of $8,040,- 000 per year is used to purchase bonds obtainable at 115 or less, and since August 1, 1911, has been applied to the redemption of the bonds drawn by lot. Almost all these bonds are held, it is understood, by Andrew Car- negie and are not on the market. A more interesting issue to us is the collateral trust smkmg fund 10-60 year gold 5's of 1903. The author- ized issue was $250,000,000, of which $200,000,000 was reserved for exchange with preferred stock under the conversion plan. As a claim on the assets, these bonds rank next to the 5's of 1901. They are further pro- tected by a sinking fund of $1,010,000 per annum to be used imtil 1913 for the purchase of bonds at 110 or less and after 1913 for the redemption of bonds, drawn by lot, at 110. This last named feature introduces *a speculative element into the security which is supposed to enhance its value. If the estimates already quoted of the asset value of the property of the corporation are Tl IK UxNITED STATES STEEL CORPORATION 261 correct, these bonds have behind them chiefly the earning power of the corporation. Tlie preferred stock issue is 7 per cent cumulative. Dividends have not been missed since the formation of the corporation. The conunon stock drew 4 per cent in the first two years; 1/^ per cent in 1903; nothing from that date till 1906; ll/^ per cent in 1906; 2 per cent until 1909, when 4 per cent was paid, and 5 per cent since 1909. Steel has been a prince now for several years. Is it likely to become so much of a pauper that dividends or even interest will be threatened ? There can be no doubt but that the corporation is still in danger; a bad slump or even insolvency is conceivable. On the other hand, there are at least two good reasons for believing that the danger is rapidly lessening and in a few years will be a thing of the past. One of these reasons is that the physical condition of its properties is excellent, according to all reports, and is being constantly improved. We hi re already alluded to the large appropriations for depreciation and for bet- terments. It is estimated that following the completion of the Gary plant, the capacity of the corporation was increased about 75 per cent; yet the interest charges are practically the same as they were at the beginning. In addition, new ore deposits, it is said, of a value of $400,- 000,000 have been located on the lands of the Steel corporation. The second reason is that the demand for steel in this country is apparently insatiable. Steel rail production to-day is nearly three times that of 1881 ; yet this particular kind of product which was of great im- portance in 1881 is now only a fraction of the entire steel trade. The demand for structural shapes and for machinery, already enormous, is just beginning to grow. MICROCOPY RESOLUTION TEST CHAR< (ANSI and ISO TEST CHART No 2! 1.0 I.I I'm t 1^ 1 2.5 2.2 2£ 1.8 4 -APPLIED \MAGE Inc ■T t6^^ tos! Mo"^ 'VK»ei JS ^ai ulster N#w forh U6G4 USA g i^'f>) *82 0300 - Phon« Mm VV: 262 CORPORATION FINANCE To get an idea of what may be expected in the next ten or twenty years, let us observe the per capita increase in the production of pig iron in the last three decades as shown ! elcw: 1880 171 pounds 1890 329 " 1900 399 « 1905 619 " 1910 669 " If the steel business, then, grows, as the biggest and most farsighted men in that line expect, and if the pres- ent policy of improving and enlarging the proper- ties contmues, as there is no reason to doubt, we may safely conclude that the earnings of the Steel Corpora- tion will become very much larger than they are now. Of course, those earnings will not grow continuously. The steel busmess is speculative and erratic in its very nature and always will be, so long as periods of depres- sion and of prosperity alternate. Yet the enterprise and efficiency of the United States Steel managers seem to be almost a guarantee that at the worst steel earnings will never sink so low that interest charges cannot be met; it is reasonable to expect that they will never sink so low that preferred dividends cannot be met ; and it is even reasonable to hope that the common dividends will always be maintained at or above their present level. "Svn' CHAPTER XVI SELLING SECURITIES— THE PROSPECTUS 134. The four methods of selling securities.— When- ever new securities— whether of an established company, of a new concern or of a reorganization— are issued, these are four possible methods of disposing of them. The first method is by an inside distribution of the se- curities to people already interested in the business. This method we have already considered. In the case of a close corporation the distribution of the securities is obviously a simple matter of bargain-making among the few people involved. In the case of a consolidation the distribution to insiders is carried on by exchanging tlie new securities for old securities as already explained. The second method is to work through the Wall Street, or some similar market, which is considered in the chapter following. The third method is to sell them to the public through established bond or brokerage houses. This method will he discussed both in this chapter and under the head of underwriting. The fourth method is by direct appeal to the public throtigh newspaper and magazine advertising, through circular and individual letters and through salesmen. In a great many corporations the promoter finds the first three methods unavailable and is forced to resort to this fourth method. This is particularly true of speculative enterprises. The principles that should be followed in the presen- 203 264 CORPORATION FINANCE tation and selling of corporate securities direct to the public are not different from the principles that should be followed in selling other articles. These principles are treated in the treatise on Selling and Buying and need not be reviewed here. Something should be said, however, about the document in which the leading facts with regard to the securities are stated and the pros- pects of the company discussed, namely, the prospectus. ^ 135. General characteristics of a good prospectus.— The promoter's prospectus should be, and with success- ful flotations usually is a work of art. A good prospec- tus will appeal to a large number of people, will arouse their interest, will hold their attention from beginning to end, and will engender confidence. A poor prospec- tus will nullify whatever success the promoter may have had in stimulating curiosity on the part of the prospec- tive buyers of his securities. It goes without saying that it should be well written and attractively printed. In this respect the same rules that apply to other selling literature should be followed. Naturally the prospectus will emphasize the strong features and minimize the weak spots of the business. The promoter must take care, h(swever, in so doing that he does not misstate or conceal any material fact. Otherwise he may be held liable for fraud, or at least anyone who subscribes to the corporation's securities on the strength of the prospectus may have good legal grounds for withdrawing from his contract. The skill- ful prospectus writer, who is presenting to the public securities which he knows to be highly speculative in character, must find some means of reconciling these apparently inconsistent requirements. He must pre- sent all the important facts and yet he must make his prospectus strong, attractive and convincing. Any )$>&V S1:LLING securities— the prospectus 265 well-trained writer should be able to do the trick if he studies his proposition carefully. Obviously in any prospectus the strikingly attractive features of the enterprise will be made prominent and much will be said about them. Perhaps the statements with regard to them will be printed in bold face or other prominent type, so as to catch the eye of the reader at once. Statements as to the more doubtful and risky features of the enterprise will be tucked away in some obscure comer. Thus the law will be satisfied and at the same time it will take a very careful, intelligent reading to ascertain from the prospectus the real facts of the case. Another means of avoiding legal objections is to make sweeping general statements without making the writer or any other definite person responsible for them. Such phrases as "competent judges have reported," or "after expert examination we believe," or "witnesses who have seen the property are thoroughly convinced," are very common introductions in prospectuses. The statements in themselves may be untrue; yet by using such phrases the writer may succeed in divesting himself of any personal responsibility. Most prospectuses, as any reader of them will testify, are so vague, that what the writer implies assumes a much more prominent place in the average reader's mind tlmn what he actually says. In a recent mining pros- pectus, for instance, we have the following typical sentence: "We have every reason to believe that the corporation will have assets at the end of the year that will astonisli each and every holder of the stock, and it is our belief that claims, titles and rights cannot be bought outright for $1,000,000 or more." Notice that this sentence does not contain any single statement of I 266 CORrORATIOX FINANCE fact to which the prospectus-writer could be bound down. Another hoary trick that is worked over and over again in the prospectuses of new companies, is to call attention to the immense profits of other companies working in the same filed. It is very seldom indeed that a copper-mining prospectus is issued that does not call attention in big type to the profits made by the holders of the original stock of Calumet and Hecla, the Copper Queen, Anaconda, and other classic examples. The reader is expected to infer that the new corporation will have a similar history. 136. A typical speculative prospectus. — The pros- pectus of a company designed to own and publish a magazine is given in part below. Tlie reader will find in these few paragraphs illustrations of all the principles mentioned above. In this case, although the magazine is stated to have been in existence for twenty-eight years, not one word is said as to its record; instead, all the emphasis is given to "prospects," "purpose" and "possibilities." It IS a medium that can treat any subject with justice to it- self and its readers ; therefore, its pulling power for subscrip- tions, you will agree, covers possibly a greater field for circula- tion, than any magazine that you can recall. Its field of expan- sion i^ simply unlimited. From an advertising standpoint, I might say, after years of experience, I do not know of a publication that has such pros- pects for money making as The Blank Company. Being a practical publisher, it is my purpose to put The Blank Company in the place it should enjoy, and in order to do this, I have deemed it wise to share its future with a number of my friends, and am, therefore, organizing a company capital- ized at $50,000 for the immediate expansion of The Blank Com- pany. Tlie stock is secured by the property, the name and the good will, which, if put up at auction, would be considered a SIXLING SECriUTIES-THE PROSPECTUS 267 bargain, if purchased at man>' times the amount of the com- pany's capitalization. * If you have looked into the magazine field, you will know that altliough some of the larger magazines are capitalized for over a half-million dollars, they are all making phenomenal money for their early investors. The general magazine field I consider pretty well covered, but a magazine of the unique name that The Blank Company possesses, can be expanded and developed and larger profits made from it than any other publication enjoys. To illustrate the earning power of magazines, permit me to say that one magazine was sold some time ago to a well-known newspaper publisher for nearly $700,000, in spite of the fact that at that time it had a circulation of only 250,000 and a shrinking in its advertising patronage. Another well-known magazine, whose circulation had dropped down below 50,000 and had practically no advertising, declined an offer of $10,000 for its name and good will. I will recall that if you had been able to buy a thousand dollars worth of Munsey's stock, on the ground floor basis (that you are now oflTered in The Blank Company) for your invest- ment the thousand dollars in Munsey's now would be paying you $10,000 to $12,000 a year in dividends. If you could have invested only $100 in MutiseyX your hold- ings would now be worth from ten to twelve thousand dollars and would be paying you $1,000 to $1,200 a year in dividends ; a larger investment would have made you wealthy. An English author, who ten years ago obtained $2,000 worth of McClure's Magazine stock in exchange for a manuscript, sold his holdings recently for $20,000, having received in dividends during that time the round sum of $14,000. For his $2,000 worth of manuscript he received in a decade $84,000 in cash, a profit of 1,700 per cent. Everybody's, The Ladies* Hone Journal and many other magazines, represent wonderful money-making investments. The same opportunity is knocking at your door at this mo- men*. The Blank Company with its twenty-eight years of continuous existence, with an unlimited alvertising field and with 268 CORPORATION FINANCE Ir I: * ■ m a subscription list that can be increased beyond that of any other publication in existence, offers you a rare opportunity in associating yourself with an enterprise which will make money for its stockholders very rapidly. If you want to go in with me in developing and expanding The Blank Company, I will offer you some of its stock at its par value, $10 per share. This opportunity, however, will only remain open for a short while. Stock can be purchased on a basis of 3 per cent for cash with subscription, or 10 per cent down and 10 per cent per month. 137. A typical investment prospectus.— In the above remarks we have had in mind principally the pros- pectuses of highly speculative companies. We need not pass judgment here on the legitimacy of the methods that are used by such companies to obtain subscriptions for their stock. It is certainly improper to delude subscribers. On the other hand, it is unquestionably proper to present a new enterprise in a favorable light. Just where the dividing line between an Jionestly favor- able and a dishonestly deceptive presentation comes is a question which every promoter must settle with his own conscience. The prospectuses of well-kno>vn, entirely legitimate investment securities often go to the other extreme. They present merely a dry, formal statement of the facts with sometimes a tabulation of the assets and earnings of the company or bald figures of some other kind. For instance, several of the leading banks of the world— including Baring Brothers and Company of London, Comptoir National d'Escompte de Paris, Credit Lyonnais of Paris, Deutsche Bank of Berlin, J. P. Morgan and Company, the First National Bank and the National City Bank of New York— co-operated in issuing on March 1, 1909, a $50,000,000 5 per cent SELLING SECURITIES— THE PROSPECTUS 269 internal gold loan of the Argentine Government. Much might have been said as to the wealth, high stand- ing and prospects of the Argentine Republic and as to the small amount of the loan in comparison with the great resources back of it. The bonds were sold at the price of 99 per cent of the face value, thus yielding to the purchaser something over 5 per cent, a high rate on the loans of a government of good standing. We can imagine, taking the examples that have been given above as a basis, how a promoter used to getting up prospectuses for speculative concerns would have reveled in the opportunities that this issue would have afforded him, how he would have enlarged on the Argentine Republic's reputation and prosperity, how many word pictures he would have drawn to illustrate his statements. The prospectus issued by the great banks that have been named, however, compressed a description of the bonds, a statement of the terms on which they would be issued, and the argument on behalf of the bonds into the four brief, cold paragraphs that follow: Provision is made for a sinking fund of 1 per cent. By the operation of this sinking fund the loan will be paid off in t'i-rty-six years at the latest. The contract with the Argentine Government provides that said fund is to be applied half yearly to the purchase or tender of bonds at or under par or by draw- ings at par should the bonds be at over par. The first operation of the sinking fund will take place in the month of December, 1909. Drawn bonds will be payable on March 1st or Septem- ber 1st following the date of the drawing. The Government undertakes not to increase the sinking fund or to redeem the whole of the loan before March 1st, 1914. We reserve to ourselves the absolute right in our discretion \o close the application list at any time without notice and to 270 CORPORATION FINANCE reject any or all applications and also to allot Smaller amounts than applied for. All applications should be made on forms which may be ob- tained at our offices, and must be accompanied by a deposit of $50 per bond. If no allotment is made, the deposit will be returned in full, and if only a portion of the amount applied for be allotted, the balance of the deposit will be appropriated towards the amount due on March 10th, 1909. If any further balance remains, such balance will be returned. In case of failure to pay the balance of the subscription when due, all right in any previous payment will vest in us absolutely without accountability there- for. Although such a presentation is unattractive, it is frequently effective. The coldness and dryness carry with them the sense of conservative safety. For that reason, a statement of this kind is sometimes put for- ward as a prospectus of what is in reality a highly speculative company; and this trick when skillfu^y executed has been known to succeed. 138. The ideal prospectus. — Even in the most formal prospectus, however, it is usually well to use untechnical expressions and to present facts in such a manner that they will be not merely significant, but interesting. Some such tendency is coming into evidence, even in the presentations of strictly investment securities. The number of people who are possible investors in such securities is constantly increasing and the amount of such securities is also increasing. In order to create a market for these immense issues among people who are not familiar with the technical jargon of the financial world, it is necessary to change somewhat the old- fashioned formal method of presentation. This change is undoubtedly for the better. As the intelligent in- SELLING SECURITIES— THE PROSPECTUS 271 terest of the public in financial affairs grows, we may expect to see the typical prospectus of a speculative corporation and the presentation of a strictly investment security approaching each other more closely in tone and in form. Athough in this country the prospectus, as has been indicated, is so frequently used to present speculative and even swindling schemes in a false light that pros- pectus-writing has come to be regarded almost as a dishonorable method of securing money for an enter- prise, and although this opinion is not without basis, yet it must be borne in mind, on the other hand, that there are such things as a legitimate direct appeal to the public for funds and an honest prospectus. In England this method of raising funds is much more generally used for reputable enterprises than in this coimtry. To take one instance, it is said that the English Eastman Kodak Company was floated with- out any assistance whatever from bankers or under- writers. About $5,000,000 of stock was sold to the public through direct newspaper advertising, circulariz- ing and the issue of an attractive prospectus. That the method in this instance has been entirely successful is shown by the fact that the company's stock is now sell- ing at the rate of about $675 a share. It is to be re- gretted that the number of similar instances in this country is so small. 139. Selling through havUng houses.— The securities of almost ali large legitimate corporations are sold through banks and brokerage houses. The advantage of this method to the investor is that he is protected more or less by the investigation and experienced judgment of his banker. The disadvantages are three: first, on ac- count of his leaving the investigation to the banker he 272 CORPORATION FINANCE i i i i ! It f '■ m does not acquire that first-hand knowledge of the enter- prise in which he invests that it would be desirable for him to obtain; second, that he is thus left practically at the mercy of his banker; third, that the broker's com- mission, which is often not inconsiderable, intervenes between the buyer of the security and the selling corpo- ration. The advantage to the corporation of selling through a bank or brokerage house is that the corporation officials may feel certain that the issue will be success- fully disposed of in this way, especially if it is "under- written," as explained in Chapter XVIII. With a corporation of any size, the bond or brokerage house will probably be one of the large concerns that carry on their work in the Wall Street district of New York, the State Street district of Boston, the La Salle Street district of Chicago, or the corresponding financial center of some other large city. 140. Requirements of reputable ba./'ing houses.^ The good Wall Street houses will not undertake to float issues of small size — certainly none less than $100,000 and preferably not that small — for two reasons; first, because there is not enough profit in selling small issues to pay for the expenses; second, because a small issue of stocks or bonds never becomes well-known to the public and is therefore not readily marketable. As to the kinds of enterprises that will be taken up, the better houses prefer in the order named, steam railroads, electric rail- roads and industrials. Most of them will not touch mines, oil companies, or any other highly speculative enterprise. Tht only practicable means for getting funds for such an enterprise from the public ordinarily is by direct solicitation. There are not many high-class Wall Street houses SELLING SECURITIES— THE PROSPECTUS 278 ti.f^agcd in selling securiti md there are a considerable number of imitation banking houses whose main object is to get their hands on the money of "suckers." The working plan of such swindlers is to receive persons who come to them with securities to sell, no matter how worthless the securities may be, with open arms, wax entliusiastic over the market for the securities, make numerous high-sounding promises as to the sales which they will be able to make, and in conclusion demand from the victim as his "guarantee of good faith" a sum of money for expenses. Of course this money is not honestly spent. The high-grade banking houses, on the contrary, will receive any new proposition that is pre- sented to them, especially if it comes from a stranger, witli skepticism ; and, if they show any interest at all, it is to be expected that they will make a long and thorough investigation, before committing themselves in any manner. It is poor policy to approach one of these houses without having a business introduction of some kind. Generally speaking, it is well to present the proposition in writing in the first place, giving a clear and complete statement with all the supporting evidence that can be added. A Wall Street banker of the class that the writer has in mind is not likely to be carried off his feet by persuasive personal eloquence and is more hkely to yield to cold figures than to impassioned appeals. It takes a man who has spent a lifetime in the Street to tell absolutely what are the sound, reliable houses and what are the more or less shady concerns. There are Wall Street firms which, to the writer's knowledge, are rc/yarded by Wall Street bankers as worse than banditti, which nevertheless have kept in existence and have apparently been prosperous for many years. Such r— VI— 18 274 CORPORATION FINANCE firms may maintam expensive suites of offices, may have pious-looking personages at their head and may give an appearance of permanence and honesty. The only sure sign of their general unreliability, that the writer can give, is that thej^ are out looking for business, that they make an effort to secure for themselves the flota- tion of securities of small corporations and that they are willing to pretend to sell such securities without having first made an adequate investigation. Even this symp- tom, however is not always present, for the heads of such concerns are shrewd and experienced enough to make a pretense at times of conducting an investigation before they accept the proposition that has been presented to them. The first step in the investigation of an enterprise by a reputable house will be to get the complete record of all the men who have any connection with it. If there is a flaw in the reputation of any of them, the whole proposition will probably be dropped. Next, the prospects of the enterprise itself will be looked into. Every large house engaged in selling securities keeps on its own staff capable men who are qualified to form an expert judgment as to the merits of the common forms of business enterprises, such as street railroads, manufacturing plants, and so on. In addition, unless the house is absolutely satisfied, it will probably obtain reports based on searching examinations by three classes of professional experts, namely, engineers, lawyers and accountants. If all of these are favorable, from begin- ning to end, the proposition will perhaps be accepted. The three essential factors in making a proposition acceptable are: (1) Good reputation of the men connected with the enterprise. SELLING SECURITIES— THE PROSPECTUS 275 (•2) Absence of risky factors in the general nature of the business or in the general situation. For instance, a street railway company would not be taken up if the pci>ple of the locality in whicli it had been located were for some reason bitterly hostile to public service corpo- rations. In the same way, as has been said, the good banking houses will not deal in the securities of unde- veloped mines, no matter how promising. (3) Practical certainty of profits sufficient to meet all fixed charges. This almost goes without saying; yet it is worth noting, because many people seem to im- agine that if a new corporation promises to have consid- erable profits its securities are safe investments. It is necessary that these profits should not only be large in the aggregate, but should be steady enough and certain enough to guarantee that the corporation will never be compelled to pass any of its interest payments or other fixed charges. 141. 2'heir methods of selling securities. — The good Wall Street houses are so exceedingly careful in their investigations because they sell most of the securities they handle, not to the public at large through adver- tising and through wide distribution of prospectuses, but to a comparatively small number of their clients. These clients include not only indivduals, some of whom have regular sums to invest every year, but also such institutions as insurance companies, saving banks and trust companies. It is necessary in order to hold this clientele that the house should establish and maintain a reputation for the strictest integrity and conservatism. So long as this reputation is maintained there is seldom any difficulty in selling whatever securities the house may accept. The following extract from an article in PI 276 CORPORATION FINANCE the "Bond Buyers' Dictionary" gives further details as to the methods of such houses. It is throu^ the retail bond dealers that the great investing public of the country is reached. The other day a retired mer- chant died in Pittsburgh whose wealth was estimated by bankers to exceed $50,000,000. Of the several million persons who read of his death in the newspaper the following morning only a few had ever heard his name before. There are thousands of similar capitalists in the United States, each possessing a for- tune greater than was owned by any single individual in the country fifty years ago, whose names are entirely unknown to the average newspaper readcn There are several hundred thousand others who possess independent fortunes. It is with these individual investors that the retail bond merchant deals. All have a large list of wealthy customers, to which they are continually adding. The customers of some are mostly in New York or Pennsylvania, of others in New England, of other in Canada, of others in the West or the South. Some have wealthy foreign customers. The number of regular customers may range from 5,000 to as high as 25,000. There is one retail bond house in Wall Street, which has been in business for seventy-five years, that has a list which could not be purchased for several million dol- lars. It includes 22,000 names, and these customers purchase, on an average, nearly $5,000 of bonds a year apiece, or a total of more than $100,000,000 a year. This house would not hesitate to purchase a block of $5,000,000 or $10,000,00 or even $20,000,000, of municipal, county, or railroad bonds, knowing that it would be able to dispose of the entire block in the course of a few months in small lots to its regular customers. Practically every large retail bond house in Wall Street now employes salesmen, who travel over the country selling bonds, very much as drummers sell tea or coffee. Some of the largest houses employ as many as forty salesmen ; aUogether, more th»n 800 are employed in Wall Street. Each has his own territory and possesses his own customers. Many make salaries of from SELLING SECURITIES— THE PROSPECTUS 277 $10,000 to $15,000 a year, and some even more. All arc, to some extent, experts on values. In addition to employing sales- men the retail bond houses advertise extensively. The reputation of a bond house, and the following which it possesses of the customers of a bond house purchase securities from it, not because of personal and expert knowledge of the se- curity and safety of the bonds, but because of the reputation of the house. The average investor whether he invests $5,000 or $500,000 a year, after a superficial examination, purchases securities almost entirely on the recommendation of his bond dealer. The enormous profits the bond dealers make is the price they charge for lending this credit to corporations and municipalities. Practically every one of the leading Wall Street bond houses may boast that no investor has necessarily ever lost a single dollar through the purchase of bonds on their recommendation. With such a record, is it any wonder that, when such a bond house offers a block of bonds for sale, accom- panied by a recommendation, that the entire issue is often over- subscribed within twenty-four hours of the opening of the books? The profit of the banking hou*^ ^ may take one of two forms, either a commission on the sales or the difference between the price at which it buys the securities and the price at which it sells them. Commission is more com- mon and is regarded as more profitable. The amount of commission depends altogether on the size and repu- tation of the issue, and no definite statement on this point can well be made. The question frequently comes before such a house, Do you absolutely guarantee the securities that you offer to be safe investments? Invariably the answer is: No, we give you freely the benefit of our experience and of our best judgment, but whatever risk is involved is yours, not ours; we guarantee nothing. Nevertheless, 278 CORPORATION FINANCE it is a well-known fact that almost all houses of the best character will protect their customers in case of loss or risk. In the first place, the house does not lose interest in the security as soon as the issue has been sold. It watches the future career of the issuing corporation with the closest attention and frequently exerts strong influence toward a conservative management of the cor- poration. If in spite of all its care and its efforts, the security depreciates i? alue, as will happen once in a long time, the house w'a probably offer to buy it back from its customers at the sellmg price. This is not laid down as an infallible rule, but as a custom. Of course, the house does not feel bound to follow that course un- less it has very strongly recommended the security in the first place. Its motive in making the ofFer is simply to maintain its hard-won reputation for fair dealing. .f CHAPTER XVII SELLING CANADIAN SECURITIES 142. Markets for Canadian corporation securities. — The methods of sale of corporation securities in Canada, in their broad principles, are similar to those in the United States, described in foregoing pages. Generally speaking. Great Britain is relied upon to purchase the majority of these securities, Canada a few, while the United States supplies but little capital. These facts are shown in the following tables. The first shows the volume of bonds, also the share of corporation bonds of Canadian companies, for each of the eight years ended December, 1912: CANADIAN COBPOHATION BOND SALES, 1905-1912 Year Corporation Bond Sales Total Bond Sales 1905 $125,497,284 $184,874,581 1906 85,694,000 58,987,008 1907 58,981,200 82,685,740 1908 72,297,000 196,856,521 1909 182,482,500 265,158,252 1910 140,251,900 281,000,590 1911 218,978,700 266,812,988 1912 146,728,820 280,782,982 Total $925,810,904 $1,461,608,612 The various proportions of the Canadian bond sales, for the same years, taken by the United States, Canada and Great Britain are shown in the following table: 279 I I I i I 280 CORPORATION FIXAXCE f* ; ^1 PEECENTAGE SHARES OF CANADIAN BOND SALES, 1905-1912 Year United States Canada Great Britain 1905 6.86 26.06 67 07 1906 7.62 43.16 49 20 1907 5.78 17.86 76.35 1908 3.21 12.52 84.26 1909 3.90 23.50 74 00 1910 1.50 17.00 81.50 1911 6.58 16.86 76.56 1912 11.91 16.96 72.13 143. Canadian prospectus and British investor.—ln drafting a prospectus for the British market, those re- sponsible for the sale of Canadian corporation securities must always bear in mind the conservative attitude and the demand for full information, of the British investor. The history of the company must be given, and details of past earnings, estimates of future earnings, details of assets, and so on. No tricks should be played in the prospectus. The facts should be given. Otherwise, if trouble should come later, the faith of the investor in the veracity and honesty of the promoters will disappear, which is not helpful, especially if further issues are to be made. It should be remembered that the maintenance of Canadian credit is important to every borrower. Sir Frederick Taylor, manager of the Bank of Montreal in London, expresses this very clearly. Writing in a Cana- dian financial paper, he says: It must be obvious to everyone with any knowledge of the subject, or who gives the matter intelligent consideration, that interruption— let alone stoppage— of the flow of capital from England into Canada would instantaneously check the develop- ment of the Dominion, with results bordering on the disastrous. It 18 not uncommon to hear certain of our countrymen, who should know better, speaking lightly— sometimes almost defiant- SELLING CANADIAN SECURITIES 281 ly — of securing money in New York or Paris if London is not prepared to lend what is required. The answer to these unwise and inexperienced individuals is : "Try Paris, try Wall Street, and see what the result will be." Money will be forthcoming from the United States and else- where in ever-increasing volume for private enterprise in our country, so long as we continue to prosper, but it is to the London market that the Dominion and Provincial Governments, tlie great transportation companies, the large cities, etc., must come for money. If London discontinued, or even curtailed, the supply of funds to Canada, it would be for some good rea- son — a reason which would apply equally in the case of other money centres. But as a matter of fact, even to-day when our credit in London is high, it is rubbish to talk of Canada financing her requirements to any material extent in Paris or in New York; while if our credits were injured in London, it would be practically impossible to get money in either of the other two places. Notwithstanding the fact that the progress and develop- ment of the Dominion of Canada have reached a stage which has aroused the wonder of the civilized world, Canadians are united in the belief that the development of their country is still in its initial stage, and therefore this motto should hang upon the walls of every office, business house and financial institution in Canada : The maintenance of our credit in London is vital. The large difference between the exports and imports of Canada causes that country to send many securities to the London market. If too many securities were offered it would mean that Canada was importing too many goods or exporting too little, or both. Doubtless some Canadian securities have been offered which should not have been issued, and the country's imports have been unwisely increased by the extravagance of a pros- perous people, but the main cause each year is the same. As one of the leading financial authorities has said, Can- 282 CORPORATION FINANCE ada needs more than ever new mileage of railways, vast quantities of new rolling stock, warehouse and port facil- ities, municipal expenditures in hundreds of new towns, and an enlarged scale of improvements in all the older municipalities, the building of ordinary roads, bridges, and other conveniences, in many new areas of settlement! the creation of plants for new industries and the general mcrease of existing plants throughout all Canada, the erection of private dwellings in greater numbers and of more permanent construction than in the past, and many other forms of betterment which need not be detailed. 144. A typical Canadian prospectus.— We may ex- amine the typical prospectus of a Canadian corporation issue m London— that of $2,100,000 seven per cent cu- mulative participating preferred shares of $100 each, of the A. Macdonald Company, Limited. This pros- pectus gives details of capital, authorized and issued; terms of payment for the stock; history of the com- pany; list of its branches, particulars of assets, earn- ings, profits; certificates of chartered accountants and appraisal companies; names and occupations of the di- rectors, information as to how the proceeds of the issue will be applied. Indeed, almost all that is necessary for the investor to judge of the value of the offering is given in the prospectus. This is as it sliould be. A lengthy letter from the company's general man- ager, with considerable information, is included. It is written in a conservative tone, as the following extract will show: The business of the A. Macdonald Company was founded more than twenty years ago by Mr. Alexander Macdonald, who, prior to that time, had conducted a retail grocery store in the city of Winnipeg. Mr. Macdonald originated the idea of founding a wholesale grocery business on the mail order plan. SELLING CANADIAN SECURITIES 283 Instead of sending travellers on the road to visit the retail trade, he inaugurated the publication of a price list or cat- alogue, twice a month, which was mailed to all retailers. The {•oiiipany's price lists were accompanied by order forms and envelopes, so that all the retailer had to do was to write his order and mail it to the company. Gradually, as the business grew, branches were opened at various points, the original warehouse in Winnipeg becoming !lie head office of the company. As the branches grew in num- ber the demand for the price list also increased, until at the present time there is probably not a retail grocer in the terri- tory covered who does not regularly receive this price list. Satisfied with moderate profits, and able, through this es- tablishment of branches, to deliver goods promptly, the Mac- (jonald Company has built up an enormous business in North- ern Ontario and in the Provinces of Manitoba, Saskatchewan and Alberta. So great has been its success that the entire stock of merchandise has been turned over at the rate of nearly ten times per annum. 145. Growing United States market for Canadian securities. — While the bulk of Canadian corporation bonds is sold in Great Britain, there is a growing market for them in the United States. There is no sound reason wliv there should not be a much wider market for Cana- (lian securities in the United States than there is; for there are few better, and both countries have much in common and clear ideas of each other's opportunities and methods. Already there is a considerable amount of United States capital invested in Canadian enterprises, more than is generally appreciated on either side of the border. But so far, such investments have been largely confined to a few wealthy Americans or to the big in- dustrials, so that the average United States investor has had little interest in the wonderful development of Can- li' 284 It' I I COaPOKATION FINANCE ada particularly in comparison with tlie vast influx of British capital during the last few years. of rTS-"' ^""^^ *"'' -"'""' '•'»P°n^iWe for the sale of Canadian securities, are becoming far more c'osslv associated with United States financifl hou"s T^t U^itld SUtr"'"'' ^"'^ "' ^""'""''^ -""«- » ^ iJ^'^t ''V» /"'■•'y K^"' *'I«»i«on in Canada to The r»l °l ^^ speculative and unworthy offermg,. Ihe Canadian investor, who is slowly becoming more of a power m his own country, is beginning to esd^w worthless mining, oil, land and other stocks with wS he IS baited. This situation was created probablyi; cause of bitter lessons learned in the past, and te^^ » many excellent securities are offered'in tte 4w n^ J^l '" "*" ~"'"™'' *••' »™'<»' in Canada needs a higher rate of interest than three per cent to meet the increased cost of living, which ap^ars in ex- pected and unexpected places. Small bond denomina- tions are popular, and successful efforts have been made by financial houses to appeal to investors with limited savings. """cu Unlit ^T^fi '^'^?* '■«''«^ community and fox farm finance.-An interesting development in Canadian cor- poration financing appeared in Canada in 1912 and 1918 --the issue of securities by fox farming companies, chiefly on Prince Edward Island. The review of busi- ness conditions during 1912, issued by the Canadian Bank of Commerce, referring to this industry, said: Prince Edward Island has savings deposits of about $10,- 000,000, and is, per capita, probably the richest rural com- munity in the Dominion. To its prosperous industries of agri- culture and fishing has been added in late years black fox SELLING CANADIAN SECURITIES 285 ranching, which has reached important proportions and may be said to have outgrown the experimental stage. The present stock of breeding animals, numbering about 400, four-fifths of the total number in captivity in the world, is said to be valued at $2,800,000, and the estimated value of the young foxes this year is $1,800,000. A business which promises such attractive profits may have for a while a disturbing effect upon the regular occupations of the province, but the possibilities of breeding in captivity the more valuable native fur-bearing animals are such as should enlist wide interest and a careful study of the subject. Here is reproduced the prospectus of the Tuplin Sil- ver Black Fox Corporation, Limited, which offered $200,000 six per cent bonds. The Tuplin Silver Black Fox G)rporation, Limited WE OFFER ^200,000.00 SIX PER C£NT BONDS (In denominations of $100.00 and $500.00) at par, with 40 Per Cent Bonus of Common Stock of The Tuplin Silver Black Fox G>rporation, Limited. (Incorporated under the Nova Scotia Joint Stock Companies' Act) CAPITAUZATION 6% Bonds, redeemable at 105% $300,000.00 Common Stock, par value of shares $10.00 each. . 800,000.00 PAYMENTS MAY BE MADE IN FULL, OR 25% on Application, 25% on April 1st, 25% on May 16th, 25% on July Ist. Interest payable semi-annually, October 1st and April Ist. Interim receipts for partial payments will be exchanged for Bonds and Stock Certificates when final payment is made. Sub- scribers have the right to pay in full at any tim% Accrued interest will be charged on all installments unpaid on April Ist. 286 CORPORATION FINANCE OIRECTOSS J. H. Winfield, General Manager, Maritime Telegraph & Tel^ phone Company, HaUfax Presided Prank F. Tuplin, Foxbreeder, Summerside, P. E. I., Vice-President Dr. C. F. Fraser, Director Eastern Trust Co. .Halifax, N. S. Hon. Senator William Dennis, President Herald Publishing __ /^° Halifax, N. S. .W. H. Covert, Director Yarmouth Light and Power Co., _ , Halifax, N.S. Dr. M. A. Currj, Physician Halifax, N. S. C. L. Grant, Merchant Charlottetown, P. E. I. BANKERS The Canadian Bank of Commerce Halifax N. S SOLICITORS Covert & Pearson Hulifax, N. S. TRUSTEES AND TRANSFER AGENTS The Maritime Trust Corporation Halifax, N. S. C. L. Grant, Managing Director Charlottetown, P. E. I. F. A. Bowman, Secretary Halifax, N. S. FACTS ABOUT THE INDUSTRY The Tuplin Silver Black Fox Corporation, Limited, incor- porated under the Nova Scotia Joint Stock Companies' Act, was organized for the purpose of engaging in Purpose of the raising and selling of the Silver or Black Corporation Fox, an industry which has passed the experi- mental stage and presents the opportunity for profits on a large scale. The Corporation's assets consist of eleven pairs of Silver Black Foxes, purchased from the famous ranch of Frank P. SELLING CANADIAN SECURITIES 287 TupHn, at New Annan, on the outskirts of Summerside. This stock consists of nine pairs of proved breeders, which pro- duced and raised thirty-two pups in the jear The 1912, together with one pair, one and one- Assets half years, old, and one pair raised in 1912. These foxes are the cream of Mr. Tuplin's stock. Mr. Tuplin is known as the largest and most successful breeder of Silver Black Foxes in the world. By process of selection, from year to year, he retained for his own ranch the pick of all the foxes raised, and it is this particular stock which has been purchased by the Corporation. The capitalization of the Corporation consists of $300,000.00 six per cent ten-year bonds, redeemable at 105%, on any in- terest date, and $300,000.00 of common stock The in shares of a par value of $10.00 each. It is Capital estimated that the bonds will be all redeemed within three years, thus returning to the in- vestor his outlay, when the common stock will have the benefit of all the net earnings. The sale of these eleven pairs of foxes to the Corporation car- ries with it a guarantee of at least twenty-eight young foxes, to be raised during the present year, with a Estimated forfeit of $5,000.00 for each young fox short Earnings of that number. Thus the Corporation has a guaranteed return of twenty-eight young as a profit for the first year. But a conservative estimate of the progeny for 1913 is thirty-five foxes. Tho Corporation has given an option for the sale of the twenty-°ight young at $4,500.00 each, so that a market for the increase has been secured which will make guaranteed profits for the first year $126,000.00. If the increase amounts to thirty-five, of which there is little doubt, as nine pairs produced thirty-two last year, leaving only three to be produced by the other two pairs, the profits would be $157,500. The net earn- ings are estimated as below : — f Iff 288 CORPORATION FINANCE 35 young foxes in September, 1913, to be sold at $4,500.00 each $157,500.00 Less Bond Interest at 6% 18,000 00 r»- -J J r ,«., $139,500.00 umdend of 10% on common stock . . 30 COO.OO Available for sinking fund to redeem bonds $109,500.00 Wliile options on the get of 1913 are to-day selling for $4,500.00, it is confidently expected that, as in previous years, prices will stiffen to higher figures before delivery date is reached. The mortgage securing the bonds provides that no dividend at the rate of more than 107o per annum shaii Bond be paid on the common stock until all the Redemption bonds shall have been redeemed, and that no dividend whatever on the common stock shall be paid in any one year unless at least $100,000.00 shall have been paid off in that year. The market for the Corporation's output is broad and ex- panding. Russia is a buyer and a demand for breeding ani- mals comes from many points outside of ^^^ Prince Edward Island. As to pelts the Silver Market or Black Fox is the rarest fur-producing animal in the world and its pelt, apart from the value of the animal as a breeder, brings the highest price of any fur. Silver or Black Fox pelts, of good quality, readily bring from $1,000.00 to .$3,000.00 each. Undoubtedly the ulti- mate value of the Silver Black Fox industry must be the market value of pelts, but there can be no doubt that for many years the demand for live stock from various parts of the world, by persons engaging in this business, will be such that the prices for live animals will much exceed the pelt value. It is believed that the present or higher prices will obtain for seven or eigl.t years at least. The sale of six pairs of this year's pups to a Russian company at $100,000.00, or $16,000 a pair, is a proper SELLING CANADIAN SECURITIES 289 basis of calculation of live stock value of the season's litter. The price on which this Corporation bases its estimates is only ^9,000 per pair. The contract with Frank F. Tuplin, from whom the foxes were purchased, provides that he shall care for them, raise the young, and attend to the animals on his own Maiiaf/ement ranch at New Annan, near Summerside, until September, 1913, and the Corporation has his guarantee to pay $5,000.00 for every fox less than twenty-eight that may be produced. After that date the Corporation may build a ranch, or make a new contract with Mr. Tuplin, who has taken a substantial interest in this Corporation. The Tuplin ranch, where the Corporation'^, foxes are being cared for, and wliere the young will be raised, is the best equipped in Prince Edward Island. It is located on the outskirts of Summerside, admirably situated in the bush, with plenty of trees for shade for the animals, and is equipped with a first-class water sys- tiin, with hydrants for fire protection, washing pens, and gen- eral sanitary requirements. The Directors decided that it was in the best interests of tlie Corporation to sell options on the guarantee of twenty- eight at the prevailing figure today, reserving Breeding Stock any extra pups for sale on or about delivery for next year date at the then prevailing figures. It may, however, be decided to be in the interests of the shareholders to retain some of the additional increase in order to produce higher returns next year. The Corporation's Solicitors report that the corporation has luen duly and properly incorporated and organized, the bonds secured by a mortgage or deed of trust to LctftiUtif of the Maritime Trust Corporation as Trustee, Organisation and the shares issued as fully paid and non- assessable shares, under a certain contract iiniile with Chester McLurc, dated the th day of — , C— VI— 19 290 CORPORATION FINANCE A number of Canadians are said to have written to the Department of Commerce at Washington seeking to buy some of the blue and silver foxes from the gov- ernment's preserves in Alaska, but no citizen of the United States had made similar request up to Julv, 1913, although the Department is understood to be anx- ious to get citizens of the United States to go in for fox breeding. It is not necessary to discuss the matter here, further than to say that there are undoubtedly large profits in the industry which will probably result in the formation of numerous companies. The consequent issue of stocks and bonds, in turn, will create a situation of interest, not without danger, to he investor. CHAPTER XVIII SELLING SECURITIES— THE WALL STREET MARKET 147. The principal stock exchanges of the United States. — The stock exchange oft'ers the best market for a great many corporate securities. Some readers are perhaps already familiar with the organization of that market and its manner of conducting business and will find much of the information given in this chapter already familiar. In spite of the importance of the Wall Street stock exchange, however, and in spite of the glib manner in which almost every one talks about it and against it, surprisingly few people have a correct understanding of its operations. What is said about the Xew York Stock Exchange and Wall Street in this chapter applies in general, with slight modifications, to a considerable number of smaller stock exchanges in the larger cities of the United States. Chief among these exchanges are: (1) The Boston Stock Exchange, on which local securities are bought and sold and which is the chief market for the stocks of copper-mining companies. (2) The Philadelphia Stock Exchange, on which local securities and the securities of the Lehigh Valley, the Pennsylvania and the Reading Railroads are bought and sold. (3) The Pittsburg Stock Exchange, the principal liiisiness of which is the handling of securities of the local steel companies, and of the United States Steel Corporation. 201 292 CORPORATION FINANCE t« 1^ if]}' (4) There are stock exchanges also in Baltimore, St, Louis, Chicago and San Francisco, all of which are comparatively small and the operations of which are confined to local securities. (5) In this group should be included the Consolidated Stock Exchange of New York, or the "Little Ex- change," as it is frequently termed, whose members buy and sell the same stocks that are traded in on the New York Stock Exchange, or "Big Exchange." The transactions on the Consolidated are on a much smaller scale than on the "Big Exchange"; stocks are custom- arily bought and sold in ten share lots or multiples of ten, instead of in one hundred share lots or multiples of one hundred, as on the New York Stock Exchange. The reader will see from this brief summary that large aealings in securities of corporations of national impor Lance are confined almost wholly to the floor of the New York Stock Exchange. With some excep- tions the stock of any corporation will be bought and sold on one exchange and one only; the chief exceptions, to most of which allusion has already been made, are: Amalgamated Copper Company stock, which is handled both in New York and in Boston; Pennsylvania Rail- road Company, Lehigh Valley Railroad Company, and Reading Railroad Company, both in New York and in Philadelphia; United States Steel securities, in New York, Boston, Chicago and Pittsburg. 148. Listing securities. ~Jn the first paragraph it was stated that the stock exchanges offer an excellent market for the sale of securities of certain corporations only. This limitation must be stated, because each of the exchanges confines Its members, so far as trades on the floor are concerned, to a comparatively small number of approved securities. On the New York Stock Ex- THE WALL STREET MARKET 293 t'liange all new securities offered for approval are in- vestigated before being "listed." The Exchange has strict rules governing the admission of securities to the "listed" class. There is a committee of five to whom are referred all applications for including securities among those listed. Accompanying the application, there must be filed a complete description of the prop- erty of the corporation, a full and true balance sheet, an income account, and information on certain other points. In the case of bonds a full statement of the terms under which the bonds are issued, a certified copy of the mortgage, and proof that the mortgage has been properly recorded, must be submitted. The exchange strongly recommends — a recommendation that has all the force of an order — that corporations whose securi- ties are listed shall furnish to their stockholders com- plete annual reports at least fifteen days prior to annual meetings. ]\Iany industrial corporations which are unwilling to comply with the requirements as to publicity, were for- merly admitted to the "unlisted" class. This means that their securities were bought and sold on the floor of tile exchange in the same manner as the listed securities, and so far as the general public was concerned there was no apparent difference between the two classes. There was, in fact, however, a very important difference, for the corporations whose securities were imlisted were not required to give complete reports as to their opera- tions to the stock exchange committee or to their stockholders. Although the public did not appreciate the fact that such a distinction existed, men in the finan- cial district were fully alive to its importance. Listed se- curities almost without exception were much more Iff^ii/ 294 CORPOllATION FINANCK ir highly regarded by bankers and were more acceptable as collateral for bank loans. For this reason, most corporations preferred to meet all the requirements and have their securities listed. About 85 per cent of the securities handled on the New York Exchange entered the listed department, and the unlisted group— partly on account of the force of the growing demand for publicity— rapidly doclined in numbers and in importance. Among the last converts from the unlisted to the listed class were two industrial companies of great size and importance, the American Sugar Refining Company and the American Smelting and Refining Company. Tliis entrance into the listed department was rightly interpreted as a final proof that the day of corporate secrecy, so far as stockholders are concerned, had gone by, and shortly thereafter the use- less "unlisted" class was abandoned. 149. The Curb Market— There are a considerable number of large corporations that are unwilling or unable to furnish even the very moderate amount of information that is necessary in order to have their se- curities entered on the Stock Exchange list. There are other securities that are very highly speculative in their nature, or that are issued by corporations which are not honestly and efficiently managed— "cats and dogs" such securities are called in Wall Street slang— which are bou^rht and sold in considerable quantities in the Wall Street district. As such securities would not be admissible under the rules of any reputable exchange, an outside unorganized market has come into existence. This is known as the Curb [Market, for the reason that the meetings of the brokers who participate in it are held in the open air in one of the streets in the Wall Street district near the street curb. There are no written rules THE WALL STREET MARKET 295 and no fixed organization for the Curb Market. Any- one may go among the throng of brokers standing on the street and buy or sell securities if he can find anyone else to trade with him. As a matter of fact, however, a stranger would not be able to transact any business, for no one would be sure that he would live up to what- ever obligations he might contract. In practice, in or- der to do business on the "Curb," a broker must either have high standing and reputation on his own account or must be a representative of an established brokerage firm. Among the well-known and important nrpora- tions whose securities are bought and sold in the Curb Market we may mention the former subsidiaries of the Standard Oil and American Tobacco companies and a number of industrials, the stocks of which are also traded in on local exchanges outside New York, such as the Baldwin Locomotive Company, the J. I. Case Com- pany, Cluett-Peabody Company, Goodrich Company and Studebaker Company. Most of the other active stocks on the Curb Market are of mining companies. The Curb Market is also the center of transactions in "rights" (which are described in Chapter XXIV) and in contracts for purchase and delivery of stock and bonds that are not yet issued. Such stocks and bonds are traded in "w. i.," to use the Wall Street abbrevia- tion, which stands for "when issued." 150. Stoch Excliange methods. — The scene on the floor of any of the regular stock exchanges and on the street where the curb brokers congregate always seems to an uninitiated observer strange and confusing. On the larger exchanges he sees a number of posts set up at regular intervals, each post bearing the initials of several of the corpoi ations whose securities are listed on tliat particular exchange. Around each post, if it is a i I M 296 CORPORATION FINANCE M 1 r rf' i ry; is i busy day, are a large number of brokers, eaeh armed with a pencil and a memorandum jjad, and many of them engaged in making frantic signs to other brokers. The signs, which are unintelligible to the outsider, in- dicate offers to buy at a certain price or acceptances. A broker who has the stock or bonds of any corpora- tion to sell goes to the post to which that corporation is assigned, offers his stock and receives bids. Any reader who has never visited an exchange must not get the idea that this proceeding is as simple and unexciting as it seems when described in cold print. If the market is at all active, the seller may have to fight his way to the center of a struggling group, yell out his offer at the top of his voice, and accept one or more of the bids that may be yelled back at him in the twinkling of an eye. The noise that comes from the floor of a crowded stock exchange during an active business day resembles nothing so much as the roaring of wild beasts. It has often been remarked, as an indication of the good faith and high standards of honor that must pre- vail as a rule among stock-exchange brokers, that in the midst of all this confusion and outcry a hasty sign from the purchaser and a nod from the seller of a block of securities may close a deal involving thousands of dollars. Each broker makes his own memorandum of the transaction and at the close of the day the houses which they represent compare notes and through the stock exchange clearing house settle their balances. It is very seldom that a serious error or even a misunder standing occurs. Differences of opinion as to prices and quantities of securities are, of course, inevitable once in a while, but are usually adjusted in the friend- liest manner. The volume of business transacted in this manner on THE WALL STREET MARKET 297 the leading stock exchanges is enormous. Million share days on the New York Stock Exchange, though boinewhat ahove the average, are not at all uncommon. In other words, $100,000,000 worth of business is trans- acted. Of course it goes without saying that such quantities of shares are not bought outright, taken out of the market and placed in a vault. On the contrary, the great mass of the business of buying and selling is speculative. What is actually bought and sold is the right to receive or the right to deliver certain quantities of shares at the end of the day at the price tixed in the deals between brokers. In most cases no actual delivery is made. Through the stock exchange clearing house the transactions in the same stock offset each other and only the balances are delivered by those who sold to those Avlu) buy. jNIany floor traders seldom see any stock certificates because they make it a rule to sell during the day as much as they buy. They make both sales and purchases with the view to "scalping" small profits, % and 1/1 per cents. L)l. Importance of speculative dealings. — Nothing need be said here as to the ethics of speculation, a sub- ject which is adequately treated in another volume. It may be well to remark, however, that all these specula- tive transactions on the stock exchange, particularly the small transactions, perfoim at least one very useful service, namely, they tend to steady security prices. O!)viously, if a stock starts to move up or down and a group of floor traders are at hand all trying to sell at each slight advance with a view to getting their small speculative profits, the price will probably not soar very rapidly. Tlie same remark in substance will apply to all speculative dealings. Enough has been said about the stock exchanges and ' f J 298 CORPORATION FINANCE 1)1 'li It) A Hi I'. Stock and bond brokers to give some idea perhaps of their methods of operation. It is no part of the business of stockbrokers to l)iiy and sell to any large extent on their own account, although many of them, to be sure, do not by any means abstain from so doing. Their main function, however, is to serve as agents for other persons who may desire to buy or sell securities. Some of these persons are true investors who are either parting with some of their stockholdings for cash or are buying securities outright with a view to holding them for the sake of dividends and of future increases in their value. Such persons, however, are in the minority; most of the buying and selling of stocks on the stock exchanges is speculative. Of this speculative business a small pro- portion is carried on by the outright purchase of stocks or bonds, which the purchaser hopes will rise in value within a short time so that he may sell at a substantial profit; or by tlie outright sale of securities which the seller hopes to be able to buy back within a short time at a substantial reduction. The great mass of specula- tive business, however, and for that matter of all the business transacted in Wall Street, consists of buying and selling "on margin." 152. Btii/ing on margin.— By marginal transactions are meant those in which most of the necessary funds are borrowed and only a small percentage or "margin" is required of the person for whom the securities are bought or sold. The procedure in making a marginal speculative purchase is somewhat as follows: The speculator desires to own, we will say, one hundred shares of a stock which is selling at or near a par of $100; the least margin lliat will be accepted by reputable brokers in such a case will be $10 per share. The specu- lator, therefore, assuming that he does not already have THE WALL STREET MARKET 299 an account with his broker, gives hiin a check for $1,000 and an order to buy the one hundred shares. A repre- sentative of the brokerage firm buys the one hundred shares on the floor of the exchange in the manner already described. At the end of the day he must be prepared to pay for the shares, which means an outlay of approxi- mately $10,000 (100 shares at $100 each). In order to raise this amount the broker arranges with his bank to accept the shares, after they are bought, as collateral for a loan, which on standard stocks will be about 80 per cent of the market value, or on this block, $8,000. There still remains a difference of $1,000 which the broker must supply out of his own funds. If the stock sliortly after this transaction advances, we will say ten points, the fortunate speculator will perhaps give an order to sell, and the broker will secure approximately $11,000 for the block. With this he repays the bank loan of $8,000, reimburses himself for his loan of $1,000 and after deducting interest on the $9,000 supplied by the bank and by himself and deducting his brokerage charges, he turns the rest over to the speculator. On the other hand, if the stock goes down seven or eight points the speculator is called upon to put up additional marf?in or, failing that, the broker sells the stock, repays the bank loan, reimburses himself, deducts interest and brokerage charges as before, and returns to the specu- lator anything that may happen to be left of his $1,000. 1.53. Selling short— If the speculator chooses to sell on margin, or "sell short" in the Wall Street phrase, he deposits his $1,000 as before and orders the broker to sell. The broker's representative executes the sale on the floor of the exchange and of course is called upon to make delivery at the end of the day. As neither the speculator nor the broker owns the stock that WS^ PI 3U0 CORPORATION FINANCE Iff '■■ i i IM :ifr is has been sold, it is necessary for the broker to borrow the stock from some owner. This he does in the "loan corner," as it is called, of the stock exchange, where stocks are loaned to "shorts" on payment of the market price. In form this loan is a sale of stock ; it is provided, however, that on return of the stock the amount paid for the stock will be given back. This borrowed stock the broker uses to make delivery of the block that he has sold If within a short time the stock goes down, the fortunate speculator orders his broker to buy a block at the lower price; the broker uses the block that he buys to repay the lender of the stock with which delivery was originally made. He turns over to the speculator his $1,000 margin plus the difference between the price at which the block of stock wa sold and the price at which it was bought and minus brokerage charges. The bro- kerage house, when it borrowed stock with which to make delivery, paid to the lender the market value of the stock and is allowed interest on this sum ; the speculator, therefore, in his "short" operations is relieved of interest charges. On the other hand, if the stock goes up several points in this case, the broker will call for more margin; failing that, he will buy a block of stock with which to repay the stock he has borrowed, will deduct from the speculator's margin the difference between the price at which the stock was sold and the price at which it was bought, together with brokerage charges, and will then return to the speculator anything that may be left of his $1,000. 154. Stock exchange houses vs. bucket shops. — The following quotation from a circular letter issued by a large brokerage house gives an accurate statement of the terms upon which reputable brokers handle marginal transactions: THE WALL STREET MARKET 801 We execute commission orders for the outright purchase, in any amount, of listed stocks. Our charge is that fixed for all members of the New York Stock Exchange, Vs of 1 per cent of the par value, or 12^/2 cents a share, except that we make a minimum charge of $1 for any one transaction. Our requirement for doing business upon margin is 10 per cent upon the par value of the active Stock Exchange issues quoted at 50 or below; 15 per cent for those quoted between 50 and 100; and 20 per cent for those quoted above 100. We reserve the right, when opening f> margin account, to refuse to purchase those securities which either have not a ready market or are not available for collateral purposes. Those who desire to sell active stocks short, may do so upon a maintained margin of 15 per cent, in the case of stocks selling at par or below, and upon a margin of 20 per cent in the case of those selling above par, we, of course, to reserve the right to discriminate against any particular securities. Wc do not buy or sell less than 100 shares of stock or $10,000 of bonds, upon margin, so that $1,000 is the least amount with which such an account can be opened. Our in- terest charges depend upon the cost of our own funds and are figured at the end of each month, so we cannot say in advance just what rate will be charged, but we will be glad to take this question up in detail at any time. In opening margin accounts we require either a bank refer- ence or an introduction from some of our friends. We never open margin accounts for women or in the name of a woman nor do we open margin accounts for bank officials or bank employees. Just a word should be said here about bucket shops and swindling brokerage concerns of all kinds. The characteristic of all such concerns is that whatever money is turned over to thdm for buying and selling stocks nev-r gets out of their own pockets. Whatever may be saiu as to the ethics of true stock exchange w i'i 302 CORPORATION FINANCE ■^|a: H i V l^lf III! speculation, and as to its moral and economic effects, it is certainly true that Wall Street ought not to be blamed for the existence of the methods of the bucket shops. Wall Street brokers are, as a rule, entirely honorable in their dealings with customers. They make it their business to execute whatever orders are given to them by their customers under conditions which are fully and clearly set forth. If : Ije customer misunder- stands those conditions or misji Iges the market, it is his own .ault, not the broker's. A legitimate broker will make every effort to guide his customer aright and protect him from loss, for the broker's reputation and success depend directly on the success of his customers. The bucket shop, on the other hand, obviously prospers from the losses of its customers. 155. The classes of Wall Street speculators.— The Wall Street speculative contingent may roughly be di- vided into three classes: first, Wall Street men, bank- ers, brokers or corporation officials, who buy and sell securities on a large scale and who make it their business to keep in constant touch with all that goes on in the stock market ; second, substantial men of property and business standing whose first interests are not in the Wall Street game, but who take a "flier" once in a while in some security or group of securities of which they have special knowledge; third, the liangcrs-on, the true lambs, a class made tip largely of professional men, brokcti-down business men and women, who are suffer- ing under the delusion that they can make money in WhII Street without having a special knowledge either of Wall StrccI mclhods nr of the conditions in some par- ticular line of industry. This third class is by no means .so large as the niornlists, the muck-rakers and the comic papers repre.«jent; yet it is true that its representative!! THE WALL STREET MARKET ;303 arc only too painfully in evidence. 1 . is true also that the Fucnibers of this class inevitably lose in the long run, and that too often they are infected with a poison that ruins them both financially and morally. It is more than doubtful, however, if Wall Street ought to be held responsible for the losses of such people. For the most part tliey are weak and foolish and it may safely be said that if they had not fallen victims to the Wall Street cra/e tliev would have found some other means of losinir their monev. * 1.3G. A summary vieiic of the stock market. — What j)retedcs is intended to present to the reader a bird's- eye view of the Wall Street market, or the stock ex- change market, for securities. To recapitulate: only a comparatively few large corporations have their secur- ities listed on any of the stock exchanges; those corpora- tions whose securities are listed have a M'ell-advertised, continuous and easily accessible market for their secur- ities; this market is utiliy.ed both by investors and by sjjeculators, but, so far as stocks are concerned, the spec- ulative element is of chief importance; most of the speculation is carried on by means of marginal pur- chases and sales; the speculators may be classified under the three heads, Wall Street operators, business men and "lambs." With these leading facts before us, we are noAv ready to discuss briefly the process of selling a new security through the stock exchange markets. ^yf. Stimulating speculative interest. — If u , new security is a small issue put out by one of the less im- portant companies, the process of selling it through a •^tock exchange will not be much difl'erent from that ^vliich has been described in previous chapters. The new security will be advertised, inquiries will he invited, an alluring prospectus will l)e issued, the new security I '!4 30t CORPORATION FINANCE h ii \h ,1 .{ i will be listed and the corporation managers will then sit back and wait for orders to reach them. Let us suppose, however, that a new stock of a large issue is to be put out by )ne of the well-known com- panies. In that case, the corporation managers, or the syndicate which is underwriting and handling the sale of that stock, will not only take all the means mentioned in the preceding paragraph to insure the success of the sale, but will go further. Tiiey will take measures to create a si^eculative interest in the stock and to "make a market" at a good price. In addition to their advertisements and prospectuses, they will probably set to work other forces still better fitted to secure buj'ing orders from marginal specula- tors. Xow the average speculator is not much attracted by brass band announcements or even by newspaper stones, no matter how well written and convincing they may seem. But he rises to a tip like a hungry fish to the bait. He reasons that what is known to evervhodv will bring little profit to himself, but that information which comes to h'm confidentially by word of mouth gives him an exceptional opportunity. Therefore, AVall Street, from morning to night in an active market, hums with tips, rumors and gossip. The tips that are thus circulated are not all valueless by any means, although it must be admitted that a speculator who follows them too closely will ])robably be a heavy loser in the end. The first move, then, of the managers of a large rew stock issue will proba])ly be to see to it that rumors as to the extent an;] high quality of the issue, and above all, as to the "interests" thnt will support its market price, begin to pjrculnte. Thus the Mppctite of speculators will he stimulate*! and large buying orders from them will prob- THE WALL STREET MARKET 305 ably await the first appearance of the stock on the market. The next step will be to range the brokers in favor of the new issue, so that whatever advice they give to their customers will tend to favor its purchase. The most di- rect method of securing the brokers' favorable attention is by seeing to it that the new stock is acceptable as col- lateral for bank loans. Partly for this reason it is very important that among the persons interested from the be^iiming in the new issue should be representatives of large banking interests. If the broker feels sure that the stock will be acceptable as collateral, he knows that AC will be able to carry large amounts of it for his cus- tomers on easy terms. 1)8. Syndicate operations. — The next step is to se- cure an apreenient among the syndicate members and j)erhaps w. large banking and brokerage interests out- side the syndicate that the price of that particular re- curity will be held at a given figure. Thus when the liiterl)oroug' .Metropolitan Company, the great $240,- 000,000 merger of the transportation lines of New York City, was formed, the members of the syndicate were said to have agreed that the price of the common stock should not be allowed to fall below fifty. In order to maintain the price at this point they were compelled at'tt r the stock had been issued to purchase large blocks and take them off the market. In this particular case tlie syndicate, for reasons which need not be here dis- cussed, went to pieces after about a year, and the price of the common stock suddenly broke ver}' sharply. During the year, however, the agreement was lived up to. Where such an agreement is made and maintained the effect is to steady the price of the stock, or at least C— VT— 20 ;joG CORPORATION FINANCE !f,i !| ;; I 1 1 3 ' i i 1 II II if II m^^^' i to hold it above the figure agreed upon, and thereby to attract both speculators and investors. 159. Stock market manipulation. — The fourth step in making a market for a new issue is to manipulate the I)rice in such a manner as to gain the good will of specu- lators and brokers and arouse expectations of large profits. Manipulating a stock is a process that requires great skill, judgment and cool nerve. Several men in the Wall Street district have become famous for their abilities along this line; foremost among them is the well-known and successful operator, the late James R. Keene. To Mr. Keene was entrusted most of the large speculative stock flotations of recent years. He was almost uniformly successful. One method by which a manipulator may fix a quota- tion for his security is by "wash sales," by which is meant selling with one hand and buying with the other. Brokers on the New York Stock Exchange, according to the rules of the exchange, are not allowed to be parties knowingly to such a process. They are not sup- posed to know, however, and as a matter of fact, cannot know, whether or not a selling order given to them is matched by a buying order simultaneously given to an- other broker. By means of such matched orders a ma- nipulator may raise or depress the price of a stock al- most at will with no further expense than brokerage commissions — provided, of course, that his plans are not mterfered with by large buying or selling orders from other parties. It is customary for a stock market ma- nipulator in this manner to fix or attempt to fix the price of a security at the beginning and then gradually raise Its price and thus stimulate speculative interest in the security. As the security advances in price and stockholders THE WALL STREET MARKET 307 begin to send in their orders to buy, the manipulator, if his plans work out successfully, gradually feeds out small amounts of the stock that he has on hand. This process must be very gradual and carried on in such a manner that it cannot easily be observed ; otherwise, the stock-market price will be depressed, stockholders will take warning and will begin to sell and the market will be spoiled. Furthermore, it is not well to allow the price to go up too rapidly or too steadily; otherwise the ma- nipulation will be too apparent and furthermore no op- portunity will be given to prospective buyers to pur- chase at slight recessions from previous prices. The price of a skillfully manipulated stock will move upward and downward by jerks, the tendency on the whole be- ing upward. If the manipulation is secret and skillful, not even the most expert observer can be certain whether tlie price is subject to manipulation or not. It will be impossible here to enter into a study of all the intricacies of manipulation and of the schemes which have been successfully worked in the past. The object of this chapter is attained if the reader sees that the se- curities, stocks especially, of large corporations may be sold through the stock market at much higher prices than would be possible if the same stocks were sold direct to investors. A further study of this interesting branch of our subject will be found in the volume on Invest- ment AND Speculation, I 14 :ii 111 H III CHAPTER XIX SELLING SECURITIES— THE UNDERWRITING SYNDICATE 160. Origin of underwriting. — One means of float ing an issue of securities, we have seen, is to dispose of them through the agency of banking and brokerage houses. In such cases the financial houses may not merely undertake to sell the securities, but may make themselves responsible for the success of the sale. One method of so doing is by agreeing to take for them- selves, if no other purchasers are found within a specified period, all of the unsold portion of the issue at a certain agreed price. Thus the issuing corporation is relieved of part of its risk and the buyers of the securities are made to feel that well-informed financiers have faith in their value. This process — modified more or less, as described later in this chapter — is known as under- writing. The origin of underwriting is to be found in the famous London institution called Lloyd's. Lloyd's Coffee House was the place where the export and import merchants of London assembled in the 17th century to transact their business with shippers. As all such trade at that time was peculiarly subject to mishaps of all kinds, the practice grew up of dividing the risk on cargoes and shipments among a large number of mer- chants; each party to the agreement wrote his name under the contract and from this custom arose the name "underwri^^ing." We are to discuss in this chap^^er the 308 THE UNDERWRITING SYNDICATE 3U9 same principle r.s it is now applied to new issues of se- curities. The essential part of the arrangement is the iiisiiiiiig of someone against loss or failcire. A secon- dary feature is the division of the risk among a con- siilerable number of people, so that no one of the in- surers is liable to suffer great loss. IGl. Advantages of underwriting to the corporation. — Tliere are several reasons why banking and brokerage lioiises may properly carry on this business of financial underwriting and why the business is usually profitable both to themselves and to the corporation which issues the underwritten securities. In the first place, the hankers are presumably experts in the valuation of se- curities. Their judgment as to the price which should he set on a new security or as to the terms of exchange, if the new security results from a conversion of an old security, is a valuable, authoritative judgm'^nt. In the second place, the bankers are also experts in selling se- curities and each house involved in the imderwriting usually has an established clientele to whom it may readily dispose of almost any securities that it recom- mends. The corporation, on the other hand, has no facilities whatever for selling stocks and bonds; its ac- tivities are in the field of transportation, or industry, or trade, not in finance. Two further reasons are even more potent in inducing corporation managers to have new security issues under- written. First, even though the corporation can obtain expert financial advice and is reasonably sure to make a success ultimately of the sale of any securities it puts out, yet the time that will eldpse before the sale is com- pleted and the money received is always uncertain. Xow the corporation ordinarily would not be trying to sell new securities if it did not need money at once or in aio V s\ CORPORATION FINANCE f! !C> [1 j k 'i i .' 5 II. w liii the near future. It is disastrous to the success of many industrial or commercial operations to hold them in abeyance until the tedious process of selling a large block of bonds or stocks is completed; yet it is dangerous to go ahead so long as the sale is incomplete. This delay can be aT aided by having the security underwritten tor the underwriters will pay the corporation within a definite period. The second reason that appeals strongly to corporation managers is that the credit of a corporation is seriously affected by any apparent in- ability to market its securities. One failure— or even a success that is too hard-won-would hamper the corpo- ration greatly both in getting loans and in making future sales of stock. 162. Advantage to the buyers of securities.— There are telling advantages to the buyers of securities also in having them underwritten. As was pointed out in Chapter XVI, reputable banking houses never sell se- curities until after they have been satisfied by a search- mg investigation that the securities are all that they are represented to be. Though this does not mean a guar- antee on the part of the banking house, it does mean that the buyer has the advantage of their expert, and presumably impartial, examination of every question, legal, financial, accounting, engineering or commercial! that pertains to the new security. This investigation is expensive; no ordinary investor could afford it on his own account. He is, therefore, willing to pay a little higher price for a security if this service has been per- formed. Another advantage to the buyer is that he may be sure that the whole security issue has been sold by the cor- poration. A half-soKl issue is a sign of weakness and a hindrance to the completion of the corporation's plans jp«»' THE UNDERWRITING SYNDICATE 311 M serious as to 'reduce the value usually of the portion that has heen sold. Suppose, for instance, that an in- dustrial company desires to build a new plant at a cost of SI 0,000,000 and sells only $8,000,000 worth of the securities which are intended to finance the project. Wiiat can the company do? It can neither complete the plant nor return the $8,000,000. In all probability the money will be used unprofitably and the stocks or bonds sold by the company will be poorly secured. This danger is avoided when the whole block of securities is taken at one time by underwriters. A third advantage to the buyer is that any reputable hanking house will w^atch closely any security that it has underwritten, and will come to the assistance of the security-holders in case the corporation later gets into difficulties. As will be brought out in our study of re- orLfanization, the committees formed to assist in devising phms to reorganize insolvent corporations almost always contain representatives of banking houses who are there to look after the interests of their clients. For these reasons underwriting certainly adds to the value of securities. The underwriters naturally are not impelled by charitable motives; they expect a reasonable compensation for their risk and trouble, and frequently the compensation runs well up into millions of dollars. Barring collusion and graft, which have been only too apparent in isolated cases, it may be laid down as a general rule, however, that the underwriters give more tlian value received. There is no question in the writer's mind but that our corporation financing is cleaner and more efficient because underwriting is the general prac- tice. It is hard to over-estimate the value of examina- tion and supervision by fair-minded financial experts. 1G3. When is undencriting advisable? — It must not 812 H'p'r; CORPORATION FINANCE ? . ! ; be inferred that every new stock or bond issue ongl.t tn be underwritten. Small issues, say $500,000 or less can usually be sold to a comparatively small number of mvestors by direct solicitation on the part of the corpo- ration. Then again, well-established, successful corpo- rations frequently sell new stock or bond issues to their stockholders at bargain prices. Ordinarily there is no risk in such a sale and consequently no necessity for underwriting. An interesting concrete case, in which there is doubt as to whether new issues of bonds should be underwritten or not, was brought to public attention in Mar^h, 1909. At the annual meeting of the stockholders of the Penn- sylvania Railroad Company Mr. ]Moorfield Storey, a Boston lawyer, submitted the following resolution: Whereas, the Pennsylvania Railroad Company is to-day the first railroad corporation in the world, and its securities are entitled to rank witli the best that can be offered, and, therefore, to command the I^-ghest price in tlic markets, both of this and foreign countries ; and, Whereas, There is now abundant capital in ii.e hands of capitalists and combinations of capitalist . thi^ world over, who are seeking opportunities for bnyinp such seounties, and it is desirable that the directors of this conipaiiy should Uh advan- tage of the opportunity which these conditions afford to obtain the highest price possible for such securities as the company now proposes to sell ; and, Whereas, The sale of railroad securities to the highest bidder after open competition will do much to remove the public belief that such securities are issued for excessive amounts, and thus tend to prevent legislation adverse to these corporations, which is now threatened. Resolved, That the stockholders of the Pennsylvania Rail- road Company desire to have the proposed issue of securities 80 oflPered as to be open to competitive bidding by responsible THE UNDEKWRITING SYNDICATE 313 li.Miking houses, and thn,t the issue of securities should, be adver- lisiil in advance, it being retjuired that such bids shall be acconi' jxiiiiwl by certified check for such amount as may be necessary to insure good faith. This reasoning sounds plausible at the first hearing, hilt is far from eonviiicing. It fails to take unto ac- count tlie risks involved in the proposed plan and the advantage to the railroad of having the right kind of hanking connections in periods of financial stress. In the course of an able discussion of this proposal the Xeic York Evening/ Post said: Tliose who hold different views appeal to the Pennsylvania's own experience in 1903. Early in that year, when the stock «iis selling around 157, the shareholders were offered $75,000,- ()()l) new stock at 120. Before the time for closing the sub- MTiption list expired, the price of the old stock had fallen almost to 120, and the management was confronted with the (lifRruIty that beset the Steel Corporation the same year, when lionds which had been offered to the shareholders at par were s« lling in the open market at 65. Needless to say, the Steel bonds were finally sold to a syndicate and not to the share- lioldcrs. When Pennsylvania dropped to around 120, in the >pring of 1903, a banking syndicate was hastily formed to inuKrwrite the new issue for which a commission of 2y2 Piany banking houses follow a definite policy in this respect and refuse absolutely to underwrite more than a certain sum, say $100,000 or $.)00,000 or $1,000,000, depending on the size of the house, even when the risk seems particularly small. THE UNDKUWUITING SYNDICATF 315 Another reason for co-operation among bankers is llial each house desires to offer a variety ol' securities to its clientele. If it specializes too much or offers only a tew securities, it cannot expect to attract and hold reg- ular ciistomers. A third reason for co-operation is in order that a Itioad geographical distribution may be obtained and the ale of the security issue be made correspondingly easy. A Pittsburg steel company, we will say, is putting out a large new bond issue and gets a New York banking house to underwrite the issue. New York and Pitts- hiirg investors may be loaded with similar bonds already; under such circumstances the New York banking house will certainly invite houses in Boston and Chicago and other centers, which are not yet saturated with such bonds, to participate in the underwriting. For these reasons the banks and brokerage houses that handle this business on a large scale always band them- selves together in the case of an issue of considerable size into an underwriting syndicate. By means of the syndicate the risk, the trouble and the profits are div* '^d among several houses. The sjTidicate so formed may lielong to any one of five types. 10.5. Five Ujpes of syndicates. — Originally the nor- mal arrangement was to have the syndicate as a whole j>narantee the price of the issue, and let the corporation attend to the selling. Under this plan, to give an ex- ample, a corporation putting out a $.),000,000 bond issue would offer the bonds to the public at a fixed price, say 95, and the syndicate would agree to accept any of the bonds not bought by the public at a lower price, say 00. This is underwriting in the original sense of the word, it is a species of insurance. Under siich a plan the syndicate would have two sources of profit; first, a «^!' 316 CORPORATION FINANCE ? i i < 'I i 11 : I if III commission on the portion sold to the public, or a fixed bonus; and, second, the difference between the whole- sale price to them and the retail price at >vhich they would ultimately dispose of the bonds. The ordinary commission would range between 2 and 5 per cent. This type is seldom used nowadays, principally for the reason already given that the corporation is not well equipped to attend to the sale of securities. A second type, also rather unusual, is a syndicate formed to take an "underwriter's option." Under this plan the syndicate takes the block of bonds or stock at a fixed price, payable only as resold. As fast as the syndicate disposes of the bonds it turns over the proceeds to the corporation, after deducting whatever it receives above the fixed price. The corporation pays somewhat less for this service than for other kinds of underwriting, because the syndicate takes no risk ; on the other hand, as the corporation cannot be certain when it will get its money, the type is not much favored by conservative corporation managers. The third type of syndicate comes into existence when a large banking house has bouglit for itself a big secur- ity issue and wishes to distribute the risk. In such a case the original underwriter frequently calls upon other banking houses and upon individuals to take portions of the issue at prices low enough to be attractive. The agreement with the parties who are called in may be ex- ecuted in anticipation of a contract that is about to be made between the original imderwriter and the corpora- tion. Full details as to an excellent example of tlis type of underwriting syndicate will be found in the agreement made in order to guarantee the conversion of the United States Steel Corporation preferred stock, which is given in full on pages 270-277. THE UNDERWRITING SYNDICATE 317 1G(). A fourth type — [woling the sale of the security. —The fourth type of syndicate acts as a unit in making a contract for the purchase of an issue and pools the sale of tlie stock or bonds. The chief difference between the third and fourth types lies simply in the fact that the syndicate members deal directly with the corpora- tion, not with a banking house. They thus secure for themselves all the profits of the underwriters. Such a syndicate is always managed by some one house or in- dividual having complete authority. Its organization and management are further discussed below. On the whole, this is probably the best lown and most common form of large syndicates. To illustrate the workings of this type we will sup- pose that a syndicate has been formed, under the leader- ship of Speyer & Company, to underwrite a $25,000,000 bond issue at 90; to the public the price of the issue, we will say, is 95. One concern may agree to take $1,000,- )0, or one-twenty-fifth of whatever amount the public fails to buy; another concern may take $2,500,000, or one-tenth of whatever is left unsold, and so on. All the bonds are left, in this form of sjTidicate, with Speyer k Company, who offer the bonds to the public and sell all that they can. If the whole issue is taken by the public, each party to the syndicate receives his profits, after deducting expenses, without further trouble. If the public does not take the whole issue, each member must take his agreed proportion at the syndicate price, 00. In good times the risk in such a transaction is slight; if the public is indisposed to buy bonds, however, or if any serious mistake in their valuation has been iniule, the sjTidicate members may lose heavily. 1(57. A fifth type— distributing the security.— T!\\e nooUng arrangement a\w\c described, although it se- ;3i8 t'^ CORPORATION FINANCE J I cures centralized and efficient management, is apt to prove unsatisfactory in that it does not bring into play the whole selling machinery of the various syndicate members. For this reason it has become more and more customary of late years to distribute the security issue among the members of the syndicate. This is the fifth type of an underuriting syndicate. Strictly speaking of course, the distribution of securities is not an under- writmg in any sense, but a sale. It is a sale at a special price, however, made under certain restrictions and de- signed to serve exactly the same purpose as true under- writing; the term therefore is freely applied to it in the Street. Chief among the restrictions on the sale is an agreement, either tacit or written, that the securities shall not I)e resold to the public at less than a certain fixed price. Frequently it is also agreed that some one or two of the syndicate members shall be given the first opportunity to advertise a sale of the securities, and that the other members are to keep out )f the open market for a limited period. Sucii an agreement would not bar any of the syndicate members from selling the securities to their regular clients. Among the members of a syndicate of this type there are frequently several individuals and institutions who are buying the securities, not for resale, but for invest- ment; they are simply getting on the ground floor, making their investment at the special sj-ndicate price. Readers will perhaps recall that this' practice was brought to public attention and much discussed during the great insurance investigation of 1904. Mr. George W. Perkins, later of the firm of J. P. ^forgan and Com- pany, and Mr. James IT. Hyde, among others, alleged that their participation as imlividuals in syndicates, which was disclose m hat has been said with regard to the various types of underwriting syndicates, it is evident that the tendency is growing for the corporation to sell its new security issues at fixed prices to the large bank- ing houses and then wash its hands of the business of selling the securities. Experience has demonstrated that this is the best method for the corporation. Bank- ing houses also prefer this method to the original under- writing, which consisted simply in guaranteeing the price, for two reasons: first, because they can thus con- trol the price and time of sale and bring to bear their skill in selling; second, because the underwriters, having full control of the securities, can post them as collateral and secure bank loans, thereby reducing their direct cash obligations. In making this last statement the writer has in mind the distinction between "banking houses" and "banks" which may not be familiar to all readers. "Banking houses," so-called, seldom carry deposits to any great extent from other people, and do not make a business of loaning money. Their chief interests lie in buying and selling securities. "Banks," on the other hand, draw their profits mainly from receiving deposits and making loans. CHAPTER XX THE MANAGEMENT OF THE UNDERWRITING SYNDICATE 169. Informal agreements. — As there are only a few large banking houses and institutions, even in the whole country, which ordinarily take part in large underwrit- ing syndicates and as these houses are thoroughly fa- miliar with each other's policies and resources, the agree- ments among them are frequently quite informal. In one large transaction recently, as was later brought out on the witness stand, J. P. Morgan and Company formed an underwriting syndicate simply by allotting a certain proportion of the security issue to each of several large firms and institutions. The members of the syndi- cate were not consulted at all or even advised in writing, but were merely called on the telephone and notified of their participation. The informality was possible in this case because the sjrndicate was expected to make good profits and J. P. Morgan and Company well knew that everyone concerned would gladly take as large an allotment as the syndicate managers would grant. 170. A formal syndicate agreement. — Ordinarily, however, a formal syndicate agreement is drawn up and signed. As these agreements are not generally made public, their exact terms seldom become known. The most elaborate and perhaps the most important agree- iiitnt of this nature that has been given out, was pro- duced on the witness stand in the famous suit to prevent the conversion of United States Steel preferred stock into l)onds, referred to in Chapter XV. The agreement c—vi— 21 821 322 CORPORATION FINANCE is of such interest and importance that it is given in full below : U. S. STEEL CORPORATION PREFERRED STOCK RE- TIREMENT SYNDICATE AGREEMENT. An ageeement made the 12th day of March, 1902, by and between J. P. Morgan & Co., co-partners, as Bankers, of the City of New York, parties of the first part, and the sub- scribers hereto (hereinafter called severally, parties of the second part). Wheeeas, The United States Steel Corporation (herein- after called the "Steel Company") proposes to make with J. P. Morgan & Co., a certain contract or contracts whereunder in behalf and on account of the Steel Company they are to offer to all of the preferred stockholders of the Steel Company, severally and ratably, the preferential opportunity of subscrib- ing for and of taking at par the "Ten-Sixty Year" Five Per Cent Sinking Fund Gold Bonds of the Steel Company in even amounts approximately equal to 40 per cent of their several holdings of preferred stock, such subscriptions to be payable in such preferred stock at par, provided that every such subscrip- tion stockholder at the time of such original subscription pay- able in preferred stock shall have the right of his option then to make an additional subscription payable in cash for such bonds to an amount equal to 25 per cent of his stock subscrip- tion; such bonds to be authorized now for the principal sum of $260,000,000 and Whereas, In and by such contracts J. P. Morgan & Co. are to guarantee to the Steel Company, that subscriptions for such bonds will be made for the aggregate sum of at least $100,000,000, payable in i)rcferri'«l stock to the extent of four- fifths of said sum, and in cash for the remaining one-fiftli thereof; such contracts to provide for the paynjent or allow- ance to J. P. Morgan k Co., of a commiss'on of 4 per rent upon the aggregate par amount of all such bonds, which shall be sold and delivered under their said offer, or to them, they SYNDICATE MANAGEMENT 323 having the prior right to take all of such bonds which shall be ort'cml for subscription, and which shall not be taken by the preferred stockholders under such offer ; and Whereas, upon the terms of this agreement, and for the purposes above mentioned all of the parties hereto now desire to form a syndicate to provide and to furnish to J. P. Morgan & Co. for delivery to the Steel Company the preferred stock, ami the cash required under their said guaranty, and to receive from J. P. Morgan & Co., four-fifths of the net commissions by them received under the said contract or contracts with the Steel Company, which contracts J. P. Morgan & Co. arc authorized from time to time to make, modify and perform, as in the exercise of their unlimited discretion from time to time they may deem proper, do agree, as follows, viz. : First. On signing this agreement each subscriber has de- livered to J. P. Morgan & Co. certificates for preferred stock of the Steel Company in the amount indicated in his stock sub- scription hereto, which preferred stock, to such extent as may 1k' required to meet the requirements of their said guaranty, is to be delivered to the Steel Company at par in exchange for the Ten-Sixty Year Five Per Cent Gold Bonds of the Steel Company for an equal amount at par, to be received therefor hy any subscriber, and any such preferred stock not so delivered to the Steel Company is to be returned to the subscribers rata- l)ly according to their several subscriptions. Second. Each subscriber further agrees to pay J. P. Mor- gan Sc Co. in cash the sum specified in his cash subscription hereto, for which cash J. P. Morgan & Co. shall receive from the Steel Company bonds as aforesaid at par equal to the amount of such cash payment by such subscribers. Tiiuin. The several deliveries and undertakings of the several subscribers under this agrcenient shall be made and per- formed hy tiie subscribers respectively when and as requested I'.v J. 1', Morgan k Co. or by the subscribers, of any of said I i\e IVr Cent Sinking Fund Gold Bonds of the Steel Company. I'oriiTit. The several subscribers shall be called upon to ir 324 CORPORATION FINANCE ■ : i make payments of cash in respect of their several subscriptions only ratably according to the several amounts thereof; but each subscriber shall be so responsible to the full extent of the sev- eral undertakings regardless of performance or non-perform- ance by any other subscriber. In the same proportion except as otherwise provided the several subscribers shall be responsible for loss resulting to the Syndicate under this agreement. Noth- ing herein contained shall constitute the parties hereto partners, or shall render any of the subscribers liable to contribute more than his several proportionate amount as herein provided. Fifth. In the case of the failure of any subscriber to perform any of his undertakings hereunder as and when called for by them, J. P. Morgan & Co. in behalf of themselves and the syndicate shall have, and at their sole and exclusive option they may exercise, the right to exclude such subscriber from all interest in the Syndicate, and in their discretion, without any proceedings, either at law or in equity, they may dispose of such subscriber's participation hereunder of any interest or right of such subscriber hereunder or under any of said proposed contracts, but nevertheless, each subscriber in default shall be responsible to J. P. Morgan & Co. for the benefit of themselves and the other subscribers hereto for all damages caused by any failure on his part. At any public sale under this article of any interest or right of any subscriber J. P. Morgan & Co. or any party thereto may become purchaser for their own or for his own benefit, without accountability ; but notwithstanding any sale, whether public or private, the de- faulting subscriber shall be responsible to J. P. Morgan & Co. and to the Syndicate for all damages caused by such failure on his part. Sixth. J. P. Morgan & Co. shall have full power in their discretion from time to time, to agree with the Steel Company upon the terms and provisions of any contracts such as are above referred to; and also, from time to time, to enter into any agreements with the Steel Company modifying the said contracts as they may deem expedient. They may deliver to SYNDICATE MANAGEMENT 325 till' Stiul Company a copy of this agreement, having annexed tlarito a list of the subscribers; and thereupon to the extent of tlitir several subscriptions, the subscribers, severally and respectively, but not jointly, and no one for any other, shall become responsible for the performance of such contracts with the Stcei Company in discharge of the obligations thereunder of J. P. Morgan & Co. Any and all contracts with the Steel Company made by J. P. Morgan & Co. shall be open to in- spection by any subscriber at the office of J. P. Morgan & Co. Seventh. J. P. Morgan & Co. shall be the sole and final judges as to whether at any time it is to the interest of the Syndicate to proceed further under this agreement or under said proposed contracts; and wherever they may deem ex- pedient, they may abandon the objects contemplated, in this agreement and said proposed contracts and all further pro- ceedings thereunder. In such event all the cash or stock and bonds by them received and then held for account of the Syndi- cate, and the proceeds of such stock and bonds shall remain charged with the payment of all expenses and liability by them incurred hereunder and shall be applied: — First to the payment of any and all expenses and obligations incurred by J. P. Morgan & Co. under any provisions of this agreement. Secondly, in repayment to the subscribers (so far as the same may be sufficient for that purpose) of all amounts of preferred stock or of cash by them respectively delivered here- under to J. P. Morgan & Co., such repayment to be made to the subscribers ratably. Eighth. J. P. Morgan & Co, shall be sole managers of the Syndicate, and in behalf of the Syndicate they may make any and all arrangements, and may perform any and all acts, even though not herein provided for, in their opinion necessary or expedient to carry out the purposes of this agreement, or to promote or to protect what they deem to be the best interests of the Syndicate. Tlie enumeration of specific powers in this or in any other article of this agreement shall not be construed as in any way *j2r> rOHI'ORATION FINANCi: t .. ' I j f abridging the general powers of this article intended to be con- ferred upon or reserved to J. P. Morgan & Co. Ninth. From tii' such action. No subscriber shall be entitled to receive any of said bonds before October 1, 1903. In the meantime, in their discretion, J. P. Morgan & Co. either themselves nmy retain all or anv part of such bonds, or they may deliver to any subscriber his proportionate part thereof, upon his agreenunt to hold the same subject to sale by J. P. Morgan & Co. and to return the same upon call of J. P. Morgan & Co. at any time before October 1,1903. Should any subscriber desire to withdraw from sale the por- tion of bonds to which he may be entitled hereunder, J. P. Morgan & Co., in tluir discretion may deliver to any sub- scriber his portion of such bonds upon his agreement to hold the same for himself without sale until October 1, 1903, or until the complete sale by J. P. Morgan & Co. at an earlier date of all bonds held by or for the Syndicate. Tenth. Until October 1, 1903, or until the final distribu- tion hereunder, J. P. Morgan k Co. in such manner, at such prices, on such terms, and in such amounts as they may deem expedient, shall have power for account of the Syndicate, to make purchases of the 5 per cent gold bonds and of the pre- ferred stock of the Steel Company, and they may resell any such bonds and stocks which they may have purchased and in their discretion they may make any further undertakings of any kind with any persons concerning any such bonds and stocks. They may apply towards any such purchasers any SYNDICATE MANAGEMENT 32; sums realized from any sales of bonds and stocks of the Steel (oinpimy under any provisions of this agreement; and they iiiav make advances, or may procure loans, and may secure the MiiiK' to such amounts and in such manner as from time to time lluv may deem expedient for any of the purposes of this agrt'fiiiont. Em.vk.nth. J. P. Morgan & Co. shall issue to the subscribers suitable receipts in respect of payments made hereunder, and thev may issue to the respective subscribers certificates of intcri'st of such tenor and form as they may deem suitable. Such certificates of interest and rights and obligations here- under of the respective subscribers may be made transferable in such manner and on such terms and conditions as J. P. Mor- gan & Co. may prescribe. Twelfth. J. P. Morgan & Co. shall have authority from time to time and at any time to incur such expenses as they may deem proper in carrying out, or endeavoring to carry out, this agreement or said proposed contracts, or in doing any act or thing which they may deem to be in the interest of tlic Syndicate, and all such expenses shall constitute and be a prior charge in their favor upon any and all money's, stocks and bonds by them received hereunder shall hold by them as bankers in general account. They also shall have power and authority, in their sole and absolute direction, finally to fix and pay all compensations or depositaries, brokers, agents and counsel, or others, and in the expense account may be included brokers' commissions as usually paid. Tmikteenth. After the complete performance of the entire oblifration of the Syndicate hereunder, but not before the first flay of October, 1903, unless otherwise determined by J. P. Morgan & Co., in the exercise of their unrestricted discretion, j)iiymeiit may be made to the Syndicate by J. P. Morgan & Co. for the purpose of this agreement, out of any moneys for .>ucli j)urposes received or retained by J. P. Morgan & Co. ForRTEENTH. J. P. Morgan & Co. shall not be liable under any of the provisions of this agreement nor for any matter 828 CORPORATION FIXANCE therewith connected except for good faith in performing or in refraining from performing or carrying out, the obligations by them herein expressly assumed; the implication of anv obligation not herein expressly assumed by them being hereby expressly denied and waived. It is understood that, in the same manner as other subscrib- ers, J. P. Morgan & Cr>. may become subscribers hereto, that as such subscribers they shall be liable for all subscriptions by them made, and that in all respects they shall be entitled to the same rights and benefits as any other subscriber. Any sub- scriber hereto may, on his own account, make any agreement with any other subscriber or with the Steel Company. Fifteenth. This agreement shall bind, and is for the benefit of the parties hereto and their administrators and execu- tors, severally and respectively, but no assignment hereunder shall be valid unless assented to in writing by J. P. Morgan & Co. All rights and powers J. P. IVIorgan & Co. hereunder shall vest in said co-partnership firm, as from time to time consti- tuted, without further act or assignment. Sixteenth. Nothing herein contained shall be construed as creating any trust or obligation whatsoever in favor of any person or corporation other than the subscribers, nor any obligation in favor of the subscribers excepting only as herein is expressly provided. Seventeexth. Each subscriber shall set opposite his sub- scription hereunder an address, to which notices, calls or other communications may be sent, and any notice, call or other communication addressed to any subscriber at the address so given, and either at such address or mailed, shall be deemed actually given to such subscriber, and shall be sufficient for all the purposes hereof. If any subscriber shall fail so to furnish an address to J. P. Morgan & Co., he shall not be entitled to any notice of calls or offers, or any other notice hereunder, and he shall be deemed to assent to any action of J. P. Morgan & Co. Eighteexth. In consideration of the irrevocable rights in them vested hereunder and the promises of the several sub- SYNDICATi ... ^TAGEMENT 329 scribe rs, J. P. Morgan & Co. have become parties to, and in good faitli will endeavor to consummate the purposes of this agreement ; and, after receipt thereof from the Steel Com- {mnv, they will, as herein provided, deliver to the Syndicate the said Five Per Cent Gold Bonds, or the proceeds thereof, and the said cash compensation. Ix WITNESS WHEREOF, the parties of the first part have hircunto affixed their signatures, and the parties of the second part at various dates have affixed their subscriptions hereto, it being understood that for convenience this agreement may be subscribed in several parts and copies with the same force and effect as if all the subscriptions were on one part or copy thereof. SUBSCRIPTION FOR FIVE PER CENT GOLD BONDS Name Address Preferred Stock Cash 171. Characteristics of syndicate agreements. — The most prominent feature of this agreement, as the reader has no doubt observed, is the absohite and unrestricted authority retained by the managers of the syndicate. Such phrases as "J. P. Alorgan & Company shall have full power in their discretion," "J. P. Morgan & Com- pany shall be the sole and final judges," "J. P. Morgan k Company shall have authority from time to time and at any time," "J. P. Morgan & Company, in the exer- cise of their unrestricted discretion," and so on, abound. In this respect the agreement is typical of all underwrit- ing' syndicates. Indeed, it is easy to see that without such unrestricted authority the syndicate managers could not carry on their operations with the necessary promptness and secrecy. The real check to any abuse of this power is to be found in the necessity resting on each banking firm to preserve its reputation for integ- rity absolutely unstained. For the same reason this agreement, like most other 330 CORPORATION FINANCE I H ■ such agreements, is marked hy „pen dealing, so far as the essential things are concerned. At the very begin ning of the agreement J. P. Morgan and Company state the commission which they are to receive. There IS nothing «m their part concealed from the other syndicate members; they state clearly what their profits and what the profits of each member are to be. The same rule holds true even in cases where the original underwriter is to make an extra profit over and above what goes to the other sjnidicate members. Secret prof- its are not permissible under the code of ethics that governs underwriting transactions. Sometimes it hai)pens that one of the underwriting firms finds its allotmcnls too large for some reason, in which case it will probably form a sub-svndicate. The members of the sub-syndicate are usually individuals or smaller banking firms. They are not brought into con- tact at all with the original syno ite and have no part m its workings, but are responsible solely to the other members of the sub-sj-ndicate. 172. Functions of underwriting syndicates.— UnAtr- writing syndicates may handle the securities of (a) Established corporations. (b) Reorganized corporations. (c) New corporations. The first case is the one that has been kept in view so far in this discussicm and need not be further considered. The second case presents some points of difference which will be referred to in the chapters dealing with reor- ganization. In both cases the sjTi(hcate is handling in- vestment securities and its sole problem is to market those securities to the best advantage. The third case is closely allied with promotion; the syndicate methods m this case recpure some further consideration. SYNDICATE MANAGEMENT 331 173. Underwriting speculative securities. — The se- curities of a new corporation, no matter how brilliant its prospects may be, are almost always speculative; the only exception is when a new corporation is formed to take over a business already established, and this excep- tion we need not consider here. The first distinction, tlidi, between a syndicate formed to underwrite the se- curities of a new corporation and other syndicates is that it is iiandling stocks and bonds of doubtful value which it cannot recommend unreservedly. A second distinction is that the syndicate must be prepared to put up more cash or furnish more credit in proportion to the size of the security issues than would ordinarily be necessary. This follows from the fact tliat conservative banks are not willing to lend much iiKinty on speculative stocks and bonds. A third distinction is that the syndicate must be pre- pared to carry the proposition through to the end; in no other way except at an enormous sacrifice can the money needs of the new corporation be met. A fourth distinction lies in the fact that for their own protection the syndicate members must build up and maintain the credit of the new corporation. Evidently there are several difficult and dangerous problems here to be solved. It is essential to their so- lution that the syndicate should absolutely control the new corporation. Without control measures may be taken that will impair the credit of the corporations and f»rinp heavy losses upon the syndicate. Even with full control such enterprises are usually deemed too risky to f»e participated in by banking houses of the best class. At least if such houses do enter the syndicate they accept orily small allotments, knowing full well the danger of becoming more deeply involved as the enterprise pro- ; 332 CORPORATION FINANCE tup 1 '' ^' I ^1 ! 5 I ceeds. No one can teU in advance what the cash re- quirements of a new corporation may be Each enterprise of this nature has' its own variations ot the difficulties and dangers that have been cited and requires a solution that will exactly fit its own peculiar- ities Perhaps the ber* way of explaining the usual solution will be to present the facts of a particular in- stance with which the writer happens to be familiar. 174. An example of speculative underwriting. -In the spring of 1902 the promoter of a smelting and re- fining company in Mexico succeeded in convincing a number of Philadelphia financiers that his proposition was worth looking into. They made a thorough investi- gation, satisfied themselves that the proposed plant would certainly prove profitable, and undertook to finance its construction. Engineers' estimates called for an expenditure of something over $2,000,000 and a period of three years before the plant would begin to earn expenses. As a matter of fact, the expenditure was approximately $8,000,000 and the construction work was not completed until early in 1907. A syndicate of Philadelphia and Baltimore capital- ists and banking houses was formed to underwrite the enterprise. Next an entirely different sjTidicate of banking houses was organized, which agreed to take the notes when issued up to a certain amount of syndicate No. I, the notes to be secured by the stock of a corpora- tion organized to construct the plant. The corporation was capitalized at $2,000,000. half preferred and half common stock. All its stock was sold to s>'ndicate Xo. I. for $1,000,000. Syndicate No. I then posted the stock and gave notes to svTidicate No. TT. which loaned the $1,000,000. Thus syndicate No. I was not called upon for cash, except for expenses, and the construction SYNDICATE MANAGEMExNT 333 company was supplied with $1,000,000 with which to begin operations. Next, after expending the $1,000,000, the construc- tion company issued $500,000 of its own notes, which being its only obligations were accepted by Philadelphia banks. The discount on this and the other sales, for the sake of simplicity, we will eliminate. Up to this point one-half the necessary funds had been secured and at the end of two years the work of construction had been more than half completed. Now a new corporation was formed which was to operate the plant. The reader will obs ' e that the first corporation existed simply to carry on construction. The operating corporation at once took over the stock of the construction company, title to which up to this time had remained with syndicate No. I. Then the operating corporation put out a first-mortgage bond issue, based on all its property then owned and thereafter to be constructed, and sold during the next two years $1,500,000 bonds. In this way the whole $3,000,000 necessary to built the plant was raised by borrowing and the members of syndicate No. I furnished nothing to the enterprise but tlieir credit. The diagram on page 334 will perhaps assist the reader in arriving at a clear understanding of the whole series of transactions. The plant at the date of writing has been running a little over two years. Earnings have been more than siitticient to meet all interest charges and other expenses, and it is expected that larp< profits will be earned in the future. Although the enterprise is not yet beyond the speculative stage, its chief difficulties have l>een over- come and its prospects appear bright. The first use to which surplus earnings will l)e devoted, according to the present plans, will be the paying off of the $1,000,000 of notes issued by syndicate No. I, and of the $500,000 1 334 CORPORATION FINANCE 1^ 1 SYNDICATE MANAGEMENT 335 notes of the construction company. As soon as these obligations are met the construction company may be dissolved and the operating company will begin to pay, it is expected, big dividends. It may seem strange that a new plant could thus be constructed wholly with borrowed funds; yet there is nothing especially unusual about the operation. The secret of the success of the syndicate in this instance lay in the fact that they were themselves strong financially and could borrow the first $1,000,000 readily. This left a margin of safety to those who loaned funds di- rectly to the two corporations. Furthermore, the sj^- dicate members were shrewd and prudent enough not to use up all the available credit of their corporations at the heginning. On the contrary, the essential feature of their plan of operation was to leave the best lien till the last. Thus they were able to borrow $1,500,000 on first mortgage bonds at a time when most corporations under ordinary management would have been compelled to call on their stockholders for funds. Much more complicated instances might have been cited. The principles followed in all those that have proved successful, however, have l)een the same, namely: utilize the credit of the backers of the corporation at the beginning and save the best security that the corporation can offer till the end. Working in this way, the under- writing syndicates of new corporations frequently bor- row large sums on advantageous terms. CHAPTER XXI ;lf INVESTMENT OF CAPITAL FUNDS 175. The importance of tcise investment. — The next question that confronts the promoter or manager of a new corporation after he has succeeded by one means or another in raising the necessary funds is, How shall those funds be invested? This seems a very easy prob- lem at first sight; and indeed the simple process of in- vesting is easy enough. To invest capital funds wisely and to the best advantage for the future of the corpora- tion, however, is a task that requires careful thought and foresight. A great many mistakes are made just at this point. The causes of failure of a great many failed corporations may be traced back unquestionably to errors in the original investment. Of course, each corporation has its own peculiar con- ditions to meet and no general principles can be laid down that will take the place of keen observation and careful reflection over all factors in the particular situa- tion that each manager faces. Xevertheless, there are some principles with regard to investment of capital funds so universal and some fatal errors so common that a short study of the problem is evidently worth while. Even if the result of this study is only a series of gener- alities, still experience shows that these generalities are worth making and worth keeping constantly in view. 170. The installment method of getting canh ai needed. — Tn the first place, a new corporation as a rule does not require all of the capital funds that will be nee* 836 INVESTMENT OF CAPITAL FUNDS 337 essary lor its development at the outset. On the other side, as we emphasized in connection with the subject of promotion, the corporation managers should have in siglit from the very beginning all the capital funds that they are likely to need ; for an effort to raise additional cajjital for an enterprise that is only half or two-thirds completed, and not on a paying basis, is painful and fre- quently unavailing. The manager or promoter of the ♦ corporation, then, looks for some method of reconciling these conflicting requirements. The simplest and best method, from the corporation's standpoint, is to obtain subscriptions before the new concern is started for more than enough stocks and bonds to carr>' it through to success, but to have the cash for these securities payable in installments. This method is common and works very well with enterprises, the total capital cost of which can be accurately estimated in ad- vance — such enterprises, for instance, as the erection of an office building or the construction of a railroad. In such cases the installments may be certain definite per- centages due at days fixed in advance, say 10 per cent when the corporation is organized, !^5 per cent at the expiration of three months, 25 per cent at the end of six months, 20 per cent at the end of nine months, and the remaining 20 per cent at the end of a year. Ir* this way the sale of securities is facilitated, because buyers prefer tisiially to pay in installments, and the corporation gets its funds as needed. The case is quite different, however, when the total nmnnnt of capital funds needed cannot be foretold. A corporation may be formed, for instance, to open up a mine or construct a tunnel or start a magazine. No- hndy can foresee absolutely what obstacles the under- ground work of the mine or tunnel will encounter, or (—VI— 22 «VIK^ 838 COlil'OUATiON FINANCE h I how quickly the magazine will "take" with the reading public. The promoter of such an enterprise, if he is honest with himself, will recognize that the corporation perhaps may need less and probably will need a great deal more capital funds than he anticipates. In order to meet this situation he will, if he can, induce people to subscribe capital funds to an amount greater than will probably be needed, issue part-paid stock when install- ments to a certain amount, say 50 per cent, have been « paid and make the rest of the installments payable at the option of the corporation. Thus the corporation can get all the funds it needs and at the same time does not have to carry large sums for which it has no partic- ular use. This is the ideal arrangement for such a corporation. 177. Disadvantages of this method.— UnfoTtunniely this plan does not appeal to the average stockholder. He does not like the idea of being liable at all times for the unpaid installments, particularly as the calls for additional payments in many such enterprises are apt to come during periods of financial distress at the very time when it will be extremely disagreeable for him to meet them. Moreover, in large corporations such an arrangement gives to the managers of the corporation an opportunity for manipulation that they are not al- ways virtuous enough to resist. Take the case, for ex- ample, of a well-known street railway company, which may be recognized by some of our readers, but whose name it would be improper to give in this connection: This company has a very large amount of part-paid stock outstanding, the remaining installments being due and payable at the Oj>tion of the board of directors. It is strongly suspected that the board on several (Kicasions have agreed among themselves in advance to issue a call I^^ ESTMExNT OF CAPITAL FUNDS 339 for ail installment and have thus given themselves plenty of time to aceumulate casii. Then the eall has been issued and the installment made payable at a very early date, so as to make it difficult for most of the stock- holders to meet the call. The result naturally has been in each instance that considerable amounts of the part- paid stock were thrown on the market and bought up at barrol)Iem is not solved in just the right manner, either the corporation will have more funds on hand than it 340 CORPORATION FINANCE needs and its rate of profits on stock will therobv be diminished, or else it will not have enough funds and ib development wUl thereby be checked. 179. How much shall be invested in fixed capitalf- The next questior to consider is. What proportion of the capital funds shall be put into "fixed" and what into working capital? The distinctions between fixed, semi-fixed current and quick assets were discussed in Chapter VII. The fixed and semi-fixed . ssets to- gether-those assets, in other words, which cannot be readily converted into cash-constitute the corporation's fixed capital. Working capital is somewhat different It consists, not of the current assets, brt of the differ- ence between current assets and current obligations. In other words, it consists of that amount of current assets which IS not furnished by trade and other short-time creditors and by temporary bank loans. The amount of fixed capital required by any corpora- tion depends, of course, on the nature of its operations, industrial and mining corporations must have machin- ery; railroad companies must have track and rolling stock; trading companies must have office furniture be- fore they can start business. The necessary total of fixed capital is not always so great as it appears to an outsider, for the reason that in most enterprises land, buildings and even machinery can be rented to better advantage than they can be bought. Accountants rec- ognize this fact and are in the habit, in estimating the true cost of production in a manufacturing establish- ment, of charging an estimated rent for the land and buildings even though they be owned in fee by the corporation. It is well for corporation managers to consider this possibility, especially in starting a new enterprise, and where possible avoid the investment of INVESTMENT OF CAPITAL FUNDS 341 lar^'c i»iims in fixed assets until after the success of the enterprise is assured. One of the characteristics of fixed capital Is that, al- thoii^^h it may be essential and valuable to the corpora- tion wliieh owns it, it is likely to have very little value if put on the market for sale. Its value remains, in other words, only so long as the concern is "going." Therefore, the smaller the proportion of a corporation's capital invested in fixed assets, the better off it is in case of failure or bankruptcy. 180. Forms of working capital. — Working capital may take any or all of four forms: (1) Cash, either on hand or in banks. (2) Bills and accounts receivable. (3) Raw materials and finished products in stock. (4) Securities of other corporations held, not for control, but for temporary investment. As an illustration take the following table, which shows the current assets and current liabilities of the United States Rubber Company for two recent fiscal years, as shown on the published balance sheets, and the working capital, or excess current, assets over cur- rent liabilities: CURRENT ASSETS. Inventories $18,404,726 $18,088,169 (Hsh 2,061,401 2,728,880 Bills receivable 8,681,126 9944250 Accounts receivable 8,687,681 8,494,284 Totals $82,884,884 $25,746,088 842 CORPORATION FLNANCE tl CUBRENT LIABILITIES. Loans and notes payable $ 6,821,077 $ 2,440,077 Accounts payable 737,384 362,634 Due General Rubber Co 7,269,441 7,164,111 Reserve for discount 872,989 874,735 Totals $1 5,700,891 $10,841,657 Working capital $17,133,993 $14,903,476 181. How much working capital shall he carried?— The amount of actual cash needed by a corporation varies with the size of its pay-roll and other current demands for cash, with the amount and character of its accounts payable considered in connection with its ac- counts receivable, with the discounts that it may obtain on purchases by making cash payments, and with its facilities for securing temporary loans. The force of these considerations must be estimated by the corpora- tion managers. Obviously there is a waste in carrying unnecessarily large bank balances; if any interest is received on sucli balances, it will not usually run higher than 3 per cent. On the other hand, every corporation naturally desires to stan,' -veil with banks and will carry large enough I)alances to make its deposits worth having. Otherwise, the corporation in times of difficulty may turn to banks in vain for temporary assistance. The amount of accounts receivable cannot be dete^ mined by the financial management of a corporation, but depends on the volume of sales, on the custom of the trade as regards payment and on the efficiency of the credit department in granting credits and in making collections. The amoimt of finished products and raw materials on hand is directly determined, of course, by the operat- ing department of each company. Nevertheless, the executive heads of the company should and usually do INVESTMENT OF CAPITAL FUNDS 34S txerc'ise some discretion in this regard, particularly with a vitw to reducing the amount of working capital thus invested to a minimum. A great many manufacturing corporations, on account of improper purchasing and accounting methods, are wasteful in this regard. Care- ful perpetual inventories of goods in stock will often make it possible to buy and sell more closely without interfering in the least with the operating efficiency of the business. Although this is a topic which belongs rather to organization and accounting than to finance, its importance to a corporation's financial management should not be overlooked. 182. The practice of large corporations. — The fol- lowing compilation made by the Wall Street Journal is of particular interest in that it shows the practice with regard to working capital of the largest and best- managed corporations. A study of reports of the leading industrial companies shows that the United States Steel Corporation takes the lead in work- ing capital, with the Standard Oil Co. second, the International Harvester Co. third and the General Electric Co. fourth. Including sinking and reserve fund assets invested in securi- ties, amounting to $32,442,400, the working capital of the U. S. Steel Corporation is $261,789,886. The International Harvester Co., aside from the Standard Oil Co., probably has a larger working capital to gross business than any other corporation of consequence. Its working capi- tal as of December 81, 1907, aggregated $77,087,811, while its gross business amounted to only $78,206,890. The General Electric Co. also shows up well from the stand- point of working capital, reporting $61,235,724 on January 31 last, compared with its gross businesti cf $70,977,168. The following table gives the working capital of several of the prominent industrial companies, togetlter with gross business and capitalization: ■t p 344 CORPORATION FINANCE Company. ^''°" ^Vorking Capital Bminess. Canial. stock United States Steel Corp'n.. $767,014,767 •$261, 885 $868,588600 Standnrd Oil ' Company 250,000,000 100,027,150 Inter. Harvester Company.... 78,206,890 77,087,811 120,000,000 General Electric Company.... 70,977,168 61,235,724 65,167,400 West. Elec. Mfg. Company.... 83,026,240 19,061,807 24,969,000 Lackawanna St'l Company.... 38,011,410 13,881,340 84.721400 Republic I. & St'l Company.... 81,229,428 6,720,000 47,607,900 Bethlehem Steel Company.... 15,000,000 7,434,573 29,770,000 Am. Steel Found. Company.... 19,463,521 4,834,843 17,184,000 Midvale Steel Company i ,804,929 750,000 Alii s-Chalmers Company 12,522,074 86,790,000 Cambria Steel Company 1 4,597,865 45,000,000 "To**' $780,970,851 $1,889,670,450 The above figures show that the twelve companies in question are well fortified with working capital. The aggregate working capital stands at $780,970,851, as compared with total stock capitalization of $1,889,570,450. The figures given above indicate that the companies in ques- tion are in a strong position to weather any depression that may reasonably be exix-cted. • Inrludes sinking and reserve fund assetn amounting to |3d,4«l,40L INVESTMENT OF CAPITAL FUNDS S45 To invest working capital to any considerable amount in the securities of other corporations is not a very coni- inon or coiiunemlable practice. It is justifiable only in those companies that have great fluctuations in demands cush and that cannot secure fair mterest on bank tor halances. The buying and selling of securities is no jjiirt of the business of any corporations except the few which are distinctly organized for that purpose. Prof- its that are derived from this source are justly regarded as speculative and highly uncertain. 183. Factors that affect working capital. — Consider- ing the situation as a whole the proportion of working to fixed capital in any business may be said to depend upon five fact'~rs, as follows: (1) Volume of business. (2) The regularity of supply of whatever raw ma- terials are used and the savings which may be effected hy huying raw materials in large quantities. If it is necessary for the corporation to pick up large batches of raw materials at irregular periods in order to get ad- \antageous terms, of course the working capital must be correspondingly increased, for two reasons : first, be- cause larger amounts of raw materials must be carried in stock than would otherwise be necessary; second, be- cntiso larger bank balances must be maintained in order to meet these irregular demands. (3) Regularity of the demand for the product of the corporation. The same considerations apply here as were named in connection with the preceding factor. (4) Customs of payment in the business. Some manufacturing corporations normally buy on 90 days* time and sell on 80 days* time. This arrangement makes it possible to meet the accounts payable out of accounts 846 CORI'OKATION FINANCE receivable and lessens the necessary amount of working (5) The length of time required to turn out the finished product. It takes three or four years normally to bmld a b.g steam vessel. During that period the ship-buildmg corporation will necessarily pay out larm sums for lumber and materials and a big working capi- tal, therefore, will be necessary. The same remark ap- plies to all concerns in which the period of manufacture IS lengthy. There is one great industry of the United Sutes .which can usually get along with a very small proportion of M'orking capital, namely, railroad operation. The prime reason is that the railroads are manufacturing a commodity, that is, transportation, which is continually .m ilemand and which is paid for ordinarily as soon as it IS produced. There are no outlays to speak of for cur- rent raw materials; the only raw materials that railroads use are for fixed assets and may be regarded as part of the cost of securing fixed capital. 184. The icorking capital of the Pennsylvania Rail- road.~KvL'n among railroads there may be exceptional circumstances which make necessary large working capitals. The I'enusylvania Railroad, for example, in the early part of 1909 was completing its immense ter- mmal improvements in and near Xew York City. In a sense it was engaged in the contracting business on a great scale, for it was building tracks, tunnels and sta- tions. Therefore, it needed ten.porarily as much work- mg capital as a manufacturing corporation should have Making a strict classification of current assets and liabilities, the Pennsylvania Railrc«d's cash posit* ,n at the end of 1908 compared with its position twelve months liefore as follows : INVESTMENT OF CAPITAL FUNDS 847 CURRENT ASSETS. 1908 190r Char,ge$ ( .i>li *5(i,0:J5,H9S $37;J85,673 Inc. f 1^640^34 Hills & ,i< lis. ricv U^94.0H0 1»,0(J9,840 Dec. 3,775,760 Cash asMls $70;J19,97H 955,455^13 Inc. 914,864.465 CUUKENT LIABILITIES. I'iiyn.lU \ v <>iuh $14,:?27,:W;9 ^0,326,1641 Dec. 9 5,998.795 Int. .inriinl, etc 3,i31,;J48 3,875,982 Inc. 355,366 .\|i^c<•llllll.lllls 4,211,496 3,9«6,996 Inc. 244,500 Curniit liabilities 921,670,1 13 937,0(,«,142 Dec. 9 5,399,029 Excels lur. assets 48,649,865 28,386,371 Inc. 20,263,494 This makes the company's net free capital, subject to the company's need of money to carry on its everyday business of transportation, more than $48,000,000 and SJO.OOO.OOO in excess of what it had been the year before. Tlu other assets, not to be classed as quick items but more or less subject to liquidation in time, and deferred and contingent liabilities, compare as follows: DEFERRED AND CONTINGENT ASSETS. 190fi 1907 Chamgtt Our otl N. \ W. & C. & < ' -t"'lv> 915,492,68,'; 915,492,685 I. ..in. tor ( cms.. &r 12.t03,KS4 18,412,493 Dec. 9 6,OO8,05» Diif from ('iintri>llrH cnni- l''"'<> 3,159,784 462,218 Inc. 2.697,5«« Mit. rills on hand 10,«9,483 15,929,925 IVc. 5,480,U2 .Sink, fund assets M.lt8,308 7,772,627 Inc. 375,581 'l"'»t'l 9*9.653,994 958,069,948 Dec. 9 8,4I5,9M DEFERRED AND CONTINGENT LIABILITIES. Cir tnisN rhfMl out 9 2,043,fl03 $ 1,4244171 In. fund 2.500,0O() De« . 2,500/X)0 Sinking' furi.l llnb 10339,0.57 9»\i<»M Inc. 523,101 ' "• 'I 915.1 13.969 919.054,921 Dec. 9 34»40,952 • * - .lif. 4 con. «wt».93*.540,0«5 939.015,027 Dec. f 4,474.002 848 CORPORATION FINANCE til 185. General conclusions as to working capital- Many other industries, particularly those inanufactur ing staple articles of trade, require a comparatively small proportion of working capital. On the other hand, there are Imes of business, such, for instance as publishing, in which only a little fixed capital (offiee furniture, plates, etc., chiefly) is needed. This is true more or less of all trading corporations. As was intimated at the beginning of this chapter, the principles herein laid down are of a very broad and general nature and can be successfully applied only by keen intelligence. Perhaps the chief practical con- clusion is that the most careful thought must be given to securing a proper proportion of working capital. No matter how valuable the fixed assets of a corporation may be, if it does not have all the funds necessary to transact current business and to meet current obliga- tions, it will inevitably prove a failure. Right here is where most of the mistakes and failures of the early stages of corporate management occur. :Managers trust that the current sales will take care of current ex- penses; when the inevitable hitch occurs they have no other resources to use and the corporation suddenly plunges into the quicksands of financial trouble and dis- credit. This problem of providing sufficient working capital will crop out again when we come to consider the causes of corporate insolvency. CHAPTER XXII DISPOSITION OF GROSS EARNINGS 186. Determination of income. — The ordinary fomi of income statement of a corporation is somewhat as follows : (a) Gross earnings from operation or manufacture. (b) Deduct operating or manufacturing ex- penses. (c) Net earnings from operatioi: or manufacture. (d) Add income from other sources. (e) Total income. (f) Deduct taxes. (g) Balance applicable to fixed charges. (h) Deduct interest. (i) Deduct rentals. ( j ) Deduct sinking fund and other charges. (k) Balance applicable to dividends and surplus. (1) Deduct dividends, (m) Surplus from the year's operations. It goes without saying that each corporation has its own method of stating ac?:ounts and that there are many variations from this standard form. The essen- tial items, however, are those stated above. It would be weH for the reader to study with some care the income accounts of large corporations which are made public from time to time and which are printed in the financial cojnnms of all inetroiH)litan newspapers. If any of the ifims given above are not altogether clear, the reader 35U couporat:o\ finance should turn to the volume on Accounting Practic, The relations between accounting and finance are «, close that a fair understanding oMhe has^cpr ne ,^ o aceonnting is necessary in order to deal intellS v.th the prob ems of financial management. In wh" is saul below m reference to each of the items in h mcH^nje account it will be assun.ed that the reader fam,l.ar w,th accounting terms and with the element of accounting i^ractice. 187 Honestif in stating gross carnings.-Perhm he only comment needful on the first item "gross earS! ings .s that ,t should be honestly stated. This remark IS tnte enough, and yet not uncalled for. A great nZ corporation managers are in the habit of including in the.r gross earnings sales that have been made to parties of doubtful credit which are represented merely l,y a ! couns receivable that are probably bad. In L case f holding companies it is not so uncommon as it should be to include in the gross earnings sales made from one company to another in the combination. Of course this IS simply a juggling with figures. A still more flag- rant instance of dishonesty was disclosed by Mr. Mephen L.ttle, an accountant of wide reputation, who n 1804 was called upon to investigate the condition of the insolvent Atehison, Topeka and Sante Fe Rail- road Company. Mr. Little found that the railroad had paid out millions <,f dollars in rebates to shippers which had nc»t been deducterw*f*? Operating ex- pense's are also often grossly misstated, although in this instance the fault is apt to be due. not so much to the DISPOSITION OF GROSS KAUMNXiS 351 (lisliontsty of the corporation managers, as to their i^rnorunce of correct accounting principles. The oper- ating' expenses ought always to include not only the actual expenditures for raw materials, lahor and current repairs, hut also a liberal allowance fcr anticipated re- pairs and renewals and for depreciation. Repairs in the early years of a corporation's activities are seldom as great a l)urden as in later years. Ac- 0)iintants figure that most manufacturing machines will show a rising percentage of necessary repairs each year for the first five to ten years of their existence and after that a fairly steady ratio will be maintained. Now it is evident that unless some allowance is made during the first few years for the rise in this item during the fol- lowing years, a misleading statement of operating ex- penses will be presented. Corporations differ greatly in their handling of charges for renewals of machinery and equipment. Many of them figure that the new machines they buy are additions to their capital and therefore should not he charged against the income account at all. If the new machine, however, replaces to any extent an old maeliine. this reasoning i^^ obviously incorrect. Only the difference between the value of the old and the value of the new machine could j)roperly be charged to capital aeeontjt. Conservative corporations in this country, railroads particularly, are in the habit of charging the whole cost of the new cijuipment, as a rule, as a part of operating expenses. The Knglish railroad practice, "H the other hand, is t(» charge the whole expense to lapitnl and to raise new capital fimds to meet it. We nIiiiII have . Xccetnty for depreciation reserves. — Tlie sub- 352 COUI'OUATION FINANCE « a lilt m > • h ject of depreciation is too large and important to re- ceive full consideration in this place; a more extended treatment will be found in the volumes on accounting. As the desirability of allowing properly for deprecia- tion ought to be indelibly impressed on the mind of every person interested in corporation management, however, some brief remarks on the subject, even at the risk of reiteration, are worth making here. There are three general causes of depreciation, as follows : (a) Failure to keep property in first-class working condition. (b) The gradual breaking down of property in spite of all that may be done to keep it in good condition. (c) ^lost important of all, obsolescence or the im- pairment of value because of new inventions and pro- cesses. It is difficult for anyone not directly familiar with modern manufacturing enterprises to conceive of the rapidity with which changes in mechanical methods fol- low each other. Each important change is apt to make necessary a general revision of all the machinery and processes of manufacture. In the intense competition between industries, no concern that allows itself to fall behind in the race to install the latest and most eco- nonncal devices will long be able to survive. American manufacturers have long been famous for the vifpw and fearlessness with which they adopt new machinery and processes, even though the ohanifc may make almost worthless the expensive e<|ui|)ment that liad previously been installed. The Carnegie Steel Company, it is said, time after time, has relentlessly sent to the scrap heap costly machi-'.es and even whole plants that were found to be inferior to new inventions. DISPOSITION OF GROSS EARNINGS 353 This polity certainly pays in the long run, as the striking success of the Carnegie Steel Company shows. Where products are being turned out in great quantities, a very shght saving in the cost of producing each unit may i>r()ve to be the margin between bankruptcy and prosperity. Yet, though the policy is to be praised and followed, it nuist not be forgotten that it involves large lossts lor the time being whenever old machines are superseded by new. These losses ought to be foreseen and i)rovidcork U()09 u'jA ("6) 48; - 0,!00 - Phon« (716) 288 - ",989 _ f^. 35G CORPORATION FINANCE I • in dividends is a total loss. On the other hand, it is also true that the only reason for the corporation's ex- istence is that it may pay dividends to the stockholders There is a conflict of interest here evidently and often a strong conflict of opinion between the managers of a corporation and the stockholders as to whether dividends should be paid or not. In the next chapter some striking examples will be cited. Assuming that a corporation has a balance for the year applicable to dividends and surplus, and that all persons concerned are agreed that some dividends should be paid, the question takes the form. How large an amount shall be thus distributed to stockholders? The first and most natural answer to this question is that all the profits of each year belong to the stockholders and should be paid out in dividends; and this answer is deemed entirely satisfactory by many intelligent people. The English corporations almost invariably follow this practice, and some important American corporations as well. The New York Central Railroad Conipany, for instance, has for many years paid out in dividends each year almost all the net earnings of the year. There are two distinct disadvantages in this practice: First, it does not permit the corporation to create a surplus of any considerable size; second, it makes the dividend rate irregular. The first disadvantage will be more fullv discussed in Chapter XXIII. The second disadvantage is of great importance and calls for some explanation. 192. Variahilitif of profits.— In all lines of business the profits necessarily vary from year to year. This is tnie because all tlie factors which enter into and d^ termine profits are variable. These facts are: DISPOSITION OF GROSS EARNINGS 357 (a) Volume of sales. (b) Prices obtained. (c) Prices of raw materials. (d) Wa.as. In no line of business is the volume of sales the same from year to year and in no line even where the general trend is upward can the volume be expected to increase steadily and regularly. Some fair degree of regularity, to be sure, can be attained in the cases of large public service corporations, such as waterworks, street railways and steam railroads, that deal with great masses of people. Even here there are sometimes surprising fluc- tuations. In most lines of industry, prices are very unstable and show big variations from year to year. In fjeneral it may be said that those industries have the most regular prices and volume of sales which are con- cerned with the necessities of life; and the farther you ^t't away from those necessities, the more violent are the fluctuations in those two items. To make these statements more definite let us examine the records of some of the leading industrial, street rail- road and steam railroad companies during the year of depression, 1908. The following gives the percentage of production of the leading industrial companies, com- pared with normal: United States Steel Corporation 60 Republic Iron and Steel 90 I.iikcns Iron & Steel 60 Corn Products Refining 75 Stiindnrd Oil 95 General Electric 60 Wcstinghouse 60 PcnnNvlvania Steel 60 Maryland Steel 60 358 CORrORATION FINANCE Jones & Laughlin 55 Amalgamated Copper 100 National Lead 95 American Smelting & Refining 80 Sloss-Sheffield Steel & Iron 80 International Paper 70 United States Rubber 75 Allis-Chalmers 65 American Can 75 American Car & Foundry 35 Pressed Steel Car 20 Railway Steel Spring 75 American Locomotive 4:0 Bethlehem Steel Corporation 50 International Harvester 100 United States Realty & Improvement 100 Orders for new railway equipment in 1908 were less than 40 per cent of those received during 1907 and hardly 20 per cent of orders booked in the big rush of business in 1905. The course of new business during the preceding four years may be gathered from the fol- lowing comparison : Year Loco. Orders Fgt. Car Orders 1908 1,182 62,700 1907 8,282 161,700 1906 5,642 310,816 1905 6,265 841,316 In striking contrast is the record of the following railroad and street railway companies. Notice partic- ularly the small fluctuations in the street traffic in large cities. The decrease in street railway gross earnings was less than 1 per cent and in steam railroad gross earnings about 19 per cent. DISPOSITION OF GROSS EARNINGS 359 ELECTRIC STREET RAILWAYS. Coniiiaiiy and Period 1908 1907 Decrease. I5.)ston, May-July •$ 3,596,000 $ 3,623,000 $ 37,000 Miss. Elec, Apr.-Junc 1,995,813 1,924333 '71,509 lliicago Rys., Mch.-May 2,6i5,533 2,571,324 •51,209 Twin City, Apr.-Junc 1,174,389 1,492,671 18,282 liiiteil St. Louis, Mch.-May 3,645364 2,735,406 90,042 Detroit United, Mch.-May 1,675,012 1,675,743 701 Total $14,012,170 $14,025,477 $13307 * Increase. STEAM RAILROADS. Company and Period 1908 1907 Decreaits Lake Shore, April-June $ 9,182,851 $11,160,400 $ 1,977,549 New Haven, April-June 10,913,741 12,670,010 1,756,269 I'tniisylvnnia, Jan.-Mch 31,375,489 37,203,589 5,828,100 Louis.' & Nashville., Feb.-Apr.. 10,073,863 12,012,701 1,938,839 Missouri Pac, Feb.-Apr 9,467,500 11,927,834 2,460324 Boston & Maine, Apr.-June... 8,836,556 10,499303 1,662,746 Total $79,849,999 $95,473,826 $15,623327 The explanation of the different manner in which the street railways and steam railroads have fared is largely to be found in the different character of their traffic. Street railway gross is 95 per cent derived from pas- senger receipts, while from 65 to 70 per cent of railroad gross is realized from freight; and in periods of uni- versal curtailment freight earnings quickly feel the depression. Even with an absolutely invariable volume of sales and level of prices any industry would still be subject to great variations in profits by reason of changes in raw material prices and in wages. This statement is obvious enough without any elaboration. It should be remarked that the amount of wages paid out is not de- pendent altogether on the nominal rate of wages, but also to a great extent on the efficiency of labor. When times are good and sales in all lines are heavy, it becomes 360 CORPORATION FINANCE necessary to employ vvorkingmen of an inferior grade, who in bad times are always "out of a job." Taking on such men means a great reduction in the average efficiency of labor and in economy of production. 193. Regularity of dividends desirable.— Wt are safe in saying, then, that great fluctuations in profits are inevitable in most lines of business and cannot be altogether avoided, even by the large public service corporations which furnish the necessities of life. It follows that if all the earnings each year are paid out in dividends, the rate of dividends will fluctuate— in many cases fluctuate violently. The reader may per- haps ask at this point, 'Why not let them fluctuate ? Let the stockholders in a corporation take their profits as they are earned, just as the owner of an individual busi- ness or partner in a firm would do. The answer to this question is that stock, and espe- cially the stock of large corporations, is widely held by people of all classes who are not in touch with business aiFairs and not prepared to take care of haphazard re- turns that drop into their laps from time to time, but who desire above all things a steady, regular and de- pendable income. Such people do not want lean years and fat years; they want a series of moderately good years. They belong, not to the speculative, but to the investment class. On account of the demand that such people create for regular dividend-paying securities, the market prices of such securities are far higher than they would otherwise be. For example, take two stocks, one of which pays over a series of five years, 4 per cent, 7 per cent, 6 per cent, 3 per cent and 5 per cent, averaging H per cent for the period, and compare it with another stock which has regularly paid 5 per cent each year; you will always find a marked differ- DISPOSITION OF GROSS EARNINGS 361 dice in market price in favor of the second stock. The principal reason for this difference is that so many pct)ple prefer a regular dividend payer. It is for the best interests of all a corporation's stock- holders to pay regularly a steady rate of dividend, inasmuch as the market price is thereby enhanced. The corporation manager, then, is confronted with the prob- lem of reconciling this demand with the irregularity of the corporate profits. The only safe method of accom- plishing this result is to pay out in dividends no more than the minimum earnings of the corporation in its worst years. Thus the dividends may always be kept at a fixed rate and whatever is earned above the dividend requirements will go into the company's surplus. 194. Prudence in paying dividends. — This may seem an unnecessarily harsh rule, for it keeps the rate of dividends low and thereby unnecessarily, it may seem, cuts down the stockholders' income. In the long run, however, it works no injustice. As we shall see in suc- ceeding chapters, whatever surplus is saved out of in- come, goes to increase the company's earning power and eventually its regular dividend rate. Looking back over the ground covered in this chapter, we see that great care, prudence and foresight on the part of a corporation directorate in the distribu- tion of gross earnings is necessary in order to give per- manence and long-continued success to the corporation. The board of directors must see to it that the gross earn- ing of each year are not overstated and that operating expenses are not understated. In connection with the latter item they must take care that sufficient reserve has hccn set aside to provide for accrued repairs and for depreciation. They must, of course, meet all the fixed cliarges of the corporation out of income under penalty a(52 CORPORATION FINANCE I of seeing the company forced into bankruptcy. They must i)ay cumulative preferred dividends so far as practicable, although in this regard some discretion is permitted to them. Finally they nmst resist unwise pressure from stockholders for larger dividends than the condition of the company in the long run will warrant. If they do not resist these demands, the com- pany will be compelled probably sooner or later to reduce its dividend rate, thus removing its stocks from the class of desirable investments and lowering their market prices. The ideal corporation director will stand like Horatius at the bridge, defending the wealth and profits of the corporation from the onslaughts of hungry stockholders wlio do not possess either foresight or intimate knowledge of the business. A corporation which has such a directorate is peculi- arly fortunate and, whatever its line of business, may reasonably expect to attain a lasting success. A cor- poration which does not have such a board will perhaps prosper for a season and apparently enrich its officers and stockholders. In tlie end, however, it will prove to be but a mushroom growth. All the while its vitality is dwindling, its substance is being eaten out and sooner or later, to the surprise of unwary investors, it suddenly crumbles away. I CHAPTER XXIII BETTIJIMENT EXPENSES 195. Two classes of betterments. — All improvements and all expansions of property may be grouped under the general name "betterments." The question as to whether betterments should be made or not is primarily something for the operating officials of the company to decide. They should understand thoroughly the condi- tion of the property, the cost of the proposed better- ments and the prospects for additional business, and from the study of these factors should be able to draw pretty definite conclusions as to their advisability. All betterments may be roughly divided into two groups : (a) Those which are practically certain to bring about an immediate increase in revenue. (b) Those which are expected to prove profitable in the long run, but which may or may not bring immediate returns. As an example of the first class, we may suppose that a manufacturing company is about to put in a new and expensive engine; in such a case the proper officials should be able to calculate in advance almost exactly the annual saving that will be made possible by this partic- ular improvement. As an example of the second class, we may suppose that the same company is considering the advisability of building a Young Men's Christian Association reading room and gymnasium for the benefit of their employes. 868 3G4 CORPORATION FlxNANCE •i > tl I Their motives, we may presume, are not in the least phUanthropic; they expect the investment to yield big returns in the form of a better satisfied and more intelli- gent force of workingmen. The extent of the returns, however, cannot be calculated exactly and in any case will not be immediate. The dividing line between the two classes is not al- ways very clear and there may often be more difficulty than in the two examples just cited in assigning a pro- posed betterment to its proper class. The classification, however, consciously or unconsciously, is almost always made by intelligent corporate officials and directors. 196. Sources of funds for betterments.— Once a betterment expense has been agreed to, the next ques- tion is how to raise the necessary funds. This is a purely financial question, which deserves even fuller consideration than is possible within our space limits. At bottom the problem of raising capital funds for betterments is of the same general character as the prob- lem of raising the initial capital funds when a corpora- tion starts business. There are, however, as we shall see, some important variations in the problem. The sources of capital funds, whether at the begin- nmg or during the corporation's existence, are the same as have already been given, namely: (a) The active managers of the corporation. (b) Surplus earnings. (c) Trade creditors. (d) Banks. (e) The investing public. (f) The speculative public. For our present purpose we may eliminate sources (a), (c) and (d). There is nothing to be said with regard to them that has not already been said in Chapter BETTERMENT EXPENSES 365 \'II. There remain: source (b), from which the funds may be obtained by one of two methods, either direct appropriations from surplus, or abnormally high oper- ating expenditures; source (e), which may be reached either by the issue of medium-term notes or by the issue of bonds; and source (f) from which funds may be ob- tained by the sale of new stock. 197. Appropriations from earnings. — The safest and surest known method for providing for betterments and building up any concern is by making appropriations out of earnings. Expansion that is financed in this manner will be very slow, to be sure, unless the profits of the concern are inordinately large. This very slow- ness, however, is in some respects an advantage. It necessitates a gradual growth, a kind of evolution of the business, and thus automatically provides against waste and recklessness. It is practically certain that any concern which is built up altogether or in large part by means of appropriations from each year's sur- plus will be conducting its business along conservative lines. That it is not impossible by this method to con- struct in time an immense and profitable concern is proved by the history of two of our great industrials, the Carnegie Steel Company and the Baldwin Locomotive Works. The Carnegie Company had its inception in 1871 in an insignificant steel-making plant which was Itought with a few thousand dollars that Andrew Carnegie and his associates were able with great (lifRcultv at that time to command. It has since expanded until it is to-day worth, as a gomg concern, perhaps a half-billion dollars; and all that expansion has been the result of profits slowly turned back into the business. In this respect the history of the Baldwin Locomotive Works is closely similar. If 866 COKPORATlOxX FINANCE It s. 198. Objections to this method,— Yet in spite of these great successes we must not overlook the two obvious disadvantages of this method of obtaining funds for betterments. The first and most vital objection is that the slowness of the process may occasion the loss of valuable opportunities. While an old, conservative company is thus gradually acquiring the funds neces- sary for the expansion of its business, it may well be that a somewhat more daring concern may borrow the funds necessary for expansion and thus capture the op- portunity that was at first open to both of them. Conservatism undoubtedly is a business virtue; yet for the best results it needs to be mixed with a strong dash of speculative fervor. The second objection is that the ordmary stockholder in any concern desires to enjoy the profits of a business as they are earned and objects strongly to having those profits diverted to betterment expenses. It is true that an increase in the corpora- tion's assets is an increase in hi*' assets, for he is part owner of the corporation. It is true, also, that an in- crease in assets will be to some extent reflected in a rise in the market value of his stock, so that he may sell out if he chooses and put his money into a more liberal cor- poration. This last, however, is not a wholly satisfac- tory argument to the stockholder, for market values are based more largely on earnings and dividends than they are on underlying assets. This is a truth that will be found fully illustrated in the volume on Investment AND Speculation. Thus the body of stockholders is apt to oppose strenuously a reduction in their dividends in order to provide for betterments. It seems to them as if they were being compelled to make a sacrifice for the benefit of future stockholders. 199. The attitude of stockholders.— An example BETTERMENT EXPENSES 367 that was conspicuous a few years ago was the deter- mined struggle on the part of minority stockholders in the Wells-Fargo Express Company for larger divi- dends. This company was controlled by the Harriman party, and Mr. E. H. Harriman, following his usual policy, was, as it seemed, too much inclined to sacrifice dividends to financial strength. The minority stock- holders stated that the Wells-Fargo Company had been piling up an enormous surplus, which was not needed or used in the business, but was invested in the securi- ties of other companies. The majority stockholders — that is the Harriman party — ^rejoined that the security holdings of the Wells-Fargo Company were for the sake of control and for the prevention of ruinous competition; in other words, that earnings had been consistently devoted to betterments. The undeniable facts are that the company was highly prosperous, was paying rel^'tively small dividends and was more or less harassed by a body of dissatisfied stockholders. The objections by the stockholders in such cases may be induced by any or all of three motives: (1) They may simply be anxious for present divi- dends, even though they be paid at the risk of reducing the corporation's future earnings and prosperity. Human nature is so constituted that to almost all of us $1 this year looks better than $2 five years from now. (2) Some of the stockholders may have speculative tendencies which lead them to desire a good market price and a quick sale for their stock — perhaps with the idea that after a while the dividends will be cut and they will be able to repurchase stock at much lower prices. This motive will always be strong when many of the stockholders belong to the speculating, rather than to the investing class. Here is one of the best reasons ■ r- 868 CORPORATION FINANCE why a conservative corporation manager will desire to put his stocks on an investment basis from the very beginning, if possible. (3) The stockholders in a corporation which has a large funded debt may reason that whatever sums are diverted from dividends to betterments go to increase the security and the value of the corporation's bonds rather than of its stock. We shall have occasion to deal with this motive and its results when we take up in Chapter XXVIII the methods of manipulation for the benefit of the body of stockholders. It is enough to say here that this motive, although narrowly selfish, is still entirely legitimate and often has great weight. Wlierever these motives are at work — and some or all of them are likely to be strong in almost any body of stockholders — objections to heavy betterment expendi- tures out of earnings will be in evidence. In the Wells-Fargo case the protesting stockholders however disagreeable they might make themselves, did not have much influence with the management, because they were distinctly in the minority. It often happens, however, that the active managers of a corporation are more prudent or more farsighted than the majority of their stockholders and for the good of the corporation desire to pursue a policy of small dividends and large betterment expenses which would not be supported if it were clearly presented to the stockholders. In order to attain their object the corporation officers must keep the stockholders more or less in the dark; and this they do by the very simple process of charging expenditures for betterments imder operating expenses. 200. The case of the Lehigh Volley Railroad.— Tht history of the I.ehigh Valley Railroad so well illustrates the workings and the results of this species of well-inten- BETTERMENT EXPENSES 369 tioned deceit that it is worth a rapid review. In the year 1897 new interests, which were represented in the active management by President Walters, came into control of this company. The five years following, 1898 to 1902 inclusive, were a period of remarkable development and prosperity for almost all the railroads and industrial corporations of the United States, and the Lehigh Valley was no exception. Gross earnings from operation increased 25 per cent; the revenue tonnage increased 150 per cent; at the same time the average freight rate per ton per mile showed a slight gain. On the other hand, the outlay per train mile for moving this tonnage decreased. Thus earnings were apparently going up while running expenses rela- tively were decreasing, and a largely increased net income would naturally have been expected to follow. The facts were, however, that the gross income (not gross earnings) decreased from $6,800,000 in 1898 to $4,800,000 in 1901 and $4,650,000 in 1902, when the anthracite coal strike was in progress. iVn inquiring stockholder, who might have chanced to consider with care these strange and anomalous figures, would perhaps have turned to the balance sheet of the company in the expectation of finding therein revealed some noteworthy addition to assets purchased out of earnings. But our inquiring friend would have been disappointed. He would have found the compara- tive figures of the important assets of the road as follows: ASSETS 1898 Tost of Road $18,689,291.96 Tost of Equipment 19,018,419.98 SKuritics owned 82,949,822.14 r-VT— 84 1902 $18,689,291.98 19,018,419.98 39,800,209.80 370 CORPORATION FINANCE The only change here is an increase in the securities owned, which is not sufficient in amount to account for all that apparently should have been saved out of earn- ings. The book values of road and equipment, it will be noticed, have not been changed. The true explanation could have been found only by analysis of the operating expenses of the railroad. In the first place, the proportion of total operating ex- penses to gross earnings from operations— or operating ratio, as it is called— had risen from 70 per cent in 1898 to 81 per cent in 1902. As a normal railroad operating ratio would be 60 to 65 per cent, it is evident that this extraordinarily high ratio of the Lehigh Valley in 1902 indicated one of two things: either bad management or inflated operating expenses. We may get some light as to which was responsible in the present case by a slight further analysis of operating expenses. In 1895 22 5-10 per cent of the total operating expense went to maintenance of way; in 1902 over 40 per cent. In 1895 the average train-load was 384 tons; in 1902, 467 tons. Evidently large sums had been devoted during the interim to betterments which greatly increased the economy and efficiency of the road's management. We are now informed that during the five years, 1898 to 1902, all new equipment, all side-tracking and other expansions of track, all construction of bridges and buildings, all reballasting of track and similar items had been charged to operating expenses. Professor Edward Sherwood JMeade, to whose searching analysis we are indebted for much of the information here presented, estimates that in these five years the Lehigh Valley under IVfr. Walters' management, spent almost $13,000,000 on betterment expenses which ordinarily would have been provided for by new issues of stock or BETTERMENT EXPENSES 871 bonds; in other words, the $13,000,000 under a different management would have been distributed to stock- liolders. In 1902 a new management came into power, and the report for the fiscal year 1903 shows some radical changes in accounting methods. Net income, for in- stance, which had been $4,650,000 the preceding year, suddenly jumped to $8,300,000. The new manage- ment, after appropriating $1,250,000 for betterments and after paying all fixed charges, was still able to show over $2,000,000 available for dividends; this, in the face of a defiicit after allowing for fixed charges the pre- ceding year of over $1,200,000. In 1904 the stock was given a dividend of 1 per cent. In 1905 it was put on a 4 per cent basis. Between 1901 and 1908 the gross earnings of the Lehigh Valley were increased about 83 per cent. Its net earnings were considerably more than doubled, and yet its fixed charges were increased scarcely at all. The figures below tell the whole story of this remarkable growth more plainly than it could be put in words: 1908 1901 Increane Miles operated 1,447 1,882 65 Gross earnings $86,510,154 $26,688,588 $8,826,621 Gross, per mile 24,500 19,800 5,200 Net earnings 12,188,582 5,765,113 6,418,469 Net, per mile 8,420 4,170 4,250 Chgs, less other inc .. . 4,818,008 4,864,800 448,208 Charges, per mile 8,820 8,150 170 Surplus 7,870,674 1,400,818 5,970,261 Surplus, per mile 5,100 1,018 4,087 Now, what is the meaning of these facts and figures? In the first place, it is plain that the road was in poor 872 CORPORATION FIxVAxNCE If i I i' condition prior to Mr. Walters' administration and that he left it in such excellent condition that its net earnings afterward showed a phenomenal increase. There can be no question but that the millions which Mr. Walters poured into the property were wisely spent and have since ])een efficiently administered. To an investor or corporation manager this review should be an inspiring story of honest profits ably secured. Nevertheless, it must be admitted that Mr. Walters' policy, so far as the stockholders were concerned, was one of evasion and deceit. True it is that whatever he did was intended for their own best interests; yet it is also true that they would not always have approved of his actions if they had known exactly what was going on. We do not need to enter into the ethics of the case. It is plain, however, that the stockholders, from any or all of the motives we have previously mentioned, might with justice have objected to Mr. Walters' course. As a matter of fact, they did finally become alive to the situation and helped in bringing a new management into power. 201. Policy of the Union Bag and Paper Company. — Another illustration of large operating expenses being used to beguile stockholders into putting a large portion of earnings into betterments is to be found in the recent history of one of the smaller trusts, the Union Bag and Paper Company. In a review of this com- pany's condition, recently issued, we find the following remarks: Benefit is now being derived from the liberality with which outlays for repair work, maintenance and improvements have been made. Since the formation of the company nine years ago, about $8,000,000 have been expended in construction, purchaw of woodlands, etc., in addition to requiremrnts for ordinary r<- BETTERMENT EXPENSES 373 pairs and maintenance which liave been charged directly to operating expenses, and also in addition to the amounts ex- ptiulid in 1906 for the property of the Gres Falls Company and that of the Allen Bros. Company. All told over $6,000,000 have been expended, since the company's incorporation, for ad- ditional property and new construction, and the company has increased its capital obligations only to the extent of $2,439,- 000. While the company's physical and producing capacity has been undergoing improvement, i.^ .^nancial position has also been bettered, net working capital ht ving been increased in the past four years by approximately $1,068,000 or about 100 per cent. 202. Borrowing funds for betterments. — The third means of raising funds for betterments is through issues of medium-term notes. It is not necessary to consider this method with great care, inasmuch as it has already been discussed in Chapter VIII. The examples given there were sufficient to show the dangers of this method. Obviously it cannot properly be utilized except to pro- vide for betterments which are practically certain to yield large and immediate profits; otherwise the corpo- ration will be incurring obligations that must be met out of income and that will perhaps become exceedingly dangerous. A much better method, generally speaking, of secur- ing the funds for permanent betterments is by means of long-term bonds. As has been previously explained, large well-established corporations do not usually expect to pay off these bonds when they fall due, but plan to refund them by new issues. In other words, what they actually do is to incur a permanent fixed charge. Now if a betterment is of such a character that it is practically certain to produce profits year after year larger than the fixed charges assumed in order to make the better- Mrs^- 374 CORPORATION FINANCE IF^i!# ment, it is no doubt good policy to raise the necessary funds by the issue of long-time obligations. 203. Policy of the Pennsylvania Railroad,— Th^ set- tied policy of the Pennsylvania Kailroad is the best known and most consistent illustration of the working of this principle. This company, it is understood, separates all its betterment expenses into the two classes previously named : First, those which wUl in all human probability result in a permanent saving or profit more than equal to interest on the funds thus invested; second, those which will probably prove profitable, but which may or may not yield profits in the immediate future. To the first group the Pennsylvania management assigns such betterments as shortening and straighten- ing a line, cutting down grades, providing new equip- ment where an increase in traffic is certain, and so on; to the second class they assign such betterments as a large part of the tunnel construction in and around New York City, providing new equipment for a hoped-for in- crease in traffic, operating passenger stations, and so on. The Pennsylvania Railroad's custom is to pay for all betterments of the first class by bond issues and for all betterments of the second class by appropriations from surplus. Thus the stockholders secure at the same time the maximum of returns and the maximum of safety. It is the ideal policy as regards betterments and will no doubt be more gene -ally adopted in the future by railroad and industrial corporations. To illustrate its workings in the concrete case of the tunnel into New York City and accompanying improve- ments, the following figures are presented. Up to the end of 1908 the total cost of the tunnel extension, as shown by the annual reports, was $7T,.528,664, of which only 60 per cent had been capitalized. The total cost BETTERMENT EXPENSES 375 is covered by the following charges on the books and appropriations of surplus profits: Cost on Books, December 31, 1908 $46,528,664 Charged to surplus income of 1908 1,000,000 Charged to profit and loss account in 1907 7,000,000 Charged to profit and loss account in 1906 13,000,000 Charged to profit and loss account in 1905 5,000,000 Charged to profit and loss account in 1903 5,000,000 Total cost of tunnel extension at end of 1908. . $77,628,664 The cost on the books given above is the figure at which the Pennsylvania Railroad carried the work then accomplished as an asset. But in 1908 the Pennsylvania Railroad proper required the lines west of Pittsburg to assume a part of the burden and accord- ingly the Pennsylvania Company turned over $10,000,- 000 in securities, deducting the value thereof from its profit and loss surplus. Assuming that the income derived from these securities will defray the interest charges on $10,000,000 of the capital invested in the tunnel, the Pennsylvania Railroad will have to look to the operation of that property to yield fixed charges upon capital borrowings for that purpose of only about $36,500,000. 204. General conclusions as to the financing of better" ments. — The only remaining method to consider of se- curing funds for betterments is by means of stock issues. The comparative merits of increasing capitalization by means of stock, as compared with bond, issues are too obvious to need much discussion. A bond issue is a cheaper means of getting the necessary fimds, for bonds can always be sold to better advantage than stock which yields the same return; on the other hand, bond issues 376 CORPORATION FINANCE if'i ' !| are objectionable in so far as they tend to increase the fixed charges and thereby imperii tlie safety of the com- pany. New stock issues are safe enough, but of course tend to reduce the rate of distribution on the stock al- ready outstanding. We may, perhaps, lay down this general rule, that betterments of the second class— fol- lowing the classification we have given— ought to be financed either out of surplus or by means of new stock issues; betterments of the first class ought to be financed by bond issues, or in rare cases by issues of medium-term notes. In what is said with regard to the financing of better- ments, as in all other general questions of corporation policy, we must be content with broad conclusions. Corporation managers who differ from the general principles here laid down are not necessarily to be con- demned offhand. They may have good reasons which do not appear on the surface. Every business man must base has actions, not so much on general principles, as on the important concrete factors that confront him! At the same time it is also true that a clear understand- ing of these principles and of the practice of large cor- porations will aid the corporation manager in handling more intelligently and more successfully whatever peculiar and difficult problems arise before him. CHAPTER XXIV CREATION AND USE OF A SURPLUS 205. Definition.— One of the most talked about topics in the field of Corporation Finance is the "surplus," its formation and its management. Yet in spite of all the discussion, there is still a great deal of confusion even in the minds of lawyers and men familiar with financial affairs as to what a surplus is and what it is ^n)()d for. The main principles that govern the manage- ment of surplus are not different from those which should control the management of other capital funds, and are simple enough to seem obvious when they are once clearly stated. That they are not always clearly comprehended, however, is proved by the loose writing and thinking with regard to the subject that is so often manifest. A brief satisfactory definition of surplus is that it is the difference between the assets and the obligations of a corporation, including under "obligations" all the outstanding stock of the corporation, as well as its re- serves and debts. Suppose, for instance, that we have a corporation with assets of all kinds, having a total hook valuation of $1,000,000, and having 6n the other side of the account debts represented by accounts pay- able, bank loans, notes and bonds of $500,000, deprecia- tion and other reserves of $50,000 and outstanding cap- ital stock amounting to $250,000; it is evident that the corporation must have secured $200,000 of its assets from some other source within the business; and that 877 378 11!^ COIlPORxVTIOX FINANCE i mi I li source we call surplus. The surplus account, as is ex- plained in the volume of Accounting Pkactice ap- pears on the liability side of the balance sheet, because It IS an amount for which the corporation must render an account. 206. Four sources of surplus.— In our discussion of the corporation's surplus, we will consider: (a) How it is obtained. (b) What is done with it. (c) Its uses and management. One possible, though very unusual, means by which a corporation obtains a surplus is by inheritance. Take, for instance, a corporation which is a consolidation of two companies, each having a surplus of its own. The consolidation may conceivably simply guarantee the bonds and other outstanding debts of the subsidiary companies, may issue dollar for dollar in stock for the stock of the subsidiary companies and may transfer the former surpluses bodily to its own accounts. As we have seen in our study of the formation of consolida- tions, however, (Chapter XIV), the new corporation will usually issue securities far in excess of the market value of the assets of flie old companies. The con- solidation, therefore, will not only not start out with a surplus usually, but will be compelled greatly to over- value its assets in order to make a balance sheet possible. We may dismiss this first possible source of surplus, then, with the statement that it is too uncommon to be worth Oiscussion. The second source of surplus, which also is rather unusual, is the selling of the corporate stock or bonds above par. Evidently the corporation in such a case receives a sum of money greater in amount than the obligations which it incurs. Now this extra sum may CUEATION AND USE OF SURPLUS 379 be handled by an accountant in three or four different ways. One way is to include it in the corporation's sur- plus account. The propriety of this method may be disputed, but this is an accounting rather than a finan- cial question. A surplus may originate, in the third place, in whole or in part from the sale of a corporation's fixed or semi- fixed assets. Thus if a manufacturing company owns a plant which has become obsolete and worthless for manufacturing purposes, and the value of which has been fully covered by a depreciation reserve — in other words, written off the books— and afterwards sells this plant, the sum resulting would go into the surplus ac- count. Of course, the reader will understand that if the value of the plant in such a case had not been written off the books, but was still included in the corporation's bal- ance sheet, the only effect of its sale would be a transfer of the amount received from the property account to cash or notes receivable or whatever was taken in pay- ment for the plant. A similar source of surplus is a revaluation of the fixed assets of a corporation when the revaluation shows an increase in their value. This increase would nat- urally be represented on the liability side of the balance sheet by a corresponding gain in the surplus. Gen- erally speaking— and it must be remembered that there are some exceptions to this rule — an upward revaluation of assets is not in accordance with correct accounting or financial principles. Therefore, this fourth source of surplus is not commonly found. 207. The fifth source— saving.— This brings us to the fifth and most common source of surplus, namely, saving from income. The uses to which income should he ])ut have been discussed at some length in Chapter 880 ■I 11^ I It : ' H COHPOKATION FINANCE XXI ; and the final uses, after the fixed charges and re r„T "•." ""=? ^'"''"^ '"'■ -«« found to b?di'^ dends and surplus. It »iU do no harm to reiterate th. ^portant principle there laid down that the dividend of practically every corporation should be maintatoed tuatmg dividends destroy the confidence of the invest- mg pubhc and greatly reduce the credit of thelrlra- to below what it might possess. The proper pE with few exceptions, is to ascertain the minimum ni earamgs of a company in the years of greatest depredl l.on and rigidly hold the dividends It or b<^w Xt lerred to the company's surplus account. That this method of forming a surphis may build it up w,th great rapidity is shown by the record of th great mdustnal concern, the Standard Oil Company Sus Tafo TTT' *'/ ^""^ appropriated to^u': plus and to dividends, and the totals of each item for seven year, are as foUows: Year n^j,, ^ Surplut 1907 :::;:::: 'S'ZCI ^'^'^'' «*«'««*.««>• 1905 TAlltl ^^^^^30 43.786.931 1904 :: ll'^'l^'l •^^^S.SSO i8.m.03fi ^*'^^^^3 43.851.956 20.761.407 •A^nnl- ■ ■; ■. 9S13^0,,0n ^279.258.980 ^^^^, Approximated; not reported after 1906. *W^Ind?nT''f •""* '"'' '''"™- ">« proportion of dividends paid will vary with the fluctuations in earn- CREATION AND USE OP SURPLUS 381 ings. The greater those fluctuations the more rapid wUl be the increase in surplus. The converse proposition IS that a stable rate of earnings makes unnecessary the creation of a big surplus. 208. Policy of the " trusts r-Prohssor Edward S. Meade s weU-known volume on "Trust Finance" gives the result of a careful study of the dividend and surplus policy at the beginning and during the existence of all our important mdustrial combinations or "trusts " The prime object of the managers of almost all these com- binations at the beginning. Professor Meade points out. was to pay dividends and thereby encourage the sale of stock. They were therefore averse, as a rule, to ap- propriating any considerable amounts to the surplus ac- count. They even, in some cases, incurred a deficit in order to pay dividends. Professor Meade computes that twenty-six important consolidations, which he has studied with especial care, earned in the four years 1898-1901, $150,201,890. He says: This amount, although large in the aggregate, represents but little more than 8 per cent per annum. It would appear, as already stated, that every consideration of prudence would incline the directors of these companies to reserve practically all their profits in order to strengthen the financial position of their companies. So far from following the path of prudence. however, 61.9 per cent— almost two-thirds of these profits- were paid out in dividends, leaving 88.1 per cent for the sur- plus reserve. The inadequacy of this reserve may be better understood when it is compared with the outstanding capital "hose permanent value it was intended to secure. A reserve of only 4.2 per cent is the net result of the operations of three years. The industrial trusts are excellent examples of cor- porations which for reasons of their own were reluctant 882 i- If n II J V i i 111 ! :l :i CORPORATIOxV FINANCE iii t to keep dividends down to a conservative basis and to create large surpluses. The results of their imprudence are familiar to most of us— perhaps entirely too familiar to some. The common and preferred stock of most of these companies received dividends for a few years but at the first hint of trade aid financial depression, earn- mgs fell off, dividends were stopped and the market prices of the stocks dropped with a thud. We have here presented an impressive lesson that ought to be masteri^d by every corporation director and stockholder— the les- son that in times of plenty provision should be made through creation of an adequate uirplus account out of income, for the seasons of famine that are sure to come. 209. How should surplus he invested.~We have next to consider what form the surplus of a corporation should take, or, in other words, how it should be invested. Its possible forms or uses are as numerous as the uses to which the original capital funds of a corporation may be put, and may be classified under the foUowinff heads: (a) Cash. (b) Securities. (c) Decrease of current liabilities. (d) Sinking fund. (e) Increase in stock of raw materials or finished products on hand. (f) Betterments. (g) Extensions and additions to fixed assets. It goes without saying that the surplus should be used to strengthen the weak spots, whatever they may be, in the corporation's capital equipment. We can be some- what more specific, however. 210. The surplus as n ''rain?/ day fund.*'— There are two distinct and opposed opinions as to the true function CREATION AND USE OF SURPLUS 383 ol u surplus; one, that it should be merged with the rest of the corporation's capital funds; the other, that it should be set aside as an insurance against future losses. Let us first consider the justification and the results of tills second opinion. Its advocates base their case on the assertion that the original investment of capital funds should be sufficient to carr on properly all the business of the company; if these funds are not sufficient, then tliey should be increased by borrowing or by bringing in new stockholders, not by saving out of profits. The arguments in favor of providing funds for betterment by borrowing, rather than by saving, have already been given and have been found to have considerable weight. The advocates of this opinion are convinced of the ad- visability of maintaining dividends at a stable rate and conceive it to be the true function of a surplus account to equalize the dividends over a series of years. In other words, the surplus account should be, in their view, as it has well been called, simply a "rainy day fund," to be drawn upon for dividends whenever the necessity arises. It follows, if this opinion is correct, that the surplus ought to take the form of cash or something that may nadily be turned into cash, for example, securities. Otherwise, it will not be readily available for dividends in periods of financial stress when it is most likely to be needed. It is true, to be sure, that a surplus may be in- vested in permanent assets and yet be treated as a "rainy (biy fund," for these assets may be made the basis of temporary loans to the corporation. The objection here is that it is tmcertain whether such loans can be obtained "lien they are most needed and, moreover, it is unsafe to base tempornrv' loans on a corporation's fixed assets. On the whole, then, we may say, that if the surplus ac- 384 CORPORATION FINANCE i .)■■ ' ^f i i Nl'! count IS to be regarded simply as a kind of reservoir in which future dividends for lean years are to be stored that reservoir should be filled with cash or easUy market- able securities. The chief exponents of this policy are the great -t-nglish and German shipping companies, particularly the Cunard Company and the Hamburg- American Line. The former company is said to have nearly one- third of its total assets invested in securities which have no direct connection with its shipping business. If tiie company runs into a period of intense competition dur- ing which it cannot earn dividends, or should it sustain severe losses, enough securities would be sold to maintain the regular dividend rate. There are obvious advan- tages m this course; on the other hand, there are disad- vantages equally obvious and for most corporations of controlling importance. The first disadvantage is that to build up a cash sur- plus is almost a waste of that much capital. It is a waste because capital in that form earns next to nothing. If it is kept as a permanent cash balance it may, to be sure, draw interest at 2 or 8 per cent, or in exceptional cases, even 3'/2 per cent; but this is a totally inadequate return on an industrial investment. If the surplus is in the form of marketable securities the case is almost as bad; for the only securities that are marketable in times of stringency are high grade bonds which do not yield above taxes more than SVi per cent or 4 per cent at the outside. As the second disadvantage, it must be borne in mind in this cfmnection that funds so invested, though safe enough from the corporation's standpoint, do not give the corporation stockholder safety sufficient to compensate for the small yield. Wliat is meant by this statement is that the surplus, however invested, is CREATION AND USE OF SURPLUS 385 part of the corporation's capital and would be swallowed up by the corporation's creditors in case of bankruptcy. hus the surplus goes to protect the creditor rather than tl^ stockholder. The stockhohler would be much better off, so far as safety is concerned, if his portion of the surplus were turned over to him individually and he would himself buy good securities with the proceeds 211. Putting the surplus hack into the property.- Having these disadvantages in view, corporation man- agers m this coimtry have almost universally put the s... plus of their corporations back into the property Sometimes it is used to increase the cash balance wher^ more cash is really needed in the business, or to buy n Loth hese cases however, the object is not to separate .surplus from the business, as it is when the rainy day un.l IS formed, but to make it productive in the bus ness Sometimes it goes into betterments, as explained in the prcviou. chapter, or into extensions or into some other of e seven forms mentioned above. Just which form shall be chosen by the corporation management depends on cc.ns.derat.ons which have already been discuss'Id in tlH' chapter on "Investment of Capital Funds." As a '••'"nal return on capital invested in commercial enter- •nses m this country M.,uld run from G per cent on up, .s evident that as a rule the investment of surplus in Perhaps the stockholder may object at this point that '" surplus ,s taken from the profits which ought to be '■med over to him. The objection is superficial and '•'-Is to take mtn account the various mt HhmIs by which ;' surplus may be. and in the end. must be, distributed vo the corporation stockholders. Some of these methods I i' m »8G CORPORATION FINANCE are not well understood; indeed it is doubtful whether half the stockholders in business corporations realize how or when their surplus is distributed to them. This is the interesting topic which will be the subject of our next chapter. i fit. tiff If 11: i: CHAPTER XXV DISTRIBUTION OF THE SURPLUS 212. Efect of a surplus on assets and dividends.— Ordinarily, as stated in the preceding chapter, a sur- plus IS formed out of savings from income and is in- vested m the capital assets of the corporation. Thus it becomes merged at once with the capital funds. The average stockholder feels that it is lost to him. He sees to be sure, that the assets of the corporation are increased hy .he formation of a surplus, and he will admit prob- ably, if you pres« him, that theoretically this increase in assets IS a good thing for the corporation and for every stockholder and tends to increase the value of his stock, llie admission however, is apt to be grudgingly made and probably does not disturb the stockholder's convic- tion that whatever sums are devoted to surplus are taken out of the pockets of the owners of the corporation. He sees how these sums are taken away from him, but does not see clearly in what form they come back to him. 1 le object of this chapter is to explain the methods by wimh the surplus may be and generally is returned. It has already been mentioned-and, for that matter. ■s sclf-evident-that surplus wisely invested in capital assets increases the earning power of the corporation and t urefore its ability to pay large dividends. Moreover. tl'e surplus when properly invested so as to extend the sales of the corporation or its ownings of raw materials. -r Its control over competitive plants, tends strongly to make earnings more stable, and therefore to make prac- 887 ;j88 CORPORATION FINANCE hi M I t ticable a distribution in dividends of a larger proportion of earnings. This is a point not often alluded to and worth a word of explanation. It is evident that gen- erally speaking the larger the business a concern does, the more stable and dependable will be its earnings — for slight local fluctuations up and down will almost always balance each other. If a big jobbing corporation loses trade for local reasons in one section of the country, it may reasonably hope that gains in other sections will at least counterbalance the loss. It is also true that con- trol, even partial control, over the prices of raw materi- als or of unfinished products tends to make earnings more stable. It may well happen for these reasons that a relatively small surplus will have a more than propor- tionate influence on a corporation dividend rate — ^not so much, to reiterate, because it increases earnings, as be- cause it makes them more uniform. Frequently — and this is especially true of a close co^ poration — no individual stockholder would be able to save and invest to such good advantage as the corpora- tion can do for him. Take once more the famous ex- ample of the Carnegie Steel Company. Does anyone suppose that any single stockholder in that company would have become as wealthy if the earnings had reg- ularly been paid out to the stockholders in dividends instead ot being put back year after year into the prop- erty? Tlie stockholders did not receive very large div- idends for many years, and some perhaps were inclined to complain that they were not getting the returns on their investment that were justly due them. In this ease the stockholders were never given any considerable proportion of earnings, nor was the vast surplus of tlie company distributed, except to a limited extent, until the sale of the Carnegie Steel Company in 1901 to the DISTRIBUTION OF THE SURPLUS 389 United States Steel Corporation. Then the extraor- dinary strength and riches of the company were sudden- ly revealed. Ahnost a half-billion dollars in cash or sal- able securities were showered upon the fortunate stock- holders of the company. Pittsburg, like a night-bloom- ing cereus, suddenly blossomed with millionaires. 213. Distribution through stock watering.— Th\s chapter is not to deal, however, with the distribution of surplus through its effect on dividends or through the final sale of the company's assets, but rather with the more direct and usual methods. First among these methods to be mentioned is the declaration of an extra stock dividend. In the year 1880 the Chicago, Rock Island and Pacific Railroad Company was a highly suc- cessful corporation with large earning power, due in part to the fact that for many years a considerable pro- portion of the earnings had been put back into the prop- erty. The directors of the corporation thought it wise to increase their dividend payments, and yet on account of the popular prejudice against large railroad earnings did not wish to increase the dividend rate. They there- fore adopted the plan of consolidating with themselves a small subsidiary railroad, the stock of which they al- ready owned; they paid for that stock and for the stock of the Chicago, Rock Island and Pacific Railroad Com- pany by an immense issue of stock of an entirely new corporation, the Chicago, Rock Island and Pacific Railway Company. This stock of the new corpora- tion was distributed to the old stockholders in the pro- portion of two new shares to one old share. Then on .ill the stock outstanding they declared and main- tained a dividend rate nearly equal to what had pre- viously been paid. In efFect this process was a capital- ization of a surplus of the corporation and a distribution %m I 390 ( OUi'OU ATIOX FINANCK :fe: !ii^ li\ I'- 'if m^^^ k of the surplus to stockholders. A more recent instance of somewhat the same kind is the well-known Chicago and Alton deal, which is discussed in Chapter XXVIl. The essential feature of such a transaction is the cap- italization of surplus and distribution of this extra capitalization to stockholders. The reader may inquire as to the advantage of this course. Surely, he will say, two shares of a total capital stock of $2,000,000 are worth no more than one share of a total capital stock of $1,000,000. The two shares in the first instance repre- sent no larger proportion of assets and earnings than the one share in the second instance. This reasoning is plausible and true so far as it goes ; yet the fact remains that the stockholders gain something by a stock dividend. In the first place, the dividend rate is kept down by this means, and in the case of public service corporations public hostility is to some extent avoided. In other words, the stock is watered, and the dividend rate main- tained. The American Telephone and Telegraph Com- pany is one of the many examples of companies which have thus greatly increased their capitalization from time to time, apparently with this object in view. A discussion of the ethics of such a transaction would be interesting, but is outside the scope of this volume. In the second place, it is well known to corporation managers and to all who have studied the stock market with any care that two sliares of stock, each paying i per cent per annum, nill have a combined market price higher than one share of stock paying 8 per cent per annum. This seems a curious anomaly, but is readily explained. There are more people able and willing to buy low-priced than there are to buy high-priced se- curities. Therefore, tl>e market for the two shares in this ilhistration is wider than the market for the one DISTRIBUTION OF THE SURPLrS 391 share; that is to say, the demand for the two shares is .somewhat greater and therefore their combined price will be higher. This same principle leads the promoters of mining and oil and other highly speculative companies to fix the par value of their shares at a low figure, $10 or $1 or 10 cents, or even as low as 1 cent. Applying the principle to stock dividends we see that there may be a real gain to a stockholder in an increase in the number of shares he liolds, even though there is no change in the amount of dividends he receives. 214. Distribution through subscription privileges. — We are ready now to discuss the most common and im- portant method of distributing a surplus, namely, the granting of subscription privileges for new issues of stock. In most states, as the reader is already aware, stock cannot be regarded as fully paid if it is sold for less than its par value. No state, however, makes it obligatory under any circumstances to sell stock at more than its par value; yet tlie stocks of successful corpora- tions which are able to maintain stable dividend rates of more than 6 to 7 per cent per annum, almost always have market values higher than par. Here is an oppor- tunity for the corporation directors, if they see fit, to give the stockholders a valuable privilege — the privilege, namely, of buying new stock issues at less than the market prices. The relative advantages of providing funds for im- provements and extensions of property by bond issues, l)y stock issues and by appropriations from earnings, have been discussed in Ciiapter XXII. It was there laid down as a general principle that provision of per- manent capital funds by means of stock issues is not ad- visable unless all the new stock is taken by the old stock- 392 CORPORATIOxV FINANCE it '; '*i ■1 ji-- ■ il holders. This condition will be fulfilled, however, when he old stockholders are given the valuable privilege of huying the new stock at less than its market value, and under such cu-cu,nstances the raising of additional capi- tal funds by stock issues is a very common and on the whole commendable method. We have now to consider exactly how surplus may be distributed by means of these privileged subscriptions" and how each stock- holder may best secure his share of the advantages that should accrue to him. 215. An opportunity thus given for cheap investment -Ihe privilege of buying a certain amount of stock below the market price enables the stockholder, if he chooses to make a new investment on exceptionally lavorable terms. For instance, in 1902 the Illinois Central Railroad Company put out a new stock issue and gave to its stockholders of record the privilege of buying the new stock at par in any amount up to 20 per cent of their stockholdings. Thus if a man had 100 shares ot old stock, he ^^as given an opportunity to buy 20 shares of the new stock at par. The average price of II mois Central stock during the six months follow- ing the date of the new issue was l,56|/2, thus showing a large paper profit to those who bought the new stock As this stock was then paying an 8 per cent dividend, those who bought and held it for investment were get- ting much more than the usual market return on their investment. A great many stockholders, howe-er, do not care to increase their capital investment, but prefer to take their profits at once. In such a case thev have a choice among four different methods of securing the profits, as follows: (a) A stockholder may buy outright the proportion DISTRIBUTION OF THE SURPLUS 393 of new stock allotted to him as a speculation, and a little later at some favorable opportunity may sell it. (b) He may sell "short" after the issue of new stock is announced and deliver when he gets his quota of new stock. (c) Instead of selling "short" he may sell outright an amount of his old holdings just equal to the amount of new stock that he has a right to buy. (d) He may sell his privilege or "right" to subscribe to the new stock. It will be well to compare briefly the advantages of these four methods. 216. Cashing the privilege.— The subsequent sale.— The first-named method is the simplest, but not gener- ally the best. The chief difficulty is that the stock- holder must pay cash for his quota of the new stock; and that means that he must either borrow the money or must lose the interest on some of his own funds. Frequently the subscriptions to the new stock are pay- ahle in installments. There may be a period of several months or a year between the date of the first installment and the final issue of the stock. For many stockholders it may prove decidedly inconvenient either to use their own funt^s or to borrow money. Another disadvantage lies in the well-known fact that the market price of any stock after a privileged subscription has been allotted to it almost always tends downward. One reason ob- viously is that the new issue increases by so much the total amount of stock outstanding; the second reason is that after a "right" has once been granted, investors fi^nire that there will be no additional rights for a number of years; a third reason is that the chief men interested in a corporation that is about to put out a neAv issue and the underwriters of a new issue will usu- i 394 CORPORATION FINANCE ally "bull" the previously outstandinpr stock in advance, in order to create u good denuuid for the new issue. Xow a stockholder who follows the first of the four liiethods and does not sell his stock until after he has paid for and i-cceived it, will probably sell on a falling market and will not reap as much profits as one who follows either of the other three methods. On the other hand, it must be said for this first method, that it is ab- solutely safe— a statement which cannot be ;ii)plied to the method next to be considered." -'17. Cashing the privilege.— "Short selling. "—Tht mechanism of "sliort selling" has already been treated in Chapter XVII. In the case immediately before us a stockholder who had the rigjit to sid)scribe to twenty shares of a new issue might deposit a margin of 10 to 15 per cent with his broker and instruct him to sell short. The broker borrows the twenty shares in order to make delivery and keeps on borrowing until the stockholder is able to get his twenty new shares from the corporation and turn them (ner to the broker to repay the borrowed stock. Under this arrangement the stockholder will be more likely tlian under the first method to get the top market price, because he will sell immediately after a "right" is announced— sometimes, if he has inside in- formation, even before such announcement is made. This method further makes it unnecessary for the stock- holder to borrow any money. He simply turns over his rights to his broker who uses, in order to pay for the new stock, the money that he has received from the "short" sale. All this sounds very easy and simple and, as a matter of fact, it usually works out all right. The difficulty comes in the fact that any man who sells sliort runs the risk of being caught in a bull movement of that stock DISTRIBUTION OF THE SURPLUS 395 or even in a "corner." * The reader may perhaps sug- gest tliat in such a case he may easily make delivery from ills old stock and thus obviate any serious loss. The answer here, however, is that probably he has sold short the amount of his old stock as well as of his quotp of new stock, or has in some other way tied up the old stock; otherwise, he would probably follow the third, rather than the second, method. Successful corners are not very common in Wall Street or any other market. When they do come, however, they bring disaster and ruin in their train. 218. Cashing the privilege.— Sale of old stoch.~The third method is not open to either of the objections that have been specified. The stockholder is much more hkely to get the best market price t.'-an under the first metliod ; he is not involved in the dangers that attach to the second. He picks his o^n time to sell and from the proceeds of the sale has funds enough to buy the same amount of new stock with large profits in addition. The sale of part or all of the stockholder's shares will not im])air in any way his right to subscribe to the new slocu, inasmucii as this right is always granted to stock- holders of record on a given day; it makes no difference whether the stockholder of record increases or decreases his lioldings after that day. The only fault to be found with this method is that it is not practicable for all stock- holders. A great many of them, in all probability, will have their holdings posted as collateral for loans, or for some other reason will not care to part with stock even temporarily. 219. Cashing the privilege.— Sale of rights.— The fourth method, the sale of "rights," is the next best plan iThe menninf!: of the term "comer" Is explained In the volume on Investment and Specui^tion. 396 CORPORATION FIX ANTE ii I ; I I : ■ ;■; i if: M'- Hii. ordinarily and is much used by those who do not care either to increase their holdings or to decrease them even temporarily. It is customary when any of the large corporations give their stockholders a "subscription privilege" to a new stock issue, to send out to each holder of record a formal statement of the number of new sliares to which he has a right to subscribe. Such doc- uments may be endorsed and transferred in the same way as stock certificates arA are bought and sold on many of the stock exchanges and on the New York Curb Market. These documents are themselves known as rights," just as certificates of stock are loosely called stock" As . t. stated in Chapter XVII, there are confusing ditterencts of terminology between the New York and some of the othei- stock exchanges, particularly Phila- delphia In New York a "right" is the privilege to subscribe to a certain amount, usuallv a fractional part of a share of new stock. A stockholder, therefore, has as many "rights" as he has shares. In Philadelphia, on the other hand, a "right" means the privilege of buying one of the new shares of stock. To illustrate, suppose that the Lehigli Valley Railroad Company, whose se- curities are listed on both exchanges, should issue new stock to old stockholders at less than the market price and should give the subscription privilege at the rate of one new share to every five old shares. In that case the holder of five shares would have one "right" to dispose of on the Philadelphia or five "rights" on the New York Exchange. Of course the Philadelphia "right" would be worth five times as much as the New York "right." The difference is merely in terminology. Tt may be thought that the third and fourth methods would yield practically iie same returns, but this is an DISTRIBUTION OF THE SURPLUS 397 error. The third method is almost always more prof- itable, the reason being that there is a much broader demand for stock than there is for "rights" to subscribe to stock. As was explained in Chapter XVII, there is a large body of purchasers not directly concerned with the stock market, who are constantly taking the standard stocks out of that market and holding them lor perma- nent investment. This demand does not e \'ist in the case of "rights," because few people, outside vf those whose hiisJDess it is to kiiow such things, understand how the value of a "right" is figured or even what it is. It nonld often be greatly to the advantage of these per- manent investors if they did buy "rights" instead of stock. As the matter now stands, however, almost the only buyers are stock brokers and their immediate fol- lowers who buy as a quick speculation in the hope of making a quick profit. As they are willing to buy only in ease they think they are getting a bargain, it follows [hv* t'>? price of rights is usually less than it should be thetjretically. 220. Theoretical value of a right. — Let us see how the value of ft right should in theory be ascertained. The reader may perhaps have jumped at the conclusion that the vahie would be the difference between the market price of the old stock and the price at which the new stock is sold to stockholders. This is incorrect, however, because it fails to take into consideration the change in the value of each share brought about by an increase in the amotmt of stock outstanding. The new stock, it must be remembered, is issued at less than the market price, and does, not, therefore, bring to the com- pany's treasury its proportionate amount of assets. For this reason it is inevitable that the market price of 398 CORPORATION' FINANCE J-; m each share after the new stc.ck has heen iss,,eci should be iess tlian it was hefore. ^ To ilhistratc these ahstract and rather vague state- ments take the case previously cited, that of the Illinois stock ^0 per cent and gave to each live shares of old stock the i,r,v, ege of suhscrihing to one new share at par. Ihe nmrket pnce of the old stock at the tin.e the rights were gianted was ahont 170, giving a premium or excess ahove par, of .$70 per share^ xfw tL4 "To' be added for each share of the old stock, $20 in assets becaus. each old share has the right to sub;cribe to 00!: htth of a iiew share at par. At the same time there is to be added $20 to the capital stock for each $100 preX ously outstandin.^. The market value of each share, therefo^re, after the new stock has been issued, will be IO0T20 ^^•"'^- ^' ^^'bich in theory would be the market price of each share after the new stock issue. As a matter of fact, the average price of Illinois Central shares during Ihe six months following August,1902. was 152 3-5. The va^.e of the "right" belonging to each share of old stock wo.dd, of course, be in this ease one-fifth of the ditrerence between par and the market pnce of each share of new stock, or 1-5 of 58 1-3. ap- proxmiately 11 2-3. The f<,llowing formula, commonly used on the Xew 1 ork Stock Kxchange, gives directly (he theoretical va ue of u nght. Let V represent Ihe p,eun-un, on the oljl shares and R represent the percentage of increase. I hen the value of a right will he fo,md bv the formula I X 1{ 1 .fn '^PPl.ving this formula to the Illinois Central mm 'i^sv DISTIUBUTION 01 THE SURPLUS 399 70 X ^2 .2 example, we would have ' ^ '2 = /^ = 11.66. As + 14 1.2 has been stated these theoretical prices for "rights" are seldom obtained because speculative iiurchasers of rights are not willing to go that high, ^loreover, there are some assumpti )ns underlying these mathematical form- ulae which may or may not be true. It is assumed, for instance, that the stock market price of the old stock is a norma' price uninfluenced by speculative factors. It is assumed, also, that the company's use of the funds which come to it from the sale of new stock will be neither more nor less remunerative than the use of the capital funds previously in its possession. It is assumed, moreover, that the market price after the new stock has heen issued will be uninfluenced by speculative factors. Tliere is a risk in all these assumptions, as the profes- sional stock market trader well knows, and he is there- fore unwilling to pay the full theoretical price for the rights. Summing up, then, we may conclude that of the four methods of securing profits from privileged subscrip- tions, which have been described, the third method is, on the whole, likely to yield the largest returns. The sec- ond method comes next in that respect, but has the dis- advantage of being dangerous. The fourth method comes next, and the first method is, on the whole, least desirable. It will not do to accept these conclusions as heing true at all times and under all circumstances. They are merely generalizations based on experience. 221. Privilege xuhsmpthns a» a method of stock "K'ntering. — So far as distribution of surplus is con- cerned, giving "rights" to privileged subscriptions to new issues of stock produces the same effect, though not to an equal degree, as a stock dividend. The assets Hi tf !; III ::'-\\ H ill;| fU WO CORPORATION FINANCE f U I s ■. of the company in proportion to the number of shares are diminished, and the stockholder gets the benefit. If the old rate of dividends is maintained on all the stock outstanding after the new issue, each stockholder may be truthfully said to have come into possession of some of the company's surplus. The privileged subscription is a device for increasing capitalization without propor- tionately increasing assets. In that sense it is "stock watering." The meaning of the terms "stock watering" and "overcapitalization" have been sufficiently discussed and need not be given further attention. It is enough to reiterate that whatever may be said for or against the practice in connection with public serA'ice corporations, it is in private corporations, wlien properly used, a simple and legitimate means of making a corporation's capital- ization correspond to its earning powers; and is in addi- tion, as outlined in this chapter, a legitmate means of transferring to the stockholder a part of the surplus which his company has created for him. ^tf': 1 ; • 1. 1 J 5!: Street do not oy any means have a monopoly, as some of the cases to be cited will show, on dubious finance. As a basis of classification we will take up methods of manipulation under the four heads: (a) Manipulation by officials. (b) JNIanipulation by directors (c) Manipulation for stockholders as a body. (d) Manipulation for controlling stockholders. Of course, this classification is not exact. We shall find constant overlapping, for the obvious reason that any man or group who desire to manipulate will prob- ably try to make their control as complete as possible, and will work through stockholders' meetings, directors' meetings, and officers' administration. Nevertheless, this classification will be found convenient and for the present purpose sufficiently accurate. 226. Eccorhitant salaries.— The most obvious and common method by which a corporation official may milk a corporation of its profits is by paying himself an exorbitant salary. This is a practice so frequent and so easy that it would be superfluous to cite examples. A corporation official cannot, to be sure, absolutely fix his own salary, for that power is reserved to the directors. If the official, however, is a powerful stockholder, or if two or three officials can get hold of a majority of the stock, or if an official can bring outside pressure to bear upon the board of directors, he may cause a salary to be allotted to him far in excess of what he is actually worth to the company. It is not at all unusual for minority stockholders in small corporations to be de- prived of profits because the president, or other official, who owns the controlling stock raises his own salary as fast as profits go up. Tl would be very difficult — prac- tically impossible — in such a case to prove fraud. No MANirULATION BY CORPORATION OFFICERS 405 tijiirt would undertake to say that a salary was fraudii- knl, or that directors were acting heyond their powers ill a^ixrin^' to it, unless the salary were heyond all reason. 'i'll. Fraudulent contracts. — Another favorite method of manipulation hy officers is the use, or rather abuse, of their power to purchase and to make contracts on behalf of the corporation. The evil of purchasing of- ficers being in league with the firms from which they buy supplies and getting a rake-off on the corporation's purciiases, has been so much exploited as to make un- necessary any further illustration. There is no question but tliat something of the kind does go on in many of the larger corporations. Yet the purchasing agent is geneially a subordinate official whose policy is closely scrutinized by his superiors and who is subject to instant dismissal if any strong tendenoy on his part toward "flfrafting" is discovered. His delinquencies are not so interesting to in this study as those of his superiors. Let us examine briefly a few instances in which high cor- porate officials have misused their power to bind the corporation. In the Illinois courts some years ago suit was brought by II. P. Killjoy, a stockholder, against the Mandarin Brewing Association. He alleged, and seems to have proved to the satisfaction of the court, that in 1896 three brothers purchased a majority of the stock and ol)tained control of this brewing corporation They (Iccted themselves to the directorate and to most of the c(»rj)oration offices One of the brothers owned a piece .of real estate which the corporation purchased at an a?!i(t!!nt nllegcd to have bern far in excess of its true vahie. The brothers, as directors, paid themselves large salaries as officers and no dividends were forthcoming H. w^W 40G CORPORATION FINANCE r s f T I i 4 ill lip II N| ; H r i If- to the stockholders. The stockholders were kept in ignorance of the purchase of the real estate and of the size of the salaries. Although the court was so far convinced of the truth of these allegations that a re- ceiver was appointed for the company, no criminal or civil action was taken against the three brothers. The facts cited in a recent case in the Massachusetts courts are of interest in this connection. Samuelson, defendant in the case, was treasurer of the Easton Ferry Company. He sold bonds of the company and neglected to account for them. He charged the com- pany for bank discounts larger than the bank charged, claiming that this extra discount was for his own per- sonal indorsement, which appeared on the notes. He purchased coal in his own name at a low price and, as treasurer, bought the same coal for the company from himself at a high price. In this case the court ruled that Samuelson sliould be charged with the market value of the bonds that he had sold and should refund the difference between the market price of the coal and the price at which he had purchased it from himself for the company. Here again there was no hint of criminal liability or punishment. Take another case, this time from the New York courts. Two officers of a paper company obtained an option to purcliase a manufacturing plant for $75,000. The same plant was sold to the corporation, of which one of the defendants was president, for $100,000. The deed was taken directly from the owner of the plant to the corporation reciting a consideration of $1. The majority of the stockholders bad no knowledge of^ the option price of ?|^7;3,000 until later. On learning the facts they elected new officers who, on behalf of the company, brought suit against the defendants for the MANirULATION BY CORPORATION OFFICERS 407 (litl'trcnce between the true purchase price and the price charged to the cori)oration. The suit was unsuccess- ful. " As this is not a legal treatise, a discussion of the exact legal reasons for the decisions of the court in each of the three cases cited is not necessary here. The important feature common to the three cases and common to practically all similar cases is that in the present state of the law an official may make contracts and purchases directly advantageous to himself and disadvantageous to the corporation without fear of punishment — pro- vided, of course, that he and his lawyers make no legal blunders. Assuming that he avoids this pitfall, the worst that can happen to him through the operation of the law is a restitution of his ill-gotten gains, which is, of course, no punishment at all. His true punishment conies simply in the fact that sooner or later his dis- honesty will be discovered and his reputation among honorable business men vill be indelibly smirched. 228. New companies for profitable business. — A third method by which corporation officials often transfer an undue portion of corporate profits to themselves is by the formation of new companies for profitable busi- ness. Every corporation, whether it be railroad, in- dustrial, trading or financial, will find some features of its operations more profitable than others. The ordinary stockholder may not know anything about the actual operation of the business or about the oppor- tunities for large profits; obviously the officers who do understand the situation are under a strong temptation to use their knowledge for their own, instead cf for the corporation's, benefit. Tlie writer, for instance, knows of a company of con- siderable size, which is in the business of buying and sell- 408 roiiroiiATiox rix a\( i : ing domestic rugs and carpets. The concern began to deal in a small way in oriental rugs and Smith and Jones, the president and officenianager,rcs])cctively, discovered at once that in their town this business was extra- ordinarily profitable. Instead of taking hold of the business and developing it for the established corpo- ration of which they were officers, Jones resigned his position, organized a new company, in which Smith was secretly a large stockliolder, and quickly secured all the oriental rug trade of their city for the new cor- poration. The stockholders of the first corporation retain Smith as their president to this day and regard him highly for his business ability. At the same time, Smith is growing rich from the profits of the new cor- poration. The stockholders, even if they know all the facts, would not be justified in saying that they had been defrauded. All that they have lost, in fact, is an op- portunity. The ethics of the proposition is too big a question to be here discussed. Whether the action of the officials in this case be regarded as right or wrong, it is certainly true that its eflPect was to transfer possible profits from the corporation to the officers. Take another instance, which has been related to the writer by a public accountant. The Automatic Dooi Fastening Company is a corporation with a large cap- italization. It controls a patent device that can be cheaply manufactured and readily sold at a good price The officers easily sold the stock to a number of smal investors who were impressed w^ith the high value ol the patent and the large profits which would certainlj be forthcoming as soon as it was put on the market The corporation secured the necessary amount of capita funds, and manufactured the device; at this point th( stockholders learned that a subsidiary corporation MANIPULATION BY CORPORATION OFFICERS 409 owned l)y the officers, had been formed in each section ot the country where sales were expected to be large and that every subsidiary corporation had a hard and fast eoiitract with the parent company by which the sub- sidiary company got the device at a price that barely covered the cost of manufacture and was given exclusive selliiiK rights in its own section. Practically all the j)i(){its evidently were thereby transferred from the cor- poration to the subsidiary companies. However the des- patch lines have now been taken over by the railroad companies, so that there is no possibility of manipula- tion in the future. Tliere is nothing new in such an arrangement. Tliirty-five years ago when the numerous short-distance raihoads of the United States were first being consoli- dated into systems, railroad officials discovered that the most profitable traffic was that which moved over long distances. It was not long after this discovery before twenty-five or thirty "despatch lines" and "fast freight lines" were in existence, each of which handled the tlirough long-distance traffic over two or more railroads under contracts by which much the greater portion of tlie large profits went to the despatch line companies. It is almost needless to add that the chief stockholders of these new companies were railroad officials. Tlie same principle was applied by Commodore Vanderbilt when the New York Central System was t'oiined by holding in his own hands the stock of com- l)anies which owned the important terminals of the rail- road. These terminals were then leased to the New York Central on terms that were not generally exorbi- tant, but that nevertheless yielded a large return to the Commodore. Although the Vanderbilt family for many years have not held a majority or anything like a 41U C01ll»0UATI0\ l-IX.VNCE 1*^ majority of the Xew York Central stock, yet they have been able to dominate the niana^cnient of that road and to secure for themselves lar^^e profits through their ownership of these terminal companies. 229. Mia use of inside information. — The fourth method of milking- a corporation for the benefit of its officers is by making use of "inside" information. This is, on the whole, the safest and least disreputable method. Indeed the line between the proper and improper use of the information that necessarily comes into the officers' possession is so indistinct that no one has yet been able to trace it. We are all agreed, no doubt, that it is quite improper for the president of a corpora- tion to make a business of speculating in the stock of his company, specially if he "sells short" and thereby puts himself under temptatitm to mismanage the com- pany. On the other hantl, probably few people would raise any objection to an officer's investing m some shares of his company's stock, if he has good reason to believe that the stock is selling below its true value; nor does there seem to l)e any valid objection to his selling this same slock, if later he discovers that spec- illative forces have raised it far above its true value. Now just where shall the line between what is proper and improper in this regard be drawn? Xo one can say. It is as shadowy as the line between speculative and investment buying Whatever (loul)t tlurc may J)c as to whether the use of inside information by a corporation officer to guide his buying and selling of stock is improper or not, there can certainly be no (piestion but that the use of such in- formation l)y an officer in order to enrich himself directly at the expense of the corporation is wholly un- MAMI'lLATION BV COUrOUATION OFFICERS 411 justiHiible. The three cases cited below are fair ex- amples (tf what is sometimes done: (a) An officer of an oil refining company in Pennsyl- vania, who liad no authority to sell stock for the cor- poiatioit received a buying order addressed to him- self as an official of the corporation for 5,000 shares at '20 cents a share. He filled the order by transferring j.OOO shares from himself to the purchaser and then took for himself 5,000 shares of treasury stock at the special price of 2 cents a share. In this case, the facts I>tiii<,' fully proved, the court ordered a refund of the difference between the two prices to the corporation. (b) The XYZ Manufacturing Company, with capi- tal stock of $500,000, one-half paid in, went into re- ceivers' hands. The company had notes for $20,000 out- standing, bearing 10 per cent interest and secured by a mortgage on its property. The president, knowing the condition of the company, just before the failure, steined the notes in exchange for $30,000 face value of his stock in the company. Ten thousand dollars »vas paid on the notes when they fell due, but the other stockholders objected to paying the remainder. The president transferred his claim for the remaining i^'lO.OOO to an outsider and the court enforced payment of the claim. (c) Robinson, the treasurer of a railroad company, whi ' was in poor condition, bought up outstanding notes of the company at a large discount with his own money and as treasurer saw to it that the notes were paid when due at their full face value. The court lii'ld that the treasurer had done nothing illegal. He was nt liberty to buy the notes for himself, as he was !!ndvn and too skillfully practiced. As an accountant of wide experience says, in speaking of corporate manipulation by officers, "That this is con- stantly being done is obvious from the fact that so many men, drawing salaries with large corporations, of $10,000 to $15,000 a year, become millionuires in a very short period. It is a mere matter of arithmetic to demonstrate that this is not done out of the money that they save." jIAMI'LLATION BY CORPORATION OFFICERS 413 ■>3i. Canada fairly free from manipulation.— Com- parativtly little is heard in Canada respecting manipula- tion by corporation directors. The chief complaint along that line seems to have been regarding the profits made bv promoters of new companies and of industrial con- solidations, which naturally has included directors. The investor, in future, will undoubtedly keep a sharp watch upon this opportunity for abuse. The tendency in the Dominion is for corporations to employ reputable chartered accountants and appraisal eonipanies to examine and report upon their financial position for the benefit of shareholders and prospective investors. This is a gratifying development. With regard to dividend and other official announce- ments of corporations, Canada has been notably free from the premature divulgence of information. The secrecy with which such announcements as that of the Canadian Pacific Railway, for instance, are guarded, is noteworthy. Not a whisper is bet d in financial circles until the statements are issued from the directors* meet- infj or the office of the president. Few cases have come to light wherein Canadian di- rectors have benefited in stock operations by the receipt of "inside" information. CHAPTER XXVII %^ 1W* . ; 31 MANIPULATION BY DIRECTORS 232. Usual methods.-As has already been stated, it IS difficult to draw the line between manipulation bv officers and manipulation by directors, for in most case's more or less collusion between the two is essential to the success of any of their fraudulent schemes. It is possible, however, to draw a distinction between those lorms of manipulation which are primarily intended for the benefit of officers and those forms which are primarily for the benefit of directors; with the latter class of manipulative methods we have now to deal The method that was given the first place in our con- sideration of manipulation by officers, namely, exorbi- tant salaries, is not worth attention here. Directors to be sure, are frequently allowed fees for attending meetings, and sometimes these fees seem to be somewhat excessive. They are frequently prescribed, however, in the by-laws, in which case, of course, the stockholders as a body would have no ground for complaint against the directors as a body. In any case, the fees are not large enough to make it worth while for the directors to attempt to defraud the stockholders and enrich them- selves by this particular method. Without much question the courts would set aside aten out of a more than half interest in a successfully-run factory. I was employed in this case by order of the court upon the complaint of A that B and C were waiting the assets of the company. I cannot see how umler the laws of the state A has nny redress whatever, except to show fraud in the first issue of additional stock and in the subsctjuent decreasing of the capital MANIPULATION BY DIRECTORS 431 stock. But from the point of view of law it will be exceedingly dirticult to bring in this evidence. However, there is a ray of hope in the horizon ; namely, that the state statutes forbid the directors to put a mortgage on a mining or manufacturing plant without calling a special stockholders' meeting and ob- taining the consent of two-thirds of the stock. These directors had two-thirds of the stock and could have easily complied with the requirement but their attorney evidently overlooked this point and we believe that we can have this mortgage set aside and a receiver appointed. In this case the receiver could start suit against B and C and then bring out these fraudulent tran- sactions. The cases that have been cited seem scarcely to call for comment. They all— and especially the last case- however, give point to one precept, which controlling stockholders would do well to keep before them, namely DO NOT PART \MTH CONTROL. A swindling or hostile board of directors can do more in one session to wreck a corporation and bring loss to its honest stockholders than a capable board can accomplish in years toward repairing the damage. 241, Form of annual statements in Canada. — Those interested in Canadian corporation finance have scope for considerable improvement in the form of presentation of their annual statements. An examination of such statements issued during any one year reveals numerous differences in the method of presenting these statements. It would not be so surprising to find differences between the financial statements of concerns carrying on busi- iiisses of different natures, but there docs not seem to he a great deal of room for wide variation between those of firms carrying on exactly the same nature of business. Bearing in mind that the object of a financial state- ment should be to place before the shareholders or the 432 CORPORATIOxX FINANCE II public, generally, the exact position of the company at a certain date, there should he no great difficulty in pre- senting the various figures in such a manner as to ac- complish this object. It will not be disputed, that in a large number of instances this is not done, and one might safely assert that in the majority of instances financial statements leave much to be desired. Some examples of these lackings in the financial state- ments of some of the best-known concerns in Canada follow : Various industrial concerns, which for years were the recipients of bounties from government, made no state- ment of the sums received (m this account in their annual reports, but included them as profits. A large industry first shows its dividends paid and later shows the amount (;f rent paid. Almost fifty per cent of Canadian financial statements show somewhere near the top of the column the amount brought forward from the previous year, afterwards adding thereto the profits of the current year before making the necessary deductions. Probably as large a proportion show, first, the divi- dends paid and afterwards make their appropriations for depreciation and other reserves. This is not sufficient. Take, for instance, the first group mentioned. It would hardly be possible for any- one, not knowing that a firm was the recipient of a gov- ernment bojmty, to form a correct conclusion concerning that firm's earning capacity if the financial statement made no mention of bounties, but simply represented them as earnings. 242. JVhnt should he incIiiitctJ in the statement. — Mr. T. C. Allum, the IMontreal correspondent of the Mone- tary Times of Canada, discussing this matter, says: MANIPULATION BY DIRECTORS 433 One first looks at a statement to ascertain what the earnings of the current year were. First must be represented receipts duo to the nature of the business. After this may be shown the costs of operation, divided into as many general headings as jRiniissible. The total of these itemized costs is shown and is tlien deducted from the receipts of gross earnings. The re- niiiiiider is the gross profits. Then should be shown, earnings from other sources which may be considered as regular and reasonably dependable. Then may be shown expenses of sale or iiiaimffcment, the remainder being the net profits from opera- tions. All these items should follow regularly and systemati- cally, much as they would occur in the conduct of the business. Then would be shown the bond interest and other fixed charges. This being deducted from the net profits from opera- tions, would show the surplus or deficit for the year. This is probably what the shareholder has been looking for. It is also wliat the bondholder is looking for. Both are desirous of know- ing what shape the company is in after all the charges have birn met, which the company is obligated to pay during oper- ations or on certain stated dates. 243. Quarterly statements.— There is some disposi- tion in Canada for large corporations to issue quarterly statements to shareholders, as is done by many companies in the United States. The Dominion Steel Corporation issued the first of such statements concerning the opera- tions of the company for the first three months, ended June 30, of the company's year. The statement did not give any further particulars than the amount avail- al)le for dividends and dividends paid. The figures were: Karnings available for dividends $705,262 Dividends on preferred stocks 245,000 n.1nno. ^♦60,262 1 per cent dividend on common 818,977 $141,285 C— VI— 28 ^34 CORPORATION FINANCE There is a division of public oxjinion in Canada on the advisability of such reports, however. One of the leading corporation presidents of this country is of the opinion that tlie United States Steel Corporation is not a guide for any ordinary company. With their enormous business, numerous plants, located at different points, owning their own railways, coal mines, ore de- posits, and other properties, they can keep their state- ments practically regular from month to month. "The shares of our Canadian industrial companies," he added, "are largely held for investment, and these holders are quite content with annual reports. Monthly reports would be misleading, as owing to a strike or fire or changing from one contract to another, some months do not show any profit at all, and monthly reports would simply enable the brokers to 'bear' the stock in bad months. This would induce frightened shareholders to sell, and in good months the stock would be boomed and perhaps the same persons who sold the stock at a low price would buy it back at a higher price." CHAPTER XXVIII MANIPULATION BY AND FOR STOCKHOLDERS 244. Cheating creditors. — The subject matter of this chapter is concerned with manipulation directed toward one of two objects; either toward depriving creditors of some of their just rights for the benefit of the body of stockholders ; or toward increasing the profits of con- trolling stockholders at the expense of minority inter- ests. In the first case the stockholdei j may be either acting as a body, or manipulation carried on primarily for the benefit of the majority stockholders may be of such a character that the minority can successfully obtain a share in its advantages. Generally speaking, manipulation by and for stockholders as a body is con- fined to small close corporations. We shall find, how- ever, one or two notable exceptions to this rule. We are all of us familiar, some of us perhaps to our loss, with the old trick of an individual or partnership buying stock of goods on credit, disposing of it quickly and secretly, concealing the returns and shortly after- ward going into bankruptcy. The trick may be worked by corporations as well as by partnerships or by in- dividuals. Indeed, the corporation affords an additional advantage to the swindlers in that its bankruptcy need not affect them in the least. Credit-men understand tbe game in all its variations thoroughly and are es- pecially cautious in granting credit to small close cor- porations, no matter how imposing may be their title and the capitalization. This scheme, of course, is simply 485 436 C:ORPORATION FINANCE a. I ■f. f, a plain case of fraud and has no especial interest for us in this study. A slightly different method of reaching much the same result is to have a corporation pile up a large debt on the strength of its assets and then to allow the assets to depreciate. Stockholders of a corporation whose out- standing bonded debt is high are always under tempta- tion to encourage this policy By so doing they may secure large dividends for themselves over a series of years and at the end leave assets of small value to satisfy the bondholders. As we have already found in our study of corporate mortgages (Chapter IX) properly drawn instruments of this character provide that the property mortgaged shall be maintained in at least as good condition as at the time that the mortgage is drami, on penalty of having the corporation put into the hands of receivers. If the trustee under the mort- gage performs his duties properly he will see to it that this provision is enforced. If the stockholders and directors acting for the stockholders really desire to evade the provision, it may require the closest atten- tion and rigorous action on the part of the trustee to forestall them. 245. The Chicago and Alton deal — The well-known instance of the Chicago and Alton Railroad deal illustrates another variation of the same principle. The facts with regard to the Chicago and Alton manipula- tion which were fully brought out in an investigation by the Interstate Commerce Commission in 1907, may be briefly summarized as follows: A close syndicate in 1898 bought about 80 per cent of the outstanding com- mon stock of the Chicago and Alton Railroad Company. The company had been managed with great conserva- tism for several years and had saved from its earnings MANIPULATION BY STOCKHOLDERS 437 and put back into the property a surplus of $12,500,000. \()\v a surplus is legally, of course, the property of the stot'kliolders of a corporation. It is so unusual, how- ever, for stockholders to distribute this surplus directly to themselves that bondholders naturally look upon it as in part a protection to themselves and buy bonds with that imderstanding. Ordinarily, as has been ex- phiined, the surplus is invested in the form of perma- Ment assets of the corporation, and the value of these assets is a strong factor in influencing the bond buyer. The syndicate of common stockholders in this case, de- termined to secure for themselves, and incidentally the other stockholders, the accumulated surplus of the com- puTiy. They therefore issued new bonds to the extent of .S.'}2,000,000, which were sold at 65 and the proceeds, about J^^'i 1.000,000, turned into the company's treasury. They then deelared an extra cash dividend of 30 per eeiit and tlius transferred a large share of the cash ob- tained by the bond issue into their own pockets. The action was much discussed at the time, was condemned by some and defended by others, but did not arouse much public interest until the investigation by the Inter- state Commerce Commission in 1907 brought it into prominence. Then, probably to the surprise of the members of the syndicate, the verdict was practically unanimous against them. They were tried before the bar of public opinion and were found guilty of misuse of corporate funds which had been entrusted to their eare. There can be no question but that this unanimity on the part of the public is highly significant. It means that betv>'een 1898 and 1907 a notable gain in the public's knowledge of corporation finance and in the public's conception of what is and what is not justifiable had taken place. The gentlemen who composed the 438 CORPORATION FINANCE u syndicate ought not to l>f too severely criticised, for they ineiely acted in accordance with the custom of the period. AVe may well hope and believe that manipula- tion of this kind and of the other kinds that have been enumerated will become less and less frequent as our conceptions of the trusteeship implied in almost aU corporate activities become clearer. 246. Manipulation through snbsidianj companies.— Another method that is very commonly used when stockholders plan to get the better of the creditors of their corporation, is the device of interposing one or more corporations between the creditors and the assets on which they think they have a claim. A case in point which was recently settled out of court, and in which the names of the parties concerned, therefore, cannot here be given, is that of an amusement company operat- ing a large park in one of the cities of the United States. The operation of the park was extremely costly and, as the price of admission was only ten cents, the returns were not sufficient to pay expenses. There were, how- ever, a large number of shows and amusement enter- prises in the park which were highly profitable. The stockholders of the corporation as individuals were interested in these sideshows and secured large profits. The corporation which owned the park, on the strength of its apparent prosperity, was able to borrow large amounts of money. When the time Tor settlement came the creditors learned the true state of affairs and were informed that their claims were practically worthless. Fortunately in this case they were able to bring such pressure to bear on the stockholders that their claims were settled. It is cpiite evident, however, that as a method of getting loans and avoiding re-payment the scheme is workable. MANIPULATION BY STOCKHOLDERS 4:J9 Here is another instance which shows that eminent and entirely respectable railroad 'li'xctors are not above working the same trick for th« 'netit of their road. The \. K. Railway owned a m - ^ »rity of the stock of a small rail and boat line whicii had income bonds outstanding. The large company, being in control, was able to apportion traffic and earnings as it pleased and gave less than its share to the small line. Three of Mie boats owned by the small company were being paid for on the installment plan and one of these payments was allowed to lapse, thereby forfeiting the interest of the small company in the boats. The large railroad company then bought the boats from the vendors, being allowed the amount which had already been paid by the small company. Then a consolidation of the large and the sniall companies was determined upon and, as the earnings of the small company had been practically stopped, its shareholders received only one share in the new consolidated company for every ten shares in their ])(>ssession. The income landholders received no interest after the large company came into control and when the consolidation took place were compelled to consent to a great reduction of their claims. The case was threshed out in the courts and it was decided that all the steps taken were legal, except the voluntary passing of the payment on the boats. 247. Central of Georgia income account. — Another case in point, that several years ago attracted a great deal of attention in the financial world, was set forth in the suit of income bondholders of the Central of Georgia Railroad Company for the payment of inter- est in full on the bonds. The reader will recall that in describing the uutiire f)f income bonds it was stated that they are falling into disuse on account of the in- 440 CORPORATION FINANCi: evitahle disputes that arise as to what are and what are not profits. The bonds in question were issued in 1895 at the time of the reor^ranization of the ohl Central Railroad and IJanking Company of Georgia. This ease well illustrates the subject now under dis- cussion, inasmuch as it discloses one method of i lanipula- tion in favor of stockholders at the expense of creditors. The principal fact alleged by counsel for the income bondholders, and practically admitted by the railway company, was that a subsidiary corporation, the Ocean Steamship Company, almost ail of the stock of which is owned by the Central of Georgia Railway Company, had been making large profits and that these profits had been appropriated by the railway company. Evi- dence disclosed that the Ocean Steamship Company kept no separate bank account but deposited all its funds to the credit of the Central of Georgia Railway Com- pany. There were, however, separate books of account for the two companies and it was claimed at the suit, on behalf of the railway company, that the earnings of the steamship company were simply loaned to the parent corporation. These earnings, the reader should under- stand, were not used in order to declare dividends on the stock of the Ocean Steamship Company held in the treasury of the railway company, but were turned over bo00 for the first two years and thereafter at the rate of « per eent of the appraised value of the lot. The company had the ri^dit to pur- chase at the appraised value at the end of five years. The lease was to heeoine void by non- performance of any of its conditions and, in the event of its being voided, the owners of the lot were to ^'et full title to whatever buildin^rs the theatre company mi^ht erect on the lot. The company erected a building and conducted a theatre. In 100.> Mcintosh sold his stock to Robert Henry, and Ileiuy became a director and treasurer of the compiiny. K. S. James ^rave ten shares of stock to his son, K. S. James. Jr., and made him the thin! director. In 15)07 James, Sr., transferred ten shares to another son, Alfred .James, and ten shares to a clerk, L. R. ()s^(K)d. In the snuw year the new board of directors elected were .lames. Sr., James. Jr., and Osgood, thus forein«r IKnry out. In lOOH, as the company was not strong enou^di financially to buy the lot. the stockholders gave the directors the i ight to dispose of the company's option to any stockholder. The directors immediately sold the option for >^M) to .Tames, Sr., who there- upon resigned as |>re.si(lent and director and had his son Alfred elected in his place. James. Sr.. then used his option to buy the lot for J'^.jO.OOO and made an agree- ment with th<- company fixing its appraised value at $rM.000 and its amui.il rcntMJ at ^H.MH). Alfred .Tames then resigned his offices afid his fat!)er was re-elected president and direet«.r. The board failed to pay the MANIPULATION HV STOCK IIOLDKKS UH mil when due and Janses, Sr., as owner of the lot under the lerins of the lease to the couiiiany, declared the lease void and was placed in possession of the lot and the hiiildin^ erected thereon. Henry, the minority stock- liolder, hrought suit and it was finally decided that sufR- cieut evidence of fraud had heen produced to warrant the court in reinstating the lessee in possession of the tiieatre under the terms of the lease. It may he inferred from the decision that two factors which decided the court in favor of the plaintiff were, first, that the James family were evidently acting as a unit, and, second, that the books of the corporation had l»(( 11 destroyed. These were tactical errors which might readily have heen avoided; if they had not been present, it is safe to say that the whole series of transactions would have been found legal. A more simple anrl common case is stated in a recent decision of one of the federal circuit courts. The officers and owners of a majority of the stock of a wire company \oted as stockholders to lease the property of the com- pany at a low rental to another corporation, all of whose stock was held by these same majority stockholders. Xo frajid was siu)wn and the petition of the minority stock- holders to set aside the lease was not granted. In another federal court case it was shown that the majority stockholder of a gas company absolutely dominated the board of directors and in»st the corporation. There can be no (juestion. judging from the facts as presented to the court, that large sums had been de- liberately withheld from the p-irtncrsbip and transferred 448 coRroi; vTioN fixn ^in ce to the CDrporution by the inunipulation of the aecoimts and hills receiviihle. Vet this iimnipulation eould be carried on so easily by the corporation that it was im- possible to prove fraud or ba1 . licnu'dk'H for man ipiilat ion. —The examples that have been cited in these three chapters on corporate manipulation seem to the writer not only interesting but highly instructive. It is an unpleasant duty to record instance after instance of cunning rascality, cs|)ecially when the record to be truthful must set forth at least temporary sjiccesses on the part of the rascals. As was said at the bejjfinnin'f, the swindlin«j operations are for the most |)art in a field which the law does not reach and their perpetrators are seldom given the legal punishment to which they are justly entitled. For- tunately the ptinishmcnt of social opprobriuuj and loss of business standing is generally visited upon them. The j)urpose of tlicse chapters will have been secured if they serve to warn owners of cr)rporate securities of the facilities which the corporate form affords for graft and dishonesty. The writer desires to reiterate that instances of the kind that have been narrated are rare compared with the vast amount of entirely lumorable and legitimate business transacted under the corporate form of business organization. Nevertheless they are fre- <|uent enough to demand attention and, so f:ir as pos- sible, prevention. One preventive is for security-holders to insist on complete and absolute [)ublicity as to the nffairs of their organi/ations. Another prtvt iilive is for them to attend stockholders' meetings and take an active interest in all that goes on in the corporation. A third preventive is to see tf) it that under the cumii- MANirULATION BY STOCKHOLDERS 449 lative system of voting every stockholder gets a chance to be represented. A fourth preventive is to insert explicit provisions iti the corporate by-laws as to salaries of officers, amount of indebtedness to be incurred, amount of surplus to be set aside each year, and so on. The best preventive of all, however — without which all the other measures will prove of small avail — is for the security-holder to investigate with the greatest care tlie reputation of all the officers and directors of the corporation. r— VI- MICROCOPY RESOLUTION TEST CHART lANSI and ISO TEST CHART No 2) 1.0 12.8 1^ !: 1^ 2.5 2.2 2£ 1.8 /1PPLIED IIVMGE Inc IB"!! tail Mom SI'MI S□c^•5t•r, N** Yc'h 1*60^ USA ("(■) »82 ~ 0300 - Phon« (716) IBS 5989 - fat fl CHAPTER XXIX INSOLVENCY AND RECEIVERSHIPS 252. Ttt'o Ujpes of insolvenci/.— The causes of in- solvency have perhaps been sufficiently indicated in connection with the subject of management of capital funds and of earnings. At any rate, they may be inferred to be the reverse of the principles of sound corporate finance, which were there laid down. It will do no harm, however, to recapitulate briefly the prinicpal causes. A great many business men, even the managers of large corporations, are evidently not fully alive to the dangers which threaten any corporation. It is well to distinguish between two types of in- solvency. The distinction for our purpose is important, although in law and in ordinary business language it has not been clearly kept in view. We may call one type "true" and the other "legal" insolvency. True insol- vency exists where the value of an individual's, firm's or corporation's assets is less than its total debts. This, by the way, is substantially the definition given in) the National Bankruptcy Act, but it is declared by eminent legal authorities to be a definition without' precedent in the law. Such insolvency may or may not lead to failure. Certainly if failure is not to follow there must be an improvement in the condition of the business. It frequently happens, however, where debts are not immediately payable, that a concern insolvent in this sense will manage to pull out of its difficulties and meet its obligations when they finally mature. 4ffO INSOLVENCY AND RECEIVERSHIPS 451 Legal insolvency exists when a concern's cash assets are insufficient to meet its liabilities as they fall due. It may well be, and frequently is, true in such a case that the total assets would far overbalance the total obliga- tions. As obligations are almost uniformly payable in cash and cash only, however, it really makes no differ- ence how great the value of the firm's unsalable assets may be. Legal insolvency almost of necessity leads immediately to suspension or, in the case of small concerns, to bankruptcy. The only escape would be a compromise of some kind accepted by creditors. 253. Causes of true insolvency. — True insolvency may exist from the very beginning of corporate existence, although not usually without bad faith on the part of the incorporators. It is possible, however, that the value of a corporation's assets at the beginning may be honestly over-estimated, that the corporation may borrow an undue amount of money secured by such assets, and that the money thus obtained may be fool- islily expended. In such a case, unless a marked rise in the value of the assets takes place, the corporation may be said never to have been truly solvent. It is only a question of time until the inevitable failure arrives. A second cause of true insolvency may be a great and perhaps unavoidable decline in the value of a corpora- tion's assets. If, for instance, a cyclone demolishes the property of a corporation that does not carry insurance ai^^ainst s.ich a calamity, insolvency will necessarily be tlie result. The fall in the value of the assets may be (hie simply to ordinary causes, which are not offset by a •lepreciation reserve. Any one of a hundred otheH events, wb'-h will occur to every reader, may reduce the value of assets below obligations. It may be stated, however, that a conservatively managed corporation is yj 1 i- . i< i '; f ,1 452 CORPORATION FINANCE i'K not likely to suffer in this way. The principles of in- surance and of depreciation are now so widely applied that a high degree of protection is afforded. The third cause of true insolvency, especially with trading companies, is bad management in buying and selling goods. The lack of a proper system of cost ac- counting may lead corporation managers to a long- continued course of selling below cost. The fact that such a course has been followed may not become entirely apparent for a number of years; then it is found that the corporation has been gradually consuming its capi- tal funds in order to pay running expenses. The complexity of modern business is such that fre- quently an accurate and searching analysis carried on at considerable expense is necessary in order to deter- mine whether a business is being carried on at a profit or not. Many a concern has seen its sales growing, its gross profits swelling and apparently its surplus increasing, while at the same time, owing to lack of care to maintain its fixed assets in good condition and to keep up its established trade, it has in reality been moving rapidly into insolvency. An anecdote is told of a large wholesale dealer in men's clothing who was selling quantities of goods at prices which expert accoimtants found to be considerably below cost, including in cost all the selling and administrative expenses. The ac- countant approached the manager of the company and asked him how he could afford to carry on his business. "Ah," was the naive reply, "you see our transactions are on so much larger a scale than those of any of our competitors." It seems needless to add that this par- ticular concern did not long keep out of the bankruptcy court. The fourth cause of true insolvency is actual fraud INSOLVENCY AND RECEIVERSHIPS 453 or theft, a cause which need not be here discussed. 254. One cause of legal insolvency — "lack of capital." —As to the causes of legal insolvency, we have a val- uable mass of information collected by the two great mercantile agencies, Bradstreet's and Dun's. The Brad- street Company summarize their judgments as to the prime causes of all the business failures that occurred in the United States during the four years preceding the crisis of 1907, in the following table: Ccmte* of Failure, Incompetence ... Inexperience .... Lack of capital. .. I'nwise credits . . , Kiiltires of others. Il'.travagance ... Vcjrlect , Conipetition , SiHfific conditions Speculation , Fraud Percentage*. 190T 23.6 4.9 37.1 2.3 1.4 .9 2.5 1.2 163 .T lO.l 1906 22.3 4.9 35.9 2.6 2.0 1.0 2.3 1.0 17.3 .8 10.0 1905 24.4 4.8 33.4 3.5 2.2 1.1 2.9 1.5 163 .7 9.2 1904 23.1 5.1 32.3 3.4 2.5 .8 3.1 13 19.1 .8 8.6 The reader will notice that "lack of capital" heads the list and that personal incompetence comes second. Un- fortunately no distinction is made between lack of per- manent capital and lack of working capital. It seems safe to say, however, that lack of permanent capital does not usually in itself lead to insolvency; most businesses may be automatically adjusted to any reasonable amount of capital. The difficulty comes rather in the form in which the capital funds are invested, particularly in sac- rificing quick in order to build up fixed assets. To make this statement concrete let us examine the Wall Street Journal's analysis of two typical instances of financial difficulty. In February, 1909, the Ameri- can Ice Company was reported to be facing insolvency 1 1 i 454 CORPORATION FINANCE 1 and reorganization and the Journal commented as fol- lows: The annual report just submitted shows that the floating debt, about $650,000 a year ago, has now reached the threaten ing proportions of something like $1,250,000. Herein lies the whole trouble with the American Ice Company. The concern transacted a gross business during the year ended October 31 of $8,120,000, and it is clear that to maintain this volume of business ample liquid capital is essential. The report evidences the need of working funds in other ways; it shows that $72- 728 was expended for interest on its floating debt. Where the company will raise money is a problem. It is known that institutions friendly to the company which have helped It out of difficulties in the past, have withdrawn further support. The company has Httle credit of its own to borrow on. The treasury contains several hundred thousand dollars worth, par value, of securities of subsidiary concerns, but these are hardly sufficient for collateral for a loan as large as Amer- lean Ice requires. Evidently the company was in danger of legal, not true, msolvency. After the above paragraphs were writ- ten the ice company denied its allegations and asserted that It was not in serious need of financial assistance. Nevertheless the quotation indicates clearly enough where a trained financial writer looks for symptoms of weakness. 255. The case of the Detroit, Toledo and Ironton Railway Compamj.-The paragraphs that follow con- stitute an attempt to explain the failure of the Detroit, Toledo and Ironton Railway Company. The company in question, a reorganization of the old Detroit Southern, began business in the earlv part of 1905. When the management of the property again passed into the hands of the court this year, its new career had lasted about two and a INSOLVENCY AND RPX'EIVERSHIPS 455 half years, during no part of which had it succeeded in earning the fixed charges wliich tlie capitalization of the reorganization j)laii had fastened upon it. In the first full fiscal year of its operation as an extended system, the deficit after payment of interest charges and taxes amounted to $270,000 ; in the second fiscal year which ended June 30th last, the deficit reached the .sum of $371,000. After that, presumably, the company ran still further behind. As to the question of working capital, the Detroit, Toledo & fronton's balance sheet of June 30, 1905, practically the be- ginning of its career, shows current assets of $1,218,524 and current liabilities of $390,194, making an apparent working balance of $828,330. Among these current assets was an item, "due from reorganization committee, $1,050,000." A year later this item had disappeared into equipment account, and the inference is that it never was a part of true working capital. In that case, the new company began without any working capi- tal, but with an actual funded debt of about $200,000. If President Zimmerman's theory that the receivership is pri- marily attributable to the clause of the Hepburn law which for- bade the company to proceed with its Kentucky coal mining project is true, the Detroit, Toledo & Ironton as it exists was not a success to begin with. That is, it did not have and could not obtain a current revenue sufficient to carry its own obliga- tions, aside from the cost of the Ohio River Bridge and Ken- tucky extension, and could only become a self-sustaining prop- erty by tapping an entirely new and rather distant source of traffic. Such a development naturally could not take place ixcept through the investment of much additional capital and the completion of works bound to take a year or two in con- struction. Meanwhile the company was exposed in a perilous financial condition to the usual danger of adverse general con- ditions, which did not fail to arrive. 4 The two causes assigned in this case are : First, lack of earning power in the assets sufficient to meet fixed charges, which is a condition of true insolvency; 456 CORPORATION FINANCE and, second, lack of current assets, or of workinj? capital. » 256. Additional causes of legal insolvency.— V^q have found in our study of financial management that It IS not usually advisable for a concern to allow its ac- counts payable to exceed 70 to 80 per cent of its ac- counts receivable; that its bank loans should be repre- sented for the most part by cash in the bank; and that Its finished products on hand should not be offset by any corresponding liability. If these relations are not main- tained, the company is apt to sink first into an unprof- itable and next into a highly dangerous situation. The concern begins to lose profits, if its working capital is msufficient to permit taking full advantage of all con- ^derable discounts for the prompt payment of bills. Ihis pomt has already been discussed in connection with financial management. It is obvious that as working capital decreases the corporation manager is driven to depend more and more upon his current sales and ac- counts receivable for funds with which to pay his bills If for any reason his sales fall off sharply or his debtors fail to pay promptly, he will be unable to meet his own obligations promptly. Unless he can secure extensions or arrange for loans from some other source failure is mevitable. Let us give attention again— for this is an important point— to the fact that a concern may fail in this manner although Its assets may be thoroughly sound and far in excess of obligations, its business large and growing, and its profits great. Carelessness or lack of apprecia- tion of the necessity of keeping up working capital may thus be the sole cause of legal insolvency. As to the statement that the trouble with many concerns is "lack of capital." our analysis has indicated that the proper INSOLVENCY AND RECEIVERSHIPS 457 wording of this phrase in most cases would be "lack of woriving capital." ^V. slightly diflFerent cause of legal insolvency arises when a corporation, in order to pay dividends, unduly increases its quick obligations. It may well be in such a case that the dividends have been earned and are prop- erly due to the stockholders. If the profits that are to be used for dividends, however, have been put back into the property or into any sort of permanent invest- ment, the payment of the dividends will involve borrow- ing money. Among conservative financiers this is universally regarded as a dangerous practice. Divi- dends ought to be provided for in advance by so large an accumulation of cash that their payment will not unduly reduce, even temporarily, the corporation's working capital. A third frequent cause of legal insolvency is inability to renew medium term notes or refund long-time obliga- tions when due. This siuation may not be the fault, so much as the misfortune, of the corporation. The ob- ligation may fall due during the height of a crisis when borrowing of money on any terms is next to impossible. It may have been entirely proper to issue the obligations in the first place ; the as >ets may be far more than suffi- cient in value to cover them: and yet the actual cash to meet them may not be forthcoming. We shall have oc- casion in the following pages to discuss a recent case of failure and reorganization which falls within this class. 257. Tivo methods of handling insolvency — Bank- ruptcy and dissolution. — There is so much confusion — not only in the public mind, but even among lawyers — as to the exact nature of the remedy that should be ap- plied when a corporation gets into financial difficulties, that it seems proper to preface our study of corporate 458 CORPORATION FINANCE V- reorganization by a brief survey of the legal aspects ot insolvency, receivership and bankruptcy. Much of what IS said in tiiis chapter will apply to individual proprietorships and to partnerships, as well as to cor- porations. Additional information on the topics here briefly treated will be found in the volume on Com- mercial Law. The reader is probably alreadv aware that the con- stitution of the United States confers upon Congress the sole authority to establish a uniform law as to bank- ruptcy procedure for the whole country, and that the atest expression of this authority is found in the Na- tional Bankruptcy Act of 1898. Bankruptcy may be either voluntary or involuntary. It may be 'asked for by an insolvent individual or partnership in order to obtain a discharge from his or its debts; or it may be asked for by cretlitors whose claims are unsatisfied in order to obtain an equitable division of the property of he oankrupt. The Bankruptcy Act, as amended in IJIO, provides that all corporations, except municipal, railroad, insurance and banking, may file voluntary petitions m bankruptcy; involuntary petitions may be filed against all "moneyed, business and commercial" corporations except municipal, railroad, insurance and banking corporations. It will be noticed that charitable and religious corporations are not prohibited from filing voluntary petitions. The presumption is that they may do so. As a matter of fact, it is seldom to the interest either of stockholders or of creditors to force a corpora- tion into bankruptcy. Indeed, the chief reason that may lead to such drastic action is the desire of unsecured creditors to prevent secret deals and transfers of the corporation's assets and to expose any past irregularities m the conduct of the corporation. Bankruptcy is espe- INSOLVEiNCY AND RECEIVERSHIPS 459 cially valuable at times as a means of making invalid liens or judgments that have been secured by favored creditors within four months of the period of bank- ruptcy. A second method of handling the affairs of an insol- vent corporation is by a dissolution of the corporation and a distribution of its assets to creditors and share- holders. This method is even more infrequent than bankruptcy and is plainly out of place except for cor- l)()rations, the organization and good will of which are not worth saving. 2.58. A third method — Appointment of a receiver. — A third method is the use of what is known in law as a "bill in chancery." The objects sought to be obtained by this method are, first, to come to an equitable settlement l)etween the corporation and its creditors, and, second, to preserve the corporation's organization and continue its business. The "bill in chancery" is, in lay language, simply a petition presented to a court of equity asking the court for protection and supervision of the corpora- tion's property and business until a settlement of the conflicting claims may be secured. If the petition is granted, the court at once appoints an officer responsible solely to the court known as a "receiver," whose busi- ness it is to conduct the corporation's affairs until he is discharged. The petition may be presented by any one of four parties: (a) the corporation itself; (b) the stockholders; (c) secured creditors; or (d) unsecured creditors. A petition of this character presented by a corpora- tion in its own name is unusual and instances of its being granted by the court are still rarer. It is also somewhat unusual to find petitions by stockholders presented and granted. A complaining stockholder is usually told by ■1^ r *r; 111 i 4C0 CORPORATION FINANCE the court that his proper course, if he is dissatisfied with the management of the corporation, is to elect new di- rectors. Moreover, a complaint by a stockholder that his corporation is insolvent and should be placed in a receiver's hands is seldom necessary, for in such a case creditors will be more than likely to take the initiative. Where the corporation itself is willing that a receiver should be appointed the petition is usually presented by friendly unsecured creditors. This is, in fact, the usual method of securing what is known as a "friendly re- ceivership." It is doubtful, however, in many states, whether an unsecured creditor can successfully apply for a receivership in the face of opposition on the part of a corporation. Secured creditors have a far stronger case and a petition on their part based on the proved insolvency or mismanagement of the corporation is not generally denied. Unlike petitions in bankruptcy, bills in chancery may be presented either in the federal courts or in any of the state courts which have jurisdiction. Here is a frequent cause of much confusion and frequently of conflict be- tween courts. The legal questions involved are entirely too complicated and technical to be discussed in this chapter. All that need be said is that where large in- ter-state corporations are involved the tendency is grow- ing to apply to the federal courts for relief. One reason is that the judges of these courts are especially familiar with cases of this kind; another reason of still greater importance is that federal judges in different parts of the country work together more harmoniously than do the judges of different states. 259. Duties of a receiver.— If the corporation is car- rying on simply a trading business and goes into bank- ruptcy, the activities of the receiver in bankruptcy will INSOLVENCY AND RECEIVERSHIPS 461 he comparatively simple. He will dispose of the assets as rapidly as he can and will use the funds thus obtained, so far as they will go, to settle with creditors. There may be a considerable waste in this process, for the established trade and business connections of the failed company will go for nothing. Yet, on the whole, it is the quickest and most certain method of satisfying the obligations of the company, and it is usually followed. Unless the corporation's borrowings have been far in excess of the value of its tangible assets, the obligations will be met and the loss will all be borne by the stock- holders. In an ordinary bankruptcy the stockholders* interests are very little considered. Where the failed corporation is a large manufactur- ing or railroad company with a great amount of fixed caiptal and a receiver is appointed by a court of equity, his duties are entirely different. He has as his object in ihis, as in the former case, the payment of corporate obligations. It is very seldom, however, that this ob- ject, when the corporation has large fixed assets, can be attained by the sale of these assets. Ordinarily there is no one to buy them except at a tremendous sacrifice. It would evidently be quite impossible to find cash buyers for the millions of dollars of property of any of the great industrial combinations or of any of the great railroads. Therefore, the receiver is permitted in such a case to go on with the business. No profitable ac- tivities of the concern are allowed to cease. It goes on manufacturing or transporting, or whatever its business may be, under the receiver's administration, just as it did uader the administration of its own officers. As the holders of claims against the failed corporation cannot hope for immediate payment in cash, a settlement with them must be made in some other manner — usually 462 CORPORATIOx\ FINANCE through a reorganization, a subject to which con- Mderable attention is given in the following chapter" ''^0 fcetver^s powers.-The receiver Is a ve' powerful ofhcal. So long as no actual fraud or obvious nusn..na,.ement on his part is proven, he is at libert^^ to make such disposition of the assets and earnini under h.s charge as he sees fit. He may use his no3 altogether for the benefit of the creditors! or he .T It in part also for the benefit of the stockholders: he has the latter object in view, he will naturally do what he can to de ay a settlement until a favorable period ar- rives and will thus preserve as much of the property as possible for the stockholders. P^"perty as the stockholders-and frequently more equitable to every one concerned-to have a receiver of their own choosing appomted. In recent years it has become cus- tomary for corporations which are getting into diffi- eulties to secure from the court the appointment of what are generally known as "friendly" receivers. Fre- quently the friendly receivers are officers of the corpo- ration. In order to get this result there must be collusion between one or more of the creditors and the corporate officials. The creditor or creditors and the of! fieials go secretly-often at dead of night-to some udge who /ms jurisdiction; the creditor complains that us debt IS unpaid and the officials confess insolvency; then the creditor asks for the appointment of some man previous y agreed upon to act as receiver and the judge then and there duly appoints him. Of course, the judge must be fully aware of this scheme and must approve It On account of the conflicting jurisdictions of our state and federal courts, however, it is usually a very easy matter to find one among the several judges INSOLVENCY AND RECEIVERSHIPS 463 with the proper authority who will do what is wanted. It will not do to say off-hand that in every case the appointment of friendly receivers is absolutely wrong, or that the judge who makes the appointment is corrupt. As has been intimated, insolvency sometimes results from causes beyond the control of corporate officials and iiasty action on the part of receivers would cause heavy unnecessary loss. We cannot absolutely con- demn, therefore, either the officials who request the ac- tion or the judge who complies with the request. Nev- ertheless, the transaction, being secret and more or less irregular, seldom reflects credit on any one concerned. Since the receiver, however he may be appointed, is a court officer, his expenses are court expenses and until paid constitute a lien on the corporate assets that goes ahead of all other claims. Receivers' certificates may be issued in order to secure funds for practically any pur- pose that the receiver deems proper. The funds may be used to purchase new supplies or equipment or to im- prove and extend the property. 261. Business failures in Canada.— The following statistics of Bradstreet's shows the record of failures in Canada during 1911 and 1912. Considering the large number of companies in operation and their immense capitalization in the aggregate, the list is small: Fiiilures Number Assets I.inbilitiM •I lie to 1912 1911 1912 1911 19U' 1911 ImmniH-tpnce .... 21t 226 $1,12I.:j>h ijl,3l7,77l $ -\HI,',,3J9 a 2.471 "99 Moxprrience . 67 41 2()l.7fil 93,032 m.4<.H 200.851 c.k of capital.. 660 691 2,1Hi,(m 2.930.8.i4 .»,fi«0.6fi8 6.249.820 ii«ise credits... 17 12 148,.Wi (i2S.W 201.714 lS0Ji44 nliircs of otiiers. 12 16 77.fWi7 117,12,5 iUi^m 188,023 Kvlnivagance .... II 12 29,160 308,000 (JS/jIO 417 900 ,V''-'''''"L •*« •'« »".87! IH3.(.'10 •.m:m 3.32,'793 <"t.. petition 13 1:. 39,.W8 33.699 78.958 74 150 NTciflc conditions. 168 .'01 6.W.0I9 780,501 1,081.139 1J14;687 Speculation 6 13 2;i.800 123.600 .W.600 406,486 '^""^ ■__!!! __L^ _J1W.«<« W»,8HS 1,271.129 1300,757 '''«'*"' >319 1.401 $5,61 1,6T4 W.420331 $123iI!3M $13,087,009 464 CORPORATION FINANCE I * k^^^ Nineteen hundred and twelve was the most favorable m five years in Canada, both as regards failures and lia- bilities, and there individuals were charged with respon- sibility for 85.3 per cent of all failures. Lack of capital IS the Dominion's besetting business trouble, with 503 per cent of all failures charged to it, as against 16.3 per cent due to incompetence, 6.7 per cent resulting from fraud, 5.1 per cent produced by inexperience, and 4 3 per cent attributed to neglect; specific conditions, fraud, speculation, extravagance and competition were less in their effects than in 1911, while the other personal causes were more hurtful. Specific conditions were credited with 12.8 per cent of all failures, as against 14.6 per cent in 1911. As regards liabilities, lack of capital, with 45.8 per cent charged thereto, compares with 47.8 per cent in 1911, and specific conditions were also less hurtful; but incompetence, with 22.8 per cent in 1912, as against 18.9 per cent in 1911, was more hurtful, as was fraud, with 10.3 per cent in 1912, against 9.9 per cent in' 1911, and inexperience, with 8.5 per cent in 1912 and 1.5 per cent in 1911. Fortunately, large corporation breakdowns are infre- quent in Canada, with the exception, perhaps, of indus- trial consolidations, the experience of many of which has not been altogether happy. Disaster is sometimes met, as in the United States, by receiverships and later reor- ganization. Frequently, as we have already seen, bond and shareholders of companies which have met trouble are called together to face matters, to have their hold- ings "cut" and to reorganize. An example of receivership may be cited. In August, 1913, at a meeting of the directors of the Canada Iron Corporation. Limited, it was decided to apply to the courts for the appointment of a receiver. The object INSOLVENCY AND RECEIVERSHIPS 465 was to obtain a reduction of fixed charges, which was taken to mean that a financial reconstruction would be effected, in which the bondholders would be asked to accept stock in lieu of their secured lien. The bonds are held in England and listed on the London Stock Ex- change. The first-mortgage issue was £600,000 of six per cents, but in addition there was a "consolidated" is- sue of $1,718,000 not listed. There was $2,909,000 of preferred stock outstanding and $4,832,000 of common. Xo dividends had been paid. The dumping of United States pig iron into Canada was alleged to have seriously hurt the company's busi- ness in 1911 and the first half of 1912, but the last re- port stated that conditions during the latter half of 1912 and the opening of 1913 were better. In addition to mines and furnaces, the company owned six foundries for production of carwheels, pipes and castings. The directors complained that the abolition of the Canadian piff iron bounty left them at the mercy of United States (lumping. A receiver was appointed and carried on the business of the company pending reorganization. While the ap- plication for the receivership was voluntary on the part of the company, it was understood to have been made on the instance of the second-mortgage bondholders, whose interest instalment due had not been paid, and that the bondholders would have a substantial measure of control of the company under the proposed reorgani- zation. d 1 r— VI— 30 li CHAPTER XXX PRINCIPLES OP REORGANIZATION 262 Season, for reorganizaUon—There are tw general classes of reorganization- first ff. necessary as the result of insdrnev " 'co^rthl: t.*^ ->:^h apply in all kinrf-^rniXr' ^""^'^'^ Ihe reasons for reorganization in lieu of « .™„i sale of property have already been all" d«l to I I to make them plain, however, we shol.id ^i! etheml: .nto a^oun? jjf^ ""-P^ation is one factor to take ThT'tock !' "'! ""^ "' •"""= "-"rtKages on its lin^. ow„am:;'i:;-„--^-^-„.^. 466 PRINCIPLES OF REORGANIZATION 467 oiitstanding mortgage bonds based on each of the branch lines mortgage bonds based on the terminals and real estate holdmgs. and very likely, in addition, a general mortgage bond issue to cover whatever property is left. Then there will probably be preferred and common stock and short-tmie claims, including accounts payable accrued wages and bank loans Such a group of cor-' porate relationships and obligations may be taken as t} Ileal. It IS. m fact, not half so complex as the finan- cial organization of many large raUroad and industrial companies. fin ^r'^^T* *.° ^^'' complicated financial scheme we find the railroad property to be practically, for operat- ing purposes, an indivisible unit. The word "indi- visible, as here used, does not mean, of course, that the property is actually physically merged into one. It ^^ould be possible for the branch line bondholders to mark out and segregate their property and take it for hemselves; for the terminal bondholders to do the same; or the mam line bondholders to do the same; and so on. It IS indivisible, however, in the sense that a division of «ie property would destroy most, if not all, of its value. 11ns statement applies only to a well-constructed, uni- fied railroad system. If any part of the system is su- perfluous. It may be lopped off and taken by its own bondholders. This, for instance, was the case with the M. Louis and San Francisco Railroad, which was o^Mied by the Atchison, Topeka and Santa Fe. up to l.e bankruptcy of the latter road in 1898. and was then aken over by the St. Louis and San Francisco bond- holders. The same thing was true of the Oregon Short Line which was temporarily cut off from the Union I aeific system m the bankniptcv of 189.3. Assuming that a failed corporation possesses prop- m m 468 CORPORATION FINANCE Mi erty which is commercially indivisible, the question that arises in case of bankruptcy is, What arrangement can be made to prevent the property from being split up into segments by the conflicting claims of the various security-holders ? How can it be held together, put back on its feet and restored to its rightful position as a valuable profit-making business? Every bondholder, as well as every stockholder, is keenly interested in find- ing the right answer. The value of any bond, as has already been shown, depends in large part on the earn- ing power and prosperity of the issuing corporation. 263. The formation of committees. — In the process of getting an answer the first step is to ascertain as nearly as possible the exact status of each of the cor- poration's obligations. Usually this task is left to the receivers or to such persons as are selected to act as a reorganization committee. Each class of bondholders chooses representatives whose duty it is to represent the interests of that particular class. These representatives are usually called a committee and are selected in va- rious ways. Sometimes a meeting of the bondholders of one class is called and the members of the committee are elected. Sometimes banking houses which have under- written one or more of the bond issues come forward and offer to serve on reorganization committees. Gen- erally these members of the committee are self-chosen, and are of such character and standing that they readily secure the support of their fellow bondholders. Shortly after the breakdown of a big corporation it is quite customary for one of the heavy bondholders of each class to send a circular letter to the other bondholders of that class stating that they should be represented in the pending negotiations and asking that they place their interests in his hands. Usuallv he states in the PRINCIPLES OF REORGANIZATION 469 circular that his only interest in the matter is to secure tlie rights of the persons to whom he appeals and that he M'ill act in good faith with that sole object in view. The bondholders signify their consent by depositing their bonds with some stipulated trust company. If a majority of the bonds of a given class are deposited, the self-appointed representative or committee is authorized to act on their behalf. We should bear in mind, how- ever, that the committee's authority is only that of a representative. It cannot bind the bondholders to any terms whatever. Whether the bondholders accept the plan which their committee approves or not will depend largely on their estimate of the character and intelli- gence of the members of the committee. Within a few days after an important insolvency is announced, there will usually come into existence a number of different duly authorized committees, one representing the general mortgage bondholders, one the bondholders of each of the subsidiary companies, one the debenture bondholders, if there is such an issue, and so on. Ordinarily it is not necessary for the bona fide first mortgage bondholders to organize. They are so well protected that they can afford to sit quiet while the other claimants fight it out. Usually also the stock- holders do not organize. They have practically no voice in the reorganization, anywny, if the receivership is unfriendly; if it is friendly their interests are already ])rotected. Sometimes, however, the stockholders as a body, or the preferred and common stockholders, each acting as a class, will appoint committees of their own when burdensome assessments seem imminent. Once the committees are appointed the "jockeying for position" and the arguments pro and con as to the strength of each of the competing claims on the corpora- 470 CORPORATION FINANCE tion's assets begin. If many different claims are in- volved, it will probably be necessary for the committee of each class of security-holders to appoint a single rep- resentative and have these representatives form a general reorganization committee. It is the duty of this committee to discuss terms of reorganization and finally to agree upon a plan which may be submitted to the security-holders. 264. Why not foreclose.— The reader may well in- quire at this point why the bondholders as a whole or some class of bondholders do not foreclose and sell under their mortgage and thus get enough cash to meet their own claims, or failing that, bid in the property for them- selves. It may correctly be suggested in this connec- tion that for the purpose of buying the property when it is sold, each bond would be accepted at its par value. This question has already been answered in part by the statement in the last chapter to the effect that it would be next to impossible to sell a large corporation to an outsider for cash, because the amount involved is too large. Besides, an outsider who wished to get con- trol of the property could accomplish his purpose much more economically by buying the securities of the failed corporation at the low prices at which they naturally sell during the period of reorganization. In answering the second part of the question we must consider that the bondholders whose securities are close to the property would not have anything to gain by a sale. Their principal and interest, presumably, are well protected and they could not by any process of juggling get more than principal and interest. With the junior mortgage bondholders the situation is somewhat differ- ent. They might at times, if the reorganization scheme appears unfavorable to them, have something to gain PRINCIPLES OF REORGANIZATION 471 by compelling foreclosure, and bidding in the property. In this case, however, they might be forced to settle all the claims that rank ahead of their own in cash, which would ordinarily be too large an undertaking. How- ever, the possibility of such action on their part is always recognized by the reorganization committee and their claims are in consequence treated with greater respect than they would otherwise command. The result is that foreclosure proceedings are usually only a form. After reorganization plans have been completed fore- closure is simply a method of transferring the property of the old corporation to a new corporation. 265. Problems confronting the reorganization com- mittee. — The reorganization committee, then, once formed has a reasonably free hand. At the same time it must act with due circumspection in order not to arouse the hostility of any powerful body of security- holders. It must treat everybody with apparent jus- tice; it must reconcile conflicting claims and interests. The success of whatever plan of reorganization it adopts will depend upon the extent to which the plan is ac- cepted by security-holders. As noted above, the first and perhaps most important duty of the committee, therefore, is to form some working estimate of the rela- tive values of the different classes of securities. First, they must consider whether there has been an impairment of assets and earnings suflicient to affect the first mortgage bonds. Usually this question may he answered in the negative. If an affirmative answer has to be given, any attempt at reorganization might as well be given up, for nothing can be done except to allow the first-mortgage bondholders to take whatever property is left. Assuming that the first mortgage bondholders are still in an entirely safe position, the re* 472 CORPORATION FIXAxNCE I IKf mM organization committee next considers the situation of the bondholders secured by mortgages on outlying or small sections of property. lAIortgages of this nature on railroads are usually divisional, terminal, branch line or real estate; with industrial corporations there may be mortgages on unessential plants or property. For in- stance, a consolidation may originally have taken in twenty plants, and may have found ten of the plants so uneconomical that it has transferred almost all their busmess to the other ten; or a merchandising cor- poration may have gone into general trucking; or a paper mill may oAvn a great expanse of forest land, not all of which is essential to its business. In such cases the outlying mortgage bondholders may be allowed to take their property, and their claims may then be elim- inated from further consideration. It may well be, on the other hand, that the separate pieces of property so mortgaged are highly essential, in which case the bond- holders would be able to insist on a settlement of their claims in full. Thus a railroad could not well get along without its terminals or without equipment, and the re- organization committee would have to allow full value to all bonds based upon such property. A manufac- turing corporation may derive its chief profits indirectly from its control of the sources of raw materials, in which case the reorganization committee would arrange to pay bonds based on such property in full, even if the prop- erty taken in itself were not of great value. Disputes are bound to arise in connection with many of these claims on specific pieces of property. A railroad branch line, for instance, may earn very little revenue for itself, according to the railroad's method of figuring, and may have absolutely no value except as an adjunct to the failed railroad. Yet it may PRINCIPLES OF REORGANIZATION 473 turn over to that railroad a large and highly profitable traffic. The bondholders will naturally point to this traffic as justification for a demand that their claims be paid in full. The other interests involved will point to the isolated position of the branch line apart from the railroad as sufficient ground for attaching very little value to the branch line bonds. Usually a compromise is necessary. Both parties have much to lose and noth- ing to gain by a permanent separation of main and branch lines. Each side will probably "bluff" so far as it dares, and each will finally concede something. The reorganization committee next takes up the claims of the general mortgage bondholders and en- deavors to ascertain how much assets and earnings are left for them after satisfying prior claims. This may or may not be a particularly difficult task; that all de- pends on the nature sr ' complexity of underlying mortgages. The value • the general mortgage bonds will depend to a great extent on the wording of the mortgage. It may cover only such property as was in existence when the mortgage was drawn or may contain an "after-acquired property" clause. Next in order of consideration are the debenture bonds. As these bonds are chiefly claims on earnings, not on assets, the reorganization committee in estimating their value will try to find out how much of the corporation's income is left for them after paying prior interest charges. Finally, the reorganization committee will consider what must be done for the preferred and common stock- liolders. Sometimes in heavily over-capitalized concerns tile common stock will be wiped out absolutely. It is more usual, however, to try to preserve something for 474 CORPORATION FINANCE n .1 the stockholders, with the proviso, usually, that the stockholders pay certain cash assessments. 266. Necessity for fa«A.— Another factor in reorgan- ization not previously mentioned is the current or floating debt of the corporation. This debt may take the form either of loans and medium-term notes having specific security or of unsecured obligations, such as accounts payable. Whether secured or unsecured, this floating debt must be paid in cash; otherwise the creditors of this class will certainly attach the assets of the corporation and effectually prevent the success of reorganization. The only path of escape from the floating debt would be through foreclosure and sale of the property, and this path does not lead to reorganiza- tion. The reorganization committee, therefore, must by some means raise cash sufficient to meet all this floating debt in order that the reorganized company may begin business. Furthermore, there must be enough cash left over to provide the reorganized company with a fair working capital; otherwise it will begin at once to get into new difficulties, as is well illustrated by the career of the Detroit, Toledo and Ironton Railroad reviewed in the last chapter. The committee also, if it desires to have the reorganized company prosper, must see to it that its fixed charges are not larger than its minimum net earnings. We have thus, four main objects of every reorganization: (a), to pay the float- ing debt; (b), to provide working capital; (c), to bring the property up to at least normal efficiency; (d), to reduce fixed charges below minimum earnings. The first three of these objects require cash in large amounts; especially is this true since a company which is approaching insolvency almost always lets its ac- counts payable accumulate, its working capital decline, PRINCIPLES OF REORGANIZATION 476 and its property become impaired. Of course, this may not be the situation at all if the corporation has simply met with some temporary reverse, which brought it into a condition of legal insolvency. In such a case the problems of reorganization are comparatively simple. As a general thing, however, the reorganization com- mittee will find it necessary to raise cash from every available source. As sufficient cash makes the attain- ment of the first three objects named above easy, we may say that the reorganization committee will consider two things of prime importance: first, to raise cash; second. to reduce fixed charges. 267. Raising cash by assessments. — There are three possible methods of securing cash; first, by the sale of some of the corporate property; second, by the issue of new securities; third, by assessments on the security- holders. The first method is almost never practicable. If the corporation possesses outlying property non- essential to its business, it is more than likely that this property has been heavily mortgaged and must be turned over to the mortgagees. The second method, as a general thing, is equally impracticable. Obviously a corporation is not likely to fail unless it has already exhausted its borrowing power, and the sale of the stock of an insolvent corporation is out of the question. These considerations again do not necessarily apply wlien the corporation is not a true insolvent but has merely suffered a temporary setback. Even in true insolvency cash is sometimes raised through consider- able issues of receivers' certificates, which in reorgan- ization are funded along with the first mortgage bonds into a ne first mortgage issue. At times this may be entirely proper and expedient. The efficiency of the corporation's assets may have become impaired and a 476 CORPORATION FINANCE httle cash raised by receivers' certificates may put them into such a condition as to enhance its earning power vastly more than the amount of the extra fixed charges thus imposed. The third method— assessment on the securitv-holders -IS almost universal. Naturally the first and heaviest assessments fall on the common and preferred stock- holders. The possibility of raising cash by this method is limited by the stockholders' estimate of the value of the stock of the reorganized company. They are given the choice either of paying the assessment or of for feitmg their equity in the corporation's assets. If the assessment is made too high evidently the stockholder will choose to forfeit whatever rights remain to him rather than to pay what is asked. The reorganization committee will therefore endeavor to keep the assess- ment down to what it considers a reasonably low figure. Under these conditions the average stockholder almost always finds it worth while to pay his assessment and retam an interest in the company. If he cannot raise the necessary cash he will sell his stock in the open market for whatever it will fetch to someone who has both the courage and the means to meet the assessment. It IS almost always true that the stock of a failed com- pany sells at an abnormally low figure. It is frequently true that a short time after reorganization, the stock of the reorganized company sells at a price considerably above the price of the old stock during the receivership plus the assessment. In other words, experience has demonstrated that the stockholder will d„ better if he sticks with the company than if he forfeits or sells his shares. By paying the assessment be reduces his losses. Sometimes, although rarely, it becomes necessary to PRINCIPLES OF REORGANIZATION 477 assess the junior bondholders also. It seems strange that a creditor of the corporation should ever be forced to pay an assessment in order to remain a creditor, yet the logic of the situation compels the bondholders, when they are thus as ;essed, to accept it with as good grace as they can muster. The bondholders will not ;m" II >u ■ ■ i 1 "I 490 CORPORATION FINANCE count that carried rc!)ate.s by the company as an asset— the recorded earnings of the railroad had been deliber- ately inflated. The annual net earnings, according to the company's reports, had been as follows: 1891 $ 7,631,598 1«92 10,953,896 1«93 12,126,866 Accoiding to Mr. Little they should have been: 1891 $ 5,204,880 1892 7,853,173 1 893 8,085,608 1894 5,956,615 This startling anouncement completely changed the plans which had been formulated. It was evident that H far more radical reduction of fixed charges would be essential. A new committee proposed the second and finel re- organization i)lan in March, 181).). The purposes of this plan were stated to be : (a) To reduce fixed charges to a safe limit; (b) To pro\ ide for future capital requirements; (c) To liquidate the floating debt; (d) To reinstate existing securities upon equitable terms in the order of their priority; (e) To consolidate and unify the system. The committee proposed foreclosure under the first mortgage and the formation of a new railway company which was to issue (a) Commo»' '^tock .Jj^l 02,000,000 (b) .5 per , . non-cumulative preferred stock $111,486,000 ^^ TYPICAL REORGANIZATIONS 491 (c) General 4 per cent bonds .$96,990,582 (d) Adjustment ^ 4 per cent bonds $51,728,310 Old common stockholders were to receive share for share new common stock provided they paid an assess- iiiciit of $10 per share and for this $10 were to receive sio i.i new preferred stock. An underwriting syndicate una -anteed to take the place of defaulting stockholders. The old general mortgage bondholders were given 75 per cent of their holdings in new general mortgage bonds and 40 per cent in adjustment bonds. The .second-mortgage bondholders were to be assessed $4 for every $100 of their holdings and were to receive 113 per cent in new preferred stock. It was provided that ad- ditional bonds under the general mortgage might be is- sued at the rate of $3,000,000 per year up to a limit of .^30,000,000 and that thereafter additional adjustment bonds might be issued at the rate of $2,000,000 per year lip to a limit of $20,000,000. The St. Louis and San Francisco Railroad and some other smaller subsidiary lines were not included in the reorganization plan, but were turned over to their own 1 ondholders. It will be seen that this plan accomplished the Ave purposes named by the committee. It brought about a very radical reduction of fixed charges affecting even tile first mortgage bondholders. It gave room for ad- ditional issues of bonds under certain restrictions to jirovide for future improvements and extensions. It lirought in about $14,000,000 cash to meet current ob- 1 ignitions. It retained the relative claims of the various security-holders to the road's assets and earnings. Fi- nally, by lopping ofiP nonessential lines, it helped to con- !>ulidate and unify the system. iThe so-cnlled adjustment t>onds wetv in reality Income bonds. n i;f 492 CORPORATION FINANCE The principal opposition to the plan came from some of the minority stockholders who believed that the for- mer management had proved untrue to then interests and that this management had not been entirely elimi- nated. This opposition, however, was unable to muster enough votes to defeat the reorganization plan The high credit and prosperity of the Atchison in the last few years indic.:tes that the reorganization was car- ried through on sound lines. There has never been a question raised since the reorganization but that the com- pany could easily meet all its obligations. The road has been greatly improved and strengthened physically and earnings have grown far more rapidly than expenses. The changes in the decade following 1897 are shown in the following tabulation: 1897 1907 ^^'^^age 6,479 9,273 Gross earnings $30,621,230 $93,683,407 Net earnings 7,754,041 32,153,692 Annual surplus 1,452,446 21,168,724 Katurally the market price of the Atchison securities has steadily risen. Nobody suffered in the end from the reorganization. On the contrary, all the security- holders who retained their interests have seen them steadily appreciate in value. The Atchison reorgan- ization of 1895 may well be taken as a fair type of a highly successful readjustment of charges. 274. Growth of the Rock Island StjHtem.—We will consider now an entirely different kind of reorganization —one in which not necessity but desire for quick specu- lative profits was the controlling factor. In order to understand the situation it will be well to review hastily th« history of the Rock Island Railroad. The line was completed between Chicago and Rock Island in 1854, TYPICAL reorganization: 493 and from Rock Island to Council Bluffs in 1869. The company was prosperous almost from the beginning. Its road ran through a well-settled and fertile territory where traffic was large and certain and construction was cheap. Capitalization was very moderate, especially as compared with many other western railroads whose con- struction was paid for not in cash but in extravagant allotments of stocks and bonds to the contractors. In 1880 tlie road was earning so much and paying such large dividends that it seemed desirable to water the stock. This was accomplished by an exchange of the stock of the Chicago, Rock Island and Pacific Railroad Company for the stock of a new Chicago, Rock Island and Pacific Railway Company in the ratio of about two to one The new Railway Company also took in some other properties previously i trolled by the Railroad Conjpany, and was, therefore, in form, though not in fact, a consolidation. The new railway company d'i not continue to be as prosperous as it was in the beginning. The middle '80s were hard years for western railroads, for all of them were forced into competitive railroad building, which for the time being was largely unprofitable. The Rock Is- land dividends and the market prices of the road's se- curities suffered severely. Nevertheless, the road's man- a^rcnient was conservative and able and the company not only survived, but even paid dividends through the try- ing depression of 1893-1897. After 1897 the road shared in the renewed prosperity of the United States and began in its conservative way to plan for further expansion and development. In 1901, however, the conscT^atism of the company suddenly disappeared as if the earth had swallowed it. Directors and officers who had served for years and dec- i 494 CORPORATION FINANCE ades were removed, and new men — younger men of an entirely different type— were put into their place. With the older m iiere vanished also the former ideals and purposes of i,.e company and a very different path toward success and prosperity was entered. The reason for these changes is to be found in the fact that during 1900 and 1901 a small coterie of speculative promoters known as "the 3Ioore crowd," of whom we have heard in connection with the formation of the United States Steel Corporation, had quietly bought a majority of the common stock in the Wall Street market. The process of buying had been carried on so patiently and warily that it was hardly suspected and the price of the stock was very little increased. The financial world first got an inkling of the situation when in April, 1901, JMr. William II. Moore and Mr. D. G. Reid were elected to the directorate. The principal men in the new party, which now rap- idly assumed full control of Rock Islands affairs, were Mr. W. H. Moore, his brother Mr. J. H. Moore, Mr. D. G. Reid and Mr. William B. Leeds. No one of these men had had any experience -n railroad man- agerial positions and none of them had ever been prom- inently identified before with railroad operations. All of them, however, were bold and successful speculative promoters and all of them were well versed in the ways and wiles of the speculative security market. Their successes had been gaineil in the promotion of the com- panies which were taken into tiie United States Steel Corporation. Their interest in railroad affairs, there- fore, it was easy to see, was entirely financial. They did not take, and as a matter of fact never have taken, any active part in the operating management of their road. All their energies have been given to maintain- TYPICAL REORGANIZATIONS 495 ing its financial status and at th« same time directing for their own benefit its financial operations. In the two annual meetings of June, 1901, and June, 1902, the stockholders increased their capital stock from s^jO,000,000, at which it had been placed in 1880, to $7.5,000,000. Also the stock of some smaller roads, in- cluding the important Choctaw, Oklahoma and Gulf, was bought by the Rock Island, payment being made partly in cash and partly in Rock Island securities. 275. Rock Island reorganization. — The "Moore crowd" now brought forward the scheme of reorganiza- tion which they had devised primarily, it appears, with a view to selling a large part of their stock without los- ing control. The plan involved two holding companies and a double exchange of securities. It is perhaps the most complex and ingenious scheme on a larjre scale for attaining the purpose just named that has yet been suc- cessfully put through. The operating company under this scheme remained the same as it had been since 1880, the Chicago, Rock Island and Pacific Railway Company. The first hold- ing company (whose prime object, apparently, was to meet any legal objection that might afterwards arise to the consolidation of competing railway companies) was the Chicago, Rock Island and Pacific Railroad Com- pany, incorporated in Iowa. The second holding com- pany was the Rock Island Company, incorporated in Xew Jersey. The outstanding bonds and other secu- rities of the old "railway" company were left undis- turbed. The new "railroad" company issued stock to the amount of $75,000,000. The Rock Island Company issued .$96,000,000 common and $54,000,000 preferred stock. The last-named company then delivered $127,- ■^00,000 of its preferred and common stock to the Chi- 'I 496 CORPORATION FIXAxNCE • n cago, Rock Island and Pacific Kaihoad Company ol Iowa in exchange for all the $12.5,000,000 common stock of tiie Iowa company. After this transaction the last- named company had in its treasury most of the common and preferred stock of the Rock Island Company; it also had the right to issue .$75,000,000 bonds. It now of- ferred for each share of the railway company's stock, one share of its own 4 per cent bonds, one share of Rock Island Company coiimion stock and $70 of Rock Island Company preferred stock. These bonds were to be col- lateral trust secured by the deposit of all the "railway" company shares obtained by the "railroad" company. Thus the "railway" stockholders would, in case of de- fault, get back exactly the stock Mhich they had ex- changed. The "railway" stockholders readily accepted this proposition, which was ecjuivalent to giving a large stock dividend, and figured that even if they retained in their own hands all the securities which they received by the exchange they could not lose and might benefit by the exchange. If they did not care to retain all the secur- ities they received, they could easily dispose of their Rock Island common and preferred shares and thus get a large inmiediate cash payment. We shall understand better why the "Moore crowd" desired this reorganization if we examine the charter provisions of the Rock Island Company. One of the important clauses reads as follows: There shall be five classes of directors. The first class shall contain a majority of the whole number of the directors as fixed at any time by the by-laws. The holders of the preferred stock shall have the right to the exclusion of the holders of the com- mon stock to choose directors of the first class. TYPICAL REORGANIZATIONS 497 Thus a majority of the Rock Island Company preferred stock could elect a majority of the board of directors of that company and this board, through the company's holdings of "railroad" stock could completely control all the affairs of the Chicago, Rock Island and Pacific Rail- way Company, the operating company. Now the out- standing preferred stock of the Rock Island Company is only a little over $4.5,000,000; therefore the owner- sliip of approximately $22,.300,000 par value of this preferred stock would be sufficient to give complete con- trol over the whole Chicago Rock Island and Pacific Railway Company, having a total capitalization of about $225,000,000. Indeed, if this $22,500,000 preferred stock were carried on a margin of $20 a share, $5,400,- 000 cash would suffice to secure control. The advantage of this reorganization to the "Moore crowd" may readily be seen if we compare the price they paid for control in the "railway" company with what is necessary for control in the Rock Island Company. As- suming that they bought all their stock outright and paid in the neighborhod of 140, which was not far from the average market price while they were buying control of the "railway" company, their investment would have heen $52,500,140. In exchange for this under the re- organization scheme they obtained stock and bonds which at the market prices of the early part of 1908 were worth : -7 I I Rock Island Company common $18,375,049 Rock Island Company preferred 21,918,808 Chicago, Rock Island & Pacific Railroad Co. 4% bonds 32,766,712 Total $73,069,569 C— VI— 32 498' CORPORATIOX FINANCE 'J ■ As the preferred stock was all that was necessary for control, tiiey were left free to sell their bonds and com- mon stock, and it will be observed that this sale would have brought to them just about as much cash as they had originally paid for conti il of the Chicago Rock Island and Pacific Railway Company. In other words control of the Rock Island ConipanV, carrying with it control of both subsidiary companies', cost them in cash next to nothing. In addition, the Rock Island Company later obtained control of another great railroad system, the St. Louis and San Francisco. The Rock Island directors ac- complished this by offering to exchange for each share of common stock of the St. Louis and San Francisco $60 par value in the common stock of the Rock Island Company and $60 par value in a new issue of .5 per cent gold bonds, the bonds being secured by deposit of the "Frisco" common stock as collateral. ' It Avill be ob- served that this great addition to the Rock Island system did not disturb in any way the controlling force of a majority of the relatively small issue of Rock Island Company preferred stock. Thus by reorganization and purchase the "JMoore crowd" with a very small expendi- ture of cash, have under their control a system with an aggregate mileage of 14,270 miles. 276. Westinghouse reorganhation.— This reorgani- zation of 1908, although not essentially different in I)rinciple from the Santa Fe reorganization, introduces some new features that are worthy of attention. Owing to space limits it is necessary to confine our attention to these peculiar features. This is .1 typical instance of a company which was strong in equipment and ability and which" was doing a large and profitable Imsiness and yet suddenly found i ;il TYPICAL REORGANIZATIONS 499 itself technically insolvent. Its difficulties resulted from a lack of sufficient working capital. The company's assets were too largely fixed, and quick assets were re- latively too small, considering the amount and char- acter of the company's business. In prosperous times the company was able to prosper with the rest of the country. In the period of strain, however, it was very quickly stripped of cash and, being unable to obtain capital, necessarily went to the wall. It naturally followed that the most active and influ- ential body of creditors in planning the reorganization were merchandise creditors; next to them came the bank creditors ; the bond and note bolders were little consulted and their claims were not disturbed. The problem before the reorganizers of this company differed from that which confronts most reorganizers ill that the company needed simply to be tided over a bad I)cri()d. Xo one apparently felt any question as to the renewed prosperity of the company as soon as normal business conditions should be restored. The permanent fixed charges were met even during the period of re- organization. All that was necessary, therefore, was to take care of the floating debt. The main elements in the floating debt were notes payable to banks, $7,919,000, and merchandise debts, •*'<4,762,000. After much discussion and consideration of two or three plans, the merchandise creditors, through tlieir committee, finally agreed to accept new common stock of the company at par in full settlement of their claims on certain conditions specified below: (a) Such of the bank debt as would not accept new common stock to be provided for partly by convertible bonds of an issue already authorized previous to the I 11 i 500 CORPORATION FINANCP: u I bankruptcy and partly by 5 per cent notes running for an average period of 5 years. (b) The existing issues of convertible bonds, deben- ture certificates and collateral notes not to be disturbed. (c) The preferred and common stockholders each to pay a 25 per cent assessment in cash. It will be observed that none of the sacrifices under this plan were to be made by the bond and note holders. Indeed, it would have been impossible to impose sacri- fices upon these classes or to refuse or modify their claims, for in that case they would certainly have been prompt to bring foreclosure proceedings, buy the prop- erty at a forced sale and thus reduce the unsecured claims and wipe out the stockholders. The bond and note holders, in other words, were in an impregnable position because the company, even in the worst times, was more than earning the permanent fixed charges. The bank creditors came next in order of preference, and their only loss, therefore, was an extension of time of payment of their obligations. The unsecured credit- ors, knowing the weakness of their position, were willing to accept stock in payment. Under the circumstances it was both expedient and just that the stockholders should be called on for particularly heavy assessment. It was expedient because the prospects of the company were excellent and the stock, even through the reorgan- ization, sold at fairly good prices. The stockholders, therefore, could well afford to pay this assessment rather than forfeit the stock. It was just that they should pay because the difficulties of the company could have been preventeu if less had been paid out in dividends and more cash had been reserved for an emergency. Such protests as were made by the stockholders for these TYPICAL REORGANIZATIONS 501 reasons proved unavailing and the plan as outlined above has been carried into effect. The company operating under this plan has re- established itself as a firm and prosperous corporation. There was no reason to fear the result. The plan pro- vided for all the floating debt incurred uefore the re- organization, it enlarged only very slightly the fixed eharges of the company, and it introduced new and conservative elements into the management of the com- pany. The cash working capHal on hand after reor- ganization was sufficient for the needs of the next two years, even if business had been very poor indeed. In addition it was at once clearly stated on good authority that dividends on the new common stock of the company would not be paid for at least two years, thus giving time for the accumulation of a substantial surplus. These drastic measures proved effective in strengthen- ing the con'oany's financial position and enabling it to fro forward steadily, almost as if no setback had oc- curred. ¥1 CHAPTER XXXII CANADIAN REORGANIZATIONS 277. Canadian rcorgankatims and sacrifice of secw rities.—Several reorganizations of important Canadian corporations have already been discussed in this vohime Competent financial authorities, both in Canada and Great Britian, have hinted that company reorganiza- tions m the Dominion have been too numerous and that primary financing should be effected with such monetary modesty as will increase the safety of all the securities, especially the bonds. Bondholders and shareholders of several corporations have undoubtedly had to sacrifice a considerable portion of their holdings in order to see proposed reorgani::ation schemes effected. Almost every prominent financial visitor from Great Britain from whence so much capital is obtained for Canada,' issues a warning on this point and also on the evils of over-capitalization. These are matters which demand the serious attention of Canadian financiers. 278. Txco Canadian reorganizations.—We may brief- ly examine the reorganization schemes of two Canadian corporations. The Canadian Cereal and Milling Com- pany, which at one time was a part of the International Milling Company of Moose Jaw, found it necessary to reorjranize in 1912. A new company, the Canadian Cereal and Flour Mills, Limited, was formed. Addi- tional working capital was obtained by means of the issue of $250,000 seven per cent cumulative preferred 502 CANADIAN REORGANIZATIONS 503 stock. The new company was given the following cap- italization: Stock Authorized Issued Preferred $2,000,000 $ 750,000 Common 2,000,000 760,000 $4,000,000 $1,600,000 This compares with $8,000,000 capital of the old com- pany, the assets of which have now been transferred in consideration of $500,000 preferred shares of the new company. The ordinary shares were used as a bonus to the imderwriters in consideration of their taking $250,000 of preferred at par. The Dominion Sawmills, Limited, a merger of timber properties of British Columbia, was reorganized in 1912. The company's bonds were practically all held in Great Britain. A public issue of £1,027,500 seven per cent participating cumulative preference shares at 97^ was made in the London market in July, 1911. In the scheme of capital reconstruction of this company the ex- isting six per cent first mortgage debentures, of which there were outstanding £930,000, part of a total of £1,000,000, were exchanged for an equivalent amount of five per cent debenture stock in the new company, to be known as the United Sawmills and Timber Company, while a bonus of three fully-paid $1 shares in respect of each £20 of debentures — say fiften per cent — were also allotted. The $2,000,000 of cumulative seven per cent partici- pating $100 preferred shares were replaced by an equiv- alent amount of six per cent income debenture stock, to- gether with a bonus of four per cent in fully-paid $1 shares of the new company. The $4,201,200 of $100 I 504 CORPORATION FINANCE shares exchanged on the basis of six new fully-paid $1 shares in respect of every $100 share now outstanding. The capital of the old company was $5,000,000 seven per cent participating cumulative preference shares, $5,000,000 ordinary shares, and £1,000,000 six per cent first mortgage debenture bonds. 279. Intricate financing of a reorganization. — One of the largest and most important reorganizations in Can- ada of recent years was effected in 1913, when the Span- ish River Pulp and Paper Mills, Ijimited, took over the Lake Superior Paper Company, Limited, necessitating a reconstruction of finances. The directors and share- holders of the Spanish River Company approved a plan authorizing the acquisition of the total issued capital stock of the Lake Superior Paper Company, Limited, consisting of $3,000,000 in preference shares and $5,- 000,000 in common shares. Spanish River shareholders authorized the directors to effect an agreement between the company and a sjti- dicate, whereby the syndicate agreed to deliver to the company 30,000 preference shares of the Lake Superior Paper Company of the par value of $3,000,000 and 50,- 000 common shares of the par value of $5,000,000 and to pay in cash to the company the sum of $900,000 in certain fixed instalments in consideration of the issue to the syndicate of 37,000 fully-paid preference shares of the company of the par value of $8,700,000 and 50,- 000 fully-paid common shares of the par value of $5,- 000,000, and the guarantee by the company of the pay- ment of the principal and the int( rest and sinking f mid upon existing issue of first mortgage bonds of the Lake Superior Paper Company, amoimting to $50,000,000. It was also proposed to increase the capital stock of the Spanish River Company to $20,000,000 by the crea- CANADIAN REORGANIZATIONS 506 tion of 70,000 additional preference shares and 60,000 additional common shares. Under the arrangement $900,000 cash was added to the working capital of the Spanish River Company. This is how the securities of the Spanish River Com- pany stood before and after reconstruction. In 1912, the Spanish River Company absorbed the Ontario Pulp and Paper Company, Limited. SECUKITIES OF THE SPANISH KIVER PULP AND PAPEK COMPANY, LIMITED, BEFOEE KECONSTBUCTION Authorized Issued Bonds, 6% $2,500,000 $2,425,000 Ontaria Pulp 1,500,000 1,500,000 Preferred Stock 7% 8,000,000 8,000,000 Common Stock 4,000,000 3,000,000 SECCEITIES OF THE S ANI8H HIVEE PULP AND PAPEK COMPANY AFTER RECONSTRUCTION Authorized Issued 6% first mortgage bonds ^^'^^'T^ Redeemed by sinking fund '^°'""" $2,425,000 6% bonds of Ontario Pulp and Paper , ,nn noo ^ T • 't.^ 1.600,000 1,600,000 Company, Limited ••• i.«w,www (Guaranteed by the Spanish River Pulp and Paper Mills, Limited) C% bond. I..k. Superior Pap,r con. ^ pany. Limited • • • "' ' (Guaranteed by the Spanish River Pulp and Paper Mills, Limited) 7% .„,.,uUtivc partidp..i.g prefer- ^_^^^ coZoflU:::::::;:::::::.- .omm s^m I 50G CORPORATION FINAxNCE The preference shares issued in exchange for the Lake Superior Paper Company shares were not to carry divi- dends until after July 1, 1014. The total fixed assets of the Spanish River Pulp and Paper Company, including the Lake Superior Company plants, but excluding all timber areas, amount to ap- proximately $13,000,000, while the total mortgage in- debtedness against these assets consists of $8,925,000 six per cent first mortgage bonds. The surplus of current liquid assets, including pulp wood, paper, accounts, and the like, over and above current liabilities, after deduct- ing the additional working capital, amounts to $2- 100,000. The company financing this reorganization made an arangement with the syndicate from which the Spanish River Pulp and Paper IMills, Limited, purchased the shares of the Lake Superior Paper Company, Limited, for the distribution among the preference and common shareholders of the Spanish River Pulp and Paper Mills, Limited, of $000,000 of the common stock of the Span- ish River Pulp and Paper 3Iills, Limited, received by the syndicate on the sale of the shares of the Lake Su- perior Paper Company, Limited. Upon this distribu- tion, shareholders received a bonus amounting r/ithont adjustment of fractions, to approximately ten per cent of their holdings of the preferred stock of the Spanish River Pulp and Paper Mils, Limited, and to twenty per cent of their holdings of common stock of that com- pany. 280. Further financing.— Sm further financing of this somewhat intricate reorganization is explained in the following quotations from letters issued by the sec- retary of the company and by the vice-president and general manager, respectively: CANADIAN REORGANIZATIONS 507 '% In the circular issued in July last it was proposed to raise additional working capital by a further issue of preferred >Iiares, but this plan of ^nancing has been changed, and an issue of term notes submitted, this issue providing the necessary capital for the re(juirenients of the company, it being intended that during the currency of these notes, no dividends on the company's capital stock should be declared or paid. The re- arrangement of the finances of the joint companies has been effected by large financial interests in London, England, who deem it advisable to reduce the number of the board of directors to seven. The preparation and publication of the report have had to be deferred pending a settlement of the basis of the new finan- cial arrangement for the company. These have now been completed and will take the form of an issue of £300,000 of term notes, which have been underwritten at 95 by the London finan- cial group, consisting of Messrs. Robert Fleming and Co., the British, Foreign and Colonial Corporation and their friends, the Canadian Agency, Limited, and Messrs. R. Niveson and Company. The proceeds of this issue will put the company in funds and enable its operations to be carried on successfully. 281. Financing 'which raised problems. — Another im- portant reorganization was that of the Canadian Coal and Coke Company. This caused considerable criticism and comment. The plan of reconstruction called for the creation of an issue of $4,000,000 seven per cent cumulative preference stock of the holding company which was to be offered par for par in exchange for Ixmds both of the Canadian Coal and Coke Company and of the subsidiary companies then in the hands of the public. All bonds still remaining in the treasury of the liolding company, both its own and those of subsidiary companies were to be cancelled. In a letter addressed to the Iwrndholders of the com- 508 CORPORATION FINANCE panics concerned, the secretary of each of them stated: The companies now require about $1,500,000 to pay off their existing liabilities and to carry on the works now in progress It has been found impossible, in the prevailing financial con- ditions, to obtain the necessary funds by the sale of bonds ranking pari-passu with the existing issues. The work in progress has recently been carried out on the personal credit of the directors; but the time has arrived when the plan above outlined IS rendered absolutely necessary. This plaa will, we believe, protect all existing investments in the several com- panies, and place the consolidated company in a position to earn and pay at an early date seven per cent dividends on the cumulative preference stock now proposed to be cr-ated. The co-operation of all the bondholders and shareholders of the five companies is earnestly solicited in carrying out the proposed plan of reorganization and consolidation. A majority of the bondholders of each of the four operat- ing companies have approved of the plan of reorganization recommended by the directors of the several companies. The result of carrying through the proposed plan will be that the present bondholders will have a preferred claim on the earnings of the company for their investment and the only charge ranking prior to the preferred shares will be the charge given for the new money necessary to bring the combined under- takings to complete success. The same letter detailed the various obstacles and difficulties encountered by the companies and stated the basis of the transfer of the subsidiary companies and the reorcranization and consolidation of the undertakings of those companies in the Canadian Coal and Coke Com- pany, Limited, as follows: 1. That the holders of the six per cent mortgage bonds of the five above-named companies should convert the bonds held by them, on the basis of par of exchange, into CANADIAN REORGANIZATIONS 509 seven per cent cumulative participating preference stock of Canadian Coal and Coke Company, Limited. 2. That for the purpose of effecting this conversion the Canadian Coal and Coke Company, Limited, should create $4,000,000 par value of its seven per cent cumu- lative participating preferred stock. 3. That all the properties and assets of the companies, other than the Canadian Coal and Coke Company, Lim- ited, should be conveyed to and vested in the Canadian Coal and Coke Company, Limited, freed from the charges and liens created by the outstanding bonds of the respective companies. 4. That the Canadian Coal and Coke Company, Lim- ited, should assume, pay and perform all the debts, liabilities and obligations of each of the four companies whose properties are so conveyed to it, other than the liabilities created by the outstanding bonds of those com- panies. 5. That the Canadian Coal and Coke Company, Lim- ited, should issue to each holder, other than itself, of or- dinary shares of the capital stock of the four companies operating, vi^hose properties are so conveyed to it, fully- paid ordinary shares of the capital stock of the Cana- dian Coal and Coke Company, Limited, on the basis of par of exchange. 6. The entire property and assets of all the four oper- ating companies would then be vested in the Canadian Coal and Coke Company, Limited, free from any ciiarges and liens, except such as may be created for the purpose of liquidating the current debts and liabilities if the five companies above mentioned. 282. Question, of bondhohlerg' majorily. — Much criti- cism folowed the announcement of this plan, both by the Canadian financial press, by sections of the investing () 510 CORPORATION FINANCE public and by some holders directly interested. The chief bone of contention appeared to be that a bare ma- jority of the company's bondholders could cancel the mortgage, the minority having to submit (although the mortgage was common to all) and accept the proposed stock issue. Of this phase, the Montreal Finan^nd Times said : We arc entirely out of sympathy with the altogether too prevalent practice among Canadian industrial companies of exchanging bonds for secondary securities such as income bonds or preferred stock whenever it becomes inconvenient to carry them as a first mortgage claim any longer. The practice of conversion is being so general that it is apparently regarded as a matter of course not only by directors and "controlling in- terests," but by the investing public. If the thing goes on much longer it will be impossible to issue standard bonds in Canada, or at least to have them accepted, and valued, as such by the investor, for it is becoming a recognized thing that as soon as the money is safe in the treasury and the bonds are nicely dis- tributed and the underwriters have "got from under," the mort- gage is liable to be torn up with the utmost complacency and the supposed mortgage-holders to find themselves put off with a very secondary security. We have no special opinion to express regarding the pres- ent re-financing plans of the Canadian Coal and Coke directors, the latest management to adopt the policy to which we take exception. We are discussing the system in a general way. The Canadian Coal and Coke Company is only following the prevailing practice — taking the line of least resistance, tread- ing a path which has been l>eaten smooth for it by many similar corporations. But we do hope that in future the bondholders of Canadian industrial corporations will see to it that they arc getting the kind of protection which their bonds purport to offer. 283. As to a "hare majoriti/."—Thls stricture brought CANADIAN REORGANIZATIONS 511 a reply from Mr. C. H. Cahan, K.C., a distinguished Montreal lawyer, who in a letter to the same paper, said: I would like to say that the particular clauses of that deed which you describe as "a flagrant example" are drawn in form and terms approved by the authorities of the London Stock Exchange. Palmer, the acknowledged English authority, says of these provisions that: "Unless the majority is thus enabled, in special circumstances, to determine what is to be done on behalf of the whole body, the minority, however small, is placed in a position to dictate to the majority, and the interests of the whole of the majority imperilled by the ignorance, perverse- ness, fraud or cupidity of an insignificant minority, or the de- lay which would result if it were necessary to obtain the con- sent of every debenture holder." Palmer adds that the draftsman who omits to insert some such provision, runs the risk of being accused of neglecting the best interests of the bondholders; and in view of the ab- sence in Canada of a comprehensive insolvency act, and of the ixisting state of our law respecting the voluntary liquidation of companies, even stronger language might very appropriate- ly be applied to any professional draftsman in this province who would exhibit, by such omissions, his own inexperience or negligence. In the case of the trust deed and mortgage of the Canadian Coal and Coke Company, Limited, a quorum consisting of the holders of at least fifty per cent of the par value of the bonds outstanding must be present at the meeting of the bondholders, and if a poll is demanded, the resolution amending the pro- visions of the trust-.U-ed and mortgage must Ik- passifl by three-fourths of the votes given on such poll. Holders of over ,,r^v-]mU of the outstanding bonds may defeat the proposed pro- .Tcdings by merely absenting themselves from the n.eeting; and, in any case, three votes must be polled in favor of the resolu- tion to every single vote polled against it. 512 CORPORATION FINANCE As to the merits of the reorganization scheme adopted by the Canadian Coal and Coke Company, Limited, and by its four subsidiary companies, it suffices to say that out of the several millions of bonds represented at the four meetings of bondholders, only one holder of $25,000 par value of bonds polled his vote against the scheme proposed. I may add that the trust deed and mortgage, above re- ferred to, was not drafted by me and that I have written the above on behalf of clients who are large holders of these bonds, and who do not think that your criticisms are well founded so far as they were applied by you to the terms of the trust-deed and mortgages of the Canadian Coal and Coke Company, Limited. The financial journal in printing this letter replied with the f oUowmg brief comment : We cannot, however, agree with Mr^Cahan that the emi- nent English authority, Palmer? whom he cites, had any such conception of the rights of majority as is implied in the present procedure in the Canadian Coal and Coke Company, or that the fact that only one bondholder present at the meet- ing last week voted against the conversion proposals, is any proof that those proposals were in the interests of the bond- holders as a whole. These illustrations show the numerous phases of cor- poration reorganization in Canada. It is also seen that a keen interest is taken in every move of promoters and financiers in that coimtry. So far as the Canadian Coal and Coke reorganization is concerned, the company was in trouble, and it is difficult to see how they could have escaped otherwise than they did. At the same time, the incident raised important points for consideration of cor- poration financiers. QUIZ QUESTIONS {The numbers refer to the numbered sections in the text.) CHAPTER I 1. What are "non-stock" corporations? 2. What are "stock" corporations? For what pur- pose are they usually organized? 3 What is the most striking distinctive feature of the corporation compared with other forms of business association? 4. In what sense is "corporate entity a fiction? 5. In what nations have corporations been prominent features of business life ? 6. Show briefly how the use of corporations has spread in recent years. . . 7. State how and why the corporate form is well adapted to raising large amounts of capital. 8 In what sense is a corporation more permanent than a partnership or than individual proprietorship? IIow is this attribute an advantage? 9 Show how and why the corporate form better lends itself to an efficient, centralized control of a bus- iness than the partnership form. 10 Can an interest in a corporation be more readily transferred from one person to another than an mterest in a partnership? Why? C— VI— 83 518 5U CORPORATION FINANCE 11. What is the principle of limited liability of cor- porate stockholders? Is the principle universally ap- plicable? Name the principal advantages of the cor- porate form of organization. 12. Name the principal disadvantages of the cor- porate form. Mention two kinds of enterprises in which these disadvantages outweigh the advantages. CHAPTER II 13. What are the legal instruments that define and control a corporation's activities? 14. How far is the common law applicable to cor- porations ? 15. Is it important to consider the provisions of the constitution of the state in which a corporation is formed ? "Wliy ? 16. Discuss the relative advantages of two methods of securing „ ^thority to incorporate. 17. Wliat is a charter? What is a certificate of in- corporation? What are articles of incorporation? What information should a charter ordinarily contain? 18. Draw up a charter for a company (imaginary or otherwise) following the model given in the text. 19. Can a new corporation assume a name which has already been adopted by a corporation chartered in some other state? Do any of the states prescribe "ny part of the names of corporations organized under their laws? 20. Why is it important to state the purposes for which a company is formed fully and carefully in the charter? Why did the New Jersey Court of Errors QUIZ QUESTIONS 515 and Appeals hand down a decision adverse to the rail- road company in the instance cited in the text? 21. What is the minimum number of incorporators in most states? 22. What topics are usually considered in the by- laws of a corporation? Draw up a brief set of by-laws for a company (imaginary or otherwise) following the model given in the text. 23. What are the usual by-law provisions as to stock, meetings, officers, dividend payments and by-law amendments ? How may new rules of action be adopted without the formality of amending the by-laws? ^ \\ CHAPTER III 24. What are the four fundamental rights of the body of stockholders of a corporation? May a board of directors ordinarily sell the assets of their corpora- tion without the consent of the stockholders? 25. Name the four fundamental rights of each in- dividual stockholder. What is a proxy? Write a proxy conferring the right to vote in favor of a proposed amendment at a special meeting called for the purpose of considering the amendment. When is a proxy irre- vocable? 26. Can stockholders force a board of directors to declare a dividend, provided the company is admitted to have earned large profits? What is meant by the "right to dividends"? 27. Does a stockholder have a legal right to inspect the books of his company? How does the movement in favor of publicity of accounts work in favor of stockholders? 516 CORPORATION FINANCE 28. What are the two chief universal liabilities of stockholders ? 29. What are the two classes of creditors ? Has either class a right to interfere in the internal management of the debtor corporation? 30. What are "dummy" directors? How are they sometimes kept under control? 31. What in general are the powers of a board of directors? May those powers be delegated? Under what circumstances do directors become liable for loss suffered by their corporation? 32. Why is it stated in the text that the corporate form is "almost ideally adapted, so far as efficiency and economy go, to the conditions of present-day industry"? CHAPTER IV 33. By virtue of what legal principle do corpora- tions chartered in one state of the Union extend their operations to other states? Give the gist of the de- cision of the Supreme Court in the case of The Bank of Augusta vs. Earle. 34. May a state regulate in any manner corporations doing business within its borders, but chartered in an- other state? If so, how? 35. Give three reasons in favor of securing a charter from the state in which a corporation has its principal office. Why are not these reasons decisive in all eases? 36. From the tables given in the text estimate the organization fees and the annual franchise taxes of a corporation with $50,000 capital stock in New Jersey, New York, Delaware, Maine and South Dakota. What QUIZ QUESTIONS 617 other expenses will probably be incurred in starting a new company? 37. Name four states which have liberal incorpora- tion laws. 38. Why is it desirable to secure a charter in a state which has an established and well-adjudicated corpora- tion law? 39. Name three states which bear poor reputations as states of incorporation. Name three states which bear good reputations. 40. If you were about to incorporate a manufactur- ing company, located in Massachusetts, designed both to operate a plant and to buy up the scock of several competing companies, the capitalization to be $2,000,- 000, in what state would you take out a charter? What other states would you be inclined to consider favorably? Base your answer on the data given in the text and state your reasons fully. An excellent method of get- ting familiar with the main features of the various state laws is to make up a number of simUar hypothetical cases and consider each one carefully. 41. What is a "subscription contract'* ana when is it used? 42. What is meant by the statement that a capable lawyer can generally fit out any corporation with the exact powers and privileges that will prove most ad- vantageous. . . 43. Discuss the Companies' Act of the Dommion. How is a charter forfeited? What are the provisions of the Companies' Act in regard to liability of share- holders? What are the powers and limitations of the directorate under this act? . * 44. What conditions complicate the incorporation of companies in Canada? 518 CORPORATION FINANCE CHAPTER V 45. In your opinion should stock certificates be maJe fully negotiable? Give your reasons in full. 46. What is the "par value" of a share of stock? The "market value"? Is there any good reason for the custom of giving shares a nominal value in money? 47. Define fully "preferred stock," showing wherein the preference may consist. 48. Name and discuss four uses of preferred stock. What is "voting stock"? 49. What is the object of "cumulative voting"? How is that object attained? 50. What is a "voting trust"? What is the usual plan of organization? What is the usual object in establishing a voting trust? 51. Describe the formation of the Dominion Sttji and Coal Corporation, Ltd. In your opinion was this the best way to settle the trouble between the two orig- inal companies? CHAPTER VI 52. Define "quasi-public corporations," "private cor- porations," "close corporations." 58. What is a "parent company"? ^Vllat is the dif- ference between a "parent company" and a "holding company"? 54. Why does a holding company usually aim to se- cure more than a bare majority of the stwk of its subsid- iary companies? What is the distinction between the ordinary balance-sheet of a holding company and its "consolidated" or "general" balance sheet? QUIZ QUESTIONS 519 55. Under what plan were the early "trusts" or- ^ranized? Why do most "trusts," so-called, now take t\ie form of holding companies? 5(5 Taking the chart of organization of the Inter- horough-^letropolitan Company, show what relation of ownership and control exists between the New York City Railway Company and the Interborough-Metro- politan Company. i, j u 57 How many companies are directly controlled by the Standard Oil Company of New Jersey ? How many indirectly? CHAPTER VII 58. Enumerate from memory the principal topics covered in the first six chapters of this book. 59. What are the six sources of corporate funds? In what sense may profits be called a possible source of funds? In what sense do trade creditors supply cor- porate funds? Can a corporation manager or promoter ordinarily sell the stock or bonds of his company to a bank? If not, why not? 60. What are the important classes of mvestorsf 61. How would you distinguish between an "invest- ment" and a "speculative" security? 62. What are the important classes of buyers of speculative securities? 63 Why is it desirable that a corporation should borrow a considerable proportion of its funds? What proportion of the funds used by the five companies named in the text are borrowed? 64. What kinds of securities ordinarily will a cor- l)()ration offer in order to secure funds from (a) trade 520 CORPORATION FINANCE creditors, (b) banks, (c) the investing public, and (d) the speculative public^ Name and describe the six im- portant groups of corporate assets. What securities may be issued corresponding to each group? In deter- mining what securities a corporation may "jsue, are the earnings of the corporation, as well as its /issets, taken into consideration ? If so, how i 05. What proportion of the corporate capitalization for the year mentioned in the text is invested in corpo- rations capitalized at more than a million dollars? 66. What is the Canadian attitude toward the par- ticipation of banks in the flotation of security issues? What is the position of the bank if the flotation is suc- cessful? Unsuccessful? 67. How does a Canadian bank make loans to cor- porations? 68. What conditions make it comparatively safe for a Canadian bank to make lai^je loans to corporations? CHAPTER VIII 69. How are corporate funds secured from trade creditors? What two qualifications limit the general statement that a corporation should buy as much as it can on credit? What is a conservative percentage of accounts, bills and notes payable to quick assets? 70. What are the main points that will be considered by a careful banker in determining how much credit he is willing to extend to a corporation? 71. What are the essential features of a valid nego- tiable promissory note? What is the chief objection to using short or medium term notes sold to the public as a means of securing corporate ftmds? Under what QUIZ QUESTIONS 521 circumstances is it good financial policy for a corpo- ration to issue such notes? In general should the short- lime obligations of a corporation ever be based on the corporation's permanent assets? 72 Under what conditions are short-term notes a de- sirable means of securing money? What sort of corpo- rations use this method of raising money? 78. Describe the short-term loan made by the Ca- nadian Northern Railway Co. , , ^ j 74. What is the attitude of Canadian bankers toward short-term notes? TV'iy? 75. Discuss the problems created by short-term loans. CHAPTER IX 76 What three opinions are prevalent as to the chief factor that determines the value of fixed assets? 77 What are the characteristic features of a mort- gage? What is a mortgage bond? What is a mort- irage deed of trust? . . , 78. What are the essential and usual provisions of a corporate deed of trust? 79. Define "closed." "open-end" and "limited open- end" mortgage deeds of trust. Which of the three types is generally the best? Why? CHAPTER X 80. Give from memory the principal descriptive words applied to corporate bonds indicating (a) their security, (b) their purposes, (c) their manner of pay- ment and (d) their conditions of redemption. 522 CORPORATION FINANCE 81. What is a junior mortgage bond? How is the fact that it is a junior bond sometimes disguised? 82. What are sinking fund bonds? What are the principal objections to tiieir use? 83. What are collateral trust bonds? Why may they sometimes be sold more readily than the securities on which they are directly based ? H< may they be used to finance the process of buying control of subsidiary corporations ? 84. What is an equipment trust bond? Why are they so highly regarded by investors? 85. In what way does the Grand Trunk Railway short-term loan of July, 1913, resemble an issue of equipment notes? CHAPTER XI 86. Compare English with American practice with reference to the use of debenture bonds. What reasons lead to the issue of debenture bonds from time to time by some corporations in this country? 87. What are income bonds? What is the chief ob- jection to their use? 88. Define "participating," "profit sharing" and "joint" bonds and "receiver's certificates." 89. What are registered bonds? Coupon bonds? What are the advantages and disadvantages of each form? \Vhat are redeemable bonds? 90. What are convertible bonds? What are their advantages and disadvantages to the corporation? CHAPTER XII 91. "What is a promoter? Does he have a legitimate and useful function or m.t' Give your reasons. QUIZ QUESTIONS 523 92. What is meant by the promoter's "discovery" of ...proposition? Illustrate in detail with reference to Jme hypothetical case, such as a new gold mme in Alaska or a proposed creamery in a small country town. 93. What is meant by "assembling" a proposition? Illustrate in detail with reference to the same hypo- tlietical case used in the previous question. 94. What are the first steps in financing a proposi- tion? What is the advantage of carrying the develop- ment of the proposition as far as practicable before asking outsiders to supply funds? 95 Why should a promoter usually endeavor to raise more money in advance of complete development of a proposition than he expects will be needed? 96 Why is it usually better for a promoter to se to a large number of small buyers than to a small number of large buyers? 97. To whom should a promoter go first, generally speaking, for funds? Why? 98. Show how the principles of promotion laid down are applied in the illustration given in the text. CHAPTER XIII 99. Why are professional promoters usually unsuc- cessful in the long run? 100. Why do lawyers and bankers in small communi- ties do a considerable amount of promotion work? To what extent do the large metropolitan bankers and promoters enter the field of promotion ? 101. What are the advantages of engineermg firms us promoters? . 102. Is a promoter in any sense an agent of his cor- poration? A promoter buys a manufacturing plant for 524 CORPORATION FINANCE •$10,000 and sells it to a corporation which he promotes for $20,000, representing this latter sum to be the price he paid for the plant: is he legally entitled to his $10,00^ profits? If not, what course may he pursue in order to evade the law ? 103. Why is it difficult to enforce the principle that misleading statements by a promoter are fraudulent? 104. A promoter makes a contract on behalf of his corporation which is not yet formed: how may the cor- poration become bound by this contract without for- mally ratifying it? 105. How did the promoters of the Rubber Goods Manufacturing Company receive their pay? Of the American Smelting and Refining Company? In gen- eral what two plans of determining a promoter's profits are most commonly used? 106. What are the chief risks and tasks that a pro- moter must generally assume? 107. Do you think that promoters in general are or are not overpaid? Give your reasons. CHAPTER XIV 108. Why is there a strong tendency toward consol- idation among small as well as among large industrial establishments? 109. What are the principal difficulties that are apt to confront a promoter who undertakes to consolidate several existing concerns? 110. Describe briefly the process of "discovering" a consolidation. 111. What is the usual method of "assembling" a con- solidation? What is a "basis of consolidation"? What are the characteristic features of the two agreements cited in the text? QUIZ QUESTIONS 525 112. Why is it important for the promoter of a con- solidation to consider with especial care the means of •providing his new corporation at the outset with suffi- cient cash ? 113. Why does the promoter of a consolidation gen- erally try to raise cash by means of a bond issue? How may he manage to dispose of bonds issued by a new corporation with small or uncertain assets? 114. How does the problem of forming a large con- solidation differ from the problem of forming a small consolidation? 115. What is the usual basis of consolidation or ex- change and how is it determined? 110. What was the basis of exchange in the forma- tion of the Interborough-Metropolitan Company? In what respects was it faulty? 117. What has been Canada's experience in forming consolidations? What are the advantages of consolida- tions in Canada as cited by the promoters? 118. Wliat is the basis of consolidations ordinarily? Describe some prominent amalgamations. 119. How are stocks watered in forming a consolida- tion? 120. What has been the usual result in the reorgan- ization of overcapitalized industrial consolidations in Canada? 121. Describe the formation of the Canada Transpor- tation Lines, Ltd. Were the Canadian promoters well paid for their share in this consolidation? CHAPTER XV 122. What were the conditions under which the steel business of the United States was conducted in the decade, 1890-1900? 1! 526 CORPORATION FINANCE 123. What were the chief steel companies in the field in 1901 and why had most of them been formed in tkic three years, 1898-1901? \ 124. What is meant by "integration" of an industry? How did this factor operate to bring about the forma- tion of a great steel combination? 125. Why was not the promotion of the United States Steel Corporation an especially difficult task? Why were the four Moore companies included in the com- bination? What was the original capitalization of the United States Steel Corporation? 126. Was the prospectus issued by the promoting syndicate misleading? How much cash did the syn- dicate furnish? 127. What were the approximate profits of the pro- moting syndicate? 128. What percentage of the stock of the underlying companies was secured by the Steel Corporation? Give from memory a list of some of the important assets of the corporation. 129. What have been the principal additions to the Steel Corporation? Give briefly the terms of the Hill ore lease and of the Tennessee Coal, Iron and Railroad Company deal. What is the approximate cost of the steel rail mill at Gary, Indiana? 130. Describe briefly the preferred stock conversion plan of 1002. What objections were raised to the plan? What important changes in the interior financial or- ganization of the corporation have been made? 131. Give briefly the argument tending to show that the Steel Corporation is greatly over-capitalized. Give briefly the argument on the other side of the question. 182. What in general is the policy of the Steel Cor- QUIZ QUESTIONS IS27 poration toward its employes? Do the subsidiary com- oanies of the corporation compete with each other? 133. What are the principal outstanding securities of the Steel Corporation? What reasons may be given for expecting that these securities over a period of years will rise in value ? CHAPTER XVI 134. Name the four methods of selling corporate securities. 135. What are the characteristics of a good prospec- tus? Why are statements in speculative prospectuses usually vague? 136. Show that the characteristic features of specula- tive prospectuses are present in the example cited in the text. 137. What are the characteristics of strictly invest- ment prospectuses? Is it safe to assume that these characteristics are never apparent except when the se- curity offered is of the highest grade? 188. What would be the characteristics of an ideal prospectus? 139. What are the advantages and disadvantages to a corporation of selling its securities through large bond and banking houses ? 140. What are the characteristics of large, high-class hanking houses in contrast to disreputable concerns and what are *he essential factors that make a proposition acceptable to them ? 141. ^Vhat are the usual banking house methods of selling securJ^-es? Do such houses guarantee the safety of tne securities thev sell ? ) 528 CORPORATION FINANCE 142. Where is the big market for Canadian securities? 143. Why is it important that the British investor ha given full and correct information? 144. What information should be jiven in the pros- pectus? 145. What is the tendency of the United States mar- ket for Canadian securities? Why? 146. Which is Canada's richest rural community? What is its principal rural industry? How has it been financed? CHAPTER XVII 147. Name the principal stock exchanges of the United States. 148. What percentage of the securities handled on the New York Stock Exchange are "listed"? What are the requirements for listing? 149. Wliat is the "curb" market and what classes of securities are bought and sold in this market? 150. Describe briefly the method of handling trans- actions on the floor of a stock exchange. 151. What is the relative importance of speculative as compared with investment business, and what func- tion is performed by the speculative business? 152. Describe the process of buying securities "on margin." 153. Describe the process of selling securities "short." 154. What are the characteristics of stock exchange houses in contrast to "bucket shops"? 155. Into what three classes may Wall Street specu- lators be divided? 156. Give from memory a brief review of the char- acteristics of the Wall Street security market. QUIZ QUESTIONS 529 157. What measures may be taken to stimulate speculative interest in a security that is about to be issued ? 158. With what object is a syndicate frequently formed to assist in the flotation of a security? 159. By the use of what methods may the price of a stock market security be manipulated and kept under control ? CHAPTER XVIII 160. What is underwriting? How did the practice and the word originate? 161. What are the chief advantages to the corpora- tion in having its new issues underwritten? 162. What are the advantages to the buyers of se- curities J 163. When is underwriting inadvisable? What is your opinion as to the merits of the Pennsylvania Rail- road controversy referred to in the text? Give your reasons. 164. Why do the underwriting houses in almost every case band themselves together into syndicates? 165. Describe three types of syndicates. 166. Describe the type of syndicate in which the sale of the security is pooled. 167. Describe the type of syndicate in which the un- derwritten issue is distributed among the members of the syndicate. 168. Name some of the principal underwriting houses. What is the distinction between a bank and a l)anking house? C— VI— 34 fiSO CORPORATION FINANCE CHAPTER XIX C 169. Why are underwriting syndicate agreements frequently quite informal ? 170. Make an abstract showing the principal points covered in the agreement of the syndicate formed to underwrite the preferred stock conversion of the United States Steel Corporation. 171. Mention two general characteristics of under- writing agreements. 172. With what three classes of corporations do un- derwriting syndicates deal? 173. AVhat are the peculiar problems and difficulties involved in underw riling the security issues of new or speculative corporations? 174. Review from memory the example of specula- tive underwriting given in the text and make sure that you understand thoroughly all the operations involved. What conditions made possible the construction of a new plant in this case wholly with borr(,\v.id funds? What principles followed in this case are applicable in all cases where it is desired that an imdeveloped corpo- ration should borrow as much as possible? CHAPTER XX 175. What mistake is frecjuently made in the invest- ment of the original capital funds of a corporation? 170. What are the advantages of the installment method of getting funds for a corporation only as the funds are needed? 177. AAHiat are the disadvantages of this method? QUIZ QUESTIONS 581 178. What are the other possible methods of getting cash as needed, when the total amount necessary cannot be accurately foreseen? 179. What considerations determine how large an amount must be invested by a corporation in fixed cap- ital? What is working capital? 180. What are the four forms which working capital may take? 181. What factors determine how large an amount of working capital should be carried by a corporation? 182. Of the companies named in the text, which one has the largest percentage of working capital to gross business? Can you suggest any reason? 183. What are the five factors that immediately affect working capital and determine its amount? Why do railroads require only a small proportion of working capital ? 184. About how much working capital did the Penn- sylvania Railroad Company carry in 1908? Why was this amount greater than that carried bv most railroad companies? 185. Why is it of the utmost importance that a cor- poration should be supplied with the proper amount of working capital? CHAPTER XXI 186. Draw up from memory a model corporate in- come statement, arranging the items in their proper order. 187. By what common methods may a company's statement of gross earnings be padded? 188. What expenditures and what reserves should r>32 CORPORATION FINANCE always be included under the head of operating ex- penses ? 189. What are the causes of depreciation? What is a depreciation reserve? What method of allowing for depreciation has been in common use among steam and electric railroad companies? Is a depreciation reserve usually set aside as a separate sum to be invested outside the corporate business ? 190. Why should "income from other sources" be * stated separately? Why should cumulative preferred dividends be paid regularly, if practicable? 191. Should a corporation ordinarily pay out all its profits in the form of dividends to its stockliolders? If not, why not? 192. What four factors determine the amount of profits? What industries are apt to have the most regular profits? Why are the profits of railroad equip- ment companies so variable? 193. Why is it desirable that a corjioration should establish and maintain from year to year a regular dividend rate? How may regularity of dividends be secured in spite of irregularity of profits? 194. Why is great prudence and foresight on the parts of the directors in declaring dividends essential to the best interests of a corporation ? CHAPTER XXII 19.5. What arc the two important classes of better- ments? 190. What arc the three important sources of funds for betterments f 197. What are the advantages of providing for bet- terments !)y appropriations from earnings? QUIZ QUESTIONS 583 198. What are the two objections to this method? IN, 199. What three motives may lead stockholders to oppose a policy of providing for betterments by appro- priations from earnuigs? How do corporation offic .rs sometimes manage to follow this policy without the consent of even a majority of stockholders? 200. Review briefly from memory the case of the Lehigh Valley Railroad Company and show how Presi- dent Walters for some years pursued the policy referred to above. 201. Show how the Union Bag and Paper Company is now profiting by reason of having previously pursued this policy. 202. When antl how may funds for betterments safely be borrowed ? 203. What policy as to provision for betterment ex- (lenditures is followed by the Pennsylvania Railroad? 204. What are the comparative merits of bond and of stock issues as means of raising funds for better- ments? CHAPTER XXIII 205. Define "surplus." 200. Give and discuss briefly four sources of surplus. 207. What is the fifth source of surplus? Can a surplus be bu'lt up to any considerable amount by this inetluKl? 208. What was the policy of most of the industrial trusts as to surplus in the first few years of their exist- ence f What were the results of their policy? 200. How may a surplus be invested? What general principle should be followed? 534 CORPORATION FINANCE 210. What is meant by using the surplus as a "rainy day fund"? What companies follow this practice? What is the argument in its favor? What are its dis- advantages? 211. What is the usual practice in this country with reference to the use of a surplus? CHAPTER XXIV 212. What should be the eflFect on dividends of putting a surplus back into the property of a corpora- tion? Is the effect ever to increase dividends in a pro- portion greater than the proportion of surplus so in- vested to the original corporate capital? If so, when? 213. How may stock- watering be a method of dis- tributing a surplus to stockholders? Give an illustra- tion. Why is it that a stock paying a regular dividend of 4 per cent often sells for more than half as much as a stock paying an equally regular and certain dividend of 8 per cent? 214. What are subscription privileges? How may they be used as a method of distributing surplus? 213. How does a subscription privilege give an op- portimity for cheap investment? What four methods may be used by stockholders in order to secure quick cash profits? 216. Wliat is the methml known as the "subsequent sale"? What are the objections to its use? 217. What is the "short selling" method? Wliat is the objection to its use? 218. What is the method known as "sale of old stock"? WTiy cannot it always be used? 219. Wliat is the method known as "sale of rights"? QUIZ QUESTIONS 586 What is meant by a "right" in New York? What does Wie same word mean in Philadelphia? What is the Objection to the use of this method? 220. What factors determine the theoretical value of a right? What is the formula commonly used on the New York Stock Exchange? Why is the market value of a right usually less than its theoretical value? 221. is the granting of privileged subscriptions a methcKl of stock watering? Are they objectionable on tha* account? CHAPTER XXV 222. What good reason can you give for taking up the study of corporate manipulation? 228. Is it true that the corporate form favors manipulation? If so, why? 224. Is any force at work in the financial and in- dustrial world which has a strong teiidcncy to check manipulation? 225. What four classes or bodies of persons may endeavor to manipulate a corporation for their own »>enefit? 286. How may high salaries be used as a method of manipulation? 227. How may the power to bind a corporation by purchases and contracts become a means of manipula- tion? Is it usually iwssible to find a legal remedy or punisliment f J2S. How may the power to form new companies to handle esptciiUy profitable business l>e used as a method (»f manipulation? How was this principle applied by Commodore Vanderbilt? 536 CORPORATION FIXANCK 229. How may a corporate officer manipulate a cor- poration by reason of having "inside" information. 230. Is there reason to think that the use of these hA methods of manipulation is not uncommon? 231. Why have Canadian companies been compara- tively free from manipulation? CHAPTER XXVI 232. Wliy do not directors who wish to manipulate a corporation m their own interest enrich themselves by voting exorbitant fees to themselves? What four methods do such directors commonly use? 233. How may directors misuse their power to make contracts on behalf of their corporation? Illustrate by reference to the case of the Minnesota railroad company cited in the text. 234. Why do not the courts interfere in such cases? 235. How may directors manipulate by forming new companies or transferring credit or assets of their company to some other company ? Give an illustration. 236. State a few methods of juggling the accounts of corporations wl.ich are not infrequent. How may directors profit by juggling the accounts of their cor- poration ? 237. Wliat is meant by "window-dressing"? How may it be used f)y directors as a method of manipula- tion ? 238. What remedies for this kind of manipulation may be suggested? 239. How may directors secure gain for themselves by inflicting loss or even bankruptcy on their corpora- tion? Give two illustrations. QUIZ QUESTIONS 587 240. Review the essential features of the case cited 11^ the text. IIow mi|?ht the manipulation of the cor- \>t4ration in this case liave heen prevented? 241. What faults are there in the form of the Annual Statements in Canada? 242. What information should there be in an annual statement of a corporation? 243. What is the attitude in Canada toward quarterly reports? Why? CHAPTER XXVII 244. How may stockholders fraudulently secure profit for themselves at the expense of the creditors of the corporation? 245. What are the essential facts in the well-known case of Chicago and Alton Railroad Company? 246. How may subsidiary companies lie used as a means of manipulatitng a corporation and defrauding creditors ? Illustrate. 247. Review the main facts in the Central of Georgia Railway case cited in the text. 248. Show how the minority stockholders in a cor- poration may be "squeezed" by wilful mismanagement on the part of the majority stockholders and illustrate by reference to the case of the Olympic Theatre Com- pany cited in the text. 249. Review from memory the series of transactions in the real estate proposition cited in the text and show exactly how the minority stockholders in the I^ong View Land Company were defraiided. 2.50. Review from memory the series of operations carried on by I^. A. Ehrenbahn cited in the text and 588 CORPORATION FINANCE show how they all worked in favor of the manipulation of his deceased brother's estate in his own interest. 251. Mention four measures preventive of manipuld** lion that should be taken by honest stockholders. CHAPTER XXVIII 'true" and "legal" in- 252. Distinguish between solvencv. » 258. Mention four possible causes of true insolvency. 254. What are the chief causes, according to Brad- street's table, of legal insolvency? What is the real meaning of the phrase "lack of captial" when used in this connection ? 255. What were the two causes, according to the Wall Street Journal, of the failure of the Detroit, Toledo and Ironton Railway Company in 1909? 250. :Menti()n three immediate causes of legal in- solvency in addition to "lack of capital." 257. What is bankruptcy? Can a corporation be- come a voluntary bankrupt ? Can all corporations be- come involuntary bankrupts ? Is dissolution of the cor- poration a common mctluMl of handling insolvency? If not, why not? 258. What is a "bill in chancery"? By whom may it be presented? How may a friendly receiver for a corporatirm l)e obtained? \Vhat courts have jurisdic- tion in case's of corporate insolvency and receiverships? 259. What, briefly stated, are the duties of the re- ceiver of a faiiffl corporation? 260. From what source does he obtain his authority? How are his powers limited? May he incur debts bind- ing on the insolvent corporation ? Does he receive a fee? QUIZ QUESTIONS 589 261. What is the principal cause of failures in Can- ada? Are there many corporation failures in Canada? Vh»at percentage of failures are charged to individuals? I CHAPTER XXIX 262. Why is it usually necessary and desirable to re- organize large insolvent corporations rather than to sell their property and distribute the assets among the creditors? 263. Why is the formation of committees usually the first step in reorganization? How are these committees appointed? How much authority do they possess? How may a general reorganization committee be formed? 264. Why are bondholders usually ready to agree to a reorganization rather than foreclose and force a sale and distribution of assets? 265. What are the main problems and difficulties that confront a general reorganization committee? How are the relative standing and value of the various issues of mortgage bonds and other claims on the corporation determined? What concession is usually made to the stockholders of the corporation? 266. Name the four main objects of every reorgani- zation. Why is it necessary' usually to raise considerable amounts of cash ? 267. What are the three possible methods of raising cash? Why do almost all reorganizations of insolvent corporations involve assessments on security holders? How large may the assessments on stockholders be I > lade ? Under what circumstances may bondholders be induced to pay assessments? 540 CORPORATION FINANCE 268. What three classes of fixed charges are usually reduced in reorgahization if What threat may be us^d to force an acceptance of a reasonable reduction ? WH»«t principle is usually followed in determining the maxi- mum total amount of fixed charges to be imposed upon the reorganized company ? 269. How are bondholders usually compensated for the reduction in their yearly interest? What is the effect on the total capitalization of the company ? What factors determine whether or not the reorganized com- pany shall operate under the charter of the old com- pany? Why is a voting trust frequently formed at the time of organization? 270. Summarize briefly from memory the principles of reorganization laid down in this chapter. CHAPTER XXX 271. Sketch from memory the growth of the Santa Fe System. What were the effects on the comp«ny's financial strength of the rapid expansion in the years 1884-1888? 272. What were the main results of the reorganiza- tion of 1889 ? What were some of the events that led up to the failure of the company in 1893? 278. What was the substance of the so-called English plan of reorganization? Why was it not adopted? What were the main features of the plan that was finally adopted? What have been the results of this reor- ganization? 274. Sketch from memory the growth of the Rock Island System. 275. Outline the plan of reorganization brought for- QUIZ QUESTIONS 54L ward in 1902. What was the prime object of this re- o'^anization? Was that object attained? Show how civNitrol of the Rock Island System may have been se- cured by the Moore crowd without any permanent out- 276. Why did the Westinghouse Company fail? What was the main problem that confronted the reor- ganization committees? What were the main features of the plan adopted? . 277. How may the necessity for future reorganization be guarded against when forming the consolidation? 278. Describe the reorganization of the Dommion Sawmills, Limited. 279. Describe the financing of the absorption of the Lake Superior Paper Co., Limited, by the Spanish River Pulp and Paper Mills, Limited. 280. Wliat further information is given in the letters issued by the executives of this company? 281 What problems are raised by the reorganization .)f the Canadian Coal and Coke Co.? What were the terms of its reorganization? 282. What was the principal objection to the plan? 288. In view of Mr. Cahan's letter do you think the objection is justified? INDEX Accountant's work in consolidation, 313-313. Adaptability of corporate form, 5-8. Addicks, J. Ed., 19. "Allen" corporations, 51. A. Macdonald Company, Limited, Prospectus of, 382-283. Allum, T. C, on annual statements, 433-433. Amalgamated Asbestos Corpora- tion, 234-235. American Bridge Company, 243, 250. American Ice Co., 453-454. American Kitchen Products Co. of Canada, Limited, charter of, 70-72. American Law Review, 403. American Locomotive Co., 137. American Sheet Steel Co.. 243, 248, 255. American Steel and Wire Co., 240, 243, 344, 246. 347, 255. American Steel Hoop Co., 343, 348, 355. American Telephone and Telegraph Co. Number of stockholders, 7. Watered stock, 390. American Tin Plate Co., 243, 348, 255. American Thread Co., M2, 115. 12«i. Annual statements in Canada. Form of, 431-W3. What should be Included In, 432- 433. Appointment of receiver, 459-460 Argentine Republic bonds, 23. Ariuona, corporate laws of, 54, 57, 5H. Atchison, Topeka and Santa F€ R. U. Co., 350. 4«7. First reorgani«atlon, 487-489. Growth. 484-t8«. Second reorgnniiatlon, 489-493. Atlantic and Pacific R. R. Co., 485. Atwood, Albert W., 336. B Bad management, 453. Balance sheets, 96-97. Baldwin Locomotive Works, 365. Baltimore and Ohio R. R. Co., 157. Bank of Augusta vs. Earle, 49-51. Bank loans. 128-129. Bankruptcy and Insolvency, 457- 459. Psnks and corporations ada, 118-134. Banks, function of, 107. "Bare majority," 510-513. Bay State (Has Co. 19. Bethlehem Steel Corporation, 113, 115, 137, 135. Betterment exi)enses, 363, 376. Borrowing funds for, 373-374. Classes of, 3(i3-364. Conclusions as to, 375-376. I.ehigh Valley R. R. policy. 3«8- 372. Pinnsylvania R. R. policy, 374- 37,5. .Sources of funds for, 3(>4-365. .Stockhold.rs' attitude toward, 366-368. I'nion Bag and l'a|.cr Co. policy, 372-373. Bill in Chancery, 459. in Can- 548 MICROCOPY RESOIUTION TEST CHART (ANSI and ISO TEST CHART No 7, 1.0 I.I *" 111^ III 3 2 1 2.5 2.2 2£ 1.8 ^ >>IPPLIED INA^GE Inc 5^ 'fi-J E foreign states, 49-51. Statements to banks, 198-199. Cunard Co., 389. Curb market, 994-995. C-VI-85 Daggett, Stuart, 484-485. Dartmouth College case, 9. Deed of trust, 151. Delaware, corporate laws of, 53, 54, 56, 57, 59. Detroit, Toledo and Ironton Rail- way Co., 454-456. D<»ductions from income, 355. Defining and controlling instru- ments, 17. Depreciation reserves, 351-354. Dill, James B., 95. Directors, "Dummy," 44-45. Liabilities of, 45-47. Manipulation by, 414-431. District of Colimibia, corporation laws of, 54, 57, 59, 60. Dissolution, 459. Disadvantages of corporate form, 13-16. Dividends, Cumulative, 80. Fluctuations in, 560. Non-cumulative, 80. Paying, 355-356, 361-369. Reductions in, 366. Regularity of, 360-361. "Domestic" corporations, 51. Dominion Steel and Coal Corpora- tion, Limited, History of, 86-99. "Dumnqr** directors, 44-45. E Eastman Kodak Co., 971. Eflciency of corporate organisation, 47-48. Electric railroads, 359. Equipment companies, 356. Equipment trust bonds, 165. Erie Railroad Co., 137. Essential features of bj^wa, 8S- d46 INDEX Essential features of charter, 20-22. Expenses of incorporation, 13-14. Extra-provincial, licensing acts, 69- 70. Federal Act (See Companies' Act of the Dominion), 65. Federal Steel Ck)., 240, 243, 244, 246, 347, 255. Fixed assets, 377. Value of, 147-149. Foreign corporations, 51. Fraud, 452-453. Frick, H. C, Coke Co., 341. G Gates, John W*., 255. General Electric Co., 343-344. Government control of corporations, 15-16. Greene, Thomas L., 111. Gross earnings, Determination of, 349-350. Statement of, 350. Gulf, Colorado & Santa F€ R. R., 485. H Hall, Henrjr, 182. Harriman, E. H., 367. Hamburg-American Line, 3