'nf^^^"^^^ "^ y^nf^^^^^^^^ ''^rC^n'r^^^ii^^^ \y''Wiv^^^^^&3 v^''^" y^^^ 'M'^^^^^^ ^^"^r^^^^il^^ ^^'' Wn°^ . "J^Ki-Vi /^I'/M •.o-»V^'C/.\ ; 'o'SH, (J /S^^R^^S"^ JL° ??s^ ^ ^^^K^^^SLo ^° ?V^ " ^^^F^^S^ » J?r?°«k y^ ^^S^fe^^M^o J^ ;°'^>' <^TSi0^'*S^'' ''f^^^mi^. ^^i^^^mi^. ^t^^^^my. Mi^^^^mf, f^H^^^^im^j v Digitized by the Internet Archive in 2007 with funding from Microsoft Corporation http://www.archive.org/details/corporationfinanOOIougrich MODERN BUSINESS THE PRINCIPLES AND PRACTICE OF COMMERCE, ACCOUNTS AND FINANCE PREPARED AND EDITED UNDER THE DIRECT SUPERVISION OF JOSEPH FRENCH JOHNSON, A.B., D.C.S. DEAN NEW YORK UNIVERSITY SCHOOL OP COMMERCE, ACCOUNTS AND FINANCE AUTHOR "money AND CURRENCY," " SYLLABUS OF MONEY AND BANKING," ETC, Copyright, 1909 BY DE BOWER-ELLIOTT COMPANY TABLE OF CONTENTS INTRODUCTION. CHAPTER I. THE CORPORATE FORM. ECTION PAGE 1. " Non-Stock " Corporations t.. . 1 2. ** Stock " Corporations 2 S. Definitions 2 4. The Fiction of " Corporate Entity/' 3 5. Corporations in Ancient Nations 4 6. Popularity in Modern Times 5 7. Adaptability to Raising Large Amounts of Capital . . 5 8. Permanence 8 9. Centralization of Control ». . . . 9 10. Transferability of Ownership 10 11. Limited Liability 11 12. Disadvantages of the Corporate Form 12 CHAPTER IL LEGAL STATUS OF THE CORPORATION. AS, Defining and Controlling Instruments ., .. . . . 17 14. Common Law of Corporations 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 Name 24 20. The Corporate Purposes 24 21. Other Important Features of the Charter 28 22. The By-Laws. 28 23. Essential Features of the By-Laws . . . ^ . . 38 vii viii CONTENTS CHAPTER III. INTERIOR ORGANIZATION. SECTION PAGE 24. Rights of Stockholders 37 25. The Proxy and its Uses 38 26. The Right to Dividends 40 27. The Right to Information 41 28. Liabilities of Stockholders 42 29. Rights of Creditors 44 30. " Dummy " Directors 44 31. Powers and Liabilities of Directors 45 32. The Efficiency of Corporate Organization 47 CHAPTER IV. WHERE AND HOW TO INCORPORATE. 33. A Corporation May be Chartered in Any State and Do Business in Other States 49 34. The Regulation of " Foreign " Corporations ... .51 S5, Choosing the State of Incorporation ...... 52 36. Comparative Charges in Several States 53 37. Liberality of Corporation Laws in Several States . . 55 38. Permanence of the Laws 56 39. Reputation of Various States 57 40. Comparative Summary of the Advantages and Disadvan- tages of the Important States of Incorporation . . 58 41. Agreements Prior to Incorporation 63 4i2. The Wide Range of Choice in Incorporation .... 64 CHAPTER V. CORPORATE STOCK. 43. Stock Certificates Not Fully Negotiable . . . . .65 44. Par vs. Market Value of Stock 68 45. Nature of Preferred Stock 71 46. Uses of Preferred Stock 73 47. Cumulative Voting 75 48. Voting Trusts ,., . . 77 CONTENTS ix CHAPTER VI. TYPES OF BUSINESS CORPORATIONS. SECTION PAGE 49. Further Classification of Corporations . . . . . 79 50. The " Parent " Company , .... 81 51. Nature of a Holding Company 81 52. The Holding Company as a Means of Organizing "Trusts" 83 53. Complexity of Holding Companies 86 54. Organization of the Standard Oil Company .... 87 CHAPTER VII. THE SOURCES OF CORPORATE FUNDS. 55. Summary of Preceding Chapters . 91^ 56. Four Sources of Corporate Funds 91 57. The Investing Public as a Source of Funds .... 93 58. Difference Between Investment and Speculation . . 94 59. The Speculative Public as a Source of Funds , , , 95 60. Desirability of Borrowing Funds 96 61. Distribution of Security Issues 102^ CHAPTER VIII. SHORT TIME LOANS. 62. Trade Credit as a Source of Funds 105 63. What Reliance Should be Placed on Bank Loans ? . .107 64. Notes Sold to the Public as a Source of Funds . . .114* CHAPTER IX. THE CORPORATE MORTGAGE. 65, What Determines the Value of Fixed Assets? . « .119 66, Nature of a Mortgage Bond . . 121 67. Essential Features of a Deed of Trust 122 68. Classification of Mortgage Deeds of Trust . . . .125 s CONTENTS CHAPTER X. TYPES OF CORPORATION BONbS. SECTION PAGE 69. Classification of Bonds 127 70. Mortgage Bonds 129 71. Sinking Fund Bonds 130 72. Collateral Trust Bonds , . 133 '73, Equipment Trust Bonds 135 CHAPTER XI. TYPES OF CORPORATION BONDS {continued). 74. Debenture Bonds 141 75. Income Bonds 144 76. Other Types of Bonds 147 77- Purposes^ Manner of Payment^ and Conditions of Re- demption of Bonds 149 78. Convertible Bonds 151 CHAPTER XII. CORPORATE PROMOTION — THE NEW ENTERPRISE. 79. The Function of a Promoter 154 80. "Discovery" of a Proposition 156 81. " Assembling " a Proposition 157 82. Financing a Proposition — The Initial Development . 158 83. Foresight in Providing Funds 160 84. Advantages of a Wide Distribution of Stock . . . . l6l 85. " Starting Right " in the Sale of Stock l6l 86. A Concrete Illustration . 162 CHAPTER XIII. THE PROMOTER AND THE CORPORATION. 87. Professional Promoters 167 88. Lawyers and Bankers as Promoters 169 89. Engineering Firms as Promoters 169 90. Secret Profits are Illegal 171 91. Misleading Statements Constitute Fraud 174 CONTENTS XI SECTION PAGE 92. Contracts on Behalf of the Corporation and Their Ac- ceptance 175 93. The Promoter's Pay 175 94. The Promoter's Risks and Labors 178 95. Is the Promoter Over-Paid? 178 CHAPTER XIV. CORPORATE PROMOTION — FORMING CONSOLIDATIONS. 96. The Importance of Small Industrial Combinations . .180 97. Difficulties in the Promoter's Task 181 98. " Discovery " of a Small Consolidation 182 99- Basis of Consolidation 183 100. The Necessity for Cash 190 101. One Method of Raising Cash 191 102. Problems in Forming a Large Consolidation . . . .194 103. Basis of Consolidation .195 104. The Interborough-Metropolitan Consolidation . . .196 CHAPTER XV. THE UNITED STATES STEEL CORPORATION. 105. Preparing the Ground 199 106. The Steel Consolidations Preceding the Formation of the United States Steel Corporation 200 107. A Condition of Unstable Equilibrium 201 108. Method of Promotion 205 109- Prospectus of the Corporation 206 HO. Profits of the Promoters 209 111. Capitalization at the Beginning 209 112. Additions to the Steel Corporation 211 113. Financial Changes ........... 213 114. Basis of Capitalization 215 115. Operating Policy of the Corporation 218 116. Securities of the Corporation and Their Standing . .219 CHAPTER XVI. SELLING SECURITIES — THE PROSPECTUS AND THE BANKING HOUSE. 117. The Four Methods of Selling Securities . . . . .223 118. General Characteristics of a Good Prospectus ^ . . 224 xii CONTENTS SECTION PAGE 119. A Typical Speculative Prospectus ., 226 120. A Typical Investment Prospectus 228 121. The Ideal Prospectus 230 122. Selling Through Banking Houses 231 123. Requirements of Reputable Banking Houses . . . . 232 124. Their Methods of Selling Securities . . . . . .235 CHAPTER XVII. SELLING SECURITIES — THE WALL STREET MARKET. 125. The Principal Stock Exchanges of the United States . 239 126. Listing Securities .... t. ..... . 240 127. The Curb Market 242 128. Stock Exchange Methods 243 129. Importance of Speculative Dealings 245 130. Buying on Margin 246 131. Selling Short 247 132. Stock Exchange Houses vs. Bucket Shops .... 248 133. The Classes of Wall Street Speculators 250 134. A Summary View of the Stock Market 251 135. Stimulating Speculative Interest 251 136. Syndicate Operations 253 137. Stock Market Manipulation 254 CHAPTER XVIIL SELLING SECURITIES — THE UNDERWRITING SYNDICATE. 138. Origin of Underwriting 256 139. Advantages of Underwriting to the Corporation . . . 257 140. Advantages to the Buyers of Securities 258 141. When is Underwriting Advisable? 259 142. Why Underwriting Syndicates are Formed .... 262 143. Three Types of Syndicates 263 144. A Fourth Type — Pooling the Sale of the Security . . 268 145. A Fifth Type — Distributing the Security .... 265 146. The Large Underwriting Houses 267 CONTENTS xiii CHAPTER XIX. MANAGEMENT OF THE UNDERWRITING SYNDICATE. SECTION PAGE 147. Informal Agreements 269 148. A Formal Syndicate Agreement 269 149. Characteristics of Syndicate Agreements 277 150. Functions of Underwriting Syndicates 278 151. Underwriting Speculative Securities 279 152. An Example of Speculative Underwriting .... 280 CHAPTER XX. INVESTMENT OF CAPITAL FUNDS. 153. Importance of Wise Investment 284 154. The Installment Method of Getting Cash as Needed . 284 155. Disadvantages of this Method 286 156. Other Possible Methods 287 157. How Much Shall be Invested in Fixed Capital? ... 288 158. Forms of Working Capital 289 159. HowMuch Working Capital Shall be Carried? . . . 290 160. The Practice of Large Corporations 291 161. Factors that AiFect Working Capital 293 162. The Working Capital of the Pennsylvania Railroad . . 294 163. General Conclusions as to Working Capital .... 295 CHAPTER XXI. DISPOSITION OF GROSS EARNINGS. 164. Determination of Income 297 165. Honesty in Stating Gross Earnings 298 166. What Are Operating Expenses? 298 167. Necessity for Depreciation Reserves 299 168. Income From Other Sources and Deductions . . . 302 169. HowMuch Shall be Paid Out in Dividends? . . . .303 170. Variability of Profits 304 171. Regularity of Dividends Deeirable 308 172. Prudence in Paying Dividends 309 xiv CONTENTS CHAPTER XXII. BETTERMENT EXPENSES. SECTION PAGE 173. Two Classes of Betterments . .311 174. Sources of Funds for Betterments 312 175. Appropriations from Earnings 313 176. Objections to This Method 314 177. The Attitude of Stockholders 314 178. The Case of the Lehigh Valley Railroad 316 179- Policy of the Union Bag and Paper Company . . . 320 180. Borrowing Funds for Betterments 321 181. Policy of the Pennsylvania Railroad 322 182. General Conclusions as to the Financing of Betterments 323 CHAPTER XXIII CREATION AND USE OF A SURPLUS. 183. Definition 325 184. Four Sources of Surplus 326 185. The Fifth Source — Saving 327 186. Policy of the " Trusts '* 329 187. How Should Surplus be Invested 330 188. The Surplus as a " Rainy Day Fund " 330 189. Putting the Surplus Back Into the Property ,.. . . 333 CHAPTER XXIV. DISTRIBUTION OF THE SURPLUS. 190. Effect of a Surplus on Assets and Dividends . . .335 191. Distribution Through Stock Watering 337 192. Distribution Through Subscription Privileges . . . 339 193. An Opportunity Thus Given for Cheap Investment . 340 194. Cashing the Privilege — The Subsequent Sale . . . 841 195. " " " —Short Selling 342 196. " " " — Sale of Old Stock .... 343 197. " " " — Sale of " Rights " . . . . 343 198. Theoretical Value of a Right 345 199. Privileged Subscriptions as a Method of Stock Watering 347] CONTENTS XV CHAPTER XXV. MANIPULATION BY CORPORATION OFFICERS. SECTION PAGE 200. Ought We to Study Manipulation ? 349 201. The Corporate Form Favors Manipulation .... 349 202. Is Manipulation a Necessary Evil.^ 350 203. Scope of the Chapters on Manipulation 351 204. Exorbitant Salaries 352 205. Fraudulent Contracts 353 206. New Companies for Profitable Business 355 207. Misuse of " Inside " Information 358 208. Is Manipulation by Officers Common? 360 CHAPTER XXVI. MANIPULATION BY DIRECTORS. 209- Usual Methods 361 210. Fraudulent Contracts 362 211. Attitude of the Courts 365 212. New Companies for Profitable Business 366 213. Juggling Accounts 367 214. An Accountant's Observations 370 215. Remedies for This Kind of Manipulation .... 371 216. Inflicting Loss on the Corporation 373 217. The Danger in Losing Control of a Corporation . . . 375 CHAPTER XXVII. MANIPULATION BY AND FOR STOCKHOLDERS. 218. Cheating Creditors 379 219. The Chicago and Alton Deal 380 220. Manipulation Through Subsidiary Companies . . .382 221. Central of Georgia Income Account 383 222. Squeezing the Minority Stockholders 385 223. A Complicated Real Estate Proposition 387 224. Robbing a Partnership to Pay a Corporation . . .389 225. Remedies for Manipulation 392 xvi CONTENTS CHAPTER XXVIII. INSOLVENCY AND RECEIVERSHIPS. SECTION PAGE 226. Two Types of Insolvency 394 227. Causes of True Insolvency ... 395 228. One Cause of Legal Insolvency — " Lack of Capital " . S97i 229. The Case of the Detroit^ Toledo & Ironton Railway Com- pany 398 230. Additional Causes of Legal Insolvency 400 231. Two Methods of Handling Insolvency — Bankruptcy and Dissolution 401 232. A Third Method — Appointment of a Receiver . . . 403 233. Duties of a Receiver 404 234. Receiver's Powers 406 CHAPTER XXIX. PRINCIPLES OF REORGANIZATION. 235. Reasons for Reorganization 408 236. The Formation of Committees 410 237. Why Not Foreclose? 412 238. Problems Confronting the Reorganization Committee . 413 239. Necessity for Cash 416 240. Raising Cash by Assessments 417 241. Reducing Fixed Charges 420 242. Capitalization of the Reorganized Corporation . . . 422 243. Summary of the Chapter 424 CHAPTER XXX. THREE TYPICAL REORGANIZATIONS. 244. Growth of the Santa Fe System 425 245. First Reorganization of the Santa Fe and Its Results . 429 246. Second Reorganization and Its Results 431 247. Growth of the Rock Island System 434 248. Rock Island Reorganization 437 249. Westinghouse Reorganization 440 Quiz Questions 445 INTRODUCTION Twenty years ago a knowledge of corporation finance was not essential to the average business man. Only the larger concerns, roughly speaking, were organized in the corporate form. We have only to look around us to see that the situation to-day in this respect is en- tirely different. The corporate form, though not yet universal, is far ahead of partnerships and of individual proprietorships in popularity and in influence on busi- ness methods. As its advantages become better known we may expect to see it adopted even by small and back- ward concerns. This tendency is bringing to the front numerous problems of corporation law and management with which every man in business should be familiar. From this point of view the present volume is written. It is intended primarily for the information and guidance of business men of all stations and degrees. Most of what is said here will be found applicable both to large and to small corporations. The facts and illustrations, however, are largely drawn from the experience of the big industrial and railroad combina- tions. The chief reason for directing attention to the big corporations is that their methods are well developed and are worthy of study and imitation by the managers of smaller corporations. Most of us have a great deal to learn from the men who control the financial affairs of such companies as the United States Steel Corpora- tion, the Union Pacific Railroad Company, and the Pennsylvania Railroad Company, to mention three of our greatest and best managed corporations. INTRODUCTION While the first object of the volume is to serve business men, the author trusts that it will prove useful also to at least four other groups : (a) To stock and bond brokers and their employes, many of whom, the writer has observed, have only a fragmentary knowledge gained from experience, not a comprehensive knowledge, of financial operations. (b) To lawyers, all of whom should have a clear understanding of the financial as well as the legal phases of corporate organization and management. (c) To bankers, who are constantly dealing with all kinds of business corporations. (d) To accountants, to whom a comprehension of corporation methods and problems is almost as essential as a knowledge of strictly accounting principles. This list might be indefinitely extended. It is not too much to say that everyone directly or indirectly connected with modern business ought to possess for his own protection and advancement a correct understand- ing of the principles of corporation finance. The thirty chapters in the volume may be conveniently classified into seven groups: Chapters I-VI present the elements of corporation law. They may be omitted by lawyers, but are essential to all other readers. Chapters VII-XI describe all the methods and in- struments that are used in this country in raising funds for corporations. Chapters XII-XV explain how corporations are promoted, and give in illustration a brief account of the United States Steel Corporation. Chapters XVI-XIX discuss the four methods of selling the securities of a corporation. INTRODUCTION Chapters XX-XXIV deal with the problems of honest financial management of a corporation. Chapters XXV-XXVH discuss the schemes and tricks of dishonest manipulators. Chapters XXVIII-XXX are concerned with the causes of insolvency and the problems of reorganization. The reader should bear in mind that all these questions are treated from the standpoint of corporation officials, not from the standpoint of stockholders or of prospective investors. Additional light may be obtained from the volume on Investment and Speculation^ in which the interests of buyers of securities are kept to the front, and from the volumes on Accounting and on Commercial ■^'^^' W. H. Lough, Je. New York University School of Commerce, Accounts and Finance. CHAPTER I THE CORPORATE FORM 1. "Non-stock" corporations. — Everybody knows in a vague way that a corporation is an association of in- dividuals formed to carry on an enterprise. Compara- tively few people, however, understand just what the corporation is in the eyes of the law or the extent and the limitations of its activities. Obviously, the first step in the study of corporation finance should be an examina- tion of the powers and possibilities of this peculiar and wonderfully effective form of organization. Corporations fall into two distinct groups. There are, first, corporations without capital stock, or "non- stock" corporations; to this class belong almost all churches, hospitals, chartered clubs, universities and other strictly social and charitable organizations. The prime characteristic of such corporations is that the members share equally in all the privileges of member- ship without regard to the amount of money that each may have contributed. There is no arrangement for transacting a money-making business and distributing profits or losses. In fact, non-stock corporations exist either for the common benefit of all the members or for the purpose of serving the public at large. Many in- teresting questions as to the rights and powers of such corporations might be discussed; but the discussion would be out of place in this volume. 2. '^ Stock" corporations, — We are here concerned only with the second class, namely, "stock" corporations; i-i 1 ^''"'' • 'COftPOfeATION FINANCE Tto this class belong all business corporations. Two ap- parent exceptions, mutual insurance societies and stock exchanges, both of which are ordinarily "non-stock" corporations, may be noted; both organizations in their fundamental character, however, are simply clubs which, like many other clubs, offer to their members certain valuable privileges. "Stock" corporations, on the other hand, are formed with the object of carrying on busi- ness ventures; they have a capital stock divided into transferable shares; they are intended to make profits which are to be distributed to their members, or stock- holders, in proportion to the number of shares each one possesses; each stockholder secures his shares by pur- chase for valrable consideration from the corporation or by transfe. from some previous stocldiolder ; each stockholder is c owner of the corporation and its assets to the extent of the number of shares that he holds. 3. Definitions, — The most famous definition of a corporation, and a definition that in its main features is as sound to-day as it ever was, is that given in the Dart- mouth College case in 1819 by Chief Justice Marshall of the United States Supreme Court, who referred to a corporation as "an artificial being, invisible, intangible, and existing only in contemplation of law." Blackstone, author of England's greatest legal text-book, gives a definition that is almost as well-known as Chief Justice Marshall's in the following words: "A corporation is an artificial person created for preserving in perpetual succession certain rights, which being conferred on natural persons only, would fail in the process of time." You will note that this definition emphasizes the most striking distinctive feature of the corporation, namely, its artificial personality. The corporation is an entity or being in itself, apart from the persons who organize THE CORPORATE FORM S and own it. Let us review some of the results of this legal fiction that the creation of a corporation brings into the world a new person, — artificially created, to be sure, but yet endowed with many of the powers of an ordinary human being. In the first place, as the corporation has an existence apart from the lives of any or all its owners, it is not broken up by the death or withdrawal of any owner. In the second place, the corporation has the right to buy and sell and contract debts in its own name and for itself; it may even owe money or lend money to some or all of its owners. In the third place, it may sue and be sued in the courts, without thereby involving any of its owners. In the fourth place, it may enter into all kinds of legal contracts, just as an individual might do. 4. The fiction of ^'corporate entity" — Here, then, is the first and most fundamental fact about the corpora- tion for the student to grasp and keep always clearly in view, that itils a separate, distinct artificial person. It is true that within the last few years the courts of the United States have shown a strong tendency to go be- hind this artificial personality and to throw responsibility on the owners and managers of a corporation, especially in case of fraud. Clark, the author of a standard legal work, says: That a corporation is a legal entity, separate and distinct from the members who compose it, is a mere legal fiction, in- troduced for the convenience of the corporation in transacting business, and of those who do business with it ; and, when urged to an intent and purpose not within its reason and policy, the fiction will be disregarded, and the fact that the corporation is really a collection of individuals will be recognized, even at law. Courts of equity, in every instance, look behind the corporate 4 CORPORATION FINANCE entity and recognize the individual members and will do so when- ever justice requires. Yet the fact remains that the corporation's existence, property, contracts and debts all adhere to the corpora- tion itself and not to the individuals who together own the corporation. It is true, also, that this artificial per- son, the corporation, has neither mind nor body and can- not therefore think or act. The law, however, easily gets over this difficulty by treating the managers and officers of the corporation as agents empowered to carry on its operations. \ 5. Corporations in ancient nations, — This fiction of artificial personality seems to be at first sight an un- necessary and even absurd idea, and the results that fol- low from the adoption of this fiction appear more like the spinning of legal cobwebs than the working out of common-sense principles. But a little further study reveals that the corporate form substantially as it exists to-day has been used by many ancient and modern nations. It seems, therefore, that there must be some good reason or reasons for its widespread use. The archaeologists tell us that as far back as the prosperous days of Babylon the inhabitants of that ill-fated country in their commercial transactions used corporations some- what as we use them now. The Romans also developed and made great use of the corporate form of organizing enterprises. Indeed, it is asserted by Blackstone, and was at one time universally believed, that our modern corporations are descendants in a direct line of the ancient Roman corporations. Although this theory is no longer fully accepted, it remains true that the Roman law with regard to corporations has had considerable influence in the development of our modern corporation law. Without going further into this historical survey. THE CORPORATE FORM 5 which is a little outside the scope of this book, we 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- lishments 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 ^^re used 6 CORPORATION FINANCE principally because of the facilities which they afforded for raising and handUng large amounts of capital. In this respect they are obviously far superior both to in- dividuals and to partnerships. Not even the richest individual — ^not John D. Rockefeller nor Andrew Car- negie nor Lord Rothschild — would be able out of his own ^ resources to build and operate one of the great railroad systems of the United States. Even if one of these men were able individually to take care of an enterprise of this size, he would not care to do it. Men of great wealth do not consider it advisable to put all their money into one business. They scatter their investments, so that if one proves a failure profits on the others may more than counterbalance the loss. Nor would a partnership, great and wealthy as some partnerships have been, be an efficient method of bring- ing together the vast amounts of capital that are re- quired for every great enterprise. It would be an extraordinary coincidence if several men of immense wealth, who might conceivably construct and own in partnership a big railroad or a big industrial trust, were able to harmonize inevitable differences of opinion and to co-operate efficiently in a partnership arrangement. It is probably safe to say that in the whole commercial history of the world we could not find a single instance of, say, a billion or even half a billion — perhaps even a hundred million — dollars of capital raised and man- aged under a partnership agreement. It is well to remember in this connection that even the greatest in- dividual fortunes are mere dots compared to the total wealth of a vast country like the United States. Furthermore, of these individual fortunes only a small part ordinarily is free at any one time to be used or in- vested as the owner wills. THE CORPORATE FORM 7 The corporate form, on the other hand, has infinite possibiKties 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 25,000 stockholders, the Pennsylvania Railroad Company nearly 59,000, and the United States Steel Corporation not far from 110,000. 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 ob- 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 of the corporate form is permanence. When an in- dividual owner of a business dies, his business dies with him. It may, to be sure, be carried on by his family or bought by strangers; on the other hand, it may be that no practicable method of disposing of it except at an enormous sacrifice will be found. This is largely a matter of chance, because no organization for carrying on the business is in existence. A partnership is almost equally subject to chance. When a partner dies, the firm is thereby automatically dissolved. The surviving partner or partners may, of course, form a new firm and take over the interest of the deceased partner. In so doing, however, disputes are liable to occur, especially in those lines of business where the earnings are irreg- ular and the value of the assets is not clearly defined. If the surviving partners are unable to continue the business properly or are disposed to drive a hard bargain, the estate of the deceased partner may be deprived of a large part of its rightful interest in the business. Here, again, there is no permanent machinery for managing the business. The partnership, like the in- dividual business, is subject to all the uncertainties and calamities that beset the lives of individual human beings. The corporation, on the other hand, exists until it becomes bankrupt, is allowed to lapse or is voluntarily dissolved. The death of any man, even if he owns 99 per cent, of the stock of the corporation, does not affect the corporation itself. It is an "artificial being," a creature of the law not subject to the infirmities of human existence. It is so organized that if one officer dies or withdraws, a successor may be quickly chosen. As the corporation exists apart from the persons who own it and as control is vested in its officers, the death or withdrawal of an owner does not at all disturb its 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 group 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, both within the corporation and outside. Persons not connected with the corporation are expected 10 CORPORATION FINANCE to have their dealings only with the duly authorized officers, and if they do not exercise reasonable care in this respect may find whatever agreements or contracts they make invalid. This will be more clearly understood by the reader after a study of the chapters on agency in the volume on Commercial. Law. Furthermore, the relations of the corporate officers to each other are clearly defined and the gradations of authority are so marked that each one may understand clearly just how far he is empowered to act on his own judgment and what questions he should refer to his official superiors. The great advantage of this care in organization and in delegation of power is so obvious that it need not be dwelt upon at any length. A well-managed corporation carries on its affairs with the. precision and smoothness of a well-disciplined army. 10. Transferability of ownership, — ^A fourth advan- tage of the corporate form is the ease with which its ownership may be transferred. An individual owner who desires to sell his property must find a purchaser for all of it at one and the same time. A partner who de- sires to sell his interest in the firm must either make some satisfactory arrangement with the other partners, which may be a difficult matter, or must find a purchaser who offers satisfactory terms and is personally acceptable to the other partners, and that is likely to prove still more difficult. Altogether the problem of withdrawing funds that have been invested in an individually-owned prop- erty or in a partnership is almost always hard and frequently insoluble. Under the corporate form the problem is much simpler. The ownership of a corpo- ration is represented by shares, any or all of which may be transferred from hand to hand without interfering in the least with the stability of the corporation. An owner 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 liability, — 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 la CORPORATION FINANCE 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 they 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 stockliolders outside the failed business. An important exception to this principle of limited liability exists in the case 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 -psiT value of their holdings of bank stock. A similar rule applies in California to stockholders of corporations of all kinds and there are one or 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. No 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, likes to reflect that at any moment, through the fraud or mis- management of some subordinate or partner, or through some unavoidable natural calamity, he may be compelled to give up his home and personal property in order to satisfy the demands of business creditors. The corpo- rate form of business relieves him of this haunting spectre. 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: r( 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) Centralization 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 investments^ 12. Disadvantages of the corporate form, — In view of these advantages it maj^ 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 and annual franchise taxes on corpo- rations, which taxes are in addition to the ordinary state and local taxes on property. These taxes are, however, uniformly small, as the reader may see by turning to the table of fees and taxes in Chapter IV. In addition. \ 14 CORPORATION FINANCE legal assistance is almost always necessary in forming corporations, and there may be an additional charge on this account of from $25 up. These corporate expenses are, of course, too slight to be worth much consideration, except in the case of very small enterprises, where they may sometimes be of sufRcient importance to prevent the adoption of the corporate form. (2) Limited POWERS. As the corporation derives all its powers from the state in which it is incorporated, and as all its powers should be distinctly stated in its articles of incorporation (see Chapter II), it may be somewhat hampered at times by lack of authority to carry on oper- ations that would be profitable. This, however, is a superficial objection that may be readily dismissed; for a good corporation lawyer will always find it possible to include in the statement of the powers of the corporation authority for every act that would be necessary in prac- tice. If not, it is always easy to form a new corporation for whatever specific action is desired, j This point also is further discussed in Chapter II. f(S) Limited credit. A lender of money would, of course, prefer, other things being equal, to lend to an individual or a partnership, rather than to a corporation, because the liability of the owners of the property in the former case is unlimited, and in the latter case, as has been explained, is limited. Thus a partnership which is converted into a corporation will sometimes be em- barrassed more or less by reluctance of its creditors to continue extending credit as freely as before the con- version. This objection, which is of importance usually only in the case of a small and closely held business, may be overcome, if desired, by the officers or certain stock- holders personally endorsing the corporation's notes and bills payable. By so doing they, of course, lose the THE CORPORATE FORM 15 advantage of limited liability, but they retain all the other advantages of the corporate form. There are some business activities, however, in which the personal element is so prominent as to make unhmited liability desirable. A firm of accountants, for instance, could not be changed to a corporation without forfeiting to some extent the confidence of the business public, for every public accountant is and ought to be personally liable to the fullest extent for the honesty and accuracy of his work. The same thing may be said of bankers and engineers, and to some extent of business advisers and systematizers ; for such activities the corporate form, on account of its limited liability feature, is ill-adapted. (4) Governmental control. Some concerns are strongly averse, for good reasons, to any publicity what- ever as to their operations and financial results. They may perhaps be making so much money that they desire to keep it secret in order to avoid attracting competitors ; or their real business may be quite different from their ostensible business, and they would not desire to attract attention to this fact by the inclusion of unusual powers in articles of incorporation. For fear of governmental supervision, therefore, they retain the partnership, even with all its disadvantages. The reader will readily see that this list of disadvan- tages of the corporate form does not include anything of great importance to most legitimate kinds of business. Certainly the disadvantages are of little weight in most cases in comparison with the obvious and substantial gains that may be had by adopting the corporate form. We are justified in concluding, therefore, that the tendency toward the corporate form of conducting busi- ness, which has been referred to above, will not dimin- ish, but rather will increase in the coming years. The 16 CORPORATION FINANCE corporation is the efficient twentieth centuiy means of conducting business. In city and in country, from the captains of finance to the smallest units in the army of business, in transportation, in manufacturing, in trad- ing, even in farming, the corporation has come to be recognized as the best form yet discovered for organizing the production of wealth. To confess oneself ignorant of the nature, the func- tions, the abuses and the possibilities of this mighty in- strument is indeed a confession of business inefficiency and narrowness. The pages that follow are to be de- voted to a discussion of the formation and management of corporations which, it is hoped, will place this truly important and somewhat difficult subject in a clear light before our readers. CHAPTER II LEGAL STATUS OF THE CORPORATION 13. Defining and controlling instruments, — The cor- poration, we have said, is a "creature of the law," and this statement is to be taken hterally. This artificial creature has no existence, no powers, no privileges, no duties, ex- cept those which are conferred upon it either by express statement or by implication. The artificial creature, in other words, does not have what we may call the natural rights of an individual to live unmolested and to pursue whatever objects he pleases, so long as the rights of oth- ers are not interfered with, but only artificial rights. In order to determine in any particular case, therefore, what a corporation may or may not do and what its standing is, we must look to the particular instruments which give it being and control its actions. These instruments in every state in the Union are three in number: (1) The Constitution of the State. (2) The General Corporation Act. (3) The Charter of each particular corporation. Supplementing the charter, practically all corporations have a set of by-laws for their own guidance. In order to understand the legal status of a corporation we must consider briefly each of these instruments. 14. Common law of corporations, — It must be borne in mind, in connection with what follows in this chapter, that corporations of one kind or another have been in existence for a very long time, and that the courts of England and of the United States have given a large 1-2 17 18 CORPORATION FINANCE number of decisions dealing with the duties and powers of corporations. These decisions form the great body of common law with reference to corporations; and this common law, for which search must be made through the precedents of many years, governs where it is not super- seded. Corporations as forms of business organization, however — and especially as forms of organization for relatively small enterprises — are comparatively modern. From the very beginning the English Parliament and the state legislatures of this country have found it ex- pedient to enact statutes in order to define clearly the powers and duties of corporations. These statutes in every state are now so explicit and comprehensive as to govern the great mass of corporate activities. They form the body of statutory law with reference to corpo- rations. The reader will find in the volume on Com- mercial Law a full exposition of the relations between common and statutory law and of the manner in which statutes of the legislature are interpreted by the courts. For our purpose it is enough to say that the statute law supersedes the common law wherever the two disagree and that statute law with regard to corporations is so voluminous that we need rarely go back of it to the common law. 15. The state constitution. — The fundamental law in each state of the Union is the constitution of the state, and no provision which conflicts with any clause in the state constitution will be legal. This is a point, not merely of theoretical, but also at times of distinct practi- cal importance. For instance, the Constitution of the State of Pennsylvania prescribes that all Pennsylvania corporations shall elect their offieers by what is known as "cumulative voting" — a method that is described at some length in Chapter VI. In one case, with which LEGAL STATUS OF THE CORPORATION 19 the writer happens to be familiar, certain stockholders of a small Pennsylvania corporation planned to pass a rule against cumulative voting and by means of that rule to elect all members of the board of directors. Great was their chagrin and surprise when they discovered that no Pennsylvania corporation is competent to enforce such a rule as they proposed. It frequently happens that some of the ordinary statute provisions of a state are found, when tested in the courts, to be in conflict with some provision of the state constitution and there- fore null and void. The reader, then, should not forget that behind every enactment of the legislature looms the constitution of the state, a fundamental factor that should not be left out of his reckoning. 16. Method of creating the corporation.— -ThQ direct legislative authority to create a corporation may be given in one of two ways, by special enactment of the legisla-r''^ ture for the benefit of this particular corporation, or by a general act which governs the creation of all corpora- tions. Formerly the first named method was universal. It proved itself, however, both inconvenient and unfair. Authority to incorporate was granted arbitrarily by the legislature for certain enterprises and denied to others equally deserving. It was necessary to have a "pull" in order to get the desired enactment. Favoritism and corruption, coupled with unwise conservatism, were the natural results of this method. It has therefore fallen into disuse and is definitely prohibited by the constitu- tions of many states of the Union. One rather conspic- uous exception to the general rule that corporations are no longer formed and managed under the provision of special enactments is the Bay State Gas Company, a corporation organized by Mr. J. Edward Addicks, and now controlled, it is understood, by Mr. Thon^as W, 20 CORPORATION FINANCE Lawson. This company was given large powers and privileges by a special act of the Legislature of Dela- ware during the time when Mr. Addicks was reputed to be the political boss of the State. . The present-day method of creating the corporation is by compljang with the provisions of a general corpo- ration act — ^in some states called an "enabling act." Such an act usually prescribes the general purposes for which corporations may be lawfully formed, the chief powers which they may possess — such as power to hold property in the parent and in other states, power to hold its own stock, power to hold stock of other corporations (not conferred by all states), power to borrow money, power to do business in other states, and so on — the num- ber of incorporators and stockholders, the manner and lawful purposes of issue of capital stock, the rights of the^ stockholders, the minimum numbers of directors and of officers, the character and amount of taxes, the nature of reports required, the exact form to be followed in incor- porating, and so on. Under such a general act any citizens of the state — sometimes of other states — who meet the requirements of the law may form a corporation. Thus the favoritism and corruption in- cident to the old method of special enactment* are eliminated. The universal establishment of these general corporation acts is one of the most important reforms in business methods of the second half of the nineteenth century. Though many of these acts — as is pointed out in Chapter IV — are far from perfect, we all have reason to be profoundly thankful that they exist at all. 17. Essential features of the charter. — We come now to the immediate instrument of incorporation, the LEGAL STATUS OF THE CORPORATION 21 charter — sometimes called the certificate of incorpora- tion or the articles of incorporation. Where the charter is obtained under a general corporation act, it is drawn by the incorporators or their attorney and presented to the proper state official, usually the secretary of state. If the charter as drawn is approved, the secretary of state signifies his acceptance thereof, and the corporation comes into being. There is no favoritism in this pro- cedure, as there is in the granting of charters by special acts; the secretary of state has no authority to refuse any charter which is properly drawn and which complies with the provisions of the state law. A charter need not be a very lengthy instrument, al- though large companies sometimes find it desirable to prevent future misunderstanding by inserting into the 'charter a great many details not absolutely essential. In practically all states every charter must contain, among other things, the following information: (1) The name of the corporation. (2) The purpose or purposes for which it is formed. (3) The amount of capital stock, and if there is a division into classes of stock, the rights of each class. (4) The number of shares of stock. (5) The location of the principal business office. (6) The period of existence of the corporation, which is usually unlimited or perpetual. (7) The names and usually the post-office addresses of the incorporators. If the reader desires a more detailed statement of the requirements in any particular state, he cannot do better than to go direct to the statutes of that state. It would lead us too far afield if we were to enter here on any comprehensive legal study of charter forms and provi- ^2 CORPORATION FINANCE sions. A few remarks, however, as to the essential fea- tures of a charter and the presentation of the sample form following will not be out of place and will help to make clear some points of corporation practice that might otherwise be obscure. 18. ^ sample charter. — The following is a very brief and simple charter, which conforms to the laws of the State of New Jersey. The form in other states would be slightly different. The writer is indebted to Mr. Thomas Conyngton for permission to copy this form from his manual "The Modern Corporation." CERTIFICATE OF INCORPORATION OF THE CARHART DRUG COMPANY. We, the undersigned, for the purpose of forming a corpora* tion under and by virtue of the provisions of an act of the Legislature of the State of New Jersey, entitled " An Act con- cerning corporations (Revision of 1896)," and the several sup- plements thereto and acts amendatory thereof, do hereby sever- ally subscribe for and agree to take the number of shares of stock of the said corporation hereinafter placed opposite our respective names, do further certify and set forth as follows: First — The name of said corporation shall be "CARHART DRUG COMPANY." Second^ — The location of its principal office in the State of New Jersey shall be at No. 15 Exchange Place, Jersey City. The name of the agent who shall be therein and in charge thereof, upon whom process against this Corporation may be served, is the Corporation Trust Company of New Jersey. Third — The objects for which this corporation is formed are: (a) To manufacture, prepare, compound, mix, com- bine, buy, sell and generally deal in all manner of LEGAL STATUS OF THE CORPORATION 23 chemicals, chemical products, drugs and pharmaceu- tical compounds and preparations, and to patent, register or otherwise protect the same.^ (b) To obtain, purchase or otherwise acquire formulae, patents and secret processes for the manufacture and preparation of chemicals, drugs and the compounds and preparations thereof, and to operate under, sell, assign, grant licenses in respect of, or otherwise turn the same to account. (c) To enter into, carry out or otherwise turn to ac- count contracts of every kind; to have and maintain offices within and without the State ; to acquire, hold, mortgage, lease and convey or otherwise use or dis- pose of real and personal property in any part of the world ; and in general to carry on such operations and enterprises and to do all such things in connection therewith as may be permitted by the laws of New Jersey and be necessary or convenient in the conduct of the Company's business. Fourth — The total authorized stock of the corporation shall be twenty -five thousand dollars ($25,000), divided into two hun- dred and fifty (250) shares of the par value of one hundred dollars ($100) each, and the amount of capital stock with which said corporation will begin business is five thousand dollars ($5,000). Fifth — The names and post-office addresses of the incor- porators and the number of shares subscribed for by each are as follows: Names Addresses Shares Willis J. Carhart. . .15 Exchange Place, Jersey City, N. J. 40 Sheldon McCammis. " " " " " " " 5 John B. Whelan ..." " " " " " " 5 Sixth — The period of existence of said corporation shall be unlimited. In Witness Whereof, we have hereunto set our h^nds and 24 CORPORATION FINANCE seals this 21st day of July, A. D. nineteen hundred and eight. Willis J. Carhart. (L. S.) Sheldon McCammis. (L. S.) John B. Whelan. (L. S.) In the presence of Harmon Watson. Thomas O'Connell. (Execution in due form.) 19. The corporate name, — The name of a corporation is part of its property and sometimes — especially after the corporation has been long enough established to have acquired good will — is highly valuable property. For that reason, a new corporation is not allowed to assume a name already taken by a previously existing corpora- tion nor even a name so similar as to cause confusion. If the older corporation, however, in such a case were not incorporated or licensed in the same state as the new company, the state authorities would have no right to reject the new company's charter on account of the sim- ilarity in name. Under such circumstances the only remedy of the older company would be to bring suit in the courts. Some states lay down certain arbitrary rules, such as that the prefix "The" must be used, or that the word "incorporated" or "limited" must follow the corporate name. Alabama, Colorado, Kentucky, Con- necticut, Delaware, Kansas, Missouri, North Carolina and Virginia require the word "company" to be a part of the corporate name. As a matter of business, it is usually very desirable for a new corporation to adopt some distinctive, self-explanatory, short name, and to avoid so far as possible hackneyed words and phrases. 20. The corporate purposes. — There is no more im- portant section of the charter than that in which the LEGAL STATUS OF THE CORPORATION 25 corporate purpose or purposes are stated. For most corporations, the activities of which are to be confined to some one Hne of business, a brief and simple statement is all that is necessary. The incorporators and their attorney should bear in mind in this connection, however, that it costs nothing at the beginning to insert a very full and comprehensive description of all the possible activities of the corporation and that the absence of the right word or phrase may at some future time cause serious inconvenience. The corporation is not obliged to carry out all of the purposes named in the charter; on the other hand, it has no authority to do anything which is not so named or clearly implied. The courts, to be sure are generally liberal in their interpretation of the implied powers of corporations; but it is better to keep out of the courts and to take a little care at the beginning so as to avert any future disputes as to whether proposed activities are beyond the purposes and powers of the corporation or not. To illustrate the care with which the purposes of a large company are stated in order to comprehend and give legal authority for any possible future activity, the charter of the United Steel Corporation, which was drawn by one of the greatest corporation lawyers of the United States, Judge James B. Dill, of New Jersey, may be cited. The section of the charter, in which the purposes of this great corporation are stated, is too long to be quoted in full. Nine paragraphs are devoted to describing all the manufacturing, landowning, mining, trading, contracting, inventing and patenting, security- buying, selling and holding activities which could be thought of by all the eminent lawyers and business men who helped Judge Dill to draw the charter. Then follow the two paragraphs quoted below, in which, as £6 CORPORATION FINANCE the reader will observe, the incorporators aim to provide for any other possible activity 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 hold, purchase, mortgage and convey real and personal property either in or out of the State of New Jersey. Without 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 down March 5, 1909. The c^s^ involved the right of a rail- LEGAL STATUS OF THE CORPORATION 21 road company to acquire and hold the stock of certain trolley companies near Atlantic City. The court de- nied this right and said, among other things: The power to purchase, hold, etc., stock and bonds of other corporations conferred by Section 51 of the general corporation act is to be exercised subject to the limitations imposed by Sec- tion 2 of the same act ; that is to say, the power exists as a pri- mary power only when the purpose to exercise it as such is expressed in the certificate of incorporation; and otherwise it exists as an incidental power only so far as necessary or con- venient to the attainment of the objects that are set forth in the charter or certificate of incorporation. It is only by reference to the certificate of incorporation that the Attorney General and other officials interested on behalf of the people can readily determine what powers have been granted and whether the company is usurping franchises not granted by the state. It is by reference to the articles of association that investors can conveniently ascertain the character of the contract into which they are entering and the property rights they are acquiring in purchasing stock of the company. It must not be forgotten that stock ownership by one com- pany in another is only a mode by which the former company engages in the business of the latter. But since the second com- pany (if Section 51 were unqualified in its effect) might like- wise hold stock in any other corporation or corporations, and these might do the same ad infinitum, stock ownership in any company under such a system would not evidence a participation in any definite kind of business, but in effect a participation in a "blind pool" subject to the uncontrolled will of the majority. There would be an end at once of all practical force to the doc- trine that incorporation evidences a contract between the state and the corporation or between the corporators and stockholders themselves. Evidently the eminent lawyers who drew up the charter, or certificate of incorporation, of the railroad 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 number 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 usually 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 corporate property. As in the case of the charter, we will run over briefly some of the important features of corporate by-laws. First, the reader should study with care the following set of by-laws, which is used by a New York corporation, but could be adapted with slight changes to any small company. This set is taken from Mr. Conyngton's ex- cellent manual, '*The Modern Corporation." BY-LAWS OF THE STANDARD BLEACHING COMPANY, NEW YORK CITY Article I. — Stock. 1. Certificates of Stock shall be issued in numerical order from the stock certificate book, be signed by the President and Treas- urer and sealed by the Secretary with the corporate seal. A record of each certificate issued shall be kept on the stub thereof. 2. Transfers of Stock shall be made only upon the books of the Company and before a new certificate is issued the old cer- tificate must be surrendered for cancellation. The stock books of the Company shall be closed for transfers twenty days before general elections and ten days before dividend days. 3. The Treasury Stock of the Company shall consist of such issued and outstanding stock of the Company as may be do- nated to the Company or otherwise acquired, and shall be held subject to disposal by the Board of Directors. Sucl^ stock 30 CORPORATION FINANCE 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 maj ority 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, shail be : 1. Calling of Roll. 2. Proof of due notice of Meeting. 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 stockholders and who shall be elected annually by ballot by the stockholders for the term of one year, and shall serve until the election and acceptance of their duly qualified successors. Any vacancies may be filled by the Board for the unexpired term. Directors shall receive no compensation for their services. 2. The Regular Meetings of the Board of Directors shall be held in the principal office of the Company in New York City at 3 P. M. on the third Tuesday of each month, if not a legal holiday, but if a legal holiday, then on the day following. 3. Special Meetings of the Board of Directors to be held in the principal office of the Company in New York City may be called at any time by the President, or by any three members of the Board, or may be held at any time and place, without notice, by unanimous written consent of all the members, or with the presence of all members at such meetings. 4. Notices of both regular and special meetings shall be mailed by the Secretary to each member of the Board not less than five days before any such meeting, and notices of special meetings shall state the purposes thereof. No failure or irregu- larity of notice of any regular meeting shall invalidate such meeting or any proceeding thereat. 5. A Quorum at any meeting shall consist of a majority of the entire membership of the Board. A majority of such quorum shall decide any question that may come before the meeting. 6. Officers of the Company shall be elected by ballot by the Board of Directors at their first meeting after the election of directors each year. If any office becomes vacant during the year, the Board of Directors shall fill the same for the unex- S2 CORPORATION FINANCE pired 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. S. Reports of Officers and Committees. 3. Unfinished Business. 4. New Business. 5. 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 instiniments 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 &um and with such sureties as may be required by the Board of Directors. Article V. — Dividends and Finance. 1. Dividends shall be 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 outstanding 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 may 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 by-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 practically universal. Frequently the engraved certificate of stock 1—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 70) 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 70) 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 meeting of stockholders for the transaction of important business. Special meetings may be called from 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 in writing mailed to his last-known address. Meetings of the directors also are usually required 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 to otherwise manage its affairs. The essential officers of a corporation are the presi- dent, the secretary and the treasurer. The duties of each officer should be and usually are clearly specified in the by-laws. Ordinarily the president, briefly stated, is the chief executive officer; the secretary keeps the LEGAL STATUS 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 earnings, not out of the capital of the corporation, 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 sfurred 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 will 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 liabilities 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 ofi 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 form he has committed those assets to the care of other people. 37; 38 CORPORATION FINANCE The rights of stockholders as a body 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 stockholders, 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 number, 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. (3) 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 ah-eady 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 me at all meetings of the stockholders of the 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 corporation 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 Union Pacific Railroad, for instance, which is incorpo- rated in 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 officials from New York to Salt Lake City, each official carrying a 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- ing. Any lone stockholder who appears in person will find that his presence adds nothing to the effectiveness of the proceedings and does not change their character in the least. Of course, in smaller companies the stock- holders are more likely to be present in person, although even there representation by proxy is the estabhshed custom. One point about a proxy that should be impressed on the mind of every stockholder is that it is never under any circumstances irrevocable. The courts will not rec- ognize an irrevocable proxy as a valid agreement. No matter what the wording of the original proxy may be, no matter if it clearly and emphatically states that it is irrevocable, a stockholder may, as a matter of fact and of law, revoke it at his will. The second right, as has already been intimated, is of small practical importance. 26. The right to dividends, — The third right — to share in dividends — is so often misunderstood by stock- holders that its limitations need to be carefully noted. In the first place, notice that nothing is said as to earn- ings. A corporation may be getting enormous yearly profits and yet an individual stockholder may not draw any dividends whatever; nor can the stockholder get at these earnings until dividends are declared. In the second place, it will be pointed out in connection with the 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- perous 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 stockliolders 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 obl:ain trade information that could be used to the detriment of the corporation. Thus the anomaly was presented of a stockholder of a corpo- ration being able to work against the corporation's in terests. The courts, recognizing the situation, have greatly modified and almost nullified this original right. No stockholder can now on legal grounds demand that he be furnished with information as to the customers of the corporation, the persons from whom supplies are bought and their prices, the corporation's contracts, and other points of similar nature. In most states he gets all the information that rightfully- belongs to hinl if he 42 CORPORATION FINANCE obtains simply a summary of the profit and loss account for the preceding year and of the balance sheet at the end of the corporation's fiscal year. Indeed, he cannot in all states secure even this meagre and apparently in- nocuous information. 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 almost all the important corporations voluntarily give to their stockholders and to the public fairly complete annual 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 publicity 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 corporatipn'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. The 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 stockholders, — The next topic to consider is that of liabilities of stockholders, which may be grouped under the following four heads : ( 1 ) Their liabiHty to the corporation or to unsatisfied INTERIOR ORGANIZATION 43 creditors 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 California and Minnesota, their liability for all the debts of the corporation up to an amount equal to the face value of tlieir stockholdings. In the case of national banks the same rule holds good. A few other exceptions to the general principle that stockholders as individuals are not liable for corporate debts might be given, but would be out of place in this brief and general review of corporation law. 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 difficulties, the owners of stock at the time may suddenly find themselves con- fronted by a demand for the inmiediate payment of un- paid installments. It is a very unpleasant and not especially uncommon situation. Buyers of stock should 44 CORPORATION FINANCE 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 earnings is a practice which we shall 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 diverting to stockholders assets pledged to creditors of the corporation and for that reason is not permis- sible, if any objection is raised. 29. Rights of creditors.^^The creditors of a corpora- tion are of two distinct kinds, secured and unsecured. The secured creditors are those who have had set aside for them under some form of agreement certain parts of the property of the corporation which are to be devoted, in case the corporation fails at the specified time to meet its debt, to paying the creditor in full. The exact procedure will be discussed at some length in 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 to them. We will 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 I INTERIOR ORGANIZATION 46 shall also be stockholders. In most states the owner- ship of a single share is sufficient to meet this re- quirement. 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, Powers 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' CORPORATION FINANCE indicated, is given complete control over the corpora- tion's assets and officers. Very seldom, indeed, will the courts restrain the directors from taking any action short of selling 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 other 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 in 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, has two important standing committees, the executive and the finance. The executive committee holds frequent meetings and conferences with the chairman of the board of directors and with the president of the corporation and between meetings of the full board of directors has complete authority to settle such questions as would come before the board. The finance committee, as its name implies, handles with full authority such financial questions as in most corporations would be referred to the board of directors. The usual duties of corporation officers have already been treated in the preceding chapter. One officer not INTERIOR ORGANIZATION 47 mentioned there, who is in several large corporations of much importance, is the chairman of the board of directors. 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 paid officer to whom the presi- dent of the corporation 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 the full 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. (3) 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 attach 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 whole arrangement if he compares the corporation to a double pyramid, as shown in this diagram: CORPORATION FINANCE Clerks and Iaborers 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 authority to the president or other chief execu- tive officer, who 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 laborers at the base of the pyramid. Thus responsibility and authority conferred by the stockholders and exercised over the employees are both centered in this chief executive officer. It is an organ- ization almost ideally adapted, so far as efficiency and economy 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 railroad 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 be 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 privileges and immunities of citizens in the several states." A corporation is not a citizen, but an artificial person created by law, which is an entirely different thing. In an early case before the Supreme Court of the United States, The Bank of Augusta vs. Earle, the right of a corporation to make a contract outside the 1-4 4.y 50 CORPORATION FINANCE state of its incorporation was brought 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 by Chief Justice Taney is so important and informing that some of the salient paragraphs are quoted below: It is very true that a corporation can have no legal existence 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 where that law ceases to operate, and is no longer obligatory, the 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 it does not by any means follow that its existence there will not be recognized in other places; and its residence 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, are 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 doubted 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 which it does not reside; provided such contracts are permitted to be made by them by the laws of the place.? The corporation must no doubt show that the law of its crea- tion gave it authority to make such contracts, through such agents. Yet, as in the case of a natural person, it is not neces- sary that it should actually exist in the 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. 34. 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 is 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 estate. 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 35. Choosing the state of incorporation. — Unless there is some 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 consideration 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 corporation 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 favored 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 cerns 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- theless, 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 privileges in all the important states. 36. 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; (Including all Filing and Incidental Fees.) Capital Stock New New South of Company. Jersey. York. Delaware. Maine. Dakota. $1,000 $35.00 $16.00 $25.00 $27.00 $13.00 5,000 35.00 17.50 25.00 27.00 13.00 10,000 35.00 20.00 25.00 27.00 13.00 54 CORPORATION FINANCE Capital Stock New New South of Company. Jersey '. York. Delaware. Maine. Dakota, 25,000 35.00 2T.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 28.00 5,000,000 1,010.00 2,515.00 365.00 517.00 43.00 10,000,000 2,010.00 5,015.00 615.00 1,017.00 43.00 COMPARATIVE TABLE OF ANNUAL FRANCHISE TAXES. $1,000 $1.00 $1.50 $5.00 $5.00 None 5,000 5.00 7.50 5.00 5.00 it 10,000 10.00 15.00 5.00 5.00 u 25,000 25.00 37.50 5.00 5.00 it 50,000 50.00 75.00 10.00 5.00 (( 100,000 100.00 150.00 . 10.00 10.00 (C 500,000 500.00 750.00 25.00 50.00 it 1,000,000 1,000.00 1,500.00 50.00 75.00 « 5,000,000 4,000.00 7,500.00 150.00 275.00 (( 10,000,000 4-,250.00 15,000.00 275.00 525.00 (i South Dakota and Delaware are fair examples of what are sometimes called the "bargain 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 very WHERE AND HOW TO INCORPORATE 55 small; in such cases it is customary and obviously economical 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 necessary. In other states competent attorneys should always be secured, and their fees may be expected to range from $50 up. In this connection it may be well to remark also that the necessary corpo- rate records, which 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 carry 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. 37. Liberality of corporation laws in several states, — ^The chief respect in which state laws differ, so far as liberality is concerned, is in granting or denying the right to buy and sell the securities of other corporations. 66 CORPORATION FINANCE In 1888 New Jersey, first of aU the states, enacted that corporations formed under its laws might hold the stock of other corporations. This privilege has proved of the greatest importance in the financial and industrial development of this country, as wiU be explained in the following chapter. The New Jersey act in this re- spect has been followed by Delaware, Maine, and New York. The great industrial trusts, for this reason primarily, have almost uniformly obtained New Jersey charters. ) The recent ruling in the Court of Errors and Appeals of that state limiting and defining the right to hold shares in other companies has been men- tioned in Chapter III. VjAnother feature in which the various states differ widely with regard to liberality 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 irritating 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. 38. Permanence of the laws, — In 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, in 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- sidered 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. In this respect New Jersey is particularly favored and this furnishes an additional reason why the large corporations tend so strongly to incorporate in that state. The liabilities imposed upon stockholders have already been treated in the preceding chapter. Massachusetts, New York, California and Minnesota, as there noted, impose certain Uabilities additional to the usual liability on capital stock. In the fkst two states these liabilities are not apt to prove a serious matter. Corporations, however, generally avoid California and Minnesota.^ 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. New Jersey is so popular a state for incorporation that its provisions are well-known and its reputation is reasonably good. 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, Massachusetts, Pennsylvania and Illinois have reasonably — Massachusetts perhaps unreasonably — strict requirements, and all as^ states of incorporation are in good repute, Among aU the 58 CORPORATION FINANCE states. New York, under its "Business Corporations Law," as amended in recent years, perhaps best com- bines the advantages of liberality and of high repute. Its laws, however, have not been so thoroughly tested and settled by the courts as 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 advisabihty of buying stock of a company incorporated in some other state than the one in which it does business we give below a brief summary of the advantages and disadvantages of several states: ARIZONA. Advantages: 1. Stock may be issued for money, property, or services. The fact that it can be issued for services may be an important advantage. 2. Directors' meetings may be held outside of the territory. 3. The organization fee is very small. Moreover, there is no annual franchise tax. Disadvantages: 1. Stockholders' meetings must be held within the territory. 2. The corporation laws are unadjudicated. CONNECTICUT. Many promoters do not care to incorporate in Connecticut as they imagine that the advantages are not very great. As a matter of fact, after a thorough analysis we find that 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 ig 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. 3. There is no annual franchise tax. 4. Corporations may hold stock in other corporations. Disadvantages : 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. 2. There is an inheritance tax on the stock. 3. The organization fees are comparatively high, from $25 to $2,510. DELAWARE. 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 $20 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. DISTRICT OF COLUMBIA. Advantages: 1. Very small cost of incorporation, probably not exceeding $10. 2. No franchise or inheritance tax. • 60 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 cash. 2. 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 done in the name of the corporation till 10 per cent is fully paid iii?N> 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 directors is conclusive as to value of the prop- erty — always provided there is no evidence of fraud. 2. 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. 5. Low organization fees, ranging from $10 to $517 for a $5,000,000 corporation. Disadvantages : 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 Disadvantages : 1. Stockholders' meetings must be held within the state. 2. The corporation cannot 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 $10 for a $10,000 cor- poration to $1,200 for a $5,000,000 corporation; there is no filing fee. NEVADA. Advantages: 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 without 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 whatever. 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. NEW JERSEY. Advantages: 1. Corporations may hold stock in other corporations. New Jersey was the first state to authorize the formation of holding companies. • 62 CORPORATION FINANCE 2. Incorporators may be non-resident. 3. Stock may be issued for property or cash. Judgment of the directors is conclusive as to value of property. No pro- vision is made for this judgment being set aside upon evidence of fraud. 4. Directors' meetings may be held outside of the state, if by-laws so provide. 5. Cumulative voting is permitted. 6. A voting trust may be created. 7. Laws are all well adjudicated. Disadvantages : 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, but this does not apply to non-residents. Fees are from $25 to $1,000; filing fee $10. NEW yORK. Advantages: 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 held outside of the state. 3. Corporations may hold and control the stock of other cor- porations. 4. Cumulative voting is permitted. 5. A voting trust may be created, limited, however, to five years. Disadvantages : 1. Stockholders' meetings must be held within the state. 2. One incorporator and one director must reside within the state. 3. One-half of the capital stock must be paid in within a year from incorporation. 4. Detailed books and accounts of the business are required. WHERE AND HOW TO INCORPORATE 63 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 number 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 be subscribed, in order to make the contract binding. Usually the subscription list is accompanied by a pros- pectus (described in Chapter XXIII) which more fully states what the corporation is expected to accomplish. It should 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 immediately binding, it will become binding as soon as the proposed corporation is properly organized and prepared to handle funds. • 64 CORPORATION FINANCE The remaining step in incorporation is very simple and has already been touched upon in Chapter I. It consists of drawing up a charter in proper legal form, filing it with the secretary of state or such other official as is designated by the laws of the state in which the charter is to be obtained, and receiving notice of his acceptance thereof. 42. The wide range of choice in incorporation, — If the reader has acquired by the reading of this chapter a clear conception of the freedom and liberality of corporation laws and of the ease with which almost any legitimate business may be put into the form of the cor- poration, the main purpose of the chapter will have been fulfilled. The advantages of the corporate form for almost all kinds of business were pointed out in the first chapter. One of the chief advantages named was flexibility, by which was meant the ease with which the corporate form could be adapted to small or to large enterprises. Now we are in a position to expand still further the meaning of that word "flexibility" in con- nection with corporations and to say that it means also the ease with which the corporate form may be adjusted to any sort of a business need. If the incorporators cannot find in one state the authority or the cheapness that they desire, they may pick out some other state in which those qualities are prominent in the general cor- poration law. If the incorporators desire permanence and legal stability above all things, they may go to still another state. The range of choice is wide. It takes only a little effort and ingenuity for a capable lawyer to fit out a business enterprise with the exact corporate powers and organization that will prove most advan- tageous. CHAPTER Yi CORPORATE STOCK 43. Stock certificates not fully negotiable. — As has already been saidfcorporate stock is not a tangible thing ; it is simply a right to share under certain limitations in the management, the assets and the earnings of the issuing corporation. Stock is represented by certifi- cates, which are in the possession of the owners. These certificates, however, it must not be forgotten, are merely evidence, not proof, of the ownership of stock. Actual ownership is proved by reference to the books of the company in which the names of the stockholders and the number of shares held by each one are entered. Certificates of stock are not, therefore, strictly speaking, negotiable instruments, but quasi-negotiable^a term which the reader will find defined in the volume on Commercial Law. The question as to whether stock certificates ought to be made negotiable or not has been much agitated, es- pecially among lawyers. A committee of the Commis- sion on Uniform State La;ws, which is a body of lawyers appointed by the governors of forty-one states, issued a report in March, 1909, strongly advocating amend- ments to existing laws which would make transfer of ownership of corporate stock complete on delivery of endorsed certificates of stock without waiting for the formal transfer on the books of the corporation; in other words, the proposed amendments would make certificates of stock true negotiable instruments. The 1-5 65 66 CORPORATION FINANCE important sections of the text of the proposed amend- ments are as follows: Section 1. Title to a certificate and to the shares represented thereby may be transferred, (a) By the delivery of the certificate, if indorsed either in blank or to be a specified person appearing by the certificate to be the owner of the shares represented thereby. (b) By delivery of the certificate with a written assign- ment thereon, or a power of attorney to sell, assign, or transfer the certificate of the shares represented thereby signed by the person appearing by the certificate to be the owner of the shares represented thereby. Such assignment or power of attorney may be either in blank or to a specified person. The provisions of this section shall be applicable although the charter or articles of incorporation or code of regulations or by-laws of the corporation, issuing the certificate and the certificate itself provide that the shares represented thereby shall be transferable only on the books of the corporation or shall be registered by a registrar or transferred by a transfer agent. Section 17. Nothing in this act shall be construed as for- bidding a corporation to treat as owner in every way the person who may be registered on its books as the owner of shares. '\ In an editorial in The Journal of Accountancy, the writer said as to this proposed amendment : Accountants,, as well as lawyers and business men, have a di- rect interest in this proposition. If it is adopted by the states in which numerous corporate charters are granted, the effects will be felt in many different forms. Indeed, it is doubtful, judging from their explanatory notes, whether the commission- ers realize what an extensive reform they are proposing. At first glance, to be sure, it does not appear that any considerable revision of present practice is intended; yet the act plainly points toward passing the rights and privileges of stockholders along with transfers of stock certificates. [The change would no doubt facilitate somewhat the purchase CORPORATE STOCK 6T and sale of stock by removing the technical requirement that transfers must be made on the books of the corporation. It would enable the stock exchange brokers to carry on their busi- ness more easily and more smoothly. It would make stock cer-' tificates more acceptable to banks as collateral for loans. These are the strongest arguments in favor of the act. ^^ On the other side of the question, it should be remarked that making certificates of stock fully negotiable subjects them to increased danger of forgery, theft and loss. Many people, no doubt, would prefer the comparative safety of the present sys- tem, just as many investors, when a choice is offered, take regis- tered rather than coupon bonds. This is a point of considerable importance. A far stronger argument against the proposed measure, however, is that it would destroy the value of a cor- poration's record of its stockholders and would thereby foster fraud. Accountants are only too familiar with cases in which corporations are organized simply for the purpose of transfer- ring property from one hand to another in such a manner as to conceal profits or to swindle creditors. Under the present ar- rangement it is generally possible, if fraud is suspected, to get access to the stockholders' ledger and to learn who are the owners of the corporation. If a connection between the former owners of the transferred property and the stockholders of the corpora- tion can be proven, a case of fraud may be made out. Under the proposed arrangement it would be impossible to discover the true owners of such a corporation. The stockholders' ledger, indeed, might be kept, but it would be of small value. The cer- tificates of stock, and consequently the ownership of the cor- poration, might change hands a half dozen times without ap- pearing on the corporation's books. 1 Numerous similar cases will occur to any accountant. We do not wish to go on record as absolutely opposed to this act. We have no doubt that it would be a convenience to cor- poration officials, bankers and business men generally if stock certificates were made fully negotiable. We would emphasize the fact, however, that this provision would also prove a great convenience where fraud or manipulation is intended. It would 68 CORPORATION FINANCE make secrecy as to corporate ownership even easier than it is now and would tend to lessen the responsibility that ought to attach to the stockholders of corporations. We think these evils important enough to outweigh the advantages that have been named. For that reason we suggest that the law with regard to transfers of stock ought to be left unchanged until further pro- vision has been made for publicity of corporate accounts and for detection and punishment of the frauds which the corporate form already too much favors.^ 44. Par vs, market value of stock. — Each share of stock in practically every case has a nominal money value. The most common nominal value of each share is $100; other nominal values conmionly used are $50, $25, $10 and $1. This nominal money value of each share is sometimes called the "par value." To the un- initiated the par value of stock often seems quite an important matter. They are apt to regard it as being of much the same character as the face value, say, of a promissory note. A little reflection, however, will readily convince anyone that there is no close analogy between the par value of a share of stock and the face value of a note, and that the par value of a share throws no light whatever on the actual value of that share. To make this proposition clear, let us suppose that three oil wells are discovered by three diiFerent individ- uals, the three wells being practically identical in location, quality of oil produced, amount of flow, per- manence, cost of operation, access to markets, and other essential attributes. Each of the owners, we will say, interests some friends and outsiders and organizes a corporation to work his well. One owner is extremely conservative and therefore has his corporation issue only 1000 shares of a par value of $1 per share; the second 1 The Journal of Accountancy, March, 1909. CORPORATE STOCK 69 owner, being somewhat more sanguine, thinks his well is worth more and, therefore, has his corporation issue 1000 shares, each of a par value of $10; the third owner is blessed with a vivid imagination which leads him to have his corporation issue 1000 shares, each of a par value of $100. Now what will be the actual value of a single share in each of these companies? Obviously each share entitles the owner to one one-thousandth of the assets and earnings of the well. As the wells, ac- cording to our supposition, are equally profitable, there will be no difference whatever between the three shares so far as their actual values are concerned. Any number of further examples, drawn from ex- perience, might be given to illustrate this truth. In fact, a simple inspection of the prices for stock bought and sold on the various stock exchanges of the country is sufficiently convincing. Most of the shares of stock there traded in have par values of $100; their market values will be found to range between next to nothing and $600 or $700 — sometimes even more for bank stock. The fact, then, that a certain share of stock has a nominal value is of small importance. Its practically valuable attribute is its right to a certain share in the corporation's assets and earnings. How much is that share to be? That question may be answered simply by knowing how many shares of stock are outstanding. If a corporation's assets are worth $1,000,000 and there are 1000 shares in the hands of stockholders, we know at once that the true value of each share is $1000 with- out reference to its par value. This leads us to a question which was brought up several years ago by a prominent corporation lawyer and has been much discussed. Why not eliminate these useless par values and make each share in form as it is 70 CORPORATION FINANCE Countersigned this day of 19.... hy Transfer Agent. w 8 O o i5 o 6 o a I t ^^ 1=1 _M ST* 5Q 8 rt 1 e »:! «M "< r/) (> ert § >M h-o OS * O •^ o 'd ^ o o cc es a « o <» ^ S a ^ P o 12^ ^ •ifjBpjDas M ^y[ioji Ava^ JO iJuisduioo ^snax AlO ••••61 JO Avp siqi p3i3:jstSaH CORPORATE STOCK 71 in practice simply 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 eliminate 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 gained 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, it is not very seriously advocated and probably will never be adopted simply because the custom of assigning 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 of shares of stock need not correspond. ; This question will be somewhat further discussed in Chapter VII in connection with capitalization. 45. Nature of preferred stock. — In 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 certain amounts of stock in a separate class and grant to this class spe- 73 CORPORATION FINANCE ciiic 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 the 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 79 tions. In reorganization after bankruptcy it is necessary to cut down the claims of the various bond issues outstanding in order to put the reorganized cor- poration 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. 46. Uses of preferred stock, — 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 iseparating a company's stock into diiFerent voting classes. Sometimes the preferred stock has no vote at all ; sometimes it elects a limited number of stockholders. 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 74 CORPORATION FINANCE 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 conmion stock. If the subsidiary 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 cormnon 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 75 stock may receive on the average as large or larger divi- dends. 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 common 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. 47. Cumulative t;o^m^.-r-Originally the universal cus- tom as to the voting power of corporate stock was to give one 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. The chief objection to the original custom is that it puts the control of the corporation absolutely in the hands of the owners of the majority of the stock. Un- der this custom they elect, not merely the majority, but all of the members of the board of directors. Hence the minority stocldiolders may find themselves unrepresented and absolutely powerless. This is unfortunately the condition of the minority in almost all American corpo- rations. In order to provide to some extent against this, ac- knowledged evil and the abuses which are likely to to fol- low, it is very common in England to restrict the number of votes 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 76 CORPORATION FINANCE 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 principal 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 on the whole more widely scattered and held in smaller lots 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 effect 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 there are 1000 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 whom would represent the majority stock- CORPORATE STOCK 77 holders. Under the cumulative voting system, however, each share having five votes, the majority would cast altogether 2,750 votes and the minority 2,250. The majority could safely give 916 2-3 votes to each of three nominees and thus elect a majority of the board, leaving the other two directors to be elected by the 2,250 votes of the minority. But if the majority should attempt to elect four directors they could give only 687% 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 hypothetical 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 including such a provision in a state constitution. There can hardly be a doubt, however, as to the wisdom of putting it into the by-laws of most corporations. . 48. 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. This 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 triistees usually issue in return 78 CORPORATION FINANCE for the stock so deposited "voting trust certificates," which certify that the stock is held in trust by the trustees and which may be sold and transferred in the same man- ner 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 certain 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. CHAPTER VI TYPES OF BUSINESS CORPORATIONS 49. 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 pecuharly subject to legislative control. Private corporations are those which carry on any 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 79 80 CORPORATION FINANCE 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 readily 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 community, 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 industry are the parent company and the holding company. These two TYPES OF BUSINESS CORPORATION 81 types are frequently, even usually, confused, although the distinction between them should be kept in view. 50. 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 whole 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 companies in this country and a great many American companies have British subordinate corporations. Another reason for this method of organization is to avoid excessive local taxation. As the capitalization of each of the subordi- nate 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 reduced. 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 organization of a subordinate company at each branch. Obviously a parent company is also a holding company in the sense that it owns the stock of other corporations; but these subordinate com- panies have been created by its officers in its interest, and are in reality simply forms in which sections of its busi- ness are organized. 51. 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 ft)r the 1—6 82 CORPORATION FINANCE 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 subsidiary companies and directs their operations. Sometimes 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 ex- tent of the control, the 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 fre- quently involves loss to one or more of the subsidiary companies; that is to say, production is often concen- trated 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 subsidiary com- panies, there will inevitably be strong objections and legal obstacles to the plans of the holding company. It is also to the holding company's interest to own as much as it can get of the stock of those subsidiary 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 first balance sheet shows as assets of the holding company TYPES OF BUSINESS CORPORATION 83 simply the securities in its treasury and the first income statement reports merely the dividends and interest re- ceived on those securities ; the second balance sheet — us- ually called "consolidated" or "general" — shows as assets the physical property of the subsidiary companies and the second income statement shows their combined prof- its. A lack of knowledge of these simple facts has frequently caused confusion in the minds even of stock- holders of holding companies, many of whom do not understand the status of their own company. 52. The holding company as a means of organizing ^'trusts." — The holding company is the method now used in 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- ration finance to discuss, and both have been given*up in 84» CORPORATION FINANCE 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 any bonds, securities, or evidences of indebted- ness 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 im- portance 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 sov- ereign states had passed searching and stringent laws in pro- hibition of any attempt to restrict competition ; laws whose de- tailed minuteness of specification could hardly be improved upon; which had been proved effective against the only per- manent 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 common 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 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 them. TYPES OF BUSINESS CORPORATION 85 A trust could not exist in New York. The courts of New York would not allow the creation of a holding company to per- petuate 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. The 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 would 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. 86 CORPORATION EINANCE 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 inevitable and desirable. It is inevitable because by means of combination production as a rule can be carried no 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." 53. Compleooity 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 in- tricate and extensive organization, 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 accom- panying chart of the Interborough-Metropolitan Company, which was prepared for the Public Service Commission of the First District of the State of MANHATTAN RYT CO. (lie nil.C9 OP UXVWTCO TRACK) St6ck «< BON OS wyu" • )t i«ea > o.e I a.000 »«.v.'i.r oce* sfki9t* i.ooo.oeo. MAn:k:ooNs.«« t9«e aa.oes.ooa SUBWW KEIALTY CO STOCK •e.oooieoo MORTGAGES VJi e.Beqeeo i.n.T.caowNs4a.8oo.ooo. or stock NVaTY nrrERBOROUGHKVrCQ (o-z* MILES or tr*ckJ STOCK tspeeiooo. BONDS tVMTa.«»«M •eiooc>oooA«rrMO«»xto 1 B T CO ov»~e «ea.eoo or ♦loo.ooo.or sto;jk NEWYORKMjONG ISLA^iDRRCQ (TMt «TCINWAV TONNtL) X rcocYVM»«iv9a?oooor3Tocn pVfID TRANSIT SUBVtfWl CONSTRUCTION CO. STOCK ♦«oeAOce z INTCR-MtT.CO OWrtS^AS.VIS.eOO. Or STOCK INTERBOROUGH RAPID TRANSIT CO. oPtRATca 7«.^8MiLco or track LCAeeorxoKi the city •OrNeWVORK.. ATA RKrtTAk IN l907 0P4^789.S4«.i9 CAPITAL STOCK. ♦35.000,000 -»t*note:3 out I. mav- i9oe 15.000.000 5*/* MOTES out I «A«CH-«9io lO.OOO.OOO Tnc. suamMV, liaseo rnon the citv. has z» mixa or noAO ^incu.'OinaziiZ_aaaQWt),£]!;.T£risis!<^F WHICH ig^HiLCS i» WNOeRaROUND,8cS>«Mll.E« CLODATCD-THC MANHATTAN UlASC is^oR sovcAnswiTHAncNcvvAi. pnivikesc eresYZAite. THE bnooKuvN rxTCNsiON lease i« ron aSTEAaet vvith a PRiviueac ' COOVVN9 •a.eo4,e ' or STOCK. NEWYDRK&qUEENSCOUrnYRKCC ( 7dt.A-7 MILES or track) BONOS CONSOL. ■»> ••«• •teinwmvrv. «iki»ri t.eoe.ooo. nsvoTown Rv 8y>i«C« iBo.eoo. rLu«HiNstiCPRvai»i«8a Be.ooe. z t.dTCO OMKI3 «4 9,7SO or STOCK CnyiSLANDRRCO. ( a MILtS or TRACKy STX>CK % 50.000 BONDS 1». aw •laoaeeoL INCOME C>iai8 i.eooooo4(.4«o.ooo MORTGAGES loo.ooft all NOTES FWyABLC fiaas.^oo «.AVE.R.RCOSFIRSl CONSOLIDATED WORTGAGE OA3^E.D MAY iS^JSOtt. THE STOCKS SO PUEOSEb ARE OWNED BY THE NEW YORK CITY RAILWAY CO. Z UNION Rv:co. ( SI.B MiLEB or track) * TOTAL BONDS IVM.T.G.S/* 1*48 ia.ooo.ooo. NOTES PAYABLE STOCK 4.e4e.07T ♦4,71! a,ooo,ooe « OPERATED BY THE OfllONRY.CO. BRONX TRACTION C( ie.77 MILE.S or TRACK STOCK • WSkioo NOTES PAYABLE i6i.«.M YONKERS R.RCO. («4.46 M1LC8 or track) BONDS IWMlTViBJua^a 4i.oo<40oo NOTES PAYABLE i4eB.4»l ^I.IO STOCK i.ooo.o'oo 9^ TARRYTOV/N, WHITE PLA JJ^ViMARONE CK . RAILWAY { £3^a tvLca or T R ri sK J ^ TOTAL PLE BONDS iw mT.q B5* laaa • 300,000 NOTES PAYABLE Bca.4Bo.«43 STOCK so<»ooo SOUTHERN BOULE'V*\RDRRCQ (7MILC8 OF TRACkJ^^^ ^^ BONDS(cl) i«TMT.'G.B>i»40»e5o.ooo NOTES PAYABLE «a.«sa»t>9o STOCK espooo ue.m WESTCHESTER EXECTRICRRCC ^3789 MILES or TOACX.^ ^ . TOTAu' RL90S BONDS |WMT.h.BJ*i»4» 4BOO.OOO NOTE PAYABLE l.aa».4Ti ♦■.307 1 STOCK 90C1000 AH Chart of Interborough-Metropolltan System, i >;ITAN CO. II 0» STOCK k9l«.0OO t.eM.«oo '.392,000 M) STOCK, t I ET. SEC.CO. B^iWECOACHOQl I BARK COACH • l.S»eiOOO ATOCK OWNCO NYITRANSPORTATION CrtPiTAu STOCK ♦^yogooo 4a4|39S.OOOSTOCK. OWNCO MEIBOPOUTAN SECURniCS04 A MO t-OINS CXt OPERATES NO ROAO STOCK/_s«%Bmo)#30;0Oftooa OI.C ••OO.eoO STOCK OWNCO*"^"'"""'''" NyWESTCHESTER8kOCNRTR«mOMOO BRONX PPANCNISKS tUDCXXOOO STOCK OWNeO VaftUACORTLfiNDT ST. FERRIES FKCQ CQ #I,IIS.OOO COMMON STOCK OMNEO ELECTRIC STORAGE BfflTERY Ca O&MKONSTocKtia.oaaazB i?wcFewqEO fteM^soo ^ AIL 9ECUIUTIC9 OmNCD(l£MltCaor TPMQ JEHOME i¥J»RK PK CO. STOCK ^ooo.BONDS«»»K>QOoo ui. eTocK(4i.Boo.ooo)on'Neo DPLESTRACTIONCQ^ IINCMHSES IN THE BRONX ALL STOCK IftSUCO MtOOqOOO) OW4CO N.V: CITV KV. CO. 5roCK«20.ooo,ooo OEncTT %{^i>7«Kta9: AUUTMt • I.OOCiOOa STOCK OWKEO 28&29«ST. CROSS ITiYVN HY.CO. (S.7MH.ESTBftCy.) BONDS 5?tj9t>6(o}i4 isoqooo OU».s»i>4» ♦ytsetoeo. FCM conponATc kirc ocK tc rixtn CHARGES 3/WE.R.R..CO. MILES or TRACK ) ••« vcTAns « -400, ooo. ►VRLEM R.R.CO. eaoF track) ALr STOCK (^i,ocoooo)OMn«ii:o in svstcm THIRTYrpURTHarrCROSSTOWNHiaX). »^..,^^ ,( •» MILES OF TWACKjT BONDS p<<.' iss^ro-) * ..oc^^ooo.' kCASEO fO« COBPO«tf,TE UFB-lO^ON STOCK Ji owns • Jtcoo BONDS l»e>f»M9sBoooio-MErsRY.CoaMrNa«Boqooo DCS. Bi*. , IBOOOO- ..... AH. LEASED FOR •••YCAKS - 71* STOCK U FlXEI? '=M>«XI6Ee CO. OWNS ^.««.OB«.«00 evocK WBTHDPOLrMN STREET RAILVaWCQl ( &4AMILE.SOF track) STOCK *5E.OOOOPO eEhfL^COL-TPUST 5% i»97 RCFUNOINC 4tb eooa METCROSSrrOWNlVB^ IS20 LEX.AVE.8kPAV.F. e> 1993 COL.«<.9''~AVe. tV»?&|»93 aO.rcRRV 6?* 1919 SWAY SURrACE IW 6?6 1984 REAUESTATE KffSS'S. E"WAY SURFACE ZV ejk MET. CaOSSTOWN a^s* ro« corporate i fc FIXE D CM . ^ArO>Srr.FERR\'RRCQ MILES OF TRACK) «oeo-BVSTCM owiis V44&oec M.TG.«j»i909 «a3€^oco ©TOCK 41.000,000 - met. SEC.CO.OvvN6«Bao( SCRIP «>» ^ LEASE. exCIREO 19 ^ NINTH AVE.R.R.Ca 16.1. MILES OF TRACK STOCK »eoo.ooo LEASE EXPIRES Kr7S-iy>H < BLEECKp!^sr^8.FU^^Np«iyi '^ STOCK ♦900.000- SYSTEM OWNS JlQ ♦ .TDAOOO taOQOOO - BONDS *jt neo LEASED FOR a09YIEARB-IS> ON STOCK Sc FiXCO CHARCCS CENl'HAL CROSSTOWN R.R.CO. ( aesMiLES OF track) STOCK feooooo- SYSTEM OWNS taoa.ooo BONOS iv leee . ascoeo tVCX>NZA^ I0S2 (t) LEASED FOR 999VEARSS>(0NST0CK8c. FIXED CHRRSeS CHRISTOPHEIH &olO'J> Sa:R.H.CO. STOCH4»Bo.eee(swn.!:aoFTWAeK)6CNDS-4?fcisi»«Eio.ooo LEAs»« r©a conposiATj: iirE-95*ON stock CENTRi^ PARSCJ.T&tE.RIVERR.RCO. (aO.-rV MlLtS OP TRACK ) STOCK «i.epo.ooO.- SrSTEKl OWNS i336.900 LEASCO FOR eOOVEARS (MS.OOO SIX^TH: /WE.RR CO. (It MILES OF track) STOCK s e.ooo.ooo. ^lew York Public Service Commission. TYPES OF BUSINESS CORPORATION 87 New York. The Interborough-Metropolitan Company controls all the street car, elevated and subway railway lines in the principal 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 Rapid Transit Company. The relations of these two companies to each other, to their direct sub- sidiaries, and to the subsidiaries of their subsidiaries, are as clearly as possible presented in the chart. 54. 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 controlled by the Standard Oil Company of New Jersey. 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 is the "parent" of something over half of the subsidiaries shown in this list; it is a true holding company, in the sense in which that term has been defined in this chapter, so far as the other subsidiaries named are concerned. I. COMPANIES WHOSE STOCK IS OWNED DIRECTLY BY THE STANDARD OIL COMPANY Total Per Cent Capital Owned by Name. Stock. Standard, Anglo-American Oil Co., Ltd $5,000,000 100 Atlantic Refining Co 5,000,000 100 Bedford Petroleum Co 350,000 99.3 Borne-Scrymser Co 200,000 99.9 Buckeye Pipe Line Co 10,000,000 100 Carter Oil Co 2,000,000 100 Chesebrough Mfg. Co 500,000 55.5 Continental Oil Co 300,000 100 Colonial Oil Co 250,000 99.7 Crescent Pipe Line Co 3,000,00(T 100 88 CORPORATION FINANCE Total Per Cent Capital Ownedhy Name. Stock, Standard. Clarksburg Light & Heat Co 100,000 51 Deutsch-Amerikanische Petroleum Gesellschaf t 2,250,000 100 Deutsch-Amerikanische Petroleum Gesellschaft , (share warrants) 5,250,000 99.9 Empire Refining Co 100,000 78.5 Empreza Industrial de Petrolio 500,000 70 Eureka Pipe Line Co 5,000,000 100 Forest Oil Co ? ? Gilbert & Barker Mfg. Co 40,000 100 Galena-Signal Oil Co. pfd 2,000,000 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 200,000 100 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 25,455,200 99.9 New York Transit Co 5,000,000 100 Northern Pipe Line Co 4,000,000 100 Northwestern Ohio Natural Gas Co 2,775,250 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 Romano- Americana 2,500,000 100 Reserve Gas Co 2,225,000 50 Raffinerie Franyaise 80,000 100 River Gas Co ■. 190,000 5^.Q Solar Refining Co 500,000 99.8 Southern Pipe Line Co 10,000,000 100 South Penn Oil Co 2,500,000 100 South West Pennslvania Pipe Lines 3,500,000 100 Standard Oil Co., 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 89 Total Per Cent Capital Owned by Name, Stock. Standard. Underhay Oil Co 25,000 98.8 Union Tank Line Co 3,500,000 99.9 Vacuum Oil Co 2,500,000 100 Waters-Pierce Oil Co 400,000 68.6 West India Oil Refining Co 300,000 50 West Virginia Oil Co 200,000 50.6 West India Oil Co 100,000 99.3 Washington Oil Co 100,000 71.4 II. COMPANIES WHOSE STOCK IS OWNED PRIMARILY BY SUBSIDIARY COMPANIES Amerikanische Petroleum Anlagen $187,500 100 Automaat Co 10,000 100 Eschweiler Petroleum Import 7,500 25 Ghent Petroleum Co 200,000 60 Hollandsche Petroleum Vereeniging 12,000 100 Mannheim Bremer Petroleum Actien Gesellschaf t . . . 750,000 100 Petrolifere Ghent 20,000 74.5 Petrolifere Nationalc 10,000 100 Petroleum Raff, vorm August Korff 375,000 54.6 Societe Anonyme H. Reith Co 412,500 61 Rheinische Petrol. Actien Gesellschaf t 250 100 Actien Gesellschaft Atlantic 287,500 60 American Petroleum Co 3,140,000 51.3 Street Tank Wagon Business-Duren 4,250 71 Gibraltar Petroleum Co 25,000 100 Imperial Oil Co., Ltd 4,000,000 83.1 Det Danske Petroleums Aktieselskab 756,000 51.3 Tidewater Oil Co 20,000,000 31.1 Tank Storage and Carriage Co., Ltd. pfd 300,000 100 Tank Storage and Carriage Co., Ltd., ordinary 42,195 100 Societa Italo-Americana pel Petrolio 1,000,000 60 Aktieselskabet Ostlandske Petrol. Cie 162,000 9.2 Krooks Petrol, and Olje Aktiebolag 270,000 10 Skanska Petroleums Aktiebolaget 135,000 60 Svenska Petroleums Aktiebolaget 27,000 75 Sydvenska Petroleums Aktiebolaget 98,550 24.7 Kestkustens Petroleums Aktiebolag 177,500 15.3 Koenigsberger Handels Compagnie 575,000 49.8 Petroleum Import Compagnie 80,000 100 Schweizerische Petroleum Handels Gesellschaft 60,000 60 Societe Anonyme Petrolea 80,000 66.5 Wachs. & Flossner Petrol. Gesellschaft,,,.,,,,,,.. 25,000 * 100 90 CORPORATION FINANCE Total Per Cent Capital Owned by Name. Stock. Standard. Westphalische Petroleum Gesellschaft 25,000 100 S. T. Baker Oil Co 50,000 100 Galena Oil Co. — Societe Anonyme Fran9aise 40,000 100 Queen City Oil Co., Ltd 200,000 87.4 Connecting Gas Co 825,000 49.9 Cumberland Pipe Line Co 1,000,000 99.9 East Ohio Gas Co 6,000,000 100 Franklin Pipe Line Co 50,000 39 New Domain Oil and Gas Co , 1,000,000 99.9 Prairie Oil and Gas Co 10,000,000 100 St. Paul Petroleum Tanks (Lim.) 250,000 55 Societa Meridionale pel Commercio del Petrolic 120,000 Societa per gli Olii Minerali 156,000 52.1 Society Tunsienne des Petroles 80,000 65 International Oil Co., Ltd 2,750,000 99.4 Vacuum Oil Co., Proprietary Limited 500,000 100 Vacuum Oil Co., Reszvenytarsasag 2,100,000 100 Vacuum Oil Co., Limited 275,000 99.9 Vacuum Oil Co.— Soci^t6 Anonyme Fran^aise 400,000 100 Deutsch — Vacuum Oil Co 625,000 100 Vacuum Oil Co.— Societa Anonyme Italiana 100,000 100 Vacuum Oil Co.— Aktiebolag 27,000 96.6 Taylorstown Natural Gas Co 10,000 70 Total $229,963,195 Standard Oil Co. of New Jersey 98,338,300 Grand total $328,301,495 CHAPTER VII SOURCES OF CORPORATE FUNDS 55. Summary of preceding chapters, — The first six_ chapters of this book cover those fundamental features of corporation law which are essential to an understand- ing 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 stockholders; of directors; of officers; the process of incorporation ; the factors to consider in select- ing the state of incorporation; the relative advantages and disadvantages of several states; the characteristics of common and preferred stock; the uses of cumulative voting and of voting trusts ; the nature of a close corpo- ration; of an ordinary operating company; of a parent company; of a holding company. All of this matter, although 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- ject we are now ready to take up. It must not be for- gotten at any stage of this study, however, that all finan- cial measures must comply with and be in harmony with the legal principles that have been discussed. 56. Four sources of corporate funds, — In financing a corporation the managers may go for funds to six dif- ferent sources, as follows: ~V" 92 CORPORATION FINANCE ^ (a) Active interests in the business (b) Profits of the business (c) Trade creditors (d) Banks (e) The investing pubhc (f) The speculative pubHc. There is no need of discussing in detail methods of raising funds from people 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 in- terested to invest as much as he can and will on terms that are settled by direct bargaining. Profits that are not paid out from a surplus that may be one of the most important sources 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 furnishing 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 93 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 go- ing 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 ANii 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 loans, usually not longer than ninety days. We will dis- cuss the requirements of banks in detail in the next chap- ter. It is enough for the present to say that funds se- cured from banks will almost always be short-time loans in strictly limited amounts backed by unexceptional se- curity. • 57. 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 who have inherited money; (c) estates held in trust; 94i CORPORATION FINANCE (d) savings institutions; (e) insurance companies. Business 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 investment securities. One of the great problems of raising funds for many kinds of business is to arouse interest and inspire confi- dence in this 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. 58. 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 some- what technical sense by the leading financial papers, re- fers to a security or other property which is practically certain, so far as human minds can foresee, not to de- preciate 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 conclusive, that the security or property will not depreciate in value, then the terms semi-investment or semi-speculative may be applied. To illustrate, a United States Government bond is certainly an investment, and so is a first mortgage bond on any of the standard railroads. Most of the in- dustrial bonds, however, even where the earnings are large and the prospects apparently good, would be classed as semi-investments, because there is always dan- ger that competition or some new invention will cut into SOURCES OF CORPORATE FUNDS 95 the business. In the same way high-grade preferred stocks of successful railroads and industrial companies would be called either semi-investment or semi-specula- tive issues. For our purposes in this book these finer distinctions are not necessary and would perhaps be con- fusing. We shall, therefore, use the word "investment" in a more popular sense to include both the true invest- ment and the semi-investment or semi-speculative se- curities. 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 to 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 specu- lative in character. When the terms "highly specu- lative" or "purely speculative" are used, however, it is generally safe 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. ^ 59. 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 difference 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 96 CORPORATION FINANCE 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 se- cured through accounts and bills payable, through bank loans or through bonds and mortgages. The owned funds are secured through issues of stock. 60. Desirability of borrowing 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 cor- poration to be out of debt is no credit to it, but rather a sign either that it is in a dangerous position or that it is not intelligently managed. Only one method of raising funds is cheaper than borrowing, and that method is stealing. Therefore, a corporation should borrow as much as it can within the limits of safety. To illustrate the desirabihty 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 97 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 ex- [ tent of $10,000 and borrows $5,000 from banks at an 3 average rate of 5 per cent. Then, only $35,000 stock need be issued, the income of which, after deducting in- 1 terest charges of $2,750, will be $3,250, or 9.3 per cent, ^|2 a satisfactory return. \\i 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 lim- its 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 Company, A. Booth & Company, and United States Leather Com- pany) selected practically at random, which will perhaps make these statements somewhat more vivid and con- crete. Assuming that the balance sheet of the first- named concern is based on the actual value of the prop- erty (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 "Patents, trade-marks, etc., $92,000," leaving approxinfately 1—7 98 CORPORATION FINANCE HERRING-HALL-MARVIN SAFE CO. Assets: Real estate and buildings ^202,652 Machinery, &c 298,864 Stocks on hand at cost 207,076 Work in process & materials 320,988 Bills & accts. rec. & cash 372,830 Insurance, &c., paid in adv 8,095 Stock of other companies 1,000 Patents, trade-marks, &c 92,000 Total $1,512,506 Liabilities: Capital stock $700,000 Debentures maturing to 1915 410,000 Bills payable 170,354 Accounts payable 92,561 Reserves for completion of contracts 64,208 Contingent liability reserves 16,000 Surplus of year's operation 59,383 Total $1,512,506 AMERICAN THREAD CO. Assets: Land, water, & steam power, mills, machinery, plant & effects $12,694,896 Stocks-in-trade at net cost 4,960,971 Accounts receivable, net 1,016,445 Cash at bankers & in hand 341,483 Sundry investments 229,840 Advance payments 38,292 . Total $19,281,927 Liabilities : Com. stock ($3.50 paid up) $4,200,000 5% 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 60,000 SOURCES OF CORPORATE FUNDS 99 Depreciation fund 2,076,987 Div. on com., payable July 588,000 Profit & loss 344,891 Total $19,281,927 BETHLEHEM STEEL CO. Assets: Property account $37,857,260 1st mtge. bonds reed, in part payment for property 518,848 Inventories 6,795,542 Notes and accts. receivable 2,513,186 Cash on hand & in bank 4,230,418 Deferred charges 943,a24 Total $52,858,578 Liabilities; Capital stock $29,770,000 Bonds of Bethlehem Steel Co 16,159,000 Notes & accts. payable, &c 5,735,154 Bond interest accrued 103,145 Reserved for depreciation 400,000 Reserved for relining furnaces, &c 97,885 Surplus 593,421 Total $52,858,578 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 119,448 Treasury preferred stock 20,800 Treasury common stock 170,650 Plants, steamboats, real estate, etc 5,510,927 Total $9,757,827 100 CORPORATION FINANCE Liabilities: Common stock $3,000,000 Preferred stock 2,500,000 Surplus 1,522,700 Undivided profits 202,138 Accounts payable 931,989 Bills payable I,601,i00 Total $9,757,827 UNITED STATES LEATHER CO. Assets: Cash $2,505,159 Due by customers 10,761,665 Bills receivable 1,277,339 Doubtful debts, val 8,832 Other debtors 1,070,602 Hides & leather 15,269,784 Bark at tanneries 1,677,962 Sundries, pers. property, &c 654,627 Advance to other companies 1,920,921 Drawbacks 464,492 Railroad mortgage 100,000 Tannery plants, etc 6,847,706 Stock of other cos 56,760,181 Bonds of other cos 6,879,888 Real estate interests 490,235 Treasury stock Good-will, &c 62,832,300 Unexpired insurance 106,293 Total $169,627,987 Liabilities : Common stock $62,882,300 Preferred stock 62,282,300 Bonds less in treas 5,080,000 Accrued interest, etc 67,960 Current accounts 609,585 Foreign exch. not due 2,072,904 Bills payable 13,080,000 Miscellaneous 639,729 Surplus 22,913,209 Total $169,627,987 SOURCES OF CORPORATE^ ^UN1)S 101 $1,420,000. The borrowings, including bonds, bills pay- able and accounts payable, are approximately $670,000, or something over 47 per cent of funds. To arrive at the actual funds utilized in the property of the American Thread Company we should deduct from the $19,281,000 assets the depreciation fund of $2,076,000. Of the total funds, approximately $17,- 200,000, about $7,750,000 is borrowed (including bonds, debts to stock- and bond-holders and to English Sewing Cotton Co., and accounts payable) . The percentage of borrowing is 45. Deducting reserves for depreciation we find funds of the Bethlehem Steel Company to be approximately $52,- 500,000. Borrowings are about $22,000,000 or 42 per cent. In the case of A. Booth & Company there are funds of about $9,750,000 and borrowings of $2,500,000, or 25.6 per cent. As the firm failed in September, 1908, this low percentage of borrowings tends to confirm what has already been said, to the effect that abnormally small borrowings indicate either a weak or a mismanaged com- pany. In estimating funds in the United States Leather Company, we should, of course, deduct "good-will." It is not improper also to deduct stocks and bonds of other companies, all of which were obtained in exchange for preferred and common stock. This leaves actual funds of approximately $42,700,000, against borrowings of $20,800,000, about 49 per cent. It goes without saying that this analysis of the five balance sheets is superficial and that the results are merely suggestive. To ascertain the exact proportion of borrowed to owned funds in each case we should have first to learn the exact, not the nominal, value bf the lOS! ' • * CdRPORATION FINANCE 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 figures 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. 61. 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 funds from each of the four sources outside the business itself named above the corporation manager will offer: SOURCES SECURITIES (a) To trade creditors Bills and notes payable (b) To banks Notes payable and en- dorsed notes receivable (c) To the investing pub- Mortgage bonds and per- lic haps preferred stock (d) To the speculative Stock. public. 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 CORPORATE FUNDS 103 (b) Property that could be sold without breaking up the business, though the sale would probably be at a heavy sacrifice, such as, outlying real estate, securities of other companies control of which is not essential to the 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 borrowed money, as follows: (a) Mortgages and mortgage bonds obtainable as a rule on good terms up to 60 to 75 per cent of the ap- praised value of real estate; 50 per cent of buildings; 25 to 40 per cent of machinery ; 50 to 90 per cent of se- curities. (b) and (c) Income, profit-sharing and car-trust bonds, on a great variety of terms, preferred stock in some cases and to some extent short-term notes and bank loans. (d) and (e) Accounts payable and bank loans. Group (f ) and the diiFerences between the other as- sets and their corresponding liabilities are usually rep- resented by stock issues and by surpluses. The reader will understand, no doubt, that this classification is merely approximate and is not always followed in prac- tice; yet an analysis of balance sheets will reveal, on the whole, a close adherence by corporation managers to the principles just stated. In all industries, more or less, and especially in rail- roads and stable manufacturing concerns, the creditors of the corporation, as we shall see later, pay mol-e at- 104 CORPORATION FINANCE tention to the ineome account than to the balance sheet. The gross earnings of any corporation are necessarily devoted to the following purposes: (1) Operation; (2) maintenance; (3) fixed interest charges and rentals; (4) floating interest charges; (5) betterment and sur- plus; (6) dividends. The stability and amount of the earnings will, of course, greatly affect — in fact, determine largely — the value of a corporation's assets, and in that way will affect the amount and kind of securities that it may wisely issue. ' CHAPTER VIII SHORT-TIME LOANS 62. Trade credit as a source of funds, — The preceding chapter named, without describing, the three forms in which 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 in turn and see what we can discover as to the principles that 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 days is usually allowed before trade creditors begin to press for payment and a company whose business is worth having can often considerably lengthen the av- erage time of settlement, if that policy proves desirable. In some lines — especially when the sales are in 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. • 105 106 CORPORATION FINANCE 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 and with safety. These two quaHfications 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 unwilling 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 98-100) , we find: (1) That on the date of the balance sheet the quick liabilities of the Herring-Hall-Marvin Safe Company were about 70 per cent of quick assets and about 29 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 as- sets, including stocks, investments and advance pay- ments. ) SHORT-TIME LOANS lOT (3) That the corresponding percentages for the Beth- lehem Steel Company were 85 per cent and 44 per cent. (4) That the corresponding percentages for A. Booth and Company were 83 per cent and 64 per cent. (5) That the corresponding percentages for the United States Leather Company were 100 per cent and. 82 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 over 75 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 business, on the seasons, on the nature of the company's assets, on the ease with which bank credit may be secured, and on the general commerical 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 until we begin a study of the financial management of corporations. 63. What reliance should be placed on bank loans? — Bank loans are not usually to be had except on first- class securities 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 for such statements, adopted by the New York State Bankers' Association, and widely used, is pre- sented on pages 108-109. Let us see how critically a banker will examine one of these statements when pre- sented by a corporation with which he is not thoroughly; 108 CORPORATION FINANCE o H O Ph P^ O o p^ o p:! O Ph 1^ % M" a a -! PI « DO t>0 « bo d ^3 02- 5 a -^ c3 i» £ o PI -^t Oi 03 « SI'S ■^ g X 0.2 o -^ d „ « • •^ § S S • S "^"^^ --^ 5 a <=> « . » c3 • ■ oi aj'd « S -*^ja ISA 2 «02 ai 002 W t-t-.IH fiWO SHORT-TIME LOANS 109 3 a 5^ .a : ^ ^«^ M «J 3&-& 3^0-2^.5 >^^.2|t: h.t;>hx:3o_go+->c6Scs:i3 x-sx! =* 'S U..S -^ .S >-> !>^a H 5i 4» 05 ^ t3 »5 '^ « W 5 C6 eS ^_. ,y ^^ c '-' bo o ■^ S oj > O cs _ f-j s a^ 1 § g - ^S ° S . 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W eSco > CO be +2 £ g .-oS I = «-2-S S 148 CORPORATION FINANCE < o O < c g Pi O ffi cc H cc Pi ^2; «f3 rfn ^ i B O 3 C ^^ « -^ S ^ I c S § ft « QJ O -O > 'O c c « S S 3 a 9i. ft ^ ft 60 rQ n3 (/i « rn -^ W3 -c •£ M *H o 52 cc I 60 pi t: 's § *y « 4. T^ ^ 42 fe 'O CO "^ QJ ft.S ^ ft C r "^ ft o n, 3 •^ ^H CO a bi f-^ § ft H ^ c .^ rr- O *^ I ^^ '^ ^ a 2 ^ ^-^ 3 M W •3 a ja "> -43 - en ft 52 ft H o c 60 .a i^ o a 4-1 03 1| CA C •^ ^ •a & ^ .as" C 9 fco 3) C O s ■? ^^r ^ O -tJ ft >^ a -^ =« ^S ft J5 •J2 ft .^ I ^ 60 (U -M 4-> "^ O «H o ft (U « 60 o B Pi 3 CO ft CO « -. « 3 •M eg f® CO 4^ 5 4) CO ^ S £ ;S .•s ^ J^ pa© (U £
  • . . $110.00 Common stock 4.00 $107.50 American Steel and Wire Company of New Jersey: Preferred stock , ,. . 117.50 . .. Common stock ., 102.50 National Tube Company : Preferred stock 125.00 Common stock 8.80 125.00 208 CORPORATION FINANCE National Steel Company: Preferred stock , 1S5.00 Common stock . ...,...., 125.00 American Tin Plate Company: Preferred stock 125.00 Common stock , 20.00 125.00 American Steel Hoop Company: Preferred stock . 100.00 Common stock ...... 100.00 American Sheet Steel Company : Preferred stock . ., 100.00 Common stock ,. . 100.00 With reference to the last four companies, the aggregate amount of stocks so to be offered was arranged with the princi- pal stockholders of those companies, who have requested the dis- tribution of such amount among the four companies, to be made in the percentages above stated. Statements furnished to us by officers of the several companies above named and of the Carnegie Company show that the aggre- gate of the net earnings of all the companies for the calendar year 1900 was amply sufficient to pay dividends on both classes of the new stocks, besides making provisions for sinking funds and maintenance of properties. It is expected that by the con- summation of the proposed arrangement the necessity of large deductions heretofore made on account of expenditures for im- provements will be avoided, the amount of earnings applicable to dividends will be substantially increased, and greater stability of investment will be assured, without necessarily increasing the prices of manufactured products. All shares of the United States Steel Corporation deliverable to or for account of the syndicate, which shall not be required for the acquisition of the stock of the Carnegie Company or for delivery to depositors under terms of this circular, are to be retained by and to belong to the syndicate. It is proper to state that J. P. Morgan & Co. are to receive no compensation for their services as syndicate managers be- THE UNITED STATES STEEL CORPORATION 209 yond a share in any sum which ultimately may be realized by the syndicate. J. P. Morgan & Co., Syndicate Managers. 110. Profits of the 'promoters, — The sum which ulti- mately was realized by the syndicate was never made public, but it is easy to figure that it must have been in neighborhood of $240,000,000, face value, of common stock, against which should be off-set $25,000,000 cash furnished by the syndicate and the expenses of promo- tion. Assuming that the common stock was sold by the syndicate members at an average price of thirty, which is probably lower than the actual average, we have gross profits of $72,000,000. Deducting the $25,000,000 and assuming expenses to have been $1,000,000, we have left net promoters' and underwriters' profits of $46,000,000 — a huge sum and yet not too great, considering the risk and the financial power and ability required in the unprecedented undertaking. The provision of cash by the syndicate was a somewhat unusual method of meeting this part of the financial problem involved in promoting a consolidation. 111. Capitalization at the he ginning, — It is worth noting that the $160,000,000 Carnegie stock obtained in exchange $98,000,000 preferred stock, $90,000,000 common stock and $144,000,000 bonds of the Steel Cor- poration. In addition $160,000,000 Carnegie bonds ob- tained an equal amount of United States Steel collateral bonds. Thus the par value of the stocks and bonds given to Carnegie Company security holders was nearly one-half billion ' dollars, more than one-third the total capitalization of the corporation. The aggregate capi- talization of the other seven original companies was $457,000,000 and the par value of Steel stock given in 1—14 ^10 CORPORATION FINANCE exchange was $532,000,000, an increase of $75,000,000. The terms of exchange were so liberal that 98 per cent of the stock of the original eight companies was acquired. Shortly afterwards two other companies were taken in, namely: 1. The American Bridge Company which had been formed in April, 1900. This company had absorbed twenty-six separate concerns and embraced over nine- tenths of the bridge-building interests of the United States. 2. The Lake Superior Consolidated Iron Mines Com- pany, which owned and operated valuable mines in the Mesaba range of the Lake Superior iron region. Practically all the securities of the Lake Superior Company were acquired and 85 per cent of the stock of the American Bridge Company. The capitalization of the United States Steel Corpo- ration at the end of the first year was as follows : Capital Stock, Preferred . $ 510,281,100.00 " " Common 508,302,500.00 Capital Stock of Subsidiary Cos., outstand- ing . 215,914.38 U. S. Steel Bonds . 303,757,000.00 Other bonds - 56,997,326.00 $1,379,553,840.38 The figures following will give some idea of the enormous extent of the steel corporation's property at the beginning: 213 diff*erent plants and transportation companies; 41 mines; nearly 1,000 miles of railroad; a lake fleet of 112 vessels which constituted one-third total tonnage of Northern Lakes; controlled 78 blast fur- naces, one-third of the number in United States; owned I i THE UNITED STATES STEEL CORPORATION ^11 57,000 acres of coking coal land; leased 50,000 acres Pocahontas Coal land, W. Va.; owned considerable areas of steam and gas coal in Illinois. The most im- portant assets of all were the ore deposits in the Lake Superior region, which were estimated by Mr. Schwab at 750,000,000 tons. 112. Additions, — The principal additions to the steel corporation have been: 1— Shelby Tube Co. . .- 1901 2— Union Steel Co. 1902 S — Holdings of Chemung Iron Co., Duluth. .i 1903 4— Properties of Clairton Steel Co 1904. 5 — Lease of Hill holdings in Lake Superior Region .... 1906 6 — Tennessee Coal, Iron and Railroad Company 1907 The Shelby Steel Tube Company was a small and greatly over-capitalized concern which was, however, the largest maker of seamless tubing in the world. The Union Steel Company was a consolidation of seven coke-mining, sheet steel, tin plate and steel com- panies in and near Sharon, Penna. The Chemung Iron Company was a Detroit concern hich owned a large and important block of Mesaba re deposits. The Clairton Steel Company was a Pittsburg concern which owned a large plant, 2,600 acres of coking coal land, 20,000 acres of mineral lands in the Marquette Range and considerable railroad and limestone proper- ties. On April 15, 1907, the notable lease of the Hill ore lands was ratified. The lease provides that a royalty of $1.65 per gross ton for ore of a fixed grade was to be paid in 1907 and the royalty increased 3 4-10 cents per ton each succeeding year. The minimum to be mined 212 CORPORATION FINANCE and shipped was 750,000 tons in 1907 and is to increase 750,000 tons per year until it reaches 8,250,000 tons. The lease will continue until the ore is exhausted, the option being reserved, however, to the steel corporation to determine the lease in 1915. In November, 1907, the corporation acquired about $30,000,000, or practically all, of the outstanding com- mon stock of the Tennessee Coal, Iron and Railroad Company. The stock was paid for at the rate of $11,- 904.76 par value of the 10-60 year sinking fund 5 per cent bonds of the steel corporation for $10,000 par of Tennessee common. Most readers no doubt will recall the circumstances surrounding this deal. It was made possible by the ability of the steel corporation to put up ready cash in the critical time of the October, 1907, crisis. The cash was used to buy in the steel corpora- tion's own bonds with which to pay for Tennessee stock. The operation thus had a double effect of supplying cash to persons who needed it badly, and of supplying a security, which was acceptable as collateral, in place of the unavailable Tennessee stock. The Tennessee Company owned 16 blast furnaces, 450,000 acres of coal, ore and limestone and timber lands, large developed coal mines and a big steel rail mill at Ensley, Ala. Besides these large purchases the steel corporation has also increased its holdings by building out of its earnings an entirely new plant. At Gary, Indiana, there has been erected a large modern steel rail mill at a cost of $75,000,000. The mill began operations in 1908. At Duluth, Minn., 1,350 acres of ground have been purchased and arrangements have been partially made to put up another large steel mill. Both these new plants are called for by the great increase in the western demand for steel. THE UNITED STATES STEEL CORPORATION 213 113. Fina7icial 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 be exchanged, dollar for dollar, for an equal amount of preferred stock and $50,000,000 was to be sold for cash. Each preferred 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 eiFected. To this plan 99 8-10 per cent of the stock voted at the annual meeting assented. The plan was objectionable, however, to certain stock- holders 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 objectionable in that the issue was to be underwritten by a syndicate which in- cluded 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 bonds not taken by the stockholders and they were to get a 4 per cent commission on all the bonds sold to the stock- holders or otherwise. It was objected that under this 1 See a copy of the agreement in Chapter XIX. ^14 CORPORATION FINANCE agreement the syndicate took a very slight risk inasmuch as it was practically certain that at least $100,000,000 worth of bonds would be sold, and got an excessive com- mission. The objections on this score were never satis- factorily answered. The opponents of the conversion plan secured a tem- porary injunction and brought suit to restrain the di- rectors from carrying out the plan. The decisions of the court, however, were in favor of the steel corpora- tion management, on the ground that no fraud was shown and that the great majority of the stockholders had approved the issue. The danger of disaster to the corporation, on account of its great increase in bonded obligations, is somewhat lessened by the fact that the interest on these sinking fund 5's must lapse for two years before foreclosure proceedings can be commenced. This provision is a safeguard to the corporation, though, of course, it would not be of great value in a period of prolonged depression like that from 1893 to 1897. The slump in the steel business in 1903 made it neces- sary for the corporation to economize. Several mills were dismantled and some of the sub-executive offices were abolished. It became desirable to change somewhat the financial organization of the corporation. In March, 1903, the original Carnegie Company of Pennsylvania, the National Steel Company and the American Steel Hoop Company were combined under the name of the Carnegie Steel Company of New Jersey and later in the year the American Sheet Steel Company and the American Tin Plate Company were combined as the American Sheet and Tin Plate Company. Early the next year the corporation's search for wider markets led to the formation of the United States Steel Products Export Company, which is the selling agency for all THE UNITED STATES STEEL CORPORATION 215 the foreign business of the corporation. The direct con- trol of this company is in the Federal Steel Company. 114. 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 aggregate capitalization of the first ten companies to enter the corporation was approximately $710,000,000. In exchange for this amount of stock the corporation issued $868,000,000 stock and $144,000,000 bonds, an increase 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 $542,000,000 of 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 Company, 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 Steel Sheet companies, all of which were promoted by the same interests as the American Tin Plate Company, the same principle was followed. Similarly, Mr. John W. Gates testified that of the $80,000,000 capitalization of the American Steel and Wire Company, $20,000,000 to $30,000,000 was water. Of the $100,000,000 capitalization of the Federal Steel ne CORPORATION FINANCE Company, about $45,000,000 represented tangible assets and $10,000,000 cash assets, while the rest was water. These statements are enough to indicate that of the $710,000,000 capitalization of the original companies, a large share stood for nothing more tangible than good 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 good 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- ductive capacity of the steel corporation and that these plants had been valued on March 12, 1900, by the part- ners of the Carnegie Company in a legal proceeding at $75,000,000. On the other hand, Mr. Charles M. Schwab, then president of the steel corporation, sub- mitted the following valuation: 1— Iron-ore Properties ., $ 700,000,000 2— Plants, Mills, Fixtures, Equipments 300,000,000 3— Coal and coke fields, 87,589 acres 100,000,000 4 — Transportation properties 80,000,000 5— Blast Furnaces ,. . . 48,000,000 6— Natural Gas Fields 20,000,000 7— Lime Stone Properties . 4,000,000 8— Cash and cash assets , 214,278,000 I $1,466,278,000 There is not such a great difference between these two 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; 217 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 1902 , $133,308,000 1903 109,171,000 1904 73,176,000 1905 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 capitalization. 218 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 safely 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, subsidiary companies $ 9,367,412 Sinking Funds, U. S. Steel Bonds 25,624,410 New Construction 176,137,166 Increase in surplus 82,223,107 $293,352,095 115. Operating policy, — A careful study of the op- erating policy of the steel corporation belongs elsewhere. Our attention may be turned, however, to a few con- spicuous facts, THE UNITED STATES STEEL CORPORATION 219 The corporation's relations with its employes have so far been exceptionally harmonious. There has been no strike or serious trouble of any kind. At the end of 1902 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- agement. The scheme has proved practicable and has been 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- companies. 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 common agencies. The idea is to stimulate each com- pany by internal competition and otherwise to the highest pitch of efficiency. The operating ratio or per cent of manufacturing costs to gross business has been very 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. 116. Steel securities. — The securities of the United States Steel Corporation now outstanding are: 220 CORPORATION FINANCE 1— Underlying bonds $ 107,155,749 2— Coll. Tr. Gold 5's, 1901 288,798,000 S— " " Skg. Fd. 5's, 1903 204,231,521 Total Bonds $ 600,185,270 4— Preferred Stock 360,281,100 5— Common Stock . 508,302,500 Total Securities $1,468,768,870 The underlying bond issues are too numerous and too small in 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 April 1, 1915, are secured by the deposit of all the securities owned by the corporation. A sinking fund of $3,040,- 000 per year is used to purchase bonds obtainable at 115 or less, and after April 1, 1911, may be applied to the redemption of bonds to be 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 sinking fund 10-60 year gold 5's of 1903. The autho- rized 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 until 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 A THE UNITED STATES STEEL CORPORATION 221 correct, these bonds have behind them chiefly the earning power of the corporation. The preferred stock issue is 7 per cent cumulative. Dividends have not been missed since the formation of the corporation. The common stock drew 4 per cent in the first two years; % per cent in 1903; nothing from that date till 1906; 1% V^^ ^^^^ i^ 1906; and 2 per cent since then. It is expected to maintain its 2 per cent rate. 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 have already alluded to the large appropriations for depreciation and for bet- terments. It is estimated that by the partial completion of the Gary plant, the capacity of the corporation has been increased 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. ^2 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 twenty-eight years as shown below: 1880 171 pounds 1890 329 " 1900 399 " 1905 619 " 1906 662 " That the corporation managers have faith in the fu- ture of the steel trade and of the Steel Corporation is evident from their contract with the Hill ore interests. The contract pledges the corporation to a minimum output of 8,250,000 tons of ore in 1917 at a royalty of $16,417,500 per year. Of course the corporation does not expect to let its own ore lie idle. It evidently in- tends to expand its business enormously. If the steel business, then, grows, as the biggest and most f arsighted men in that line expect, and if the pres- ent policy of improvement and enlarging the proper- ties continues, 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 business 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* CHAPTER XVI SELLING SECURITIES— THE PROSPECTUS 117. The four methods of selling securities, — ^When- ever new securities — whether of an estabUshed 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 ob- viously 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 the new securities for old securities as already explained. The second method is to work through the Wall Street, or some similar, market, which is consideredTui the chapter following. The third method is to sell them to the public through established bondorjbrokerage houses. This method will be discussed both in this chapter and under the head of underwriting. The fourth method is by ^rect appeal to the public through 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- 224 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 volume on Business Organization 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. 118. General characteristics of a good prospectus, — The promoter's prospectus should be and with successful flotations always is a work of art. A good prospectus 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, however, 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 comparatively inconsistent requirements. He must pre- sent all the important facts and yet he must make his prospectus strong, attractive and convincing. Any SELLING SECURITIES— THE PROSPECTUS 225 well-trained writer should be able to do the trick if he chooses. 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 corner. Thus the law will be satisfied and at the same time it will take a very careful, intelligent read- ing 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 than 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 astonish 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 1—15 2S6 CORPORATION 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 field. 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. 119. ^ typical speculative prospectus, — The pros- pectus of a company designed to own and publish a magazine is given in part below. The 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 is 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 capitalized at $50,000 for the immediate expansion of The Blank Company. The stock is secured by the property, the name and the good will, which, if put up at auction, would be considered a bargain, A SELLING SECURITIES— THE PROSPECTUS ^27 if purchased at many times the amount of the company's cap- italization. If you have looked into the magazine field, you will know that although 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 offered 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 Munsey'^s, 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 $34,000 in cash, a profit of 1,700 per cent. Everybody^ The Ladies* Home Journal and many other magazines, represent wonderful money-making investments. The same opportunity is knocking at your door at this mo- ment. The Blank Company, with its twenty-eight years of continuous existence, with an unlimited advertising field and with S28 CORPORATION FINANCE a subscription list that can be increased beyond that of any other publication in existence, offers you a rare opportunity in asso- ciating 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. 120. 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 honestly favor- able and a dishonestly deceptive presentation comes is a question which every promoter must settle with his own conscience. The prospectuses of well-known, 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 229 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 thirty-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 to close the application list at any time without notice and to 230 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 skillfully executed has been known to succeed. 121. 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 231 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. Although 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 country. 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 selling at the rate of about $675 a share. It is to be regretted that the number of similar instances in this country is so small. 122. Selling through banking houses, — The securities of almost all 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 ^2 CORPORATION FINANCE 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 selUng 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. 123. Requirements of reputable banking 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 pre- fer 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. The 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 I SELLING SECURITIES— THE PROSPECTUS 233 engaged in selling securities and 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 enthusiastic 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, with 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 likely 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 regarded by Wall Street bankers as worse than banditti, which nevertheless have kept in existence and have apparently been prosperous for many years. Such 2M CORPORATION FINANCE firms may maintain 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 they 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 ^35 (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 people of the locality in which 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. 124. Their 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 individuals, 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 2S6 CORPORATION FINANCE the "Bond Buyers' Dictionary" gives further details as to the methods of such houses. It is through the retail bond dealers that the great investing public of the country is reached. The other day a retired mer- chant died in Pittsburg whose wealth was estimated by bankers to exceed $50,000,000. Of the several million persons who read of his death in the newspapers 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 reader. 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 others 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 $10,000,000 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 few months in small lots to its regular customers. Practically every large retail bond house in Wall Street now] employs 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 ; altogether, more than 300 are employed in Wall Street. Each has his own territory and possesses his own customers. Many make salaries of from SELLING SECURITIES— THE PROSPECTUS S3T $10,000 to $15,000 a year, and some even more. All are, 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 among investors, is its principal stock in trade. The majority 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-jfour hours of the opening of the books ? The profit of the banking house may take one of two forms, either a commission on the sales or the diiFerence 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 jrours, not ours; we guarantee nothing. Nevertheless, 2S8 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 in value, as will happen once in a long time, the house will probably offer to buy it back from its customers at the selling 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 deahng. CHAPTER XVII SELLING SECURITIES— THE WALL STREET MARKET 125. The principal stock exchanges of the United States, — The stock exchange offers the best market for a great many corporate securities. Some readers are perhaps already famihar 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 New 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 business of which is the handling of securities of the local steel companies, and of the United States Steel Corporation. ^39 ^40 CORPORATION FINANCE , (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 dealings in securities of corporations of national importance are confined almost wholly to the floor of the New York Stock Exchange. With few 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 State Steel securities, both in New York and in Pittsburg. 126. Listing securities, — In 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 I THE WALL STREET MARKET ^41 approved securities. On the New York Stock Ex- change these approved securities fall into two groups, the "listed" and the "unlisted." The exchange has strict rules governing the admission of securities to the 'listed" group. 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 complete annual reports at least fifteen days prior to annual meetings. Many industrial corporations, which are unwilling to comply with the requirements as to publicity, have been admitted to the unlisted department. This means that their securities are bought and sold on the floor of the exchange in the same manner as the listed securities, and so far as the general pubhc is concerned there is no apparent difference between the two classes. There is, in fact, however, a very important difference, for the corporations whose securities are unlisted are not required to give complete reports as to their opera- tions to the stock exchange conmiittee or to their stockholders. Although the public do not appreciate the fact that such a distinction exists, men in the financial district are fully alive to its importance. Listed se- 1—16 M2 CORPORATION FINANCE curities are almost without exception much more highly regarded by bankers and are more acceptable as col- lateral for bank loans. For this reason, most corporations prefer to comply with the requirements and have their securities listed. About 85 per cent of the securities handled on the New York Exchange are in the listed department, and the unlisted group — partly on account of the force of the growing demand for publicity — is rapidly declining in numbers and in importance. Among the latest converts from the unlisted to the listed class are two industrial companies of great size and importance, the American Sugar Refining Company and the American Smelting and Refining Company. The day is not far distant, we may hope, when practically all the large corporations will willingly carry on their business in the open and meet the requirements that are necessary in order to have their securities listed. 127. 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 securities placed in the unlisted department. 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 bought and sold in considerable quantities in the Wall Street district. As svich 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 THE WALL STREET MARKET 243 district near the street curb. There are no written rules 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 order 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 corpora- tions whose securities are bought and sold in the Curb Market we may mention the Standard Oil Company, the American Tobacco Company common stock, and the Chicago Subway Company. Most of the other active stocks on the Curb Market are of mining companies. There are also some large bond issues which, for one reason or another, are not listed on the stock exchange, including Chicago, Burlington and Quincy 4's, National Railway of Mexico 4l/^'s, and Western Pacific 5's. The Curb Market is also the center of transactions in "rights" (which are described in Chapter XXVII) 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 abbreviation, which stands for "when issued." 128. Stock Eoochange 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 corporations whose securities are listed on ^44 CORPORATION FINANCE that particular exchange. Around each post, if it is a busy day, are a large number of brokers, each armed with a pencil and a memorandum pad, 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 friendliest manner. THE WALL STREET MARKET 245 The volume of business transacted in this manner on the leading stock exchanges is enormous. Million share days on the New York Stock Exchange, though somewhat above 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 fixed 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 who buy. Many 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 14 P^r cents. 129. Importance of speculative dealings, — Nothing need be said here as to the ethics of speculation, a subject which is adequately treated in another volume. It may be well to remark, however, that all these speculative transactions on the stock exchange, particularly the small transactions, perform at least one very useful service, namely, they tend to steady security prices. Obviously, 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. The same remark in substance wiU apply to all speculative dealings. Ue CORPORATION FINANCE Enough has been said about the stock exchanges and stock and bond brokers to give some idea perhaps of their methods of operation. It is no part of the business of stockbrokers to buy 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 the 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." 130. Buying 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 that will be accepted by reputable THE WALL STREET MARKET 247 brokers in such a case will be $10 per share. The specu- lator, therefore, assuming that he does not already have an account with his broker, gives him 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 shortly 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 margin 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. 131. 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 248 CORPORATION FINANCE 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 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 was sold and the price at which it was bought and minus brokerage charges. Credit will be allowed to the speculator also in this case for whatever dividends may have accrued on the borrowed block of stock while in the hands of the broker. 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 stocl 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, toi gether with interest and brokerage charges, crediting the stockholder with any dividends that may have accruec on the stock while in his hands, and will then return t( the speculator anything that may be left of his $1,000J 132. Stock exchange houses vs, bucket shops. — The following quotation from a circular letter issued by THE WALL STREET MARKET 249 large brokerage house gives an accurate statement of the terms upon which reputable brokers handle marginal transactions : We execute commission orders for the outright purchase, in any amount, of hsted stocks. Our charge is that fixed for all members of the New York Stock Exchange, % of 1 per cent of the par value, or 12% 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 a 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 partic- ular securities. We 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 250 CORPORATION FINANCE money is turned over to them for buying and selling stocks never gets out of their own pockets. Whatever may be said as to the ethics of true stock exchange 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 the customer misunder- stands those conditions or misjudges the market, it is his own fault, 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. 133. 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 hangers-on, the true lambs, a class made up largely of professional men, broken-down business men and women, who are suffer- ing under the delusion that they can make money in^ Wall Street without having a special knowledge eithe] of Wall Street methods or of th^ conditions in some par- THE WALL STREET MARKET • 251 ticular line of industry. This third class is by no means so large as the moralists, the muck-rakers and the comic papers represent; yet it is true that its representatives are only too painfully in evidence. It is true also that the members 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 they are weak and foolish and it may safely be said that if they had not fallen victims to the Wall Street craze they would have found some other means of losing their money. 134. A summary view of the stock market, — What precedes 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 well-advertised, continuous and easily accessible market for their secur- ities; this market is utilized both by investors and by speculators, but, so far as stocks are concerned, the specu- lative element is of chief importance; most of the speculation is carried on by means of marginal purchases 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 now ready to discuss briefly the process of selling a new security through the stock exchange markets. 135. Stimulating speculative interest, — If the new security is a small issue put out by one of the less im- portant companies, the process of selling it through a stock exchange will not be much different from that 252 CORPORATION FINANCE which has been described in previous chapters. The new security will be advertised, inquiries wiU be invited, an alluring prospectus will be issued, the new security 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 one 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. They will take measures to create a speculative 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 jBtted to secure buying orders from marginal specula- tors. Now the average speculator is not much attracted by brass band announcements or even by newspaper stories, no matter how well written and convincing they may seem. But he rises to a tip like a himgry fish to the bait. He reasons that what is known to everybody will bring little profit to himself, but that information which comes to him confidentially by word of mouth gives him an exceptional opportunity. Therefore, Wall Street, from morning to night in an active market, hums with tips, rumors and gossip. The tips that are thus circulated are not aU valueless by any means, although it must be admitted that a speculator who follows them too closely will probably be a heavy loser in the end. The first move, then, of the managers of a large new stock issue will probably be to see to it that rumors as to the extent and high quality of the issue, and above all, as to the "interests" that will support its market price, begin 4 THE WALL STREET MARKET to circulate. Thus the appetite of speculators will be stimulated and large buying orders from them will prob- 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 beginning 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 he will be able to carry large amounts of it for his cus- tomers on easy terms. 136. Syndicate operations, — The next step is to se- cure an agreement among the syndicate members and perhaps with large banking and brokerage interests out- side the syndicate that the price of that particular se- curity will be held at a given figure. Thus when the Interborough-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 after the stock had been issued to purchase large blocks and take them off the market. In this particular case the 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 very sharply. During the year, however, the agreement was lived up to. Where such an agreement is made and maintained, ^54 CORPORATION FINANCE the effect is to steady the price of the stock, or at least to hold it above the figure agreed upon, and thereby to attract both speculators and investors. 137. Stock market manipulation,' — The fourth step in making a market for a new issue is to manipulate the price 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, James R. Keene. To Mr. Keene have been entrusted most of the large speculative stock flotations of recent years. He has been 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 interfered 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. THE WALL STREET MARKET 255 As the security advances in price and stockholders 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 purchase 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 being up- ward. If the manipulation is secret and skillful, not even the most expert observer can be certain whether the 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. CHAPTER XVIII SELLING SECURITIES— THE UNDERWRITING SYNDICATE 138. 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 reheved 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 two hundred years ago 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 mei chants; each party to the agreement wrote his nam( under the contract and from this custom arose the name "underwriting." We are to discuss in this chapter the ^56 THE UNDERWRITING SYNDICATE 25T same principle as it is now applied to new issues of se- curities. The essential part of the arrangement is the insuring^ of someone against loss or failure. A secon- dary feature is the ^ivisjon of the risk among a con- siderable number of people, so that no one of the in- surers is liable to suffer great loss. 139. Advantages of underwriting to the corporation, — There are several reasons why banking and brokerage houses 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 bankers^e presumably^jperts in the valuation of se- curities. Their judgment as to the price which should be 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 judgment. In the second place, the bankers are also experts in selling se- curities and each house involved in the underwriting 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 elapse before the sale is com- pleted and the money received is always uncertain. Now the corporation ordinarily v/ould not be trying to sell new securities if it did not need money at once or in 1—17 ^58 CORPORATION FINANCE 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 selHng 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 avoided by having the security uaderwritten, for the underwriters will pay the corporation within a definite period. The second reason that appeals strongly to corporation managers is that the credit^f 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. 140. 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 ^ a search- ing 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 -sold issue is a sign of weakness and a hindrance to the completion of the corporation's plans i THE UNDERWRITING SYNDICATE 259 so serious as to reduce the value usually of the portion that has been sold. Suppose, for instance, that an in- dustrial company desires to build a new plant at a cost of $10,000,000 and sells only $8,000,000 worth of the securities which are intended to finance the project. What 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 banking house will watch close ly any^ security that it has u nderwr itten, and will come to the assistance of tlie^ security-holders in case the corporation later gets into difficulties. As will be brought out in our study of re- organization, the committees formed to assist in devising plans 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 janderwr itmg certainly adds_to_the value of securi ties. 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 than 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. 141. When is underwriting advisable? — It must not ^60 CORPORATION FINANCE be inferred that every new stock or bond issue ought to be underwritten. Small issues, say $500,000 or less, can usually be sold to a comparatively small number of investors 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 March, 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 en- titled to rank with the best that can be offered, and, therefore, to command the highest price in the markets, both of this and foreign countries; and. Whereas, There is now abundant capital in the hands of capitalists and combinations of capitalists the world over, who are seeking opportunities for buying such securities, and it is desirable that the directors of this company should take ad- vantage of the opportunity which these conditions afford to obtain the highest price possible for such securities as the com- pany 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 be- lief that such securities are issued for excessive amounts, and thus tend to prevent legislation adverse to these corporations, which is now threatened* t/i^ J' <^f«'''^ I t'^ ''t Resolved, That the stockholders of the Pennsylvania Rail- road Company desire to have the proposed issue of securities so offered as to be open to competitive bidding by responsible THE UNDERWRITING SYNDICATE 261 banking houses, and that the issue of securities should be ad- vertised in advance, it being required that such bids shall be accompanied by certified check for such amount as may be necessary to insure good faith. This reasoning sounds plausible at the first hearing, but is far from convincing. It fails to take unto ac- count the risks involved in the proposed plan and the advantage to the railroad of having the right kind of banking connections in periods of financial stress. In the course of an able discussion of this proposal the New York Evening Post says: Those who hold different views appeal to the Pennsylvania's own experience in 1903. Early in that year, when the stock was selling around 157, the shareholders were offered $75,000,- 000 new stock at 120. Before the time for closing the sub- scription list expired, the price of the old stock had fallen almost to 120, and the management was confronted with the diffi- culty that beset the Steel Corporation the same year, when bonds which had been offered to the shareholders at par were selling in the open market at 65. Needless to say, the Steel bonds were finally sold to a syndicate and not to the shareholders. When Pennsylvania dropped to around 120, in the spring of 1903, a banking syndicate was hastily formed to underwrite the new issue for which a commission of 2% per cent was allowed. Before the whole operation was concluded the old stock had touched 110%. Under favorable conditions a road in such high credit as the Pennsylvania, the St. Paul, the Great North- ern, the Union Pacific, the IlHnois Central, or the North- western could get a better price for an issue of bonds by shopping among the international banking houses than by con- fining negotiations to one banking firm. But all of the roads named have at one time or another been forced to borrow; when the prices of investment securities were falling or when money market conditions were unfavorable. A railroad which has established permanent banking connec- 262 CORPORATION FINANCE tions has a guarantee that money can be raised in troublesome times, when necessary, as well as when investors are clamoring for securities. When acting in such capacity bankers are sup- posed to advise a railroad what kind of securities will find the readiest market, exactly when the securities should be issued, a very important point, and what price the public should be asked to pay for the issue. It is also the business of railway bankers to protect the market for a new issue until the securities reach the hands of investors. 142. Why underwriting syndicates are formed, — It would naturally be expected that each of the large financial houses engaged in the underwriting business would handle on its own responsibility whatever busi- ness comes its way, and that rivalry would prevent their co-operating to any considerable extent. The fact is, however, that these houses have long since learned that it is inadvisable for any one of them, no matter how powerful, to guarantee the success of a large security issue. It is true that the banker's judgment and ex- perience should enable him to avoid heavy risks; yet a certain amount of risk is inevitable. A banker does not know what may happen in the financial world, does not know when the bankruptcy of some big concern or un- expected political events may create a sudden panic. If he is caught at such a time with his funds tied up in a large issue of new and unsalable securities, he may be forced into bankruptcy and is almost certain to suffer severe loss. It is not considered conservative banking, therefore, for any one house or even any two or three houses to underwrite a large issue. Many banking houses follow a definite policy in this respect and refuse absolutely to underwrite more than a certain sum, say $100,000 or $500,000 or $1,000,000, depending on the size of the house, even when the risk seems particularly small. THE UNDERWRITING SYNDICATE 263 JAnother reason for co-operation among bankers is that each house desires to offer a variety of securities to its clientele. It it specializes too much or offers only a few securities, it cannot expect to attract and hold reg- ular customers. A third reason for co-operation is in order that a broad geographical distribution may be obtained and the sale 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- burg 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 me ans ^of thp syndicate the risk, th e tro uble and thej)rofitsjje divided among sgveralji ouses . The syndicate so formed may jlong toTahy one of five types. 143. Three Jyj^ies^f gi/ndicg^e^.— Originally the nor- lal arrangement was to have the indicate as a whole guarantee the_^rice of the issue, and let the corporation ittend tojthe selling. Under this plan, to give an ex- iple, a corporation putting out a $5,000,000 bond is- }ue would offer the bonds to the public at a fixed price, Jay 95, and the syndicate would agree to accept any of bhe bonds not bought by the public at a lower price, say^ )0, This is underwriting in the original sense of the^ ^ord; itjs a species of insurance. Under such a plan the syndicate would have two sources of profit; first, a ^64 CORPORATION FINANCE 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 which they would ultimately dispose of the bonds. The ordinary commission would range between 2 and 5 per cent. This type is seldom used nowadayjs, 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 tgiake ajr "underwjjt^r's option.Ji Under this plan the syndicate takes the block of J)onds or stock at ji^ fixed pricei, 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, Tbecause the syndicate takes no riskj on the other hand, lis 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 bought for itself a Jbig secur- ity issue and wishes to distribute the risk. In sucITaT case the original underwriter frequently calls upon other banking houses ^nd upon individuals to take porti ons of Ihe 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 underwriter and the corpora- tion. Full details as to an excellent example of this 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 below. THE UNDERWRITING SYNDICATE ^65 7 IM, A fourth type — pooling 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 the stock or bonds. The chief differ ence between the thir d and fo urth types lies simply in the fact that the^yiidicaje m^embersj.eal jirgc^^ with the corp oration^ no t with a ba nkin g hous e. They thus secure for them- gelves all thejprofits of the underwriters.. Sijph a syndi- cate is always managed by some one house 6r inffividiiar having complete authority. Its organization and man- agement are further discussed below. On the whole, this is probably the best known andjnost^c ommo aforni 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,- 000, 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 syndicate, with Speyer & 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, 90. 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 made, the syndicate members may lose heavily. ,^ 145. A fifth type — distributing the security. — The pooling arrangement above described, although it se- 266 CORPORATION FINANCE 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 th e se curity issue_ .among the me mbers of the syndicate^,:^ This is the fifth type of an underwriting syndicate. Strictly speaking, of course, the distribution of securities is not an under- writing in any sense, but a sale. It^is a sale at a special price, however, made under certain restrictions afid'He- 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 be 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 oppor- tunity to advertise a sale of the securities, and that the other members are to keep out of the open market for a limited period. Such 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 in on the ground floor, making their investment at the special syndicate 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, now of the firm of J. P. Morgan and Com- pany, and Mr. James H. Hyde, among others, alleged that their participation as individuals in syndicates, which was disclosed during the investigation, was for the THE UNDERWRITING SYNDICATE 267 purpose of buying bonds at especially low prices for the insurance companies which they represented. One ob;^ jection to allowin g inve stors to j)artjcjpate in sy ndica tes^ ^f this type is that tiiey may decide later tq^sell the securities allotted to them before the banking members of the syndicate are through selling, and may thereby^ break the price. With the view to avoiding such a re- sult syndicate managers are exceedingly careful in choosing members who buy for investment, not for re- sale,,^ "^46. The large underwriting houses. — The Wall Street Journal^ in a recent article dealing with the prac- tice of the big corporations in disposing of bond issues to underwriting syndicates of the third, fourth and fifth types, says: One method is to sell the bonds in a block to one of the great underwriters. Pennsylvania, Baltimore and Ohio, Union Pacific, and many others, sell direct to Kuhn, Loeb & Com- pany, get the money, and thereafter take only an indirect in- terest in the bonds. Rock Island sells to Speyer & Company, 'Frisco to Blair & Company and others, New York Central, Lake Shore, Southern Railway, Erie and others to J. P. Mor- gan & Company. The price at which these railroads sell their bonds to the underwriters is not generally known. It is taken to be a private matter, but it often leaks out. Another method, not uncommon, is to sell the bonds to the big retail bond houses who distribute them to a wide and wealthy public through advertising and through correspond- ence. Each of these houses has its clientele. Some are strong in New York, others in Canada, others in the South, etc. They are more or less specialists, and get to be known for a particular grade of bonds or stocks. These two methods, of course, overlap greatly. Harvey Fisk & Sons, for instance, known for years as a big retail bond house of wide clientele, frequently underwrite whole issues of 268 CORPORATION FINANCE securities, as in the case of the Electrical Securities collaterals, recently brought out. Similarly, Fisk & Robinson took the whole issue of the new Buffalo & Susquehanna Railway 4I/2S. J. P. Morgan & Company, Kuhn, Loeb & Company and Speyer & Company generally participate to a greater or less extent in any extensive new bond issue, because their clientele demands it, even though these firms may not be the original underwriters. Summing up what 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 preferthis,method to the original under- writing, which consisted simply Jn gu aranteeing the "price, for two reasons : first, because they can thus con- trol the price and time of sale and bring to bea r their skill in selling; second, because the underwriters, having ~Tull control of the securities, can post them as collateral and secure bank loans, thereby reducing their direct "i^h 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 dejgosits to any greal extent from other people, and do not make a business oJ loaning money. Their chief interests lie in b uying am felling securities*-^ "Banks," on the other hand, drawj their profits mainly from receiving deposits and makin j loans. CHAPTER XIX THE MANAGEMENT OF THE UNDERWRITING SYNDICATE 147. 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 others' 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 syndicate 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. 148. 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- ment of this nature that has been given out, was produced on the witness stand in the famous suit to prevent the conversion of United States Steel preferred stock into bonds, referred to in Chapter XV. The agreement is 269 270 CORPORATION FINANCE of such interest and importance that it is given in full below: U. S. STEEL CORPORATION PREFERRED STOCK RE- TIREMENT SYNDICATE AGREEMENT. An agreement 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 sec- ond part). Whereas, 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 subscription; such bonds to be authorized now for the principal sum of $250,000,000 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 preferred stock to the extent of four-j fifths of said sum, and in cash for the remaining one-fifthj thereof; such contracts to provide for the payment or allow- ance to J. P. Morgan & Co., of a commission of 4 per cent 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 271 having the prior right to take all of such bonds which shall be offered 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, and the cash required under their said guaranty, and to receive frem 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. are au- thorized from time to time to make, modify and perform, as in the exercise of their unlimited discretion from time to time the}^ may deem proper, do agree, as follows, viz. : First. On signing this agreement each subscriber has delivered 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 be 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 by any subscriber, and any such preferred stock not so delivered to the Steel Company is to be returned to the subscribers rata- bly according to their several subscriptions. Second. Each subscriber further agrees to pay J. P. Morgan & 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. Third. The several deliveries and undertakings of the several subscribers under this agreement shall be made and per- formed by the subscribers respectively when and as requested by J. P. Morgan & Co. or by the subscribers, of any of said Five Per Cent Sinking Fund Gold Bonds of the Steel Company. Fourth. The several subscribers shall be called upon to 272 CORPORATION FINANCE 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 or for his own benefit, without accountability; bu*- 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 the Steel Company a copy of this agreement, having annexed SYNDICATE MANAGEMENT 273 thereto a list of the subscribers; and thereupon to the extent of their 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 Steel 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 proceed- ings thereunder. In such event all the cash or stock and bonds by them received and then held for account of the Syndicate, 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 y 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 dehvered 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. The enumeration of specific powers in this or in any other article of this agreement shall not be construed as in any way 1—18 *^ 274. CORPORATION FINANCE abridging the general powers of this article Intended to be con- ferred upon or reserved to J. P. Morgan & Co. Ninth. From time to time before October 1, 1903, J. P. Morgan & Co. in behalf of the Syndicate, may make sales of all or any part of the bonds received by them for account of the Syndicate. Any such sales may be made by J. P. Morgan & Co. either publicly or privately, by themselves, or in such man- ner as they may deem proper, and shall be upon such terms and for such price or prices as they may deem expedient. Each subscriber hereby assents to, and agrees to be bound by any 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 may retain all or any part of such bonds, or they may deliver to any subscriber his proportionate part thereof, upon his agreement 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 Octo- ber 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 their 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 & 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 purchases any SYNDICATE MANAGEMENT 275 sums realized from any sales of bonds and stocks of the Steel Company under any provisions of this agreement; and they may make advances, or may procure loans, and may secure the same to such amounts and in such manner as from time to time they may deem expedient for any of the purposes of this agree- ment. Eleventh. J. P. Morgan & Co. shall issue to the sub- scribers suitable receipts in respect of payments made here- under, and they may issue to the respective subscribers certifi- cates of interest of such tenor and form as they may deem suitable. Such certificates of interest and rights and obliga- tions hereunder of the respective subscribers may be made trans- ferable in such manner and on such terms and conditions as J. P. Morgan & 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 the Syndicate, and all such expenses shall constitute and be a prior charge in their favor upon any and all moneys, stocks and bonds by them received or held hereunder. Any and all moneys by them received hereunder shall hold by them as bankers in general account. Thej'^ 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. Thirteenth. After the complete performance of the en- tire obligation of the Syndicate hereunder, but not before the first day of October, l903, unless otherwise determined by J. P. Morgan & Co., in the exercise of their unrestricted dis- cretion, payment may be made to the Syndicate by J. P. Morgan & Co. for the purpose of this agreement, out of any moneys for such purposes received or retained by J. P. Morgan & Co. FouETEENTH. J. P. Morgan & Co. shall not be liable under any of the provisions of this agreement nor for any. 276 CORPORATION FINANCE matter therewith connected except for good faith in perform- ing or in refraining from performing or carrying out, the obli- gations by them herein expressly assumed; the implication of any obligation not herein expressly assumed by them being hereby expressly denied and waived. It is understood that, in the same manner as other subscribers, J. P. Morgan & Co. 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. Morgan & 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. Seventeenth. Each subscriber shall set opposite his subscription 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 ac- tually 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 no- tice of calls or offers, or any other notice hereunder, and he shall be deemed to assent to any action of J. P. Morgan & Co. Eighteenth. In consideration of the irrevocable rights in them vested hereunder, and the promises of the several SYNDICATE MANAGEMENT 277 subscribers, J. P. Morgan & Co. have become parties to, and in good faith will endeavor to consummate the purposes of this agreement; and, after receipt thereof from the Steel Com- pany, 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. In witness whereof, the parties of the first part have hereunto 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 149. Characteristics of syndicate agreements. — The most promine nt feature of this agreement, as the reader has no doubt observed, is the^bsolute and unrestricted authority retained by t he manage rs of the syndicate. "Such phrases as "J. P. Morgan & Company shalTTiave full power in their discretion," "J. P. Morgan & Com- pany shall be the sole and final judges," "J. P. Morgan & 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 integrity absolutely unstained. For the same reason this agreement, like most other 278 CORPORATION FINANCE such agreements, is marked by open 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 on 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 syndicate members. Secret prof- its are not permissible under the code of ethics that governs underwriting transactions. Sometimes it happens that one of the underwriting firms fiunds its allotments too large for so me reasQlL^in which case it will probably form a sub-syndicate. The members of the sub-syndicate are usually individuals or smaller banking fii^ms. They are not brought into con- tact at all with the original syndicate and have no part in its workings, but are responsible solely to the other members of the sub-syndicate. 150. Functions of underwriting syndicates, — Under- 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 discussion and need not be further considered. The second case presents some points of diiFerence which will be referred to in the chapters dealing with reor- ganization. In both cases the syndicate is handling in- vestment securities and its_SQle^it)HenLJs_to^ii]^^ those securities to the best advantage. The third case Is closely allied with promotion; the syndicate methods in this case require some further consideration. SYNDICATE MANAGEMENT 279 151. 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, then, between a syndicate formed to underwrite the se- / curities of a new corpor ation and other syndicates is that it is handling^ocks and bonds of doubtful value which it cannot recommend, unre&ervedty, A second distinction is that the syndicate must be prepa red to put up mo re cash or furnish more credit in proportion to the size of the security issues than would ordinarily be necessary. This follows from the fact that conservativ e ba nks are not willing to lend much^ ^ money on sp eculative stocksjiidbonds. A third distinction is that the syndicate must be pre- pared to carry Jhepropositimi-throu^hJi)Jhe end; in no ot^ier 3vay_£^cept at an enormous sacrifice Qan the money^ needs of the new corporation bejnet. ^ A fourth distinction lies in the fact that for their own protection the syndicate members must build up and maintain th e credit of jbhe new corporation. ^ Evidently there are several difficult and dangerous p^ddems here to_be solved. It is essential to their so- lution th_at the syndicate sh ould absolutely control the new corporatioii. _ Without^ control measures may be taEen that will impair the credit of the corporation and bring heavy losses upon the syndicate. Even with full control such enterprises are usually deemed too risky to be participated in by banking houses of the best class. At least if such houses do enter the syndicate they accept only small allotments, knowing full well the danger of becoming more deeply involved as the enterprise pro- 280 CORPORATION FINANCE ceeds. No one can tell in advance what the cash re- quirements of a new corporation may be. Each enterprise of this nature has its own variations of the difficulties and dangers that have been cited and requires a solution that will exactly fit its own peculi- arities. Perhaps the best 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. 152. 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 $3,000,000 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 syndicate 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 syndicate No. I, for $1,000,000. Syndicate No. I then posted the stock and gave notes to syndicate No. II, who loaned the $1,000,000. Thus syndicate No. I was not called upon for cash, except for expenses, and the construction SYNDICATE MANAGEMENT £81 company was supplied with $1,000,000 with which to begin operations. Next, after expending the $1,000,000, the construction 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 observe that the first c orporation exis ted simply to carry on con: - struction. 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 of bonds. In this way the whole $3,000,000 necessary to builtl4;he plant was raised by borrowing and the members of syndicate No. I furnished nothing to the enterprise but their credit. The diagram on page 282 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 sufficient to meet all interest charges and other expenses, and it is expected that large profits will be earned in the future. Although the enterprise is not yet beyond the speculative stage, its chief difficulties have been over- come and its prospects appear bright. The first use to which surplus earnings will be 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 $500,000 283 CORPORATION FINANCE SYNDICATE MANAGEMENT S83 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 oXjhe_success^of the syndicate in this instance lay in the fact that they were themselves strong financially _ and could borrow^ the first $1,000,0 00 re adily. , This left a margin of safety to those who loaned funds directly to the two corporations. Furthermore, the syndicate members were shrewd and prudent enough not to use up all the available credit of their corporations at the beginning. On the contrary, the essenti al feature oL- their plan of operation was to leave the best lien till the last. Thus they were able to borrow $1,500,000 on first mortg age bonds at a time w hen mos t c orporations under ordinary management would have been compelled to call on their stockholders for fund s. STuch more compEcated instances might have been \ (cited. The principles followed in all those that havef proved successful, however, have been 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. I CHAPTER XX INVESTMENT OF CAPITAL FUNDS 153. The importance of wise 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. Nevertheless, 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. 154. The installment method of getting cash as needed. — In the first place, a new corporation as a rule does not require all of the capital funds that will be nec- ^84 INVESTMENT OF CAPITAL FUNDS 285 essary for its development at the outset. On the other side, as was emphasized in connection with the subject of promotion, the corporation managers should have in sight from the very beginning all the capital funds that they are likely to need; for an effort to raise additio nal capital for an enterprise that is onlyjialfjo r 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 niethod, from the corporation's standpoint, is to obtain subscriptions before the new concern is started for more_than enough stocks andjbonds^ to carry it through to success, but tojiave the^ash_f or these securities payablejnjnstall^^ 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 ofBce 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, 25 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. In this way the sale of securities is facilitated, because buyers prefer usually to pay in installments, and the corporation gets its funds as needed. The case is quite different, however, when the total amount 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- body can foresee absolutely what obstacles the under- ground work of the mine or tunnel will encounter, or 286 CORPORATION FINANCE 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. 155. Disadvantages of this method. — Unfortunately this plan does not appeal to th e^ ave rage s tockhold er. He does not like the idea of being liable at all times^f or _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 option of the board of directors. It is strongly suspected that the board on several occasions have agreed among themselves in advance to issue a call INVESTMENT OF CAPITAL FUNDS 287 for an installment and have thus given themselves plenty of time to accumulate cash. Then the call has been issued and the installment made payable at a very early date, so as to mak e it difficult for most of the stock - holders to meet the calL The result naturally has been in each instance that considerable amounts of thgjQ^art- paid stock were throvi^n on the ma rket and bought up at "Sargainprices byTEejdirectorsjindjthe^ With the funds received from the installment the corporation has been in position to put its property in good condition and show excellent earnings for a year or two, thus al- lowing the directors to sell stock at high prices. After it was distributed the directors have issued another call and have repeated the milking process. Experiences like this have made buyers of securities very cautious J n the purchase of part-paid stock. Generally speaking, it is a^difficult thing to sell any stock that is not labeled *'full paid and non-assessable." 156. ^Other possime methods. — It follows that the managers of a corporation, the needs of which for capi- tal funds cannot be estimated in advance, are driven to take one of two courses : either they must sell at the be- ginning a far greater amount of securities than will probably prove necessary, and put their idle funds to some use outside the original purpose of the corporation, or else they must trust to luck that they will be able to sell more securities when additional capital funds are needed. Neither one of these alternatives is free from serious objections. Here, then, is the first great prob lem in connection with the investment of capital funds, that of getting the^ _fund&- when and if they prove to be neede d^ If that problem is not solved in just the right manner, either the corporation will have more funds on hand than it S88 CORPORATION FINANCE needs and its rate of profits on stock will thereby be diminished,^ else it will not have enough funds and its development will thereby be checked. 157. How much shall be invested in fixed capital? — The next question to consider is, What proportion of the capital funds shall be put into "fixed" and what into *^orking" capital? The distinctions between fixed, semi-fixed, current and quick assets were discussed in Chapter VII. The fixed and semi-fixed assets to- gether — those assets, in other words, which cannot be readily converted into cash — constitute the corporation's fixed capital. Work ing capital is somewhat different. It consists , not of the current assets, but of the difference 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 , build ings and even machinery can be rented to better advantage than they can be bought. Accountants rec- 'bgnize 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 INVESTMENT OF CAPITAL FUNDS 289 enterprise, and where possible avoid the investment of large sums in fixed assets until after the success of the enterprise is assured. One of the characteristics^ of fixed capitaj-is that, al- though it may be essential and valuable to the corpora- tion which owns it, it is likely to have very Uttle value^ if put on the market f or sala Its value remains, in 'other words, only so long as the concern is "going." Therefore, t he sma ller the proportion of a corporation's capital invested in fixed assets^ ihe better off it is in case^ of^ailure or bankruptcy. 158. Forms of working capital. — Working capital may take any or all of four forms : (l)^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, whicK shows the current assets and current liabilities of the United States Rubber Company for the fiscal year ended March 31, 1908, compared with the preceding year and the working capital, or excess current assets over current liabilities : CUEEENT ASSETS. 190T 1908 Inventories :. . . $18,404,726 $13,533,169 Cash , 2,061,401 2,723,380 Bills receivable 3,681,126 994,250 Accounts receivable 8,687,631 8,494,234 Totals ........ .|. .r.,.: , $32,834,884 $25,745,033 1—19 290 CORPORATION FINANCE CURRENT 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 $15,700,891 $10,841,557 Working capital $17,133,993 $14,903,476 159. How much working capital shall he carried? — The amount of actual cash^eeded 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 J_aTge bank balances *, if any interest is received on such balances, it will not usually run higher than 2 per cent. Oi\ the other hand, every corporation naturally desires to stand well with banks and will carry large enough balances 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 de- termined 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 amount 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 291 exercise some discretion in this regard, particularly with a view 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. 160. 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-man- aged 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 $261,789,885. 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 31, 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 business of $70,977,168. The following table gives the working capital of several of the prominent Industrial companies, together with gross busi- ness and capitalization for their respective fiscal years : 292 CORPORATION FINANCE Company Gross Working Capital Year Ended Business Capital Stock United States Steel Dec. 31, 1907 $757,014,767*$261,789,885 868,583,600 Internat. Harvester Dec. 31, 1907 78,206,890 77,087,811 120,000,000 General Electric Jan. 31, 1908 70,977,168 61,235,724 65,167,400 Westh. Elec. Mfg. Mch. 31, 1907 33,026,240 19,061,807 24,969,000 Lack. Steel Dec. 31, 1907 33,011,410 13,881,340 34,721,400 Republic I. & Steel June 30, 1907 31,229,423 6,720,000 47,607,900 Beth. Steel Dec. 31, 1907 15,000,000 7,434,573 29,770,000 Am. Steel Foundries July 31, 1907 19,463,521 4,834,843 17,184,000 Midvale Steel Oct. 31, 1907 .., . .. 1,804,929 750,000 Allis-Chalmers June 30, 1907 .,. 12,522,074 35,790,000 Cambria Steel Co. Dec. 31, 1907 ...,.., 14,597,865 45,000,000 Total $730,970,851 $1,389,570,450 The above figures show that the twelve companies in question are well fortified with working capital. The aggregate working capital stands at $730,970,851 as compared with total stock cap- itahzation of $1,389,570,450. The figures given above indicate that the compamies in ques- tion are in a strong position to weather the depression through which they are now passing. * Includes sinking and reserve fund assets amounting \m $32,442,401, INVESTMENT OF CAPITAL FUNDS 293 To i nvest wo rkingjeapital to any considerable amount in^e securitie&-Qf _other corporations is not a very com- mon or commendable practice. It is justifiable only in those companies that have great fluctuations in demands for casb^^nd that cannot secure fair interest on bank balances. The buying and selling of securities is no part 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. 161. 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 factors, 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 by buying 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- vantageous terms, of course the working capital must )e correspondingly increased, for two reasons : first, be- xause larger amounts of raw materials must be carried stock than would otherwise be necessary; second, be- Luse larger bank balances must be maintained in order meet these irregular demands. (3) Regularity of the demand for the product of the corporation. The same considerations apply here as ^ere 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 30 days' time. This arrangement makes it possible to meet the accounts payable out of accounts 294^ CORPORATION FINANCE receivable and lessens the necessary amount of working capital. (5) The length of time required to turn out the finished product. It takes three or four years normally to build a big steam vessel. During that period the ship-building corporation will necessarily pay out large 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 States which can usually get along with a very small proportion of working capital, namely, _ railroad ^peration . The prime reason is that the railroads are manufacturing a commodity, that is, transportation, which is continually in demand 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. 162. The working capital of the Pennsylvania Rail- road, — Even among railroads there may be exceptional circumstances which make necessary large working capitals. The Pennsylvania Railroad, for example, in the early part of 1909 was completing its inmiense ter- minal improvements in and near New 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 temporarily as much work- ing capital as a manufacturing corporation should have. Making a strict classification of current assets and liabilities, the Pennsylvania Railroad's cash position at the end of 1908 compares with its position twelve months before as follows: INVESTMENT OF CAPITAL FUNDS 295 CURRENT ASSETS. 1908 1907 Changes Cash $56,035,898 $37,385,673 Inc. $18,640,225 Bills & accts. rccv 14,294,080 18,069,840 Dec. 3,775,860 Cash assets $70,319,978 $55,455,613 Inc. $14,864,365 CURRENT LIABILITIES. Payrolls & vouch $14,227,369 $20,226,164 Dec. $ 5,998,795 Int. accrued, etc 3,231,248 2,875,982 Inc. 355,266 Miscellaneous 4,211,496 3,966,996 Inc. 244,500 Current liabilities $21,670,113 $27,069,142 Dec. $ 5,399,029 Excess cur. assets 48,649,865 28,386,471 Inc. 20,163,394 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 $20,000,000 in excess of what it had been the year before. The 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. 1908 1907 Change* Due on N. & W. & C. & RO. stocks $15,492,685 $15,492,685 sans for cons., &c 12,403,834 18,412,493 Dec. $ 6,008,659 uc from controlled com- panies 3,159,784 462,218 Inc. 2,697,566 aterials on hand 10,449,483 15,929,925 Dec. 5,480,442 Sink, fund assets 8,148,208 7,772,627 Inc. 375,581 Total $49,653,994 $58,069,948 Dec. $ 8,415,954 DEFERRED AND CONTINGENT LIABILITIES. Car trusts chgd out $ 2,043,803 $ 1,424,871 Inc. $ 618,929 Taxes chgd out 2,731,109 3,023,197 Dec. 292,088 Due Penna. Co 2,290,897 Dec. 2,290,897 Extr. exp. fund... 2,500,000 Dec. 2,500,000 Sinking fund liab 10,339,057 9,815,956 Inc. 523,101 Total $15,113,966 $19,054,921 Dec. $ 3,940,955 Excess def. & con. assets $34,540,028 $39,015,027 Dec. $ 4,474,999 £96 CORPORATION FINANCE 163. General conclusions as to working capital, — Many other industries, particularly those manufacturing stable articles of trade, require a comparatively small proportion of working capital. On the other hand, there are lines of business, such, for instance, as publishing, in which practically no fixed capital (office furniture, perhaps, excepted) 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 obligations, 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 expenses; when the inevitable hitch occurs they have no other resources to use and the corporation suddenly plunges into the quicksands of financial trouble and discredit. This problem of providing sufficient working capital will crop out again when we come to consider the causes of corporate insolvency. CHAPTER XXI DISPOSITION OF GROSS EARNINGS 164. Determination of income. — The ordinary form of income statement of a corporation is somewhat as follows : (a (b (c (d (e (f (g (h (i (J (k (1 (m Gross earnings from operation or manufacture. Deduct operating or manufacturing ex- penses. Net earnings from operation or manufacture. Add income from other sources. Total income. Deduct taxes. Balance applicable to fixed charges. Deduct interest. Deduct rentals. Deduct sinking fund and other charges. Balance applicable to dividends and surplus. Deduct dividends. Surplus from the year's operations. It goes without saying that each corporation has its own methods of stating accounts and that there are many variations from this standard form. The essen- tial items, however, are those stated above. It would be well 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 columns of all metropolitan newspapers. If any of the items given above are not altogether clear, the reader 897j 298 CORPORATION FINANCE should turn to the volume on Theory and Practice of Accounting and go over the explanation there given of the income statement. The relations between accounting and finance are so close that a fair understanding of the basic principles of accounting is necessary in order to deal intelligently with the problems of financial management. In what is said below in reference to each of the items in the income account it will be assumed that the reader is familiar with accounting terms and with the elements of accounting practice. 165. Honesty in stating gross earnings, — Perhaps the only comment needful on the first item "gross earnings" is that it should be honestly stated. This remark is trite enough, and yet not uncalled for. A great many corporation managers are in the habit of including in their gross earnings sales that have been made to parties of doubtful credit which are represented merely by accounts receivable that are probably bad. In the case of 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 flagrant instance of dishonesty was disclosed by Mr. Stephen Little, an accountant of wide reputa- tion, who in 1894 was called upon to investigate the condition of the insolvent Atchison, Topeka and Santa Fe Railroad Company. Mr. Little found that the railroad had paid out millions of dollars in rebates to shippers which had not been deducted from its state- ment of gross earnings. 166. What are operating expenses? — Operating ex- penses are also often grossly misstated, although in this instance the fault is apt to be due, not so much to the DISPOSITION OF GROSS EARNINGS 299 dishonesty of the corporation managers, as to their ignorance of correct accounting principles. The oper- ating expenses ought always to include not only the actual expenditures for raw materials, labor and current repairs, but also a liberal allowance for anticipated re- pairs and renewals and for depreciation. Repairs in the early years of a corporation's activities are seldom as great a burden as in later years. Ac- countants figure that most manufacturing machines , will show a rising percentage of necessary repairs each I year for the first five to ten years of its 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 be charged against the income account at all. If the tew machine, however, replaces to any extent an old lachine, this reasoning is obviously incorrect. Only he difference between the value of the old and the value f the new machine could properly be charged to capital account. Conservative corporations in this country, railroads particularly, are in the habit of charging the whole cost of their new equipment, as a rule, as a part of operating expenses. The English railroad practice, on the other hand, is to charge the whole expense to capital and to raise new capital funds to meet it. We shall have occasion to consider this point further in con- nection with "betterment expenses." 167. Necessity for depreciation reserves, — The sub- 300 CORPORATION FINANCE ject of depreciation is too large and important to receive 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) Most important of all, obsolescence or the im- pairment of value because of new inventions and processes. It is difficult for anyone not directly familiar with modern manufacturing enterprises to conceive of the rapidity with which changes in mechanical methods follow each other. Each important change is apt to make necessary a general revision of all the machinery and processes of manufacture. In the intense com- petition between industries, no concern that allows itself to fall behind in the race to install the latest and most economical devices will long be able to survive. Ameri- can manufacturers have long been famous for the vigor and fearlessness with which they adopt new machinery and processes, even though the change may make almost worthless the expensive equipment that had previously been installed. The Carnegie Steel Company, it is said, time after time, has relentlessly sent to the scrap heap costly machines and even whole plants that were found to be inferior to new inventions. DISPOSITION OF GROSS EARNINGS 301 This policy 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 slight saving in the cost of producing each unit may prove to be the margin between bankruptcy and prosperity. Yet, though the policy is to be praised and followed, it must not be forgotten that it involves large losses for the time being whenever old machines are superseded by new. These losses ought to be foreseen and provided against when the first steps of an enter- prise are taken. The only possible means of so do- ing is to charge as part of tlie operating expenses every year a liberal sum for depreciation — a sum that will take care, not merely of decay due to old age and lack of repair, but of obsolescence as well. Anything like a scientific treatment of depreciation has unfortunately been conspicuously absent from the accounts of most American corporations. Manufac- turers have been too willing to make rough guesses where fairly exact scientific deductions might have been drawn. Electric and steam railroads have uniformly I declined to make any allowance whatever for deprecia- tion on the ground that the value of their franchises is steadily rising and that this is sufficient to offset what- ever depreciation of their property is going on. There is a certain amount of truth, to be sure, in this assertion ; yet it reveals a woefully careless habit of thought. Such slap-dash methods fortunately are now being eradicated, so far as interstate steam and electric lines are concerned, through the control over their accounts now exercised by the Interstate Commerce Commission. Recent rulings of the Commission have very properly made it obligatory on railroads to form as accurate estimates as they can of the annual depreciation of their S02 CORPORATION FINANCE property and to set aside every year as part of operating expenses an adequate depreciation charge. To avoid any possible misunderstanding by those who may not be familiar with accounts, it may be well to state at this point that depreciation reserves, so called, are not sums set apart and invested outside of the prop- erty, but are merely the total charges against gross earnings over a series of years on account of deprecia- tion. The depreciation reserves are not separable from other capital funds invested in the business except as a matter of accounting. 168. Income from other sources and deductions, — We have now reached in our income statement the item "net earnings derived from operation." To these earnings should be added "income from other sources." In order to make the income account a clear and ac- curate statement of results of the year's operations, it is very important that this "income from other sources" should be stated separately and not confused with "net earnings from operation"; otherwise the cor- poration managers will be claiming credit for returns that are quite distinct from the company's own opera- tion. Income from other sources* includes dividends on the stocks of subsidiary and other companies, inter- est on the bonds of such companies, interest on bank deposits, rentals of property owned by the corpora- tion and not used in its own operations, and other items of that nature. Such returns are frequently temporary or irregular, in which case, in order to make the situation clear, they ought to be specifically named in the income statement. We now deduct taxes which, it will be noted in our model income statement, should not be included under fixed charges. There is some difference of opinion on DISPOSITION OF GROSS EARNINGS 303 this point. It is not a matter of sufficient importance, however, to be worth arguing over. The view here taken is that taxes are variable in amount, and are not, therefore, on the same basis as the regularly recurring fixed charges. As to the nature of interest and rentals, little need here be said. Sinking funds have been sufficiently treated for our purpose in another place. The deduction of fixed charges leaves as a balance the income applicable to dividends and surplus. Pre- ferred dividends, as have previously been explained, are classified as cumulative and non-cumulative. Cumula- tive dividends, to the corporation managers, are often extremely disagreeable things. They are not so bad as interest charges, for they may be deferred as often as necessary. On the other hand, the fact that they are cumulative makes them pile up at an alarming rate, and in the course of a very few years, if they are not paid, they become a charge ahead of the common stock that makes common stock dividends seem an unattain- able vision. For the best interests of common stock- holders, therefore, it is usually very desirable to pay cumulative preferred dividends regularly. If a shrink- age in profits makes a temporary lapse necessary, the lost ground should be regained at the first opportunity. 169. How much shall he paid out in dividends. — The next question to consider in disposing of the earnings of a corporation is. How much shall be paid out in non- cumulative and in common dividends. Mr. Thomas F. Woodlock has well said that the payment of dividends is the only absolutely non-productive expenditure that an honest corporation makes. This may sound like a meaningless paradox, but it is literally true. So far as the corporation itself is concerned, whatever is paid out 304 CORPORATION FINANCE 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 Company, 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 fully discussed in Chapter XXIII. The second disadvantage is of great importance and calls for some explanation. 170. Variability of profits. — In all lines of business the profits necessarily vary from year to year. This is true because all the factors which enter into and de- termine profits are variable. These factors are: DISPOSITION OF GROSS EARNINGS 305 (a) Volume of sales. (b) Prices obtained. (c) Prices of raw materials. (d) Wages. 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 general 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 further you get 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 Lukens Iron & Steel 60 Corn Products Refining . 75 Standard Oil . . . 95 General Electric i 60 Westlnghouse , 60 Pennsylvania Steel 60 Maryland Steel 60 1—20 306 CORPORATION 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 40 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 last four years may be gathered from the following comparison : Year Loco, Orders Fgt. Car Orders 1908 1,182 62,700 1907 3,282 151,700 1906 5,642 310,315 1905 6,265 341,315 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 307 ELECTRIC STREET RAILWAYS. Company and Period 1908 1907 Decrease, Boston, May-July $ 3,596,000 $ 3,623,000 $ 27,000 Mass. Elec, Apr-June 1,995,842 1,924,333 *71,509 Chicago Rwys., Mch.-May .... 2,625,533 2,574,324 *51,209 Twin City, Apr.-June 1,474,389 1,492,671 18,283 United St. Louis, Mch.-May... 2,645,364 2,735,406 90,042 Detroit United, Mch.-May 1,675,042 1,675,743 701 Total $14,012,170 $14,025,477 $13,307 * Increase. STEAM RAILROADS. Company and Period 1908 1907 Decrease. 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 Pennsylvania, Jan.-Mch 31,375,489 37,203,589 5,828,100 Louis. & Nash., Feb.-Apr. . . . 10,073,862 12,012,701 1,938,839 Missouri Pac, Feb.-Apr 9,467,500 11,927,824 2,460,324 Boston & Maine, Apr.-June.. 8,836,556 10,499,302 1,662,746 Total $79,849,999 $95,473,826 $15,623,827 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 308 CORPORATION FINANCE necessary to employ workingmen 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 efBciency of labor and in economy of production. 171. Regularity of dividends desirable, — ^We 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 aff*airs 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 5 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 difl'er- DISPOSITION OF GROSS EARNINGS 309 ence in market price in favor of the second stock. The principal reason for this difference is that so many people 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. 172. 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 Wventually its regular dividend rate. i 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 distribution of gross earnings is necessary in order to give perma- nence 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 been set aside to provide for accrued repairs and for depreciation. They must, of course, meet all the fixed charges of the corporation out of income under penalty 310 CORPORATION FINANCE of seeing the company forced Into bankruptcy. They must pay cumulative preferred dividends so far as practicable, although in this regard some discretion is permitted to them. Finally they must 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 who 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 the 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. CHAPTER XXII BETTERMENT EXPENSES 173. 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. 311 312 CORPORATION FINANCE Their motives, we may presume, are not in the least philanthropic; 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. 174. 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- ning 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 313 VII. 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. 175. 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 bought with the few thousand dollars that Andrew Carnegie and his associates were able with great difficulty at that time to command. It has since expanded until it is to-day worth, as a going 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. 314 CORPORATION FINANCE 176. 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 ordinary 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 his 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. 177. The attitude of stockholders, — An example BETTERMENT EXPENSES 315 that has been conspicuous lately is the long-drawn-out struggle on the part of minority stockholders in the Wells-Fargo Express Company tor larger dividends. This company is controlled by the Harriman party, and Mr. E. H. Harriman, following his usual policy, has been perhaps too much inclined to sacrifice dividends to financial strength. The minority stockholders contend that the Wells-Fargo Company has been pihng up an enormous surplus which is not needed or used in the business, but is invested in the securities of other com- panies. The majority stockholders — that is the Harri- man party — rejoin that the security holdings of the Wells-Fargo Company are for the sake of control and for the prevention of ruinous competition; in other words, that earnings have been consistently devoted to betterments. The undeniable facts are that the com- pany is highly prosperous, is paying relatively small dividends and is more or less harassed by a considerable 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 316 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 XXVII 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. Wherever 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 may make themselves, do not have much influence with the management, because they are distinctly in the minority. It often happens, how- ever, 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 better- ment 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 stock- holders more or less in the dark ; and this they do by the very simple process of charging their expenditures for betterments under the head of operating expenses. 178. The case of the Lehigh Valley Railroad, — The history of the Lehigh Valley Railroad so well illustrates the workings and the results of this species of well-inten- BETTERMENT EXPENSES 317 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. An 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 1902 Cost of Road $18,639,291.95 $18,639,291.95 Cost of Equipment ,. 19,018,419.98 19,018,419.98 Securities owned . . . .. 32,949,322.14 39,300,209.80 318 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 ^ve years, 1898 to 1902, all new equipment, all side-tracking and other expansions of track, all contruction of bridges and buildings, all reballasting of track and similar items had been charged to operating expenses. Professor Edward Sherwood Meade, to whose searching analysis we are indebted for much of the information here presented, estimates that in these five years the Lehigh Valley under Mr. 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 319 bonds; in other words, the $13,000,000 under a different management would have been distributed to stock- holders. 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 deficit 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 have increased about 33 per cent. Its net earnings have considerably more than doubled, and its fixed charges have been increased scarcely at all. The figures below tell the whole story of this remarkable growth more plainly than it could be put in words. i 1908 1901 Increase Miles operated .... 1,447 1,382 65 Gross earnings . . . . $35,510,154 $26,688,533 $8,826,621 Gross, per mile . . . 24,500 19,300 5,200 Net earnings 12,183,582 5,765,113 6,418,469 Net, per mile 8,420 4,170 4,250 Chgs, less other inc. 4,813,008 4,364,800 448,208 Charges, per mile . 3,320 3,150 170 Surplus 7,370,574 1,400,313 1,013 5,970,261 4,087 Surplus, per mile . . 5,100 Now what is the meaning of these facts and figures? In the first place, it is plain that the road was in poor 320 CORPORATION FINANCE condition prior to Mr. Walters' administration and that he left it in such excellent condition that its net earnings have since shown 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 been 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. 179. 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 out- lays for repair work, maintenance and improvements have been made. Since the formation of the company nine years ago, about $3,000,000 have been expended in construction, purchase of woodlands, etc., in addition to requirements for ordinary re- BETTERMENT EXPENSES 321 pairs and maintenance, which have been charged directly to operating expenses, and also in addition to the amounts ex- pended in 1906 for the property of the Gres Falls Company and that of the Allen Bros. Company. AU 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, its financial position has also been bettered, net working capital having been increased in the past four years by approximately $1,058,000 or about 100 per cent. 180. Borrowing funds for betterments. — The third means of raising funds for betterments is through issues of medium-termnotesj^ 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 was 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_pxQfi±&; 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 gaxj?ff these bonds when they fall due, but plan to refund theni^bj^jaew issues^ In other words, what they actually do is to incur a permanent fixed charge. Now i^ a betterment is of such a character that it is practically certam to producejprofit§ year after year larger than the fixed charges assumed in order to make the better- S22 CORPORATION FINANCE ment, it is no doubt good policy to raise the necessary; funds by the issue of long-time obligations. 181. Policy of the Pennsylvania Railroad. — The set- tled policy of the Pennsylvania Railroad 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 will in all human probability result in a permanent saving or profit more than equal to interest on the funds thus invested ; second, V 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 trafiic 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 sYork 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 b etterments of the second class by appropriations fromsurpjus. . 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 generally 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 $77,528,664, of which only 60 per cent has been capitalized. The total cost BETTERMENT EXPENSES 323 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 190T . . 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 of end of 1908 . . $77,528,664 The cost on the books given above is the figure at which the Pennsylvania Railroad carries the work already 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 to date of only about $36,500,000. 182. 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 comparativ e me ritsLof increasing capitalization by^^ means of gtock^^ as^ompared_with bond, issues are too obvious to need much discussion. A bond issue is a cheape r means of getting the necessary funds, for bonds can always be sold to better advantage than stock which yields the same return; on the other hand, bond issues SU CORPORATION FINANCE are objectionable insofar as they tend to increase the fixedjcharges and thereby imperil the safety of the com- pany. New^tock 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 r — -y^* Applying this formula to the Illinois Central ~ 1 ij I, 70 X. 2 14 ^^ ^^ . example, we would have , ^ =" :ro~ "= lX«o6. As 1 "T" .ifi l.Z DISTRIBUTION OF THE SURPLUS 347 has been stated these theoretical prices for "rights" are seldom obtained because speculative purchasers of rights are not willing to go that high. Moreover, there are some assumptions underlying these mathematical f orm- ulse which may or may not be true. It is assumed, for instance, that the stock market price of the old stock is a normal 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 been issued will be uninfluenced by speculative factors. There is a risk in all these assumptions, as the profes- sional stock market trader well -knows, and he is therefore 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 1 the whole, likely to yield the largest returns. The second method comes next in that respect, but has the disadvantage 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 being true at all times and under all circumstances. They are merely generalizations based on experience. 199. Privilege subscriptions as a method of stock watering, — So far as distribution of surplus is con- cerned, giving "rights" to privileged subscriptions to new issues of stock produces the same eff'ect, though not to an equal degree, as a stock dividend. The assets 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 348 CORPORATION FINANCE outstanding after the new issue, each stockholder may be truthfully said to have come into possession of some of the company's surplus. The privileg ed subs cription is a device for increasing capitalization without propor- Jionately jncrea^^^ assets^ ^lajbhat s en se it is * 'stock watering." The meaning of the terms "stock watering" and , "overcapitahzation" have been sufficiently discussed and need not be given further attention. It is enough to r reiterate that whatever may be said for or against the 1 practice in connection with public service corporations, it I is in private corporations, when properly used, a simple [,'and legitimate means of making a corporation's capital- fization correspond to its earning powers; and is in addi- jtion, as outlined in this chapter, a legitimate means of j transferring to the stockholder a part of the surplus which his company; has created for him. CHAPTER KXV MANIPULATION BY CORPORATION OFFICERS 200. Ought we to study manipulation? — So far we have been dealing with and endeavoring to formulate the principles of honest and efficient corporate manage- ment; the rest of this book will deal with dishonesty, in- efficiency and failure. Sometimes any study of rascal- ity is condemned offhand on the ground that it may suggest swindling practices to persons who otherwise would not have thought of them. Perhaps there is something to be said in favor of this view ; if any readers of this volume feel themselves morally weak it may be well for them to omit the next three chapters. On the other side of the argument, we may say that a thorough knowledge of fraudulent methods does not by any means encourage fraud, for it reveals that almost all such methods, however cunning they may appear, are un- sound and dangerous. Furthermore — and this is the important point — ^honest men ought certainly to acquire as clear an insight as they can into the methods of swindlers in order that they may be on their guard and may protect themselves and those who are dependent upon them. 201. The corporate form favors manipulation, — The corporation, as practically every business man now ap- preciates, is for most concerns the most convenient, use- ful and efficient form of organization that has yet been devised. It is likewise true that the corporation so far has proved itself a most efficient form in the hands of 349 350 CORPORATION FINANCE rascals for transferring other peoples' rightful property into their own pockets. In an address on "Abuse of Corporate Privileges" printed in the American Law Review Mr. Seymour D. Thompson has described from the lawyer's point of view the present conditions. He says: Our corporate life is honeycombed with corruption. A cor- poration is formed; its business is put into the hands of cer- tain managers holding some of its stock and expert in the man- agement of its business. Debts are created and the managers become the creditors. The result is that rings are organized within rings, wheels within wheels, combinations within com- binations. The managers, in the character of creditors, seize upon and foreclose the property of the corporation, and by well-known processes squeeze the other stockholders out and be- come themselves proprietors with larger holdings than they had before. This sweating process, dignified by the name of fore- closing and reorganizing, has come to be a regular industry in our courts of justice. Courts of justice have neither the time nor the means to take upon themselves the management of all the corporations in the country; and therefore the outraged and complaining stockholders are told that they cannot come into court until they have exhausted all the remedies within the corporation. . 202. Is manipulation a necessary evil? — Now this de- plorable condition, which is one of the chief evils of the American business world, is not, fortunately, a necessary evil. We may well doubt, indeed, whether the lawyers with their quibbles and conservatism will do much to remedy conditions. But we may expect much from the growing interest of the public in corporate affairs. The evil exists chiefly because the corporate form of organ- ization is still a thing in which most people have had little experience and the workings of which they do not MANIPULATION BY CORPORATION OFFICERS 351 clearly understand. The true remedy, then, for the evils of corporate manipulation, is publicity and educa- tion. These three chapters following, which constitute the first attempt, so far as the author knows, to classify and describe the methods commonly used for defrauding some of the owners of a corporation for the benefit of others, will fulfill their chief purpose if they have some slight influence in checking this evil. Perhaps the words "fraud" and "swindling" in the preceding paragraphs should not have been used; they do not convey exactly the conception which is in the author's mind in writing these chapters. We are not to be concerned here with ordinary clear cases of fraud ; a study of such cases belongs to law rather than to finance. Moreover, a clear-cut instance of fraud is not usually a very dangerous thing, because the victim may seek and obtain redress in the courts. The chief danger comes not from crude and obviously illegal larceny, but from acts that cannot be proven fraudulent and that belong in the shadowy borderland, bounded by shrewd dealing on the one side and on the other by plain swin- dling. Some of the practices to be described are allow- able, although most of them are discredited under the rules of the business game as those rules are generally interpreted. 203. Scope of the chapters on manipulation, — It should be made plain also at the beginning that in these chapters not much will be said about "malefactors of great wealth" or about large "predatory corporations," although some of these corporations furnish shining examples which cannot be overlooked. We shall deal rather with everyday small business corporations and with those kinds of manipulation that may be found in every section of the country. The "sharks" of Wall S52 CORPORATION FINANCE Street do not by 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) Manipulation 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 desires 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. 204. Exorhitant 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. It would be very difficult — prac- tically impossible — in such a case to prove fraud. No MANIPULATION BY CORPORATION OFFICERS 353 court would undertake to say that a salary was fraudu- lent, or that directors were acting beyond their powers in agreeing to it, unless the salary were beyond all reason. 205. Fraudulent tontracts. — ^Another favorite method of manipulation by 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-oiF on the corporation's purchases, has been so much exploited as to make un- necessary any further illustration. There is no question but that something of the kind does go on in many of the larger corporations. Yet the purchasing agent is generally a subordinate official whose policy is closely scrutinized by his superiors and who is subject to instant dismissal if any strong tendency on his part toward "grafting" is discovered. His delinquencies are not so interesting to us 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 H. 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 obtained control of this brewing corporation. They elected themselves to the directorate and to most of the corporation offices. One of the brothers owned a piece of real estate which the corporation purchased at an amount alleged to have been far in excess of its true value. The brothers, as directors, paid themselves large salaries as officers and no dividends were forthcoming 1—23 S54. CORPORATION FINANCE 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 personal 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 should 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 ofi criminal liability or punishment. Take another case, this time from the New York courts. Two officers of a paper company obtained an option to purchase 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 had no knowledge of the option price of $75,000 until later. On learning the facts they elected new officers who, on behalf of the company, brought suit against the defendants for the MANIPULATION BY CORPORATION OFFICERS 365 difference between the true purchase price and the price charged to the corporation. 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 comes simply in the fact that sooner or later his dis- honesty will be discovered and his reputation among honorable business men will be indelibly smirched. 206. 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 of for the corporation's, benefit. The writer, for instance, knows of a company of con- siderable size, which is in the business of buying and sell- 856 CORPORATION FINANCE ing: domestic rugs and carpets. The concern began to deal in a small way in oriental rugs and Smith and Jones, the president and office manager, respectively, dis- covered at once that in their town this business was extraordinarily profitable. Instead of taking hold of the business and developing it for the established corpo- ration of which they were officers, Jones resigi^ed his position, organized a new company, in which Smith was secretly a large stockholder, 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 knew 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 effect 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 Door Fastening Company is a corporation with a large capitalization. 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 small investors who were impressed with the high value of the patent and the large profits which would certainly be forthcoming as soon as it was put on the market. The corporation secured the necessary amount of capital funds, and manufactured the device; at this point the MANIPULATION BY CORPORATION OFFICERS 357 stockholders learned that a subsidiary; corporation, owned by the officers, had been formed in each section of the country where sales were expected to be large and that every subsidiary corporation had a hard and fast contract 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 selling rights in its own section. Practically all the profits evidently were thereby transferred from the corporation to the subsidiary companies. There is nothing new in such an arrangement. Thirty-five years ago when the numerous short-distance railroads 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 through long-distance traffic over two or more railroads under contracts by which much the greater portion of the 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. The same principle was applied by; Commodore Vanderbilt when the New York Central System was formed by holding in his own hands the stock of com- panies which owned the important terminals of the railroad. 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 majority^ of the New York Central stock, yet they; 358 CORPORATION FINANCE have been able to dominate the management of that road and to secure for themselves large profits through their ownership of these terminal companies. 207. Misuse of inside information, — The fourth method of milking a corporation for the benefit of its ofiicers 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 im- proper 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 corporation to make a business of speculating in the stock of his company, especially if he "sells short" and thereby puts himself under temptation to mismanage the company. On the other hand, probably few people would raise any objection to an officer's investing in 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 be any valid objection to his selling this same stock, if later he discovers that speculative 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? No one can say. It is as shadowy as the line between specula- tive and investment buying. Whatever doubt there may be 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 question but that the use of such in- formation by an officer in order to enrich himself directly at the expense of the corporation is wholly un- justifiable. The three cases cited below are fair examples of what is sometimes done: MANIPULATION BY CORPORATION OFFICERS 359 (a) An officer of an oil refining company in Pennsyl- vania, who had no authority to sell stock for the corporation, 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 5,000 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 being 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 receivers' hands. The company had notes for $20,000 outstanding, bearing 10 per cent interest and secured by a mortgage on its property. The president, know- ing the condition of the company, just before the failure, secured the notes in exchange for $30,000 face value of his stock in the company. Ten thousand dollars was 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 $10,000 to an outsider and the court enforced payment of the claim. (c) Robinson, the treasurer of a railroad company, which 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 held that the treasurer had done nothing illegal. He was at liberty to buy the notes for himself, as he' was under no obligation to buy them for the road. He could meet them when due with the road's money, as that money was there to pay any or all of the road's debts and not any special debt. 860 CORPORATION FINANCE The strlkmgjf eature of these three cases, as in several of the other cases cited, is that although_the_^x)fficials were obviously unfaithful to their trust and were not acting in good faith as agents for the corporation, never- theless they were able to escape legal punishment. 208 Is manipulation by officers common? — The four methods that have been given and illustrated, by which corporations are frequently deprived of part of their just profits by their own ofiicers are: ( a ) Exorbitant salaries. (b) Collusion or fraud in marketing, purchases and contracts. (c) Formation of new companies for especially profitable business. Xd) Misuse of confidential information which comes to ofiicers by virtue of their position. It would certainly be a gross exaggeration to say that all or a majority of the corporation ofiicers of the United States are guilty of any of these practices. On the contrary, it is probably true that their dealings with or for the corporation which they serve are in most cases absolutely honorable. Yet it must be regretfully ad- mitted that these four methods of milking a corporation are only too well-known and too skillfully practiced. As an accountant of wide experience says, in speaking of . corporate manipulation by ofiicers, "That this is con- l stantly being done is obvious from the fact that so many • men, drawing salaries with large corporations of i $10,000 to $15,000 a year, become millionaires 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." CHAPTER XXVI MANIPULATION BY DIRECTORS 209. Usual methods. — As has already been stated, it is difficult to draw the line between manipulation by officers and manipulation by directors, for in most cases 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 forms 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 directors' fees for attending meetings much higher than $10 to $25 for each meeting and would look with suspicion on an especially large number of meetings. 361 362 CORPORATION FINANCE Eliminating this possible method of manipulation, then, as of small consequence, we may set down four important and not uncommon means of transferring an undue proportion of a company's assets and profits to the pockets of its directors. These four methods are : (a) Fraudulent purchases and contracts. (b) Formation of new companies for especially profitable business. (c) Deceiving the body of stockholders by means of juggled accounts. (d) Forcing the corporation unnecessarily into bank- ruptcy or into receivers' hands. The reader will observe that the first two methods have been discussed in the preceding chapter. There are, however, some variations that should be mentioned between the application of these methods by officers and by directors. 210. Fraudulent contracts. — The number of cases of fraudulent purchases and contracts by directors that have been brought before the courts are so numerous that it is difficult to make a selection. The following instances are typical: (a) In an Alabama case the facts brought out were as follows: The promoters of a large electric manu- facturing company obtained as a profit in its formation approximately $2,000,000 of stock and were thereby able to exercise considerable influence on the board of directors. The directors, in spite of the demands of several stockholders, neglected to seek to recover from the promoters any portion of their excessive profit. Suit was brought by a stockholder to compel the directors to act and they replied that they deemed the proposed attempt to recover inexpedient. It is intimated in the court's decision that they were improperly influenced MANIPULATION BY DIRECTORS 363 by the promoters and the court ordered them to make the attempt. (b) Three directors of a corporation formed to build a sunmier resort hotel caused the corporation to pur- chase the land on which the hotel was to be located from themselves at a 200 per cent profit to themselves. The land was purchased subject to a heavy mortgage. When only $25,000 had been subscribed toward the $90,000 required to erect the hotel, the directors made a contract to start construction of the building. Their object in so doing was to enhance the value of other land in that vicinity which they owned. The corpora- tion became insolvent and the directors, on foreclosing their mortgage on the land, virtually became the owners of the land and of as much of the hotel building as had been erected. The court in this case held that the direc- tors were liable to the stockholders for the depreciation in the market value of the stock. (c) Two of three directors of a South Dakota corporation, for the purpose of securing control of the corporation for themselves, caused the issue and im- mediate sale to one of their friends of a large amount of new stock sufficient to give the two directors and their friend together a majority. The court held that as the friend knew all the facts, the sale of the stock conferred no rights upon the purchaser. It may be inferred from this decision that if the purchaser had been an innocent party, the transaction would have been valid. (d) In a somewhat similar instance in New York a full board of directors authorized the issue of sixty- seven shares of stock to increase its capital. The presi- dent of the company reported at a subsequent meeting that he had received no subscriptions, and four of the 364. CORPORATION FINANCE seven directors thereupon took the stock without knowl- edge of the holder of the majority of stock previously issued, who was also a director. In this case the court allowed the purchasers to hold and vote the stock, but enjoined them from using it to the injury of the pre- vious majority holder. (e) A railroad company was organized in Minnesota to build a local road in that state. Capital stock of $2,000,000 and bonds to the extent of $1,500,000 were authorized. A director and owner of a majority of the outstanding shares drew up a contract with the XYZ Construction Company under which the company was to build the road and receive 331 shares of its capital stock together with first mortgage bonds to the amount of $20,000 per mile. The XYZ Construction Company then made a contract on its own account with the firm of A & B, under which the firm was to pay $5,446 for each $20,000 block of bonds and in addition was to furnish the material necessary to build the road. The director above referred to was interested with A & B and was to receive for himself an agreed share of the railroad bonds. The actual cost of construction was to be about $14,000 a mile. The contract came before the board of directors and two directors, whom we will call Smith and Jones, voted for the contract with the understanding that they also were to become interested with A & B and to receive a portion of the profits. Afterwards they offered to contribute one-fourth of the cash required for actual construction of the road in order to become partners with A & B. Their offer was refused. They then brought suit, exposed the whole transaction and asked to have the contracts declared void for fraud. The court held that there was no fraud on the face of the transaction but that MANIPULATION BY DIRECTORS 365 fraud could plainly be inferred, inasmuch as the cor- poration was made to pay more than was necessary for contruction. They held, however, that the two direc- tors. Smith and Jones, having knowledge of the trans- action, did not come into court with "clean hands" and could not cry fraud because they lost what they had attempted to gain. The contract, therefore, was noi set aside. 211. Attitude of the courts. — These illustrations, taken almost at random, indicate what opportunities for fraudulent manipulation are open to corporate directors and how slight is the danger of legal punishment. As may be observed over and over again, the courts assume that a corporation is honestly managed in accordance with the wishes of the stockholders unless the contrary is absolutely proved. Stockholders who object to the contracts and purchases made by their directors are apt to be told that their true remedy is to elect a new board. Obviously this principle of the law, however far from applicable it may be in particular cases, works out, on the whole, for the good of the greatest number. Most corporations are honestly managed. Directors are rightly believed generally to have a far more extensive knowledge of the affairs of the corporation and of the contracts and purchases that should be made than the body of stockholders have. The courts, therefore, ordinarily do not desire to set aside contracts made by the directors or even by investigation to cast doubt upon those contracts. The attitude of the courts, it must be admitted, is correct. On the other hand, as the in- stances given above plainly indicate, it is also true that this attitude gives directors almost unlimited op- portunities for fraudulent manipulation. The onl^ 366 CORPORATION FINANCE practicable remedy in the long run is for the stockholders to be exceedingly careful to elect men of proved probity to their directorate. 212. New companies for profitable business, — The second method of manipulation by directors that has been named is the formation of new companies for profitable business. A few typical illustrations will best explain the working of this method. (a) The directors of a New York building and loan association, the charter of which required the funds to be invested in first mortgages, nevertheless bought some second mortgages. The association became insolvent and receivers were appointed. Some of the directors then organized a realty company which took from the receivers the land and buildings owned by the associa- tion at 50 cents on the dollar and made part payment with additional second mortgages. The directors thus secured for themselves at small cost most of the valuable assets of the association. The court discharged the re- ceiver and appointed another receiver to conserve the remaining assets. (b) The Strong Lumber Company and the Hoffman Manufacturing Company elected three men, consti- tuting a majority of both boards, directors of both com- panies. The HoflTman Manufacturing Company, which had the better credit, accepted time drafts drawn upon them by the Strong Lumber Company, although no consideration had been given. To secure themselves from personal liability the three men as directors of the Strong Company placed a mortgage on the property of that company and issued bonds which were turned over to the Hoffman Company. When the facts were presented, the court entered a decree setting aside the mortgage. MANIPULATION BY DIRECTORS 367 (c) The directors of a railroad company in Nevada were members of a syndicate which intended to build a connecting road. The road was built and paid for by the syndicate and was mortgaged heavily. The ^ syndicate received all the bonds and stock and then transferred 51 per cent of the stock to the railroad com- pany, of which they were directors, in consideration of this company's guaranteeing the bonds. The guar- antee of the bonds allowed the syndicate to sell them at a good price. The court held that allegations of fraud were not sustained and that the whole transaction was legitimate. In the last two cases the profit to the directors evi- dently came in the form of increased credit for companies in which they were interested. It seems clear in both cases that there was no corresponding advantage to the corporation ; otherwise the corporation in each case would have made the arrangement on its own account. The reader will observe, no doubt, that directors have opportunities of the same kind as those which fall to officers, when it is discovered that some particular feature of a company's business is especially profitable. Either the directors or the officers, or both together, may organize a new company of their own to handle that business and thus may divert profits to themselves. 213. Juggling accounts. — The third means open to directors, who wish to manipulate corporate affairs for their own interests, is to tamper with the corporation's books and thus give the stockholders a wrong impression as to the company's condition. The methods that may be used to accomplish this object are so numerous and so complicated that it would be impracticable to enumerate all of them here. Indeed, this section of our subject belongs to accounting rather than to finance. 368 CORPORATION FINANCE ^A few typical instances, however, which' have been supplied by some of the most experienced and best known public accountants in the United States to the writer, may be enumerated. The reader will find further light on this important subject in the volume on Auditing. (a) The directors of a holding company, which owned the entire stock of four separate manufacturing companies, desired to present a favorable report of the year's operations to their stockholders. In order to do so they took into account dividends paid by three of the companies and ignored altogether a very heavy loss incurred by the fourth company. Their excuse for so doing — ^which excuse, however, carries very little weight — was that the holding company as a stockholder in the other companies was entitled to the benefit of all the dividends declared, but could not be called upon to make up any loss that might be sustained; this excuse obviously overlooks the fact that the loss incurred by the fourth company constituted a diminution of the assets of the holding company. A firm of certified public accountants was called upon to sign the mislead- ing report prepared by the directors. The accountants were given access to the books of the holding company but were refused the books of the subsidiary companies. The firm lost the audit, which went to more pliable accountants (not holding the degree of certified public accountant), and the original report was presented to the stockholders. Presumably the directors seized the opportunity to sell their stock in the holding company at a high price. At any rate, the holding company went into bankruptcy not long afterwards. (b) A railroad company, when the time for the annual report and audit approached, deliberately withheld the MANIPULATION BY DIRECTORS 369 intertrafflc claims of other companies, amounting to a considerable sum, by simply pigeon-holing the docu- ments and not recording them as a part of their current obligations. This action was taken, it is stated, by order of the executive committee of the board of directors, who were about to ask authority for a new stock issue and who desired to bring out the issue shortly after the annual report appeared. The certified public account- ants, who had charge of the annual audit, in this case discovered the deception through a general analytical study of the year's operations whereby it was seen that while such intertraffic claims ought to exist, they] were not in evidence. (c) An industrial company was enabled to maintain a market value for its stock through the payment of unearned dividends out of capital. The deficit was not shown on the books and was not known to the stock- holders until after an audit by public accountants. Its existence, however, should have been known to the directors and in all probability was known during the period in which unearned dividends were declared. In this case judgment was obtained in the courts against the directors and restitution of the unearned dividends was obtained. (d) In a case brought in the federal courts stock- holders asked for the cancellation of stock alleged to have been fraudulently and secretly issued by the board of directors. It was stated that a person, to whom the certificate was issued without consideration to the com- pany, executed to one of the directors a power of attorney authorizing him to vote the stock and delivered the certificate signed in blank. Thus, although no transfer appeared on the books of the corporation, the stock was actually owned and voted by one of the 1—24 370 CORPORATION FINANCE directors. As the stock of this corporation was widely scattered and as the reports to stockholders were frag- mentary and misleading, the whole transaction would have passed unnoticed if it had not been accidentally revealed to one of the stockholders. The court in this ease merely cancelled the certificate in question and neither civil nor criminal liability was found to attach to the directors. 214. An accountant's observations, — A certified pub- lic accountant, whose experience in handling such cases has been exceptionally large, has been kind enough to sum up for the writer the results of his observations in the following note : The methods employed for the purpose of giving a wrong impression to the stockholders or the public as to the company's condition as shown by the published balance sheet are almost in- numerable, but I will cite a few. Where the accounts are subject to audit and it is desired to make a good appearance at the date of the balance sheet, the practice of borrowing a large sum of money from brokers or bankers for a few days is often resorted to. By this means at the date of the balance sheet the company has apparently a large amount of available funds, though in point of fact the loan is repaid a few days later. In the same way, where such a corporation as a loan and investment company finds itself hold- ing securities of a speculative character, such as mining stock, it is quite customary to make a sale of these securities to brokers a few days before the date of the balance sheet, with the under- standing that the company is to repurchase them at the same price less commission for the accommodation a few days later. In this way the company avoids showing on its published bal- ance sheet any investments that are not of a gilt-edged charac- ter, and in both the instances quoted above it is very hard for the auditor to find any grounds for refusal to give an unquali- MANIPULATION BY DIRECTORS 371 fied certificate to the balance sheet ; the condition is as stated by the accounts at the particular date at which they are drawn up. Again, where it is desired to conceal from stockholders the fact that the company is making large profits or, on the other hand, incurring heavy losses, the valuation placed upon invest- ments in stocks and bonds of other corporations or the valua- tion placed upon merchandise on hand is often juggled, the officers of the company constituting themselves the arbiters as to what is really the actual value of such assets. Another _window-dressin g_plan often employed is to treat the balances due on current account from the branch houses of the corporation as though they were accounts receivable due from ordinary customers. Goods on consignment are often similarly treated as though they were accounts receivable and included in the balance sheet at sale price under this caption in- stead of at cost price. 215. Remedies for this kind of manipulation, — ^What little has been said here with regard to juggling accounts by directors is sufficient to drive home at least one truth, namely, that the only safety for stockholders lies in insisting upon frequent and thorough examina- tions by certified public accountants of the highest standing. The chief asset of a public accountant is his unquestioned reputation for penetration and integrity. The loss of that reputation means the loss of his profes- sional standing and of his clientele. He has, therefore, the strongest motive to lay bare the true condition of any corporation which he is called upon to examine and to state the exact facts to the stockholders. The stock- holders may safely place confidence in him — ^unless, to be sure, he happens to be one of those black sheep, a few of whom find temporary employment in all professions. In England it is customary for the stockholders them- selves to elect a public accountant to serve as the annual S7% CORPORATION FINANCE auditor of their company. It will be a fortunate day for American stockholders when this practice becomes prevalent also in this country. We may lay it down as a general principle that officers and directors who are worthy of their trust will not object to having their operations scrutinized at least once a year by an impar- tial and absolutely independent expert. Another tendency which works indirectly toward the same result is the growing demand on the part of the people of the United States for publicity in corporation affairs. The demand for publicity is especially eiFec- tive in the case of railroads and other public service corporations, most of which are now required to render complete annual reports either to the Interstate Com- merce Commission or to some corresponding state authority. The primary purpose of this requirement is to obtain information that will aid legislatures and com- missions in deciding upon reasonable rates and prices. It is doubtful, in the opinion of the writer, whether this result will be achieved. There can be no question, how- ever, but that the interests of stockholders of such companies have been greatly advanced by a general adoption of this requirement. It is now possible for an investor to obtain such a complete and authoritative ' knowledge of the interior affairs of the principal American railroads as to make possible an intelligent judgment of the honesty and efficiency of the manage- ment. Seeing the advantages that are thus gained, the stockholders of other large corporations are insisting more and more forcibly on a similar pubUcity and in- vestors are refusing to buy the securities of companies which do not present satisfactory annual reports. That this attitude is making itself felt is evident from the MANIPULATION BY DIRECTORS 373 numerous conversions, referred to in Chapter XVII, of securities quoted on the New York Stock Exchange from the unhsted to the listed department. 216. Inflicting loss on the corporation, — The fourth important method of manipulation by directors is through forcing heavy losses and frequently even bank- ruptcy on their companies. Here again a few examples selected from a mass of cases which the writer has exam- ined will best illustrate the principal variations of this method. (a) The G. and R. Railroad Company, a Kentucky corporation, constructed a road from Graceton to Rawlings for which it was heavily indebted. Robinson, a director, with the assistance of other directors, used the profits of the road to make improvements and thus made impossible the payment of interest on the outstand- ing bonds. The company was thus forced into bank- ruptcy and at the bankrupt sale all the property and rights were sold to Robinson. Robinson and others then formed a new corporation to hold the road. Five years later the stockholders of the bankrupt corporation brought suit against the heirs of Robinson to have the court adjudge the road as held in trust for the G. and R. Railroad Company. The court found that Robinson had violated his duties of trust by willfully mismanag- ing the road and misappropriating the earnings and, therefore, returned the property to the original stock- holders, compensation being allowed to Robinson's heirs for the amount actually paid by Robinson for the road. Evidently Robinson's actions in this instance, although finally declared unlawful, woilld have passed unchallenged but for the enterprise and persistency of one or two of the stockholders. (b) In a recent case in the federal courts, certain 874 CORPORATION FINANCE trustees of a building and loan association sold a valu- able piece of real estate to a trust company, in which some of the trustees were also interested, in exchange for securities of doubtful value. A mortgage on the real estate was taken from the trust company as a guarantee that the securities would realize the price agreed upon for the property, but by agreement the mortgage was not recorded. Later the trust company desired to sell the property and the trustees passed a resolution authorizing the cancellation of the mortgage, and it was cancelled without the knowledge or consent of the stockholders. Shortly afterwards the trust com- pany became insolvent, the securities held by the build- ing and loan association were found to be worthless and next to nothing was obtained for the property that had been sold. This may be taken as a typical instance of loss willfully inflicted on a corporation by its own directors. (c) A corporation was indebted to its directors and they caused mortgage bonds to be issued to them for the indebtedness. The bonds were immediately as- signed to a rival corporation. Before anything further had been done the stockholders learned of this trans- action and brought a suit for damages. The court held that the directors would be personally liable for what- ever consequences of their acts might affect injuriously the interests of non-consenting stockholders. (d) A stockholder of a Montana mining corporation in an action alleged that officers and directors in pur- suance of a plan to depreciate the company's stock, in order to render practically worthless stock held by the plaintiff and others similarly situated, refused to sell treasury stock of the corporation in order to procure funds with which to prosecute assessment work on the MANIPULATION BY DIRECTORS 375 company's mining claims essential to compliance with the state and federal laws. Further the directors sys- tematically depreciated the value of the treasury stock by words and actions, refused to accept money offered therefor, removed the books of the company from the state, declined to give the plaintiff any information re- garding the company's affairs and in general so con- ducted its business as to destroy the value of its shares. Their object in so doing was to make it necessary for the company to give up its mining claim in order that they might re-locate the property in their own names. In this case the court decided that fraud had been sufficiently shown and placed a receiver in charge of the property. The decision, however, would not have been reached except for certain imprudent remarks on the part of some of the directors. 217. The danger in losing control of a corporation, — The most interesting instance that has come to the writer's notice is given by a certified public accountant in one of the Western States, who vouches for its being a typical and actual case of manipulation by directors. He writes as follows: A owned a majority of the capital stock outstanding in a manufacturing concern. Besides himself he had two dummies for the two other members of the board of directors. B de- sired to buy an interest in the concern and bought less than half of A's stock (leaving A still in control), with the understanding that B was to become a member of the board of directors, and that A and B should select another person whom they might interest at some future date when selling more stock. There- fore, they mutually decided to place a dummy temporarily on the board. B is a crook, as develops afterwards. C (the agreed-upon dummy) proves to be a bigger crook than B, thus giving B a majority in the board of directors. After this ar- rangement has been carried through, B and C trump up some 376 CORPORATION FINANCE imaginary charges against the methods of management of A, and thus the majority of the board depose A as president and manager of the concern. A opposes the action and the case is brought into the court. B and C being the majority of the board of directors, the court upholds their action and gives an injunction against A not to interfere with B and C. B and C then buy some worthless vacant property for a few dollars, which they appraise at an excessive value and sell to the company, taking stock in payment at the increased values. This stock is then divided between B and C, thus leaving A in the minority as a stockholder. The factory then burns down and a low settlement is made with the insurance companies, be- cause suspicion was directed toward B for having set fire to the property. Their assets having thus been reduced, and wishing to make an excellent impression upon the court, and further wishing to hide their fraudulent action in placing the excessive value on the vacant, valueless property, they decrease the capi- tal stock to about 10 per cent of the original capital stock. Each stockholder obtains his proportionate share of the new stock. In this manner B and C beat A from a half interest to a sixth interest. They then incorporate a new company called The Investment Company, of which B and C are the only stockholders and in which B and C put up $5,000, which they loan out on improved realty to the manufacturing company, obtaining therefor a note secured by a mortgage. They then proceed to incorporate another company, which succeeds the old manufacturing company. They value the as- sets of the old company at about one-third of what they stand on the books. The new company purchases the assets at the re- duced value, giving the stockholders of the old company stock in the new concern in proportion of one to three, thus reducing the holdings of A from a half to an eighth interest in the same assets of which he was originally the owner. The new company then contracts with D, who is another crook, to build it a factory. The contract made with him is at a figure which is about $5,000 higher than the ordinary contractor would have built it for. MANIPULATION BY DIRECTORS 377 In addition to this B and C give him a large block of stock as a part consideration for the building of the plant. This $5,000 in excess of the real cost of the factory is paid to D every other day in cash and the books indicate that such cash was for his pay-roll. But circumstantial evidence points to the fact that these payments are bogus transactions on the books and that in fact the money goes into the bank account of the Investment Company. Then the Investment Company begins to play treasurer for the new company, because it has no funds. Thus it loans the $5,000 back to the manufacturing company. The new manu- facturing company needing more funds, the Investment Com- pany sells the $5,000 note above mentioned to the manufactur- ing company, permitting the manufacturing company to credit the Investment Company for this $5,000 on its books. The manufacturing company then puts up the $5,000 note as col- lateral for a loan of $3,000 at the Bank. The result is that the Investment Company secures a credit in its favor for $5,000 for an actual value of but $3,000. After this transaction the Investment Company shows signs of anxiety for the money it has advanced, $5,000 in cash and $5,000 in notes. It there- fore secures its claims by a mortgage from the manufacturing company on its new plant for $10,000. The plant is completed, the stock bonus issued to the contrac- tor, and this stock transferred to the Investment Company. Circumstantial evidence shows that no consideration was paid by the Investment Company to the contractor for this stock. As the case stands at present, the Investment Company is trying to foreclose its mortgage and if successful, will entirely defeat the interest of A, who in less than eight months was beaten 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 wasting the assets of the company, I cannot see how under the laws of the state. A has any redress whatever, except to show fraud in the first issue of additional stock and in the subsequent decreasing of the capital 378 CORPORATION FINANCE stock. But from the point of view of law it will be exceedingly difficult 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 obtain- ing 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 transac- tions. 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 WITH 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. I CHAPTER XXVII MANIPULATION BY AND FOR STOCKHOLDERS 218. 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 controlling stockholders at the expense of minority interests. In the first case the stockholders 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 success- fully obtain a share in its advantages. Generally speaking, manipulation by and for stockholders as a body is confined to small close corporations. We shall find, however, 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 a stock of goods on credit, disposing of it quickly and secretly, concealing the returns and shortly afterward going into bankruptcy. The trick may be worked by corporations as well as by partnerships or by individuals. Indeed, the corporation affords an addi- tional advantage to the swindlers in that its bankruptcy need not affect them in the least. Credit-men under- stand the game in all its variations thoroughly and are especially cautious in granting credit to small close cor- porations, no matter how imposing may be their title and their capitalization. This scheme, of course, is 379 380 CORPORATION FINANCE simply 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 outstanding bonded debt is high are always under temptation 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 drawn, 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. 219. 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 381 and put back into the property a surplus of $12,500,000. Now a surplus is legally, of course, the property of the stockholders 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 understanding. Ordinarily, as has been explained, the surplus is invested in the form of perma- nent 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, determined to secure for themselves, and incidentally the other stockholders, the accumulated surplus of the com- pany. They therefore issued new bonds to the extent of $32,000,000, which were sold at 65 and the proceeds, about $21,000,000, turned into the company's treasury. They then declared an extra cash dividend of 30 per cent and thus 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 care. There can be no question but that this unanimity on the part of the public is highly significant. It means that between 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 382 CORPORATION FINANCE syndicate ought not to be too severely criticised, for they merely acted in accordance with the custom of the period. We 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 all corporate activities become clearer. 220. Manipulation through subsidiary 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 for 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 quite evident, however, that as a method of getting loans and avoiding re-payment the scheme is workable. MANIPULATION BY STOCKHOLDERS 383 Here is another instance which shows that eminent and entirely respectable railroad directors are not above working the same trick for the benefit of their road. The N. E. Railway owned a majority of the stock of a small rail and boat line which 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 the 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 small 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 possession. The income bondholders 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. 221. Central of Georgia income account, — Another case in point, that at the time of writing this book is attracting attention in the financial world, is set forth in the suit of the income bondholders of the Central of Georgia Railroad Company for the payment of interest in full on the bonds. The reader will recall that in describing the nature of income bonds it was stated that they are falling into disuse on account of the in- 384 CORPORATION FINANCE evitable 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 reorganization of the old Central Railroad and Banking Company of Georgia. This case well illustrates the subject now under dis- cussion, inasmuch as it discloses one method of manipula- 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, is that a subsidiary corporation, the Ocean Steamship Company, almost all of the stock of which is owned by the Central of Georgia Railway Company, has been making large profits and that these profits have 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 thcj stock of the Ocean Steamship Company held in th( treasury of the railway company, but were turned ovei bodily under the fiction of a "loan"; therefore the earnings of the steamship company did not appear at all in the income account of the railway company, and the railway company thereby avoided showing sufficient profits to pay interest to the income bondholders. The counsel for the railway company urged, according to the brief of petitioners' counsel, "that the net earnings of the steamship company should not be included in the income account of the railway company and that unless MANIPULATION BY STOCKHOLDERS 385 a dividend is declared by the steamship company no part of the net earnings of the steamship company belong to the railway company or are pledged to the bond- holders, and that the question of declaration of a dividend is a matter of discretion lodged with the board of directors of the steamship company, with which a court of equity should not interfere. In other words, the railway company interposes the doctrine of *corpo- rate entity' and desires to have what it regards as the *sacredness' of the doctrine taken cognizance of by a court of equity." At the date of writing no decision has been given by the court and no one can say exactly what the law on the subject is. It seems clear, however, to a layman that the subsidiary corporation is here used as a device to prevent the income bondholders from securing profits that have actually been earned. These cases are sufficient to show what risks creditors may unwittingly take on themselves and how careful they should be in fixing the terms of their mortgage. Especially is this true in dealing with corporations which carry on several activities and which may through separate companies readily divert their earnings from [the rightful creditors to the stockholders. 222. Squeezing the minority stockholders, — We are [ready now to take up the second group of manipulative methods to be discussed in this chapter, namely those methods which are designed to enrich controlling stock- holders at the expense of minority interests. Let us consider first the following instance, taken from a Missouri court decision, of willful mismanagement : The Olympic Theatre Company was organized in May, 1903, with a capitalization of $50,000. E. S. James, Sr., obtained 240 shares, par value $100, and 1—35 386 CORPORATION FINANCE J. S. Mcintosh, 150 shares; the other 110 shares were never issued. Three days after the organization the company obtained a hundred-year lease of a lot in St. Louis. Under the terms of the lease the company was to pay the owner a rent of $2,500 for the first two years and thereafter at the rate of 6 per cent of the appraised value of the lot. The company had the right to pur- chase at the appraised value at the end of five years. The lease was to become void by non-performance of any of its conditions and, in the event of its being voided, the owners of the lot were to get full title to whatever buildings the theatre company might erect on the lot. The company erected a building and conducted a theatre. In 1905 Mcintosh sold his stock to Robert Henry, and Henry became a director and treasurer of the company. E. S. James gave ten shares of stock to his son, E. S. James, Jr., and made him the third director. In 1907 James, Sr., transferred ten shares to another son, Alfred James, and ten shares to a clerk, L. R. Osgood. In the same year the new board of directors elected were James, Sr., James, Jr., and Osgood, thus forcing Henry out. In 1908, as the company was not strong enough financially to buy the lot, the stockholders gave the directors the right to dispose of the company's option to any stockholder. The directors immediately sold the option for $50 to James, Sr., who there- upon resigned as president and director and had his son Alfred elected in his place. James, Sr., then used his option to buy the lot for $50,000 and made an agree- ment with the company fixing its appraised value at $65,000 and its annual rental at $3,500. Alfred James then resigned his offices and his father was re-elected president and director. The board failed to pay the MANIPULATION BY STOCKHOLDERS 387 rent when due and James, Sr., as owner of the lot under the terms of the lease to the company, declared the lease void and was placed in possession of the lot and the building erected thereon. Henry, the minority stock- holder, brought suit and it was finally decided that suffi- cient evidence of fraud had been produced to warrant the court in reinstating the lessee in possession of the theatre under the terms of the lease. It may be 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 been destroyed. These were tactical errors which might readily have been 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 and 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 voted 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. INTo fraud was shown 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 induced the board to purchase worthless bonds of another corporation in which he was interested, by which he was able to make a large individual profit. Here again the minority stockholders, in spite of their unremitting efforts, were unable to prove fraud. 223. A complicated real estate proposition, — Here is an instance furnished by a prominent accountant 388 CORPORATION FINANCE and which is stated to be typical of the operations of a certain group of companies. The Suburban Development Company is a close corporation which speculates in acreage and sells city lots on a commission basis. The company sells a piece of property belonging to an outsider. Smith, to the Redbank Realty Company. This last named company is in reality a subsidiary corporation, all of whose stock is owned by the Suburban Development Company. The Suburban Development Company collects a commission from Smith for selling his property. The company now organizes a third corporation, the Long View Land Company, which buys the property at a handsome advance and assumes the mortgage which was on the property when Smith owned it. The Long View Land Company, in addition to assuming the mortgage, issues all its stock to the Suburban Development Company for the balance of its purchase price. The Long View Land Company now makes a contract with the Suburban Development Company whereby the last-named corporation sells the lots on a commission of 20 per cent. The Long View Land Company is also charged an exorbitant amount for office rent and pays large salaries to its officers, who are_ the stockholders in the Suburban Development Coi pany. The Suburban Development Company now pushei the sales of the lots owned by the Long View Land Com- pany. When no outsiders can be induced to buy, other subsidiary corporations are formed which buy lots at high prices from the Long View Land Company. Thus this company is given a fictitious appearance of great prosperity and a surplus is created on the books. With such a showing it is easy to find purchasers of the MANIPULATION BY STOCKHOLDERS 389 stock of the Long View Land Company, which is in the treasury of the Suburban Development Company. After all but the controlling shares are sold, the sub- sidiary companies which have bought lots from the Long View Land Company go into bankruptcy, the lots are returned and the paper profits of the Long View Land Company suddenly vanish into thin air. The object of this complicated series of transactions, as the reader will see, is simply to sell the minority stock of the Long View Land Company. The majority shares must be retained in the hands of the manipulators in order to avoid investigation and litigation. The com- pany advertised and kept before the public in all these transactions is, of course, the Long View Land Com- pany. All the time, however, the stockholders of the controlling corporation are calmly pocketing all the real profits. The above illustrations are typical. It would seem impossible to enumerate all the possible variations in method. The feature common to them all, however, is the transfer of property from one corporation to another corporation owned by the majority stockholders of cor- poration number one. This is what the minority stock- holder must always fear and, so far as possible, provide against. There is no other way of preventing such manipulation except by associating only with honest majority stockholders in companies where the fullest publicity obtains. 224. Robbing a partnership to pay a corporation, — One more instance should be added to the list already given, for it shows very clearly what may be accom- plished in the way of defrauding helpless and ignorant minority owners. James Ehrenbahn, a partner in the firm of L. A. 390 CORPORATION FINANCE Ehrenbahn and Company, manufacturers of agricul- tural implements, died in the year 1896. He had an undivided one-fourth interest in the firm and in addi- tion had loaned the firm $3,000. He also had a one-third interest in a credit against the firm of $12,000, the other two-thirds belonging to his brother, L. A. Ehrenbahn. The firm held property whose book value was approximately $260,000. Immediately after the death of James Ehrenbahn the surviving partners caused to be written o& to profit and loss accounts and bills receivable alleged to be uncollectible amounting to $110,000, leaving a net book value of the property of the firm of approximately $150,000. L. A. Ehrenbahn was acting not only for himself but also for the estate of his brother, of which he had been appointed adminis- trator. The surviving partners made no attempt to close the affairs of the firm, but continued in business and made large profits, of which they rendered no ac- counting. In continuing the business they used up money and property belonging to the estate of James Ehrenbahn. About October 1, 1898, the surviving partners agreed to form a corporation, lease to it the plant and real estate of the co-partnership and sell to it on credit, the terms being indefinite, the personal property, accounts and bills receivable in the hands of the surviving partners. The corporation took over the inventory of finished products at an appraised value to be paid for out of money received from the sale of implements on hand. The organization of the cori)oration was in 1898 and its operations began the same year, but no stock was issued until 1903. A peculiarity of the business thus transferred was that large amounts of agricultural instruments were MANIPULATION BY STOCKHOLDERS 391 sold "on consignment" to agents who had the privilege of either returning the goods or of paying for them. The corporation now began to deal with these agents, sent them new stocks of goods and allowed them without protest to return the goods which had been sent them on consignment by the partnership; thus the accounts and bills receivable of the partnership were rendered worthless and their place was taken by accounts re- ceivable of the corporation. Furthermore, the corpora- tion used no diligence in collecting the accounts re- ceivable of the partnership that were left outstanding. In March, 1903, L. A. Ehrenbahn for himself, and assuming to act as administrator of his brother's estate, delivered a new lease to the corporation of the land and buildings belonging to the partnership at the excessively low rate of $1,000 a year. In the same year the partner- ship made a final sale to the corporation of the personal property for $20,000, although this same property had been valued in 1898 at $50,000. Between 1898 and 1903 the corporation paid nothing for the property or for its use. Beginning in 1904 the corporation paid annual 10 per cent dividends on a capitalization of $100,000. The record does not show what dividends were paid between 1898 and 1904. When the case came into court on complaint of the heirs of James Ehrenbahn decision in substance was that the corpora- tion should be compelled to pay a price to be fixed after investigation by a master for the personal property and real estate. It was adjudged, however, in the case of accounts and bills receivable, that no legal liability lay against the corporation. There can be no question, judging from the facts as presented to the court, that large sums had been de- liberately withheld from the partnership and transferred 392 CORPORATION FINANCE to the corporation by the manipulation of the accounts and bills receivable. Yet this manipulation could be carried on so easily by the corporation that it was im- possible to prove fraud or bad faith. 225. Remedies for manipulation, — 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, especially when the record to be truthful must set forth at least temporary successes on the part of the rascals. As was said at the beginning, the swindling operations are for the most part 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 punishment of social opprobrium and loss of business standing is generally visited upon them. The purpose of these chapters will have been secured if they serve to warn owners of corporate 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 to the vast amount of entirely honorable andj legitimate business transacted under the corporate form of business organization. Nevertheless they are fre- quent enough to demand attention and, so far as pos- sible, prevention. One preventive is for security-holders to insist on complete and absolute publicity as to the affairs of their ^ organizations. Another preventive 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 to it that under the cumu- MANIPULATION BY STOCKHOLDERS lative system of voting every stockholder gets a chance to be represented. A fourth preventive is to insert expHcit provisions in 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 the reputations of all the officers and directors of the corporation. > CHAPTER XXVIII INSOLVENCY AND RECEIVERSHIPS 226. Two types of insolvency, — 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 principal 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 filially mature. 394 INSOLVENCY AND RECEIVERSHIPS 395 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. 227. 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- ishly 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 against such a calamity, insolvency will necessarily be the result. The fall in the value of the assets may be due simply to ordinary causes, which are not offset by a depreciation reserve. Any one of a hundred other events, which will occur to every reader, may reduce the value of assets below obligations. It may be stated, however, that a conservatively managed corporation is 396 CORPORATION FINANCE 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 reahty 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 accountants 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 397 or theft, a cause which need not be here discussed. 228. 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 Bradstreet Company summarize their judgments as to the prime causes of all the business failures that oc- curred in the United States in the years 1904-1907, in the following table: Causes of Failure. Incompetence Inexperience Lack of capital... Unwise credits . . . Failures of others Extravagance Neglect Competition Specific conditions Speculation Fraud Percentages. 1907 4.9 37.1 8.3 1.4 .9 f.5 IS 16.3 .7 10.1 1906 22.3 4.9 35.9 2.6 2.0 1.0 2.2 1.0 17.3 .8 10.0 1905 24.4 4.8 33.4 3.5 2.2 1.1 2.9 1.5 16.3 .7 9.2 1904 23.1 5.1 32.2 3.4 2.5 .8 3.1 1.3 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 sacrificing quick in order to build up fixed assets. To make this statement concrete let us examine the Wall Street Journal's analysis of two recent instances of financial difficulty. In February, 1909, the Ameri- can Ice Company was reported to be facing insolvency 398 CORPORATION FINANCE 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 hke $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 little 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- ican Ice requires. Evidently the company was in danger of legal, not true, insolvency. Since the above paragraphs were written the ice company has denied its allegations and states that it is not in serious need of financial assistance. Nevertheless the quotation indicates clearly enough; where a trained financial writer looks for symptoms and causes of weakness. 229. The case of the Detroit, Toledo and Ironton Railway Company, — 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 early 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^ I I INSOLVENCY AND RECEIVERSHIPS 399 half years, during no part of which had it succeeded in earning the fixed charges which the capitalization of the reorganization plan 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 & Ironton'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 cap- ital, 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 except 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. The two causes assigned in this ease are: Firsts lack of earning power in the assets sufficient to meet fixed charges, which is a condition of true insolvency; 400 CORPORATION FINANCE and, second, lack of current assets, or of working capital. 230. Additional causes of legal insolvency, — ^We 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 insufficient to permit taking full advantage of all con- siderable discounts for the prompt payment of bills. This point 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 inevitable. 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 401 wording of this phrase in most cases would be "lack of working capital." A slightly different 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 a 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 j to renew medium term notes or refund long-time obliga- tions when due. This situation 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 assets 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. 231. Two 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 1-26 40a CORPORATION FINANCE reorganization by a brief survey of the legal aspects of insolvency, receivership and bankruptcy. Much of what is said in this chapter will apply to individual pro- prietorships and to partnerships, as well as to corpora- tions. Additional information on the topics here briefly treated will be found in the volume on Commeecial Law. The reader is probably already 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 latest 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 creditors whose claims are unsatisfied in order to obtain an equitable division of the property of the bankrupt. The Bankruptcy Act provides that a corporation cannot become a voluntary bankrupt, but that corporations engaged principally in manufactur- ing, trading, printing, publishing, mining or mercai tile pursuits, owing debts to the amount of $1,000 o] over, may be adjudged involuntary bankrupts. The converse of this statement is that all other corporations,^^ including those engaged in banking ^ and transportatioi are incapaMe of becoming bankrupfs. As a matter oi fact, it is seldom to the interest either of stockholderi§ or of creditors to force a corporation into bankruptcy Indeed, the chief reason that may lead to such drasti^ action is the desire of unsecured creditors to prevenj secret deals and transfers of the corporation's assets and to expose any past irregularities in the conduct oi the corporation. Bankruptcy is especially valuable at INSOLVENCY AND RECEIVERSHIPS 403 times as a means of making invalid liens or judgments that have been secured by favored creditors within four months of the period of bankruptcy. A second method of handling the affairs of an in- solvent 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- porations, the organization and good will of which are not worth saving. 232. A third method — Appointment of a receiver. — A third method is the use of what is known in law as a '^IHn chancery." The objects sought to be obtained by this method are, first, to come to an equitable settlement between 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 j 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 the court that his proper course, if he is dissatisfied with 404 CORPORATION FINANCE 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 m 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. JJnlike 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. 233. Duties of a receiver, — If the corporation is cai rying on simply a trading business and goes into bank- ruptcy, the activities of the receiver in bankruptcy will be comparatively simple. He will dispose of the assets INSOLVENCY AND RECEIVERSHIPS 405 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 capital and a receiver is appointed by a court of equity, his duties are entirely different. He has as his object in this, 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 under 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 through a reorganization, a subject to which con- 406 CORPORATION FINANCE siderable attention is given in the following chapters. 234. Receivers powers. — The receiver is a very powerful official. So long as no actual fraud or obvious mismanagement on his part is proven, he is at liberty to make such disposition of the assets and earnings under his charge as he sees fit. He may use his power altogether for the benefit of the creditors, or he may use it in part also for the benefit of the stockholders. If he has the latter object in view, he will naturally do what he can to delay a settlement until a favorable period ar- rives and will thus preserve as much of the property as possible for the stockholders. In view of his power it is always very important to the stockholders — and frequently more equitable to every one concerned — to have a receiver of their own choosing appointed. In recent years it has become cus- tomary for corporations which are getting into diffi- culties 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- ficials go secretly — often at dead of night — to some judge who has jurisdiction; the creditor complains thai his debt is unpaid and the officials confess insolvency: then the creditor asks for the appointment of some mai previously agreed upon to act as receiver, and the judg< then and there duly appoints him. Of course, th< judge must be fully aware of this scheme and must approve it. On account of the conflicting jurisdictioi of our state and federal courts, however, it is usuall; a very easy matter to find one among the several judges with the proper authority who will do what is wantec INSOLVENCY AND RECEIVERSHIPS 407 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 hasty 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. This fact has already been referred to in the discussion of receivers' certificates. Receivers' certificates may be issued in order to secure funds for practically any purpose that the receiver deems proper. The funds may be used to purchase new supplies or equipment or to improve and extend the property. If the development of a corporation has been greatly hampered by lack of funds a receivership may thus prove a very desirable thing, for the receiver has an opportunity to put the company into prime condi- tion. Receiverships have been known in this way to prove the salvation of an insolvent concern. The receiver usually charges and gets a very large fee for his services. There has been much complaint and agitation at times on this account, especially in connection with bank receiverships. The size of re- ceiver's fees during the panic year, 1907, in New York City became almost a public scandal. This, however, brings up questions which do not properly fall within the scope of corporation finance. CHAPTER XXIX PRINCIPLES OF REORGANIZATION 235. Reasons for reorganization, — There are t^p general classes of reorganization: first, those that are necessary as the result of insolvency; second, those that prove desirable in order to readjust the securities and the means of cojQtrol of a company. The prindples of reorganization also are somewhat differently applied in railroads and in manufacturing concerns. In order to bring out these distinctions we shall take up in the following chapter three typical reorganizations : First, of an insolvent railroad; second, of an insolvent indus- trial; and, third, of a solvent railroad. In this chapter our attention will be confined to the general principles which apply in all kinds of reorganizations. The reasons for reorganization in lieu of a simple sale of property have already been alluded to. In order to make them plain, however, we should give them some further consideration. The complexity of the financial organization of a large corporation is one factor to takej into account. In the case of a railroad the parent com-j pany will probably own the securities of a numBer of 1 subsidiary companies. Each one of these subsidiary companies will have one or more mortgages on its line. The stock and perhaps some of the bonds of the sub- sidiary companies will be owned by the parent company and will perhaps be posted as security for a collateral trust bond issue. The parent company will perhaps own a main line and several branch lines, and will havej 408 PRINCIPLES OF REORGANIZATION 409 outstanding mortgage bonds based on each of the branch lines, mortgage bonds based on the terminals and real estate holdings, 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-time claims, including accounts payable, accrued wages and bank loans. Such a group of cor- porate relationships and obligations may be taken as typical. They are, in fact, not half so complex as the internal organization of many large railroad and in- dustrial companies. In contrast to this 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 would be possible for the branch line bondholders to mark out and segregate their property and take it for themselves ; for the terminal bondholders to do the same ; for the main line bondholders to do the same ; and so on. It is indivisible, however, in the sense that a division of the property would destroy most, if not all, of its value. This 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 St. Louis and San Francisco Railroad, which was owned by the Atchison, Topeka and Santa Fe, up to the bankruptcy of the latter road in 1893, and was then taken 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 Pacific System in the bankruptcy of 1893. Assuming that a failed corporation possesses prop- 410 CORPORATION FINANCE 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. 236. 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 bond holders 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 tlie 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 Iiaiids. Usually he states in the PRINCIPLES OF REORGANIZATION^ 411 circular that his only interest in the matter is to secure the rights of the persons to whom he appeals and that he will 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^ authority Js only that of a representative. It can not 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, anyway, if the receivership is unfriendly ; if it is friendly their interests are already protected. 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 " a nd the arguments pro and con as to the litrength of each of the competing claims on the corpora- 413 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 dutyxiE. this committee to discuss terms of reorganization and finally To agree upon a plan which may be s ubmi tted to^ the security-holders. 237. 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 I PRINCIPLES OF REORGANIZATION 413 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. 238. 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 jowst^important dut^ therefore, is to f OTm 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 sufficient to affect the first mortgage bonds. Usually this question may be 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- 414 CORPORATION FINANCE organization committee next considers the situation of the bondholders secured by mortgages on outlying or small sections of property. Mortgages 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 business to the other ten; or a merchandising cor- poration may have gone into general trucking; or a paper mill may own 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 mayjwell^ b^^on the other hand, ttiat the separate pieces of property so mortgaged are highly essential, in which case the bond- Tiolders 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^n full, even if the prop- perty taken in itself were not of ^reat 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 PRINCIPLES OF REORGANIZATION 415 except as an adjunct to the failed railroad. Yet it may- 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 wiUjirobably "MuflT" 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 and complexity of underlying mortgages* The value of 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 merely claims on^earnings, not Qn_assetSa_ 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 f o^Jhe preferred and common stock- holders. Sometimes in heavily^over-capitalized concerns the cominoii_stockjyill Jb e wiped o ut absolutely. It is 416 CORPORATION FINANCE more usual, however, to try to preserve something for the stockholders, with the proviso, usually, that the stock- holders pay certain cash assessments. 239. Necessity for cash, — 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 attacks the assets of the corporation and eff'ectually 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 b^ sonie jneans raise cash suflicient to meet all this floating^ debt in order that the reorganized company may begin business. Furthermore, there must be enough casli left over to provide the reorganized company with a Tair workings 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 £ommittee also, if it desires to have the reorganized company prosper, must ^e to it that its fixed charges are not larger th an its jninimum net earnings. We have thus, four main \ objects of every reorganization: (a), to pay the float- ^ ingdebt; (b), to provide working capital; (c), to bring the property up to at least normal efficiency; (d), to J 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- PRINCIPLES OF REORGANIZATION 4.17 counts payable accumulate, its working capital decline, 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 fliings of prime importance: first, to raise cash; second^ to^reduce Sked charges. 240. Raising cash by assessments, — There are three possible methods of secu ring 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. inEe 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 when 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 new first mortgage issue. At times this may be entirely proper and expedient. The efficiency of the 1—27 418 CORPORATION FINANCE corporation's assets may have become impaired and a little cash raised by receivers' certifi cates 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 security-holders — ^is almost universal. Naturally the first and he^iesi 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^jpaying the assessment or of fgr^ j[eiting 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 retain an interest in the company. If he cannot raise the necessary cash he will sell his stock in the ope: market for whatever it will fetch to someone who hi 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 also tru( that within a short period 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 do better if h sticks with the company than if he forfeits or sells hisj shares. By paying the assessment he reduces losses. I PRINCIPLES OF REORGANIZATION 419 Sometimes, although rarely, it becomes necessary to assess the junior bondholders also. It seems strange that a creditor of the corporation should ever be forced to^y an assessment in order tq^remain a creditor, yet theTogic of the situation compels the bondholders, when they are thus assessed, to accept it with as good grace .as^ they can muster. The bondholders will not and cannot equitably be compelled to pay unless the burden is too heavy for the stockholders to carry alone. If the amount of cash needed is so large that most of the stockholders would rather lose their equity in the property than furnish their proportion of the cash, the bondholders find themselves in an unpleasant dilenmia. Either they must take some of the burden off the stock- holders' shoulders, or they must take the whole burden themselves and eliminate the stockholders altogether. Almost always they prefer the former alternative. When the Atchison, Topeka and Santa Fe Railroad, for instance, was reorganized in 1894, the cash require- ments were so large that each stockholder would have been compelled to pay in the neighborhood of $14 per share, and it was more than doubtful if that stock of the reorganized company was worth this amount. The re- organization committee, therefore, imposed $4 of the assessment on the junior bondholders. Usually the cash needed by the company is not required at once, and the terms of payment of the assessments may therefore be made fairly easy, thus reserving some of the cash resources of the corporation. Another means of providing funds for future use is to base the bond issues of the reorganized company on a limited open-end mortgage, so that the company need not be hampered for many years to come by a dearth of funds. 420 CORPORATION FINANCE 241. Reducing fixed charges, — Having p rovided the reorganized company with sufficient cash, the reorgan- ization committee now takes up its final and most difficult problem, reduction of fixed charges. The fixed charges that may be eff*ected are of three kinds: guarantees, rentals and interest. A company may be dissolved in reorganization, in which case it is, of course, released from its previous contracts and the reorganized com- pany may or may not renew them. If guarantees of^interest^iid^ividends on subsidiary company securi- ities have proved burdensome and unprofitable, the reorganization committee has an opportunity to dis- pense with them. It does not follow that the com- mittee will always take this action. The guarantee may be necessary in order to hold control of the sub- sidiary companies. Frequently, however, the holders of the guaranteed stock and bonds will submit to a re- duction of the guarantee rather than take back their property. Much the same thing may be said of Rentals.. The owners of abased property would ordinarily have great difficulty in leasing it to any other corporation and could not very well operate it themselves. Especially is this true when the leased property has been constructed in the interest of the failed corporation. The owners, therefore, have practically no choice in the matter. They must submit to any reasonable reduction that the reorganization committee demands. Far more important usually in its effect on fixed charges is the substitution for the jpte rest- bearing securi- ties of the old corporation of dividend-paying securities of the new corporation. Sometimes, also, old securitie^^B which bear interest at a high rate are converted into ne^^W securities bearing interest at a low rate. The result of PRINCIPLES OF REORGANIZATION. 421 this readjustment, if the reorganization is to prove suc- cessful, must be to bring the total fixed charges below the net earnings of the corporation even in the worst years. Ordinarily the reorganization committee wiU first make a conservative estimate of the lowest earnings likely to occur in the future and will cut down interest charges accordingly. Of course this reduction is not proportionate on all the bond issues, but is adjusted in accordance with the relative strength of the various claims against the corporation, as already indicated. One of the great^ adyanta^es^qf reorganization is the possibility which it affords of unifying and simpli:L f ying the complicated and sometimes conflicting obliga- tions tha t hav e been imposed at various times. The --reorganization committee will usually arrange for a few comprehensive, well-defined mortgages in place of the numerous mortgages previously existing and will increase the amount authorized under each mortgage. This principle, however, cannot be extended too far. The committee cannot, for instance, without getting into legal difficulties, absorb any of the old bond issues, interest on which has unquestionably been earned for several years previous. The old first mortgage issue and the first mortgage bonds on highly important specific pieces of property will therefore generally be left untouched. On top of them, however, the com- mittee may impose a new general mortgage bond issue of large size sufficient to refund all the existing issues that are to be absorbed, to refund the old first mortgage bonds when they finally fall due and to pro- vide for necessary improvements and extensions. This general mortgage issue will be designed evidently to become in time a first lien on all the corporation prop- erty. For these new general mortgage bonds the old 423 CORPORATION FINANCE junior bonds wiU be exchanged on such terms as may be finally agreed to. 242. Capitalization of the reorganized corporation. — Assuming that the reorganization committee has succeeded in determining the relative values of the various issues of mortgage bonds, it may now proceed to a corresponding allotment of the new general mortgage bonds. Suppose, for instance, that there had been outstanding $1,000,000 second mortgage bonds, $500,000 branch line bonds and $1,500,000 debenture bonds, and that the new general mortgage issue avail- able for exchange is fixed on the basis of the lowest earnings at $2,000,000; suppose also that the reorgan- ization committee estimates the first-named issue on the basis of lowest earnings to be worth 80 per cent of its par value, the second-named issue, 60 per cent, and the third-named issue, 60 per cent: It would then offer to the bondholders of the first class $800 in new general mortgage bonds for each $1,000 of the old bonds, and to the bondholders of the second and third classes, $600 in the new bonds for $1,000 of the old bonds. As the values of the old issues and the amount of the new issue are figured on the same basis, lowest net earnings, they must, of course, exactly correspond. Not every case is so simple by any means, as our illustration. The same principle, however, would always be applied. It is felt to be equitable, as well as necessary in order to satisfy the bondholders, that they should be com- pensated for the reduction of their interest-bearing principal. This is accomplished by giving them at least enough dividend-paying principal to bring the par value of their holdings in the reorganized company up to an equality at least — sometimes considerably more than an equality — with the par value of their old secur- PRINCIPLES OF REORGANIZATION 42S ities. Formerly it was customary to give them the difference between the par value of their old bonds and the par value of their allotment of new interest-bearing bonds in the form of income bonds. Income bonds have abeady been described and characterized. They are a fallacy and a delusion and at the present time are practically unused. Their place in reorganization has now been taken by preferred stock. The debenture bondholder in our jUustration who got $600 in new bonds forj l,000 in old bonds wouldjander the present practice probably get also at least $400 in preferred stock. He thusTiasarchance to shareTn the future prosperity of the company. He may well hope and even expect that in the end he will more than recover his losses. The same principle is applied to all the other bondholders, so far as practicable, and even to the preferred and common stockholders. It follows that one usual and almost necessary result of a reo rga nization is a great increase in capitalization. The reorganization committee en* deavors to remedy the failures and disappointments of the past and present by drawing heavy drafts on the future. It is only fair to say that in this country these drafts have usually sooner or later been honored. The final problem which the reorganization committee must settle is whether to revive the old company and the old charter or to take out anew charter and organize a new company. The first course involves a maintenance of all the previously existing contracts and obligations of the company not provided for in the reorganization scheme. Its advantage, of course, lies in the retention of the charter which may perhaps confer valuable privileges. The question is at bottom legal rather than financial. In truth, it is a matter usually of no very great consequence. 424» CORPORATION FINANCE To insure stability of financial management, until after the reorganized company is well started, it is not uncommon to place the new stock in the hands of a vot- ing trust for a period of years. The nature and operations of such a trust have already been described. 243. Summary of the chapter, — Briefly the principles and the results of reorganization may be summed up as follows : ^ (a) The reorganization must remove the immediate causes of bankruptcy by providing cash and at the same time reducing fixed charges. , (b) The reduction of securities bearing fixed charges may well be and usually is accomplished by a great increase of dividend-paying securities. (c) In determining who shall stand the losses caused by the company's insolvency, the reorganization com- mittee will first rank the securities in the order of their safety and will then impose the losses in inverse order. (d) In so doing the directors must of necessity con- sider primarily the ability of the security-holders to make trouble for or to wreck the reorganized company if their demands are not satisfied. (e) In raising necessary cash they will naturally im- pose the first and heaviest assessments on stockholders, but they must bear in mind that if they go beyond certain limits the stockholders will forfeit their shares rather than pay the assessments. The working out of these principles will be further discussed in connection with the illustrations cited in the following chapter. A CHAPTER XXX5 THREE TYPICAL REORGANIZATIONS 244. Growth of the Santa Fe System, — The prin- ciples of reorganization laid down in the preceding chapter will be much better understood if we consider their application in a few typical instances. For this purpose we will take, first, the forced reorganization of the insolvent Atchison, Topeka and Santa Fe Railroad Company in 1894; second, the voluntary reorganization of the prosperous Chicago, Rock Island and Pacific Railway Company in 1902; third, the forced reorganiza- tion of the Westinghouse Electric Manufacturing Company in 1908. It is necessary to go back several years in order to get a typical case of a large railroad receivership and re- organization, for American railroads in the last twelve years have enjoyed extraordinary, and up to 1907 almost uninterrupted, prosperity. It is true that a considerable number of railroad systems, including the Seaboard Air Line, the Chicago, Great Western, the Detroit, Toledo and Ironton, the Chicago, Cincinnati and Louisville, the International and Great Western, the Western Maryland and the Macon and Birmingham went into the hands of receivers as the result of the fi- nancial panic of October, 1907. None of these roads, however, is of first-rate importance and their problems have not proved as intricate and difficult as the problems of the numerous railroad reorganizations following the great crisis of 1893. We shall find it therefore more 425 426 CORPORATION FINANCE instructive — even if not of so great current interest — to study one of the 1893 reorganizations rather than one of later date.^ Like most of our great railroad systems, the Atchi- son, Topeka and Santa Fe has grown by leaps, so to speak. It was chartered in Kansas in the year 1863, and contruction on the first section of the road was begun in 1869. The main line from Kansas City to Colorado, thence in a southerly direction to Albuquer- que, New Mexico, and thence southwest to a con- nection with the Southern Pacific Railroad at Deming, Arizona, was not completed until 1881. In 1882 the Atchison exchanged its stock for the stock of the Sonora Railroad, and thus secured an entrance to Guaymas, Mexico. The company by using a section of the track of the Southern Pacific had a through route from Kansas City to the Pacific Coast. To appreciate the importance of reaching the Pacific Ocean it must be borne in mind that traffic from any of the Pacific Coast ports may move readily and cheaply by water to any other of these ports. The Santa Fe was therefore in a position to take through business by its part-water- and-part-rail route from any port on the Pacific Coast to the East. This route, though important, could not, however, bring to the Santa Fe a large proportion of the traffic to and from the Pacific Coast in the face of the existing competition of the all-rail routes, particularly of the Santa Fe's chief competitor, the Southern Pacific. President Strong of the Santa Fe therefore entered into 1 Acknowledgment should be made here, in connection with the following i reviews of the Santa Fe and Rock Island reorganizations, of the informa- tion obtained from ^Mr. Stuart Daggetfs " Railroad Re-Organization." Most of what follows as^ to these two companies is based on Mr. Daggett's re- searches. He is one of the first to bring to bear on financial problems the thorough, scientific methods of university scholarship. J TYPICAL REORGANIZATIONS 427 an alliance with the St. Louis and San Francisco Rail- road, which owned the charter of a company known as the Atlantic and Pacific Railroad Company. By the terms of this alliance the two roads jointly financed the operations of the Atlantic and Pacific and by means of purchase and of new construction endeavored to secure a through rail route to San Francisco. In 1885 — one of the great railroad building years of the United States — ^the Atchison, by construction, purchase and lease combined, managed to reach Los Angeles. The main line of the road still had its eastern terminal, however, at Kansas City and the system did not reach the Gulf of Mexico, or in fact any of the rapidly developing agricultural country south of Kansas. To remedy this defect a road, known as the Gulf, Colorado and Santa Fe, had been constructed, partly in the interest of the Santa Fe, from Galveston to a point about two hundred miles north, and another line known as the Southern Kansas Railroad was built south from Arkansas City to connect with the track of the Gulf, Colorado and Santa Fe. In 1886 the stock of the last- named road was bought by the Atchison and the bonds, to the extent of about $17,000 per mile, were assumed. In 1887 the Atchison purchased the Chicago and St. I^ouis Railroad between Chicago and Streator, Illinois, and other subsidiary companies constructed new track up to Streator. By 1888 it had thus obtained its Chicago entrance. In the meantime between '86 and '89 it had built a large number of branch lines in all directions largely for the purpose of forestalling competition. "The method of financing these competitive extensions varied," says Mr. Daggett. "Sometimes the parent company guaranteed the principal and interest of the 42a CORPORATION FINANCE branch line bonds; sometimes it took these into its treasury and issued collateral bonds against them; sometimes, perhaps more frequently still, it leased new- roads for a rental equivalent to the annual interest on their bonds. If the branches could have earned their fixed charges, the burden of the Atchison would have been nominal, but as in large part they could not, it was real and serious." The results of the rapid expansion of the Santa Fe from 1884 to 1888 are well summarized by Mr. Daggett in the following table: ISSJt 1S88 Mileage 2,799 7,010 Bonds $48,258,500 $163,694,000 Stock (Atchison) ........ 60,673,150 .75,000,000 Gross earnings 16,699,662' 28,265,339 Operating expenses . 9,410,424 21,958,195 Net earnings from operation 7,289,237 6,307,145 Net profits excluding divi- dends 5,147,883 def. 2,933,197 Net profits, including pay- ments for dividends and interest on floating debt . def. 5,557,323 It should be noted that while the bond indebtedness (including the assumed bonds of subsidiary companies) had considerably more than tripled, gross earnings had increased only about 70 per cent and net earnings from operation had declined. Evidently, unless this tendency should be speedily reversed, the company was doomed to insolvency. In addition the floating debt had in- creased from approximately $3,300,000 in 1884 to over $8,000,000 in 1888, and the road had consequently been forced to authorize, in October, 1888, $10,000,000 of three-year notes TYPICAL REORGANIZATIONS 429 245. First reorganization of the Santa Fe and its results, — The situation was so obviously dangerous that a committee of the directors was appointed in 1889 to bring about a friendly„reqr^ardzation^nd ther^^ ^;y^rt_bankruptcy. About one-third of the $163,000,000 of bonds were direct obligations secured by mortgages on the Atchi- son's own property, while the other two-thirds con- sisted of obligations of thirty-two subsidiary companies. From what has been said in the preceding chapter, it will be seen that the entanglements and conflicts of these various issues were almost beyond unraveling. The directors first aimed at simplification and with that object in view suggested that two large issues be put forth, one of 4 per cent general mortgage bonds, to the amount of $150,000,000, and one of 5 per cent income bonds to a total of $80,000,000. Some $14,000,000 were to be sold in order to raise necessary cash and the remainder of the two bond issues was to be exchanged for the numerous existing issues. Income bonds were much used in reorganization at that period and were not received with the distrust which they now excite. The proposal to the original bondholders that they should exchange their mortgage bonds in part for income bonds was not, of course, altogether palatable; yet it must be remembered that the bonds which were to be thus exchanged had always been regarded as more or less speculative in character and had for that reason been sold, for the most part, well below par, and, further- more, that the branch line bondholders would have lost rather than gained by a forced bankruptcy and fore- closure sale. Moreover, the basis of the exchange was such as to compensate them in part for their loss of fixed interest payments by a larger principal. In other 430 CORPORATION FINANCE words, as usually happens in reorganizations, the com- pany proposed to cut down its current fixed charges and held out in place thereof hopes of high optional pay- ments in the future. The reorganization plan was accepted and put into effect. After this reorganization, the Atchison policy of rapid expansion was apparently renewed with fresh vigor. In 1890, by an exchange of securities, the St. Louis and San Francisco Railroad was brought into the Atchison system. This acquisition of 1,300 miles at one stroke did not prove nearly as profitable as was anticipated. In the same year the Colorado Midland, 346 miles long, was purchased. When the $10,000,000 note issue of 1888 fell due in 1891, the directors found themselves unable to meet the payment out of earnings and therefore arranged for a two-year extension. In 1892 the need of addi- tional funds for improvements and extensions, which, as the reader may have noted, had not been at all provided for in the reorganization of 1889, made necessary a new issue of second mortgage bonds. As the terms of issue of the $80,000,000 income bonds forbade any prior lien (ex- cept the first mortgage) being placed upon the property, it was necessary before placing a second mortgage to arrange for the protection of the income bondholders. This was accomplished by making the second mortgage cover an issue of $100,000,000 4 per cent bonds, $80,000,000 of which were to be exchanged doUar-for- doUar for the income bonds, and $20,000,000 to be sold for cash. Thus in 1893, by a coincidence, which may be called unfortunate, but which with wise manage- ment would never have occurred, the Atchison had to face largely increased fixed charges and the payment of the $10,000,000 note issue, both coming at the same time J TYPICAL REORGANIZATIONS 431 with the panic and the traffic losses of that disastrous year. In January, 1894., the inevitable insolvency arrived. 246. Second reorganization and its results. — Several bondholders' committees, according to the custom in re- organization, were quickly formed. Among others the English holders of second-mortgage bonds sent over a strong committee which put forward what was known as the English plan of reorganization. This plan involved foreclosure either by the first or second mortgage bondholders. In either case the first mortgage issue would be left undisturbed and overdue interest would be paid either in cash or in new securities. A new income mortgage bond issue was to be exchanged for the second mortgage bonds and was also to provide compensation for an assessment of $12 per share on the stockholders. By paying this assessment the stock- holders would retain their stock interest in the road, as well as receive income bonds. The income bonds were to have voting power. The substance of the plan, it is evident, was to reverse the former conversion of in- come bonds into second mortgage bonds. In the re- conversion the English bondholders were to secure an increase in principal and the important privilege of voting. The plan was not acceptable to the stock- holders, however, who felt that part of the load thus imposed upon them ought rightfully to be borne by the second mortgage bondholders. Before the argument had been carried far a new factor was introduced into the situation, namely, the publica- tion of the report of Mr. Stephen Little, an expert ac- countant who had thoroughly investigated the Atchison books. Mr. Little found that by means of peculiar fic- titious accounts — most important of which was an ac- 43a CORPORATION FINANCE count that carried rebates by the company as an asset — the recorded earnings of the railroad had been dehber- ately inflated. The annual net earnings, according to the company's reports, had been as follows : 1891 . ., $ 7,631,598 189^ 10,953,896 1893 12,126,866 According to Mr. Little they should have been : 1891 $ 5,204,880 1892 ,. . 7,853,173 11893 8,085,608 1894? 5,956,615 This startling announcement completely changed the plans which had been formulated. It was evident that a far more radical reduction of fixed charges would be essential. A new committee proposed the second and final re- organization plan in March, 1895. The purposes of this plan were stated to be: (a) To reduce fixed charges to a safe limit; (b) To provide 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) Common stock $102,000,000 (b) 5 per cent non-cumulative preferred stock $111,486,000 TYPICAX. REORGANIZATIONS 433 ^(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- ment of $10 per share and for this $10 were to receive $10 in new preferred stock. An underwriting syndicate guaranteed to take the place of defaulting stockholders. iThe 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 up 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 bondholders. It will be seen that this plan accomplished the five purposes named by the conmiittee. It brought about a very radical reduction of fixed charges affecting even the first mortgage bondholders. It gave room for ad- ditional issues of bonds under certain restrictions to provide for future improvements and extensions. It brought in about $14,000,000 cash to meet current ob- ligations. It retained the relative claims of the various security-holders to the road's assets and earnings. Fi- nally, by lopping off nonessential lines, it helped to con- solidate and unify the system. 1 The so called adjustment bonds were in reality income bonds. 1—28 434 CORPORATION FINANCE The principal opposition to the plan came from some of the minority stockholders who believed that the former management had proved untrue to their interests and that this management had not been entirely eliminated. 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 indicates 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 since 1897 are shown in the following tabulation: 1897 1907 Mileage 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 Naturally the market price of the Atchison securi- ties 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. 247. Growth of the Rock Island System. — 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 the history of the Rock Island Railroad. The line was completed between Chicago and Rock Island in 1854, TYPICAL REORGANIZATIONS 435 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 the 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 controlled by the Railroad Company, and was, therefore, in form, though not in fact, a consolidation. The new railway company did 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- agement 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 conservatism of the company: suddenly disappeared as if the earth had swallowed it. Directors and officers who had served for years and dec- 436 CORPORATION FINANCE ades were removed, and new men — younger men of an entirely different type — were put into their place. iWith the older men there vanished also the former ideals and purposes of the 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 Moore 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, Mr. Wilham H. Moore and Mr. D. G. iReid were elected to the directorate. The principal men in the new party, which now rap- idly assumed full control of Rock Island 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 in 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 gained in the promotion of the com- panies which were taken into the 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- TYPICAJ. REORGANIZATIONS 437 ing its financial status and at the 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 $50,000,000, at which it had been placed in 1880, to $75,000,000. 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 secu- rities. 248. 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 large 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 New 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 deUvered $127,- 438 CORPORATION FINANCE 500,000 of its preferred and common stock to the Chi- cago, Rock Island and Pacific Railroad Company of Iowa in exchange for all the $125,000,000 common stock of the 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- fered for each share of the railway company's stock, one share of its own 4 per cent bonds, one share of Rock Island Company common 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 which they had ex- changed. The "railway" stockholders readily accepted this prop- osition, which was equivalent to giving a large stock div- idend, and figured that even if they retained in their own hands all the securities which they received in exchange they could not lose and might benefit by the exchange. If they did not care to retain all the securities they re- ceived, they could easily dispose of their Rock Island common and preferred shares and thus get a large im- mediate 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 chose directors of the first class. TYPICAL REORGANIZATIONS 439 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 Railway Company, the operating company. Now the outstanding preferred stock of the Rock Island Com- pany is only a little over $45,000,000; therefore the ownership of approximately $22,500,000 par value of this preferred stock would be sufficient to give complete control over the whole Chicago, Rock Island and Pa- cific Railway Company, having a total capitalization of about $225,000,000. Indeed, if this $22,500,000 pre- ferred 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. Assuming that they bought all their stock outright and paid in the neighborhood of 140, which was not far from the average market price while they were buying control of the "railway" company, their investment would have been $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 1903 were worth : Rock Island Company common $18,375,049 ' Rock Island Company preferred 21,918,808 Chicago, Rock Island & Pacific Railroad Co. 4% bonds 32,765,712 Total $73,059,569 440 CORPORATION FINANCE As the preferred stock was all that was necessary for control they 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 control of the Chicago Rock Island and Pacific Railway Company. In other words, control of the Rock Island Company, 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 will 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 "Moore crowd" with a very small expendi- ture of cash, have under their control a system with an aggregate mileage of 14,270 miles. 249. Westinghouse reorganization, — This recent re- organization, although not essentially different in prin- cij)le 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 a typical instance of a company which was strong in equipment and ability and which was doing a TYPICAL REORGANIZATIONS 441 large and profitable business and yet suddenly found itself technically insolvent. Its difficulties resulted from a lack of sufficient working capital. The com- pany's assets were too largely fixed, and quick assets were relatively too small, considering the amount and character 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 ob- tain 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 holders were little consulted and their claims were not disturbed. The problem before the reorganizers of this company differed from that which confronts most reorganizers in that the company needed simply to be tided over a bad period. No 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 their 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 442 CORPORATION FINANCE 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 a 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 aif ord 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 prevented 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 443 reasons proved unavailing and the plan as outlined above has been carried into effect. Just how successful the company will be under this plan remains to be seen. There is no reason, however, to fear the result. The plan has provided for all the floating debt incurred before the reorganization, has en- larged only very slightly the fixed charges of the com- pany, and has introduced new and conservative elements into the management of the company. The cash work- ing capital on hand is estimated to be amply sufficient for the needs of the next two years, even if business should be very poor indeed. In addition it has been recently stated on good authority that dividends on the new common stock of the company will not be paid for at least two years, thus giving time for the accumula- tion of a substantial surplus. The readers of this book are urged to watch closely the future course of the Westinghouse Electric and Manufacturing Company, and to note for themselves whether the opinions here expressed are confirmed or not by the company's ex- perience. 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 to 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? How 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 interest in a partnership? Why? 445 446 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 corporate 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 apphcable to cor- porations? 15. Is it important to consider the provisions of the constitution of the state in which a corporation is formed? Why? 16. Discuss the relative advantages of two methods of securing authority to incorporate. 17. What is a charter? What is a certificate of incorporation? 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 any 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 447 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? of directors? 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 amend- ments? 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 pro- posed amendment at a special meeting called for the purpose of considering the amendment. When is a proxy irrevocable? 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? us CORPORATION FINANCE 28. What are the two chief universal liabihties of stockholders? 29. What are the two classes of creditors? Has either class a right to interfere in the internal manage- ment 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 cases? 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 449 other expenses will probably be incurred in starting a new company? 37. Name four states which have Hberal incorpo- ration laws? 38. Why is it desirable to secure a charter in a state which has an estabhshed 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 stock 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 similar hypo- thetical cases and consider each one carefully. 41. What is a "subscription contract" and 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. CHAPTER V 43. In your opinion should stock certificates be made fully negotiable? Give your reasons in full. 44. What is the "par value" of a share of stock? The 1—29 450 CORPORATION FINANCE "market value"? Is there any good reason for the custom of giving shares a nominal value in money? 45. Define fully "preferred stock," showing wherein the preference may consist. 46. Name and discuss four uses of preferred stock. What is "voting stock"? 47. What is the object of "cumulative voting"? How is that object attained? 48. What is a "voting trust"? What is the usual plan of organization? What is the usual object in establishing a voting trust? CHAPTER VI 49. Define "(juasi-public corporations," "private cor- porations," "close corporations." 50. What is a "parent company"? What is the difference between a "parent company" and a "holding company"? 51. Why does a holding company usually aim to se- cure more than a bare majority of the stock 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? 52. Under what plan were the early "trusts" or- ganized? Why do most "trusts," so-called, now take the form of holding companies? 53. Taking the chart of organization of the Inter- borough-Metropolitan Company, show what relation of ownership and control exists between the New York City Railway Company and the Interborough-Metro- politan Company. 54. How many companies are directly controlled by QUIZ QUESTIONS 451 the Standard Oil Company of New Jersey? How many indirectly? CHAPTER VII 55. Enumerate from memory the principal topics covered in the Grst six chapters of this book. 56. What are the six som:ces 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 seU the stock or bonds of his company to a bank? If not, why not? 57. What are the important classes of investors? 58. How would you distinguish between an "invest- ment" and a "speculative" security? 59. What are the important classes of buyers of speculative securities? 60. 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? 61. What kinds of securities ordinarily will a cor- poration offer in order to secure funds from (a) trade 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 shall issue are the earnings of the corporation, as well as its assets, taken into consideration? If so, how? ^62 CORPORATION FINANCE CHAPTER VIII 62. 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? 63. 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? 64. 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 funds? Under what circumstances is it good financial policy for a corpo- ration to issue such notes? In general should the short- time obligations of a corporation ever be based on the corporation's permanent assets? CHAPTER IX 65. What three opinions are prevalent as to the chief factor that determines the value of fixed assets? 66. What are the characteristic features of a mort- gage? What is a mortgage bond? What is a mortgage deed of trust? 67. What are the essential and usual provisions of a corporate deed of trust? 68. Define '^closed," "open-end" and "hmited open- end" mortgage deeds of trust? Which of the three types is generally the best? Why? QUIZ QUESTIONS 453 CHAPTER ES 69. 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. 70. What is a junior mortgage bond? How is the fact that it is a junior bond sometimes disguised? 71. What are sinking fund bonds? What are the principal objections to their use? 72. What are collateral trust bonds? Why may they sometimes be sold more readily than the securities on which they are directly based? How may they be used to finance the process of buying control of subsidiary corporations? 73. What is an equipment trust bond? Why are they, so highly regarded by investors? CHAPTER XI 74. 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? 75. What are income bonds? What is the chief ob- jection to their use? 76. Define "participating," "profit sharing" and "joint" bonds and "receiver's certificates." 77. What are registered bonds? Coupon bonds? What are the advantages and disadvantages of each form? What are redeemable bonds? 78. What are con\ertible bonds? What are their advantages and disadvantages to the corporation? 464 CQRPORATION FINANCE CHAPTER XII 79. What is a promoter? Does he have a legitimate and useful function or not? 'Give your reasons. 80. What is meant by the promoter's "discovery" of a proposition? Illustrate in detail with reference to some hypothetical case, such as a new gold mine in Alaska or a proposed creamery in a small country town. 81. What is meant by "assembhng" a proposition? Illustrate in detail with reference to the same hypo- thetical case used in the previous question. 82. 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? 83. Why should a promoter usually endeavor to raise more money in advance of complete development of a proposition than he expects will be needed? 84. Why is it usually better for a promoter to sell to a large number of small buyers than to a small number of large buyers? 85. To whom should a promoter go first, generally speaking, for funds? Why? 86. Show how the principles of promotion laid down are applied in the illustration given in the text. CHAPTER XIII 87. Why are professional promoters usually unsuc- cessful in the long run? 88. Why do lawyers and bankers in small communi- ties do a considerable amount of promotion work? To QUIZ QUESTIONS 455 what extent do the large metropolitan bankers and promoters enter the field of promotion? 89. What are the advantages of engineering firms as promoters? 90. Is a promoter in any sense an agent of his cor- poration? A promoter buys a manufacturing plant for $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 $10,000 profits? If not, what course may he pursue in order to evade the law? 91. Why is it difiicult to enforce the principle that misleading statements by a promoter are fraudulent? 92. 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? 93. 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? 94. What are the chief risks and tasks that a pro- moter must generally assume? 95. Do you think that promoters in general are or are not overpaid? Give your reasons. CHAPTER XIV. 96. Why is there a strong tendency toward consol- idation among small as well as among large industrial establishments? 97. What are the principal difiiculties that are apt 456 CORPORATION FINANCE to confront a promoter who undertakes to consolidate several existing concerns? 98. Describe briefly the process of "discovering" a consolidation. 99. 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? 100. 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? 101. 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? 102. How does the problem of forming a large con- solidation differ from the problem of forming a small consolidation? 103. What is the usual basis of consolidation or ex- change and how is it determined? 104. What was the basis of exchange in the forma- tion of the Interborough-Metropolitan Company? In what respects was it faulty? CHAPTER XV 105. What were the conditions under which the steel business of the United States was conducted in the decade, 1890-1900? 106. What were the chief steel companies in the field in 1901 and why had most of them been formed in the three years, 1898-1901? I QUIZ QUESTIONS 457 107. What is meant by "integration" of an industry? How did this factor operate to bring about the forma- tion of a great steel combination? 108. 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? 109. Was the prospectus issued by the promoting syndicate misleading? How much cash did the syn- dicate furnish? 110. What were the approximate profits of the pro- moting syndicate? 111. 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. 112. 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? 113. Describe briefly the preferred stock conversion plan of 1902. What objections were raised to the plan? What important changes in the interior financial or- ganization of the corporation have been made? 114. 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. 115. What in general is the policy of the Steel Cor- poration toward its employes? Do the subsidiary com- panies of the corporation compete with each other? 116. What are the principal outstanding securities of the Steel Corporation? What reasons may be given 458 CORPORATION FINANCE for expecting that these securities over a period of years will rise in value? CHAPTER XVI 117. Name the four methods of selling corporate securities. 118. What are the characteristics of a good prospec- tus? Why are statements in speculative prospectuses usually vague? 119. Show that the characteristic features of specula- tive prospectuses are present in the example cited in the text. 120. 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? 121. What would be the characteristics of an ideal prospectus? 122. What are the advantages and disadvantages to a corporation of selhng its securities through large bond and banking houses? 123. What are the characteristics of large, high-class banking houses in contrast to disreputable concerns and what are the essential factors that make a proposition acceptable to them? 124. What are the usual banking house methods of selling securities? Do such houses guarantee the safety of the securities they sell? J QUIZ QUESTIONS [459 CHAPTER XVII 125. Name the principal stock exchanges of the United States. 126. What percentage of the securities handled on the New York Stock Exchange are "listed"? What are the requirements for listing? 127. What is the "curb" market and what classes of securities are bought and sold in this market? 128. Describe briefly the method of handling trans- actions on the floor of a stock exchange. 129. What is the relative importance of speculative as compared with investment business, and what func- tion is performed by the speculative business? 130. Describe the process of buying securities "on margin." 131. Describe the process of selling securities "short." 132. What are the characteristics of stock exchange houses in contrast to "bucket shops"? 133. Into what three classes may Wall Street specu- lators be divided? 134. Give from memory a brief review of the char- acteristics of the Wall Street security market. 135. What measures may be taken to stimulate speculative interest in a security that is about to be issued? 136. With what object is a syndicate frequently formed to assist in the flotation of a security? 137. By the use of what methods may the price of a stock market security be manipulated and kept under control? 460 CORPORATION FINANCE CHAPTER XVIII 138. What is underwriting? How did the practice and the word originate? 139. What are the chief advantages to the corpora- tion in having its new issues underwritten? 140. What are the advantages to the buyers of se- curities? 141. 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. 142. Why do the underwriting houses in almost every case band themselves together into syndicates? 143. Describe three types of syndicates. 144. Describe the type of syndicate in which the sale of the security is pooled. 145. Describe the type of syndicate in which the un- derwritten issue is distributed among the members of the syndicate. 146. Name some of the principal underwriting houses. What is the distinction between a bank and a banking house? CHAPTER XIX 147. Why are underwriting syndicate agreements frequently quite informal? 148. 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. 149. Mention two general characteristics of under writing agreements. i QUIZ QUESTIONS 461 150. With what three classes of corporations do un- derwriting syndicates deal? 151. What are the peculiar problems and difficulties involved in underwriting the security issues of new or speculative corporations? 152. 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 borrowed funds? What principles followed in this case are applicable in all cases where it is desired that an undeveloped corpo- ration should borrow as much as possible? CHAPTER XX 153. What mistake is frequently made in the invest- ment of the original capital funds of a corporation? 154. What are the advantages of the installment method of getting funds for a corporation only as the funds are needed? 155. What are the disadvantages of this method? 156. What are the other possible methods of getting cash as needed, when the total amount necessary cannot be accurately foreseen? 157. What considerations determine how large an amount must be invested by a corporation in fixed cap- ital? What is working capital? 158. What are the four forms which working capital may take? 159. What factors determine how large an amount of working capital should be carried by a corporation? 160. Of the companies named in the text which one 463 CORPORATION FINANCE has the largest percentage of working capital to gross business? Can you suggest any reason? 161. 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? 162. About how much working capital did the Penn- sylvania Railroad Company carry in 1908? Why was this amount greater than that carried by most railroad companies? 163. Why is it of the utmost importance that a cor- poration should be suppHed with the proper amount of working capital? CHAPTER XXI 164. Draw up from memory a model corporate in- come statement, arranging the items in their proper order. 165. By what common methods may a company's statement of gross earnings be padded? 166. What expenditures and what reserves should always be included under the head of operating ex- penses? 167. 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? 168. Why should "income from other sources" be stated separately? Why should cumulative preferred dividends be paid regularly, if practicable? QUIZ QUESTIONS 463 169. Should a corporation ordinarily pay out all its profits in the form of dividends to its stockholders? If not, why not? 170. 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? 171. Why is it desirable that a corporation 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? 172. Why is great prudence and foresight on the part of the directors in declaring dividends essential to the best interests of a corporation? CHAPTER XXII 173. What are the two important classes of better- ments? 174. What are the three important sources of funds for betterments? 175. What are the advantages of providing for bet- terments by appropriations from earnings? 176. What are the two objections to this method? 177. What three motives may lead stockholders to oppose a policy of providing for betterments by appro- priations from earnings? How do corporation officers sometimes manage to follow this policy without the consent of even a majority of stockholders? 178. 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. 464 CORPORATION FINANCE 179. Show how the Union Bag and Paper Company is now profiting by reason of having previously pursued this policy. 180. When and how may funds for betterments safely be borrowed? 181. What policy as to provision for betterment ex- penditures is followed by the Pennsylvania Railroad? 182. What are the comparative merits of bond and of stock issues as means of raising funds for better- ments? CHAPTER XXIII 183. Define "surplus." 184. Give and discuss briefly four sources of surplus. 185. What is the fifth source of surplus? Can a surplus be built up to any considerable amount by this method? 186. What was the policy of most of the industrial trusts as to surplus in the first few years of their exist- ence? What were the results of their policy? 187. How may a surplus be invested? What general principle should be followed? 188. 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? 189. What is the usual practice in this country with reference to the use of a surplus? CHAPTER XXIV 190. What should be the effect on dividends of putting a surplus back into the property of a corpora- QUIZ QUESTIONS 465 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? 191. 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? 192. What are subscription privileges? How may they be used as a method of distributing surplus? 193. How does a subscription privilege give an op- portunity for cheap investment? What four methods may be used by stockholders in order to secure quick cash profits? 194. What is the method known as the "subsequent sale"? What are the objections to its use? 195. What is the "short selling" method? What is the objection to its use? 196. What is the method known as "sale of old stock"? Why cannot it always be used. 197. What is the method known as "sale of rights"? What is meant by a "right" in New York? What does the same word mean in Philadelphia? What is the objection to the use of this method? 198. 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? 199. Is the granting of privileged subscriptions a method of stock watering? Are they objectionable on that account? 1—30 466 CORPORATION FINANCE CHAPTER XXV 200. What good reason can you give for taking up the study of corporate manipulation? 201. Is it true that the corporate form favors manipulation? Why? 202. Is any force at work in the financial and in- dustrial world which has a strong tendency to check manipulation? 203. What four classes or bodies of persons may endeavor to manipulate a corporation for their own benefit? 204. How may high salaries be used as a method of manipulation? 205. How may the power to bind a corporation by purchases and contracts become a means of manipula- tion? Is it usually possible to find a legal remedy or punishment? 206. How may the power to form new companies to handle especially profitable business be used as a method of manipulation? How was this principle applied by Commodore Vanderbilt? 207. How may a corporate officer manipulate a cor- poration by reason of having "inside" information? 208. Is there reason to think that the use of these four methods of manipulation is not uncommon? CHAPTER XXVI 209. Why do not directors who wish to manipulate a corporation in their own interest enrich themselves by voting exorbitant fees to themselves? What four methods do such directors commonly use? QUIZ QUESTIONS 467 210. 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. 211. Why do not the courts interfere in such cases? 212. How may directors manipulate by forming new companies or transferring credit or assets of their company to some other company? Give an illustration. 213. State a few methods of juggling the accounts of corporations which are not infrequent. How may directors profit by juggling the accounts of their cor- poration? 214. What is meant by "window-dressing"? How may it be used by directors as a method of manipula- tion? 215. What remedies for this kind of manipulation may be suggested? 216. How may directors secure gain for themselves by inflicting loss or even bankruptcy on their corpora- tion? Give two illustrations. 217. Review the essential features of the case cited in the text. How might the manipulation of the cor- poration in this case have been prevented? CHAPTER XXVII 218. How may stockholders fraudulently secure profit for themselves at the expense of the creditors of the corporation? 219. What are the essential facts in the well-known case of Chicago and Alton Railroad Company? 220. How may subsidiary companies be used as a 468 CORPORATION FINANCE means of manipulating a corporation and defrauding creditors? Illustrate. 221. Review the main facts in the Central of Georgia Railway case cited in the text. 222. 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. 223. 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 Long View Land Company were defrauded. 224. Review from memory the series of operations carried on by L. A. Ehrenbahn cited in the text and show how they all worked in favor of the manipulation of his deceased brother's estate in his own interest. 225. Mention four measures preventive of manipula- tion that should be taken by honest stockholders. CHAPTER XXVIII 226. Distinguish between "true" and "legal" in- solvency. 227. Mention four possible causes of true insolvency. 228. What are the chief causes, according to Brad- street's table, of legal insolvency? What is the real meaning of the phrase "lack of capital" when used in this connection? 229. What were the two causes, according to the Wall Street Journal of the failure of the Detroit, Toledo and Ironton Railway Company in 1909? QUIZ QUESTIONS 469 230. Mention three immediate causes of legal in- solvency in addition to "lack of capital." 231. 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 method of handling insolvency? If not, why not? 232. What is a "bill in chancery"? By whom may| it be presented? How may a friendly receiver for a corporation be obtained? What courts have jurisdic- tion in cases of corporate insolvency and receiverships? 233. What, briefly stated, are the duties of the re- ceiver of a failed corporation? 234. 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 ? CHAPTER XXIX 235. 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? 236. 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. 237. Why are bondholders usually ready to agree to a reorganization rather than foreclose and force a sale and distribution of assets? 238. What are the main problems and difficulties that confront a general reorganization committee? How 470 CORPORATION FINANCE 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? 239. Name the four main objects of every reorgani- zation. Why is it necessary usually to raise considerable amounts of cash? 240. 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 made? Under what circumstances may bondholders be induced to pay assessments? 241. What three classes of fixed charges are usually reduced in reorganization? What threat may be used to force an acceptance of a reasonable reduction? What principle is usually followed in determining the maxi- mum total amount of fixed charges to be imposed upon the reorganized company? 242. 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? 243. Summarize briefly from memory the principles of reorganization laid down in this chapter. CHAPTER XXX 244. Sketch from memory the growth of the Santa Fe System. What were the effects on the company's QUIZ QUESTIONS 471 financial strength of the rapid expansion in the j^ears 1884-1888? 245. 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? 246. 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? 247. Sketch from memory the growth of the Rock Island System. 248. Outline the plan of reorganization brought for- ward in 1902. What was the prime object of this re- organization? Was that object attained? Show how control of the Rock Island System may have been se- cured by the Moore crowd without any permanent out- lay? 249. 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? INDEX Accountant's work in consolidation, 182-183. Adaptability of corporate form, 5-8. Addicks, J. Ed., 19. " Alien " corporations, 51. American Bridge Co., 203, 210. American Ice Co., 397-398. American Law Review, 350. American Locomotive Co., 119. American Sheet Steel Co., 205, 208, 215. American Steel and Wire Co., 200, 203, 204, 206, 207, 215. American Steel Hoop Co., 203, 208, 215. American Telephone and Telegraph Co. Number of stockholders, 7. Watered stock, 338. American Tin Plate Co., 203, 208, 215. American Thread Co., 98, 101, 106. Appointment of receiver, 403-404. Argentine Republic bonds, 23. Arizona, corporate laws of, 54, 57, 58. Atchison, Topeka and Santa F^ R. R. Co., 298, 409. First reorganization, 429-431. Growth, 426-428. Second reorganization, 431-434. Atlantic and Pacific R. R. Co., 427. Atwood, Albert W., 196. Bad management, 396. Balance sheets, 82-83. Baldwin Locomotive Works, 313. Baltimore and Ohio R. R. Co., 129. Bank of Augusta vs. Earle, 49-51. Bank Loans, 108-109. Bankruptcy and insolvency, 401- 403. Banks, function of, 93. Bay State Gas Co., 19. Bethlehem Steel Corporation, 98, 101, 107, 117. Betterment expenses, 313, 314. Borrowing funds for, 321-322. Classes of, 311-312. Conclusions as to, 323-324. Lehigh Valley R. R. policy, 316- 320. Pennsylvania R. R. policy, 322- 323. Sources of funds for, 312-313. Stockholders' attitude toward, 314-316. Union Bag and Paper Co. policy, 320-321. Bill in Chancery, 403. Blackstone, 2, 4. Bonds, see "Corporate Bonds." Booth, A. & Co., 99, 101, 107. Boston and Maine R, R. Co., 145- 146. * Bucket shops, 248-S50. By-laws, 26-34. California, corporate laws of, 57. Capital, lack of, 397-398. Capitalization, Factors affecting, 102, 104. In reorganization, 422-424. Of U. S. steel Corporation, 216. Carnegie, Andrew, 199, 204. 473 474 INDEX Carnegie Steel Co., 99, 201, 203, 204, 206, 209, 216, 300, 301, 313, 336. Central of Georgia R. R. Co., 383- 385. Centralization of corporate man- agement, 9-10. Charter, Essential features of, 20-22. Important feature of, 28. Where to obtain, 62. Chicago and Alton R. R. Co., 380- 382. Chicago, Burlington & Quincy R. R. Co., 134. Chicago, Rock Island & Pacific R. R. Co., 337, 435, 437, 438, 439. Chicago, Rock Island & Pacific Railway Co., 337, 435, 437, 439, 440. Choctaw, Oklahoma and Gulf R. R., 437. Classification of corporations. Close, 80. Holding companies, 81-87. Large, 80. Non-stock, 79. Open, 80. Parent companies, 80-81. Small, 80. Stock, 79. Colorado Midland R. R., 430. Commission on Uniform State Laws, 65-66. Common law of corporations, 17-18. Connecticut, corporation laws of, 57, 58-59. Contracts, Manipulation by directors, 362- 365. Manipulation by officers, 353-355. Conway, Jr. Dr. Thomas, 162. Conyngton, Thomas, 22, 29, 53. Corporate bonds, Collateral trust, 133-135. Convertible, 151-153. Debenture, 141-144. Equipment trust, 135-140, Gold, 152. Income, 144-147. Joint, 147, 149. Names of, 130. Manner of payment of, 128. Mortgage, 121-122, 129. Participating, 14v. Payment of, 149, 151. Profit-sharing, 147. Purposes of, 128, 149-151. Receivers' certificates, 149. Redeemable, 151. Redemption of, 128, 141-151. Registered, 151. Security of, 127-128. Sinking fund, 130-133. Serial, 151. Corporate entity, 3. Corporate form, abuse of, 350. Corporate funds. Borrowing, 96-102. Security issues, 102-104. Sources of, 91-96. Corporate mortgage. Closed, 125-126. Deed of trust, 122-125. Limited open-end, 125-126. Open-end, 125-126. Trustee under, 380. Corporate name, 24. Corporate purposes, 24-28. Corporate organization, 53. Efficiency of, 47-48. Flexibility of, 64. "Corporation Finance," 97. Corporation laws, Comparative summary, 58-62. Liberality of, 55-56. Permanence of, 56-57. Reputation of, 57-^8. Corporations in ancient nations, 4. Corporations, Definitions of, 2. Right to do business in foreign states, 49-51. Statements to banks, 108-109. Cunard Co., 332. Curb market, 242-243. INDEX 475 Daggett, Stuart, 426-427. Dartmouth College case, 2. Deed of trust, 123. Delaware, corporate laws of, 53, 54, 56, 57, 59. Detroit, Toledo and I ronton Rail- way Co., 398-400. Deductions from income, 303. Defining and controlling instru- ments, 17. Depreciation reserves, 299-302. Dill, James, B., 25. Directors, " Dummy," 44-45. Liabilities of, 45-47. Manipulation by, 364-375. District of Columbia, corporation laws of, 54, 57, 59-60. Dissolution, 403. Disadvantages of corporate form 13-16. Dividends, Cumulative, 72. Fluctuations in, 308. Non-cumulative, 72. Paying, 303-304, 309-310. Reductions in, 314. Regularity of, 308-309. *' Domestic " corporations, 51. "Dummy" directors, 44-45. Federal Steel Co., 200, 203, 204, 206, 207, 215. Fixed assets, 327. Value of, 119-121. Foreign corporations, 51. Fraud, 396-397. Frick, H. C. Coke Co., 201. Gates, John W., 215. General Electric Co., 291-292. Government control of corporations, 15-16. Greene, Thomas L., 97. Gross earnings, Determination of, 297-298. Statement of, 298. Gulf, Colorado & Santa F6 R. R., 427. H Hall, Henry, 152. Harriman, E. H., 315. Hamburg-American Line, 332. Herring-Hall-Marvin Safe Co., 97- 98, 106. Hyde, James H., 266. Eastman Kodak Co., 231. EflSciency of corporate organization, 47-48. Electric railroads, 307. Equipment companies, 306. Equipment trust bonds, 137. Erie Railroad Co., 117. Essential features of by-laws, 33- 36. Essential features of charter, 20-22. Expenses of incorporation, 13-14. Illinois Central R. R. Co., 340, 346. Illinois, corporation laws of, 57. Important feature of charter, 28. Incorporation, Agreements prior to, 63-64. Expenses of, 53-55. Where to incorporate, 52-53. Wide range of choice in, 64. Income, 302-303. Income bonds, 144-147. Influence of corporations, 16. Individuals interested in corpora- tion, 37. Inheritance of surplus, 326. 476 INDEX Inside information, 358-360. Insolvency, Causes of legal, 397-398, 400-401. Causes of true, 395-397. Detroit, Toledo & I ronton, 398- 400. Methods of handling, 401^04. Installment method of getting cash, 284-287. Integration, 202. Interborough-Metropolitan Co., 86- 87, 253. International Harvester Co., 291. Interstate Commerce Commission, 301, 372, 380. Inventions, 302. Investment, Amount in fixed capital, 288-289. Amount in working capital, 290- 291, 293-294. Definition of, 94-95. Importance of, 284. Of surplus, 330, 340. Practice of large corporations, 291^93. Jones and Laughlin Steel Co., 206. Journal of Accountancy, 66, 110, 183. Lack of capital, 395-396. Lawson, Thomas W., 20. Leeds, Wm. B., 436. Lehigh Valley R. R. Co., 316-320, 344. Liabilities, Of directors, 45-47. Of stockholders, 42-44. Of stockholders of National Banks, 12. Limited credit of corporations, 14- 15. Limited liability of corporations, 11- 13. Limited powers of corporations, 14. Little, Stephen, 298, 431. M Maine, corporation laws of, 53, 54, 56, 57, 60. Manipulation by directors, Accountant's statement, 370-371. Attitude of courts, 365-366. Contracts, 362-365. Juggling accounts, 367-370. Loss of control dangerous, 375- 378. Loss to corporation, 373-375. Methods of, 362. New companies, 366-367. Remedies, 371-373. Manipulation by officers. Contracts, 353-355. Corporate form favors, 349-350. Methods of, 352. Misuse of inside information, 358-360. Necessary evil, 350-351. New companies, 355-358. Ought we to study, 349. Remedy, 351. Salaries, 352-353. Manipulation by and for stockhold- ers. Central of Georgia R. R. income account, 383-385. Chicago and Alton deal, 380-382. Creditors, causing loss to, 379-380. Ocean Steamship Co., 384. Remedies, 392-393. Squeezing minority stockholders, 385-387. Subsidiary companies, 382-383. Marshall, Chief Justice, 2. Massachusetts, corporation laws of, 57, 60-61. McPherson, F. H., 184. Meade, Edward S., 84, 132, 204, 318, 329. Meetings of stockholders, 34. Method of creating corporation, 19- 20. Method of getting cash, 287-288. Midvale Steel Co., 41. INDEX 477 Minnesota, corporation laws of, 57. Moore Companies, 203, 206. « Moore Crowd," 436, 437, 438, 439. Morgan, J. P., 205. Morgan, J. P. & Co., 269, 277. Mortgage bond, nature of, 121-122. N National Steel Co., 201, 203, 204, 207, 215. National Tube Co., 201, 203, 204, 206, 207. Nevada, corporation laws of, 61. New Jersey, Corporation laws of, 53, 54, 56, 57, 61-62, 84r-85. Incorporation of U. S. Steel Cor- poration, 206. New Jersey Court decision, 26-27. New York, corporation laws of, 53, 54, 56, 57, 58, 62. New York Central R. R. Co., 304- 357. New York Curb Market, 344. New York Evening Post, 261-262. New York, New Haven & Hartford R. R. Co., 144. New York Stock Exchange, 346. " Non-stock " corporations, 1. Northern Pacific-Great Northern, 134, 149. O Obligations, quick, 401. Ocean Steamship Co., 384. Officers of Corporation, 34-35. Oliver Mining Co., 201. Operating expenses, 298-299. Oregon Short Line, 147, 409. Over-estimation of assets, 395. Ownership of stock, 33-34. Pennsylvania, Corporation laws of, 57. Cumulative voting required, 18-19, 77. Pennsylvania R. R. Co., 260-261. Annual report of, 322-323. Number of stockholders, 7. Policy of, 322. Perkins, George W., 266. Permanence of corporations, 8-9. Personality of corporations, 3-4, 8, 17. Petition for receiver, 403. Philadelphia Stock Exchange, 348. Pittsburg, Bessemer and Lake Erie R. R., 201. Pittsburg Steamship Co., 201. Pooling, 83. Popularity of corporate form, 5. Post, William, 110. Powers of directors, 45-47. Prices of raw materials, 305. Production percentages of indus- trial companies, 305-306. Profits, variability of, 304-308. Promoters, Bankers as, 169. Contracts by, 175. Definition, 154. DiflBculties of, 181-182. Engineering firms as, 169-171. Function of, 154-156. Lawyers as, 169. Misleading statements by, 174- 175. Pay of, 175-177, 178-179. Professional, 167-169. Risks and labors of, 177-178. Secret profits of, 171-179. Promotion, Assembling a proposition, 157- 158. Basis of consolidation, 183-190, 195-196. Discovery of a proposition, 156- 157. Discovery of small consolidation, 182-183. Distribution of stock, 161. Financing a proposition, 158-159. Illustration from Electric R. R. Co., 162-166. 478 INDEX Methods of raising cash, 191-193. Necessity for cash, 190-191. Of industrial combinations, 180- 181. Of Interborough - Metropolitan consolidation, 196-198. Providing funds, 160-161. Sale of stock, 161-162. Prospectus, Characteristics of, 224r^26. Ideal, 230-231. Investment, 228-230. Speculative, 226-228. Proxy, 38-40. Purposes of U. S. Steel Corporation, Q Quick Obligations, 401. R Railroad reorganization, 426. Railroads reorganized in 1907, 425. Receivers' certificates, 148, 149. Receiver, Duties of, 404-406. Powers of, 406-407. Regulation of " foreign " corpora- tions, 51. Reid, Daniel G., 215, 436. Reorganization, Assessments for cash, 417-419. Atchison, Topeka & Santa F6 R. R. Co., 425-434. Capitalization in, 422-424. Cash requirements, 416-417. Committees, 410-412. Fixed charges reduced, 420-422. Foreclosure, 412-413. Problems of, 413-416. Reasons for, 408-410. Rock Island Co., 437-440. Summary, 424. Westinghouse Co., 440-443. Report of Industrial Commission, 175-177. Revaluation of fixed assets, 327. "Right," 341, 342, 343, 344, 345- 347. Rights of creditors, 44. Rights of stockholders, 37-38. Rock Island Co., 437-438, 439, 440. Rock Island System, Growth, 434-437. Reorganization, 437-440. Roosevelt, Theodore, 57. S St. Louis & San Francisco R. R. Co., 409, 427, 430, 433, 440. Salaries, manipulation of, by oflS- cers, 352-353. Sale of old stock, 345. Sale of rights, 343-345. Sample by-laws, 29-33. Sample charter, 22-24. Saving from income, 327-328. Schwab, Charles M., 216, 217. Securities, Banking house methods of selling, 231-232. Buying on margin, 246-247. Listing, 240-242. Methods of selling, 223-224, 235- 238. Requirements of banking houses. i Selling short, 247-248. Selling above par to obtain sur- plus, 327. Short selling, 342-343. South Dakota, corporation laws of, 53, 54, 5"^. Southern Kansas R. R. Co., 427. Southern Pacific R. R. Co., 426. Speculation, Definition of, 96-97. Importance of, 245-246. Speyer & Co., 265. Standard Oil Co., 291. Lack of publicity of accounts, 42. Organization of, 87-92. Surplus of, 328-329. INDEX 479 State constitution, 18-19. Stimulation of speculative Interest, 251,253. Stock, Buying, 340-341. Certificates of, 65-68. Common, 71. Form of certificate of, 70. Nature of, 33-34. Par vs. market value of, 68-71. Preferred, "cumulative," 72. Preferred, nature of, 71-73. Preferred, "non-cumulative," 72. Preferred, uses of, 73-75. Watering, 347, 349. Stock corporations, 2. Stock Exchange, 239-^40. Methods of, 243-245. Volume of business, 245. Stockholders, Attitude towards betterment ex- penses, 314-316. Liability of, 42-44. Meetings of, 34. Surplus belongs to, 333-334. Stock market manipulation, 254-255. Stock market, 251. Subscription contract, 63. Subscription privilege, 339. Surplus, Advantages of cash, 331-332. Cunard Co. policy, 332. Definition of, 325-326. Disadvantages of keeping in cash, 332-333. Distribution of, 380-381. Distribution through stock-water- ing, 337-339. Distribution through subscription privileges, 339-340. Sale of old stock, 343. Sale of rights, 343-344. "Short selling," 342-343. Subsequent sale, 341-342. Effect on assets, 335-337. Effect on dividends, 335-337. Fixed assets as a form of, 327. Functions of, 331. Hamburg-American Co. policy, 332. Investment of, 339-342. Obtained by inheritance, 326. Policy of trusts, 329-330. Rainy day fund theory, 330-333. Revaluation of assets as a source of, 327. Saving from income as a source of, 327-329. Sources of, 326-329. Uses of, 333-334. Syndicate operations, 253-254. Taney, Chief Justice, 60. Taxes, 302-303. Thompson, Seymour D., 350. Transfer of stock, 34. Transferability of corporate owner- ship, 10-11. "Trust Finance," 84, 132, 204, 331. Trusts, 83. Surplus of, 329-330. U Underwriting, Advantages to buyers, 258-259. Advantages to corporation, 257- 259. Origin of, 256-257. When advisable, 259-262. Underwriting houses, 267-268. Underwriting syndicates. Characteristics of, 277-278. Distributing securities through, 265-267. Example of speculative dealing by, 280-282. Formal agreement of, 269-277. Functions of, 278. Handling speculative issues, 279- Informal agreements of. Pool sale through, 265. Types of, 263-264. Why formed, 262-263. 480 INDEX Union Bag and Paper Co., 320-321. Union Pacific R. R. Co., 40, 129, 151, 409. U. S. Leather Co., 100, 101, 107. U. S. Steel Corporation, 291, 337, 436. Additional companies, 211-212. Basis of capitalization, 215-218. Capitalization at beginning, 209- 211. Conditions before formation, 199- 205. Cost of charter, 54. Earlier steel consolidations, 200- 201. Financial changes in, 113-115. Formation of, 194. Method of promotion, 207-210. Number of stockholders, 7. Operating policy, 218-219. Profits of promoters, 209. Prospectus of, 206-209. Record of earnings, 217. Securities of, 220-222. Standing committees of, 46. Syndicate agreement, 270-277. Value of assets, 395-396. Vanderbilt, Commodore, 357. Volume of sales, 305. Voting, cumulative, 75-77. Voting trusts, 77-78. W Wabash R. R. Co., 145. Wages, 305. Wall Street, 343. Wall Street Journal, 367, 391, 397. Wall Street speculators, classes, 250-251. Wells Fargo Express Co., 315-316. Westinghouse Electric & Manufac- turing Co., 440-443. Western Union Tel. Co., 129. West Virginia, corporation laws of, 54-57. Woodlock, Thomas F., 303. Working capital, 400-401. Forms of, 289-290. Importance of, 284, 296. Practice of Pennsylvania R. R. Co., 294-^95. 'Mri^JSr *j4&S mM w§ '^ 5ii, m s>'°}K< Ife m il m m .°«°»M°:c ;.;^< El'i^^(^j>WJ!i'^K(^/mfj^Sl ^'••'7??V5*^'mK ^%<^\Wf^i^m(cm ^^^M^'-'^fiicm M^^^W'-'^^^iicm ^>^M^'^^M(cm UNIVERSITY OF CALIFORNIA LIBRARY "Xi'oy. ^f.^^^^^J^^^iiSjJ ^/Wfl^MPi¥#Jl^