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LOS ANGELES

LIBRARY



J AN 131949
MAY 5 J960



RAILROAD FINANCE



AILRO
F I N A N C



BY

FREDERICK A. CLEVELAND, Ph.D., LL.D

AND

FRED WTLBUR POWELL, A.M.




D. APPLETON AND COMPANY
NEW YORK AND LONDON

1923



COPTRIGHT, 1912, Bt

D. APPLETON AND COMPANY



Printed in the United States of America



" - l )



PREFACE

The purpose of this volume is to describe the methods
of financing Railroads in the United States, A pre-
liminary draft was used as a series of lectures before the
Wharton School of the University of Pennsylvania in 1901
K and 1902. Later, in collaborating with Mr. Powell, the
f^ historic sivie of "Railway Promotion and Capitalization in
"^ the United States" was v.-orked out for the Carnegie In-
^\^ stitution and published by Messrs. Longmans, Green &
Company. During the years which have followed, as
time could be found, this collaboration has continued.
Since the first two chapters of this volume traverse the
same subject as the volume above referred to, use is made
^J,i of some of the same materials.

r\ Frederick A. Cleveland.

Washington, D. C.



1



CONTENTS

CHAPTEB PAGE

I. — The Economic Basis of Raileoad Investment . . 1
Capital devoted to transportation enterprise — The
economic advantage to be capitalized — Tlie induce-
ment to investment — Saving made possible by better
roads — Advantage of turnpike construction — How
profits were divided — Investment basis of tlie canal
— Capitalization of its advantage over the turnpike
in the long haul — A view from the interior — Eco-
nomic advantages of the railroad over the canal —
The railroad's supremacy over the canal — Its ad-
vantage as a long-distance carrier.

II. Promotion and Undebwriting 14

Promotion and exploitation — Surveys — Location and
operating efficiency — Incorporation — Monopoly privi-
leges — Banking privileges — Tax exemptions — Local
subsidy enabling acts — Methods of appeal for finan-
cial support — The prospectus — Public meetings — The
press and the pulpit — House to house canvass — The
financial agent — The banker as a financial agent —
Appeal to the creditor class of investors — Under-
writing and holding syndicates — The "financial"
banker — Conditions precedent to accepting risk —
Profits of financing — What is underwriting? — The
underwriting syndicate — The holding syndicate —
Individual withdrawals — Sales of underwritten se-
curities — Possibilities of loss — Influence of the great
houses — Conspicuous independent operations — The
nature of the financial support — In general — Indi-
vidual subsidies — Local subsidies — State subsidies
— National subsidies — Land grants — Loans of credit.

III. — Capitalization ; Original and Supplementary. . 34
Need for exact definition of "capital" — Confusion
of ideas — A definition submitted — Capital as an in-
strument of a going concern — Classification and
valuation of capital assets — Classification of capital
vii



CONTENTS

CHAPTER PAGE

liabilities — Practical considerations in original cap-
italization — The corporation's interest in the choice
of capital issues — Advantage of issue of shares —
Preferred rights and privileges to shareholders —
Obligations to creditors — Long and short term credit
obligations — Contracts with lessors — Appropriations
out of surplus for capital use — The marliet for
original shares — The market for bonds — Forms in
which capital may be obtained — Inadequacy of in-
itial capitalization of American railroads — Issue of
additional securities — Privileged subscriptions —
Short term notes.

IV. Finances of Construction 50

Definition — Construction financed through sales of
shares — Supplementary bond issues — Exchange of
shares for land, labor, and materials — Share capital
for roadbed ; bonds for rails and equipment — Subsi-
dies as collateral aids to capitalization — Bonds
favored by investors — Secured on tributary territory
rather than on railroad property — Bonds sold at
discount ; shares given as bonus — Land bonds — Net
earnings applied to construction — Agencies of con-
struction — Construction directly by the railroad —
Early railroads built by small contractors — Large
contractors and construction companies — Contract
work paid for in securities — The dependent or
"inside" construction company — Large profits of pro-
moters — Fraudulent contracts — Use of privileged in-
formation for personal profit — Speculative land
companies — Types of construction company con-
tracts — Texas and Pacific — Wisconsin Central — The
Credit Mobilier — Building of the Union Pacific — Du-
rant — His quarrel with Ames — The compromise —
Evasion of the law — Fear of congressional action —
Shares sold to members of congress — Attitude of
Ames — Construction of the California lines — The
Contract and Finance company — The Pacific Im-
provement company — System responsible for in-
ferior work and overconstruction — Construction of
extensions — Railroads usually built in sections —
viii



CONTENTS

CHAPTER PAGE

Separate corporations — Endorsement of bonds by
parent company — Share subscriptions — Collateral
trust bonds — Modern construction methods illus-
trated — The Western Pacific — The St. Paul exten-
sion — Construction of special structures — Bridges
— Bridge bonds — Bridge company bonds — Joint in-
terest in bridge construction — Terminals — Terminal
bonds — Terminal company bonds — Joint ownership
of terminal property.

V. — Financing Equipment 81

Definition — Cash purchase — Manufacture in railroad
shops — Purchase with proceeds of bonds — Purchase
on the installment plan — Directly from manufac-
turer — Through a trustee — The equipment or car
trust — Adequate security of car trust certificates —
Forms of car trust agreements — Subsidiary equip-
ment companies — Equipment company bonds —
Rental contracts — Rolling stock companies — Private
car lines — Provision for repairs and renewals — Re-
placement of equipment — Provision for obsolescence
— Abuses of repairs and renewals account — Re-
quirements of interstate commerce commission —
Reserve account for each class of equipment — The
theory behind the new requirement.

VI. — Organization for Financial Management ... 95
Corporate powers of management — Financial —
Management — Financial organization — The treas-
urer — Transfer agent and registrar — Fiscal agent —
Transfer and registration of securities — Organiza-
tions for protection of investors — Dutch bureaus of
administration — Association of American Bond and
Shareholders — Investment trusts — The voting trust —
Independent auditors — Public accountants — Protec-
tion of the corporation from its financial officers —
Prevention of fraudulent issue of securities — The
Schuyler frauds.

VII. — Protection of the Corporate Estate as a Function

OF Management 107

The protection of capital — The law of property —
ix



CONTENTS

CHAFTEB PAGE

luheritance and remainder interests — The law of
waste — The law of uses — The law of agency and
trusteeship — Corporation law — Provisions for pro-
tection of corporate capital — Prerequisites for en-
forcing the law — Information necessary to protec-
tion of the corporate estate — Officers required to
keep full and true accounts — Early forms of capital
accounts — More recent requirements for statement
of capital — Defective in form but adequate in ef-
fect — Provisions for independent verification of
statements — Verification of capital account — Protec-
tion of shareholder and creditor the central thought
— Statutory provisions for preservation of evidence
necessary to enforce official responsibility — Laws
making falsification or destruction of records a mis-
demeanor — Laws making false statements a misde-
meanor — The double balance sheet as an instrument
for protection of capital — British law makes such
statement possible — American practice in violation of
principles of law — Exact information a primary ne-
cessity — Interstate commerce commission balance
sheet — Summary consolidated balance sheet — Sug-
gested arrangement in double balance sheet form
of accounts prescribed by interstate commerce
commission — Suggested form for current account.

VIII. — Financial Considerations in Maintenance and

Additions and Betterments 129

Problems of management — Elements of mainte-
nance — Repairs and replacements — Depreciation —
Maintenance of subsidiary properties — Maintenance
of capitalized funds — Working capital funds — Con-
struction and equipment funds — Funds for additions
and betterments — Sinking funds — Employees' insur-
ance, pension, and provident funds — Property insur-
ance funds — Additions and betterments — Definition
— Reduction of operating expenses — Notable changes
effected by Harriman — The capitalization of im-
provements — English practice — American prac-
tice — Need for additional protection to invest-
ors — Surcharged maintenance accounts — Tendency
X



CONTENTS

CHAPTEB PAGE

to abuse — Reserve account for extraordinary ex-
penditures — Direct charges against surplus — The
new official classification of accounts — Provision
against understatement of operating expenses.

IX. — Some Financiax, Aspects of Operation .... 149
Operation concerned with net earnings — Earnings
and the rate of transportation — Tendency to limit
earnings — The problem of management — Earnings
and volume of traffic — Encouragement of settlement
and of local industries — Encouragement of through
traffic — Expenses and efficiency of management — In-
terest of the public as represented by government —
Uninterrupted service — Adequacy of service — Pro-
visions for health, comfort, and convenience —
Safety — Interest of railroad employees — Interest of
supply dealers — Tendency to Increase expenses —
Opportunity for economical management — Contract-
ing and purchasing — Labor cost and labor efficiency
— Efforts to promote labor efficiency — Economical
purchase of materials and supplies — Economical use
of materials and supplies — Economical use of rail-
road property and equipment — "Scientific manage-
ment" as a factor in economical operation — Ob-
.stacles in the way — Managerial responsibility of the
directorate — Company work vs. contract work.
X. — Management and Distribution of the Surplus . 166
Control vested in the directors — Scope of authority —
Uses made of the surplus — Protection of the cor-
porate estate — Improvement of the personnel — In-
crease of business — Reduction of the funded debt —
Equalizing dividends — Distribution of invested
surplus — Dividends representing subscribed surplus.

XI. — Accounts and Statistics 178

Development of the accounting department — Inade-
quacy of accounts of early railroads — Lack of ad-
ministrative control — Progress toward uniformity
— Effect of publicity requirements of state and na-
tional laws — Uniformity attained under Hepburn act
— Organization of accounting department — Chief ac-
counting officer — General accounts — Supervision of
xi



CONTENTS

CHAPTEB PAGE

treasurer's accounts — Traveling auditors — Freight
auditor — Tlie waybill — local and through — Inter-
line — The waybill en route — Collections — Agents'
abstracts of waybills forwarded and received — In-
terline balances — Auditor of passenger receipts —
Tickets — Cancellations and cash collections — Re-
ports of agents and conductors — Interline ticket re-
ports — Auditor of disbursements — Payrolls — Requi-
sitions for materials and supplies — Vouchers — Dis-
tribution of expense — Classification of operating ex-
penses — Interline balances — Joint facilities ac-
counts — Claims — Classification of operating reve-
nues — Operating account — Income account — Profit
and loss account — The general balance sheet — Sta-
tistical functions of the accounting department —
Importance of operative statistics — Units of meas-
urement — Distribution of expense — Direct and in-
direct — Freight and passenger — Allocation of
common expenses — The operating ratio — Freight
statistics — Commodity units — Passenger statistics —
Reports — Provisions of the Hepburn act — Inade-
quacy of early reports — Essentials of an adequate
report.

XII. — Causes of Insolvency 215

Insolvency distinguished from bankruptcy — Insol-
vency distinguished from deficit — Credit considered
as a "short sale" — Rights of shareholders and of
bondholders — Fixed charges — Burdensome leases —
Vermont Central lease — Heavy fixed charges — Ex-
cessive mileage — Faulty construction and low
credit — Unproductive branch lines — Dishonest prac-
tices — Inadequate reports — Competition of rates and
of service — Hostile legislation — Floating debt the
immediate cause of insolvency — Insufficient working
capital — Effect of general business conditions on
railroad earnings — Inadequacy of early reorganiza-
tions.

XIII. — Receivebship 227

The receiver — Bondholders' right to possession and
sale — Trustee as representative of bondholders —
xii



CONTENTS

CHAPTER PAGK

Obstacles in the way of trustees — Public lien — Pub-
lic policy against segregation of properties — Limita-
tions of trustee as to management and sale — Com-
plexity of interests in the property — Earning power
the real security — Position of shareholders — The
public interest — Receivership a necessary expedient
— Conflicting interests — Solvent receivership — Appli-
cation for a receiver — "Friendly" receivership —
Secret application — Application by public officials
proposed — Qualifications for receiver — The court the
judge as to fitness — Jurisdiction of receivers — The
Northern Pacific controversy — Financial and admin-
istrative aspects of receivership — Repairs and bet-
terments — Construction — Interest payments — Pay-
ment of back claims — Reduction in wages — Methods
of raising money — Receivers' certificates — Excessive
issues — Termination of receivership — Surrender of
property — Foreclosure — Reorganization.

XIV. — Reobganization 248

Why reorganization is necessary — Special reasons
for readjustment without foreclosure — The principle
underlying a mortgage — "Strict" foreclosure rare —
Administrative purpose of reorganization — Financial
purpose of reorganization — Reorganization commit-
tees — Bankers as disinterested parties — Deposit of
securities — Rights of dissentient parties — Advantage
of bondholders at foreclosure sale — Sacrifices of
shareholders — Assessments — New securities to rep-
resent assessment — Partial loss of proprietorship —
Assessment of junior bondholders — Conversion of
bonds into shares — The margin of safety — Reduction
of lien of bonds — Mortgage bonds replaced by in-
come bonds — By preferred shares — Reduction of
rate of interest — Underlying bonds not disturbed
— Status of the reorganized corporation — Free from
old contracts — Provision for future of new corpo-
ration — Reserves for betterments — Provisions for re-
tirement of maturing bonds — Function of the under-
writing syndicate — The rating trust — Insures control
of the new corporation — Results of reorganizations
xiii



CONTENTS

CHAPTER PAGE

— Reduction of fixed charges — Increase of aggregate
capital.

XV. — Consolidation , 272

Conveyances, leases, and share control — Union of
connecting lines — Some early consolidations — Popu-
lar opposition — Period of trunk line develop-
ment — Through lines from Chicago and St. Louis
to the seaboard — Effect of Sherman anti-trust act —
Community of interest — Vanderbilt — Pennsylvania —
Union Pacific — The seven great financial interests —
Regimal grouping — Huntingdon's plan for a single
company — Progress of consolidation in New Eng-
land — Similar tendency throughout the country —
Motives of consolidation — Efficiency of operation —
Strategic position — Terminals — Restraint and elim-
ination of competition — Speculative gains — Forms of
consolidation — Direct union — Merger — Conveyance —
Foreclosure — Share ownership — For income — For
control — Acquisition of shares — Collateral trust
notes as aids to consolidation — Minority or "work-
ing" control — Individual holding of balance of
power — Minority control and stock market "raids"
— Tendency toward absolute ownership — Simplifica-
tion of organization — The lease as a means of con-
solidation — Terms — Long term leases as preliminary
mergers — Rentals.

XVr. — Consolidation (Continued) 303

Railroad trust proposed — Holding companies —
Pennsylvania — Southern Pacific — Wisconsin Cen-
tral — Great Northern — Southern Railway Security
■ — Richmond Terminal — Georgia — Oregon and Trans-
continental — Reading — Railroad Securities — North-
ern Securities — The federal suit — Rock Island—
"Queen and Cresent" group — Richmond — Washing-
ton — Railroads as holding companies — Lake Shore —
Missouri Pacific — New Haven — Boston Railroad
Holding company — Single railroad holding com-
pany proposed — Results — Operation — Rates — Secu-
rity values — Public interest.

xiv



CONTENTS

CHAPTEE PAGE

XVII. — Overcapitalization 322

Fuudamental concepts relating to capital — As re-
lated to the corporation — As related to investors —
As related to the public — Determination of the
amount of capitalization — Lack of evidence in ac-
counts — Standards of appraisement — Amount of lia-
bilities — Original cost less depreciation — Impossible
of determination — No relation to present value — Cost
of reproduction — Official appraisals — Distinction
between valuations for taxation, rate-making, and
capitalization — Non-physical values — Realization
value — Occasions of inflation — Construction — Reor-
ganization — Consolidation — Share dividends — Re-
sults — Tends toward high rates on non-competitive
traffic — Inadequate facilities — Opportunity for fraud-
ulent practice — The interest of the investor — Un-
necessary mileage — Inconsistency of public attitude
— Prejudice against high dividend rates — State regu-
lation of issuance of securities — Massachusetts —
Texas — New York — Other states — Regulation by
interstate commerce commission — The argument in
favor of federal regulation — Railroad securities com-
mission — Full publicity recommended.

XVIII.— Bibliography 353

Bibliographical aids — Periodicals — Histories — Re-
ports of foreign observers — Promotion — Construction
— Equipment — Additions and betterments — Manage-
ment — Accounts — Statistics — Reports — Re-
ceivership — Reorganization — Consolidation —
Overcapitalization — Alphabetical list of sources and
materials.



XV



CHAPTER I
THE ECONOMIC BASIS OF RAILROAD INVESTMENT

Capital Devoted to Transportation Enterprise. — A
hundred years ago the only railroad known was the tram-
way. Twenty-five years later the steam locomotive ex-
isted as an object of speculative interest, but it had no
place in the W'Orld's industrial system. The second quar-
ter of the nineteenth century was given over to experi-
ments, and to the development of the practical side of con-
struction and management; yet during this brief experi-
mental period about eighteen thousand miles of railroad
were built, and over $1,500,000,000 of capital expended.
More than nine thousand miles of this development took
place within the United States, a new country, with little
capital available. It is at first a matter of surprise that
so much capital should have been devoted to a new un-
dertaking, and more especially that a large proportion of
the expenditure should have been in a country slightly de-
veloped and little known.

Some writers have regarded this as a period given over
to reckless adventure, which brought with it wholesale de-
struction of capital and national disaster. But whatever
the disturbances of credit due to railroad promotion, the
fact remains that it was a time of great material progress,
and that few of these early railroads were unsuccessful
from the viewpoint of national wealth. In England such
enterprises as the Liverpool and Manchester, and the Lon-
don and Southampton were got under way. In America
the Western, the Boston and Providence, the Old Colony,
and the Boston and Lowell of Massachusetts; the Hartford
and New Haven of Connecticut; the Philadelphia and Co-
3 1



RAILROAD FINANCE

lumbia and the Philadelphia and Trenton of Pennsylvania ;
the Camden and Amboy of New Jersey ; the Baltimore and
Ohio and the Baltimore and Susquehanna of Maryland
were a few among the many successful projects launched
before 1850. Taking the entire list of roads built during
this early period, it would be difficult to find even a local
tramline which has not become a permanent part of some
splendid system of transportation.

In England, Germany, France, Belgium, and in the
United States these early railroads were, and are to-day,
among the most valuable and productive properties in the
whole economic system. Furthermore, not a few of these
early roads were regarded as conservative investments, and
subsequent experience has approved the judgment of the
men of that day who had sufficient capital fully to equip
the enterprises. "Within a century it is probable that the
people of the United States had invested no less than twelve
billion dollars in the improvement of country roads and
turnpikes, one billion dollars in river and harbor and canal
improvement, state and national, and twelve billion dollars
in the construction and equipment of tramlines and rail-
roads; not less than twenty-five billion dollars of capital
found employment in inland transportation enterprise.
. The Economic Basis of the Railroad. — The principle
underlying investment is certainty of return. Before the
investor will be attracted to an old and well established
enterprise, there must be assurance of income on cap-
ital expenditure. To attract him to new and untried
fields, there must be assurance of increased profits
— ^something above the current rate. Something in the
nature of a "bonus" must be held out to cause thoughtful
men to turn away from old and well-known lines of invest-
ment. What was there to give this assurance? What
was the situation which offered profits in transportation
development ?

2



ECONOMIC BASIS OF RAILROAD INVESTMENT

The Inducement to Investment. — A vast wilderness
with only a fringe of civilization, a continent almost unex-
plored, was the America of 1790. The frontiersman was
still to be found in the small clearings of Maine, New
Hampshire, and Vermont. Fully two-thirds of New York
and Pennsylvania were yet unclaimed — a common hunting
ground. In this situation was found the extraordinary in-
ducement, the "bonus" held out to investors in any
schemes of transportation which would make the inland
resources available. Here were whole empires of valuable
timber and agricultural lands, rich deposits of iron, coal,
and other minerals — all materials of national wealth —
waiting, a prize to him who might claim them as a reward
for enterprise. The cost of transportation equipment has
been enormous; yet the inducement has been at all times
sufficient to attract the investor.

Saving Made Possible hy Better Roads. — The financial
inducement to transportation improvement was of two
kinds: the saving which it would make within the terri-
tory already developed; and the interior resources which
might be reclaimed beyond the reach of the system sup-
planted.^ By way of illustration of the relative advan-