THE QUARTERLY JOURNAL OF ECONOMICS AUGUST, 1914 RAILROAD OVER-CAPITALIZATION SUMMARY Over-capitalization in (1) construction, 602. (2) Replacement of property as inviting stock-watering, 602. - Incompetence or fraud, 603. The Rock Island and Boston & Maine affairs, 604. — (3) Division of an accumulated surplus, 606.- Indirect devices therefor, 607.Magnitude of railway surpluses, 608. - Equitable interest of the public therein, 609. The opposing views stated, 610. The just intermediate opinion, 611. — The Massachusetts gas companies, 613. — Difficult to apply in practice, 614. (4) Refunding as a concomitant of inflation, 616. (5) Stock-watering incidental to consolidation, 617. — Financial advantage of mergers, 618. - The New Haven collapse, 619.- Connecticut trolley finance, 620. — The Rhode Island companies, 621. — The Boston & Maine road and the Westchester Co., 622. - (6) Reorganization and stock-watering, 624. — The Third Avenue Railroad case, 626. -Conclusion, 628. -- OVER-CAPITALIZATION, which may be defined as an excessive issue of securities in proportion to the physical assets, seems to be associated dynamically with six phases of railroad finance. In other words, no fewer than six particular occasions present themselves as opportune for inflation of capital issues. These arise: in connection with construction; through replacement of property; by division of accumulated surplus; as a concomitant of refunding; as an incident of consolida tion; and, finally, as a feature of financial reorganization. The provision of entirely new capital directly affords opportunity, of course, for an undue issuance of shares or bonds. But this subject is so extended in its ramifications as to require treatment by itself. With this exception, it is believed that the above-stated scheme of classification comprehends practically all phases of over-capitalization. (1) The importance of construction as inviting an over-issuance of securities is emphasized by the proposition pending in Congress to so enlarge the jurisdiction of the Interstate Commerce Commission as to include all operations and accounts of construction companies along with operating railroads. The need of wider authority has been brought to public attention by a number of recent scandals, particularly those of the St. Paul Pacific coast (Puget Sound) extension and of the St. Louis and San Francisco.1 A large body of experience, dating from the earliest days of railroading, has clearly proven the imminence of financial excess in this connection. The persistence of these practices is well exemplified also, altho on a small scale, in a number of recent cases before the state railroad commissions.2 (2) The capitalization of expenditures for replacement of property which ought to have been paid for from income is probably one of the most common corporate errors of the time. Improper manipulation of betterment and maintenance accounts leads readily and immediately to the augmentation of capitalization with 3 1 These and a number of others are discussed in extenso by the author in the Railway Age Gazette, vol. lvi, 1914, pp. 1177 and 1225. ? Nebraska Railway Commission, 6th Ann. Rep., 1913, p. 255; and P. S. C., Missouri, vol. i, 1913, p. 141. Cf. P. S. C., New York, 2d D., 1910, vol. i, p. 132. The out a corresponding investment of new funds. intricacy of the subject is manifested by the case of the Kansas City Southern before the Supreme Court of the United States in 1913. The company desired to pay for the entire cost of a much better re-location of a part of its main line from the proceeds of a bond issue, without any deduction whatsoever for the cost or value of the old bit of line which was abandoned. This was defended on the ground that operating expenses would be so substantially reduced in consequence of the relocation as to fully support the enhanced interest charges. Both the Interstate Commerce Commission and the Supreme Court held, however, that such action amounted virtually to the payment of dividends from capital. For, the argument continued, all dividends or interest upon the securities originally issued to pay for the old line, if continued, evidently imposed two burdens upon present earnings; those, namely, associated both with the original and with the new investment. The government also made the valid plea that it was really the first investment which alone made the second one possible. This the company denied, alleging that the reduced operating expenses would fully offset the larger fixed charges.2 The boundary line is indeed vague between mere neglect to differentiate income from capital, and downright deception of others in this regard. Expenditures may be capitalized, not for real betterments, but for pretended ones which ought to be paid for from earnings. 1 231 U. S. 423. 2 Cf. Ripley, Railroads: Rates and Regulation, p. 67. In this connection an ingenious argument against the American practice of charging betterments to income account may be mentioned. It is to the effect that capital outlay is at least subject to a greater degree of publicity than revenue expenditure; and consequently that deceptive or speculative action is more likely to be thwarted. The argument naturally has no force under our present American régime of governmentally standardized accounting. See McDermott, Railways. Real improvements may be paid for in excess of their actual value. Or, even worse, current expenses in the form of bills payable, wages and supplies may be met by issues of interest-bearing script. Floating debt may be allowed to accumulate in paying current expenses, while dividends which ought to have been cut off continue to be paid; and then this floating debt may be refunded into permanent securities. Is it not clear that in each instance, capitalization is expanded unduly in proportion to the actual worth of the property? Such things are usually done so as to disguise the facts. But however details may vary, the principle is fundamentally the same. The resources of the future are improperly exhausted for the benefit of the present. Failure to charge replacement outgo to income rather than capital account has accompanied recently the financial distress of two important roads. Both affairs were deceptive in the extreme, on the Rock Island wilfully and perhaps even fraudulently so, while on the Boston & Maine the mistaken policy seems to have been due rather to ignorance, neglect or inefficiency. The facts as to the Rock Island were brought to light in 1914 in connection with reorganization proceedings. After the management had issued a highly encouraging statement indicating a liberal upkeep of roadbed and equipment for 1913, an expert investigated the matter from another angle for the bondholders. He reported a corporate starvation policy so extreme that about 20,000, that is to say, one-half,- of the company's freight cars were worn out and should be retired at a cost for replacement of $15,000,000; also that inadequate or, as it was termed, "deferred maintenance work" would necessitate another $8,000,000 expenditure. These two items alone transformed a reported surplus of $13,600, 1 Report by Vice-President McKenna, of the St. Paul, May, 1914. 000 for the preceding year into a profit and loss deficit of $10,291,000. Obviously the only way to save the property was to capitalize this deficit at once by an assessment upon security holders. A similar experience, this, to the Atchison and the Baltimore & Ohio twenty years before, repeated almost word for word! The complete collapse of the Boston & Maine Railroad in 1913 affords a second recent instance of the penalty imposed by years of self-deception in matters of replacement and depreciation.1 Large sums which under the dictates of ordinary intelligence and prudence ought to have been invested in the property from earnings were for years diverted to the payment of excessive dividends, not absolutely excessive in the sense of affording an unreasonable return on the capital, but relatively so, in the sense that they brought about a progressive impoverishment of the road. Such deceptive financiering need not necessarily be in the nature of a fraud upon stockholders, however great the losses which they may be called upon to bear through having innocently dissipated their capital thinking they were merely spending their income. Undoubtedly it has thriven in the past upon the pretended need of secrecy in the matter of accounts. From the public point of view, in the last analysis it invariably entails an undue burden of securities upon the shoulders of the community to be supported out of current earnings, while at the same time exposing patrons to the exasperation of a halting, unsafe and inadequate service. The primary lesson to be learned by railroad managements is that, not more than current earnings but at all times far less, should be distributed in the way of dividends. The moral for the public is that it must be prepared to countenance such rates as shall yield, not only regular normal rates of 1 27 I. C. C. Rep. 593; cf. p. 622, infra. |