The "Innocent" Investor
Is the State obliged to protect, or is even justified in protecting, the innocent victims of stockwatering? That is to say, should rate-making authorities fix the charges of public service corporations high enough to return some interest to the purchasers of fictitious securities? All the facts and presumptions of the case seem to demand an answer in the negative. In the first place, it is impossible to distinguish the "innocent" holders from those who were fully acquainted with the questionable and speculative nature of the stock at the time it came into their possession. In the second place, the civil law has never formally recognised any such claim on the part of even innocent investors, nor any such obligation on the part of itself. It has never laid down the principle that any class of investors in fictitious stock has a legal or moral right to obtain the normal rate of interest on such stock through the imposition of sufficiently high charges upon the consumers. Nor have the courts, except in isolated instances, sanctioned any such principle. On the contrary, the Supreme Court of the United States, in the case of Smyth vs. Ames, declared that a railroad "may not impose upon the public the burden of such increased rates as may be required for the purpose of realising profits upon such excessive valuation or fictitious capitalisation." In the third place, when we consider the matter from the side of morals, we see that the innocent investors are not the only persons whose rights are involved. If charges are placed high enough to cover interest on fictitious capital, the cost and the injury fall upon the consumers. The latter have a right to the services of utility corporations, such as railways and gas companies, at a fair price; that is, a price which will return to the capital put into the concern the prevailing rate of interest, plus whatever gains are obtained by exceptional efficiency. To require them to pay more than this, is to compel them to give something for nothing; namely, to provide interest on capital which does not exist, and from which they receive no benefit. When, therefore, the State intervenes to secure fair charges for the consumers, it should base them upon the capital actually invested and used in the business of public service.
Frequently, however, the State has permitted overcapitalisation, and charges sufficient to pay normal dividends thereon, for long periods of years. Has it not thereby encouraged investors to cherish the expectation that these high charges would be permitted to continue, and that the fictitious stock would remain indefinitely as valuable as when it came into their possession? Is it not breaking faith with these investors when it reduces charges to the basis of the actual investment? A sufficient answer to these questions is found in the fact that the State has never officially sanctioned the practice of stockwatering, nor in any way intimated that it would recognise the existence of the fictitious stock when it should take up the neglected task of fixing fair rates and charges. At the most, the civil law has merely tolerated the practice, and the resulting extortion upon the public. And there has never been a time when the greater and saner part of public opinion did not look upon overcapitalisation as at the least abnormal and irregular. Neither from the civil law nor from public sentiment have the devices of inflating capitalisation received that measure of approval which would confer upon investments therein the legal or the moral status of vested rights. To the "innocent investor" in watered stocks the maxim, caveat emptor, is as fairly applicable as to the man who has been deceived into lending his money on insufficient security, or the man who has been induced by the asseverations of a highly imaginative prospectus to put his money into a salted gold mine, or the man who buys stolen goods from a pawn shop, or the man who because of insufficient police protection loses his purse to a highwayman. In all these cases perfect legal safeguards would have prevented the loss; yet in none of them does the State undertake to make the loss good to the innocent victim.
Such seems to be the strict justice of the situation as between the consumer and the innocent investor. It may sometimes happen that a particularly grave hardship can be averted from the latter at a comparatively slight cost to the former. In such a case equity would seem to require that some concession be made to the investors through the imposition of somewhat higher charges upon the consumer.
Magnitude of Overcapitalisation
Probably the majority of the great steam railroads, street railways, and gas companies that were organised during the last quarter of the nineteenth century inflated their capitalisation to a greater or less extent. Since the year 1900 the trusts have been the chief exponents and illustrations of the practice. According to President Van Hise, "the majority of the great concentrations of industry have gone through two or three stages of reorganisation, the promoters and financiers each time profiting greatly, sometimes enormously."[194] For example; in 1908 the "water" in the American Tobacco Company was estimated by the Commissioner of Corporations at $66,000,000; the United States Shipbuilding Company diluted its twelve and one-half million dollars of capital with more than fifty-five millions of "water"; the United States Steel Corporation contained at the time of its organisation fictitious capital to the amount of $500,000,000; and at least fifty per cent. of the common stock of the American Sugar Refining Company represented no actual investment.[195] Owing to the penetrating and widespread criticism, and the government investigations and prosecutions of the last few years, the practice of stockwatering has very greatly diminished. Perhaps the most flagrant recent example is that of the Pullman Company, which according to the testimony of R. T. Lincoln before the Federal Commission on Industrial Relations, distributed among its stockholders $100,000,000 in stock dividends between 1898 and 1910.
Nevertheless the temptation to inflate capital will exist until the device is stringently prohibited by law. Both the nation and the states ought to adopt the policy of forbidding the sale of stock at less than par value, and restricting issues of stock to the amount required for the establishment, equipment, and permanent betterment of a concern, including a sum to cover the loss of interest to the investors during the early period of the business. Any extraordinary risks to which an enterprise is liable can be protected by the simple device of allowing a correspondingly high rate of interest on the securities. With such legislation enacted and enforced, neither the investor nor the consumer could be deceived or defrauded; and the financing and management of corporations would become less speculative, and more beneficial to the community. The present chapter may be fittingly closed with a moderate and significant statement from the pen of Professor Taussig: "It is doubtful whether the whole mechanism of irregular and swollen capitalisation was at any time necessary or wise. Why not provide once for all that securities shall be issued only to represent what has been invested?... It is sometimes said that freedom, even recklessness, in the issue of securities was a useful device, in that it enabled the projectors to look forward to returns really tempting, and at the same time concealed these returns from a grudging public.... A more simple and straightforward way of dealing with the issue of securities might thus have dampened in some degree the feverish speculation and restless progress of railway development. But a slower pace would have had its advantages also, and, not least, restriction of securities would have saved great complications in the later stages of established monopoly and needed regulation."[196]