The exchange of new securities for old on a large scale usually takes place when a railroad is unable to meet maturing obligations. Of 18 reorganizations and 42 plans, 15 reorganizations and 39 plans have had to do with the extrication of companies from financial embarrassment. But though impending insolvency is the usual occasion it is not the only one. Reorganization sometimes occurs when prosperity is too great as well as when it is too little. Or a management may desire to get rid of hampering restrictions, or it may desire to manipulate the conditions of control. This last named cause—the desire to manipulate conditions of control—has been fortunately an infrequent cause of reorganization. An example is, however, afforded by the Rock Island reorganization of 1902. It will be remembered that the Chicago, Rock Island & Pacific Railway had long been a prosperous road in the Middle West, and that its control had required the ownership of between 40 and 50 per cent of $75,000,000 of common stock, quoted at over 160 in the early part of 1902. By the issue of new bonds, new preferred and new common stock to a total of $270 for every $100 of old common stock, and by giving to the preferred stockholders the right to elect a majority of the directors, the owners of the property were able to part with a large portion of their holdings and yet retain absolute control. A somewhat similar case was that of the Chicago & Alton. This road had been a conservatively capitalized enterprise, doing a large business between Chicago, St. Louis, and Kansas City. It had paid 7 per cent or better on its two classes of stock for eighteen years without a break, and had accumulated in that time an uncapitalized construction expenditure of $12,444,178. In 1899 a syndicate of Eastern capitalists bought control, and the following year reorganized the property by forming a holding company, which issued $22,000,000 in 3½ per cent bonds, $19,489,000 in preferred and $19,542,800 in common stock to exchange for the $22,230,600 old common and preferred shares outstanding. At current prices on January 3, 1899, a majority of both the old issues would have cost $19,030,048; on January 4, 1901, however, a majority of both of the new issues represented an investment of $10,729,437; and this investment it would have been possible to reduce to $2,241,377 by the sale of the new bonds received, without in any way endangering control.[684]
It is evident that both the Rock Island and the Chicago & Alton reorganizations were influenced by the very great prosperity of the companies concerned. It was desired to reap a profit by the sale of new securities as well as to lessen the investment required for control; although it may be remarked that the advantage of retaining control depended on the future prosperity of the roads. Reorganizations concerned with manipulation of control are therefore closely allied with reorganizations due to too great prosperity. These latter may, however, take place independently, and are likely to occur whenever profits are extraordinarily large, and a simple stock dividend is deemed inadvisable. An example was the reorganization of the Chicago, Rock Island & Pacific in 1880, when the formation of a new company and the exchange of new stock for old was deemed wise, in view of the large earnings which were to be distributed.
The desire to eliminate hampering restrictions is seldom the sole cause for a reorganization, but frequently it is a contributing one. When, for instance, the managers of the Union Pacific wished to extend their system in the years following 1880, they were forced to establish a separate organization for each branch line. By the terms of the charter nothing could be consolidated with the main stem except the Kansas Pacific and the Denver Pacific, the consolidation with which was provided for in the original acts.[685] This obviously prevented considerable economies, and could be remedied only by a new incorporation. The Northern Pacific was hampered in yet another way because the consent of three-fourths of the preferred stock was required by the terms of the reorganization of 1875 to the imposition of new mortgages;[686] and similarly the Atchison, after 1889, found it extremely difficult to issue new bonds because of the position of the outstanding income bonds. In this last case the restriction was the sole cause of the reorganization which followed. It should be remarked that the cancellation of such provisions sometimes works considerable injustice. Restrictions on future increases in capital, for instance, may have facilitated the issue of bonds in the past, and in this case have formed part of the consideration given for subscriptions. The readjustment is defended on the ground of the need of the corporation, or is so accomplished as not to lessen the value of the creditors’ holdings.[687]
The typical railroad reorganization, as has been said, occurs when a road ceases to be able to pay interest on its outstanding obligations. Whether because of excessive capitalization or because of unexpectedly low earnings, or owing to an accumulation of floating debt which ties up all current resources, the reorganizing railroad finds itself incapable of meeting payments falling due. For this, experience shows that two deep-seated causes have generally been responsible. First, there is the almost entire freedom in matters of capitalization which railroads have enjoyed. Far from the recommendation of Secretary Taft that no railroad company engaged in interstate commerce be permitted to issue stock or bonds and put them on sale in the market except after a certificate by the Interstate Commerce Commission that the securities are issued with the approval of the Commission for a legitimate railroad purpose,[688] American railroads have in the past been practically unrestricted. It was open to the Erie to increase its capitalization per mile from $81,068 in 1864 to $117,760 in 1872, with no corresponding addition to its property; it was open to the Union Pacific to create a capitalization of $104,561 per mile by 1870, of which about one-quarter was in the form of government bonds; and it was possible for the Atchison to issue $129,162,350 in new bonds and stocks between 1884 and 1889 while its net earnings seriously decreased. Had there been a supervision of new issues, or had even a certain percentage of stocks to bonds in those instances been required, failures would have been less frequent and reorganizations less common. New construction would probably have been less rapid, but not so much so as is often asserted. A smaller number of new enterprises might have yielded larger profits; the chances for land speculation might have tempted many, and liberal regulations might have allowed a generous profit while at the same time eliminating all inflation due to fraud. Unfortunately railroad-hungry communities seldom stopped to count the cost. West, South, North, and East, privileges were offered to railroads, donations of land and money were made, and exemptions from taxation were conferred.
The second fundamental cause of railroad distress has been competition. If unrestricted capitalization has increased the load which the railroads have had to bear, unrestricted competition has impaired their ability to support any load at all. The forms which this competition has taken have been mainly two: first, the cutting of rates, either openly or by secret concessions; second, reckless extensions of line, generally followed by rate-cutting. The cutting of railroad rates is now a subject familiar to all. Illustrations may be found in the history of any great railroad system. President Hadley has made classical the theory that roads will take business until rates fall below the specific cost of hauling a given shipment; that is, below the additional cost which the articles in question impose. Even this limitation is often non-existent. Railroads which serve different cities will take freight when a war is in progress whether or not the rate repays the specific cost of hauling. If their rival imitates them they hope to wear it out by their superior ability to stand the loss. If it does not, the city which they serve will temporarily eject all others from common market, and may obtain so firm a footing that a permanent increase in business will result. All of the railroads which have been studied, in fact, have suffered more or less from rate-cutting. Repeated attempts at pooling and agreements to maintain rates have improved conditions only during the short periods in which the agreements have been of effect. In the South there have been scarcely more successful attempts to secure harmony by community of stock control. Competition by means of extensions has been also vigorously practised. The reader will recall the growth of the Atchison from 1884 to 1889. It was after the dissolution of the Southern Railway Security Company that the East Tennessee entered upon its policy of purchase and of new construction. The entrance of the Reading into New England was the direct cause of its failure in 1893; and that of the Baltimore & Ohio into New York largely contributed to its difficulties in 1887. Sometimes such extension is into territory where there is no business to justify it. Sometimes the business is there, but has to be divided among too many rivals. Sometimes the new lines are so poorly built as to be unduly expensive to work, and not infrequently they are so good that the resources of the expanding road are strained in acquiring them. In any one of these four cases new extension causes a drain upon the parent road which may readily bring about its failure.
Other conditions may lead to railroad failure. Simon Sterne alleges the following causes to be often responsible:[689]
1. The control of railroads by stock which represents little or no original cash investment.
2. The development of the territory served by individual railroads at a slower rate than is anticipated, and the influence of competition in reducing profits when the territory has developed.
3. The undertaking of railway construction when there is considerable activity in the money market, and when capital commands a high rate of interest.
4. The circumstance that railways, lacking reserve capital, can never avail themselves of a cheap market for labor or supplies, but must always buy when everything is inflated, because then only can they float their loans and borrow capital.