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Business Failure, Judicial Intervention, and Financial Innovation: Restructuring U.S. Railroads in the Nineteenth Century

Published online by Cambridge University Press:  13 December 2011

Peter Tufano
Peter Tufano
Affiliation:
PETER TUFANO is associate professor in the finance area at the Harvard Business School.
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Abstract

This article describes the problems faced by reorganizers of distressed railroads in the late nineteenth century and how they were addressed by a combination of judicial intervention and financial innovations. In particular, the judicial innovations of supersenior financing, the equity receivership process, and the setting of upset values permitted firms to raise funds. The private financial innovations of deferred coupon debt, contingent charge securities, and voting trusts made subsequent default less likely. The private innovations can be interpreted as responses to both the distress of the railroads as well as the intervention by the courts that emasculated prior debt contracts.

Type
Articles
Information
Business History Review , Volume 71 , Issue 1 , Spring 1997 , pp. 1 - 40
Copyright
Copyright © The President and Fellows of Harvard College 1997

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References

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30 William Z. Ripley, Railroad Finance and Organization, 396.

31 Arthur S. Dewing, The Financial Policy of Corporations, 109–115.

32 Stuart Daggett, Railroad Reorganization, 352.

33 Unfortunately, Poor's does not report the dollar value of securities issued to the public for cash as part of these reorganizations. Poor's Bureau of Information and Investigation, , Poor's Manual of Railroads (New York, 1900), xx.Google Scholar

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40 Joseph Weiner, “Conflicting Functions of the Upset Price in a Corporate Reorganization,” 143.

41 Stuart Daggett, Railroad Reorganization. These results are curious, because stock holders who paid assessments would have been better off to not pay the assessment, wait one month and then purchase the stock in the market.

42 See Louisville Trust Co. v. Louisville, New Albany and Chicago Railway Co 174 U.S. 674, (1899), and Northern Pacific Railroad Company v. Boyd 228 U.S. 482 (1913).

43 Samuel Spring, “Upset Prices in Corporate Reorganizations,” 502–503.

44 Joseph Weiner, “Conflicting Functions of the Upset Price in a Corporate Reorganization,” 142. Emphasis added.

45 John E. Tracy, Corporate Foreclosures, Receiverships and Reorganization, 13. For examples of reorganization committees, see Campbell, E.G., The Reorganization of the American Railroad System, 1893–1900 (New York, 1938), 145–189.Google ScholarChernow, Ron, The House of Morgan: An American Dynasty and the Rise of Modern Finance (New York, 1990), 67.Google Scholar On Morgan's role in general, see Carosso's, Vincent P. standard work, The Morgans: Private International Bankers 1854–1913 (Cambridge, Mass., 1987).Google Scholar

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49 See Maury Klein's two volume work, Union Pacific (New York, 1987)Google Scholar and his earlier history, The Great Richmond Terminal. Stover's, Among John F. many works, see History of the Baltimore & Ohio Railroad (West Lafayette, Ind., 1987)Google Scholar, and History of the Illinois Central Railroad.

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52 W. Hastings Lyon, Corporation Finance, 294.

53 Arthur S. Dewing, The Financial Policy of Corporations, 132.

54 Arthur S. Dewing, Study of Corporate Securities, 224–228.

55 Tufano, Peter, “Financing Acquisitions in the late 1980s: Sources and Forms of Capital,” in The Deal Decade: What Takeovers and Leveraged Buyouts Mean for Corporate Governance, ed. Blair, Margaret M. (Washington, D.C., 1993), 289–320.Google Scholar Deferred-interest obligations were used to finance almost 30% of the debt raised in conjunction with the financing of leveraged buy-outs in the 1980s. Like late nineteenth-century rail-roads, these firms faced imminent financial distress based on their high level of fixed financial charges.

56 Stuart Daggett, Railroad Reorganization, 365.

57 The earliest security resembling preferred stock reportedly was issued in 1698 by Mine Adventurers' company in the United Kingdom. See Evans, George H. Jr's, British Corporate Finance 1775–1850 (Baltimore, Md., 1936), 73.Google Scholar The earliest uses of preferred stock in this country were in conjunction with the recapitalization of failed railroads in the late 1840s and 1850s. See Evans, George H. Jr's articles, two, “The Early History of Preferred Stock in the United States,” The American Economic Review 19 (March 1929): 43–58Google Scholar, and “Preferred Stock in the U.S. 1850–1878,” The American Economic Review 21 (March 1931): 56–62. Later in the present article, I document the large relative increase in the use of preferred stock from historical levels in conjunction with the railroad reorganizations of the 1870s, 1880s, and 1890s.

58 Poor's Bureau of Information and Investigation, Poor's Manual of Railroads, xcviii–ci.

59 Rodgers, Churchill, “The Corporate Trust Indenture Project,” The Business Lawyer 20 (April 1965): 551–559Google Scholar; Draper, Cecil M., “A Historical Introduction to the Corporate Mortgage,” Rocky Mountain Law Review 2 (Feb. 1930): 71–98.Google ScholarStetson, Francis L., Some Legal Phases of Corporate Financing Reorganization and Regulation (New York, 1917).Google Scholar

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69 Cushing, Harry A., Voting Trusts: A Chapter in Modern Corporate History (New York, 1927), 15.Google Scholar

70 For example, the trust agreement might specify that the trust would be terminated at the end of a fixed period of time, when mortgage bonds (or preferred stock) had received full interest payments over a given number of years, or “until such time as the property gets thoroughly on its feet.” See Harry A. Cushing, Voting Trusts, 19.

71 Cushing, Voting Trusts, 72.

72 Samuel Spring, “Upset Prices in Corporate Reorganizations,” 498.

73 This argument is related to the more general thesis that legal innovations had a direct bearing on the evolution of competition and development. See Horwitz, Morton J., The Transformation of American Law, 1780–1860 (Cambridge, Mass., 1977)Google Scholar and Horwitz, , The Transformation of American Law, 1870–1960: The Crisis of Legal Orthodoxy (Oxford, 1992).Google Scholar In these works, Horwitz traces the development of property rights in the American legal system. He notes how legal innovations were used to promote business competition and economic development through private enterprise. Horwitz also discusses the changing status of the corporation in American political and legal history.

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75 William Carr, Receivers' Certificates, 3.

76 The Commercial and Financial Chronicle, 21 June 1884, 720.

77 Arthur S. Dewing, The Financial Policy of Corporations, 105. Dewing here cites A. W. Machen, Jr., A Treatise on the Modem Law of Corporations (1908).

78 Quoted from Samuel Spring, “Upset Prices in Corporate Reorganizations,” 492, 498. An early case that raises this issue is Munn v. Illinois, 94 U.S. 113, 125 (1876), in which the Court held that holders of conflicting liens could not break apart a railroad and force sale of die separate parts.

79 “Railroad Mortgages as Securities,” Commercial and Financial Chronicle, 26 May 1877, 480.

80 Metcalfe, Lyne S., “Priority over Mortgage of Debts Contracted by Railroad before Receivership,” Central Law Journal 39 (Sept. 1894): 241–244.Google Scholar

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83 Heft's Manual (1916), 1.

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85 See Hurst, James Willard, Law and Markets in United States History (Madison, Wise., 1982), 39–40.Google Scholar

86 The idea of writing contracts that circumvent court enforcement has recently been discussed by economic theorists. See Robert Merton, “No Fault Default: A Possible Remedy for Certain Dysfunctional Consequences of Corporate Leverage,” Unpublished manuscript (1991) and Schwartz, Alan, “Contracting About Bankruptcy,” Journal of Law, Economics & Organization 13 (April 1997): 127–46.CrossRefGoogle Scholar

87 Income bonds fell into disfavor early in the twentieth century, even though federal income taxes, first levied in 1913, favored bonds over stocks. The rights of income bond holders are contingent on accounting results, but firms could manipulate earnings. Railroads could redefine “capital improvements” as “maintenance expenses.” In Union Pacific Railroad Co. v. U.S. 99 U.S. 420 (1878), the court held that the latter reduced the income to which an income bond holder could claim, but the former didnot. Earnings could also be hidden through a variety of transfer prices. For example, the Supreme Court of Georgia found that the Central of Georgia Railroad, which reported five year cumulative earnings of $32.95, actually had earned $1,321,934 and thus had defrauded its income bond holders. See Dewing, Arthur S., “The Position of Income Bonds, as Illustrated by Those of the Central and Georgia Railway,” Quarterly Journal of Economics 25 (May 1911): 397.CrossRefGoogle Scholar Stetson, who was the foremost corporate lawyer of his day and who was known as “Morgan's attorney general,” made clear that the real problem with income bonds was going through the courts to enforce them: “Much litigation in respect of income bonds has arisen because of the disputes as to the computation of earnings … The case of Mackintosh v. Flint ir P. M. R. Co. illustrates the difficulty of determining the amount of net earnings, and the difficulty even greater of finding a judicial officer fully equal to solving the problem.” See Stetson, Francis L., Some Legal Phases of Corporate Financing Reorganization and Regulation (New York, 1917), 69–70.Google Scholar If the goal of the deferred-interest and contingent-charge securities was to reduce court intervention and the uncertainty it created, then income bonds' ultimate failure was that they required courts to enforce their terms.

88 Harry A. Cushing, Voting Trusts, 17.

89 See Albro Martin, “Railroads and the Equity Receivership.”