The financial policy of corporations

Front matter

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Preface

This book is a study of the financial structure and the financial problems of large business corporations. The corporation has been gradually called upon to assume the operation of those business enterprises which require considerable capital and skill of management but which are not comprehensive enough for governmental operation. To this conceptual creature of the law modern society has delegated some of the most important functions of its economic life. And to enable its many members to co-operate with each other and derive the benefits of each other's capital, the fascinating realm of corporation finance has been gradually built up.

The problems connected with this highly artificial realm of corporation finance are intimately connected with great and far-reaching economic and social questions. In the ease with which they effect the transfer of property, corporation securities are a substantial bulwark of an economic democracy; in the ease with which they perpetuate the form without the substance of property ownership, they jeopardize the very existence of an economic democracy. It is such contradictions as this that give to the financial problems of corporations an importance far beyond mere descriptive economics.

It is perhaps not too much to hope that this study will be of value to two groups of persons. There are many business men and bankers who are concerned with finance as a means to a purely practical end — namely that of administering their particular businesses wisely and with broad judgment. If this study helps them to accomplish this practical purpose and to see their daily problems in a wider perspective, it will have served a good end.

It is my hope, too, that this study will help to strengthen college teaching in contemporary economic problems. Amerivi PREFACE

can students are turning, in increasing numbers, to contemporary social and economic courses of study. Those educated in the older humanitarian moulds of thought may regret this change in the students' point of view. Nevertheless, it is present. It cannot be stifled, nor circumvented by the substitution of the study of other peoples and other times. The alert undergraduate of vigorous, virile personality, the best foundation for the making of American men, wants to know how banks are organized, how railways are run, and how the average man one meets on the street is getting a living. These may be very prosaic questions, but they are very vital ones. And the college undergraduate demands — I know this from an intimate teaching acquaintance with many young men in two of our universities — that his college course shall give him a direct and sympathetic appreciation of the foundation upon which rest those great social and economic questions which present themselves in any direction he turns — the newspaper, the periodical, politics, even the banter of the dilettante in social reform.

I have a strong belief that there is no opposition between the theory and the practice of sound finance. As in all other spheres of social activity, good practice is based on sound theory and sound theory has its constant pragmatic justification in successful practice. In their mutual desire to strengthen our economic fabric the practical business man turns more and more to the economist, and the economist feels an increasing sympathy and a greater respect for the constructive genius of modern business activity.

A small, temporary imprint of Volumes I and II was first printed in 19 19 and these volumes are now reprinted with unimportant changes. The last volumes were finished in 1920.

Arthur S. Dewing.

Cambridge, Massachusetts.

Introduction

Finance is the science of money. As the value of money Hes in the value of other things for which it is exchanged, any transaction in which goods or services are given for money, might be called a financial operation. The term "finance," however, broad as would be its most general definition, is ordinarily narrowed to embrace only a study of the principles and the methods of obtaining control of money from those who have saved it, and of administering it by those into whose control it passes. The term is employed usually in connection with relatively large transactions, in which there may have been difficulty in bringing together the requisite amount of money, or in which a number of different parties are concerned. Regarded, indeed, as a science or a body of scientifically related facts, finance has come to refer to large capitalistic undertakings whether conducted by a government or its political subdivision, or by an individual or group of individuals.

The science of finance may be conveniently divided into public finance and private finance. The former deals with the methods of securing money for the conduct of government and the administration of the public funds; the latter with the methods of securing money for private, usually gainful, enterprises and the administration of this money by individuals, corporations, and voluntary associations. The two fields are distinct. In the former, money is spent so that it may yield, ostensibly, the greatest value for the members of the community; while in the latter the money is spent so that it will yield, ostensibly too, the greatest ultimate profit to those who contributed it. The point of view is different throughout, although there is this in common, that in each case the ultimate economic sanction is the largest value with the least viii INTRODUCTION

waste, and the ultimate ethical sanction is justice to all concerned.

Private finance in its turn may be further subdivided into various departments, such as personal finance, partnership finance, and corporation finance. From another point of view it may be subdivided according to the kind of industry for which the money is gathered— banking finance, railroad finance, public utility finance, industrial finance, or mining finance. The present book is concerned wholly with private finance, and especially with those financial operations carried on by the modern economic unit known as the business corporation.

The primary purpose of the present work is to describe the financial processes of corporations. Without attempting to formulate a legal or historical definition, a corporation may be described as an organization sanctioned by government to carry on some specific and clearly defined undertaking. The corporation is considered as separate from its members; it is capable of expressing purposes and ideals of its own, of owning property, of contracting debts, of suing and being sued — all in its own name without in any way involving its incorporators, officers, directors, or shareholders. In these respects corporations are to be distinguished from partnerships and purely voluntary associations involving the individual responsibility of their members.

Speaking in general terms, corporations may be divided according to their main purpose into those existing for an altruistic or ideal purpose, such as churches, colleges, and scientific societies; and those existing for an economic purpose, the business corporations, such as railroads, banks, and gas works. The term "corporation finance" includes, specifically, the financial transactions of the latter group.

Corporation finance deals with both fact and policy. It is concerned with fact, in so far as it describes the prevailing

INTRODUCTION ix

customs and methods which are employed in the financial administration of the modem corporation; it deals with policy, in so far as it succeeds in formulating principles or rules of expediency which may serve as guides to sound financial procedure. The two should be distinguished. For example, that short-term notes have been issued extensively by railroads since 1910 as a means of securing money from investors, is a plain fact about which there can be no dispute. That such a course has been inexpedient and should not be continued, is a judgment of policy over which there may be a dispute. One is a clear statement of empirical fact, and the other a statement of financial policy. Both kinds of statement find places in a science of finance. Yet care must be exercised to distinguish between them, for the former is objectively true, while the latter is significant only as the product of mature generalizations, based on grounds of economic expediency. As in all other branches of the social sciences, what purports on its face to be an inductive principle, turns out on analysis to represent merely a summary statement of a limited, though extensive, area of experience.

The assumption that business corporations as a class are organized and conducted primarily for profit, does not obscure the still more important fact that in receiving a profit, all private corporations must serve a public end. The railroads were built originally by money collected from men who hoped to obtain large profit through their operation. Nevertheless the railroad has wrought a veritable social and economic revolution, welding into a coherent industrial unity the peoples of widely separated geographical regions. Built by private means, and administered by private agencies, the railroads, the electric light companies, the gas works, were conceived primarily to yield a profit; yet this profit was possible only so long as they served real human need. This is the presupposition of the social justice of private property.

X INTRODUCTION

Empirical facts and theoretical psychology both substantiate the belief that individtial initiative, personal ambition, and even the primitive passion of conquest, are forces which are necessary to produce the greatest efficiency of economic production with the least waste of social capital. The difficulty about the modern practice of this theory lies in the inadequacy of the quantity of capital that can be devoted by a single individual or group of individuals to a single enterprise. Yet economic progress, since the industrial revolution, has depended more and more on increasing the quantity of capital at the command of a single enterprise. The capitalization of the Pennsylvania railway system is close to a billion dollars; that of the New York Central system is the same — an amount of capital inconceivable for a private enterprise to command a century or even half a century ago. The all-important economic problem of the last hundred years has been to secure the initiative and coherence, the force of individual ambition with its attendant responsibility, that goes with the private conduct of enterprise, and at the same time secure to the private managers the necessary capital to carry on vast and expensive undertakings. In brief, it has been the problem of retaining the force and responsibility of private business without the limitations of private capital.

The problem has been solved by the corporation.^ The officers and directors of the corporation retain the responsibility of private effort, the stockholders furnish the capital in unlimited amounts. Although merely an immaterial form, it has nevertheless wielded an economic and social influence greater than any other purely conceptual entity of the last century. The contribution of the corporation to the evolu-

*The books and monographs on the development and economic significance of toe corporation have been legion. See particularly for legal aspects Baldwin, S. E in Two Centuries' Growth of American Law (Yale Bicentennial Series [igoi], and for brief account of early American corporations, Davis, J. S., Charters for American Business Corporations in the Eighteenth Century. 15 Jour. Am. Stat. Assn 426 (1916).

INTRODUCTION xi

tion of the form of modern industry has been no less potent than that of machinery to its technique.

Aside from the form of the corporation itself, as a conceptual entity, three wide-spread influences have tended to accentuate the importance of corporation finance. These are the broader distribution of wealth among small capitalists, the increasing public responsibilities which private corporations assume as they increase in size and influence, and lastly the widening breach between the persons who save capital, that is to say, the capitalistic forces of society, and the managers of business enterprise, that is to say, the entrepreneurs.

The extent to which the Fourth Liberty Loan was subscribed throughout the country was a revelation to most economists of the potential saving power of the workers, the small farmers, the shopkeepers, in fact the great body of American men and women whose individual margin between receipts and expenditures is ordinarily small. True, the Great War has very much increased the margin of the ordinary worker, farmer, and small entrepreneur, nevertheless the latent power of saving has been present to a far larger and wider extent than anybody realized, even the observant student of contemporary economic conditions. Much of this vast fund of the small savers has been finding its way into the economic current through the instrumentality of co-operative banks, savings banks, and life insurance companies, so that the ultimate origin of the savings has not been at first sight clear. Statistics show, however, that the real owners of the railroads of this country are the life insurance companies and the small national, state, and savings banks; and the real owners of these institutions are the thrifty wage earners, shopkeepers, farmers, and country merchants.

The means of the economic development in this country have come, as in England, France, and Holland, from the wide-spread thrifty, industrial, middle class. The United xii INTRODUCTION

States Steel Corporation has over a hundred thousand individual stockholders, the Pennsylvania Railroad and the American Telephone and Telegraph have fifty thousand each; beyond this number there are the millions of creditors of the life insurance companies and savings banks whose contributions have made possible the enormous bonded issues of those corporations. Sporadic cases exist of large capitahsts. The large merchants and large banks use their own resources. But the resources of even such concerns are insignificant compared with the aggregate of the small savers of the country to whom the accumulation of capital is merely incidental to the every-day planning of life. This fact explains why there is no capitalist class, for the great industries of this country are owned by the people. It explains, also, why our unstable economic life produces so little of individual permanency — and yet so great permanency of our fundamental economic institutions. All this is possible because wealth has assumed the form of corporation securities instead of titles to land.

Another cause for the increasing importance of corporation finance lies in the influence wielded by the great private corporations in our economic and social organization. Soon after the United States entered the Great War it was realized that one of the essential elements to our success was an efficient transportation system. Because of the narrow vision and still narrower understanding of men who composed the Interstate Commerce Commission, the railroads had not been allowed to increase their rates in proportion to the costs of operation. Consequently, their earnings had declined and with their earnings their credit. As a result, the railroads had been unable to improve their plants in proportion to the demands of our widening economic activities, so that when the crucial test of the war came, the railroads were — quite as disastrously as the various departments of the government — unprepared for the test.

INTRODUCTION xiii

The railroads are by no means the only great corporations essential to our national life. When the Westinghouse Electric and Manufacturing Company failed in 1907, creditors, co-operating with the receivers who acted under instructions from the court, sought every means to rehabilitate the corporation. The business interests of the country required the active existence of this concern, because it was then the second largest manufacturer of electric equipment in the country. The ideas of eminent domain, of the inviolability of franchise contracts, of regulated monopoly as applied to public service enterprises — all testify to the important place which these enterprises occupy in our modern life. The telephone system, the gas works, the electric light and power company, and the street railroad, are all private corporations of varying size whose activities are indissolubly bound up with the industrial hfe of their communities.

These two aspects — the widening ownership of the corporation and the widening public concern in its success — have developed together. The success or failure of a business conducted by a single individual or a group of individuals is not of wide pubhc interest. Thousands of small businesses fail every year without the fact being noted except in the tables of the credit statistician. The big businesses, with their legions of stockholders, are big because of wide-spread ownership, and of the public concern which such business activity entails. It is this interaction between increasing size with its increasing number of stock- and bondholders and an increasing public importance, which is one of the most significant elements in contemporary economic history.

And these changes have been concurrent with a growing divergence between the owners and the operators of these large corporate enterprises. The economist has long since distinguished between the parts which management and capital play in industry, though he has failed to recognize the fact that xiv INTRODUCTION

this separation has applied in practice only to large businesses. In small industries the separation is difficult and inexpedient: the farmer is both owner and operator of his farm ; the pharmacist owns and operates his comer drug store; the local country butcher owns his shop, slaughters his cattle, and sells his meat. But as enterprises increase in size and scope, the operators find themselves able to employ profitably more capital than they individually can command. Then they are ^'backed" by others — first wealthy friends, then the local community, then the great army of small savers who live on less than they produce. In the same way, the first bankers in the rich Italian cities of the Po Valley seven centuries ago were business men who participated in the maritime ventures of others, and somewhat later the first English banks were the goldsmith companies which owned and loaned their gold. As wealth increased on the one hand and business specialization on the other, men who had little if any capital, but marked ability, were led to assume the management of enterprises built with capital furnished by others.

Under the simpler economic conditions of earlier times, when the owner and the manager were one, finance was comparatively simple. But now with a constantly increasing diversification in the elements of a business, the financial methods of the proprietor-manager have given place to others which are increasingly complex.

The field of corporation finance has been progressively widened, following the changes in the form under which industries are conducted. From 1830 to 1890 railroads and banks were the only great industries requiring the use of large amounts of capital and hence requiring, of necessity, the corporate form of organization. Therefore, the financial terms, methods, and policies connected with the new form became established in railroad finance before they were carried over into othefSndustries. Just prior to the panic in 1893, however,

INTRODUCTION xv

manufacturers conceived the idea of organizing their competitive businesses into large units for which new capital could be secured from public subscribers. Family businesses and partnerships of several generations were changed into corporations, and these in turn merged into great industrial consolidations. And concurrently the financial practices were transformed to agree more nearly with the established practices of railroad finance. It is this entire body of precedents, practices, policies — based on accident, on law, and on past expediency, and applying to all kinds of corporations — which forms the substance of corporation finance.

This work is divided into five volumes. The first deals with the form of securities likely to be issued by a corporation. The second traces the embryonic development of a corporate enterprise through the period of organization, or promotion. A third discusses various problems arising from the financial administration. A fourth section describes the methods which may be pursued in obtaining the money necessary to expand a corporation and the forms which this expansion may take. And the fifth and last section is concerned with the failures of business enterprises and the various means to be employed to rehabilitate a bankrupt corporation. The volumes are interrelated ; no single phase of corporation finance is complete in itself.

Contents

Volume I — Corporate Securities

I Capitalization and Common Stocks 3

Elemental conceptions of capital, 3; Economic capital, S ; Capitalization, 5 ; Capital stock, 6 ; Two types of capital stock, 7; Certificates of association, 9; Massachusetts trusts, II ; Certificates of part ownership, 13; Stock without par value, 13; Assessment, 16.

Chapter I

Elemental conceptions of capital, 3 ; Economic capital, 5 ; Capitalization, 5; Capital stock, 6; Two types of capital stock, 7; Certificates of association, 9; Massachusetts trusts, 11; Certificates of part ownership, 13; Stock without par value, 13; Assessment, 16.

The securities which a corporation may issue consist of two general types: stocks and bonds. Their characteristics, rules, etc., will be discussed in detail in the succeeding chapters of this voliune. Here it is advisable to consider first the general subject of capital and capitalization.

The elemental conception of finance, is capital. The word "capital" has been used, unfortunately, in such a variety of senses that it is now meaningless outside of its context. As a conception of economic theory it has been defined, interpreted, and reinterpreted according to the training or whim of the economist. As a conception of accounting, it has been variously conceived as an asset or a liability, as property or merely an equity. In our common speech it has come to imply a variety of meanings all vaguely in accord with the variety of views current in the business world.

From the point of view of the theoretical economist, trained in the positivism of Smith, Mill, and Cairnes, capital means one thing, namely, the material goods created through the labor of man which are devoted to the production of wealth. The term "capital" designates both material goods made by men, and society's instruments of production. With this theoretical definition we are not here concerned, except to comment that all other conceptions of capital are ultimately based on this description; a-U other conceptions presuppose the three elements — labor, material goods, and productiveness — involved in the definition used by the classical economists.

We are here concerned with the term "capital" as used in business, together with two related terms expressive of different aspects of the fundamental idea of property value: namely, "capitalization," and "capital stock." By "capital" is meant — in ordinary usage — the actual property devoted to some productive end.^ It is the substance of the business. In some cases it is convenient to distinguish between gross and net capital, the former referring to the investment of the proprietors plus their borrowed capital and the latter to the proprietors' own capital alone.^ At all events the word "capital" must be used to refer to actual physical goods, the muscle and the sinew of economic production.

The terms "capitalization" and "capital stock" are representative. They refer not to physical goods, but to the values set over against the actual capital of the business. They are of accounting or representative significance; they stand for the liabilities of a business and not its assets.^ Capitalization is the sum of the various values by which the proprietary interests of a corporation care to evaluate the actual capital. That portion of the total capitalization of a business which they, the proprietors, claim represents their own personal

^ Two modern writers dealing with capital from tlie same point of view as id tiiis book have said, "Capital assets are all those funds, properties and equipment required for continuous, productive use." Cleveland and Powell, Railroad Finance, 322 (1912).

' Ripley uses the term "gross capital" to refer to an aggregate of funded liabilities where there has been no effort made to avoid duplications,_ and "net capital" to the sum of such liabilities where all duplication has been avoided. Ripley, W. Z., Railroads Finance and Organization, 61 (1915). This distinction is of the utmost importance in railroad finance, and recent public utility finance.

^ A great deal has been written from the different points of view of economic theory, finance, and accounting in the effort to distinguish between and define the different uses of the concept of capital and its derivatives. See particularly Cleveland and Powell, Railroad Finance, Chap. Ill and XVII (1912); Ripley, W. Z., Railroads, Finance and Organization, Chap, 11 (1915). Every treatise on economics feels compelled to discuss the question, but few shed much illumination.

Among the books on corporation finance, strictly speaking, the most exhaustive discussions are found in Lyon, W. H., Capitalization (1912), whose main efforts are directed toward clarifying our usage of these words. See also discussion in Cooper, P., Financing an Enterprise, Part IV (1915).

capital, they call "capital stock"; that portion which they admit is borrowed from others, they call "debt." In brief then, and as used hereafter in these pages, "capital" refers to the actual wealth employed in an undertaking, and "capitalization" to the representation of this wealth in terms of purely artificial and, in the end, fictitious values.* A part of these representative values, namely those contributed by the proprietors, is designated "capital stock"; and the other part, that contributed by outsiders, is spoken of as "debt."

In a single-proprietor business, or even in a partnership, capital is the total of assets of the business. In concrete cases it is determined from an inventory of the actual property owned by the proprietor or the partnership. In businesses conducted by corporations, this simple way of ascertaining capital cannot be used, owing to the necessity of establishing a balance between the assets and the liabilities. The capital is not the aggregate of assets, because the apparent assets are generally inflated by fictitious bookkeeping entries, such as bond discount or the various balances from contingent reserve accounts. It is, on the contrary, the actual or real wealth values used by the corporation — those which have a positive and marketable value. That is, it is the amount of economic goods segregated by the corporation for its own purposes."*

The term "capitalization," or the valuation of the capital.

* Ripley makes the same distinction: "The property brought into being as capital remains forever entirely distinct from its capitalization, albeit linked in a causal relation thereto. Capital is reality. Capitalization is merely a record of past operation and a bench mark or standard of measurement for the future.' Eipley, W. Z., Railroads, Finance and Organization, 55 (igiS)-

= There are two distinct uses of the word "capital," both accepted by business men One refers to the total property employed in a business, irrespective of its final ownership, and the other to the amount actually owned by the proprietary interests Thus an individual or a corporation takes $100,000 of its own money and borrows $200,000 more, investing the entire amount in a plant, its equipment, and a stock of merchandise. It is possible to refer to the capital as either $300,000 or $100 000, according to whether one follows the first or the second usage. In the present discussion the first usage is followed as more consonant both with current business practice and with the idea of capital as expressed by sound economic theory.

includes the capital stock and the debt. In individual proprietary and partnership businesses the term has no significance, as there is no occasion to represent the capital of a business other than in terms of actual property. But with the corporation the matter is entirely different. The corporation is conceived to be the recipient of a fixed amount of property which remains constant, no matter what the fortunes of the business. This is the capital stock. In addition, the corporation borrows money from outside sources. The sum of these amounts represents the securities or the representative values issued against the actual capital employed in the business. In a concrete case it is often difficult to determine the exact amount of capitalization, because much corporate debt represents merely temporary borrowings more or less completely offset by an ever-changing volume of current assets. The idea, however, of capitalization is that it shall represent the capital stock and the permanent or funded debt. It is the total securities or representative values issued by the corporation against its actual property."

Capital stock, common stock, or merely stock, represents invariably the interests of the proprietors in the corporate enterprise. In no sense can stock represent an outside claim; in no sense can the stockholder regard himself as a creditor.^

^ It is very difficult to determine the capitalization of a railroad. While in a simple case it may be fixed by adding together its capital stocks and its bonds one is always perplexed by a variety of other liabilities. In some railway systems, like the Lackawanna, the rentals must be capitalized. In others, like the New Haven, the current debt must be included, as this current debt was incurred in order to construct permanent additions to the property of the road. On the other hand, there must be various adjustments for joint bonds, collateral trust bonds issued on proprietary lines, and all contingent liabilities, as in the case of the Great Northern, Northern Pacific collateral trust joint bonds. For example, Ripley questions to the length of an appendix, the extreme difficulty of proportioning the capitalization of jointly owned termmal roads.^ Ripley, W. Z., Railroads, Finance and Organization, 609 (1915). In actual practice, great care must be .exercised in any given case and no general rule can be laid down as to what liabilities to include and what not to include in determining the net capitalization of any railroad.

' This distinction is sometimes obscursd by such anomalous cases as redeemable stock and participating bonds. Yet, as clearly brought out in the American Malting and later cases, the distinction is still recognized by the law of corporations and is fundamental to corporation finance.

The fundamental idea of stock is that it represents the proportionate contribution to the original capital or property of the corporation. Stock is the share of interest, the share of responsibility of management, and the share of profit or loss.* So far as the complexity of modern business permits, the stockholder is the business partner of the old-fashioned partnership, but lacking certain of the legal implications attending the position of partner. Unfortunately this original simplicity has been modified by the demands of the increasingly complex financial organization of business, so that in many forms of stock this original simplicity of motive is obscured or almost entirely obliterated.