with their rivals; anxiously scanning the commercial horizon for signs of business depression, crop failures, famines, or labor disturbances; hoping and scheming for a few crumbs of subsidy, to introduce a modicum of fixed income into their earnings; engaged in a business as shifting and unstable as the sea on which that business is conducted - is it any wonder that the experienced ship-owners hold fast to their profits and regard the results of a year like 1900 as a gift of Providence to be guarded with zealous care?

Into this peculiar business came the promoters of the International Mercantile Marine Company. Attempting to apply to the shipping industry, the same principles of consolidation and capitalization which had been superficially successful on land, they imposed upon the new corporation an unusually heavy burden of capitalization, and they so arranged the capitalization as to make conservative financial management of the new company very difficult. The purchase price of most of the subsidiary companies was based on the profits of 1900. In the vendors' agreement between the syndicate and the White Star line, for example, it was stated that

the valuation of the said shares hereunder and under said principal contract shall, subject as hereafter provided, be a sum equal to ten times the net profits of the company of the year 1900, subject to the following exceptions . . . (a) a sum for depreciation equal to 6 per cent on the amounts at which the property of the company stood on its books on the first day of January, 1900, and a sum for insurance £3 10s. on the same amount

1

equal to

...

It was further stipulated that the earnings of steamships employed by the British government should "be credited . . . with net earnings of the same amount as were earned or would be earned by similar steamships of the company for the same periods in their ordinary trades."

The year 1900, as has been shown, was one of abnormal profits. The Cunard Company nearly doubled its net earnings, and it is reasonable to suppose that other companies were equally

1 For the text of these vendors' agreements, see Report of the U. S. Commissioner of Navigation, 1902, Appendix T, pp. 380 et seq.

fortunate. A partial record of the prosperity of this year is furnished by the record of dividends. The average dividend of twenty-five leading companies in 1896 was 6 per cent; in 1898, 7.7 per cent; and in 1900, 9.4 per cent. In the extract from the vendors' agreement quoted above, we find a recognition of the fact that the profits of 1900 were exceptional, viz., the provision reducing the earnings of ships employed in the government service to the general average of private employment. This reservation, however, does not go far enough. The mere fact of a large government employment, as has been shown, was sufficient to heavily increase the earnings of ships in private employment, and in capitalizing the earnings of this single year, the promoters of the Shipping trust made a serious mistake.

Indeed, so apparent was the mistake, and so clearly did the trade foresee that reaction was impending, that this fact was openly urged upon the shareholders by the Leyland line as an inducement to fall in with Mr. Morgan's plans. Said Mr. Ellerman, in May, 1901, at the shareholders' meeting of Frederick Leyland and Company:

The outlook for freights in the near future is, in my judgment, an uncertain one. We have had prosperous times, and I feel that the near future may bring, at all events for a time, a reflux of bad times, particularly when the tonnage which is usually employed in the North Atlantic trade, but which is now employed in government transport work, returns to normal employment; in addition to which a large amount of tonnage is building in America for employment in the Atlantic trade . .

1

Not only was the amount of capitalization excessive, but what was more important, the arrangement of the capital of the Shipping trust, taken in connection with the amount of the different issues, was open to serious criticism. In addition to an amount of bonds fully sufficient to absorb the maximum earnings of the company, a liability of $54,600,000 of cumulative preferred stock was assumed, all of whose passed dividends must be paid before the common stock receives anything. Our previous discussion has shown the shipping business to be so irregular that even with

1 Report of Commissioner of Navigation, 1901, p. 321.

the most moderate capitalization, in some years dividends must be passed, and in other years paid out of reserve. At all times, the directors should have a free hand in determining whether profits shall be distributed to stockholders, used for replacements and depreciation, invested in securities, or held in cash. The irregularity of the business is so great, that a free disposition of profits to stockholders is out of the question. The policy of a well-managed shipping company is dominated by the necessity of reserving from two-thirds to three-fourths of the profits in order that one-fourth may be paid out in dividends. In view of this fact, the absolute amount of the Shipping trust's capitalization is of much less consequence than the nature of the liabilities which it includes. The fact that the company is excessively capitalized is of less consequence than the fact that the arrangement of this capitalization is such as to make prudent financial administration very unpopular with stockholders. In this arrangement, fixed charges and obligatory payments predominate. Of the $170,600,000 of capital, $122,600,000 consist of bonds and cumulative preferred stock. If the debenture interest is passed, while the form of the bonds puts foreclosure proceedings out of the question, the unpaid interest must be discharged before anything is paid on the preferred stock; and if the preferred stockholder is forced to await the convenience of the corporation, the hope of the common stockholder of receiving anything on his investment becomes remote. In other words, a conservative administration of the finances of the shipping consolidation involves a series of postponements, an accumulation of deferred claims. The collection of a reserve sufficient to pay dividends in years of depression, if we may judge from the experience of other companies capitalized on a basis similar to that of International Mercantile Marine, is likely to be seriously interfered with by the importunities of deferred claimants.

It would be going too far to say that the International Mercantile Marine Company is a failure. Its future lies in the hands of the stockholders. If they will sanction a policy of conservatism in the distribution of earnings there is no reason to suppose that the preferred stock of the company may not eventually be raised to the rank of an investment. The unfortunate experience of

the corporation up to the present time, however, emphasizes the fact that it is necessary, in arranging the capitalization of a new company, to take into careful account the conditions of the business in which the new concern is to operate, and in every case to assume that industrial history is to be repeated. The "economies of combination" are no doubt considerable, but they are too problematical to be safely included in an estimate of earnings available for distribution to stockholders.

EDWARD SHERWOOD MEADE.

VII

THE CAPITALIZATION OF PUBLIC-SERVICE

CORPORATIONS1

XAMINATION of the statutes and the judicial decisions of our American commonwealths reveals, aside from those cases where no definite policy has ever been entertained, two distinct theories as to the proper basis for capitalization of corporations. One is that the total amount of stock and bonds issued should stand in a definite relation to the actual investment of capital in the enterprise.The other is that capitalization should be based upon earning capacity alone, let the source of such revenue power be what it may,-property, patents, franchises, or mere good will. Under the first policy, an enterprise to be capitalized at $1,000,000 must represent that sum of money paid in at some time, either as cash or an equivalent in tangible property. This is the policy consistently followed in Massachusetts, and somewhat less stringently perhaps in Connecticut.3 Five years ago a reform in this direction was seriously proposed for New York, although little seems to have been actually accomplished.4

The second policy presupposes that, at a market rate of 6 per cent, an earning capacity of $60,000 per year is properly capitalizable at $1,000,000, be the actual investment what it may. The franchise or the good will, it is contended, can be sold for valuable consideration. In the eyes of the law it is property

1 From the Quarterly Journal of Economics, Vol. XV, 1900, pp. 106-137.

2 For the purposes of this article both stock and bonds are alike classed as capital. Cf. the reasoning in Statistics of Railways in the United States, 1888, p. 13. The inclusion of floating debt is variously viewed in different states.

3 In Connecticut, until recently, special legislation, especially in the case of street railway corporations, prevailed. For this reason the general laws mean but little, save for those traction companies organized since 1893.

A special committee of the Assembly reported in favor of limiting capitalization to one and one-half times the cost of construction.