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onds, this figure must be $5,000,000. There are further provisions to the effect that the size of the bond issue itself must be not less than $1,000,000 for gas and electric companies, and not less than $5,000,000 in the case of telephone obligations. Some Criticisms of These Requirements. The figures of minimum gross receipts do not appear well chosen from the standpoint of bond invest- ment in general. The distinctions as to population requirements would scarcely appeal to investors throughout the country. The alternative tests for railroads, based on either mileage or revenues, are confusing and unnecessary. The $10,000,000-gross requirement by itself is too high; it would have eliminated, for example, the Bangor and Aroostook Railroad, one of the few lines to make a satisfactory exhibit during the 1930–1933 depression as well as before. Equally unwarranted is the requirement of $5,000,000 gross for telephone concerns, as against only $1,000,000 for gas and electric utilities. This provision would have ruled out the bonds of Tri-State Telephone and Telegraph Company prior to 1927, although they were then (and since) obligations of unquestioned merit. We believe that the following proposed requirements for minimum size, although by necessity arbitrarily taken, are in reasonable accord with the realities of sound investment: Minimum Requirement of Size Municipalities 10,000 population Public-utility enterprises $2,000,000 gross Railroad systems $3,000,000 gross Industrial companies $5,000,000 gross Industrial Bonds and the Factor of Size. Since industrial bonds are not eligible for savings banks under the New York law, no minimum size is therein prescribed. We have expressed the view that industrial obliga- tions may be included among high-grade investments provided they meet stringent tests of safety. The experience of the past decade indicates that dominant or at least substantial size affords an element of protection against the hazards of instability to which

companies $5,000,000 gross Industrial Bonds and the Factor of Size. Since industrial bonds are not eligible for savings banks under the New York law, no minimum size is therein prescribed. We have expressed the view that industrial obliga- tions may be included among high-grade investments provided they meet stringent tests of safety. The experience of the past decade indicates that dominant or at least substantial size affords an element of protection against the hazards of instability to which industrial enterprises are more subject than are railroads or public utilities. A cautious investor, seeking to profit from recent lessons, would apparently be justified in deciding to confine his purchases of fixed-value bonds to perhaps the half dozen lead- ing units in each industrial group, and also perhaps in adding the sug- gested minimum requirement of $5,000,000 annual sales. Such minimum standards may be criticized as unduly stringent, in that if they were universally applied (which in any event is unlikely) they would make it impossible for sound and prosperous businesses of mod- erate size to finance themselves through straight bond issues. It is con- ceivable that a general stabilization of industrial conditions in the United States may invalidate the conclusions derived from the extreme variations of the past ten years. But until such a tendency in the direction of stabil- ity has actually demonstrated itself, we should favor a highly exacting attitude toward the purchase of industrial bonds at investment levels. Large Size Alone No Guarantee of Safety. These recommenda- tions on the subject of minimum size do not imply that enormous dimen- sions are in themselves a guarantee of prosperity and financial strength. The biggest company may be the weakest if its bonded debt is dispropor- tionately large. Moreover, in the railroad, public-utility, and municipal groups, no practical advantage attaches to the very largest units as com- pared with those of medium magn

of industrial bonds at investment levels. Large Size Alone No Guarantee of Safety. These recommenda- tions on the subject of minimum size do not imply that enormous dimen- sions are in themselves a guarantee of prosperity and financial strength. The biggest company may be the weakest if its bonded debt is dispropor- tionately large. Moreover, in the railroad, public-utility, and municipal groups, no practical advantage attaches to the very largest units as com- pared with those of medium magnitude. Whether the gross receipts of an electric company are twenty millions or a hundred millions has, in all probability, no material effect on the safety of its bonds; and similarly a town of 75,000 inhabitants may deserve better credit than would a city of several millions. It is only in the industrial field that we have suggested that the bonds of a very large enterprise may be inherently more desir- able than those of middle-sized companies; but even here a thoroughly satisfactory statistical showing on the part of the large company is neces- sary to make this advantage a dependable one. Other Provisions Rejected. The New York statute includes an addi- tional requirement in respect to unsecured railroad bonds, viz., that the net earnings after interest charge must equal $10,000,000. This does not appear to us to be justified, since we have previously argued against attaching particular significance to the possession or lack of mortgage security. There is a certain logical fallacy also in the further prescription of a minimum size for the bond issue itself in the case of public utilities. If the enterprise is large enough as measured by its gross business, then the smaller the bond issue the easier it would be to meet interest and prin- cipal requirements. The legislature probably desired to avoid the inferior marketability associated with very small issues. In our view, the element of marketability is generally given too much stress by investors; and in this case we do

also in the further prescription of a minimum size for the bond issue itself in the case of public utilities. If the enterprise is large enough as measured by its gross business, then the smaller the bond issue the easier it would be to meet interest and prin- cipal requirements. The legislature probably desired to avoid the inferior marketability associated with very small issues. In our view, the element of marketability is generally given too much stress by investors; and in this case we do not favor following the statutory requirement with respect to the size of the issue as a general rule for bond investment. Chapter 10 SPECIFIC STANDARDS FOR BOND INVESTMENT (Continued) THE RELATION OF THE VALUE OF THE PROPERTY TO THE FUNDED DEBT In our earlier discussion (Chap. 6) we pointed out that the soundness of the typical bond investment depends upon the ability of the obligor cor- poration to take care of its debts, rather than upon the value of the prop- erty on which the bonds have a lien. This broad principle naturally leads directly away from the establishment of any general tests of bond safety based upon the value of the mortgaged assets, where this value is consid- ered apart from the success or failure of the enterprise itself. Stating the matter differently, we do not believe that in the case of the ordinary corporation bond—whether railroad, utility, or industrial—it would be advantageous to stipulate any minimum relationship between the value of the physical property pledged (taken at either original or reproduction cost) and the amount of the debt. In this respect we are in disagreement with statutory provisions in many states (including New York) which reflect the traditional emphasis upon property values. The New York law, for example, will not admit as eligible a gas, electric, or telephone bond, unless it is secured by property having a value 662/3% in excess of the bond issue. This value is presumably book value, which either may be the or

cal property pledged (taken at either original or reproduction cost) and the amount of the debt. In this respect we are in disagreement with statutory provisions in many states (including New York) which reflect the traditional emphasis upon property values. The New York law, for example, will not admit as eligible a gas, electric, or telephone bond, unless it is secured by property having a value 662/3% in excess of the bond issue. This value is presumably book value, which either may be the original dollar cost less depreciation or may be some more or less artificial value set up as a result of transfer or reappraisal. Special Types of Obligations: 1. Equipment Obligations. It is our view that the book value of public-utility properties—and of railroads and the typical industrial plant as well—is no guidance in determining the safety of the bond issues secured thereon. There are, however, vari- ous special types of obligations, the safety of which is in great measure [180] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. dependent upon the assets securing them, as distinguished from the going-concern value of the enterprise as a whole. The most characteris- tic of these, perhaps, is the railroad-equipment trust certificate, secured by title to locomotives, freight cars, or passenger cars, and by the pledge of the lease under which the railroad is using the equipment. The invest- ment record of these equipment obligations is very satisfactory, particu- larly because until recently even the most serious financial difficulties of the issuing road have very rarely prevented the prompt payment of inter- est and principal.1 The primary reason for these good results is that the specific property pledged is removable and usable by other carriers. Con- sequently it enjoys an independent salable value, similar to automobiles, jewelry, and other chattels on which personal loans are made. Even where there might

obligations is very satisfactory, particu- larly because until recently even the most serious financial difficulties of the issuing road have very rarely prevented the prompt payment of inter- est and principal.1 The primary reason for these good results is that the specific property pledged is removable and usable by other carriers. Con- sequently it enjoys an independent salable value, similar to automobiles, jewelry, and other chattels on which personal loans are made. Even where there might be great difficulty in actually selling the rolling stock to some other railroad at a reasonable price, this mobility still gives the equipment obligation a great advantage over the mortgages on the railroad itself. Both kinds of property are essential to the operation of the line, but the railroad bondholder has no alternative save to permit the receiver to oper- ate his property, while the holder of the equipment lien can at least threaten to take the rolling stock away. It is the possession of this alter- native which in practice has proved of prime value to the owner of equip- ment trusts because it has virtually compelled the holders even of the first mortgages on the road itself to subordinate their claim to his. It follows that the holder of equipment-trust certificates has two sep- arate sources of protection, the one being the credit and success of the bor- rowing railway, the other being the value of the pledged rolling stock. If the latter value is sufficiently in excess of the money loaned against it, he may be able to ignore the first or credit factor entirely, in the same way as a pawn-broker ignores the financial status of the individual to whom he lends money and is content to rely exclusively on the pledged property. The conditions under which equipment trusts are usually created sup- ply a substantial degree of protection to the purchaser. The legal forms are designed to facilitate the enforcement of the lienholder’s rights in the event of nonpayment. In pra

the money loaned against it, he may be able to ignore the first or credit factor entirely, in the same way as a pawn-broker ignores the financial status of the individual to whom he lends money and is content to rely exclusively on the pledged property. The conditions under which equipment trusts are usually created sup- ply a substantial degree of protection to the purchaser. The legal forms are designed to facilitate the enforcement of the lienholder’s rights in the event of nonpayment. In practically all cases at least 20% of the cost of the equipment is provided by the railway, and consequently the amount of the equipment obligations is initially not more than 80% of the value 1 See Appendix Note 17, p. 744 on accompanying CD, for information on the investment record of such issues. of the property pledged behind them. The principal is usually repayable in 15 equal annual installments, beginning one year from issuance, so that the amount of the debt is reduced more rapidly than ordinary depre- ciation would require. The protection accorded the equipment-trust holder by these arrange- ments has been somewhat diminished in recent years, due partly to the drop in commodity prices which has brought reproduction (and there- fore, salable) values far below original cost, and also to the reduced demand for equipment, whether new or used, because of the smaller traf- fic handled. Since 1930 certain railroads in receivership (e.g., Seaboard Air Line and Wabash) have required holders of maturing equipment obli- gations to extend their maturities for a short period or to exchange them for trustee’s or receiver’s certificates carrying a lower coupon. In the unique case of one Florida East Coast Railway issue (Series “D”) the receivers permitted the equipment-trust holders to take over and sell the pledged equipment, which seemed to have been less valuable than that securing other series. In this instance the holders realized only 43 cents on the dollar from the sale and

lders of maturing equipment obli- gations to extend their maturities for a short period or to exchange them for trustee’s or receiver’s certificates carrying a lower coupon. In the unique case of one Florida East Coast Railway issue (Series “D”) the receivers permitted the equipment-trust holders to take over and sell the pledged equipment, which seemed to have been less valuable than that securing other series. In this instance the holders realized only 43 cents on the dollar from the sale and have a deficiency judgment (of doubtful value) against the road for the balance. These maneuvers and losses sug- gest that the claim of “almost absolute safety” frequently made in behalf of equipment issues will have to be moderated; but it cannot be denied that this form of investment enjoys a positive and substantial advantage through the realizability of the pledged assets.2 (This conclusion may be supported by a concrete reference to the sale in November 1939 of Chicago and North Western new Equipment Trust 21/2s, due 1940–1949, at prices to yield only from 0.45 to 2.35%, despite the fact that all the mortgage issues of that road were then in default.) 2. Collateral-trust Bonds. Collateral-trust bonds are obligations secured by the pledge of stocks or other bonds. In the typical case, the collateral consists of bonds of the obligor company itself, or of the bonds or stocks of subsidiary corporations. Consequently the realizable value of the collateral is usually dependent in great measure on the success of the enterprise as a whole. But in the case of the collateral-trust issues of investment companies, a development of recent years, the holder may be said to have a primary interest in the market value of the pledged 2 See Appendix Note 18, p. 747 on accompanying CD, for comment and supporting data. securities, so that it is quite possible that by virtue of the protective conditions in the indenture, he may be completely taken care of under conditions which mean virtua

measure on the success of the enterprise as a whole. But in the case of the collateral-trust issues of investment companies, a development of recent years, the holder may be said to have a primary interest in the market value of the pledged 2 See Appendix Note 18, p. 747 on accompanying CD, for comment and supporting data. securities, so that it is quite possible that by virtue of the protective conditions in the indenture, he may be completely taken care of under conditions which mean virtual extinction for the stockholders. This type of collateral-trust bond may therefore be ranked with equipment-trust obligations as exceptions to our general rule that the bond buyer must place his chief reliance on the success of the enterprise and not on the property specifically pledged. Going behind the form to the substance, we may point out that this characteristic is essentially true also of investment-trust debenture obli- gations. For it makes little practical difference whether the portfolio is physically pledged with a trustee, as under a collateral-trust indenture, or whether it is held by the corporation subject to the claim of the deben- ture bondholders. In the usual case the debentures are protected by ade- quate provisions against increasing the debt, and frequently also by a covenant requiring the market price of the company’s assets to be main- tained at a stated percentage above the face amount of the bonds. Example: The Reliance Management Corporation Debenture 5s, due 1954, are an instance of the working of these protective provisions. The enterprise as a whole was highly unsuccessful, as is shown vividly by a decline in the price of the stock from 69 in 1929 to 1 in 1933. In the case of the ordinary bond issue, such a collapse in the stock value would have meant almost certain default and large loss of principal. But here the fact that the assets could be readily turned into cash gave significance to the protective covenants behind the debentures. It made

ue 1954, are an instance of the working of these protective provisions. The enterprise as a whole was highly unsuccessful, as is shown vividly by a decline in the price of the stock from 69 in 1929 to 1 in 1933. In the case of the ordinary bond issue, such a collapse in the stock value would have meant almost certain default and large loss of principal. But here the fact that the assets could be readily turned into cash gave significance to the protective covenants behind the debentures. It made possible and com- pelled the repurchase by the company of more than three-quarters of the issue, and it even forced the stockholders to contribute additional capital to make good a deficiency of assets below the indenture requirements. This resulted in the bonds selling as high as 88 in 1932 when the stock sold for only 21/2. The balance of the issue was called at 1041/4 in February 1937. In Chap. 18, devoted to protective covenants, we shall refer to the history of a collateral-trust bond issue of an investment company (Financial Investing Company), and we shall point out that the intrinsic strength of such obligations is often impaired—unnecessarily, in our opinion—by hesitation in asserting the bondholders’ rights. 3. Real Estate Bonds. Of much greater importance than either of the two types of securities just discussed is the large field of real estate mortgages and real estate mortgage bonds. The latter represent partici- pations of convenient size in large individual mortgages. There is no doubt that in the case of such obligations the value of the pledged land and buildings is of paramount importance. The ordinary real estate loan made by an experienced investor is based chiefly upon his conclusions as to the fair value of the property offered as security. It seems to us, how- ever, that in a broad sense the values behind real estate mortgages are going-concern values; i.e., they are derived fundamentally from the earn- ing power of the property, either actual or pr

. There is no doubt that in the case of such obligations the value of the pledged land and buildings is of paramount importance. The ordinary real estate loan made by an experienced investor is based chiefly upon his conclusions as to the fair value of the property offered as security. It seems to us, how- ever, that in a broad sense the values behind real estate mortgages are going-concern values; i.e., they are derived fundamentally from the earn- ing power of the property, either actual or presumptive. In other words, the value of the pledged asset is not something distinct from the success of the enterprise (as is possibly the case with a railroad-equipment trust certificate), but is rather identical therewith. This point may be made clearer by a reference to the most typical form of real estate loan, a first mortgage on a single-family dwelling house. Under ordinary conditions a home costing $10,000 would have a rental value (or an equivalent value to an owner-tenant) of some $1,200 per year, and would yield a net income of about $800 after taxes and other expenses. A 5% first-mortgage loan on the savings-bank basis, i.e., 60% of value, or $6,000, would therefore be protected by a normal earning power of over twice the interest requirements. Stated differently, the rental value could suffer a reduction of over one-third before the ability to meet interest charges would be impaired. Hence the mortgagee reasons that regardless of the ability of the then owner of the house to pay the carry- ing charges, he could always find a tenant or a new purchaser who would rent or buy the property on a basis at least sufficient to cover his 60% loan. (By way of contrast, it may be pointed out that a typical industrial plant, costing $1,000,000 and bonded for $600,000, could not be expected to sell or rent for enough to cover the 5% mortgage if the issuing company went into bankruptcy.) Property Values and Earning Power Closely Related. This illustration shows that under norma

to pay the carry- ing charges, he could always find a tenant or a new purchaser who would rent or buy the property on a basis at least sufficient to cover his 60% loan. (By way of contrast, it may be pointed out that a typical industrial plant, costing $1,000,000 and bonded for $600,000, could not be expected to sell or rent for enough to cover the 5% mortgage if the issuing company went into bankruptcy.) Property Values and Earning Power Closely Related. This illustration shows that under normal conditions obtaining in the field of dwellings, offices, and stores, the property values and the rental values go hand in hand. In this sense it is largely immaterial whether the lender views mort- gaged property of this kind as something with salable value or as some- thing with an earning power, the equivalent of a going concern. To some extent this is true also of vacant lots and unoccupied houses or stores, since the market value of these is closely related to the expected rental when improved or let. (It is emphatically not true, however, of buildings erected for a special purpose, such as factories, etc.) Misleading Character of Appraisals. The foregoing discussion is important in its bearing on the correct attitude that the intending investor in real estate bonds should take towards the property values asserted to exist behind the issues submitted to him. During the great and disastrous development of the real estate mortgage-bond business between 1923 and 1929, the only datum customarily presented to support the usual bond offering—aside from an estimate of future earnings—was a statement of the appraised value of the property, which almost invariably amounted to some 662/3% in excess of the mortgage issue. If these appraisals had cor- responded to the market values which experienced buyers of or lenders on real estate would place upon the properties, they would have been of real utility in the selection of sound real estate bonds. But unfortunately they were pure

um customarily presented to support the usual bond offering—aside from an estimate of future earnings—was a statement of the appraised value of the property, which almost invariably amounted to some 662/3% in excess of the mortgage issue. If these appraisals had cor- responded to the market values which experienced buyers of or lenders on real estate would place upon the properties, they would have been of real utility in the selection of sound real estate bonds. But unfortunately they were purely artificial valuations, to which the appraisers were will- ing to attach their names for a fee, and whose only function was to deceive the investor as to the protection which he was receiving. The method followed by these appraisals was the capitalization on a liberal basis of the rental expected to be returned by the property. By this means, a typical building which cost $1,000,000, including liberal financing charges, would immediately be given an “appraised value” of $1,500,000. Hence a bond issue could be floated for almost the entire cost of the venture so that the builders or promoters retained the equity (i.e., the ownership) of the building, without a cent’s investment, and in many cases with a goodly cash profit to boot.3 This whole scheme of real estate financing was honeycombed with the most glaring weaknesses, and it is sad commentary on the lack of principle, penetration, and ordinary com- mon sense on the part of all parties concerned that it was permitted to reach such gigantic proportions before the inevitable collapse.4 3 The 419–4th Avenue Corporation (Bowker Building) floated a $1,230,000 bond issue in 1927 with a paid-in capital stock of only $75,000. (By the familiar process, the land and building which cost about $1,300,000 were appraised at $1,897,788.) Default and receiver- ship in 1931–1932 were inevitable. 4 See Appendix Note 19, p. 748 on accompanying CD, for report of Real Estate Securities Committee of the Investment Bankers Association of Amer

gigantic proportions before the inevitable collapse.4 3 The 419–4th Avenue Corporation (Bowker Building) floated a $1,230,000 bond issue in 1927 with a paid-in capital stock of only $75,000. (By the familiar process, the land and building which cost about $1,300,000 were appraised at $1,897,788.) Default and receiver- ship in 1931–1932 were inevitable. 4 See Appendix Note 19, p. 748 on accompanying CD, for report of Real Estate Securities Committee of the Investment Bankers Association of America commenting on defaults in this field. Abnormal Rentals Used as Basis of Valuation. It was indeed true that the scale of rentals prevalent in 1928–1929 would yield an abundantly high rate of income on the cost of a new real estate venture. But this con- dition could not properly be interpreted as making a new building imme- diately worth 50% in excess of its actual cost. For this high income return was certain to be only temporary, since it could not fail to stimulate more and more building, until an oversupply of space caused a collapse in the scale of rentals. This overbuilding was the more inevitable because it was possible to carry it on without risk on the part of the owner, who raised all the money needed from the public. Debt Based on Excessive Construction Costs. A collateral result of this overbuilding was an increase in the cost of construction to abnormally high levels. Hence even an apparently conservative loan made in 1928 or 1929, in an amount not exceeding two-thirds of actual cost, did not enjoy a proper degree of protection, because there was the evident danger (subsequently realized) that a sharp drop in construction costs would reduce fundamental values to a figure below the amount of the loan. Weakness of Specialized Buildings. A third general weakness of real estate-bond investment lay in the entire lack of discrimination as between various types of building projects. The typical or standard real estate loan was formerly made on a home, and its pecul

s of actual cost, did not enjoy a proper degree of protection, because there was the evident danger (subsequently realized) that a sharp drop in construction costs would reduce fundamental values to a figure below the amount of the loan. Weakness of Specialized Buildings. A third general weakness of real estate-bond investment lay in the entire lack of discrimination as between various types of building projects. The typical or standard real estate loan was formerly made on a home, and its peculiar virtue lay in the fact that there was an indefinitely large number of prospective purchasers or ten- ants to draw upon, so that it could always be disposed of at some mod- erate concession from the current scale of values. A fairly similar situation is normally presented by the ordinary apartment house, or store, or office building. But when a structure is built for some special purpose, such as a hotel, garage, club, hospital, church, or factory, it loses this quality of rapid disposability, and its value becomes bound up with the success of the particular enterprise for whose use it was originally intended. Hence mort- gage bonds on such structures are not actually real estate bonds in the accepted sense, but rather loans extended to a business; and consequently their safety must be judged by all the stringent tests surrounding the purchase of an industrial obligation. This point was completely lost sight of in the rush of real estate financ- ing preceding the collapse in real estate values. Bonds were floated to build hotels, garages, and even hospitals, on very much the same basis as loans made on apartment houses. In other words, an appraisal showing a “value” of one-half to two-thirds in excess of the bond issue was considered almost enough to establish the safety of the loan. It turned out, however, that when such new ventures proved commercially unsuc- cessful and were unable to pay their interest charges, the “real estate” bondholders were in little better posi

tate values. Bonds were floated to build hotels, garages, and even hospitals, on very much the same basis as loans made on apartment houses. In other words, an appraisal showing a “value” of one-half to two-thirds in excess of the bond issue was considered almost enough to establish the safety of the loan. It turned out, however, that when such new ventures proved commercially unsuc- cessful and were unable to pay their interest charges, the “real estate” bondholders were in little better position than the holders of a mortgage on an unprofitable railroad or mill property.5 Values Based on Initial Rentals Misleading. Another weakness should be pointed out in connection with apartment-house financing. The rental income used in determining the appraised value was based on the rentals to be charged at the outset. But apartment-house tenants are accustomed to pay a substantial premium for space in a new building, and they con- sider a structure old, or at least no longer especially modern and desir- able, after it has been standing a very few years. Consequently, under normal conditions the rentals received in the first years are substantially larger than those which can conservatively be expected throughout the life of the bond issue. Lack of Financial Information. A defect related to those discussed above, but of a different character, was the almost universal failure to sup- ply the bond buyer with operating and financial data after his purchase. This drawback applies generally to companies that sell bonds to the pub- lic but whose stock is privately held—an arrangement characteristic of real estate financing. As a result, not only were most bondholders unaware of the poor showing of the venture until default had actually taken place, but—more serious still—at that time they frequently found that large unpaid taxes had accrued against the property while the own- ers were “milking” it by drawing down all available cash. Suggested Rules of Procedure. From this detail

lly to companies that sell bonds to the pub- lic but whose stock is privately held—an arrangement characteristic of real estate financing. As a result, not only were most bondholders unaware of the poor showing of the venture until default had actually taken place, but—more serious still—at that time they frequently found that large unpaid taxes had accrued against the property while the own- ers were “milking” it by drawing down all available cash. Suggested Rules of Procedure. From this detailed analysis of the defects of real estate bond financing in the past decade, a number of specific rules of procedure may be developed to guide the investor in the future. In the case of single-family dwellings, loans are generally made directly by the mortgage holder to the owner of the home, i.e., without the inter- mediary of a real estate mortgage bond sold by a house of issue. But an extensive business has also been transacted by mortgage companies (e.g., Lawyers Mortgage Company, Title Guarantee and Trust Company) in 5 See Appendix Note 20, p. 750 on accompanying CD, for example (Hudson Towers). guaranteed mortgages and mortgage-participation certificates, secured on such dwellings.6 Where investments of this kind are made, the lender should be cer- tain: (a) that the amount of the loan is not over 662/3% of the value of the property, as shown either by actual recent cost or by the amount which an experienced real estate man would consider a fair price to pay for the property; and (b) that this cost or fair price does not reflect recent spec- ulative inflation and does not greatly exceed the price levels existing for a long period previously. If so, a proper reduction must be made in the maximum relation of the amount of mortgage debt to the current value. The more usual real estate mortgage bond represents a participation in a first mortgage on a new apartment house or office building. In consid- ering such offerings the investor should ignore the conventional “appra

and (b) that this cost or fair price does not reflect recent spec- ulative inflation and does not greatly exceed the price levels existing for a long period previously. If so, a proper reduction must be made in the maximum relation of the amount of mortgage debt to the current value. The more usual real estate mortgage bond represents a participation in a first mortgage on a new apartment house or office building. In consid- ering such offerings the investor should ignore the conventional “appraised values” submitted and demand that the actual cost, fairly presented, should exceed the amount of the bond issue by at least 50%. Secondly, he should require an estimated income account, conservatively calculated to reflect losses through vacancies and the decline in the rental scale as the build- ing grows older. This income account should forecast a margin of at least 100% over interest charges, after deducting from earnings a depreciation allowance to be actually expended as a sinking fund for the gradual retire- ment of the bond issue. The borrower should agree to supply the bond- holders with regular operating and financial statements. Issues termed “first-leasehold mortgage bonds” are in actuality second mortgages. They are issued against buildings erected on leased land and the ground rent operates in effect as a first lien or prior charge against the entire property. In analyzing such issues the ground rent should be added to the bond-interest requirements to arrive at the total interest charges of the property. Furthermore, it should be recognized that in the field of real estate obligations the advantage of a first mortgage over a junior lien is much more clean-cut than in an ordinary business enterprise.7 6 Since 1933 real estate financing on single-family homes has been taken over so substan- tially by the Federal government, through the Federal Housing Administration (F.H.A.), that practically no real estate bonds of this type have been sold to investors. Fi

total interest charges of the property. Furthermore, it should be recognized that in the field of real estate obligations the advantage of a first mortgage over a junior lien is much more clean-cut than in an ordinary business enterprise.7 6 Since 1933 real estate financing on single-family homes has been taken over so substan- tially by the Federal government, through the Federal Housing Administration (F.H.A.), that practically no real estate bonds of this type have been sold to investors. Financing on larger buildings has been greatly restricted. Practically all of it has been provided by financial insti- tutions (insurance companies, etc.), and there have been virtually no sales of real estate secu- rities to the general public (to the end of 1939). 7 See Appendix Note 21, p. 750 on accompanying CD, for examples and comment. In addition to the above quantitative tests, the investor should be satisfied in his own mind that the location and type of the building are such as to attract tenants and to minimize the possibility of a large loss of value through unfavorable changes in the character of the neighborhood.8 Real estate loans should not be made on buildings erected for a spe- cial or limited purpose, such as hotels, garages, etc. Commitments of this kind must be made in the venture itself, considered as an individual busi- ness. From our previous discussion of the standards applicable to a high- grade industrial-bond purchase, it is difficult to see how any bond issue on a new hotel, or the like, could logically be bought on a straight invest- ment basis. All such enterprises should be financed at the outset by pri- vate capital, and only after they can show a number of years of successful operation should the public be offered either bonds or stock therein.9 8 Footnote to 1934 edition: “One of the few examples of a conservatively financed real estate- bond issue extant in 1933 is afforded by the Trinity Buildings Corporation of New York First 51/2s, due

ue on a new hotel, or the like, could logically be bought on a straight invest- ment basis. All such enterprises should be financed at the outset by pri- vate capital, and only after they can show a number of years of successful operation should the public be offered either bonds or stock therein.9 8 Footnote to 1934 edition: “One of the few examples of a conservatively financed real estate- bond issue extant in 1933 is afforded by the Trinity Buildings Corporation of New York First 51/2s, due 1939, secured on two well-located office buildings in the financial district of New York City. This issue was outstanding in the amount of $4,300,000, and was secured by a first lien on land and buildings assessed for taxation at $13,000,000. In 1931, gross earnings were $2,230,000 and the net after depreciation was about six times the interest on the first- mortgage bonds. In 1932, rent income declined to $1,653,000, but the balance for first-mort- gage interest was still about 31/2 times the requirement. In September 1933 these bonds sold close to par.” This footnote and the sequel well illustrate the importance of the location factor referred to in the text. Despite the improvement in general business conditions since 1933, the less- ened activity in the financial district resulted in a loss of tenants and a severe decline in rental rates. The net earnings of Trinity Building Corporation failed even to cover deprecia- tion charges in 1938 and were less than interest charges, even ignoring depreciation; princi- pal and interest were defaulted at maturity in 1939; the guarantee by United States Realty and Improvement Company, the parent enterprise, proved inadequate; and the holders were faced with the necessity of extending their principal and accepting a reduction in the fixed coupon rate. In this instance an undoubtedly conservative financial set-up (a quantitative factor) did not prove strong enough to offset a decline in the rental value of the neighbor- hood (a qualita

noring depreciation; princi- pal and interest were defaulted at maturity in 1939; the guarantee by United States Realty and Improvement Company, the parent enterprise, proved inadequate; and the holders were faced with the necessity of extending their principal and accepting a reduction in the fixed coupon rate. In this instance an undoubtedly conservative financial set-up (a quantitative factor) did not prove strong enough to offset a decline in the rental value of the neighbor- hood (a qualitative factor). 9 The subject of guaranteed real estate mortgage issues is treated in Chap. 17. Chapter 15 TECHNIQUE OF SELECTING PREFERRED STOCKS FOR INVESTMENT OUR DISCUSSION of the theory of preferred stocks led to the practical con- clusion that an investment preferred issue must meet all the requirements of a good bond, with an extra margin of safety to offset its contractual disadvantages. In analyzing a senior stock issue, therefore, the same tests should be applied as we have previously suggested and described with respect to bonds. More Stringent Requirements Suggested. In order to make the quantitative tests more stringent, some increase is needed in the mini- mum earnings coverage above that prescribed for the various bond groups. The criteria we propose are as follows: MINIMUM AVERAGE-EARNINGS COVERAGE Class of enterprise For investment bonds For investment preferred stocks Public utilities Railroads Industrials 13/4 times fixed charges 2 times fixed charges 3 times fixed charges 2 times fixed charges plus preferred dividends 21/2 times fixed charges plus preferred dividends 4 times fixed charges plus preferred dividends These increases in the earnings coverage suggest that a corresponding advance should be made in the stock-value ratio. It may be argued that since this is a secondary test it is hardly necessary to change the figure. But consistency of treatment would require that the minimum stock-value cov- erage be raised in some such manner as shown

es fixed charges 2 times fixed charges plus preferred dividends 21/2 times fixed charges plus preferred dividends 4 times fixed charges plus preferred dividends These increases in the earnings coverage suggest that a corresponding advance should be made in the stock-value ratio. It may be argued that since this is a secondary test it is hardly necessary to change the figure. But consistency of treatment would require that the minimum stock-value cov- erage be raised in some such manner as shown in the table on page 191. [190] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. The margins of safety above suggested are materially higher than those hitherto accepted as adequate, and it may be objected that we are imposing requirements of unreasonable and prohibitive stringency. It is true that these requirements would have disqualified a large part of the preferred-stock financing done in the years prior to 1931, but such sever- ity would have been of benefit to the investing public. A general stabiliza- tion of business and financial conditions may later justify a more lenient attitude towards the minimum earnings coverage, but until such stabi- lization has actually been discernible over a considerable period of time the attitude of investors towards preferred stocks must remain extremely critical and exacting. Class of enterprise Minimum current stock-value ratio For investment bonds For investment preferred stocks Public utilities Railroads Industrials $2 bonds to $1 stock $11/2 bonds to $1 stock $1 bonds to $1 stock $11/2 bonds and preferred to $1 junior stock $1 bonds and preferred to $1 junior stock $1 bonds and preferred to $11/2 junior stock Referring to the list of preferred stocks given on page 192 of accom- panying CD, it will be noted that in the case of all the industrial issues the stock-value ratio at its lowest exceeded 1.6 to 1, and also that the average earnings coverage exceeded

stocks Public utilities Railroads Industrials $2 bonds to $1 stock $11/2 bonds to $1 stock $1 bonds to $1 stock $11/2 bonds and preferred to $1 junior stock $1 bonds and preferred to $1 junior stock $1 bonds and preferred to $11/2 junior stock Referring to the list of preferred stocks given on page 192 of accom- panying CD, it will be noted that in the case of all the industrial issues the stock-value ratio at its lowest exceeded 1.6 to 1, and also that the average earnings coverage exceeded 5.6 times.1 Mere Presence of Funded Debt Does Not Disqualify Preferred Stocks for Investment. It is proper to consider whether an investment rating should be confined to preferred stocks not preceded by bonds. That the absence of funded debt is a desirable feature for a preferred issue goes without saying; it is an advantage similar to that of having a first mort- gage on a property instead of a second mortgage. It is not surprising, therefore, that preferred stocks without bonds ahead of them have as a 1 We do not consider it necessary to suggest an increase in minimum size above the figures recommended for investment bonds. class made a better showing than those of companies with funded debt. But from this rather obvious fact it does not follow that all preferred stocks with bonds preceding are unsound investments, any more than it can be said that all second-mortgage bonds are inferior in quality to all first-mortgage bonds. Such a principle would entail the rejection of all public-utility preferred stocks (since they invariably have bonds ahead of them) although these are better regarded as a group than are the “non- bonded” industrial preferreds. Furthermore, in the extreme test of 1932, a substantial percentage of the preferred issues which held up were pre- ceded by funded debt.2 To condemn a powerfully entrenched security such as General Elec- tric preferred in 1933 because it had an infinitesimal bond issue ahead of it, would have been the height of absurdity. Th

lic-utility preferred stocks (since they invariably have bonds ahead of them) although these are better regarded as a group than are the “non- bonded” industrial preferreds. Furthermore, in the extreme test of 1932, a substantial percentage of the preferred issues which held up were pre- ceded by funded debt.2 To condemn a powerfully entrenched security such as General Elec- tric preferred in 1933 because it had an infinitesimal bond issue ahead of it, would have been the height of absurdity. This example should illus- trate forcibly the inherent unwisdom of subjecting investment selection to hard and fast rules of a qualitative character. In our view, the presence of bonds senior to a preferred stock is a fact which the investor must take carefully into account, impelling him to greater caution than he might otherwise exercise; but if the company’s exhibit is sufficiently impressive the preferred stock may still be accorded an investment rating. Total-deductions Basis of Calculation Recommended. In cal- culating the earnings coverage for preferred stocks with bonds preced- ing, it is absolutely essential that the bond interest and preferred dividend be taken together. The almost universal practice of stating the earnings on the preferred stock separately (in dollars per share) is exactly similar to, and as fallacious as, the prior-deductions method of comput- ing the margin above interest charges on a junior bond. If the preferred stock issue is much smaller than the funded debt, the earnings per share will indicate that the preferred dividend is earned more times than is the bond interest. Such a statement must either have no meaning at all, or else it will imply that the preferred dividend is safer than the bond interest of the same company—an utter absurdity.3 (See the examples on page 194.) 2 Out of the 21 such issues listed on p. 192 of accompanying CD eleven were preceded by bonds, viz., five public utilities, one railroad, and five (out of 15) industrials.

debt, the earnings per share will indicate that the preferred dividend is earned more times than is the bond interest. Such a statement must either have no meaning at all, or else it will imply that the preferred dividend is safer than the bond interest of the same company—an utter absurdity.3 (See the examples on page 194.) 2 Out of the 21 such issues listed on p. 192 of accompanying CD eleven were preceded by bonds, viz., five public utilities, one railroad, and five (out of 15) industrials. 3 See Appendix Note 28, p. 760 on accompanying CD, for comment upon neglect of this point by writers of textbooks on investment. The West Penn Electric Company Class A stock is in reality a second preferred issue. In this example the customary statement makes the pre- ferred dividend appear safer than the bond interest; and because the Class A issue is small, it makes this second preferred issue appear much safer than either the bonds or the first preferred. The correct statement shows that the Class A requirements are covered 1.26 times instead of 7.43 times—a tremendous difference. The erroneous method of stating the earnings coverage was probably responsible in good part for the high price at which the Class A shares sold in 1937 (108). It is interesting to observe that although the Class A shares had declined to 25 in 1932, they later sold repeatedly at a higher price than the 7% preferred issue. Evi- dently some investors were still misled by the per-share earnings figures, and imagined the second preferred safer than the first preferred. An Apparent Contradiction Explained. Our principles of preferred- dividend coverage lead to an apparent contradiction, viz., that the pre- ferred stockholders of a company must require a larger minimum coverage than the bondholders of the same company, yet by the nature of the case the actual coverage is bound to be smaller. For in any corpora- tion the bond interest alone is obviously earned with a larger margin than the bond interes

imagined the second preferred safer than the first preferred. An Apparent Contradiction Explained. Our principles of preferred- dividend coverage lead to an apparent contradiction, viz., that the pre- ferred stockholders of a company must require a larger minimum coverage than the bondholders of the same company, yet by the nature of the case the actual coverage is bound to be smaller. For in any corpora- tion the bond interest alone is obviously earned with a larger margin than the bond interest and preferred dividends combined. This fact has cre- ated the impression among investors (and some writers) that the tests of a sound preferred stock may properly be less stringent than those of a sound bond.4 But this is not true at all. The real point is that where a com- pany has both bonds and preferred stock the preferred stock can be safe 4 See, for example, the following quotations from R. E. Badger and H. G. Guthmann, Invest- ment Principles and Practices, New York, 1941: “Similarly, it is a general rule that, on the average, the interest on industrial bonds should be covered at least three times, in order that the bond should be considered safe” (p. 316). “From the authors’ viewpoint, an industrial preferred stock should be regarded as specu- lative unless combined charges and dividend requirements are earned at least twice over a period of years” (p. 319). “One is probably safe in stating that, where combined charges are twice earned, including interest charges on the bonds of the holding company, the presumption is in favor of the soundness of such holding company issue. Likewise, where combined prior charges and pre- ferred dividend requirements are earned 1.5 times, the preferred stock of the holding com- pany will be favorably regarded” (p. 421). See also F. F. Burtchett, Investments and Investment Policy, New York, 1938, p. 325, where the author requires larger coverage of fixed charges on bonds than on preferred stocks of merchandising enterprises. EXAMPL

s of the holding company, the presumption is in favor of the soundness of such holding company issue. Likewise, where combined prior charges and pre- ferred dividend requirements are earned 1.5 times, the preferred stock of the holding com- pany will be favorably regarded” (p. 421). See also F. F. Burtchett, Investments and Investment Policy, New York, 1938, p. 325, where the author requires larger coverage of fixed charges on bonds than on preferred stocks of merchandising enterprises. EXAMPLES OF CORRECT AND INCORRECT METHODS OF CALCULATING EARNINGS COVERAGE FOR PREFERRED STOCKS A. Colorado Fuel and Iron Company: 1929 figures Earned for bond interest $3,978,000 Interest charges 1,628,000 Preferred dividends 160,000 Balance for common 2,190,000 Customary but incorrect statement Correct statement Int. charges earned. . . . . . . . . . . . . . . .2.4 times Int. charges earned 2.4 times Preferred dividend earned . . . . . . . . . .14.7 times Interest and preferred Earned per share of preferred . . . . . . .$117.50 dividends earned 2.2 times Note: The preceding statement of earnings on the preferred stock alone is either worthless or dangerously misleading. B. Warner Bros. Pictures, Inc.: Year ended Aug. 28, 1937 Earned for interest $10,760,000 Interest charges 4,574,000 Preferred dividends 397,000 Balance for common 5,789,000 Customary but incorrect statement Correct statement Int. charges earned . . . . . . . . . . . . . . . .2.35 times Int. charges earned 2.35 times Preferred dividends earned . . . . . . . . .14.8 times Interest and preferred Earned per share of preferred . . . . . . .$56.99 dividends earned 2.1 times C. West Penn Electric Company: 1937 figures Gross $40,261,000 Net before charges 13,604,000 Fixed charges (include preferred dividends of subsidiaries) 8,113,000 Dividends on 7% and 6% preferred issues 2,267,000 Dividends on Class A stock (junior to 6% and 7% Pfd.). 412,000 Balance for Class B and common 2,812,000 Customa

ges earned 2.35 times Preferred dividends earned . . . . . . . . .14.8 times Interest and preferred Earned per share of preferred . . . . . . .$56.99 dividends earned 2.1 times C. West Penn Electric Company: 1937 figures Gross $40,261,000 Net before charges 13,604,000 Fixed charges (include preferred dividends of subsidiaries) 8,113,000 Dividends on 7% and 6% preferred issues 2,267,000 Dividends on Class A stock (junior to 6% and 7% Pfd.). 412,000 Balance for Class B and common 2,812,000 Customary but incorrect statement Correct statement Times interest or Earned Times earned dividends earned per share Fixed charges… 1.68 times Fixed charges… 1.68 times 6% and 7% Charges and preferred preferred (combined)…2.42 times $16.11 dividends 1.31 times Class A……….. 7.43 times 54.79 Fixed charges, preferred dividends, and Class A dividends .1.26 times Year Liggett & Myers Tobacco Co. Commonwealth & Southern Corp. Number of times interest earned Number of times int. and pfd. dividend earned Number of times fixed charges earned Number of times fixed charges and pfd. dividend earned 1930 15.2 7.87 1.84 1.48 1929 13.9 7.23 1.84 1.55 1928 12.3 6.42 1.71 1.44 1927 11.9 6.20 1.62 1.37 1926 11.2 5.85 1.52 1.31 1925 9.8 5.14 1.42 1.28 enough only if the bonds are much safer than necessary. Conversely, if the bonds are only just safe enough, the preferred stock cannot be sound. This is illustrated by two examples, as follows: The Liggett and Myers preferred-dividend coverage (including, of course, the bond interest as well) is substantially above our suggested minimum of four times. The bond-interest coverage alone is therefore far in excess of the smaller minimum required for it, viz., three times. On the other hand, the Commonwealth and Southern fixed-charge coverage in 1930 was just about at the proposed minimum 13/4 times. This meant that while the various bonds might qualify for investment, the 6% preferred stock could not possibly do so, and the purchase of that issue

g, of course, the bond interest as well) is substantially above our suggested minimum of four times. The bond-interest coverage alone is therefore far in excess of the smaller minimum required for it, viz., three times. On the other hand, the Commonwealth and Southern fixed-charge coverage in 1930 was just about at the proposed minimum 13/4 times. This meant that while the various bonds might qualify for investment, the 6% preferred stock could not possibly do so, and the purchase of that issue at a price above par in 1930 was an obvious mistake. “Dollars-per-share” Formula Misleading. When a preferred stock has no bonds ahead of it, the earnings may be presented either as so many dollars per share or as so many times dividend requirements. The second form is distinctly preferable, for two reasons. The more important one is that the use of the “dollars per share” formula in cases where there are no bonds is likely to encourage its use in cases where there are bonds. Secu- rity analysts and intelligent investors should make special efforts to avoid and decry this misleading method of stating preferred-dividend cover- age, and this may best be accomplished by dropping the dollars-per-share form of calculation entirely. As a second point, it should be noted that the significance of the dollars earned per share is dependent upon the mar- ket price of the preferred stock. Earnings of $20 per share would be much more favorable for a preferred issue selling at 80 than for a preferred selling at 125. In the one case the earnings are 25%, and in the other only 16%, on the market price. The dollars-per-share figure loses all compar- ative value when the par value is less than $100, or when there is no-par stock with a low dividend rate per share. Earnings of $18.60 per share in 1931 on S. H. Kress and Company 6% Preferred (par $10) are of course far more favorable than earnings of $20 per share on some 7% preferred stock, par $100. Calculation of the Stock-value Ratio. The

d selling at 125. In the one case the earnings are 25%, and in the other only 16%, on the market price. The dollars-per-share figure loses all compar- ative value when the par value is less than $100, or when there is no-par stock with a low dividend rate per share. Earnings of $18.60 per share in 1931 on S. H. Kress and Company 6% Preferred (par $10) are of course far more favorable than earnings of $20 per share on some 7% preferred stock, par $100. Calculation of the Stock-value Ratio. The technique of applying this test to preferred stocks is in all respects similar to that of the earn- ings-coverage test. The bonds, if any, and the preferred stock must be taken together and the total compared with the market price of the com- mon stock only. When calculating the protection behind a bond, the pre- ferred issue is part of the stock equity; but when calculating the protection behind the preferred shares, the common stock is now, of course, the only junior security. In cases where there are both a first and second preferred issue, the second preferred is added to the common stock in calculating the equity behind the first preferred. EXAMPLE OF CALCULATION OF STOCK-VALUE RATIOS FOR PREFERRED STOCKS PROCTER AND GAMBLE COMPANY Capitalization Face amount Low price 1932 Value at low price in 1932 Bonds $10,500,000 8% pfd. (1st pfd.) 2,250,000 @ 140 $3,150,000 5% pfd. (2d pfd.) 17,156,000 @ 81 13,900,000 Common 6,140,000* @ 20 128,200,000 * Number of shares. = 13.8:1 = 10.4:1 = 4.6:1 Should the market value of the common stock be compared with the par value or the market value of the preferred? In the majority of cases it will not make any vital difference which figure is used. There are, how- ever, an increasing number of no-par-value preferreds (and also a num- ber like Island Creek Coal Company Preferred and Remington Rand, Inc., Second Preferred in which the real par is entirely different from the stated par).5 In these cases an equivalent would have to

10.4:1 = 4.6:1 Should the market value of the common stock be compared with the par value or the market value of the preferred? In the majority of cases it will not make any vital difference which figure is used. There are, how- ever, an increasing number of no-par-value preferreds (and also a num- ber like Island Creek Coal Company Preferred and Remington Rand, Inc., Second Preferred in which the real par is entirely different from the stated par).5 In these cases an equivalent would have to be constructed from the dividend rate. Because of such instances and also those where the market price tends to differ materially from the par value (e.g., Nor- folk and Western Railway Company 4% Preferred in 1932 or Eastman Kodak 6% Preferred in 1939), it would seem the better rule to use the market price of preferred stocks regularly in computing stock-value ratios. On the other hand the regular use of the face value of bond issues, rather than the market price, is recommended, because it is much more convenient and does not involve the objections just discussed in relation to preferred shares. Noncumulative Issues. The theoretical disadvantage of a noncumu- lative preferred stock as compared with a cumulative issue is very simi- lar to the inferiority of preferred stocks in general as compared with bonds. The drawback of not being able to compel the payment of divi- dends on preferred stocks generally is almost matched by the handicap in the case of noncumulative issues of not being able to receive in the future the dividends withheld in the past. This latter arrangement is so patently inequitable that new security buyers (who will stand for almost anything) object to noncumulative issues, and for many years new offer- ings of straight preferred stocks have almost invariably had the cumula- tive feature.6 Noncumulative issues have generally come into existence as the result of reorganization plans in which old security holders have been 5 Island Creek Coal Preferred has

ng able to receive in the future the dividends withheld in the past. This latter arrangement is so patently inequitable that new security buyers (who will stand for almost anything) object to noncumulative issues, and for many years new offer- ings of straight preferred stocks have almost invariably had the cumula- tive feature.6 Noncumulative issues have generally come into existence as the result of reorganization plans in which old security holders have been 5 Island Creek Coal Preferred has a stated par of $1 and Remington Rand, Inc., Second Preferred has a stated par of $25, but both issues carry a $6 dividend and they are entitled to $120 per share and $100 per share respectively in the event of liquidation. Their true par is evidently $100. The same is true of American Zinc Lead and Smelting First $5 Prior Pre- ferred and $6 (Second) Preferred; par of each is $25. 6 The only important “straight,” noncumulative preferred stock sold to stockholders or the public since the war was St. Louis-San Francisco Railway Company Preferred. In the case of Illinois Central Railroad Company Noncumulative Preferred, the conversion privilege was the overshadowing inducement at the time of issue. virtually forced to accept whatever type of security was offered them. But in recent years the preferred issues created through reorganization have been preponderantly cumulative, though in some cases this provision becomes operative only after a certain interval. Austin Nichols and Com- pany $5 Preferred, for example, was issued under a Readjustment Plan in 1930 and became cumulative in 1934. National Department Stores Pre- ferred, created in 1935, became fully cumulative in 1938. Chief Objection to Noncumulative Provision. One of the chief objec- tions to the noncumulative provision is that it permits the directors to withhold dividends even in good years, when they are amply earned, the money thus saved inuring to the benefit of the common stockholders. Experience shows that non

y $5 Preferred, for example, was issued under a Readjustment Plan in 1930 and became cumulative in 1934. National Department Stores Pre- ferred, created in 1935, became fully cumulative in 1938. Chief Objection to Noncumulative Provision. One of the chief objec- tions to the noncumulative provision is that it permits the directors to withhold dividends even in good years, when they are amply earned, the money thus saved inuring to the benefit of the common stockholders. Experience shows that noncumulative dividends are seldom paid unless they are necessitated by the desire to declare dividends on the common; and if the common dividend is later discontinued, the preferred dividend is almost invariably suspended soon afterwards.7 Example: St. Louis-San Francisco Railway Company affords a typical example. No dividends were paid on the (old) preferred issue between 1916 and 1924, although the dividend was fully earned in most of these years. Payments were not commenced until immediately before dividends were initiated on the common; and they were continued (on the new pre- ferred) less than a year after the common dividend was suspended in 1931. The manifest injustice of such an arrangement led the New Jersey courts (in the United States Cast Iron Pipe case)8 to decide that if divi- dends are earned on a noncumulative preferred stock but not paid, then the holder is entitled to receive such amounts later before anything can be paid on the common. This meant that in New Jersey a noncumulative preferred stock was given a cumulative claim on dividends to the extent that they were earned. The United States Supreme Court however, handed 7 Kansas City Southern Railway Company 4% Noncumulative Preferred, which paid divi- dends between 1907 and 1929 while the common received nothing, is an outstanding excep- tion to this statement. St. Louis Southwestern Railway Company 5% Noncumulative Preferred received full dividends during 1923–1929 while no payments were made on the commo

oncumulative preferred stock was given a cumulative claim on dividends to the extent that they were earned. The United States Supreme Court however, handed 7 Kansas City Southern Railway Company 4% Noncumulative Preferred, which paid divi- dends between 1907 and 1929 while the common received nothing, is an outstanding excep- tion to this statement. St. Louis Southwestern Railway Company 5% Noncumulative Preferred received full dividends during 1923–1929 while no payments were made on the common; but for a still longer period preferred dividends, although earned, were wholly or partially withheld (and thus irrevocably lost). 8 Day v. United States Cast Iron Pipe and Foundry Company, 94 N.J. Eq. 389, 124 Atl. 546 (1924), aff ’d. 96 N.J. Eq. 738, 126 Atl. 302 (1925); Moran v. United States Cast Iron Pipe and Foundry Company, 95 N.J. Eq. 389, 123 Atl. 546 (1924), aff ’d, 96 N.J. Eq. 698, 126 Atl. 329 (1925). down a contrary decision (in the Wabash Railway case)9 holding that while the noncumulative provision may work a great hardship on the holder, he has nevertheless agreed thereto when he accepted the issue. This is undoubtedly sound law, but the inherent objections to the non- cumulative provision are so great (chiefly because of the opportunity it affords for unfair policies by the directors) that it would seem to be advis- able for the legislatures of the several states to put the New Jersey deci- sion into statutory effect by prohibiting the creation of completely noncumulative preferred stocks, requiring them to be made cumulative at least to the extent that the dividend is earned. This result has been attained in a number of individual instances through insertion of appro- priate charter provisions.10 Features of the List of 21 Preferred Issues of Investment Grade. Out of some 440 preferred stocks listed on the New York Stock Exchange in 1932, only 40, or 9%, were noncumulative. Of these, 29 were railroad or street-railway issues and only 11 were industrial

mulative preferred stocks, requiring them to be made cumulative at least to the extent that the dividend is earned. This result has been attained in a number of individual instances through insertion of appro- priate charter provisions.10 Features of the List of 21 Preferred Issues of Investment Grade. Out of some 440 preferred stocks listed on the New York Stock Exchange in 1932, only 40, or 9%, were noncumulative. Of these, 29 were railroad or street-railway issues and only 11 were industrial issues. The reader will be surprised to note, however, that out of only 21 preferred stocks selling continuously on an investment basis in 1932, no less than four were non- cumulative. Other peculiarities are to be found in this favored list, and they may be summarized as follows (see page 192 of accompanying CD): 1. Both the number of noncumulative issues and the number of preferred stocks preceded by bonds are proportionately higher among the 21 “good” companies than in the Stock Exchange list as a whole. 2. The industry best represented is the snuff business, with three companies. 9 Wabash Railway Company et al. v. Barclay et al., 280 U.S. 197 (1930), reversing Barclay v. Wabash Railway, 30 Fed. (2d) 260 (1929). See discussion in A. A. Berle, Jr., and G. C. Means, The Modern Corporation and Private Property, pp. 190–192. 10 See, for example, the provisions of George A. Fuller Company $3 Convertible Stock; Aeolian Company 6% Class A Preferred; United States Lines Company Convertible Second Preferred. A trend in the direction of preferred stocks with this type of provision is observ- able in numerous recent reorganization plans of railroads. See various plans presented in 1936–1938 for Chicago and Eastern Illinois Railroad, Missouri Pacific Railroad, Erie Railroad, St. Louis-San Francisco Railroad. An early example of this type of preferred is that of Pittsburgh, Youngstown and Ashtabula Railway. But here the dividend becomes cumula- tive only if the full $7 rate is earned

e Second Preferred. A trend in the direction of preferred stocks with this type of provision is observ- able in numerous recent reorganization plans of railroads. See various plans presented in 1936–1938 for Chicago and Eastern Illinois Railroad, Missouri Pacific Railroad, Erie Railroad, St. Louis-San Francisco Railroad. An early example of this type of preferred is that of Pittsburgh, Youngstown and Ashtabula Railway. But here the dividend becomes cumula- tive only if the full $7 rate is earned and less has been paid. 3. Miscellaneous peculiarities: a. Only one issue has a sinking fund provision. b. One issue is a second preferred (Procter and Gamble). c. One issue has a par value of only $1 (Island Creek Coal). d. One issue was callable at close to the lowest market price of 1932–1933 (General Electric). Matters of Form, Title, or Legal Right Relatively Immaterial. We trust that no overzealous exponent of the inductive method will conclude from these figures either: (1) that noncumulative preferreds are superior to cumulative issues; or (2) that preferreds preceded by bonds are superior to those without bonds; or (3) that the snuff business presents the safest opportunity for investment. The real significance of these unexpected results is rather the striking confirmation they offer to our basic thesis that matters of form, title, or legal right are relatively immaterial, and that the showing made by the individual issue is of paramount importance. If a preferred stock could always be expected to pay its dividend without question, then whether it is cumulative or noncumulative would become an academic question solely, in the same way that the inferior contrac- tual rights of a preferred stock as compared with a bond would cease to have practical significance. Since the dividend on United States Tobacco Company Preferred was earned more than sixteen times in the depres- sion year 1931—and since, moreover, the company had been willing to buy in a large part of the

uld always be expected to pay its dividend without question, then whether it is cumulative or noncumulative would become an academic question solely, in the same way that the inferior contrac- tual rights of a preferred stock as compared with a bond would cease to have practical significance. Since the dividend on United States Tobacco Company Preferred was earned more than sixteen times in the depres- sion year 1931—and since, moreover, the company had been willing to buy in a large part of the preferred issue at prices ranging up to $125 per share—the lack of a cumulative provision caused the holders no concern at all. This example must of course, be considered as exceptional; and as a point of practical investment policy we should suggest that no matter how impressive may be the exhibit of a noncumulative preferred stock, it would be better to select a cumulative issue for purchase in order to enjoy better protection in the event of unexpected reverses.11 11 See, for example, the record of American Car and Foundry Company 7% Noncumulative Preferred. For many years prior to 1928 this issue sold higher than United States Tobacco Company 7% Noncumulative Preferred. By 1929 it had completed 30 years of uninterrupted dividend payments, during the last 20 of which its market price had never fallen below 100. Yet in 1932 the dividend was passed and the quotation declined to 16. Similarly, Atchison, Topeka and Santa Fe Railway Company Preferred, a 5% noncumulative issue, paid full divi- dends between 1901 and 1932 and was long regarded as a gilt-edged investment. As late as Amount Rather Than Mere Presence of Senior Obligations Important. The relatively large number of companies in our list having bonds out- standing is also of interest, as demonstrating that it is not the mere pres- ence of bonds, but rather the amount of the prior debt which is of serious moment. In three cases the bonds were outstanding in merely a nomi- nal sum, as the result of the fact that near

l divi- dends between 1901 and 1932 and was long regarded as a gilt-edged investment. As late as Amount Rather Than Mere Presence of Senior Obligations Important. The relatively large number of companies in our list having bonds out- standing is also of interest, as demonstrating that it is not the mere pres- ence of bonds, but rather the amount of the prior debt which is of serious moment. In three cases the bonds were outstanding in merely a nomi- nal sum, as the result of the fact that nearly all of these companies had a long history, so that some of them carried small residues of old bond financing.12 By a coincidence all three of the noncumulative industrial preferred stocks in our list belong to companies in the snuff business. This fact is interesting, not because it proves the investment primacy of snuff, but because of the strong reminder it offers that the investor cannot safely judge the merits or demerits of a security by his personal reaction to the kind of business in which it is engaged. An outstanding record for a long period in the past, plus strong evidence of inherent stability, plus the absence of any concrete reason to expect a substantial change for the worse in the future, afford probably the only sound basis available for the selection of a fixed-value investment. The miscellaneous peculiarities in our list (mentioned under 3, above) are also useful indications that matters of form or minor drawbacks have no essential bearing on the quality of an investment. 1931 the price reached 1081/4, within a half-point of the highest level in its history, and a yield of only 4.6%. The very next year the price fell to 35, and in the following year the dividend was reduced to a $3 basis. It was later restored to 5% but in 1938 the dividend was omitted entirely. This history might be pondered by investors willing to pay 112 for Norfolk and Western 4% Noncumulative Preferred in 1939. 12 These companies were General Electric, American Tobacco, and

estment. 1931 the price reached 1081/4, within a half-point of the highest level in its history, and a yield of only 4.6%. The very next year the price fell to 35, and in the following year the dividend was reduced to a $3 basis. It was later restored to 5% but in 1938 the dividend was omitted entirely. This history might be pondered by investors willing to pay 112 for Norfolk and Western 4% Noncumulative Preferred in 1939. 12 These companies were General Electric, American Tobacco, and Corn Products Refining. The University of Michigan study by Dr. Rodkey recognizes this point in part by ignoring certain bond issues amounting to less than 10% of capital and surplus. Chapter 16 INCOME BONDS AND GUARANTEED SECURITIES I. INCOME BONDS The contractual position of an income bond (sometimes called an adjust- ment bond) stands midway between that of a straight bond and a pre- ferred stock. Practically all income obligations have a definite maturity, so that the holder has an unqualified right to repayment of his principal on a fixed date. In this respect his position is entirely that of the ordinary bondholder. However, it should be pointed out that income bonds are almost always given a long maturity date, so that the right of repayment is not likely to be of practical importance in the typical case studied. In fact we have discovered only one instance of income bondholders actu- ally having received repayment of their principal in full by reason of maturity.1 Interest Payment Sometimes Wholly Discretionary. In the mat- ter of interest payments some income bonds are almost precisely in the position of a preferred stock, because the directors are given practically complete discretion over the amounts to be paid to the bondholders. The 1 This was a $500,000 issue of Milwaukee Lake Shore and Western Income 6s, issued in 1881, assumed by the Chicago and Northwestern in 1891, and paid off at maturity in 1911. St. Louis-San Francisco Railway Company Income 6s

rest Payment Sometimes Wholly Discretionary. In the mat- ter of interest payments some income bonds are almost precisely in the position of a preferred stock, because the directors are given practically complete discretion over the amounts to be paid to the bondholders. The 1 This was a $500,000 issue of Milwaukee Lake Shore and Western Income 6s, issued in 1881, assumed by the Chicago and Northwestern in 1891, and paid off at maturity in 1911. St. Louis-San Francisco Railway Company Income 6s and Adjustment 6s were both called for repayment at par in 1928, which was 32 and 27 years, respectively, prior to their maturity. This proved fortunate for the bondholders since the road went into receivership in 1932. The history of the ’Frisco between its emergence from receivership in 1916 and its subsequent relapse into receivership in 1932 is an extraordinary example of the heedlessness of both investors and speculators, who were induced by a moderate improvement, shown in a few years of general prosperity, to place a high rating on the securities of a railroad with a poor previous record and a top-heavy capital structure. [202] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. customary provisions require that interest be paid to the extent that income is available, but many indentures permit the directors to set aside whatever portion of the income they please for capital expenditures or other purposes, before arriving at the “available” balance. In the case of the Green Bay and Western Railroad Company Income Debentures “Series B,” the amounts paid out between 1922 and 1931, inclusive, aggre- gated only 6% although the earnings were equal to only slightly less than 22%. The more recent indentures (e.g., Colorado Fuel and Iron Company Income 5s, due 1970) tend to place definite limits on the percentage of earnings which may be withheld in this manner from the income bond- holders; but a considerable degre

ving at the “available” balance. In the case of the Green Bay and Western Railroad Company Income Debentures “Series B,” the amounts paid out between 1922 and 1931, inclusive, aggre- gated only 6% although the earnings were equal to only slightly less than 22%. The more recent indentures (e.g., Colorado Fuel and Iron Company Income 5s, due 1970) tend to place definite limits on the percentage of earnings which may be withheld in this manner from the income bond- holders; but a considerable degree of latitude is usually reserved to the directors. It may be said that individual income-bond issues may be found illustrating almost every step in the range of variation between straight preferred stocks and ordinary bonds. Low Investment Rating of Income Bonds as a Class. Since the contractual rights of income bonds are always more or less superior to those of preferred stocks, it might be thought that a greater proportion of income bonds than of preferred stocks would deserve an investment rating. Such is not the case, however. In fact we know of only one income obligation which has maintained an investment standing continuously over any length of time, viz., Atchison, Topeka and Santa Fe Railway Company Adjustment 4s, due 1995.2 We have here a contrast between 2 After more than forty years of uninterrupted interest payments, this issue lapsed temporarily from grace in 1938. May 1 interest (on bonds entitled to semiannual interest) was deferred but paid six months later. The price dropped from 1031/4 to 751/8 but recovered to 961/4—all in the year 1938. This recovery is a striking commentary on the eagerness of investors for so-called “prime bonds.” Some guaranteed income bonds of leased railroads have maintained a high investment standing, similar to that of guaranteed railroad stocks. Example: Elmira and Williamsport Railroad Income 5s, due 2862, guaranteed by Pennsylvania Railroad and by an important subsidiary. (Note the 1,000-year maturity.) Also observe the superi

e dropped from 1031/4 to 751/8 but recovered to 961/4—all in the year 1938. This recovery is a striking commentary on the eagerness of investors for so-called “prime bonds.” Some guaranteed income bonds of leased railroads have maintained a high investment standing, similar to that of guaranteed railroad stocks. Example: Elmira and Williamsport Railroad Income 5s, due 2862, guaranteed by Pennsylvania Railroad and by an important subsidiary. (Note the 1,000-year maturity.) Also observe the superior position of Chicago, Terre Haute, and Southeastern Income 5s, guaran- teed by the Chicago, Milwaukee, St. Paul and Pacific Railroad, in the reorganization of that system (infra p. 209). Among the newer crop of income bonds, one has qualified as an investment issue almost from the start: Allied Owners Corporation 4s-5s, virtually guaranteed by Loews, Inc. In the authors’ view, there was no excuse for making this an income bond in the reorganization of 1936. theory and actuality, the reason being, of course, that income bonds have been issued almost exclusively in connection with corporate reorgani- zations and have therefore been associated with companies of second- ary credit standing. The very fact that the interest payments are dependent on earnings implies the likelihood that the earnings may be insufficient. Preferred-stock dividends are equally dependent upon earn- ings, but the same implication is not associated with them. Hence the general investment status of income bonds as a class is seen to have been governed by the circumstances under which they are created rather than by the legal rights which attach to them. To use an analogy: If it had been the general practice here, as in England, to avoid mortgage-bond issues wherever possible, using them only where doubtful credit made this pro- tection necessary, then we might find that mortgage bonds in general would occupy an investment position distinctly inferior to that of deben- ture bonds.3 Increased Volume of I

as a class is seen to have been governed by the circumstances under which they are created rather than by the legal rights which attach to them. To use an analogy: If it had been the general practice here, as in England, to avoid mortgage-bond issues wherever possible, using them only where doubtful credit made this pro- tection necessary, then we might find that mortgage bonds in general would occupy an investment position distinctly inferior to that of deben- ture bonds.3 Increased Volume of Income Bonds Probable. Looking forward, it may be true that in the future income obligations will show a larger proportion of investment issues than will be found among preferred stocks. The numerous reorganizations growing out of the 1930–1933 depression and the continued weakness of railway earnings have created a large new crop of income bonds, and some of these companies may later so improve their position as to place their income obligations in the investment class, as happened to the Atchison, Topeka and Santa Fe after its reorganization in 1895. There is also the point, so far almost over- looked, that income bonds effect a substantial saving in corporation taxes as compared with preferred stocks, without important offsetting disad- vantages. Some strong companies may some day be led to replace their present preferred stocks—or to do their new financing—by income obli- gations, for the sake of this tax saving, in the same way as they are now creating artificially low par values for their shares to reduce the transfer taxes thereon. A development of this kind in the future might result in a 3 This actually proved to be the case in the industrial financing of 1937–1939. Practically all the bond issues were debentures and were sold at unusually low interest rates. It may be said, we believe, that industrial debentures now connote a higher type of security than industrial mortgage bonds. respectable number of income-bond issues deserving to rank as fixed- value investmen

or their shares to reduce the transfer taxes thereon. A development of this kind in the future might result in a 3 This actually proved to be the case in the industrial financing of 1937–1939. Practically all the bond issues were debentures and were sold at unusually low interest rates. It may be said, we believe, that industrial debentures now connote a higher type of security than industrial mortgage bonds. respectable number of income-bond issues deserving to rank as fixed- value investments.4 Calculations of Margins of Safety for Income Bonds. The tech- nique of analyzing an income-bond exhibit is identical with that for a pre- ferred stock. Computations of earnings on the issue taken separately must, of course, be rigorously avoided, although such calculations are given by the statistical agencies. We suggest that the minimum earnings coverage recommended in the preceding chapter for preferred stocks be required also for income bonds when selected as fixed-value investments. Example: The following analysis of the Missouri-Kansas-Texas Rail- road Company income account for 1930 will illustrate the proper method of dealing with all the senior securities of a company having adjustment bonds. It also shows how the two methods of figuring the fixed charges of a railroad system (discussed in Chap. 12 on accompanying CD) are to be applied to the analysis of income bonds and preferred stock. Note that interest on income or adjustment bonds is not part of the total interest charges when calculating the coverage for the fixed-interest bonds. In this respect the position of an income bond is exactly that of a preferred stock. Note also that the statement made by the statistical ser- vices that 57.29% was earned on the M-K-T Adjustment 5s. (i.e., that the “interest was covered” more than eleven times) is valueless or misleading. Significance of These Figures for the Investor in Early 1931. The 1930 earnings were somewhat lower than the ten-year average and could then ap

arges when calculating the coverage for the fixed-interest bonds. In this respect the position of an income bond is exactly that of a preferred stock. Note also that the statement made by the statistical ser- vices that 57.29% was earned on the M-K-T Adjustment 5s. (i.e., that the “interest was covered” more than eleven times) is valueless or misleading. Significance of These Figures for the Investor in Early 1931. The 1930 earnings were somewhat lower than the ten-year average and could then apparently be viewed as a fair indication of the normal earning power of M-K-T. The coverage for the preferred stock was clearly inadequate from any investment standpoint. The coverage for the adjustment-bond inter- est on the more conservative basis (the net-deductions method) was 4 The Associated Gas and Electric Company used the device of “bonds” convertible into pre- ferred stock at the option of the company, and obtained this tax saving without the burden of a fixed-bond obligation. The income-bond form would have been far less misleading to the ordinary investor than this extraordinary invention. Income bonds have been favored over preferred stocks in railroad reorganizations because of legal restrictions on insurance companies which would prohibit them from hold- ing preferred shares in place of their old bonds. Conceivably this consideration, as well as the tax saving, could induce corporations to do new financing through income bonds in lieu of preferred stocks. Missouri-Kansas-Texas Railroad Company, Calendar Year 1930 (All dollar figures in thousands) Gross revenue $45,949 Railway operating income (net after taxes) 13,353 Gross income (net after rents, plus other income) 12,009 Fixed charges (fixed interest and other deductions) 4,230 Balance for adjustment interest 7,779 Adjustment interest 696 Balance for dividends (net income) 7,083 Preferred dividends 4,645 Balance for common 2,438 Net after taxes exceeds gross income. Hence use net-deductions test. Net deduct

as-Texas Railroad Company, Calendar Year 1930 (All dollar figures in thousands) Gross revenue $45,949 Railway operating income (net after taxes) 13,353 Gross income (net after rents, plus other income) 12,009 Fixed charges (fixed interest and other deductions) 4,230 Balance for adjustment interest 7,779 Adjustment interest 696 Balance for dividends (net income) 7,083 Preferred dividends 4,645 Balance for common 2,438 Net after taxes exceeds gross income. Hence use net-deductions test. Net deductions = difference between net after taxes and balance for adjustment interest = $13,353 - $7,779. Times earned Net deductions = $ 5,574 $13,353 = 2.40 $5,574 Net deductions and adjustment interest = 6,270 $13,353 = 2.14 $6,270 Net deductions, adjustment interest, and preferred dividends = $10,915 $13,353 $10,915 = 1.22 below our minimum requirement of 21/2 times, so that this issue would not have qualified for investment. The coverage for the fixed-bond inter- est was substantially above our minimum and indicated a satisfactory degree of protection. Naturally the disastrous decline of earnings in 1931–1933 could not have been foreseen or fully guarded against. The market price of M-K-T fixed obligations suffered severely in 1932; but since the company’s debt structure was relatively conservative, it did not come so close to insol- vency as the majority of other carriers. In fact, the 1932–1934 interest was paid on the adjustment bonds, although such payment was not obligatory. Subsequent developments are worth describing because of their prac- tical bearing on bond investment. The following table should prove instructive: Year Balance for interest Net deductions earned, times Range for year 41/2s, 1978 Adj. 5s 1930 11,999,000 2.40 921/2–101 86– 1081/2 1931 5,579,000 1.22 431/2– 98 34– 95 1932 4,268,000 1.01 36– 703/4 13– 60 1933 3,378,000 0.86 55– 771/2 323/4–65 1934 2,093,000 0.65 631/8– 833/4 29– 621/2 1935 2,457,000 0.71 281/2– 64 111/4–361/2 1936 4,

ry. Subsequent developments are worth describing because of their prac- tical bearing on bond investment. The following table should prove instructive: Year Balance for interest Net deductions earned, times Range for year 41/2s, 1978 Adj. 5s 1930 11,999,000 2.40 921/2–101 86– 1081/2 1931 5,579,000 1.22 431/2– 98 34– 95 1932 4,268,000 1.01 36– 703/4 13– 60 1933 3,378,000 0.86 55– 771/2 323/4–65 1934 2,093,000 0.65 631/8– 833/4 29– 621/2 1935 2,457,000 0.71 281/2– 64 111/4–361/2 1936 4,773,000 1.09 521/2– 83 303/4–743/4 1937 3,274,000 0.86 38– 793/4 181/2–80 1938 1,120,000 0.49 25– 453/4 10– 24 It will be seen that the 1930 earnings did not in fact prove a guide to the future normal earning power of M-K-T. Yet this mistake need not have proved very costly to an individual investor who bought the fixed-inter- est bonds in 1931. Despite the decline in earnings and investment quality, he had several opportunities to sell out advantageously during the next six years. As we point out later (Chap. 21), proper investment technique would have compelled such a sale, in view of the changed exhibit. After 1934, interest on the adjustment bonds was paid only in 1937. The price range of that issue is interesting chiefly as a reflection of the heedlessness of bond buyers. Note that at the 1937 highs they paid the same price for the adjustment 5s as for the 41/2s, despite the totally inad- equate earnings coverage, and despite the fact that in 1932, 1934 and 1935 the senior issue had sold more than twice as high as the adjustments. Senior Income Bonds. There are a few instances of income bonds which are senior in their lien to other bonds bearing fixed interest. The Atchison Adjustment 4s are the best known example, being followed by 4% fixed-interest debenture issues which have regularly sold at a lower price except briefly in 1938. The situation holds true also with respect to St. Louis Southwestern Railway Company Second Income 4s.5 While the 5 The various reorgan

ue had sold more than twice as high as the adjustments. Senior Income Bonds. There are a few instances of income bonds which are senior in their lien to other bonds bearing fixed interest. The Atchison Adjustment 4s are the best known example, being followed by 4% fixed-interest debenture issues which have regularly sold at a lower price except briefly in 1938. The situation holds true also with respect to St. Louis Southwestern Railway Company Second Income 4s.5 While the 5 The various reorganization plans for this road (1936–1939) all give the Second Income 4s much better treatment than is offered the junior fixed-interest issues. An unusual case is afforded by Wabash Railway Noncumulative Income Debenture 6s, due 1939, interest on which was payable “from net income.” Although called debentures, they are secured by a direct lien and have priority over the Wabash Railroad Refunding and General Mortgage. Although entitled by their terms only to noncumulative interest dependent on earnings, this theoretical status of such bonds is rather confusing, the practical proce- dure called for is, obviously, to treat the interest thereon as part of the company’s fixed charges, when dealing with the system as a whole. II. GUARANTEED ISSUES No special investment quality attaches to guaranteed issues as such. Inex- perienced investors may imagine that the word “guaranteed” carries a positive assurance of safety; but, needless to say, the value of any guar- anty depends strictly upon the financial condition of the guarantor. If the guarantor has nothing, the guaranty is worthless. In contrast with the atti- tude of the financial novice, Wall Street displays a tendency to underesti- mate the value of a guaranty, as shown by the lower prices often current for guaranteed issues in comparison with the debentures or even the pre- ferred stock of the guarantor. This sophisticated distrust of guarantees dates back to the Kanawha and Hocking Coal and Coke Company case in 1915, when

the financial condition of the guarantor. If the guarantor has nothing, the guaranty is worthless. In contrast with the atti- tude of the financial novice, Wall Street displays a tendency to underesti- mate the value of a guaranty, as shown by the lower prices often current for guaranteed issues in comparison with the debentures or even the pre- ferred stock of the guarantor. This sophisticated distrust of guarantees dates back to the Kanawha and Hocking Coal and Coke Company case in 1915, when the guarantor railroad endeavored to escape its liability by claiming that the guaranty, made in 1901, was beyond its corporate pow- ers and hence void. This attempt at evasion, encouraged by the outcome of antitrust suits in the Ohio and federal courts, in the end proved com- pletely unsuccessful; but it cast a shadow over the value of all guarantees, from which they have not completely emerged even after 25 years.6 We know of no important case in which a solvent company has escaped the consequences of its guaranty through legal technicalities.7 interest was paid regularly from 1916 through 1938, despite the fact that the company entered receivership in 1931 and defaulted upon the junior-mortgage (fixed) interest in 1932. This issue was also given superior treatment in the various reorganization plans for the Wabash filed to the end of 1939. 6 See Appendix Note 29, p. 761, for a condensed history of this famous case. 7 However, the shadowy form of “insolvency” provided for in Chap. XI of the Chandler (Federal Bankruptcy) Act has been availed of to induce holders of guaranteed issues to mod- ify their contract without sacrifice by the guarantor company and to force acceptance of the modified terms by minority holders. Example: Modification of guaranty of Trinity Building 51/2s by United States Realty and Improvement proposed in March 1939. Contrast this with the full payment in October 1932 of the unpurchased portion of Savoy Plaza Corporation Debenture 51/2s, which had also

I of the Chandler (Federal Bankruptcy) Act has been availed of to induce holders of guaranteed issues to mod- ify their contract without sacrifice by the guarantor company and to force acceptance of the modified terms by minority holders. Example: Modification of guaranty of Trinity Building 51/2s by United States Realty and Improvement proposed in March 1939. Contrast this with the full payment in October 1932 of the unpurchased portion of Savoy Plaza Corporation Debenture 51/2s, which had also been guaranteed by United States Realty and Improvement. At that time unguaranteed First Mortgage bonds of Savoy Plaza had been selling as low as 5. Note also the full payment in 1939 of Utica, Clinton and Binghamton Railroad First 5s through funds supplied by Delaware and Hudson Railroad, the guarantor, although Delaware and Hudson had not been operating the line for a great many years. Status of Guaranteed Issues. If a company guarantees interest, div- idend, or principal payments, its failure to meet this obligation will expose it to insolvency. The claim against the guarantor ranks equally with an unsecured debt of the company, so that guaranteed issues deserve the same rating as a debenture bond of the guarantor and a better rating than its preferred stock. A guaranteed issue may also be entitled to an invest- ment rating because of its own position and earning power independent of the guaranty. In such cases the guaranty may add to its security, but it cannot detract therefrom even if the guarantor company itself is in bad straits. Examples: The Brooklyn Union Elevated Railroad 5s (see pages 78–79) were guaranteed by the Brooklyn Heights Railroad Company, which went into receivership in 1919; but the bond came through the reorganization unscathed because of its own preferred position in the Brooklyn Rapid Transit System. Similarly U. S. Industrial Alcohol Company Preferred div- idends were guaranteed by Distilling Company of America; the latter enterprise became bank

even if the guarantor company itself is in bad straits. Examples: The Brooklyn Union Elevated Railroad 5s (see pages 78–79) were guaranteed by the Brooklyn Heights Railroad Company, which went into receivership in 1919; but the bond came through the reorganization unscathed because of its own preferred position in the Brooklyn Rapid Transit System. Similarly U. S. Industrial Alcohol Company Preferred div- idends were guaranteed by Distilling Company of America; the latter enterprise became bankrupt, but the Alcohol Company was easily able to continue the dividend out of its own earnings and later to retire the preferred issue at 125. A common or preferred stock fully guaranteed by another company has the status of a bond issue as far as the guarantor is concerned. If the guaranty proves worthless, it would naturally return to the position of a stock—usually a weak issue, but possibly a strong one, as in the case of U. S. Industrial Alcohol Company Preferred just mentioned. A similar situation obtains with respect to income bonds of one company guaran- teed by another (e.g., Chicago, Terre Haute, and Southeastern Railway Company Income 5s,8 guaranteed by the Chicago, Milwaukee, St. Paul and Pacific Railroad Company). The value of a guarantee is sometimes very evident when part of an issue is guaranteed and part is not. 8 Interest was continued on these income bonds (through 1939) despite receivership of the guarantor company in 1935 and default on all its own obligations. This was due not to the guarantee but to the strategic importance and substantial earnings of the Terre Haute division. Note that in this case a divisional second-mortgage income bond fared substantially better than the first mortgage on the main line of the system. Not the terms but the facts determine investment performance. Example: ANACOSTIA AND POTOMAC RIVER RAILROAD FIRST 5S, DUE 1949 $500,000 guaranteed by Washington Ry. & Elec. Co. price 110 in 1939 $2,100,000 unguaranteed price 80 in 19

is was due not to the guarantee but to the strategic importance and substantial earnings of the Terre Haute division. Note that in this case a divisional second-mortgage income bond fared substantially better than the first mortgage on the main line of the system. Not the terms but the facts determine investment performance. Example: ANACOSTIA AND POTOMAC RIVER RAILROAD FIRST 5S, DUE 1949 $500,000 guaranteed by Washington Ry. & Elec. Co. price 110 in 1939 $2,100,000 unguaranteed price 80 in 1939 In this case the Anacostia company’s earnings coverage was inade- quate (1.36 times in 1938), but that of the guarantor company was high (over 4 times in 1938 on a consolidated basis and over 11 times in that year on a parent-only basis inclusive of interest for which it was contin- gently liable). Exact Terms of Guaranty Are Important. The exact terms of a guaranty have obviously a vital influence upon its value. A guaranty of interest only is likely to be much less significant than a guaranty of prin- cipal as well. Examples: Philippine Railway Company First 4s, due 1937, were guar- anteed as to interest only by the Philippine government. The earnings of the road itself were poor. Interest was paid promptly up to maturity, but principal was defaulted. The price of the bond reflected this situation, having sold no higher than 39 since 1929.9 Minneapolis, St. Paul and Saulte Saint Marie Railroad First Consoli- dated 4s and 5s due 1938: All the 4% bonds and about half the 5% bonds were guaranteed as to interest only by Canadian Pacific Railway. Princi- pal was defaulted on maturity, and the Canadian Pacific ceased to pay interest, the price of the bonds declining to 6.10 On the other hand, this company’s First and Refunding 51/2 s, Series B, due 1978,—a junior lien—are also guaranteed as to interest by Canadian Pacific and in accordance with the guaranty continued to receive interest after the senior lien was in default. These bonds sold at 64 in 1939, whereas 9 Efforts ma

re guaranteed as to interest only by Canadian Pacific Railway. Princi- pal was defaulted on maturity, and the Canadian Pacific ceased to pay interest, the price of the bonds declining to 6.10 On the other hand, this company’s First and Refunding 51/2 s, Series B, due 1978,—a junior lien—are also guaranteed as to interest by Canadian Pacific and in accordance with the guaranty continued to receive interest after the senior lien was in default. These bonds sold at 64 in 1939, whereas 9 Efforts made by a protective committee to induce the Philippine government to buy the bonds or assume liability for the principal resulted only in a scandal and a jail sentence for the chairman of the committee in 1939. The bonds sold at 7 in 1939. 10 Bondholders brought legal action in 1939 to compel Canadian Pacific to continue to pay interest until the principal was discharged. the senior issues sold at 6. Note that in 1931 they sold as low as 35, whereas the 1st Consolidated Guaranteed 5s, due 1938, sold at 45 and the Cana- dian Pacific (unsecured) Debenture stock sold at 567/8. It is clear that the value of the long-term Canadian Pacific guaranty was not fully appreci- ated in 1931. A similar disadvantage attaches to a guaranty of dividends running for a limited period. Examples: The actual working out of such a situation was shown in the case of American Telegraph and Cable Company common stock, which was guaranteed as to 5% dividends (only) for 50 years from 1882 by the Western Union Telegraph Company under a lease terminating in 1932. Because of the long record of dividend payments, investors came finally to consider the dividend as a fixture, and as late as 1922 the stock sold at 70. But in the meantime the strategic or trade value of the leased cable properties was rapidly diminishing, so that the value of the stock at the expiration of the lease was likely to be very small. A settlement was made in 1930 with Western Union under which the American Telegraph and Cable stockh

legraph Company under a lease terminating in 1932. Because of the long record of dividend payments, investors came finally to consider the dividend as a fixture, and as late as 1922 the stock sold at 70. But in the meantime the strategic or trade value of the leased cable properties was rapidly diminishing, so that the value of the stock at the expiration of the lease was likely to be very small. A settlement was made in 1930 with Western Union under which the American Telegraph and Cable stockholders received the equivalent of about $20 for the prin- cipal of their stock.11 A rather unusual example of the importance of the exact terms of a guaranty was supplied by Pratt and Whitney Preferred (retired in 1928). According to the security manuals, the dividend on this issue was “guar- anteed” by its parent company, Niles-Bement-Pond. But in fact the Niles company agreed to make up unpaid dividends on Pratt and Whitney Pre- ferred only to the extent that Niles had earnings available therefor after payment of its own preferred dividends. Hence no dividends were received by Pratt and Whitney Preferred stockholders from November 1924 to June 1926 without any claim being enforceable against Niles-Bement-Pond. In view of the possibility of such special provisions, particular care must be exercised to obtain complete information regarding the terms of a guar- anty before purchasing any security on the strength thereof. 11 An alert investor might have taken warning of this possibility from statements contained in the annual reports of Western Union, starting with 1913, wherein this company’s own holdings of American Telegraph and Cable stock were written down annually towards an estimated value of $10 per share in 1932. Joint and Several Guarantees. Such guarantees are given by more than one company to cover the same issue, and each company accepts responsibility not only for its pro rata share but also for the share of any other guarantor who may default. In other words,

from statements contained in the annual reports of Western Union, starting with 1913, wherein this company’s own holdings of American Telegraph and Cable stock were written down annually towards an estimated value of $10 per share in 1932. Joint and Several Guarantees. Such guarantees are given by more than one company to cover the same issue, and each company accepts responsibility not only for its pro rata share but also for the share of any other guarantor who may default. In other words, each guarantor con- cern is potentially liable for the entire amount of the issue. Since two or more sponsors are better than one, bonds bearing a joint and several guarantee are likely to have special advantages. Example: The most familiar class of issues backed by such a guaranty are the bonds of union railroad stations. An outstanding example is sup- plied by Kansas City Terminal Railway Company First 4s, due 1960, which are guaranteed jointly and severally by no less than 12 railroads, all of which use the company’s facilities. The 12 guarantors are as follows: Atchison, Alton, Burlington, St. Paul, Great Western, Rock Island, Kansas City Southern, M-K-T, Missouri Pacific, ’Frisco, Union Pacific and Wabash. The value of each of these individual guarantees has varied greatly from road to road and from time to time, but at least three of the com- panies have consistently maintained sufficient financial strength to assure a Terminal bondholder that his obligation would be met with- out difficulty. Investors have not fully appreciated the superior protec- tion accorded by the combined responsibility of the 12 carriers as compared with the liability of any one of them singly. The price record shows that the Kansas City Terminal Railway Company 4s frequently sold at no higher prices than representative issues of individual guar- antor companies which later turned out to be of questionable sound- ness, whereas at no time was the safety of the Terminal bond ever a matter of doubt

t difficulty. Investors have not fully appreciated the superior protec- tion accorded by the combined responsibility of the 12 carriers as compared with the liability of any one of them singly. The price record shows that the Kansas City Terminal Railway Company 4s frequently sold at no higher prices than representative issues of individual guar- antor companies which later turned out to be of questionable sound- ness, whereas at no time was the safety of the Terminal bond ever a matter of doubt.12 It would seem good policy for investors, therefore, to favor bonds of this type, which carry the guaranty of a number of substantial enterprises, in preference to the obligations of a single company. 12 See Appendix Note 30, p. 762 on accompanying CD, for supporting data. Federal Land Bank Bonds. A somewhat different aspect of the joint and several guarantee appears in the important case of the Federal Land Bank bonds, which are secured by deposit of farm mortgages. The obli- gations of each of the 12 separate banks are guaranteed by the 11 others, so that each Federal Land Bank bond is in reality a liability of the entire system. When these banks were organized, there was created concur- rently a group of Joint Stock Land Banks which also issued bonds, but the obligations of one Joint Stock Bank were not guaranteed by the others.13 Both sets of land banks were under United States government supervi- sion and the bonds of both were made exempt from federal taxation. Practically all of the stock of the Federal Land Banks was subscribed for originally by the United States government (which, however, did not assume liability for their bonds); the Joint Stock Land Bank shares were privately owned. At the inception of this dual system, investors were disposed to con- sider the federal supervision and tax exemption as a virtual guarantee of the safety of the Joint Stock Land Bank bonds, and they were therefore willing to buy them at a yield only 1/2% higher than that retur

y all of the stock of the Federal Land Banks was subscribed for originally by the United States government (which, however, did not assume liability for their bonds); the Joint Stock Land Bank shares were privately owned. At the inception of this dual system, investors were disposed to con- sider the federal supervision and tax exemption as a virtual guarantee of the safety of the Joint Stock Land Bank bonds, and they were therefore willing to buy them at a yield only 1/2% higher than that returned by the Federal Land Bank bonds. In comparing the nonguaranteed Joint Stock bonds with the mutually guaranteed federal bonds, the following obser- vations might well have been made: 1. Assuming the complete success of the farm-loan system, the guar- antee would be superfluous, since each bond issue separately would have enjoyed ample protection. 2. Assuming complete failure of the system, the guarantee would prove worthless, since all the banks would be equally insolvent. 3. For any intermediate stage between these two extremes, the joint and several guarantee might prove extremely valuable. This would be par- ticularly true as to bonds of a farm-loan district subjected to extremely adverse conditions of a local character. 13 The word “Joint” in the title referred to the ownership of the stock by various interests, but it may have created an unfortunate impression among investors that there was a joint responsibility by the group of banks for the liabilities of each. For a comprehensive account and criticism of these banks, see Carl H. Schwartz, “Financial Study of the Joint Stock Land Banks,” Washington, D. C., 1938. In view of the fact that the farm-loan system was a new and untried undertaking, investors therein should have assured themselves of the largest possible measure of protection. Those who in their eagerness for the extra 1/2% of income return dispensed with the joint guarantee com- mitted a patent mistake of judgment.14 14 A number of

nsive account and criticism of these banks, see Carl H. Schwartz, “Financial Study of the Joint Stock Land Banks,” Washington, D. C., 1938. In view of the fact that the farm-loan system was a new and untried undertaking, investors therein should have assured themselves of the largest possible measure of protection. Those who in their eagerness for the extra 1/2% of income return dispensed with the joint guarantee com- mitted a patent mistake of judgment.14 14 A number of the Joint Stock bond issues defaulted during 1930–1932, a large proportion sold at receivership prices, and all of them declined to a speculative price level. On the other hand, not only were there no defaults among the Federal Land Bank bonds, but their prices suffered a relatively moderate shrinkage, remaining consistently on an investment level. This much more satisfactory experience of the investor in the Federal Land Bank bonds was due in good part to the additional capital subscribed by the United States government to these Banks, and to the closer supervision to which they were subjected, but the joint and several guarantee undoubtedly proved of considerable benefit. Note also that Joint Stock Land Bank bonds were made legal investments for trust funds in many states, and remained so after 1932 despite their undoubtedly inadequate security. Since May 1933 the Joint Stock Land Banks have been prohibited from taking on new business, and orderly liquidation has been in process. Chapter 17 GUARANTEED SECURITIES (Continued) GUARANTEED REAL ESTATE MORTGAGES AND MORTGAGE BONDS The practice of guaranteeing securities reached its widest development in the field of real estate mortgages. These guarantees are of two differ- ent types: the first being given by the corporation engaged in the sale of the mortgages or mortgage participations (or by an affiliate); the second and more recent form being the guaranty given by an independ- ent surety company, which assumes the co

Chapter 17 GUARANTEED SECURITIES (Continued) GUARANTEED REAL ESTATE MORTGAGES AND MORTGAGE BONDS The practice of guaranteeing securities reached its widest development in the field of real estate mortgages. These guarantees are of two differ- ent types: the first being given by the corporation engaged in the sale of the mortgages or mortgage participations (or by an affiliate); the second and more recent form being the guaranty given by an independ- ent surety company, which assumes the contingent liability in return for a fee. The idea underlying real estate mortgage guarantees is evidently that of insurance. It is to the mortgage holder’s advantage to protect himself, at some cost in income return, against the possibility of adverse develop- ments affecting his particular property (such as a change in the charac- ter of the neighborhood). It is within the province of sound insurance practice to afford this protection in return for an adequate premium, pro- vided of course, that all phases of the business are prudently handled. Such an arrangement will have the best chance of success if: 1. The mortgage loans are conservatively made in the first instance. 2. The guaranty or surety company is large, well managed, independent of the agency selling the mortgages, and has a diversification of business in fields other than real estate. 3. Economic conditions are not undergoing fluctuations of abnormal intensity. The collapse in real estate values after 1929 was so extreme as to con- travene the third of these conditions. Accordingly the behavior of real estate mortgage guarantees during this period may not afford a really fair guide to their future value. Nevertheless, some of the characteristics which they revealed are worthy of comment. [215] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. This Business Once Conservatively Managed. In the first place a striking contrast may be drawn between the way

s to con- travene the third of these conditions. Accordingly the behavior of real estate mortgage guarantees during this period may not afford a really fair guide to their future value. Nevertheless, some of the characteristics which they revealed are worthy of comment. [215] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. This Business Once Conservatively Managed. In the first place a striking contrast may be drawn between the way in which the business of guaranteeing mortgages had been conducted prior to about 1924 and the lax methods which developed thereafter, during the very time that this part of the financial field was attaining its greatest importance. If we consider the policies of the leading New York City institutions which guaranteed real estate mortgages (e.g., Bond and Mortgage Guar- antee Company, Lawyers Mortgage Company), it is fair to say that for many years the business was conservatively managed. The amount of each mortgage was limited to not more than 60% of the value, carefully determined; large individual mortgages were avoided; and a fair diver- sification of risk, from the standpoint of location, was attained. It is true that the guarantor companies were not independent of the selling com- panies, nor did they have other types of surety business. It is true also that the general practice of guaranteeing mortgages due only three to five years after their issuance contained the possibility, later realized, of a flood of maturing obligations at a most inconvenient time. Neverthe- less, the prudent conduct of their activities had enabled them success- fully to weather severe real estate depressions such as occurred in 1908 and 1921. New and Less Conservative Practices Developed. The building boom which developed during the “new era” was marked by an enormous growth of the real estate mortgage business and of the practice of guaran- teeing obligations of this kind. New people, new c

, later realized, of a flood of maturing obligations at a most inconvenient time. Neverthe- less, the prudent conduct of their activities had enabled them success- fully to weather severe real estate depressions such as occurred in 1908 and 1921. New and Less Conservative Practices Developed. The building boom which developed during the “new era” was marked by an enormous growth of the real estate mortgage business and of the practice of guaran- teeing obligations of this kind. New people, new capital, and new meth- ods entered the field. Several small local concerns which had been in the field for a long period were transformed into highly aggressive organiza- tions doing a gigantic and nation-wide business. Great emphasis was laid upon the long record of success in the past, and the public was duly impressed—not realizing that the size, the methods, and the personnel were so changed that they were in fact dealing with a different institution. In a previous chapter we pointed out how recklessly unsound were the methods of financing real estate ventures during this period. The weak- ness of the mortgages themselves applied equally to the guarantees which were frequently attached thereto for an extra consideration. The guaran- tor companies were mere subsidiaries of the sellers of the bonds. Hence, when the crash came, the value of the properties, the real estate bond com- pany, and the affiliated guarantor company all collapsed together. Evil Effects of Competition and Contagion. The rise of the newer and more aggressive real estate bond organizations had a most unfortu- nate effect upon the policies of the older concerns. By force of competi- tion they were led to relax their standards of making loans. New mortgages were granted on an increasingly liberal basis, and when old mortgages matured, they were frequently renewed in a larger sum. Furthermore, the face amount of the mortgages guaranteed rose to so high a multiple of the capital of the guarantor companies

agion. The rise of the newer and more aggressive real estate bond organizations had a most unfortu- nate effect upon the policies of the older concerns. By force of competi- tion they were led to relax their standards of making loans. New mortgages were granted on an increasingly liberal basis, and when old mortgages matured, they were frequently renewed in a larger sum. Furthermore, the face amount of the mortgages guaranteed rose to so high a multiple of the capital of the guarantor companies that it should have been obvious that the guaranty would afford only the flimsiest of protection in the event of a general decline in values. When the real estate market broke in 1931, the first consequence was the utter collapse of virtually every one of the newer real estate bond companies and their subsidiary guarantor concerns. As the depression continued, the older institutions gave way also. The hold- ers of guaranteed mortgages or participations therein (aggregating about $3,000,000,000 guaranteed by New York title and mortgage com- panies alone) found that the guaranty was a mere name and that they were entirely dependent upon the value of the underlying properties. In most cases these had been mortgaged far more heavily than reason- able prudence would have permitted. Apparently only a very small fraction of the mortgages outstanding in 1932 were created under the conservative conditions and principles that had ruled up to, say, eight years previously. Guarantees by Independent Surety Companies. During the 1924–1930 period several of the independent surety and fidelity compa- nies extended their operations to include the guaranteeing of real-estate mortgages for a fee or premium. Theoretically, this should have repre- sented the soundest method of conducting such operations. In addition to the strength and general experience of the surety company there was the important fact that such a guarantor, being entirely independent, would presumably be highly critical of the

t Surety Companies. During the 1924–1930 period several of the independent surety and fidelity compa- nies extended their operations to include the guaranteeing of real-estate mortgages for a fee or premium. Theoretically, this should have repre- sented the soundest method of conducting such operations. In addition to the strength and general experience of the surety company there was the important fact that such a guarantor, being entirely independent, would presumably be highly critical of the issues submitted for its guar- anty. But this theoretical advantage was offset to a great extent by the fact that the surety companies began the practice of guaranteeing real estate mortgage bonds only a short time prior to their debacle, and they were led by the general overoptimism then current to commit serious errors in judgment. In most cases the resultant losses to the guarantor were greater than it could stand; several of the companies were forced into receivership (notably National Surety Company), and holders of bonds with such guarantees failed to obtain full protection.1 LEASEHOLD OBLIGATIONS EQUIVALENT TO GUARANTEES The property of one company is often leased to another for a fixed annual rental sufficient to pay interest and dividends on the former’s capital issues. Frequently the lease is accompanied by a specific guaranty of such interest and dividend payments, and in fact the majority of guaranteed corporate issues originate in this fashion.2 But even if there is no explicit guaranty, a lease or other contract providing fixed annual payments will supply the equivalent of a guaranty on the securities of the lessee company. Examples: An excellent instance of the value of such an arrangement is afforded by the Westvaco Chlorine Products Corporation 51/2s, issued in 1927 and maturing in 1937. The Westvaco Company agreed to sell part of its output to a subsidiary of Union Carbide and Carbon Corporation, and the latter enterprise guaranteed that monthly payment

o explicit guaranty, a lease or other contract providing fixed annual payments will supply the equivalent of a guaranty on the securities of the lessee company. Examples: An excellent instance of the value of such an arrangement is afforded by the Westvaco Chlorine Products Corporation 51/2s, issued in 1927 and maturing in 1937. The Westvaco Company agreed to sell part of its output to a subsidiary of Union Carbide and Carbon Corporation, and the latter enterprise guaranteed that monthly payments would be made to the trustee sufficient to take care of the interest and retirement of the 51/2% bonds. In effect this arrangement was a guaranty of interest and principal of the Westvaco issue by Union Carbide and Carbon, a very strong concern. By reason of this protection and the continuous pur- chases for redemption made thereunder, the price of the issue was main- tained at 99 or higher throughout 1932–1933. This contrasts with a decline in the price of Westvaco common stock from 1161/2 in 1929 to 3 in 1932. (The entire bond issue was called at 1001/2 in September 1935.) Another interesting example is supplied by the Tobacco Products Cor- poration of New Jersey 61/2s, due 2022. The properties of this company were leased to American Tobacco Company under a 99-year contract, 1 But in the case of the independent surety companies the guarantees proved of substantial, if only partial, value. The bankruptcy estate of National Surety Company yielded a large cash payment to holders of bonds bearing its guarantee. Some of the other companies managed to remain solvent by affecting a kind of composition with bondholders, involving the issuance of new bonds carrying a guarantee of interest at rather low rates, though not of principal. Examples: Metropolitan Casualty Company, Maryland Casualty Company, United States Fidelity and Guaranty Company. 2 For example Pittsburgh, Fort Wayne and Chicago Railway Company Preferred and Com- mon receive 7% dividends under a 999-year lease to th

onds bearing its guarantee. Some of the other companies managed to remain solvent by affecting a kind of composition with bondholders, involving the issuance of new bonds carrying a guarantee of interest at rather low rates, though not of principal. Examples: Metropolitan Casualty Company, Maryland Casualty Company, United States Fidelity and Guaranty Company. 2 For example Pittsburgh, Fort Wayne and Chicago Railway Company Preferred and Com- mon receive 7% dividends under a 999-year lease to the Pennsylvania Railroad Company. These dividends are also guaranteed by the Pennsylvania. expiring also in 2022, providing for annual payments of $2,500,000 (with the privilege to the lessee to settle by a lump-sum payment equivalent to the then present value of the rental, discounted at 7% per annum). By means of a sinking-fund arrangement these rental payments were calcu- lated to be sufficient to retire the bond issue in full prior to maturity, in addition to taking care of the interest. These Tobacco Products 61/2s were the equivalent of fixed obligations of American Tobacco Company. As such they ranked ahead of American Tobacco Preferred, dividends on which, of course, are not a fixed charge. When the bonds were created in 1931 the investing public was either sceptical of the validity of the lease or—more probably—was not familiar with this situation, for American Tobacco Preferred sold at a much higher relative price than the Tobacco Products bonds. At the low price of 73 in 1932 the bonds yielded 8.90%, while American Tobacco preferred was selling at 95, to yield 6.32%. In January 1935 the lease was commuted by a lump-sum payment resulting in the redemption of the Tobacco Products 61/2s at par. Specific Terms of Lease Important. Example: As in the case of guaranteed issues, the details of the lease arrange- ment may have a vital bearing on the status of the issue benefiting there- from. Some of the elements here involved are illustrated by the following example: Geor

32 the bonds yielded 8.90%, while American Tobacco preferred was selling at 95, to yield 6.32%. In January 1935 the lease was commuted by a lump-sum payment resulting in the redemption of the Tobacco Products 61/2s at par. Specific Terms of Lease Important. Example: As in the case of guaranteed issues, the details of the lease arrange- ment may have a vital bearing on the status of the issue benefiting there- from. Some of the elements here involved are illustrated by the following example: Georgia Midland Railway First 3s, due 1946. Not guaranteed, but property leased to Southern Railway until 1995, at a rental equal to pres- ent bond interest. (Price in January 1939, 35.) In this case the lease agreement is fully equivalent to a guarantee of interest up to and far beyond the maturity date. The value of the guaranty itself depends upon the solvency of the Southern Railway. The status of the bond issue at maturity in 1946 will depend, however, on a number of other factors as well, e.g.: 1. The market value of a long-term rental obligation of Southern Rail- way. If interest rates are low enough, and the credit of Southern Railway high enough, the issue could be refunded at the same 3% interest rate into a longer maturity. (This would seem far from probable in 1939.) 2. The value of the Georgia Midland mileage. If this mileage actually earns substantially more than the rental paid, then Southern Railway could be expected to make a special effort to pay the bonds at maturity, for fear of otherwise losing control of the property. This would involve an agreement to pay such higher rental (i.e., interest rate) as may be nec- essary to permit extension or refunding of the bond maturity. (However, traffic-density data in private hands in 1939 indicated that this mileage was not a valuable part of the Southern Railway System.) 3. Possible payment on grounds of convenience, etc. If the Southern Railway is prosperous in 1946, it may take care of this maturity merely to avoid

r fear of otherwise losing control of the property. This would involve an agreement to pay such higher rental (i.e., interest rate) as may be nec- essary to permit extension or refunding of the bond maturity. (However, traffic-density data in private hands in 1939 indicated that this mileage was not a valuable part of the Southern Railway System.) 3. Possible payment on grounds of convenience, etc. If the Southern Railway is prosperous in 1946, it may take care of this maturity merely to avoid insolvency for part of the system. There is also the technical possi- bility that by the terms of its own “blanket” Development and General Mortgage (under which sufficient bonds are reserved to refund the Geor- gia Midland 3s at maturity), it may be considered to have an obligation to provide for payment of these bonds in 1946. (Here also, as in the two previous paragraphs, the bondholder in 1939 could not be too confident of the strength of his position). The foregoing discussion will perhaps adequately explain the low price of the Georgia Midland 3s at the beginning of 1939. It is interest- ing to note, as an element of security analysis, that the key fact in this situation—the unprofitable character of the mileage covered—was not a matter of public record but required a check into supplementary sources of information. Guaranteed Issues Frequently Undervalued. The Tobacco Prod- ucts example illustrates the fairly frequent undervaluation of guaranteed or quasi-guaranteed issues as compared with other securities of the guar- antor enterprise. A well-known instance was that of San Antonio and Aransas Pass Railway Company First 4s, due 1943, guaranteed as to prin- cipal and interest by Southern Pacific Company. Although these enjoyed a mortgage security in addition to the guaranty they regularly sold at prices yielding higher returns than did the unsecured obligations of the Southern Pacific.3 3 A. S. Dewing, in his A Study of Corporation Securities, pp. 293–297, New York, 1

ompared with other securities of the guar- antor enterprise. A well-known instance was that of San Antonio and Aransas Pass Railway Company First 4s, due 1943, guaranteed as to prin- cipal and interest by Southern Pacific Company. Although these enjoyed a mortgage security in addition to the guaranty they regularly sold at prices yielding higher returns than did the unsecured obligations of the Southern Pacific.3 3 A. S. Dewing, in his A Study of Corporation Securities, pp. 293–297, New York, 1934, makes the following statements with respect to guaranteed bonds: “There may be, however, instances in which a holding or controlling corporation will main- tain the interest or rental on an unprofitable subsidiary’s bonds for strategic reasons.” (Here fol- low examples, including details concerning San Antonio and Aransas Pass First 4s, due 1943, showing failure of the issuer to earn its charges in most years.) “Yet its [San Antonio and Aransas Pass Railway’s] importance to the Southern Pacific Company’s lines is such that the guarantor company very wisely meets the bond interest deficit… In spite of such instances, the rule holds good almost always that the strength of a guaranteed bond is no greater than that of the corporation issuing it and the earning capacity of the property directly covered by it.” Examples: A more striking contrast was afforded by the price of Barnhart Bros. and Spindler Company First and Second Preferred (both guaranteed as to principal and dividends by American Type Founders Company) in relation to the price of the guarantor’s own pre- ferred stock which was not a fixed obligation. Additional examples of this point are afforded by the price of Huyler’s of Delaware, Inc., Pre- ferred, guaranteed by Schulte Retail Stores Corporation, as compared with the price of Schulte Preferred; and by the price of Armour and Company of Delaware guaranteed preferred, as compared with the preferred stock of the guarantor company, Armour and Company of Illinoi

American Type Founders Company) in relation to the price of the guarantor’s own pre- ferred stock which was not a fixed obligation. Additional examples of this point are afforded by the price of Huyler’s of Delaware, Inc., Pre- ferred, guaranteed by Schulte Retail Stores Corporation, as compared with the price of Schulte Preferred; and by the price of Armour and Company of Delaware guaranteed preferred, as compared with the preferred stock of the guarantor company, Armour and Company of Illinois. Some comparative quotations relating to these examples are given below. COMPARATIVE PRICES AND YIELDS OF GUARANTEED SECURITIES AND SECURITIES OF THE GUARANTOR* Issue Date Price Yield, % San Antonio & Aransas Pass 1st 4s/1943 (GTD) Jan. 2, 1920 561/4 8.30 Southern Pacific Co. Debenture 4s/1929 Jan. 2, 1920 81 6.86 Barnhart Bros. & Spindler 7% 1st Pfd. (GTD) 1923 low price 90 7.78 Barnhart Bros. & Spindler 7% 2d Pfd. (GTD) 1923 low price 80 8.75 American Type Founders 7% Pfd 1923 low price 95 7.37 Huyler’s of Delaware 7% Pfd. (GTD) April 11, 1928 1021/2 6.83 Schulte Retail Stores 8% Pfd. April 11, 1928 129 6.20 Armour of Delaware 7% Pfd. (GTD) Feb. 13, 1925 951/8 7.36 Armour of Illinois 7% Pfd. Feb. 13, 1925 927/8 7.54 * If the reader traces the subsequent history of the various issues in this table, he will find a great variety of developments, including assumption through merger (San Antonio and Aransas Pass Railroad), redemption (Barnhart Brothers and Spindler), and default (Huylers of Delaware, Inc.). But the fact that the guaranteed issues were relatively undervalued is demonstrated by the sequel in each case. It is obvious that in cases of this sort advantageous exchanges can be made from the lower yielding into the higher yielding security with no It seems clear to us that these statements misinterpret the essential character of the obliga- tion under a guarantee. Southern Pacific met the San Antonio and Aransas Pass bond inter- est deficit, not out of “wisdom” bu

ers of Delaware, Inc.). But the fact that the guaranteed issues were relatively undervalued is demonstrated by the sequel in each case. It is obvious that in cases of this sort advantageous exchanges can be made from the lower yielding into the higher yielding security with no It seems clear to us that these statements misinterpret the essential character of the obliga- tion under a guarantee. Southern Pacific met the San Antonio and Aransas Pass bond inter- est deficit, not out of “wisdom” but by compulsion. The strength of a guaranteed bond may be very much greater than that of the corporation issuing it, because that strength rests upon the dual claim of the holder against both the issuing corporation and the guarantor. impairment of safety; or else into a much better secured issue with little sacrifice of yield, and sometimes with an actual gain.4 INCLUSION OF GUARANTEES AND RENTALS IN THE CALCULATION OF FIXED CHARGES All obligations equivalent to bond interest should be included with a company’s interest charges when calculating the coverage for its bond issues. This point has already been explained in some detail in connec- tion with railroad fixed charges, and it was touched upon briefly in our discussion of public-utility bonds. The procedure in these groups offers no special difficulties. But in the case of certain types of industrial com- panies, the treatment of rentals and guarantees may offer confusing vari- ations. This question is of particular moment in connection with retail enterprises, theater companies, etc., in which rent or other obligations related to buildings occupied may be an important element in the gen- eral picture. Such a building may be owned by the corporation and paid for by a bond issue, in which case the obligation will be fully disclosed in both the balance sheet and the income account. But if another company occupies a similar building under long-term lease, no separate measure of the rental obligation appears in the incom

connection with retail enterprises, theater companies, etc., in which rent or other obligations related to buildings occupied may be an important element in the gen- eral picture. Such a building may be owned by the corporation and paid for by a bond issue, in which case the obligation will be fully disclosed in both the balance sheet and the income account. But if another company occupies a similar building under long-term lease, no separate measure of the rental obligation appears in the income account and no indication thereof can be found in the balance sheet. The second company may appear sounder than the first, but that is only because its obligations are undisclosed; essentially, both companies are carrying a similar burden. Conversely, the outright ownership of premises free and clear carries an important advantage (from the standpoint of preferred stock, particu- larly) over operation under long-term lease, although the capitalization set-up will not reveal this advantage. Examples: If Interstate Department Stores Preferred had been com- pared with The Outlet Company Preferred in 1929 the two exhibits might have appeared closely similar; the earnings coverage averaged about the same, and neither company showed any bond or mortgage liability. But Outlet’s position was in actuality by far the stronger, because it owned its land and buildings while those of Interstate (with a minor exception) were held under lease. The real effect of this situation was to place a substantial 4 In Note 31 of the Appendix, p. 762 on accompanying CD, will be found a concise discus- sion of certain interesting phases of guarantees and rentals, as illustrated by the N. Y. and Harlem Railroad and the Mobile and Ohio Railroad situations. fixed obligation ahead of Interstate Department Stores Preferred which did not exist in the case of Outlet. In the chain-store field a similar obser- vation would apply to a comparison of J. C. Penney Preferred and S. H. Kress Preferred in 1932; f

ntial 4 In Note 31 of the Appendix, p. 762 on accompanying CD, will be found a concise discus- sion of certain interesting phases of guarantees and rentals, as illustrated by the N. Y. and Harlem Railroad and the Mobile and Ohio Railroad situations. fixed obligation ahead of Interstate Department Stores Preferred which did not exist in the case of Outlet. In the chain-store field a similar obser- vation would apply to a comparison of J. C. Penney Preferred and S. H. Kress Preferred in 1932; for the latter company owned more than half of its store properties, while nearly all the Penney locations were leased. Lease Liabilities Generally Overlooked. The question of liability under long-term leases received very little attention from the financial world until its significance was brought home rudely in 1931 and 1932, when the high level of rentals assumed in the preceding boom years proved intolerably burdensome to many merchandising companies. Example: The influence of this factor upon a supposed investment security is shown with striking force in the case of United Cigar Stores Preferred. This issue, and its predecessor, had for many years shown every sign of stability and had sold accordingly at a consistently high level. For 1928 the company reported “no funded debt” and earnings equal to about seven times the preferred dividend. Yet so crushing were the liabilities under its long-term leases (and to carry properties acquired by sub- sidiaries), that in 1932 bankruptcy was resorted to and the preferred stock was menaced with extinction. Such Liabilities Complicated Analysis. It must be admitted that in the case of companies where the rental factor is important, its obtrusion has badly complicated the whole question of bond or preferred stock analysis. Fortunately the investor now has some data as to the extent of such leasehold obligations, since they are now required to be summarized in registration statements filed with the S.E.C., and the actual rent pay- men

s resorted to and the preferred stock was menaced with extinction. Such Liabilities Complicated Analysis. It must be admitted that in the case of companies where the rental factor is important, its obtrusion has badly complicated the whole question of bond or preferred stock analysis. Fortunately the investor now has some data as to the extent of such leasehold obligations, since they are now required to be summarized in registration statements filed with the S.E.C., and the actual rent pay- ments must be stated each year (on Form 10-K).5 But the problem remains whether or not these rentals should be treated, in whole or in part, as the equivalent of fixed charges. To some extent, certainly, they are identical rather with fixed “overhead”—e.g., depreciation, taxes, general expense—which it has not been found feasible to add in with bond inter- est for the purpose of figuring a margin of safety. One type of solution is obvious: If the company meets the earnings test, even after adding rents paid to bond interest, the rent situation need not worry the investor. 5 The S.E.C. forms group “rents and royalties” together, but in the typical case this entire item relates to rents and can be treated as such. Example: SWIFT AND COMPANY 33/4S, DUE 1950 1934–1938 Average Results Balance for dividends $8,630,000 Interest paid 2,107,000 Rentals paid 996,000 Interest earned 5.1 times Interest and rentals earned 3.8 times We feel, however, that it would be neither fair nor practicable to require every company to meet a test so severe. A compromise sugges- tion based on some study of actual exhibits may be hazarded, viz.: (1) that one-third the annual rentals (for building space) be included with fixed charges (and preferred dividends), to compute the earnings coverage; and (2) that in the case of retail establishments (chain stores, department stores) the minimum coverage required for interest plus one-third of rentals be reduced from 3 to 2. This reduction would recognize the

require every company to meet a test so severe. A compromise sugges- tion based on some study of actual exhibits may be hazarded, viz.: (1) that one-third the annual rentals (for building space) be included with fixed charges (and preferred dividends), to compute the earnings coverage; and (2) that in the case of retail establishments (chain stores, department stores) the minimum coverage required for interest plus one-third of rentals be reduced from 3 to 2. This reduction would recognize the rela- tive stability of retail business, after allowance is made for the special bur- den attaching to the rental factor. The corresponding coverage required for a retail company’s preferred stock would be reduced from 4 to 21/2. Examples: (A) NONRETAIL BOND ISSUE LOEW’S, INC., 31/2S, DUE 1946 August 1934–August 1938 Average Results Balance for dividends $10,097,000 Interest (and subsid. preferred dividends) paid. 2,614,000 One-third of rentals paid 1,107,000 Interest, etc., earned 4.86 times Interest and one-third of rentals earned 3.71 times (B) RETAIL ENTERPRISE PREFERRED STOCK 1934–1938 Average Results McCrory Stores Corp. McLellan Stores Co. 6% Preferred 6% Preferred Balance for common stock . . . . . . . . . . . . . . . $1,682,000 $1,148,000 Interest on bonds . . . . . . . . . . . . . . . . . . . . . . . abt. 200,000 One-third of rentals . . . . . . . . . . . . . . . . . . . . . 770,000* 434,000 Preferred dividends . . . . . . . . . . . . . . . . . . . . . 300,000 180,000 Preferred dividend (and interest earned) . . . 4.36 times 7.38 times Preferred dividend, interest and 1/3 of rentals earned . . . . . . . . . . . . . . . 2.33 times 2.87 times * 1935–1938 average. Conclusions: Loew’s 31/2s pass our quantitative test for nonretail bond issues. McLellan Preferred does, but McCrory Preferred does not, pass our suggested test for retail-store preferred stocks. The four preceding examples illustrate a simplified technique for earn- ings coverage. Instead of first computin

ed dividend (and interest earned) . . . 4.36 times 7.38 times Preferred dividend, interest and 1/3 of rentals earned . . . . . . . . . . . . . . . 2.33 times 2.87 times * 1935–1938 average. Conclusions: Loew’s 31/2s pass our quantitative test for nonretail bond issues. McLellan Preferred does, but McCrory Preferred does not, pass our suggested test for retail-store preferred stocks. The four preceding examples illustrate a simplified technique for earn- ings coverage. Instead of first computing the amount available for the charges, we divide the charges (and preferred dividends) into the balance after charges (and preferred dividends) and add 1 to the quotient. The reader is warned that these suggested standards and the calcula- tions illustrating them are submitted with considerable hesitation. They represent a new departure in analytical method; the data for rentals paid are available only at some effort; most serious of all, the arithmetical stan- dards proposed are arbitrary and perhaps not the best that can be devised. We might point out, further, that the new test may yield some unexpected results. Note that McLellan Preferred has sold (in 1939) at a lower price than McCrory Preferred—a point that may be justified by other factors. Note, further, that if the same calculation as above is applied to W. T. Grant 5% Preferred—a high-priced issue, which earned its dividend nearly ten times over in 1934–1938—we should find that the preferred dividend plus one-third of rentals was covered not quite 21/2 times.6 Status of Guaranteed Obligations. Some additional observations may properly be made as to the computation of earnings coverage in the case of guaranteed obligations. In the typical case the properties involved in the guarantee form part of the whole enterprise; hence both the earn- ings therefrom and the guaranteed payments are included in a single income statement. Example: Neisner Realty Corporation 6s, due 1948, are guaranteed by Neisner Brothers, Inc. Th

ls was covered not quite 21/2 times.6 Status of Guaranteed Obligations. Some additional observations may properly be made as to the computation of earnings coverage in the case of guaranteed obligations. In the typical case the properties involved in the guarantee form part of the whole enterprise; hence both the earn- ings therefrom and the guaranteed payments are included in a single income statement. Example: Neisner Realty Corporation 6s, due 1948, are guaranteed by Neisner Brothers, Inc. The corporation’s operations and interest charges are included in the parent company’s consolidated statement. When the guaranteed security is outstanding against a separately operated property, its standing may depend either on its own results or on those of the guarantor. Hence the issue need be required to pass only one of three alternative tests, based on (1) earnings of issuing company, independent of the guarantee; or (2) combined earnings and charges of the issuing and guarantor companies; or (3) earnings of guarantor com- pany applied to its own charges plus its guarantees. 6 This stock, par 20, sold at 25 in 1939 although callable at 22. Examples: a. Indiana Harbor Belt Railway General 4s and 41/2s, due 1957. Guaranteed as to principal and interest by New York Central Rail- road and an important subsidiary. The Standard Statistics Bond Guide gives as the interest coverage that of the guarantor, the New York Central System. But the showing of the company itself is much better, e.g.: Charges earned N. Y. Central System Indiana Harbor Belt 1938 0.59 times 2.98 times 1937 1.12 times 3.81 times b. This is the typical situation, in which coverage is calculated from a consolidated income account, including operations of both the parent (guarantor) company and its guaranteed subsidiaries. c. Minneapolis, St. Paul and Sault Sainte Marie 51/2s, due 1978, guar- anteed as to interest by Canadian Pacific Railway. The “Soo line” shows earnings of only a small part of total in

e.g.: Charges earned N. Y. Central System Indiana Harbor Belt 1938 0.59 times 2.98 times 1937 1.12 times 3.81 times b. This is the typical situation, in which coverage is calculated from a consolidated income account, including operations of both the parent (guarantor) company and its guaranteed subsidiaries. c. Minneapolis, St. Paul and Sault Sainte Marie 51/2s, due 1978, guar- anteed as to interest by Canadian Pacific Railway. The “Soo line” shows earnings of only a small part of total interest charges. Coverage for this issue might best be computed by applying earnings of Canadian Pacific Railway to the total of its own interest charges plus the guaranteed inter- est on these and other bonds guaranteed by Canadian Pacific Railway. SUBSIDIARY COMPANY BONDS The bonds of a subsidiary of a strong company are generally regarded as well protected, on the theory that the parent company will take care of all its constituents’ obligations. This viewpoint is encouraged by the com- mon method of setting up consolidated income accounts, under which all the subsidiary bond interest appears as a charge against all the com- bined earnings, ranking ahead of the parent company’s preferred and common stocks. If, however, the parent concern is not contractually responsible for the subsidiary bonds, by guaranty or lease (or direct assumption), this form of statement may prove to be misleading. For if a particular subsidiary proves unprofitable, its bond interest may conceiv- ably not be taken care of by the parent company, which may be willing to lose its investment in this part of its business and turn it over to the sub- sidiary’s bondholders. Such a development is unusual, but the possibility thereof was forcibly demonstrated in 1932–1933 by the history of United Drug Company 5s, due 1953. Examples: United Drug was an important subsidiary of Drug, Inc., which had regularly earned and paid large dividends, gained chiefly from the manufacture of proprietary medicines and o

e taken care of by the parent company, which may be willing to lose its investment in this part of its business and turn it over to the sub- sidiary’s bondholders. Such a development is unusual, but the possibility thereof was forcibly demonstrated in 1932–1933 by the history of United Drug Company 5s, due 1953. Examples: United Drug was an important subsidiary of Drug, Inc., which had regularly earned and paid large dividends, gained chiefly from the manufacture of proprietary medicines and other drugs. In the first half of 1932, the consolidated income account showed earnings equal to ten times the interest on United Drug 5s, and the record of previous years was even better. While this issue was not assumed or guaranteed by Drug, Inc., investors considered the combined showing so favorable as to assure the safety of the United Drug 5s beyond question. But United Drug owned, as part of its assets and business, the stock of Louis K. Liggett Company, which operated a large number of drug stores and which was burdened by a high-rental problem similar to that of United Cigar Stores. In September 1932 Liggett’s notified its landlords that unless rents were reduced it would be forced into bankruptcy. This announcement brought rudely home to investors the fact that the still prosperous Drug, Inc., was not assuming responsibility for the liabilities of its (indirect) subsidiary, Liggett’s, and they immediately became nervously conscious of the fact that Drug, Inc., was not respon- sible for interest payments on United Drug 5s either. Sales of these bonds resulting from this discovery depressed the price from 93 earlier in the year down to 42. At the latter figure, the $40,000,000 of United Drug 5s were quoted at only $17,000,000, although the parent company’s stock was still selling for more than $100,000,000 (3,500,000 shares at about 30). In the following year the “Drug, Inc., System” was voluntarily dis- solved into its component parts—an unusual development—and the U

sible for interest payments on United Drug 5s either. Sales of these bonds resulting from this discovery depressed the price from 93 earlier in the year down to 42. At the latter figure, the $40,000,000 of United Drug 5s were quoted at only $17,000,000, although the parent company’s stock was still selling for more than $100,000,000 (3,500,000 shares at about 30). In the following year the “Drug, Inc., System” was voluntarily dis- solved into its component parts—an unusual development—and the United Drug Co. resumed its entirely separate existence. (It has since shown an inadequate coverage for the 5% bonds.) Consolidated Traction Company of New Jersey First 5s were obliga- tions of a large but unprofitable subsidiary of Public Service Corporation of New Jersey. The bonds were not guaranteed by the parent company. When they matured in 1933 many of the holders accepted an offer of 65 for their bonds made by the parent company. Saltex Looms, Inc., 1st 6s, due 1954, were obligations of a subsidiary of Sidney Blumenthal & Co., Inc., but in no way guaranteed by the par- ent company. The consolidated earning statements of Blumenthal regu- larly deducted the Saltex bond interest before showing the amount available for its own preferred stock. Interest on the bonds was defaulted, however, in 1939; and in 1940 the bonds sold at 7 while Blumenthal pre- ferred was quoted above 70. Separate Analysis of Subsidiary Interest Coverage Essential. These examples suggest that just as investors are prone to underestimate the value of a guaranty by a strong company, they sometimes make the opposite mistake and attach undue significance to the fact that a com- pany is controlled by another. From the standpoint of fixed-value invest- ment, nothing of importance may be taken for granted. Hence a subsidiary bond should not be purchased on the basis of the showing of its parent company, unless the latter has assumed direct responsibility for the bond in question. In other cases the exhibi

rs are prone to underestimate the value of a guaranty by a strong company, they sometimes make the opposite mistake and attach undue significance to the fact that a com- pany is controlled by another. From the standpoint of fixed-value invest- ment, nothing of importance may be taken for granted. Hence a subsidiary bond should not be purchased on the basis of the showing of its parent company, unless the latter has assumed direct responsibility for the bond in question. In other cases the exhibit of the subsidiary itself can afford the only basis for the acceptance of its bond issues.7 If the above discussion is compared with that on page 179 of accom- panying CD, it will be seen that investors in bonds of a holding company must insist upon a consolidated income account, in which the subsidiary interest—whether guaranteed or not—is shown as a prior charge; but that purchasers of unguaranteed subsidiary bonds cannot accept such consol- idated reports as a measure of their safety, and must require a statement covering the subsidiary alone. These statements may be obtainable only with some difficulty, as was true in the case of United Drug 5s, but they must nevertheless be insisted upon. 7 As a practical matter, the financial interest of the parent company in its subsidiary, and other business reasons, may result in its protecting the latter’s bonds even though it is not obligated to do so. This would be a valid consideration, however, only in deciding upon a purchase on a speculative basis (i.e., carrying a chance of principal profit), but would not jus- tify buying the bond at a full investment price. Concretely stated, it might have made United Drug 5s an excellent speculation at 45, but they were a poor investment at 93. Chapter 18 PROTECTIVE COVENANTS AND REMEDIES OF SENIOR SECURITY HOLDERS IN THIS AND the two succeeding chapters we shall consider the provisions usually made to protect the rights of bond owners and preferred stock- holders agai

ase on a speculative basis (i.e., carrying a chance of principal profit), but would not jus- tify buying the bond at a full investment price. Concretely stated, it might have made United Drug 5s an excellent speculation at 45, but they were a poor investment at 93. Chapter 18 PROTECTIVE COVENANTS AND REMEDIES OF SENIOR SECURITY HOLDERS IN THIS AND the two succeeding chapters we shall consider the provisions usually made to protect the rights of bond owners and preferred stock- holders against impairment, and the various lines of action which may be followed in the event of nonfulfillment of the company’s obligations. Our object here, as throughout this book, is not to supply information of a kind readily available elsewhere, but rather to subject current practices to critical examination and to suggest feasible improvements therein for the benefit of security holders generally. In this connection a review of recent developments in the field of reorganization procedure may also be found of value. Indenture or Charter Provisions Designed to Protect Holder of Senior Securities. The contract between a corporation and the owners of its bonds is contained in a document called the indenture or deed of trust. The corresponding agreements relating to the rights of pre- ferred stockholders are set forth in the Articles, or Certificate, of Incor- poration. These instruments usually contain provisions designed to prevent corporate acts injurious to senior security holders and to afford remedies in case of certain unfavorable developments. The more impor- tant occurrences for which such provision is almost always made may be listed under the following heads: 1. In the case of bonds: a. Nonpayment of interest, principal, or sinking fund. b. Default on other obligations, or receivership. c. Issuance of new secured debt. d. Dilution of a conversion (or subscription) privilege. [229] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here f

ford remedies in case of certain unfavorable developments. The more impor- tant occurrences for which such provision is almost always made may be listed under the following heads: 1. In the case of bonds: a. Nonpayment of interest, principal, or sinking fund. b. Default on other obligations, or receivership. c. Issuance of new secured debt. d. Dilution of a conversion (or subscription) privilege. [229] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. 2. In the case of preferred stocks: a. Nonpayment of (cumulative) preferred dividends for a period of time. b. Creation of funded debt or a prior stock issue. c. Dilution of a conversion (or subscription) privilege. A frequent, but less general, provision requires the maintenance of working capital at a certain percentage of the bonded debt of industrial companies. (In the case of investment-trust or holding-company bonds it is the market value of all the assets which is subject to this provision.) The remedies provided for bondholders in cases falling under 1a and 1b above are fairly well standardized. Any one of these untoward devel- opments is designated as an “event of default” and permits the trustee to declare the principal of the bond issue due and payable in advance of the specified maturity date. The provisions therefor in the indenture are known as “acceleration clauses.” Their purpose in the main is to enable the bondholders to assert the full amount of their claim in competition with the other creditors. Contradictory Aspects of Bondholders’ Legal Rights. In consid- ering these provisions from a critical standpoint, we must recognize that there are contradictory aspects to the question of the bondholders’ legal rights. Receivership1 is a dreaded word in Wall Street; its advent means ordinarily a drastic shrinkage in the price of all the company’s securities, including the bonds for the “benefit” of which the receivership was insti- tuted. As we

eir claim in competition with the other creditors. Contradictory Aspects of Bondholders’ Legal Rights. In consid- ering these provisions from a critical standpoint, we must recognize that there are contradictory aspects to the question of the bondholders’ legal rights. Receivership1 is a dreaded word in Wall Street; its advent means ordinarily a drastic shrinkage in the price of all the company’s securities, including the bonds for the “benefit” of which the receivership was insti- tuted. As we pointed out in a former chapter, the market’s appraisal of a bond in default is no higher on the whole, and perhaps lower, than that of a non-dividend-paying preferred stock of a solvent company. The question arises, therefore, whether the bondholders might not be better off if they did not have any enforceable claim to principal or inter- est payments when conditions are such as to make prompt payment impos- sible. For at such times the bondholder’s legal rights apparently succeed 1 “Receivership” was formerly a convenient term, applying to all kinds of financial difficulties that involved court action. As a result of the Chandler Act (Bankruptcy Act of 1938), receivers have been largely replaced by trustees. No doubt the word “receivership” will con- tinue to be used—for a while at least—because the terms “trusteeship” and “bankruptcy” are not quite satisfactory, the former being somewhat ambiguous, the latter having an overdras- tic connotation. “Insolvency” is a suitable word but awkward to use at times. So-called “equity receivers” will still be appointed in the future in connection with stock- holder’s suits, voluntary liquidations, and other special matters. only in ruining the corporation without benefiting the bondholder. As long as the interest or principal is not going to be paid anyway, would it not be to the interest of the bondholders themselves to postpone the date of payment and keep the enterprise out of the courts? Corporate Insolvency and Reorganization.

awkward to use at times. So-called “equity receivers” will still be appointed in the future in connection with stock- holder’s suits, voluntary liquidations, and other special matters. only in ruining the corporation without benefiting the bondholder. As long as the interest or principal is not going to be paid anyway, would it not be to the interest of the bondholders themselves to postpone the date of payment and keep the enterprise out of the courts? Corporate Insolvency and Reorganization. This question leads into the broad field of corporate insolvency and reorganization. We must try, within as brief a space as possible, first, to describe the procedure fol- lowed prior to the amendatory legislation beginning in 1933; secondly, to summarize the changes brought about by the recent statutes; and, finally, to evaluate the bondholder’s position as it now appears. (The lat- ter will be especially difficult, since the new laws have not yet had time to prove their merits or deficiencies in actual practice.) The old pattern for corporate reorganization went usually as follows: Inability to pay interest or principal of indebtedness led to an application by the corporation itself for a receiver.2 It was customary to select a “friendly” court; the receiver was generally the company’s president; the bondholders’ interests were represented by protective committees ordi- narily formed by the investment banking houses that had floated the issues. A reorganization plan was agreed upon by the committees and then approved by the court. The plan usually represented a compromise of the conflicting interests of the various ranks of security holders, under which, generally speaking, everyone retained some interest in the new company and everyone made some sacrifice. (In numerous cases, how- ever, small and well-entrenched issues at the top were paid off or left undisturbed; and in hopeless situations stock issues were sometimes com- pletely wiped out.) The actual mechanics of reor

by the committees and then approved by the court. The plan usually represented a compromise of the conflicting interests of the various ranks of security holders, under which, generally speaking, everyone retained some interest in the new company and everyone made some sacrifice. (In numerous cases, how- ever, small and well-entrenched issues at the top were paid off or left undisturbed; and in hopeless situations stock issues were sometimes com- pletely wiped out.) The actual mechanics of reorganization was through a foreclosure or bankruptcy sale. The properties were bought in in behalf of the assenting security holders; and creditors who refused to participate received in cash their pro rata share, if any, of the sale price. This price was usually set so low that everyone was better off to join in the plan and take new securities rather than to stay out and take cash. Between 1933 and 1939 this procedure was completely transformed by a series of remedial laws, the most important of which was the Chandler 2 Other “events of default”—e.g., failure to meet sinking-fund or working-capital requirements— rarely resulted in receivership. Almost always bondholders preferred to overlook, or negotiate over, these matters rather than harm themselves by throwing the company in the courts. Act. The defects for which a cure was desired were of two kinds: On the one hand the necessity for paying nonassenting bondholders had devel- oped into a dilemma; because unduly low “upset,” or minimum, foreclo- sure-sale prices were being frowned on by the courts, whereas payment of a fair price involved often an insuperable problem of finding the cash. More serious was the fact that the whole mechanics of reorganization tended to keep complete dominance of the situation in the hands of the old controlling group—who may have been inefficient or even dishonest, and who certainly had special interests to serve. Beginning with the 1933 changes, a reorganization technique was set up under

inimum, foreclo- sure-sale prices were being frowned on by the courts, whereas payment of a fair price involved often an insuperable problem of finding the cash. More serious was the fact that the whole mechanics of reorganization tended to keep complete dominance of the situation in the hands of the old controlling group—who may have been inefficient or even dishonest, and who certainly had special interests to serve. Beginning with the 1933 changes, a reorganization technique was set up under which a plan accepted by two-thirds of the creditors and a majority of the stockholders (if they had some “equity”), and approved by the court, was made binding on all the security holders. This has done away with the cumbersome and otherwise objectionable device of the foreclosure sale. As perfected by the Chandler Act and the Trust Inden- ture Act of 1939, the new procedure for other than railroad companies includes the following additional important points:3 1. The company must be turned over to at least one disinterested trustee. This trustee must decide whether any claims should be asserted against the old management and also whether or not the business is worth continuing. 2. Actual responsibility for devising a reorganization plan devolves on three disinterested agencies: (1) the trustee, who must present the plan in the first instance; (2) the S.E.C. (when the liabilities exceed $3,000,000), who may submit an advisory opinion thereon; (3) and the judge, who must officially approve it. Although the security holders and their pro- tective committees may make suggestions, their acceptance is not asked for until the disinterested agencies have done their work. Furthermore, apparently wide powers are now given the court to force acceptance upon 3 Provisions 1 to 4 appear in Chap. X of the Chandler Act, an outgrowth of the famous Sec. 77B, which was added to the old bankruptcy act in 1933. Railroad reorganizations are governed by Sec. 77, which was carried over into the Ch

ove it. Although the security holders and their pro- tective committees may make suggestions, their acceptance is not asked for until the disinterested agencies have done their work. Furthermore, apparently wide powers are now given the court to force acceptance upon 3 Provisions 1 to 4 appear in Chap. X of the Chandler Act, an outgrowth of the famous Sec. 77B, which was added to the old bankruptcy act in 1933. Railroad reorganizations are governed by Sec. 77, which was carried over into the Chandler Act intact, and by Chap. XV, added in 1939 (see footnote 12, p. 238). There is also a Chap. XI proceeding under the Chandler Act, relating to “arrangements” of unsecured indebtedness only. Note resort to such proceedings by Haytian Corporation in 1938 and by United States Realty and Improve- ment Company in 1939. In the latter case the only matter affected was its guarantee of Trin- ity Buildings Corporation 51/2s, the company seeking to keep its own structure unchanged. Difficulties developed, and the proceedings were replaced by others. classes of holders who have failed to approve in the requisite percentage; but the exact extent of these powers is still uncertain. 3. The reorganization plan must meet a number of standards of fair- ness prescribed in the statute, including provisions relating to voting power, publication of reports, etc. The court must specifically approve the new management. 4. The activities of protective committees are subject to close scrutiny and supervision. Reorganization costs of all kinds, including compensa- tion to all and sundry, must receive court sanction. 5. As distinct from reorganization procedure proper, the Trust Inden- ture Act prescribes a number of requirements for trustees acting under bond indentures. These are designed both to obviate certain conflicts in interest that have caused considerable complaint and also to insure a more active attitude by the trustee in behalf of the bondholders. There is no doubt at all in our mi

vision. Reorganization costs of all kinds, including compensa- tion to all and sundry, must receive court sanction. 5. As distinct from reorganization procedure proper, the Trust Inden- ture Act prescribes a number of requirements for trustees acting under bond indentures. These are designed both to obviate certain conflicts in interest that have caused considerable complaint and also to insure a more active attitude by the trustee in behalf of the bondholders. There is no doubt at all in our minds that in the typical case the recent legislation4 will prove highly beneficial. It should eliminate a number of the abuses formerly attaching to receiverships and reorganizations. It should also speed up materially the readjustment process. This should be true, especially, after more definite standards of fairness in reorganiza- tion plans have come to be established, so that there will not be so much room as heretofore for protracted disputes between the different ranks of security holders.5 4 Legislation analogous to the mechanics of the 77B and Chandler Act provisions was applied to real estate readjustments in the Schackno and Burchill Acts passed by the New York State Legislature in 1933. In the same year The Companies’ Creditors Arrangement Act, adopted in Canada, provided that insolvent Canadian Companies might escape proceedings under the Bankruptcy Act and work out compromises with creditors with the sanction of the court. When properly approved, such compromises are binding on minority groups. See W. S. Lighthall, The Dominion Companies Act 1934, annotated, pp. 289, 345 ff., Montreal, 1935. 5 The tendency of the S.E.C. advisory opinions, as well as the findings of the I.C.C. in rail- road reorganizations, has been strongly in the direction of eliminating stockholders when there appears to be no chance that earnings will cover former interest charges. For a discus- sion of this point by one of the authors, see Benjamin Graham, “Fair Reorganization Plans under Cha

ng on minority groups. See W. S. Lighthall, The Dominion Companies Act 1934, annotated, pp. 289, 345 ff., Montreal, 1935. 5 The tendency of the S.E.C. advisory opinions, as well as the findings of the I.C.C. in rail- road reorganizations, has been strongly in the direction of eliminating stockholders when there appears to be no chance that earnings will cover former interest charges. For a discus- sion of this point by one of the authors, see Benjamin Graham, “Fair Reorganization Plans under Chapter X of the Chandler Act,” Brooklyn Law Review, December 1938. Despite the improvements in the law, railroad reorganizations have been subject to extraordinary delays since 1933. In our opinion, however, this was due not so much to weak- nesses remaining in the statute as it was to the extraordinary problem of devising fair plans for extremely complicated corporate structures when the question of future earning power was both highly controversial and of critical importance. Alternative Remedy Suggested. Despite these undoubted reforms in reorganization technique, we shall be bold enough to venture the assertion that the ideal protective procedure for bondholders may often be found along other and simpler lines. In our opinion—given a sufficiently simple debt structure—the best remedy for all injuries suffered by bondholders is the immediate vesting in them of voting control over the corporation, together with an adequate mechanism to assure the intelligent exercise of such control. In many cases the creditors would then be able to marshal the company’s resources and earnings for their own protection in such a way as to avoid recourse to expensive and protracted judicial proceedings. Our suggestion falls into two parts: First, voting control by bondhold- ers would, by the terms of the indenture, constitute the sole immediate remedy for any event of default, including nonpayment of interest or prin- cipal. During such control, unpaid interest or principal would be consid- e

In many cases the creditors would then be able to marshal the company’s resources and earnings for their own protection in such a way as to avoid recourse to expensive and protracted judicial proceedings. Our suggestion falls into two parts: First, voting control by bondhold- ers would, by the terms of the indenture, constitute the sole immediate remedy for any event of default, including nonpayment of interest or prin- cipal. During such control, unpaid interest or principal would be consid- ered subject to a grace period. But the directors representing the bondholders should have the right to apply for a trusteeship under the Chandler Act, if they feel that comprehensive reorganization is preferable to an indefinite continuance of the moratorium plus control. Secondly, this voting control could best be implemented through the indenture trustee— a large and financially experienced institution, which is competent to rep- resent the bondholders generally and to recommend to them suitable candidates for the controlling directorships. Stockholder’s interests should continue to be represented on the board by minority directors. What this arrangement would mean in effect is the turning of a fixed- interest bond into an income bond during the period of bondholders’ control; and the postponement of maturing debt until voluntary exten- sion or refinancing becomes feasible or else until liquidation or sale is found to be the desirable course. It should also be feasible to extend the basic technique and principle of voluntary recapitalization by statute (now applying only to the various stock issues) to include a bond issue as well, when the plan emanates from bondholders’ representatives who have the alternative of keeping control and merely waiting. Obviously, however, control cannot well be vested in creditors when they belong to several classes with conflicting interests. In such cases Chandler Act proceedings would seem necessary to cut the Gordian knot. But, theoretica

basic technique and principle of voluntary recapitalization by statute (now applying only to the various stock issues) to include a bond issue as well, when the plan emanates from bondholders’ representatives who have the alternative of keeping control and merely waiting. Obviously, however, control cannot well be vested in creditors when they belong to several classes with conflicting interests. In such cases Chandler Act proceedings would seem necessary to cut the Gordian knot. But, theoretically at least, a voting-control arrangement is possible with a simple senior and a simple junior lien. If default should occur only with respect to the junior lien, voting control would pass to that issue. If the senior lien is defaulted, it would take control as a single class. Although these suggestions may inspire doubt because of their nov- elty, it should be pointed out that the idea of voting by bondholders is both an old one and growing in vogue. Although in the past it was an exceptional arrangement, we now find that many reorganization plans, providing for issuance of income bonds, give voting powers to these secu- rities, generally calling for control of the board of directors until all or most of the issue is retired or if interest is not paid in full.6 Furthermore, many indentures covering fixed-interest bonds now provide for a vote by bondholders on amendments to the indenture.7 It is also common for Canadian trust indentures to provide for meetings of bondholders in order to amend the terms of the indenture, including even the postpone- ment or change of interest or principal payments.8 Such meetings may be called by the trustee, by a stated proportion of the bondholders, or in certain instances by the company itself. It may be objected that the suggested arrangement would really give a bondholder no better legal rights than a preferred stockholder and would thus relegate him to the unsatisfactory position of having both a limited 6 Examples: The reorganizatio

r to amend the terms of the indenture, including even the postpone- ment or change of interest or principal payments.8 Such meetings may be called by the trustee, by a stated proportion of the bondholders, or in certain instances by the company itself. It may be objected that the suggested arrangement would really give a bondholder no better legal rights than a preferred stockholder and would thus relegate him to the unsatisfactory position of having both a limited 6 Examples: The reorganization plan of New York State Railways (Syracuse System), dated February 1939, provides that the holders of the new income notes shall be entitled to elect two-thirds of the directors until at least 80% of the notes have been retired. Commercial Mackay Corporation Income Debentures, due 1967, elect one-third of the directors until all bonds are retired. National Hotel of Cuba Income 6s, due 1959 (issued in 1929), were given voting control in the event of default of one year’s interest. Older examples of voting rights given to bond- holders include Erie Railroad Prior Lien 4s and General 4s, Mobile and Ohio Railroad General 4s, Third Avenue Railway Adjustment 5s. The 1934 reorganization of Maple Leaf Milling Company, Ltd. (Canada), provided that the Indenture Trustee of the 51/2s due 1949 (later extended to 1958) would exercise effective control of the company by ownership (in trust) of 2 out of 3 management or voting shares. 7 Generally excluded from this provision are changes in maturity dates of principal or inter- est, the rate of interest, the redemption price and the conversion rate. Examples: Richfield Oil Corporation Debenture 4s, due 1952. The Industrial Rayon First 41/2s, due 1948, are unusual in that the indenture permits a two-thirds vote of bondholders to postpone interest payments. However, the New York Stock Exchange required an undertaking not to invoke this clause, as a condition of listing the issue. 8 See the S.E.C. Report on the Study and Investigation of the Wo

ates of principal or inter- est, the rate of interest, the redemption price and the conversion rate. Examples: Richfield Oil Corporation Debenture 4s, due 1952. The Industrial Rayon First 41/2s, due 1948, are unusual in that the indenture permits a two-thirds vote of bondholders to postpone interest payments. However, the New York Stock Exchange required an undertaking not to invoke this clause, as a condition of listing the issue. 8 See the S.E.C. Report on the Study and Investigation of the Work, Activities, Personnel and Functions of Protective and Reorganization Committees, Pt. VI, pp. 135–177, especially pp. 138–143, 164–177, Washington, 1936. interest and an unenforceable claim. Our answer must be that, if the con- trol device can be developed properly, it would provide an adequate rem- edy for both bondholders and preferred stockholders. In that case the basic contractual advantage of bonds over preferred shares would vanish, except to the extent of the right of bonds to repayment at a fixed date. We repeat, in conclusion, the point made in our discussion of the theory of preferred stocks (page 188 on accompanying CD) that the contractual disadvantage of preferred shares is, at bottom, not so much a matter of inherent legal rights as it is of practical corporate procedure and of the investor’s own shortcomings. Tendency of Securities of Insolvent Companies to Sell below Their Fair Value. Some additional aspects of the corporate-reorgani- zation question deserve attention. The first relates to the market action of securities of insolvent companies. Receiverships in the past have been pro- ductive generally of a vast and pervasive uncertainty, which threatens extinction to the stockholders but fails to promise anything specific to the bondholders. As a result there has been a tendency for the securities of companies in receivership to sell below their fair value in the aggregate; and also a tendency for illogical relationships to be established between the pr

tion. The first relates to the market action of securities of insolvent companies. Receiverships in the past have been pro- ductive generally of a vast and pervasive uncertainty, which threatens extinction to the stockholders but fails to promise anything specific to the bondholders. As a result there has been a tendency for the securities of companies in receivership to sell below their fair value in the aggregate; and also a tendency for illogical relationships to be established between the price of a bond issue in default and the price of the junior stock issues. Examples: The Fisk Rubber Company case is an excellent example of the former point; the Studebaker Corporation situation in September 1933 illustrates the latter. MARKET VALUE OF FISK RUBBER SECURITIES IN APRIL 1932 $7,600,000 First 8s @ 16 $ 1,200,000 8,200,000 Debenture 51/2s @ 11 900,000 Stock issues Nominal Total market value of the company $ 2,100,000 BALANCE SHEET, JUNE 30, 1932 Cash $ 7,687,000 Receivables (less reserve of $1,425,000) 4,838,000 Inventories (at lower of cost or market) 3,216,000 $15,741,000 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363,000 Net current assets $15,378,000 Fixed assets (less $8,400,000 depreciation) 23,350,000 The company’s securities were selling together for less than one-third of the cash alone, and for only one-seventh of the net current assets, allowing nothing for the fixed property.9 STUDEBAKER CORPORATION, SEPTEMBER 1933 Issue Face amount Market price Market value 10-year 6% notes and other claims $22,000,000 40 $8,800,000 Preferred stock 5,800,000 27 $1,500,000 Common stock (2,464,000 shares) 6 14,700,000 Total value of stock issues $16,200,000 The company’s debt, selling at 40 cents on the dollar, was entitled to prompt payment in full before the stockholder received anything. Never- theless, the market placed a much larger value upon the stock issues than upon the prior debt. Vol

PORATION, SEPTEMBER 1933 Issue Face amount Market price Market value 10-year 6% notes and other claims $22,000,000 40 $8,800,000 Preferred stock 5,800,000 27 $1,500,000 Common stock (2,464,000 shares) 6 14,700,000 Total value of stock issues $16,200,000 The company’s debt, selling at 40 cents on the dollar, was entitled to prompt payment in full before the stockholder received anything. Never- theless, the market placed a much larger value upon the stock issues than upon the prior debt. Voluntary Readjustment Plans. Realization of the manifest disad- vantages of receivership has often led bondholders to accept suggestions emanating from the management for a voluntary reduction of their con- tractual claims. Arrangements of this kind have varied from the old-fash- ioned type of “composition” (in which creditors extended or even curtailed their claims, while the stockholders retained their interest intact) to cases where the bondholders received a substantial part of the stock equity. Examples: At the end of 1931 Radio-Keith-Orpheum Corporation, needing funds to meet pressing obligations, found ordinary financing impossible. The stockholders ratified a plan under which in effect they surrendered 75% of their stock interest, which was given in turn as a bonus to those who supplied the $11,600,000 required by purchasing debenture notes. (Continued large losses, however, forced the company into receivership a year later.) In 1933 Fox Film Corporation effected a recapitalization of the same general type. The stockholders gave up over 80% of their holdings, and this stock was in turn exchanged for nearly all of approximately $40,000,000 of 5-year notes and bank debt. 9 As pointed out in Chap. 50, below, the Fisk Rubber 8s later proved to be worth close to 100 and the 51/2s more than 70. The Kansas City Public Service Company readjustment plan, also consummated in 1933, was designed to meet the simpler problem of reducing interest charges during a supposedly tempora

on of the same general type. The stockholders gave up over 80% of their holdings, and this stock was in turn exchanged for nearly all of approximately $40,000,000 of 5-year notes and bank debt. 9 As pointed out in Chap. 50, below, the Fisk Rubber 8s later proved to be worth close to 100 and the 51/2s more than 70. The Kansas City Public Service Company readjustment plan, also consummated in 1933, was designed to meet the simpler problem of reducing interest charges during a supposedly temporary period of sub- normal earnings. It provided that the coupon rate on the 6% first-mort- gage bonds should be reduced to 3% during the four years 1933–1936, restored to 6% for 1937–1938, and advanced to 7% for 1939–1951, thus making up the 12% foregone in the earlier years. A substantial sinking fund, contingent upon earnings; was set up to retire the issue gradually and to improve its market position. It was obvious that the Kansas City Public Service bondholders were better off to accept temporarily the 3% which could be paid rather than to insist on 6% which could not be paid and thereby precipitate a receiver- ship. (The previous receivership of the enterprise, terminated in 1926, had lasted six years.) In this case the stockholders were not required to give up any part of their junior interest to the bondholders in return for the concessions made. While theoretically some such sacrifice and trans- fer would be equitable, it was not of much practical importance here because any stock bonus given to the bondholders would have had a very slight market value.10 It should be recognized as a principle, however, that the waiving of any important right by the bondholders entitles them to some quid pro quo from the stockholders—in the form either of a contri- bution of cash to the enterprise or of a transfer of some part of their claim on future earnings to the bondholders.11 In 1939 additional legislation of a temporary nature was adopted, designed to facilitate so-called “volu

ock bonus given to the bondholders would have had a very slight market value.10 It should be recognized as a principle, however, that the waiving of any important right by the bondholders entitles them to some quid pro quo from the stockholders—in the form either of a contri- bution of cash to the enterprise or of a transfer of some part of their claim on future earnings to the bondholders.11 In 1939 additional legislation of a temporary nature was adopted, designed to facilitate so-called “voluntary reorganizations” of railroads by making them binding on all security holders.12 This statute was 10 In 1936 the company effected a second voluntary rearrangement, under which the interest rate was fixed at 4%, and the bondholders received a rather nugatory bonus of common stock. In 1939 still a third voluntary modification was accepted, in which bondholders took 30% in cash and 70% in preferred stock for their bonds—the money being advanced as a loan by the R.F.C. 11 The reorganization of Industrial Office Building Company in 1932–1933 is a remarkable example of the conversion of fixed-interest bonds into income bonds without sacrifice of any kind by the stockholders. A detailed discussion of this instance is given in the Appendix Note 32, p. 763 on accompanying CD. 12 This is the Chandler Railroad Readjustment Act of 1939, which actually adds a new Chap. XV to the Bankruptcy Act. Action thereunder must be begun before July 31, 1940, and must be substantially concluded within a year after its initiation. As far as the reorganization technique intended specifically to aid the Baltimore and Ohio and Lehigh Valley roads, which had previously proposed voluntary reorganization plans. These were designed to reduce fixed-interest charges and to extend cur- rent and near maturities. The stockholders, in each case, were to retain their interests intact. As we have previously stated, it is our opinion that voluntary readjust- ment plans are desirable in themselves, but they sh

year after its initiation. As far as the reorganization technique intended specifically to aid the Baltimore and Ohio and Lehigh Valley roads, which had previously proposed voluntary reorganization plans. These were designed to reduce fixed-interest charges and to extend cur- rent and near maturities. The stockholders, in each case, were to retain their interests intact. As we have previously stated, it is our opinion that voluntary readjust- ment plans are desirable in themselves, but they should be proposed after voting control over the corporation has passed to the bondholders, and they are in a position to choose between alternative courses of action. Change in the Status of Bond Trustees. Not the least important of the remedial legislation enacted since 1933 is the “Trust Indenture Act of 1939.” This undertakes to correct a number of inadequacies and abuses in the administration of their duties by bond trustees. The chief criticism of the behavior of indenture trustees in the past is that they did not act as trustees at all but merely as agents of the bondholders. This meant that as a general rule they took no action on their own initiative but only when directed to do so and were fully indemnified by a certain percentage of the bondholders.13 Indentures have said practically nothing about the duties of a trustee but a great deal about his immunities and indemnification. The 1939 statute aims directly at this unsatisfactory situation by including the following provision (in Section 315): Duties of the Trustee in Case of Default (c) The indenture to be qualified shall contain provisions requiring the inden- ture trustee to exercise in case of default (as such term is defined in the inden- ture) such of the rights and powers vested in it by such indenture, and to use the same degree of care and skill in their exercise, as a prudent man would exercise or use under the circumstances in the conduct of his own affairs. There are further provisions limiting the use

n (in Section 315): Duties of the Trustee in Case of Default (c) The indenture to be qualified shall contain provisions requiring the inden- ture trustee to exercise in case of default (as such term is defined in the inden- ture) such of the rights and powers vested in it by such indenture, and to use the same degree of care and skill in their exercise, as a prudent man would exercise or use under the circumstances in the conduct of his own affairs. There are further provisions limiting the use of so-called “exculpatory clauses,” which in the past made it impossible to hold a trustee to account is concerned, it is not significantly different from that provided in Section 77. In both cases approval of the I.C.C., of a court, and of a suitable percentage of security holders is required. The important difference is that under the new Chap. XV there is no bankruptcy in the involved legal sense. The company continues to administer its own affairs, and no contracts or other obligations are affected except those specifically included in the plan of readjustment. 13 See Appendix Note 33, p. 766 on accompanying CD, for further discussion and an exam- ple on this point appearing in the first edition of this work. for anything except provable fraud or else negligence so gross as to be equivalent thereto. A further cause of complaint arose from the fact that the indenture trustee has frequently been a creditor of the obligor (e.g., a trust company holding its promissory notes) or else has been controlled by the same interests. These situations have created conflicts of interest, or an unwill- ingness to act impartially and vigorously, which have militated strongly against the bondholders. The Trust Indenture Act of 1939 contains strin- gent provisions designed to terminate these abuses.14 The Problem of the Protective Committee. Reform in the status of indenture trustees may lead to a solution of the vexing problem of the protective committee. Since 1929 the general status o

has been controlled by the same interests. These situations have created conflicts of interest, or an unwill- ingness to act impartially and vigorously, which have militated strongly against the bondholders. The Trust Indenture Act of 1939 contains strin- gent provisions designed to terminate these abuses.14 The Problem of the Protective Committee. Reform in the status of indenture trustees may lead to a solution of the vexing problem of the protective committee. Since 1929 the general status of protective com- mittees has become uncertain and most unsatisfactory. Formerly it was taken for granted that the investment bankers who floated the issue would organize a protective committee in the event of default. But in recent years there has been a growing tendency to question the propriety or desirabil- ity of such action. Bondholders may lack faith in the judgment of the issu- ing house, or they may question its ability to represent them impartially because of other interests in or connections with the enterprise; or they may even consider the underwriters as legally responsible for the losses incurred. The arguments in favor of competent representation by agen- cies other than the houses of issue are therefore quite convincing. The dif- ficulty lies however, in securing such competent representation. With the original issuing houses out of the picture, anybody can announce him- self as chairman of a protective committee and invite deposits. The whole procedure has become unstandardized and open to serious abuses. Dupli- cate committees often appear; an undignified scramble for deposits takes place; persons with undesirable reputations and motives can easily inject themselves into the situation. The new bankruptcy legislation of 1938 introduced some improve- ment into this situation by subjecting the activities and compensation of 14 The remedial legislation was an outgrowth of a trust indenture study made by the S.E.C. and was greatly stimulated by the opinion deli