Chapter XXVI: Our Railroad Methods

DECEPTIVE FINANCIERING.—OVER-CAPITALIZATION.—STOCK “WATERING.”—FINANCIAL
RECONSTRUCTIONS.—LOSSES TO THE PUBLIC.—PROFITS OF CONSTRUCTORS.—BAD
REPUTATION OF OUR RAILROAD SECURITIES.—UNJUST AND DANGEROUS
DISTRIBUTION OF THE PUBLIC WEALTH.

The following chapter, on the subject of “Our Railroad Methods,” was delivered by me as a Fourth of July address at Mr. H. C. Bowen’s Annual Symposium at Woodstock, Conn., to an assemblage of over 3,000 people. It was so favorably received by the press and the public in general, that I have been encouraged to publish it in this book without any material changes:

In the whole range of our law-making there is no one branch in
which there has been such an utter lack of judgment, foresight
and just regard for the rights of the citizen, as in the
legislation provided for our railroads and railroad companies.
For the most part, the statutes relating to this class of
corporations are a set of general enactments, loosely defining
the large powers granted to the incorporators, comparatively
silent on the duties and obligations of the companies to the
public, and conferring upon them a virtual _carte blanche_ as to
their methods of finance and of conducting their business.

In a country whose products are mainly bulky, and have to be
carried to markets hundreds or thousands of miles distant, it is
of the first moment that its railroads should be built with the
strictest economy and on the lowest possible capitalization. The
low cost of land and the cheapness of material for road-bed are
especially favorable to our securing this advantage; but the
laws have permitted a system of inflated financiering which
neutralizes these natural adaptations and immensely increases
the cost of transportation.

As railroads have to be largely built with borrowed money, their
construction in this country afforded an opportunity for
establishing credit relations with the great lending centres of
Europe, which might have been of incalculable value in promoting
the development of our vast resources in various directions.
England, Holland and Germany have indeed loaned us very large
amounts for railroad enterprises; but the law has permitted
these undertakings to be conducted with so much concealment,
misrepresentation and actual fraud, and has so disregarded the
rights of the bondholders, that American credit has become a
scandal and a by-word on the European bourses. The result is,
that foreign capitalists are seeking other fields of investment;
and their respective Governments are encouraging them by opening
up new colonies, and thus getting fresh sources for the supply
of products which otherwise would have continued to be readily
taken from the United States. Such are the rewards of immoral
financiering; and these bad methods are directly traceable to
the encouragements afforded by our negligently constructed
railroad laws.

Perhaps I may best succeed in making myself understood on this
subject by illustrating the way in which our railroads are
usually built. Under the laws of the State of New York—which are
a fair sample of the laws of most other States—a number of
persons form a company under the general railroad laws,
registering at Albany the proposed route of the road, the amount
of capital stock and bonds to be issued, and a few other
particulars required in the papers of incorporation. The
incorporators then proceed to form themselves into a syndicate
or company, for the purpose of contracting to build and equip
the road. Here comes the first step in the system of “crooked”
financiering. In their capacity of incorporators, the same men
make a contract with themselves, in the capacity of
constructors. Of course, they do not fail to make a bargain to
suit their own interests. They would be more than human if they
did. Usually, the bargain is that the construction company
undertakes to build the road for 80 to 100 per cent. of the face
value of the first mortgage bonds, with an equal amount of
stock, and sometimes also a certain amount of second mortgages
thrown in, virtually without consideration. The first mortgages
are supposed to represent the real cash outlay on the
construction and equipment; but, as a matter of fact, the true
cash cost of the work done and materials furnished ranges from
60 to 80 per cent. of the amount of first lien transferred to
the constructors. The Construction Company disposes of the
bonds, partly by negotiating their sale to the public through
bankers, at an advance upon the valuation at which they had
received them, and partly by using them in payment for rails and
equipment. Beyond the profits made from building the road for
the first mortgage bonds, there remains in the hands of the
constructors the entire capital stock and any second mortgage
bonds they may have received, _as a clear bonus_, to be held for
future appreciation, and to keep control of the Company and be
ultimately sold on a market deftly manipulated for that purpose.

This is the way in which a large majority of our railroads have
been and others are still constructed. It will thus be seen that
the actual cash cost of a railroad is ordinarily less than 60
per cent. of the stock and bonds issued against the property,
and that its first mortgage exceeds the amount of the legitimate
actual cost of the road.

The basis of all the discredit, the embarrassments, the
bankruptcies and the robberies of our railroad system is thus
laid at the inception of the enterprises. They rest upon an
intrinsically rotten and dishonest foundation; and the evil is
far from having reached the end of its mischief to the
financial, political and social interests of the country. In
some few cases, railroads thus exorbitantly capitalized have
proved able to earn the interest on their debt, provide for
additional outlays on construction and betterments, and even to
pay dividends on their stock; but, in a large majority of cases,
they have had to undergo a process of financial reconstruction,
in order to bring the debts of the Company within its ability to
meet its fixed charges. It is not a risky estimate to suppose
that of our present 125,000 miles of railroad, with its
$7,500,000,000 of stock and debts, 60 per cent. has undergone
this process of debt-scaling and rehabilitation. Were it not
that the new roads have opened up new country for settlement,
which has become an immediate source of traffic, these bad
financial results would have been more general and worse than
they have proved to be. The risks attending the building of
lines into unsettled regions ought to have been a reason why
they should be constructed upon conservative principles; but, in
reality, the prospects of settling new populations and of
tapping new sources of wealth, have been so magnified to the
eyes of distant and credulous lenders as to enable the
speculative constructors to easily consummate their illegitimate
schemes.

The general result of this system of financiering has been to
deprive the legitimate original investors of their chances of
making a fair return out of their investment. As a rule, the
bondholders have provided all the capital expended, and the
stockholders have invested nothing. The bondholders incur all
the risks; the stockholders have no responsibilities. If the
enterprise proves a success, the bondholders get their interest,
while the stockholders, without a dollar of original outlay, get
vastly more than ever falls to the mortgage creditors through
the stock becoming an instrument of profitable speculation. If
the enterprise is a failure, the bondholder has to forego
interest and finally to accept a new mortgage for a less amount
and at a lower rate of interest; whilst the original stockholder
has, in the meantime, made money out of artificially “booming”
the shares in Wall Street.

The profits realized on these speculative constructions are
enormous, and have constituted the chief source of the
phenomenal fortunes piled up by our railroad millionaires within
the last twenty years. It is no exaggeration to characterize
these transactions as direct frauds upon the public. They may
not be such in a sense recognized by the law, for legislation
has strangely neglected to provide against their perpetration;
but, morally, they are nothing less, for they are essentially
deceptive and unjust, and involve an oppressive taxation of the
public at large for the benefit of a few individuals, who have
given no equivalent for what they get. The result of this system
is that, on an average, the railroads of the country are
capitalized at probably fully 50 per cent. in excess of their
actual cost. The managers of the roads claim the right to earn
dividends upon this fictitious capital, and it is their constant
effort to accomplish that object. So far as they succeed, they
exercise an utterly unjust taxation upon the public, by exacting
a compensation in excess of a fair return upon the capital
actually invested. This unjust exaction amounts to a direct
charge and burthen on the trade of the country, which limits the
ability of the American producer and merchant to compete with
those of foreign nations, and checks the development of our vast
natural resources. In a country of “magnificent distances,” like
ours, the cost of transportation is one of the foremost factors
affecting its capacity for progress; and the artificial
enhancement of freight and passenger rates due to this false
capitalization has been a far more serious bar to our material
development than public opinion has yet realized. The hundreds
of millions of wealth so suddenly accumulated by our railroad
monarchs is the measure of this iniquitous taxation, this
perverted distribution of wealth.

This creation of a powerful aristocracy of wealth, which
originated in a diseased system of finance, must ultimately
become a source of very serious social and political disorder.
The descendants of the mushroom millionaires of the present
generation will consolidate into a broad and almost omnipotent
money power, whose sympathies and influence will conflict with
our political institutions at every point of contact. They will
exercise a vast control over the larger organizations and
movements of capital; monopolies will seek protection under
their wing; and, by the ascendancy which wealth always confers,
they will steadily broaden their grasp upon the legislation, the
banking and the commerce of the nation.

The illegitimate methods by which the wealth of this class has
been accumulated cannot always remain a mystery to the masses.
The time will come when every citizen will clearly perceive how
his interests have been sacrificed for the creation of this
abnormal class; and, when that time comes, a series of public
questions will arise that will strain our political institutions
to their very foundations. Already the working masses begin to
see the dim outline of the gigantic wrong that has been
inflicted upon them in common with all other classes. If they do
not understand the exact method by which a portion of the
rewards of labor has thus been diverted from them, they clearly
comprehend which is the class responsible. The labor troubles
that have so seriously shaken confidence during the spring of
this year have been largely stimulated by an idea that a serious
wrong has been done to the workman in the creation of these
abnormal fortunes. It is not surprising—although it may lead to
disappointing results—if workingmen should reason that, if
railroads can afford to make a few men so wonderfully rich, they
can afford to pay their employees higher wages and for shorter
hours. Nor can we wonder if, when capitalists are on every hand
piling up their wealth by the tens of millions, the laborer
should conclude that he ought to be able to get a few dollars a
week more, or deduct an hour or two off his day’s work, without
very seriously hurting the employing class. This may be and is
very fallacious reasoning; but it is what might very naturally
be expected under these circumstances, from a class who are not
trained to think beyond surface depth. It will be of no avail to
tell the workmen that this unjust distribution of wealth is
final and irrevocable; that there is no power of redress by
which a wrong of this nature can be righted; or that, as voting
citizens, they are as much responsible as anybody else for
permitting the neglects and defects of legislation that have
made these inequalities possible. This class never reason either
calmly or logically, and it will take a great deal of fruitless
agitation to satisfy them of the hopelessness of their methods
of seeking reparation.

The Socialistic seductions which have captivated such large
masses of the working population of Europe will all the more
readily find acceptance among our millions of laborers because
they have before their eyes such conspicuous instances of the
unequal division of wealth and of the overwhelming power of
organized capital. Certainly, if any facts could be supposed to
justify the doctrines of Socialism and Communism, it would be
the sudden creation of such fortunes as those which, within a
very few years, have come into the hands of our railroad
magnates. A few years later, the public will understand much
better than it now does how facts like these have contributed to
the raising of questions of government which will dangerously
test the cohesion and endurance of our political institutions.

Artificial methods of establishing our railroad corporations
have naturally led to artificial methods of regulating their
operations. Over-capitalization incapacitates the roads for
competition; for it necessarily holds out a temptation to
parallel existing roads by others at a lower capitalization. As
roads running between the same points were multiplied,
competition for “through” business became more active, until not
only were dividends threatened on some of the best lines, but
some roads were driven into default on their mortgages. At this
point the “pool” was introduced—a device by which all lines
running between the same points agree to put their business from
through traffic into a common aggregate, to be distributed among
the several members according to certain accepted percentages.
It was hoped that, in this way, uniformity of charges could be
maintained, at such rates as were necessary to make the business
satisfactory to each member. This, however, was soon found to be
a step “from the mud into the mire.” The pool was discovered to
operate as a premium on the construction of new parallels.

Speculators were quick to perceive that they could build new
lines on the same routes for much less cost than the old ones,
and that, with a lower capitalization, they could easily compel
the pool to admit them to membership, with all the privileges of
a ready-made traffic and with all the guarantees the pool could
afford of exemption from competition, and of ample charges.
Thus, the pools that, in the first instance, were made necessary
through the evils of speculative methods of construction,
became, in turn, the source of a new and even worse form of the
same evil. New roads were built, or sets of old detached ones
were connected, so as to afford additional parallels to the
existing trunk lines, with no other object than to compel the
latter to support them by dividing with them a portion of their
traffic, or to accept the alternative of a reckless cutting down
of rates. The end to this viciously excessive system of
construction can only come when the pools have been reduced to
such a low condition that they will no longer care to take
newcomers into their co-partnership; in which case speculative
builders will see no chance for profit in such ventures. The
fate of the “Nickel Plate” and of the West Shore speculations,
by which nearly 1,000 miles of needless road was built to divide
traffic with the Vanderbilt system, serves as a warning against
the danger of building roads to live upon pool support; but,
nevertheless, the Eastern trunk pool still stands exposed to a
great deal of harassing outside competition from possible and
contemplated new combinations of existing detached links. Routes
of the latter kind are even more formidable competitors than new
lines, because they can be provided at a lower capitalization,
and have already the support of an established way traffic. It
would not be surprising if, within the next three or four years,
several new routes should in this way be established between New
York and Chicago.

It will thus be seen that the very contrivance intended to stave
off the vicious effects of artificial capitalization is
contributing, by a sort of punitive process, towards the end of
reducing earnings to a just ratio to the true value of the
properties. The weakness of the pool, arising from its
temptations to new competitors to enter the field, is not the
only cause of its failure. Up to this time it has been found
impossible to find a form of pool stringent enough to restrain
the members from cutting rates against each other. The modes of
possible evasion are so numerous, the sacrifices of special
advantages that each member has to make are so galling, the
small share that remains to each road in a numerously divided
business is so small, and the temptations of agents to get
freight “by hook or by crook,” in dull times are so
irresistible, that the strictest watching and the severest
penalties fail to secure a faithful observance of the pool
agreements. Much forbearance is shown towards transgressions,
and deliberate violations have to be condoned or connived at;
but, all the time, the pools are in imminent danger of
jealousies and breaches of faith causing their disruption. No
sooner have they won public confidence by maintaining harmony
through a period of prosperous business, than the public wake up
to find that some member has been secretly “cutting,” and the
agreements are torn to pieces.

The result is, that the public have lost all confidence in the
ability of the pool to regulate competition; and, still worse
for the railroads, their managers are losing faith in them also.
The great crucial test of this expedient so far as respects the
Eastern lines, is likely to come when the number of smaller
outside competitors, of the character just alluded to, comes to
be increased. The pool will not be likely to admit them into its
fold, which already includes too many diverse interests to
permit of harmony; and if it did, the danger of disagreements
and disruption would be only thereby increased. And yet, if
those routes are shut out, they will act as so many free lances,
attacking the older lines in every direction, and doing business
at rates which will leave the pool companies no alternative but
to follow suit. In this dilemma, the outlook for some time ahead
is not an encouraging one for the older companies. To my view,
it seems very probable that their original sins of construction
and their subsequent transgressions of stock “watering” are
about to find them out. The natural law of competition is a
terrible foe to the violators of commercial justice. It is the
inevitable police power of trade. Its working may be evaded for
a time; its final conquest over wrongs and monopolies may
sometimes be delayed beyond the limits of human patience, and
men may at such times lose confidence in its power to right the
wrongs of society; but its ultimate success in the restoration
of equity and fair-play is as certain as the rising of the sun.

My absolute confidence in the ultimate triumph of this principle
prompts me to venture the assertion that, _at no very distant
period_, the wrongs practised in the original construction of
our railroads and in the subsequent “waterings” of their stocks,
will be compensated through competition adjusting the profits of
the companies to the equivalent of a fair return upon a _true
valuation_ of the properties; that is, a value measured by what
they are able to earn under the conditions of free competition
and the now current cash cost of providing like facilities.
That, it appears to me, is the solution towards which our
railroad problem is now steadily working; and neither
Congressional legislation, nor State regulation, nor the
resistance of organized capital, can be expected much longer to
stave off that result.

It may, however, be very properly asked, whether legislation
has no duty in the premises? To me, it appears that it has a
very weighty one. The consequences of the original neglect
to prescribe proper regulations for the construction,
capitalization and financial management of railroads has
been so fully exposed by their past history, that the
Legislatures will greatly err if they neglect to impose
restrictions upon future corporations that will prevent
farther repetition or perpetuation of the evils. When the
Government bestows upon railroads important privileges and
franchises, under which fundamental private rights are held
in abeyance for the common good, it is due to the public
protection that the recipients of these favors should be
held under restrictions which will prevent them from abusing
the privilege to the public disadvantage.

When a railroad company capitalizes its property at double its
actual cost, and seeks to collect charges calculated to yield
dividends upon such false capital, it grossly perverts and
abuses the privileges conferred by its charter, and virtually
perpetrates a public robbery. This appears to be a perfectly
plain proposition, and yet this glaring wrong has been so long
tolerated that not only the railroads, but a portion of the
public even, have come to regard it as a sort of right inherent
in these corporations. One of the first duties of the State
Legislatures, therefore, is to enact laws requiring that the
stocks and bonds issued against any railroad hereafter built
shall, in no case, exceed in the aggregate the _true cash cost_
of the property; the penalty for the violation of this
restriction to be forfeiture of charter. The responsibility of
managers should be definitely fixed. All extensions, betterments
or improvements should be provided for by issues of stock or
bonds on like conditions. The issue of mortgages should be
restricted within 60 per cent. of the true cost of the property.

In order to prevent wrongful speculative profits being realized
by the incorporators, they should be prevented from becoming the
constructors of their road, directly or indirectly; and all
contracts for construction, equipment, extensions or
improvements should be made upon open competitive bids, the
lowest bid to be accepted, with substantial guarantees for the
faithful performance of the contract. Also, it should be made
the duty of a board of State railroad commissioners to see to it
that all these conditions are strictly complied with.
Regulations should be provided prohibiting issues of stock for
any other than construction or equipment purposes, forbidding
the payment of dividends not actually earned, and enforcing the
amplest publicity of details relating to current traffic and the
financial affairs of the companies.

Had our original railroad laws incorporated provisions of this
character, our railroads would have all along ranked as the
safest and most stable investments of the country; the discredit
that hangs over our corporate enterprises would have been
averted; transportation would have been done at lower rates with
steadier charges, and we should have been saved the social and
political excrescence of an aristocracy based upon ill-gotten
wealth. After our bitter experience of the dangerous results of
neglecting to guard the railroad interest by some such
restraints as the foregoing it surely is not too early now to
apply these safer methods to all future enterprises of this
character. Not only is such legislation due as a measure
necessary for the protection of our commerce and investors, but
it would go very far towards remedying the evils that have grown
up under the old and badly regulated system. To a man of
business it is hardly necessary to point out what would be the
competitive advantages of roads constructed under the proposed
regulations. As a rule, their capitalization would not exceed 50
to 60 per cent. of that of the older companies, and they could,
therefore, be run upon a much lower rate of charges.

The thoroughly conservative nature of their organization would
bespeak fer them a degree of public confidence which would
enable them to get all the capital needed for really legitimate
undertakings, whilst purely speculative ventures would be put
under conservative check. Under these circumstances new roads
could do a profitable business, and yet compete disastrously
with the old excessively capitalized companies. The ultimate
result of this competition from the new order of roads would
inevitably be to reduce the earnings of the older class to a
point which would admit of interest and dividends being earned
_only on the same rate of capitalization as existed among the
new-system companies_. In other words, the effect of the honest
method of capitalization here suggested would be to squeeze all
the “water” out of the old companies, and to bring them in
effect, though possibly not in form, to the same financial level
as the new.

If my reasoning here is correct, there is cause for our great
railroad capitalists to look out for the security of their
investments. The basis for their wealth may prove far less
certain than they have imagined it to be. With the prevailing
and steadily increasing public feeling against the methods of
railroad capitalists and the working of our railroad system,
what assurance can there be that, when a remedy for these
corporate wrongs comes to be clearly propounded, it will not be
eagerly urged upon the attention of the Legislatures and adopted
without much ceremony? The dash of a Governor’s pen is,
therefore, all that stands between the railroad millionaire and
the sudden extinction of a large portion of his inflated paper
wealth. Is this a chimerical conclusion? The question, it seems
to me, deserves a far more serious consideration than those most
vitally concerned have yet bestowed upon it. No man can
confidently deny the possibility of such a result as is here
indicated. No one familiar with the present public temper on the
subject of railroad monopoly can reasonably question _the
probability even_ of a settlement of this kind being ere long
resorted to. Under these circumstances, it is a question very
pertinent to the times, whether the foundation of our railroad
aristocracy is as broad or as firm as it has been supposed to
be, and whether a healthy solution of the great railroad problem
is as difficult and as remote as some despondent people have
represented it to be.

A ONE THOUSAND DOLLAR BOND OF THE STATE OF GEORGIA.
Repudiated.
]

------------------------------------------------------------------------