PROPERLY speaking stock-watering is the reappraisal by its owners of a corporate property which has, or is alleged to have, increased in value on their hands, without any new outlay upon their part, and the issue to themselves of new evidences of value equal to such supposed increase. It is indisputable that, as regards railroads, this practice has been not infrequently very grossly abused, especially of late years, and that these abuses of it now impose a very heavy additional burden upon the cost of transportation. Fraudulent and secret issues of stock by corrupt managements or dishonest officials have also contributed to this result, but the transaction in this case differs from strict stock-watering in much the same way as the money of counterfeiters differs from excessive issues by government of irredeemable legal tenders. Both processes directly inflate the volume of the securities which represent the value of the railroad system, and, in so far, constitute stock-watering, but while the first is, strange to say, legitimate in character, the last is a mere fraud.
In America, as in England, the private corporation owning the thoroughfare is the basis of the whole railroad system. In thus surrendering the control of this system out of its own hands, the community as a rule made one and but one reservation in its own favor ; it was almost universally stipulated that the rate of profit upon the capital invested in the work of construction should not exceed a certain annual percentage, varying, according to locality, from 10 to 20 per cent. Within this limit the corporations were free to earn and to divide all that they could.
This constituted the railroad usury law, and like all usury laws was an exceedingly clumsy contrivance. It had two obvious defects ; no provision was made for ascertaining the real, as contradistinguished from the nominal cost of any road, and nothing was said in regard to arrears of unpaid dividends. It was absurd to suppose that even the most honest capitalist would accept the strict construction of a law which insured him a certain loss in each bad year or unprofitable enterprise, and limited him in case of success to a reasonable profit. Of course, therefore, the law was no sooner enacted than it was circumvented. How this was done in England has already been stated, but it is in America that the process has been conducted on the most magnificent scale. The principle operated upon in both countries was the same. The doubt raised was whether the stipulated percentage was to be paid upon what the property cost its holders, or upon what it was actually worth. Interpreting it in the way last specified, the capitalist proceeded to act accordingly. The result as a whole bids fair to be most disastrous, and yet, in not a few cases, it is very difficult to take any just exception to it. Many roads were constructed, and proved, if not commercial failures, very gradual successes ; for years no dividends were paid, — the money which should have gone to dividends, which rightfully belonged to the capitalists, was absorbed in construction. Fairly speaking, this was so much new capital belonging to the owners, and by them invested in the enterprise ; just as much so as if the allotted dividends had been paid to the stockholder and by him instantly handed back to the treasurer of the company. In the vast majority of other cases very small dividends were paid, far below the limit fixed in the law, and the balance found its way into construction. In all of these instances heavy arrears accumulated against the property, and these arrears might fairly and justly be claimed as capital, actually paid in, and which should be represented by evidences of value. Wherever stock was issued under such circumstances the operation would not seem justly open to criticism. The difficulty was that no provision whatever had been made in the law to meet the case. It therefore devolved upon the owners of the property to cast up the balance-sheet themselves, and to decide all nice points, undoubtedly in their own favor. Where a people so provides for its own interests it needs no prophet to foretell the consequences. No landlord deals in this way with a tenant.
The history of the companies which have been consolidated into what is known as the Pittsburg Fort Wayne & Chicago Railroad, furnishes a very fair illustration of what may be expected to ensue from this disregard of ordinary precautions. Here the process of watering was early commenced, as a simple and desperate expedient for raising money at an enormous discount for the purpose of completing an enterprise of doubtful success. In the earlier history of one of these companies we read : “ The stock subscriptions which were paid in cash into the treasury of the company were very small, — amounting perhaps, in all, to less than three per cent on the final cost of building and equipping the road. The stock subscriptions were paid for mostly in uncultivated lands, farms, town lots, and labor upon the road.” Of the whole road as it stands we are told, that, “of the $18,663,876, now representing the cost of the road and equipment, &c., the shareholders contributed in cash only about ten per cent, or less than $2,000,000 ; and their contributions in cash, bonds, notes, lands, and personal property, labor, &c., amounted to something less than $4,000,000, or rather more than twenty per cent of the present cost of the work. The difference between this sum and the capital stock as now shown by the books of the company, is made up of dividends which were paid in stock, interest on stock paid in stock, premium on stock allowed to stockholders at the time of consolidation, which was paid in stock, and a balance of stock still held by the trustees.
This, however, was in the early days of the enterprise, the days of doubtful success, when the stock was thought worthless, and was almost given away. But in 1866 a new era dawned upon the Fort Wayne road ; it began to pay dividends. In 1870 the stock of the company, the history of a portion of which has just been given, stood at $11,500,000, while its indebtedness amounted to about $13,600,000 more, being in all some $1,150,000 above the cost of road and equipment as they stood upon the books of the company. In June of this year, a lease was effected of the entire property by the Pennsylvania Railroad Company. The Fort Wayne stockholders had their option between annual dividends of 12 per cent on the stock then in existence, or the more moderate rate of 7 per cent on a proportionately increased amount. They wisely chose the latter, and forthwith the $11,500,000 of stock became $19,714,000, — while the road which was claimed to have cost only $24,000,000, was suddenly represented by $33,400,000 of securities, none of which bore a less interest than 7 per cent.
The great masterpieces of Commodore Vanderbilt have, however, so eclipsed all other performances in this line that they may be said to constitute an epoch in the history of paper inflation, — it might also be said of bubble-blowing. It is only necessary, therefore, in this connection, to recount the history of the chain of roads, now reduced in number to two, which connect New York and Chicago by way of Albany. The distance between these points is 982 miles. It is useless to begin the story further back than 1852, when the through line was completed, consisting of sixteen independent links, several of which were themselves made up of numerous smaller and once independent roads. That was a year of active and much needed consolidation. The New York Central led off under a special act of legislature. Eleven roads went into the consolidation with an aggregate capital of $23,235,600. The stock lowest in value of the eleven was settled upon as the par of the new concern, and the stocks of the other ten companies were received at a premium varying from 17 to 55 per cent. By this simple financial arrangement, $8,894,500 of securities, of which not one cent was ever represented by property, but which in reality constituted so much guaranteed stock, was made a charge, principal and interest, against future income. This was the price paid to get rid of the vested rights which had been allowed to settle down upon this thoroughfare. Between 1852 and 1868 the stock and indebtedness of the consolidated company had been increased, for one reason or another, until, when Mr. Vanderbilt became president in the latter year, they amounted in round numbers to $40,000,000, representing a road which its construction account showed had cost $36,600,000. Vanderbilt had for some years been president of the Hudson River road, and, as such, in 1867 had doubled its capital stock, ($7,000,000), calling in 50 per cent of the increased amount and thus watering to the extent of $3,500,000. Extending his control over the Central, he now proceeded to better his previous instructions. A stock dividend of 80 per cent, not a dollar of which was called in, was suddenly declared. Over $23,000,000 of securities were thus created at once. Operations stood still at this point, but only for a moment. The next measure was a consolidation of the Central and the Hudson River railroads. This was effected in the succeeding year upon a stock basis of $90,000,000 ; — a further watering of 27 per cent being allotted to the Central, while the turn of the Hudson River road now having come again, there was provided for it the munificent amount of 85 per cent. The result of these astounding feats of financial legerdemain was that a property which in 1866 appeared from its own books to have cost less then $50,000,000, and which was than represented by over $54,000,000 of stock and indebtedness, was suddenly shot up to over $103,000,000 in 1870, upon the whole of which interest and dividends were paid. At the same time the cost of the road stood upon the books of the company at less than $60,000,000, or about $70,000 per mile, while in evidences of property each mile was charged with no less than $122,000. The average cost of railroads throughout the world has been somewhat less than $100,000 per mile, while in America it has stood at about half of that amount. According to the books of the company over $50,000 of absolute water has been poured out for each mile of road between New York and Buffalo.
The next step towards Chicago was one of 88 miles to Erie. This was made up of a consolidation of two roads effected in 1867, which went in with $2,800,000 of capital and came out with $5,000,000. The total capital account of the company was then a trifle over $3,200,000. In 1869 the consolidation of the lines between Buffalo and Chicago was effected, and this road became a party to it with $6,000,000 of stock and $4,000,000 of indebtedness, — at least 30 per cent of water in excess of all cost of construction.
The next step in the line is one of 96 miles to Cleveland ; this was filled by the celebrated Cleveland Painesville & Ashtabula road, which in the six years between 1862 -67 divided 120 per cent in stock, 33 per cent in bonds, and 79 per cent in cash. Having really cost less than $5,000,000 in money it was consolidated at nearly $12,000,000.
The next step was from Cleveland to Toledo, 148 miles. Here it was that Vanderbilt began his operations, for in 1866 he secured possession of this road and signalized his administration of its affairs by the issuing of a scrip dividend of 25 per cent upon its $5,000,000 of capital.
The last two roads were consolidated into the Lake Shore road, 258 miles in length, in 1867 ; the stock and indebtedness of the new company was $22,000,000. In 1869 the work of consolidation was perfected from Buffalo to Chicago by the merging of all the connecting links into the Lake Shore & Michigan Southern Railroad Co., operating nearly 1,300 miles of road, represented by $57,000,000 of stock and indebtedness, which was increased to $62,000,000 in 1871, and which it had the further privilege of increasing to about $73,000,000. These figures throw a very curious light upon the real cost of railroad construction in America. They represent a nominal outlay of but $48,000 per mile, and yet it is not denied that in the amount was included $20,000,000 of fictitious capital. These roads, not improbably, may have cost those who constructed them in cash, actually paid in either directly in money or in dividends which had never been drawn out, the full amount of the consolidation capital. The profits had, it is true, been very unequally divided, but substantial justice was done in the end; what had been lost in one road was made good in another, but as a whole the community was, perhaps, paying for nothing which it had not received. No credit on this account is due to those managing the affairs of the company. They undoubtedly regarded the Vanderbilt operations as masterpieces of railroad management, and only regretted that the earnings of the company under their control could by no possibility justify any similar performances ; and yet the contrast between the results hitherto arrived at upon this line, under a system of moderate, average watering, and those achieved further east by Vanderbilt is singularly suggestive. It is probably safe to say that the Vanderbilt stock-waterings between Buffalo and New York annually cost the American people not less than $3,000,000 in excess of all remuneration which ever under any construction of right belonged to the owners of the lines. Under these circumstances it would seem, judging by the example of the Lake Shore road, that comparatively legitimate and reasonable waterings should satisfy any one not inordinately rapacious.
The science of stock-watering as thus far described had not yet, however, attained perfection ; in fact had not gone beyond the English precedents. What might be called the American system remains to be described. The stock of corporations is in this country given away as a sort of gratuity, — the right to direct railways and to tax trade is habitually thrown in as a makeweight. In the earlier days of railroad financiering it would naturally have seemed almost impossible to accomplish such a result, but time and experience brought even this about. It originated in the system of railroad mortgages. Very early, and very naturally in the immature days of the system, attempts were made to construct railways upon an insufficient capital. Funds gave out before the enterprises were half developed, and projectors had their election between abandonment or progress at any price. The obvious resource was to mortgage the property already in existence. Soon the market was weighed down with every conceivable description of railroad security. First there was a floating debt ; then preference stock, to be followed in rapid succession by first, second, and third mortgages ; construction and equipment bonds closing up the dreary procession, which not seldom ended at the tomb of a receivership. All these evidences of indebtedness were, however, secured on property really in existence. The art was not at once discovered of mortgaging something thereafter to be created. Presently new roads were projected, the business of railroad construction and financiering being now reduced to a system. The country through which these roads were to pass was young and poor, and capital had to be brought in from outside. There was abundance of it, but the risk involved was great, and the temptation to incur it must not be small. In the first place, the new road as an enterprise promises well. The next thing is to raise the money necessary to construct it. This is done, not by laying an assessment upon the stock, — that is not heard of as yet, and has no value in the market, — it exists only in name. In place of this, the bonds are put upon the market at a stated price, which, or a portion of which, is advanced by the capitalist, and construction is carried on with the proceeds. The stock itself then passes as a gratuity into the hands of those advancing money upon the bonds. The result is, that by this ingenious expedient the capitalist holds a mortgage, paying a secured and liberal interest, on his own property, which has been conveyed to him forever for nothing. The stock is at once nothing and everything. Given away, the donees own and manage the road, and, receiving a fixed and assured interest upon their bonds, enjoy a further right to exact an additional sum, and one as large as they are able to make it, from the developing business of the country, as dividends on the stock. Instances of this form of railroad financiering need not be specified, for it is now the common course of Western railroad construction. The new country needs its railroads, and is willing to pay anything for them, while the capitalists of the old country specify their own terms of construction, which are only too eagerly accepted.
So far as those immediately involved in these transactions are concerned no exception can be taken to them. Both are fair and equal contracting parties, and both understand the bargain they make. The occupant of the new country wants his railroad, and the capitalist is asked to embark his means in an enterprise full of risk. They both make the best terms they can, but the terms are made in advance ; there is no fraud and no chicane. While, therefore, the contract is not unfair as a private transaction, as a matter of public policy such a method of railroad construction cannot but excite very lively apprehensions for the future. The community, in its over eagerness to stimulate construction beyond all healthy limit, is continually binding itself to conditions which hereafter it will find very hard to fulfil.
The absolute disposal of the control of a road and all its securities, on condition that it is built, would seem to be a contract of a sufficiently sweeping nature, and it certainly marks the limit of legitimate railroad construction. Not seldom, however, the embryotic enterprise is bolstered up extraneously. Simple mortgages are not sufficient, and the credit of the road is guaranteed by land-grants, or by national or state or town or county loans, or by the credit of connecting or established lines, or by any or all of these combined. Every expedient which the mind of man can devise has been brought into play to secure to the capitalist the largest possible profit, with the least possible risk. The Pacific Railroad furnishes a fine example of all these ingenious devices. In speaking of this enterprise it is not pleasant to adopt a tone of criticism towards the able and daring men who with such splendid energy forced it through to completion. It was a work of great national import and of untold material value. Those who took its construction in hand incurred great risk, and at one time trembled on the verge of ruin. This enterprise was to them a lottery, in which they might well draw a blank, but, should they draw a prize, the greatness of the prize must justify the risk incurred. The community asked them to assume the risk, and was willing to reward their success. Success was thought to be well worth all it might cost. At the same time the process of construction afforded a curious example of the methods through which fictitious evidences of value can be piled upon each other. The length of the united road was 1919 miles, and the cost of construction was estimated at $60,000,000. To meet this outlay a stock capital was authorized of $100,000,000 for each of the two great divisions of the line; upon this, however, no dependence was placed as a means of raising money ; it was only a debt to be imposed, if possible, on the future business of the country. A curious mystery hangs over this part of the financial arrangements of the concern. Probably not $20,000,000 ever has been, or ever will be, derived from this source. The rest is very clear. There was the government subsidy of $30,000 a mile, and $30,000 a mile of mortgage indebtedness; there was a land grant of $12,800 acres a mile, and, where there were States, there were bonds, with interest guaranteed by the State and gifts of real estate from cities, where cities existed; and there were even millions of net earning applied to construction. The means to build the road were not grudgingly bestowed. Meanwhile, of the real cost of construction but little is correctly known ; absolutely nothing indeed of the western division, or Central Pacific. Managed by a small clique in California, the internal arrangements of this company were involved in absolute secrecy. The eastern division was built, however, by an organization known as the Credit Mobilier, which received for so doing all the unissued stock, the proceeds of the bonds sold, the government bonds, and the earnings of the road, — in fact, all its available assets. Its profits were reported to have been enormous, and they made the fortunes of many, and perhaps of most of those connected with it. Who, then, constituted the Credit Mobilier ? It was but another name for the Pacific Railroad ring. The members of it were in Congress ; they were trustees for the bondholders, they were directors, they were stockholders, they were contractors ; in Washington they voted the subsidies, in New York they received them, upon the Plains they expended them, and in the Credit Mobilier they divided them. Ever-shifting characters, they were ubiquitous, — now engineering a bill, and now a bridge, — they received money into one hand as a corporation, and paid it into the other as a contractor. As stockholders they owned the road, as mortgagees they had a lien upon it, as directors they contracted for its construction, and as members of the Credit Mobilier they built it. What is the community to pay for it ?
At the close of 1870, with $103,000,000 of their capital yet unsubscribed, and thus reserved for issue, should the earnings of the roads at any future period make watering practicable ; with this amount of stock in reserve, the two companies operated 2,083 miles of road, represented by stock and debt to the amount of $240,000,000. Thus the last results of Vanderbilt’s genius have been surpassed at the very outset of this enterprise. The line from Chicago to New York represents now but $60,000 to the mile, as the result of many years of inflation, while the line between Omaha and Sacramento begins life with the cost ot $115,000 per mile. It would be safe to say that the road cost in money considerably less than one half of this sum. The difference is the price paid for every vicious element of railroad construction and management ; costly construction, entailing future taxation on trade ; tens of millions of fictitious capital ; a road built on the sale of its bonds, and with the aid of subsidies ; every element of real outlay recklessly exaggerated, and the whole at some future day is to make itself felt as a burden on the trade which it is to create.
Enough has been said to illustrate the bearing which stock-watering and extravagant construction have upon taxation. It would be useless to attempt to estimate the weight of the burden imposed through these means upon material development. The statistics which should enter into any reliable estimate are not accessible, and any approximation would be simply a matter of guess-work. A table was published, during the year 1869, in a leading financial organ,* comparing the capital stocks of twenty-eight roads as they stood on July 1, 1867, and May 1, 1869. During those twenty-two months it was found that the total had increased from $287,036,000 to $400,684,000, or 40 per cent. Carrying the comparison on nine of these roads back two years further, it was found that, in less than four years, their capitals had increased from less than $84,000,000 to over $208,000,000, or 150 per cent. A portion of this, perhaps 25 per cent of the whole, represents private capital actually paid in and expended ; another portion, perhaps equally large, represents dividends the payment of which was foregone and the money applied to construction ; the whole of the remainder may be set down as pure, unadulterated “water,” which calls for an annual tax-levy of some three or four millions a year.
There is, however, another and very important side to this question. What may be called the wrongs of the community and the exactions of the capitalist have alone been discussed hitherto. It now remains to consider the subject from the capitalist point of view. Almost every balance-sheet presents items of loss as well as of profit ; — that relating to railroads is no exception to this rule. It has been noticed that the laws which limited the profit on capital paid into railroad construction made no provision to guarantee any profit up to that limit. In regard to this the capitalist took his risk. He built railroads in every direction, and the community undertook to say to him that, where he made a success he must content himself with reasonable profits ; — where he made a failure he must submit to a total loss. Here, then, in this absence of a guarantee of reasonable profit, lay the real security which the community saw fit to take for itself against excessive profit. It was a case of resort had to the doctrine of averages. That it was no meaningless security is a thing very susceptible of proof ; — indeed, it is not too much to say that the loss incurred by private capital in ill-considered railroad enterprises, — the mere amounts of money actually paid into construction, and since wiped out of existence by insolvency or loss of interest, — it is safe to say that this often forgotten element in the account would constitute more than a set off for the largest amount of watered stock ever alleged to have been issued. People continually refer to the brilliant successes in railroad enterprises ; — they do not so often count the failures, or remember the fact that not a few of our thoroughfares were actually given by capitalists to the communities which now enjoy them. This statement is very susceptible of proof. The profits upon railroad enterprises, as a whole, are not excessive, — the business is one which affords in this country even less than the average return upon the capital invested in it. The actual cost in money, up to the present time, of the 55,000 miles of railroad now in operation in the United States cannot have been less than $40,000 per mile, or, in all, twenty-two hundred millions of dollars, and was probably much more. Perhaps one quarter in amount of the cost to both sides of the war of the rebellion. The net earnings of the system, — that part which alone represents profit on capital, — cannot certainly be estimated at more than 33 per cent of the gross earnings, or in this case $150,000,000 per annum. Here, then, under the most favorable circumstances, is a system returning 6.82 per cent upon the capital actually invested in it. In America this cannot surely be considered excessive ; — had the State governments guaranteed the investments the money could not have been obtained at a lower rate.
An examination of the system in detail would indicate a similar result. In Massachusetts, the net earnings average 7.26 per cent on the construction accounts of the roads ; in New York, they average 7.5 per cent ; but in Ohio they fall to 4.8 per cent ; while in Pennsylvania they rise to 8.3 per cent. Such facts as these would seem to indicate many and very heavy counterbalancing losses. Nor are such difficult to find. Beginning with the Grand Trunk in Maine, and passing down by the Vermont Central to the Boston, Hartford & Erie in Massachusetts, and thence to the Erie in New York, and the Philadelphia & Erie in Pennsylvania, and the Atlantic & Great Western in Ohio, and so on by the Ohio & Mississippi to the North Missouri, it is not difficult to enumerate name after name, representing thousands of miles of roads and hundreds of millions of investment, which are synonymous only with loss and insolvency, or at best with hopes long deferred.
It is in this way that a certain just, though rude average is evolved out of a conflict of shrewdness and simplicity, excessive cunning and unreasoned action. The difficulty with averages is, however, an obvious one. The burden is necessarily to be placed just where the public interest demands that it should not he placed. A thoroughfare like the New York Central makes good the deficiencies of a number of local enterprises which have no connection with it. It is thus on the chief arteries that the greatest obstruction is placed, and the transportation tax is to be levied indefinitely wherever it can most readily be found. The mere fact that a sort of average is educed is no alleviation of particular ills complained of. Each road is constructed on its own merits, and without regard to the profit or loss involved in the operation of another road perhaps hundreds of miles off. That the through routes of the country, — the main arteries of travel and commerce should ultimately be as nearly as possible free, is of the greatest moment to the whole American people ; that they should ever become so under a system which causes them to make good the deficiencies of an entire system, is to the last degree improbable. The true rule would seem to be, that, while the owners have a right to the stipulated return on the cost of their whole property, whether the same was paid in by them in money or in undivided profits within the limit of dividends, yet that beyond this the community ought resolutely to insist that every increase of value should contribute only to the freedom of intercourse.
In conclusion, the practical remedy of the abuse of stock-watering in its most objectionable shape would after all seem to be both obvious and easily to be secured. There has never been in America any recognized and uniform mode of keeping railroad accounts. The want of this has opened the door to all the evils, not fraudulent, which have been described. A very brief statement of the case will make this apparent. All railroad expenditures are incurred either on account of the construction or of the operation of roads. Construction should properly represent cash paid in by stockholders, upon the full amount of which they have a right to receive dividends, if the earnings justify their payment ; the operation of the road, on the other hand, is to be fully provided for out of the earnings, and it is only the balance left over after thus providing for it which can be devoted to the payment of dividends. No method of keeping these accounts having been prescribed by government, as a consequence no two corporations have kept them alike. Certain corporations early closed their construction accounts, and consequently the whole cost of developing their roads was afterwards charged to operating expenses. In such cases the community simply doubled and trebled its railroad facilities out of an excessive transportation tax. In other words, instead of paying an annual interest on capital invested in railroads, it pays in the capital itself, thus gradually accumulating a property out of all proportion to the evidences of value which represent it in private hands. This is what is known as a conservative system of management. On the other hand, another system of management charges all doubtful amounts to construction, thus perhaps running the company in debt, but at the same time reducing operating expenses to a minimum and nominally leaving heavy net profits to furnish dividends to the stockholders. The result of this system is that the securities of a road rapidly reach an amount which more than represents the full value of the property. This is what is not infrequently known as a progressive or enterprising management. In each extreme the public is practically defrauded.
So long as this license in railroad accounts is permitted it is impossible for any community to do more than guess at the real amount of paid-in capital represented by its railroad system. On the one hand the proceeds of the transportation tax are habitually perverted to the work of construction ; and, upon the other hand, the private capital which should do the work of construction is applied to the payment of dividends. The responsibility of fixing the cost of their thoroughfares is thus devolved upon the private corporations which own them. That such a power should be abused is almost inevitable ; that it now does exist and always has existed is a striking evidence of legislative improvidence. A public and uniform system of railroad accounts, kept in a manner specified by government, and audited by government officials, would have obviated much of the difficulty and prevented innumerable frauds. Finally, a responsible department of the executive should have charge of the subject and should be empowered to decide as to the amounts of private capital, directly or indirectly paid into construction, and authorize the issue of securities accordingly.
* The Commercial and Financial Chronicle of May 15, 1869.