Information, institutions and agency: the crisis of railroad finance in the 1890s and the evolution of corporate oversight capabilities

Accounting History,  Jul 2005  by Chandar, Nandini,  Miranti, Paul J

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The initial stage in a reorganisation involved the placement of the enterprise in the hands of a receiver who took control of corporate property and infused liquidity through the issuance of receivers' notes. Purchasers of these securities had superior rights over all creditors or equity investors, being subordinated only to employee wage claims. The receiver also provided bridge financing that enabled the line to continue its operations during the frequently lengthy negotiation of an acceptable plan of reorganisation to all stockholder groups.

Receivers had two options in restoring railroad finances. First, they could secure permanent financing by assessing existing equity owners for additional cash. In this case the receiver imposed a requirement that preferred and/or common shareholders subscribe to the purchase of additional shares. Such subscribers might benefit from a recovery in the market value of their original shares as well as from capital gains on their assessments. Although they might prove effective in restoring solvency, assessments per se could not eradicate capital deficits, reduce the level of interest charges or change the relative proportions of fixed and contingent financing contracts (Daggett, 1908, pp.348-58; Dewing, 1920, Vol.5, chapter 5).

The second option, re-capitalisation, promised not only to infuse cash but also to eliminate capital deficits and to reduce debt and lower interest costs.

The charts presented in Figures 1a and 1b show how the financial structure was changed in the reorganisation to dramatically reduce fixed charges and make the railroads more operationally efficient. While reorganisations generally involved an average one-third increase in total capitalisation (Figure 2a), the weighting of longterm capital structures shifted from bonds to greater reliance on preferred stock (Figure 2b).

The involvement of J.P. Morgan and a few bankers was ubiquitous in the reorganisation and recapitalisation process. As a consequence, they achieved new, unprecedented levels of power and control over railroad operations, and the process became termed "morganization" (Chernow, 1990).

Another important step in re-capitalisation often involved the booking of accounting adjustments to reduce or eliminate any deficits in retained earnings. Any capital surplus derived from the issuance of common shares could be written off against such deficits. Another technique involved the upward revaluation to estimated fair market value of any long-term assets, such as land, and the recording of unrealised holding gains, which also diminished deficits. The justification for such adjustments derived from an estimated increment in the value of adjoining real estate that resulted from the successful railroad development and improved access to efficient transportation services. Similar offsets against deficits also came about from the assignment of higher fair market values or the extension of the useful lives for rolling stock and stationary facilities.