The Financial Organization of Society [Second Impression ed.]

Citation preview

Ute eon ea De

be

a

gtk wie

Paresh

ac

ie

ae

Sh ce

Sate yar AINE

THE FINANCIAL ORGANIZATION OF SOCIETY

THE UNIVERSITY OF CHICAGO CHICAGO, ILLINOIS

PRESS

THE BAKER & TAYLOR COMPANY NEW YORK ——

THE CAMBRIDGE UNIVERSITY PRESS LONDON THE MARUZEN-KABUSHIKI-KAISHA TOKYO, OSAKA, KYOTO, FUKUOKA, SENDAE

THE MISSION BOOK COMPANY SHANGHAI

THE FINANCIAL

|

ORGANIZATION OF SOCIETY BY

HAROLD G?’ MOULTON ASSOCIATE PROFESSOR OF POLITICAL ECONOMY UNIVERSITY OF CHICAGO

583006 7

|

,

THE

a

UNIVERSITY OF CHICAGO CHICAGO, ILLINOIS

PRESS

€

Copyricut JANUARY ro21 By THE UNIVERSITY oF CHICAGO All Rights Reserved

Published January 1921 Second Impression April 1921

Composed and Printed By The University of Chicago Press Chicago, Illinois, U.S.A.

EDITOR’S PREFACE Collegiate training for business management is now so widely attempted that the time has arrived when experiments should be conducted looking toward the organization of the business curriculum into a coherent whole. Training in scattered “business subjects” was defensible enough in the earlier days of collegiate business training, but such a method cannot be permanent. It must yield to a more comprehensive organization. There can be no doubt that many experiments will be conducted looking toward this goal; they are, indeed, already under way. This series, “Materials for the Study of Business,” marks one stage in such an experiment in the School of Commerce and Administration of the University of Chicago. It is appropriate that the hypotheses on which. this experiment is being conducted be set forth. In general terms the reasoning back of the experiment runs as follows: The business manager administers his business under conditions imposed by his environment, both physical and social. The student should accordingly have an understanding of the physical environment. This justifies attention to the earth sciences. He should also have an understanding of the social environment and must accordingly give attention to civics, law, economics, social psychology, and other branches of the social sciences. His knowledge of environment should not be too abstract in character. It should be given practical content, and should be closely related to his knowledge of the internal problems of management. This may be accomplished through a range of courses dealing with business management wherein the student may become acquainted with such matters as the measuring aids of control, including statistics and accounting; the communicating aids of control, including foreign language; organization policies and methods; the manager’s relation to production, to labor, to finance, to technology, -to risk-bearing, to the market, vii

Vili

EDITOR’S PREFACE

to-social control, etc. Business is, after all, a pecuniarily organized scheme of gratifying human wants, and, properly understood, falls little, if any, short of being as broad, as inclusive, as life itself in its motives, aspirations, and social obligations. It falls little short of being as broad as all science in its technique. Training for the task of the business manager must have breadth and depth comparable with those of the task. Stating the matter in another way, the modern business manager is essentially a solver of business problems—problems of business policy, of organization, and of operation. These problems, great in number and broad in scope, divide themselves into certain type groups, such as are indicated in the preceding paragraph, and in each type group there are certain obstacles to be overcome, as well as certain aids, or materials of solution. If these problems are grouped (1) to show the significance of the organizing and administrative, or control, activities of the modern responsible manager, and (2) to indicate appropriate felds of training, the diagram on the opposite page (which disregards much overlapping and interacting) results. It sets forth the present hypothesis of the School of Commerce and Administration concerning the basic elements of the business

curriculum. : The present volume in the series is designed to give the student an understanding of the financial institutions which the manager utilizes and which largely condition his financial policies. It presents one phase of his social environment. L. C. MarsHAty

EDITOR’S PREFACE BASIC ELEMENTS

,

ix

OF THE BUSINESS CURRICULUM Of problems of adjustment to physical environment a) The earth sciences b) The manager’s relationship to these Of problems of technology a) Physics through mechanics, basic, and other sciences as appropriate b) The manager’s administration of technology Of problems of finance a) The financial organization of society

CONTROL

b) The

manager’s

adminis-

tration of finance 1. Communicating aids of conOf problems connected with the trol, for example market a) English a) Market functions and b) Foreign language market structure 2. Measuring aids of control, b) The manager’s adminisfor example tration of marketing (ina) Mathematics cluding purchasing and b) Statistics and accounting traffic) of ces practi and ards Stand 3. Of problems of risk and riskcontrol bearing a) Psychology a) The risk aspects of modb) Organization policies and ern industrial society methods b) The manager’s administration of risk-bearing Of problems of personnel a) The position of the worker in modern industrial society b) The manager’s administration of personnel Of problems of adjustment to social environment a) The historical background b) The socio-economic institutional life c) Business law and government

AUTHOR’S

PREFACE

Increasing interest in the systematic study of financial problems is everywhere manifest since the war. Not only are ; the classes in finance in our colleges, universities, and schools of commerce literally flooded with students; the high schools are also seeking to incorporate the subject in their rapidly developing commercial curricula; Y.M.C.A. and institute study courses in finance are being formed throughout the country; and, more significant still, many business houses, recognizing the dependence of successful business management upon a thorough knowledge of financial principles, are now organizing special courses for their employees and officials. Even the business manager who has already “arrived” is reading and studying financial literature as never before. The présent volume is designed to serve as the basis of a general survey course in finance and to enable the general reader to obtain a clear understanding of the nature of the modern financial: system, and of the economic functions performed by each of the numerous financial institutions—investment banks, stock exchanges, commercial banks, trust companies, savings institutions, commercial paper houses, discount companies, Federal Reserve and Federal Farm Loan institutions, etc.—which together comprise this system. Perhaps the most striking feature of the modern economic organization is the dependence of practically all business enterprise upon borrowed funds—that is, upon credit. As the charts on pages 134, 136, and 650 indicate, the funds used

by business concerns—whether organized on an individual, ed _a partnership, or a corporate basis—must largely be borrow ies securit se purcha from the rank and file of individuals, who ions. - or make deposits in savings or commercial banking institut the meet to evolved Now the modern financial structure has all of pment develo and needs of this credit system—the origin largely being time the financial institutions of the present xi

xii

AUTHOR’S PREFACE

-attributable to the necessity of raising fixed and working capital for the uses of modern capitalistic enterprise. The teacher will wish to know precisely where a course organized on the basis of this volume would fit into the economics or school of commerce curriculum, and wherein it differs from

the traditional course in money and banking. The answer to the first question may best be given by means of a diagram: (Advanced Specialized Courses)

é ue _ Financial

Course) p Organization

of Society

Money, Prices and the Cost of Living Advanced Banking Theory International Financial Problems | Business Cycles Commercial Bank Management

Investment ment

Bank

Manage-

:

Business Finance Investment and Speculation Law of Bills and Notes Banking Law

The survey course in Financial Organization is designed as a one quarter, or semester, course, and is a prerequisite to each of the advanced specialized courses in the field. F ollowing this series of advanced or graduate courses would come research or seminar courses in each of the various special fields of inquiry. . The primary purpose of a survey course in financial organization as a prerequisite to more advanced study is of course to give the student a view of the entire financial system before undertaking a highly critical study of any single part of it; each financial institution can obviously be fully underst ood and critically appraised only when it is envisaged as a part of a larger financial structure. All teachers will doubtless concur with this doctrine and all, I fancy, will agree that for one reason or another it has seldom been practiced, largely because

of historical accident.

All of our so-called “applied” economics

AUTHOR’S PREFACE

xiii

courses have been developed, one at a time, either to meet the need for an elaboration of the theoretical material outlined in the general introductory course in economics, or the demand for more practical instruction as a training for business. Accordingly, we have witnessed in the financial field the development of a whole series of specialized courses: money; banking ~ (or money and banking)—meaning by banking, as a rule, only commercial banking; investments; corporation finance; speculation; foreign exchange; bank management, etc. It was inevitable that there should be much duplication of material in

these specialized courses; and at the same time the want of a common background of training on the part of the students in any one course necessarily militated against a highly critical - analysis. The present treatise constitutes an attempt to bring together within a single volume, and in a single course, the material that is necessary as a background to advanced study in any of the special fields of financial inquiry suggested in the outline of courses above. It is believed that much economy of teaching effort may thus be achieved and that at the same time the advanced courses may be lifted to a substantially higher plane than obtains in most institutions at present. The treatise therefore differs from the traditional volume in money and banking, in that it is more inclusive in scope. The attempt to organize a general survey course in the field of finance has, however, not only resulted in combining in a single volume certain material that is common to all financial courses; it has also, inevitably, led to a substantial shift in emphasis and in the point of view from which the material is presented. As is indicated above, and as is more clearly revealed in the charts to which reference has been made,

the numerous financial institutions which make up the modern

financial system are united in a common task of furnishing fixed and working capital for business enterprises, the various types of institutions being very closely interrelated as parts of a general financial structure. I may frankly say that I did not fully appreciate this fact until I undertook to describe the practical operations of each of the numerous types of financial

xiv

AUTHOR’S

PREFACE

institutions that exist today, and to point out the economic significance of each. The very attempt to explain the economic function of each financial institution inevitably carried one into a discussion of its relation to other financial institutions, and thus to a consideration of the relation of the financial system in general to the economic system in general. A more complete statement of the relationship here suggested, as well as an explanation of the use of the term Financial Organization of Society, will be found in the introductory chapter. Another reason for making the introductory course in finance’a general survey rather than a discussion merely of money and of commercial banking is found in the fact that almost every financial institution in the United States now conducts under a single roof and under the direction of a single management, nearly every variety of financial operation. As is indicated in the chapter on “Financial Integration,” the

department-store financial institution has become the prevailing type. In consequence, it is difficult to justify a survey course

designed to acquaint the student with the principles of finance, which selects for discussion only a single function performed by any banking organization—such as commercial banking—to the exclusion of all the others. This is particularly the case if the needs of the business student be held in mind. The modern business has its setting in the midst of a financial system upon which it is at all times dependent in many ways; and the business man needs to know not merely the relation of his business to the commercial banking department of say, the First National Bank of New York, but to all of the other departments of that bank as well. Moreover, because of the close interrelations that exist between the departments

of an integrated financial institution, the student of banking

organization and theory will gain a very inadequate view of modern finance if he studies the commercial banking department as though it were an isolated institution. In colleges where but a single course can be devoted to the study of finance, it would seem that a course which pre-

sents a general view of the system as a whole, would prove both

AUTHOR’S

PREFACE

XV

of more practical and of more cultural value to the student than one which considers merely certain special features of the financial system. The author anticipates no little criticism for having failed to include in a volume on finance a thorough discussion of so important and vital a subject as the relation of money and credit to prices. A word of explanation is therefore in point. In chapter ii there is presented a very brief statement of the relation of money and prices. The emphasis is, however, not placed upon the causes of price changes; it is merely pointed out that the values of goods are expressed in terms of money and that these money prices fluctuate widely and more or less continuously. Now the reason for not entering into a discussion of the causes of price changes at that place is merely that the price question cannot be intelligently discussed until an analysis of the commercial banking system has been made;

and by the time the analysis of the commercial banking system, including its relation to other financial institutions and to the general business organization as conditioned by the phenomena of the business cycle, was completed, limitations of space did not well permit an adequate discussion of this most vital aspect of the modern financial system. The controversial issues with reference to the relation of money to prices are therefore necessarily left for consideration in advanced courses. It is believed that enough data bearing on the price question are presented in the treatise for the purposes in hand. If, in the view of any teacher, such is not the case, the text material may be readily supplemented by lectures and by collateral reading.

In the preparation of the volume I am indebted to Mr. Walter Buckingham Smith, of the Department of Political Economy of the University of Chicago, for assistance in construction of the various charts; and to Messrs. Hardy, Keister, Marshall, Meech, Thompson, Smith, and Viner, of the same

department, for many helpful criticisms, as well as for assistance in reading the manuscript. I am also indebted to Professor E. G. Nourse, of Iowa State College, for criticisms of the

xvi

AUTHOR’S. PREFACE

chapter on Agricultural Credit. But most of all I think I am indebted to the generations of suffering students who have patiently submitted to experimentation as the volume has slowly evolved through mimeograph, preprint, and preliminary editions to its present form. H. G. M. Cxicaco, Ittinors December 25, 1920

TABLE

OF CONTENTS PAGE

CHAPTER I.

INTRODUCTION

Cuapter II. UNIT

THe NATURE

I. II. III. IV.

AND FUNCTIONS OF A PECUNIARY

; / 4 . . Unit. Pecuniary the of Definition and Origin 6 jt . The Pecuniary Unit and Business Administration a The Pecuniary Unit and the Apportionment of Family oeLe Expenditures... aut The Pecuniary Unit and Beonomic Oresneation:

CuapTer III.

THE STANDARD FOR DEFERRED PAYMENTS

I. Why Gold Is Used as the Standards

w.prtcrwsstn

Il. Relation of Money and Prices . . . III. Economic Consequences of Price Changes’ IV. Price Changes and Social Maladjustments

mel

O

e cea gednecic ee 2 . . . 30

. Cuaprer IV. OTHER FUNCTIONS AND SERVICES OF MONEY 4! + + . . Exchange of I. Money as a Medium . . - + + © + 4? II. Money asa Storeof Value. III. The Use of Money in Production . . - + + + 483 . . - + + 45 IV. The Role of Money in War Finance . . + - 48 Finance. Peace in Money of V. The Réle AND CHAPTER V. THE PECUNIARY SysTEM AND ECONOMIC RDS SocIAL STANDA tien 754 vine I. Monetary Evaluation and Social Tdeals)ot) - 56 « . . Wealth with Money of on II. The Confusi . 60 . Nation Ill. The Quantity of Money Required by a CHAPTER VI.

I. II. III. IV. V. VI.

THE REGULATION

OF METALLIC

CURRENCY

» . The Necessity of Government Coinage System e Coinag Bad a of Effects Social and ic Econom . Coinage Rules and Regulations of the United States > + + ..llism Gresham’s Law and Bimeta . . ard Stand Single the e Why Gold Becam cine ihe Production of Gold and Silver in the World + °° + + + + Discovery of America. es

65 67 69 73 79 82

sae

xviii

- CONTENTS
SE) wholesaler, borrows, let us say, $10,000 from the bank and purchases a stock of goods with the money. In the course of two months he sells these goods for $12,000, or at a gross profit of 20 per cent, the goods purchased being the direct means of liquidating the loan. Similarly, the manufacturer, Mr. Y. borrows $20,000 with which to operate his plant and equipment. In the course of three months, say, he has produced and sold $25,000 worth of goods, thus being enabled to repay his loan directly from the uses to which the borrowed funds were put.

1 See pp. 151-61.

NATURE

AND FUNCTIONS OF CREDIT

125

The borrower for investment purposes, on the other hand, invests $10,000 in a factory. He does not contemplate selling the factory within a few weeks or months; on the contrary, he expects to use it for many years as the basis for his manufacturing enterprise. Ten years or more must usually elapse before the accumulated profits will permit the repayment of the principal of the loan. Investment credit furnishes capital for the development and maintenance of industries. ! Commercial credit provides funds for running or operating business establishments engaged in the producing, manufacturing, and marketing of goods. It is by means of the former that the business manager assembles land, labor, and materials, and constructs permanent and durable capital goods; it is by means of the latter that the business manager assembles labor, supplies, and materials, and produces and markets the consumptive

goods required by society. |/Consumptive credit refers to the granting of loans or the selling of goods on time to individuals who use the money or the goods received in satisfying consumptive wants. If the obligations thus created are met at maturity, it will not be because the funds or property borrowed were devoted to productive uses; it will be because the borrower has other Such credit, therefore, usually involves sources of income. somewhat greater risk of non-payment at maturity, particularly of prompt payment, than does either investment or commercial credit. IV.

THE BASIS OF CREDIT

There has been a great deal of discussion, participated in by both economists and practical credit men, concerning the essential basis of a credit or borrowing operation.” Some writers on the subject have stoutly insisted that confidence is

the basis of all grants of credit; that if one did not have confi-

dence that the borrower would repay a loan he would never

think of making the loan, save on grounds of friendship or

philanthropy.) Others have held that property, rather than «For a consideration of consumptive credit see chap. xxviii.

126

THE FINANCIAL ORGANIZATION OF SOCIETY

confidence, is the basis of all genuine credit transactions. And still others insist that character is the essential factor; while some recent writers have indulged a propensity for alliteration by stating that the bases of credit are\character, capital, and capacity; or the man and the means; or reliability and resources. Without attempting to enter into a discussion of the reasons for these different statements of the basis of credit, a tabular exhibit of matters commonly: investigated by competent credit men will indicate that while confidence must exist before a loan will be granted, such) confidence has its basis in a knowledge of the borrower’s financial standing and ability and of his personal integrity. The things that are usually investigated may be grouped in two general classes as follows: PERTAINING

TO

THE

MAN

a) Record for honest dealing b) Personal attributes 1. Gambling and drinking tendencies : 2. Political and other “outside” activities 3. Style of living, including wife’s social ambitions c) Ability 1. Common sense and shrewdness 2. Education and technical training 3. Ageand general experience 4. Success already attained

PERTAINING

TO

THE

BUSINESS

a) Ratio of quick assets to current liabilities b) Amount of capital invested and property owned c) Earnings of business _ d) Character and rate of turnover of stock e) Location of business f) Character of the business organization g) Insurance carried h) Nature and intensity of the competition

This list of factors is by no. means inclusive; it is designed

merely to be suggestive of the character of the investigation that must be made if credit is to be conservatively extended. It will be noted, also, that the points raised in the parallel columns are not entirely unrelated. A man of excellent business ability, for instance, would be practically certain to have a proper \

NATURE

AND

FUNCTIONS

OF CREDIT

127

ratio of quick assets to current liabilities, substantial earnings etc.; and, on the other hand, if it were found that a business was poorly equipped and managed, there would be a definite reflection upon the manager’s business capacity. Investigation, both of the man and of the business, usually serves, however, to furnish a more adequate basis for a sound judgment than investigation of either one alone. One may conclude from this brief analysis that before deciding to extend credit one should have confidence, first, in the ability of the borrower to pay as promised, and, second, in his willingness and intention to pay. One is a matter of property and business ability; the other a question of honesty and business integrity. The basis of credit may be diagrammatically presented as follows: 1. Character of man (Intention to pay) _ /Credit ————— Confidence ———— 2. Character of business* (Ability to pay)

V.

THE

SIGNIFICANCE

OF CREDIT

While the economic significance of the credit system cannot be adequately discussed in the present chapter, a few of the ways in which credit is of assistance in the conduct of modern affairs and some of its broader social aspects may, however, be suggested. \/Credit enables governments to obtain possession of funds with which to meet pressing emergencies, when no other means are available. It also enables individuals to surmount tempoposrary difficulties or embarrassments. For example, it makes g pendin ments sible the purchase of goods for consumptive require before home a of e the receipt of income; it permits the purchas e the the entire purchase money is in hand; and it makes possibl acquisition of an education on borrowed funds. t Credit makes it possible for honest and capable men withou modern of t capital to secure the funds required for the conduc : Collateral security is also often required.

See pp. 386-90.

128

THE FINANCIAL ORGANIZATION

OF SOCIETY

industry. Similarly, it enables people with funds in excess of their immediate needs to lend the surplus to capable men of affairs who utilize them in productive activities. This process of lending funds tends to shift “capital” from the hands of those who have not the desire or the ability to make use of the funds to those who are willing and able to assume the risks of capitalistic enterprise. The result is a more effective utilization of the national resources. The ability to borrow makes it possible for the business manager to adjust the volume of his capital to the varying requirements of business. When the demand for his products is very large at certain seasons and in certain years of extraordinary business activity, he may enlarge the volume of output by borrowing additional working capital and in dull seasons and years he may reduce the volume of capital employed. This expansion and contraction of loans, as we shall later see, finds reflection in the condition of the commercial banking institutions which constitute the foundations on which the credit structure is reared.? With reference to the broader aspects and relations of the credit system, it may be pointed out that its/ development has depended upon the growth of three tings: sta sense of business morality, or what may amount to thé same thing, a recognition of the fact that honesty is the best policy ;/second, _ a telatively stable monetary standard for deferred payments; |and third, a legal system designed to safeguard the rights of individuals and to enforce a prompt fulfilment of contracts. The evolution of these three supports of the credit system has been one of the most significant features of the transformation from medieval to modern industrial society. All of these developments have been very closely interrelated; moreover, each has contributed to, and each has been accelerated

by, the growth of the credit system.

The institution of credit has made possible the growth of large-scale business enterprise and, in turn, the specialized industrial society of the present time. For the moment industry t See chap. xxiii below.

NATURE

AND FUNCTIONS

OF CREDIT

129

passed beyond the handicraft stage, each enterprise usually ~ required a volume of capital greater than could be furnished by the proprietors. Accordingly borrowing became an indispensable handmaiden of business. The growth of the capitalistic (profit-making) system of industry has, moreover, been marked by an ever-enlarging scale of business enterprise, instituted, under the competitive régime of the eighteenth and nineteenth centuries, in the expectation of obtaining larger profits through enlarged output, decreased costs of production, and lowered selling prices. The various stages in the transformation from the medieval household non-profit-making economy to the twentieth-century capitalistic industrial system are outlined in chapter xi below. It need merely be noted here, therefore, that the steadily expanding scale of both industrial and commercial undertakings is dependent upon ever enlarging aggregations of capital, the assembling of which has been made possible only by a great extension of the credit system, whereby funds might be raised for a given enterprise

from a veritable multitude of individual investors.

Small

accumulations of capital which could not be effectively utilized by their owners are thus joined with other accumulations and placed under the control and management of individuals who are able to make the most effective use of capital resources. Since nearly every business enterprise is nowadays in greater or lesser degree dependent on the use of borrowed funds, it

is not difficult to understand why writers should stress the importance of credit in the extravagant introductory paragraph of this chapter. pervasive, fundamental institution—one to the conduct of a capitalistic industrial

terms noted in the Credit is in truth a that is indispensable system.

QUESTIONS FOR DISCUSSION 1. Give a definition of credit.

ents? 2. What is the difference between credit and credit instrum all? at borrow (3, Do you know of any businesses that do not take “4. Give concrete illustrations of borrowing operations that ons the form of the borrowing of actual goods. Are the operati kind? in settled by a return of goods

130

THE FINANCIAL

ORGANIZATION

OF SOCIETY

. Give concrete illustrations of borrowing operations that take the form of the borrowing of money or “funds.” 6. With what function of money is credit most closely associated? - What are the bases for the two different classifications of credit

given in the chapter? . Which classification do you regard as more significant? Why? . What is the essential distinction between commercial and investment credit, that of the length of time for which the credit is extended or the use to which the funds borrowed are devoted ? : To. What is the explanation of the fact that investment credit usually runs for long periods of time and commercial credit for short periods ? Ir. Turn to the chart on page 136 and indicate where commercial credit might be placed. | I2. Where would “capital”%]q FARE eRUED oI 941) TONVHOXA YOOLS pue

ALVAOdAOO aSladdagiNna

TS

x

‘spun yenizy | | si0j1sodaq ‘s2]81Sq “232

pue

SEPCHeyS:

ee heeae Sen ONIIYOA TVLIdV9

NOILVaOdaOD

je siakey sumiuory

SAINVdNOD

SYaLOWOdd LNANLSAANI aNvV §f ONIANVG TVAdSaNI SNOILLN.LILSNI MOT ddqgveyo PuCg) "S98nH{ “8N)

spuog “¢

S210KY WIA] ONS °7

649035 “|

hq peouspiay

daxl4i

|

AHL

ONIONVNId

SSINVdINOD |f SSINV'

|

!

SNOILOLIIISNI GaAZITIIN NI

:&q peouapuq

“II

”

oBueyoxy jo siftg *Z

SON: Aross1u0ry °°}

| udIdVdSMIN

sioyisodegy

MODERN

FINANCIAL STRUCTURE.

137

interval while awaiting payment, it all comes to much the

same thing in the end—working capital is largely borrowed from the commercial banks. The corporation chart does indicate, however, that a portion of the working capital is usually derived from the sale of securities. Indeed, if a business is to have a good credit standing with its bank, it must, in fact, provide a considerable part of its working capital by stock subscriptions. Fourth, one might conclude from the corporation diagram of that savings banks are associated only with the problem -bank savings many fact, of matter a As raising fixed capital. loans are also made for working capital purposes (see chap. xvii). Fifth, the position of the trust company in the financial chart structure of society is not adequately revealed. As the fixed of raising the to only related is y compan stands, the trust banks savings with n positio parallel a in placed capital and is see (chap. and insurance companies. In fact, as we shall later variety of xviii below), the trust company performs so wide a m to indifunctions that it is impossible in the present diagra The comcate its relationship to the entire financial structure. y would go mercial banking department of the trust compan with the bond with the commercial banks, the bond department s banks, the houses, the savings department with the saving es. But, insurance department with the insurance compani variety of great in addition, the trust company performs a ion with connect services for the holders of corporate securities in in trust, ges mortga the safekeeping of valuables, the holding of l financia the the transfer of ownership of stocks and bonds, reorganization of companies, etc. impression of Finally, the diagrams tend to give a false is that more truth specialization by financial institutions. The and by a roof one and more there is being conducted under financial of ty varie single administrative organization a great tments, depar many has activities. Just as the trust company with it iated assoc has the commercial bank nowadays usually three or two last in the savings and bond departments, and, on given ns natio desig years, trust departments as well. The

138

THE FINANCIAL ORGANIZATION

OF SOCIETY

the diagram must, therefore, be considered as representing types of financial functions rather than (in every case) distinc t and specialized financial institutions.* :

The remaining chapters of the volume will be devote d toa discussion of the services and functions that are perfor med by the numerous parts of this financial organization, the problems of regulation that have arisen in connection with the various types of financial institutions, and the interrelatio ns of this intricate financial mechanism with the larger econom ic organization of which it forms so important a part. tSee chap. xxix.

CHAPTER

XI

THE CORPORATION AS A DEVICE RAISING CAPITAL

FOR

At the head of the diagram showing the financial institutions and agencies that function in the raising of capital in the modern industrial world (p. 136) is placed the corporation, the dominant type of business organization at the present time. In discussions of the corporation as a form of organization for the conduct of business, its advantages over the partnership have usually been listed as follows: (1) greater ease of raising capital; _(2) perpetual (or, at least, definite) existence; (3) centralization of managerial responsibility and power. It is the purpose of the present chapter to outline the significance of the corporation as a capital-raising institution—to account for its origin and development in terms of capital requirements. It is not too much to say that the outstanding advantage of the corporation over the partnership is its greater effectiveness in assembling the capital required for large-scale enterprise. Partnerships may be—and some have been—given a perpetual life. Partnerships may delegate the management to a single individual or group of individuals and hold them responsible for results, quite after the fashion of the corporate organization. Indeed, some modern partnerships are thus organized; while the “silent partner” is, of course, a common phenomenon. But without shares of stock and bonds and without the principle of limited liability the partnership could not possibly effect the accumulation of the large quantities of capital required by the great majority of modern businesses. Some modern rf. partnership associations, it is true, have the equiv.

| shares and some have been organized with a limited liability; 2_. but these features constitute the very essence of the corporate form of organization. To the extent that they have now been 139

140

THE FINANCIAL ORGANIZATION OF SOCIETY

taken over by partnerships the latter may be said to have “corporationized.”

I. ADVANTAGES OF THE CORPORATION IN RAISING. CAPITAL The corporation is for several reasons an effective agency

for the raising of capital. In the first place, the division of the capital into small units in the form of shares of stock or bonds makes it possible to attract funds from people of very

moderate means.

To this end the par value of bonds and of

shares ‘ofstock is made small, often very small in the case of shares. While the standard unit is $100, many companies are organized that sell shares at $10, $5, $1, and evenat 5 cents each Investments are thus brought within the reach of every class. Second, the division of thé shares and bonds of corporations into small denominations also makes it possible for individuals to diversify their investments and thus reduce the risks of loss

to a minimum. Even so small a fund as $10,000 may be

invested in a hundred or more different companies. It is of note that “baby bonds,” of $100 denominations, and with instalment-payment provisions, have become increasingly popular in recent years. Third, the division of corporate securities into bonds and

shares serves to attract the investments of people of different temperaments and of different economic position. Bonds, constituting a first claim upon earnings, make their appeal to those who are by temperament conservative, or whose economic position is such as to make safety of investment the prime requisite. On the other hand, stock offers an opportunity of higher returns and thus appeals to people who are willing to . take chances in the hope of large rewards, and to those whose

economic position is such that they can afford to assume larger risks, Similarly, the division of stock into preferred and common shares is calculated to appeal to investors of different degrees of conservatism. The preferred stock, while not so safe as

bonds, is still relatively safe in well-established companies,

_

THE CORPORATION

AND THE RAISING OF CAPITAL

141

and it yields a higher return than bonds. Common stock is subject to still greater risks, but affords the possibility of very large returns. Nowadays there is, moreover, a great variety of subclasses of shares, notes, and bonds, all designed to facilitate the raising of funds through varied appeals. Fourth, the easy transferability.of-bonds.and shares, made -

possible by the development of organized stock exchanges, enables an individual to withdraw his investment in a corporation at almost a moment’s notice. The significance of this for our present purpose is that the ease with which one may get out of a corporation has an important bearing on his willingness to get in. Under present conditions one is not necessarily committed to a given undertaking once and for all; with readily marketable securities the investor retains almost instantaneous command over capital. Fifth, the large aggregations of capital made possible by virtue of these various advantages, together with the limitedliability principle discussed below, give to the corporation unusual competitive | strength _and_ stability, and this in its turn renders securities the more attractive to the general investing public. _ Sixth, the corporation now universally embodies the principle of limited liability, i-e., liability of each shareholder only to the amount (usually) of his individual stock. This is

indispensable to the assembling of the vast amounts of capital required by modern business establishments, for it would be utterly impossible to induce an individual to purchase shares of stock in a corporation of large size if his individual liability to creditors was equal to the entire capital. Unlimited liability will be assumed only where the number of owners is few, where

they are well known to each other, and where the amounts involved are relatively small. It should be noted that the principle of limited liability applies only to stock, the bondholders being creditors of the corporation. It is apparent, finally, therefore, that even without the principle of limited liability the corporation would have «See pp. 155-56.

142

THE FINANCIAL

ORGANIZATION

OF SOCIETY

advantages over the ordinary partnership in the assembling of capital, since the sale of bonds would in any event make it possible to draw funds from a large number of investors. The growth of large-scale enterprise was dependent upon lumited liability. Light will be thrown upon the importance of the principle of limited liability from the point of view of facilitating the raising of capital by a brief review of its history. For a considerable period during English industrial history, jointstock companies did not enjoy the principle of limited liability. Following a period of great speculation in the shares of unincorporated “companies,”* in which many people were financially ruined, the so-called Bubble Act of 1719 prohibited unincorporated companies from acting as corporate bodies or selling transferable stock. This prohibition interfered with the formation of genuine trading companies and “greatly hindered the employment of accumulated capital.”? The strict enforcement of the act, however, was found to be impracticable and for many years it was allowed to remain a dead letter, many new unincorporated companies continuing to be formed. The Bubble Act was repealed in 1825 and the Crown was empowered to grant charters of incorporation; but the individual owners of the corporation were made personally liable for the whole or any part of the debts of the corporation. During the next thirty years men of investment and social standing held aloof from concerns in which the smallest invest-ment involved so great a risk. Of 4,049 companies registered provisionally from 1844 to 1855, 3,084 were abandoned before © complete registration. The principle of limited liability was - so important, however, for the raising of the capital required for the rapidly expanding size of industrial enterprises that . Parliament finally passed an act in 1856 permitting the formation of corporations “with limited or unlimited liability, with all the benefits of incorporation.” Banking and insurance companies were, however, still excluded. The complete acceptSee p. 144. 2S. E. Perry, “History of Companies’ Legislation in England,” Journal of the Institute of Bankers, Vol. XXIX,

THE CORPORATION

AND THE RAISING OF CAPITAL

ance of the limited liability principle, adoption of a general incorporation law paved the way for the great expansion in enterprise that marked the second half

143

together with the by the act of 1856, the size of business of the nineteenth

century.*

In the United States, however, it appears that the principle © was accepted from the very beginning. Davis informs us that “limited liability was recognized as an attribute of an incorporated company almost invariably without specific mention; indeed, it was a principal object desired through incorporation.” With scarcely an exception, early American corporations, in fact, enjoyed the advantages incident to limited liability.

Tl.

STAGES

OF CORPORATE

DEVELOPMENT,

A study of the changes that have occurred in the organization of industry from the Middle Ages to the present time indicates that the development of the corporation was in truth very largely governed by capital requirements. While the germ of the corporate idea is no doubt to be found in the guild associations of the early Middle Ages, the first corporations of significance, from the point of view of business enterprise, were the great trading companies of the sixteenth and seventeenth centuries. These companies were organized for the

purpose of developing trade with foreign dominions and as colonizing agencies.’ The early corporation embodied numerous features; it was a bundle of special rights and privileges, and has been aptly called a collection of monopoly grants of power. While there was no single reason for the use of the corporate organization, large capital requirements were nevertheless in every case the paramount factor. The shares of stock of small t Loc. cit. 2 Essays in Earlier History of American Corporations, IV, 317-29. 3 The joint stock was also used in the sixteenth and seventeenth cen-

~ turies in mining companies, and in nearly every important monopoly. Wm. E. Price, English Patents of M: onopoly, p. 131.

144

THE FINANCIAL ORGANIZATION OF SOCIETY

denomination made it possible to secure capital contributions from a large number of individuals. Moreover, unusual risks were involved, owing to the uncertainties both of ocean transportation and of trade, and this was a serious deterrent to the advancement of large sums by any one individual. The joint-stock company made it possible for individuals to distributé their risks over a number of different undertakings. Investment opportunities were few before the corporate era. These early corporations were necessary not only for the raising of capital for overseas enterprises. They appear to have been quite as serviceable in the accommodation of would-be investors. Macaulay? writes: During the interval betweén the Restoration and the Revolution _ the riches of the nation had been rapidly increasing. Thousands of busy men found every Christmas that, after the expenses of the year’s housekeeping had been defrayed out of the year’s income, a surplus remained; and how that surplus was to be employed was a question of some difficulty. In our time, to invest such a surplus, at something more than three per cent on the best security that has ever been known in the world, is the work of a few minutes. But in the seventeenth century, a lawyer, a physician, a retired merchant, who had saved some thousands and who wished to place them safely -and profitably, was often gréatly embarrassed. Three generations earlier, a man who had accumulated wealth in a profession generally purchased real property, or lent his savings on mortgage. But the number of acres in the kingdom had remained the same; and the value of these acres, though it had greatly increased, had by no — means increased so fast as the quantity of capital which was seeking for employment. Many, too, wished to put their money where they could find it at an hour’s notice and looked about for some species of property which could be more readily transferred than a house or a field. A capitalist might lend on bottomry or on personal security but, if he did so, he ran a great risk of losing interest and _ principal. There were a few joint-stock companies, among which the East India Company held the foremost place; but the demand for the stock of such companies was far greater.than the supply. Indeed, the cry for a new East India Company was chiefly raised * Quoted in Bagehot, Lombard Street (1912), pp. 131 ff.

THE CORPORATION

AND THE RAISING OF CAPITAL

145

by persons who had found difficulty in placing their savings at interest on good security. So great was that difficulty that the practice of hoarding was common. We are told that the father of Pope, the poet, who retired from business in the City about the time of the Revolution, carried to a retreat in the country a strong box containing

near twenty thousand pounds, and took out from time to time what was required for household expense; and it is highly probable that this was not a solitary case. At present the quafttity of coin which is hoarded by private persons is so small that it would, if brought forth, make no perceptible addition to the circulation. But in the earlier part of the reign of William the Third, all the greatest writers on currency were of opinion that a very considerable mass of gold and silver was hidden in secret drawers and behind wainscots. The natural effect of this state of things was that a crowd of projectors, ingenious and absurd, honest and knavish, employed themselves in devising new schemes for the employment of redundant capital. It was about the year 1688 that the word stockjobber was first heard in London. In the short space of four years a crowd of companies, every one of which confidently held out to subscribers the hope of immense gains, sprang into existence—the Insurance Company, the Paper Company, the Lutestring Company, the Pearl Fishery Company, the Glass Bottle Company, the Alum Company, the Blythe Coal Company, the Swordblade Company. There was a Copper Company, which proposed to explore the mines of England, and held out a hope that they would prove not less valuable than those of Potosi. There was a Diving Company, which undertook to bring up precious effects from shipwrecked vessels, and which announced that it had laid in a stock of wonderful machines resembling complete suits.of armour. In front of the helmet was a huge glass eye like that of a Cyclops; and out of the crest went a pipe through which the air was to be admitted. The whole process was exhibited on the Fine gentlemen and fine ladies were invited to the show, Thames. regaled, and were delighted by seeing the divers in hospitably were iron their panoply descend into the river and return laden with old which Company, Fishing and ship’s tackle. There was a Greenland of the could not fail to drive the Dutch whalers and herring busses out promised which Company, Tanning a was ‘There Ocean. Northern to furnish leather superior to the best that was brought from Turkey of and Russia. There was a society which undertook the office assumed which and terms, low on education giving gentlemen aliberal

146

THE FINANCIAL ORGANIZATION

OF SOCIETY

the sounding name of the Royal Academies Company. In a pompous advertisement it was announced that the directors of the Royal Academies Company had engaged the best masters in every branch of knowledge, and were about to issue twenty thousand tickets at twenty shillings each. There was to be a lottery—two thousand prizes were to be drawn; and the fortunate holders of the prizes were to be taught, at the charge of the company, Latin, Greek, Hebrew, French, Spanish, conic sections, trigonometry, heraldry, japanning, fortification, bookkeeping, and the art of playing the theorbo,

The second stage in corporate development came during the seventeenth and eighteenth centuries when the corporate principle was extended to such enterprises as insurance, banking,

and inland navigation.

The importance and “the” supposed

limitations of the joint-stock company during this period may be glimpsed by reference to a well-known quotation from Adam Smith:

The only trades which it seems possible for a joint-stock company to carry on successfully without an exclusive privilege are those

of which all the operations are capable of being reduced to what is called routine. . —. . Of this kind is, first, the banking trade; secondly, the trade of insurance in fire and from sea risks and capture in time of war; thirdly, the trade of making and maintaining a navigable cut or canal; and fourthly, the similar trade of bringin g water for the supply of a great city.

He adds that in order to render the use of the joint-stock company feasible, two other circumstances should concur: “first, that the undertaking is of greater and more general utility than the greater part of the common trades ; and secondl y, that it requires a greater capital than can easily be collectedinto a private copartnership.” It appears that the corpor ation

was not regarded as particularly well adapted to the efficient

conduct of most lines of business, but that it was a very useful

device in lines of activity where it was sums of capital. The third stage in corporate history transportation period, beginning in Adam Smith, who died in 1790, had

hecessary to raise large

may be designated the — England about 1780. foreseen the use of the

THE

CORPORATION

AND THE RAISING OF CAPITAL

147

corporation in connection with canal building, although the great era of canal transportation came after his time—from 1780, to 1815. The corporation was almost universally used as a means of assembling the large capital required for canal construction. It is significant from the point of view of the capital-raising function of corporations, to note that the canal companies did not conduct transportation; the canal barges were run by individual boatmen. The use of the corporation was here dictated solely by capital-raising requirements. This was also true of the turnpike companies. With the development of railway transportation after 1830 the use of the corporation was greatly extended. While in the case of the railroads the corporation was early used both as a capital-raising and as an operating device, the capital-raising ~ feature was of primary importance. It was manifestly impossible to raise the funds required by individual or partnership means. As with the old trading companies, not only was the volume of capital required very.large, but the risks assumed were likewise exceptional. of the corporate The fourth stage is that of the extension form of organization to producing, manufacturing, and mer-

cantile enterprises. Although the corporation was used to some extent in ordinary business in both England and the

United States before 1800, it was not until after the development of efficient and cheap transportation systems that it became the dominant form of organization in manufacturing and mercantile lines. During the earlier years of its history the factory system did not require very large aggregations of

capital, for the simple reason that markets were narrowly circumscribed, owing to the inadequacy and the great cost of transportation, as also to the decentralization of wealth and population. The volume of output that could be sold by any single plant was thus definitely limited. Under these conditions only a few thousands of dollars of capital was required for the largest business establishment; individuals and partnerships found no serious handicap in financing such enterprise.

But

while the early factories did not require large capital. in view

148

THE FINANCIAL ORGANIZATION

OF SOCIETY

of market limitations, their development gave rise to an insistent pressure for wider markets, in order to make possible a larger and more profitable scale of industrial enterprise; and this undoubtedly hastened the development of efficient transportation. The widening of markets that resulted from the development of modern transportation facilities gave in turn a tremendous impetus to the enlargement of the size of business undertakings. Given cheap transportation to the markets of the world, there was almost no limit to the profitable size of the business unit. By 1845 railroad transportation had definitely proved itself, both in England and in the United States ; and before 1860 it had succeeded in linking the great Middle West with all the markets of the world. * The second half of the nineteenth century then witnessed a gigantic effort on the part of industries to expand the scale of their productive operations to a point where they could take full advantage of the world-markets that were available to them. Cheap transportation meant reduced costs for the laying down of goods in distant markets. And the enlarged output made possible by widened markets still further reduced the cost per unit and made possible a competition over ever- widening areas. This tremendous growth in the size of the producing unit, and also in the size of the commercial and distributing businesses concerned with the marketing process, made the use of the corporation as a capital-raising device just as indispensable here as it was in foreign trading, finance, insurance, and transportation. Where during its earlier history the factory required a capital of perhaps a few thousand dollars, the large-scale business enterprises of the present necessit ate capital accumulations of hundred of thousands, millions, and

even hundreds of millions of dollars.

Thus did the changing structure of industrial society , with its ever-increasing size of business undertaking and everenlarging capital requirements, gradually extend the scope of corporate industry, until today the corporation is the domi:

THE

CORPORATION

AND THE RAISING OF CAPITAL

nant form of business organization. advantages of the corporation as an - be repeated that intrinsically and tion is a capital-raising device. We

149

Without minimizing the operating agency, it may historically the corporashall see in the following

and in other chapters that this changing industrial structure, with the existence economic problems

development of the corporation, has called into most of the financial institutions that function in the system of today, and has profoundly modified the of organization and control of all of them.

QUESTIONS

FOR DISCUSSION

/

1. Is the corporation to be regarded primarily as an efficient form of organization for the conduct of a business once established, or primarily as an efficient instrument for raising capital? Is it either exclusively ? 2. What advantages do shares of stock and bonds afford as a means of raising capital? 3. Why should both bonds and stock have been developed? 4. What is the purpose of issuing different kinds of stock and bonds ? 5. Without bonds and stock it would be impossible for an individual of moderate means to diversify his investments. Why? Indicate the probable results of such a situation. 6. In what way, precisely, is the ready transferability of bonds and shares an inducement to investment? 7. What would people do with temporarily idle funds in the absence of an opportunity to invest in readily marketable securities? 8. Indicate how the perpetual existence of a corporation might facilitate the raising of capital. 9. What is the significance of the limited liability principle from the viewpoint of capital raising? Has it any significance from any other point of view? 10. What opportunities for investment existed in England before the extensive development of the joint-stock company? 11. Have we had speculative manias since the time of which Macaulay wrote? (See pp. 186-87 below.) Do plenty of opportunities for conservative investment always deter people from indulging in

speculation ?

150

THE

FINANCIAL

ORGANIZATION

OF

ues

During that period of English history when corporations were not granted the limited liability principle, did they possess any advantage over partnerships in the raising of capital? Were they subject to any comparative disadvantages? 13% Why was it so difficult to enforce the Bubble Act in England? 7. How do you account for the hostility to the principle of limited liability that was manifest in England until the middle of the I2.

nineteenth century?

15. Suggest some of the probable industrial consequences of the

16.

17. 18.

IQ.

refusal to permit limited liability in England between 1825 and 1856. What were the outstanding industrial requirements of this period ? Do you know of any Giabaes of corporations today whose liability is not limited to the individual shareholders’ contributions? Outline the different stages in corporate development and indicate why each new stage developed. Has Adam Smith’s prophecy, come true? What did he overlook ? Are there any great divisions of economic activity that are not at the present time characteristically organized on the corporate basis? If so, what? Is this likely to be a permanent state of affairs ? ~

CHAPTER CREDIT

XII

INSTRUMENTS

The borrowing or credit operations of modern society are’ evidenced by written documents, drawn up in legal form, and known as credit instruments. As has already been noted, the term “credit” is often loosely employed in such a way as to give the impression that credit is a form of currency. It is not credit, however, that is used as a form of currency; it is rather the instruments which are the written evidences of antecedent credit operations that serve as media of exchange. In the present chapter we shall consider the various types of credit instruments which are employed in modern credit operations and discuss the development of certain legal principles which have made possible the effective use of these instruments in transferring the ownership of wealth. As is indicated in the diagrams on pages 134 and 136, the capital of modern businesses is usually divided into two classes,

fixed-andworking. \/The financial instruments that are used in evidencing the loans made in the raising of fixed capital are

usually called investment credit instruments; while those evidencing borrowed working capital are known as commercial credit instruments. Let us consider the various types of instruments that fall within each class.

I. INVESTMENT CREDIT INSTRUMENTS \The three principal types of investment credit instruments are bonds, stock certificates, or shares, and short-term notes. An explanation is perhaps necessary for designating a share of stock as a credit instrument; for from a certain point of view a shareholder is legally not a creditor of the corporation but a joint owner in the enterprise. He receives income from his shares only in case the earnings are sufficient to permit or warrant the payment of dividends. The bondholder, on the .

I§1

152

THE, EE

ORGANIZATION

OF SOCIETY

Su

other hand, is legally a creditor of the corporation and is_ entitled to interest on his investment, regardless of the volume of earnings. y Although the stockholder is legally not a lender of funds to the corporation, but a part owner in the enterprise, he is nevertheless for all practical purposes commonly an “outsider”’ lending his funds in anticipation of a return. The rank and file of investors in stocks are not in fact actively interested in the management of the concern. Indeed, it is a rare thing for any but a relatively small group of insiders to exercise their voting prerogatives. The familiar expression, “Shall I invest in stocks or bonds?” indicates clearly enough that in a majority of instances the purchaser makes no differentiation between stock and bonds, save as to relative certainty of income. A morigage security does not guarantee against loss. The fact that a bond is usually secured by a mortgage on the property does not insure that the bondholder cannot lose on his investment. In the event that earnings are not sufficient to pay interest on bonds, the bondholder may foreclose under the terms of the mortgage and take possession of the property; but an enterprise. whose earnings are insufficient to permit the payment. of interest on its bonds could not ordinarily be sold at a price which would equal the amount of the bondholder’s investment—whatever may have been the evaluation originally placed upon the property. Nor is there any assurance that the bondholders can conduct such an enterprise at a profit; indeed, there is a certainty that they cannot do so when the mortgage i is against only a portion of the corporation’s © property. ; In the event that interest on bonds is not paid, it is therefore usually wise to effect a financial reorganization, by means of which the amount of outstanding bonds is reduced by converting, some of the bonds into stock. \It is thus apparent that in the last analysis the safety of both bonds and stock depends upon the earning power of the corporation. It remains true, however, that bonds are usually the more conservative investment by virtue of their prior claim to earnings.™ "The fact that bonds have a maturity date is also often of practical

importance.

CREDIT INSTRUMENTS

153

There are various types of stocks. WShares of stock are divided into two main classes, preferred and common. / As the term itself indicates, preferred stock has a prior claim on dividends in the event of liquidation, and usually on the assets of the business. Because of the existence of common stock as a participant in the earnings of the corporation, it is obviously necessary to limit the extent to which preferred shares may receive dividends. Seven per cent is the usual limit. Preferred stock may be either cumulative or non-cumulative, participating or non-participating. |/With cumulative ~stock the dividends which cannot be paid in one year, because of low earnings, accumulate from year to year as an obligation prior to that on common stock. '/ With participating preferred stock the owner is entitled to share in the earnings above the + per cent limit; sometimes it is an equal participation in all earnings above 7 per cent on the common stock, and sometimes it is above 10 or above 15 per cent, depending upon the specific terms governing the issue. The great number and variety of corporations that exist have given rise to other variations on these practices, a detailed study of which is quite unnecessary for the present purpose. Some modern preferred stocks are almost equal to bonds. In recent years preferred stock has developed some additional features which now place it more nearly on an equality with bonds in the matter of certainty of income. Provisions such as the following are common to what is called “modern preferred stock.” the 1. No bonded debt exists nor can any be created without having stock No ders. consent of 7s per cent of the preferred stockhol be created priority over, or on a parity with, this issue exists nor can consent. without the same of the 2. A cumulative sinking fund of 5 per cent per annum outstanding is time any at stock ed preferr of amount greatest This increases created for retiring the issue at not more than 110. ning the maintai in assists and y the equity in the property annuall market price. and net 3. Net total assets must be maintained at 250 per cent ding. outstan stock ed preferr the of cent per 150 at quick assets

154

THE FINANCIAL

ORGANIZATION

OF SOCIETY

4. No dividends can be paid on the common stock until a reserve equal to two years’ dividend and sinking fund requirements on the preferred stock has been set up out of earnings, and none can be paid which will impair this reserve.

With these provisions in force the preferred-stock owner is in a position, from the standpoint of security, almost equal to that of the bondholder. It remains true, however, that in case dividends are not paid, the individual shareholder has no power to take possession of the management of the corporation, as has a bondholder under the terms of the usual mortgage. /The common stock of the corporation merely represents claims to such earnings as may be available after the payment of dividends on preferred stock. Dividends on common stock will accordingly vary widely in amount, depending on the volume of the earnings. Simce common stock is traditionally speculative and uncertain as to dividends, the majority of corporations do not hesitate to “pass”? common-stock dividends as a matter of financial conservatism, even though the earnings might be frequently sufficient to pay a moderate-sized return. Stock is now being issued without any par value. Stock, both preferred and common, has usually been issued with a par value, most commonly of $100, although often of $50, $25, $10, $5, and $1; it has even been as low as 5 cents in the case of highly speculative issues. During recent years, however, numerous corporations have issued stock without any par value. | In the year 1919, for instance, twenty-seven stocks of no par value were listed on the New York Stock Exchange. y When stock is issued without par value, a certain total number of shares is offered for sale and each will bring in the market a price that is determined by the estimated earning power of the corporation. , Dividends on such stock are paid, not as so many per cent on $100 par value, but as so many dollars per share. Stock without any par value is of advantage in that it is not so likely to mislead the innocent investor, who somehow will persist in believing that a stock whose par value is $00 will ultimately be worth $100, even though its temporary market price may be below that figure; hence he will pay for it more

CREDIT

INSTRUMENTS

155

than its real worth.” From the viewpoint of the corporation the issue of stock without par value is also a means whereby opposition to overcapitalization may in a measure be circumvented. | Stockholders’ “rights” are an interesting but little known form of credit instrument. Stockholders’ “rights” have arisen For instance, out of the exigencies of corporate financing. when the existing stock of a corporation is selling at, say, 105, additional capital can easily be raised by offering for sale new shares at par, or slightly above. But if additional shares are to be offered for sale at a bargain, it is only equitable that the existing stockholders should be given the first chance to subscribe for the new issue, because the increased. capitalization

may well affect the value of outstanding shares. /“Accordingly, it is the usual practice to allow existing shareholders to subscribe for the new issue in proportion to the amount of their holdings; indeed, in many jurisdictions the stockholders have a legal right to subscribe for new stock at par. Such stockholders’ privileges are known as “rights,” and they are issued to shareholders in the form of transferable ents, instruments. Upon the receipt of one of these instrum nity opportu the of the shareholder may either avail himself ed, mention figure the to purchase stock at par, or whatever fact in are rights These ’ or he may sell his right to another. as manner same the in es bought and sold on the stock exchang right lder’s shareho a of value bonds and shares. The market the issue is roughly equal to the estimated difference between tive prospec its and tion price of the new stock of the corpora

market price. terminology There are many different types of bonds. The bonds that of types ent differ employed in describing the many n. For layma the to ng baffli are in use nowadays is quite per cent 5 a s: follow as ibed instance, a certain bond is descr n gold coupo ered, regist ding, railroad collateral trust, refun fyclassi by fied simpli y greatl be bond. The whole matter may the (1) s: follow as view of s ing bonds from certain point purpose of the issue, nature of the issuing corporation; (2) the

156

THE FINANCIAL

ORGANIZATION

OF SOCIETY

(3) the conditions governing the payment of interest or principal; and (4) the character of the security. The most: important sub-classes' under each of these headings are as follows: 1. The nature of the issuing corporation a) Government bonds—national, state, territorial, county, city, township, school district, etc. b) Corporation bonds—transportation, public utility, industrial, reclamation, real estate, timber, etc. 2. The purpose of the issue a) Construction bonds c) Refunding bonds 6) Improvement bonds d) Equipment bonds 3. The conditions governing the payment of interest or principal. (Classification here is dependent upon the legal provisions governing paymeht of principal and interest.) a) Participating bonds é) Premium bonds b) Profit-sharing bonds f) Serial bonds c) Registered coupon bonds g) Callable bonds d) Gold bonds h) Convertible bonds 4. The character of the security a) First mortgage c) Collateral trust 6) Second mortgage d) Debenture ‘In the case ofa first-mortgage bond the bondholders have a prior claim against income, and against property in case interest on the bonds is not paid. The mortgage pledges the property owned by the corporation as a security for the payment of interest on the bond. Since it is obviously imposs ible to give each bondholder a share of the mortgage, the mortgage is placed in trust, and in the event of failure to pay interest the bondholders as a group may foreclose under the terms of the agree-

ment.

| As the name indicates, a second mortgage consti tutes a secondary claim against income and property. Anyth ing left * Only the main subdivisions in each case are given. For afull classification the reader is referred to Lawrence Chambe rlain, The Principles of Bond Investment (Henry Holt & Co.), chaps. viii to xi, inclusive. The kind of individual securities that might be listed under the various subclasses are legion.

CREDIT INSTRUMENTS

157

after payments have been made to the owners of the first mortgage may be devoted to meeting the claims of the secondmortgage holders. VA collateral trust bond is one which is secured, not by real estate or other physical property owned by the corporation, but by stock or bonds of other companies owned by the issuing corporation. This type of security is mainly found in connection with railroad companies. | The term “trust” indicates that these collateral securities are placed in trust with a trust company or other trustee. / In the event interest is not paid on such bonds, the holder may seize the collateral which is held in trust. )/ A debenture bond proper has no mortgage security but merely a claim against the income of the corporation—a claim, moreover, that is secondary to that of any outstanding mortgage bonds. Its claim against net earnings, however, is prior to that of preferred stock. The short-term note is now frequently employed in raising fixed capital. |/ The designation “short term” is employed because the notes in question usually run from one to five years rather than for long periods, as is the case with bonds. These notes are usually secured only by the 1income of the company. -YAccordingly it is customary for payments on the principal to be made serially, that is, a certain percentage of the total debt is paid back annually, thus gradually Sy the security back of the loan. Short-term notes are usually issued to meet temporary emergencies./ In periods of tight money and high interest rates, or of general uncertainty over the industrial future, it is difficult to sell long-time bonds on favorable terms; hence it has been found expedient to sell short-term notes which can be refunded into long-term bonds at a more propitious time. ‘/ Short-term notes are also used—and increasingly so—to provide funds fur new construction under conditions such that the debt can be paid off out of earnings within a relatively short period of time. |/Their claim on income is secondary to that of bonds. The accompanying illustrations are examples of a standard

bond and a share of stock.

rea

AO7

AAIVA

J

J

‘Aqnf{

Aed

3so107UI uoa10y} 32 94}

Ses J

0701Jo

aay Jod

AJUSM eo4 oAl 19d *yU97) PI°D pucg

peorreyy

OIYO Auedui

yu90 Jod UMUUeWor;9Y}

ysig Aepjo

‘Aqn{ ‘6ggr uo

oy}

4sIy

Arenuef pue A[N{ ut yova ‘reauo ay} uoNezueseid pue Japusrms Jo 04} Suodnodoyarey poxouue se hoy] Ayjeraaes awooaq ‘onp [Wun [edu ms |[eYsaq ‘pred y30q fedioursd pure yso1ojUT Jo sty} puog Sutog a[qeXed ye ayy Anuese jo pres prorrey Auedm0D ul oy} AIDJO “yo. sIyy, puog st yefqns 0} uoldueper uo 10 19372 Ayn‘1 ‘vOgr ye orr Jod yuaoJo 24} sed onjea ‘Joor9y} YITM pansz99e “ysor9}UI JNOJO Surqu puny yo ooS‘zz$ v ‘ead SuruuIseq ILM yey} ‘ayep se paptaoad ul oy} a3ev8}10u1 ulerey ‘pequosep sy], puog st auo Jo B Solias JO porpun:’ ‘spuoq Jo ay] ‘10U9} ‘ayep pue “yunoure paoqunu AJeaNossuod Wor euQ0} 3431q ‘peipun{ 430q ‘aatsnpour pur Suryun Ul 93e30135 0} YSrq perpungzy puesnoyy,‘sreyjoqyorym are [[e Ayjenbe parses Aqe e8e3z10u1 Jo pres prosrey AuedwoD ul 94} ainjyeu Jo ¥ soured: ur “4sn1q poyep A[n{ ‘x ‘6ggr pure Ajnp ‘papioosr SutAoauod [[@ 94} AzI10do1d pue sosyouesy Jo pres proyrey Auedwoy 03 pres ‘AueduIo UT ‘ysnxq Joy 94} JYauaq Jo 94} sIapjoy Jo pres ‘spuoq 0} [[e ay} suolstaoid Jo Gory a8e3j10ur sty} puog st *}oafqns uy asedJO XIS SY}UOUI 19}Je anp puemep ut yuawAed jo Aue jsora3u1 uo Auejo pres ‘spuoq ay} yedroursd Jo Tl? joor0y} Avuroq pasepep ‘onpse

ys1g Aepjo

OI

Pereplfo F229 suo-)

“woHOUNYaIeIGJo

610.9

eija,e\eisie 0/9) e(e'e.9 9:82.

paquios Aq ‘snquIn Ur

cecceesecccc Pee Se 22 T° ccccsecs JU

Auedwiod sey pasnes sj 9}eI0dI09 [vas0} aq ojoray ‘pexyye pue siq} Puoq 03 aq JoINsvaI], 0} oq poAvisua UO 2Y} [eraaas suodnodojaroy ‘pexauue 32 aq} AI)jo use7ysrqy peipuNyy pue ‘oulu-A}qSIq

orrinwiele-eiele)*)4/e